basel iii - a consideration of the probable effectiveness of basel iii, as compared to previous...

Basel IIIA consideration of the probable effectiveness of the “Basel III” Act,

as compared to previous capital requirements, with special reference to the Globally Systematically Important Banks and their

impact on Europe’s economy

Submitted by: Andrea Ventimiglia – S00700822Supervised by: Peter Thomas

Degree: Global Business and Financial Management

November 25th 2016

Word Count: 8700

A consideration of the probable effectiveness of the “Basel III” Act, as compared to previous capital requirements, with special reference to the Globally Systematically Important Banks and their impact on Europe’s economy

Dedication

I would like to dedicate this artefact to my father, who has always supported my personal interest towards the financial markets. Having my father as a supportive role through out my three years spent in specializing in financial management, has meant a lot to me, providing me with guidance and wisdom which he personally cultivated through out his career as a wealth manager, which started forty years ago. With his philosophy of life, my father has always taught me to never stop pursuing my own dreams and ambitions, holding the notion that the stakes can always be raised higher, according to the level of passion and determination each individual is driven by. This dissertation reflects this idea of overcoming big challenges, as it treats a topic which has not been part of my pathway degree, in fact my fascination for the banking system had only recently flourished into my mind, as I started becoming conscious of the numerous changes regarding banking regulation and the global banking system as a whole.

For a young man, who wishes to enter the world of financial markets and investment banking, it is important to express personal interest towards the topic, and given my overall experience in learning in detail the mechanisms, theories and global issues inherent in todays financial system, I aimed in raising my understanding, pushing my self to know more about correlated topics such as global banking. Based on this idea I find it very important for an aspiring investment banker to acknowledge the current changes that are affecting the financial industry today, so that further argumentation and research can be provided and shared. Additionally, I have chosen this specific topic in order to extend my understanding of the macro-economic environment we live in today, in the attempt to one day express my knowledge by putting it into practice within a investment banking career.

Thank you.

Andrea Ventimiglia DIS6A12


Abstract

After the catastrophic effects of the global financial crisis, the banking system along with the financial system have both been subject to major changes in terms of regulation. The consequences of the crisis sent entire economies and markets into turmoil, hammering the profitability of all global banks, thus the global economy as a whole.

This research paper will consider the probable effectiveness of the Basel III Act, as compared to previous capital requirements (Basel II), with special reference to the Globally Systematically Important Banks (GSIBs) and their impact on Europe’s economy. A qualitative approach to the study has been applied, and data processing is supported by quantitative methods in terms of analysing the evolvement of Europe’s economy, and the performance of major GSIBs by using online platforms with updated statistics. The literature provided has been mainly sourced using textbooks within the university’s library, and online research has been conducted to source the real documents representing Basel III, published by the Banking Commission of Banking Supervision. The Banking of International Settlements, insists on regulating banks in Europe, causing many economists and financial pioneers discussing that with Basel III, the recovery of the global economy, especially the one in Europe will be slowed down and contracted as a consequence of this capital accord implemented after the recession. This dissertation analyses all the reforms set in play by Basel III, and considers all of its possible effects on Europe’s economy, thus focusing on the



changing set of reforms present within the banking system as a whole. The findings generated from this research highlight Europe’s slow recovery from the recession suffered after the crisis, showing low levels of real GDP growth, but also showing the correlated effects on banking system. GSIBs within Europe are very dependent on the regional economic growth, thus the research expects to perceive a even slower and less performing environment for banks, supporting the notion that with Basel III being implemented, the European GSIB’s are now facing a much tighter and more challenging economic environment in order to promote their core activities.

Terms and definitions

BCBS (Basel Committee of Banking Supervision): an establishment settled by the G-10 in 1974, controlled by the central bank governors. This institution aims to improve supervisory guidelines imposed by central banks on the wholesale and retail banks. BCBS designs today’s banking policy framework for authorities to later implement within their countries. The BCBS has now more than twenty-seven member states, including the G-20

BIS (Bank for International Settlements): this international financial institution pursues the objective of global financial stability, by facilitating the interactions among central banks, and providing them with exclusive services. The institution was established in 1930 in Basel Switzerland. It holds consistent meetings treating monetary policies and fiscal reforms fostering monetary and financial corporations, and acting as a bank for the central governments.



Derivatives: are securities that hold a price that is dependent upon one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset. Its value is determined by the fluctuations in the underlying asset. Derivatives traded over the counter are not regulated, whilst derivatives traded in exchange are subject to regulation. (Molyneux, 2015)

G-20: formed in 1999, this political body is constituted by finance ministers and central bank governors representing nineteen countries (Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Republic of Korea, Mexico, Russia, Saudi Arabia, South Africa, Turkey, United Kingdom, United States) and the European Union. This political forum discusses key issues regarding the global economy, in which it aims to promote economic growth and development around the world.

Guarantees: are non cancellable liability bonds which are backed up by an insurer so that investors are guaranteed principal and interest payments. The guarantee provides investors with an additional level of comfort that the investment will be repaid in the event that the securities issuer would not be able to fulfill the contractual obligation to make timely payments. (Casu, 2015)

Macro Prudential: A method of economic analysis that evaluates the health, soundness and vulnerabilities of a financial system. It looks at the health of the financial institutions in the economy and performs stress tests and scenario analysis to help determine the system's sensitivity to economic shocks, thus allowing the calculation of bank credit losses. (BIS, 2013)

Leverage: the use of various financial instruments or borrowed capital, utilized in order to increase the potential return on the investment.

Operational Risk: the risk that banks and companies withhold when attempting to operate within a specific industry. This risk factor is referred as


http://www.investopedia.com/terms/a/asset.asp


systemic risk, and is generated by the performance of the internal procedures conducted by the people, but also the level of accuracy of the bank its self. (Casu, 2016)

Off balance sheet: business operations conducted by banks that do not involve deposits or the booking of any asset. This term is also reference as incognito leverage within the banking system, since they are not displayed on bank’s balance sheets (Casu, 2015)

OTC: other the counter is the treatment of any kind of security which is traded within a context, apart from the American Stock Exchange. These can be securities that are traded through the use of a network or institution rather than an exchange. OTC refers to debt securities and financial instruments such as derivatives. (Molyneux, 2015)

Market Risk: the risk the investor faces when experiencing losses generated by the overall performance of financial markets. This specific risk can’t be mitigated through the use of diversification, however it can be hedged against, as a form of protection on the investment.

