Basel-III Norms Highlights

Atul Kumar Thakur Dec 2011

Aim Following the recent financial meltdown, the leaders of the group of G-20 economies asked the Basel Committee on Banking Supervision (BCBS) to reach the new rules needed to prevent another financial crisis in future. The aim was to mitigate the greed ridden financial crisis instead of blocking the real factors behind it. What banks will have to do? Real impression of Basel-III norms could be sensed out with the statement of Hant Wellink, Head of Basel Committee on Banking Supervision - Partly banks will have to retain profit for years which they cannot use to pay shareholders or bonuses. For another part, this will vary from bank to bank; they will have to get it from the capital market. I think it will make a new crisis less likely. Chances are much smaller, we have made calculations on this but we can't rule it out completely. The statement reflects the genuine apprehension ahead in financial market; hence life after the Basel-III norms wouldn't remain indifferent from regulatory considerations. Bird's eye view of Basel III norms selected features Basel-III norms, with its underlying proposition of insulating banks from adverse shocks by adequately enhancing the amount of its own capital holding compared to overall deposits and other borrowing can be regarded as an improved and standard set of rules over the existing Basel-II norms. The new rule comprehensively entails how to assess risks and capital management. A consensus was reached with focus on prevention of any further International Credit Crisis with provisioning more than triple of top quality capital as reserve for addressing any meltdown sort of occurrences. Predominant component of capital is common equity and retained earnings new rules restrict inclusion of items such as deferred tax assets, mortgage-servicing rights and investments in financial institutions to no more than 15% of the common equity component. The new norms are centered around the renewed focus of central bankers on macro-prudential stability. The global financial meltdown following the crisis in U.S sub-prime market has shaped the entire propositions. Basel II vs. Basel III Earlier guidelines, popularly known as Basel-II was focused on macro prudential regulation, those features being carried out in Basel-III norms as well with added advanced support. That systemizes the changed motives of regulators now they have sharp concentration on financial stability of the system in totality instead of micro regulation of any inidual bank. Under the BaselIII norms, Key Capital Ratio has been raised to 7% of risky assets - Tier-I capital that includes common equity and perpetual preferred stock will be raised from 2 to 4.5% starting in phases from January 2013 to be accomplished by January 2015. Moreover, banks will have to set aside another 2.5% as a contingency for future stress, taking the overall capital ratio or Capital Conservation Buffer to 7%. Banks that would fail to comply after the stipulated timeline would be unable to pay idends, though they will not be forced to raise cash.

A further countercyclical buffer in average of 0%-2.5% of common equity is to be imposed depending on specific circumstances of an economy to protect the banking sector from periods of excess aggregate credit growth. A liquidity buffer, much like our Statutory Liquidity Ratio (SLR) is to be made mandatory by January 2018 to check the risk based measures and higher capital norms for systemically important bank. On paper, Basel-III will triple the quantum of capital, banks will need to maintain but whether it will make the banking sector risk-proof is doubtful. Thus, regulation would decide whether Basel-III norms is light touch set of rules or indeed an effective panacea for hassle free and ethical functioning of banking system. Impact on Indian Banks RBI Governor, D. Subbarao is stoutly confident that Indian banks are not likely to be adversely impacted by the new capital rules. At the end of June 30, 2010; the aggregate capital to risk weighted assets ratio of the Indian banking system stood at 13.4% of which Tier-I capital constituted 9.3%. It wouldn't leave any pressure on Indian banks in near future though there may be some negative impact arising from shifting some deductions from Tier-I and Tier-II capital to common equity. Despite strong fundamentals, RBI should ensure even more capital than essentially stipulated under the Basel-III norms; besides stress must be given on long term capital inflow rather on risky short term investments. Apart from innovative credit policies, RBI should also stringently ensure the well capitalized subsidiary structure for foreign banks and financial institutions operating in India. Young Committee that recommended for the establishment of Bank of International Settlements (BIS) in1930 had enough sense for volatility in international financial market and greeds of bankers. Actual effects of even the best designed rules are of no value if not backed by competent, proactive and fearless supervision. Strengthening the global banking system should be and must be the aim of every new financial law but it's equally imperative to stop the adverse lobbying that makes regulation nothing more than a print order. We can safely assume this from recently enacted Dodd Frank Act (Wall Street and Consumer Protection Act) in U.S.A which is losing its effects under the stern pressure from affluent lobbyists. Regulation couldn't have any parallel while enforcing a law; our regulatory strength has recently tested during the world wide financial meltdown. Indian banking relatively emerged unscratched compared to their western counterparts. Attention is needed from developed world for compliance of rules envisaged under the Basel-III. Co-operation at international level would be the real bone of contention for an ambitious rule like Basel-III. Meanwhile let's watch the movements around the financial circle!

