Basel III

Regulatory Outlook in Reforming Banking and Financial Markets

March 14, 2011AbstractEvolution of banking regulations within an increasingly globalized marketplace. Traces primary aspects of Basel Accords from Basel I through the upcoming implementation of Basel III. Evaluates likely effectiveness of upcoming Basel III implementation.

The Basel Accords represent convergence of international regulations to institute a framework of rules reflective of an increasingly globalized marketplace. The financial sector represents the industry at the vanguard of globalization with almost no physical products or resources to limit international movement via financial products. The litany of finance-rooted meltdowns throughout modern history illustrates the gravitas of the financial sector to engage in behavior that constitutes a moral hazard. Individual nations have long implemented regulations aimed at correcting actions of financial markets following each crisis within national borders. Globalization has exposed the limitations of individual nations to protect financial markets and the public from institutions operating beyond jurisdictional reach.

The upcoming Basel III regulations build upon aspects of the previous two generations of the Basel Accords. This examination of the major points of Basel III retraces the history of the salient points of Basel I and II. Through analysis of Basel I and II, major shortcomings of each are discussed and to illustrate the policy principles embodied within Basel III. The accords are noted as complex regulations and many aspects of each are purposely omitted, however the task of garnering agreement from international finance ministers, each seeking to constrain a marketplace beyond individual reach, is a duly noted difficult task.

Regulatory Convergence

In 1974, following a series of turbulent currency fluctuations and the collapse of the German bank “Bankhaus Herstatt” the central bank regulators of the Group of Ten (G10) nations formed the Committee on Banking Regulations and Supervisory Practices.[footnoteRef:1] Starting in 1975, the committee set about formulating regulatory reforms for banks. [1: (Basel Committee on Banking Supervision 2009)]

The committee held no compulsory power, but each nation recognized the need for regulations to ensure financial market stability. The committee aims to achieve, “two basic principles: that no foreign banking establishment should escape supervision; and that supervision should be adequate.”[footnoteRef:2] [2: (Basel Committee on Banking Supervision 2009)]

The committee members recognized international banking firms were not adequately holding sufficient assets to absorb losses, and as cross-border transactions grew the divergence of accounting standards and individual country’s piecemeal regulations emphasized the inadequacy of the system to determine bank health.

Finalized in 1987, the Accord on Capital Adequacy, commonly known as “Basel I”, established the “three pillars” framework of banking regulation. Basel I, “focused on: (1) defining regulatory capital; (2) measuring risk-weighted assets including off-balance sheet exposures; and (3) setting minimum acceptable ratios for regulatory capital to risk-weighted assets.”[footnoteRef:3] [3: (Herring)]

Regulatory Capital

Establishing the necessary amount of capital reserves is key to determining a banks health. Basel I established two tiers of assets as a means to recognize that not all equity is of equal capability to insulate a bank from unforeseen loan asset risks. The two-tier system of equity reflects compromises of the committee to achieve a consensus agreement. Herring surmises the tier structure and national interests underlying the components as follows:

Tier 1 capital is mainly shareholders’ equity (which satisfied the Germans). Tier 2 capital contains most of the compromises that facilitated agreement among the Group of Ten bank supervisors—most notably, generous use of long-term debt instruments (which pleased the French), limited acceptance of loan loss reserves (which pleased the Americans) and recognition of 45% of the unrealized capital gains on shareholdings (which satisfied the Japanese).[footnoteRef:4] [4: (Herring)]

The two tiers are known as regulatory capital, and are used to balance against the loan asset portfolio of a bank.

Categorizing Loan Risks

The second primary outcome of Basel I was the establishment of ‘risk-weight buckets’. Loans comprise several component risk factors, such that no two are identical. Basel I categorizes risks associated with loan assets of treasury bonds as inherently less risky than unsecured credit cards. The corresponding risk buckets established a system to recognize categories of risk and mitigates disincentives to holding lower risk, and lower yielding, assets (see Figure 1).

