Basel III

The risk-based capital requirements outlined above necessarily involve significant complexity, with each of a bank’s assets needing to be assigned a specific risk weight. As outlined in greater detail in another YPFS Case Study (McNamara, et al 2014D), since Basel II, banks have had the ability to make use of internal models in calculating RWA, resulting in what critics have described as an ability to “game the system” by meeting the new requirements through overly aggressive modeling that keeps RWA artificially low. Thus, as a backstop to the risk-weighted capital requirements and because during the financial crisis “[i]n many cases banks built up excessive leverage while still showing strong risk-based capital ratios,” Basel III introduces “a simple, transparent, non-risk-based leverage ratio that is calibrated to act as a credible supplementary measure to risk-based capital requirements” (Bank for International Settlements rev. 2011, 61).

at the impact produced by implementing Basel III agreement but concentrates only on a higher capital requirement. The conclusion of the report is that Romania’s financial sector can easily adapt to these requirements because the banks’ capitalization remains at a comfortable level of 14.2% (June, 2011). As a member of the European Union, Romania will implement the Basel III Agreement through Capital Requirement Directive (CRD IV). Therefore, in terms of progress in implementing the agreement, Romania fits with other European countries in the second stage according to the BIS report 2 : draft regulation published. 3

This work project aims to assess the impact of Basel III’s proposal in the Portuguese banking sector, a sector experiencing particularly difficult times in a distressed country. The industry is represented by its three largest quoted banking groups, two of them under government intervention. The impact is evaluated through the estimation of the banks’ capital ratios through Basel III’s expected implementation calendar, through the analysis of the banks’ capital needs based on their publicly available information and industry research. The impact will vary depending on the bank; on average, it will result in a decrease in banks’ excess capital. Banks will have difficulties to comply if state-owned CoCos are not considered part of regulatory capital. The new standards will penalize those banks with a recent history of poor performance, and decrease the difference between regulatory and equity capital.

According to Basel III, signed by the Committee of Banking Supervision Banks need to triple by 2015, capital reserves of high quality, up to a 7% capital adequacy. Thus, banking authorities and major global central banks decided to increase the capital base rate ranking first (core Tier 1) to 4.5% from 2% at present. However, the total rate was established at Tier 1, 6%, compared with 4% today. Banks will need to build a new type of reserve, the "preservation of capital, of 2.5%, along with Tier1 rates, consisting of common equity and if the banks will be reported as having "excessive credit conditions" that will create "a counter-book", of 0 - 2.5%.

For the 23 banks expected to be subject to BRRD2 subordination requirements, we estimate that the increased RWAs under the Basel III scenario (total RWA for this subsample would increase by 19%) would lead to a c. 13.9-14.4%% increase in BRRD2 requirements. The reason for having an estimate that is lower than the increase of RWAs, reflects the fact that BRRD2 subordination levels are partially a factor of non-risk based metrics (such as Leverage ratio exposure and TLOF). As indicated in Table 43, this increase translates into a shortfall in MREL subordinated resources ranging from EUR 6.1 billion under the low scenario to EUR 4.5 billion under the high scenario. The lower shortfall under the high BRRD2 scenario reflects the fact that non-risk based variables – leverage based and TLOF - have a greater impact on the BRRD2 high subordination calibration (see Methodology section below). The significant drop from the previous year’s analysis largely reflects the lower increase in RWA under this scenario and the strong increase in subordinated resources among GSIIs and top tier banks compared to December 2018. The fact that the share of MRC shortfall contributing to closing the MREL shortfall is nil reflects the fact that for the banks with a shortfall either (i) the MRC shortfall resulting from Basel III is nil or (ii) the subordinated MREL shortfall resulting from Basel III is nil.

The introduction of the 1988 Basel I accord has reignited the debate on the effectiveness of banks’ regulatory capital (Fiordelisi, Marques-Ibanez, & Molyneux, 2011). However, as mentioned, Tier I ratio is a risk-based capital ratio that represents the highest quality capital that can fully absorb losses in event of crisis and it mainly consists of common equity Tier I (CET I) such as common share, common share premium, retained earnings and reserves (BCBS, 2011). The new Basel III agreement increases the Tier I ratio from 4% to 6% as a minimum requirement in all times and the CET I from 2% to 4.5% as a minimum requirement in all times (BCBS, 2011). Thus, the total Tier I ratio is 6%, which consists of 4.5% CET I and 1.5% additional Tier I capital. More, Basel III requires banks to build up a capital conservation buffer of 2.5% of CET I; hence, the total minimum CET I is 7% (4.5% + 2.5%) and the minimum total regulatory capital(Tier I + Tier II) is 10.5%. These ratios are calculated based on the risk adjusted weighted assets value (RWA) and they are covered three types of risk, which are credit risk, market risk and operational risk. In addition, beside the increase in capital in relation to the amount and type, the Basel III introduced new liquidity requirements and minimum leverage ratio that will restrict the banking activities and as a result will affect banks’ performance (Jayadev, 2013). These new requirements increase the complexity of bank’s management as they restrict bank’s activities such as assets allocation, planning and risk strategies (Schmaltz, Pokutta, Heidorn, & Andrae, 2014).

