A significant negative externalities or social costs together with private costs of failure can lead to bank failures. Hence in most countries to reduce government rescue of failed banks, the national banks are set aside for special regulation called prudential control, which is more stringent than regulation of the other sectors of the economy, even in other parts of financial sectors. Furthermore, Heffernan (2006) states that the main objective of prudential control is to reduce the social costs of bank failure however banks should not take advantage of being singled out from special control and protection. Overall the prudential regulation concerns with banks regulation at micro level thus the banks behave in prudential manner to prevent contagion if one bank fails. However Boreo (2003), among other argues that increasingly macro prudential regulation play a key role in presenting the banking system from getting into trouble. Based on the complicated area of regulation, prudential control exists at international level for Basel committee comprising of panels of leading global regulators.
For many years, individual nations managed their own banking systems prudential control leading to wide inequalities and anomalies wherein some counties' banks have undue competitive advantage due to favorable prudential control. This caused loop holes thereby endangering customers, counterparties and potentially global financial system.
In 1988, the first Basel Accord was established to overcome these short comings. In June 2004 an updated Framework over 1988 Accord was developed to further strengthen international soundness and stability of the global banking system while maintaining adequate stability that the capital adequacy regulation will not be a significant source of competitive discrimination among internationally active banks (Jackson, 1999). However Basel I and Basel II post crises were criticized for their undue emphasis on capital adequacy as primary source of prudential control of banking system. Hence significant fundamental changes in Basel II gave rise to Basel III to strengthen global capital and liquidity regulations with goal of promoting a more resilient banking sector.
This report first looks at Basel II prudential control limitations and then summarizes ways to address this problems after recent global financial crises through Basel III. In section 2 the report addresses the recent Basel III proposal and its potential impacts on banks and critically analyzes the problems not addressed. The potential ways the banks could comply with new requirements is stated in section 3 and finally, section 4 evaluates the potential impact of changes on the U.K and European economy.
Section 1:
Although the present Basel II Accord has many advantages like: more transparency and detailed bank information, the rating systems, the internal models of risk evaluation, the three pillars which represent a whole, an unbiased bank competition, the actual financial crises shows limitations in Basel II framework.
Issues with Pillar 1
No penalty for Concentration in pillar 1, however left to supervisor: Loans backed by capital depends only on the risk of the loan not on portfolio to which it is added. Thus the minimum capital requirement related to any loan type due to credit risk is based on the assets holding rather than its exposure size (Gordy, 2003).
A single global risk factor rather than a country specific risk (Gordy, 2003).
Different action of financial 'promises': Complete markets in credit undermine capital weighting approaches. Financial innovations like CDS allowed banks to transform the ex ante risks thus understating the idea of capital weights.
Capital market activities of Banks: Counterparty risk and contagion arose from banks involving in capital market activities without sufficient capital. Major issue occurred through securitization and its warehousing on and off balance-sheet. For example in US, Variable Interest Entities to which banks are linked had to be undated onto balance sheets if bank becomes insolvent or funding liquidity becomes an issue. This structure was completely missed out in capital regulations.
Capital regulations are pro-cyclical: The Basel System tends to underestimate risk in good times and overestimate risks in bad times. The leverage ratio depends on current market value and doesn't take into consideration future cash flow. Also the banks risk measurement is not holistic measure over whole cycle however tends to be point in time. And finally the counterparty credit policies are easy in good times and tough in bad times.
The capital regulation under Basel II did nothing to counter this pro-cyclicality. For example banks can control their RWA via regulatory arbitrage and by varying bank capital more directly through dividends and share buyback policies.
Unclear and inconsistent definition of Capital: Applying regulatory adjusted goodwill to common equity however was applied to Tier 1 or /and a combination of Tier 1 and Tier 2 wasn't mandatory. Also they were not applied uniformly across jurisdictions leading to future regulatory arbitrage. Furthermore, banks did not provide sufficient details of their capital which compromised their ability to absorb losses during crises.
Issues with Pillar 2 and Pillar 3
Pillar 2 refers to supervisory review process: Banks are required to hold capital for risk not sufficiently captured under Pillar 1 based on stress testing and supervisors guidance. Building buffers requires supervisors to be forwards looking taking into perspective the market structure, practices and complexity. This however is quite difficult for supervisors as they may be less qualified to predict future asset prices and volatility compared to private bankers. Also based on banks' ability to generate financial innovation regularly the supervisors have to permanently update and upgrade their skills. Further to enhance Pillar 2 a robust stress testing (standard approach) was required.
For example, UK's Financial Services Regulator one of the best staffed and sophisticated of supervisors, wrote off Northern Rock to be first bank to go to Basel II IRB approach taking into consideration the reduction in capital significantly prior to crises (Sorkin, 2010).
Pillar 3 by Basel Committee refers to disclosure and market discipline that will punish banks with poor risk management practices based on the notion that the market is efficient. However the major issue is that the markets aren't efficient and there is information asymmetry.
