Basel III: Focus on Liquidity

Terry Flanagan

Although primary attention has centered around Basel III’s new regulatory metrics and their potential implications for banks’ profitability, the regulations are essentially a response to the role of risk management during the global financial crisis of 2008-2009 and a set of recommendations to address some of the perceived shortfalls.

“Historically, risk management was commonly viewed as an ‘outsider looking in’ to the various board and management committees, but today, with the emphasis on making risk management integral to the bank’s strategic vision, it now plays a critical overarching role to help shape that vision,” said Ziauddin Ishaq, global solutions lead for liquidity risk at Oracle Financial Services, a unit of Redwood City, California-based Oracle.

“Under Basel III, the dynamics and pressures will be more intense than ever before, not only because risk teams will be tasked to calculate, analyze and report a much larger number of new risk metrics with greater frequency, but also to ‘open up the risk profile’ of the institution by bringing greater transparency to the entire risk process, something a tier one institution finds challenging at the best of times,” said Ishaq.

Coupled with the drive to establish a coherent and reliable ‘risk and finance’ view of the bank, risk-management teams realize that their roles under Basel III will go beyond that of being the provider of the daily value-at-risk or credit exposure numbers, he added.

It’s been just more than five years since the Basel Committee on Banking Supervision released its milestone consultation document “Strengthening the Resilience of the Banking Sector,” which became the Basel III capital and liquidity regulations.

A key objective of the Basel III requirements is to establish a more resilient and robust banking sector, such that it could weather the storm of a future financial crisis much better than previous ones and ensure any fallout could be contained without any serious contagion to the broader global economy. “This would be partly achieved by introducing a more draconian set of regulatory capital and liquidity requirements, which ultimately would lead banks to re-evaluate the merits of their existing business models,” said Ishaq.

Ziauddin Ishaq, Oracle

Ziauddin Ishaq, Oracle

Basel III, like its predecessors Basel I and Basel II, was born out of the necessity of safeguarding the financial system against losses arising from credit risk (Basel I), market risk and operational risk (Basel II), and liquidity risk (Basel III).

“Basel III is an example of the kind of macro change that occurs,” said James Phillips, regulatory strategy director at Lombard Risk. “After the complexity of trading instruments grew, Basel I – which was primarily a credit risk related regulation – became outmoded, and Basel II came along. This dealt with some of the more complex trading that had emerged and the new kinds of market risks that were involved, and also introduced operational risk. Whist it was a new line of thinking, it completely missed out liquidity risk. Along came the financial crisis, which principally around liquidity risk. So this has given rise to Basel III.”

There are two categories of Basel III compliance. One is around the impact on the firm’s business model of complying with the new standards, in terms of quality and quantity of two principal measures, capital and liquidity: how much and how good is the firm’s capital base and liquidity buffer?

For this there are new measures and new styles of what is considered qualifying liquid assets. “The nature of capital that can be included in the firm’s capital base has been significantly redefined to reclassify under-performing assets and to remove poor-quality capital,” said Phillips.

Firms have had to significantly reconsider how and where to do business, “and that has reflected itself in quite a bit of coming and going for the business that firms are in, or are out of,” Phillips said. “For some firms it’s simply been a matter of geographic closure or consolidation.”

The second major area of impact is a significant operational impact, which is reflected in two aspects. One is the governance aspect of monitoring the performance of the firm against the now improved standards, which include both quantitative measures as well as less quantitative ones, such as mandatory stress testing. The second aspect is reporting, and in that context there is a significant increase in the quantity and granularity of data, and the frequency with which data is gathered by regulators.

Featured image via robert/Dollar Photo Club

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