Why would Basel III be Effective on Hedging Against Financial Risks Essay

Why would Basel III be Effective on Hedging Against Financial Risks and another Potential Financial Crisis - Essay Example The risk created due to the changes in the economic situation quickly eroded the capital of the banks thus making Basel II also a pro-cyclical accord. (Varotto)1 Basel-III is a new initiative by the Basel Committee on Banking Supervision to improve the liquidity as well as the capital adequacy of the banks amid the financial crisis. Though still in the consultative phase, Basel III is considered as an upgradation of the existing Basel –II framework and has placed new requirements on the economic capital of the banks. According to the new changes, the core capital of the banks will be increased as a percentage of the Tier 1 capital of the bank where the Tier 3 capital of the banks and financial institutions may be scrapped under the new rules. There will be many major changes under the new capital accord making banks more capable of facing the challenges of any future economic shocks. (Standard & Poors)2 This paper will discuss the notion of why Basel III will be effective on h edging against the financial risks and other potential financial crisis in the future. Prior Research Basel-III is still in a consultative phase and there is generally a dearth of the research on the topic and how it is going to affect the financial system. Basel II was launched in order to make banks’ capital more risk sensitive in the wake of the overall risks faced by the financial system as a whole. The current financial crisis has largely exposed the inability of the Basel II to actually safeguard the banks against the changes taking place at the global level due to the financial crisis. (The Economist)3 It’s being argued that the Basel-II failed to allow the banks to safeguard themselves against the extreme stress faced during the current economic crisis. Basel-III accord is therefore aimed at ensuring that balance sheets of the banks should be further strengthened to help them safeguard against the extreme situations. (Hauswald)4 It is also argued that Basel II was actually the underlying cause of the current financial crisis and Basel-III may not also result into better management of the banks in the wake of the potential financial crisis. This line of argument is however, based upon the notion of the pro-cyclical nature of the accord and how banks can actually circumvent the regulations in order to take benefit from them. (Lall)5 It is also argued that Basel-III may slow down the economic growth- a feature which was actually not present in the previous Basel accords. This is due to the higher liquidity requirements for the banks as well as the holding of large amount of Tier-1 capital thus restricting the ability of the banks to lend aggressively. (Corrigan)6 Understanding the Main Proposals of the Basel III Framework Basel-III is different from Basel II and Basel-I on different counts including the introduction of two new ratios which banks have to manage besides changing the ratios for the core capital and Tier 1 capital while at the s ame time eliminating the Tier 3 capital altogether. As such new Basel-III accord attempts to lay down new rules and regulations for capital, liquidity as well as the leverage of the banks to improve their risk management practices, supervision and internal governance mechanism. (Summerfield)7 The overall purpose of the accord is to strengthen the capital of the banks so that the extreme risks arising due to the financial crisis could be avoided. It is because of this reason that the new accord proposes to hold more buffer capital while at the same time advocating for higher cash holdings. As such, new accord propos