Moral Hazard: a phenomenon within the banking system, which occurs when an agreement affects one party to behave against the interest of other parties. (Casu, 2015)

Table of Contents 1.0 Introduction………………………………………………………………………………

..8



1.1 Aims and Objectives………………………………………………………………….9

1.2 Dissertation Process………………………………………………………………….9

2.0 Literature Review………………………………………………………………………102.1 Universal

Banking……………………………………………………………………102.2 Credit

Risk…………………………………………………………………………..102.3 Exposure Default, Loss Given Default, Probability of

Default……………………...112.4 Stress Testing and Credit Risk

Models……………………………………………...122.5 Capital Requirements, Tier-1 & Tier-2

…………………………………………….142.6 Risk Weighted

Assets……………………………………………………………….152.7 Correlation Coefficient

Indicator…………………………………………………...15

3.0 Methodology……………………………………………………………………………...163.1 Theoretical Framework: The Efficient Market Hypothesis (EMH)

…………………163.2 Research Process…………………………………………………………………...16 3.2.1 Qualitative and Quantitative Methods……………………………………….17 3.2.2 Primary and Secondary Data………………………………………………...18



3.2.3 Validity and Reliability………………………………………………………..19 3.2.4 Limitations…………………………………………………………………...20

4.0 Presentation of Findings………………………………………………………………..214.1 Basel III………………………………………………………………………………

214.1.1 Raising Capital

Requirements……………………………………………….214.1.2 Strengthening Credit Risk

Coverage………………………………………..234.1.3 Leverage

Ratio………………………………………………………………244.1.4 Capital

Buffers………………………………………………………………254.1.5 Liquidity Standards, Liquidity Cover Ratio and Net Stable

Funding Ratio…274.2 Data Analysis of Europe’s

GSIBs……………………………………………………294.2.1 Return on Equity

…………………………………………………………....304.2.2 Revenue……………………………………………………………………..

314.2.3 Credit

Provisions……………………………………………………………324.3 Macro Economic Environment in

Europe…………………………………………..334.3.1 House Hold Savings in

Europe……………………………………………...334.3.2 Real GDP Growth in

Europe……………………………………………….34Andrea Ventimiglia DIS6A18


4.3.3 Correlation between ROE and Real GDP Growth in Europe……………...35

5.0 Conclusion………………………………………………………………………………...36

6.0 Appendix …………………………………………………………………………………39Table 1.0 Phase in arrangements 2013- 2019 of Basel III………………………………....39

Table 2.0 Phase in arrangements of completed post-crisis reforms……………………...40

Table 3.0 Basel III, The three pillar phase approach………………………………………41

Table 4.0 Asset category for Required Stable Funding Factors…………………………...42

Table 5.0 Presentation of Findings of GSIBs in the EU……………………………………43

Table 5.1 Real GDP Growth in Europe’s individual countries……………………………..44

7.0 Annex……………………………………………………………………………………...45

Official Regent’s University of London Document: Application for Ethical Approval for Proposed Research……………………………………………………………………….....45



1.0 Introduction

This research focuses on identifying the possible effectiveness of the new regulatory framework implemented by the Basel Committee of Banking Supervision during 2013. The Basel III Act, aims to secure the banking industry in order to give the correct guidelines for a global economic recovery to flourish in a controllable fashion. The scope of the research process will be analysing the effectiveness of the reforms exemplified by Basel III, and its potential catalyst effect in stimulating driving forces within the macro-economic environment. Special references will be made to the European economy, explaining in detail the full effects of the newly updated capital requirements, compared to its previous ones endorsed back in 2005 with the implementation of Basel II. For these reasons, the research question addresses the following enquiry:

A consideration of the probable effectiveness of the “Basel III” Act, as compared to previous capital requirements with special reference to the Globally Systematically Important Bank’s and their impact on Europe’s economy?

The nature of this research focuses on solving the problem that generated during the global financial crisis of 2007. Systemic risk was blamed as one of



the main issues that caused the global recession to be so damaging and contagious. Given this scenario, for the first time in modern history the banking industry was being put into question, and the idea of trusting banks in managing individual’s or a family’s savings, started to become a moral hazard belief within the consciousness of the consumer. To restore trust between the banking industry and the consumers within the economy, new reforms had to be designed and implemented, addressing issues towards the banking system’s culture, and its relationship with reforms focusing on capital adequacy.

The author’s personal rationale behind this research question is stimulated by the intrinsic will of understanding in full depth the new reforms affecting the banking industry, given its popular use in the modern world, combined to the author’s personal interest in engaging this business sector, for a hypothetical career within it.

1.1 Aims and Objectives

The two main objectives that this research questions aims in achieving by the end section of this academic paper are the following:

i) Has credit risk been mitigated and safeguarded properly within GSIB’s capital structures?

ii) What are the possible effects on the whole economy in Europe, since Basel III’s implementation?

1.2 Dissertation Structure

This dissertation will follow a straight and linear process, in which the main topics reviewed will initially be explained and treated within the literature



review, then moving on to explaining the methodology and different approaches used in order to collect, process and analyse sources of primary and secondary data. Following this part, the individual reforms and credit absorption tools will be described in full detail explaining how each feature will affect the capital structures of the GSIBs.

In addition to the qualitative analysis of the content expressed in Basel Act III, a presentation of findings concerning bank performance vs macro-economic indicators will be exhibited. The last two sections will instead address a correlated analysis of these two realms measured in the presentation of findings, hopefully addressing a firm conclusion on which to deduct a possible economic analysis of Europe along, with the financial health status of the selected GSIBs.

2.0 Literature Review:

2.1 Universal Banking: Source: Modern Banking, P.19

Universal banking is a specific system of commerce that can only be adopted by banks which have big enough capital structures, and large enough reserves in order to offer investors the full range of banking and financial services, together with other non-banking and non-financial services. Institutions that can handle this practice have been named Globally Systemically Important



Banks (GSIB) by the Basel Committee of Banking Supervision. GSIB’s have been fully affected by the new regulatory framework imposed by the Basel Committee, limiting profits and growth over the last eight years. However, with the implementation of Basel III these selected banks can now operate within a safer environment, allowing access to the following services for any private or corporate client:

Credit lines, Loans, Deposits, Asset management, Investment advisory, Payment processing , Insurances, Securities transaction, Stockbroking, Underwriting, Financial Analysis, Mergers and Acquisitions (Heffernan, S. 2006)1

