T

he G20 Summit in Seoul from November 11 to 12, 2010 endorsed the Basel III Accord as the core elements of the new financial regulatory framework. The accord was mainly designed for banks in advanced industrialized economies with mature and well-developed financial markets in response to the Global Financial Crisis (GFC) of 2007-9.

It has not, however, addressed the needs of emerging economies that are increasingly playing a prominent role in global finance.

The accord is the basic foundation for transforming the global financial system, coordinated by the Financial Stability Board (FSB), into a safer system and to ensure its resilience to periodic stress tests.

Basel III was developed by the Basel Committee on Banking Supervision (BCBS) and adopted by the Group of Governors and Heads of Supervisions of member countries of the Bank of International Settlement (BIS), in July 2010. A higher global minimum capital standard for commercial banks was then agreed upon on Sept. 12, 2010.

Basel III primarily covers standards and regulations on shadow banks and complicated derivatives that do not exist in the emerging economies. The core of the financial system in emerging economies is the banking system that still relies on deposits and loans. The banks are owned either by the state or business conglomerates.

The state uses its banks as an instrument to pursue its industrial and development policies. Non-bank financial institutions, such as insurance and pension funds, the main components of shadow banks, are still in the early stages of development.

To build an effective and efficient financial market, Basel III strongly recommends the use of credit-rating and credit-scoring systems and stress testing. These tests better capture tail events and incorporate the systemic risk dimension in banks’ risk management to supplement the shortcomings of the VAR (Value-at-Risk) model that uses the assumption of normality.

The VAR and other tests, however, are difficult to implement in emerging economies. This is because of the weakness in market infrastructure in the developing economies due to a combination of relatively weak legal and accounting systems, limitation in data availability and the dominant role of state-owned enterprises, including in the financial system. The weak market infrastructure cannot protect property rights well, enforce contracts or seize collateral pledged by credit defaulters.

In underdeveloped economies, it is also difficult to enforce laws and regulations against the public sector and politically well-connected business groups. The governments use their banks to finance its industrial policies. Meanwhile, private banks are intertwined with their business affiliates, which are prone to insider trading and principal agency problems. This is because interconnected banks tend to evaluate loan applications from affiliates less rigorously than those from unaffiliated credit applicants.

Credit insurance companies and inter-agency financial stability forums have been established in many emerging economies to preserve financial stability and address financial crises. Nevertheless, state-owned banks and companies in these countries are implicitly guaranteed by their owners.

Basel III comprises three areas to strengthen regulation and supervision of the banking system. First, to improve the banking system’s ability to absorb shocks arising from financial and economic distress. The focus on common equity mitigates the “too big to fail” problem and forces banks to bear the cost of failure they have been imposing on society. Second, to improve the risk management and governance of the banking system and, third, to upgrade its transparency and disclosure policies.

The Basel III framework covers both the micro as well as macro prudential regulations. The micro type of regulations help strengthen the resilience of individual banking institutions. The macro prudential regulations address wider risks that can be built up across the entire banking system and the whole economy.

Basel III is not only a firm-specific risk-based structure, but also a system-wide and systemic-risk-based framework and it upgrades standards relating to capital, liquidity and leverage of the banking system. The combination of new micro- and macro-prudential reforms addresses both institution- and system-level risks. Basel III is more specific in defining the capital adequacy ratio: the capital ratio itself, the numerator of the solvency ratio or the capital and the denominator or risk-weighted assets.

To mitigate the “too big to fall” problem, Basel III focuses on common equity, the highest quality component of a bank’s capital. This forces bank to bear the costs of failure they have been imposing on society.

In addition, Tier 1 also includes other instruments, such as retained earnings, other reserves and certain preference shares, which have a loss-absorbing capacity on a “going concern” basis or solvency of the bank. Innovative capital instruments that are currently permitted in limited amounts will be phased out. Tier 2 capital will be simplified.

This typically consists of subordinated debt, and provides loss-absorbing capacity on a “gone concern” basis following insolvency and liquidation. Tier 3 capital uses to cover a portion of bank’s market risk capital charge is to be phased out and deductions from capital will be harmonized.

Basel III adopts a stricter definition of core capital and simplifies and harmonizes deductions and filters that are applied to its calculation, particularly in calculating Tier 3. Stricter criteria are now applied for other qualifying financial instruments that can be included in the calculation of capital and certain types of assets of questionable quality are excluded from these calculations. Basel III corrected the complex set of minimums and maximums of various elements of capital (Tier 1, Tier 2 and Tier 3) in Basel II.

Before the Global Financial Crisis (GFC) of 2007-2009, for example, global banks raised their leverage by investing the Tier 1 component of their capital in debt-like or hybrid “innovative” instruments.

The stricter definition of capital level under Basel III upgrades the quality of capital and significantly raises the level of required bank capital, improves its transparency and disclosure and makes the capital adequacy of global banks comparable. The higher capital quality banks would make banks stronger, improve their loss-absorbing capacity and allow them to withstand periods of stress.

The writer is a professor of economics at the University of Indonesia in Depok, West Java.