Download Bank capital adequacy rules: rationale and consequences

Bank capital adequacy rules:
rationale and consequences
Firuz Shakirov
Cedric Goussanou
Andrew Wiggins
John Geelkens
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
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
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: 2013 - 2017
Basel II (2004)
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
New requirements under BASEL III
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
Micro-prudential reforms
Capital Capital
adequacy
ratio
=
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%.
Additional rules on microprudential
regulation
New liquidity standard: framework for liquidity risk management
the stock of high-­‐quality liquid assets coverage ratio:
v  Liquidity
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
Source: BCBS (2010)
Macro-prudential reforms
Procyclicality during an economic downturn
Limit of Procyclicality:
Economic
downturn
Lending
contracts
Objective of Basel III:
Decrease
in capital
ratios
Increase
in Risks
Growth in
RWA
Ø  Reduce pro-cyclicality and
prevent the destabilizing
effects experienced in 2007-08
financial crisis.
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.
Macroeconomic Consequences
Two Studies
l 
l 
(1) MAG = Macroeconomic Assessment Group (BCBS and FSB),
December 2010
(2) IIF = Institute of International Finance, June 2010
Structure: 1.Methods and Models
2. Results
3. Open issues and Conclusion
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)
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 12th year.
Source: BCBS (2010 b)
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
Macroeconomic Consequences:
IIF
1.Methods and Models
- Focus on "costs" of implentation (G3)
- Comparison between a "base" scenario and a "regulatory
reform" scenario (2011-2020; 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
Macroeconomic Consequences
IIF – 2.Results
2011-2015
2011-2020
Real GDP (% Difference)
US
-2.6
-2.7
Japan
- 1.9
-1.5
EU
- 4.3
-4.4
G3 (GDP weighted)
-3.1
-3.1
Employment (million)
US
-4.58
-4.87
Japan
-0.46
-0.43
EU
-4.68
-4.83
G3
-9.73
-10.12
Emerging Countries: possibly significant negative
spillovers
Source: IIF
Estimates
Macroeconomic Consequences
IIF
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.
Current Status of Basel 3 as of
October 2012
• 
• 
• 
8 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
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)
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
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
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
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
References
—  BCBS (2010a), “Group of Governors and Heads of Supervision announces higher global minimum
capital standards”, 12 September 2010.
—  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 2012.
—  BCBS (2012), “ Basel III regulatory concictency assessment (level 2). Preliminary report:
Europeen Union”, October 2012.
—  BCBS (2012), “ Report to G20 Finance Ministers and Central Bank Governors on Basel III
implementation”, October 2012.