Basel 3 = Basel 1.8? And is this a bad thing?

The proposed and partly ratified changes imposed on the Basel II accord have certainly exercised the minds of bankers (and a surprising number of others) over the last year. But are they really a major change? Do they reflect any change of philosophy? Or are they actually a step backwards away from some of the basic assumptions of Basel II. I believe that these widely touted Basel 3 requirements are better understood as a partial rollback of the original accord.

The basic concept of the Basel accord is the better alignment of capital with institutional risk as measured by extreme percentiles of the distribution of portfolio value. A couple of points come out of this:

• Banks should operate on a consistent global playing field.

• Market values are good measures of asset values

• More sophisticated approaches to risk measurement should be rewarded with lower capital

• Avoid double counting of Risk and incorporate where robust correlation effects

• Limit the extent of ad hoc regulatory supervision.

• Quantitative measures are better than qualitative ones


In some ways the new adjustments are consistent with that philosophy. For example, the introduction of an Incremental risk capital calculation to capture credit risk in the trading book. This is very much in line with the concepts of IRB and IMM, indeed is almost an integration of them both – which incidentally is why it will be difficult to implement. Similarly, macroprudential risk is an extension of scope of the Basel II accord to consider the entire system rather than one element within the system. So too the changes to the definitions of capital – the removal of T3 capital, the more precise use of equity in T1.



But I believe the bulk of the modifications run counter to the underlying philosophy of Basel. For example, the double counting of risk under Stress VaR and the general VaR calculations, the double counting of IRC and the specific market risk capital models. The use of simple Leverage and liquidity ratios as an additional constraint on banks to reign in lending may be more binding on many banks than the capital requirement. The use of liquidity adjustments to valuation clearly notes the limitations of market prices as measures of asset value. The introduction of a range of additional liquidity metrics that will be incorporated into regulatory judgments on appropriate bank liquidity levels.



Is this a bad thing? Should we be concerned that Basel III is moving away from the original philosophy of Basel. Yes and No.

Yes, in so far as the original philosophy was valid, no in so far as it was not. It seems to me that we definitely should be concerned about double counting and the introduction of ad hoc rules that leave much to the judgment of individual regulators – this definitely casts doubt on the Basel project – the imposition of a consistent playing field.

No – we should not be concerned about these amendments in that they reflect true weaknesses of the original accord – the lack of attention they gave to liquidity risk, downplaying of counterparty credit risk in the trading book (which to be fair was less of a concern when the accord was drafted), the inevitable procyclicality of any risk based capital measure. It is indeed the last of these that is probably the most important. Regulators like the rest of us, live in a real world, with banks that affect the real economy. Reality has a bad habit of forcing us to compromise theoretical ideals with the practical effects of those ideals. A major overhaul of Basel that dramatically increased capital requirements (as for example the imposition of countercyclical capital buffers) could jeopardize the very recovery it was design to forestall. And that would be far too big a price to pay for Basel III.

So after all is said and done, perhaps the new amendments do look less like Basel 3 and more like Basel 1.8?