.The financial crisis of 2007-2009 led to The Bank for International Settlements to develop Basel III. This is a series of amendment of Basel II. The main aspects of Basel III were put into effect by January, 2013 and others will be phased in up to 2019. It was felt that the minimum capital requirements before the financial crises were not enough to absorb the losses the banks ultimately incurred. Basel I and II dealt with capital only and their capital adequacy rules failed to eliminate risks by securitizations, derivatives and repurchase agreements and ignored systemic risks associated with the build-up of leverage in the financial system. (Shearman & Sterling, 2011).Basel I assigned risk weights against each asset but was criticised for its ‘one size fits all’ approach and absence of risk sensitivity in estimating capital requirements. (IIMB, 2013).Failings of Basel II included the absence of additional capital requirements and this led to banks deleveraging. Additionally, Basel II assumed that its risk based capital requirements would minimise the risk of excessive leverage. Moreover, Basel II did not consider liquidity risk. (IIMB, 2013).Although, many large banks complied with Basel II (by keeping their 8% minimum capital ratio) they still suffered large declines in return on equity. (Cosimano &Hakura, 2011).
Basel III is a comprehensive set of measures designed to limit unnecessary risks by banks and so create a resilient financial system which can endure financial and economic pressures. The foundation of Basel III is based on the three pillar structure of the Basel II regulations. The pillars are; minimal capital requirements, risk management and supervision and market discipline. (Kpmg.com, 2011)
The diagram below shows the breakdown of the Basel III proposals.
(Kpmg.com, 2011)
Under Basel III the main form of Tier 1 capital should be common equity such as common shares issued by banks. The elements of capital base are restricted in that Common equity Tier 1 must at least be 4.5% of risk weighted assets (RWA) and this is more than twice the level set previously. The basic 8% minimum capital ratio is the same but the new framework sets that Tier 1 capital must be a minimum of 6% RWA. (Kpmg.com, 2011)
The capital ratios are calculated using the following formula:
(Kpmg.com, 2011)
Both elements of capital ratio have been affected under Basel III.A reduction in eligible capital will mean less capital is available for minority interests, investments in financial institutions, and deferred tax. The diagram below shows the possible percentage range of potential increases to risk-weighted assets.
(Kpmg.com, 2011)
Two capital buffers will be added and both are to be raised through common equity. These are a capital conservation buffer equal to 2.5% of RWA and a countercyclical buffer of an additional 0 to 2.5 % of RWA (Norton Rose Fulbright, 2010).During the crises it was noted that some banks continued to distribute earnings to shareholders despite having incurred heavy losses. These buffers have been introduced to impose distribution constraints on banks if they do not hold the required capital buffers. The aim of this is to allow banks to rebuild the buffer. The capital conservation buffer is required to be large enough to allow banks to sustain the minimum requirements and draw on capital in periods of stress. Additionally, the countercyclical buffer will add capital to the conservation buffer when there is excess credit growth in the economy (The manager, 2015).Hence, capital is built up during growth phases of the financial cycle and theoretically will be enough to cover any subsequent losses in a downturn and so continue to supply credit to the real economy.(Eesti Pank,2015).The countercyclical buffer has been introduced because banks increase lending in a growth period and subsequently reduce lending in an economic downturn and this makes funding more difficult and expensive in an economic downturn.
Excess leverage was a common feature to many banks prior to the crisis, and so reducing excess leverage is a Basel III requirement.
The method for calculating the leverage ratio is:
(Shearman & Sterling, 2014).
The exposure measures are a total of a bank
i.on -balance sheet assets
ii. Derivative exposures
iii. Securities finance transactions
iv. Other off-balance sheet exposures such as guarantees.
(Shearman & Sterling, 2014).
A leverage ratio will become effective from January, 2018. (Switzerland, UK and China are already implementing Leverage ratio).At present, regulators are monitoring leverage ratio data. From 1 January 2015 institutions are required to disclose their leverage ratio. The purpose of this ratio is to avoid steep leverage by firms while still showing strong risk-based capital ratios.
A leverage ratio ensures that banks with a large amount of low risk-weighted assets hold extra loss absorbing capacity. Hence the leverage ratio may be better at containing aggregate risk and offer more protection against unusual losses in the financial system. (Ecb.europa, 2015).Additionally, the leverage ratio could be advantageous in easing issues surrounding model risk in the calculation of risk weights.
Criticisms of the ratio are that the ratio could lead to reduced lending and the non-risk adjusted measure could encourage banks to focus on higher risk lending which leads to potential higher returns. (Kpmg.com, 2011).However, increased risk-taking should raise banks’ risk-weighted assets, such that at some point the risk-weighted capital framework becomes binding again and so risk taking arising from the ratio will be limited. (Ecb.europa, 2015).
