Transcript Basel III An analysis of the new global capital regulatory

Arafat Al Fayoumi
February 20,2011
Ⅰ．Basel Ⅲ - Overview -
Ⅱ．Basel Ⅲ and Financial Systems
Ⅲ．Basel Ⅲ and Monetary Policy
Overview
The oversight body of the Basel Committee, the Group of
Governors and Heads of Supervision, at its meeting in
September, 12 2010, announced a substantial strengthening of
existing capital requirements, in line with the agreements
reached on the 26 July 2010 regarding its agenda of global
financial reform.
Conti……
A new regime of rules and regulations has been
developed by regulators in order to strengthen the
resilience of the banking sector against future
shocks, as well as to supplement the current recovery
process. The rules mean that the banks will now need to
hold a prodigious amount of capital, far more than the
current requirement.
Ｉ-１. Basel Ⅲ
 Capital Requirement
Capital Conservation Buffer & Counter-cyclical Buffer
Introduction of Leverage Ratio
 Introduction of Liquidity Standards
・
Liquidity Coverage Ratio (LCR)
・
Net Stable Funding Ratio (NSFR)
Capital Requirement
The requirement of minimum common equity (MCE) has
been increased from 2% to 4.5% of risk-weighted assets
(RWA).
Member countries are to begin implementation on
January, 1st, 2013 and hence, must integrate the rules
with national laws and regulations before this date. As of
January, 1st, 2013, banks will be required to have 3.5%
MCE of RWA, 4% as of January, 1st, 2014 and 4.5% as of
January, 1st, 2015.
Capital Requirement …cont.
An additional conservation buffer of 2.5% has also been
introduced, effectively bringing the common equity
requirement to7%.
This reinforces the changes in the definition of 'Capital' made
in July 2010, along with the higher capital requirements for
trading, derivative and securitization activities to be
introduced at the end of 2011.
The phase in starts from January, 1st, 2016 and stretches up till
January, 1st, 2019. Beginning with 0.625% of RWA on January,
1st, 2016, it will notch up each year by 0.625% reaching the
final level of 2.5% of RWA on January, 1st, 2019.
Capital Requirement …cont.
If regulators see free flowing credit, a countercyclical buffer
can also be imposed within a range of 0% to 2.5% of common
equity or other fully loss absorbing capital to prevent excessive
growth of credit within the banking sector.
Capital Requirement …cont.
The Tier I requirement will be increased from 4% to 6%. The
phase-in arrangement is similar to that of common equity i.e.
Between January, 1st, 2013 and January, 1st, 2015. On January
1st, 2013 Tier I will increase from the current level of 4% to
4.5%, and to 5.5% on January, 1st, 2014.Finally, on January, 1st,
2015 it will increase to 6% as stipulated.
The total capital requirement remains unchanged at 8%, and
hence does not need to be phased in. The difference between
the total capital requirement of 8.0% and the Tier I
requirement can be met with Tier II and higher forms of capital.
Capital Requirement …cont.
The capital requirements mentioned above are also
supplemented by a non-risk based leverage ratio. In July, it was
agreed to test a minimum Tier I ratio of 3%. Under the new
rules, the same will be tested during the parallel run period
between 2013 and 2016 and on the basis of the results, final
adjustments will be made in the first half of 2017, with the aim
of migrating to Pillar I treatment by January, 1st, 2018.
Ⅰ-２. Calibration of the Capital Framework
Common
Equity (after
deductions)
TierⅠCapital
Minimum
４．５
６．０
８．０
Conservation Buffer
２．５
Minimum plus
consevation buffer
７．０
８．５
１０．５
Countercyclical buffer
range*
０－２．５
*Common equity or other fully loss absorbing capital
Total Capital
（％
）
Ⅰ-３. Basel Ⅱ and Basel Ⅲ
８％-
４％-
Basel Ⅱ
Ｔｉｅｒ Ｉ
TierⅡ
CET I（2%-)
CETⅠ：７％-
Minimum CETI（4.5）＋Buffer（2.5）
Ｔｉｅｒ Ｉ
Basel Ⅲ
CET I
(4.5%-)
＋Counter
Cyclical
Buffer
TierⅡ
Capital Cons.
Buffer(2.5%-)
Tier I ： 8.5％-
Minimum（6）＋Buffer（2.5）
＋Counter
Cyclical
Buffer
＋Counter
Cyclical
Buffer
Tier I ＋Tier Ⅱ： 10.5％Minimum（8）＋Buffer（2.5）
Phase-in arrangements (shading indicates transition
periods)
(all dates are as of January ,1st )
Ⅰ-４．Phase-in arrangement
(all dates are as of January, 1st, percent)
2011
Leverage Ratio
2012
2013
2015
3.5
4.0
4.5
Capital Conservation Buffer
Minimum common equity plus
capital conservation buffer
2016
2017
Parallel run
1 Jan 2013 – 1 Jan 2017
Disclosure starts 1 Jan 2015
Supervisory monitoring
Minimum Common Equity Capital
2014
3.5
Phase-in of deductions from CET1 (including amounts
exceeding the limit for DTAs, MSRs and financials )
