Analysis of Basel III :

Third Time’s The Charm?

Group 2:
Ahsan Khawar
Fahd Iqtidar
Hafiz Shoaib
Hashim Rashid
Waqas Ahmad
Major Improvements:
 Tighter definitions of Common Equity; banks must hold
4.5% by January 2015, then a further 2.5%, totaling 7%.

 The introduction of a leverage ratio,

 A framework for counter-cyclical capital buffers,

 Measures to limit counterparty credit risk,

 Short and medium-term quantitative liquidity ratios

Objectives:
 The objective of the Basel Committee's
reform package is to improve the banking
sector's ability to absorb shocks arising from
financial and economic stress, whatever the
source, thus reducing the risk of spillover
from the financial sector to the real economy.
Capital Requirements:
 Tier 1 capital: the predominant form of Tier 1
capital must be common shares and retained
earnings
 Tier 2 capital instruments will be harmonized
with Tier 3.
 Tier 3 capital will be eliminated.
Tier 1 Capital: Detailed Overview
 Tier 1 capital: the predominant form of Tier 1 capital
is made up of common shares and retained earnings.

 Tier 1 capital is considered the more reliable form of

capital, which comprises the most junior
(subordinated) securities issued by the firm.

 These include equity and qualifying perpetual

preferred stock.
Tier 1: Capital Ratio Requirements
 The Tier 1 capital ratio is the ratio of a bank's core equity
capital to its total risk-weighted assets.

 Risk-weighted assets are the total of all assets held by the

bank which are weighted for credit risk according to a
formula determined by the Regulator (usually the country's
central bank).

 Assets like cash and coins usually have zero risk weight,
while debentures might have a risk weight of 100%.
Tier 1: Explaining the Capital Ratio
 A 10% Tier 1 capital ratio may approximate but
does not mean that a bank is holding in its vaults $1
for every $10 that a customer has in their account
balance.
Tier 1: Calculation of Capital Ratio
 Suppose, Bank has an equity of 2$ and deposits of 10$.

 It invests 9$ in loans and 3$ in securities.

 Now, assuming a risk weight of 90% for loans and 100%

for investments, we get a weighted average of 11.10$.

 Applying 10% to this we get a capital requirement of

1.10$.
Tier 2 Capital:
 Tier 2 capital is senior to Tier 1, but
subordinate to deposits and the deposit
insurer's claims. These include preferred stock
with fixed maturities and long-term debt with
minimum maturities of over five years.
Tier 3 Capital:
 Tier 3 Capital is the Tertiary capital held by banks to meet
part of their market risks, that includes a greater variety of
debt than tier 1 and tier 2 capitals.

 Tier 3 capital is used to support market risk, commodities

risk and foreign currency risk.

 To qualify as tier 3 capital, assets must be limited to 250%

of a banks tier 1 capital, be unsecured, subordinated and
have a minimum maturity of two years.
Capital Requirements of Basel III:
 BASEL II:
Tier 1 capital ratio = 4%
Core Tier 1 capital ratio = 2%

 BASEL III:
Tier 1 Capital Ratio = 6%
Core Tier 1 Capital Ratio (Common Equity after deductions) =
4.5%

 The difference between the total capital requirement of 8.0% and

the Tier 1 requirement can be met with Tier 2 capital.
Capital Requirements of Basel III:
Capital Buffers:
 Another proposal of Basel III looks towards introducing
a series of measures to promote the build up of capital
buffers in good times that can be drawn upon in periods
of stress.

 These buffers have the objective of reducing pro

cyclicality from Basel requirements.

 We will now explain two important phenomenon: Pro

cyclicality and counter cyclicality.
 Pro Cyclicality:
 In business cycle theory and finance, any economic
quantity that is positively correlated with the overall
state of the economy is said to be procyclical.

 Gross Domestic Product (GDP) is an example of a

procyclical economic indicator.

 Many stock prices are also procyclical, because they

tend to increase when the economy is growing quickly
Pro Cyclicality: Critique of Basel II
 Procyclical has a different meaning in the context of economic
policy. In this context, it refers to any aspect of economic policy
that could magnify economic or financial fluctuations.