that those jurisdictions that have undergone an assessment of their final rules have so far promptly rectified identified issues and are continuing with regulatory reforms. The RCAP process has thus far helped improve member jurisdictions’ consistency with the Basel III standards. As a result, regulations to adopt and implement Basel III standards are stronger than would otherwise have been the case absent the Committee’s efforts at monitoring and assessing implementation. However, the Committee has also published studies of banks’ calculations of risk-weighted assets in both the banking and trading books. The results revealed material variations in the measurement of risk-weighted assets across banks, even for identical hypothetical test portfolios. The Committee is actively considering possible policy reforms to improve the comparability of outcomes. In doing so, it needs to ensure an optimal balance between the risk sensitivity of the framework and its complexity.

Shadow banking, defined by Standard & Poor’s Rating Services for purposes of its analysis of alternative financing in infrastructure as “the system of finance that exists outside regulated depositories, commercial banks, and publicly traded bonds,” consists of participants including “pension funds, insurers, sovereign wealth funds, and export credit agencies, alongside finance companies, private investment funds, business development corporations, asset managers, hedge funds, and sponsored intermediaries such as money-market funds” (2013, 3). Given that such institutions are not subject to the NSFR established by Basel III, they do not face the same standards as do the banks that have historically dominated the project finance.

An excessive on – and off balance sheet buildup of leverage was one of the underlying flaws which amplified the financial and economic crisis. During the crisis, the banking sector was forced to reduce its leverage in such unfavorable manner that created downward pressure on asset prices. This resulted in a further deterioration in the loop between losses, reducing bank capital and available credit. (Basel Committe on Banking Supervision, 2010)(Accenture, 2012). In order to prevent an excessive buildup of leverage on balance sheets in the future, Basel III a leverage ratio requirement to supplement the risk- based framework. The leverage ratio aims to mitigate the risk of destabilizing de-leveraging processes, such as presented during the crisis, which can damage the economy and to reinforce the risk based requirements with a non-risk based backstop measure. Although the regulatory leverage ratio is not intended to be a binding instrument at this stage, the Basel Committee on Banking Supervision is reviewing the option of mandating the instrument as of 2018.

An ongoing concern of the banks at international level is implementing and respecting the international banking standards, in order to align with the rules imposed by the practice field and in the recognition of the national commercial banks by business partners and by customers worldwide. In this paper I proposed an approach to evolution and comparative of the main agreements governing the international banking activity, namely Basel I, Basel II and Basel III, in order to reflect the motivations for which they have appeared and to show the main changes that must be made by the commercial banks in order to accommodate to the requirements imposed.

to 21% for large commercial banks and 17.5% for small- and mid-sized banks; accordingly, an estimated CNY396 billion (US$62.38 billion) in capital will be released into the market. 123 The result of the reduced RRR rate is that it will ease banks’ credit crunch caused by a high RRR, suggested the chief economist at the Bank of Communications in China. 124 Lowering RRR has been shown to translate automatically into higher loan growth; in a move to help boost liquidity and support economic growth, the PBC again cut banks’ RRR by 0.5% (i.e., 50 basis points), effective 18 May 2012. 125 After this latest cut, the RRR is reduced to 20% for large financial institutions (down from the previous cut in February 2012 to 20.5%). According to Bloomberg News, a 50 basis point cut in RRR in February 2012 added CNY 350-400 billion (approximately US$63.4 billion) to the domestic financial market. 126 Incidentally, this reduction would also encourage the banking industry to increase lending to SMEs, which would not likely to be achieved by Basel III as previously explained. China is the world’s second largest economy, also known as the locomotive of the world’s economy; therefore, the PBC’s recent cut in RRR rate serves as a reminder of how a national government, despite being a Basel III member, can reverse Basel III requirements (for raising banking capital ratios) by changing macroeconomic

and Basel regulatory standards. 35 This, however, is likely to be challenging for Islamic banks due to the constraints imposed by Shari’ah and the scarcity of available products that satisfy the Basel requirements. For example, to meet the new Basel III capital adequacy requirements, Islamic banks would require acceptable Tier 1 and Tier 2 capital on the one hand and would have to ascertain the value of the risk-weighted assets in their portfolios with the new risk-weights on the other hand. As PSIA cannot be accepted as capital under the stringent definitions of Basel III, one option may be to come up with long-term equity-based sukuk that fulfils the definition of capital under the new regulatory requirements. 36 Similarly, as Basel III pays more attention to market risks and counterparty risks, the risk weights for partnership contracts such as mudarabah and musharakah and sale-based instruments such as salam and istisna are likely to increase. 37

Discussing the target of the Basel III agreement, its upgrades or its actions is simple, because at the end the goal remains positive and unanimous: economic and financial stability and harmony across the globe. On the other hand it is advisable and necessary to observe from a bit more skeptical and scenarist view in order to detect expectation and potential response in both financial sphere and real economy. Throughout the analysis conducted under this article we will start by defining the implementation effects of these new rules on banks as well as on the real economy and shareholders, observing also the dichotomy of qualitative or quantitative effects. Following we will build possible scenarios of the impact on banks and their response to ensure adaptation towards the new structure of regulatory oversight.