Section 2:
In order to strengthen the resilience of the banking sector the Basel Committee proposed a number of measures to increase the quality, consistency and transparency by focusing on four areas; capital quality, capital requirement, leverage ratios, and liquidity requirements. The diagram below outlines the major difference between Basel II and Basel III. A significant fact concerning Basel III is that it is a fundamental upheaval of Basel II, with many elements of regulation being updated.
With respect to regulatory capital framework Basel committees key components are as follows:
Improving quality and consistency of regulatory capital: Basel III will substantially increase the quality and quantity of capital and liquidity in the banking system. Tier 1 capital will comprise common equity and retained earnings with tighter definition of common equity. Also Tier 2 capital is restated as a 'going concern' reserve to protect depositors in the event of insolvency and Tier 3 was abolished altogether. Banks in future will be required to hold larger share of capital comprising primarily of common equity which can absorb the losses of the going concern entity without regulatory authority intervention. Based on this the requirement for common equity will go up from 2% to 4.5%. Also the required Tier 1 ratio will go up from 4% to 6% and the minimum ratio for total Tier 1 and Tier 2 capital to RWA's will remain same at 8%. Also intangible assets like minority interests, deferred tax assets and goodwill will be deducted from common equity.
Improve the risk coverage: During the crises the major issue that Basel proposal faced capturing on and off balance sheet risk related to SPV. However going forward Basel III undertook various changes in banks:
The capital requirement for counterparty credit risk must be determined using stressed inputs, to remove pro-cyclicality a significant issue in Basel II. Furthermore capital charges must be included with the company's deteriorating creditworthiness.
Undertake Pillar 1 capital charge for transaction related to counterparties especially financial guarantors, whose probability of default is positively correlated with the amount of exposure.
For regulated financial firms with asset base of at least 25 billion apply a multiplier of 1.25 to assets value correlation of exposures.
Large and illiquid derivative exposures to counterparty will be required to apply for tougher margining period to determine regulatory capital.
Promote use of centralized exchanges; the banks will qualify for zero risk weight for counterparty risk exposure if dealing with centralized exchanges.
The Basel committee is also trying to improve the usefulness of risk management by linking both internal risk measure of firm (prices and volatility) with external factors such as the behavior of other banks and investors. Further to monitor concentration risk use of common stress tests across all banks (Alexander, Eatwell, Persaud & Reoch, 2010)
Enhance leverage ratio: Basel Committee enhanced the coverage of counterparty exposure in enhancing risk coverage part and inclusion of off balance sheet exposure in supplemental 3% non-risk based leverage ratio. Thus banks can overcome the capital market activities criticism. However still this is not enough to enhance macro-prudential focus. Hence a leverage caps - linking asset growth to equity growth must be created as stated by Morris & Shin (2008) (bank capital should be a constraint on balance sheet growth)
Addressing pro-cyclicality: The most innovative proposal of Basel III framework is the conservation of Tier 1 capital via restriction on dividends, share buy-backs, and discretionary bonuses if a bank's capitalization falls within specific ranges above its minimum regulatory requirement. These proposal counters macro prudential tools currently under consideration by regulators and governments. The overall aim is to address harmful trends like rising leverages, lending growth, and liquidity mismatches before they become excessive. However Alexander (2011) states that perhaps a more holistic regulatory approach is needed to address counter-cyclical capital
Importance of Buffers: The Basel Committee is proposing the banks to hold two capital buffers above regulatory minimum:
A capital conversion buffers intended to absorb losses in stress times.
A countercyclical buffer intended to rise during excessive credit growth periods hence the financial system remain resilient to downturn.
The capital conversion and counter cyclical buffers will be kept at 2.5% of RWA and will consist entirely of common equity. Globally the countercyclical buffer will vary between zero and 2.5% of the RWAs depending on the domestic credit cycle. Also banks that do not maintain capital conversion buffer will face restrictions on payout of dividends, share buyback and bonuses.
These buffers ensure that the minimum proportion of bank's balance sheets must be financed through common equity will increase to 7% of RWAs at neutral point in the credit cycle, rising 9.5% at the peak. This constitutes a significant relative to Basel II, under which the minimum common equity requirement was in effect below 2% on a like-for-like basis.
However Basel III is not without its limitations as it treats bank capital as a buffer not a charge and ignores the liability-side of balance sheet that is unstable short term funding and forex exposure and excess asset growth in boom period (Alexander 2011).
Sources: BIS and Bank Calculations Sources: BIS and Bank Calculations
Liquidity Risk Requirements: This proposal focused on assets liquidity to ensure banks have a 30- day liquidity cover for emergency situation. The Basel Committee introduced the Liquidity coverage ratio for stress scenario. Furthermore, the LCR acts as buffers focus more on 'loss absorbency' Alexander (2011). This requires banks to place robust automated reporting solution to meet the liquidity requirements. The first challenge the banks face is consolidate clean exposures, liabilities, counterparties and market data in a centralized risk data warehouse. Furthermore, the banks face issues concerning interfacing or merging their current risk and finance systems to meet the Basel III liquidity ratio requirement. Also certain participants argue that LCR won't be viable for countries like Australia and Denmark with limited liquid assets.
