The New Global Minimum Capital Standards: perspective Basel III

Narayan Prasad Pokhrel1

Background:

Capital Adequacy Ratio (CAR) is a ratio that regulators in the banking system use to watch
bank's health, specifically bank's capital to its risk. Regulators in the banking system track a
bank's CAR to ensure that it can absorb a reasonable amount of loss. Regulators in most
countries define and monitor CAR to protect depositors, thereby maintaining confidence in
the banking system. CAR is the ratio which determines the capacity of a bank in terms of
meeting the time liabilities and other risk such as credit risk, market risk, operational risk, and
others. It is a measure of how much capital is used to support the banks' risk assets.

Bank's capital with respect to bank's risk is the simplest formulation; a bank's capital is the
"cushion" for potential losses, which protect the bank's depositors or other lenders.

The ratio is calculated by dividing sum of Tier1 and Tier2 capital by the sum of risk weighted
assets.

Two types of capital are measured for this calculation. Tier one capital is the capital in the
bank's balance sheet that can absorb losses without a bank being required to cease trading.
Tier two capital can absorb losses in the event of a winding-up and so provides a lesser
degree of protection to depositors.

Advantages of using CAR

In early phases of Basel implementations, bank's capital adequacy was calculated as assets
times’ ratio. This approach did not take risk profiles of assets into account. It is obvious that
a bank should keep more capital in reserves for riskier assets.
Since different types of assets have different risk profiles, CAR primarily adjusts for assets
that are less risky by allowing banks to "discount" lower-risk assets. So, for example, in the
most basic application, government debt is allowed a 0% "risk weighting". This also means
that government debt is subtracted from total assets for purposes of calculating the CAR.
On the other hand, investments in junior tranches of instruments collateralized with subprime
mortgages are very risky, and would be assigned 100% risk weighting.
Tier 1 Capital: This is the bank's core capital comprising of share capital, disclosed reserves and
minority interests. Some institutions expand this definition to include restricted forms of "equity-like"
capital instruments.

Tier 2 Capital: This includes supplementary Capital consisting of general loan loss reserves and
revaluation reserves on investments and properties held for investment purposes.

Risk-Weighted Assets: This includes the total assets owned. The value of each asset is
assigned a risk weight (for example 100% for corporate loans and 50% for mortgage loans)

1
Assistant Director, Nepal Rastra Bank
and the credit equivalent amount of all off-balance sheet activities. Each credit equivalent
amount is also assigned a risk weight.

Capital Requirement under Basel III

The Group of Central Bank Governors and Heads of Supervision, the oversight body of the
Basel Committee on Banking Supervision (“BCBS”), issued a press release announcing a
substantial Strengthening of the capital requirements. These elements are intended to form
part of a package of reforms to be known as Basel III. Table below shows the minimum
capital requirement under Basel III.
Calibration of the Capital Framework
Capital Requirement and buffers (%)
Common Tier 1 Total
Equity Capital Capital
Minimum 4.5 6 8

Conservation buffer 2.5

Minimum + Conservation buffer 7 8.5 10.5

Countercyclical buffer range 0 to 2.5

BCBS has 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%.
On top of that there’s a “conservation buffer” of another 2.5 percentage points; to a first
approximation, any bank which is going 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 which is
sensible.
A requirement to maintain countercyclical buffer in the range of 0% to 2.5%, consisting of
common equity or other fully loss-absorbing capital, will be phased in to protect the banking
sector from periods of “excess aggregate credit growth,” by effectively extending the
required amount of the capital conservation buffer to counter a system-wide build up of risk
resulting from such credit growth. This would be implemented based on national
circumstances.
With the conservation buffer, then, banks need 7% common equity, 8.5% Tier 1 capital, and
10.5% Tier 2 capital.
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 we could 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.

Opinion:
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. Basel III keeps looking at the gorilla called perceived risk, while losing track of
the ball.
Basel III mentions 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.
References:
BCBS press release: Group of Governors & Heads of Supervision announces higher global minimum capital
standards (12 September 2010)
BIS Press Release: Group of Governors & Heads of Supervision reach broad agreement on Basel Committee
capital & liquidity reform package (26 July 2010)
Morrison & Foerster client alert: More, More, More: A Summary of the Basel Proposals (2 February 2010),