The LCR by means of a buffer (that should cover part of the difference between a banks’ financial inflows and outflows in times of stress), is intended to ensure that banks hold liquid assets of high quality (HQLA) in order to withstand stressful situations for a time horizon of thirty days. Assets are considered to be HQLAif they can be easily and immediately converted into cash at little or no loss of value ( 2 ). According to the Basel III requirements, HQLA should

Banks would have very limited scope to increase prof- itability or minimise cost. Banks with a very low profit- ability margin will be affected most because they will require more capital as conversion from profit to capital will be less. Under Basel III the capitalisation ratio is arrived at by dividing equity capital by the risk weighted assets. How can banks minimise the risk weighted assets? Banks can change the business mix focussing more on retail/short term loans rather than corporate. Banks need to change their customer mix and ensure proper pricing to maximise risk adjusted return. Banks must seek low cost funding with a thrust on low cost stable deposit base. This could mean opting for the business correspondent or business facilitator model prescribed by the RBI, which would pre-empt the need to operate full-fledged branches while still reaching the goal of financial inclusion. Banks must improve systems and procedures, refining their rating model so as to obtain the proper risk weight, going in for data cleaning and modernising systems and proce- dures to meet operational needs. Operational efficiency will ensure economising on capital through the lowering of risk weighted assets.

The Basel Committee’s oversight body – the Group of Central Bank Governors and Heads of Supervision (GHOS) –agreed on the broad framework of Basel III in Sep- tember 2009 and the Committee set out concrete proposals in December 2009. These consultative documents formed the basis of the Committee’s response to the financial crisis and are part of the GLOBAL INITIATIVES to strengthen the financial regulatory system that have been endorsed by the G20 leaders (which represent 85% of the word GDP). The GHOS subsequently agreed on key design elements of the reform package at its July 2010 meeting and on the calibration and transition to implement the meas- ures at its September 2010 meeting.

It should be noted that certain jurisdictions may choose not to adopt some or all of the advanced approaches of the Basel III framework for the measurement of risks. Such choices are not deemed to be deviations for the purpose of assessment; the relevant provisions will be considered as non- applicable, in line with the approach adopted by the Committee when developing Basel II. 5

The Basel Committee’s oversight body – the Group of Central Bank Governors and Heads of Supervision (GHOS) –agreed on the broad framework of Basel III in Sep- tember 2009 and the Committee set out concrete proposals in December 2009. These consultative documents formed the basis of the Committee’s response to the financial crisis and are part of the GLOBAL INITIATIVES to strengthen the financial regulatory system that have been endorsed by the G20 leaders (which represent 85% of the word GDP). The GHOS subsequently agreed on key design elements of the reform package at its July 2010 meeting and on the calibration and transition to implement the meas- ures at its September 2010 meeting.

This paper provides an assessment for the Italian economy of the costs - both during the transition period and in the long run - of the new regulatory standards (the Basel III reform), focusing exclusively on capital and liquidity requirements. The analysis is fully consistent with those of the Macroeconomic Assessment Group (MAG, 2010a,b) and of the Long-term Economic Impact group (BCBS, 2010a). Overall, the economic impact of the new regulation is small. For each percentage point increase in the capital ratio implemented over an eight-year horizon, the level of GDP would decline by 0.00-0.33%, corresponding to a reduction of the annual growth rate of output in the transition period of 0.00-0.04 percentage points. If non- spread effects – i.e. effects due to deleveraging of banks’ balance sheets – are also taken into account, the GDP loss would rise to 0.03-0.39%, corresponding to a 0.00-0.05 percentage point decrease in average annual output growth. The maximum GDP loss occurs around nine years after the beginning of the transition period; thereafter, output slowly recovers and by the end of 2022 it is above the baseline value. Compliance with the new liquidity standards also has a small effect on output. The above estimates suggest that the economic costs of stronger capital and liquidity requirements are small and become negligible if compared with the potential benefits that can be reaped from reducing the frequency of systemic crises and the amplitude of boom-bust cycles.

The “Level 2” assessment process assesses the compliance of domestic regulations implementing Basel III with the international minimum requirements defined by the Basel Committee. By identifying domestic regulations and provisions that are not consistent with the rules agreed by the Committee and by assessing their impact on financial stability and on the international level playing field, this process will promote full and consistent implementation of Basel III. It will also facilitate an effective dialogue among members and provide peer pressure if needed. The conclusions following each jurisdiction’s assessment will be published by the Committee. This assessment programme supports the Financial Stability Board’s monitoring of the implementation of the agreed G20/FSB financial reforms and is fully consistent with the “Coordination Framework for Monitoring the Implementation of Agreed G20/FSB Financial Reforms” put in place by the FSB. 4