Welcome to Basel III

SUB: BANKING INSURANCE

Table of Contents
Topics:
1. Introduction Why does it matter? How has it been received? What does it mean for consumers? 2. Overview 3. Studies on Basel III 4. Summary of proposed changes 5. US implementation 6. Basel III, the Banks, and the Economy What is Basel III and who is making the decisions? What is the timetable for Basel III? 7. Macroeconomic Impact of Basel III 8. Capital and Liquidity What are the current rules?

9. The Basel II revisions made four major changes to the risk weighted asset calculations: Will the originally proposed changes or timetable be modified? What are the current rules? Ratings. Internal risk modeling Trading assets. What are the proposed changes? Higher capital ratios. Use of a leverage ratio as a safety net. Tougher risk weightings for trading assets. Elimination of softer forms of capital. New liquidity requirements. Contingent capital. 10. Banking Day backgrounder: Basel III 11. Basel III in the offing 12. Weaknesses of Basel III Nothing in Basel III prevents that problem from recurring. How effective will the new rules be? What stays the same?

What are the major areas of disagreement? Net stable funding ratio. Higher capital ratios. Use of a leverage ratio. What are the likely effects of Basel III? 13. Conclusion

Introduction
BASEL III is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010-11. This, the third of the Basel Accords developed in a response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.05 to 0.15 percentage point. Outside the banking industry itself, criticism was muted. Bank directors would be required to know market liquidity conditions for major asset holdings, to strengthen accountability for any major losses. It is the third set of banking rules agreed by central bankers and regulators from around the world at meetings in Basel, Switzerland, hence the name. Banks will have to raise hundreds of billions of euros in fresh capital over the next few years. More specifically, they will have to increase their core tier-one capital ratio a key measure of banks' financial strength to 4.5% by 2015. In addition, they will have to carry a further "counter-cyclical" capital conservation buffer of 2.5% by 2019.

Why does it matter?

The idea is that if banks hold a bigger capital cushion they will be better prepared for another downturn so we avoid a re-run of the financial crisis. Instead of holding capital equivalent to just 2% of their risk-bearing assets, banks will have to hold 7% of topquality capital in reserve.

How has it been received?

The deal is important because it removes much of the uncertainty that has dogged the banking sector in recent months, and markets breathed a sigh of relief today because the

new rules will be phased in over a much longer time period than expected. The British Bankers' Association had called for a long timetable, warning that the rules "suck money out of the economy". The new rules were welcomed by the European Central Bank, the Financial Services Authority and American regulators.

What does it mean for consumers?

There won't be a return to the era of cheap money as banks build up their capital reserves ahead of the deadlines. UK banks have already made big efforts to raise their capital levels since the crisis struck, and taxpayer-backed Lloyds Banking Group now has a core tier-one capital ratio of 9% while Barclays's is 10%. Angela Knight, chief executive at the BBA, warned the move would end the "cheapmoney era" as it becomes more expensive to run a bank, which will in turn be passed on to consumers through higher loan and mortgage costs.

Overview
Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash flows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

Studies on Basel III

In addition to articles used for references (see References), this section lists links to recent high-quality publicly-available studies on Basel III. This section may be updated frequently as Basel III is currently under development. Date Source Article Title / Link Comments OECD: OECD analysis on the failure of bank Dec Systemically Economics regulation and markets to discipline 2011 Important Banks Department systemically important banks. BNP Paribas: Jun Economic Basel III: no Achilles' BNP Paribas' Economic Research 2011 Research spear Department study on Basel III. Department

OECD: Feb Economics 2011 Department Jan Moody's 2011 Analytics

Macroeconomic Impact of Basel III

OECD analysis on the macroeconomic impact of Basel III.

Basel III New Capital Basel III standards, key elements of new and Liquidity regulations, framework, and key Standards FAQs implementation dates. Beyond OECD study on Basel I, Basel II and III.

OECD Journal: May Thinking Financial 2010 Basel III Market Trends May 2010

May 2010

May 2010

Bair said regulators around the world need FDICs Bair Says to work together on the next round of capital Bloomberg Europe Should Make standards for banks ... the next round of Business Week Banks Hold More international standards, known as Basel III, Capital which Bair said must meet very aggressive goals. Finance ministers from the G20 group of industrial and emerging countries meet in FACTBOX-G20 Bussan, Korea, on June 45 to review Reuters progress on financial pledges made in 2009 to strengthen regulation regulation and learn lessons from the financial crisis. "The most important bit of reform is the The banks battle back international set of rules known as Basel A behind-the-scenes 3, which will govern the capital and The Economist brawl over new liquidity buffers banks carry. It is here that capital and liquidity the most vicious and least public skirmish rules between banks and their regulators is taking place."

Summary of proposed changes

First, the quality, consistency, and transparency of the capital base will be raised. o Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings o Tier 2 capital instruments will be harmonized o Tier 3 capital will be eliminated. Second, the risk coverage of the capital framework will be strengthened. o Promote more integrated management of market and counterparty credit risk o Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit ratingS o Strengthen the capital requirements for counterparty credit exposures arising from banks derivatives, repot and securities financing transactions

Raise the capital buffers backing these exposures Reduce procyclicality and Provide additional incentives to move OTC derivative contracts to central counterparties (probably clearing houses) o Provide incentives to strengthen the risk management of counterparty credit exposures o Raise counterparty credit risk management standards by including wrongway risk Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework. o The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives: Put a floor under the build-up of leverage in the banking sector Introduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simpler measure that is based on gross exposures. Fourth, the Committee is introducing a series of measures to promote the build up of capital buffers in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting countercyclical buffers"). o The Committee is introducing a series of measures to address procyclicality: Dampen any excess cyclicality of the minimum capital requirement; Promote more forward looking provisions; Conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and o Achieve the broader macro prudential goal of protecting the banking sector from periods of excess credit growth. Requirement to use long term data horizons to estimate probabilities of default, downturn loss-given-default estimates, recommended in Basel II, to become mandatory Improved calibration of the risk functions, which convert loss estimates into regulatory capital requirements. Banks must conduct stress tests that include widening credit spreads in recessionary scenarios. o Promoting stronger provisioning practices (forward looking provisioning): Advocating a change in the accounting standards towards an expected loss (EL) approach (usually, EL amount: = LGD*PD*EAD). Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio called the Net Stable Funding Ratio. (In January 2012, the oversight panel of the Basel Committee on Banking Supervision issued a statement saying that regulators will
o o o

allow banks to dip below their required liquidity levels, the liquidity coverage ratio, during periods of stress. The Committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions.

