Skip to main content

Like the British Citizen Army on the Somme – two years in the making, one day in the destroying – Basel III is starting to unravel. After four years in preparation, a recent short meeting at the BIS in Basel  decided that the liquidity targets that previously had to be fully met by 2016 would only have to be met for 50% by then, with 100% compliance not until 2019.

This is a major change and warmly welcomed by the banks, especially in the EU, whose transposition of Basel III demanded compliance even earlier than the BIS deadlines.

What was the problem with Basel III?

Basel III has become problematical given the lack of realism behind the European Banking Authority’s framework for banks to strengthen their capital, under which the EU’s top 100 banks had to submit plans for approval in mid-2012.

The plans – all approved – showed how Basel III compliance would be achieved via a mixture of:

  • Capital raising in the markets
  • Disposal of non-core assets and businesses

The plans have now been shown to be unworkable:

  • Capital markets are shut to bank shares
  • There is no market in the EU amongst banks for one another’s non-core assets and businesses: everyone is a seller. This drives down the price, undershooting the disposal values stated in the plan and failing to strengthen capital

The only other route to compliance is to make business more expensive for customers and cut its supply. That exacerbates any recession and this realisation is what is making politicians put pressure on the BIS to dilute the rules.

Basel III impacts every component in the Capital Adequacy calculation

Basel III is more stringent than Basel II in four important areas:

1.       Liquidity rules

2.       Direct reduction of the bank’s current eligible capital;

3.       Recalculates upwards the bank’s total assets-at-risk;

4.       Increases the percentage of total risk assets that must be held as Tier I and Tier II capital.

Examples of results of Basel III compliance

Liquidity

BeforeAfter

Bank takes in 100 on deposit at 1% and re-lends at 1.25% plus risk margin of 1%

Bank takes in 100 on deposit but has to deposit 10 at 0% at the central bank. It can only lend 90 at 2.25%

Depositor receives 1% p.a. credit interest

Depositor receives credit interest calculated at:

  • 1% * 90; minus
  • 2.25% * 10 (the bank’s opportunity cost)

Eligible capital

BeforeAfter

Bank has 50 of bonds that it counts as Tier I capital out of total Tier I of 500

Bank has a reduction of 50 in Tier I capital as the bonds are re-classified as Tier II, leaving it undercapitalised

Bank has 30 of bonds that it counts as Tier II capital out of total Tier II of 200

  • Bank’s Tier II capital increases to 220 as 50 are backed in from Tier I and 30 backed-out into Senior Debt
  • Cost of Tier II capital increases because the 50 backed-in are priced as Tier I
  • Cost of Senior Debt increases as the 30 backed-out of Tier II remain priced as Tier II

New Credit Conversion Factors increase bank’s total assets-at-risk

BeforeAfter

Bank has 7000 of mortgage loans to which it allocates a CCF of 5%. The risk asset amount for calculation of Tier I capital is 350

  • CCF increased to 8%
  • New risk asset amount for calculation of Tier I capital is 560

Bank has 5000 of credit card loans to which it allocates a CCF of 60%. The risk asset amount for calculation of Tier I capital is 3000

  • CCF increased to 80%
  • New risk asset amount for calculation of Tier I capital is 4000

Tier I Capital ratio raised as a percentage of assets-at-risk

BeforeAfter

Tier 1 capital ratio is 4% under Basel II – Tier I capital needed to support the 7000 of mortgage loans is 350 * 4% = 14

  • Tier I capital ratio increased to 7%
  • Tier I capital needed to support the 7000 of mortgage loans is 560 * 7% = 39.2

Tier 1 capital ratio is 4% under Basel II – Tier I capital needed to support the 5000 of credit card loans is 3000 * 4% = 120

  • Tier I capital ratio increased to 7%
  • Tier I capital needed to support the 5000 of credit card loans is 4000 * 7% = 280

Return on Capital

BeforeAfter
  • RoC target was 15% so mortgage loan portfolio needed to produce 15% * 14 = 2.1
  • On 7000 that is a loan margin of 3 bp
  • RoC target is now 20% so mortgage loan portfolio needs to produce 20% * 39.2 = 7.84
  • On 7000 that is a loan margin of 11 bp
  • RoC target was 15% so credit card loan portfolio needed to produce 15% * 120 = 18
  • On 5000 that is a loan margin of 36 bp
  • RoC target is now 20% so credit card loan portfolio needed to produce 20% * 280 = 56
  • On 5000 that is a loan margin of 112 bp

At the end of the pipe are dramatic increases in the cost of credit, caused by the simultaneous and compounding rises in every component of the calculation.

How does work itself out in the bank?

All Business Lines will find larger amounts of capital imputed by Financial Control to their Business Unit Profit and Loss account, for existing business.

The reaction of the Business Units is predictable:

  1. increase margins from customers on credit facilities;
  2. Reduce lines where it is possible to do so, to reduce the capital charges into their own BU P&L.

The secondary results of this situation will not be far behind:

  1. Customers seek alternative providers
  2. Inadequate lines exist to carry out the daily business, payments get queued, more operational staff are needed to manage the queues, and more credit staff are needed to agree excesses

Operating costs and operational risk increase, then requiring more capital to support that side as well.

Impact on the wider economy

The new capital adequacy regime leads to a contraction of bank credit. This shrinkage exacerbates the current recession. Basel III becomes a matter of public policy.

Up to now politicians have agreed that institutions must be well capitalised to ensure that they do not need more government funding in future. That view is melting now that this policy conflicts with the more immediate aims of economic growth.

BIS decision on Liquidity Rules

The change of BIS policy on Liquidity Rules is the first sign that European politicians are asking whether the balance has gone wrong between getting banks to support the economy and making sure they are robustly capitalised. The wind has changed and the BIS is bending.

PDF of Basel III published in Offshore Investment February 2013