CBM – Assignment 4

Critical Analysis of BASEL III &

Deutsche Bank and the road to Basel
III

By
Group- 1

Gunjan Kishor – PGP/23/267

Shailja Yeleswarapu – PGP/23/295
Niranand Rattan - PGP/23/152
Pulkit - PGP/23/465
Vishal - PGP/23/183
Sharan Gull- PGP/23/049
Akash Alok- PGP/23/271
What are the Basel norms?

 Basel norms or accords are the international banking regulations issued by the Basel
Committee on Banking Supervision.

 The Basel standards attempt to coordinate banking laws around the world to improve
the international banking system.

 It is based on the Basel Banking Oversight Committee arrangement, which focuses on

bank risks and financial risks.

Why these norms?

 Banks give credit to different types of borrowers, and each carries its own risk.
 They lend the money raised from the market, i.e., equity and debt, and the deposits of
the public.
 This makes the bank exposed to a variety of risks of default, and as a result, they fall
at times.
 Therefore, Banks required to keep aside a certain amount of capital as security against
the risk.
 The Basel Committee has produced norms called Basel Norms for Banking to tackle
this risk.

The Basel Committee has issued 3 sets of regulations known as Basel-I, II, and III.
BASEL I:
 Introduced in 1988 and focused on credit risk.
 It defined capital and the framework of risk weights for banks. The least capital
requirement was fixed at 8% of risk-weighted assets (RWA), which means assets
associated with different risk profiles.
 For example, an asset-backed by collateral would be less risky than personal loans,
which have no collateral.
 India adopted Basel-I guidelines in 1999.

BASEL II:

These are reformed version of Basel I, came in 2004.

Based on 3 parameters, which the committee calls its pillars:

Capital Adequacy Requirements (CAR): Banks required to maintain a minimum CAR of

8% of risk assets
Supervisory Review: According to this, banks needed to use better risk management
techniques in managing and monitoring all the3 types of risks that a bank faces, viz. credit,
market, and operational risks.
Market Discipline: This needs increased disclosure requirements. Banks need to compulsory
disclose their risk exposure, etc., to the central bank.

Basel II norms in India and overseas are yet to be fully implemented through India follows
these norms.
BASEL III:

In 2010, Basel III guidelines were released. Basel 3 is an international legal arrangement with
a series of measures to enhance risk management, transparency, oversight, and supervision in
the financial industry to strengthen the banking regulatory system. Owing to the global
recession crisis of 2008, it was implemented. Basel III is just a continuation of the Basel
Committee's efforts on Banking Supervision to strengthen the Basel I and Basel II banking
regulatory system.

The guidelines focused on four essential banking parameters: capital, liquidity, leverage,
and funding.
Counter-Cyclical Capital Buffers:
The guidelines propose the maintenance of additional capital buffers during stable periods to
absorb the shocks during the crisis.
This capital promotes lending when times are rough, and the buffer decreases the banking
operation. The buffer ranges from 0% to 2.5% and consists of common stock and other
resources which absorb the loss.
Strengths:
It would make banks act in a pro-cyclical manner. This buffer will serve as an alternative to
the capital buffer provided by the government.
Weakness:
This could reduce the bank's profitability because of the increase in capital cost for the banks.
Therefore, the banks may attempt to compensate by increasing their risks.
Measures to Limit Counterparty Credit Risk:
Basel III imposes a more conservative approach as compared to Basel II while calculating
counterparty credit risk. When the risk model is prepared, the assumptions are based on
historical data in addition to period economic and market stress.
Strengths:
I would reduce the financial institution's dependence on each other, and it would increase the
risk-adjusted weighting for banks' funding from other financial institutions.
Weakness:
The cost of hedging the currency risk might increase the interest rate offered to the end-user.
Improving Capital Base:
• The CAR is to be maintained at 12.9%.
• Minimum Tier 1 capital ratio has to be maintained at 10.5% and Tier 2 capital ratio at 2% of
risk-weighted assets.
• Banks needs to maintain a capital conservation buffer of 2.5% to ensure that banks keep a
capital reserve used to absorb losses during financial and economic stress cycles.
Strengths:
The measures mentioned above will improve the investor's confidence in the bank's reported
capital ratios. Some investors expressed apprehension over Tier 1 capital reserves as it was
difficult to determine which bank had sufficient stocks to face the crisis.
Weakness:
It will increase the bank's capital cost, which would increase the borrowing cost for retail and
commercial customers.
 Leverage Ratio:
The committee recommended supplementing Basel II's risk-based capital requirement, with a
leverage ratio of at least 3%. This acts as a safety net and is intended to limit global leverage
selling in the banking sector.
Strengths:
The main strength of the leverage ratio is the monitoring of off-balance-sheet leverage and
also increases transparency by adding onto the risk-based model.
Weakness:
It may have unintended consequences as it may incentivize banks to focus more on high-risk
assets with greater potential returns than low-risk assets because all assets are equally
weighted.
Liquidity Ratios:
The norms recommend that the Liquidity Coverage Ratio (LCR) be equal to or greater than
100 percent. In 2015, LCR was introduced, and in 2018, Net Stable Funding Limit (NSFR)
was raised.
Strengths:
These norms would count the interconnectedness of the financial system and ensure that the
banks maintain a defined level of high-quality assets. Implementation options include
contingent capital, bail-in debt, and capital surcharges.
Weakness:
Some banks might be underfunded, and these norms will decrease the availability of credit;
hence those banks might increase their stable deposits, which could lead to mispricing of
stable funding.
Basel III Exceptions:
The Basel III proposal is based on the banking practices followed in the U.S. and Europe,
which makes it more specific and increases restrictiveness, making it more challenging to
implement in other countries. Since the recommendations are not legally binding, the member
countries might choose not to implement the recommendations.
Since these recommendations place regulations on banks, which would increase their
operating cost and on the other hand, non-banking financial institutions operate without any
supervision and regulations might shift services to non-banking financial institutions, thereby
going the risk to unregulated non-bank institutions.
Shortcoming of Basel III
1) Quality, Consistency and Transparency of the capital- To ensure that adequate and
highest quality capital is there to absorb the losses which might arise and thus a great cushion
is provided. To that effect, a new definition of capital to exclude all items that do not
resemble capital is a good move. But this will not be effective in solving the problems of
calculating capital ratio risk-weighted assets basis. The system does not solve the problem of
regulatory arbitrage as the risk weights are arbitrary, and only pro cyclicality of the banking
industry is boosted.
2) Widen the scope of risk coverage- To strengthen counterparty credit exposure risk
management. However, to control counterparty risk, better will be to push trading for
derivatives on the organised exchanges. One can take cue from the lessons of the late 1990s
by Brokesley Born.
3) Leverage ratio as a “supplementary” measure - Leverage and capital ratios may not be
necessarily supplementary. As a matter of fact they are equivalent. A bank may hold less
Capital compared compared to unweighted balance sheet, thus referring to more risk culture
in the banks for long. It is pertinent to note that leverage ratio is more objective, than the risk-
adjusted capital ratio.
Case: Deutsche Bank and the road to Basel III