Two liquidity ratios have been introduced. A liquidity coverage ratio(LCR) which will require banks to hold more liquid, low yielding assets that can be converted into cash to meet its cash outflows for a 30 day period in a high stress period specified by supervisors.(Nortonrosefulbright,2010).These will probably have a negative impact on profitability. The LCR is calculated using the following formula:
Stock of High Quality Liquid Assets (HQLA) > 100%
Net Cash Outflows over a 30-day time period
(JPMorgan, 2014)
Secondly, Net stable funding ratio (NSFR) has been introduced which is designed to encourage banks to use stable sources (such as capital, preferred stock and debt of maturities of more than one year) to fund their activities. This may lead to higher funding costs and reduced yields for banks. The NSFR is calculated using the following formula:
Available amount of stable funding (ASF) > 100%
Required amount of stable funding (RSF)
(JPMorgan, 2014)
Differing views exist as to impact of increasing bank equity. Admati,DeMarzo,Hellwig and Pfleiderer,2010 felt that higher capital requirements will lower leverage and the risk of bankruptcies.However,BIS,2010b felt that the costs involved in setting up higher capital requirements will ‘increase banks’ marginal cost of loans if the marginal cost of capital is greater than the marginal cost of deposits’ and this would lead to more expensive bank loans and consequently this would hinder economic recovery as borrowers would require fewer loans due to the elevated costs.
Kashyap, Stein, and Hanson (2010) found an increase of 6 basis points in US banking lending spreads following a study to examine the effects of increasing capital to asset ratio (in line with Basel III) and how this impacted bank lending rates and lending volume. Likewise, studies by Bis (2010b) Angelini (2011) and Slovik and Cournede (2011) noted increases in basis point (although notably higher) in lending spreads.
Various studies suggest that the increase in the equity-to-asset ratio required by Basel III is predicted to reduce loans for the 100 largest banks by 1.3 percent in the long run. (Cosimano and Hakura, 2011).Additionally, the extra equity-to-asset ratio requirements in a booming economy will mean lending is reduced even further. In countries which experienced the crises, the expected reduction in the volume of loans over time is an average 4.6% whereas countries not involved in the crises, the expected reduction in loans over time is 14.8%.These differences are explained by ‘cross-country differences in the interest elasticity of loan demand and bank’s net cost of raising equity’.(Cosimano and Hakura, 2011).The table below shows the impact of a 1.3% point increase in the Equity-Asset Ratio on Loans based on regressions for 2001-09:
(Cosimano and Hakura, 2011).
It is possible that Basel III could encourage a move towards ‘shadow-banking sector`. The shadow banking system is a network of financial institutions comprised of non-depository banks such as investment banks, hedge funds, non-bank financial institutions and money market funds.(investinganswer,2015).These are not subject to traditional bank regulations and so could offer cheaper loans such that ‘a corporation could save $1.6 million on each $1 billion borrowed` from a financial institution which is exempt from the Basel III framework.(Cosimano and Hakura, 2011).Therefore, the increase in loan rates and decrease in loan levels will adversely affect the recovery of the economy. The shadow banking sector has grown since the financial crises due to strict regulations (such as Basel III) imposed on banks. A drop in asset prices could force investors to recall their money from investments and this would mean that funds would have to sell their holdings and this would push asset prices even lower.(Financial Times,2015)
Research shows that the largest banks in the world would increase their lending rates on an average by 16 basis points in order to increase their equity to asset ratio by 1.3 percentage points needed to be meet the new Basel regulation .Increase in lending rate is estimated to cause loan growth to decline by 1.3% in the long run (Cosimano and Hakura, 2011).However, a study by Bank of England, 2014 suggests that banks reduce loan growth initially after implementing the Basel III changes but that loan growth returns to normal within 3 years and that how banks respond to Basel III will depend on ‘bank size, capital buffers held, the business cycle, and the direction of the change in capital requirements.’
Capital Requirements Directive IV is an EU legislative package covering prudential rules for banks and investment firms and its purpose is to implement Basel III in Europe. (Bank of England, 2013).Globally, most countries have started to implement Basel III risk based capital reforms but not the leverage and Liquidity ratios. Minimum capital levels are in line with BCBS requirements in Europe and Americas and are much higher in Asia, Middle-East and Africa as they had higher existing capital ratios.(Moody,2014)
In conclusion, Basel III should reduce excessive risk taking and hence create a more robust financial sector. The stricter requirement for equity will not only ensure that banks allocate a larger proportion of equity to a given volume of risk weighted assets but moreover will specify that the equity is a higher proportion of Tier 1 capital. Banks can meet this requirement of Basel III by raising equity which can be costly or they can reduce their assets. The combined effects of this are that return on equity and so profitability will be reduced. Moreover, the liquidity ratios will further limit profitability by stipulating that banks hold a certain amount of liquid assets, and this will reduce vulnerability to liquidity shocks. In addition, the Leverage ratio will limit the options of banks. Basel III will be work intensive, time consuming and costly to implement. Smaller banks may find it hard to raise the necessary capital and consequently may be phased out. Larger banks may be able to employ specialists who could implement the changes but this can be expensive. Additionally, investor returns are likely to be adversely affected and this is unfortunate as this will discourage investors at a time when banks will want new investors to help increase their capital. Also, a reduction in lending is likely to occur. Overall, Basel III should improve corporate governance and risk management thereby creating a banking system with less procyclicality and more transparency for capital markets.