The Lehman Brothers example
The Lehman Brothers’ blow up (or more generally the subprime crisis) is often considered a defining event in banking regulations. It showed that even big banks were likely to understate risks and to not understand risks too well or were likely to pursue expansion too aggressively, ignoring the costs related to expanding. It also underscored a need for a fundamental strengthening of the Basel II and Basel II.5 framework.
The bank sector situation
The banking sector had entered the crisis with too much leverage and inadequate liquidity buffers. These defects were accompanied by poor governance and risk management. The banks’ incentive structures were also too skewed and encouraged risk-taking.
The combination of these factors was manifest in the mispricing of credit and liquidity risk and the excess credit growth. These factors were visible on the financials of banks like Bank of America (BAC) and Citibank (C), investment banks like Morgan Stanley (MS) and Goldman Sachs (GS), and other banks included in an ETF like the Financial Select Sector SPDR Fund (XLF).
To address these concerns, Basel Committee on Banking Supervision came out with Basel III Accord in September 2010. Basel III Accord had a new capital framework. It revised and strengthened the three pillars of Basel II.
Basel III Accord’s main features
- Introduces an additional common equity layer—the capital conservation buffer—of 2.5% that when breached, restricts earnings payouts to help protect the minimum common equity requirement
- Introduces a buffer capital known as countercyclical capital buffer, which places restrictions on bank participation during economic boom, with the aim of reducing their losses in credit busts that generally follow in the economic cycle later on
- It proposes additional capital and liquidity requirements that would be held by large banks—called systemically important banks—whose failure would threaten the entire banking system
- Introduces a leverage ratio—a minimum amount of loss-absorbing capital relative to all of a bank’s assets and off-balance sheet exposures, regardless of risk weighting
- Places liquidity requirements on banks—a minimum liquidity ratio intended to provide enough cash to cover funding needs over a 30-day stress period
- Contains additional proposals for systemically important banks, including requirements for augmented contingent capital and strengthened arrangements for cross-border supervision and resolution
The Federal Reserve implemented Basel III Accord on U.S. banks. It’ll be done in a phased manner and will be completed by 2019. There’s been some criticism of Basel III Accord, and it can be further improved.