Basel III Norms


Ajit Kumar AJIT KUMARWISDOM IAS, New Delhi.

In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008. A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding. Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk. Basel III is the third in the series of Basel Accords.  These accords deal with risk management aspects for the banking sector.  Basel III is the global regulatory standard (agreed upon by the members of the Basel Committee on Banking Supervision)  on bank capital adequacy, stress testing and market liquidity risk.   (Basel I and Basel II are the earlier versions of the same, and were less stringent)
About Basel III
 
According to Basel Committee on Banking Supervision "Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector".
 
Thus, we can say that Basel III is only a continuation of effort initiated by the Basel Committee on Banking Supervision to enhance the banking regulatory framework under Basel I and Basel II.   This latest Accord now seeks to improve the banking sector's ability to deal with financial and economic stress, improve risk management and strengthen the banks' transparency.
 
Basel III measures aim toimprove the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source; improve risk management and governance; and strengthen banks' transparency and disclosures.
 
The basic structure of Basel III remains unchanged with three mutually reinforcing norms.
 
- Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs) : Maintaining capital calculated through credit, market and operational risk areas.
-  Supervisory Review Process : Regulating tools and frameworks for dealing with peripheral risks that banks face.
-  Market Discipline :   Increasing the disclosures that banks must provide to increase the transparency of banks
 
Features of Basel III  
 
(i) Better Capital Quality :   One of the key elements of Basel 3 is the introduction of  much stricter definition of capital.  Better quality capital means the higher loss-absorbing capacity.   This in turn  will mean that banks will be stronger, allowing them to better withstand periods of stress.
 
(ii) Capital Conservation Buffer:    Another key feature of Basel iii is that now banks will be required to hold a capital conservation buffer of 2.5%.  The aim of  asking to build conservation buffer is to ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of financial and economic stress.
 
(iii) Countercyclical Buffer:   This is also one of the key elements of Basel III.   The countercyclical buffer has been introducted with the objective to increase capital requirements in good times and decrease the same  in bad times.  The buffer will slow banking activity when it overheats and will encourage lending when times are tough i.e. in bad times.  The buffer will range from 0% to 2.5%, consisting of common equity or other fully loss-absorbing capital.
 
(iv) Minimum Common Equity and Tier 1 Capital Requirements :   The minimum requirement for common equity, the highest form of loss-absorbing capital, has been raised under Basel III from  2% to 4.5% of total risk-weighted assets.  The overall Tier 1 capital requirement, consisting of not only common equity but also other qualifying financial instruments, will also increase from the current minimum of 4% to 6%.   Although the minimum total capital requirement will remain at the current 8% level, yet the required total capital will increase to 10.5% when combined with the conservation buffer.
 
(v) Leverage Ratio:     A review of the financial crisis of 2008 has indicted  that the value of many assets fell quicker than assumed from historical experience.   Thus, now Basel III rules include a leverage ratio to serve as a safety net.  A leverage ratio is the relative amount of capital to total assets (not risk-weighted).   This aims to put a cap on swelling of leverage in the banking sector on a global basis.   3%  leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018.
 
(vi) Liquidity Ratios:  Under Basel III, a framework for liquidity risk management will be created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2015 and 2018, respectively.
 
(vii) Systemically Important Financial Institutions (SIFI) : As part of the macro-prudential framework, systemically important banks will be expected to have loss-absorbing capability beyond the Basel III requirements. Options for implementation include capital surcharges, contingent capital and bail-in-debt.
 
Basel III and the Banks

The Basel III regulations contain several important changes for banks' capital structures. First of all, the minimum amount of equity, as a percentage of assets, will increase from 2% to 4.5%. There is also an additional 2.5% "buffer" required, bringing the total equity requirement to 7%. This buffer can be used during times of financial stress, but banks doing so will face constraints on their ability to pay dividends and otherwise deploy capital. Banks will have until 2019 to implement these changes, giving them plenty of time to do so and preventing a sudden "lending freeze" as banks scramble to improve their balance sheets.

