Background

On 12 September 2010, the Group of Central Bank Governors and Heads of Supervision (Governors) – the oversight body of the Basel Committee on Banking Supervision (Committee) released the much anticipated next generation of global banking rules – the Basel III Accords (Basel III). These rules are designed to protect the world economy from the next financial crisis by targeting the most critical element of the world's banking system – capital adequacy.

The Committee's release of the Basel III framework on 12 September 2010 (the Release), together with its release on the global liquidity standard reform on 26 July 2010, will be presented to the G20 summit for approval, which is scheduled to be held in Seoul, South Korea in November 2010.

Increased Minimum Capital Requirements

Risk-based measures

The key capital requirements under Basel III are summarised as follows:

  1.  Common Equity Risk-Based Capital

Common equity consists of common equity and other qualifying instruments, which is considered the highest form of loss absorbing capital.

 

The minimum requirement for the common equity risk-based capital will be increased from 2% of risk-weighted assets (RWAs) to 4.5% of RWAs. However, when combined with the capital conservation buffer (described below), the resulting common equity requirement under Basel III, will be about 7% of RWAs.  

  1.  Tier 1 Risk-Based Capital

The minimum tier 1 capital requirement will increase from 4% of RWAs to 6% of RWAs under Basel III. When combined with the conservation buffer, the resulting tier 1 capital requirement under Basel III will be 8.5% of RWAs.  

  1.  Total Risk-Based Capital

The minimum total capital under Basel III remains unchanged at 8% of RWAs. However, when combined with the capital conservation buffer, the resulting total risk-based capital will be 10.5% of RWAs.  

  1.  Capital Conservation Buffer

The capital conservation buffer is designed to ensure that the banks maintain a capital cushion which is above the minimum capital requirements described in paragraphs (a), (b) and (c) above. This buffer provides banks with an extra source of capital to draw on during times of financial stress.

 

The capital conservation buffer will be at 2.5% of RWAs and must consist of common equity. Although the banks are allowed to draw on this buffer during periods of stress, the more of the buffer that is drawn on by a bank (i.e. as the buffer is depleted), the greater the restrictions will be imposed on it in respect of earnings distributions such as dividends and discretionary employee bonuses.

 

Therefore, banks are likely, as a practical matter, to target levels of capital that exceed not just the minimum capital requirements, but treating the capital conservation buffer as mandatory.  

  1.  Counter Cyclical Capital Buffer

In addition to the capital conservation buffer described above, the Basel III framework also contemplates a countercyclical capital buffer, which will be implemented in accordance with national circumstances. This buffer can be drawn on by the banks during periods of excess credit growth which potentially results in a build-up of systemic risk. The details of circumstances upon which this buffer may be triggered are still subject to negotiations. The buffer will cover a range of 0% to 2.5% of RWAs, which will consist of common equity "or other fully loss absorbing capital".  

Non-risk-based leverage ratio

The risk-based capital measures described above are further supplemented by a non-risk-based leverage ratio which serves as a backdrop to those risk-based measures described above. The leverage ratio is a ratio of gross loans and investment to capital. The Committee has set the minimum tier 1 leverage ratio to be tentatively at 3% of RWAs. The appropriateness of the 3% will be assessed during a parallel run period from 2013 – 2017, which means that the leverage ratio requirement will not be finally determined until 2018.

Transitional Periods

It was noted in the Release that since the onset of the global financial crisis of late 2008, there are banks which will need to raise a significant amount of additional capital to meet the higher capital requirements under Basel III. In order to ensure that those banks can meet the higher capital requirements through reasonable earnings retention and capital raising, while at the same time continue leading to the economy, the Release includes a detailed schedule of transitional arrangements over generous transitional periods (please refer to Annexure 2 of the Release: www.bis.org/press/p100912.htm).

These transitional arrangements provide that most of the new capital requirements will be gradually phased in from the beginning of 2013 over the next 6 years. The banks are expected to fully comply with the new capital requirements as of 1 January 2019.

BaseI III implications on the Australian banks

Once the Committee has finalised the Basel III capital and liquidity package at the G-20 summit in November 2010, the next focus of Basel III will shift to the critical phase of national implementation. One can imagine that the path towards implementation may be difficult for those banks which need to raise a substantial amount of capital in order to meet the new capital rules (notably some European banks in Germany and Spain). Australian banks, on the other hand, have already satisfied the new capital rules. The Australian Prudential Regulation Authority has always run a more conservative capital regime than the regulators in some other member countries. Moreover, the Australian banks raised considerable amount of new capital in late 2008 and 2009 to strengthen their capital levels. This means that there are no real concerns for the Australian banks to raise additional capital to achieve the new rules under Basel III.

How effective will the new rules be?

The new capital rules under Basel III are widely viewed as the strictest global banking rules ever proposed by a global financial regulator and certainly reduce the probability of a systemic failure of the banking system like the global financial crisis of late 2008. It should be borne in mind that even well capitalised financial institution may still be at risk of failure in a financial crisis. As showed in the 2008 crisis, for example, Standard and Poor's estimated just days before Lehman Brother's collapse that it had a tier 1 capital ratio of 11%.

Moreover, the rules do not resolve the moral hazard problem that the systemically important banks are too big or too interconnected to fail. The Release therefore provides that the Committee will require the systemically important banks to have loss absorbing capacity beyond the minimum capital requirements and maintain additional capital which may include "combinations of capital surcharges, contingent capital and bail-in debt". The extent of these additional capital requirements are still subject to further negotiations but some of the affected banks have already raised concerns that the combination of the new minimum capital requirements and the additional capital requirements applicable to them will have a significantly adverse impact on their competiveness, business models and profitability.

Basel III rules certainly are not the guarantee to save the banks from the next financial crisis of excess credit growth and over-optimism. Strong and sophisticated regulators are expected to continue monitoring and supervising the risk of individual institution as well as the overall financial system.