BASEL III

AN EVALUATION OF NEW BANKING REGULATIONS

Group 7
Pratik Nandi (PGP/20/283)
Purvi Jaiswal (PGP/20/285)
Anshul Singh (PGP/20/316)
Anupam Mazumdar (PGP/20/317)
Nipan Talukdar (PGP/20/335)
Riju Pathak (PGP/20/342)
Introduction
Basel Committee :

• Liquidity is a major risk for most banks worldwide

• A combined USD 2287 billion gap in liquid investments to be filled in 4 years

• 91 of the worlds biggest banks have a USD 577 capital shortfall compared to the 7% requirement for
equity tier 1 capital

• The tier 1 capital was only 5.7% for most of the 91 banks

• Banks having tier 1 capital below 7% to face restrictions on bonus, dividends, payouts etc

• Most banks issued “Contingent Convertible Bonds” to make up for capital if bank suffered losses
below its specified ratios.
Challenges in Designing International
Banking Regulations

Complexity in designing a
Increased global regulation Basel Committee does
interconnection means More restrictive not have supranational or
Over- Dependence on
bank failures in one framework might affect legal authority to
Capital adequacy ratios.
country would negatively certain countries more regulate banks of
influence another negatively than others member nations.
Past Basel Accords
Established in 2004, Based on 3 pillars.
Basel I

Basel II
Established in 1988 1st pillar:
Minimum capital ratio fixed at 8% Govt. debt from single A rated country=
Capital ratio indicates the ratio of bank’s 20%, from AAA rated country = 100%
capital to on-balance sheet risk weighted High risk assets to have weight>100%
assets. Promotes Value at Risk
Focused on credit risk 2nd pillar:
Suggested appropriate risks for different Promotes regulator intervention
types of loans
3rd pillar:
Risk weights:
Higher transparency of bank holdings
Govt. debt and cash = 0%
Disadvantage:
Loans secured by mortgages = 50%
Over reliance on external credit rating
Private sector loans = 100% agency: Non uniform ratings, Procyclicity
 BASEL III: Improving capital base
Recommends raising the quality, consistency and transparency maintaining capital ratio 7%
Seeks to improve the banking sector's ability to deal with financial stress and improve risk management
Declaration of common equity and retained earnings as predominant form of tier 1 capital
Assets included in the Tier 1 capital also must be able absorb losses
Strengths
◦ Maintaining a high quality capital base
◦ Increase in investors trust
◦ Increase in bank’s ability to absorb losses in difficult period

Weaknesses
◦ Increase in bank’s amount and cost of capital
◦ Increase in borrowing cost for retail and commercial customers
◦ Banks are allowed to operate with less capital, decrease in GDP and less number of available loss
Leverage Ratio
 Recommends supplementing risk based capital requirement of Basel II with a leverage ratio
 Leverage Ratio = High _ Quality _ Capital
Total _ Assets
 Goal is to limit bank’s leverage and to discourage rapid deleveraging that might destabilize the economy

Strengths
◦ Increase in transparency
◦ Monitoring off balance sheet leverage

Weaknesses
◦ it treats the risk of every asset and activity as exactly the same, regardless of its actual risk profile
◦ Banks focus on high risk assets if high importance to leverage ratio is given
◦ Might counteract other ratios
Measures to limit Counterparty Credit Risk
• Risk that the opposing party will fail to honor an agreement
• Basal II does not ensure enough capital by banks
SUMMARY • Basal III requires banks to include a period of economic and market stress in the model
• Apply a multiplier of 1.25 to historical observations while calculating correlation
• Zero risk weight to deals processed through exchanges and clearing houses

• Previous capital frameworks did not account for high interconnectedness of large financial
institutions
STRENGTHS • Banks counterparty exposure and correlation between financial firms’ asset values increased
• Hence banks held fewer assets from other financial institutions
• Therefore, recommendation to decrease financial institutions dependence on one another