Figure 1: Risk Weights of Basel I[footnoteRef:5] [5: (Ong)]

The risk weighting of assets provides the basis for which a bank can calculate a capital ratio and determine regulatory compliance. Utilizing the risk weights of Basel I to illustrate an example of incentives to hold assets of low risk and return are noted in Table 1. Holding more risk-weighted assets requires larger amounts of equity.

Table 1: Risk Weight Example

Asset Type

Amount

Risk Bucket

Calculated Risk Weight

Cash holdings

100,000

0%

0

U.S. Treasuries

50,000

20%

10,000

Residential Mortgages

1,000,000

50%

500,000

Bank held real estate

300,000

100%

300,000

Calculating the Capital Ratio

The Basel Accords established a tier one minimum percentage of 4%, with a minimum of 2% comprised of core capital restricted to shareholder equity and disclosed reserves. Tier one and tier two equity required an aggregate minimum of 8%. Tier one equity is divided by the weighted average assets derives the capital ratio of a bank. Both tier one and tier two equity divided by risk-weighted assets derive the total capital ratio. The resulting ratios were aimed to insulate a bank from unexpected loan losses resulting from credit risk of loan assets.

Table 2: Ratio Example

Total risk weighted assets (Table 1):

810,000

Shareholder Equity (Tier 1):

40,000

Aggregate Non-shareholder Equity Assets (Tier 2):

25,000

Tier 1 Ratio: 40,000 / 810,000 =

4.94%

Total Capital: Tier 1 + Tier 2 Ratio: ( 40,000 + 25,000 ) / 810,000 =

8.02%

The tier one ratio and core capital ratio are the primary benchmarks of bank health due to relatively unambiguous valuation and liquidity, just as cash assets are risk weighted at zero. The superiority of tier one and core capital stems from the fact that losses are most effectively absorbed through shareholder equity, and not other forms of less liquid equity.

Basel I Falls Short

The intentions of regulators paradoxically served to make many banking institutions riskier as firms recognized these ratios as the ideal levels of leveraging to aspire to. The three main criticisms and shortcomings of Basel I undermining the aims of the accords are:

1. “Cherry Picking”: Banks enhanced profits by securitizing and selling the least risky components of their loan assets, thereby augmenting the overall risk held on their books. For example, ‘A’ quality residential mortgages are securitized and sold, while lower credit quality loans are held. Securitization replenishes a bank’s capital to facilitate further lending activities and realize quick profits, and due to the fact that all residential mortgages carried the same risk weighting in Basel I there was no regulatory difference between residential mortgage credit quality.

2. Arbitrage of Debt: The risk weight distinction between short and long term debt instruments resulted in an arbitrage strategy of selling and re-sale of short-term debt. Long-term debt instruments are thus swapped for strings of short-term debt. This strategy basically ‘games’ the risk weighting system to leverage the firm to enhance returns.

3. Emerging Markets: The Basel Accords were formulated for industrialized economies, and not intended for imposition on developing economies. Developing countries began to implement the Basel Accords because they found lending institutions charged lower rates of interest assuming the implementation of Basel I as an important step for stabilization and best practices anywhere.

Basel II

The first Basel Accord focused on limiting bank exposure to unforeseen credit risks of loan assets, while the second incarnation vastly expanded the scope of regulation to address other risk factors. Basel II specifically aimed to limit market and operational risk factors, in addition to credit risk.[footnoteRef:6] The shortcomings of Basel I exposed the reality that banks respond to the rules of regulators, but do not self regulate in the interest of greater market returns. In November 2007, A Financial Times article summed up the effects of the first Basel Accord with: [6: (Bryan)]

Likewise, executives' behaviour has been a direct response to flawed incentive structures in individual banks.

