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The Basel III Accord--its impact on economy

| Updated: October 18, 2017 05:08:26

The Basel III Accord--its impact on economy

Banks are a vital part of a nation's economy. In their traditional role as financial intermediaries, banks serve to meet the demand of those who need funding. With the advent of globalisation, banking activities are no longer confined to the borders of any individual country. With cross-border banking activities rapidly increasing, the need for international cooperation in bank regulation has likewise increased. Basel Committee on Bank Supervision (BCBS) has promulgated guidance on issues critical to ensuring health in the banking systems across the world. Basel III, published in 2010, is the most recent Accord. Each Accord is purported to improve upon the previous one, but early indications suggest that Basel III is not flawless and so it will likely not be the last Accord.
At the heart of all the Basel Accords is the issue of regulating bank capital or, more accurately, developing rules to ensure that banks maintain sufficient levels of capital. The role of capital in preserving a safe and sound banking system cannot be overstated. By maintaining sufficient amounts of capital, banks are able to ensure that they are capable of meeting their obligations to their creditors. Likewise, having sufficient amounts of capital will instill confidence in depositors and other bank creditors that the bank will repay them, even if some of the bank's assets default.  
The BCBS promulgated Basel III in September of 2010. Formally titled, "A Global Regulatory Framework for More Resilient Banks and Banking Systems," Basel III reflects the BCBS' attempts to apply lessons learned from the financial crisis and apply them to the existing framework of banking regulation. Thus, Basel III does not replace Basel II, but rather augments it. The primary goal of Basel III is to improve the ability of banks to absorb asset losses without affecting the rest of the economy. In terms of capital regulation, as will be seen below, Basel III focuses mainly on the quantity and quality of capital held by banks.
Among the most important parts of Basel III is its new definition of regulatory capital, which is more restrictive and emphasises greater quality. Basel III retains the tier 1 and tier 2 distinction, but limits their composition to higher-quality capital that is better able to absorb losses. Under Basel III, Tier 1 capital must be mostly of "core capital, which consists of equity stock and retained earnings. In addition, many items that were formerly included in a bank's capital calculation under Basel II, including some forms of subordinated debt, will be excluded under Basel III. Those capital instruments that will no longer qualify as "capital" under Basel III will be phased out of a bank's capital calculation over a ten-year period starting in 2013. This transition period will help those banks that do not currently possess sufficient amount and types of capital to comply with the new requirements.
In addition to increasing the quality of capital, Basel III increases the quantity of capital that banks must hold. By the time participating countries fully implement Basel III in 2019; banks are expected to maintain a total capital ratio of 10.50 per cent, an increase from the 8 per cent requirement under Basel II. As with Basel I and Basel II, banks under Basel III must maintain a minimum total capital ratio of at least 8 per cent of risk-weighted assets. However, under Basel III, after a bank has calculated its 8 per cent capital requirement, it will have to hold an additional capital conservation buffer equal to at least 2.50 per cent of its risk-weighted assets, which brings the total capital requirement to 10.50 per cent of risk-weighted assets. The purpose of the capital conservation buffer is to ensure that banks have sufficient capital levels to absorb asset losses, especially during periods of financial and economic stress.
To improve the quality of capital held by banks, Basel III also increases the amount of tier 1 capital that banks are required to hold. As mentioned above, tier 1 capital includes higher quality capital in the sense that it is comprised of items representing ownership in the bank and unencumbered sources of funds. Under Basel III, banks will be required to maintain an amount of tier 1 capital equal to at least 6 per cent of risk-weighted assets, a 2 per cent increase over the current requirement of 4 per cent. In addition, banks will also have to hold more core capital. As mentioned above, core capital is a subset of tier 1 capital that includes common equity, and thus represents the highest quality capital. Under Basel III, banks will have to hold an amount of core capital equal to at least 4.50 per cent of risk-weighted assets, whereas in the previous Basel Accords, core capital had to represent only 2 per cent of risk-weighted assets. The total amount of core capital that banks are required to hold increases to 7 per cent if one includes the capital conservation buffer, which must also be comprised of core capital.                 
To combat procyclical behaviour, Basel III will require banks to maintain a countercyclical buffer. The amount of the counter-cyclical buffer will range from 0-2.50 per cent of risk-weighted assets. The exact amount of the counter-cyclical buffer will be decided by national regulatory authorities and will generally be determined by the amount of credit in an economy, with more credit leading to a higher buffer. The purpose of the counter-cyclical buffer is to ensure that banks are sufficiently capitalised during periods of excess credit growth, which usually occurs when the perceived risk in assets is low. Thus, the counter-cyclical buffer can be viewed as an extension of the capital conservation buffer in the sense that it counteracts the trend of low capital levels during times of low risk.

