basel accords faq.pdf

8/14/2019 Basel Accords FAQ.pdf

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THE BASEL CAPITAL ACCORDS

BY JOE LARSON

APRIL 2011

I. Introduction

Banks are a vital part of a nations economy. In their traditional role as financia l

intermediaries, banks serve to meet the demand of those who need funding. As such, banks make

it possible for people to buy homes and for businesses to expand. Banks therefore facilitate

spending and investment, which fuel growth in the economy. However, despite their important

role in the economy, banks are nevertheless susceptible to failure. Banks, like any other business,

can go bankrupt. However, unlike most other businesses, the failure of banks, especially very

large ones, can have far-reaching implications. As we saw during the Great Depression and, most

recently, during the global financial crisis and the ensuing recession, the health of the bank

system (or lack thereof) can trigger economic calamities affecting millions of people.

Consequently, it is imperative that banks operate in a safe and sound manner to avoid failure.

One way to ensure this is for governments to provide diligent regulation of banks. Yet, with the

advent of globalization, banking activities are no longer confined to the borders of any individual

country. With cross-border banking activities rapidly increasing, the need for international

cooperation in bank regulation has likewise increased.

Ready to meet this need is the Basel Committee on Bank Supervision (BCBS). In its role

as the international advisory authority on bank regulation, the BCBS has promulgated guidance

on issues critical to ensuring health in the banking systems across the world. One such issue, and

one that played an important role in the recent global financial crisis, is the regulation of bank

capital. Addressing this issue has been an ongoing process for the BCBS over the past twenty


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years, and has resulted in the promulgation of capital adequacy standards that national regulators

can implement. These standards are known collectively as the Basel Accords, named after the

city in Switzerland where the BCBS resides. The Basel Accords have caused disagreement at

times, but they are nevertheless important to the formulation of regulatory policy relating to bank

capital. In all, the BCBS has produced three such accords. Basel III, published in 2010, is the

most recent Accord. Each Accord has purported to improve upon the previous one, but early

indications suggest that Basel III is not flawless and so it will likely not be the last Accord.

This FAQ will attempt to provide an overview of the Basel Accords and the process that

has led to Basel III. In doing so, it will limit its focus to those aspects of the Accords that directlyaddress the determination of a banks capital adequacy vis--vis the level of the credit risk (i.e.

the risk of asset loss) in the bank. Part II of the FAQ will describe regulatory capital, which

forms the basis of the Accords, and why it is important to the safety and soundness of the banks.

Part III will provide background information to better understand the origin of the Basel

Accords, including a brief description of the Basel Committee on Bank Supervision, the entity

that promulgated the Accords, as well as the developments that led to its decision to address

international capital regulation. Part IV will then describe Basel I and its shortcomings. Part V

will first describe how Basel II addressed the faults in Basel I. Part V will also discuss the faults

in Basel II itself, including those exposed by the global financial crisis. Part VI will discuss the

features of Basel III and some early critiques of it. Part VII will provide some concluding

remarks.


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II. Importance of Regulating Bank Capital

At the heart of all the Basel Accords is the issue of regulating bank capital or, more

accurately, developing rules to ensure that banks maintain sufficient levels of capital. Thus,

before one can fully understand the capital accords, one must first understand the concept of

capital.

As with any business, a bank has a balance sheet that is comprised of assets, liabilities,

and equity. Bank s fund their assets through a combination of their liabilities and equity. A banks

liabilities represent that banks de bt and traditionally consist of deposits of money from people

who entrust the bank to hold onto their money and return it when asked to do so. On the otherside of the balance sheet are a banks assets that, for the most part, consist of loans to its

customers, from which the bank derives income in the form of interest charged to the borrowers.

Obviously, there are more items that can be included in a banks liabilities and assets, but

deposits and loans are the most common examples.

If the total value of a banks assets exceeds that banks liabilities, the amount of that

difference is referred to generally as the banks capital. Therefore, a banks capital represents

the amount of assets not funded by debt. It follows then that if the banks liabilities e xceed a

banks assets, a bank is negatively capitalized. When this situation occurs, a bank owes more to

its debtors than it can provide from its assets and is thus insolvent. As one can see, it is therefore

important that a bank maintain a positive capital position to ensure the bank is able to repay its

liabilities.

Besides preventing insolvency, capital is especially important to a bank for a couple of

other reasons. First, it protects against the risk of loss that is inherent in banks assets. Tr aditional

banks are in the business of loaning money to people with the expectation that those people will


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repay that amount, plus interest. However, when banks make loans, there is always the risk that

the bank may not be repaid. Even the most creditworthy borrower can have an unlucky

experience that prevents repayment of a loan. If such an event occurs, and the borrower defaults,

the bank has lost money that it owes to its own creditors, the depositors at that bank, and must

therefore rely on its capital to pay those depositors.

