The Financial System and Basel Accords

In the previous articles, we have already read about how banks are the main pillars of the financial system. It is obvious that since banks are so important to the economy as a whole, the government must create a system to protect these banks from collapsing in case a negative economic event occurs.

Governments all over the world have their own set of rules to protect the banking system. Many of these rules have been designed to prevent customers from financial fraud. However, there is a set of rules which prescribes how the banks must utilize the funds that they source from the depositors. Here too, each country has its own laws. However, there is an international standard on which the laws of every country need to be based. This standard is called the Basel Accord.

In this article, we will understand what the Basel Accord is and how it protects the financial system as a whole.

What are the Basel Accords?

The Basel Accord is a set of rules which banks all over the world are expected to follow. These rules are created by the Bank of International Settlements. Since this bank is located in Basel, Switzerland, these laws are known as the Basel Accord.

There are three Basel Accords that have been created until now, and the fourth one is said to be in progress. At present, most banks around the world are expected to be compliant with Basel 3 regulations.

The Basel 3 regulations were created after the financial crisis of 2008. This is because the financial crisis of 2008 served as a wakeup call and pointed out glaring inefficiencies in the banking system.

The collapse of the banking system could not be blamed only on the banks. The rules required to regulate the entire system were almost non-existent. The capital controls set out by the banks proved to be ineffective. In the absence of the injection of funds by the public sector, the banking industry would have collapsed in 2008.

Some of the major points mentioned in the third Basel accord have been listed below:

• The Basel Accord determines the amount of reserves that a bank is expected to hold. Reserves can be thought of as rainy day funds that have been stashed away by banks. These funds need not be in cash only. Government securities and other liquid assets are also considered to be a part of the reserve fund.

• The Basel 3 Accord was a major improvement over the Basel 2 Accord when it came to risk management. Under the Basel 2 system, banks were only expected to hold 2.5% of their risk-weighted assets in reserves.

  However, under the Basel 3 system, banks are now expected to hold 7% of their assets in reserves. The risk weights of the assets have also been changed. As a result, we can say that there is almost a 300% increase in the reserve fund. This has been done to ensure that banks do not face a liquidity crisis. Out of the 7% figures mentioned above, 2.5% is called the capital conservation fund and should only be drawn under exceptional circumstances.

• The Basel 3 Accord has made certain changes to the Asset side as well. Risky assets, such as subordinated debt as well as securitized assets, are being given a higher risk weight. This means that if a bank has more securitized assets on its balance sheet, it will have to set aside more funds as reserves in order to cover the increased risk

• The Basel 3 Accord also proposes a leverage ratio. This is the maximum amount of leverage that banks will be allowed to undertake. Hence, the riskiness of banks will be reduced. Banks cannot use unnecessarily high levels of leverage, even if they are using it to buy supposedly safe assets.

• Basel 3 system also uses a countercyclical approach in order to ensure the solvency of banks. This means that under the Basel 3 accord, banks are supposed to keep larger sums of money aside as reserves during periods of high growth. This money can then be drawn upon when the external circumstances become unfavorable.

• The Basel 3 accord also has special rules in place which ensures that crisis in a certain bank or financial institution can be contained there itself. The accord emphasizes on the need to prevent contagion in order to safeguard the financial system.

• The Basel Accord also makes certain changes to ensure high liquidity is available to the banks at all times. The 2008 event was an outlier because it was the only time in the history of banking where the liquidity completely froze. The regulators, as well as market participants, had not expected this period of economic inactivity and hence were taken by surprise.

  The Basel 3 Accord provides detailed specifications about the liquidity requirements. Special metrics such as Net Stable Funding Ratio (NSFR) and Liquidity Coverage Ratio (LCR) have been created in order to help banks keep track of their liquidity position.

The bottom line is that the Basel Accord is an important mechanism to ensure continued solvency of banks all over the globe. Since banks enable the solvency of the global financial system, the Basel Accord indirectly enables the smooth functioning of the global financial system.