 In particular, the financial regulations of the Basel II Accord have

been criticized for their possible procyclicality.

 The accord requires banks to increase their capital ratios when they
face greater risks. Unfortunately, this may require them to lend less
during a recession or a credit crunch, which could aggravate the
downturn
Enter: Counter Cyclicality & Basel III
 An economic or financial policy is called 'countercyclical‘ if it
works against the cyclical tendencies in the economy.

 Using Countercyclical capital buffers, banks increase their capital

in good times, not bad. And then, in bad times, they disappear.

 Regulators can abolish the buffers immediately, if there’s some

kind of credit crisis. When write-downs eat into bank capital, they
eat only into the buffer, which is no longer required, rather than the
underlying minimum capital requirement.
Capital Buffer Requirements:
 BASEL II:
There is no Countercyclical Capital Buffer

 BASEL III:
A countercyclical buffer within a range of 0% – 2.5% of common
equity or other fully loss absorbing capital will be implemented
according to national circumstances.

Banks that have a capital ratio that is less than 2.5%, will face
restrictions on payouts of dividends, share buybacks and bonuses.
Leverage Ratio:
 Basel III introduces a new form of regulation, The
leverage ratio. Its objectives are to:

 Put a floor under the build-up of leverage in the banking

sector.

 Introduce additional safeguards against model risk and

measurement error by supplementing the risk based measure
with a simpler measure that is based on gross exposures.
Impacts of Basel III :
 WHY is it Important?
The recent financial crisis proved:
1. Capital levels that large international banks operated with were insufficient, in
times of financial distress.
2. Reserve Capital lacked quality.
Basel III would result in:
3. Tightened definition of common equity
4. Limitation of what qualifies as Tier 1 capital
5. Market discipline through new disclosure requirements
6. Identification of inter-linkages and common exposures among all financial
institutions
7. Systematic capital surcharge for systematically important financial institutions
Negative Impacts of Basel III:
1. Regulatory authorities can underestimate the riskiness of
sovereign debt on banks balance sheet

2. Reduction in credit
 Decreased availability and increased borrowing cost
 Fewer borrowers have access to funding
 Significantly more onerous conditions
 Higher unemployment

3. Banks not meeting the ratio requirements cannot pay out

dividends, bonuses, share buybacks
 Raise investor concerns over dividends
Negative Impacts of Basel III:
4. Banks may have to come up sizeable amounts of:
 New equity
 Retained earnings, or
 Dispose of assets
to meet the new capital ratios.

5. Restrict lending for exports in economies where export credit is financed by

banks but guaranteed by governments
 Basel III doesn’t take into account the importance of export credit guarantees
 Competitiveness of systems with export guarantees might collapse
 Can result in governments removing private banks from the equation
Impacts of the Leverage Ratio:
 Since excessive leverage was evidently a contributory factor
to the stress experienced by the banking sector since 2007,
the introduction of a consistent leverage ratio measure could
usefully complement risk-adjusted regulatory capital metrics
and help to identify outliers.

 The effectiveness of the Basel III proposal will crucially

depend on the final definition of the leverage ratio.
 If poorly calibrated, it could lead to outcomes that might be
seen as undesirable from a broader perspective, such as a
reduction in liquidity in the repo market as banks reduce their
portfolios to manage the leverage ratio calculation.
Dealing With Regulatory
Arbitrage
Outline…
 What is regulatory arbitrage and what is wrong
with it?
 Two regulatory principles.
 Techniques for dealing with arbitrage.
 Is unified supervision the answer?
Regulatory Arbitrage
Definition:
“Regulatory arbitrage means exploiting the gap between
the economic substance of a transaction and its legal or
regulatory treatment, taking advantage of the system’s
intrinsically limited ability to attach formal labels that
track the economics of transactions with sufficient
precision”
Frontiers of Regulatory Arbitrage
 Among financial products and techniques through
innovation.
 Among financial markets
 Among jurisdictions
 Flying beneath regulatory radar
 1 Frontier: Financial Innovation
st

Case:
 Sub prime Mortgages and SPVs
2 Frontier: Among Financial Markets
nd

Case:
 Banks indulging in securities offering business by
registering with Federal Bank bypassing SEC,
getting benefit of ease and speed.
3 Frontier: Among Jurisdictions
rd

 Favorable tax regulation in Luxemburg and Ireland

has attracted a lot of financial business to these
places.
 Corporate governance regulation may also be a
reason for regime switching.
4 Frontier: Flying Beneath Radar
th

 Hedge Funds Case:

Earn higher return due to lack of regulatory
requirements

 Reinsurance Firms Case

 What’s Wrong With Regulatory
Arbitrage?
 Financial conglomerates able to “game” the system
and avoid proper oversight.

