By Eleanor Bloxham
September 13, 2010

By going soft on the ratios most important to the solvency of banks in a future crisis, Basel III took the easy route on banking reform

The new Basel III rules increasing minimum equity requirements for banks will go into effect over the next decade. Two ratios, however, most important in a crisis, will only begin to be “observed” next year and the year after with implementation not expected to initiate until much later.

Those ratios are the net liquidity ratio and the net stable funding ratio. These measures, however, are critically important to the solvency of banks, and the failure to include them is a real failure of regulation to address the issues which led to the crisis.

In a crisis situation, banks don’t just need a certain level of equity — they need liquidity i.e. cash to meet the calls of depositors — and stable funding to meet their ongoing obligations.

According to the Basel Committee’s own statements: “Throughout the global financial crisis which began in mid-2007, many banks struggled to maintain adequate liquidity. Unprecedented levels of liquidity support were required from central banks in order to sustain the financial system and even with such extensive support a number of banks failed, were forced into mergers or required resolution. These circumstances and events were preceded by several years of ample liquidity in the financial system, during which liquidity risk and its management did not receive the same level of scrutiny and priority as other risk areas. The crisis illustrated how quickly and severely liquidity risks can crystallise and certain sources of funding can evaporate, compounding concerns related to the valuation of assets and capital adequacy.”

Punting on the liquidity and net stable funding ratios for many years to come is reminiscent of the way legislators in the US punted on off balance issues as a study item in the Sarbanes-Oxley bill in 2002, an issue that plagued us during the worst of the financial crisis, and its aftermath. (The Frank Dodd Act mentions off-balance sheet frequently with respect to the riskiness of banks.

In a Basel consultative document issued in December, the Committee stated: “One of the main reasons the economic and financial crisis became so severe was that the banking sectors of many countries had built up excessive on and off-balance sheet leverage. This was accompanied by a gradual erosion of the level and quality of the capital base. At the same time, many banks were holding insufficient liquidity buffers. The banking system therefore was not able to absorb the resulting systemic trading and credit losses nor could it cope with the reintermediation of large off-balance sheet exposures that had built up in the shadow banking system.

For the last three decades, liquidity has been one of the issues US bank supervisors are supposed to monitor in the so-called CAMELS ratings of banks. (L stands for liquidity in “CAMELS”.)

Clearly with the Basel Committee punting on the liquidity and net funding stability ratios, issues as fundamental as any others in the latest crisis, it will be now be left to — and incumbent upon — the banking supervisors of individual nations and boards of banks to step up their game.

–Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance, a board advisory firm.

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