Basel III

Introduction

In December 2010, the Basel Committee on Banking Supervision (BCBS) published its reforms on capital and liquidity rules to address problems, which arose during the financial crisis. One of the main reasons the crisis became so severe was that the banking sectors of many countries had built up excessive on and off balance sheet leverage. This was accompanied by the wearing down of quantity and quality of capital. Therefore the banking system was unable to absorb the resulting losses. The objective of the BCBS to strengthen the regulatory capital framework resulted in the Basel III framework. The framework consists of two separate policy documents (BCBS 2010a) and (BCBS2010b) wherein capital and liquidity standards are set out.

Basel III strengthens the Basel II framework rather than replaces it. Whereas Basel II focused on the asset side of the balance sheet, Basel III mostly addresses the liabilities, i.e. capital and liquidity. The new framework will (a) impose higher capital ratios, including a new ratio focusing on common equity, (b) increase capital charges for many activities, particularly involving coun-terparty risk and (c) narrow the scope of what constitutes Tier 1 (T1) and Tier 2 (T2) capital.

The Basel framework (continues to) consists of three pillars:

Pillar 1 is the part of the new Basel Accord, which sets out the calculations of regulatory capital requirements for credit, market and operational risk.
Pillar 2 is the part of the new Basel Accord, which sets out the process by which a bank should review its overall capital adequacy and the process under which the supervisors evaluate how well financial institutions are assessing their risks and take appropriate actions in response to the assessments.
Pillar 3 is the part of the new Basel Accord, which sets out the disclosure requirements for banks to publish certain details of their risks, capital and risk management, with the aim of strengthening market discipline. This is intended to improve effective risk management by allowing for comparison of the performance across sectors through these disclosure requirements.

This whitepaper addresses the changes of Basel III concerning Pillar 1 and Pillar 2 and the impact hereof. The remainder of the article is structured as follows: Section 2 discusses the new capital requirements. Subsequently the most important changes with respect to risk coverage are discussed in section 3. Sections 4 and 5 set out the metrics concerning leverage and liquidity respectively. The impact the changes are explained in section 6. For some comments on the legal authority of the framework, please refer to section 7. The time horizon is shortly illustrated in section 8. For suggestions and critics about the new Basel framework refer to section 9. The bibliography completes this exposition.

Capital

Capital serves as a buffer to absorb unexpected losses and to fund ongoing activi-ties of the firm. Banks are required by their regulators to hold minimum amounts of capital. Capital ratio’s depend on two things; the capital buffer and risk weighted assets. To improve the quality, consistency and transparancy of the capital base the fol-lowing changes are proposed under the new Basel III framework:

Increase of requirements on minimum Tier 1 (T1) capital.
Increase in the standards for instruments to qualify as T1 capital.
Harmonisation of Tier 2 (T2) capital instruments and the elimination of Tier 3 (T3) capital.
Revision of appropriate capital deductions such as minority interests and deferred tax assets.

The new minimum capital ratio’s are displayed in Figure 1. These are percentages of total risk-weighted assets

The minimum requirement for common equity will be raised from the current 2% level to 4.5%. The T1 capital requirement will increase from 4% to 6%. The capital conservation buffer above the regulatory minimum requirement must be calibrated at 2.5% and be met with common equity. A countercyclical buffer within a range of 0-2.5% of common equity or other fully loss-absorbing capital is implemented according to national circumstances. This buffer is to be implemented by the national supervisor (for example DNB in the Netherlands) when there is excessive credit growth in the economy. These buffers are designed to restrict the bank’s ability to distribute its earnings until the buffers are rebuilt. Also, these buffers are not strictly additional minimum capital requirements and may be drawn down during periods of stress.

Linked to the discussions on crisis management is the question of how to handle the “Too Big to Fail” problem. Systematically important financial institutions (SIFIs) are global financial services firms - almost exclusively banks - so big that governments believe they will be forced to rescue these institutions rather than risk lasting damage to the world financial system. SIFIs should have loss absorbing capacity beyond the standards announced. The additional loss absorbency requirements are to be met with a progressive Common Equity Tier 1 (CET1) capital requirement ranging from 1% to 2.5%, depending on a bank’s systemic importance. For banks facing the highest SIB (systemically important bank) surcharge, an additional loss absorbency of 1% could be applied as a disincentive to increase materially their global systemic importance in the future.