It is possible that banks will be less profitable in the future due in part to these regulations. The 7% equity requirement is a minimum and it is likely that many banks will strive to maintain a somewhat higher figure in order to give themselves a cushion. If financial institutions are perceived as being safer, the cost of capital to banks would actually decrease. Banks that are more stable will be able to issue debt at a lower cost. At the same time, the stock market might assign a higher P/E multiple to banks that have a less risky capital structure.

Basel III and Financial Stability 

Basel III is not a panacea, and will not single-handedly restore stability to the financial system and prevent future financial crisis. However, in combination with other measures, these regulations are likely to help produce a more stable financial system. In turn, greater financial stability will help produce steady economic growth, with less risk for crisis fueled recessions such as that experienced following the global financial crisis of 2008-2009.

While banking regulations may help reduce the possibility of future financial crises, it may also restrain future economic growth. This is because bank lending and the provision of credit are among the primary drivers of economic activity in the modern economy. Therefore, any regulations designed to restrain the provision of credit are likely to hinder economic growth, at least to some degree.
Nevertheless, following the events of thefinancial crisis, many regulators, financial market participants and ordinary individuals are willing to accept slightly slower economic growth for the possibility of greater stability and a decreased likelihood of a repeat of the events of 2008 and 2009. (Find out how the Tier 1 capital ratio can be used to tell if your bank is going under.

Basel III and Investors

As with any regulations, the ultimate impact of Basel III will depend upon how it is implemented in the future. Furthermore, the movements of international financial markets are dependent upon a wide variety of factors, with financial regulation being a large component. Nevertheless, it is possible to generalize about some of the possible impacts of Basel III for investors.
It is likely that increased bank regulation will ultimately be a positive for bond market investors. That is because higher capital requirements will ultimately make bonds issued by banks safer investments. At the same time, greater financial system stability will provide a safer backdrop for bond investors, even if the economy grows at a slightly weaker pace as a result. The impact on currency markets is less clear; but increased international financial stability will allow participants in these markets to focus upon other factors while perhaps eventually giving less focus to the relative stability of each country's banking system.

Finally, the effect of Basel III on stock markets is uncertain.

RBI allows banks to expand capital base to meet Basel III norms

At a time when public sector banks (PSBs) have been struggling with a low capital base, the Reserve Bank of India (RBI) in March 2016 allowed banks to beef up its capital adequacy by including certain items such as property value, foreign exchange for calculation of its Tier-I capital.
The new norms revealed by the regulator suggest that banks can now include the value of the property while calculating its Tier-I or core capital base. But not the entire value of the property would be included; instead only 45 per cent of the property value would be counted.
However, this comes with caveats. For instance, the regulator has stated that the property value would be counted only if the bank is able to sell the property readily at its own will and there is no legal impediment in selling the property. Apart from this it also mandates that the valuation should be obtained from two independent valuers, at least once in every three years.

Analysts with a credit rating agency said considering revalued assets (real estate) as part of common equity may only serve the purpose of regulatory capital requirement. That hardly improves the credit profile of banks. The asset has to be ready (available) to absorb loss in times of need.

Foreign exchange, another item that was not included while calculating the capital base, can also be included. “Foreign currency translation reserves arising due to translation of financial statements of a bank’s foreign operations to the reporting currency may be considered as CET1 (common equity tier-1) capital. These will be reckoned at a discount of 25 per cent,” said the regulator.

Apart from these two, gains arising out of setting off the losses at a later date can also be counted as Tier-1 capital, up to 10 per cent. This will be a breather for the lenders, especially PSBs, which have been grappling with the issue of mounting bad loans and depleting capital base.

According to RBI sources, this move would help in unlocking Rs 30,000-35,000 crore of capital for PSBs and up to Rs 5,000 crore for private banks.  

The government estimates that state-run lenders would require Rs 1.8 lakh crore over the next four years. Banks would have the onus to raise the balance Rs 1.1 lakh crore from the market. This is because the finance ministry has promised to pump into PSBs Rs 25,000 crore each in FY16 and FY17 and Rs 10,000 crore each in FY18 and FY19. RBI’s move on Tuesday will serve in meeting the capital requirements.

