New regime for capital adequacy, liquidity and stability

After finding numerous weaknesses in the global regulatory framework and in banks' risk management practices, the regulatory authorities have focused on streamlining the global capital and liquidity rules (Basel III) with a view to improving and strengthening the banking sector's ability to absorb shocks arising from financial and economic stress. People directly or indirectly involved in the financial services industry need to be aware about the changes in the Capital and Liquidity Adequacy Requirements published in December 2010 and later in March 2013 as a supplement. The Basel Committee on Banking Supervision (BCBS) termed the new framework as Basel III: A global regulatory framework for more resilient banks and banking systems. It introduced several new or enhanced rules including introduction of a new and stricter definition of capital-designed to increase quality, consistency and transparency of the capital base-by increasing capital requirements for counterparty credit risks arising from derivatives, repurchase agreements (repos) and securities financing activities. The Basel III contains measures that address reduction of the cyclical effects of Basel II as well as the reduction of systemic risks and introduction of a global liquidity standard. The two new liquidity ratios - the short-term Liquidity Coverage Ratio (LCR) and the longer-term Net Stable Funding Ratio (NSFR)-speak of the need for banks to increase their high-quality liquid assets and obtain more stable sources of funding while requiring them to adhere to sound principles of liquidity risk management. The Basel III also imposes a new leverage ratio, a supplement to the risk-based Basel II framework.
The main aim of Basel III is to improve financial stability. Views on the causes of the financial crisis are well (and extensively) documented. Before the crisis, there was a period of excess liquidity. As a result, liquidity risks had, for many banks and supervisers, become practically invisible. When liquidity became scarce (particularly as wholesale funding dried up) as the crisis developed, banks found that they had insufficient liquidity reserves to meet their obligations. Also, banks had insufficient good quality (i.e. loss absorbing) capital. Low inflation and low returns had led investors to seek ever more risks to generate returns. This led to increased leverage and riskier financial products.
The banks had to turn to their central banks for liquidity support and some to their governments for capital injections or support in dealing with assets of uncertain value, for which there were no other buyers. Several major institutions are still dependent on state (i.e. taxpayer) support.
The Basel proposals have five main objectives:
(1) To raise the quality, quantity, consistency and transparency of the capital base to make sure that banks are in a better position to absorb losses;
(2) strengthen risk coverage of the capital framework by strengthening the capital requirements for counterparty credit risk exposures;
(3) introduce a leverage ratio as a supplementary measure to the Basel II risk-based capital;
(4) introduce a series of measures to promote the build-up of capital buffers in good times that can be drawn upon in periods of stress. Linked to this, the Committee is encouraging the accounting bodies to adopt an expected loss provisioning model to recognise losses sooner; and
(5) set a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement, underpinned by a longer-term structural liquidity ratio.
Basel II refers to guidance that was issued in July 2009 ("Revisions to Basel II market risk framework"). It included additional capital requirements for the trading book and revisions to the treatment of securitisations that came into effect on January 1, 2012. The Basel III also goes further and recommends changes to Pillar 2 (banks' internal assessment of capital requirements and supervisory review of risk management and capital assessment) and Pillar 3 (market discipline). The Committee provides additional guidance on key areas to consider as part of Pillar 2 (e.g. risk concentrations): these were expected to be implemented immediately. On Pillar 3, the Committee reiterates banks' responsibility to make sure that their disclosures to market participants evolve to keep up with changes in their risk profile. The Committee also makes detailed recommendations regarding, for example, the disclosure of traded securitisations. The following depicts the timeline of Basel phase by phase to date:

Figure: Timeline of Basel: Phase by Phase from Pre Basel to Basel Capital Accord up to Basel III
After the financial crisis of 2008-2009, the Basel Committee of Banking Supervision (BCBS) of the Bank for International Settlements (BIS) embarked on a programme of substantially revising its existing capital adequacy guidelines. The resultant capital adequacy framework is termed 'Basel III', and the G20 endorsed the new Basel III capital and liquidity requirement at their November 2010 summit in Seoul.
Basel III Regulations:
Basel III is the BCBS' comprehensive response to the 2008 financial crisis - culminating in two years of regulatory reform including Basel 2.5. It introduces a new regulatory regime for capital, liquidity and banking supervision (Moody's Analytics, 2011). The evolution from Basel I to Basel III is shown in the figure below:
 

The BCBS identified several factors that contributed to the global financial crisis. Banks were highly leveraged, held insufficient capital (specifically insufficient high-quality capital) and had inadequate liquidity buffers. The crisis was compounded by pro-cyclicality and the interconnectedness of systemically important 'too big to fail' financial institutions. Furthermore, individual banks had inadequate risk management and corporate governance processes and regulatory supervision was not strong enough. It is important to note that the Basel II doesn't go away. The Basel III just introduces enhancements to the Basel II framework. The summary of the reforms under Basel III is given in the table below highlighting the key points to consider:
 

