Basel III & How its Different From Basel

8/13/2019 Basel III & How its Different From Basel

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Basel III & How its Different FromBasel II

History & Comparison


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The Basel Committee

The Basle Committee on Banking Supervisioncomprises representatives of the central banks andsupervisory authorities of the Group of Ten countries(Belgium, Canada, France, Germany, Italy, Japan,

Netherlands, Sweden, Switzerland, United Kingdom,United States) and Luxembourg. The Committeemeets at the Bank for International Settlements,Basle, Switzerland.


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What Basel Committee is for?

Basel Committee suggests the internationallyaccepted, unanimous and critically questionedCapital Adequacy requirements and regulations forBanks.


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Basel III History

After the subprime crisis in 2007, it became clearthat Basel II had significant shortcomings andtherefore Basel III was proposed to close the gaps.During the subprime crisis many banks failed, due to

liquidity shortages and an insufficient capital base toabsorb losses Nordell and onnqvist(2010).


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A target standard ratio:

Capital Ratio = Eligible Capital / Risk weighted Assets


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Eligible Capital

Tier 1Paid-up share capital/common stockDisclosed reserves

Tier 2

Undisclosed reserves Asset revaluation reservesGeneral provisions/general loan-loss reservesHybrid (debt/equity) capital instrumentsSubordinated debtThe sum of tier 1 and tier 2 elements will be eligible for inclusionin the capital


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Tier 1

Includes only permanent shareholders' equity(issued and fully paid ordinary shares/common stockand perpetual non-cumulative preference shares)and disclosed reserves (created or increased by

appropriations of retained earnings or other surplus,e.g. share premiums, retained profit,2 generalreserves and legal reserves).In the case of consolidated accounts, this also

includes minority interests in the equity ofsubsidiaries.


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Tier 2

Undisclosed reservesSuch reserves consist of that part of the accumulatedafter-tax surplus of retained profits which banks in somecountries may be permitted to maintain as an undisclosedreserve. Apart from the fact that the reserve is notidentified in the published balance sheet, it should havethe same high quality and character as a disclosed capitalreserve; as such, it should not be encumbered by anyprovision or other known liability but should be freely and

immediately available to meet unforeseen future losses


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Tier 2 General provisions/general loan-loss reserves

provisions or loan-loss reserves held against futureHybrid (debt/equity) capital instruments

includes a range of instruments which combine characteristics of equitycapital and of debt. Their precise specifications differ from country tocountry, but they should meet the following requirements:

they are unsecured, subordinated and fully paid-up;

they are not redeemable at the initiative of the holder or without thepriorconsent of the supervisory authority;they are available to participate in losses without the bank beingobligedto cease trading (unlike conventional subordinated debt);

although the capital instrument may carry an obligation to pay interestthat cannot permanently be reduced or waived (unlike dividends onordinary shareholders' equity), it should allow service obligations to bedeferred (as with cumulative preference shares) where the profitabilityof the bank would not support payment.


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Tier 2

Subordinated term debtIncludes conventional unsecured subordinated debtcapital instruments with a minimum original fixed term tomaturity of over five years and limited life redeemablepreference shares


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Risk weights

0%CashClaims on central governments and central banksdenominated in national currency and funded in thatcurrencyOther claims on OECD2 central governments and centralbanksClaims collateralized by cash of OECD central-government securities or guaranteed by OECD centralgovernments.


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Risk weights 0, 10, 20 or 50% (at national discretion)

Claims on domestic public-sector entities, excluding centralgovernment, and loans guaranteed by such entities.

20%Claims on multilateral development banks

Claims on banks incorporated in the OECD and loansguaranteed by OECD incorporated banks(c) Claims onbanks incorporated in countries outside the OECD with aResidual maturity of up to one year and loans with a residualmaturity of up to one year guaranteed by banksincorporated in countries outside the OECD

Claims on non-domestic OECD public-sector entities,excluding central government, and loans guaranteed4 bysuch entitiesCash items in process of collection


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Basel III Enhancements From Basel II

Capital LevelsBasel II only required a core capitalreserve ratio of 2 percent in different

types of equity while Basel III hasproposed an increase to 4.5 percentHSBC(2010). Furthermore, an increasein non-core tier 1 capital from 4 to 6percent was also introduced in the newBasel III regime HSBC(2010).


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Capital Definitions Under the Basel II regime debt-like instruments qualifiedas tier 1 capital. However, debt like instruments may faceilliquidity and may become severely devalued during acrisis S & P(2010). This may hinder a financial institutionsability to absorb losses using these debt like instruments.Hence, under Basel III, in order to improve the quality ofcapital held to absorb losses, retained earnings andcommon stock have been listed as the only approved tier

1 capital.


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For reference

An examples of how convertibles are a bad choice.Lloyds held convertible bonds (CoCos) under BaselII as their tier 1 capital buffers. Lloydss CoCos, upona trigger event would cause conversion in the form of

equity Bishop(2009). During the 2007 crisis theseinstruments did not perform as a buffer, they insteadput added stress on the institutions who issuedthem. Lloyds conversion of debt to equity severelydepressed their stock prices due to the conversionsflood of equity onto the market.


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Risk Weightings Risk weightings assign credit risk weights to assets thatbanks carry. These weights reflect the riskiness of certainlending and also have an element which encouragessome lending more than others. The 2007 crisis stemmedfrom a real-estate bubble. During this period Basel II hada 50 percent risk weighting on mortgages which evidentlydid not reflect the risk associated with such an asset.Risk weightings under Basel III have not changed except

in the area of mortgage lending. Under Basel III, thisweighting has been reduced to 35 percentMcKinsey(2010)


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Leverage LimitUnder Basel II, a leverage limit did not exist per se,however some countries regulators required it. A leveragelimit denotes the factor that a bank is allowed to build upits assets versus its capital. Basel III prescribes thisamount 3 percent or 33 times bank capital S&P(2010).


