Tytuł: Basel III as a new global paradigm of bank regulatory standard

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Studenckie Prace Prawnicze, Administratywistyczne i Ekonomiczne 12

Marcin Winiarski

Opiekun naukowy — Scientifi c Tutor

Basel III as a new global paradigm

of bank regulatory standard

JEL classifi cation: E58, G 21

Keywords: Basel III regulatory, capital requirements, capital ratio, Basel III impact, LCR, NFSR Słowa kluczowe: Regulacja Bazylei III, wymogi kapitałowe, wskaźnik kapitałowy, wpływ Ba-zylei III, LCR

Abstract: This paper focuses on the analysis of the implementation of the international banking regulatory capital requirements according to Basel III. Determined are the main provisions and their step by step realization. Reviewed are the qualitative impacts on banks and macroeconomics effects. Abstrakt: Ten artykuł skupia się na analizie wdrażania międzynarodowych bankowych wy-mogów kapitałowych zgodnie z regulacją Bazylei III. Zdeterminowano główne przepisy oraz ich realizację postępową. Dokonano przeglądu skutków jakościowych dla banków oraz efektów mak-roekonomicznych.

1. Background to the strengthening of bank’s regulatory requirements

One of the main reasons the economic and fi nancial crisis, which began in 2007, became so severe was that the banking sectors of many countries had built up ex-cessive on and off-balance sheet leverage. This was accompanied by a gradual erosion of the level and quality of the capital base. At the same time, many banks were holding insuffi cient liquidity buffers. Therefore the banking system was not able to absorb the resulting systemic trading and credit losses, nor could it cope with the reintermediation of large off-balance sheet exposures that had built up in the shadow banking system. The crisis was further amplifi ed by a procyclic-al deleveraging process and by the interconnectedness of systemic institutions through an array of complex transactions. During the most severe phase of the

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Studenckie Prace Prawnicze, Administratywistyczne i Ekonomiczne 12, 2012 © for this edition by CNS

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crisis, the market lost confi dence in the solvency and liquidity of many banking institutions. The weaknesses in the banking sector were rapidly transmitted to the rest of the fi nancial system and the real economy, resulting in massive contraction of liquidity and credit availability. Ultimately the public sector had to step in with unprecedented injections of liquidity, capital support and guarantees, exposing taxpayers to signifi cant losses.1

The consequences of this crisis were extremely severe, in particular for the countries of the European Union (EU). In order to restore the stability of the bank-ing sector and to ensure the availability of credit resources for the real economy, countries of the EU took unprecedented measures to save the banks. By October 2010, the European Commission had approved 4.6 bln EUR2_{for fi nancial}

institu-tions, more than 2 bln EUR were used in 2008–2009.

From September 2008 to December 2010 Basel Committee prepared a num-ber of publications defi ning changes in new regulations. Based on the Basel Committee documents, the European Commission prepared the legislative amendments to the Capital Requirements Directives (CRD) IV.3_Proposed

solutions are an integral part of the measures and are taken by the European Commission in response to the fi nancial crisis, as s third set of the amendments to CRD. They complement the two previous sets of amendments which were adopted by the Commission in 2008 (CRD II)4_{and 2009 (CRD III).}5_The

pro-visions of the CRD II, including changes related to the classifi cation of own funds, large exposures, quality standards for liquidity risk management and se-curitization came into force at the end of 2010.

CRD III provisions, including capital requirements for the trading book and for re-securitizations, disclosure related to securitization exposures and guidelines for remuneration policies, came into force at the end of 2011. Basel III is a part of Dodd-Frank Act (DFA), a regulatory fi nancial reform in the US. Dodd-Frank and Basel III contain similar principles. “Basel III should make the fi nancial sys-tem more stable and reduce the likelihood of future fi nancial crises by requiring

1_{A global regulatory framework for more resilient banks and banking systems, Basel Committee}

on Banking Supervision — Basel III, Basel, December 2010. p. 1.