2.2 Credit Risk: Source: Introduction to Global Banking p.329-331

According to the Basel Committee on Banking Supervision (2000), credit risk can be defined as the “the potential risk that a bank borrower or counterparty will fail to meet its obligations in accordance with the agreed terms”2. This category of risk is a central aspect that has always been present within traditional lending activities. In simpler words credit risk is described as the risk of a loan not being repaid, or partially repaid. Other events linked to credit risk can be the holding of bonds and other securities by part of the counterparty. In a reality where banks have to offer a diversified spectrum of financial instruments such as guarantees and derivative products, again; credit risk becomes an inherent concern. However, this specific category of risk is also known as counter-party risk. Counter-party risk is defined as the risk associated with the deterioration in the counter-party’s creditworthiness as a “migration” risk that becomes effectively a “downgrading” risk, in the case where a rating agency that issued the public credit rating, subsequently downgraded that specific security (Resti and Sironi 2010). Counter-party risk thus affects the exposure of both parties within the trade, making it essential for bank officials and managers to consider strongly the 1 Heffernan, S. (2006) Modern Banking. West Sussex, United Kingdom: John Wiley & Sons, Ltd, p.19 22 Casu, B. (2015) Introduction to Global Banking. Edinburgh Gate, United Kingdom: Pearson p.329



counter-party’s risk when evaluating financial contracts. Bank managers should have the correct judgement whilst investigating the borrower’s ability to meet his/her obligations in depth, before and after having issued a contract. In addition to minimizing the bank’s exposure to credit risk, managers should be able to mitigate credit losses by developing portfolios that consist of loans and securities where the degree of credit risk is diversified. Counterparty-risk can also be referred as: default risk (Investopedia 2016), and is therefore present in most financial instruments such as: foreign exchange transactions, financial futures, swaps, bonds, equities and options. 2.3 Exposure Default, Loss-Given Default, Probability of Default:

Source: Modern Banking p.192-219

Exposure at default (EAD) is the total value that a bank is exposed to, at the time of a loan’s default, caused by a debtor who completely fails to meets his/her obligations, due to lack of liquidity. Exposure at default, along with loss given default (LGD) and probability of default (PD), are all risk factors that are simultaneously used in order to calculate the overall credit risk. All three factors function as elements that banks must identify and quantify in order to calculate the formula for Expected Loss (EL), (bis.org 2016).

Expected Loss=EAD×LGD× PD

Loss given default (LGD) is the amount of capital a bank looses when a borrower defaults on any given outstanding debt. There are ways to calculate this distribution, and most GSIB’s prefer to do this by comparing actual total losses to the total amount of potential exposure sustained at the time, when a loan or any other security, goes into default. Therefore, in order to calculate LGD, the banks themselves have to first review their entire loan portfolio, and by doing this they must use cumulative losses and exposures for the calculation in order to determine LGD.



Probability of Default (PD) is the third component needed to calculate expected loss (EL), meaning; the chances that a company or individual will be unable to meet the required payments stated on their obligation date. This risk factor allows the borrower admittance to a credit extension or credit line. PD is assigned directly to each individual loan, based on the creditworthiness of the debtor and the intrinsic risk characteristics of the financial instrument issued. This is done by accessing and reviewing past-due loans and analysing how they have behaved in specific market stress scenarios (Investopedia 2016).

2.4 Stress Testing and Credit Risk Models: Source: Credit Risk Management: Measurements in and out of the Financial Crisis p.208-228

Since the implementation of Basel II in 2005, internal bank regulators have been challenged with the goal of improving stress test models in order to quantify and qualify a bank’s exposure to credit risk. Various models have been developed since 2005, and yet the accuracy of their results don’t seem to satisfy the Basel Committee supervisors. Stress tests have the function of evaluating the bank’s capability to meet the adequate capital requirements so that they can under go and survive a severe 30-day or 2-year market scenario. The outcome of these models predict the credit losses and the estimated amount of revenue and cash reserves needed to cover the bank’s losses, thus replicating the scenario of a crisis or a recession such as the 2007 financial crisis.

“Many observers, however, have argued that back-testing over 250 days is simply not enough, given the high standard errors that are likely to occur if the period is not representative of true market conditions” (Allen, L. 2010)3

According to Allen, L, back testing is an incorrect approach when undertaking a credit stress test, and that a retrospective analysis can not in any way estimate future market scenarios. This critique on back testing models can be supported

33 Allen, L. (2010) Credit Banking: Measurement in and out of the Financial Crisis. New Jersey, U.S, Wiley Finance p.208



by literature theories such as the “efficient market hypothesis” theory, developed by Maurice Kendall, and his “random walk” theory. According to these theories, financial instrument prices reflect the available information regarding the instrument. The change in price is affected according to the new information released to the public domain, information that can either affect the value to go down or up. If we consider a short / medium term horizon, Kendall would agree in suggesting that a “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts” (Malkiel, B. 1973)4

The problem with back-testing then, is that even if banks are given a wide-ranging sample of observations to be tested, the actual individual data will be subject to substantial error in classification, such as the categorization of bank loans and their capability of going into default. According to Carey and Hrycay (2001), there are three ways to predict the expected loss distribution for a portfolio containing only classified loans. These are the following:

I. Advanced Internal rating based

II. Mapping to external rating regulators

III. Credit scoring

Credit scoring is considered the most appropriate and accurate way to identify default probabilities by using a back testing model. Yet it is not considered to be the most efficient when it comes down to processing extensive amounts of data. This specific model is accurate enough in quantifying the rating grades, but research has proven that by using this model, only one third of the potential defaulting banks could be identified, thus not solving the problem of identifying which banks would need external intervention.

44 Malkiel, B. (2016) A Random Walk Down Wall Street: The Time-tested Strategy for Successful Investing. New York, U.S.A., W.W. Norton Inc. 13th Edition.



Before the global financial crisis of 2007, it was noted by the BIS that in 2005 a full report regarding stress tests and their application in sixty-four global banks had been made. Results highlighted the recurring theme that banks where mainly considering only market risk factors within their models, thus avoiding credit risk, operational risk and systemic risk. Official findings from the BIS’s report found that at the time, 80% of all reported tests, resulted in exercising exclusively market risk related stress tests, thus exposing the banking culture’s lack of pragmatism when evaluating risk as an overall factor.

2.5 Capital Requirements, Tier 1 & Tier 2: Source: Introduction to Global Banking p.210 – 217

During the Capital Accord of 1988, commonly known as Basel Act I, the BCBS first presented the standard measures regarding capital requirements and its application within banking institutions members of the G-10.

With rapid technological advancement covering the two decades following the early nineties, financial markets and banking systems innovated themselves, introducing newly diversified instruments which where much more complex to understand. Many of these instrument appeared very opaque in the eyes of the regulators, in terms of categorizing them under what kind of capital they would’ve generated over time, and so for this reason, the BCBS decided to revise Basel I. The regulatory framework was updated with a clearer definition of capital, and tighter standards in terms of incentives and penalties, concerning capital requirements and to credit risk exposure.