As on Sept 2010, Proposed Basel III norms ask for ratios as: 7-9.5%(4.5% +2.5% (conservation buffer) + 0-2.5%(seasonal buffer)) for Common equity and 8.5-11% for tier 1 cap and 10.5 to 13 for total capital (Proposed Basel III Guidelines: A Credit Positive for Indian Banks)'

US implementation
The US Federal Reserve announced in December 2011 that it would implement substantially all of the Basel III rules. It summarized them as follows, and made clear they would apply not only to banks but to all institutions with more than US$50 billion in assets:

"Risk-based capital and leverage requirements" including first annual capital plans, conduct stress tests, and capital adequacy "including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions" - see scenario analysis on this. A risk-based capital surcharge Market liquidity, first based on the US's own "interagency liquidity riskmanagement guidance issued in March 2010" that require liquidity stress tests and set internal quantitative limits, later moving to a full Basel III regime - see below. The Federal Reserve Board itself would conduct tests annually "using three economic and financial market scenarios." Institutions would be encouraged to use at least five scenarios reflecting improbable events, and especially those considered impossible by management, but no standards apply yet to extreme scenarios. Only a summary of the three official Fed scenarios "including company-specific information would be made public" but one or more internal company-run stress tests must be run each year with summaries published. Single-counterparty credit limits to cut "credit exposure of a covered financial firm to a single counterparty as a percentage of the firm's regulatory capital. Credit exposure between the largest financial companies would be subject to a tighter limit." "Early remediation requirements" to ensure that "financial weaknesses are addressed at an early stage". One or more "triggers for remediation--such as capital levels, stress test results, and risk-management weaknesses--in some cases calibrated to be forward-looking" would be proposed by the Board in 2012. "Required actions would vary based on the severity of the situation, but could include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales."

It was unclear as of December 2011 how these rules would apply to insurance, hedge funds and other large financial players. The announced intent was "to limit the dangers of big financial firms being heavily intertwined".

Basel III, the Banks, and the Economy

By November, banking regulators are likely to complete an international agreement that will determine how strong banks must be. Tough new rules on capital and liquidity are being negotiated through the Basel Committee on Banking Supervision (Basel Committee). The agreement, which is known as Basel III because it will be the third version of these rules, will have a large effect on the worlds financial systems and economies. On the positive side, newly toughened capital and liquidity requirements should make national financial systems and indeed the global financial system safer. Unfortunately, enhanced safety will come at a cost, since it is expensive for banks to hold extra capital and to be more liquid. It is beyond serious dispute that loans and other banking services will become more expensive and harder to obtain. The real argument is about the degree, not the direction. The banking industry argues that Basel III will seriously harm the economy. For example, the Institute of International Finance (IIF) calculated that the economies of the US and Europe would be 3% smaller after five years than if Basel III were not adopted. My own analyses, and those of other disinterested parties, generally suggest a much smaller cost that would seem to be considerably outweighed by the safety benefits. As the recent crisis clearly attests, severe financial crises can cause permanent damage to the worlds economy, imposing economic loss and emotional pain on hundreds of millions, if not billions, of people. It is worthwhile to give up a little economic growth in the average year in order to avoid these major impacts, as my work suggests would be the case. On the other hand, if the industry is right, the additional safety is probably not worth the cost and a more modest regulatory revamp would be preferable.

What is Basel III and who is making the decisions?

Basel III is a set of proposed changes to international capital and liquidity Requirements and some other related areas of banking supervision. It is the second major revision to an original set of rules, now known as Basel I, which was promulgated by the Basel Committee in 1988. The committee was established in the mid1970s, after the failure of a small German bank (Herstatt) sent shudders through the global financial system as a result of poor coordination between national regulators. The Basel Committee is composed of banking regulators from a number of industrialized countries, with a core membership concentrated in the traditional banking powers within Europe, plus the US and Japan. The Basel accords are not formal treaties and the members of the committee do not always fully implement the rules in national aw and regulation. One prominent example of this is in the United States. We had not implemented the Basel II revisions for our commercial banks by the time of the financial crisis, which put any such changes on

hold. It is not clear whether we would eventually have implemented them, despite having been closely involved in the negotiations that led to that agreement. In truth, few countries choose to implement every detail of the Basel accords and they sometimes find unexpected ways to interpret the aspects they do implement. Despite this, the accords have led to much greater uniformity of capital requirements around the globe than existed prior to Basel I. In fact, the uniformity extends well beyond the countries represented on the Basel Committee, as most nations with significant banking sectors have modeled their capital regulation on the Basel rules. The Basel Committee is loosely affiliated with the Bank for International Settlements (BIS) which is often referred to as the club for the worlds central bankers. The BIS provides certain financial services to central banks and also serves as a vehicle to promote cooperation between them. In addition, it provides support services to the Basel Committee and several other multilateral bodies focused on the worlds financial systems. Prominent among these is the Financial Stability Board (FSB) which was charged last year by the heads of government of the Group of Twenty (G20) nations with the mission of promoting financial stability around the world. In that capacity, it has been a prominent advisor to the Basel Committee in its work on Basel III.

What is the timetable for Basel III?

