New Rules Will Curb Risks in U.S. and European Banks

Basel III banking rules will help curtail risk at largest investment banks

Banks have time to comply with new rules if earnings keep pace

Global coordination, effective supervision key to reducing risk

The rules, commonly known as Basel III, will require banks to hold more and better quality capital and liquid assets to protect against the excessive risk-taking that led to the biggest financial meltdown in 80 years.

Banks will have to retain more of their profits, raise additional capital or reduce their exposure to riskier assets to meet the additional capital and liquidity requirements.

The IMF Staff Position Note, Impact of Regulatory Reforms on Large and Complex Financial Institutions says that a few banks with a global reach handle the vast majority of cross-border finance, and their actions affect financial centers across the world. In the years before the global economic crisis, the build-up of financial risks in these institutions often went unnoticed and unchecked by the regulators and supervisors in charge of overseeing the banks’ activities.

Under the proposals still under discussion by the Group of Twenty leaders of advanced and emerging economies, national regulators may also impose extra charges on systemically important banks. The goal is to prevent institutions from becoming too important, or too complex, to fail and to avoid bailing out these institutions at taxpayers’ expense.

The IMF said requiring banks to hold more capital and liquidity will create a stronger banking system. The stricter Basel III rules will affect banks’ profitability and trigger adjustments in banks’ balance sheets and business strategies, such as shrinking and reposition assets away from the most capital intensive activities, and passing the cost to customers. This could lead to higher risk activities moving out of the banks and into less-regulated parts of the financial system, or to jurisdictions with less stringent regulations.

Regulate locally, cooperate globally

The IMF study said the Basel III rules give banks adequate time to adjust to the new requirements to hold more capital and liquid assets. This assumes global economic growth and bank earnings...