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Basel III Enhancements From Basel II Liquidity Coverage

The result of the 2007 crisis came in the form of a liquiditycrisis. Banks simply could not convert capital to cash tocover losses. In Basel II a liquidity regime was not inplace; however, under Basel III, a 30 day liquidity

coverage ratio has been introduced. This has been putinto place to compensate for an illiquid market. Thisregime is prescribed to hold highly liquid assets whichcould compensate for outflows of cash for a 30 day periodof liquidity shortage KPMG (2010). Assets held by banksare weighted, with government bonds having a 100percent weighting and corporate bonds having weightingsof 0-50 percent depending on their underlying weightingsKPMG(2010).


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Conservation BuffersThe capital conservation buffer is capital held above tier 1capital. In Basel II no conservation buffer is required.Basel III does not require this buffer; however, if a bankdoes not have this 2.5 percent buffer they are not allowedto distribute earnings. The closer the banks capital levelsare to the prescribed core tier 1 capital requirements, themore constrained they are S & P(2010). The purpose ofthis is to incentivize the holding of capital to absorb capital

during economic downturns. If held, this buffer brings theamount of common equity to 7 percent and total capital to10.5 percent Nordell and Ronnqvist(2010).


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Basel III Enhancements From Basel II Cyclicality

Basel II has always been criticized as being pro-cyclical sincecapital reserve risk weightings are set according to the riskiness ofunderlying loans UEAPME (2003). Hence, in times of crisis whencredit ratings of underlying loans are downgraded the amount ofcapital held by a bank is reduced. In short, during asset bubbles oran economic boom, a bank may see assets have high ratings

therefore requiring less capital Bishop(2009). However, when thisis followed by a downturn as the markets deteriorate and assetsare downgraded and become riskier, more capital is needed.Basel III, in order to remedy the fact that the amount of capital heldis related to the riskiness of a banks lending portfolio, it hasintroduced a countercyclical capital buffer S&P(2010).

During asset bubbles, additional capital should be built up. BaselIII has created an accommodation for asset bubbles since banksare encouraged to hold a counter cyclical capital buffer of 2.5percent S&P(2010)


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Systemically Important Insti tutions Systemically important institutions must be safer thaninstitutions less significant. Banks which operate on aglobal scale are at a higher risk of spreading contagionswhich effect international markets. A good example of this,Bank Hauss Herstatt, which was a relatively insignificanttrading outfit which caused a virtual shutdown in theforeign exchange trading market after it was shut down byGerman regulators for over-trading Nordell and

Ronnqvist(2010)


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Basel III's effect on Banks Pressure on Profitability, As with all industries, increasedregulation translates into downward pressure onprofitability.

With new capital requirements, banks must either raise morecapital, or sell off existing assets. Raising more capital will

mean banks need to cut costs, therefore many banks will closebranches and cut jobs to accommodate increasing capitalrequirements. Additionally, more liquid assets will have to beheld in order to satisfy the 30 day liquidity ratio S&P(2010).Therefore, more liquidity translates into smaller returns and

less profitability. This downward pressure on returns on equitymeans banks will seem less attractive to investors. Additionally,it is these investors which banks will be seeking to raise morecapital to comply with the new buffers.


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Basel IIIs impact on the world's economy Just one example of how Basel III will affect the world'seconomy can be drawn from the forecasted ramificationsin the UK. According to the ONS National Accounts BlueBook in 2010, the UKs banking sector contributed 10percent of the gross domestic product. Now, with morestringent regulatory measures soon to be in place, it islikely that the productivity of this sector will likelydecrease.Basel III has reduced the profitability of this sector and as

such reduced the attractiveness to invest in an industrywhich contributes to 10 percent of the economy. Growthin the sector will likely be reduced and subsequentlyemployment by the industry will follow suit.


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Basel IIIs impact on the world's economy As money pours into the economy it experiences something calledthe money multiplier effect, where one pound of injected cashtranslates into several more Investopedia(2011). That being said,bank loans play a vital role in the creation of this effect. The newBasel III regime likely means less loans will be given out which willlikely translate into less money being multiplied and in turn lessgrowth Reuters (2011).

Consumers may find it more difficult to get credit, corporations whofrequently use bank loans as a signal of credit worthiness may findthat the banks ability to lend is severely reduced. The ramification ofthis is a less leveraged economy which will likely grow at a slowerpace Reuters(2011).The OECD has expressed Basel III will likely reduce economicgrowth by 0.05 to 0.15 percent a year Reuters(2011) since economicoutput is mainly driven by increases in bank lending. Moreover, suchstricter Regulations will likely cost 10 million jobs across the worldReuters(2011). That being said, this could be justified as the cost fora more resilient economy. These 10 million people who will soon beout of a job worldwide will eventually need to be absorbed by the restof realm of finance.


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Conclusion

Basel III was created in response to the gaps thatsurfaced in Basel III after the 2007 financial crisis.Most elements of the regime seem to shore up theglobal financial system and perhaps renew investorconfidence in banks. Systemically important bankinginstitutions will undoubtedly be less profitable andthe world's economy will grow at a slower pace;however this is the cost of resilience.

Basel III & How its Different From Basel

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