The G20 heads of government have charged the Basel Committee with finalizing the Basel III rules in time for the G20 meeting in Seoul, Korea on November 1112, 2010. The process leading to that started with the issuance of consultation papers in December of 2009 that outlined the changes proposed by the Basel Committee for the capital and liquidity requirements1. Comments were solicited by midApril of 2010 and many parties responded at length. In parallel, the Basel Committee, with assistance from the BIS and the FSB, has been conducting a Quantitative Impact Study (QIS) to estimate the potential effects on the financial markets and the economy of putting in place the proposed changes. he intention is to implement Basel III by the end of 2012, although it seems clear that there will be transition periods, observation periods, or phaseins for a number of the more important requirements, as well as grandfathering of certain features of existing regulation. All of these exceptions would be intended to ease the transitional impact of Basel III,

Macroeconomic Impact of Basel III

An OECD study released on 17 February 2011, estimates that the medium-term impact of Basel III implementation on GDP growth is in the range of 0.05 to 0.15 percentage point per year. Economic output is mainly affected by an increase in bank lending spreads as banks pass a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements effective in 2015 (4.5% for the common equity ratio, 6% for the Tier 1 capital ratio), banks are estimated to increase their lending spreads on average by about 15 basis points. The capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio)

could increase bank lending spreads by about 50 basis points. The estimated effects on GDP growth assume no active response from monetary policy. To the extent that monetary policy will no longer be constrained by the zero lower bound, the Basel III impact on economic output could be offset by a reduction (or delayed increase) in monetary policy rates by about 30 to 80 basis points. Basel III is an opportunity as well as a challenge for banks. It can provide a solid foundation for the next developments in the banking sector, and it can ensure that past excesses are avoided. Basel III is changing the way that banks address the management of risk and finance. The new regime seeks much greater integration of the finance and risk management functions. This will probably drive the convergence of the responsibilities of CFOs and CROs in delivering the strategic objectives of the business. However, the adoption of a more rigorous regulatory stance might be hampered by a reliance on multiple data silos and by a separation of powers between those who are responsible for finance and those who manage risk. The new emphasis on risk management that is inherent in Basel III requires the introduction or evolution of a risk management framework that is as robust as the existing finance management infrastructures. As well as being a regulatory regime, Basel III in many ways provides a framework for true enterprise risk management, which involves covering all risks to the business.

Capital and Liquidity

Capital is one of the most important concepts in banking. Unfortunately, it can be difficult for those outside the financial field to grasp, since there is no close analogy to capital in ordinary life. In its simplest form, capital represents the portion of a banks assets which have no associated contractual commitment for repayment. It is, therefore, available as a cushion in case the value of the banks assets declines or its liabilities rise. For example, if a bank has $100 of loans outstanding, funded by $92 of deposits and $8 of common stock invested by the banks owners, then this capital of $8 is available to protect the depositors against losses. If $7 worth of the loans were not repaid, there would still be more than enough money to pay back the depositors. The shareholders would suffer a nearly complete loss, but this is a considered a private matter, whereas there are strong public policy reasons to protect depositors. If bank balance sheets were always accurate and banks always made profits, there would be no need for capital. Unfortunately, we do not live in that utopia, so a cushion of capital is necessary. Banks attempt to hold the minimum level of capital that supplies adequate protection, since capital is expensive, but all parties recognize the need for such a cushion even when they debate the right amount or form. The subject of capital, and regulatory capital requirements, is a complex one and will only be summarized here. A more complete discussion can be found in Bank Capital: A Primer. As explained in that paper, common stock is not the only type of security that is considered to be capital because of the protection it provides depositor and other parties that regulators care about. Certain forms of preferred stock, and to a limited extent debt, can also serve as capital.

It is worth noting that bank regulation generally uses the reported accounting numbers as the basis for calculating capital levels, without adjusting for market valuations except to the extent they are captured by standard accounting rules, such as occurs with certain mark to market requirements. In particular, the market capitalization of bank stocks in the heart of the crisis tended to be substantially lower than the accounting value of the equity of these banks. Essentially, the market believed that accounting. values were overstated or that substantial new losses would occur in the future or the market was too low for technical reasons unrelated to expectations of future performance. None of these factors would directly affect regulatory capital levels, although regulators are always wise to note these divergences in case they indicate that the market has determined that the bakes are in worse shape than appears on the surface. Liquidity refers to the ability to sell an asset, or otherwise convert it to cash, without incurring an excessive loss in doing so. Liquidity almost always increases the longer the timeframe being considered. A house, for example, may be a very illiquid asset if one needs to sell it within a week, but may be quite liquid if one is given five years to manage the sale. More broadly, the liquidity of a bank often refers to the matching of its obligations with its funding sources. A bank with highly liquid assets would generally be considered fairly liquid even if its funding sources were of quite short maturities, since the assets could be liquidated as needed to cover any loss of funding. A bank with less liquid assets might be fine if its funding sources were locked in for long periods, but could be in serious trouble in a panic if it relied on shortterm debt or deposits that might flow away.

What are the current rules?

The core of the Basel rules on capital reflects a belief that the necessary level of capital depends primarily on the friskiness a banks assets. Since capital exists to protect against risk, it stands to reason that more is needed when greater risks are being taken. The focus is on the asset side because liabilities are generally known with great precision, since a deposit or a bond must be repaid based on specific contractual terms. (This is a major contrast with the insurance industry, where the future costs of promises to protect against various events, such as fires, are unknown.) Unlike bank liabilities, bank assets can go down, or occasionally up, in value. In particular, bank loans may not be repaid and securities may default or may need to be sold at a time when their market value has declined. The original, Basel I, rules grouped all assets into a small number of categories and applied a riskweighting to each category. The total value of each asset is multiplied by its risk weighting and this adjusted amount is added across all assets to produce a total riskweighted asset (RWA) figure. The percentage weighting for each category ranges from 0%, for extremely safe investments such as cash and US government securities, to 100% for riskier classes of assets. (In a few cases, the weightings now exceed 100% for certain very risky assets, such as loans in default or imminent danger of default and the riskiest trenches of securitizations.) For example, residential mortgage loans often have a 50% riskweighting, so that a $1 million mortgage would generate a riskweighted asset of $500,000. If a bank were trying to hold capital equal to 10% of its RWA, then it would need $50,000 of capital to cover this mortgage.