The second reason why capital is important is to protect against the volatility in a banks

liabilities. Banks fund much of their assets through customer deposits. However, such deposits

are a risky source of funding because depositors can generally demand that the bank repay them

at any time. If depositors withdraw large amounts of money within a short timeframe, the bankcould find itself paying such withdrawals with its capital because most of a banks assets, such as

loans, cannot be liquidated quickly. If the withdrawals are large enough, the bank may exhaust

its capital and find itself insolvent.

In the recent global financial crisis, the risk of insolvency was an important issue

confronting several important banks in the United States. Because of the importance of these

banks, their failure would have posed systemic risk to the financial system and were thus

considered too big to fail. As a result, the government had to intervene and inject capital into

these banks in order to prevent the collapse of the entire financial system.

The role of capital in preserving a safe and sound banking system cannot be overstated.

By maintaining sufficient amounts of capital, banks are able to ensure that they are capable of

meeting their obligations to their creditors. Likewise, having sufficient amounts of capital will

instill depositors and other bank creditors with confidence that the bank will be able to repay

them, even if some of the banks assets default.


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III. Basel Committee on Bank Supervision (BCBS)

Up until the 1970s, bank regulation lacked, for the most part, international reach. Nations

were left to decide for themselves how to best regulate the banks that did business within their

borders. This all changed in 1974 when the Herstatt Bank in Germany failed. At the time Herstatt

Bank failed, there were several unsettled international transactions between Herstatt Bank and

American banks, where the American banks had already paid Herstatt Bank deutschmarks, but

the American banks had not received the dollars owed to them in return. Before the transactions

could settle and the American banks could receive the dollars owed to them, Hertstatt Bank

failed, causing significant losses for its American counterparties.The Herstatt incident highlighted the significant risks that accompany international

banking, and exposed the need for coherent international cooperation between nations to

minimize future risks associated with international banking. In response to the Herstatt incident,

the member nations of the G-10 (a group of countries with the ten largest economies in the

world) established the Basel Committee on Bank Supervision (BCBS) in 1974. Initially

comprised of the head of the central banks (or equivalent) of each member of the G-10, the

membership of the Committee subsequently expanded to include representatives of 27 countries.

The BCBS works under the auspices of the Bank for International Settlements (BIS). The BIS is

an intergovernmental organization owned and operated by the central banks of numerous

countries across the world and is responsible for fostering international cooperation on monetary

and financial policy. The BIS also serves as a central bank to the central banks of its members.

As its name suggests, the Basel Committee on Bank Supervision focuses its work on

matters relating to bank supervision and regulation. The BCBS serves as a forum for its members

to discuss issues and problems relating to bank regulation. In the course of these discussions, if


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the members of the BCBS come to a common understanding or agreement on an issue, the

BCBS will issue supervisory guidance and standards relating to that issue. However, the

issuances of the BCBS are only advisory in nature and are not binding on the members of the

BCBS or any other nation. As a matter of best practice, though, the members of the BCBS, as

well as many non-members, usually adopt the recommendations of the BCBS in whole or in part.

Thus, the promulgations of the BCBS form a type of soft law.

As the work of BCBS proceeded through the 1970s and 1980s, it was becoming

increasingly apparent to the Committee that one of the issues it needed to address was that of

capital regulation. As the preceding section explained, the level of capital maintained by a bankis an important aspect of that banks safety and soundness. However, for a variety of reasons,

bank regulators across the world had diverse standards relating to capital regulation, with some

nations lacking enforceable capital standards.

With international banking and business growing at an increasing rate, the members of

the BCBS wanted to confront the issue of capital regulation at an international level to ensure

that those who banked internationally would be protected by the fact that banks across the world

were subject to some common degree of capital requirements. Indeed, by the mid 1980s, some of

the largest and most internationally active banks took advantage of the lax capital regulation by

holding extremely low levels of capital. However, not every nation at this time maintained a lax

regime for regulating capital. The U.S., for example, implemented relatively strict capital

requirements in the early 1980s. By doing so, though, nations like the United States were putting

their banks at a competitive disadvantage vis--vis the banks in other countries that maintained

more lax regulatory regimes.


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A lax regulatory capital regime creates a competitive advantage for banks because lower

capital requirements allow banks to lend more, which results in more interest income and, thus,

higher profits. For example, compare two banks governed by two different capital standards,

where Bank A is required to hold an amount of capital equal to 2% of its assets, and Bank B is

required to hold an amount of capital equal to 8% of its assets. If Bank A has $100 worth of

capital, Bank A can lend up to $5,000. For Bank B however, that same $100 worth of capital

only allows it to lend up to $1,250. As one can see, the higher capital requirement puts Bank B at

a competitive disadvantage.

