Basel III and its Implications on Emerging Markets. Arafat Al Fayoumi February 20,2011. Ⅰ ． Basel Ⅲ - Overview - Ⅱ ． Basel Ⅲ and Financial Systems Ⅲ ． Basel Ⅲ and Monetary Policy . Ⅰ ． Basel Ⅲ – Overview Capital requirement, leverage ratio, liquidity standards. Overview.
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Arafat Al Fayoumi
Ⅱ．Basel Ⅲ and FinancialSystems
Ⅲ．Basel Ⅲ and Monetary Policy
The oversight body of the Basel Committee, the Group of Governors and Heads of Supervision, at its meeting in September, 12 2010, announced a substantial strengthening of existing capital requirements, in line with the agreements reached on the 26 July 2010 regarding its agenda of global financial reform.
A new regime of rules and regulations has been developed by regulators in order to strengthen the resilience of the banking sector against future
shocks, as well as to supplement the current recovery process. The rules mean that the banks will now need to hold a prodigious amount of capital, far more than the current requirement.
Capital Conservation Buffer & Counter-cyclical Buffer
Introduction of Leverage Ratio
・ Liquidity Coverage Ratio (LCR)
・ Net Stable Funding Ratio (NSFR)
The requirement of minimum common equity (MCE) has been increased from 2% to 4.5% of risk-weighted assets (RWA).
Member countries are to begin implementation on January, 1st, 2013 and hence, must integrate the rules with national laws and regulations before this date. As of January, 1st, 2013, banks will be required to have 3.5% MCE of RWA, 4% as of January, 1st, 2014 and 4.5% as of January, 1st, 2015.
An additional conservation buffer of 2.5% has also been introduced, effectively bringing the common equity requirement to7%.
This reinforces the changes in the definition of 'Capital' made in July 2010, along with the higher capital requirements for trading, derivative and securitization activities to be introduced at the end of 2011.
The phase in starts from January, 1st, 2016 and stretches up till January, 1st, 2019. Beginning with 0.625% of RWA on January, 1st, 2016, it will notch up each year by 0.625% reaching the final level of 2.5% of RWA on January, 1st, 2019.
If regulators see free flowing credit, a countercyclical buffer can also be imposed within a range of 0% to 2.5% of common equity or other fully loss absorbing capital to prevent excessive growth of credit within the banking sector.
The Tier I requirement will be increased from 4% to 6%. The phase-in arrangement is similar to that of common equity i.e. Between January, 1st, 2013 and January, 1st, 2015. On January 1st, 2013 Tier I will increase from the current level of 4% to 4.5%, and to 5.5% on January, 1st, 2014.Finally, on January, 1st, 2015 it will increase to 6% as stipulated.
The total capital requirement remains unchanged at 8%, and hence does not need to be phased in. The difference between the total capital requirement of 8.0% and the Tier I requirement can be met with Tier II and higher forms of capital.
The capital requirements mentioned above are also supplemented by a non-risk based leverage ratio. In July, it was agreed to test a minimum Tier I ratio of 3%. Under the new rules, the same will be tested during the parallel run period between 2013 and 2016 and on the basis of the results, final adjustments will be made in the first half of 2017, with the aim of migrating to Pillar I treatment by January, 1st, 2018.
*Common equity or other fully loss absorbing capital
TierI ： 8.5％-Minimum（6）＋Buffer（2.5）
TierI ＋TierⅡ： 10.5％-Minimum（8）＋Buffer（2.5）
(all dates are as of January ,1st)
Ⅰ-４．Phase-in arrangement(all dates are as of January,1st,percent)
The Liquidity Coverage Ratio (LCR) is also set to be introduced on January 1st, 2015, after an observation period beginning in 2011.
The revised Net Funding Stability Ratio (NFSR) will move to a minimum standard by January 1st, , 2018. The Committee intends to put in place various means and processes of review, in order to fully comprehend the implications of these financial standards.
・ Most of Financial crises have been triggered by liquidity problems.
・ Even immediately before its collapse, Lehman’s capital adequacy ratio was a double-digit figure. (Capital adequacy ratio may not be very effective for preventing liquidity-driven financial crises.)