Consequently, by maintaining high capital levels during "good" economic times, banks can avoid drastic measures to conserve capital during bad economic times, and thus avoid credit crunches. Assuming a counter-cyclical buffer of 2.50 per cent, Basel III could potentially require banks to maintain, at a minimum, a capital level equal to 12.50 per cent of its total risk-weighted assets.
Basel III also implements a leverage ratio, which will require banks to maintain an amount of capital that is at least equal to 3 per cent of the bank's total assets. As opposed to the risk-weighted capital ratios, which compare a bank's capital to the bank's risk-adjusted assets, Basel Ill's leverage ratio will compare a bank's capital level to its total assets, regardless of their risk level. By requiring a leverage ratio, Basel III ensures that banks maintain at least some amount of capital at all times, and thereby limits the ability of banks to engage in practices designed to evade minimum capital requirements. Thus, the leverage ratio will serve as a capital floor to ensure that banks have at least some amount of capital to protect it against unforeseen losses.
Bangladesh Bank (BB) vide BRPD Circular No. 18 dated December 21, 2014 issued "Guidelines on Risk Based Capital Adequacy (Revised Regulatory Capital Framework for banks in line with Basel III)" where BB also revised the Action Plan/Roadmap. The phase-in arrangements for Basel III implementation is as follows:
Our banking system with the phases of time shall have to build up their capacity to cope up with the Basel regulations which will ultimately put the banks into a solid capital base. This will help the banks to understand their capacity to face any financial shocks in a stress situation. Moreover, the regulator will also be able to understand the health of the bank which will prompt the regulator to take action, even choosing the path of merger against the delinquent bank.   
One of the obvious criticisms of Basel III cenres on the level of capital it requires banks to hold. Critics who say the amount is too high point to the impact it will have on lending. By requiring banks to have higher levels of capital, Basel III reduces the amount of money a bank can lend. For example, if a bank has BDTk 100 worth of capital, under Basel II it could lend up to BDTk 1250 of risk-weighted loans (BDTk 100 would be the 8 per cent minimum capital level required by Basel II). However, when Basel III is fully implemented, that same BDTk 100 of capital could now represent up to (l2.50 per cent of the bank's total risk-weighted assets, which means the bank can lend up to only BDTk 800.
Critics point out that a reduction in lending will inhibit economic growth. Banks and their ability to inject money in the economy through lending are an important component in economic growth. Therefore, by imposing lending restrictions in the form of higher capital requirements, Basel III is effectively restricting banks from doing their part in sponsoring a robust and healthy economy.
The true economic impact of Basel Ill's requirements is, of course, debatable. Given the short amount of time that has elapsed since Basel III was approved, it is obviously too early to say with any certainty what the real impact will be. However, preliminary reports have projected what this impact might be. A report produced by the Institute of International Finance (IIP) (an organisation representing banks) concluded that Basel Ill's requirements would result in a 3.10 per cent drop in a nation's Gross Domestic Product (GDP) for over 1 per cent increase in a bank's capital ratio. In contrast, a similar report produced by the Bank for International Settlements (BIS) concluded that GDP would decrease by only 0.09 per cent for every 1 per cent increase in the capital ratio requirement. While both reports agree that Basel III will have least negative impact on economic growth, they underscore the uncertainty surrounding the extent of the negative impact of Basel Ill's requirements.
Related to the economic argument is the concern raised by banks that higher capital levels will hurt bank profits. Critics argue that banks will compensate for the income lost from their reduced lending ability by increasing the interest rates they will charge on loans, thus making credit more expensive to borrowers. To accomplish this, banks will take on riskier assets regardless of the concomitant higher capital requirements. Therefore, with the higher capital requirements, not only will there be less lending, but the lending that does take place will be more expensive and riskier.
One redeeming aspect here is Basel Ill's implementation timeline, which does not call for full implementation of all of Basel Ill's requirements until 2019. Such a lengthy timeline should give banks plenty of time to adjust to higher capital requirements and allow for a gradual and orderly transition from the old capital rules to the new ones.
On the other hand, there are critics who hold the opposite view, that the capital requirements imposed by Basel III are too low to ensure a bank to absorb losses of the same magnitude as those experienced during the financial crisis. In support of their argument those calling for even higher capital requirements point out that many of the banks affected by the financial crisis, especially those in the United States, already had capital levels at or above the Basel III levels. Some studies even suggest that the necessary minimum capital ratio should be closer to 5-20 per cent, which would effectively double Basel Ill's requirements.
Maybe the biggest criticism of Basel III is what it fails to do. Many of the criticisms of Basel II go unaddressed in Basel III. For example, Basel III does not address the problems associated with Basel IPs methods of assigning risk to a bank's assets- it does nothing to change the calculation of the bank's risk-weighted assets and leaves in place the use of external rating agencies to determine risk. Nor does Basel HI do anything to harmonise the ERB approaches to prevent vastly different risk-weighting methodologies from bank to bank. Thus, while Basel III has attempted to improve the numerator of the capital ratio, it has done nothing to improve the denominator, which many would argue needed the most reform. Yet, if the criticisms already put forth are any indication, Basel III may be just one of many steps yet to come.
The writer is with Prime Bank. Views expressed here are of the writer's and not necessarily of the organisation he represents.
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