BASEL III

Basel III
Amirsaleh Azadinamin

Electronic copy available at: http://ssrn.com/abstract=2007817

BASEL III Abstract The current financial crisis has illuminated certain characteristics of the market including its weakness in dealing with credit events and how vulnerable it is to outside shocks. Other characteristics of the market revealed by the crisis were high leverage in banking, low quality of capital, and excessive credit growth. This paper looks upon various recommendations of Basel III that cover the shortcomings of the two previous accords. Basel III also dampens the risk factors associated with counterparties as it is believed that the failure of too big to fail institutions that are interconnected can increase the market risk by starting a chain reaction. The accord is supposed to make banking industry more stable and less vulnerable in turbulent times. The paper also explains how various ratios have been updated or newly adopted to deal with the issue of risk in addition to what had been covered in Basel II, for instance, the operational risk. The paper also sheds some light on new definitions and guidelines provided by Basel III to illuminate their proper implementation. Capital and common equity are definitions that have been newly revised as part of Basel III accord for safer implementations.

Electronic copy available at: http://ssrn.com/abstract=2007817

BASEL III Continuing evolution of banking Following the 2007-8 crisis of credit, and as an attempt to prevent more financial crisis in the foreseeable future, the Basel III accord has been designed to revise numerous standards for banks. The accord was designed to strengthen the banks in terms of capital requirements and to increase their loss-absorbing abilities; and this is what Basel III was intended for initially (Price & Ennic, 2011). Authors Price and Ennic (2011) go on to continue that the conclusion from the crisis made them realize that the bank fragility is more prevalent than previously thought and that the motivation for governments to assist banks in poor financial condition is very strong during a crisis (p. 1). Regarding Basel accords there are two points to be taken notes from: first, Basel III accord was drawn and designed based on the Basel II accord and the shortcomings that contributed to the financial crisis of 2007-8. Secondly, the Basel accords are not legally binding on the participating countries. They are used strictly as guidelines to help banks cope in hard times and create a safeguard for all stakeholders; however, they are expected to be implemented starting 2013 and be fully complied by 2019. The reforms are designed to attain higher degrees of soundness and safety that will change various ratios such as the leverage and liquidity ratios. The article Basel III, Basel 2019 (2011) mentions that in the beginning, the new capital requirements presented to the G20 Seoul meeting had higher

standards, but later on fears and worries that harsher regulation would trigger a credit crunch in the still fragile economic environment made the committee realize Basel III rules had to be relaxed from the first much harsher proposal and also implementation time had to be lengthened (p. 165).

BASEL III The underlying logic of Basel framework The underlying logic in changes seen in Basel accords is based on the views of policymakers and these views have been formed based on how markets have evolved overtime. Many guidelines that are recommended today in Basel III may not have been perceived as necessary decades ago. New instruments in finance and creation of various financial vehicles have caused for new guidelines to be called on. The changes in guidelines reflect the changes in perceptions on various issues including risk taking appetites of the banks. Policymakers have assessed risks in its various forms and have changed the requirements accordingly. Price and Ennic (2011) mention that regulators in the United States imposed various capital requirements only since 1981 as a response to the late 1970s stagflation and the early 1980s recession; and before then, supervisory agencies directed institutions to increase capital only after a caveat was issued based on case-by-case examinations. It was always a vague issue whether supervisory institutions had the authority to order banks to increase their capital; however, the U.S. congress resolved this issue in 1983 with the International Lending Supervision Act, which explicitly gave the agencies authority to set and enforce capital requirements (p. 2). The response did not stop at that point and U.S. regulators became wary that not all assets must be treated the same and the regulatory capital ratios did not capture differences in risks among various classes of banks assets, and thus, in applying the requirements, high-yielding riskier assets must be prioritized. Basel I imposed an 8 percent minimum capital requirement and implemented risk adjustment of assets by putting them into four broad categories with a credit-risk weight for each ranging from 0 percent for government bonds to 100 percent for corporate debt and unsecured personal loans (Price & Ennic, 2011, p. 2).