Case Background

Organisation Background Issues Future

CEO Joseph Biggest question: Banks have to clear How to meet the
Ackerman steps Can Deutsche Bank a series of new regulatory
down meet the capital regulatory hurdles requirements?
Co-CEOs Jurgen requirements Issue of fresh equity Basel III’s effect on
Fitschen and Anshu required under capital meant company
Jain to publicly Basel III? diluting the equity profitability?
address investment Basel III value of existing What lines of
analysts and regulations shares business to focus on
shareholders introduced as a Profitability in going forward in a
response to the steady decline since new banking
global financial 2008; stricter norms environment?
crisis to further erode
Quality, profitability
consistency,
transparency of
capital base
History: A brief history of Deutsche bank and business overview is provided in the below
points:
Founded at forefront of economic crisis of 1870s (HQ at Frankfurt)
Company objective – “To transact banking business of all kinds, in particular to
promote and facilitate trade relations between Germany and overseas markets”
Deutsche Bank merged with Disconto- Gesellschaft.
A shortage of liquidity paralyzed banks
Transferred money from Jews to government
Recovery of 1958 – 1) Issued first currency bond 2) Expanded in 12 countries 3)
Reopening market to international firms
1990 - Established numerous subsidiaries worldwide
Acquired its way into 80 countries by 2001, and got listed on NYSE
2007 - Revenues from Sales and Trading increased from 30% to 42% while
traditional commercial and retail banking dropped from 22% to 19%
By 2011 – 1) Deutsche Bank became a global giant and had employed 100,654 people
in 72 countries 2) Increased its assets from EUR 640 billion to EUR 1,860 billion
2012 - Assets dedicated to investment banking €1860 billion (June 2012) which was
more than 3 times of assets dedicated to commercial/ retail banking
Tier 1 capital ratio – 10.2%; Tier 2 capital ratio – 13.6%
By 2012 - One of the largest banks in Germany, indeed one of the largest financial
institutions in Europe and the world

Non-domestic revenues as % of total

100%
90%
80% 73%
70% 60% 62%
60% 56% 55% 53% 53% 51%
50% 46% 43%
40% 37%
30% 26% 27% 25%
20% 17%
10%
0%
2002 2007 2011

JP Morgan Chase Citigroup Barclays

BNP Paribas Deutsche Bank
Deutsche Bank faced competition in international markets from players like JPMC,
Citigroup, Barclays and BNP Paribas
 Investment Banking Assets VS Revenue
100%
90%
80%
70%
60%
50%
40%
30% 20%
20% 14% 12% 13% 16%
10% 7% 3% 3%
0%
Investment Bank Asset Growth Investment Bank Revenue Growth

JP Morgan Chase Citigroup Barclays Deutsche Bank

Focus on globalization after easier cross-border transactions and global communication
since late 1990s
 Revenue by Activity Revenue by Business activity

