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Next month:
NEWS: Do tax
shelter funds bring
equity or debt to
companies?
TABLE: Corporate
income tax rates
RESEARCH PAPER:
The determinants
of loan contracts
Q&A: Are
exchange losses
part of operating
or financial
results?

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* * *

NEWS: Basel III

For a very long time now, weve been wanting to write an article on this topic in order to
present factually the main prudential restrictions that apply to banks or that are going to apply
to them (Basel III). But the gestation of these new rules has been long, and the project has
been modified and amended on numerous occasions. It seems today, nearly 5 years after the
G20 Summit at Pittsburgh which was the starting point, that the main features of the future
regulatory framework are stable and that we can describe them without too much of a risk of
having to draft a major amendment in 3 months time.
The Basel Committee was set up in 1974 by the Central Banks of 10 major western countries,
following the collapse of a medium-sized German bank, the Herstatt Bank, which, as a result of
its over-zealous activities on the foreign exchange market, in particular with US banks, led to a
temporary paralysis of the US banking system. The Basel Committee gets its name from the
fact that it is hosted by the Bank for International Settlements (BIS), based in the Swiss town of
Basel.
Its three aims were to improve the safety of banking systems, to establish minimum standards
in terms of prudential control over banks, and to promote the harmonisation of competition
among the major banks. Since it was set up, the Basel Committee has been a body which
makes recommendations that only acquire legal force if they are adopted and transposed by
governments into their countries statutes and regulations.
In 1988, an agreement was reached called Basel I which required banks to have a minimum
of 8 in capital each time they granted 100 in loans to a company. This is the Cooke ratio, the
name of the first chairman of the Basel Committee. To calculate this ratio, loans were
weighted at 0% for sovereign OECD risks, at 10% for certain public sector entities, at 20% for
NEWS: Basel III 1-6
THIS MONTH'S GRAPH: The /$ exchange rate since 2000 and the price of 12 month /$
calls at the money
6-7
RESEARCH PAPER:
Credit default swaps: a positive role for financing companies
7-8
Q&A: Why not take the value of equity as opposed to its book value in
order to calculate returns on equity?

9-10


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loans to OECD banks or short-term loans for non-OECD banks and 100% for others, especially
companies.
The regulatory capital requirement is a long way off the strict definition that we give it. Basel I
identifies core capital (Tier 1) made up of share capital and reserves, which must represent at
least 50% of regulatory capital. This first half can, in turn, be made up of up to 50% of
preference shares. The other 50% of regulatory capital, called Tier 2, can also be split into two
categories: perpetual instruments (Upper Tier 2) and instruments with a maturity (Lower Tier
2). In an extreme case, real capital can only make up one-quarter of regulatory capital and
accordingly, 2% of risk-weighted assets. This is the capital structure with which RBS was
authorised to take its share of ABN Amro in the autumn of 2007 and it is no surprise that this
didn't help it much in weathering the storm that was already threatening.
Goodwill and investments in other financial institutions are deducted in the calculation of
regulatory capital.
All in all, the Cooke ratio is simple but crude. It is only concerned with the solvency of a bank,
leaving aside other sources of fragility such as liquidity, market or operational risks.
Additionally, the way it takes credit risk into account is simplistic and is based on the
borrowers belonging to institutional categories.
* * *
Some years later, bank collapses (Barings in 1995), trader fraud (Dawa in 1995, Sumitomo in
1996) or state bankruptcies (Argentina in 2003) raised awareness of the limitations of the
Cooke ratio and the existence of market and operational risks that it did not cover. Parallel to
that, the progress of information technology means that banks are now able to better analyse
the characteristics of their assets and to develop sophisticated analysis models such as the VaR
(Value at Risk for market activities
1
).
Then came Basel II in 2004, which is applied mainly by European banks (since 2008) and
Japanese banks (since 2007) but not by US banks, as the US regulator considers that on the
basis of impact studies, Basel II would lead to reductions in regulatory capital which it held to
be inopportune.
The main aim of Basel II is not to increase regulatory capital but to make it more proportionate
to the risks taken and to take into account the risks overlooked by Basel I.
Basel II rests on 3 pillars:
1/ Capital requirements that are more clearly defined and that no longer only cover credit risk
but also market and operational risks. The McDonough ratio succeeded the Cooke ratio. It still
makes provision for a ratio of 8% of regulatory capital but accepts a more refined weighting in

