The Minimum Capital Requirements

Published Date: 02 Nov 2017

"The objective of the reforms 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 spill over from the financial sector to the real economy." (BCBS, 2011)

In order to ensure compliance within the Eurozone, member states have decided to create an authority which supervises the implementation of Basel III. The EBA’s [2] role is to ensure proper implementation of the new requirements, a task which was previously dealt with by national regulators. This step forward was done with the aim of providing a single and harmonised picture of the requirements listed in the new Basel III framework as well as eliminating possibilities for regulatory arbitrage within the European Union member states.

Part of the EBA’s activities include the conduction of stress tests on European banks in order to ensure solvency in tough economic times and to detect as early as possible any existing weaknesses in the banks’ capital structures. Also, the authority was structured in a way that enables deep consultation and feedback with stakeholders before implementation of certain tasks.

Minimum Capital Requirements

It is vital for banks to have a good capital structure which acts as a cover for risk exposures. One of the main lessons learnt from the various crises is that it is impossible to have different definitions of capital across jurisdictions. The lack of transparency and a different understanding of what high quality capital was, made it impossible to compare and monitor the performance of financial institutions in different countries.

One important step in the right direction is that in Basel III, tier 1 and tier 2 capital have been redefined, since there previously existed certain components which were unable to absorb losses during the stress period of the recession. Also, tier 3 capital as present in the previous accord has now been eliminated because it only served for the purpose of covering market risks.

In the Basel III regulatory framework, capital is divided into two main categories:

Tier 1 Capital [3] which is composed of common equity, retained earnings and hybrid capital.

Tier 2 Capital [4] which is composed of revaluation reserves, undisclosed reserves and subordinated term debt.

The new requirements have increased the minimum of risk weighted assets [5] covered by common equity from 2% to 4.5%. But this measure alone was not seen to be enough. Therefore Basel III introduces the concept of a 2.5% Capital Conservation Buffer in order to have a total of 7% common equity. Furthermore tier 1 capital must cover 8.5% of risk weighted assets with total capital reaching 10.5%. Also the BCBS has provided national supervisory bodies with the power to introduce another 2.5% buffer, the counter-cyclical buffer, which would enable banks to build up pools of funds in good economic times in order to be able to absorb losses in periods of economic distress. Therefore total capital could be increased from the previous 8% imposed in Basel II up to 13% in Basel III.

Seeing the jump in formal capital requirements from Basel II to Basel III one starts to question to what extent can the economic systems of different countries continue to pile up pressures in the capital adequacy areas of each nation’s banks? It is true that the stricter the requirements, the safer the financial system is, however regulators must ensure the banks’ ability to meet the new and future requirements. Any move towards a Basel IV process will certainly have to think very hard in this area.

Figure 1: Capital Requirements

Leverage Ratio (LR)

Since leverage, or rather the abuse of, is considered as one of the major contributors of the financial crises, the Basel committee has made sure that this issue is properly tackled in the new regulatory framework. Many banks built up excessive leverage, and as a result in particular moments where the market forced banks to reduce their leverage levels, many institutions were then unable to cope with the market’s needs. These situations then resulted in declines in bank capital and a contraction of credit availability both to the markets themselves, and, more obviously, to the institutions’ owned by customers.

Aims of the new Leverage Ratio (LR)

Countercyclical measure:

Cyclicality can be defined as "trend". Pro-cyclicality is moving within the trend Counter-cyclicality is moving against the trend or cycle. In order to reduce pro cyclicality, supervisors can limit the build-up of leverage in a good period, by setting a ceiling on the leverage multiple. On the other hand, during economic downturns, this limit could be relaxed, since limits on the leverage ratio could increase pro cyclicality by encouraging banks to deleverage during downturns. Certainly the application of this regulatory measure will need very careful management in the light of the dividend pay-out policies of every individual institution.

Less regulatory arbitrage:

The introduction of this new leverage ratio can help in reducing regulatory arbitrage by acting as a backstop to risk based capital requirements.

Simplicity:

The committee has tried to put forward a simple and transparent ratio that is easily understood by all financial institutions and without leading to high costs. Furthermore, this ratio can be applied in any jurisdiction regardless of the capital adequacy regime used in a country. [6] Of course whilst simplicity and easy manageability is always a virtue, one must always keep an eye on the possibility of regulatory capture at some time, place, or circumstance, leading to loopholes which would be abused.

Figure 2: Calculation of Leverage Ratio

Liquidity

In accounting terms the concept of liquidity is a continuous funds flow measurement. Liquidity standards management has failed to play an important part in financial regulation for many years. Different countries enacted different liquidity measures, resulting in a situation of not having a uniform understanding of the liquidity concept. However in response to the recent crisis, two new liquidity ratios have been introduced in the new regulatory framework by the Basel Committee. These are the Liquidity Coverage Ratio and the Net Stable Funding Ratio.

Liquidity Coverage Ratio (LCR)

This ratio deals with the short-term aspect of liquidity. Financial institutions must report results at least once every month. The LCR ensures that banks have enough high quality liquid assets [7] in order to survive a 30 day stress period, where commitments increase and resources tighten. Financial institutions must be able to meet the LCR at all times.

The test in this ratio therefore involves awareness of both the quantitative extent/value of each day (and cumulatively) of the stress, and of the assets needed to match it. In a graphical representation the formula reads as per Figure 2 below.

Figure 3: Calculation of LCR

Net Stable Funding Ratio (NFSR)

The Net Stable Funding Ratio promotes long-term funding of the assets and activities of financial institutions. A minimum acceptable amount of stable funding [8] , which is a reliable source of funds over a period of one year, is established by means of this ratio.

This ratio, in conjunction with the Liquidity Coverage Ratio, acts as a minimum enforcement mechanism for reinforcing supervisory measures. The NSFR was created with the aim of limiting over-reliance on short term funding during time of restricted liquidity and encourage for a better evaluation of liquidity risk. The underlying concept here therefore is long term stability.

Figure 4: NFSR Calculation

Conclusion

The basic mechanics of the Basel III regulatory framework as have been explained here have been created with the aim of having better global risk-management in the financial system, encouraging transparency and filling the loopholes highlighted in the previous accords.

However it is also evident that certain other delicate issues do not appear to have been tackled appropriately, and therefore we have to wait in order to see whether this framework will help us in preventing future financial crises. These issues include:

Failure to properly define and identify ‘systematically important’ financial institutions.

The ‘one-size-fits-all’ approach is seen by many critics as inappropriate and a possible source for the creation of future deficiencies in the financial system.

Basel III fails to deal with the most essential regulatory problem. In essence this is that the ‘promises’ that make up any financial system are not (and probably cannot be) treated equally. Banks are still able to shift these promises around institutions by transforming risky instruments with derivatives to minimise their capital costs.

Lack of interaction between Basel III and other regulatory frameworks such as the Dodd-Frank Act [9] and the Volcker rules [10] .

The only thing that we are relatively sure about is that Basel III makes considerable improvements on the previous accord, and that it will certainly contribute to having a more resilient banking system around the globe.