Key enhancements:
New Capital Enhancements seek to improve both quality and availability of capital—
l At the firm level, Basel III seeks to improve the quality of capital that banks hold and make the definitions of types of capital more comprehensive.
l The amount of required regulatory capital has been increased, particularly in the trading book where increased capital allocations will be enforced for securitised and OTC derivatives products. Furthermore, counterparty risk must be taken into consideration.
l On top of this a fixed conservation buffer has been introduced. Additional Core Tier 1 capital must be accrued in boom times in order to absorb losses of the core capital if the bank is under financial or economic pressure.
New Liquidity Ratios aim to address funding needs under stress
l It is now widely acknowledged that an increased level of capital alone is not enough to prevent another crisis. Another objective of Basel III is therefore to ensure that banks have sufficient liquidity to withstand the stressed liquidity scenarios. Two ratios have been introduced to tackle this: these ratios address both short-term liquidity coverage (30 days) and longer-term structural funding.
l Meeting these new liquidity requirements will require a convergence of risk and finance systems which will be a key challenge for banks.
STRENGTHENING THE BANKING INDUSTRY : Two new ratios (the leverage ratio and countercyclical ratio) have been introduced to better monitor systemic risks. In addition, measures aimed at Systemically Important Financial Institutions (SIFIs) are being devised.
Leverage Ratio: The Committee is introducing a leverage ratio which simply measures the ratio of capital to total assets. The leverage ratio addresses the build-up of excessive leverage in the financial system. Through pro-active management, the BCBS hopes to avoid the destabilising effect of deleveraging at the time of stress. This ratio includes both on- and off-balance sheet items and securitisations. It also serves as a "safety net", to guard against any inaccuracies or unforeseen problems with risk weightings.
Countercyclical ratio: The countercyclical ratio addresses the problem of pro-cyclicality or 'credit bubbles'. With this measure, the BCBS aims to protect banking systems against the risks involved with excess credit growth, which has proven to be lethal in many jurisdictions. It is the first time the regulatory community is availing itself of a "macro tool" that complements its traditional approach of measuring risks at institutions. Unlike the conservation buffer which is fixed, the countercyclical ratio evolves within a defined range.
TIMELINE:  The Basel III has been ratified by G20 members. However, it is not clear if all of the G20 states will implement it in its entirety. It is also unlikely that all members will implement it at the same time. Other BCBS countries are supposed to implement the Basel II framework as per the BCBS timelines. The US has pledged to implement this framework, although it has not fully adopted the Basel II. We expect leading emerging markets to also adopt Basel III, as already announced by some Asian states including China. It is notable that some countries, such as the UK and Australia, started addressing these issues with local regulation in 2009 and 2010 (specifically liquidity and stress testing).
Basel III Phase - arrangements as outlined in January 2013 (All dates are as of  January 01)

 CAPITAL ENHANCEMENTS: Basel III introduces significant changes to the amount of capital banks need to hold and the quality of capital. These changes affect the risk-weighting rules for credit and market risk, the definition of the capital, and the minimum level of capital adequacy ratio itself (see blue highlights in the ratio definition below):

 The regulation increases capital requirements for counterparty credit with the objective of expanding the coverage of the capital base.
Significant changes are proposed to the composition of capital: Tier 1 capital is composed of common equity. Tier 1 ratio increases from 4 per cent to 6 per cent. Within the Tier 1 ratio, the minimum Core Tier 1 ratio increases from 2 per cent to 4.5 per cent to reflect the higher quality requirement. Tier 2 capital is harmonised and simplified, and Tier 3 capital is being abolished altogether. Including the additional conservation buffer and countercyclical buffers, regulatory capital requirements for banks rise from a minimum level of 8-10.5 per cent depending on the size of countercyclical buffer (including the countercyclical buffer it could go up to 13 per cent). The leverage ratio is an alternative measure for the risk-weighting process and aims to guard against the build-up of excessive leverage in the banking system.
According to the BCBS guidance, the requirements are to be phased in by 2019. However, the final implementation schedule is determined by national supervisers.

 BASEL III- NEW LIQUIDITY REQUIREMENTS: Basel III introduces new liquidity regulations which aim to ensure banks have sufficient liquidity over both the short and the longer term. The global financial crisis highlighted the problem that banks did not maintain sufficient levels of liquid assets. When the crisis hit, some banks were unable to meet their obligations and governments had to step in and provide liquidity support. One striking example of this was Northern Rock in the UK. To reduce the risk of this happening again, banks will now have to comply with two new ratios:
— The liquidity coverage ratio (LCR) is designed to improve banks' resilience to short-term liquidity shortages by ensuring that they have sufficient liquid reserves to cover net cash outflows over a 30-day period (i.e. to withstand an acute stress scenario lasting one month). Cash and central bank eligible securities are considered liquid reserves for this purpose.

— The Net Stable Funding Ratio (NSFR) is designed as an incentive for banks to improve the longer-term structural funding of their balance sheets, off-balance sheet exposures and capital markets activities.

 The effects of the LCR and NSFR could be significant. In its November 2010 review, McKinsey estimates that the LCR would lead to the European banking industry needing to raise approximately €1.3 trillion in liquid assets, and the effect of the NSFR would be an additional €2.3 trillion. In the US, the banking industry would see a shortfall in short-term liquidity of $800 billion, and long-term funding of $3.2 trillion.
Under the Basel Committee on Banking Supervision (BCBS) guidance, the requirements are being phased in by 2019. As always with Basel regulation, there will be significant variation in timelines across countries. The countries that have started to implement some form of the liquidity regulation are the UK, Australia, and Bahrain.
Basel III regulations will increase capital requirements and drive up capital as well as liquidity costs and thus increase pressure on banks' profitability that requires complying with requirements of these new regulations. Since banks in Bangladesh are required to follow Guidelines on Risk Based Capital Adequacy (Revised Regulatory Capital Framework for banks in line with Basel II) as per instruction of the Bangladesh Bank, each bank should be aware of the significant enhancements in Basel II requirements through implementation of Basel III. Getting prepared early with regards to the requirements of Basel III will leave the banks, especially commercial banks, with the comfort of capability to comply with the upcoming guidelines to be issued by the central bank in due course.  
Md. Kishlur Rahman ACA, ACMA is a banker.
 [email protected]