Basel III
From Wikipedia, the free encyclopedia

Basel III (or the Third Basel Accord) is a global, voluntary regulatory standard on bank capital adequacy, stress testing and market liquidity risk. It was agreed upon by the members of the Basel Committee on Banking Supervision in 201011, and was scheduled to be introduced from 2013 until 2015; however, changes from April 1, 2013 extended implementation until March 31, 2018.[1][2] The third installment of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III was supposed to strengthen bank capital requirements by increasing bank liquidity and decreasing bankleverage.
Contents [hide]

1 Key principles

o o o

1.1 Capital requirements 1.2 Leverage ratio 1.3 Liquidity requirements

2 Implementation

o o o

2.1 Summary of originally (2010) proposed changes in Basel Committee language 2.2 U.S. implementation 2.3 Key milestones

2.3.1 Capital requirements 2.3.2 Leverage ratio 2.3.3 Liquidity requirements

3 Analysis on Basel III impact

o o o

3.1 Macroeconomic impact 3.2 Critics 3.3 Further studies

4 See also 5 References 6 External links

Key principles[edit]
Capital requirements[edit]

The original Basel III rule from 2010 was supposed to require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of "risk-weighted assets" (RWA).[3] Basel III introduced "additional capital buffers", (i) a "mandatory capital conservation buffer" of 2.5% and (ii) a "discretionary counter-cyclical buffer", which would allow national regulators to require up to another 2.5% of capital during periods of high credit growth.

Leverage ratio[edit]
Basel III introduced a minimum "leverage ratio". The leverage ratio was calculated by dividing Tier 1 capital by the bank's average total consolidated assets;[4] The banks were expected to maintain a leverage ratio in excess of 3% under Basel III. In July 2013, the US Federal Reserve Bank announced that the minimum Basel III leverage ratio would be 6% for 8 Systemically important financial institution (SIFI) banks and 5% for their bank holding companies.[5]

Liquidity requirements[edit]
Basel III introduced two required liquidity ratios.[6] The "Liquidity Coverage Ratio" was supposed to require a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the Net Stable Funding Ratio was to require the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.[7]

Implementation[edit]
Summary of originally (2010) proposed changes in Basel Committee language[edit]

First, the quality, consistency, and transparency of the capital base will be raised.

Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings Tier 2 capital: supplementary capital, however, the instruments will be harmonised Tier 3 capital will be eliminated.[8]

Second, the risk coverage of the capital framework will be strengthened.

Promote more integrated management of market and counterparty credit risk Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit rating Strengthen the capital requirements for counterparty credit exposures arising from banks' derivatives, repo and securities financing transactions

Raise the capital buffers backing these exposures Reduce procyclicality and

Provide additional incentives to move OTC derivative contracts to qualifying central counterparties (probably clearing houses). Currently, the BCBS has stated derivatives cleared with a QCCP will be risk-weighted at 2% (The rule is still yet to be finalized in the U.S.)