The Basel II revisions made four major changes to the risk weighted asset calculations:
Refinement of categories. Basel II broke the categories down in much greater detail than in Basel I, with more variation in the risk weighting, since it was realized that the crudeness of the original simple categories was encouraging a great deal of gaming and misallocation of resources. In addition to the values were overstated or that substantial new losses would occur in the future or the market was too low for technical reasonsunrelated to expectations of future performance. None of these factors would directly affect regulatory capital levels, although regulators are always wise to note these divergences in case they indicate that the market has determined that the baks are in worse shape than appears on the surface. Liquidity refers to the ability to sell an asset, or otherwise convert it to cash, without incurring an excessive loss in doing so. Liquidity almost always increases the longer the timeframe being considered. A house, for example, may be a very illiquid asset if one needs to sell it within a week, but may be quite liquid if one is given five years to manage the sale. More broadly, the liquidity of a bank often refers to the matching of its obligations with its funding sources. A bank with highly liquid assets would generally be considered fairly liquid even if its funding sources were of quite short mturities, since the assets could be liquidated as needed to cover any loss of funding. A bank with less liquid assets might be fine if its funding sources were locked in for long periods, but could be in serious trouble in a panic if it relied on shortterm debt or deposits that might flow away.

What are the current rules?

The core of the Basel rules on capital reflects a belief that the necessary level of capital depends primarily on the riskinessof a banks assets. Since capital exists to protect against risk, it stands to reason that more is needed when greater risks are being taken. The focus is on the asset side because liabilities are generally known with great precision, since a deposit or a bond must be repaid based on specific contractual terms. (This is a major contrast with the insurance industry, where the future costs of promises to protect against various events, such as fires, are unknown.) Unlike bank liabilities, bank assets can go down, or occasionally up, in value. In particular, bank loans may not be repaid and securities may default or may need to be sold at a time when their market value has declined. The original, Basel I, rules grouped all assets into a small number of categories and applied a riskweighting to each category. The total value of each asset is multiplied by its risk weighting and this adjusted amount is added across all assets to produe a total riskweighted asset (RWA) figure. The percentage weighting for each category ranges from 0%, for extremely safe investments such as cash and US government securities, to 100% for riskier classes of assets. (In a few cases, the weightings now exceed 100% for certain very risky assets, such as loans in default or imminent danger of default and the riskiest tranches of securitizations.) For example, residential mortgage loans often have a 50% riskweighting, so that a $1 million mortgage would generate a riskweighted asset of $500,000. If a bank were trying to hold capital equal to 10% of its RWA, then it would need $50,000 of capital to cover this mortgage.

The Basel II revisions made four major changes to the riskweighted asset calculations: Refinement of categories. Basel II broke the categories down in much greater detail than in Basel I, with more variation in the risk weighting, since it was realized that the crudeness of the original simple categories was encouraging a great deal of gaming and misallocation of resources. weaknesses inherent in using a small number of categories, the weightings had been fairly arbitrary and influenced by political considerations. For example, Germany particularly wanted mortgages to carry a lower risk weighting than other bank loans.

Ratings.
Ratings from the major credit rating agencies became a significant factor in the risk weightings, which had not been true when only broad categories were used.

Internal risk modeling.

It was agreed that the sophisticated global banks could use their own internal risk rating models to determine the risk weightngs for their own particular assets, with some exceptions. The idea was to align regulatory risk calculations with the considerably more sophisticated risk models that were being used b major banks in their own decision making. This concept counts on the selfinterest of the banks to lead them to use the best possible estimates of risk in their own management of assets.

Trading assets.
Basel II promulgated a different method for calculating the risk of assets that were held in trading accounts, based on the assumption that the risk level of trading assets was principally determined by how far the assets could realistically fall in value before a bank could dispose of the investments. Thus a value at risk (VAR) approach was used, utilizing statistical techniques to estimate from historical data how large a loss might be taken in unusually unfavorable circumstances. Capital adequacy under the Basel Rules is determined by calculating a ratio of the level of capital to the total riskweighted assets. Basel I defined two tiers of capital, a distinction that has been retained. Tier 1, the strongest, consists mainly of common stock and those forms of preferred stock that are most like common. Tier 2 adds in certain types of preferred stock that are less like common stock and more like debt, as well as certain subordinated debt securities. In addition, Tier 2 includes some accounting reserves that provide a protective function similar to other forms of capital3. The two tiers are intended to ensure that there is enough total capital available to handle even extreme occurrences and that the bulk of this capital is the stronger Tier 1 variety. Generally, banks have plenty of Tier 2 capital, so the practical focus has been on ensuring there is enough of the stronger, Tier 1, form of capital.

The Basel calculations include a number of deductions from the stated balance sheet figures for capital. First, and probably most importantly, the Basel agreements require the deduction of goodwill, (which arises when a company or asset is purchased for more than its book value), effectively treating it as worthless for these purposes. Second, individual national regulators have chosen to fully exclude.

What are the proposed changes?

The financial crisis exposed or underlined a number of areas of weakness in the Basel II rules. These problems led to many proposed changes under Basel III, including the following.

Higher capital ratios.

The consultative document did not specify figures, but made clear that the minimum acceptable Tier 1 and Tier 2 riskweighted capital ratios would be raised. This will have major effects, but is difficult to discuss further until the proposed levels are known. Speculation centers on an increase of a couple of points in the minimum ratios, but this is not clear.

Use of a leverage ratio as a safety net.

Most broadly, the crisis pointed out the problems with using riskweighted asset calculations that are intrinsically based either directly on historical experience, in the case of the internal ratings used by the large banks, or indirectly, in the case of the risk weightings that are set by the Basel Committee. The value of many assets fell considerably more sharply and quickly than was suggested by historical experience, in some cases because good quality data did not exist for very many years and therefore had only reflected the favorable market conditions of recent times. In response, there is broad agreement that a straight leverage ratio should be given more regulatory weight. In this context, a leverage ratio is simply the ratio of capital to total assets with no riskweighting of the assets. This has the major disadvantage that as much capital would have to be held to back a U.S. government bond as to back a risky loan, but it does avoid the problems caused by inappropriately low risk weightings. The Basel III rules therefore propose to include a leverage ratio as an additional test of capital adequacy to serve as a safety net to protect against problems with risk weightings.

