Big challenges face the global community in making its financial institutions more resilient to withstand the difficulties that arise from the macroeconomic environment and, at the same time, better aligning their private interests with those of wider society.
This is no easy task. It is not easy either to keep tabs on the international responses to try and deliver these aims.
This is no better illustrated by some of the recent changes to the capital requirements of financial institutions outlined by the Basel Committee on Banking Supervisions. (Click here for a PowerPoint of the above chart.) The so-called Basel III framework will, in effect, increase the capital that banks are required to hold and, in particular, specific types of capital. In the process this will reduce gearing, i.e. the amount of assets relative to capital. Recent announcements have detailed how large global banks will have to hold even more capital. This blog tries to make sense some of the changes afoot. Further reading is identified below.
The details of the Basel III framework are complex, there are an enormous amounts of financial acronyms to sift through and the definitions of capital change from time. But, at the heart of the proposals is the aim of increasing the resilience of our financial institutions. To do this the proposals focus predominantly on the liability side of a bank’s balance sheet. More specifically, they focus on long-term liabilities which help banks to resource their assets, i.e. to fund their provision of credit (their assets). This capital is ranked by its quality or by tiers; this terminology has recently changed.
Tier 1 capital is now split into two groups: Common Equity Capital (CET1) and Additional Tier 1 (AT1). The former – the ‘best’ capital – is made up of common equity (ordinary share capital) and retained profits. Holders of common equity can expect to receive dividend payments, but these are discretionary, largely dependent on the financial well-being of the firm. The remainder of CET1 are the retained profits of the firms and, hence, that parts of profits which are not distributed to its shareholders (owners). Additional Tier 1 capital – ‘second best’ capital – comprises preference shares and perpetual subordinated debt. Preference shares are more akin to bonds and provide regular coupons. However, their payment continue to place a burden on firms during more difficult financial times. Subordinated debt is debt where the creditors would not have any financial redress before depositors and other creditors have been attended to. Perpetual subordinated debt (bonds) is debt with no maturity date. Finally, Tier 2 capital is subordinated debt where the time to maturity is greater than five years.
The Basel III framework outlines a series of ratios known as Capital Adequacy Ratios (CARs) that financial institutions should meet. The ratios define a type of capital (numerator) relative to risk-weighted assets (denominator). The denominator involves weighting a bank’s category of assets by internationally agreed risk factors. These range from zero for government debt instruments to 1.5 for certain types of loans to companies. In other words, the more risky a given level of assets are the greater is the denominator and the lower is the financial institution’s capital adequacy.
From January 2013, the so-called ‘hard core minimum’ of Basel III, which is a combined level of Tier 1 and Tier 2 capital, will need to be the equivalent to 8 per cent of the bank’s risk-weighted assets. This is actually unchanged from Basel II. But, it is not quite as simple as this. First, the composition of capital matters. The overall 8 per cent ratio must be meet by a Common Equity Capital (CET1) ratio, including retained reserves, of no less than 4.5 per cent (previously 2 per cent). Second, there is the phasing-in between 2016 and 2019 of additional Common Equity Capital (CET1) equivalent to 2.5 per cent of risk-weighted assets. This is known as the Capital Conservation Buffer. Third, depending on the assessment of national regulators/supervisors, like the Bank of England here in the UK, financial institutions generally could be required to hold further Common Equity Capital of between 0 per cent and 2.5 per cent of risk weighted assets. This is known as a Counter-Cyclical Buffer. So, for instance, if the regulators/supervisors become unduly worried by rates of credit growth, they can impose additional capital requirements. This is an example of macroeconomic prudential regulation because it focuses on the financial system rather any one single financial institution.
In September 2011, Basel III added a fourth qualification to the ‘hard core’. This too will be phased-in from 2016. It is to be applied to those financial institutions, which through a series of indicators, such as size, are to be identified as global systemically important financial institutions (G-SIFIs). Depending on their global systemic importance the amount of CET1 relative to risk weighted assets could increase by between a further 1 to 2.5 per cent (and even by as much as 3.5 per cent, if necessary). These four qualifications could take the overall capital adequacy ratio from 8 per cent to as much as 15.5 per cent: 8 per cent plus 2.5 per cent capital conservation buffer plus 2.5 per cent for G-SIB surcharge plus 2.5 per cent for counter-cyclical buffer.
However, capital requirements may be even more stringent in the UK for retail banks. The UK’s Independent Commission on Banking has proposed that retail banks in the UK become legally, economically and operationally independent of the investment part of banks. In other words, that part of the bank which focuses on deposit-taking from households and firms be separated from the investment bank which largely provides services involving other financial institutions. The ICB proposed in its report last Autumn that the separate retail subsidiary faces an overall CAR of between 17 to 20 per cent with a CET1 ratio of at least 10 per cent. We will have to wait to see whether this comes to pass as the government’s legislation passes through Parliament, but it is not expected that the ICB’s proposals come into force before 2019.
