Must-know: Basel III’s shortcomings

Basel III’s shortcomings

Basel III addresses most of Basel II and II.5’s deficiencies. But it still has some shortcomings.

Firstly, the increased regulatory capital required under Basel III will increase barriers to enter into the sector. This will benefit the existing players by reducing competition. On the other hand, it increases the capital requirements for bigger players—systemically important banks—who are more likely to be more efficient, hindering their growth.

Secondly, it doesn’t change the risk-weighting method, which was the main reason behind the subprime crisis. This method was the undoing of banks like Bank of America (BAC) and Citibank (C) during the subprime crisis. Banks often hold structured AAA-rated products, but those structured products are backed by assets that are often junk rated and not AAA-rated.

Basel III also incentivizes banks to accumulate AAA assets, as they have little or no capital requirement. This was true for investment banks like Morgan Stanley (MS) and Goldman Sachs (GS) and for many smaller banks included in an ETF like the Financial Select Sector SPDR Fund (XLF).

Thirdly, a lot of risk weighting depends on credit rating agencies. So Basel III is still dependent on bond rating agencies, as weights are assigned based on the rating. Evidence from the subprime crisis shows that credit rating agencies can go wrong.

Fourthly, it aims to harmonize banking regulations across the world. Different countries have different regulatory requirements. Some countries, like India, have better regulatory frameworks than Basel III. In fact, some academic studies suggest that when regulations are sought to be harmonized across the world, they tend to move towards the worst regulations.

Lastly, it’s been suggested by some economists that Basel III Accord is likely to hurt a country’s growth by keeping the scarce capital tied up. This is even truer for less developed and developing nations.