This brought to the creation of Basel II, and it’s official endorsement in 2004 by the G-20 leaders4. However, Basel II did not succeed in addressing a clear definition of capital, and no universal definition was actually underpinned. Basel III aims to raise the quality, consistency and transparency of banks’ capital structures (Casu, 2015). Under this accord, a bank’s capital will consist of Tier-1 and Tier-2 capital. Tier-1 being the bank’s core capital, whilst Tier-2 the supplementary capital.

Tier-1 Capital: This is a combination of common equity and retained earnings. Since Basel III’s full implementation in 2016, Tier-1 capital will have to be composed using the following weights, of which 82.3% of only common stock equity, and the remaining 17.7% will be composed by retained earnings5. According to Basel III, common equity Tier-1 must be at least 4.5% of risk-weighted assets at all time, and Total Tier-1 Capital must always be at a minimum of 6% of risk weighted assets (bis.org 2016).

Tier-2 Capital:This categorized form of capital instead is the sum of the following element: revaluation and undisclosed reserves, retained earnings, loan loss reserves, subordinated term debt and stock surplus. Tier-2 capital is capped following the Basel III regulatory framework, at 2% of risk-weighted assets at all times.2.6 Risk Weighted Asset: Source:

www.investopedia.com/terms/r/riskweightedassets.asp

This is a banking term that refers to a method for measuring the risk inherent in a bank’s assets, which is typically deducted by the bank’s total loan portfolio. The calculation is based on the capital adequacy ratio implemented by the Basel Committee as mentioned earlier. Risk-weighted assets are therefore used 45 Casu, B. (2015) Introduction to Banking. Edinburgh Gate, United Kingdom, Pearson, 2nd Edition. p.208 56 Casu, B. (2015) Introduction to Banking. Edinburgh Gate, United Kingdom, 2nd Edition. p.218



to determine and calculate the minimum amount of capital that a bank must hold to reduce their chances of becoming insolvent. Before doing so, banks must run a risk assessment for each category of asset held within their portfolio. In order to avoid confusion and misunderstandings, regulators have focused on making it clear to the banks that they must group their assets together by risk category so that the amount of capital is matched, with the risk level of each asset. This is intended to prevent very large amounts of capital from going lost when one single asset class declines aggressively in value within markets (Investopedia 2016). To summarize the calculation of total risk weighted assets a bank must sum its credit risk weights assets together with its operational risk weighted assets, and minus the sum of excessive qualified credit provisions.

2.7 Correlation Coefficient Indicator: Source: Investopedia

The correlation coefficient is a measurement that determines the the degree to which two variables move along one another, meaning that the correlation coefficient can measure the movements which are associated to the two variables. The value of this measurement can range from -1.0 to 1.0. A perfect negative correlation would be represented by the the value -1.0, whilst a perfect positive correlation would be 1.0. This analysing technique will allow the research to look at the linear relationship between the real GDP growth of Europe’s economy, and the return on equity of the four selected GSIB’s. If the correlation coefficient is close to the 0 value this means that the correlation is very weak, meaning that there is no linear relationship between the two variables. This statistical measurement is often used in finance, in order to see the behaviour of two variables against one another. The following measurement is calculated using the following formula:

Pxy=Covariance (rx ,ry )σxσy



3.0 Methodology

3.1 Theoretical Framework: The Efficient Market Hypothesis (EMH)

Developed by Maurice Kendall (1953), the efficient market hypothesis explains the theory claiming the impossibility for any investor in beating the market by simply predicting future values of its own selected stock portfolio, and contradicts the investor’s ability to gain value by predicting movements concerning stock prices8. The theory puts forward the argument that beating the market is simply impossible due to the causes generated by the market’s efficiency, meaning that all shares are traded at a fair value. If the market is considered to be strongly “efficient”, this means that the price of a stock adjusts quickly and without biases to newly released public information, thus reflecting the new value given by the newly released information.

The efficient market hypothesis however has been strongly questioned in the past, suggesting that it is being disrupted due to the advancement of technology, increasing speculation, and the increase in size of the interconnectedness between financial markets around the world (Clarke, 2010).

3.2 .0 Research Process

The research process will be using an inductive approach. The question at stake, relates to the spectrum of contemporary social sciences such as: finance, economics and banking, it is appropriate to choose an inductive approach in order to answer the question in the best of ways. More over, the fact that Basel III determines many current issues within these topics, and that it has been addressed only in the last five years of our history, supports the notion of using an inductive approach to the question, thus guaranteeing more

88 Bodie, Z, Kane, A, Marcus, A.J (2014) Global Investments, Berkshire, United Kingdom, McGraw Hill, 10th Edition, p.349-350



space and freedom for a concluding interpretation to the research question. This is because an inductive approach, is delivered by building upon an abstract theory as the research is being processed9. The complete opposite process would be by using a deductive approach, which would rely on testing a singular or a set of fixed theories or hypotheses, and therefore starting with a pre-grounded theory on which to base a strictly correlated and limited conclusion.

The problem with applying a deductive approach to this research is based on the lack of availability concerning the comparable data between Basel 2.5 and Basel III. Only five years divide Basel III from Basel II, and since then, the financial cycle became much more persistent in contrast to the overall bank’s credit growth.

(Figure 1. Source: Bank for International Settlements (BIS) www.bis.org)

3.2.1Qualitative and Quantitative Methods

The following research question will need both qualitative and quantitative methods of research to be used. The qualitative part will involve making observations concerning Basel III documentation, analysing texts and monitoring reports in depth and using critical thinking.

99 Saunders, M, Lewis, P, Thornhill, A. (2009) Research Methods for Business Students, Edinburgh Gate, United Kingdom, Pearson Education, 5th Edition, p.125-127



The quantitative part of this research will be instead presented in the second half of the findings, where the author has personally decided to use certain statistical data sourced by organizations such as the OECD.org and the European Central Bank (ECB).“There four main methods used by qualitative researchers are the following: 1.observation, 2. analysing text and documents, 3. interviews and focus groups, 4. audio and video recording.”1010 For this research, the first, second and fourth method will be used. It is important however that the term “observation” is understood properly, acknowledging its non-reliable nature due to the fact that different observers may record different observations. In order to tackle this issue, this paper will make reference to a selection of non-bias observers, sponsored by reliable and valid sources listed in the bibliography. Another reason for conducting qualitative methods would in making observations regarding the banking culture, focusing on the ethics and behaviours within the selected industry.

The features suggested within quantitative methods instead, can be categorized as the following according to Halfpenny, P (1979): hard data, objective, hypothesis testing and abstract. Leaving aside the normal functions that quantitative methods are able to underpin, it is important to understand that the documents and reports published by the BIS and the ECB are considered exclusively as forms of quantitative research, thus dealing with statistics and economic variables. Quantitative research praised by governments, based on its efficiency of identifying quick answers based on reliable variables (Cicourel, 1964).1111In terms of quantitative methods, this paper will deliver the using the following:

1. Using official statistics, this paper will analyse previous collected data, in order for large data sets to be used in an advantageous and innovative way.