Tougher risk weightings for trading assets.

A second major problem was that the risk weightings for trading assets were clearly set too low, again reflecting an excessive reliance on favorable recent history. This has already been dealt with in a major set of changes that took effect in what might be considered Basel Imia, through a substantial toughening in the methodology for determining risk weightings of trading assets. It appears that capital requirements in these areas have roughly doubled, on average, compared to the old methodology. These rules changes are retained under Basel III.

Elimination of softer forms of capital.

The financial crisis demonstrated that some securities that were considered capital instruments were unusable as a practical matter in a severe financial crisis. Capital is only useful if it can be made to absorb losses in order to protect other parties, but regulators were effectively blocked from forcing that loss absorption in the case of subordinated debt, which had counted in certain cases as Tier II capital. Since these were legally debt instruments, the holders could force a bankruptcy or insolvency proceeding if they were to suffer a loss. Putting a major financial institution into insolvency was viewed as a very risky move by policymakers, especially after the insolvency of Lehman Brothers caused severe market turmoil. As a result, subordinated debt will no longer count as capital even for Tier II purposes and other soft forms of capital are being eliminated or subjected to tighter onditions. Exclusion of some balance sheet items from capital. Following a similar logic, the Basel Committee decided that certain balance sheet items should be excluded from capital because they might not truly be aailable to absorb losses in a crisis. For example, a bank or bank holding companys ownership stake in an insurance company would no longer count as capital, on the theory that it represented capital at the level of the insurer and should not be required to do double duty. Put another way, an insurer could easily be hit by the same financial crisis as the bank and its own loss of capital would cause problems both t the insurer and then at the bank which was counting on the value of its investment. Minority interests, which represent partial ownership of a part of the banking group by outside parties, would also cease to count. Yet another category is deferred tax assets which represent the value of previous losses which can be used to offset taxes on future profits. Since the value of these assets is dependent on future profits, Basel III moves to effectively exclude them. (They were already limited in some countries, such as the US, where only tax benefits foreseen to be used over the next year were allowed.) Higher capital requirements for counterparty credit risks. The crisis also showed how much counterparty credit risk existed, causing the committee to tighten the rules for when capital must be set aside and how much must be earmarked for these risks. This includes making a distinction on the amount of capital needed to back exchangetraded derivatives, which carry low counterparty risk, and over the counter derivatives, which will now require more capital.

New liquidity requirements.

The Basel Committee had largely ignored liquidity in the past, leaving it as one of the many items on which national regulators had discretion to regulate as they pleased. Some countries, such as France, had explicit liquidity requirements, but most viewed it only as a subjective item to keep an eye on. However, the financial crisis highlighted the fundamental fact that financial institutions depend for their survival on managing liquidty in order to prevent a fatal run on the bank if confidence in their financial strength evaporated. As a result, Basel III proposed two tough new liquidity tests that would be standardized globally. First, minimum liquidity levels would be based on a type of stress test using standardized calculations. Effectively, the test mimicked a freezing of the financial markets for a period of [x] months during which it became extremely difficult to raise new funds and

existing liabilities, such as shortterm debt, would generally roll off at maturity. Core deposits were assumed to be drawn down to some extent, but mostly to remain at the bank. Noncore deposits, such as certificates of deposit, were assumed to roll off completely as soon as they could be withdrawn. Maturing debt was assumed to roll off and not be replaced. Liquid assets could be used to cover cash needs, but haircuts of various sizes were applied to reflect the fire sale in the financial markets caused by the adverse conditions.

Second, a net stable funding ratio test was created. This measured the level of liquid assets to the level of liabilities that matured in a year or less. The intention was to force banks to move more of their borrowing to multiyear funding sources or to invest more heavily in fairly liquid assets.

Contingent capital.
Basel III endorsed the general idea of adding contingent forms of capital, but proposed further study rather than immediate implementation, given the numerous technical issues to be resolved. Contingent forms of capital are basically debt securities which would convert to equity under preagreed terms in the event that a bank ran into problems. It can be thought of as a prearranged debttoequity swap and serves the same purpose of reducing debt to equity ratios and allowing a troubled institution to recapitalize otside of an insolvency proceeding. Countercyclical capital requirements. Basel III also endorsed the idea that capital requirements should be higher in good times and somewhat lower in bad times. This would achieve the purpose of leaning against the wind and slowing banking activity when it overheats and encouraging lending when times are tough. It is unclear at this point how this might be implemented and the degree of discretion that national regulators would have.

Banking Day backgrounder: Basel III

Banking Day's guide to the new global rules designed to forestall the next financial crisis.The Basel Committee on Banking Supervision is finalizing the next generation of global banking rules - the Basel III Accords, often simply called "Basel III". Essentially, these rules aim to protect the world economy from the worst effects of future financial crises. And they aim to minimize the risk that governments will have to spend money protecting private banks and their creditors. The new rules aim to avoid the failure of Basel II - imperfect and under-adopted rules now discredited by the 2008 global financial crisis. They take a more critical view of leverage in general, and of risk "insurance" and trading in debt between banks and other players. They ask the banks to hold a larger "buffer" of capital, and more liquid assets. All these new rules reflect a deepening belief by global regulators that the banking system is prone to bouts of dangerous over-optimism - a view the Reserve Bank of Australia has held for at least two decades few believe Basel III alone will prevent future crises. As Bank of England governor

Mervyn King has put it: "it is no criticism of Basel III to say that it is not a 'silver bullet' ... In the area of financial stability, it makes sense to have both belt and braces."An important question is whether the current global financial system can benefit from a strong set of rules for banks' capital and liquidity, or whether banks and other financiers outside the formal banking system will simply work around them. Global banking regulations, including Basel rules, tend to have unintended consequences.

Basel III in the offing

Banks worldwide are awaiting updates on Basel III regulations, while Bangladesh is coping with the previous ones.