It was the 1988 Basel Accord that first created the opportunity for regulatory arbitrage whereby banks could shunt loans off the balance sheet. In effect, a new capital discipline designed to improve risk management had the unintended consequence of creating a parallel banking system whose lack of transparency explains the market seize-up since August.[footnoteRef:7] [7: (Plender)]

Some critics even went so far as to lay considerable blame at the feet of the entire Basel Accord effort:

The process of reforming the 1988 Basel Accord, that started in 1999, has been motivated by the goal of more closely matching regulatory capital to the risk profile of banks' asset portfolios. The rationale for minimum capital requirements is that they mitigate financial institutions' moral hazard. Regulators are imposing a cost on bank owners to 'encourage' them to avoid costly default. However, the limited number of risk categories in the current framework has created opportunities for banks to increase the risk to which they are exposed without increasing the amount of regulatory capital.[footnoteRef:8] [8: (Zicchino)]

Thus, the effort to compel banking institutions to balance capital reserves to risks would continue. Basel II broadened the aims of Basel I with a much more complex approach to risk. Balin notes this second generation of regulations in respect to the first, “Over the course of the Accord’s deliberation, the size of the agreement ballooned to 347 pages—a far cry from the 37 pages of the original Basel accord.”[footnoteRef:9] [9: (Bryan)]

The New Three Pillars Approach

The primary focus of Basel II is embodied in revisions to the ‘three pillars’ approach to banking regulation. The approach of Basel II is to enhance the framework of Basel I, by addressing the additional risk elements of market risk, maturity and macro interest rate changes, and operational risk, a broad category of risk related to the type of business a bank is involved. Beyond revision of the capital requirements to offset additional risk factors, Pillar 1, Basel II sought to introduce greater oversight of banking operations, Pillar 2, and enhanced transparency measures to compel banks to avoid regulatory arbitrage and dangerous levels of risk (see Figure 2).[footnoteRef:10] [10: (Maheshwari)]

Table 3: Standardized Approach Reserve Targets

Source: Basel II Accords (2006)

Figure 2: The Three Pillars of Basel II

The revisions to the minimum capital requirements sought to incorporate various banking business lines, or operational risk. The corresponding revision of minimum capital reserves are illustrated, (see Table 3), according to business lines. The new requirements compel banks to hold reserves as a percentage of average gross income over the previous three years. The mandated business line reserves comprise what became known as the Standardized Approach.[footnoteRef:11] [11: (Supervision, Basel Committee on International Banking)]

Source: 1- Web Article: New Basel Capital Accord (Basel II)

Table 3: Operational Risk Buckets

Regulators Seek Balance

In keeping with the original aims of the Committee on Banking Regulations and Supervisory Practices to encourage adequate supervision, the new Basel regulations recognized the limits of regulators enforcement resources to oversee complex banking operations within a globalized marketplace by encouraging firms to formulate their own risk models. Regulating agencies could approve the use of privately developed models and banks would then be rewarded for innovations in risk management with lower market risk reserve requirements. This approach to integrate market innovations was the committee’s attempt to encourage banks to actively manage their own risk management operations. Utilizing enhanced risk models to manage market risk became known as the Internal Model Approach.[footnoteRef:12] The purpose of the Internal Model Approach was to limit the costs of compliance by encouraging an approved self-surveillance scheme.[footnoteRef:13] Banks unable to formulate their own models also had the option of a Basic Model Approach that simply mandated reserves of 15%. [12: (Bryan)] [13: (Bryan)]

Table 4: Market Risk Buckets

Basel II also sought to incorporate aspects of volatility into reserve requirements related to maturity of loan assets. Risk buckets related to maturity comprised the aspects of market risk calculated into the new reserve requirements. The implication of market risk is the need to recalculate and monitor reserves as assets mature from one bucket to another. The inclusion of operational risk created a perfect environment for regulatory arbitrage as long-term assets were swapped for strings of short-term maturity instruments allowing higher leverage and returns.

