Basel III evolved after the last financial crisis. The new rules are to make banks and financial institutions more stable by increasing the capital ratios.
BASEL III is a new global regulatory standard on bank capital adequacy and liquidity agreed by the members of the Basel Committee on Banking Supervision. The third of the Basel Accords was developed in a response to the deficiencies in financial regulation revealed by the global financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.05 to 0.15 percentage point.
Imposing capital requirements is easy, but what is capital and what are real risk assets? Those who remember the last crisis where Bear Sterns, Fannie, Freddie and other institutions went bust, realize what untamed over leverage can cause. Basel III wants to strengthen banks capital ratios, but seems rather slack regarding what is a risky asset.
Since Fannie and Freddie guaranteed more than half of the U.S. market, its overleveraging set the tempo for the entire housing market during the bubble years. Pinto notes, “In order for the private sector to compete with Fannie and Freddie, it needed to find ways to increase leverage.” And so they did, increasing the likelihood that when the market fell, there would be a meltdown.
Basel III, by categorizing sovereign debt as risk-free, is doing precisely the same thing. Except instead of the $10 trillion U.S. mortgage market, now we’re talking about the more-than $50 trillion of sovereign debt worldwide. That does not include the untold trillions of sovereign debt credit default swaps, insurance policies bondholders buy against default.
What happens if sovereign debt risks start blowing up, while people see them as risk free? Welcome to some real Black Swans.
Further reading, courtesey of Bill Wilson The Next Financial Crisis