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What is Basel 3 ?
Basel 3 is an update to the Basel Accords.
What is in Basel 3 ?
➢ Tighter definitions of Tier 1 capital. That means banks must hold 4.5% by January 2015, then a further 2.5%, totaling 7%.
➢ The introduction of a leverage ratio.➢ A framework for counter-cyclical capital buffers➢ Measures to limit counterparty credit risk➢ Short and medium-term quantitative liquidity
ratios.
Why Basel 3 ?
To respond to the lack of adequate controls in financial institutions, which led to lax checks in the lending by banks, the Basel Committee on Banking Supervision (BCBS) has come up with updates to their guidelines for capital and banking regulations.
How BCBS puts it.
This consultative document presents the Basel Committee's proposals to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. The objective of the Basel Committee's reform package is to improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.
Tier 1 Capital
Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings.
Tier 1 capital is considered the more reliable form of capital, which comprises the most junior (subordinated) securities issued by the firm. These include equity and qualifying perpetual preferred stock.
Tier 1 Capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves (or retained earnings), but may also include non-redeemable non-cumulative preferred stock.
Tier 1 Capital
Capital in this sense is related to, but different from, the accounting concept of shareholders' equity.
Both tier 1 and tier 2 capital were first defined in the Basel I capital accord and remained substantially the same in the replacement Basel II accord.
Tier 2 capital is senior to Tier 1, but subordinate to deposits and the deposit insurer's claims. These include preferred stock with fixed maturities and long-term debt with minimum maturities of over five years.
Tier 1 Capital
Each country's banking regulator, however, has some discretion over how differing financial instruments may count in a capital calculation. This is appropriate, as the legal framework varies in different legal systems.
The theoretical reason for holding capital is that it should provide protection against unexpected losses.
Note that this is not the same as expected losses which are covered by provisions, reserves and current year profits. In Basel I agreement, Tier 1 capital is a minimum of 4% ownership equity but investors generally require a ratio of 10%.
Tier 1 Capital Ratio
The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets. The Tier 1 risk based capital ratio is the ratio of a bank's core (equity capital) to its total risk-weighted assets. Risk-weighted assets are the total of all assets held by the bank which are weighted for credit risk according to a formula determined by the Regulator (usually the country's central bank). Most central banks follow the Bank for International Settlements (BIS) guidelines in setting formulas for asset risk weights. Assets like cash and coins usually have zero risk weight, while debentures might have a risk weight of 100%.
Tier 1 Capital Ratio
A good definition of Tier 1 capital is that it includes equity capital and disclosed reserves, where equity capital includes instruments that can't be redeemed at the option of the holder (meaning that the owner of the shares cannot decide on his own that he wants to withdraw the money he invested and so cannot leave the bank without the risk coverage). Reserves are held by the bank, and are thus money that no one but the bank can have an influence on.
Tier 1 Capital Ratio
Tier 1 capital is seen as a metric of a bank's ability to sustain future losses. It is the way to track how much risk any particular bank is taking on, in terms of dollars held per dollars loaned out.
A 10% Tier 1 capital ratio may approximate but does not mean that a bank is holding in its vaults $1 for every $10 that a customer has in their account balance. The ratio looks across the columns of the balance sheet. The $10 that the customer has deposited is a liability of the bank.
Tier 1 Capital Ratio
The bank must have started with some equity capital, say $2. The ratio requires that we investigate what the bank does with those $12 (equity of $2 plus deposit of $10). If the bank lends $9 and invests $3 in Treasury securities, the question whether the Bank complies with its capital requirements will depend on the risk-adjusted asset-value of the claim against the borrower for $9 that the bank holds.
Tier 1 Capital Ratio
If the risk-adjusted value of that is 90% or $8.10, then (assuming the $3 Treasury deposit is valued at 100%) the bank's risk-adjusted assets would be $11.10, implying a Tier 1 capital requirement of $1.10. The bank's liabilities are $10. Subtracted from $11.10, they leave Tier 1 capital of $1.10, so the bank is in compliance, albeit barely.
Tier 1 Capital Ratio
Some call the loan of $9 that the bank was able to make in these circumstances fiat money because it creates the appearance that more money is in circulation than was issued by the central bank. In this example, the most that the central bank could have issued would be the $2 equity plus the $10 deposit, yet the borrower together with the depositor, believe they can purchase $19 of goods and the bank's equity holders believe they hold equity of $2. Thus, even in an economy of specie or hard money, fiat money will exist to the extent permitted by bank regulation.
Tier 2 Capital
Tier 2 capital is a measure of a bank's financial strength with regard to the second most reliable form of financial capital from a regulatory point of view.
The forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord. National regulators of most countries around the world have implemented these standards in local legislation.
Tier 2 Capital classifications
There are several classifications of tier 2 capital. In the Basel I Accord, tier 2 capital is composed of supplementary capital, which is categorized as undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt. Supplementary capital can be considered tier 2 capital up to an amount equal to that of the core capital.
Core capital
Core capital is another term for Tier 1 capital.
Tier 3 Capital
Tertiary capital held by banks to meet part of their market risks, that includes a greater variety of debt than tier 1 and tier 2 capitals. Tier 3 capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves compared to tier 2 capital.
