Basel III: Making Banks Stronger or Not?

London, UK - 25th January 2010, 00:35 GMT

Dear ATCA Open & Philanthropia Friends

[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral. ATCA conducts collective Socratic dialogue on global opportunities and threats.]

The latest Basel proposals for the banking sector require far more capital to be raised -- well in excess of the capital already raised in response to The Great Unwind and The Great Reset. This is not going down well with the financial markets in parallel with the Volcker Rule. The Basel Committee's thoughts on capital and liquidity have many far reaching and critical implications for the entire global banking system and could be in force within a few years.

Bank for International Settlements, Basel, Switzerland

Under proposals from the Basel Committee -– which have been dubbed 'Basel III' –- banks will have to maintain a so-called core capital ratio of at least 6%. For many banks, capitalisation under Basel II is deemed very weak. Transition rules would give them time to fix the situation, but not a reprieve from the need to raise more equity. Overall, this could be particularly negative for the European banks. The European banking sector as a whole will have an aggregate extra funding requirement of more than one trillion euros, nearly one and a half trillion dollars, to comply with Basel III according to a number of projections from major financial institutions. The American banks' requirements are a lot less. Under changes to the Basel capital directive designed to improve the capital strength of big banks that have collectively lost hundreds of billions in the past few years, small to medium size brokers may also have to put aside a larger proportion of their turnover as a risk-capital buffer.

European and American banks currently utilise either Basel I or Basel II. Those regulatory frameworks represent a colossal, decades-long effort at honing and perfection, with minimum capital requirements carefully calculated from detailed mathematical models and formulae. How helpful are those rules when recent history shows that the answers provided were completely wrong. Five days before the bankruptcy of Lehman Brothers in September 2008, it boasted a Basel-type “Tier 1” capital ratio of 11%, almost three times the regulatory minimum. When the share price collapsed, counter-party confidence ebbed away much faster than the capital adequacy ratio would suggest. When there is a 21st century stock market run on a publicly traded bank, capital adequacy ratios become marginalised.

The Lehman Brothers bankruptcy, followed by the government led rescue of several high flyer banks, poses an obvious conundrum for the Basel-based bank supervisors: if they have already tried and failed to make capital rules foolproof via Basel I and Basel II, why should they do better this time with Basel III? Surely, they must not just worry about hurdles being too low, if the entire track has a tendency to get flooded from time to time. If the Basel Committee overreacts to the financial crisis and devises rules that are too strict, they may endanger the global recovery. Further, how can national supervisors deal with the basket-case banks, for which no reasonable buffer will be adequate?

The Committee's "Basel III" proposal covers the following key points:

1. Tier 1 Capital Base

Raises the quality, consistency and transparency of the capital base. Some of the existing Tier 1 capital will be disqualified under the new rules. The new rules are intended to ensure that the banking system is in a better position to absorb losses on both a going concern and a gone concern basis. In addition to raising the quality of the Tier 1 capital base, the Committee is also harmonising the other elements of the capital structure.

2. Minimum Liquidity Standard

Introduces a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio. The framework also includes a common set of monitoring metrics to assist supervisors in identifying and analysing liquidity risk trends at both the bank and system wide level. Those standards and monitoring metrics complement the Committee's Principles for sound liquidity risk management and supervision issued in September 2008. Banks are required to hold significantly more government bonds on their books. The new liquidity coverage ratio aims to ensure adequate liquidity in the event of another market dislocation. It is meant to require a bank to maintain an adequate level of unencumbered, high quality assets that can be converted into cash to meet its liquidity needs for a 30 day time horizon under an acute liquidity stress scenario.

3. Leverage Ratio

Introduces a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration. The leverage ratio will help contain the build-up of excessive leverage in the banking system, and introduce additional safeguards against model risk and measurement error. To ensure comparability, the details of the leverage ratio will be harmonised internationally, fully adjusting for any remaining differences in accounting.

4. Counterparty Credit Risk - Derivatives, Repos and Securities

Strengthens the risk coverage of the capital framework. In addition to the trading book and securitisation reforms announced in July 2009, the Committee is proposing to strengthen the capital requirements for counterparty credit risk exposures arising from derivatives, repos and securities financing activities. The strengthened counterparty capital requirements will also increase incentives to move Over-The-Counter (OTC) derivative exposures to central counterparties and exchanges. The Basel Committee will also promote further convergence in the measurement, management and supervision of operational risk.

5. Countercyclical Capital Buffers

Introduces a series of measures to promote the build-up of capital buffers in good times that can be drawn upon in periods of stress. A countercyclical capital framework will contribute to a more stable banking system, which will help dampen, instead of amplify, economic and financial shocks. In addition, the Basel Committee is promoting more forward-looking provisioning based on expected losses, which captures actual losses more transparently and is also less pro-cyclical than the current "incurred loss" provisioning model.

Conclusion

Whilst the speed of the Basel reaction is admirable and most of the proposals look sensible, yet ATCA's overarching conclusion remains that the central bankers' banking group -- the Bank for International Settlements' -- Basel Committee on Banking Supervision has evaded the really difficult and critical question: if the banking system resembles a series of interlinked ships, then regulators are busy making the hulls stronger, the satellite navigation more accurate, the engineering more refined and the alarm bells much louder. However, none of that is likely to be any good if one of the ships capsizes, as a handful of banks might do in the next series of financial crises, and threatens to take other ships down with it. Unless a way is found to solve this critical problem of systemic risk, taxpayers will remain destined to rescue the most unstable banks yet again!

In part the focus on capital ratios and liquidity buffers reflects the scarcity of plausible alternatives available for consideration. Breaking up banks that are deemed too big to fail is hard to do and of uncertain benefit. Having public-sector bureaucrats run nationalised financial institutions is as unattractive as leaving the discredited samurais in charge, who are loathe to commit hara-kiri. The recent "Volcker Rule" proposed by President Obama is a welcome addition to any Socratic dialogue about the future implementation of Basel III as a mechanism to bring about greater global financial stability.

Despite promises that regulators will be vigilant and central bankers more watchful, banks are certain to get into trouble again, as they always have throughout history. The way to protect taxpayers, the Basel III argument goes, is to compel banks to have buffers thick enough to withstand higher losses and longer periods of extreme volatility in financial markets before they call for government intervention. How resilient is the Basel III strategy -- especially if the markets undergo a severe correction in double digit percentages and the loan book default is a multiple of the normal cycle -- is anybody's guess!

Think about it: the fact that the proposals are dubbed Basel III suggests that regulators have been here twice before! The record of bank-capital rules is crushingly bad in the wake of new types of securitisation instruments, excessive risk taking, self-measurement of risk and financial markets' volatility. Why will things turn out any different, now that we are going for thicker hulls, more ballast and insulation, and a brand new set of navigation equipment?

In the days when banks could not rely on governments to save them, they carried huge capital buffers to protect themselves against losses and drops in confidence. In the late 19th century a typical American or European bank had an equity buffer, ie core capital, equivalent to 15-25% of its assets! As recently as the 1960s British banks held more than a quarter of their assets in low-risk, liquid form, such as cash or government bonds. Are we in the end -- if not via Basel III then Basel IV -- likely to return to 19th century levels of capital adequacy? This would no doubt have significant consequences for the valuation of banks and the unencumbered survival of large capital financial institutions.

[ENDS]

This briefing draws on copyright material from The Economist used with permission. The relevant article can be found here.

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