A PhillipCapital report believes this would be a big positive for PSBs as it would evade the risk of huge dilution of equity. “SBI can gain Rs 20,000 crore from revaluation of property, which can add 50 basis points to Tier-1 on account of revaluation reserves only,” it said.

According to new Basel-III norms, which kick in from March 2019, Indian banks need to maintain a minimum capital adequacy ratio (CAR) of nine per cent, in addition to a capital conservation buffer, which would be in the form of common equity at 2.5 per cent of the risk weighted assets. In other words, banks’ minimum CAR must be 11.5 per cent, which is higher than the 9.62 per cent banks are required to currently maintain.

Terms Related to Basal III

Risk Weighted Assets

Global banking supervisors based in Basel Switzerland use the concept of risk-weighted assets to determine a bank’s minimum capital needs. Risk-weighted assets are computed by adjusting each asset class for risk in order to determine a bank's real world exposure to potential losses. Regulators then use the risk weighted total to calculate how much loss-absorbing capital a bank needs to sustain it through difficult markets.

Under the Basel III rules, banks must have top quality capital equivalent to at least 7 per cent of their risk-weighted assets or they could face restrictions on their ability to pay bonuses and dividends.
The risk weighting varies accord to each asset's inherent potential for default and what the likely losses would be in case of default - so a loan secured by property is less risky and given a lower multiplier than one that is unsecured.

Under the Basel II banking accord, which still governs most risk-weighting decisions, government bonds with ratings above AA- have a weight of 0 per cent, corporate loans rated above AA- are weighted 20 per cent, etc. The rules also attempt to classify assets by their credit risk, operational risk and market risk
 
Liquidity Coverage Ratio

 The LCR is intended to promote resilience to potential liquidity disruptions over a thirty day horizon. It will help ensure that global banks have sufficient unencumbered, highquality liquid assets to offset the net cash outflows it could encounter under an acute shortterm stress scenario. The specified scenario is built upon circumstances experienced in the global financial crisis that began in 2007 and entails both institution-specific and systemic shocks.

Countercyclical buffer

Losses incurred in the banking sector can be extremely large when a downturn is preceded by a period of excess credit growth. These losses can destabilise the banking sector and spark a vicious circle, whereby problems in the financial system can contribute to a downturn in the real economy that then feeds back on to the banking sector. These interactions highlight the particular importance of the banking sector building up additional capital defences in periods where the risks of system-wide stress are growing markedly.

 The countercyclical buffer aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. It will be deployed by national jurisdictions when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure the banking system has a buffer of capital to protect it against future potential losses. This focus on excess aggregate credit growth means that jurisdictions are likely to only need to deploy the buffer on an infrequent basis. The buffer for internationally-active banks will be a weighted average of the buffers deployed across all the jurisdictions to which it has credit exposures. This means that they will likely find themselves subject to a small buffer on a more frequent basis, since credit cycles are not always highly correlated across jurisdictions.
 
Capital conservation buffer

The capital conservation buffer is composed solely of common equity tier 1 capital.
For purposes of this section, the following definitions apply:

(i) Eligible retained income. The eligible retained income of a national bank or Federal savings association is the national bank's or Federal savings association's net income for the four calendar quarters preceding the current calendar quarter, based on the national bank's or Federal savings association's quarterly Call Reports, net of any distributions and associated tax effects not already reflected in net income.

(ii) Maximum payout ratio. The maximum payout ratio is the percentage of eligible retained income that a national bank or Federal savings association can pay out in the form of distributions and discretionary bonus payments during the current calendar quarter. The maximum payout ratio is based on the national bank's or Federal savings association's capital conservation buffer, calculated as of the last day of the previous calendar quarter.

(iii) Maximum payout amount. A national bank's or Federal savings association's maximum payout amount for the current calendar quarter is equal to the national bank's or Federal savings association's eligible retained income, multiplied by the applicable maximum payout ratio.