With the foregoing considerations in mind, the BCBS set out to promulgate standards thatwould harmonize the regulation of bank capital across the world, with the intent of 1) creating a

safer banking environment, and 2) leveling the competitive positions of banks in different

countries. The culmi nation of the BCBS efforts in this regard result ed in the promulgation of an

accord entitled International Convergence of Capital Measurement and Capital Standards,

which has since become known as the Basel I Capital Accord, or simply Basel I.

IV. Basel I

Basel I was finalized and approved by the BCBS in 1988. Again, because the BCBS has

no binding legal authority, countries had the option to adopt Basel Is standards. Many BCBS

member countries, as well as many non-member countries, did adopt Basel I however, and

thereby incorporated its features in their own domestic regulatory law. Since the BCBS work

focused on banking at the international level, it intended that Basel I would be applied only to

internationally active banks. However, many countries ultimately applied Basel Is requirements

to all banks.


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that the bank has accumulated and disclosed. Because these items arise from ownership in the

bank, they have the lowest priority of repayment in the event of insolvency, and therefore

represent the highest quality capital. As mentioned above, for a bank to be considered

sufficiently capitalized under Basel I, it had to maintain a capital ratio of 8%. However, Basel I

also required that half of this 8% consist of tier 1 capital (i.e., tier 1 must equal at least 4% of the

banks risk -weighted assets).

Tier 2 capital is considered less reliable and is comprised of items such as subordinated

debt and reserves held for loan-losses. Subordinated debt is debt (e.g., bonds) issued by the bank

that the bank need not pay back until it has paid all its other creditors. Thus, the debt that the bank owes to these creditors is subordinate to the debt it owes to other creditors. Therefore, a

bank can use the proceeds it obtained through the issuance of subordinated debt to pay its other

liabilities, including the deposits it owes to its customers. As one can see, tier 2 capital is clearly

of lower quality than tier 1. Whereas tier 1 consists primarily of unencumbered equity in the

bank, tier 2 is permitted to include debt held by the bank. The fact that these lower quality items

were allowed to be included in the definition of capital at all reflects the fact that there were

banks in the countries of some of the BCBS members that were not sufficiently capitalized with

owners equity, but instead had to rely, at least partial ly, on debt. Recognizing the lower quality

of tier 2 capital, Basel I limited the amount of tier 2 capita l that could be included in the banks

capital to 100% of tier 1 capital.

As noted above, the purpose of bank capital is to provide a cushion against losses in the

banks assets. Therefore, in the process of drafting Basel I, the BCBS took a risk-based approach

to developing the capital adequacy guidelines. The BCBS wanted to incorporate the idea that the

required level of capital should be proportionate to not only the quantity of assets held by a bank,


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but also to the risk of loss inherent in those assets. In other words, riskier assets (i.e., those that

have a higher chance of default, or loss) should be offset by a higher amount capital.

This idea of risk- sensitivity was incorporated in the denominator of Basel Is capital

adequacy ratio. Instead of using a capital ratio that compared a banks capital to the total face

value of its assets, Basel I used a ratio that would compare a banks capital to th e value of the

banks assets after they had been adjusted for their risk of loss or default. The resulting total was

called the banks risk -weighted assets (RWA). To do this, Basel I established four risk categories

or buckets (0%, 20%, 50%, and 100%) into which each of the bank s assets would be placed.

Which category an asset fell into determined how much of that assets value would be includedin the banks RWA. Riskier assets were placed in higher -percentage brackets, which meant that

more of that ass ets value was included in a banks RWA total, which, in turn, meant that a

banks capital requirement w ould increase.

An assets assignment into a risk class was predetermined by the Basel I guidelines. The

BCBS established these guidelines based on the perceived risk associated with the counterparty

involved in the transaction underlying the asset (e.g., the borrower of a loan). For example,

holding cash poses no risk of loss to the bank. Therefore, the Basel I guidelines placed all cash in

the 0% risk category, which meant that the bank would not have to include the value of its cash

in its total risk-weighted assets (i.e., the denominator of the capital adequacy ratio). Likewise,

according to Basel I, a loan made to a government that is a member of the Organization for

Economic Cooperation and Development (OECD), such as the United States, was perceived as

low-risk, and therefore would be placed in the 0% risk category. Conversely, Basel I considered

assets such as commercial loans (i.e., loans made to businesses) to be high-risk and, therefore,

included them in the 100% risk category. This means that 100% of the value of all commercial