BASEL III The continuing evolution of Basel Although having to enforce some capital requirements was the right step in decreasing the risk in its various forms, Basel I was seen as too primitive and a guideline that failed to address numerous issues, mainly various aspects of risks. Basel II was yet another attempt to disclose these shortcomings by addressing other types of risk, such as the operational risk, as Basel I only dealt with the credit risk. Also, to expand the topic of credit risk that was previously covered in Basel I, Basel II offered various methods and menus in calculating assets credit risk. It also applied different risk weighing to different assets (Price & Ennic, 2011). However, the work of the concerned committees did not stop there, and in a quest to attain banking without risk, Basel III came along to cover some shortcomings of Basel II. The Basel III accord not only strengthened the quantity of money, but it also increased its quality. Basel III is unquestionably a direct response to the global financial crisis that began in 2007 and culminated in the most severe threat to the worldwide banking system since the Great Depression. But the roots of Basel III can be traced indirectly to the forces that produced Basel I and Basel II, as well as the shortcomings of both of those frameworks in addressing the capital requirements of internationally active banks (King & Tarbert, 2011, p. 1). Blundell-Wignall and Atkinson (2010) also remind the reader of some highlights of Basel III and how the proposals of Basel III and its valuable elements helped in solving problems such as the insolvency resulting from contagion and counterparty risk, the lack of supervisory integration, and the lack of efficient resolution regime. The Basel III capital proposals have some very useful elements, notably a leverage ratio, a capital buffer and the proposal to deal with pro-cyclicality through dynamic provisioning based on expected losses

BASEL III (p. 9). Blundell-Wignall and Atkinson (2011) emphasize on how Basel III has tried to raise the quality, consistency, and the transparency of the capital base by raising the bar on some of the

requirements asked in Basel II, notably the definition of capital. Basel III knows equity to be the best form of capital as it can be used to write off losses. Basel III prohibits these institutions to define certain items as common equity, as they are mentioned here: 1- Good will cannot be used to write off losses as it will not be defined as common equity in Basel III accord. 2- Minority interest in case of a company takeover with a majority interest and consolidating the balance sheet, the net income of the third party minorities cant be retained by the parent as common equity (Blundell-Wignall & Atkinson, 2010, p. 16). 3- Deferred tax assets, DTA, should be deducted only if it depends on future profit realization, and not solely on tax prepayment and the like that are regardless of the future profitability. 4- Bank investments in its own shares, other banks, financial institutions, and insurance companies are also excluded from the definition of common equity if they are known to be sister companies, the activity known as cross-share holdings. The purpose is to avoid double counting of equity. Basel III has also tried to enhance the risk coverage by providing certain guidelines about off-balance sheet activities as one major problem in the crisis was the failure of the Basel approach to regulate and capture the on- and off-balance-sheet activities and its related risks such as the special purpose vehicles. Blundell-Wignall and Atkinson (2010) mention some of the propositions:

BASEL III 1- Banks must include capital charges (credit valuation adjustments) associated with deterioration in the creditworthiness of counterparty (as opposed to its outright default). 2- Apply a multiplier of 1.25 to the asset value correlation (AVC) of exposures to regulated financial firms with assets of at least $25bn, (since AVCs were 25% higher during the crisis for financial versus non-financial firms). This would have the effect of raising risk weights for such exposures (p. 16). 3- Applying tougher and longer margin periods in determining regulatory capital in cases where large derivative exposures exist. 4- Emphasis on using external ratings and its usefulness in assessing the safety of the bank in regards of capital adequacy. Nuku (2011) explains how Basel III will affect various business sectors and that its effect on retail, corporate, and investment banking will not be the same. Both retail and corporate banking activity are mainly affected by those requirements of

Basel III which affect the entire bank, in particular higher capital and liquidity standards. Some retail institutions will also be affected by measures concerning the quality of capital base. If Basel III effects upon retail products are less relevant, new requirements will affect many of standard banking products for corporate segment by increasing financing costs. Products with relatively high risk weight (structured finance or unsecured loans) will be substantially affected. Of the three segments, the investment banking and in particular capital markets supports most changes, under the impact of new capital ratios. The activity of OTC derivatives market will be affected by the fact that banks should hold a higher level of capital to cover market risk and counterparty credit risk (p. 63-64).

BASEL III As for how the final Basel III package is intended to strengthen the banking regulation, supervision, and the risk management at its core, Walker (2011) mentions that this has been designed to improve the ability of banks to absorbs shocks arising from financial stress and improving risk management and governance by increasing the transparency and capital adequacy. This will certainly help banks in strengthening their position in times of economic hardship. In line with Basel III accord and its attempt to increase the quality and quantity of capital, King and Tarbert (2011) state that among the highest priority issues in Basel III was the need to strengthen the quality, consistency, and transparency of the regulatory capital base. The reforms of Basel III seek to ensure that the capital base of every internationally active bank is backed by a high-quality buffer that can absorb losses during periods of economic distress. Basel III aims to strengthen the fundamental definition of capital, with a focus on its overall quality, transparency, and consistency (p. 3). A feature of Basel I that was also left unchanged in Basel II was setting the riskweighted capital at 8 percent, with the total capital divided 50/50 between tier 1 and 2. In Basel III the banks total capital is required at the unchanged rate of 8 percent; however, Tier 1 must constitute 75 percent of the total capital. This has been a positive step taken by Basel III in comparison to the two previous ones in safeguarding the banks and all concerned investors and depositors. In his article Basel III and Systemic Risk, David Kelly (2011) mentions that in comparison to the two previous accords, Basel III has taken an extra step to address and cover certain aspects of risks that the two previous accords had failed to do. One of the key shortcomings of the first two Basel accords is their approach to the issue of solvency and how they approached the solvency of each institution independently; however, the recent crisis