Tier 1 capital is intended to ensure that each bank remains a “going-concern”. It is thehighest quality form of a bank’s capital as it can be used to write off losses. It is composed of core capital, which consists primarily of common equity (common stock and retained earnings) and some equity-like debt instruments, which are both subordinated and discretionary (discretionary dividends are those paid, not by contractual obligation, but at the discretion of the issuer of the underlying instruments). Under Basel III, innovative hybrid capital instruments with step-up clauses are being phased out. Not included (i.e. deductions) in common equity are among others goodwill, minority interest, deferred tax assets, provisioning shortfalls, bank investments in its own shares and bank investments in other banks, financial institutions and insurance companies (to avoid double counting of equity).

The exclusion of goodwill is important, as it can’t be included in capital available to absorb losses. The mixing of intangibles with actual capital is not admissible. The exclusion of minorities is sensible because minority interests can support the risks in the subsidiary to which they relate but are not available to support risks in the group as a whole. In view of this, Basel III sets out specific criteria for the inclusion of minority interest in CET1, T1 or T2 capital and how it must be calculated. The exclusion of deferred tax assets is also sensible for banks likely to get in trouble, although it is clearly discriminatory against banks that are well run with reliable
future income.

Tier 2 capital is intended to protect depositors in the event of insolvency, and is thus re-categorised as a “gone-concern” reserve. Given the Basel III focus on incentives to redeem only dated subordinated debt remains eligible as T2 capital. As mentioned before, Tier 3 capital is to be completely abolished. T3 capital is
short-term subordinated debt and was used under Basel II to support market risk from trading activities.

Many banks will need to issue common equity to meet the new regulatory minimums. Recently, regulators, banks and investors are focusing more and more on contingent convertible (CoCo) instruments and their possible role in a bank’s capital structure. The BCBS has expressed concern that earlier “hybrid” securities
did not provide enough capital support in times of stress. As a result the BCBS requires internationally active banks to include in all non-common instruments,
intended to qualify as additional T1 or T2 capital, a provision that converts the instruments to common equity in the event the bank is deemed non-viable or
requires capital injection. This is the so-called Non-Viability Contingent Capital (NVCC) provision. In other words, the instrument will convert to common equity,
or be written off, when the bank is at the verge of becoming a “gone-concern”. The BCBS is requiring these low trigger conversions to ensure that, in the event of
another banking crisis, holders of investment in the banks rather than taxpayers, bear the financial burden. As a result, many more CoCo issuances may occur over
short to medium-term horizon as banks seek to replace non-qualifying instruments.

Risk coverage

Counterparty credit risk

In addition to Basel II revisions concerning market risk capital charges (effective from end-2010), Basel III includes a number of measures to enhance coverage of counter-party exposure. These are intended to address perceived deficiencies in Basel II during periods of acute market volatility.
These measures include:

Capital requirements must be determined using “stressed” inputs when calculating counterparty credit risk.
Banks must implement a new capital charge - credit value adjustment (CVA) - to cover the risk of mark-to-market losses on the expected counterparty risk to OTC derivatives. This is additional to the default risk capital charge
Banks must implement a new capital charge for wrong-way risk. Wrong-way risk is the risk that arises when the (credit) exposure at default is positively (adversely) correlated with the probability of default (i.e. the credit quality of the counterparty). In other words, when default risk and credit exposure increase together. This will be achieved by adjusting the multiplier applied to the exposure amount identified as wrong way risk.
Apply a multiplier of 1.25 to the asset value correlation (AVC) of exposures to regulated financial firms with assets of at least $25 bn., since AVC’s were 25% higher during the crisis for financial versus non-financial firms.
Banks will be required to apply tougher (longer) margining periods (potential losses may occur over a longer specified period of time) to determine capital requirements when they have large and illiquid derivative exposures to a counterparty.
Lower risk weightings (even zero weights) for counter-party risk exposure may be applied if they deal with centralized exchanges that meet certain criteria. This is meant to create an incentive to use centralized exchanges and will create more reliable traded price data and improvements in modeling.

