Basel III and the new economies (Part 2 of 2)

There are three components of bank capital under Basel III, namely (i) minimum common equity requirement, (ii) a conservative buffer and (iii) countercyclical buffer. The capital conservation buffer is to enable banks to maintain capital levels above the minimum requirement throughout a significant sector-wide downturn.

This conservation buffer should be phased in by January 2019 at the latest. National bank supervisors have more discretion in implementation of the countercyclical capital buffer. The three components of bank capital should be raised from a combination of raising capital in the market and restricting discretionary payments such as dividends, share buyback and bonuses to shareholders, employees and other capital providers.

The restriction of discretionary distribution of banks’ earnings will shift the risk as much as possible from depositors to shareholders and employees of banks.

Basel III raises minimum common equity requirement to 4.5 percent of risk-weighted assets (RWA) from 2 percent under Basel II. In addition, a bank is required to hold another 2.5 percent of RWA for capital conservation buffer to face economic stress. On top of these, Basel III requires banks to create a countercyclical buffer between 0 to 2.5 percent of RWA during the period of excess credit growth.

In total, therefore, banks need to maintain a common minimum required equity ratio of 7 percent of RWA. Tier 1 minimum capital requirement is increased from 4 percent to 6 percent of RWA. Total Tier 1 capital needed to be maintained by a bank is therefore is equal to 8.5 percent of RWA.

Total capital requirement of the bank increased from 8 percent in Basel II to 10.5 percent of RWA in Basel III. But, “there remains the more difficult (if not impossible job) of setting accurate risk weight against which to measure capital” (Scott, 2011).

The countercyclical capital buffer in Basel III makes the Capital Adequacy Ratio (CAR) high during a boom periods and low during sluggish periods. This partly corrects the inherently pro-cyclicality of capital regulation and mark-to-market accounting of Basel II that would precipitate an unnecessary crisis.

The shortcoming of mark-to-market valuation of credit collateral is a fundamental accounting issue faced by banking regulators and supervisors all over the world. Mark-to-market accounting distorts valuations during periods of market volatility when the long-term value of assets differs from their market prices.

Forcing excessive write-downs during a period when asset prices are below their fundamental values may lead to fire sales of illiquid assts that would result in a vicious circle of spiraling asset price devaluation.

The countercyclical capital buffer serves two purposes. First, to allow banks to grant credit during the period of stress, and therefore prevent a sudden drop in bank credit and the amplification of cyclicality through the banking system that can push the real economy deeper into recession.

The second purpose of the countercyclical capital buffer is to dampen credit growth or to act as brakes on bank lending that can cause asset price bubbles as its accumulation increases costs to the banking system. In reaction to capital shortages, banks can also reduce investment in risky assets in favor of safer investments rather than raising additional capital.

The countercyclical buffer helps ensure the availability of bank capital to support ongoing business operations and credit extension during the period of stress.

Sudden stop in bank credit during the period of stress pushes down further decline in asset prices and increases non-performing loans that would precipitate unnecessary crisis.

This self defeating process causes bank lending to become scarcer. The capital buffer should be build during the times of economic growth and to be used as a cushion to absorb losses in times of stress.

An increase in the level of capital requirements, better quality and transparency of the capital base as well as better risk capture will increase the cost of banking business and could curtail its lending, negatively affecting economic growth. To ease this, the Basel Committee has provided an ample eight-year transition period for banks to adjust to the new Basel III standards between Jan. 1, 2013 and Jan. 1, 2019. This will allow the banking industry to generate higher capital standards through retained earnings and other measures to raise capital.

Thanks to massive injections of sovereign bonds following the Asian Financial Crisis in 1997, banks in East and Southeast Asia are now better capitalized, their external exposures have been reduced and their credit risks are managed more effectively. As a result, they will not find difficulties in meeting the schedule of the capital standard.

Like important financial institutions, there are also systemically important markets and systematically important infrastructures that are very important in matured industrial economies. Again, such rules on investment portfolios are irrelevant to banks in emerging economies that still rely on deposits and loans.

The GFC in 2007-2009 in industrial countries indicated that the crisis came from the trading book, particularly the complex securitization exposure such as collateralized debt obligation (CDO).

Basel III introduces a leverage ratio to constrain the build-up of leverage in the banking industry. The current proposal by the Basel Committee is to test a leverage ratio of 3 percent of Tier 1 as part of the Pillar 2 supervisory review, with a view to migrating this to a Pillar 1 requirement by January 1, 2018.

There are two standards being proposed to ensure liquidity of bank assets. The first is the Liquidity Coverage Ratio to ensure that banks have sufficient high-quality liquid assets that can be easily converted into cash at a low cost to meet its cash outflows for a 30-day period in times of severe market shock.

The second standard is the Net Stable Funding Ratio, which is intended to promote long-term funding such as capital, preferred stock and debt maturities of more than one year, or short-term deposits that can be renewed.

The writer is professor on monetary economics at the University of Indonesia. He has served as senior deputy governor of Bank Indonesia, the country’s central bank.