If a liquidity problem leads to a “fire-sale”, FIｓmay become insolvent due to a substantial decline in the prices of various financial assets.
・ It is difficult for central banks to rescue “insolvent” FIs through LLR.
・ Although each town has its firefighters’ station, each office should have a fire extinguisher so as to prevent a fire. (If a fire spreads all over California mountains, it is difficult even for firefighters to extinguish the fire.)
A fire sale triggered by a liquidity problem is the most typical case of “negative externality”.
In the face of criticism that the proposed liquidity ratios (NSFR and LCR) could jeopardize the economy with capital being trapped in liquidity buffers, the committee has watered down the proposal and is phasing in the requirements only by 2015.
Focus on Common Equity:
Post financial crisis, some banks were observed to be taking advantage of profits from low cost government bailouts. If this continues, it could mark the beginning of another crisis. In order to avert it, Basel III focuses on raising capital through common equity.
Hybrid capital will be phased out of Tier I capital in 3 years time, with the intention of maintaining only the highest quality capital in Tier I. Hybrid Capital had until now been a favored route for raising capital with about $1 trillion being issued since 1999.
Role of External Ratings:
While the Frank-Dodd Act in the United States has tried to bring in accountability to the rating agencies by making them liable for the ratings issued; it has also mandated that sole reliance on external ratings would not be allowed. The new Basel III regulations remain silent on these issues.
The risk weight prescribed by the Committee earlier was much maligned as one of the reasons for the financial crisis, allowing banks extremely high leverage. The committee has not junked the methodology but has introduced a simple leverage ratio of Common Equity to Total Assets which has been set at 3%. This is still too low and allows banks to lend 33 times its capital.
Valuation of assets:
While the common equity requirement has been defined in terms of the risk weighted assets, a significant contributing factor to the problem has been the valuation of assets and the corresponding risk weights applied. No changes have been made to the valuation of the denominator i.e. the risk weighted assets.
・ Even large banks focus on “core” banking businesses (e.g., deposit- taking from households, loans to SMEs). The size of structured product markets is small.
・ These are the basic reasons why Emerging financial systems were not seriously involved in the recent “North-Atlantic” financial crisis.
・ It is important to maintain banks’ function as financial intermediaries while preventing their excessive risk-taking.
Source: International Monetary Fund, World Economic Outlook, October 2010.
- “Zero-bound” of nominal interest rates and fiscal consolidation in many of advanced economies
- Capital flows to emerging economies
- Will banks try to embark on more risky activities so as to maintain ROE? Will shareholders accept lower ROEs?
- How will bank stock prices react to Basel Ⅲ?
How will Basel Ⅲ capital requirement influence bank’s capital-raising?
- Will stock markets have capacity enough to absorb banks’ capital- raising pressures?
- Will good banks try to raise capital as soon as possible so as to avoid the “crowding-out” of capital markets at a later stage? (Will weak banks face difficulty in capital-raising later?
- How will the flattening of the yield curve in advance economies affect banks’ profitability and the magnitude of their capital-raising.
Ⅱ-4. “The Basel Committee’s response to the financial crisis: report to the G20” (Oct. 2010) - on “Macroeconomic impact assessment”
- Some basic questions
・ More liquid assets may bear less yield, and more stable funding may require higher funding costs. (Trade-off between liquidity and profitability)
・ If the economy needs maturity transformation services, minimum liquidity standards specifically on banks might transfer liquidity risks from banking sector to non-banking sector.
・ e.g., the share of government securities in financial assets substantially differ among jurisdictions, reflecting the level of budget deficit.
All of these questions are similar to those raised to capital standards…
－Some basic questions
・ Banks’ demand for the assets defined as “liquid” may increase, while their demand for the asset defined as “illiquid” may decrease.
・ Banks’ longer-term funding might cause steepening pressure on yield curve.
(Standard for eligible collateral)
“Do we need fiscal deficit to satisfy liquidity standards?” (This question is similar to the question of whether “central bank needs fiscal deficit to execute its market operation or not.”)
・ Market liquidity of financial markets may change, reflecting market conditions as well as the development in infrastructure.
・ Financial assets in these countries will become more liquid in future.