Rethinking Basel III and the Regulation of Derivatives

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The imposition of Basel III and the new capital requirements was seen as a way to reduce systemic risk in the financial system.  However, in the haste to implement the proposed regulations a number of flaws have emerged that mask potential risks associated with derivatives.  Paul Atkinson & Adrian Blundell-Wignall, in a recent communique, Basel Regulation Needs to be rethought in the Age of Derivatives (VOXEU, Feb 28^th) discuss some of weaknesses of Basel III.

 

The chaos that created the Eurozone debt crisis has pushed the debate on how to fix the banking system to the back burner.  The systemic threat originating from the sovereign debt crisis points for the need for recapitalizing Eurozone banks well before the Basel III timetable. Atkinson and Bludell-Wignall argue the proposed Basel III regulations are overly complicated and desperately out of date. The proposals serve as a short-term patch for a fundamentally flawed system that is overly complex.   

 

The Basel proposals use a risk-weighting system for calculating capital charges that do not fully incorporate over-the-counter derivative exposures that currently exceeds $600 trillion (end 2010).  Banks have unlimited scope to arbitrage the system by reallocating portfolios away from assets with high risk weights to assets with low risk weights, thus saving on capital costs.  The capital charges may actually encourage more risk taking by systematically important institutions and may actually make the financial system more unstable and accident prone. 

 

Bank responses to Basel incentives lead to three major problems: capital charges are portfolio invariant and depend on the borrower’s characteristics and economic environment and not portfolio composition, risk weights act as a system of regulatory taxes and subsidies and create a bias against diversification and encouraging concentration in such hazardous asset classes as US residential real estate, and the minimum capital requirements can be arbitraged downward and create a bias toward leverage.  The distortions caused by the system are often obscured by its complexity and opacity, especially as regards derivatives and accounting for unexpected counterparty credit risk losses.  The current problems with CDS, Greece and the ISDA rulings only make the problems more complicated.     

 

The Credit Valuation Adjustment (CVA) (marking unrealized losses to market) allows for the netting of gross exposures across counterparties, but may underestimate bank exposure and ignore positions for calculating the CVA charge due to highly concentrated derivative positions and bilateral netting.  The CVA charge is additive across netted bilateral positions rewarding counterparty concentration. The result is a vast, poorly diversified; highly interconnected banking system with a small capital base and that may under estimate potential risk exposure. 

 

Events such as the US subprime real estate crisis and European sovereign debt crisis may be major problems for borrowers and lenders directly affected, but a resilient, well-capitalized banking system would not allow the crisis to become global.  The Basel system should be replaced with one whose parameters cannot be arbitraged by portfolio reallocation and derivative activity.  Despite Basel III, the current system remains vulnerable to systemic risks created by derivative exposures.

 

For more on this, follow the link:  www.voxeu.org/index.php?q=node/7672