proved that the failure of one too-big-to-fail institution can increase the systemic risk by causing

BASEL III counterparties to fail as well, and hence, starting a chain reaction. Basel III addresses the issue in two ways, firstly by increasing capital buffers for risk related to the interconnectedness of the main dealers, and secondly, providing incentives for institutions to reduce counterparty risk through active management, also known as hedging. It may become apparent that the best way to hedge against a counterparty risk is collateral. David Kelly (2011) farther explains that while dealers typically have margin agreements between them, central cleaning standardizes the process the process and enforces tighter controls around collateral risk. Clearing also helps immunize the system from the failure of any one big bank as coined too big to fail, and in addition, Basel III assigns a minimal of 1-3% risk weight for cleared transactions, thereby fostering central clearing and systemic benefits. Concluding remarks Basel III has definitely played a major role in covering the shortcomings of the two previous accords and it has certainly added some risk-covering aspects to the requirements addressed by Basel II. Basel III also puts emphasis not on the quantity of capital, but also on the quality of core capital with the overriding goal of fortifying bank capital cushions on a global basis (King & Tarbert, 2011, p. 11). As Bloomberg View explains in the article Basel III Doesnt Go Far Enough (2011), the Basel III banking rules are regulators another attempt to address one of the biggest threats and fears regarding the global economy: the tendency of financial institutions to go bankrupt during bad times. It also asks banks to finance their operations with more capital as opposed to debt financing. This will diverge the threat from the taxpayers in case of the bailout, and will help in absorbing the loss by changing the threat that is directed toward taxpayers and changing it toward the direction of shareholders. In an environment that institutions are ever more vulnerable to loss and market risk due to

BASEL III interconnectedness, Basel accord comes as a savior for not just shareholders, but also for taxpayers who will pay the ultimate price in time of failure. Nucu (2011) mentions the challenges that banks may face in applying these guidelines:

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For banks, the challenge comes from three main areas: design, data quality and reporting complexity. The measures which credit institutions could take to mitigate the impact of alignment with the new standards are business model adjustment and balance sheet restructuring. The efficiency of banking corporative governance, depending on business model and risk profile, is essential for successful implementation of Basel III (p. 70). It may become obvious that Basel III has taken extra steps to covering the shortcomings of the two previous accords, but are the recommendations enough to stop another financial crisis? Only time will tell whether Basel III has covered all apparent shortcomings or a Basel IV may be called for. Nucu (2011) believes that some critics may take issue with the time frame provided to institutions for full compliance, as the implementation time that is deemed as too long to comply. In addition the new accord will have fundamental effect on the banking sector profitability due to its conservative measures and standards. However, in the meanwhile, one can assert that Basel III has covered numerous issued of risks that have been previously areas of concern.

BASEL III References Basel III, Basel 2019. (2010). Black Book - Southern European Banks: Initiating Coverage & Introducing the Success Ratio, 165-169. Basel III Doesn't Go Far Enough. (2011). Bloomberg Businessweek, (4247), 15. Basel III & Systemic Risk. (2011). Derivatives Week, 1. Blundell-Wignall, A., & Atkinson, P. (2010). Thinking beyond Basel III: Necessary Solutions for Capital and Liquidity. OECD Journal: Financial Market Trends, 2010(1), 9-33. Ennis, H. M., & Price, D. A. (2011). Basel III and the Continuing Evolution of Bank Capital Regulation. (cover story). Richmond Fed Economic Briefs, 11(6), 1-5. Nucu, A. (2011). The Challenges of Basel III for Romanian Banking System. Theoretical & Applied Economics, 18(12), 59-70. King, P., & Tarbert, H. (2011). Basel III: An Overview. Banking & Financial Services Policy Report, 30(5), 1-18. Walker, G. (2011, March). Basel III market and regulatory compromise. Journal of Banking Regulation. pp. 95-99. doi:10.1057/jbr.2011.4.

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