Provide incentives to strengthen the risk management of counterparty credit exposures Raise counterparty credit risk management standards by including wrong-way risk

Third, a leverage ratio will be introduced as a supplementary measure to the Basel II risk-based framework,

intended to achieve the following objectives:

Put a floor under the build-up of leverage in the banking sector Introduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simpler measure that is based on gross exposures.

Fourth, a series of measures is introduced to promote the build up of capital buffers in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting countercyclical buffers").

Measures to address procyclicality:

Dampen excess cyclicality of the minimum capital requirement; Promote more forward looking provisions; Conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and

Achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth.

Requirement to use long term data horizons to estimate probabilities of default, downturn loss-given-default estimates, recommended in Basel II, to become mandatory Improved calibration of the risk functions, which convert loss estimates into regulatory capital requirements.

Banks must conduct stress tests that include widening credit spreads in recessionary scenarios.

Promoting stronger provisioning practices (forward looking provisioning):

Advocating a change in the accounting standards towards an expected loss (EL) approach (usually, EL amount := LGD*PD*EAD).[9]

Fifth,a global minimum liquidity standard for internationally active banks is introduced that includes a 30day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio called the Net Stable Funding Ratio. (In January 2012, the oversight panel of the Basel Committee on Banking Supervision issued a statement saying that regulators will allow banks to dip below their required liquidity levels, the liquidity coverage ratio, during periods of stress.[10])

The Committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically importantinstitutions.

As of September 2010, proposed Basel III norms asked for ratios as: 79.5% (4.5% + 2.5% (conservation buffer) + 02.5% (seasonal buffer)) for common equity and 8.511% for Tier 1 capital and 10.513% for total capital.[11]

U.S. implementation[edit]
The U.S. Federal Reserve announced in December 2011 that it would implement substantially all of the Basel III rules.[12] It summarized them as follows, and made clear they would apply not only to banks but also to all institutions with more than US$50 billion in assets:

"Risk-based capital and leverage requirements" including first annual capital plans, conduct stress tests, and capital adequacy "including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions" see scenario analysis on this. A risk-based capital surcharge

Market liquidity, first based on the US's own "interagency liquidity risk-management guidance issued in March 2010" that require liquidity stress tests and set internal quantitative limits, later moving to a full Basel III regime - see below.

The Federal Reserve Board itself would conduct tests annually "using three economic and financial market scenarios." Institutions would be encouraged to use at least five scenarios reflecting improbable events, and especially those considered impossible by management, but no standards apply yet to extreme scenarios. Only a summary of the three official Fed scenarios "including company-specific information, would be made public" but one or more internal company-run stress tests must be run each year with summaries published.

Single-counterparty credit limits to cut "credit exposure of a covered financial firm to a single counterparty as a percentage of the firm's regulatory capital. Credit exposure between the largest financial companies would be subject to a tighter limit."

"Early remediation requirements" to ensure that "financial weaknesses are addressed at an early stage". One or more "triggers for remediationsuch as capital levels, stress test results, and risk-management weaknessesin some cases calibrated to be forward-looking" would be proposed by the Board in 2012. "Required actions would vary based on the severity of the situation, but could include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales."[13]

It was unclear as of December 2011 how these rules would apply to insurance, hedge funds and other large financial players. The announced intent was "to limit the dangers of big financial firms being heavily intertwined."[12]

Key milestones[edit]

Capital requirements[edit]
Date Milestone: Capital Requirement

2014 Minimum capital requirements: Start of the gradual phasing-in of the higher minimum capital requirements.

2015 Minimum capital requirements: Higher minimum capital requirements are fully implemented.

2016 Conservation buffer: Start of the gradual phasing-in of the conservation buffer.

2019 Conservation buffer: The conservation buffer is fully implemented.

Leverage ratio[edit]
Date Milestone: Leverage Ratio

2011 Supervisory monitoring: Developing templates to track the leverage ratio and the underlying components.

2013

Parallel run I: The leverage ratio and its components will be tracked by supervisors but not disclosed and not mandatory.