Capital leverage ratio

The newly introduced leverage ratio is intended to serve as a simple non-risk based metric to supplement risk-based requirements. This leverage ratio is calculated as

The leverage ratio will initially be a Pillar 2 supervisory monitoring tool, with Pillar 3 disclosure and eventual migration to Pillar 1 taking place as outlined in the timetable in section 8.

Liquidity Metrics

Liquidity coverage ratio

The liquidity coverage ratio is designed to ensure that a bank maintains an adequate level of unencumbered assets that can meet its liquidity needs for a 30-day
period under a severe stress scenario.

This means that the value of the assets and the outflows refer to those that would arise with a major financial shock, a deposit run-off and a 3-notch downgrade in the credit rating. High quality assets include those that can easily be converted into cash in stressed markets. On January 6th 2013, the BCBS announced revised rules on the LCR, leading to soaring bank shares, especially in France and Italy. The revised rules incorporate amendments to the definition of high-quality liquid assets (HQLA) allowing banks to hold a wider range of assets, including equities and mortgage-backed securities, as well as lower-rated sovereign and corporate bonds. Additionally, the timetable for phase-in of the initial and additional rules is extended four years, to give banks more time to build their liquidity buffers to full strength. The changes also include some refinements to the assumed inflow and outflow rates to reflect more realistic net outflows in times of stress. Two reasons are brought forward for the softening of the rules:

Concern over the costs of implementation; the risk that banks’ funding might fall short as they adjust their balance sheets. Two recent studies, one by the clearing house and the other by a group attached to the European Banking Authority, pointed this risk out. On the other hand, postponing the deadline might switch banks’ funding to unsecured bonds too slowly, leaving central banks and “the common man” more exposed to risk as a result.
The recognition that the old definitions of liquid assets no longer suffice since the bonds of some euro-zone governments are not as liquid or creditworthy as they once were

Once the LCR has been fully implemented (2019), its 100% threshold will be a minimum requirement in normal times. During a period of stress, it would be appropriate for banks to use their stock of HQLA, thereby falling temporarily below the minimum. The LCR will be introduced as planned on 1 January 2015, but the minimum requirement will begin at 60%, rising in equal annual steps of 10 percentage points to reach 100% on 1 January 2019. This graduated approach is designed to ensure that the LCR can be introduced without disruption to the orderly strengthening of banking systems or the ongoing financing of economic activity. The corresponding timetable is given below.

Net stable funding ratio

The net stable funding ratio is designed to ensure that a bank holds an amount of long-term funding at least equal to its long-term assets, such as lending.

Impact of changes

The results of the impact study done by the as well as the impact hereof, are discussed below. The estimates assume full implementation of the final Basel III package, based on data as of 31 December 2009. Cooperating banks are split in two groups: Group 1 banks are those that have Tier 1 capital in excess of 3 billion euro, are well diversified, and are internationally active. All other banks are considered to be Group 2 banks. Note that banks which are likely to fall short on the required ratio’s will not participate in the sample, leading to optimistic results.

Capital

Capital ratio’s are presented in Table 1. The ratio’s are first calculated under prevailing rules and subsequently under the Basel III accord, leading to a reduction
in the capital ratio’s.

The change in the definition of capital (e.g. deductions) would on average reduce the CET1 capital of Group 1 and Group 2 banks by 42.1% and 33.4% respectively. Due to the tighter capital requirements, cost of funding may increase reducing profitability and return on equity. In the same light, increasing the capital base (building buffers) might reduce dividends paid resulting in loss of interest by investors in bank debt and equity. Additionally the changed capital structure may lead firms to withdraw from certain entities and buyout minority interest positions.

Changes in risk-weighted assets

Risk-weighted assets (RWA) increase, as displayed in Table 2, due to charges against counterparty credit risk, securitisations and those coming from the new definition of capital.

Because of the increase in RWA’s it will be tougher to meet the higher capital ratio’s, as RWA’s constitute the denumerator of capital ratio.

