If you work in a financial institution, big changes are on the way. Lessons learned from the financial collapse of the past few years, has led to new thinking about how financial institutions need to operate. Or maybe it’s old thinking that has come back into fashion. In the years leading up to the collapse, we had a lot of growth and a lot of thinking about what limits growth. The answer, around the world seemed to be less regulation, fewer requirements for liquid assets in an emergency, and ever more complicated financial instruments to yield higher returns. Since the economy did collapse, this now appears to have been a less than perfect combination. In fact, the same combination of factors fueled the rise in world financial markets in the 20s that ended in the Great Depression. That economic event led to a number of regulations that prevented a repeat collapse for many decades. Today, some of the most critical regulations are being developed in Europe. The US government has agreed to adopt one of the most critical regulatory frameworks, Basel III. What is Basel III, and why is it so critical to financial firms (and project managers)? That’s exactly what we’re going to discuss today! Let’s dive in:
Basel III is a framework for bank regulation, named for the town in Switzerland where the “BIG 10” countries originally met. Basel III is a new set of guidelines that follows on from Basel II, which was developed in 2004. The core concept behind Basel III is that every financial institution needs to have the right amount of liquid, accessible assets for both day to day issues and for emergencies. The idea is simple, but the execution is quite difficult. Here are the three major components of Basel III:
- Liquidity requirements: Basel II generally required 2.5% reserves, but this obviously proved inadequate in the last financial crisis. Basel III increases this to 7.0%.
- Asset definition & testing: In the last financial crisis, assets that were supposed to be liquid (easily sold or converted into cash) were found to be impossible to sell. Either they were not truly liquid, or they were blended with more difficult to price or sell instruments, especially subprime loans. Basel III will do more to define risk and test it… with periodic “stress tests” that simulate a financial crisis.
- Risk adjustment: The financial crisis was not brought about by too many high-quality investments. Risky investments were made up of questionable assets that are either too complex to understand or too opaque to review caused the crisis. Basel III adjusts reserves based on risk. Financial institutions that want high-risk investments will less available cash to invest; institutions that choose lower risk investments will be able to invest more. How we identify and quantify risk now moves to the forefront of world finance.
In the US, regulators are still defining how Basel III will be applied. In December of 2011, the US agreed to apply Basel III to all banks, and to financial institutions with $50 billion or more in assets. Which institutions will be included (will Basel III apply to private firms, how?), and how international standards will be used to identify risk is still being defined. In March of 2012, 19 banks were tested, 15 passed. There are 7,400 commercial banks in the US, so this is just the beginning of a process that will take many years to complete. Banks which have not passed a stress test will eventually be seen as having undisclosed or unacceptable risk.
Which brings us back to project management. These are huge changes. If you work for a financial firm, projects will be launched before and after ever stress test. New applications need to be developed to track and test fund behavior. Other applications will be created to give senior executives more visibility into the activities of their fund managers; when the next crisis comes, regulators are expected to deal harshly with senior executives who are not aware of how fund managers use the firm’s money. Training is needed throughout the firm, not just in trading and banking groups. By increasing the reserve and liquidity requirements for banks, groups with higher-risk risk investments will look for ways to offset these requirements by reducing operating costs.
Basel III isn’t anything new, but it is big and it will bring big changes. Look at your project portfolios. If you can’t see a footprint for Basel III you should talk to department managers about their plans. While only 19 firms have been involved in stress testing so far, the thousands of other commercials banks will need to follow… soon. Get ahead of this trend, and start building new projects or at least put placeholders in your portfolios. Planning now will definitely help to keep you on track when the Basel III wave hits your firm. And that’s my Niccolls worth for today!