Basel II Hits A Roadblock

The premise of the committee’s work in formulating the Basel Accords was focused on formulating a regulation standard by which the banking sector could rely and comply. Each nation was technically free to implement the recommendations in their own manner, however the goal was to formulate an acceptable regulation regime to guide banking institutions and remove the incentive to skirt oversight. Generous timelines were given to banks needing to raise additional capital to comply with the new regulations. The implementation of Basel II encountered problems from its final agreement with, “most European Union countries wanted the Accord to apply to all banks, while the U.S., Canada, and Great Britain wanted it to apply only to large international banks. In the end, this second bloc won out.”[footnoteRef:14] At the conclusion of the final Basel II draft all countries resolved to implement the regulations by December 2008.[footnoteRef:15] [14: (Bryan, Page 12)] [15: (Bryan, Page 13)]

Herring outlines the path to implementation in the United States ran into problems when the Federal Reserve considered the size of banking institutions and competitive factors of Basel II. Large banks also began intensive lobbying efforts to curtail implementation of the accords, along with a declared intent to pursue the basic and standard approaches to capital adequacy. United States banks declared Basel II to be overly complex and cumbersome to implement, therefore the largest banks opted for the least involvement in actively managing their loan asset risks. Basel II has yet to be fully implemented in the United States. [footnoteRef:16] [16: (Herring)]

The Financial Crisis and Basel III

Following the global financial and credit crisis of 2007, a third revision of the Basel Accords is formulated to further strengthen the regulations supporting the banking sector. The financial crisis exposed many shortcomings not addressed in either of Basel I and Basel II. The rating of debt quality was unquestioned in either Basel I or Basel II, however as the financial crisis exposed the danger of this assumption in that Balin states, “banks and corporations can choose the rating agency they employ, they may bring about a “race to the bottom” among the world’s three large rating agencies where business is given to the agency that assigns a firm the best rating possible.”[footnoteRef:17] [17: (Balin, Page 15)]

Another major issue that neither Basel I, nor Basel II addressed is known as pro-cyclicality. Pro-cyclicality is the recognition that bank lending can serve to reinforce up, or down, cycles in an economy through lending policies and activities. Banks are most apt to make more “bad loans” in an “up” economic cycle due to the overall exuberance of the economy. The pullback in lending policies by banks in a “down” economy tends to exacerbate a recession. The condition of pro-cyclicality is magnified by large numbers of banks using the same regulatory model, thereby uniform adjustments to lending activities in the same direction enhances the pro-cyclicality effects.[footnoteRef:18] [18: (Herring, Page 6)]

The formulation of Basel III seek to addresses the issue of pro-cyclicality with a buffer of increased common equity, or core capital, reserves triggered by regulators constrain “bubble” situations.

Went surmises the most important aspects pertaining to capital in Basel III as follows:

The quantity of capital is increased by emphasizing the crucial role core equity capital plays in absorbing losses and providing banks an essential capital base. The core equity capital regulatory requirement is raised from the current 2% to 4.5%, and the Tier 1 capital requirement is raised from

4% to 6%. Banks have 5 years to implement these changes, which also disallows the inclusion of certain non-common equity instruments that no longer qualify as regulatory capital. Additionally, by 2019 the proposals call for an additional capital conservation buffer funded by common equity to absorb losses during periods of financial and economic stress. When this buffer falls below 2.5%, the bank's ability to distribute earnings through the payment of dividends to its shareholders and discretionary bonuses to its employees is limited until the buffer is restored. Effectively, these proposals demand the common equity ratio of 7% and bringing the total regulatory capital requirement to 10.5%.[footnoteRef:19] [19: (Went, Page 4)]

The requirement of bank management to monitor loan asset portfolios and capital reserve positions, or face curtailment bonuses, is arguably the most effective means to internalize operational change. Increased core capital requirements also address layered risk elements at the heart of previous attempts to address specific issues of risk management.

Table 5: Basel III Tier One Requirements

Source: Website http://www.basel-iii-accord.com/

Revisiting the earlier example (see Table 1 and 2), it is apparent that the example bank must raise significant levels of new equity to comply with Basel III, See Table 5.