2015 Parallel run II: The leverage ratio and its components will be tracked and disclosed but not mandatory.

2017 Final adjustments: Based on the results of the parallel run period, any final adjustments to the leverage ratio.

2018 Mandatory requirement: The leverage ratio will become a mandatory part of Basel III requirements.

Liquidity requirements[edit]
Date Milestone: Liquidity Requirements

2011 Observation period: Developing templates and supervisory monitoring of the liquidity ratios.

2015

Introduction of the LCR: Initial introduction of the Liquidity Coverage Ratio (LCR), with a requirement of 60%.

This will increase by ten percentage points each year until 2019.

2018 Introduction of the NSFR: Introduction of the Net Stable Funding Ratio (NSFR).

2019 LCR comes into full effect: Liquidity Coverage Ratio of 100% is expected of firms.

Analysis on Basel III impact[edit]

Macroeconomic impact[edit]
An OECD study[14] released on 17 February 2011, estimated that the medium-term impact of Basel III implementation on GDP growth would be in the range of 0.05% to 0.15% per year. Economic output would be mainly affected by an increase in bank lending spreads, as banks pass a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements originally effective in 2015 banks were estimated to increase their lending spreads on average by about 15 basis points. Capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points.[15] The estimated effects on GDP growth assume no active response from monetary policy. To the extent that monetary policy would no longer be constrained by the zero lower bound, the Basel III impact on economic output could be offset by a reduction (or delayed increase) in monetary policy rates by about 30 to 80 basis points.[14]

Critics[edit]
Basel III has been criticized by banks, organized in the Institute of International Finance in Washington D.C. (large American and European banks, including Goldman Sachs, Morgan Stanley, Deutsche Bank) with the argument it would hurt them and economic growth. OECD estimated that implementation of Basel III would decrease annual GDP growth by 0.050.15%,[14][16] blaming regulation as responsible for slow recovery from the late-2000s financial crisis.[17][18] Basel III was also criticized as negatively affecting the stability of the financial system by increasing incentives of banks to game the regulatory framework.[19] The American Banker's Association,[20] community banks organized in the Independent Community Bankers of America, and some of the most liberal Democrats in the U.S. Congress, including the entire Maryland congressional delegation with Democratic Sens. Cardin and Mikulski and Reps. Van Hollen and Cummings, voiced opposition to Basel III in their comments submitted to FDIC,[21] saying that the Basel III proposals, if implemented, would hurt small banks by increasing "their capital holdings dramatically on mortgage and small business loans."[22] Others have argued that Basel III did not go far enough to regulate banks as inadequate regulation was a cause of the financial crisis.[23] On January 6, 2013 the global banking sector won a significant easing of Basel III Rules, when the Basel Committee on Banking Supervision extended not only the implementation schedule to 2019, but broadened the definition of liquid assets.

Basel III Capital Regulations Please refer to the Master Circular No.DBOD.BP.BC.16/21.06.001/2012-13 dated July 2, 2012, consolidating therein the prudential guidelines issued to banks till that date on Capital Adequacy and Market Discipline - New Capital Adequacy Framework (NCAF). 2. As you are aware, Basel III Capital Regulations is being implemented in India with effect from April 1, 2013 in a phased manner. Accordingly, instructions contained in the aforesaid Master Circular have been suitably updated / amended by incorporating relevant guidelines, issued up to June 30, 2013 and is being issued as Master Circular on Basel III Capital Regulations. 3. The Basel II guidelines as contained in the Master Circular DBOD.No.BP.BC.9/21.06.001/2013-14 dated July 1, 2013 on Prudential Guidelines on Capital Adequacy and Market Discipline- New Capital Adequacy Framework (NCAF) may, however, be referred to during the Basel III transition period for regulatory adjustments / deductions up to March 31, 2017.