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What’s New CFI: Basel III and Risk Management

June 3, 2024 / 13:34 / E10

In this episode of FinPod, hosts Asim Khan and Ryan Spendelow dive deep into Basel III banking regulations. Join them as they discuss the intricacies of Basel III and its significance in risk management. Understand the historical context behind the Basel Accords and understand how it emerged as a response to the 2008 global financial crisis.

Asim and Ryan discuss the critical differences between Basel II and Basel III, from strengthened capital requirements to the introduction of liquidity ratios. Tune in to equip yourself with the knowledge and tools necessary to thrive in an ever-changing regulatory environment.


Asim (00:13)
Welcome to the What’s New at CFI podcast. I’m Asim Khan and I’m here with my colleague Ryan Spendelow Ryan, welcome to the podcast.

Ryan Spendeow (00:23)
Hey, how you doing today?

Asim (00:25)
Doing great, great to have you here. Ryan, recently you’ve published a course on Basel 3 and risk management. Can you tell us a bit about it?

Ryan Spendeow (00:35)
Yeah, sure. So the world of banking is a very, very heavily regulated industry. And one of the most prevalent of regulatory frameworks that banks have to adhere to is the Basel 3 framework. And I guess the Basel 3 framework, it’s the latest iteration of the Basel Accords. So we’ve had, unsurprisingly, Basel 1 and Basel 2. But Basel 2 really came out…

just right before the global financial crisis.

Asim (01:03)
For those who don’t know, can I ask the rhetorical question, what is Basel? Why is it called Basel? B-A-S-E-L.

Ryan Spendeow (01:09)
So Basel or Basel, depending on where you went to school. Basel is a town in Switzerland. And so it was the town where global regulators and members of central banks from the world’s largest economies got together way back in the 1970s when the Basel Committee for Banking Supervision was first established. They met in the town in Switzerland called Basel. And so they came up with Basel 1

which was the first global framework. And they named it after the town that they met in. And so as subsequent frameworks have been established, they’ve kept that name. So that’s why we use Basel.

Asim (01:51)
Here’s a bit of trivia, it’s also called Ball. If you speak Hochdeutsch, Swiss German, they call it Ball. The French speakers call it Basel.

Ryan Spendeow (01:55)
Ah, yes.

Yeah, my Swiss German isn’t quite so hot.

So yeah, so that’s why they call it Basel. And as I said, we’re up to Basel 3 now. And it’s the one regulatory framework, which is global, which anybody working in risk management in the financial services industry really does need to have at least a fundamental working knowledge of that framework.

Asim (02:23)
And so one can presume that as the evolution went from Basel 1 to 2 and now to 3, with each evolution there have been additional regulations tacked on to the original regulation, right? So how is Basel 3 different from Basel 2?

Ryan Spendeow (02:36)
That’s right.

Yeah, so that’s a really great question. Often banking regulations react to things that have happened in the banking industry. And so Basel II came out and very soon after we had the global financial crisis of 2008. And it became quickly apparent that even though Basel II had only just come out a couple of years before that, that it was deficient and wasn’t

strong enough to protect the banking industry from these large shocks. So the regulators went back to the drawing board and came out with Basel III. And the main differences between Basel III and Basel II is that banks have to hold a minimum amount of capital. So those capital requirements were strengthened under Basel III. And the purpose of having a regulatory capital is to give a buffer.

That if banks do face stress, if banks do get into problems, they’ve got this cushion so they should be able to absorb these shocks and while they’ll experience losses, they should still remain solvent. So those capital buffers were increased and the quality of the capital was also enhanced. So that was a really big thing and we spent a lot of time in this course discussing what those capital requirements are. But there are also other things that were added to Basel 3.

