Basel III – Is it Rocket Science?

Posted in Finance Articles, Total Reads: 2773 , Published on October 04, 2012

This story revolves around a first year student, Dinesh Gupta, of 2012-14 batch and another student, Prince Behl, of batch 2011-2013 in NMIMS, Mumbai.

Dinesh has one and a half year of experience in foreign exchange trading and has natural propensity for finance.

Prince has two and a half years experience in TCS and is studying Banking and Finance in NMIMS.

Both of them decided to take part in article writing competition for a finance magazine. The topic, they chose was BASEL III.

For the article, Dinesh decided to study about the concepts of Basel III as it was a novel topic for him. He started from Wikipedia to understand what BASEL is and how it was originated. There he came across new terms such as Capital requirements, TIER I capital, TIER II capital etc. To dig deeper he started searching for these keywords and read a research paper on BASEL III norms. But, still he was not confident as the terms he was searching for were defined using perplexing financial terms

So with all the knowledge and thoughts he could gather, he sat with Prince to discuss it. The discussion brought excellent insights about BASEL III and cleared most of their doubts. So they thought to pen it down for the readers in exactly the same manner as the conversation went.

Dinesh: As per my understanding, every time there’s tough time in financial markets, a new accord or modified one is thrown onto banking system claiming to bring the risk level to the minimum, but only resulting in a bigger financial debacle later on. BASEL I was launched after messy liquidation of Herstatt Bank, similarly BASEL II came in 2004 after dot com bubble burst of 2000. Now BASEL III is around for implementation after 2008 financial crisis.

Prince: No, it is not the accord or rules set by BCBS (Basel Committee on Banking Supervision) that resulted in financial markets debacle but the nagging nature of banks to find out loop holes to circumvent those rules for maximising their profits.

Dinesh: Anyways, BASEL III has strengthened the three pillars of BASEL II which are minimum capital requirement, supervisory guidance of regulatory authorities and market discipline.

Minimum capital requirement is composed of TIER I and TIER II capital, but it is still at 8% of risk weighted assets, similar to BASEL II...

Prince: Wait; did you understand what risk weighted assets are?

Dinesh: Yes, these are value of bank’s assets weighted as per their risks. It is calculated on the loans provided by banks to government, various industries and public. Now the percentage of risk depends on the credit rating of the borrower. For e.g. the government bonds held by banks carry zero percent risk and hence bank does not have to keep aside any capital for it. Similarly, for a corporate borrower, rated AA, bank would have to put aside less capital than for another corporate borrower, rated BB. In nutshell, there is different risk associated with different industries and institutions as per their credit rating.

Prince: Dinesh, first thing is that bank does not calculate risk only on loans (one of the assets) provided by it rather on all the assets (investments etc.) excluding fixed assets held by banks. Rest of your understanding is sound.

Dinesh: I also learnt that TIER I capital requirement has been changed to 6% from 4% while TIER II capital has been reduced from 4% to 2%. At this point I am unable to understand what they are composed of and what does the change signify?

Prince: TIER I capital also known as core capital of the bank is generally raised through all those instruments for which bank does not have to return the capital to public and has no restrictive clause on it. Technically, it consists of common equity of promoters and shareholders, innovative perpetual debt instruments, Perpetual Non-Cumulative Preference Shares (PNCPS) and other instruments prescribed by central bank from time to time.

While Tier II capital is composed of those instruments which provide long term capital but have maturity. Technically it is composed of Revaluation reserves, excess of general provisions and loss reserves which are not attributable to specific asset, Hybrid debt capital instruments, Subordinated debt, Innovative Perpetual Debt Instruments (IPDI) and Perpetual Non-Cumulative Preference Shares (PNCPS)

Dinesh: I also learned about the new elements introduced by BCBS that would increase the amount of equity capital that bank has to keep aside.

Prince: Yes, they are Capital conservation buffer and Counter-cyclical buffer (CCB).

