By Selwyn Blair-Ford,
head of global regulatory policy,
Wolters Kluwer Financial Services
Over the last few years measures have been proposed and debated at length by regulators, bankers, politicians and others in order to address the issues raised by the financial crisis. As the organisation responsible for providing a supranational framework for banking regulation, the Basel Committee on Banking Supervision (BCBS) assessed these measures and formed Basel III. This new framework outlines a new regulatory standard on bank capital adequacy and liquidity to banks across the world – but how sure can we be that it has truly covered the chasms revealed by the crisis? Selwyn Blair-Ford, head of global regulatory policy at Wolters Kluwer Financial Services, takes a look.
One of the issues that unravelled during the financial crisis was how holders of subordinated and long-term debt instruments claimed on the amounts outstanding in the same way as other creditors. In other words, debt that the regulator had allowed banks to count as capital was not available to absorb losses, and therefore did not behave as capital.
To remedy this, Basel III has tightened up the definition of capital so that common equity (or instruments that can be readily converted to common equity) are now the cornerstone of regulatory capital. Associated with this change is the increase in the number of items that have to now be deducted from capital, including deferred tax assets, minority interest, and a wider range of intangible items.
The minimum amount of the highest quality capital to support a firm’s business has been increased from 2 per cent to 4.5 per cent. Furthermore, tier 3 capital – the lowest quality capital acceptable under Basel II – has been abolished.
These changes ultimately mean that the financial services sector has to use more of the highest quality and most expensive capital to support business.
The crisis also revealed that there were several advanced Basel II credit models that were based on the idea of credit default, but did not adequately take into account the effect of a credit downgrade (credit migration). Firms would suffer significant economic loss without experiencing an actual default. To address this, Basel III has also increased the scope of risks covered, with incremental capital and credit value adjustments used to modify approved credit models in order to account for a wider range of risk scenarios. In addition, rules surrounding securitisation positions and the amount of capital held have also been tightened.
During the financial crisis, a major issue revealed was that many firms – in a bid to appear as if everything was ‘business as usual’ – continue to pay dividends and bonuses. These payments depleted the firms’ capital at a time when it was most needed. To tackle this problem, and the perception that capital levels were not high enough, Basel III has added capital buffers to ensure that firms will have to hold capital over and above the minimum requirements. There are two types of buffer that have been introduced by Basel III: capital conservation buffers and countercyclical buffers.
Capital conservation buffers will enable firms to hold 2.5 per cent of their risk weighted assets (RWA) over and above the minimum calculated requirements. In times of stress, a firm may use this buffer but using it will trigger restrictions on the amount of dividends and bonuses the firm is consequently able to pay.
Countercyclical buffers enable regulators in each jurisdiction to vary the amount of additional capital firms must hold – up to 2.5 per cent of their RWAs. The purpose of this buffer is to provide national regulators with tools to manage the speculative bubbles, and other system-wide issues, by increasing local capital requirements.
Post-financial crisis, existing stress testing measures were widely criticised as not being stringent or comprehensive enough. Capital measures have now been supplemented with the requirement that firms carry out fuller, severe and more meaningful stress testing on a regular basis. These new stress tests are expected to be both firm-wide and on specific aspects of a firm’s operation. Stress testing is to be further supported by the completion of reverse stress testing exercises. With these exercises, firms are to assume that they have reached the point where their business model has broken down, and need to identify the scenarios that most likely lead to this outcome.
Another measure that has been adopted by the Basel Committee is the introduction of a leverage ratio. This ratio puts a limit on the total amount of un-netted risk weighted assets a firm may hold as a multiple of tier 1 capital. The intention here is to impose globally comparable measures that limit the amount of leverage/risk the banking sector is able to take on.
A large part of Basel III has concentrated on improving liquidity standards. In many jurisdictions this initiative has received the most attention as the effect is very far reaching. The aim has been to make liquidity as important to firms as solvency. Not only must firms review their reporting systems and control frameworks, but liquidity must also be accompanied with a full, ongoing and robust stress testing programme.
Firms must also carry an adequate buffer of liquid instruments, and have prepared a full liquidity contingency funding plan. There are also new global metrics that firms must achieve which include a Liquidity Coverage Ratio (LCR) and a Net Stable Funding Ratio (NSFR). The LCR is a short-term measure and is meant to ensure that firms have enough liquidity to survive a 30-day stress period. The NSFR is designed for firms to consider the longer time horizon and the firm’s funding profile over a year or more.
Basel III has a lengthy transition period with the full accord not due to go live until January 2019. In the meantime the minimum capital requirement begins to take effect as early as January 2013, and the LCR ratio implemented in January 2015. Overall the Basel III accord represents a period of great change. It has addressed many of the problems exposed during the financial crisis. However, many still remain – significantly important financial institutions (SIFIs), living wills, sovereign debt etc. There is only a certain amount that can be gleaned retrospectively, and we have to appreciate that many of the newer and more difficult issues are still being analysed. Basel III is by no means the end of the story.