2_{Accompanying the document, Regulation of the European Parliament and the Council on}

prudential requirements for the credit institutions and investment firms, European Commission,

Commission Staff Working Paper Impact Assessment, Bruxelles, 20.07.2011, SEC (2011) 950 final, p. 4.

3_{Basel III refers to the regulation and directive of the European Commission (referred to as the}

Capital Requirements Directive IV, CRD IV), published on 20 July 2011.

4_{Directive of the European Parliament and of the Council 2009/111/WE of 16 September 2009,}

L302, 17.11.2009.

5_{Directive of the European Parliament and of the Council 2010/76/WE of 24 November 2010,}

L329, 14.12.2010.

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Сapital ratio = Eligible capital Risk-weighted Assets

these banks to hold more and better-quality capital and more-robust liquidity buffers.”6

The new regulation aspires to make the banking system safer by redressing many of the fl aws that became visible during the crisis. Improving the quality and depth of capital and renewing the focus on liquidity management is intended to spur banks to improve their underlying risk-management capabilities. The ra-tionale is ultimately — if banks come to a fundamentally revamped understanding of their risks — a new risk paradigm.

2. The main provisions of the Basel III

The combination of tightening of requirements of eligible bank’s capital with the increase in risk-weighted assets (RWA) under the rule has caused an increase in the capital ratio (Figure 1). All elements of the capital ratio are affected by the Basel III framework.

Fig. 1. Basel III framework effect on capital ratio

Source: own estimations based on A global regulatory framework for more resilient banks and banking systems, Basel Committee on Banking Supervision — Basel III, Basel, December 2010.

Due to the large impact on the banking sector increase in the level of minimum capital requirements were delineated in time which is showed below (Figure 2). The minimum level of equity as a percent of risk-weighted assets will be gradual-ly raised to 10.5% in 2019.

Basel II provides for three tiers of capital. Tier 1 capital — also called “core capital” or “basic equity.” Tier 1 capital includes equity capital and disclosed reserves. Tier 2 capital — also called “supplementary capital” — that cannot exceed Tier 1 capital. Tier 2 capital includes undisclosed reserves, revaluation reserves, general provisions or general loan-loss reserves, hybrid debt capital in-struments, subordinated term debt. Tier 3 capital to cover market risks may be used only at the discretion of national authorities, and includes only short-term subordinated debt that satisfi es the defi ned conditions.

6_{Ben S. Bernanke, testimony “Implementation of the Dodd-Frank Act” 17 February 2011,}

http://www.federalreserve.gov/newsevents/testimony/bernanke20110217a.htm.

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The main features of CRD IV are determined in the following way7: ● Raising the quality of regulatory capital.

Tier 1 must be common shares and retained earnings. Tier 2 capital will be harmonized and simplifi ed — only one class of Tier 2 capital will remain. Tier 3 capital will be eliminated.

● Improving various aspects of regulatory driven risk management prac-tices, both quantitatively and qualitatively.

Improvement of capital standards relating to exposure at default (EAD) and collateral management in the trading book; risk process evaluation with external ratings and credit rating agencies.

● Introduction of an overall maximum leverage ratio.

The leverage ratio is a non-risk based metric. The leverage ratio is the ratio be-tween Tier 1 and total balance sheet + some off-balance sheet items. The proposal describes in more detail how to deal with derivatives, commitments, etc.

The 3% leverage ratio will be monitored in 2011 and 2012, and tested from 2013 to 2017. Leverage ratio is to become binding in 2018.

7_{The road to Basel III. Developments of European banking regulations. Deloitte, Baku,}

26 October 2010, p. 16.

Fig. 2. Basel III Capital requirements

Source: own calculations based on A global regulatory framework for more resilient banks and banking systems, Basel Committee on Banking Supervision — Basel III, Basel, December 2010.

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● Measures to prevent pro-cyclical effects.

