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Too tough or not tough enough? Developing Basel III banking rules

Under the auspices of the Bank for International Settlements (BIS), banks around the world are working their way towards implementing tougher capital requirements. These tougher rules, known as ‘Basel III’, are due to come fully into operation by 2019.

This third version of international banking rules was agreed after the financial crisis of 2008, when many banks were so undercapitalised that they could not withstand the dramatic decline in the value of many of their assets and a withdrawal of funds.

Basel III requires banks to have much more capital, especially common equity capital. The point about equity (shares) is that it’s a liability that does not have to be repaid. If people hold bank shares, the bank does not have to repay them and does not even have to pay any dividends. In other words, the money raised by issuing shares carries no obligation on the part of the bank and can thus provide a buffer against large-scale withdrawal of funds.

Under Basel III, banks have to maintain sufficiently large ‘capital-adequacy ratios’. As Essentials of Economics (7th edition) explains:

Capital adequacy is a measure of a bank’s capital relative to its assets, where the assets are weighted according to the degree of risk. The more risky the assets, the greater the amount of capital that will be required.

A measure of capital adequacy is given by the capital adequacy ratio (CAR). This is given by the following formula:

Common Equity Tier 1 (CET1) capital includes bank reserves (from retained profits) and ordinary share capital (equities), where dividends to shareholders vary with the amount of profit the bank makes… Additional Tier 1 (AT1) capital consists largely of preference shares. These pay a fixed dividend (like company bonds), but although preference shareholders have a prior claim over ordinary shareholders on the company’s (i.e. the bank’s) profits, dividends need not be paid in times of loss.

Tier 2 capital is subordinated debt with a maturity greater than 5 years. Subordinated debt holders only have a claim on a company (a bank) after the claims of all other bondholders have been met.

Risk-weighted assets are the total value of assets, where each type of asset is multiplied by a risk factor. Under the Basel III accord, cash and government bonds have a risk factor of zero and are thus not included. Interbank lending between the major banks has a risk factor of 0.2 and is thus included at only 20 per cent of its value; residential mortgages under 60% of the value of the property have a risk factor of 0.35; personal loans, credit-card debt and overdrafts have a risk factor of 1; loans to companies carry a risk factor of 0.2, 0.5, 1 or 1.5, depending on the credit rating of the company. Thus the greater the average risk factor of a bank’s assets, the greater will be the value of its risk weighted assets, and the lower will be its CAR.

Basel III gives minimum capital requirements that are higher than under its predecessor, Basel II. Thus, by 2019, banks must have a common equity capital to risk-weighted assets of at least 4.5% and a Tier 1 ratio of at least 6.0%. The overall CAR should be at least 8%. In addition, the phased introduction of a ‘capital conservation buffer’ from 2016 will raise the overall CAR to at least 10.5 per cent.

Over the past few years, banks have increased their capital cushions significantly and many have exceeded the Basel III requirements, even for 2019.

But the Basel Committee has been reconsidering the calculation of risk-weighted assets. Because of the complexity of banks’ asset structures, which tend to vary significantly from country to country, it is difficult to ensure that banks’ are meeting the Basel III requirements. Under proposed amendments to Basel III (which some commentators have dubbed ‘Basel IV’), banks would have to compare their own calculations with a ‘standardised’ model. Their own calculations of risk-based assets would then not be allowed to be lower than 60–90% (known as ‘the output floor’) of the standardised approach.

While, on the surface, this may seem reasonable, European banks have claimed that this would penalise them, as some of their assets are less risky than the equivalent assets in other countries. For example, Germany has argued that mortgage defaults have been rare and thus German mortgage debt should be given a lower weighting than US mortgage debt, where defaults have been more common. If all assets were assessed according to the output floor, several banks, especially in Europe, would be judged to be undercapitalised. As The Economist article states:

Analysts at Morgan Stanley estimate that global, non-American banks could see risk-weighted assets rise by an average of 18–30%, depending on the level of the output floor. Extra capital of €250bn–410bn could be needed, a tall order when earnings are thin and investors wary. The committee’s reviews of operational and market risks would add even more.

This question of an output floor was a sticking point at the Basel Committee meeting in Santiago, which ended on 30 November. Although some progress was made about agreeing to rules on risk weighting that could be applied globally, a final agreement will have to wait until the next meeting, in January – at the earliest.

