Basel 3

Introduction

In the later part of the last decade the financial world witnessed severe turmoil due to the contagion effect of the US subprime crisis and many banks in US and Europe either went bankrupt or were on the verge of bankruptcy. Several big banks had to be rescued by providing high bailout packages by the Government. The burden of the bailout package was borne by the common man as the money came from the tax payers. While the recovery had just began, that the world was hit by another imbalance in the Eurozone. A seventeen member nations zone, the Eurozone was pegged to a single currency with the aim to facilitate trade and capital flow. However in addition to the capital, the weakness in any of the nations propagated too. More and more banks came on verge of a failure. And as we write, the policies are being carved out to revive banks and economies eventually from defaulting. However the question here is, Why did the banks in the U.S and Europe fail despite proclaiming adherence to Basel II norms prescribed by the Basel Committee for Banking Supervision(BCBS). In fact just five days before the bankruptcy of Lehman Brothers in September 2008, it had boasted Tier 1 capital of 11%, three times more than the regulatory minimum. This raised questions about the efficiency of Basel II norms.

Short Comings of Basel II

* Capital requirement ratio of 4% proved to be inadequate to withstand huge losses.

* The capital requirement was 'pro cyclical' i.e. if the global economy expands and assets prices rise the country and the counter party risk associated with the borrower tend to decrease and thus capital requirement is lowered; however in the event of recession, the reverse is also true thus raising capital requirement.

* Securitisation, a way of financing a pool of assets which involves transferring them to a third party conduit, was incentivised by Basel 2. This enabled banks to reduce their capital requirement, take on growing risks and increase their leverage.

These short comings called for more stringent regulatory process. As a result Basel Committee on Banking Supervision (BCBS) addressed these problems by introduction of new enhanced regulatory framework known as Basel 3.

Basel 3: Overview

The key elements of the proposed Basel III guidelines include the following:

* Definition of capital made more stringent, capital buffers introduced and Loss absorptive capacity of Tier 1 and Tier 2 capital.

* Forward looking provisioning prescribed.

* Modifications made in counterparty credit risk weights.

* New parameter of leverage ratio introduced.

* Global liquidity standard prescribed.

Capital requirements of Basel 3

1 Minimum Capital requirement

Under Basel 3 the total capital bank is required to hold is 8% of its risk weighted assets. Total capital includes

Tier 1 Capital

Tier I capital is core capital; this includes equity capital and disclosed reserves. It is used to absorb losses on going concern basis. Basel 3 norms require the ratio of capital to risk weighted assets to increase from 2% to 4.5%.

Tier 2 Capital

Tier II capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt, and more.

Capital Conservation Buffer

Basel 3 introduces 2.5% capital conservation buffer to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred.

Counter Cyclical capital buffer

Basel 3 introduces counter cyclical capital buffer ranging from 0 to 2.5% of bank's risk weighted assets to take care of the risks that are built up in the banking system due to excessive credit growth.

Leverage Ratio

The leverage ratio is the ratio of a bank's equity to the unweighted sum of its total assets

Leverage Ratio= Tier I Capital/Exposure

Leverage Ratio should be at least 3%.It is designed to put a cap on buildup of leverage as well as to introduce additional safeguards against financial risks

Numerator includes Tier 1 capital i.e. Common equity tier 1 and additional Tier 1 Capital.

Denominator is exposure which includes on balance sheet exposures, no netting of collateral, no netting