Possible Unintended Consequences of Basel III and Solvency II

IMF Working Papers, August 1, 2011

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In today's financial system, complex financial institutions are connected through an opaque network of financial exposures.
These connections contribute to financial deepening and greater savings allocation efficiency, but are also unstable channels of contagion.
Basel III and Solvency II should improve the stability of these connections, but could have unintended consequences for cost of capital, funding patterns, interconnectedness, and risk migration.

Network of exposures: Complex financial institutions are linked by an opaque network that enhances allocation efficiency but creates contagion channels.
Regulatory intent: Basel III and Solvency II aim to improve stability of interconnections among financial institutions.
Potential unintended consequences identified:
- Cost of capital: Regulations may affect the cost of capital for regulated entities.
- Funding patterns: Changes in regulatory requirements could alter funding behavior.
- Interconnectedness: Regulatory reform could shift patterns of interconnectedness across institutions and markets.
- Risk migration: Risks may migrate across sectors or instruments in response to regulatory changes.

Subjects: Banking; Basel III; Financial institutions; Financial regulation and supervision; Financial sector policy and analysis; Financial statements; Insurance; Insurance companies; Public financial management (PFM); Solvency
Keywords: bail-in capital proposal; balance sheet; bank assets; Basel III; capital requirement; conservation buffer; Cost of Capital; credit risk; equity capital; Europe; fair value; Financial statements; Funding; Global; holding company; Insurance; Insurance companies; Interconnectedness; preference shares; Solvency; Solvency II; unsecured debt; WP