Tier 3 capital is used to support market risk, commodities risk and foreign currency risk. To qualify as tier 3 capital, assets must be limited to 250% of a banks tier 1 capital, be unsecured, subordinated and have a minimum maturity of two years.
Changes Proposed in Basel III
First, the quality, consistency, and transparency of the capital base will be raised.➢ Tier 1 capital: the predominant form of Tier 1
capital must be common shares and retained earnings
➢ Tier 2 capital instruments will be harmonised➢ Tier 3 capital will be eliminated.
Changes in risk coverage
Second, the risk coverage of the capital framework will be strengthened.
➢ Strengthen the capital requirements for counterparty credit exposures arising from banks’ derivatives, repo and securities financing transactions
➢ Raise the capital buffers backing these exposures
➢ Reduce procyclicality and
➢ Provide additional incentives to move OTC derivative contracts to central counterparties (probably clearing houses)
➢ Provide incentives to strengthen the risk management of counterparty credit exposures
Changes : Leverage ratio
Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework.
➢ The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives:
➢ Put a floor under the build-up of leverage in the banking sector
➢ Introduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simpler measure that is based on gross exposures.
Changes : Capital build upFourth, the Committee is introducing a series of measures to promote the build up of capital buffers in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting countercyclical buffers").
* The Committee is introducing a series of measures to address procyclicality:
o Dampen any excess cyclicality of the minimum capital requirement;
o Promote more forward looking provisions;
o Conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and
Procyclicality
Procyclical is a term used in economics to describe how an economic quantity is related to economic fluctuations. It is the opposite of countercyclical. However, it has more than one meaning.
In business cycle theory and finance, any economic quantity that is positively correlated with the overall state of the economy is said to be procyclical. That is, any quantity that tends to increase when the overall economy is growing is classified as procyclical. Quantities that tend to increase when the overall economy is slowing down are classified as 'countercyclical'.
Procyclicality
Gross Domestic Product (GDP) is an example of a procyclical economic indicator. Many stock prices are also procyclical, because they tend to increase when the economy is growing quickly. Unemployment is an example of a countercyclical economic indicator.
Procyclicality :Meaning in policy making
Procyclical has a different meaning in the context of economic policy. In this context, it refers to any aspect of economic policy that could magnify economic or financial fluctuations. An economic policy that is believed to decrease fluctuations is called countercyclical.
Procyclicality :Meaning in policy making
In particular, the financial regulations of the Basel II Accord have been criticized for their possible procyclicality. The accord requires banks to increase their capital ratios when they face greater risks. Unfortunately, this may require them to lend less during a recession or a credit crunch, which could aggravate the downturn. A similar criticism has been directed at fair value accounting rules.
Countercyclical
Countercyclical is a term used in economics to describe how an economic quantity is related to economic fluctuations. It is the opposite of procyclical. However, it has more than one meaning.
Countercyclical :Meaning in policy making
An economic or financial policy is called 'countercyclical' (or sometimes 'activist') if it works against the cyclical tendencies in the economy. That is, countercyclical policies are ones that cool down the economy when it is in an upswing, and stimulate the economy when it is in a downturn.
Countercyclical :Meaning in policy making
Keynesian economics advocates the use of automatic and discretionary countercyclical policies to lessen the impact of the business cycle. One example of an automatically countercyclical fiscal policy is progressive taxation. By taxing a larger proportion of income when the economy expands, a progressive tax tends to decrease demand when the economy is booming, thus reining in the boom.
Countercyclical :Meaning in policy making
Other schools of economic thought, such as monetarism and new classical macroeconomics, hold that countercyclical policies may be counterproductive or destabilizing, and therefore favor a laissez-faire fiscal policy as a better method for maintaining an overall robust economy.
Changes : Capital build up
* Achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth.
o Requirement to use long term data horizons to estimate probabilities of default,
o downturn loss-given-default estimates, recommended in Basel II, to become mandatory
o Improved calibration of the risk functions, which convert loss estimates into regulatory capital requirements.
o Banks must conduct stress tests that include widening credit spreads in recessionary scenarios.
Macroprudential Analysis
A method of economic analysis that evaluates the health, soundness and vulnerabilities of a financial system.
Macroprudential analysis looks at the health of the underlying financial institutions in the system and performs stress tests and scenario analysis to help determine the system's sensitivity to economic shocks.
Macroprudential Analysis
Macroeconomic and market data are also reviewed to determine the health of the current system. The analysis also focuses on qualitative data related to financial institutions' frameworks and the regulatory environment to get an additional sense of the strength and vulnerabilities in the system.
Changes : Capital build up➢ Promoting stronger provisioning
practices (forward looking provisioning):➢ Advocating a change in the
accounting standards towards an expected loss (EL) approach (usually,
EL amount := LGD*PD*EAD).
Changes : Minimum capital
Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio.
The Committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions.
Externalities
In economics, an externality (or transaction spillover) is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit.
A benefit in this case is called a positive externality or external benefit, while a cost is called a negative externality or external cost.
Summary
It is hoped that the BASEL 3 updates shall guide the banks to control their lax lending practices.
The good option is to have better training and testing in the Human resources departments so that all bank employees can be trained and made aware of such practices.
Summary
If you would like to get consultants and trainers for your employees, then please feel free to contact us.
Regards,
Khawar Nehal
Applied Technology Research Center.
Contact : http://atrc.net.pk