1010 Silverman, D. (2006) Interpreting Qualitative Data, London, United Kingdom, Sage, 3rd Edition, p.18 1111 Silverman, D. (2006) Interpreting Qualitative Data, London, United Kingdom, Sage, 3rd Edition, p.35



2. Structured observations will be made, using other observations scheduled before this research question was presented, thus accessing the reliability and validity of the sources.

In order to critique the research methods used in this quantitative part of the research paper, the author is conscious with the problems surrounding the interpretation of statistical correlation in relation to what the variables actually mean.

3.2.2Primary and Secondary Data

Data can be considered the basis on which every decision, be it business or science related, is made. With data it is possible to answer questions concerning important issues, and at the same time data presentation allows the passing of information on to others. There are two variations of data, known as primary and secondary data. Primary data is basically information that has been collected originally and exclusively for the purpose in mind, thus examples such as surveys, interviews, experiments and case studies correspond to methods for collecting primary data.

Secondary data instead, will be used mostly for thus research paper. This is because the full implementation of Basel III along with its numerous reforms will be fully operational by January 1st 2019 (Table 1.0 and 2.0). It is for this reason that not enough primary data is available to be collected and compared, in order to perform a fully primary based data research. Secondary data can be defined as historically collected and processed data, by a different entity or organization, be it for the same or different reason. Collection of secondary data often involves less cost, time and effort.1212

1212 Saunders, M, Lewis, P, Thornhill, A. (2009) Research Methods for Business Students, Edinburgh Gate, United Kingdom, Pearson Education, 5th Edition, p256-257



(Figure 2: Types of Secondary Data. Source: Saunders, M, Lewis, P & Thronhill, A.)

3.2.3Validity vs Reliability

When collecting data, it is very important for the researcher to identify the validity and the reliability of the sources from which the data is being extracted. Petel and Davidson (2003), believe that there is not much distinction between the two terms, and that they are often categorized both under the term “validity”. Considering the two terms as one, leads the reader to think of both terms under a simpler word known as truth. By this, it is meant that the sources from which this paper refers to are considered real and truthful instead of bias and fictional.

When evaluating the official documents representing the regulatory framework designed by BIS, it is vital to understand that the qualitative research that has been made by the BIS organization, can be trusted and referenced upon, given the credibility and accuracy with which the organization delivers it’s reports and analysis. All literatures have been tested and reviewed based on their accuracy to answer the defined question, and the accuracy with which the objects are identified and explained.

3.2.4Limitations



This research question looks at the banking system as a whole, focusing on traditional banking activities, which can be reported and analysed using different kinds of data. The limitations affecting this research question are uniquely caused by the fact that Basel III has not been yet fully implemented, however, 90% of the reforms and regulations have been already put into action, and a consideration of their effectiveness can be analysed if we correlate banking performance to the current macro-economic environment. “Qualitative researchers suggest that we should not assume that techniques used in quantitative research are the only way of establishing the validity of findings from qualitative or field research”.1313 Having said this, it is important to have a balanced and equal combination of both qualitative and and quantitative research methods, thus adopting the analytics behind the use of primary, secondary and empirical data, and at the same time consider the qualitative research and it’s observations made based on the ability to study human phenomena in the social real world, (Silverman, 2006).

4.0 Presentation of Findings

4.1 Basel III Capital Accord

1313 Silverman, D. (2006) Interpreting Qualitative Data, London, United Kingdom, Sage 3rd Edition, p.43



Basel III’s purpose is to strengthen the regulatory framework imposed previously by Basel II, and to follow the three pillar phase system. The three pillars phase, illustrates the way in which the regulatory framework will be executed across time, acting as a timeline guide for reform implementation; reforms that banks will have had prepared for, prior to 2013. The following pillar phases are described in more detail in Table 3.0 in the Appendix.

However, given the lack of efficiency delivered by Basel II it was clear that a new set of capital requirements were under the development phase and ready to be endorsed. Due to these corrections, Basel II was only partially implemented, getting across the Pillar-1 phase, but not getting entirely through the second. Until 2013, the monitoring and supervision review phase (Pillar-2) was being undertaken, however with Basel III’s implementation, the BIS decided to describe the five years following the implementation, a transitional phase in which gradually each set of reforms would have to be applied, allowing banks to make cost efficient changes which would affect their own capital structures. The full implementation of Basel III reforms is illustrated in detail in the Appendix containing Table 1.0 and Table 2.0.

The important aspect that must be taken into account for this research paper, is the way in which Basel III will affect the GSIB’s credit availability, in order to be then used appropriately. The result of this happening would be allowing potential borrowers guided access to credit lines or permission for holding simple forms of debt instruments such as loans or mortgages.Basel III aim in achieving this by promising to accomplish the following two objectives:

i) Ensuring minimum standards of resilience so that financial firms are less likely to fail,



ii) Reducing the impact of the financial system and the economy in the case they do.1414

Basel III introduces new reforms that will enable banks to have a stronger and stricter governance, thus allowing the banking system to evaluate in greater depth their levels of operational risk, credit risk and market risk. The new regulatory framework centres on setting higher requirements for loss absorption models, increasing the quality and level of capital, while better accessing the full range of risk that banks are exposed to nowadays. The major new elements introduced by Basel III, are the leverage ratio requirements, affecting leverage for banks, and the introduction of capital buffers such as, the countercyclical capital buffer and the capital conservation buffer which will be discussed later on. Given this range of innovation in reform making, Basel III aims to mitigate the macro-economic problems inherent in today’s global economy. A new set of limitations concerning liquidity will also be implemented in Basel III, introducing the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) which will later on be discussed in greater detail.

4.1.1Raising Capital Requirements

The main issue criticized during the application of Basel II was the inconsistency with which the word “capital” was defined through out different jurisdictions, making it unclear what category of quality assets should compose the capital base numerator, but also the denominator for the capital ratio, also known as the computation of risk weighted assets. Basel III succeeds to rectify this definition of capital, making it clear to banking institutions that the use of hybrid capital would no longer be tolerated or categorized as forms of regulatory capital.

1414 BIS, (2015) Finalising post-crisis reforms: an update, A report to G-20 leaders. Basel, Switzerland, Basel Committee of Banking Supervision, p.3



Hybrid capital, is capital that can be considered debt but also equity. From a depositor’s point of view, it would act as equity, but for taxation reasons it would be seen as debt (Heurtas, 2008).

