Bank capital adequacy rules: rationale and consequences. Firuz Shakirov Cedric Goussanou Andrew Wiggins John Geelkens
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1 Bank capital adequacy rules: rationale and consequences Firuz Shakirov Cedric Goussanou Andrew Wiggins John Geelkens
2 Outline 1. Introduction 2. Regulation of the Banking Sector 3. The Basel Agreements 4. Basel III Rationale 5. Macroeconomic Consequences 6. Implementation of Basel III
3 Introduction Banks face risks - Mass withdrawals - Default and Risk premium Ø Mortgages in US before crisis Ø Interest rates on bonds after crisis Risk reduction and regulation
4 Capital Adequacy requirements BCBS = Basel Committee on Banking Supervision (central banks and banking regulators) Basel 1 (1988) Basel 2 (2004) - Implemented in Europe, not in US Basel 3 (2010) - Implementation:
5 Basel II (2004)
6 The need for Basel III Deficiency in financial regulation & Loss absorbancy The subprime crisis in 2007 and the sovereign crisis in 2009: Ø lack of capital quality and liquidity in global banking system Ø Inefficiency of the Basel II and disability of banking system to absorb credits losses. Hence, in September, 2010: Basel Comittee announced a new regulatory standard, Basel III: Ø Objectif: To strengthen bank capital requirements and to introduce new regulatory requirements on bank liquidity and bank leverage. Ø According to the Basel Committee, all regulatory capital instruments must be competent to absorb losses
7 New requirements under BASEL III
8 The key reforms and novelties introduced by BASEL III Micro-prudential reforms Ø Strengthening capital and liquidity: loss absorbing capacity Ø Enhancing financial supervision and risk management Ø Market discipline and transparency Macro-prudential reforms Mitigating procyclicality Ø New capital conservation buffer Ø Countercyclical capital buffer
9 Micro-prudential reforms Capital adequacy ratio = Capital Risk- weighted Assets v Intensified quality, consistency and transparency of the capital base. v RWA: -Counterparty credit risk on derivatives -Introduction of a 12-month stressed VaR Minimum Capital requirements: The minimum for common equity: highest form of loss-absorbing capital raised from 2% to 4.5% of total risk-weighted assets and Tier I capital ratio from 4% to 6%.
10 Additional rules on microprudential regulation New liquidity standard: framework for liquidity risk management v Liquidity coverage ratio: the stock of high- quality liquid assets total net cash ou4lows over 30 days v Leverage requirement ( 3%): non-risk based leverage ratio back-stop to the risk-based capital requirement. Market Discipline Increasing the disclosures that banks must provide to increase the transparency of banks
11 Source: BCBS (2010)
12 Macro-prudential reforms Procyclicality during an economic downturn Limit of Procyclicality: Lending contracts Economic downturn Objective of Basel III: Decrease in capital ratios Growth in RWA Increase in Risks Ø Reduce pro-cyclicality and prevent the destabilizing effects experienced in financial crisis.
13 Macro-prudential reforms Capital conservation buffer - In addition to minimum capital requirements, banks are required to hold a capital conservation buffer of 2,5% in order to absorb losses and withstand fhe future financial and economic stress. Introduction of the counter-cyclical capital buffer - During economic upturns banks are required to increase capital ratios and limit excess lending in an effort to avoid potential asset bubbles - During economic downturns (recession or credit crunch) the buffer will be released to ensure continued lending in the economy v The countercyclical capital buffer ranges from 0 to 2.5% of risk-weighted assets.