• Unintended consequences of processing over-the-counter derivative transactions outside of

banks
WEAKNESSES • Cost of hedging the interest rate and currency risk through banks will increase
• These costs may be transferred to end user
• Business maybe transferred to unregulated institutions due to high costs
 Liquidity Ratios
SUMMARY
• Two liquidity rations recommended by committee to monitor short-term and long-term scenarios
• Short-Term – Liquidity Coverage Ratio (LCR) – ratio of high quality assets to net cash outflow over a 30 day period
• Ratio value > 100%, assets to be highly liquid and banks should demonstrate ability to remain solvent in stress scenario
• Medium to Long term metric named Net Stable Funding Ratio (NSFR), ratio should be above 100%

STRENGTHS
• LCR will ensure that banks maintain a defined level of high quality assets that can withstand problems in the short term funding
• Committee assumes 30 days will provide bank management enough time to resolve liquidity crisis
• Counteracts interconnectedness of the financial system hence liquidity problems at other financial institutions will have less influence on a bank’s ability to
remain liquid
• Sets an international minimum standard and requires more detailed analysis of each bank

WEAKNESSES
• Liquidity framework will increase the cost and decrease the availability of credit
• Mispricing of stable funding may result if banks rush to obtain stable deposits due to LCR and NSFR
• Exclusion of bank debt from high quality assets will reduce liquidity
• This could also negatively affect interbank lending market which is a major source of funding for banks
Counter cyclical capital buffers
• Committee proposes the maintenance of capital buffers during stable periods to
absorb losses during periods of stress
• Buffer range is defined above the regulatory minimum capital requirement to
1 protect against losses

• Counter cyclical buffers require banks to hold capital greater than the regulatory
minimum requirement
• The goal of counter cyclical capital buffers is to counter excessive leverage and
2 unwanted lending during expansionary period

• Supervisors can also suspend the buffer requirement during periods of stress to
increase credit supply during economic downturn
3
Strengths
The committee proposed capital
buffer as an alternative to bank tax
During financial crisis heavy losses (flat rate tax on all banks, insurance
Periods of credit expansion often
destabilized the banking sector companies and hedge funds and
precede liquidity crisis
following period of excess lending second was a tax on profits and
compensation- thus creating a
centralized capital buffer)

The capital buffer requirement Capital buffer would limit moral

would serve the same purpose as hazard and would not require
the tax (chance of increase in moral responsible banks to pay for the
hazard in case of implementation of poor management of irresponsible
taxes) banks
Weaknesses
High capital surplus will increase
capital costs- reducing bank’s
profitability

Capital accumulation will be more

difficult during the expansionary
periods

Banks may attempt to compensate

for large excess capital buffer by
increasing their risks during upturns
BASEL III Exceptions
• No legal binding
• Difficult to implement globally
Country Exclusion • Ignores practices in emerging economies
• Emerging countries -> Global Business
• Global Financial crisis !!

• Shift risk to non bank institution

Non Bank • Cost shift to clients
Financial • Hedge Fund
• More services to non bank institution
Institution • Increase in systematic risk
National Regulations
• Financial Crisis-> Dodd Frank Wall street reform
• Ending Taxpayer bailout, Monitoring Compensation
Practices , Limiting Proprietary Trading & Regulating non
bank institution United
• Consumer protection Agency
• “Volcker Rule States
• Complementary to Basel III
• Principle Based Regulatory System
• General Frameworks -> No Rules
• Choice of analytical tool -> bank
Canada • Risk Management in corporate culture
• Better performance in crisis
• Differs from BASEL III

• Debate on optimal Regulatory framework

• Terms and conditions to provide assistance to
EU
individual banks in case of crisis
• Considering All banks
 Implications
Measures to Limit
Counter-cyclical Capital
Counterparty Credit Risk-
Leverage Ratio – This will Buffers- May restrict pro
Decrease bank
limit banks’ holding too cyclical behavior and cause
interconnectedness by
much leverage wary among investors and
increasing correlations &
depositors
volatility assumptions

Liquidity Ratios- Will allow

time to mitigate individual
bank’s liquidity crisis and
decrease reliance on short
term funding
 Conclusion

• Monetary Policy of Central Banks of each country (Eg: RBI’s CRR, SLR ,Repo Rates)make it difficult to
uniformly implement Basel norms
• Exercising control on the capital, liquidity and leveraging of banks will ensure that they have to withstand
crisis
• Basel III introduces a paradigm shift in capital and liquidity standards
• It was constructed and agreed in relatively record time which leaves many elements unfinished
• The final implementation date is a LONG WAY OFF