Section 3:
ING is a global financial institution of Dutch origin, currently offering banking, investments, life insurance and retirement services to satisfy needs of a broad customer base. ING is positioned sufficiently to meet the Basel Committees requirements however it criticized some new rules for being too harsh, especially those that aim to ensure banks have enough liquid assets to shield themselves in case funding markets dry up. The potential impact of the changes on the ING is stated as follows:
The requirement proposed by the Basel Committee will require stronger capital reserve and liquidity buffer to protect banks during crises. Most of the implementation won't start till 2013 however ING is sufficiently positioned to meet them.
The core Tier-1 capital ratio of its bank, which stood at 9.6% at end of 2010, will be reduced to 8.3%. However if Basel III was implemented now the ratio is around 0.5 percent higher than its earlier prediction.
The largest negative impact is through tighter guidance under Basel III and higher interest rates, which causes a drop in revaluation reserves.
The impact of Basel III is far more than expected leading to reduction in their excess capital by around €1.6 billion (50 basis points). Still for ING the solvency position remain positive even after paying its bailout fund of €2 billion in the month of May.
Under Basel III, which will be implemented from 2013 and comes fully into force in 2019, banks will be forced to hold bigger capital cushions and deeper pools of liquidity to guard against potential losses and crippling bank runs.
The "liquidity coverage ratio," which will come into force in 2015, contains a very restrictive definition of liquid assets and forces banks to hold more cash and government bonds hence putting pressure on its margins.
The regulators are considering a package of extra safeguards on systemically important financial institutions (SIFIs) to stop bailouts should one of banks get into trouble, which could see top banks holding an extra capital cushion of 1-3 percentage points
Also the net stable funding ratio, which aims to ensure banks can stay liquid for up to a year and which will be introduced in 2018, is also too harsh. It still falls short of the 100% minimum, despite its large mortgage portfolio and relatively low loan-to-deposit ratio.
In order to counter the negative impacts, banks must consider alternative methods of funding, credit, capital management, asset/liabilities management to understand compliance requirement and making it as profitable as possible, along with sufficient resilience and flexibility where required. Further, the potential ways the bank could comply with the new requirements is divided into three categories:
Restructuring of the balance sheet: The banks can address the restructuring without additional capital or reducing the profitability through various possibilities. For example reducing the pension or tax assets; restructuring their minority shareholding; moving away from unsecured interbank funding. Similarly banks might evaluate its accounting or reporting choices and when possible choose a method that offers sufficient asset treatment, improving leverage ratio and reducing regulation impact. And finally Bank most comply with local specification especially European Commission as well as global Basel III framework.
Meeting higher capital costs bar: The new core Tier-1 ratio and the proposed buffer for new leverage will directly impact the banks' capital. To overcome it, the group has to allocate more capital across all its business areas leading to increase in capital and funding costs. Hence the capital cost criteria for each businesses increases with respect to risk weighted assets. To address this business may seek to reduce their cost base or adjust their pricing schemes.
Addressing business specific regulatory challenges: The new capital requirements for trading activities and securitization charges penalties. Further the proposal also sets out new risk weights for lending to financial institutions and limits OTC netting under leverage ratio challenging the capital market business. To overcome this regulation, the businesses may include some cost or pricing adjusts, though which the additional capital or funding cost can be passed on to the customers.
Section 4:
The impact of Basel III rules is substantial on European banking sector. For 16 largest banks in Europe the European commission has launched a legislative process for establishing its fourth capital requirement directives (CRD), to be implemented in year 2010.
On the capital, Basel III proposed significant changes in tier-1 and tier-2 compilation; risk weights, especially in trading books; capital ratio. The main effect of this proposal would be capital shortfall of about 700 billion. Some 200 billion of this will be borne by the 16 largest banks. Further the leverage ratio implementation makes the proposal worse and represents an increase of 40% in the European banking system's tier-1 capital.
On the liquidity front, Basel III new standards for liquidity and funding management causes severe effects on European banking sector. Although the funding shortfall is harder to estimate, McKinsey Global Institute, 2010 believes that the European banks may need to raise between 3.5 to 5.5 trillion in additional long-term funding and an additional requirement to hold 2 trillion in highly liquid assets. Assuming the full implementation of the proposal by 2019, the pretax ROE of European banks would decrease by around 3.7 and 4.3% points from pre-crises level of 15%. The European banks currently have only about 10 trillion in long term unsecured debt outstanding. Before any mitigating action, the new funding and additional capital would reduce the ROE in 2012 by around 5% or 30% of the industry's long term average 15% ROE. The Basel III together with CRD IV proposes further changes to the trading book in form of increased risk weighted assets for the OTC derivatives that are not cleared centrally.
Conclusion:
The impact of Basel III on shape of the banking industry are unlikely to have any more success than that achieved by predictions of the impacts of the Basel I and Basel II regulation. Whilst clearly Basel III has been created to overcome the weaknesses in the regulatory environment the banking sector still isn't keen on its implementation. The capital requirements do not even need to start till 2013 and will be fully implemented by January 2018 putting burden on taxpayer for another 8 years. Meanwhile, the banks hope to reload their capital through profits which means central banks will need to keep subsidising them for another 8 years by keeping interest rates low and lending to these highly leveraged organisations at 0.5%.