Table 6: Example Bank Adjustments Required From Basel III

Shareholder Equity (Table 2)

40,000

Risk Weighted Assets (Table 1)

810,000

Core Capital needed at 4.5%

36,450

Core Capital and Conservation Buffer

56,700

Total Tier 1 Capital

68,850

Total Capital at 10.5% - 25,000 (Tier 2, Table 2)

60,050 (85,050 – 25,000)

Additional Core Capital Needed

16,700

Additional Total Capital (Tier 1 or 2)

3,350 (60,050 -56,700)

The example bank scenario illustrates that the minimum core capital needed is more than a 40% increase in equity, and an additional 3,350.00 is still required of tier one or tier two capital. The example also excludes consideration of the counter-cyclical reserve requirements that could compel an additional 20,250 of core capital, nearly doubling Basel I minimums

Implementation of Basel III is stretched over a considerable timeframe to allow banks adequate time to reinforce their balance sheets with additional capital. Appendix 1 illustrates the recommended timeframe for implementation.

Will It Work?

Basel III makes significant strides to correct the shortcomings of Basel I and the complexity embodied within Basel II. The complexity of Basel II led to the United States adopting only parts of the accord, and utilizing what would be known as the “bifurcated” approach.[footnoteRef:20] Undoubtedly, the most effective means of reinforcing the banking sector is requiring the core equity, shareholder equity and disclosed reserves (retained earnings), to be increased to over 7%. The strength of requiring greater core capital lies in the loss absorption capability. Regardless of any other aspects of Basel III, lowering bank leverage increases stability, however at the cost of dividends. Past bank performance at successfully executing regulatory arbitrage justifies the strict increase in core capital requirements as a broad means of correction. [20: (Herring, Page 6)]

The counter-cyclical component of the core capital requirements also provides regulators a more acute tool to control economic conditions beyond interest rates and monetary policy.

A very promising element to preventing future financial crises lies in a holistic approach to counter strategies of financial markets that elude specific regulation in previous Basel Accords, namely credit rating agencies and hedge funds. A recent Guardian article sums up the main points of Basel III with:

Derivatives: The G20 has called for greater standardisation and central clearing of privately arranged, over-the-counter contracts by the end of 2012.

Hedge funds: US reforms are in line with the G20 pledge that funds above a certain size should be authorised and obliged to report data to supervisors. A draft EU law includes private equity groups and restrictions on non-EU fund managers seeking European investors.

Accounting: The G20 wants common global accounting rules by mid-2011.

Credit rating agencies: The G20 wants them registered and supervised by the end of 2009. The EU has adopted a law mandating registration and direct supervision that takes effect this year. US legislation passed this year includes similar provisions.

Pay: The G20 has endorsed principles designed to stop bonus schemes in banks from encouraging too much short-term risk-taking.[footnoteRef:21] [21: (Kollewe and Wearden)]

Basel III, when fully implemented, will reduce the likelihood of another financial crisis of the magnitude of 2007, however the path to full implementation is a lengthy journey, see Appendix 1. The fate of Basel II in the United States, due to intense bank objections, illustrates that full implementation may never be realized.

Another weakness to achieving the aims of Basel III lies in the unique application that each country uses for implementation. The lack of legistlative standardization amongst nations preserves the specter of regulatory arbitrage that all generations of Basel Accords have sought to minimize. Richard Beales, writing for Reuters, noted the piecemeal regulations of the EU and the US as providing benefits to certain banks and the derivatives markets are likely to migrate to the most lax regulatory environment.[footnoteRef:22] [22: (Beales)]

The globalized nature of financial markets and electronic trading in foreign markets degrades hopes that Basel III will effectively prevent another financial crisis.

Basel III is best suited to prevent a financial crisis amongst banks that do not participate in the derivatives trading.

