From Basel II to Basel III
The Basel Committee on Banking Supervision has agreed on the new, stricter requirements to the reserve capital rules, based on the decisions made by the Finance Ministers and Central Bank Governors of the G20 countries.
The main aspects of the new Accord, which came into force on the 12th of September, 2010, are focused on increasing minimum capital requirements. The document does not annul; but rather elaborates and enhances the Basel II requirements. Basel III requirements are concentrated around Common Equity since it features the highest level of liquidity and therefore is the most effective instrument for financial loss amortization.
Capital requirements growth dynamics:
What’s new?
1. From recommendations to requirements
One of the main distinctions of the new Basel Accord is a transition from recommendations to requirements and setting responsibility for the inability to meet the requirements. Banks which are not able to meet the requirements will have to decrease bonus payments and dividends on shares.
2. Common Equity requirements
New requirements represent tighter definitions of Common Equity.
Banks will be required to hold more reserves by January 1, 2015, with Common Equity requirements raised to 4.5% from 2% at present.
3. Tier 1 Capital requirements
Under the new rules, the mandatory reserve (known as Tier 1 capital) will be raised from 4% to 6% by 2015.
4. Introduction of a Capital Conservation Buffer
The Capital Conservation Buffer is an additional reserve buffer of 2.5% to "withstand future periods of stress", bringing the total Tier 1 Capital reserves required to 7%.
This buffer is introduced to meet one of the four key objectives identified by the Committee in the December 2009 Consultative Document “Strengthening the resilience of the banking sector”; conserve enough capital to build buffers at individual banks and the entire banking sector which can then be used in times of stress.
5. Introduction of Countercyclical Buffer
According to the new rules local regulators are not only responsible for controlling banks’ compliance with the Basel requirements but also for regulating credit volume in their national economies. If credit is expanding faster than GDP, bank regulators can increase their capital requirements with the help of the Countercyclical Buffer. Varying between 0% - 2.5% it can preserve national economies from excess credit growth.
6. Leverage Ratio (Tier 1 Capital to Total Assets)
Capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described above.
According to Basel III; Tier 1 Capital has to be at least 3% of Total Assets even where there is no risk weighting. The Basel III rules agree to test a minimum Tier 1 leverage ratio of 3% during the parallel run period by 2017.
7. Liquidity Risk Measurement
Basel III introduces a new instrument for liquidity risk measurement – Liquidity Coverage Ratio (LCR). It is designed to ensure that a bank maintains an adequate level of unencumbered, high-quality assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors. The standard requires that the ratio be no lower than 100%. Its implementation is planned for 2015.
To ensure that investment banking inventories, off-balance sheet exposures, securitization pipelines and other assets and activities are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles the new Accord introduces Net Funding Stability Ratio (NFSR). It is defined as the ratio, for a bank, of its “available amount of stable funding”divided by its “required amount of stable funding”. The standard requires that the ratio be no lower than 100%.
9. Systematically Important Banks
The “systematically important” reference is for banks that are too big to fail. These banks should have loss absorbing capacity beyond the standards.
In addition to being stricter, capital requirements would vary in two ways, over the business cycle and between systemically and non-systemically important firms. Over the business cycle, capital requirements would be higher in good times (thus discourage excessive risk taking), and lower in recessions when financial institutions are reluctant to take risks. Along the size dimension, capital requirements would be higher for systemically important firms to dissuade them from taking on too much risk and endangering the financial system.
Points for Discussion
Liquidity
Ratios suggested by Basel Committee within “Liquidity Risk Management Consultative
Paper” (NSFR and LCR) have been widely criticized. The main concern is that excessively large capital reserves will be concentrated in the liquidity reserve. Influenced by this criticism the requirements to the ratios usage came out pretty vague. In addition, NSFR and LCR ratios will become obligatory for capital adequacy calculation only in 2018.
Common Equity
In the post-crisis period a number of banking institutions gained financial profit due to the government donations. Usage of such practice in the future may lead to the new banking crisis. In this regards new Basel requirements are concentrated on the Common Equity.
Capitalization
For some period of time credit risk influence was considered as the most destructive and was also named as one of the main reasons of the world financial crisis. However, risk assessment system was not changed accordingly. Only one simple requirement was introduced – Common Equity must be not less than 3% of Total Assets.
In this regards a new question appears – won’t this cause an actual ceasing of lending? On this matter we should note that from the long-term perspective capital adequacy requirements tightening does not influence the lending significantly. Even considering the post-crisis conditions, this requirement allows growing a credit portfolio that is 33 times larger than the Common Equity.
Transition period duration
Another question that is widely discussed is whether the 8-year transition period is sufficient. It is assumed that this is enough for the large banks which already started bringing profit to the shareholders after the crisis. For those banks that suffered more the transition period will be extended.
Opinions and Comments
Nout Wellink, head of the Basel Committee on Banking Supervision
"We have done it in such a way that the economy will not suffer ... I think it will make a new crisis less likely ... but we cannot rule it out completely."
Michel Barnier, EU commissioner in charge of financial reform
"The transition period to reach these ambitious objectives is the right one: it is sufficiently long to allow for gradual improvements and hence not put economic growth in danger."
Thomas Mirow, president of the European Bank for Reconstruction and Development
“Basel III is the result of the intensive work of many agencies and institutions over the past two years. It has achieved important progress in many areas, most importantly raising the quality of capital and addressing, in a measured way, bank liquidity issues.
The industry and markets have reacted with a sigh of relief that the proposed increases in minimum required capital are demanding but not excessive. This is particularly important for the current protracted recovery phase, where a much stronger increase in capital requirements could have stifled the much-needed resumption of credit”
Jean-Claude Trichet, president of the European Central Bank
"In the present episode of global recovery, after this shock we had in the previous years, uncertainty is the enemy in a way. With this decision ... we eliminate uncertainty in a large area which is a major contribution in consolidating the global economy. It's a work in progress."
Karl-Heinz Boos, managing-director of the Association of German public sector banks (VOEB)
"The agreement is a regulatory shot in the dark as no studies on the impact are envisaged. We see the danger that the ability of German banks to supply loans to the economy will be significantly curtailed. Small and mid-sized companies that have no access to capital markets will suffer in particular. It seems the timetable here was more important than quality (making this) a compromise package with risks and side effects."
Adair Turner, chairman of Britain's Financial Services Authority
"I think it's a very, very balanced package which is designed to achieve future resilience without in any way restricting the ability of the banking system to support the real economy."