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.
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)
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
- Why do reserves in banks have a zero weighting in terms of risk-based assets?
- What items have a 100% weighting? Explain why.
- Examine the table, Basel III phase-in arrangements, and explain each of the terms.
- 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?
- Explain each of the items in the Basel III capital-adequacy requirements shown in the chart above.
- What is the American case for imposing an output floor?
- What is the European banks’ case for using their own risk weighting?
- Why is it proposed that larger ‘systemically important banks’ (SIBs) should have an additional capital requirement?
- How does the balance of assets of American banks differ from that of European banks?
The Brexit vote has caused shockwaves throughout European economies. But there is a potentially larger economic and political problem facing the EU and the eurozone more specifically. And that is the state of the Italian banking system and the Italian economy.
Italy is the third largest economy in the eurozone after Germany and France. Any serious economic weaknesses could have profound consequences for the rest of the eurozone and beyond.
At 135% of GDP, Italy’s public-sector debt is one the highest in the world; its banks are undercapitalised with a high proportion of bad debt; and it is still struggling to recover from the crisis of 2008–9. The Economist article elaborates:
The adult employment rate is lower than in any EU country bar Greece. The economy has been moribund for years, suffocated by over-regulation and feeble productivity. Amid stagnation and deflation, Italy’s banks are in deep trouble, burdened by some €360 billion of souring loans, the equivalent of a fifth of the country’s GDP. Collectively they have provisioned for only 45% of that amount. At best, Italy’s weak banks will throttle the country’s growth; at worst, some will go bust.
Since 2007, the economy has shrunk by 10%. And potential output has fallen too, as firms have closed. Unemployment is over 11%, with youth unemployment around 40%.
Things seem to be coming to a head. As confidence in the Italian banking system plummets, the Italian government would like to bail out the banks to try to restore confidence and encourage deposits and lending. But under new eurozone rules designed to protect taxpayers, it requires that the first line of support should be from bondholders. Such support is known as a ‘bail-in’.
If bondholders were large institutional investors, this might not be such a problem, but a significant proportion of bank bonds in Italy are held by small investors, encouraged to do so by tax relief. Bailing in the banks by requiring bondholders to bear significant losses in the value of their bonds could undermine the savings of many Italians and cause them severe hardship, especially those who had saved for their retirement.
So what is the solution? Italian banks need recapitalising to restore confidence and prevent a more serious crisis. However, there is limited scope for bailing in, unless small investors can be protected. And eurozone rules provide little scope for government funding for the banks. These rules should be relaxed under extreme circumstances. At the same time, policy needs to focus on making Italian banking more efficient.
Meanwhile, the IMF is forecasting that Italian economic growth will be less than 1% this year and little better in 2017. Part of the problem, claims the IMF, is the Brexit vote. This has heightened financial market volatility and increasead the risks for Italy with its fragile banking system. But the problems of the Italian economy run deeper and will require various supply-side policies to tackle low productivity, corruption, public-sector inefficiency and a financial system not fit for purpose. What the mix of these policies should be – whether market based or interventionist – is not just a question of effectiveness, but of political viability and democratic support.
The Italian Job The Economist (9/7/16)
IMF warns Italy of two-decade-long recessionThe Guardian, Larry Elliott (11/7/16)
Italy economy: IMF says country has ‘two lost decades’ of growth BBC News (12/7/16)
What’s the problem with Italian banks? BBC News, Andrew Walker (10/7/16)
Why Italy’s banking crisis will shake the eurozone to its core The Telegraph, Tim Wallace Szu Ping Chan (16/8/16)
If You Thought Brexit Was Bad Wait Until The Italian Banks All Go Bust Forbes, Tim Worstall (17/7/16)
In the euro zone’s latest crisis, Italy is torn between saving the banks or saving its people Quartz, Cassie Werber (13/7/16)
Why Italy could be the next European country to face an economic crisis Vox, Timothy B. Lee (8/7/16)
Forget Brexit, Quitaly is Europe’s next worry The Guardian, Larry Elliott (26/7/16)
Italy IMF Country Report No. 16/222 (July 2016)
Economic Outlook OECD (June 2016) (select ‘By country’ from the left-hand panel and then choose ‘Italy’ from the pull-down menu and choose appropriate time series)
- Can changes in aggregate demand have supply-side consequences? Explain.
- Explain why there may be a downward spiral of asset sales by banks.
- How might the principle of bail-ins for undercapitalised Italian banks be pursued without being at the expense of the small saver?
- What lessons are there from Japan’s ‘three arrows’ for Italy? Does being in the eurozone constrain Italy’s ability to adopt any or all of these three categories of policy?
