Basel III - Rutgers University

Basel III - The new Capital Rules Basel III: towards a safer financial system - the BIS, at the 3rd Santander International Banking Conference, Madrid, 15 September 2010. Basel III a strengthening of global capital standards. the introduction of global liquidity standards a "macroprudential overlay" to better deal with system

ic risk. 5 Changes Proposed in Basel III 1. Strengthen the capital requirements for counterparty credit exposures arising from banks derivatives, repo and securities financing transacti ons 2. introduce a leverage ratio as a supplementary measure to the Basel II ris

k-based framework. 5 Changes Proposed in Basel III 3. introducing a series of measures to promote the build up of Capital B uffers in good times that can be drawn upon in periods of stress ("Red ucing procyclicality and promoting countercyclical buffers"). 5 Changes Proposed in Basel III

4. introducing a global Minimum Liquidity Standard for internationally active banks that includes a 30-day liquidity coverage ratio (LCR) requirement und erpinned by a longer-term structural liquidity ratio. 5 Changes Proposed in Basel III 5. the quality, consistency, and transparency of the capital base will be rai sed. Tier 1 capital: the predominant form of Tier 1 capital must be comm on shares and retained earnings

Tier 2 capital instruments will be harmonised Tier 3 capital will be eliminated Better capital quality the definition of common equity also called core capital is n ow stricter. Under the present system, certain types of assets of questionable quality are already deducted from the capital base. Under Basel III, these deductions will be more stringent. the new standards for common equity are significantly tougher t

han the old standards for Tier 1 capital in total. Meanwhile, various dubious things which currently count as Tier 1 or Tier 2 capital but shouldnt will be phased out even more slo wly, over a period of 10 years beginning in 2013. Some of the new rules: BASEL II: Tier 1 capital ratio = 4%

Core Tier 1 capital ratio = 2% The difference between the total capital requirement of 8.0% and the Tier 1 req uirement can be met with Tier 2 capital. BASEL III: Tier 1 Capital Ratio = 6% Core Tier 1 Capital Ratio (Common Equity after deductions) = 4.5% Core Tier 1 Capital Ratio (Common Equity after deductions) before 2013 = 2%, 1 st January 2013 = 3.5%, 1st January 2014 = 4%, 1st January 2015 = 4.5% The difference between the total capital requirement of 8.0% and the Tier 1 req uirement can be met with Tier 2 capital.

Macroprudential regulation One important goal of Basel III is to provide a macrop rudential regulation to tackle systemic risks. The intention is to mitigate pro-cyclicality and credit c onstraints which result from regulatory capital require ments. Remedies: 1. capital conservation buffer

2. capital counter-cyclicality buffer 3. capital systemic buffer for SIFIs Conservation buffer Banks also be required to hold a capital conservation buffe r of 2.5% of common equity (bringing the total common e quity requirements to 7%) to withstand future periods of s tress.

During periods of stress and banks are forced to write do wn lots of bad loans, they are allowed to use the buffer but that will bring extra regulatory oversight (constraints o n earnings distributions). Conservation buffer the capital conservation buffer operates using discrete bands:

Countercyclical buffer The countercyclical capital buffer has been calibrated within a range of 02.5%. That countercyclical buffer wont be set by the BIS in B asel; itll be left up to national regulators. During periods of rapid aggregate credit growth, the co

untercyclical buffer would build up, then in the downtu rn of the cycle , it could be released. Countercyclical buffer The idea of countercyclical capital buffers is that : wh en credit is expanding faster than GDP, bank regulator s slowly increase their capital requirements. Therefore, the credit-to-GDP ratio was selected to be

the indicator variable. Step-by-step to calculate the jurisdiction spe cific buffer Step 1: calculating the credit-to-GDP ratio The credit-to-GDP ratio in period t for each country is calculated as: RATIOt = CREDITt / GDPt 100%

Where GDPt is domestic GDP and CREDITt is a broad measure of credit to the private, non-financial sector i n period t. Step-by-step to calculate the jurisdiction spe cific buffer Step 2: calculating the credit-to-GDP gap The credit-to-GDP ratio is compared to its long term tren

d: GAPt =RATIOt TRENDt. Where TREND is a approximation of sustainable average ratio of credit-to-GDP based on the historical experience. If the credit-to-GDP ratio is significantly above its trend, t hen this indicated that credit may have grown to excessi ve levels relative to GDP.

