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Basel III: Enhancements to Basel II: Firm-specific changes

Basel II framework and global banking regulations weaknesses and loopholes were exposed in the recent financial crisis. The ineffectiveness of the existing system in preventing bank failures that resulted in subsequent huge taxpayer bailouts has led the Basel Committee to propose significant reforms to Basel II in what is now known as Basel III. These changes will be implemented over a six-year period beginning from January 2013. Basel III aims to address both firm-specific risk as well as system-specific system risk factors. In the following post we will discuss some of the major changes that will be made to the firm-specific (micro-prudential) framework:

1.       A stricter definition for capital:

Basel III aims to improve and raise the quality of capital held by banks. Banks will be required to hold a greater amount of tangible common equity (minimum raised to 4.5% against the current 2% of risk weighted assets) which has the greatest loss-absorbing capacity.

Common equity forms a part of Tier 1 Capital. There are also stricter criteria for other instruments that will be considered as part of Tier 1 Capital. These instruments must be able to absorb losses for the bank on a “going-concern” basis, i.e. it assumes that this capital will allow the bank to remain solvent. Tier 1 capital will include high quality capital and will no longer be allowed to include new innovative capital products. Minimum Tier 1 capital is proposed to be 6% of risk weighted assets.

Tier 2 capital will include instruments that will have a loss absorbing capacity for the bank on a “gone concern” basis, i.e. the capital should be able cover losses following insolvency and upon liquidation.

Tier 3 capital will cease to exist and there will be greater standardization and harmony between the deductions that will be required to be made from capital. Also there will be greater transparency and market discipline where banks will be required to make full disclosure regarding and reconcile all capital requirements.

Minimum Total capital requirements is proposed to be 8% of risk weighted assets.

2.       Strengthened liquidity requirements:

Banks will need to hold more liquid capital. The banks will need to hold highly liquid assets that would be easily convertible to cover cash outflows over a 30-day stressed period. Besides this 30-day Liquidity Coverage Ratio (LCR= (High Quality Assets)/(30 calendar -day Net cash Outflows) ? 100%) banks will also have to maintain a Net Stable Funding Ratio. The latter has been introduced to address mismatches between the maturities of a bank’s assets and liabilities and to promote more medium and long term funding of the bank’s assets and activities.

3.       An improved and enhanced level of risk coverage:

Risk weights have been recalibrated and refined in order to account for assets that would be considered low risk during normal market conditions but which could suddenly become very risky during periods of economic stress or other systemic crisis. These assets especially those that relate to capital market activities including:

  1. Those on the trading book. The regulatory arbitrage that currently exists between the banking and trading book will be eliminated under Basel III.
  2. Securitized products.
  3. OTC derivatives and repos. The counterparty credit risk will now also be accounted for more effectively under Basel III.

The capital requirements for counterparty credit risks will be determined using stressed inputs. A credit value risk adjusted (CVA) capital charge will also be assessed to cover the risk of mark-to-market losses on the expected counterparty risk  to OTC derivatives.

Sovereign risks will no longer be considered risk free but rather will be assigned weights reflecting low risk.

There are concerns that the need for higher quality more liquid capital would mean that there would be a bias towards government bonds. This could mean less lending to the private sector which could have its own adverse implications. In addition to this the supervisors may be underestimating the riskiness of sovereign debt.

Also, under Pillar 1 of the Basel III framework as in the case of Basel II, the risk weights still relies on portfolio invariance (i.e. capital required to back loans depends only on the risk of that loan, not on the portfolio to which it is added). It therefore does not adequately penalize concentrations in portfolio by requiring additional capital which again is left for Pillar 2.

4.       Distribution policies that are consistent with sound capital conservation principles:

Basel III introduces a 2.5% capital conservation buffer above the minimum requirements. This buffer will need to be held in tangible common equity and it will ensure that the interests of the bank’s shareholders, employees and other capital providers are not put ahead of those of its depositors. The buffer prevents the inappropriate distribution of capital as bonuses, dividends, etc when capital strength is weakened due to periods of economic and financial stress.

It is built up in good times and can be drawn down during periods of stress. The buffer is there to ensure that during bad times the regulatory minimum will not be breached.

There are apprehensions that this buffer could raise investor concerns regarding future dividends, etc which could lead to problems in raising the required amount of capital.

In the post we addressed some of the main enhancements made in the Basel II framework at a firm specific, micro-prudential level. Basel III has also introduced a number of macro-prudential measures to deal with systemic risk factors. These are discussed in the next post.

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