Case#1 Page 1 Basel III: An Evaluation of New Banking Regulations

Q#1 – Discuss the relationship between the capital base of banks and the 2007-2010 financial crisis and Great Depression (120 words)
 Most Economists would agree that the 2007-2010 crisis, was the worst global financial crisis since the great depression. During both of these times, the capital base of banks was severely compromised. Therefore, bank regulations are needed to improve the quality of banks’ capital base to become more resilient during economical crisis.

During the Great Depression, major banks failures resulted after the stock market crash. These failures began as debtors defaulted on loans and depositors withdrew their deposits en masse. Outstanding debt increased as prices and income fell. Bank failures increased as desperate banks called loans yet, borrowers did not have the time or money to pay. In addition, capital investment slowed and banks struggled to build up their capital reserves by making fewer loans. Many would say that the Federal Reserve allowed the money supply to shrink to 1/3 and transformed what was a normal recession to the Great Depression by restricting emergency lending to failing banks. However, the Federal Reserve could not react in part because the Federal Reserve Act, which required 40% gold backing of Federal Reserve notes issued. During this time, the Federal Reserve hit this allowable credit limit. Reduced capital reserves resulted in many bank failures to sustain the crisis during this time.

During the 2007 – 2010 crisis again, many banks failed to maintain a high quality capital basis prior to the crisis. In addition, Banks failed to build their capital as the crisis continued since investors were hesitant and banks write-offs further reduced their reserves. Attaining the necessary capital was difficult and required Government support was needed. New regulations were needed to improve banks capital base requirements in stable periods to sustain during difficult times.

Sources: http://en.wikipedia.org/wiki/Capital_adequacy_ratio http://pages.stern.nyu.edu/~igiddy/articles/capital_adequacy_calculation.pdf

Q#2-What measures should limit counterparty credit risk? (120 words)
 In an effort to reduce counterparty credit risk, Basel regulations proposed more conservative measures for the calculations of counterparty credit risk. This was accomplished when calculating the capital requirements for counterparty credit risk included not only the historical data, but included economic and market stress in such assessments. More specifically, Banks were required to increase banks correlation assumptions. This was recommended, by applying a multiplier of 1.25 to their historical information to calculate the correlations between a firm’s financial asset value and the economy. Thus, banks would be required go hold more capital to protect itself against the negative effects of other financial institutions credit risk. Much of this was the result of the interconnectivity of large financial institutions and banks counterparty exposure. Thus, this increased risk assessment needed adjusted weightings for banks funded from other financial institutions. In addition, banks would assess a zero risk weight in their assessment models if deals were processed through exchange and clearing houses. This however, could encourage banks to engage in “Over the counter” derivative trading to exchanges.

Sources:
http://www.bis.org/publ/bcbs188.htm