14 Macroeconomic Consequences Two Studies l (1) MAG = Macroeconomic Assessment Group (BCBS and FSB), December 2010 l (2) IIF = Institute of International Finance, June 2010 Structure: 1.Methods and Models 2. Results 3. Open issues and Conclusion
15 Macroeconomic Consequences: MAG 1. Methods and Models - 97 sets of models: One percentage point increase in bank capital ratios over 8(12) years, - Banks increase capital at a constant pace - Compared to a baseline forecast - Focus on transitional costs - Developed by CBs of MAG members (15 countries) and International Organizations (e.g. IMF)
16 Macroeconomic Consesquences: MAG 2. Results -Banks have to raise their capital ratio by 1.3%p - Reduction of GDP to 0.22% below baseline (8 years), followed by an increase to 0.13% below after 12 years - Annual growth rates slow by 0.03 % - points (8 ¾ years). In subsequent quarters, annual GDP growth increases by 0.03 until the end of the 12 th year.
17 Source: BCBS (2010 b)
18 Macroeconomic Consequences: MAG 3. Open issues and Conclusion - What if Banks decide to meet the requirements ahead schedule or keep a higher capital buffer? - Conclusion: capital requirements proposed are likely to have a relatively modest impact on growth
19 Macroeconomic Consequences: IIF 1.Methods and Models - Focus on "costs" of implentation (G3) - Comparison between a "base" scenario and a "regulatory reform" scenario ( ; cumulative effect is the difference) - Simple macro-banking-economic models: (a) balance sheet model (b) bank capital supply block (c) banking sector profit and loss block (d) macroeconomic block
20 Macroeconomic Consequences IIF 2.Results Real GDP (% Difference) US Japan EU G3 (GDP weighted) Employment (million) US Japan EU G Emerging Countries: possibly significant negative spillovers Source: IIF Estimates
21
22 Macroeconomic Consequences IIF
23 Macroeconomic Consequences 3. Open issues and Conclusions - Supply of bank capital as assumed? - Is pro-cyclicality avoided? - Will the stability benefits come into effect? - Conclusion: Long-run effects are probably relatively modest, but transition costs could be significant.
24 Current Status of Basel 3 as of October of the 27 member countries have issued final regulations on Basel 3 reforms Some countries have yet to fully implement Basel 2 reforms 6 of the 29 global systemically important banks will be held accountable to Basel 3 reforms on the proposed January 1st, 2013 start date
25 Main Issues of Implementation BCBS Main Implementation Issues 1. Adoption Timeframe 2. Regulatory Consistency 3. Consistency of Outcomes (particullary with regards to risk weighted assets)
26 Implementation Issues- Europe 'Maximum Harmonization' Difficult to ensure a high level of homogenity with the different approaches of the individual nations/regulators EU regulation must work to ensure a maximum harmonization
27 Implementation Issues - Europe Regulatory Consistency Definition of capital - not necessarily coherent with the Basel 3 standards (particularly in regards to capital from insurance entities and joint stock companies) Internal Ratings Base approach to credit risk - Issues with the EU approach to sovereign debt exposures and the risk weight associated with them
28 Implementation Issues - US Adoption Timeframe US faces many problems Yet to completely implement Basel 2 - currently in a parellel run of Basel 1 and 2, with most banks only held accountable to Basel 1 captial ratios
29 Implementation Issues - US Regulatory Consistency Scope of applicatoin - Only core banks are required to apply the Basel 2 reforms Securitisation - US prohibits external credit rankings in bank regulations whereas the Basel 3 reforms require the use of rankings to establish capital charges for securitization exposures
30 References BCBS (2010a), Group of Governors and Heads of Supervision announces higher global minimum capital standards, 12 September BCBS (2010b), Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements - Final report, report of the Macroeconomic Assessment Group established by the FSB and BCBS, December. BCBS (2012), Report to G20 leaders on Basel III implementation, Bank of International Settlements, June. Institute for International Finance (2010a), Interim Report on the Cumulative Impact on the Global Economy of Proposed Changes in the Banking Regulatory Framework, June. BCBS (2012), Basel III regulatory concictency assessment (level 2). Preliminary report: United States of America, October BCBS (2012), Basel III regulatory concictency assessment (level 2). Preliminary report: Europeen Union, October BCBS (2012), Report to G20 Finance Ministers and Central Bank Governors on Basel III implementation, October 2012.
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