Promotion of the more forward looking provisions, in line with the recent International Accounting Standards Board proposals. Introduction of conserve capital to build buffers that can be used in stress. Protection of the banking sector from periods of excess credit growth through introduction of additional capital buffers in such periods, up to 2.5%.

● Introduction of a global liquidity standard.

The proposal introduces two minimum standards for funding liquidity. A 30-day liquidity coverage ratio is intended to promote short-term resilience to poten-tial liquidity disruptions.

Liquidity coverage ratio (LCR) = Stock of high liquid assets / Net cash outfl ow 30 day > = 100%.

● The second standard is a longer-term structural ratio to address liquidity mis-matches, in order to provide incentives for banks to use stable sources to fund their activities.

Net stable funding ratio (NSFR) = Available stable funding / required stable funding > = 100%.

Monitoring the leverage ratio and the new liquidity measures will be the ob-ject of special monitoring based on collected statistical data. Testing and evalu-ation of the Basel III will be conducted both at the nevalu-ational level as well as at the level of the EU by the European Bank Authority (EBA) and the European Central Bank. The period of monitoring of certain requirements (e.g. liquidity standards, leverage ratio) starts from the beginning of 2012 and will last for a few years before the European Commission makes the fi nal calibration.

According to the CRD IV (Article 74), supervisory authorities must standard-ize the format and frequency of supervisory reporting date, i.e. Common Reporting (COREP). Reporting formats should be proportionate to the nature, scale and com-plexity of the activities of credit institutions. The deadline for fi nalizing the report formats was 1 January 2012 and the date of its entry into force was planned for 31 December 2012. In order to start a public consultation the Committee of European Banking Supervisors (predecessor EBA) has published a consultation paper8_with

changes to supervisory reporting COREP. In January 2013 the international bankers lobbied a 4-year delay to meet the liquidity coverage ratio (LCR).

3. Qualitative impacts of the Basel III regulation on banks

After a rebound in 2009, banks’ total market capitalization remained fl at overall in 2010 and 2011, with gains in many developing markets offset by de-clines in the US, China, and Western Europe. On both developed and developing

8_{Consultative paper on the amendments to the Guidelines on Common Reporting (COREP),}

Committee of European Banking Supervisors, London, 17.06.2010.

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markets, banks’ price-to-book value (P/BV) ratios fell sharply during 2008–09, failing to recover during 2010–2011. This refl ected the market’s view not only that profi ts would remain depressed, but also that banks would struggle to re-munerate their required capital.

In 2011, banks were facing a quandary — their revenues and profi ts were recover-ing, yet the metrics that indicated their future health were not. Stakeholders were not convinced that banking, particularly in the US and Europe, would be able to cope with the challenges on the horizon. Since then, the sovereign crisis in Europe and the depressed economic outlook have signifi cantly deepened these challenges and further damaged investor confi dence. US and European banks are of course focused on responding to the immediate crisis. But if they are to chart a course to sustain high performance, they will need to grapple with a set of fundamental long-term trends that are increasingly shaping the operating environment. These trends include9_:

● The impact of regulation on profi tability. The coming regulatory changes will be costly for banks, resulting in increases in bank equity, increased funding costs, and a tightening of consumer protection.

● A squeeze on capital and funding. A growing demand for credit, together with increasing investment in infrastructure, will put a strain on the supply of capital and funding — and thereby increase its cost.

● A widening gap between growing and non-growing markets. Emerging mar-kets represent a promising opportunity for banks that can access them — but

9_{McKinsey Global banking practice. The state of global banking — in search of a sustainable}

model, September 2011, p. 17.

Fig. 3. Average bank price-to-book value (P/BV)

Source: Thomson Reuters; McKinsey Global banking practice. The state of global banking — in search of a sustainable model, September 2011, p. 14.

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the prospects for those that cannot do so are more challenging. It is likely that the “growth gap” between the “haves” and “have nots” will increase.