Articles
Basel bust-up: A showdown looms over bank-capital rules The Economist (26/11/16)
Bank regulators fail to agree on new rules Manila Standard (2/12/16)
Bank chief Claudio Borio urges regulators to ‘stay strong’ Weekend Australian, Michael Bennet (29/11/16)
Final Basel III rules meet resistance from Europe The Straits Times (2/12/16)
This Is the Absolutely Worst Time to Weaken Global Bank Rules American Banker, Mayra Rodriguez Valladares (2/12/16)
New Basel banking rules’ impact on European economy Financial Times, Frédéric Oudéa (28/12/16)
Banks like RBS still look risky, but getting too tough could cause greater problems The Conversation, Alan Shipman (1/12/16)

BIS publications
International banking supervisory community meets to discuss the regulatory framework BIS Press Release (1/12/16)
Basel III: international regulatory framework for banks Bank for International Settlements
Basel III phase-in arrangements Basel Committee on Banking Supervision, BIS
Basel Committee on Banking Supervision reforms – Basel III, Summary Table Basel Committee on Banking Supervision, BIS

Questions

  1. Why do reserves in banks have a zero weighting in terms of risk-based assets?
  2. What items have a 100% weighting? Explain why.
  3. Examine the table, Basel III phase-in arrangements, and explain each of the terms.
  4. If banks are forced to operate with a higher capital adequacy ratio, what is this likely to do to bank lending? Explain. How are funding costs relevant to your answer?
  5. Explain each of the items in the Basel III capital-adequacy requirements shown in the chart above.
  6. What is the American case for imposing an output floor?
  7. What is the European banks’ case for using their own risk weighting?
  8. Why is it proposed that larger ‘systemically important banks’ (SIBs) should have an additional capital requirement?
  9. How does the balance of assets of American banks differ from that of European banks?
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The capital adequacy of UK banks

The Prudential Regulation Authority is the new UK authority in charge of banking regulation and is part of the Bank of England. In a report published on 20/6/13, the PRA found that UK banks had a capital shortfall of £27.1 billion (see Chart 1 below for details) if they were to meet the 7% common equity tier 1 (CET1) ratio: one of the capital adequacy ratios (CARs) specified under the Basel III rules (see Rebuilding UK banks: not easy to do and Chart 2 below).

CET1 includes bank reserves and ordinary share capital (‘equities’). To derive the CET1 ratio, CET1 is expressed as a percentage of risk-weighted assets. As Economics for Business (6th ed) page 467 states:

Risk-weighted assets are the total value of assets, where each type of asset is multiplied by a risk factor. …Cash and government bonds have a risk factor of zero and are thus not included. Inter-bank lending between the major banks has a risk factor of 0.2 and is thus included at only 20 per cent of its value; residential mortgages have a risk factor of 0.35; personal loans, credit-card debt and overdrafts have a risk factor of 1; loans to companies carry a risk factor of 0.2, 0.5, 1 or 1.5, depending on the credit rating of the company. Thus the greater the average risk factor of a bank’s assets, the greater will be the value of its risk weighted assets, and the lower will be its CAR.

The data published by the PRA, based on end-2012 figures, show that the RBS group is responsible for around 50% of the capital shortfall, the Lloyds Banking Group around 32%, Barclays around 11%, the Co-operative around 5.5% and Nationwide the remaining 1.5%. HSBC, Santander and Standard Chartered met the 7% requirement. The PRA found that banks already were taking measures to raise £13.7bn, but this still leaves them requiring an additional £13.4 for current levels of lending.

So what can the banks do? They must either raise additional capital (the numerator in the CAR) or reduce their risk-weighted assets (the denominator). Banks hope to be able to raise additional capital. For example, Lloyds is planning to sell government securities and US mortgage-backed securities and hopes to have a CET1 ratio of around 10% by the end of 2013. Generally, the banks aim to raise the required level of capital through income generation, the sale of assets and restructuring, rather than from issuing new shares.

What both the Bank of England and the government hope is that banks do not respond by reducing lending. While that might enable them to meet the 7% ratio, it would have an undesirable dampening effect on the economy – just at a time when it is hoped that the economy is starting to recover. As Robert Peston states:

I understand that both Barclays and Nationwide feel a bit miffed about being forced to hit this tough so-called leverage ratio at this juncture, because they are rare in that they have been supporting economic recovery by increasing their net lending.

They now feel they are being penalised for doing what the government wants. So I would expect there to be something of a spat between government and regulators about all this.

Articles
Factbox – Capital shortfalls for five UK banks, mutuals Standard Chartered News (20/6/13)
UK banks ordered to plug £27.1bn capital shortfall The Guardian, Jill Treanor (20/6/13)
Barclays, Co-op, Nationwide, RBS and Lloyds responsible for higher-than-expected capital shortfall of £27.1bn The Telegraph, Harry Wilson (20/6/13)
UK banks need to plug £27bn capital hole, says PRA BBC News (20/6/13)
Barclays and Nationwide forced to strengthen BBC News, Robert Peston (20/6/13)
Five Banks Must Raise $21 Billion in Fresh Capital: BOE Bloomberg, Ben Moshinsky (20/6/13)
Will Nationwide be forced to become a bank? BBC News, Robert Peston (4/7/13)

PRA news release and data
Prudential Regulation Authority (PRA) completes capital shortfall exercise with major UK banks and building societies Bank of England: Prudential Regulation Authority (20/6/13)

Questions

  1. Explain what are meant by the various Basel III capital adequacy requirements
  2. What are the banks which were identified as having a capital shortfall doing about it?
  3. Would it be desirable for banks to issue additional shares? Would this make the banks more secure?
  4. Would the raising of additional capital allow additional credit creation to take place? Explain.
  5. What other constraints are there on bank lending?
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