Basel III, the upgraded version of recommendations on global banking laws and regulations, is preparing to phase in over the next two years, although Bangladesh has just started implementing the previous version. The country will at first assess the impacts of the new rules. The new set of rules aims to strengthen the global financial industry to make it resilient, and ward off the 2008-like global crisis. Leading central bankers and national regulators who gathered in Swiss city of Basel last month said they were aiming to introduce proposals to strengthen international financial requirements on the banks by the end of 2012. The agreed reforms, which have been in the offing for several months, are part of a 'comprehensive response' to the financial crisis, the Basel Committee on Banking Supervision said in a statement. The group of regulators and the Bank for International Settlements agreed that the banks would be required to lift their reserves substantially under the new rules, and increase key capital ratios. Most of the capital requirements are in relation to risk-weighted assets. The Basel III reform would also be the cornerstone of the world's response to the financial crisis, and an endorsement by Basel's oversight body will pave the way for the G20 summit of leaders in November to give their seal of approval.

According to 27 top central bank governors, the new rules will go a long way in restoring the confidence lost during the latest financial meltdown. Basel III has been debated, anticipated, and repudiated for months. Now that it has arrived, only the anticipation is over. The debating and disagreement continue. Some say the move will certainly strengthen bank capital positions. However, there is a certain blithe assumption that raising capital requirements will result in an increase in bank capital. They say bank can raise capital ratios either by increasing capital or reducing activities. However, the banking sector in Bangladesh has just started to implement Basel II-based capital regime from January 2010. And the banks are not thinking of Basel III at the moment. But, Bangladesh Bank (BB), the central bank of the country, said it is closely following the ongoing revisions of the financial sector regulations in global forums. Atiur Rahman, the BB governor, hinted that the new capital and liquidity requirements and regulatory and supervisory recommendations would be phased in gradually in the country's financial sector. But he said these would not be implemented without assessing the impacts of the new rules. Basel III will be phased in gradually only after due assessment of their likely impacts, Rahman said. The basics of Basel III is that large internationally active banks will have to hold levels of common equity equal to at least 7 percent of their assets, much higher than the roughly 2 percent international standard or 4 percent standard for large US banks. Basel III also mentions, by 2015, the banks will have to begin building a 2.5 percent buffer of capital that must be fully in place by January 2019. If the banks fall below the buffer, regulators could force them to hold onto more of their earnings to augment their capital, which means the companies will have less money on hand to pay dividends or offer large compensation packages. Local bankers also believe Basel III is stringent in terms of capital requirements. But they said Bangladesh is far away from implementing the new Basel rules. Touhidul Alam Khan, executive vice president (corporate banking division) of Prime Bank, said the main feature of Basel III is that it increases the quality of tier I capital by eliminating some types of capital, such as contingent convertible bonds that used to be allowed in this category. The way the banks determine how much capital reserve they need to set aside to recover from losses is the core concept of Basel III.

Tier I capital is composed of equity capital and retained earnings, while tier II is supplementary capital, and tier III is short-term subordinated debt covering market risks. As Bangladesh is in stage of implementing Basel II, we may think well ahead about tier 1 capital rule under Basel III, which ultimately will be fully effective from January 2015, with the capital conservation buffer phased in between January 2016 and January 2019, he said. Khan, an expert on Basel II in Bangladesh, also said, before implementing Basel III, top banks here have to take steps to restructure their own internal risk rating models to determine the risk weightings for their assets.

regardless of the effect of Basel III, the main burden for preventing imprudent bank behavior will continue to fall on national prudential regulators such as the Australian Prudential Regulation Authority The economic cost of Basel III
Holding capital, maintaining liquidity and restricting dealings with counterparties all comes at a cost. (Steve Waldman notes that the opposite of "liquidity" is "commitment".) Estimates of the economic cost of these measures vary widely. In June 2010, bank lobby group the Institute of International Finance predicted Basel III and other measures would cost the US, the euro zone and Japan 3.1 percent of economic growth and nearly 10 million jobs over five years. The reforms would force banks to raise $US700 billion of new tier-one capital and issue $US5.4 trillion of long-term wholesale debt by 2015, it said. The IIFs estimate of economic impact looks zalarmist. Studies by the Financial Stability Board and the Basel Committee released in August 2010 argued that if the rules were phased in over four years, then for every 1 per cent rise in capital ratios, growth would fall by only 0.2 per cent over the four-year period. And they said an increase of 25 per cent in liquid assets held by banks would have less than half of the effect of a 1 per cent rise in capital ratios over the same period. The Reserve Bank governor, Glenn Stevens, noted in a speech in July 2010 that the experience of the last decade suggests surging credit and leverage doesn't do that much for growth, implying that restraining it slightly more may have a low cost. And if regulation stabilises the global financial system, he added, it is worth some cost. But we need to ensure the benefits outweigh the costs, including "unintended consequences" such as slower economic growth.

Weaknesses of Basel III

Basel III retains several flaws of the previous Basel II rules. In particular: Basel III relies heavily on an underlying mechanism - capital ratios which spectacularly failed to prevent the global financial crisis. The crisis occurred even though most banks' capital ratios appeared strong. (Lehman Brothers reported 11 per cent Tier 1 capital just days before its collapse.) Banks responded to higher capital costs by pushing business of their balance sheets and into the "shadow banking system" where capital rules did not apply. Bank of England governor Mervyn King: "When sentiment changes only very high levels of capital would be sufficient to enable banks to obtain funding on anything like normal spreads to policy rates, as we can see at present That is what happened in 2007-08. Only very much higher levels of capital levels that would be seen by the industry as wildly excessive most of the time would prevent such a crisis." Economist Raghuram Rajan in the Financial Times: "The minimum hurdle that reforms should meet is whether they would have prevented the last crisis. Any feasible level of required capital would not cross this hurdle, so let us not rely too much on it to avert the next crisis." Basel III continues to rely too much on credit ratings. The IMF, among others, has argued in recent papers that "markets need to end their addiction to credit ratings" and remove "the mechanistic use of ratings in rules and regulations". Instead ratings should be used as one of several tools to manage risk. Banks remain trusted to use their own internal models to measure risk, using models such as value-at-risk which have been shown to have substantial flaws in many situations. Risk weightings still allow banks to create very high effective leverage. Under Basel III, banks need to hold equity against their risk-weighted assets. This provides an incentive to find low-risk-weight assets which can then be leveraged. One attractive asset will be sovereign debt; AA-rated sovereign debt will still carry a zero risk weighting. Housing will continue to require less capital than business lending. Lending to most businesses, in contrast, will require capital of about 8 per cent. The essence of the global financial crisis was risky assets - mostly US sub-prime mortgages - that had been carelessly assessed by the market and classified incorrectly as risk-free, then dispersed to all corners of the financial system. The risky assets were precisely those which were regarded as "safe" under Basel II - but which in fact were not. That is, the risky assets had low "official" risk but high real risk. (The risks were also correlated: many of them had a good chance of going bad at the same time, magnifying their likely economic impact.) Basel II gave market players enormous incentives to seek out such assets - in effect, to find the best regulatory arbitrage. In a crisis where a large number of assets fall substantially in value, it matters little whether a bank's capital is 5, 10 or 15 per cent. It will still be overwhelmed.