1
For more on Value at Risk, see chapter 49 of the Vernimmen.


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line with the credit risk. This is either estimated by the internal models of the largest banks
(which have shown that they were able to develop reliable measurements of their credit risks
over a certain period) or according to a standardised approach similar to Basel I for smaller
banks. Accordingly, a loan to a company weighted at 100% under Basel I (and thus requiring
8% of capital) can, under Basel II, be weighted at 20, 50, 100 or 150% depending on its
perceived risk and the guarantees taken, leading to required regulatory capital of 1.6% to 12%
of its amount.
The market risk is taken into account through the flat-rate weighting of assets traded on a
market according to their type (standardised approach) or according to models such as the
VaR for the largest banks.
Operational risk includes the risk of fraud, computer system failure or the failure of models
used, fire, etc. This risk is difficult to measure and the regulatory capital that covers it is most
often estimated at a flat rate of 15% of annual income.
2/ The second pillar includes all of the risks that are not covered by the first pillar: risk of
inadequate loan portfolio diversification, risk of overestimating recovery values, risk of
asset/liabilities management, liquidity risk, etc. Some countries have decided to increase the
flat rate of their regulatory capital requirements in this regard, such as the United Kingdom,
and others have not (France, Germany).
3/ The third pillar concerns the discipline that the financial market can exercise over banks so
that they communicate relevant and adequate information to investors. Accordingly, this is
mainly a list of information required.
Basel II only modifies the edges of the definition of regulatory capital.
All in all, Basel II shows progress since the amount of regulatory capital is better linked to risks
taken and since market and operational risks are factored into the equation. But this came at
a price of a great deal more complexity, with a liquidity risk that is practically ignored. The
events of 2008 quickly showed that the market risk had been underestimated. It is often
assessed on the basis of models based on normal law which undervalue the frequency of
extreme risks
2
.
* * *
The 2008 crisis made bank regulators aware that banks were carrying too much debt, with
some of their capital of a poor quality, with an inadequate liquidity buffer.
As weve seen, the change from Basel I to Basel II took place by specifying the method for
calculating average risk-weighted assets (RWA) without changing the definition of capital. The
move from Basel II to Basel III went in the opposite direction. The was little impact on the

2
For more see the Vernimmen Newsletter.com n81, April 2014.


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method for calculating RWA but the definition of regulatory capital was completely overhauled
and it was increased in proportion to RWA. Moreover, new ratios were put in place to manage
the leverage effect and regulate the liquidity of banks.
Henceforward, Basel III divides capital mainly into Common Equity Tier 1 (CET 1), which
includes share capital, issue, share premiums and retained earnings. Hybrid products are
tolerated on condition that they can be used from an accounting and legal point of view in
order to absorb losses without having to go through the stage of liquidating the bank. As a
result, most quasi-capital, which was only capital in name and which was however accepted as
capital in the meaning of Basel II, is no longer considered as regulatory capital. The distinction
between Upper and Lower Tier 2 has been abolished, and, de facto, the essential capital of
banks must be constituted of hard core capital (CET1).
It is true that at face value, Basel III only requires a minimum of 4.5% of CET1 with a Tier 1 of
6% minimum (including CET 1) and thus Tier 2, 2% of a total of a minimum of 8% of average
risk-weighted assets (RWA). But Basel III makes provision for 3 additional capital buffers also
expressed as a percentage of RWA.
The first, which is mandatory, is 2.5% and is to be applied gradually between early 2016 and
late 2018. As soon as a bank operates with a regulatory capital ratio that falls below 8% + 2.5%
= 10.5% while remaining above 8%, its capacity to pay dividends and bonuses (which in this
industry are perceived to be more important than dividends) becomes dependent on the bank
regulator. This is a potential constraint and stigma which explains why banks that felt fragile or
wanted to show that they were well behaved got on board early. The others had to follow suit.
This is what explains today that most banks have a CET 1 of around 10%, even though this
regulatory constraint is only applicable from 2019.
The second regulatory capital buffer is optional. It is in the hands of the banking regulator who
can require that, during periods when the economy is doing well, banks must constitute an
additional buffer of capital that can be 2.5% of RWA. This requirement will be cancelled or
lessened during periods when the economy is not doing well and during which bank profits risk
falling, or even turning into losses. It is clearly a counter-cyclical tool since, as the reader well
knows, the amount of loans that banks can offer in the economy is directly linked to the
amount of regulatory capital. Accordingly, in February 2013, the Swiss regulator imposed an
additional buffer for real estate loans which it noted were overheating.
The third regulatory capital buffer only concerns the largest banks, 29 SIFIs (Systematically
Important Financial Institutions) at this time, which are required to constitute, from 2016 to
2018, an additional buffer of between 1% and 3.5% of their RWA: 2.5 % for HSBC and JP
Morgan; 2% for Barclays, BNP Paribas, Citi, and Deutsche Bank; 1,5 % for Bank of America,
Crdit Suisse, Goldman Sachs, Crdit Agricole, etc. 1 % for Bank of China, Santander, Socit
Gnrale, etc. National regulators can impose similar mattresses on their banks even if they