● Changing consumer behavior. Banks face several concurrent changes in consumer behavior, including a shift from borrowing to saving, and an inexorable migration to online channels.

The amended Basel III defi nitions will have a three-fold impact on banks’ cap-ital ratios — higher required (core) tier 1 ratio itself, stricter rules on (core) tier 1 capital defi nition, and more restrictive weights to calculate risk-weighted assets. Taken together, these changes will have the effect of requiring US and European banks to build up additional $1.5 trillion in equity (Figure 4). Many banks have already begun the task, but achieving this unprecedented step change in capital levels will be a great challenge. Remunerating this capital will be even more diffi cult, requiring banking profi tability to grow more quickly than it did before the crisis.

Additional equity surcharges, ranging from 1 to 2.5% of core equity, could require between $150 billion and $300 billion in new capital for systemically im-portant fi nancial institutions (SIFIs).

Beyond the new capital requirements, new regulations on the liquidity cover-age ratio (LCR) and net stable funding ratio (NSFR) aim to help banks build an additional buffer of liquid assets and to match maturities of funding to assets.

1790 2610 2015 2010 2990 5600 +660 +820 4120 2330 Europe U.S. Bank common equity, billion $

Adding additional core tier 1 capital needed to comply with Basel III

Fig. 4. Expected capital build up 2010–2015

Source: Thomson Reuters; McKinsey Global banking practice The state of global banking — in search of a sustainable model, September 2011, p. 14.

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Higher funding costs for banks for the foreseeable future as stable funding be-comes a key determinant of growth rates in developed economies. This is a major shift from the last decade. Previously, banks actively pursued growth opportun-ities without giving much thought to capital and funding constraints; the balance sheet structure was the result of a business-driven planning exercise. In future, however, the balance sheet structure will be the key strategic constraint as banks evaluate and pursue market opportunities.

The European Commission estimates10_{annual administrative expenses for}

banks Groups 1 and 2 together with the resulting adjustment of Basel III estimated at about 3.2 billion EUR (of which 31% of the amount due to the LCR, and 38% of the NSRF), which is close to 0.008% of the EU banking sector assets. These costs are mainly due to the collection of additional data, data quality assurance, mainte-nance, IT systems, analysts, reporting management and publication of information. One-off compliance costs are estimated at EUR 6.9 billion, or about 0.016% EU bank assets, these costs will be spread over a number of all European parent banks.

4. Qualitative macroeconomic impact of the Basel III regulations According to the forecasts of the European Commission, implementation of the new regulations in the long term will bring the economic benefi ts in the form of GDP growth in the range of 0.3 to 2.0% due to the expected frequency, as well as reduce the probability of systemic crises in the future in the range from 29% to 89%, in case of capital requirements rise to 10.5%. In addition, higher capital requirements, including the counter-cyclical buffer and liquidity standards should reduce the amplitude of business cycles. This is of particular importance for small and medium-sized enterprises, which are more dependent on funding banks throughout the economic cycle than large companies.

On the other hand, according to estimates of the Organisation for Economic Co-operation and Development (OECD),11_{implementation of Basel III will be}

in the medium largest decline in GDP in the OECD economies (US, EU, Japan) ranging from 0.05 to 0.15% per annum (the same euro area from 0.08 to 0.23% per annum).

The decline in GDP growth is mainly due to increasing interest rates on loans (credit spreads), as banks increase borrowers costs due to higher capital require-ments. In order to meet the requirements of capital in 2015 (4.5% of the minimum funding in the form of share capital, 6% for the minimum core capital) OECD estimates suggest that interest rates on loans (credit spreads) will increase on average by 15 basis points. In order to meet capital requirements in 2019 (7% of

10_{Commission Staff Working Paper Impact Assessment..., p. 184.}

11_{P. Slovik, B. Cournède, Macroeconomic Impact of Basel III, “OECD Economics Department}

Working Papers” 2011, no. 844, p. 9.

