Basel III arrives

By Felix Salmon
September 12, 2010
here, with a wealth of information inside it. But they conveniently also supply this table, which gets to the core of the matter:

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Basel III has arrived! The official BIS press release is here, with a wealth of information inside it. But they conveniently also supply this table, which gets to the core of the matter:

basel.tiff

There’s a lot to unpack and explain here. But the first thing to note is that we’ve moved from a simple “Tier 1 has to be 4%, Tier 2 has to be 8%” to a 3×3 matrix with all manner of different minima. It’s a bit more complicated, but it’s also more intelligent, and should be much more effective as well.

Possibly the most important thing here is the existence of the first column, setting minimum standards for common equity — which is also known as core Tier 1 capital. Such standards did exist in the past, but they were set extremely low, at just 2%, and so were generally ignored. As of now, common equity is the main thing that matters. No more throwing any old garbage into the Tier 1 bucket and calling it capital: the new standards for common equity are significantly tougher than the old standards for Tier 1 capital in total.

The absolute bare minimum for core Tier 1 capital is 4.5%, and the new minimum for Tier 1 capital in general has now been raised to 6%. The minimum for Tier 2 remains at 8%.

But that’s just the beginning. On top of that there’s a “conservation buffer” of another 2.5 percentage points; to a first approximation, any bank you’ve heard of is going to want to be well outside that buffer, because they won’t be able to pay dividends if they don’t have the full buffer in place. If there’s some kind of crisis and they’re forced to write down a lot of bad loans, they can eat into the buffer — but that will bring extra regulatory oversight, and they won’t be able to pay dividends. That’s sensible.

With the conservation buffer, then, banks need 7% common equity, 8.5% Tier 1 capital, and 10.5% Tier 2 capital.

And it doesn’t stop there, either. When credit in an economy is growing faster than the economy itself, a countercyclical capital buffer kicks in, which essentially says that banks need to have more capital in good times. That countercyclical buffer won’t be set by the BIS in Basel; it’ll be left up to national regulators. But you can probably expect the UK, US, and Switzerland to enforce it up to the maximum of 2.5%.

So when the economy’s booming, banks are going to need 9.5% common equity, 11% Tier 1 capital, and 13% Tier 2 capital.

But wait, there’s more! “Systemically important banks should have loss absorbing capacity beyond the standards announced today,” says the BIS — we don’t know what they’re going to announce on that front, but the chances are that when an announcement comes, the biggest banks are going to need significantly more capital than what we’re seeing here.

This is all very welcome stuff. But it neither can nor should be implemented overnight. Instead, there’s a timetable built in to the new capital standards:

timetable.tiff

This is even more complicated, obviously, than the capital standards themselves. But in a nutshell, the standards start being phased in on January 1, 2013, with a core Tier 1 requirement of 3.5%. That rises to the final 4.5% in 2015. Other parts of the structure take longer, but they’re all phased in by January 1, 2019 — which is more than enough time for the world’s banks to raise any extra capital they might need.

Meanwhile, various dubious things which currently count as Tier 1 or Tier 2 capital but shouldn’t will be phased out even more slowly, over a period of 10 years beginning in 2013.

Other key parts of the Basel III regime, which weren’t announced today, will also come during these years: the liquidity coverage ratio gets introduced in 2015, while the net stable funding ratio arrives in 2018.

The banks aren’t going to take all this lying down, but I’m hoping their reaction is going to be relatively muted. This is a done deal, now, and they just have to live with it. And the banks which embrace the new standards and are proud of exceeding them will ultimately be more successful than those which try to get around them. Indeed, it would be great to see non-bank lenders adopt these standards too, on a voluntary basis. Most shadow banks easily exceed these ratios already, and I’d love to see the ones which don’t slowly wither away.

Comments
9 comments so far

Well done, Felix! Basel III will certainly strengthen bank capital positions. However, there is a certain blithe assumption that raising capital requirements will result in an increase in bank capital. Capital ratios can be raised by increasing capital or reducing activities. Governments are counting on the former; I wonder if they will be pleased if the latter occurs.

Posted by Too_Late | Report as abusive

Thanks. Excellent review. FYI http://bit.ly/bIztdC

Posted by polit2k | Report as abusive

Basel III keeps looking at the gorilla called perceived risk, while losing track of the ball.

In Basel III you will find that most of the capital requirements are “in relation to risk-weighted assets (RWAs)” and, since what is most wrong with Basel II are precisely the risk-weights, which for instance counts any investment or loan to a private triple-A rated client at only 20%, and which was precisely what drove the banks to stampede after the triple-A rated securities collateralized with lousily awarded mortgages to the subprime sector, and the risk weights have not been modified at all, let me assure you that the Basel Committee still has no idea about what they are doing. Frightening!

Basel III does mention that “These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described” but since that supplement seemingly will be small and what really counts are the marginal capital requirements for different assets Basel III does not provide a solution.

Fact is that if a bank lends to a small business then it needs 8 percent in capital but if it instead lends that money to the government of a sovereign rated AAA to AA then the bank needs no capital for the risk-weighted assets since the weight is 0%… this is sheer lunacy!

The members of the Basel Committee are all still so fixated with looking at the gorilla called “perceived risk” so as to completely lose track of the ball.

Per Kurowski
A former Executive Director at the World Bank

http://subprimeregulations.blogspot.com/

Posted by PerKurowski | Report as abusive

Anyone looked into how this will impact the cost of bank services?

Posted by davew | Report as abusive

“Anyone looked into how this will impact the cost of bank services?”

A clear impact on margins is not seen yet. What I have seen is a 25bps extra margin for interest rates fixed in the range 6 to 10 years.

Posted by BaselDrei | Report as abusive

Hi Felix,

Just reviewing Tier 2 rules and I note you appear to refer to extremely high levels of Tier 2.
Under Basel II, rule of thumb was 4% tier 1 PLUS 4% Tier 2 & Tier 3 to reach 8%.
Tier 3 was (like level 3 assets) pretty meaningless so Cap Instruments that qualified will no longer eligible (unlike Level 3 assets). Tier 2 will probably comprise loss absorbing Capital Instruments with added conditionality as suggested by BIS last month that allows regulators to define an event which triggers conversion of debt to equity.. the so called ‘Bail in’.
Since Minimum Total Capital is 8% (ex. buffers) with Tier 1 min of 6% of which Common Equity must 4.5%, Tier 2 will therefore be around 2%+, there or thereabouts, not the 8%+ levels you refer to.
Kind Regards

David McKibbin

Posted by creditplumber1 | Report as abusive

Hi David — technically, the minimum level of Tier 2 capital always has been and always will be zero. When people like me talk about Tier 2 minimums, they mean Tier 2 or better, ie Tier 2 plus Tier 1. If you meet your Tier 2 minimum with Tier 1 alone, then you don’t need any Tier 2 at all.

Posted by FelixSalmon | Report as abusive

Gotcha. Thx

Posted by creditplumber1 | Report as abusive

This is just the first step for “too big to fail” (too big to understand also) financial institutions.

They must bear in mind that they will have to do more. Systemically Important Financial Institutions (SIFIs) should have higher loss absorbency capacity.

George Lekatis
http://www.basel-iii-association.com

Posted by George_Lekatis | Report as abusive
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