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are not members of the group of 29 SIFIs. In this way, Denmark has imposed an additional
buffer of 5% of RWA on some of its banks.
Basel III has tightened the deductibility rules for regulatory capital. From now on, most
intangible assets (software, etc.) must be deducted. The same goes for gains that banks can
get from valuing their debts at market value
3
.
All in all, banks are required, de facto, to have a minimum of 10.5% of their RWA in regulatory
capital, of which a minimum of 7% in CET, 1.5% in Tier 1 capital and 2% in Tier 2. Most banks
cover the majority of their regulatory capital in CET 1, i.e. with real capital.
Lets take the example of BNP Paribas, which has never been an undercapitalised bank. We
estimate its 2008 RWA, in the meaning of Basel III at around 820bn for 2008 CET 1 equity
capital of 29bn, i.e. a ratio of 3.5%. In 2013, RWAs are, in the meaning of Basel III, 627bn, or
a drop of one-quarter, for CET 1 equity capital of 65bn (up by 125%), i.e. a ratio of 10.3%. In
this case, one euro of RWA thus requires around 3 times more regulatory capital under Basel
III than under Basel II (and in this case, without taking account of the SIFI surcharge which only
applies from 2016).
And thats the story for solvency ratios.
The complexity of weighting banks assets in line with the perception of their risks and the
observation of weighting practices that differ from bank to bank for the same asset, have
raised suspicions, in particular of the US regulator, and have resulted in the encouragement of
a solvency ratio on an non-weighted basis. Basel III has taken it back in the form of a leverage
ratio which is calculated like the ratio of Tier 1 capital to the total on the banks balance sheet
and off its balance sheet items4. This should not be lower than 3% from 2018, but it is already
being applied in practice. Accordingly, the Bank of England forced Barclays in the summer of
2013 to carry out a capital increase in order to improve its leverage ratio.
In reaction Basel II's virtual failure to deal with the crucial issue of liquidity, Basel III introduces
two liquidity ratios. The first is a short-term liquidity ratio, the liquidity coverage ratio (LCR)
which aims to enable banks to withstand, over at least 30 days, massive withdrawals by
individual and corporate depositors, thanks to a stock of assets that can be easily sold and are
very low risk. The ratio is thus calculated like the division of the second by the first, and must
be at least 100%. Sixty percent of the assets taken into account are liquidities and government
securities, and for the balance, the bonds of listed companies that are rated at least AA-, or
riskier listed securities for 15%.
The second liquidity ratio restricts the ability of banks to use short-term resources (less than
one year) to finance long-term undertakings (more than one year), i.e. limit their capacity to

3
For more see the Vernimmen Newsletter.com n45, November 2009.
4
There is still some undertainty on how derivatives should be taken into account off balance sheet, i.e.,
net or not.