(iv) Private sector credit exposure. Private sector credit exposure means an exposure to a company or an individual that is not an exposure to a sovereign, the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, a MDB, a PSE, or a GSE.
 
On-balance sheet – off-balance sheet assets

There is an accounting distinction between assets that are on-balance sheet, i.e. that are recorded in the end of year picture of a company’s assets and liabilities, and assets that are not recorded on this picture, called off-balance sheet. Off-balance sheet assets include guarantees and client assets under management, among other things. An asset will as a rule be on the balance sheet if it is an asset that the company owns.

Shadow banking

All the entities and activities that are part of the credit intermediation chain, but are outside the scope of the regulator. Up until recently the regulators monitored only financial institutions collecting deposits from clients, i.e. banks, as they felt that ensuring the safety of clients’ deposits was sufficient from a prudential point of view. But other types of financial companies also provide credit or asset management such as mortgage brokers, hedge funds, money market funds, that are outside the scope of the bank regulator, hence the term ‘shadow’. It means that they are not required to abide by the same rules of safety and careful management as banks. The shadow banking system is estimated to represent 25%-30% of the financial system today.
 
Leverage  Ratio

The leverage ratio is the proportion of debts that a bank has compared to its equity / capital.
For example, if the bank lends £15 for every £1 of capital reserves, it will have a leverage ratio of 1/15 = 6.6%. A leverage ratio of 4% would mean that for every £1 of capital that a bank holds in reserve, the bank can lend £25. (1/25 = 4%). If the leverage ratio falls to 3%, it would mean that for every £1 of capital that a bank holds in reserve, the bank can lend £33 (1/33 = 3%)

If a bank kept all its deposits as cash in bank vaults. It would have a large quantity of liquid capital. Whenever a customer came to demand his deposits back, the bank could go to the bank vaults and pay everything back.  This is a very conservative method of banking. The bank wouldn’t have to worry about a fall in the value of assets or loans not paid back. However, this type of banking is not very profitable. Keeping capital reserves in the bank vaults doesn’t earn you any money.
Instead the bank will lend a percentage of its deposits to customers wishing to take out a loan. This enables the firm to gain a better rate of return on its deposits. The more the bank lends, the greater the potential to make profit. This is leverage.

Many regulators are considering raising the leverage ratio. This means that banks will have to keep more capital reserves. To increase capital reserves in order to meet higher leverage ratios requires selling assets to get cash or reducing lending. Higher leverage ratio can decrease the profitability of banks because  it means banks can do less profitable lending. However, increasing the leverage ratio means that banks have more capital reserves and can more easily survive a financial crisis.Governments are keen to increase the leverage ratio because it makes it less likely governments will have to bail them out.

Tier 1 Capital

Tier 1 capital consists of shareholders' equity and retained earnings. Tier 1 capital is intended to measure a bank's financial health and is used when a bank must absorb losses without ceasing business operations. Under Basel III, the minimum tier 1 capital ratio is 6%, which is calculated by dividing the bank's tier 1 capital by its total risk-based assets.
For example, bank ABC has $600,000 in equity and retained earnings and has $10 million in risk-weighted assets. Its tier 1 capital ratio is 6% ($600000/$10 million), which meets the minimum Basel III requirement.

Tier 2 Capital

Tier 2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss reserves, and undisclosed reserves. Tier 2 capital is supplementary capital because it is less reliable than tier 1 capital. In 2015, under Basel III, the minimum total capital ratio is 8%, which indicates the minimum tier 2 capital ratio is 2%, as opposed to 6% for the tier 1 capital ratio.
For example, bank ABC has tier 2 capital of $100,000 and risk-weighted assets of $10 million. Therefore, the tier 2 capital ratio is 1% ($100000/$10 million). Thus, bank ABC's total capital ratio is 7% (6%+1%). Under Basel III, bank ABC would not meet the minimum total capital ratio of 8%.
 
 


Monday, 11th Apr 2016, 09:34:03 AM

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