Step-by-step to calculate the jurisdiction spe cific buffer Step 3: transforming the credit-to-GDP gap into the buffer As a example: Setting the lower thresholds L=2 and up per H=10, then when: ((CREDITt / GDPt ) 100% ) (TRENDt) < 2% counter-cyclicality buffer is zero ((CREDITt / GDPt ) 100% ) (TRENDt) > 10%

counter-cyclicality buffer is at its max (2.5%) Calculating bank specific buffer For international bank, the buffer applied will reflect t he geographic composition of the banks portfolio of c redit exposures. International bank calculate their countercyclical capit al buffer as a weighted average of the buffer applied i

n jurisdictions. Calculating bank specific buffer Example : Assume that the published countercyclical buffer in the United Kingdom, Germany and Japan are 2%, 1% and 1.5% of risk weighted assets, respectively. A bank with 60% of its credit exposures to UK counter parties, 25% to German and 15% to Japanese would b

e subject to an overall countercyclical capital buffer e qual to 1.68% of risk weighted assets: buffer (0.60 2% 0.25 1% 0.15 1.5%) 1.68% Countercyclical buffer Buffer decisions would be pre-announced by 12 month s to give banks time to meet the additional capital requi rements before they take effect.

Reductions in the buffer would take effect immediately to help to reduce the risk of the supply of credit being c onstrained by regulatory capital requirements. Capital for Systemically Important Banks Basel lll also consider the contribution each institution ma kes to the system as a whole, not just the riskiness on a st andalone basis.

It has been agreed that these institutions should have los s-absorbing capacity beyond the common standards --- ad ditional loss-absorbing capacity for systemically important financial institution (SIFIs) . Work is still under way for addressing systemic risk. Total capital ratio required Total Regulatory Capital Ratio

= [Tier 1 Capital Ratio] + [Capital Conservation Buffer] + [Countercyclical Capital Buffer] + [Capital for Systemically Important Banks] Liquidity coverage ratio Liquidity problem is serious in financial crisis. The liquidity coverage ratio is used to promote banks short-term ability to potential liquidity disruptions.

It requires banks to hold a buffer of high-quality liqui d assets sufficient to deal with the cash outflows enco untered in an short-term stress. Stable funding ratio maturity mismatch is another important problem in financial crisis. The minimum net stable funding ratio (NSFR) is inte

nded to promote longer-term structural funding of b anks balance sheets and to provide incentives for ba nks to use stable sources to fund their activities. Possible Effectsto Taiwan Currently, Taiwans domestic banks have an average 8.9% of Tier 1 capital, so the 6% set by Basel is not a problem.

However, the common equity is about 3.8%-3.9%. To meet the Basels new standard of 4.5%, the bank s have to raise their capital by more than NT$200 bil lion or US$6.25 billion. Contingent capital securities Contingent capital securities are a financial innovation occurring in res ponse to the financial crisis of 2008. The issuance of such securities wa

s recommended by the Squam Lake Report (2010) and mandated unde r Basel III. Under the Basel III all non-common equity capital instruments must in corporate a mandatory write-down or conversion feature if issued by a n internationally active bank. The most common type of these conting ent capital instruments securities are long-term subordinated debt whi ch consists the main portion of Tier 2 capital. These Basel III- compliant subordinated debt are long-term debt oblig ations converting automatically to equity in times of financial stress for the issuing entity. Such securities are seen as providing avenues for aut

omatic recapitalization in times of need. Also known as CoCos, or contingent conver tible bonds. In November 2009, Lloyds Banking Group was the first to issue such a secur ity. The Lloyds issued 7bn in enhanced capital notes (ECNs), and will con vert to ordinary equity if the groups core tier 1 capital ratio falls below 5 per cent."

After that many transactions have been done. For examples, in mid-2010, Rabobank issued a contingent core note. In mid-February 2012, Credit Suisse issued contingent capital notes with a Ba sel III conversion trigger as well as a second contingency conversion trigger li nked to the bank's core capital ratio. UBS issued USD 2 billion of subordinate d loss-absorbing non-dilutive notes in February, 2012. The notes, which will qualify as tier 2 capital under Basel III standards and have a maturity of 10 ye ars. The UBS 10-year contingent capital securities, will be written off if UBS's common equity ratio falls below 5 percent or the bank faces a bailout, exem plified the loss absorbency requirement and contingent capital feature of th

e Basel III. 09-12-2012 The Commonwealth Bank of Australia (CB A) has launched an offering for perpetual, exchangeab le, resalable, listed, subordinated ("PERLS VI") unsecur ed notes that are Basel III-compliant, and the funding goal is $750 million Subdebt has become an important funding source for banks, especially for la

rge ones. According to Basel Committee on Banking Supervision (2003), sub debt issuance has been widespread in the largest European countries, Japan , and the U.S. over 1990-2002. The report shows that the subdebt of banks is on average about 3.6% of risk-weighted assets (RWA, hereafter). When considering only the 50 largest issuers, the average share of subdebt i s 5.3% of RWA. It also shows that the vast majority of issues have an initial te rm to maturity of between 5 and 15 years with an average of 11.4 years. Pen nacchi (2010) states that for the 20 largest domestic bank holding companie s in the United States, subordinated debt was equal to 2.2% of total assets in

June 2007. Flannery (2009) reports that for the 14 traditional bank holding companies i n the Supervisory Capital Assessment Program, the ratio of subordinated de bentures to total risky assets was 4.89% on average at the end of 2008. The s ubdebt capital instruments are expected to grow under the Basel guideline.

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