Exploring the Potential Implications of Basel III. By: Amy Kvien Faculty Sponsor: Sherry Forbes

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1 Editor s note: This is an abstract of Amy Kvien s research project, done in collaboration with her faculty sponsor, Professor Sherry Forbes. Their research is ongoing and will be submitted for publication at a later date. Exploring the Potential Implications of Basel III By: Amy Kvien Faculty Sponsor: Sherry Forbes Part of my research project this summer included really understanding the Basel Accords, what they do, and why. What follows is a brief survey. The Basel Accords are international regulations that focus on reducing systemic risk in the financial sector, especially by regulating leverage. Leverage, in the banking sector, is a ratio of bank capital to assets. It is important because banks often use capital to back up losses on assets. Capital is categorized into tier 1 and tier 2 capital within banking regulations. Tier 1 capital is made up of common stock, retained earnings, and preferred stock. Tier 2 capital is supplementary capital and contains undisclosed reserves, revaluation reserves (from when banks re-evaluate assets to be worth more than their previous valuation), general loan-loss reserves, and subordinated debt (debt that ranks after other debts if a company goes bankrupt). Since the early 1900 s, economists have thought that the financial sector amplifies shocks to the economy. A term, financial accelerator was introduced in Barnanke, Gertler and Gilchrist (1996) to describe this phenomenon. Leverage can be a financial accelerator because it has been shown to move procyclically with the business cycle, in the leverage cycle. During an economic expansion, there is a credit boom, which leads to higher prices, so banks must have higher capital buffers. This encourages more lending, because banks do not earn profit on their capital, which then leads to higher prices, and so on. During an economic downturn, there is a drop in the value of capital, so banks cut back lending, since they have suffered losses and are 1

2 more wary about lending out money, which leads to even lower prices, and so on. Also, Jorda et al. (2012), used annual data from 14 advanced countries over the years 1870 to 2008, to show that in booms with higher bank leverage, the subsequent busts are significantly worse. This is because a build-up of leverage in the boom heightens the vulnerability of economies, since there is less capital to back up losses in assets when the recession hits. Banks can decrease leverage in three primary ways: retaining more of their profit, selling new shares in the market, and reducing assets. Retaining earnings and issuing more shares both raise capital, while reducing assets does not raise capital, but reduces leverage since less capital is needed to back up fewer assets. Recently, more regulation on bank leverage has been introduced around the world through the Basel Accords. After the breakdown of the Bretton Woods system in 1973, the Herstatt Bank in Germany was liquidated after finding out that the bank s foreign exchange exposures amounted to three times its capital. Banks outside Germany took heavy losses on their unsettled trades with Herstatt, so countries sought an international standard for banking regulation. The central bank governors of the Group of Ten countries established the Basel Committee on Banking Supervision the next year, in 1974 (History 1). The Basel Committee published Basel I, the first of the series of regulations, in 1988, after the Latin American debt crisis began, which increased concern over the erosion of capital ratios in large international banks. Basel I was introduced to strengthen the stability of the international banking system and remove some competitive inequality from differences in national capital requirements (History 2). More than 100 countries adopted it, including almost all of the countries that have international banks. 2

3 The following things are important and of concern: risk-weighted-assets are bank s assets calculated to reflect how risky they are. Assets of a bank include loans, mortgage-backed securities, physical assets, and reserves. The Basel Accords calculate risk-weighted-assets in different ways and include different types of risk in their risk assessments. Basel I based the risk weighting on the credit risk of assets. Banks calculated their risk-weighted-assets by dividing assets into risk-weighting categories that Basel I set, for example cash and most government debt were considered to be 0% risk, so they were not counted in the risk-weighted category, but corporate debt was in the 100% risk category, so the entire amount of corporate debt had to be added into risk-weighted assets, and mortgage-backed securities were in the 50% risk category, so 50% of their value was included in the risk-weighted-assets. However, there were concerns that other types of risk were not captured in this regulation, so an amendment to Basel I was implemented in 1997, Market Risk Amendment to the Capital Accord, expanded the risk calculation to include market risk. Market risk was calculated by using internal value-at-risk models. It is the risk of losses from movements in market prices, including equity risk, interest rate risk, commodity risk, and currency risk. Basel I set a minimum capital to risk-weighted-assets ratio of 8%, as well as a tier 1 capital to risk-weighted-assets ratio of 4% (History 2). Basel II replaced and expanded Basel I in It was put into effect to better address the financial innovation that occurred in recent years, improve risk management and control, and better reflect underlying risks (History 3). Basel II consisted of three pillars, the first being minimum capital requirements, which expanded Basel I. Basel II sought to reduce vulnerability by quantifying as much risk as possible and ensuring banks had enough capital to back up the risk. Basel II calculates risk weighted 3

