What is Basel III and who is making the decisions? Basel III is a set of proposed changes to international capital and liquidity requirements and some other related areas of banking supervision. It is the second major revision to an original set of rules, now known as Basel I, which was promulgated by the Basel Committee in 1988. The committee was established in the mid? 1970’s, after the failure of a small German bank (Herstatt) sent shudders through the global financial system as a result of poor coordination between national regulators.
The Basel Committee is composed of banking regulators from a number of industrialized countries, with a core membership concentrated in the traditional banking powers within Europe, plus the US and Japan. The Basel accords are not formal treaties and the members of the committee do not always fully implement the rules in national law and regulation. One prominent example of this is in the United States. We had not implemented the Basel II revisions for our commercial banks by the time of the financial crisis, which put any such changes on hold.
It is not clear whether we would eventually have implemented them, despite having been closely involved in the negotiations that led to that agreement. In truth, few countries choose to implement every detail of the Basel accords and they sometimes find unexpected ways to interpret the aspects they do implement. Despite this, the accords have led to much greater uniformity of capital requirements around the globe than existed prior to Basel I. In fact, the uniformity extends well beyond the countries represented on the Basel Committee, as most nations with significant banking sectors have modeled their capital regulation on the Basel rules.
The Basel Committee is loosely affiliated with the Bank for International Settlements (BIS) which is often referred to as the club for the world’s central bankers. The BIS provides certain financial services to central banks and also serves as a vehicle to promote cooperation between them. In addition, it provides support services to the Basel Committee and several other multi? lateral bodies focused on the world’s financial systems. Prominent among these is the Financial Stability Board (FSB) which was charged last year by the heads of government of the Group of Twenty (G? 0) nations with the mission of promoting financial stability around the world. In that capacity, it has been a prominent advisor to the Basel Committee in its work on Basel III. What is the timetable for Basel III? The G? 20 heads of government have charged the Basel Committee with finalizing the Basel III rules in time for the G? 20 meeting in Seoul, Korea on November 11? 12, 2010. The process leading to that started with the issuance of consultation papers in December of 2009 that outlined the changes proposed by the Basel Committee for the capital and liquidity requirements1.
Comments were solicited by mid? April of 2010 and many parties responded at length. In parallel, the Basel Committee, with assistance from the BIS and the FSB, has been conducting a Quantitative Impact Study (QIS) to estimate the potential effects on the financial markets and the economy of putting in place the proposed changes. It appears that the QIS has been completed in draft form and is being reviewed by the Basel Committee and themember regulators. Release to the public is expected in September, although there is no announced deadline for this.
The QIS will presumably influence the Basel Committee’s choices on the levels of certain key ratios and on any revisions that it deems necessary to the elements of the original proposal. The intention is to implement Basel III by the end of 2012, although it seems clear that there will be transition periods, observation periods, or phase? ins for a number of the more important requirements, as well as “grandfathering” of certain features of existing regulation.
All of these exceptions would be intended to ease the transitional impact of Basel III, which could potentially be quite large by the time it is entirely phased in. What are capital and liquidity? “Capital” is one of the most important concepts in banking. Unfortunately, it can be difficult for those outside the financial field to grasp, since there is no close analogy to capital in ordinary life. In its simplest form, capital represents the portion of a bank’s assets which have no associated contractual commitment for repayment.
It is, therefore, available as a cushion in case the value of the bank’s assets declines or its liabilities rise. For example, if a bank has $100 of loans outstanding, funded by $92 of deposits and $8 of common stock invested by the bank’s owners, then this capital of $8 is available to protect the depositors against losses. If $7 worth of the loans were not repaid, there would still be more than enough money to pay back the depositors. The shareholders would suffer a nearly complete loss, but this is a considered a private matter, whereas there are strong public policy reasons to protect depositors.
If bank balance sheets were always accurate and banks always made profits, there would be no need for capital. Unfortunately, we do not live in that utopia, so a cushion of capital is necessary. Banks attempt to hold the minimum level of capital that supplies adequate protection, since capital is expensive, but all parties recognize the need for such a cushion even when they debate the right amount or form. The subject of capital, and regulatory capital requirements, is a complex one and will only be summarized here. A more complete discussion can be found in “Bank Capital: A Primer”2.
As explained in that paper, common stock is not the only type of security that is considered to be capital because of the protection it provides depositors and other parties that regulators care about. Certain forms of preferred stock, and to a limited extent debt, can also serve as capital. It is worth noting that bank regulation generally uses the reported accounting numbers as the basis for calculating capital levels, without adjusting for market valuations except to the extent they are captured by standard accounting rules, such as occurs with certain “mark to market” requirements.