Unintended Consequences

The most glaring ‘unintended consequence’ of the Basel Accords is the adoption by the non-industrialized economies of the world. The committee specifically wrote that the guidelines are intended for implementation in the developed world, however the banking sector has frequently looked to each of the accords as ‘best practices’ suited for all economies. Basel III is written to address the financial sectors of industrialized nations, however the increased capital reserve requirements may be beyond what developing country banks can reasonably obtain. Vincenzo LaVia, of the World Bank, notes to Reuters the potential effects of Basel III:

The big subsidiary in a developing country may not seem that important within its global group. But its failure could be devastating for the local economy and could spark global contagion."

La Via also said developing countries should also be given a bigger say in efforts by European and U.S. regulators to improve accounting standards to make sure they are global.

"If developing countries' concerns are not taken into account, they will have little incentive to adopt them. This could provide opportunities for regulatory arbitrage, with riskier financial transactions moving to the least-regulated markets.[footnoteRef:23] [23: (Tagaris)]

In Summary

Each of the Basel Accords represents a significant step in harmonizing regulations aimed at increasing banking sector solvency. If one were to believe that markets are efficient, then greater transparency would compel banks to operate within the regulatory framework and financial crises would be a thing of the past. However, markets are not efficient and the assumption Basel III regulations will confine banking institutions to be satisfied with constrained profits is naïve. Banks engaged in international operations, investment banking, and trading activities will continue to seek out loopholes to regulations, arbitrage, and lobbying activities to constrain budgets of regulatory agencies from effective enforcement.

Accepting the inefficiency of markets emphasizes the need for regulatory agencies endowed with robust enforcement measures aimed at preventing widespread financial distress. Greater transparency of off balance sheet items and integrated accounting standards will serve to reduce market inefficiencies as some analysts and investors are able to untangle the complex investment schemes of banks. The Basel Accords must also continue to evolve, as the financial institutions continue to seek abnormal profits thru exploiting areas of ineffective regulation. Individual banks will still fail, but efforts must continue to minimize the threat of moral hazard and repeating past mistakes.

Appendix 1: Basel III Implementation. Source: http://www.basel-iii-accord.com/

Works CitedZicchino, Lea. A model of bank capital, lending and the macroeconomy: Basel I versus Basel II. Quarterly. London: Bank of England, 2005.

Went, Peter. "Basel III Accord: Where do we go from here?" Risk Professional December 2010.

Basel Committee on Banking Supervision. "History of the Basel Committee and its Membership." 1 August 2009. Bank for International Settlements. 11 March 2011 .

Beales, Richard. "Regulatory arbitrage could go far beyond Basel III." 10 March 2011. Reuters.com. 14 March 2011 .

Balin, Bryan. "Basel I, Basel II, and Emerging Markets: A Nontechnical Analysis." 10 May 2008. www.policyarchive.org. 13 March 2011 .

Herring, R. "The Rocky Road to Implementation of Basel II in the United States." Atlantic Economic Journal  (2007): 411-429.

Kollewe, Julia and Graeme Wearden. "Basel III: the main points." 10 September 2010. guardian.co.uk. 14 March 2011 .

Maheshwari, Rahul. New Basel Capital Accord (Basel II). 24 March 2007. 13 March 2011 .

Ong, Michael K. Internal Credit Risk Models: Capital Allocation and Performance Measurement. London: Incisive Financial Publishing Limited, 1999.Plender, John. "Basel Accord sits at the root of the ongoing banking crisis." Financial Times 7 November 2007.Supervision, Basel Committee on International Banking. "Convergence of Capital Measurement and Capital Standards: A Revised Framework, Comprehensive Version." 2006.Rochet, Jean-Charles. "REBALANCING THE THREE PILLARS OF BASEL II." 1 Sept. 2004. Proquest. 13 March 2011 .Tagaris, Karolina. "Reuters.com." 6 March 2011. Reform could harm developing economies: World Bank. 14 March 2011 .

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