The deduction of these assets from the capital base which had proven in the past, to not provide any value when banks were considered failing, is the first step in order to clarify the composition of what is considered Common Equity Tier-1 capital and Tier 2 capital. Hybrid capital instruments where also being used in Basel II to compute the element non Common Equity Tier-1capital, thus disrupting the definition for Tier-1 and Tier 2 Capital. These changes in definition are a cornerstone in terms of clarifying and improving the quality of capital needed in order to improve the bank’s success to absorb losses over a certain period of time.

(Figure 3: Structure of Regulatory Capital under transitional Basel III rules: Source Monitoring Report 2016, wwww.bis.org)

However, improving the quality and the definition of capital only, would be addressing only half of the problem identified in Basel II. The other half of the problem concerning previous capital requirements, was the amount of sufficient capital needed. Hence, in Basel III, the committee has agreed to



increase the minimum level of capital, causing at the same time a rise in minimum value in terms of capital ratios. Changes in Basel III regarding capital requirements are listed as the following:

Common Equity Tier-1 ratio has been raised to 4.5% of risk weighted assets.

Tier-1 Capital has been set at 6% of risk weighted assets. GSIBs have additional loss absorbency requirement ranging from 1.0% -

2.5% of risk weighted assets. Total Tier 1 and Tier 2 capital must be at least 8% of risk weighted assets

at all time.

4.1.2Strengthening Credit Risk Coverage

To better improve the quality and level of capital, Basel III revised the weighted framework used in Basel 2.5 and quickly addressed new parameters regarding these. The reforms introduced in Basel III are based on the results found by research focusing on the identification of major sources that caused the financial crisis, and the previous progress brought out by Basel 2.5. The Basel Committee has decided to strengthen the ability of banks to capture off-balance sheet exposures and securitization activities, by simply raising the capital requirements for trading books and securitization exposures.

4.1.3Leverage Ratio

To monitor and constrain “over leverage” within the banking system, the Basel Committee has decided to add yet another safeguard instrument, allowing banks to monitor their leverage levels more effectively.

Basel III addresses a leverage ratio in order to preserve excessive concentration of leverage on the bank’s behalf. The phenomenon known as “over leveraging” banks, was one of the key issues that caused many banks to



fail and go bankrupt in 2007. Before the crisis most of the banks were providing only general protection over their assets, using standardized or internally modelled approaches which where considered weak in terms of correctly stating levels of credit risk. The newly introduced leverage ratio will act as a monitoring device that will further filter risk factors inherent in the universal banking activities, considering on and off-balance sheet leverage levels, and thus acting as an additional tool for risk capture.

The ratio of 3% will be used as a minimum required level, and it is computed using the following factors1616:

Leverage Ratio=Tier−1Capital :Total Exposures

Given previous explanation on the composition of Tier-1 & Tier-2 Capital, the discussion on total exposures should further expand the reader’s general understanding of how capital requirements are all interlinked to the various components implemented in Basel III. Moving on, total exposures are considered the sum of on-balance sheet exposures, securities transactions, off-balance sheet items and derivatives exposures. Furthermore, it is important to give value to how effective this tool will be, especially in the monitoring and supervision phase, present in Pillar-2. With the newly implemented leverage ratio, it will be easier for banks and the external regulatory boards to compare these standards between the many banks that constitute todays economy, in particular the monitoring of the GSIBs.

A set of bar charts showing the continuous leverage ratio’s evolving over time for 30 selected GSIBs, (included HSBC, Barclays, Deutsche Bank, and BNP Paribas) is provided below. The data has been collected and processed since the start of June 2011, up until December 2015, (BIS, 2016).

1616 (BIS, 2016) Basel Committee on Banking Supervision, Basel III Monitoring Report (September 2016)



(Figure 4: Fully phased-in Basel III Tier-1 leverage ratios. Source: Monitoring Report 2016, wwww.bis.org)

Since the last monitoring report published by the Bank for International Settlements in September 2016, it is evident that the selected GSIBs have been following the correct approach in terms of minimizing their leverage exposure, thus meeting the requirements set by the Basel Committee. As it can be seen, since 2013 the leverage ratio has increased significantly from just over 3.5% evolving across a three year phase up to 5.5%. The following results show positive signs of commitment by the GSIB in terms of improving and making stricter internal governance decisions. Having said this, it seems clear that in terms of leverage exposure, GSIBs seem to be changing the culture within the banking industry, proving that regulatory requirements can be met with continuity and legitimacy.

4.1.4Capital Buffers

Before the financial crisis in 2007, most banking institutions were revealing a central tendency of taking on excessive levels of risk whilst the credit cycle was booming. The same pattern was observed when the credit cycle was going through its subsequent downswing phase. The idea of credit cycles is linked to the term used in economics called procyclicality. Procyclicality can be



expressed through any economic quantity or indicator that is positively correlated with the overall state of the economy. Thus when there is a recession the credit cycle undergoes a downswing, instead during and economic boom, the credit cycle will be following an upswing trend1717.The consequences of this banking phenomenon, could be the possible spill-over of stress among different banking networks in a time where the credit cycle appears to be gaining momentum towards the apex of its downswing curve, thus representing a possible sign of recovery in terms of credit availability, signalling an end to the recessive business cycle. With this said, it is crucial to understand that the excessive level of risk taken on board by a specific bank could result in a much more dangerous and extensive problem, due to the fact that the rest of the financial network could also be affected. This infectious effect can also be considered as collateral damage.

To ensure no more excessive spill-outs, and to stabilize the banking system, Basel III proposes new reforms regarding additional capital requirements in order to defend banks from systemic risk. Basel III adopts a more macro-prudential approach whilst addressing these reforms, introducing two additional capital buffers. One of these is the capital conservation buffer: an additional layer of capital that can be deducted only at a time of stressed markets, in order to absorb losses more effectively and thus allowing continuity and maintaining a minimum level of lending and banking activity. Its implementation started on January 1st 2016, with a 0.625% of risk weighted assets, progressing every year by 0.625% in order to reach full implementation in 2019 at a 2.5% of risk weighted assets (Table 2.0 Annex).

The second buffer, is the countercyclical buffer, which will be implemented only at a time where national authorities will find it adequate using them. The function of this particular buffer is to act as an additional provision for banks, when undergoing periods were credit growth is accelerating drastically. If a hypothetical extreme downturn took place in the economy, this buffer would be activated, varying from 0% – 2.5% (according to the geographic factors that 1717 (Investopedia, 2016) http://www.investopedia.com/terms/p/procyclical.asp



ultimately shapes a bank’s portfolio of credit exposure). The goal for the countercyclical buffer is to mitigate and reduce the phenomenon of procyclicality. To conclude this description, it is clear that Basel III adopts a more macro-prudential approach in order to secure the banking industry, and that the buffers can be fine example put into practice by adopting a macro-prudential approach. Ultimately the two buffers are considered complementary to each other, given their timed specific use.