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loans would be included in the denominator of the capital adequacy ratio. Below is a chart that

provides examples of the types of assets that were placed in each risk category:

Risk-Weight Category Types of Assets Included in the Risk Category

0% Cash; assets involving the governments ofOECD countries20% Assets involving banks located in OECD

countries; cash items in the process ofcollection

50% Loans secured by mortgages on residential property

100% Assets involving businesses; personalconsumer loans; assets involving non-OECDgovernments (unless the transaction isdenominated and funded in the same currency)

Basel Is methodology to determine capital adequacy also incorporate d a process to take

into account the risk posed by a banks off -balance sheet items. As the term suggests, off-balance

sheet items are those items held by the bank, but that do not appear on that banks balance sheet.

The determination of whether an item belongs on- or off-balance sheet can sometimes be

complex. However, in general, an off-balance sheet item, whether it be an asset or liability, is

one that that the banks claim to has not ma terialized completely. For example, when a bank

extends a home equity line of credit to a customer, any unused portion of that line of credit is

considered an off-balance asset to the bank. The reason for this is that, although a line of credit is

a type of loan, and therefore is like an asset, the bank cannot derive benefit from any unused

portion of it because there is no balance from which the bank can earn interest. Thus, off-balance

sheet assets can be thought of as contingent on-balance sheet assets that remain off-balance sheet

until an event occurs (e.g., a borrower draws on a line of credit) that gives the bank the right to

the benefit of that asset.


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performance over a longer period of time. In other words, the more likely an item will be called

and the greater the risk that the banks customer would be unable to repay the bank, the higher

the conversion factor.

Once the conversion factor was applied to an off-balance sheet asset, the discounted

value of the off-balance sheet asset was treated like any other on-balance sheet asset and placed

in the appropriate risk category. This step resulted in the risk-adjusted value of the off-balance

sheet item, which was then included in the total value of the banks risk -weighted assets.

Once all of the banks on - and off-balance sheet assets were adjusted for risk, the values

were added up. The resulting sum of this calculation equaled the banks risk -weighted assets,which represented the denominator in the banks capital adequacy ratio. As mentioned above, the

bank must then ensure that value of its total capital levels (tier 1 + tier 2) are equal to at least 8%

of the banks risk -weighted assets, with tier 1 capital equaling at least 4% of risk-weighted

assets.

B. Criticisms of Basel I

As Basel I was the first coherent international attempt at regulating bank capital, it may

come as no surprise that Basel I was the target of many criticisms. One of the main criticisms of

Basel I pertains to its risk-weighting system. In particular, critics saw Basel Is bucket approach

to risk-weighting assets as arbitrary, overly broad, and not nearly sensitive enough to the unique

risks associated with each asset held by a bank. Within each bucket, there are assets with very

different levels of risk, but because they all share a common type of counterparty (e.g.,

businesses, governments, etc.), they are assumed to possess the same type of risk.

The flaw in Basel Is approach to risk -weighting assets can be seen when one applies it to

the example of commercial loans. Under Basel I, all types of commercial loans are 100% risk-


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mounted, the members of the BCBS decided that reform was in order. After several years of

negotiations and consultations, the BCBS released a set of revisions to Basel I, entitled

International Convergence of Capital Measurement and C apital Standards: A Revised

Framework, also known as Basel II.

V. Basel II

The BCBS organized Basel II around what it called the Three Pillar approach. For

purposes of this FAQ, however, attention will primarily be given to Pillar I, which is the Pillar

that most directly addresses the issue of calculating capital adequacy, and is also the Pillar that

specifically attempts to correct the deficiencies identified in Basel I. Pillars II and III, which dealwith supervisory review standards and market discipline issues, respectively, while important

aspects of capital regulation, do not have a direct bearing on the calculation of bank capital

adequacy, and therefore are outside the scope of this FAQ.

A. Features of Basel II and How they Addressed Basel I Faults

Before exploring Pillar I in depth, it is worthwhile to note what portions of Basel I that

Basel II did not change. Basel II still requires that a banks total capital equal at least 8% of the

banks risk -weighted assets. It also still assesses banks capital adequacy using the same capital

adequacy ratio, which is equal to a banks capital divided by the banks risk -weighted assets.

Basel II did not alter Basel Is definition of capital, i.e. , the numerator of the ratio. However, as

will be seen below, Basel II, or more specifically, Pillar I, does alter how a bank arrives at the

denominator, i.e. the calculation for risk-weighted assets.

As mentioned above, Pillar I addresses the way in which banks calculate their risk-

weighted assets. Pillar I was specifically designed to redress the deficiencies identified in Basel I.

