Risky Business

• Author: Ä°nci Ötker-Robe and Ceyla Pazarbasioglu
• Position: a Division Chief and is an Assistant Director, both in the IMF's Monetary and Capital Markets Department.

THE recent crisis revealed the significant risks posed by large, complex, and interconnected banks of all types and the fault lines in their regulation and oversight. Over the past two decades, financial institutions in advanced economies expanded significantly and increased their global outreach. Many moved away from the traditional banking model—taking deposits and lending at the local level—to become large and complex financial institutions (LCFIs). These global financial titans underwrite bonds and stocks, write and sell credit and other derivatives contracts, and engage in securitization and proprietary trading within and across borders. When they fail, as did the Lehman Brothers investment bank in 2008, their downfall can lead to plummeting asset prices and turmoil in financial markets and threaten the whole financial system.

International banking reforms, under what is commonly known as Basel III, will require banks to hold more and better-quality capital and liquid assets. The effect of these reforms will vary across regions and bank business models: banks with significant investment activities will face larger increases in capital requirements, and traditional commercial banks will be relatively less affected. The Basel III regulations will likely have the strongest impact on banks in Europe and North America.

These more stringent rules will affect LCFIs’ balance sheets and profitability. Banks will in turn adjust their business strategies, as they attempt to meet the tighter requirements and mitigate the effects of the regulatory reforms on their profitability. A key issue for policymakers is to ensure that the changes in banks’ business strategies do not result in a further buildup of systemic risk in the shadows of less-regulated or unregulated sectors (such as hedge funds, money market funds, special purpose vehicles) or in locations with less-onerous regulatory standards.

Tighter capital and liquidity rules

The new rules, approved by the leaders of the Group of Twenty advanced and emerging economies in November 2010, require, among other things

• higher and better-quality bank capital—mainly common equity—that can absorb greater losses during a crisis;

• better recognition of banks’ market and counterparty risks;

• a leverage ratio to limit excessive buildup of debt alongside the capital requirement;

• tighter liquidity standards, including through a liquid asset buffer for short-term liquidity stresses and better matching of...