Recommended Materials
Final Report: Recommendations Independent Commission on Banking , September 2011. (See Chapter 4 for a readable overview of Basel III and the general principles involved. See Chapter 3 for a discussion of the functional separation of retail and investment banking).
Basel Committee on Banking Supervision reforms – Basel III Bank for International Settlements
Articles
Basel III – the case for the defence Financial Times (23/1/12)
Finance: Banks face a perfect storm that is getting worse Financial Times, Patrick Jenkins (24/1/12)
Banks in EU, US and Japan to face capital reviews BBC News (9/1/12)
Questions
- What is meant by capital and by capital adequacy?
- Explain the construction of a Capital Adequacy Ratio. Distinguish between the CET1 ratio and the overall CAR ratio.
- What do you understand by macro-prudential regulation?
- How do liquidity and capital adequacy differ?
- If financial institutions provide deposits to individuals who can draw out their money readily but extend credit over long periods of time, why don’t financial institutions regularly face financial problems?
Germany is the world’s fourth largest economy and Europe’s largest. Part of its strength has come from its exports, which last year increased by 11.4% to $1.3 trillion – the first time it had ever exceed the $1 trillion mark. Germany, however, is by no means the country with the largest export sector – that mantle was taken from them by China, whose exports rose 20.3% last year to reach $1.9 trillion.
At the same time as exports have been rising from Germany, imports have also increased, showing a recovery in domestic demand as well. Despite this, Germany’s foreign trade surplus increased slightly to €158.1 billion (from €154.9 billion).
However, in the last month of 2011, its export growth did slow – the fastest drop in nearly 3 years – and that is expected to signal the trend for 2012. As the eurozone debt crisis continues to cause problems, German exports have been forecast to grow by only 2% this year, with economic growth expected to be as low as 0.7%. This is a marked change from last year, where the Germany economy grew by some 3%. Help for the eurozone is unlikely to come form Europe’s second largest economy, France, where growth in the first 3 months of 2012 is expected to be zero and figures have shown a widening trade deficit, with issues of competitiveness at the forefront. The following articles look at Germany’s prowess in the export market and the likely developments over the coming year.
German exports drop is steepest in nearly 3 years Reuters (8/2/12)
German exports set record of a trillion euros in 2011 BBC News (8/2/12)
German exports broke euro1 trillion mark in 2011 The Associated Press (8/2/12)
Surprise drop in German industrial output Telegraph, Angela Monaghan (7/2/12)
French trade deficit hits high, competitiveness at issue Reuters (7/2/12)
French trade deficit casts shadow on campaign Financial Times, Hugh Carnegy (7/2/12)
German exports fall at fastest rate in three years, sparks fears over Europe’s bulwark economy Telegraph, Louise Armitstead (8/2/12)
Questions
- What is meant by a trade surplus?
- Briefly examine some of the factors that may have contributed to Germany’s rising exports throughout 2011.
- How has the eurozone debt crisis impacted the Germany economy and in particular the export sector?
- The articles that look at France refer to a growing trade deficit, with competitiveness being a key issue. What is meant by competitiveness and why is the French economy suffering from a lack of it?
- Does France’s membership of a single currency reduce its ability to tackle its competitiveness issues?
- Why is German growth expected to remain sluggish throughout 2012? Given that Germany is a member of the eurozone, what government policies are open to the government to boost economic growth?
- China has overtaken Germany as the largest exporter, with growth of 20.3% in 2011. What factors have allowed Chinese exports to grow so quickly?
As a resident of Bristol it is with considerable interest that I’m following the development of the Bristol pound, due for launch in September 2012. One Bristol pound will be worth one pound sterling.
The new currency will be issued in demoninations of £1, £5, £10 and £20 and there is a local competition to design the notes. Participating local traders will open accounts with Bristol Credit Union, which will administer the scheme. It has FSA backing and so all deposits will be guaranteed up to £85,000.
The idea of a local currency is not new. There are already local currencies in Stroud in Gloucestershire, Totnes in Devon, Lewes in East Sussex and Brixton in south London. The Bristol scheme, however, is the first to be introduced on a city-wide scale. The administrators are keen that use of the currency should be as easy as possible; people will be able to open accounts with Bristol Credit Union, pay bills online or by mobile phone.
As the money has to be spent locally, the aim is to help local business, of which more han 100 have already signed up to the scheme. Bristol has a large number of independent traders – in fact, the road where I live is off the Gloucester Road, which has the largest number of independent traders on one street in the UK. The organisers of the Bristol pound are determined to preserve the diversity of shops and prevent Bristol from becoming a ‘clone town’, with high streets full of chain stores.
But how likely is the scheme to encourage people to shop in independent shops and deal with local traders? Will the scheme take off, or will it fizzle out? What are its downsides? The following articles consider these issues.