To add to the problem, there is no asset so safe that it cannot be made unsafe by overbidding and overbearing.

Nothing in Basel III prevents that problem from recurring.

Beyond the issue of banks' safety is another issue which Basel III cannot address. The financial system inevitably breaks down if creditors are willing to lend to foolish investors. The bail-outs of creditors during the global financial crisis may have raised expectations that creditors will be rescued from future poor decisions. The most severe critics of the system believe Basel III does little to address underlying problems with the global financial system. Adrian Blundell-Wignall, the former RBA economist who is now Deputy Director of Financial and Enterprise Affairs at the OECD, has gone further than most: his personal view is that the Basel II system proved so flawed that such frameworks might not be worth using.

How effective will the new rules be?

These are easily the toughest global banking rules yet agreed. But there is no guaranteezthey will save the banks from their next episode of over-optimism. The 2008 crisis showed that when the web of global lending unravels, even well-capitalized institutions are at risk. Strong and sophisticated regulators will continue to be needed. And they will continue to have to make tough calls about the risks taken by individual institutions and overall risks within the financial system.

What stays the same?

Regulators, with the concurrence of world leaders, have chosen to keep the essential structure of the Basel II approach intact while trying to improve the mechanisms of the accod. This is not to minimize the extent of the changes described above, which are quite significant, but rather to emphasize that they are consistent with the overall framework of Basel II. The two possible exceptions to this general statement are the leverage ratio, which does not take the riskbased approach that is at the heart of Basel II, and the addition of a liquidity test. In practice, the leverage ratio is likely to be set at levels that leave the riskbased ratios as the key determinants of the capital requirements, muting the effect adding a leverage ratio. For its part, the liquidity test is not truly inconsistent with the capital tests, but should probably be viewed as a supplement that is in the spirit of the original Basel accords. One aspect that remains the same has come under a great deal of criticism from some academics and market observers. Basel II and III both allow the sophisticated global banks to use internal risk models as key determinants of their capital reuirements. The argument in favor of this is that banks devote far more resources than regulators can to developing sophisticated approachs to evaluating the risk they are taking on and they have a strong incentive to get it right, in order to maximize their own profitability over

time. Unfortunately, we now know that the risk modeling leading into the crisis was seriously flawed by a combination of excessive reliance on a liited historical record and perverse compensation incentives. There is good reason to believe that the modeling is better now, both because of extensive efforts to fix the problems and because the historical record now includes a much worse set of event, automatically increasing their conservatism. However, many remain skeptical that the basic flaws have been fixed. A related issue is that capital requirements for trading assets are still calculated with extensive reference to Value at Risk alculations. Basel III adds layers of conservatism that appear to roughly double the capital requirements on average. However, the VAR concept appears to work better for evaluating daily or weekly risks than for somewhat longer holding periods. For this reason, some observers are skeptical that the VAR approach works effectively when applied to less liquid assets. In both cases, the Basel Committee has chosen to retain the role of standard risk models, despite an awareness of their flaws. The consensus of the committee is that the benefits outweigh the disadvantages and that there is no clearly superior approache available.

What are the major areas of disagreement?

There is broad agreement within the Basel Committee, at the G20, and even in the financial markets, that capital requirements need to be raised in light of the financial crisis. However, there are disagreements, particularly between the banking industry and the committee, on the specific approaches being taken to achieve this purpose. As will be discussed further below, the industry argues that the committee is going overboard in many areas and doing so in ways that will significantly, and unnecessarily, raise the cost of providing loans and other banking services. Some of the key areas of discord are:

Net stable funding ratio.

There seems to be a reasonable degree of acceptance that Basel rules need to cover liquidity, but the industry has pushed back very hard on the net stable funding ratio test. They believe that it would force very substantial and expensive changes to how they fund themselves and invest their assets an that the gain in safety would be marginal. They have more support from disinterested observers on this than they do on their complaints about the higher capital requiremnts, although opinion is divided in the academic community. Whatever the merits, it appears that the industry has succeeded in giving the regulators great pause on this topic and the test may be dropped fromthe initial Basel III rules and studied further. The liquidity stress test has generated less opposition, although it is certainly not without controversy either. As a result, it might be included in Basel III or might be put off along with the other liquidity test.

Higher capital ratios.

This fight will spring up in full fury once specific capital ratios are specified, but the banking industry has already made clear that they believe only moderate changes are necessary, especially given all of the other ways in which capital levels are being increased in the Basel III proposals.

Use of a leverage ratio.