As such, Pillar I focuses primarily on reforming the method of measuring credit risk, i.e. , the risk


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inherent in the banks assets. The goal of these reforms is to ensure that the calculation of risk in

a banks assets more accurately reflects the actual risk in those assets, which should reduce the

opportunity for banks to engage in regulatory arbitrage, which was one of the major problems

with Basel I.

Pillar Is approach to measurin g credit risk actually consists of three approaches: the

Standardized Approach, the Foundation Internal Ratings-Based Approach (FIRB), and the

Advanced Internal Ratings-Based Approach (AIRB). Thus, Basel II offers a menu of options to

determine the credit risk in banks.

The standardized approach is the least complex of the three approaches and most similarto Basel Is approach. The standardized approach retains the use of risk buckets to determine an

assets risk -adjusted value. However, Basel IIs standa rdized approach to risk-weighting is

different from Basel Is approach in a couple of ways.

First, Basel IIs standardized approach expand s the number of risk buckets from four to

six. In addition to the 0%, 20%, 50%, and 100% risk categories used under Basel I, the

standardized approach also includes a 150% risk category, as well as a 35% risk bucket

specifically reserved for residential loans secured by mortgages.

The next difference between Basel I and the standardized approach is the process to

determine in which bucket an asset is placed. As mentioned above, under Basel I, assets were

placed in risk buckets based on the generic identity of the counterparty involved (e.g., an OECD

country, business, etc.). Recognizing that no two assets bear identical risk profiles , Basel IIs

standardized approach attempts to make the risk-weighting determination based on the unique

risk associated with each of the banks asset s. To achieve this, Basel IIs standardized approach

utilizes credit-rating agencies, such as Standard & Poors and Moodys. Accordingly, under the


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standardized approach, assets are placed into risk buckets based on the credit rating assigned to

the counterparty involved in that asset, with higher rated counterparties assigned to lower risk

buckets . For example, under the standardized approachs guidelines, if a commercial borrower

receives a AAA rating from Standard & Poors, that loan would be placed in the 20% risk

bucket. Contrast this result with Basel I, where all such commercial loans, regardless of the

credit-worthiness of the borrower, were placed in the 100% risk bucket. In the event that a

borrower is not rated by a credit agency, Basel IIs standardized approach automatically place s

that loan in the 100% risk bucket. The standardized approach makes an exception to the credit

rating method for residential loans, which automatically receive a risk weight of 35%.Under the standardized approach, the risk-weighting an asset receives depends not only

that assets credit rating, but also on whether that asset represents a claim on a sovereign national

government. Reflecting the belief that government assets pose less risk, the standardized

approach places government assets with a given credit rating in a lower risk category than if that

asset is a claim on a private party, even if the credit rating is the same. As an example, an asset

involving a AAA-rated government ( using Standard & Poors methodology) would be risk -

weighted at 0%, whereas a loan involving a AAA-rated business would be risk-weighted at 20%.

Below is a table that provides examples of the risk-weightings received by assets as

determined by their credit ratings (using Standard & Poors ratings scale) and whether they

represent claims on governments or private counterparties. The table excludes the 35% risk

category because that category is reserved exclusively for loans secured by mortgages on

residences and such assets are automatically included in that category regardless of the

borrowers credit rating.


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Credit Rating (S&P) Government Risk-Weighting Private Counterparty Risk-weighting

AAA to AA- 0% 20%

A+ to A- 20% 50%

BBB+ to BB- 50% 100%

Below BB- 150% 150%

Unrated 100% 100%

The standardized approach is the simplest method in Pillar I to calculate credit risk, and is

therefore more suitable for smaller banks. The two remaining approaches, the Foundation

Internal Ratings-Based (FIRB) approach and the Advanced Internal Ratings-Based (AIRB)

approach, are suited more for larger and more sophisticated banks. The main difference between

the standardized approach and the two IRB approaches is that with the latter two approaches,

banks can use their own internal methodology to determine the risk level of their assets, whereas

with the standardized approach, banks must rely on the external ratings guidelines to risk-weight

their assets. Because of the sophisticated nature of the IRB approaches, if banks wish to use

them, they must demonstrate their technical ability to implement them and also receive approval

from their regulators.

To understand the methodology underlying the IRB approaches, one must first

understand the concept of unexpected losses. In essence, within the IRB framework, unexpected

losses theoretically approximate a banks credit risk, and therefore determine how much capital a

bank must maintain. Unexpected losses estimate losses in a banks assets that are not

foreseeable. Losses in a banks assets are a normal part of the banking business, and banks, for

the most part, can anticipate and prepare for those expected future losses by looking at historical


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loss rates. However, there are instances where a bank incurs losses greater than usual. These

above-average loss levels are a banks unexpected losses. Since expected losses are, by

definition, expected, banks often set aside reserves (called loan-loss reserves) to absorb those

losses. Therefore, it is those unexpected losses that a ban ks capital levels are meant to cushion.

