Basel III and Beyond: Aiming for Stability

Regulators came under attack when the financial crisis of 2008 exposed grave weaknesses in the global regulatory framework and the risk management practices in banks and financial institutions (FIs). This prompted authorities to review existing requirements and propose new measures, the most prominent of which is perhaps Basel III, a regulatory framework that aims to increase the stability of financial markets.

Cutting through the complexity of Basel III formed the basis of two sessions at the financial risk forum. Steven Hall, partner in financial risk management at KPMG UK, gave an overview of Basel III and of the likely regulatory changes in 2015, and Syril Pathmanathan and Dimitris Bartzilas, from the risk-weighted assets (RWA) optimisation and operational risk departments at Crédit Suisse, looked at the effect of Basel II and III on FIs. This article summarises the key points.

Although it was agreed in 2010 by the Basel Committee on Banking Supervision, Basel III was introduced from January 2013. Its principal aims are to:

• improve the banking sector’s ability to absorb shocks arising from financial and economic stress;
• improve risk management and governance;
• strengthen banks’ transparency and disclosures; and
• strengthen global capital and liquidity rules.

Banks are expected to phase into Basel III in the next four years and to have fully implemented it by 2019.

Under this regime, banks will have to adhere to several new or enhanced rules, which include a clearer definition of capital and the introduction of a global liquidity standard.

Capital requirements rules

The crisis showed inconsistencies in the definition of “capital” across Europe as well as a lack of disclosure among banks that would have enabled the market to compare the quality of capital. As a result, the Basel Committee clarified the definition of “capital” with a greater focus on “common equity” – the highest quality component of a bank’s capital. The new definition requires:

• common equity tier 1 (CET1) to be at least 4.5% of RWA, that is the bank’s assets weighted according to risk;
• tier 1 capital to be at least 6% of RWA at all times;
• total capital (tier 1 capital plus tier 2 capital) to be at least 8% of RWA at all times; and
• an overall CET1 ratio of 7% by 2019 to avoid restrictions on the payout of management bonuses and dividends.

How the banks responded

In September 2014, the Basel Committee published the results of the latest Basel III monitoring exercise, which took place in December 2013. This showed that European banks are on track to meet the capital requirements.

A total of 227 EU banks participated in the exercise, comprising 102 global banks with a tier 1 capital exceeding €3bn, referred to as “group 1 banks”, and the other 125 banks are referred “group 2 banks” (that is, all other banks).

According to the monitoring results, group 1 banks would have a shortfall of €100m for the CET1 minimum capital requirement of 4.5%, which rises to €15.1bn for a CET1 target level of 7%. The capital shortfall for group 2 banks is estimated at €2bn for the CET1 minimum of 4.5% and €9.4bn for a CET1 target level of 7%.

Speaking at the StrategicRISK-Zurich forum, Hall said: “It is clear that for some banks there is a significant shortfall to those capital requirements, but those shortfalls have come down considerably since last year.

“Indeed, if you looked at these shortfalls in comparison to the annual profits of the banking sector or the banks represented here, this would be a small proportion of those profits.

“So, these firms are on their way to meeting the minimum requirements.”

He added: “There is also quite a difference between different regions around the world. So, European banks tend to have lower CET1 ratios than Far-Eastern banks, for example, primarily because they were far more equity-funded already and therefore they have had less far to go in terms of meeting the requirements.”

Beyond Basel III

Although it would seem that banks are making good progress in meeting the Basel III requirements, there have been several modifications to certain elements of Basel III and, with further consultation taking place on other aspects of the regulation of FIs, further reforms can be expected.

Hall highlighted some of the main changes that have taken place and some future modifications.

Large exposures

In April 2014, the Basel Committee published the Supervisory framework for measuring and controlling large exposures.

The framework is expected to take effect from 1 January 2019 and aims to protect banks from significant losses caused by the default of an individual counterparty or a group of connected counterparties.

“Large exposures would have a particular impact for the larger banks,” Hall explained. “The framework could restrict further the interbank lending, which is going to create further issues in respect to how banks deal with major broker dealers.”

Central counterparties

The Basel Committee, the Committee on Payments and Settlement Systems and the International Organization of Securities Commissions set out to improve the interim capital requirements for bank exposures to central counterparties (CCPs). CCPs are organisations that exist in various countries that help facilitate trading done in derivatives and equities markets.

In July 2012, the Basel Committee published an interim standard for calculating regulatory capital for banks’ exposures to CCPs. This was introduced by additions and amendments to International convergence of capital measurement and capital standards (known as Basel II).

In April 2014, the final standard, Capital requirements for bank exposures to central counterparties, was published. It will take effect on 1 January 2017, and the interim requirements will apply until then.

Securitisation

In December 2013, the committee issued a consultation on revisions to the securitisation framework.

Securitisation is the process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors.

Hall said: “Securitisation has had a negative reputation in the past few years. It is considered by some to have caused many problems in the financial crisis, but I believe regulators and policymakers have realised they need to encourage securitisation to ensure real economy financing and we have seen a new capital regime for securitisation”, which should be finalised in due course.

TLAC (total loss absorbing capital)

TLAC is the new capital requirement proposal for large banks. Under this requirement, banks will potentially be required to hold 16% and 20% of their RWA. “This will again put further pressures on large banks returns on equity numbers,” Hall said.

RWA review

Regulators are conducting a review of the RWA regime.

The objective of this review is to identify any differences in RWA outcomes, to understand the sources of such differences and, if required, to formulate the necessary policy solutions to enhance convergence between banks and to improve disclosure.

What else is in the pipeline: Basel III

Hall said there were strong signals of a new conceptual framework for capital standards, which he referred to as ‘Basel IV’.

He said Basel IV would have three major implications:

• banks are likely to face significantly higher capital requirements;
• banks will likely need to improve their capital management; and
• a less risk-sensitive approach to both capital ratios and internal modelling is likely to force banks to re-evaluate the balance between lower and higher risk businesses.

More changes to come?

Looking to the year ahead, it seems the regulatory landscape is likely to become more complex. Hall said: “Basel III has had a big impact well ahead of the final implementation date with significant capital raising.

“This is not the end of the story. With a wide range of parallel and future proposals in the prudential regulatory space taking place, the attention must turn to the effect on the wider economy and what the agenda for financial services should be to support those wider jobs and growth agenda.”