Globalization: Reasons and Approach

World economy experienced accelerated trend Economies of Scale
towards globalization
• Proliferation of the internet Earnings per $1
• Staggering GDP growth projections in trade
the developing countries
Fixed costs in $100
setting
Approach: One stop solution
terminals
• Full range of commercial and
investment banking solutions % Earnings =Total =5/100=5%
• Customers doing business outside their over 5 trades Earnings/Fixed
home countries Costs
• All the services at all the locations of % Earnings =Total =50/100=50%
business over 50 Earnings/Fixed
Trades Costs
Benefits
• Improved economies of scale in investment banking activities especially sales and
trading and asset management
• Earning a piece of action from the increased volume of worldwide financial
transactions

Deutsche Bank net revenue by region

Global Competition:
• Internationalization of
banks increased the
number of competitors
• Severe competition
from Citigroup,
Barclays and BNP
Paribas
• BNP Paribas and Barclays showed significant increase in non-domestic revenues due
to smaller domestic markets

• All the banks shifted

their focus to Investment
Banking Activities
• DB lagged behind JP
Morgan Chase and
Barclays in both
investment bank asset
and revenue growth
• DB had insignificant
revenue growth
compared to its asset growth

• DB preferred borrowing
debt capital to finance their
asset growth
• DB’s EPS increased
significantly in the same
period
• The increased earnings
came from the increased
leverage and not from the
assets

 JP Morgan Chase performed considerably better than DB in terms of ROA

 DB had insignificant ROA, but its ROE was 800 points higher than JP Morgan Chase
 Over-dependence on ROE showed that its earnings were not sustainable
 DB focused on
increasing ROE and
EPS significantly till
2007 by employing
massive leverage
2008 Financial Crisis
opened their eyes, as
shareholders faced a
significant loss of
EUR 7.61
Post 2009, DB de-levered its balance sheet and focused on retained profits and issuing
equity capital for assets growth

Basel Norms:
1998
 Set out the minimum capital requirement of financial institutions to reduce
credit risk
 Bank assets classified into 5 categories on the basis of risk
 Banks required to maintain a capital which is 8% of its risk weighted assets
 Only considered credit risk, operational and market risk not covered

2004
 Upgrade Over Basel I
 Included 3 pillars
 Minimum capital requirement
  Supervisory review of banks
 Effective disclosure of bank activities to improve market discipline
 Better classification of asset risk categories

2013
 Enhanced Capital Requirement Common equity raised to 4.5% from 2%
 Tier 1 Capital requirements raised to 6%
 Additional Capital Conservation Buffer of 2.5% to bringing the total Tier 1
Capital reserves required to 7%
 Leverage Ratio should be at least 3%
 Liquidity coverage ratio >=100%

Challenges Faced by Deutsche Bank

Doubt on Deutsche Bank’s ability to meet new regulatory framework as per Basel III norms
Need to increase regulatory capital to comply with increased ratios and risk weights
In an attempt to raise new equity capital value of existing shares will get diluted
Reduction in profitability and increasing insecurity in Europe due to debts
Deutsche Bank’s increased profits came from increased leverage and not from productive
assets; in 2011 DB’s ROA was just 0.2% while ROE was 9.02%
Deutsche Bank Valuation
• On July 31, 2012: DB’s shares were trading in the range of 8.2x its trailing LTM P/E
& 0.6x its tangible BV
• Wide fluctuations in its valuation since 2006
• At 0.6x P/TB, DB was trading in the same range that it did during the depths of global
financial crisis
• Two reasons can be: Reduced leverage, Increased capital requirements (BASEL III)
Analysts Projection
2012-2013 Predicted share value = EUR 4.00 Against Revenue of EUR 32.8bn
2013-2014 Predicted share value = EUR 4.92 Against Revenue of EUR 34bn
Both years showing sharp increase from trailing 12month value of EUR3.04/share
Analysis

Recommendations:
As per the projections
• Total Capital as a % of Risk Weighted Asset is 7.476% (38,830 million euros)
for 2012
• The minimum requirement as per Basel III norms is 8.00% (8% of 519384.72
million euros)
• New Capital can be raised from existing stakeholders by the way of a rights
issue which is to be followed by a Follow-on Public Offering
Hence, bank needs to raise an additional 2,721 million euros (41,551-38,830) to meet Basel
III requirements

• To finance asset growth on balance sheet" banks primarily use one of the following
methods.
• Use profits used in the previous years.
• Issue new equity capital thereby diluting the equity value of the existing shareholders
• Borrow debt capital thereby increasing leverage (In 2012 Deutsche bank had
risk weighted assets around EUR488 billion and core tier 1 ratio of 7.2%).
• To comply with Basel III norms Deutsche Bank can go ahead by issuing hybrid
securities like convertible bonds or warrants and reducing the asset base in order
to maintain a balance between ROE and ROA and provide a realistic picture to its
investors and customers.

DB can issue hybrid

Compared to its DB needs to have a securities in order to
It needs to reduce Acquisition of
peers, DB had balanced outlook finance asset growth
risk & increase Postbank can give
higher leverage and based on RoA & and also comply
earnings stability to earnings
average profitability RoE with BASEL III
capital requirements