To arrive at a banks estimate of unexpected losses, four inputs are used, all of which are

common to both the FIRB and AIRB approaches. The first of these inputs is the probability of

default. As its name implies, this factor provides an estimate of the probability, over the course

of a year, that a given borrower will default on his or her loan.

The next input is the loss given default (LGD). This input provides an estimate of amountthe bank stands to lose if a given borrower defaults. This estimate can be thought of as the banks

net loss, since banks are usually able to recover some amount from the borrower.

The third input is the exposure at default (EAD). This input represents the additional

amount that a ba nk could lose at the time of a borrowers default. An example would be the

unused portion of any credit line available to a defaulting borrower, where the borrower still has

the ability to draw on the line, thereby creating additional assets for the bank that can also go into

default.

The final input is the maturity of the asset (i.e., the duration of the loan). The longer the

duration of a loan, the greater the chance that something will go wrong with the borrower that

causes default. Therefore, an asset with a longer maturity will, holding other factors constant,

lead to a higher risk weighting for that asset.

Once each of these inputs is determined for each of the banks assets, they are injected

into complex mathematical models (the details of which are beyond the scope of this FAQ)


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which, in turn, arrive at an estimate of the banks unexpected losses (i.e. , its credit risk). Banks

must ensure that they have capital equal to at least 8% of this amount.

The primary difference between the FIRB approach and the AIRB approach is who

determines the values associated with each of the inputs. Under the FIRB approach, a bank is

allowed to calculate the PD for each asset, while the banks regulator will determine the LGD

and EAD. With regard to the M input, the banks regulator has the discretion to assign an

estimated maturity for each asset or allow the bank to use its own calculation. Under the AIRB

approach, however, a bank is allowed to calculate the values for all four (PD, LGD, EAD, and

M) of the inputs. If a bank is allowed to use either IRB approach, its methodology and outputsmust be reviewed and verified by its regulators.

As one can see, with either IRB approach, Basel II gives banks at least some degree of

autonomy to devise the method to estimate their level of credit risk. Regardless of how a bank

constructs its model to determine the credit risk associated with each asset in its portfolio, the

output of its calculation will be used to determine the extent to which the value of that asset will

be included in th e banks risk -weighted assets.

B. Critique of Basel II

Just as with Basel I, Basel II experienced its own share of criticisms. First, relating to the

standardized a pproach, many questioned the use of rating agencies to determine an assets risk.

Since the rating agencies are paid by those they are supposed to rate, concerns arose regarding

the reliability and objectivity of the ratings they provided. Maybe the clearest example of the

flaws in the credit agency rating model was its failure to consider and protect against the trend of

securitization that occurred before and during the global financial crisis.


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Under Basel IIs standardized approach, all exposures (e.g., investment in securitized

products) to securitization held by a bank would be assigned a risk weight. However, the risk-

weighting assigned to a securitized position depends on the external credit rating assigned to it.

Thus, credit rating agencies play an important role in determining the amount of capital held by

the banks in relation to the risks they face due to securitization. Unfortunately, as the subprime

credit crisis illustrated, many credit agencies gave securitized products inaccurately high ratings,

the reason for which was two-fold. First, many rating agencies relied on faulty rating

methodology to assess risks associated with securitization. Second, as mentioned above, because

the rating agencies were being paid by the rated parties, conflicts of interest arose whichimpaired the ability of rating agencies to provide objective ratings. Consequently, because the

perceived risk of securitized exposures was low, as indicated by the high credit ratings, banks

were required to hold less capital, which left them undercapitalized relative to the real risk level

inherent in their exposures to securitized products. As a result, when the underlying assets

(particularly the subprime assets) of the securitized products defaulted, banks had too little

capital to absorb the losses they incurred as a result of their exposure to those securitized assets.

Another concern relating to the standardized approach is the lack of a uniform rating

system. Basel II does not specify which rating agency a bank must use, so banks can employ

various rating agencies (e.g. S&P, Moodys, etc.), each of which employs their own unique

methodology to assign ratings, which means the consistency of credit risk assessments across

banks could suffer. Critics also point out that the standardized approach does an inadequate job

of differentiating risk among unrated borrowers, where it simply assigns such borrowers a 100%

risk rating. Thus, in this situation, the standardized approach is a victim of the same criticisms


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banks that devised the methodologies. If this is the case, the IRB approaches amount to nothing

more than the banks regulating themselves.