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carry out transformations which is one of their economic fundamentals, but also the principal
source of their collapse (Northern Rock, Dexia, etc.).
This ratio, called the Net Stable Funding Ratio (NSFR) is calculated as the ratio of available
stable financings to required stable financings and must be higher than 100%. Its calculation
method is still being discussed but should be broadly as follows.
Available stable funding is mainly made up of: all regulatory capital and loans or deposits of
more than one year, 90 or 95% of individual and SME overnight deposits and deposits with an
agreed maturity of less than one year, 50% of deposits of less than one year of large
corporations, governments, public entities, and interbank loans of between 6 months and one
year.
Required stable funding is mainly made up of: fixed assets, assets provided as a guarantee,
loans to banks of more than one year, loans in arrears; 5% of securities issued by a
government, a public entity or a central bank; 15% of bonds or commercial papers of
companies rated at least AA; 50% of loans of at least one year to individuals, companies,
bonds or commercial paper of companies rated between A+ and BBB, property bonds rated
at least AA, loans of between 6 months and one year to other banks; 65% of mortgage loans of
more than one year; and 85% of loans of more than one year to companies or individuals.
* * *
In some ways, Basel III is evidence of the pragmatism of central bankers. They have
understood that many banks had become too big
5
for governments to have the financial
resources to be able to bail them out in the future, that they would always be one innovation
ahead of them, and that it would be very difficult to modify their culture which is geared
towards risk-taking during economic booms. So failing all else, the central banks may as well
ensure that banks are highly capitalised in order to enable them to absorb heavy losses
without going bust, and to introduce restraints on liquidity, the second usual source of
collapse. The future will tell if the restraints have been sufficient to avoid the occurrence of
systemic crises.
* * *
THIS MONTH'S GRAPH: The /$ exchange rate since 2000 and the price of 12 month /$ calls at
the money
From mid-2000 to mid-2008, the /$ exchange rate fluctuated between 0.8 and 1.6. From mid-
2008 to mid-2011 the exchange rate never went below 1.2 or above 1.6. And since mid-2011, the
band has narrowed to 1.2 to 1.4:

5
Some because they bought, in 2008-2009, other banks in order to prevent them from collapse or
liquidation (Fortis, Lehman, Bear Stearns, etc.).


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Source: Lasyntheseoneline.fr
Unsurprisingly for our readers well versed in option pricing
6
, values of at the money 12
month /$ calls are down: from around 7 % early 2000 to less than 3% today:


Source: Lasyntheseoneline.fr
The cost of getting a protection against an adverse move of the $ again the , while being in
a position to benefit from $ weakness, has never been so low. This is nothing more than the

6
For the others, Chapter 24 of the Vernimmen is here to help.


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consequence of a currency risk that has never been so small. What will happen in the future
is quite another question and this is the reason why financial hedging instruments exist!
Lets meet again in one or two years time to talk about the near future. once it will have
become part of the past!

* * *

RESEARCH: RESEARCH: Credit default swaps: a positive role for financing companies
With Simon Gueguen Lecturer-researcher at the University of Paris Dauphine
Credit default swaps (CDS) have had a bad press. The principle of these credit derivative
instruments is to enable the purchaser to transfer a default risk to which it is exposed to the
seller, in exchange for a regular cash flow
7
. They have sometimes been accused of encouraging
the spread of the financial crisis, without any causal link having been clearly established.
In the last issue of the Vernimmen Newsletter, we discussed an article that showed that the
subprimes crisis was probably a crisis provoked by a demand shock, rather than a crisis of the
financial system or linked to financial innovations. The article that we present this month
8

shows that CDSs have virtuous effects on the financing of companies and encourage
investments in the real economy.
Saretto and Tookes studied the consequences of the existence of a CDS market for non-
financial US companies on the S&P500 index, between 2002 and 2010. Their intuition is that
CDSs encourage financing for the following reasons:
Although there is a separation between the potential supplier of credit and the party that
agrees to bear the risk, the existence of CDSs make it possible to increase the number of
investors on the side of the credit offer;
Institutional investors subject to capital adequacy requirements (Basle II, Solvency II) enjoy
a reduction of these requirements when they cover their credit positions with the
purchase of CDSs, which means that they can lend more;
Banks may use CDSs to provide credit to companies with the aim of establishing a long-
term commercial relationship, without any credit risk;
Even before the lender buys CDSs, the existence of such a market offers it a way out of its
risk and this anticipated effect may encourage the lender to lend more.