4.1.5Liquidity Standards, Liquidity Cover Ratio and Net Stable Funding Ratio

During the 2007 financial crises, another issues that was seen criticized was the inappropriate way in which banks where managing their own liquidity risk. Basel III for first time manages to implement changes regarding this risk factor, introducing two capital funding ratios, allowing banks to bear losses more proficiently. The liquidity issue with banks during the crises, was caused by their inefficiency in liquidating assets in order to have enough capital available to cover extensive losses over a short period of time. This is because prior to Basel III there where no international regulatory frame works concerning liquidity risk1818! Two new capital reforms have been implemented in order to strengthen liquidity, covering short term but also long term losses, in the event of another downfall of the financial markets.

Another milestone in terms of reform application, is the introduction of the Liquidity Cover Ratio in Basel III, which stands for the short term ratio in order to maintain correct levels of liquidity for banks. Starting from January 1st 2015, this ratio will be adopted by banks, allowing the prevention from different 1818 (BIS, 2016) Basel Committee on Banking Supervision, Basel III Monitoring Report (September 2016)



forms of liquidity risk (Table 1.0 and 2.0). The Liquidity Cover Ratio will therefore enable banks to endure 30-day stress market scenarios, maintaining the adequate liquidity within capital structures. Further more this ratio will enable banks to also cover events involving the downgrading of credit ratings, along with the loss of depositors and whole sale funding (BCBS, 2010).

LCR= Highquality liquid assets

Totalnet cash outflowsupcoming

30days≥100%

The numerator is composed of Level 1 and Level 2 assets. Level 1 assets can be the following: cash, central bank reserves and marketable securities that can be backed by sovereign and central banks.

Level 2 assets instead can be sub-categorized in Level 2A and 2B. Level 2A assets are represented by a range of government securities, covered bonds and corporate debt securities. Level 2B, are assets such as: lower rated corporate bonds, residential backed securities and certain equities that must meet specific criteria imposed by Basel III. Level 2 assets cannot account for more than 40% of the high quality liquid assets, and Level 2b assets, will be capped at 15% of all high quality liquid assets.

The denominator for this formula can be calculated by taking away the total expected cash inflows (specified in a stress scenario for 30 days) from the total expected cash outflows. The total expected cash outflows can be calculated by multiplying the outstanding balances of various types of liabilities and off balance sheet commitments, by the rate to which they are expected to run off or be drawn down. Whilst instead, total expected cash inflows can be simply calculated by multiplying the outstanding balances of various categories of contractual receivables by the rate at which they are expected to flow in. The Liquidity Cover Ratio starts in 2015, with a 60% level, increasing by 10% each year until reaching 100% in 2019, where Basel III will be considered fully



operational (Table 1.0 and Table 2.0 in Appendix). However, given these minimum standards imposed on banks, the Monitoring Report of September 2016, published by the BIS and the BCBS shows that the GSIBs have already outperformed the minimum requirements set for the year 2016, and are already above the 100% minimum requirement capped for the year 2019.

(Figure 5: Liquidity Cover Ratio, Source: Basel III Monitoring Report, September 2016)

The second ratio implemented by the Basel Committee is the Net Stable Funding Ratio. Its function is very similar to the LCR, instead of covering short term liquidity, it covers the long term liquidity. The NSFR is “designed to reduce funding risk over a longer time horizon by requiring banks to fund their activities with sufficiently stable sources of funding in order to mitigate the risk of future funding stress”1919Sources of stable funding can be identified as deposits from retail and small/medium size business customers, funding by financial counterparties and also from non-financial corporate counterparties, (BCBS, 2016). The NSFR thus determines that; long term assets must be backed up with a minimum amount of assets that are commanded on the long term asset’s liquidity risk. The computation of the net stable funding ratio is as follows:

NSFR= Available amount of stable fundingRequiredamount of stable funding

>100%

1919 (BIS, 2016) Basel Committee on Banking Supervision, Basel III Monitoring Report (September 2016)



It is important to note down that the available amount of stable funding is defined as, funding that is usable over a one-year period, and that is considered stable, meaning reliable and safe. It is the supervisor’s responsibility to monitor the required amount of stable funding, by examining the liquidity risk that the selected bank is exposed to, in order to deduct the correct amount of funding needed. This supervision method is similar to the way risk-weight factors are determined, calculating the required capital needed in order to meet the parameters set by the BCBS. Further categorization of assets classes fit for required stable funding are displayed in Table 5.0 in the Appendix.

4.2 Data Analysis of Europe’s GSIBs

The following part of this research paper will provide quantitative methods of research in order to conduct a correlation analysis concerning the performance of GSIBs against evolvement of the macro-economic environment in Europe. The economic indicators provided will show growth and investment activity within the Euro Area, and the process will involve running a correlation with two of the selected indicators. The data time frame, covers a period starting from January 1st 2011, and ending in January1st 2015, thus including the transitional phase, where the implantation of Basel III was conducted. The data indicators reflecting the macro-economic environment in Europe have been collected from fully reliable sources such as, the OECD.org2020 and the ECB.eu2121. The process of data mining utilizing secondary sourced data from government websites and non-profit organization websites, allows the quantitative data to be considered as true and empirical, thus reflecting objective facts and statistics occurring in the real whole economy.

2020 OECD.org: is an international organization helping governments tackle the economic, social and governance challenges of a globalised economy.2121 ECB.eu: The European Central Bank is the central bank for the euro and administers monetary policy of the euro zone, which consists of 19 EU member states and is one of the largest currency areas in the world.



Data representing the financial performances of the four GSIBs selected, have been sourced from Morningstar.com. Furthermore, the GSIBs selected for this research sample, have been chosen based on their ranking following the quantity of assets under management. The following banks are: HSBC bank plc, Barclays bank, Deutsche bank and BNP Paribas bank. For these banking institutions, the research paper will access their financial performances in terms of: return on equity, credit provisions, and revenues through out 2011-2015 (Appendix Table 4.0).

