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Basel III a crucial framework for preventing future banking crises

Lawmakers urged to fully implement regulations amid recent turmoil
Basel III a crucial framework for preventing future banking crises
Stopping a domino effect

In the aftermath of banking crises aftershocks, financial authorities have repeatedly assured depositors that the sector is healthy and solid. However, these assurances failed to prevent the domino effect that resulted in the collapse of several U.S. banks. In the wake of these collapses, including those of Silicon Valley, Signature, and First Republic, Federal Reserve officials, led by Chairman Jerome Powell, have emphasized the strength of the sector and maintained that the incidents were isolated and not indicative of a contagion that would impact the entire financial sector.

During a period of a severe confidence crisis, Swiss bank “Credit Suisse” was acquired by its rival “UBS.” Swiss authorities intervened promptly to prevent the spread of fear and uncertainty to other banks in Switzerland and Europe.

On multiple occasions, central banks and banking supervisors have conveyed the message that the recent incidents in the banking sector were not a repetition of the 2008 global financial crisis and should not be considered as equally dangerous.

This may be true, as with the exception of Credit Suisse, European banks have weathered the turmoil. The issue appears to be limited to banks operating within the United States, as their situation was exacerbated by their exposure to the Federal Reserve’s hawkish policy of raising interest rates.

According to ECB President Christine Lagarde, the failure of U.S. banks can be attributed to the country’s incomplete implementation of the Basel III requirements. During the previous administration led by Donald Trump, regulatory obligations on liquidity reserves for small and medium-sized banks were lifted, preventing regulators from promptly accessing information on banks’ liquidity status to prevent their collapse.

Lagarde pointed out that due to the incomplete implementation of the standards, “only 14 banks – yes, just 14 banks,” were subject to the full Basel III requirements. In contrast, the ECB’s own analysis revealed that the corresponding figure for the EU was 2,200 banks.

There are over 4,000 banks in the United States, which averages to 80 banks per state across the 50 states. This number has decreased by more than two-thirds since the early 1980s when it reached a peak of over 14,000.

In an interview, MEP Jonás Fernández, a member of the European Parliament’s Committee on Economic and Monetary Affairs, emphasized that the current crisis should “encourage lawmakers to review the way we all think about banking regulation” and fully implement Basel III as soon as possible.

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In a November 2022 ECB blog, three high-level ECB officials warned that parliamentary negotiations on the banking package would “deviate from international standards.”

Instead, the regulators called for the full implementation of Basel III, which comprises “carefully crafted rules to ensure a minimum worldwide safety net against a large number of risks that we have painfully suffered through in the midst of the global financial crisis.”

The “banking package” is a crucial component of the banking regulatory framework put forth by the EU in the past 10 years, encompassing reviews of capital requirement guidelines and regulations, including those established by the Basel III reforms.

Basel III

Basel III requirements

Basel III is a global regulatory framework that promotes bank capital adequacy, stress testing, and market liquidity risks. It was developed in response to the shortcomings in financial regulation revealed by the 2007-08 financial crisis.

The Basel III regulatory framework’s first pillar requires banks to meet minimum regulatory capital requirements. The Net Stable Funding Standard (NSFR) and Liquidity Coverage Standard (LCR) are among these requirements.

The Liquidity Coverage Standard mandates that banks maintain a minimum of 100 percent reserves to ensure they have enough high-quality liquid assets to cover net cash outflows for the next 30 days.

Overall, Basel III aims to enhance the minimum capital ratios for banks to deal with unexpected losses, establish requirements for high-quality liquid asset holdings and funding stability, and mitigate the risks of excessive account withdrawals that could undermine the banks’ abilities.

Although designed as a deterrent mechanism against bank collapses, several U.S. banks were still struck by such events this year, with the possibility of re-enactments occurring in the near future.

Silicon Valley Bank was primarily geared toward providing financial services to high-risk startups. Despite being the 16th largest bank in the U.S., it was not regarded as a major player in the industry. This was largely due to its classification as a Tier IV bank, which meant that its assets were below $250 billion and it was not subject to the same level of regulation as larger financial institutions considered “too big to fail.” As a result, Silicon Valley Bank was exempt from complying with the Federal Reserve’s Net Stable Funding and Liquidity Coverage Criteria requirements.

Silicon Valley Bank’s focus on serving high-funding startups required it to maintain sufficient liquidity and comply with Basel rules on liquidity, ensuring that it had enough funds to weather economic downturns. However, during the crisis it faced, the bank was unable to cover a sudden rush of customer withdrawals, which eroded customer confidence and ultimately led to its collapse.

This was largely due to the bank’s investment of its deposits in long-term U.S. Treasuries, which declined in value as interest rates rose, causing the bank’s investment portfolio to suffer.

It is evident that compliance with the Basel III regulatory framework is crucial to ensure stability in the banking sector and prevent future crises from occurring in a domino-like fashion.

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