4 assets based on credit risk, market risk, and operational risk. Operational risk includes risk from failed internal processing, fraud, and environmental risk. Credit and market risk are calculated in the same was as in Basel I and operational risk can be calculated in a variety of ways, the simplest way being the average over the previous three years of a fixed percentage (15%) of positive annual gross income (Part 2). The second pillar gives regulators better tools and provides a framework for dealing with residual risk, which includes systemic risk, concentration risk, liquidity risk, legal risk, and more. The third pillar aims to increase market discipline by requiring institutions to disclose details on their capital, risk exposures, risk assessment, capital adequacy, and more. Under Basel II, the ratios are kept the same: capital must be at least 8% of RWA and Tier 1 Capital must be at least 4% of RWA. However, Basel II adds another regulation: common equity tier 1 capital must be 2% of RWA (Part 2). In 2011, the Basel Committee published Basel III, which further extended regulation on leverage and credit. Basel III was implemented because of concerns that Basel II amplified the Great Recession due to its procyclicality and also slowed recovery from the crisis, which may have further reduced lending (History 5). The regulation includes the following minimum requirements: common equity tier 1 must be at least 4.5% of RWA, tier 1 capital must now be 6% of RWA, and total capital still must be 8% of RWA. The regulation changed how tier 1 capital was calculated and increased its requirement from 4% to 6% to ensure banks had more of the pure, tier 1 capital to back up losses (Basel Committee). There are additional regulations in Basel III, including a capital conservation buffer, where banks must return a percentage of their earnings based on their common equity tier 1 ratio. If their common equity tier 1 ratio is the minimum 4.5% up to 5.125%, they must retain 100% of 4

5 their earnings, but if it is 7%, they do not have to retain any of their earnings (Basel Committee). This is to ensure that banks have enough capital for upcoming periods to cover any losses. One more controversial policy in Basel III is a tool that countries can use to reduce leverage during booms by applying an extra 0 to 2.5% onto the minimum 4.5% common equity tier 1 ratio. Under Basel III, all countries will be required to publish a credit-to-gdp ratio as guidance for the operation of the countercyclical capital buffer. National authorities decide when to implement the buffer and the size of the buffer (between 0 and 2.5%), banks then have a year to comply with the buffer (Basel Committee). This counter-cyclical policy requires banks to accumulate extra capital buffers when the economy is booming and allows them to draw down their capital levels during an economic downturn. Basel III also introduced a leverage ratio that requires tier 1 capital to be 3% of average total consolidated assets (Basel Committee). This is significant because before this policy, all capital regulation was based on risk-weighted-assets. There were concerns that the calculation of risk-weighted-assets was flawed, since risk is very difficult to estimate and often banks were calculating much of the risk themselves, which led to opportunistic under-estimation of risk. This requires banks to have a buffer to ensure they have a decent amount of capital to back up their assets, no matter how risky they deem them. This research is ongoing and I am currently working on exploring data to further analyze potential impacts of the Basel Accords. 5

6 Bibliography Basel Committee On Banking Supervision. "Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems." Bank For International Settlements, June Web. "History of the Basel Committee." History of the Basel Committee. Bank For International Settlements, n.d. Web. Jorda, Oscar, Moritz Schularick, and Alan M. Taylor. When Credit Bites Back: Leverage, Business Cycles, and Crises. London: CEPR, Federal Reserve Bank of San Francisco, Oct Web. Part 2: The First Pillar Minimum Capital Requirements. Bank For International Settlements, June Web. 6