In particular, the market capitalization of bank stocks in the heart of the crisis tended to be substantially lower than the accounting value of the equity of these banks. Essentially, the market believed that accountingvalues were overstated or that substantial new losses would occur in the future or the market was too low for technical reasons unrelated to expectations of future performance. None of these factors would directly affect regulatory capital levels, although regulators are always wise to note these divergences in case they indicate that the market has determined that the banks are in worse shape than appears on the surface. Liquidity” refers to the ability to sell an asset, or otherwise convert it to cash, without incurring an excessive loss in doing so. Liquidity almost always increases the longer the timeframe being considered. A house, for example, may be a very illiquid asset if one needs to sell it within a week, but may be quite liquid if one is given five years to manage the sale. More broadly, the liquidity of a bank often refers to the matching of its obligations with its funding sources. A bank with highly liquid assets would generally be onsidered fairly liquid even if its funding sources were of quite short maturities, since the assets could be liquidated as needed to cover any loss of funding. A bank with less liquid assets might be fine if its funding sources were locked in for long periods, but could be in serious trouble in a panic if it relied on short? term debt or deposits that might flow away. What are the current rules? The core of the Basel rules on capital reflects a belief that the necessary level of capital depends primarily on the riskiness of a bank’s assets.
Since capital exists to protect against risk, it stands to reason that more is needed when greater risks are being taken. The focus is on the asset side because liabilities are generally known with great precision, since a deposit or a bond must be repaid based on specific contractual terms. (This is a major contrast with the insurance industry, where the future costs of promises to protect against various events, such as fires, are unknown. ) Unlike bank liabilities, bank assets can go down, or occasionally up, in value.
In particular, bank loans may not be repaid and securities may default or may need to be sold at a time when their market value has declined. The original, Basel I, rules grouped all assets into a small number of categories and applied a risk? weighting to each category. The total value of each asset is multiplied by its risk weighting and this adjusted amount is added across all assets to produce a total risk? weighted asset (RWA) figure. The percentage weighting for each category ranges from 0%, for extremely safe investments such as cash and US government securities, to 100% for riskier classes of assets. In a few cases, the weightings now exceed 100% for certain very risky assets, such as loans in default or imminent danger of default and the riskiest tranches of securitizations. ) For example, residential mortgage loans often have a 50% risk? weighting, so that a $1 million mortgage would generate a risk? weighted asset of $500,000. If a bank were trying to hold capital equal to 10% of its RWA, then it would need $50,000 of capital to cover this mortgage. The Basel II revisions made four major changes to the risk? weighted asset calculations: Refinement of categories.
Basel II broke the categories down in much greater detail than in Basel I, with more variation in the risk weighting, since it was realized that the crudeness of the original simple categories was encouraging a great deal of “gaming” and misallocation of resources. In addition to theweaknesses inherent in using a small number of categories, the weightings had been fairly arbitrary and influenced by political considerations. For example, Germany particularly wanted mortgages to carry a lower risk weighting than other bank loans. Ratings.
Ratings from the major credit rating agencies became a significant factor in the risk weightings, which had not been true when only broad categories were used. Internal risk modeling. It was agreed that the sophisticated global banks could use their own internal risk rating models to determine the risk weightings for their own particular assets, with some exceptions. The idea was to align regulatory risk calculations with the considerably more sophisticated risk models that were being used by major banks in their own decision? making. This concept counts on the self? nterest of the banks to lead them to use the best possible estimates of risk in their own management of assets. Trading assets. Basel II promulgated a different method for calculating the risk of assets that were held in trading accounts, based on the assumption that the risk level of trading assets was principally determined by how far the assets could realistically fall in value before a bank could dispose of the investments. Thus a “value at risk” (VAR) approach was used, utilizing statistical techniques to estimate from historical data how large a loss might be taken in unusually unfavorable circumstances.
Capital adequacy under the Basel Rules is determined by calculating a ratio of the level of capital to the total risk? weighted assets. Basel I defined two tiers of capital, a distinction that has been retained. “Tier 1,” the strongest, consists mainly of common stock and those forms of preferred stock that are most like common. “Tier 2” adds in certain types of preferred stock that are less like common stock and more like debt, as well as certain subordinated debt securities.
In addition, Tier 2 includes some accounting reserves that provide a protective function similar to other forms of capital3. The two tiers are intended to ensure that there is enough total capital available to handle even extreme occurrences and that the bulk of this capital is the stronger “Tier 1” variety. Generally, banks have plenty of Tier 2 capital, so the practical focus has been on ensuring there is enough of the stronger, Tier 1, form of capital. The Basel calculations include a number of deductions from the stated balance sheet figures for capital.
First, and probably most importantly, the Basel agreements require the deduction of goodwill, (which arises when a company or asset is purchased for more than its book value), effectively treating it as worthless for these purposes. Second, individual national regulators have chosen to fully exclude or tolimit the amount of certain other accounting assets. For example, U. S. regulators limit the portion of deferred tax assets that may be counted in equity, since the value of those assets would only be realized if a bank makes future taxable profits, which may not occur if it runs into the kind of trouble that makes capital important.