 Regulators encouraged to compete – may allow

regulation to be weakened in a search for “clients.”
 PROS: Regulatory Arbitrage
 Regulatory arbitrage activities of market participants contribute
to an efficient allocation of capital and thus to an efficient
financial services industry;
 Regulatory arbitrage may mitigate or eliminate the impact of
market distorting regulation;
 It keeps regulators watchful with respect to Achieving and
maintaining a level playing field;
 It provides consumers with ample choice on the risk return
continuum of financial products and services.
 CONS: Regulatory Arbitrage
 Regulatory arbitrage may undermine adequate capital
coverage in financial markets

 It may increase information a-symmetries which may

frustrate market competition

 The leaking of transactions to less regulated

 Unregulated markets may dry up market liquidity in

regulated markets.
 TWO Regulatory Principles
 Prudential regulation should differ between types
of firm to the extent that they engage in different
activities and incur different risks.

 Consumer regulation should ensure an equivalent

level of consumer protection irrespective of the
entity which offers the product.
 Prudential Regulation
 Reducing the scope for regulatory arbitrage requires proper
consolidated supervision.

 All firms in a conglomerate group should have same

reporting date and be audited by single firm of accountants.

 Need for a “lead” regulator to co-ordinate and produce group-

wide risk assessment.
 Consumer Regulation
 Basic Principle: Same Product = Same Disclosure standards
irrespective of product provider

 Product Regulation:
 A collective savings scheme should have same disclosure
requirements whether offered by bank or insurance company.
 Securities regulator regulates the sales practices of all
collective investment schemes irrespective of which firm offers
them.
Objectives Of Unified Regulation
 Supervision of financial conglomerates.
 Regulatory efficiency.
 Regulatory flexibility.
 Developing a body of professional staff.
 Eliminating arbitrage opportunities.
 Structure of Regulation
 Prudential regulation must be based on institutions.
 Arbitrage opportunities are reduced by proper
consolidated supervision.

 Consumer regulation may be based either by

product or by institution.
 Product regulation reduces arbitrage opportunities.
 Structure of Regulation
 If prudential regulation is institutionally-based and consumer
regulation is product-based some firms will have more than
one regulator.

 This requires close coordination and cooperation between

regulators.

 Could lead to firms complaining about their regulatory

burden.
 Unified Supervision
 Putting all regulation inside a single organization is a
way of dealing with Co-ordination Problems

 Can provide firm with single Point of Contact

 But within the unified regulator the distinctions

between institutional v product and prudential v
consumer regulation will remain
US Bill 2010: DODD Bill
 Large Hedge fund regulation
 Consumer Protection Beaureu

 Oversight of bank holding companies to

evaluate risk
 Eliminate regulatory arbitrage opportunities
Basel III and Regulatory Arbitrage
 One more time, Basel III looks like a Menu Approach, and
countries will be able to do more or less, sooner or later.

 The national interpretation of Basel III will become the law,

which is going to be different from country to country.
Basel III and Regulatory Arbitrage
 The “Flexible" Countries plan to retain or attract
foreign direct investments. They know that hedge
fund managers like "regulator shopping". They try to
find the friendliest regime to do business.  
Basel III and Regulatory Arbitrage
 The “Non-Flexible" countries would
complain that a general easing of regulations
is a "race to the bottom". And, they continue
to lose money, jobs, investments.
Basel Accord and Arbitrage:
 By providing at least three alternative capital
calculation methods, Basel II creates differences that
do not exist in Basel I at least in short run
 Q uestions ?
Q ?
uestions Q ?
uestions Q ?
uestions Q ?
uestions