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the funds in the form of minimum capital, 8.5% for the minimum core capital) OECD estimates an increase in credit spreads on average by 50 points. Growth of the solvency factor by 1 percentage point impacted on increasing the credit spreads in the three analyzed OECD economies on average by 14.4 points base. These estimates were made by Macroeconomic Assessment Group (MAG)12

act-ing for the FSB (Financial Stability Board) and the Basel Committee. Accordact-ing to this analysis, the growth of the capital adequacy ratio by 1 percentage point will result in increase of credit margins in the analyzed economies with close to 15 points base (median), which brings the average decline of GDP by 0.22% after 35 quarters since the start of the new regulations implementation. This means reducing the annual rate of GDP growth by 0.03 percentage points. In addition, MAG analysis shows that the increase of the capital adequacy ratio by 1 percent-age point can lead to a decline in the effective demand for credit in the economy by 1.89%.

Conclusions

In order to improve stability of the fi nancial sector and prevent future fi nancial crises, the governments of developed countries, including the Member States of the European Union decided to introduce the new regulatory guidelines to capital requirements in the banking sector (Basel III).

The recently implemented Basel III standards include measures, such as im-provement of the quality of own funds by strengthening the defi nition, increase in the level of minimum capital requirements to 10.5%, introduction of the new mea-sures of liquidity (liquidity limits and quality standards), leverage (leverage ratio), increase in capital requirements for specifi c positions (market risk counterparty credit risk).

Basel III regulations will have an impact on the world economy and the bank-ing sector, the size of that impact varies considerably between countries. It is estimated that in the short term these regulations will lead to a reduction in the GDP growth of the world economy as a result of increased interest rates on loans and will reduce the availability of bank credits. In the long run, however, it will lead to higher GDP growth rates due to the prevention of fi nancial crises, yet these effects will have to be verifi ed.

References

Accompanying the document, Regulation of the European Parliament and the Council on prudential requirements for the credit institutions and investment firms, European Commission, Commission

Staff Working Paper Impact Assessment, Bruxelles, 20.07.2011, SEC (2011) 950 final.

12_{Assessing the macroeconomic impact of the transition to stronger capital and liquidity}

requirements — Final Report, Bank for International Settlements, Basel 2010.

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Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements — Final Report, Bank for International Settlements, Basel 2010.

Ben S. Bernanke, testimony “Implementation of the Dodd-Frank Act”, 17 February 2011, http:// www.federalreserve.gov/newsevents/testimony/bernanke20110217a.htm.

Consultative paper on the amendments to the Guidelines on Common Reporting (COREP),

Committee of European Banking Supervisors, London, 17.06.2010.

Directive of the European Parliament and of the Council 2009/111/WE of 16 September 2009, L302, 17.11.2009.

Directive of the European Parliament and of the Council 2010/76/WE of 24 November 2010, L329, 14.12.2010.

A global regulatory framework for more resilient banks and banking systems, Basel Committee on

Banking Supervision — Basel III, Basel, December 2010.

McKinsey Global banking practice. The state of global banking — in search of a sustainable model,

September 2011.

The road to Basel III. Developments of European banking regulations. Deloitte, Baku, 26 October

2010.

Slovik P., Cournède B., Macroeconomic Impact of Basel III, “OECD Economics Department Working Papers” 2011, no. 844.

Basel III as a new global paradigm of bank regulatory standard Summary

The purpose of this article is to determine the key details and effects of the introduction of Basel III global regulatory framework to capital requirements.

After the first stress of the financial crisis in 2008 global banking sector needed to increase the reliability and reduce the riskiness of activity. The implementation of Basel III regulations at the global level should prevent dramatic shocks of the banking system.

Basel III is an essential step towards the unification and harmonization of banking regulations at the global level which will last at least until 2019.

These changes were adopted in all countries of G20. The article describes the key stages of increasing capital requirements and new limits, as well as the cost of these steps for the banking sector and macroeconomic effect — the impact on the change in global GDP.

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