Dinesh: I know that capital conservation buffer is the extra 2.5% of equity capital that banks has to keep aside but have not understood the reason for keeping that extra amount.

Prince: Banks work on very high leverage which means that they are doing very risky business. So it makes sense to save for rainy day as the adage goes. BCBS has suggested building up buffer in good times which can be used to offset against losses during recession or low growth times.

Dinesh: Ok, now that makes sense.

Prince: Ok, that’s good. Are you able to understand countercyclical buffer?

Dinesh: Yes I was able to understand it but for that I had to go through Counter-cyclicality and Pro-cyclicality. I read an article defining these terms.

In business cycle theory and finance, any economic quantity that is positively correlated with the overall state of the economy is said to be pro-cyclical. That is, any quantity that tends to increase

When the overall economy is growing, is classified as pro cyclical. Quantities that tend to increase when the overall economy is slowing down are classified as countercyclical.

So I finally understood that by Counter-cyclical buffer they mean reducing capital for credit by increasing the equity capital (Counter-cyclical buffer) requirement during GDP growth or Credit boom and using that equity capital during difficult times.

Prince: It is good that you had gone through the terms trying to have deep understanding of the concept. But then let me explain it in a practical way.

Whenever the economy is in boom, it has tendency to pour in excessive credit which creates bubbles as we had seen in 2008 crisis, dot com crisis etc. In order to avoid such a situation, it is expected that central bank runs a test on its economy to understand the state of credit in its economy.

If central bank realizes that there is excessive credit, it means any time correction can happen. So in order to be prepared for it, central bank can ask for maintaining this buffer anywhere between 0-2.5percent.

Now, the question arises how central bank will quantify the credit in the economy to check if it is excessive or not?

Figure 1: Countercyclical capital buffer

Source: RBNZ

Dinesh: I came across the variable to be used by regulatory bodies for asking banks to set aside capital for Counter-cyclical buffer. BCBS decided to use deviations of the credit-to-GDP ratio with respect to its long-trend as a variable to quantify the credit. It means central bank will draw a trend line on the basis of historical data which it will use to measure the excessive credit. Here credit would be dependent variable and GDP would be independent variable, using it central bank will forecast the theoretical credit in the economy. If the actual credit goes beyond the trend line as shown in figure 1, it will be excessive credit growth and hence central bank will impose buffer. Similarly when actual credit comes below the trend line, central bank would release buffer. So in short, central bank would control the credit in the economy through this measure.

But then, if this measure is used to control credit in the economy then how the monetary policy instrument would be used by central bank as it also control credit?

Prince: It is really a million dollar question! Banks would take time to build CCB which means any new directive regarding CCB would take time to come into effect while monetary policy directives can change the situation of credit in the economy overnight. So it gives cushion to banks to bear losses of even higher degree and gives central bank ample time to assess the effect of its directive (Please see figure 2 for details). Hence both have different objectives to implement.

Figure 2: Essential monetary and macro prudential policy interaction

Source: RBNZ

Dinesh: We have covered almost all the part of Pillar I of Basel III. And I must say that a lot of my misconceptions are cleared by this conversation. Are there any major changes in Pillar II and Pillar III in BASEL III as compared to BASEL II?

Prince: There are not many changes in Pillar II and Pillar III. BCBS majorly focussed on strengthening it by bringing more transparency and more disclosures. Pillar II has given more power to authorities to manage different kinds of risks. Additionally authorities must conduct stress tests aims to assist the direction of systemic risk

Pillar III comprises  standards  for  market  disclosure  which  will  be  raised  in  order to enhance transparency. On their websites, banks will have to report more details regarding their balance sheets like revealing the terms and conditions of all instruments of their regulatory capital base and explaining which deductions were applied.

Dinesh: It was a really good conversation. Thank you for clearing my doubts. I hope we continue to have this kind of discussions in future as well.

Prince: Same here. I am expecting a treat from you. Ha Ha.......

This article has been authored by Prince Behl & Dinesh Gupta from NMIMS.

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