Articles
The Bristol Pound set to become a flagship for local enterprise The Random Fact, Thomas Foss (7/2/12)
What is the point of local currency? The Telegraph, Rosie Murray-West (7/2/12)
The Bristol pound: will it save the (local) economy? Management Today, Emma Haslett (6/2/12)
‘Bristol Pound’ currency to boost independent traders BBC News Bristol, Dave Harvey (6/2/12)
We don’t want to be part of ‘clone town Britain’: City launches its own currency to keep money local Mail Online, Tom Kelly (6/2/12)
British Town Prepares To Launch Its Own Currency — Here’s How That’s Going To End Business Insider, Macro Man (7/2/12)
They don’t just shop local in Totnes – they have their very own currency Independent, Rob Sharp (1/5/08)
Videos and webcasts
The town printing its own currency [Stroud] BBC News, Tim Muffett (22/3/10)
Brixton launches its own currency BBC News (17/9/09)
Local currency BBC Politics Show (30/3/09)
Local currency for Lewes BBC News, Rob Pittam (13/5/08)
The Totnes Pound transitionculture.org on YouTube, Clive Ardagh (21/1/09)
Local Currencies – Replacing Scarcity with Trust Peak Moment on YouTube, Francis Ayley (8/2/07)
Questions
- What are the advantages of having a local currency?
- What are the dangers in operating a local currency?
- What steps can be taken to avoid the dangers?
- Can Bristol pounds be ‘created’ by Bristol Credit Union? Could the process be inflationary?
- What market failures are there in the pattern of shops in towns and cities? To what extent is the growth of supermarkets in towns and the growth of out-of-town shopping malls a result of market failures or simply of consumer preferences?
- Are local currencies only for idealists?
Last year, we felt the cost of the cold weather and whilst we haven’t seen such low temperatures this year, gas shortages are also emerging. Across Eastern Europe, temperatures have fallen well below -30ºC and so demand for gas has unsurprisingly increased.
Thanks to these low temperatures, Russian gas supplies are running low and several countries have seen their deliveries of gas fall. However, the Russian gas monopoly, Gazprom has said that supplies have not been cut and that it has been exporting more gas during these cold times. The blame, according to Alexander Medvedev (the Deputy CEO of Gazprom), lies with the Ukraine taking gas at a pace significantly above contracted levels. The following articles consider this issue.
Russia, Ukraine argue over gas as EU reports shortage Reuters (2/2/12)
Freezing Europe hit by Russian gas shortage BBC News (4/2/12)
Gazprom says ‘Perplexed’ by EU supply drop as Ukraine takes gas Bloomberg BusinessWeek, Anna Shiryaevskaya (3/2/12)
Gazprom cuts gas supplies amid cold snap Financial Times, Guy Chazan (3/2/12)
Gazprom ‘unable to pump extra gas to Europe’ Associated Press (4/2/12)
Questions
- Using a demand and supply diagram, illustrate what we would expect to see with a gas shortage.
- What has been the cause of this current gas shortage? Use a diagram to illustrate the causes.
- What would you expect to happen to prices following this gas shortage?
- Gazprom is said to be a monopoly: what are the characteristics of a monopoly?
- As there are other gas suppliers, how can Gazprom be said to be a monopolist?
From April 2012, the average household water bill will rise by 5.7% to approximately £367. With households already feeling the squeeze this news is more than unwelcome. The increase in prices will not be standardized across England and Wales. Instead some households will suffer more than others, as their water providers increase prices significantly more than those in other areas.
There has been significant investment in the water industry over the past few years and if this is to continue, funding is required: hence the price hikes. More investment is taking place in some areas than in others and so this goes some way to explaining why some households will see their bills rise by a relatively larger amount. Ofwat, the water regulator, has said that if the investment that these price rises are paying for doesn’t materialize action will be taken. In the context of the current financial situation, consumer groups are understandably concerned about the impact this may have on the lowest income households. Tony Smith, the Chief Executive of the Consumer Council for Water has said:
‘We’ll be making sure that customers get some benefits from this and also that companies step up their help for customers with affordability problems’.
The following articles consider this issue.
How to cut your water bill The Telegraph, Kara Gammell (31/1/12)
Water bills rise by average of 5.7% Guardian, Jill Insley (31/1/12)
Water meter case study: ‘They have set the charges too high’ Guardian, Jill Insley (31/1/12)
Water bills to rise by 5.7 per cent Financial Times, Elaine Moore (31/1/12)
Welsh water imposes lowest increase The Press Association (31/1/12)
Questions
- Why are household incomes already being squeezed?
- Why would you suggest that the RPI and not the CPI has been used to make up the price rises?
- Why are there such wide variations in the amount that consumers are currently charged in different parts of the country? Do you think this is fair? You may find it useful to look at a previous blog on the site
- What is the role of the regulator, Ofwat?
- Can Ofwat’s decision to allow prices to rise by more than the RPI be justified?
