The Basel III framework is the regulatory response to the causes and consequences of the global financial crisis. The objective of the reforms is to improve the banking sector’s ability to absorb shocks arising from financial and economic stress by prescribing more stringent capital and liquidity requirements. It raises the core capital required, introduces counter cyclical measures and enhances a banks’ ability to conserve core capital during periods of stress via a conservation capital buffer.
Origins
The Basel III framework has originated in the wake of 2008 global financial crisis. From a macroeconomic perspective, the crisis was the result of sustained global imbalances and a breakdown of trust. It is said that the solution of the preceding crisis becomes the cause of the next one. The last major financial crisis was the Asian crisis of 1997-98 and the lesson learnt was to maintain a large war chest of foreign exchange reserves to protect against an attack on the country’s currency.
China and other emerging economies did exactly this as they followed an export led growth strategy. The huge amount of capital accumulated by the emerging economies was then invested in the advanced economies. This depressed yields in the financial markets of the advanced economies. In search of higher yields to improve return on investment, the market players started the process of financial engineering and innovation. Out of this emerged new structured financial products like collateralized debt obligations, mortgage backed securities and credit default swaps, which increased market complexity and illiquidity.
Along with rise in the shadow banking system, the financial sector became too big in relation of the real economy. There was a supervisory and regulatory failure as the proper authorities failed to recognize the inherent risk in these new financial products. These issues were compounded by political issues and real wage stagnation in the US.
Ultimately, banks simply entered the crisis with insufficient capital. The Basel requirement of common equity was as low as 2% of risk weighted assets. However, even then, banks did not calculate risk based properly. They indulged in capital arbitrage, utilizing a loophole which favoured lower capital requirement for the trading book and higher capital for the banking book. They securitized mortgage loans through special investment vehicles, thereby artificially enhancing credit rating and liquidity support.
Post Crisis: Basel II.5
Global initiatives to strengthen the financial system were spearheaded by the political leadership of the G20, Financial Stability Board (FSB) and the Basel Committee on Banking Supervision. In July 2009, the Basel Committee came out with some measures, dubbed Basel II.5 to plug the loopholes in the system, especially with regards to capital arbitrage. Incremental risk charge for specific risk or credit risk in trading book was introduced and capital requirements for the trading book were increased approximately threefold. Steps were also taken to manage liquidity and reputation risk, along with new disclosure practices.
The Basel III Framework
The Basel Committee published Basel III rules in December 2010. The objectives of Basel III are
Micro Prudential Elements
In attempt to increase high quality capital in banks, Tier 1 capital will be have to a minimum of 6% of risk weighted assets (RWA), compared to the 4% required currently. Tier 3 capital has been completely abolished and innovative features in non-equity capital instruments are no acceptable
The Basel III framework aims to provide enhanced risk coverage. Banks will be subject to a Credit Valuation Adjustment capital charge to protect themselves against mark to market losses related to deterioration in creditworthiness of the counterparty. Measures have been introduced to strengthen capital requirements for counterparty exposures and securities financing activities.
Basel III introduces two new liquidity standards, Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) to improve banks’ resilience to liquidity shocks. The LCR will require banks to maintain a buffer of highly liquid securities over a 30 day horizon, while the NSFR requires a minimum amount of stable sources of funding at a bank relative to the liquidity profiles of the assets, as well as the potential for contingent liquidity needs arising from off-balance sheet commitments, over a one-year horizon
Macro Prudential Elements
Basel III prescribes a capital conversation buffer of 2.5 of RWAs, comprising of Tier 1 common equity capital be built in addition to 8% total capital requirement. This is to be done outside periods of stress and banks will be draw upon this as losses are incurred during periods of stress.
The countercyclical buffer aims to ensure that banking sector capital requirements take into consideration the macro financial environment it is operating in. Credit growth and factors will signal a system wide risk build up will be monitored by national authorities and a countercyclical capital requirement will be enforced as per the prevailing conditions
During lean periods, banks’ profits decline but they are required to make higher provisions for NPAs. To address the pro-cyclicality issue, the Basel Committee is working with the International Accounting Standard Board towards an expected loss approach to provisioning as opposed to the current practice of an incurred loss approach.
Through enhanced regulatory framework for global systemic important banks (G-SIBs), the issue of interconnectedness among large banks is trying to be address.
The G-SIBs will be grouped into different categories of systemic importance by the Basel Committee, with varying level of additional loss absorbency requirements. This will range from 1% to 3.5% of risk weighted assets. This additional requirement is to be met through common equity (Tier 1 capital).
It has been proposed that banks must perform their own internal credit rating of externally rated securitization exposures in attempt to reduce excessive dependence on external credit rating.
Macroeconomic Impact
The increase in equity capital requirement is likely going to result in an increase of the weighted average cost of capital. Banks are likely going to pass on the higher cost of capital to borrowers via higher lending rates. It is safe to assume that equilibrium lending rates are going to increase marginally and result in slower credit growth.
The Macroeconomic Assessment Group set up by the FSB and the Basel Committee estimate a maximum decline in GDP of 0.22% (relative to the baseline forecasts) at the end of Basel III implementation period. However, the International Institute of Finance estimates that GDP will be 3.2% lower that it would be otherwise after 5 years.
Liquidity & Profitability of Banks
Indian banks are required to maintain minimum reserves of high quality liquid assets via the statutory liquidity ratio (SLR). The SLR is currently at 24%. However, the RBI has not yet clarified whether these reserves would count towards to the LCR. If they do not, the proportion of liquid assets with banks will increase dramatically and will have a significant adverse effect on bank earnings.
Regardless, studies have indicated Basel III requirements will have a substantial impact on profitability internationally. A study by McKinsey & Co indicates that, holding all other factors constant, return on equity is going to fall by 400 basis points in Europe and 300 basis points in the US.
Capital Adequacy of Public Sector Banks - India (Median)
Capital Adequacy of Private Sector Banks – India (Median)
Implications
It is clear that implementation of the Basel III framework would involve some costs. However, the framework would address the weakness in measurement of risk in Basel II along with the loopholes. Ultimately, it would also ensure a much safer financial system with a reduced risk of a banking crisis.
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