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Financial Crisis

‘ Finance creates crisis and,  in return, is shaped by it ’

Basel III Guidelines and Financial Reforms

The Global Financial Crisis (GFC) of 2008 exposed critical flaws in the financial system, triggering a regulatory overhaul through the Basel III framework. This framework by the Basel Committee on Banking Supervision aimed to improve the resilience of banks and prevent future financial meltdowns.

Key Impacts of the 2008 Financial Crisis:

• Jobs Lost: 8.8 million
• Unemployment Rate: Spiked to 10% by October 2009
• Home Foreclosures: 8 million
• Household Wealth Loss: $19.2 trillion evaporated
• Home Prices: Declined by 40% on average
• Stock Market Value Lost: $7.4 trillion between 2008-2009

These severe economic losses highlighted that while finance can drive growth, unchecked practices can amplify crises. In response, Basel III reforms were designed to stabilize the banking sector with both micro-prudential and macro-prudential measures.

Basel III Reforms: Core Components

Micro-Prudential and Macro-Prudential Measures

1. Capital Conservation Buffer (CCB):
   • Purpose: A 2.5% additional capital buffer (common equity) to absorb losses during economic stress.
   • Usage: Built up in good times, this buffer can be drawn down when a bank faces crisis conditions.
   • Restrictions in Breach: If a bank breaches the CCB, it must restrict payouts like dividends, share buybacks, and bonuses to retain capital until the buffer is restored.
2. Counter-Cyclical Capital Buffer (CCCB):
   • Purpose: An additional buffer (0-2.5%) determined by regulators like RBI in India to manage systemic risk during excessive credit growth.
   • Activation: Triggered when the economy is growing excessively, reducing indiscriminate lending.
   • Indicators Used: The CCCB is based on the credit-to-GDP gap, a metric showing the difference between the credit-to-GDP ratio and its long-term trend.
   • Leverage Ratio:
   • Objective: Control banks’ reliance on excessive debt, which can be destabilizing during downturns.
   • Structure: A non-risk-weighted ratio that limits on- and off-balance sheet exposure relative to Tier 1 capital.
   • Minimum Requirement for D-SIBs: 4% of leverage ratio for systemically important banks, which are heavily interconnected and thus vital to systemic stability.
3. Liquidity Ratios (LCR and NSFR):
   • Liquidity Coverage Ratio (LCR): Ensures banks have a stock of High-Quality Liquid Assets (HQLA) to cover 30 days of cash outflows in a crisis.
   • Assets Classifications: HQLAs are divided into Level 1, Level 2A, and Level 2B assets based on liquidity and stability.
   • Net Stable Funding Ratio (NSFR): Encourages banks to fund their long-term assets with stable liabilities, reducing dependence on short-term financing.

Understanding High-Quality Liquid Assets (HQLA) in LCR

HQLAs help banks withstand financial pressures by maintaining liquidity in times of crisis. The LCR mandates that banks hold a sufficient stock of these assets to handle 30 days of expected outflows.

Domestic and Global Systemically Important Banks (D-SIBs and G-SIBs)

Systemically Important Banks (SIBs) are large, interconnected institutions whose failure could jeopardize financial stability. Known as "Too Big to Fail," SIBs must maintain higher capital levels to offset their risk potential.

Characteristics Defining SIBs:

• Size: Large institutions that are vital to the economy.
• Interconnectedness: Extensive ties to other banks, increasing the risk of contagion.
• Complexity: Intricate structures and services.
• Lack of Substitutability: Few alternatives in case of failure, emphasizing the need for stability.

Visual Summary: Basel III Measures for Stability

Conclusion: The Basel III framework, with its focus on capital adequacy, leverage constraints, and liquidity management, represents a major step toward preventing future crises. By implementing these standards, banks are better equipped to maintain stability, supporting economic health and public confidence even during turbulent times.