Should financial reform go beyond Basel III?

In the aftermath of the global fiscal crisis, talk among leading economists, policymakers and regulators has been focused on how to build a financial services industry that is not exposed to the risks that felled it in recent years.

However, to some talk may be cheap and actually delivering a new framework - and one that can be effective across the world, including in the emerging markets of Asia - has appeared to be a harder task.

As the UK continues its own steps towards what the coalition government hopes will be a stronger financial services industry - which will see it axing the current tripartite regulatory model and replacing it with a new prudential body - two of the major policies to come out of Europe as a whole are Basel III and the forthcoming Solvency II. But do rules and regulations need to go even further still?

Details of Basel III, which was drawn up by the Basel Committee on Banking Supervision and announced by the Group of Governors and Heads of Supervision, were confirmed in September 2010. One of the main points to be unveiled was the decision that banks will be obligated to increase their minimum common capital requirement from two per cent to 4.5 per cent by January 1st 2015. Four years after that, an additional capital conservation buffer of 2.5 per cent will be required.

The aim of the capital and liquidity regulations is to help ensure that banks are in a position where they can adequately absorb any tremors sent through them at times of wide-scale fiscal stress, to ensure that any shocks inflicted on the financial services sector do not leak into the real economy, causing longer-lasting damage.

According to Lord Turner, chairman of the Financial Services Authority (FSA), the regulations will have a significant advantageous effect; however, they should not be seen as the finishing line of reform. Rather, he suggests that more can still be done to make the markets stable - although this may be a task that is never truly concluded.

Indeed, Lord Turner notes that the fiscal system is continually evolving - witnessing new risks as it changes - therefore the framework used to regulate also needs to constantly adjust. He points out that it is not only banker bonuses or the status of lenders as "too big to fail" that can give way to instability, but that there are also additional factors at play, such as the complexity of the financial system itself. "Today's regulators are the inheritors of a half century long policy error, in which we have allowed private sector banks to pursue their private interest in maximising leverage levels, at times influenced by a deep intellectual confusion between private costs and social optimality," he suggests.

The FSA chairman acknowledges that Basel III is a real step in the right direction, but adds that pushing equity capital requirements even higher would be the way to go in a perfect world - as he points to a recommendation made by Professor David Miles of the Monetary Policy Committee to set the rate at between 15 and 20 per cent of the value of risk-weighted assets.

Additional solutions offered by Lord Turner include making all banks resolvable and agreeing on equity surcharges for those that are considered systemically vital. These should be put at a high enough level to lower the risk of failure. He also claims that it could be as important to monitor and potentially regulate shadow banking as it is to take the same action with high-street lenders.

Elsewhere, the Organisation for Economic Co-operation and Development (OECD) has also claimed that increasing capital requirements beyond the recommendations of Basel III could be useful in order to ensure that financial services providers and the markets are more resilient when faced with capital losses. However, secretary-general of the organisation Angel Gurria said: "Risk-based weights may be vulnerable to capital arbitrage however. A leverage ratio covering all relevant assets, including off-balance sheet exposures, should therefore also be used."

Yet it is not only the banks that are the subject of regulatory reforms, but also insurance providers. Solvency II is a Europe-wide review of the capital adequacy regime of cover providers. According to the FSA, the aim of the consultation is to draw up new risk management standards and wealth requirements to replace current solvency rules. The current planned date for the implementation of the measures is January 2013.

In addition to protecting consumers, it is hoped that the raft of proposals will help to build a single market for European insurance services, as at the moment, several member states are working under their own reforms. Solvency II aims to reunite the industry through a risk-based system that also measures assets and liabilities.

According to the OECD's Mr Gurria, it is important to make sure that the implementation of any regulations is well coordinated, in order to build a better-performing global financial system, rather than one that is purely UK-centric. Indeed, in an increasingly international marketplace, with the emerging economies of Hong Kong, Singapore and elsewhere in Asia seen as playing an ever-more significant role in the industry as a whole, it may be that it has never been more important to consider the world's economies when building a regulatory framework.

As Mr Gurria noted: "The recent financial crisis and the following recession has made it clear to all of us that wide-ranging reforms of the financial sector are needed. Significant progress has been made globally, within the G20 process, within the European Union and within the UK. Well-coordinated implementation of agreed reforms will be important to avoid regulatory arbitrage and to ensure they succeed in building not just a better UK financial system, but [also] a better-functioning global financial system."

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