7
For more on CDSs, see chapter 49 of the Vernimmen.
8
A.SARETTO and H.TOOKES (2013), Corporate leverage, debt maturity and credit supply : the role of
credit default swaps, Review of Financial Studies, vol.26(5), pages 1190-1247


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A previous study, quoted in the article
9
, showed that the impact of CDS market on the cost of
lending was barely perceptible. The Saretto and Tookes article shows that there is however an
impact, but that this covers the quantity of loans agreed (increase in financial leverage) and
the maturity of the debt (a non-price element of the debt contract). According to the empirical
results, the introduction of a CDS market:
Increases financial leverage measured in market value (measured as the ratio of the total
amount of debt to the total value of the company) by 3.1 percentage points, or 19% of the
average amount of the leverage (16%);
Increases the maturity of the debt by around one year (according to test specifications),
which is very significant economically (the average maturity of debt in the sample is 8.68
years).
Finally, Saretto and Tookes show that the effects are increased in the event of credit rationing.
To summarise, CDSs help companies to find credit, especially in periods of crises.

* * *

Q&A: Why not take the value of equity as opposed to its book value in order to calculate its
returns?
Because that would be mixing apples and oranges!
Looking at return on equity is a way of measuring the company's performance. Either these
returns are book returns (ROE) or they are financial returns.
If they are book returns (ROE), we take the companys net earnings that go to its shareholders
(theyre free to pay them out in the form of dividends or to reinvest them in the company)
over to the companys equity which was contributed by the shareholders, or left at their
disposal in the form of past net earnings that were not paid out in dividends. So we answer the
question: by how much did this company, over a given financial year, increase the funds that
were entrusted to it? However, these book returns, calculated over a year, are really quite
theoretical for shareholders as they only really get their hands on them if, at the end of the
period, the company is liquidated without cost, which is fortunately a rare occurrence.
Nevertheless, they are not of no interest because, compared with returns required by the
shareholder, they can be used to measure value created or destroyed over the year
10
.
In order to make up for its rather theoretical nature, we can calculate its financial equivalent

9
A.B.ASHCRAFT and J.A.C. SANTOS (2009), Has the CDS market lowered the cost of corporate debt?,
Journal of Monetary Economics, vol.56, pages 514-523
10
For more, see Chapter 27 of the Vernimmen.


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which only takes into account the cash flows effectively paid out or collected over a given
period, not necessarily the year but the period during which the share was held by the
investor. It is the capitalisation rate that makes it possible to equalise the initial value of the
share and the value of possible dividends paid in the meantime with the current value of the
share. This is the IRR (internal rate of return) in terms of investment choice that is called TSR
(total shareholder return
11
) in this case. It answers the question: what rate of return did I
effectively enjoy over the period during which I held the share?
The ROE and TSR generally diverge. Accordingly, in 2013, the SBF 120 increased by around 20%
dividends reinvested compared with 15% for book return on equity. But if fell to 15% in 2011,
when return on equity were very positive. Over a long period, or even over a very long period,
the two should converge.
So, bringing net earnings, an accounting aggregate, to the value of equity (market cap.) and
not the book value of equity in an improbable effort to synthesise, makes no sense. In the vast
majority of these cases, shareholders don't get their hands on net earnings. Accordingly, there
is no reason to divide net earnings by the current value of the investment which is the value of
equity. At the very most, what would be measured by this ratio is the inverse of the P/E ratio
(value of equity / net earnings), but a fat lot of good that would do us!


11
For more, see Chapter 28 of the Vernimmen.