Basel III, the necessity of regulations and the fear of repercussions -

Abstract

The latest financial turmoil of 2007 revealed the vulnerability of the banking system to absorb financial shocks and to manage credit disturbances. The crisis exposed some characteristics of the market: the banking system is extremely leveraged, the growth of credit is risky and the financial innovations surpass Basel II framework. The new situation drove the Basel committee to review Basel II capital requirements and develop a new framework- Basel III. The new Basel accord requires the banks to increase the proportion of equity in their capital structure to absorb all shocks and risks that the banks would face in order to avoid any disturbance in the market. But these requirements caused conflict of interests between regulators and the banks. For regulators, equity absorbs loss of financing and reduces the strictness of risks. Whereas banks claim that the increase in capital requirements has negative effects on banks’ profits and lending ability which can cause credit crisis. For them debt is less costly than equity. In this thesis I will study the importance of banking industry in the economy, the risks that arise and thus the importance of regulations. Then, I will introduce the previous accords with their limitations and failure to cover the financial innovations that cause the latest financial crisis. Moreover, I will study Basel III accord, its strengths and weaknesses. Then I will end up with the empirical study to reveal the pitfalls of implementing this accord in a recessionary environment and the weaknesses of this accord to cover the continuous financial and banking innovations.