Introduction
The major changes from Basel II (BCBS, āInternational Convergence of Capital Measurement and Capital Standards: A Revised Framework ā Comprehensive Versionā, June 2006; āEnhancements to the Basel II frameworkā, July 2009; āRevisions to the Basel II market risk frameworkā, July 2009) to Basel III (BCBS, āBasel III: A global regulatory framework for more resilient banks and banking systemsā, December 2010 (rev. June 2011); BCBS, āBasel III: International framework for liquidity risk measurement, standards and monitoringā) are the shifts largely from risk sensitive to capital intensive in the perspective of risk management. 1 By risk sensitive we mean that each type of riskāmarket risk, credit risk, and operational riskāis being treated separately. These three types of risks are three components of Basel IIās Pillar 1 on Regulatory capital. 2 By contrast, a capital sensitive perspective leads to a more fundamental issue, that of capital, and enforces stringent capital requirements to withstand severe economic and market situations. This capital concept is extended to be total loss-absorbing capacity (TLAC) by the Financial Stability Board (FSB) report of November 2014, āAdequacy of Loss-absorbing Capacity of Global Systemically Important Banks in Resolutionā, to address global significant financial institutions (G-SFI) and the financial system as a whole.
A major reason for this shift of focus onto capital is that banks do not have enough high quality and quantity capital bases to absorb expected and unexpected losses under certain circumstances. When banks build up excessive on and off balance sheet leverage, and the capital base is reduced in a period of stress, capital buffer is required to absorb the resulting credit loss in order to maintain their intermediation role between depositors and investors in the real economy. Otherwise, without enough loss-absorbing capacity, asset prices are pressured to drop in a deleveraging process, leading to massive contraction of liquidity and credit availability, as happened in the financial crisis of 2007ā2008.
A resilient banking system to prevent bank panics and contagion to the real economy is the most important objective for regulators. Therefore, this way of examing the risk management process leads to a modern capital sensitive framework for commercial banks, largely documented in Basel Committee on Banking Supervision (BCBS), the FSB, and other regulators, supervisors, and national authorities in the world.
In this chapter, several main components in regulatory capital framework are discussed in order.
What is Capital?
Why Capital is important for a bank?
Capital requirement in Basel III.
Capital Buffers and Capital Adequacy Framework in Basel III.
Capital as Total Loss-Absorbing Capacity and Global Systemically Important Banks (G-SIBs) Surcharge.
I start with the concept of capital for a bank and address other questions in the remainder of this chapter.
Roughly speaking, capital is a portion of a bankās assets that is not legally required to be repaid to anyone or have to be paid but only very far in the future. By this broad definition, capital has the lowest bankruptcy priority, the least obligation to be repaid and the most highly liquid asset. Common equity is obviously the best capital. Besides common equity, retained earnings and some subordinated debts with long maturity and no covenant to be redeemed (if liquid enough) are also examples of a bankās capital. However, we have to be very careful to apply this concept due to its complexity.
Let us take a simple example to motivate our explanation below. A bank has $8 million of common equity and takes $92 million of deposits; and the bank has a $100 million of loans outstanding. The loan is on the asset side of the bankās balance sheet while its liability side consists of deposits and shareholder equity. If the loans perform well, the bank is able to fulfill obligations to the depositors and short-term investors, and makes a profit for the shareholders. The current capital to asset value is 8% if the risk weight to the loan is 10%. If the loan is less risky and its risk weight to the loan is assigned to be 50%, then the capital ratio (following the calculation methodology in Basel I and Basel II) is 16%.
If some losses occurred to the loan, say, $6 million worth of loan was not repaid, then the capital of $8 million can be used to protect the depositors but the capital ratio reduces to 2/94 = 2.15% (assuming the loanās risk weight is 100%). In this case, $8 million of common equity is a sound and solid capital buffer since it does not have to be repaid in all circumstances, but the capital buffer drops from $8 million to $2 million. Evidently, the $2 million of capital buffer makes the bank very fragile against possible further loss. One way to increase the capital buffer is to issue new equity, say $3 million for new shares. The new capital ratio is (2+3)/(94+3) = 5.15%. But when the market situation is extremely bad, it could be hard for the bank to issue new equity shares, or even in doing so, the new equity share would be issued at a substantial discount; thus, the new capital ratio is smaller than 5.15% in reality.
