Edited by Thorsten Beck - Vox

VOX Research-based policy analysis and commentary from leading economists
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with financial crises, in other words, much more severe than those employed in
stress tests this year both in the US and Europe.
⎡ 1 ⎤
b. The second point is that our risk factor ⎢
1 − (1 − K) MES
⎥ is a scaling-up factor
⎣ ⎦
on firm’s assets, a kind of ‘systemic risk weight’ that is rather different from
the asset-level risk weights set forth in Basel II, and now expanded in III. A
strong case can be made that the current crisis was all about large complex
financial firms exploiting loopholes in Basel risk weights to make a one-way
concentrated bet on residential and commercial mortgages. By attempting to
estimate a firm’s losses in a bottom-up, granular manner, the Basel risk weights
create room for tremendous gaming by the financial sector, and provide
incentives to enter into specific spread trades and concentrate risk. In other
words, there is a reason why firms loaded up on AAA-rated higher-yielding
securities and purchased protection on these securities from AA- or AAA-rated
insurance companies like AIG. In contrast, our approach, based on a top-down,
market-based systemic measure, incorporates the risk of the underlying assets
when we care most, namely during a financial crisis, and is much harder to
game.
6. What are the capital requirements changes under Basel III? With respect
to capital requirements, Basel III effectively increases (with the conservation of
capital buffer) capital requirements from 4% to 7%. On top of these requirements,
based on a series of firm characteristics related to Basel’s systemic risk criteria,
these capital requirements can be increased by an amount ranging from 0%-3%.
Along with a number of other adjustments, Basel III introduces a new ‘simple’
leverage ratio as a supplementary measure to risk-based capital which is to be set
at 3%. For practical purposes, Basel III continues the risk weights that are tied to
credit ratings both within and across asset classes.