Basel III: dehybridisation of capital

One of the core problems in the credit crisis of 2007-08, which continued in an attenuated form through 2011, is the risk of national banking failure stemming from inadequate banking capital. Basel II, whose main purpose was to set out standards for the regulation of capital of internationally active banks, had encouraged a hybridization of capital which was dramatically reversed by the announcement of Basel III in December 2009. This paper explores the rationale for the new capital standard under Basel III. We focus on the link between excessive hybridization of tier 1 capital as a result of implementing Basel II, and the subsequent need for government sponsored bailouts during periods of high liquidity risk. This linkage indicates that Basel II had failed to mitigate liquidity risk, and perversely, amplified it by allowing hybrid financial instruments to be treated with equity-like certainty. Basel III in effect represents a failure of the financial economic models of Basel II. To allay these failures, we propose that substantive legal distinctions replace financial risk metrics in drawing distinctions between equity, hybrid capital and debt with regards to core capital. These distinctions will provide a sense of certainty and financial stability to banking capital