Another shortcoming of the IRB approaches is their tendency to promote procyclical

bank behavior. In short, Basel IIs regulatory structure ha s the effect of inducing banks to

maintain lower amounts of capital during good economic times, which forces them to take

economically harmful action in bad times to maintain sufficient capital. During good economic

times, borrowers are generally in a better position to repay their debt obligations. The IRB

models used by banks would reflect this fact, which would result in lower estimates of risk in the

banks assets. Accordingly, the banks IRB models would require the banks to hold less capital.However, during times of economic hardship, such as the crisis of 2008-2009, when credit risk

was at its greatest, the IRB approaches would reflect the higher risk levels, which would drive up

the banks RWA total, th ereby raising the banks capital requirement. Consequently, banks

would have to take action to compensate for the periods when it held low levels of capital. To do

so, banks would be forced to improve their capital ratio by lending less. This phenomenon, called

a credit crunch, exacerbates the severity of the economic crisis, because when banks lend less,

less money is injected into the economy, which inhibits economic growth, and thus delays

recovery. During the recent global financial crisis, this exact phenomenon occurred, where banks

holding low-quality assets, such as sub-prime loans, were forced to reduce lending to prevent

their capital ratio from becoming too small.

The faults in Basel II were beginning to become apparent to the members of BCBS well

before the start of the global financial crisis erupted. When the crisis began, talks on how to

improve Basel II were already under way. However, the severity of the crisis made it clear that


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Basels faults needed to be addressed sooner rather than later. In the fall of 2010, after much

debate and negotiation, the BCBS released the latest installment of the Basel accords.

VI. Basel III

The BCBS promulgated Basel III in September of 2010. Formally titled, A Global

Regulatory Framework for More Resilient Banks and Banking Systems , Basel III reflects the

BCBS attempts to apply lessons learned from the financial crisis and apply them to the existing

framework of banking regulation. Thus, Basel III does not replace Basel II, but rather augments

it. The primary goal of Basel III is to improve the ability of banks to absorb asset losses without

affecting the rest of the economy. In terms of capital regulation, as will be seen below, Basel IIIfocuses mainly on the quantity and quality of capital held by banks.

A. Features of Basel III

Among the most important parts of Basel III is its new definition of regulatory capital,

which is more restrictive and emphasizes greater quality. Basel III retains the tier 1 and tier 2

distinction, but limits their composition to higher-quality capital that is better able to absorb

losses. Under Basel III, Tier 1 capital must be mostly of core capital, which consists of equity

stock and retained earnings. In addition, many items th at were formerly included in a banks

capital calculation under Basel II, including some forms of subordinated debt, will be excluded

under Basel III. Those capital instruments that will no longer qualify as capital under Basel III

will be phased out of a banks capital calculation over a ten-year period starting in 2013. This

transition period will help those banks that do not currently possess the sufficient amount and

types of capital comply with the new requirements.

In addition to increasing the quality of capital, Basel III increases the quantity of capital

that banks must hold. By the time participating countries fully implement Basel III in 2019,


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regulatory authorities and will generally be determined by the amount of credit in an economy,

with more credit leading to a higher buffer. The purpose of the counter-cyclical buffer is to

ensure that banks are sufficiently capitalized during periods of excess credit growth, which

usually occur when the perceived risk in assets is low. Thus, the counter-cyclical buffer can be

viewed as an extension of the capital conservation buffer in the sense that it counteracts the trend

of low capital levels during times of low risk. Consequently, by maintaining high capital levels

dur ing good economic times, banks can avoid drastic measures to conserve capital during bad

economic times, and thus avoid credit crunches. Assuming a counter-cyclical buffer of 2.5%,

Basel III could potentially require banks to maintain, at a minimum, a capital level equal to 13%of its total risk-weighted assets.

When it issued Basel III, the BCBS also indicated that it would work with the Financial

Stability Board (FSB) to implement even higher capital requirements, in addition to those

mentioned above, for large and systemically important banks. The specific details of these higher

capital requirements had not yet been developed at the time Basel IIIs release, but the BCBS

stated that they would most likely consist of a combination of capital surcharges, contingent

capital, and/or bail-in debt. Like the BCBS, the FSB is another international standard-setting

organization comprised of financial regulatory authorities from numerous nations. However,

unlike the BCBS, the FSB advises nations on the regulation of all aspects of the financial sector,

not just the banking sector.

