Basel III Presented by Matthew Petrella MBA 632 Economics Spring 2012 Week 6

Basel Committee on Banking Supervision (BCBS) Set up by the G10 central bank Governors. In response to the 1974 collapse of Bankhaus Herstatt in Germany and the Franklin National Bank in the U.S. Operates under the Bank for International Settlements (BIS), located in Basel, Switzerland. Sources: BIS Tower in Basel, Switzerland

Basel Capital Accord Created by the BCBS in 1988 following concerns for regulatory supervision of internationally active banks. Introduced a credit risk measurement framework for internationally active banks. Sources:

Basel II Revision of known as Basel II Introduced capital requirements, supervisory oversight, and market risk assessment. Minimum capital requirements outlined in Basel II direct that the greater the risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency. Basel II set the minimum capital standard at 4.0% of bank assets. Sources:

Basel III Announced 12 September 2010, the BCBS announced a new revision to Basel II in response to the recent financial crisis. Revisions included: Increase to the minimum common equity requirement. A capital conservation buffer. A countercyclical buffer. Sources:

Increased Capital Requirements Banks will be required to meet new minimum requirements in relation to risk-weighted assets (RWAs) Common equity is the highest form of loss absorbing capital. Minimum requirement being raised from 2% to 4.5% Being phased in between 1 Jan and 1 Jan Tier 1 capital includes common equity and other qualifying financial instruments based on a stricter criteria. Minimum requirement being raised from 4% to 6% Sources:

Capital Conservation Buffer Will be phased in between 1 Jan to 1 Jan Begins at 0.625% of RWAs on 1 Jan Increases by an annual 0.625% until reaching 2.5% on 1 Jan Will be maintained for use as an emergency reserve in addition to the minimum common equity capital reserve. Sources:

Countercyclical Buffer A range of 0% to 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. Purpose is to achieve the broader macro-prudential goal of protecting the banking sector from periods of excess aggregate credit growth. Countercyclical buffer will only be in effect when there is excess credit growth that is resulting in a system wide buildup of risk. Will be introduced as an extension of the conservation buffer when in effect. Sources:

Transition Period Chart Leverage Ratio Supervisory Monitoring Parallel run 1 Jan 2013 – 1 Jan 2017 Disclosure starts 1 Jan 2015 Migration to Pillar 1 Minimum Common Equity Capital Ratio 3.5%4.0%4.5% Capital Conversion Buffer 0.625%1.25%1.875%2.5% Minimum Common Equity & Capital Conservation Buffer 3.5%4.0%4.5%5.125%5.75%6.375%7% Minimum Tier 1 Capital 4.5%5.5%6.0% Minimum Total Capital 8.0% Minimum Total Capital plus Conservation Buffer 8.0% 8.625%9.25%9.875%10.5% Sources:

Impact on the U.S. Economy Sustained economic growth relies on bank loans help business expansion take place. Business expansion creates jobs which in turn grows the economy. Higher minimum capital requirements could force banks to restrict lending, which in turn can stall economic growth. Small, not large, banks will struggle the most to meet such requirements. Sources:

The Small & Local Banks Credit or debt is issued by banks and is the source of virtually all money today. When credit is not available, there is insufficient money to buy goods or pay salaries resulting in workers being laid off and businesses shutting down. Local commercial banks make most of the loans to local businesses which provide the most employment and production for the economy. These banks already struggling to meet capital requirements. Sources:

Agreement Among Opposing Views “The plunge in M3 (the largest measure of the money supply) has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the U.S. is not recovering properly.” – Professor Tim Congdon of International Monetary Research “the main exogenous constraint on the expansion of credit is minimum capital requirements.” – from “Unconventional Monetary Policies: An Appraisal” published by the BIS Sources:

Impact on America’s Largest Banks Major U.S. banks are already in compliance with the new Basel III requirements. On the day they collapsed, Lehman Brothers would have been in compliance with the new Basel III standards. Sources: -basel-iii-reforms/;

Basel III Reduces Competition By adding new regulation, new barriers to entry are erected leading to a reduction in competition. Under perfect competition profit goes to zero. Banks who are able to meet Basel III regulatory requirements should be even more profitable that before due to decreased competition. The banking sector as a whole may be less profitable. The largest banks will not be. Sources:

Big Euro Banks The new rules should not effect Europe’s largest banks; however, it is expected to force weaker banks to raise billions of euros in fresh capital over the next few years. Sources: -requirements-raised

Calculation of Risk-Weights Under Basel II risk was calculated primarily by reference to ratings assigned by the recognized ratings agencies. Basel III failed to address this leading contribution to the financial crisis. Securitization was a way to manufacture apparently risk-free assets out of pools of risk. Direct exposure to sub-prime loans that brought banks down; rather, it was exposure to triple-A-rated debt backed by pools of sub-prime loans. AAA ratings of CDOs by rating agencies made over-leveraged risky loans appear safe. Sources: