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Next Financial Crisis In The Shadows

Benefits and massive shortcomings of Basel III

Nik Bhatia

May 6

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Dear readers,

Finals have been graded and summer break begins! Statistics from the exam perfectly threaded the needle between too easy and impossible—two out of 51 students scored higher than 96%, while the median registered at a comfortably cool 64%. Why so icy? My class gets slightly more difficult for the average student as the years go by, as I am inclined to squeeze in each new global macroeconomic facet to the required knowledge set. New, as in newly teachable from my perspective, and this semester had its fair share of new components thanks to The Bitcoin Layer, which drives my research quality higher with each subscription, question, and comment from you, the loyal reader. This year, the inclusion of shadow money balance sheet mechanics tripped up more than a few of these grads.

One of the two students that aced the exam also wrote a phenomenal position paper on Basel III, why small banks dying isn’t necessarily bad for financial stability, and how shadow banks could trigger the next global financial crisis. His thesis on how risk is being stuffed into shadow banks and completely escaping the very spirit of Basel regulations will give me nightmares.

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Brian Barwick
Spring 2024
FBE 535 - Prof. Nik Bhatia

Basel III won’t stop the next crisis

Financial regulation, like the entities it tries to oversee, is becoming increasingly complex. Since the American banking system’s recovery from the Global Financial Crisis (GFC), “macroprudential” has been the major buzzword across the financial industry, a part of every central banker’s lexicon drawing a mix of praise and ire depending on the parties consulted. Among all current initiatives, one macroprudential measure in particular receives the most attention and, as a result, the most criticism—Basel III. In December 2009, with the world still reeling from the most significant financial crisis since the Great Depression, the Basel Committee on Banking Supervision (BCBS) released a new proposal for a regulatory framework built on lessons from the recent past aimed at helping prevent future banking crises from becoming globally systemic threats. This framework, most commonly known as “Basel III,” presented a new attempt to create enhanced shock absorbers in the post-GFC banking sector. Key to the proposal was a renewed emphasis on strengthening risk management and governance, increasing transparency, and enhancing banks' liquidity to better survive in crisis-like conditions.

With the introduction of strict capitalization requirements and enhanced oversight, the Basel III framework has been met with skepticism and outright hostility by many players in the American financial sector. Jamie Dimon, CEO of JPMorgan Chase, went so far as to call Basel III “anti-American” for putting U.S. banks at a perceived disadvantage.¹ However, contrary to Mr. Dimon’s position, a careful study of Basel’s proposed regulations proves the opposite to be true. Instead of putting the American financial sector on its back foot, Basel III will allow the U.S. banking system to take on a new life refocused on stable growth. While Basel III reform implementation may lead to increased consolidation in the banking sector, a study of mid-sized banking’s shortcomings shows that such a transition would actually be a net positive for the financial sector and Americans as a whole. While lack of concentration might threaten to stifle innovation and creativity, a solid counter-argument can be made that the benefits of risk-conscious Global Systemically Important Banks (G-SIBs) dominating the post-GFC banking landscape outweigh the cons.

Unfortunately, despite all its positives, Basel III does not go far enough to protect against systemic risk, due primarily to the rising predominance of shadow banks and synthetic securities. These opaque, unregulated entities act as willing buyers of some of traditional banking’s riskiest assets, obfuscating banks’ risk profiles in the process. Given how intertwined shadow banks are with the traditional sector, these actions have the potential to muddy the efficacy of Basel reforms and even elevate the sector's overall systemic risk. Thus, while Basel III’s likelihood of driving banking consolidation in the U.S. is a new positive, the risks it attempts to mitigate will still abound until the shadow banking sector is given a similar level of oversight.