There is a heated debate on this topic. Virtually all regulators agree that a simple leverage ratio is a useful way of checking to see if the riskbased approach is leading to excessively large balance sheets. Some countries, notably the US, believe that this is such a useful ratio that it ought to be mandatory and binding, so that a banks minimum required capital would be the greater of the riskbased figure and the one derived from the leverage ratio. Others, notably France, believe it is simply one useful supplemental measure and that how it is used should be up to national discretion. They further point out various technical problems that could make it very difficult to achieve uniformity, such as the differences between US and international accounting standards. Some analyses have suggested that the two different accounting regimes could show total assets on the balance sheet that diffeed by as much as 100%, so that a fixed leverage ratio could require twice as much capital in one country as another. At a minimum, there will have to be an approach that adjusts the leverage ratio for such differences. This ratio will probably remain controversial for a long time, if for no other reason than the fact that US banks have been operating under a leverage ratio for some time and are already cofigured to deal with it, while European banks have not. In a nutshell, many European banks have larger balance sheets than US banks, but focus more on lowerrisk assets, since this is what the Basel rules effectively encourage. Adding a leverage ratio would force them to operate more like US banks in their asset allocations. The most likely result is that the Basel Committee will choose to elevate the importance of the leverage ratio, but do so in a manner that allows the development of greater consensus over time. For example, there has been talk of an observation period of several years before it becomes binding, which, in practice, would allow for it to remain nonbinding if a true consensus cannot be built. Another possibility is for it to be binding, but set at a low enough level that it would rarely be the determinant of the minimum capital requirements, since the riskbased approach would almost always yield a higher requirement. Elimination of softer forms of capital. Everyone agrees that common stock provides the strongest form of capital protection. The problem is that common stock is also by far the most expensive form of capital for a bank to raise. Therefore, banks have availed themselves of substantial amounts of softer, and cheaper, forms of capital. Therefore, the industry has been fighting back against the elimination of some of these forms and has also been pushing for transition peiods in which some or all of these forms of capital would continue to count as capital. The European and Japanese banks feel particularly strongly about this, as they have relied somewhat more on these forms than have the American banks. Exclusion of some balance sheet items from capital. Banks in every country gain considerable benefit from at least one of the balance sheet items that will no longer count as captal and therefore put forth arguments as to why they should continue to

count. The Europeans are particularly concerned, because many of their corporate structures include investments in insurers and minority interests in their banks to a much greter extent than is true in the US. On the other hand, the US banks are concerned about deferred tax assets and about mortgage servicing rights, which are of lesser concern to the Europeans. There are legitimate arguments in almost all cases, which is why these items had been counted as capital in the past, but the committee strongly wants to ensure that common stock, and not softer forms of capital, really does constitute the core of capital. This difficult balancing act will be resolved by classic horse trading among the different countries on the committee, balanced by a desire to maintain the overall integrity of the Basel III proposals. Virtually every part of the Basel III proposals has been objected to by someone, so the above should not be viewed as a complete list, but merely the most important and controversial items.

Will the originally proposed changes or timetable be modified?

Despite the various controversies, it appears unlikely that the core Basel III proposals will be dropped, with the exception of the liquidity provisions. Nor does it appear likely that the timetable for initial implementation will be altered significantly. The G20 heads of government show a strong desire to finish this at their Seoul meeting in November and it appears that there is suffcient consensus to achieve this. It is possible, of course, that some disagreements will effectively be declared to be implementation details that can be delayed modestly, even if an objective observer might consider them to be more fundamental concepts rather than just details. That said, it would be a surprise if there were a major delay in a core part of the Basel III proposals, with the exception of the liquidity requirements. The one thing that might create a postponement would be the onset of a new recession or severe financial crisis, such as the Euro crisis was threatening to become. Leaders are not going to want to risk slowing their economies further under those circumstances. As noted earlier, it is highly likely that there will be a number of arrangements to ease the transition once the initial implementation date isreached, such as phasing out various forms of soft capital over a period of years and perhaps phasing in the new higher Tier 1 capital atios.

What are the likely effects of Basel III?

There is very considerable disagreement about the effects of Basel III. Virtually everyone accepts that banks and the financial system would be safer as a result of these changes, but that this would come at the cost of slower economic growth in most years due to higher credit costs and reduced availabiliy. However, the magnitude of these effects is at issue and very much affects ones view of the tradeoff. As noted earlier, the IIF, an industry group, calculated that the economies of the major economies would be about 3% smaller as a result of Basel III than they otherwise would be five years on4. This is a very large impact and the G20 leaders would probably reject Basel III if they believed these figures. Nor is the IIFs analysis even the most pessimistic. For example,

the French banking association offered calculations that suggested a 6% hit to the French economy. On the other hand, various disinterested observers have concluded that the effects would be much smaller. My own calculations, for example, suggested that a large increase in capital requirements in the US might only increase average loan pricing about 0.2 percentag points, with little effect on availability5. (I did not analyze the effects of the liquidity rules, which could be larger, and I assumed a long enough transition effect to avoid abrupt changes.) An increase in loan pricing of this magnitude would likely have quite minimal effects on economic growth. (Consider how small an effect there is on the economy of a 0.25% rate move by the Fed, which is the smallest change they normally make.) My discussions with European and US policymakers and regulators strongly suggest that the key decisionmakers are heavily discounting the industrys analyses, instead buying into the Basel Committees own apparent view that the drag on the economy would be relatively small and more thn offset by the benefits of greater systemic safety. This thinking may either be confirmed or altered on the basis of the committees Quantitative Impact Study which should be pubicly available in September. If the Basel Committee is right, the lowered growth rate during noncrisis years may be more than offset by the avoidance of truly severe recessions brought on every few decades by widespread, severe financial crises. A recession as rough as the one we recently went through causes permanent losses to the economy in addition to the awful transtory effects. The long term unemployed may find they are never able to return to work and some plant and equipment is junked or deteriorates after beig out of service for long periods. There are also very longlasting effects of the sharp increase in national debt that tends to accompany such severe recessions. It is difficult to pin down the permanent shrinkage in the economy, but most observers would agree that it is quite significant. In addition, of course, the temporary shrinkage of the economy adds up to a considerable loss before the economy recovers to more normal levels.

Conclusion
Basel III will happen, roughly on schedule, and will make a major difference to the operation of the financial system. Banking will be safer, but more expensive, with extensive ramifications throughout the economy. Despite the dry nature of discussions of financial regulation, the Basel III process bears watching closely.