Leverage ratio

Results of calculated leverage ratio’s from the study by (CEBS 2010) are outlined in Table 3. The introduced leverage ratio might lead to a decreasing demand for
lending driving the price for it up.

Liquidity

Liquidity ratio’s calculated under the Basel III framework is outlined in Table 4 below. These liquidity standards should reduce the impact of a bankrun and therefore improve the stability of the financial sector. On the other hand, this is costly and might negatively impact profitability. Additionally, demand for long-term funding will increase.

Above results are slightly outdated, but the tendency is consistent with most literature on the impact of the Basel III framework. In summary, the proposed capital and liquidity requirements might increase the cost of funding and accordingly reduce capacity of banking activities. In addition, weaker banks might be unable to meet the new Basel III criteria reducing competition. These negative effects can be compensated by the positive effect of reducing the risk on an individual banking failure reducing the risk of another banking crisis.

Legal authority

Although the Basel Committee formulates international supervisory standards and guidelines it has no legal authority. Within the European Union, the passing of Basel banking standards into legislation has until this time been achieved through the means of directives, which in turn were implemented through national measures.

The Capital Requirements Directive (CRD) that implemented Basel II throughout the EU came into force on 1 January 2007. The legal framework has since been regularly updated to reflect revisions to Basel II by series of amendments, which are sequentially numbered for ease of reference.

The CRD IV implements certain Basel III proposals, particularly these concerning the capital conservation and counter-cyclical buffers. However, the most significant part of Basel III/CRD IV is implemented by direct regulation, without the need to be written into national law. This is done in order to “maximize harmonization”. This is designed to prevent EU member states of adding EU legislation.

Time horizon

The transitional arrangement (displayed in Figure 2) for implementing the new standards will help to ensure that the banking sector can meet the higher capital
standards through reasonable earnings retention and capital raising, whilst still supporting lending to the economy.

Discussion

All the changes introduced by the Basel III framework emphasize higher capital requirements for banks over the coming years. There is also the possibility of an increase of the firm’s risk-weighted assets, depending on the firm’s circumstances. The combination of additional capital requirements and higher charges will probably cause some negative impact on return on equity. Additionally, debt-like hybrid instruments that previously enabled banks to respond to capital demands on a relatively cheap basis will generally be no longer available. Raising capital through issuing common equity is in general the most expensive form for a bank. This will crowd out weaker banks, leading to a reduction in the number of competitors.

Due to the resulting increase in demand for common equity, expected is an increase in the supply of contingent convertible (CoCo) instruments. Because of the equity-like behaviour of these CoCos, supervisors have reasons to treat them as core T1 capital. As these instruments only become common equity after passing a particular margin, which is for a lot of banks very unlikely to happen in the near future, it might be inappropriate to treat them as core T1 capital.

Adopting the countercyclical capital buffer proposal to ensure the leverage ratio will not be compromised in crisis situations seems very important: in good times, dividends, share buyback policies and bonuses will be restrained as necessary to build back buffers used up in bad times. On the other hand, because credit lags the cycle, the identification of a ‘bubble’ (leading to provisioning to offset it) could easily occur at a time when the economy is already beginning to turn down, exacerbating the cycle. This could be a reason for the countercyclical buffer to perform poorly.

Another concern is that Basel III does not deal with the most fundamental regulatory problem identified: that the ‘promises’ that make up any financial system, are not treated equally, transforming risk buckets. For example, the CDS contract makes it possible to reduce risky debt to some combination of the lower bank risk weight and a small weight that applies to moving the risk outside of the bank sector.

In addition, there is (still) a massive incentive in financial markets to transform risk in credit to avoid capital charges and reduce tax burdens for clients, thereby maximizing returns for themselves and their customers. This will probably continue despite the proposed reforms.

References

BCBS (2010a), ‘Basel III: A global regulatory framework for more resilient banks
and banking systems’, Bank for International Settlements.

BCBS (2010b), ‘Basel III: International framework for liquidity risk measurement,
standards and monitoring’, Bank for International Settlements.

CEBS (2010), ‘Results of the comprehensive quantitative impact study’.