The other bits of Basel III

September 14, 2010

All the headlines about Basel III have concentrated on the new core Tier 1 capital requirements — the amount of pure equity and retained earnings that banks are going to have to have going forward. It was banks’ core equity which proved woefully insufficient during the crisis — hardly a surprise, when the Basel II requirement for it was just 2% — and it’s core equity which has seen the biggest beefing up under Basel III, all the way to 7%.

But Melvyn Westlake reckons that there might be a bigger story here in the total capital requirements under Basel III, including not only core Tier 1 capital but everything, up to and including Tier 2. Westlake knows what he’s talking about: he works for Global Risk Regulator magazine, the trade journal which covers all these issues in enormous detail on a permanent basis. Here’s what he just sent me via email:

I would suggest that the Basel Committee intends that Tier 2 capital will have a much more significant role than in the past. It is not absolutely clear what instruments will qualify for Tier 2 in the future, but they will certainly have to be loss absorbing, possibly in a “going concern” situation as well as a “gone concern” situation.

He also notes what the Basel Committee itself has said:

During the recent financial crisis a number of distressed banks were rescued by the public sector injecting funds in the form of common equity and other forms of Tier 1 capital. This had the effect of supporting not only depositors but also the investors in regulatory capital instruments. Consequently, Tier 2 capital instruments (mainly subordinated debt), and in some cases non-common Tier 1 instruments, did not absorb losses incurred by certain large internationally-active banks that would have failed had the public sector not provided support.

It’s going to take a while (something over a decade, most likely) to fully make the switch from the current grab-bag of instruments which count as Tier 2 capital to a much safer system where holders of Tier 2 capital can and will take losses in the event that a bank comes close to failing. So far, the market in contingent convertible securities is nascent at best, and no one really understands how or whether it will evolve — maybe banks will find it easier to just issue equity instead.

But in any case, the new Tier 2 capital requirement of 10.5% is an important number: it basically means that if any bank does need a bailout, its subordinated bondholders are going to be the first to do the bailing out, rather than the government. And it should give some reassurance to the people worried about leverage, too. After all, if you calculate leverage ratios using total capital rather than just equity, they’re likely to come down substantially. And that’s without taking into account the new liquidity restrictions. Lehman’s biggest failure was in liquidity management; the new Basel rules will, if they work, stop another Lehman from happening again. The capital rules are aimed not at preventing another Lehman, but rather at shoring up the global commercial-banking system. Which is just as important.


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