In another extreme eventuality, a large number of depositors withdraw money at the same time; the bank runs into a mismatch challenge because its assetās maturing time is much longer than the liabilityās maturity. In our example with initial $8 million of common equity, when $5 million is withdrawn simultaneously, the bank is enabled to use $5 million from the capital buffer to pay to the depositor, and the capital buffer drops to $3 million. However, if barely $10 million out of total $92 million of deposits is withdrawn, the capital buffer is not enough to meet the depositorsā request, then the bank has to sell the less liquid asset (loan) at a big discount. Therefore, a high quality and adequate quantity of capital base is crucial for the bank.
Basel II and Major Changes from Basel II to Basel III
Basel II revises significantly the Basel Accord, so called Basel I (BCBS, āInternational Convergence of Capital Measurement and Capital Standardsā, July 1988), by creating an international standard for banks as well as regulators. It was expected to be implemented before but it has never been fully completed because of the financial crisis of 2007ā2008, and thus the emerging of Basel III. To some extent, Basel III is merely a revision of the Basel II framework but current regulatory risk management businesses have been largely shifted to implement Basel III and some other regulatory modifications on the global systemically important banks. It is worth mentioning that each jurisdiction has its own right to make adjustment for its domestic financial firms within the Basel III framework.
In what follows I devote myself to the capital concept in Basel II and highlight its major revisions in Basel III. The reasons for doing so are (1) to reflect current market reality since most banks are in the transition period from Basel II to Basel III and there are different phase-in periods for different capital adequacy requirements; and (2) Basel III and other regulatory requirements are also in an ongoing process to address unresolved and new issues for the banking sector. Therefore, this comparison between Basel II and Basel III not only provides a historical outlook but also a forward-looking perspective on the capital requirement framework. A more historical document about BCBS itself is presented in section āA Brief History of the Capital Requirement Frameworkā.
There are four major changes from Basel II to Basel III, which will be in full effect by 2023.
- (1)
Capital requirement - (A)
A global standard and transparent definition of regular capital. Some capitals (for instance Tier 3 and some Tier 2 capitals) in Basel II are no longer treated as capitals in Basel III.
- (B)
Increased overall capital requirement. Between 2013 and 2019, the common equity Tier 1 capital increases from 2% in Basel II of a bankās risk-weighted assets before certain regulatory deductions to 4.5% after such deduction in Basel III.
- (C)
The total capital requirement (Tier 1 and Tier 2) increases from 8% in Basel II to 10.5% in Basel III by January 2009. Some jurisdictions can require even higher capital ratios.
- (D)
A new 2.5% capital conservation buffer (see section āCapital Conservation Buffer in Basel IIIā) is introduced and implemented by January 2019.
- (E)
A new zero to 2.5% countercyclical capital buffer (see section āCountercyclical Capital Buffer in Basel IIIā) is introduced and implemented by January 2019.
- (2)
Enhancing the risk coverage in the capital framework
Increased capital charges for both the trading book and the banking book.
- (A)
Resecuritization exposures and certain liquidity commitments held in the banking book require more capital.
- (B)
In the trading book, banks are subject to new āstressed value-at-riskā models, increased counterparty risk charge, increased charges for exposures to other financial institutions and increased charges for securitization exposures.
- (3)
New leverage ratio - (A)
Introduce a new leverage ratio that measures against a bankās total exposure, not risk-weighted, including both on and off balance sheet activities.
- (B)
Implementation of the minimal leverage ratio will be adopted in January 2019.
- (C)
An extra layer of protection against the model risk and measurement risk.
- (4)
TwoNew liquidity ratios - (A)
A āLiquidity coverage ratioā (LCR) requiring high-quality liquid assets to equal or exceed high-stressed one-month cash flows has been adopted from 2015.
- (B)
A āNet stable funding ratioā (NSFR) requiring available stable funding to equal or exceed required stable funding over a one-year period will be adopted from January 2018.
Among these key changes, this chapter focuses on the capital and capital requirement (1) and briefly discusses (3). Chapters āMarket Risk Modeling Framework Under Baselā and āOperational Risk Managementā cover relevant detailed materials in this area. 3 The risk coverage in Basel III is discussed in details in chapters āMarket Risk Modeling Framework Under Baselā and āXVA in the Wake of the Financial Crisisā. Finally, chapter āLiquidity Riskā discusses the liquidity risk management. 4