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Posts published in September 2010

Technical Comment: Basel III and Much Ado about 2019

September 16, 2010

By Katrina Lamb, CFA

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The latest entrée offering itself up to the financial chattering classes for tasting and appraising is Basel III, the new incarnation of the capital adequacy guidelines financial institutions are supposed to follow to protect against losses in their risk assets portfolios.  The heart of Basel III consists of stricter reserve requirements – essentially more capital that banks have to reserve against the possibility of loss.  There is a grace period – a long grace period extending to 2019 – for banks to come into full compliance with the new requirements.  Bank stocks reacted very well to the Basel III announcement earlier this week, causing one to wonder whether this is just another regulatory lamb ambulating among the wolves.  The community of wise observers holds divergent views: Reuters columnist Felix Salmon has a rather rosy take on the new regime, while the FT’s Martin Wolf likens it to a “mouse that did not roar”.

The three-sticks appellation, of course, means that there was a Basel I and a Basel II.  So anyone with a more or less intact memory extending back to, say, 2008 may want to know: what exactly were those prequels were doing to save humanity when the entire global financial system was teetering on the event horizon of eternal oblivion?  Good question.  Let’s do a quick crash course in the evolution of the Basel capital accords and then take stock of what Basel III may or may not do to make the financial ecosystem a bit more pleasant and stable for its bedraggled denizens.

Basel is a lovely little Swiss town near a point where France, Germany and Switzerland converge, just a stone’s throw as the cuckoo flies from the Black Forest, Lake Lucerne and plenty of other lures that draw legions of central bankers from around the world into project gigs with the Bank for International Settlements (BIS).  BIS is a supranational agency which functions as a bank for central banks.  Career central bankers populate the so-called Basel Committees that analyze and provide recommendations and guidelines intended to make the world financial system function efficiently, safely and transparently (here would be the appropriate place for stand-up comedians to riff about bankers in Basel overindulging in the regional favorite Schwarzwälderkirschtorte while New York and London burned…).

The Basel Committee on Banking Supervision (BCBS) is the entity entrusted with the promulgation of capital adequacy guidelines.  Basel I, the first set of capital accords, appeared in the late 1980s and caused a kerfuffle among financial institutions that now had to ensure they had sufficient levels of capital to meet these new international guidelines (Japan’s banks were particularly flummoxed as the new rules came into effect just as bursting of the country’s legendary asset bubble was dramatically eroding their fragile capital base).  Under Basel I banks had to maintain capital levels of 8% against their risk-adjusted assets (such assets being assigned a risk weighting based on their deemed credit quality).  This was divided into two tiers.  Tier I was considered to be common equity and other things plausibly similar to common equity, i.e. the most reliable risk protection.  Tier 2 consisted of somewhat dicier forms of capital like deeply subordinated debt.  No less than 4% of that 8% capital requirement had to be Tier 1, and at least half of that 4% Tier 1 had to be “core Tier 1”, i.e. straightforward common equity.

It would be tempting at this point in the story to skip right over Basel II and compare how the Basel III changes just announced compare with that original Basel I formula – because Basel III represents a very meaningful change in the core capital requirements.  But skipping over Basel II would leave out the part of the story explaining why the Basel accords did so little to prevent the financial system’s meltdown.

The Basel II effort began in the late 1990s with an attempt to expand the 1988 accord’s purview beyond capital adequacy to more nuanced definitions of and mitigation strategies for risk.  That attempt meandered over the years, buffeted by a lack of ability to achieve broad enough consensus on many issues to close the deal and implement new guidelines.  Finally Basel II came into effect in 2006 in the form of three “pillars”: one for minimum capital adequacy guidelines (the same 8% ratio as Basel I), a second for “bank supervisory practices” and a third labeled “market discipline”.  No, you are not alone – many observers at the time had no clear idea what that third pillar was all about.  While much of the thinking behind Basel II was worthy in theory – for example extending the definition of risk beyond traditional financial metrics to include the systemic risk of critically important operational systems like payment and settlement systems – in practice Basel II deferred too much to the ability of financial institutions themselves to promulgate effective risk management and supervisory practices.  We know better now – but in the middle of the 2000s it was still the conventional wisdom to believe that large systemically critical financial institutions could regulate themselves and make disciplined, grown-up decisions when tempted by Mammon’s lavishly abundant dessert tray.

So that brings us to Basel III, which sensibly goes back to the core importance of capital adequacy.  Recall that the Tier 1 component from Basel I was 4% of risk-adjusted assets, with at least 2% comprised of pure, straightforward common equity.  Basel III more than doubles that core equity component from 2% to 4.5%, and in addition mandates that total Tier 1 (i.e. common equity plus equity-like qualifying instruments) be a minimum 6% rather than 4%.  So, just to be clear: 4.5% minimum core common equity, 6% minimum core common equity plus other Tier 1-qualifying instruments.  The base minimum capital requirement for Tier 1 + Tier 2 remains at 8%.

But then the guidelines mandate an additional “conservation buffer” of core common equity of 2.5%.  So in fact the “core common equity” component goes from 2% under Basel I to 7% under Basel II.  Effectively, then, total Tier 1 is 8.5% (of which 7% is core common equity) and total Tier 1 + Tier 2 is 10.5% (8% plus the 2.5% equity buffer).

And finally, there is another new category of risk provision called a “countercyclical buffer”.  This is expressed as a range from 0 – 2.5% that is to be applied in environments deemed to be at high risk (i.e. in the heady good times when frothy loan expansion threatens asset quality).  It is not entirely clear when and how this countercyclical buffer would be applied, so for now it is probably best to leave it out of the calculations.

Here’s the catch: financial institutions have until 2019 to bring themselves into full compliance along a gradated implementation plan (I should note in parallel that over this time period the banks will also have to phase out some of the dodgier instruments that up to now have qualified as Tier 1 – so the Tier 1 capital base should be “cleaner” as a result).  So Basel III really isn’t going to be a lifeline if we have another systemic implosion in the next several years, which is always a distinct possibility.  And there is no inherent reason why having a Tier 1 capital base of 7% rather than 2% would be the decisive factor in preventing another collapse.

Having said that, though, I am on the side of the debate that sees the glass half full here.  2% was a ridiculously low ratio for common equity against all of an institution’s on-balance sheet risk assets.  Having the new guidelines issued instills some clarity and would hopefully facilitate a climate where institutions seeking to demonstrate a newfound respect for prudence will take the jump and start to build their new provisions well ahead of 2019.  The Basel committees serve an important function in global financial markets, and I for one will welcome more forward-looking leadership from them in these very tricky times.

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