At the close of the year 2010, the world’s biggest banks combined a $2,287 billion gap in liquid investment to be filled in just four years. The 2007-2010 crisis was arguable the worst global financial crisis since the Great Depression, in which the capital bases of these major banks were severely compromised. Basel III’s main goal was to “raise the quality, consistency, and transparency of banks’ capital base, while reducing the required capital ratio to 7 per cent.” Since most banks failed to hold a top of the line capital base prior to the financial crisis, they were facing major issues rebuilding their capital due to the investor’s hesitancy to hold bank equity. The banks that held more Tier 1 Capital (bank’s core and capital base) and, therefore, better trust in deposits received much higher returns throughout the crisis.
The Basel III Committee observed that the previous structure failed to take into consideration the relationship between financial institutions. A counterparty credit risk is the risk that the opposing party will default on their agreement. Basel III adjusted from their previous restrictions and imposed more conservative limits for banks to calculate these risks. The risk assumptions are now required to include a period of economic and market stress, and to apply a multiplier of 1.25 to the observations of the relationship between the firm’s asset values and the current economic situation. The Basel III Committee also recommended applying a zero-risk weight if deals were processed through exchanges and clearinghouses. Through these limitations, banks would hold fewer assets from other financial institutions and therefore reduce the interdependence between them.
Historically, banks have relied on short-term secured funding to finance the long-term illiquid assets and therefore struggled when secured funding disappeared. Firms must be able to endure periods of low liquidity. Liquidity is necessary for a...