- Why may the Brexit vote have more serious consequences for Italy than many other European economies?
- Find out what reforms have already been adopted or are being pursued by the Italian government. How successful are they likely to be in increasing Italian growth and productivity?
- What external factors are currently (a) favourable, (b) unfavourable to improving Italian growth and productivity?
Jim Slater, who has just died at the age of 86, was a tycoon of the 1970s, probably unknown to most reader of this blog. But his legacy lives on and many will question whether the actions of the banking sector and big business today is a reflection of the lessons that were not learnt 40 years ago.
Slater was a businessman: perhaps the businessman in the 1970s, building up a company that in today’s money and the height of its success, would have been worth billions. Buying and selling companies, asset stripping and investing created Slater Walker, which shot to success and then crumbled to failure, taking with it a bailout from the Bank of England of £110 million. You might look at that figure and compare it with the bail outs of more recent times and think – peanuts. But think about how prices have changed and convert £110 million into today’s money and that’s a hefty bail out. A key question is whether the willingness of the government and Bank of England to bail out key banks and financial sector businesses has encouraged the irresponsible lending that led to the credit crunch. Was there a moral hazard? Had Slater Walker been left to fail, would the world look a slightly different place?
Perhaps a little extreme, but I wonder, if we were to look back over the past 50 to 60 years, whether we would find other cases of key businesses being bailed out, which set a precedent for other companies to grow, without necessarily taking full responsibility for it. Jim Slater will certainly leave a legacy behind him .
Jim Slater and the warning from the 1970s that we ignored BBC News, Jonty Bloom (20/11/15)
- What is meant by asset stripping?
- If a company like Slater Walker had not been bailed out, do you think the economy would have suffered?
- If Slater Walker had been left to fail, would that have changed the business model of some of our largest banks and reduced the chance of a financial crisis 40 years later?
- Do you think the concept of moral hazard is relevant here?
Lloyds Banking Group has announced that it plans to reduce its labour force by 9000. Some of this reduction may be achieved by not replacing staff that leave, but some may have to be achieved through redundancies.
The reasons given for the reduction in jobs are technological change and changes in customer practice. More banking services are available online and customers are making more use of these services and less use of branch banking. Also, the increasingly widespread availability of cash machines (ATMs) means that fewer people withdraw cash from branches.
And it’s not just outside branches that technological change is impacting on bank jobs. Much of the work previously done by humans is now done by software programs.
One result is that many bank branches have closed. Lloyds says that the latest planned changes will see 150 fewer branches – 6.7% of its network of 2250.
What’s happening in banking is happening much more widely across modern economies. Online shopping is reducing the need for physical shops. Computers in offices are reducing the need, in many cases, for office staff. More sophisticated machines, often controlled by increasingly sophisticated computers, are replacing jobs in manufacturing.
So is this bad news for employees? It is if you are in one of those industries cutting employment. But new jobs are being created as the economy expands. So if you have a good set of skills and are willing to retrain and possibly move home, it might be relatively easy to find a new, albeit different, job.
As far as total unemployment is concerned, more rapid changes in technology create a rise in frictional and structural unemployment. This can be minimised, however, or even reduced, if there is greater labour mobility. This can be achieved by better training, education and the development of transferable skills in a more adaptive labour force, where people see changing jobs as a ‘normal’ part of a career.
Lloyds Bank cuts 9,000 jobs – but what of the tech future? Channel 4 News, Symeon Brown (28/10/14)
Lloyds Bank confirms 9,000 job losses and branch closures BBC News, Kamal Ahmed (28/10/14)
Lloyds job cuts show the technology axe still swings for white collar workers The Guardian, Phillip Inman (28/10/14)
Unleashing Aspiration: The Final Report of the Panel on Fair Access to the Professions Cabinet Office (July 2009)
Fair access to professional careers: a progress report Cabinet Office (30/5/12)
- Is a reduction in banking jobs inevitable? Explain.
- What could banks do to reduce the hardship to employees from a reduction in employment?
- What other industries are likely to see significant job losses resulting from technological progress?
- Distinguish between demand-deficient, real-wage, structural and frictional unemployment. Which of these are an example, or examples, of equilibrium unemployment?
- What policies could the government pursue to reduce (a) frictional unemployment; (b) structural unemployment?
- What types of industry are likely to see an increase in employment and in what areas of these industries?
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.
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)
- Explain what are meant by the various Basel III capital adequacy requirements
- What are the banks which were identified as having a capital shortfall doing about it?
- Would it be desirable for banks to issue additional shares? Would this make the banks more secure?
- Would the raising of additional capital allow additional credit creation to take place? Explain.
- What other constraints are there on bank lending?