Basel III also implements a leverage ratio, which will require banks to maintain an

amount of capital that is at least equal to 3% of the banks total assets. As opposed to the risk-

weighted capital ratios, which compare a banks capital to the banks risk -adjusted assets, Basel

IIIs leverage ratio will compare a banks capital level to its total assets, regardless of their risk


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level. By requiring a leverage ratio, Basel III ensures that banks maintain at least some amount of

capital at all times, and thereby limits the ability of banks to engage in practices designed to

evade minimum capital requirements. Thus, the leverage ratio will serve as a capital floor to

ensure that banks have at least some amount of capital to protect it against unforeseen losses.

B. Critique of Basel III

The Basel III has been in its finalized form only since September of 2010, so it is too

early to tell whether it will be effective in practice. Nevertheless, critics have already begun to

voice their opinions on Basel III.

One of the obvious criticisms of Basel III surrounds the level of capital it requires banksto hold. Critics who say the amount is too high point to the impact it will have on lending. By

requiring banks to have higher levels of capital, Basel III reduces the amount of money a bank

can lend. For example, if a bank has $100 worth of capital, under Basel II it could lend up to

$1250 of risk-weighted loans ($100 would be the 8% minimum capital level required by Basel

II). However, when Basel III is fully implemented, that same $100 of capital could now represent

up to 13% of the banks total risk -weighted assets, which means the bank can lend up to only

$770.

Critics point out that a reduction in lending will inhibit economic growth. Banks, and

their ability to inject money in the economy through lending, are an important component in

economic growth. Therefore, by imposing lending restrictions in the form of higher capital

requirements, Basel III is effectively restricting banks from doing their part in sponsoring a

robust and healthy economy.

The true economic impact of Basel IIIs requirements is, of course, debatable. Given the

short amount of time that has elapsed since Basel III was approved, it is obviously too early to


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tell with any certainty what the real impact will be. However, preliminary reports have projected

what this impact might be. A report produced by the Institute of International Finance (IIF) (an

organization representing banks) concluded that Basel IIIs requirements would result in a 3.1%

drop in a nations gross domestic product (GDP) for every 1% increase in a banks capital ratio.

In contrast, a similar report produced by the Bank for International Settlements (BIS) concluded

that GDP would decrease by only 0.09% for every 1% increase in the capital ratio requirement.

While both reports agree that Basel III will have at least some negative impact on economic

growth, the different outcomes of these reports underscore the uncertainty surrounding the extent

of the negative impact of Basel IIIs requirements. Related to the economic argument is the concern raised by banks that higher capital

levels will hurt bank profits. Critics argue that banks will compensate for the income lost from

their reduced lending ability by increasing the interest rates they will charge on loans, thus

making credit more expensive to borrowers. To accomplish this, banks will take on riskier assets

regardless of the concomitant higher capital requirements. Therefore, with the higher capital

requirements, not only will there be less lending, but the lending that does take place will be

more expensive and riskier.

Alleviating the concerns that the increased capital requirements will hurt the economy

and reduce profits is Basel IIIs implementation timeline, which does not call for full

implementation of all of Basel IIIs requirements until 2019. Such a lengthy time line should give

banks plenty of time to adjust to higher capital requirements and allow for a gradual and orderly

transition from the old capital rules to the new ones. Indeed, even the IIF, in the report mentioned

above, admitted that the lengthy timeline for implementation resulted in a less critical appraisal

of Basel III.


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On the other hand, there are critics who hold the opposite view, that the capital

requirements imposed by Basel III are too low to ensure a bank can absorb losses of the same

magnitude as those experienced during the financial crisis. In support of their argument, those

calling for even higher capital requirements point out that many of the banks affected by the

financial crisis, especially those in the United States, already had capital levels at or above the

Basel III levels. Some studies even suggest that the necessary minimum capital ratio should be

closer to 15%- 20%, which would effectively double Basel IIIs requirements.

Maybe the biggest criticism of Basel III is what it fails to do. Many of the criticisms of

Basel II go unaddressed in Basel III. For example, Basel III does not address the problemsassociated with Basel IIs methods of assigning risk to a banks assets it does nothing to

change the calculation of the banks risk -weighted assets and leaves in place the use of external

rating agencies to determine risk. Nor does Basel III do anything to harmonize the IRB

approaches to prevent vastly different risk-weighting methodologies from bank to bank. Thus,

while Basel III has attempted to improve the numerator of the capital ratio, it has done nothing to

improve the denominator, which many would argue was what needed the most reform.

VII. Conclusion

The international regime for bank regulation has evolved considerably since the BCBS

was established in 1974. Yet, as the global financial crisis made clear, after the first two Basel

Accords, there is still room for improvement in the regulation of bank capital. While its too

early to tell with any certainty, Basel III seems to be a step in the right direction. Yet, if the

criticisms already put forth are any indication, Basel III may be just one of many steps yet to

come.


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