2018
As of
1 Jan.
2019
Migration to
Pillar 1
4.5
4.5
4.5
4.5
0.625
1.25
1.875
2.50
4.0
4.5
5.125
5.75
6.375
7.0
20
40
60
80
100
100
Minimum Tier 1 Capital
4.5
5.5
6.0
6.0
6.0
6.0
6.0
Minimum Total Capital
8.0
8.0
8.0
8.0
8.0
8.0
8.0
Minimum Total Capital plus
conservation buffer
8.0
8.0
8.0
8.625
9.25
9.875
10.5
Capital instruments that no longer qualify as
non-core Tier 1 capital or Tier 2 capital
Liquidity coverage ratio
Net stable funding ratio
Phased out over 10 year horizon beginning 2013
Observati
on period
begins
Introduce
minimum
standard
Observatio
n period
begins
Introduce
minimum
standard
Ｉ-5. Liquidity Standards
The Liquidity Coverage Ratio (LCR) is also set to be introduced
on January 1st, 2015, after an observation period beginning in
2011.
The revised Net Funding Stability Ratio (NFSR) will move to a
minimum standard by January 1st, , 2018. The Committee
intends to put in place various means and processes of review,
in order to fully comprehend the implications of these
financial standards.
Ｉ-6. Why Liquidity Standards?
 Bitter experiences of the global financial crisis
・
Most of Financial crises have been triggered by liquidity problems.
・ Even immediately before its collapse, Lehman’s capital adequacy ratio
was a double-digit figure. (Capital adequacy ratio may not be very
effective for preventing liquidity-driven financial crises.)
 In stressed circumstances, market liquidity could
dry up suddenly.
 Excessive reliance on CB’s liquidity provision may
lead to moral hazard.
 If a liquidity problem leads to a “fire-sale”, FIｓ
may become insolvent due to a substantial
decline in the prices of various financial assets.
・ It is difficult for central banks to rescue “insolvent” FIs through LLR.
 In order to prevent financial crises, it is extremely
important to avoid large-scale fire-sales.
・ Although each town has its firefighters’ station, each office should
have a fire extinguisher so as to prevent a fire. (If a fire spreads all
over California mountains, it is difficult even for firefighters to
extinguish the fire.)
A fire sale triggered by a liquidity problem is the most typical
case of “negative externality”.
Key Observations
Liquidity concerns:
In the face of criticism that the proposed liquidity ratios (NSFR
and LCR) could jeopardize the economy with capital being
trapped in liquidity buffers, the committee has watered down
the proposal and is phasing in the requirements only by 2015.
Key Observations cont…
Focus on Common Equity:
Post financial crisis, some banks were observed to be taking
advantage of profits from low cost government bailouts. If this
continues, it could mark the beginning of another crisis. In
order to avert it, Basel III focuses on raising capital through
common equity.
Key Observations cont…
Hybrid Capital:
Hybrid capital will be phased out of Tier I capital in 3 years
time, with the intention of maintaining only the highest quality
capital in Tier I. Hybrid Capital had until now been a favored
route for raising capital with about $1 trillion being issued
since 1999.
Key Observations cont…
Role of External Ratings:
While the Frank-Dodd Act in the United States has tried to
bring in accountability to the rating agencies by making them
liable for the ratings issued; it has also mandated that sole
reliance on external ratings would not be allowed. The new
Basel III regulations remain silent on these issues.
Key Observations cont…
Leverage Ratio:
The risk weight prescribed by the Committee earlier was
much maligned as one of the reasons for the financial
crisis, allowing banks extremely high leverage. The
committee has not junked the methodology but has
introduced a simple leverage ratio of Common Equity to
Total Assets which has been set at 3%. This is still too low
and allows banks to lend 33 times its capital.
Key Observations cont…
Valuation of assets:
While the common equity requirement has been defined
in terms of the risk weighted assets, a significant
contributing factor to the problem has been the valuation
of assets and the corresponding risk weights applied. No
changes have been made to the valuation of the
denominator i.e. the risk weighted assets.
Ⅱ-１.
An Emerging Markets Perspective
 Dominance of the banking sector in financial
intermediation
・ Even large banks focus on “core” banking businesses (e.g., deposittaking from households, loans to SMEs). The size of structured
product markets is small.
・ These are the basic reasons why Emerging financial systems were
not seriously involved in the recent “North-Atlantic” financial
crisis.
・
It is important to maintain banks’ function as financial intermediaries
while preventing their excessive risk-taking.
 Some emerging economies are experiencing
large-scale capital flows as well as signs of
overheating.
Ⅱ-2. IMF WEO (Oct. 2010)
Contribution to World GDP Growth (%)
2009
2010
2011
-0.6
4.8
4.2
United States
-0.5
0.5
0.5
Euro area
-0.6
0.2
0.2
Japan
-0.3
0.2
0.1
Emerging Asia
1.5
2.4
2.2
Other countries
-0.6
1.4
1.3
World GDP growth (yoy)
Source: International Monetary Fund, World Economic Outlook, October 2010.
Ⅱ-3.
Basel Ⅲ Capital Requirement
- Some basic questions
 How will Basel Ⅲ capital requirement affect bank
loans, financial intermediation and the economy?
