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, 10:43:48 AM

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