For example, leverage ratios were introduced to the Basel Accords for the first time. Banks had to have a minimum of capital so they couldn’t be overly leveraged. Leverage was one of the really big problems in the global financial crisis and got banks like Lehman Brothers and a couple of others into a lot of problems. The global financial crisis was also a crisis of liquidity. In other words, banks couldn’t access the funding that they need on a day-to-day basis to carry on

or if they could access it, it became really, really expensive. So Basel 3 also introduced liquidity requirements for the first time. Short-term liquidity requirements in terms of a liquidity coverage ratio and also a longer-term liquidity requirement in terms of the net stable funding ratio. So those are the big quantitative things. There’s also some things that were introduced under Basel 3 to limit things like procyclicality,

When the economy does well, banks do really well, but when the economy does poorly, banks do really poorly. So there were some buffers that were put into capital requirements as well. And finally, I guess one of the big things is that there was more emphasis placed on how banks report to regulators. So there was increased transparency in terms of reporting.

Asim (05:08)
Am I incorrect? I recall reading that there was also a capital charge for counter cyclicality in Basel III. Is that correct? There it is.

Ryan Spendeow (05:15)
Yeah, that’s right. Yeah. So there’s a prosicicality buffer. There’s a number of buffers and they’re all designed to protect the financial industry. So there’s capital buffers for prosicicality. There’s buffers for large banks. So if you’re a really big bank and someone like JP Morgan goes

economy and because they’re so big, they’re so interconnected, they’re complex, so they actually have buffers built in due to their size. So yeah, there’s a number of different buffers that are all in there to help protect the banking industry.

Asim (05:51)
Which doesn’t mean a bank can’t have leverage beyond a certain amount or a liquidity shortfall, but they’re gonna have to pay for it through an additional capital charge. So it could potentially make doing business a lot more expensive.

Ryan Spendeow (06:04)
Yeah, so it’s up to the national regulators of each country how they actually implement Basel III. And most countries fairly much take the recommendations and implement them pretty closely to the actual Basel III accords. So if a bank, for example, doesn’t meet a certain requirement under Basel III, maybe their capital slips below the level required under the capital framework.

Then that bank will often have restrictions put on them in terms of being able to pay bonuses or dividends to shareholders, restrictions on being able to do business until they meet the requirements again.

Asim (06:37)
There’s been pushback from the US banks.

Ryan Spendeow (06:39)
The US banks have adopted a lot of Basel 3, but they’ve often adopted it in their own way. So they’ve implemented liquidity ratios in a unique way. They use something called the supplementary leverage ratio, for example. And just recently, anybody that’s interested in risk management in the banking industry will at fairly regular intervals

read how a lot of bank CEOs, particularly in America, have got together and rallied against a certain new implementation or interpretation of Basel 3. So there has been some pushback of late about some new…

regulations that are a result of Basel 3 being implemented in the US which should make, put some restrictions on the way that some US banks would do business for sure.

Asim (07:21)
But I was there when, I think I started when Basel I was in effect and I was definitely there for Basel II. But we didn’t really notice the change, you know? Kind of day to day doing your lending business or your trading business. So I’d be interested to see how kind of things like banks returns and how it actually works in Basel.

Real life can, you know, trial. Basel II didn’t fare very well when it was put to the test in 2008, so hopefully this one will do the trick.

Ryan Spendeow (07:49)
Yeah. And there’s been some, I guess, some tests over the last few years about sort of banking capital requirements, liquidity requirements, and you’ve had Silicon Valley Bank and a few other.

Maybe not banking crises, but some stresses put on the financial system, Credit Suisse for example, okay. So the banking industry seems to have weathered some stresses over the last few years and the global regulators will say, well, that’s directly as a result of the…

of the regulatory framework that we have in place now, although I think it’s fair to say things haven’t quite been as tested as hard as 2008, but the idea is that they should survive another 2008.

Asim (08:27)

Right, right. The idea is it should survive something systemic like a contagion, right? One-offs, of course, you know, even pre-Bosel 3, we did okay in one-off cases. So great, you know, I took the course, by the way, and it’s super engaging the way you presented it. I had a lot of fun with the simulations that you created, which are a lot of fun to play with.

And they get the point across and one gets a very good idea of what Basel III is all about. Great work on that. And thank you very much for your time, Ryan. It’s been a pleasure speaking to you about this course and we’ll see you again.

Ryan Spendeow (09:04)
It’s always a pleasure. Take care.

Asim (09:06)
Okay, take care.

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