Basel III

Basel III has arrived! The official BIS press release is here, with a wealth of
information inside it. But they conveniently also supply this table, which gets
to the core of the matter:

There’s a lot to unpack and explain here. But the first thing to note is that
we’ve moved from a simple “Tier 1 has to be 4%, Tier 2 has to be 8%” to a
3×3 matrix with all manner of different minima. It’s a bit more complicated, but
it’s also more intelligent, and should be much more effective as well.
Possibly the most important thing here is the existence of the first column,
setting minimum standards for common equity — which is also known as core
Tier 1 capital. Such standards did exist in the past, but they were set
extremely low, at just 2%, and so were generally ignored. As of now, common
equity is the main thing that matters. No more throwing any old garbage into
the Tier 1 bucket and calling it capital: the new standards for common equity
are significantly tougher than the old standards for Tier 1 capital in total.
The absolute bare minimum for core Tier 1 capital is 4.5%, and the new
minimum for Tier 1 capital in general has now been raised to 6%. The
minimum for Tier 2 remains at 8%.
But that’s just the beginning. On top of that there’s a “conservation buffer” of
another 2.5 percentage points; to a first approximation, any bank you’ve
heard of is going to want to be well outside that buffer, because they won’t be
able to pay dividends if they don’t have the full buffer in place. If there’s some
kind of crisis and they’re forced to write down a lot of bad loans, they can eat
into the buffer — but that will bring extra regulatory oversight, and they won’t
be able to pay dividends. That’s sensible.
With the conservation buffer, then, banks need 7% common equity, 8.5% Tier
1 capital, and 10.5% Tier 2 capital.
And it doesn’t stop there, either. When credit in an economy is growing faster
than the economy itself, a countercyclical capital buffer kicks in, which
essentially says that banks need to have more capital in good times. That
countercyclical buffer won’t be set by the BIS in Basel; it’ll be left up to
national regulators. But you can probably expect the UK, US, and Switzerland
to enforce it up to the maximum of 2.5%.
So when the economy’s booming, banks are going to need 9.5% common
equity, 11% Tier 1 capital, and 13% Tier 2 capital.
But wait, there’s more! “Systemically important banks should have loss
absorbing capacity beyond the standards announced today,” says the BIS —
we don’t know what they’re going to announce on that front, but the chances
are that when an announcement comes, the biggest banks are going to need
significantly more capital than what we’re seeing here.
This is all very welcome stuff. But it neither can nor should be implemented
overnight. Instead, there’s a timetable built in to the new capital standards:

This is even more complicated, obviously, than the capital standards

themselves. But in a nutshell, the standards start being phased in on January
1, 2013, with a core Tier 1 requirement of 3.5%. That rises to the final 4.5% in
2015. Other parts of the structure take longer, but they’re all phased in by
January 1, 2019 — which is more than enough time for the world’s banks to
raise any extra capital they might need.
Meanwhile, various dubious things which currently count as Tier 1 or Tier 2
capital but shouldn’t will be phased out even more slowly, over a period of 10
years beginning in 2013.
Other key parts of the Basel III regime, which weren’t announced today, will
also come during these years: the liquidity coverage ratio gets introduced in
2015, while the net stable funding ratio arrives in 2018.
The banks aren’t going to take all this lying down, but I’m hoping their reaction
is going to be relatively muted. This is a done deal, now, and they just have to
live with it. And the banks which embrace the new standards and are proud of
exceeding them will ultimately be more successful than those which try to get
around them. Indeed, it would be great to see non-bank lenders adopt these
standards too, on a voluntary basis. Most shadow banks easily exceed these
ratios already, and I’d love to see the ones which don’t slowly wither away.
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COMMENTS
4 COMMENTS SO FAR | COMMENTS RSS
Sep 12, 2010
5:55 pm EDT
Well done, Felix! Basel III will certainly strengthen bank capital positions. However,
there is a certain blithe assumption that raising capital requirements will result in an
increase in bank capital. Capital ratios can be raised by increasing capital or
reducing activities. Governments are counting on the former; I wonder if they will be
pleased if the latter occurs.
Posted by Too_Late | Report as abusive

Sep 12, 2010

7:37 pm EDT
Thanks. Excellent review. FYI http://bit.ly/bIztdC
Posted by polit2k | Report as abusive

Sep 13, 2010

12:02 am EDT
Basel III keeps looking at the gorilla called perceived risk, while losing track of the
ball.
In Basel III you will find that most of the capital requirements are “in relation to risk-
weighted assets (RWAs)” and, since what is most wrong with Basel II are precisely
the risk-weights, which for instance counts any investment or loan to a private triple-
A rated client at only 20%, and which was precisely what drove the banks to
stampede after the triple-A rated securities collateralized with lousily awarded
mortgages to the subprime sector, and the risk weights have not been modified at
all, let me assure you that the Basel Committee still has no idea about what they are
doing. Frightening!
Basel III does mention that “These capital requirements are supplemented by a non-
risk-based leverage ratio that will serve as a backstop to the risk-based measures
described” but since that supplement seemingly will be small and what really counts
are the marginal capital requirements for different assets Basel III does not provide a
solution.
Fact is that if a bank lends to a small business then it needs 8 percent in capital but if
it instead lends that money to the government of a sovereign rated AAA to AA then
the bank needs no capital for the risk-weighted assets since the weight is 0%… this
is sheer lunacy!
The members of the Basel Committee are all still so fixated with looking at the gorilla
called “perceived risk” so as to completely lose track of the ball.
Per Kurowski
A former Executive Director at the World Bank