The Basel III agreement and the effects it wlll have on the banking sector

Standard

1. What is the Basel agreement

The Basel III is an international standard established by the BCBS (Basel Committee on Banking Supervision) which is a BIS (Bank for International Settlement) affiliated organization.

The BCBS was formed in 1974 to establish global standards related to bank supervision. The members consist of 44 institutions of 27 countries, including the US, England, Canada, China and Korea, and the Vice-president of each country’s central bank, and financial supervisory institution attends it.

The BCBS so far has established the Basel I, Basel II and the Basel III for the stability of the global financial market. When the BCBS releases a regulation, countries adopt it at the appropriate timing in regard to their situation.

The most important point of all the supervisory standards of the BCBS is the BIS capital adequacy ratio. [BIS capital adequacy ratio = equity ÷ RWA (Risk weighted assets) * 100] The RWA is an asset value that is calculated depending on the risk. It  is produced by classifying the banks asset according to its credit rating and then applying the risk to it.

The Basel I was first introduced in 1988. Maintaining a minimum of 8% of equity towards the risk asset is the main point and was established to improve the stability of the global financial system and prevent unnecessary competition between international banks.

But even after the Basel I was established in the early 1990’s large banks started to fail in America and in 2000 the financial crisis hit countries in Southeast Asia, Japan, Russia and Central and South America. Through undergoing this experiences, large financial institutions felt a need for capital agreement, and soon the Basel II was established. In the Basel II, the risk assets included not only the credit risk and the market risk, but also the operational risk. Please refer to the following terms for the different kinds of risk;

-credit risk : risk that a borrower will default on any type of debt

-market risk : risk that the value will decrease due to the change in value of the  market risk factors

-operational risk : risk arising from execution of a company’s business functions

But later the Basel III was established because unexpected weaknesses, the excessive debts of the banks, weakness in liquidity and the degenerated quality of equity, were noticed after the financial crisis in 2008.

2. The main contents of the Basel III

After the financial crisis, countries agreed that there’s a need for a regulation for an increase of capacity to absorb loss, relaxation of pro-cyclicality, strengthening of capital, liquidity and leverage.

1) relaxation of pro-cyclicality ; Capital conservation buffer, Countercyclical capital buffer

Capital buffer must be saved during periods of growth to suppress the negative interaction between mark-to-market, leverage and maturity mismatch during a financial crisis.

-Capital conservation buffer : the improvement of the loss absorbing capacity for future risk, saved as capital stock-common when over 2.5%

-countercyclical capital buffer : 0% saved but up to 2.5% as capital stock-common on periods of credit growth

2) strengthening of the capital regulation

To increase the quality of capital and to secure transparency and consistency of the capital ratio, tier 1, tier 1 + 2, predominant form of tier 1 including capital stock-common and retained earnings should not exceed a certain percentage.

Substantially it is demanding to meet the following ratios:

stock capital-common : 7% (4.5% + capital conservation buffer 2.5%) ~ 9.5% (includes 2.4% countercyclical capital buffer during growth period)

tier 1 + tier 2 : 10.5% (8% + capital conservation buffer 2.5%) ~ 13% (includes 2.4% countercyclical capital buffer during growth period)

tier 1 : 8.5% (6% + capital conservation buffer 2.5%) ~ 11% (includes countercyclical capital buffer during growth period)

 

3) strengthening regulation of liquidity (maturity mismatch) ; liquidity coverage ratio, net stable funding ratio

The liquidity coverage ratio is a short-term indicator which is designed to ensure that financial institutions have the assets on hand to ride out short-term liquidity disruptions. Banks are required to hold an amount of highly-liquid assets, such as cash or Treasury bonds, equal to or greater than their net cash over a 30 day period (having at least 100% coverage).

The net stable funding ratio is a long-term indicator in which ‘Stable funding/weighed long term assets’ must be over 100%.

4) leverage regulation

The leverage regulation was introduced in which the leverage ratio must be over 3% of the Tier 1 and also a borrowing limit regulation is introduced to prevent imprudent foreign loans which will hold effect from 2018.

3. Prospects and ways we can deal with it

The banks of our country nowadays have a stable capital adequacy ratio. But because the calculation method changes through the introduction of the Basel III the ratio might drop even though the same asset and liability structure. Also because the minimum capital ratio went up we need to beware to satisfy its standards.

So what are some concrete ways banks can deal with it?

Simply said, they could extend their equity or reduce their RWA.

Therefore subordinated bonds, which were regarded as equity before but not anymore, are being issued in advance until the end of this year. Also when the additional 2.5% of the predominant form of tier 1 is not being satisfied no dividends and bonuses can be given and therefore it might result in cut backs of the dividends to save retained earnings.

The liquidity regulation might also result in degeneration of profitability for the banks, since the opportunity of the banks collecting short-term funds and investing it on longer terms might decrease. And also to satisfy the new liquidity ratio they have to increase the percentage of government bonds and blue chip corporate bonds. because the Basel III does not regard bonds issued by other banks as highly liquid assets. Only corporate bonds over the rating ‘AA-’ and  government bonds of the rating ‘A+’ are considered highly liquid.

To summarize, the Basel III is demanding to separate the capital adequacy ratio into common equity, tier 1 capital and total capital and to keep it over 4.5%, 6% and 8% each and to save additional capital according to the economic conditions or the risk level of each bank. So the banks should prepare to respond to any situation sufficiently and the supervisory authorities should monitor it properly not to spoil the purpose of this regulation. Lastly the FSC needs to find ways to apply it to us efficiently, considering the necessity of this regulation and the profitability of the bank industry.

 

Min-Kyoo Song (skydome123@naver.com)

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