- “Zero-bound” of nominal interest rates and fiscal consolidation in
many of advanced economies
- Capital flows to emerging economies
 How will Basel Ⅲ capital requirement affect banks’
risk-taking activities and bank stock prices?
- Will banks try to embark on more risky activities so as to maintain
ROE? Will shareholders accept lower ROEs?
- How will bank stock prices react to Basel Ⅲ?
 How will Basel Ⅲ capital requirement influence
bank’s capital-raising?
- Will stock markets have capacity enough to absorb banks’ capitalraising pressures?
- Will good banks try to raise capital as soon as possible so as to avoid
the “crowding-out” of capital markets at a later stage? (Will weak
banks face difficulty in capital-raising later?
- How will the flattening of the yield curve in advance economies
affect banks’ profitability and the magnitude of their capital-raising.
 How will Basel Ⅲ capital requirement influence
“shadow-banking”?
- The risk of regulatory arbitrage
Ⅱ-4. “The Basel Committee’s response to the
financial crisis: report to the G20” (Oct. 2010)
- on “Macroeconomic impact assessment”
 “The group (=the Macroeconomic Assessment Group)
estimated that, if higher requirements are phased in
over four years, the level of GDP would decline by about
0.19% for each 1 percentage point increase in a bank’s
capital ratio once the new rules were in place.3
3 In
a few instances, MAG members reported impact
figures in excess of 0.5%; the three most negative
values represent the outcome of models estimated by
the Bank of Japan and the Federal Reserve.”
Ⅱ-5.
Basel Ⅲ Liquidity Standards
- Some basic questions
 How will minimum liquidity standards influence
banking sector in each jurisdiction?
・ More liquid assets may bear less yield, and more stable funding may require
higher funding costs. (Trade-off between liquidity and profitability)
 How will liquidity standards affect the structure of
financial intermediation?
・ If the economy needs maturity transformation services, minimum liquidity
standards specifically on banks might transfer liquidity risks from banking
sector to non-banking sector.

How should liquidity standards deal with the
difference in financial structure among jurisdictions?
・ e.g., the share of government securities in financial assets substantially differ
among jurisdictions, reflecting the level of budget deficit.
All of these questions are similar to those raised to capital standards…
Ⅲ-1.

Basel Ⅲ and Monetary Policy
－Some basic questions
How will liquidity standards affect the prices
of financial assets and yield curve?
・ Banks’ demand for the assets defined as “liquid” may increase, while
their demand for the asset defined as “illiquid” may decrease.
・ Banks’ longer-term funding might cause steepening pressure on
yield curve.

How will liquidity standards affect the quality
of central bank collateral?
Ⅲ-2. Possible Impact on Yield Curve
 If liquidity standards increase banks’ needs for longer-term financing, they
might steepen yield curve.
- If liquidity standards simply corrects market participants’ distorted incentives (i.e. free-ride
on central banks’ liquidity provision), the original yield curve could be regarded as too flat.
- It is not easy to judge whether liquidity standards would “correct” or “distort” yield curve.
(Interpretation I)
(Interpretation II)
?
Free ride
Regulatory Threshold
Ⅲ-3. Possible Impact on Central Bank Collateral
 Liquidity standards might encourage financial institutions to keep the most
liquid asset within themselves, while offering less liquid assets to central
banks as eligible collateral.
 Nonetheless, the above is regarded as an inherent incentives in central
banks’ collateral policy, and not directly related to liquidity standards.
- In principle, central banks are able to maintain the quality of collateral by keeping the
standard of eligible collateral at an appropriate level and/or imposing haircuts to some assets.
Financial Institutions
Financial assets
more liquid
Financial Institutions
Central Bank
Financial Institutions
Financial Institutions
(Standard for eligible collateral)
Less liquid
Ⅲ-4. Demand for Central Bank Reserves
 Liquidity standards might influence financial institutions’ demand
for central bank reserves.
 In principle, however, central banks will still be able to control
money market rates by increasing the supply of liquidity.
①
policy rate
②
Ⅲ-5. Liquidity Standards and Financial Structure
 The share of sovereign debt in financial market differs among countries,
reflecting the level of budget deficit.
 Nonetheless, the economy should need liquid assets.
- Too rigid definition of Liquid assets could be harmful.
Government
Bonds
More liquid
Government
Bonds
private debt
high rating
Private debt
low rating
(Country A)
Less Liquid
(Country B)
“Do we need fiscal deficit to satisfy liquidity standards?” (This question is similar to the question
of whether “central bank needs fiscal deficit to execute its market operation or not.”)
Ⅲ-6. Liquidity Standards from an Asian Perspective
 One of the most difficult parts of liquidity
standards is the definition of “liquid” assets.
・ Market liquidity of financial markets may change, reflecting market
conditions as well as the development in infrastructure.
 Too rigid definition of “liquid” assets can be
harmful, especially for the countries with
developing financial markets.
・
Financial assets in these countries will become more liquid in future.
 It is important to maintain sufficient flexibility in
liquidity standards and to develop securities
markets in Asia.
Thank you!