4.2.1Return on Equity (Table 5.0 Appendix)

Return on Equity has been collected in order to see if the four GSIBs selected, have proven themselves productive in revealing how much profit they can generate with the money invested by the shareholders. The bar chart above shows that with the implementation of Basel III in 2013, ROE has been undergoing some difficult years, showing that banks are decreasing their returns on average year after year, thus reflecting the bank’s continuous struggle to make ROE grow positively instead of negatively (Table. 5.0 of Appendix). An anomaly within this data set has been identified by looking at


2 0 1 1 2 0 1 2 2 0 1 3 2 0 1 4 2 0 1 5

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

Retu r n o n eq u ity 2 0 1 1 - 2 0 1 5

HSBC Barclays Deustche Bank BNP Pairbas

37


Deutsche Bank’s ROE in 2015. It appears to be very obvious that Deutsche Bank’s ROE has hit rock bottom due to the legal charges conducted by the US Department of Justice concerning the miss-selling of mortgages in the US2121. Based on these results it is simple to understand that with the new regulatory framework introduced in 2013, banks on average have fatigued over generating growing ROE figures over the last three years within Europe, reflecting a lack of trust by part of the the shareholders.

(Figure 6: Return on assets for EU banks and US banks, Source: Financial Times, 2015)

4.2.2Revenue (Table 5.0 Appendix)

Revenue is cash that banks receive at the end of each year, generated by the outcome of banking activities. As exemplified below, revenues have remained stable, if not slightly affected negatively since the implementation of Basel III. The exception however, comes with the results shown by BNP Paribas bank, which appears to be developing an increase in banking activity since Basel III’s implementation. Not a lot of analysis can be performed over this indicator due 2121 Treanor, J. (The Guardian 2016): The 14bn Deutsche Bank fine – all you need to know, September 2016: https://www.theguardian.com/business/2016/sep/16/deutsche-bank-14bn-dollar-fine-doj-q-and-a



to the general observation that it encompasses. Performance of revenues show that none of the selected GSIBs fall behind the 30,000 million USD point, reflecting no true state of emergency or failure, for any of the selected institutions.

2011 2012 2013 2014 20150.000

10.000

20.000

30.000

40.000

50.000

60.000

70.000

80.000

90.000

72.280

82.54578.337

74.59371.092

41.086

32.02635.348

31.509 31.58833.482 36.025 34.08 34.118 35.798

67.54 68.333 67.26870.864

77.097

Rev en ue 2 0 1 1 - 2 0 1 5 , US D Mil l io ns

HSBC Barclays Destche Bank BNP Paribas

Additionally, revenues standards have been expected to behave in the following way in the past years, based on the notion that since the bank regulation laws have increased, a decrease in revenue would automatically be treated as a natural reaction in terms of money generated by lending activities from banks.

4.2.3 Credit Provisions (Table 5.0 Appendix)

The credit provisions for credit losses is an item within the bank’s financial statement. This indicator represents the amount of capital that is expected to cover forms of delinquent and bad debt, or other forms of credit risk that are likely to go into default and seen as unsatisfying capital due to the phenomenon of default probability, as previously discussed in the literature review in section 2.2. (Investopedia, 2016).



The results presented, reflect a trend of shrinking credit provisions across the five-year span. Since the implementation of Basel III in 2013, banks have struggled in building up larger provisions. What this means in terms of macro-economic analysis, is that these provisions appear to be very active in terms of covering losses, thus meaning that, if the provisions themselves are shrinking the overall credit risk and probability of default is an increasing variable among the average profile of today’s bank client in Europe.

2011 2012 2013 2014 20150

2

4

6

8

10

12

14

12.127

8.311

5.849

3.851 3.7213.182 3.238 3.071

2.168 2.1141.964 1.839 2.2051.211 1.022

2.994 3.267 2.937 2.8213.561

Cr ed it P r o v isio n s 2 0 1 1 - 2 0 1 5 ( US D ) mil l io n s

HSBC Barclays Deustche Bank BNP Paribas

Additionally, if we take in consideration Basel III’s new capital requirements and reforms, these results should reflect overall, that the macro-economic framework has been successfully secured with new parameters of counter party risk calculation, thus improving the identifying of bad debts, and the unqualified borrowers which shouldn’t be engaging with high risk debt instruments, and thus reflecting the notion of a more monitored environment in which banking activities are conducted.

4.3 Macro-economic Environment in Europe

4.3.1House Hold Savings in Europe (Table 5.0 Appendix)



“This measure is defined as the subtraction of household consumption expenditure from household disposable income, plus the change in net equity of households in pension funds. Household saving is the main domestic source of funds to finance capital investment, a major impetus for long-term economic growth. This indicator is measured as a percentage of household disposable income.”2222(OECD.org, 2016).

2 0 0 9 2 0 1 0 2 0 1 1 2 0 1 2 2 0 1 3 2 0 1 4 2 0 1 5

8.29

%

6.76

%

6.32

%

5.62

%

5.95

%

5.96

%

5.79

%

House Hold Sav ing, % of House hold disposable income

Since 2009, general household savings have dropped by 2.5%, meaning that in general in Europe households have less disposable income to invest or use as a means of investment. However since the implementation of Basel III in 2013, the macro-economic environment seems to have experienced a plateau, revolving around 5.9 % as a mean result. What this means is that 5.9% of the average household disposable income can be used and injected in the banking system.

4.3.2Real GDP Growth in Europe (Table 5.0 Appendix)

2222 OECD.org, (2016) Data: Household Savings, https://data.oecd.org/hha/household-savings.htm



Below are the results for the Euro Area’s annual real GDP growth. This indicator is obtained by expressing the values of all goods and services produced in a given year (OECD.org, 2016). Real GDP reflects the pure economic growth of a country, and is commonly used as the best indicator reflecting economic growth. Illustrated below it is possible to see that real GDP has been partially volatile since 2009 until now, but if you specifically focus of the time frame since the year 2013, it is clear that Europe’s real GDP is following a positive and minimum growth path, that will probably increase slightly through out 2016, given that inflation levels remain low and are expected to remain that way until March 2017, (The Economist, 2016).

2009 2010 2011 2012 2013 2014 2015

-5

-4

-3

-2

-1

0

1

2

3

Real GDP Euro Area Growth %

4.3.3 Correlation between ROE and real GDP growth in Europe (Table 6.0 Appendix)

As mentioned earlier in the literature review, the correlation coefficient evaluates the degree to which two variables movements are associated. For this part of the research paper, given the results generated by the quantitative data, the research paper will be running a correlation between the ROE of the four GSIBs selected against the real GDP growth present and exhibited in Europe, given the data collected across the last five years. The objective is to verify if ROE has a correlated movement to Europe’s real GDP. Given the observations made in the methodology of this research paper, and the process



of quantitative data being collected, the research paper expects to see a negative correlation, given that the overall ROE has been decreasing within the banking industry, and especially in Europe.

(Figure 7: Real Investment Spending EUROPE VS US, Source: Financial Times, 2016)

Having done the calculations, the results showed that a correlation of 0,036, meaning that the correlation is positive but extremely low. This result provides us with the notion that there is no real correlation between real GDP and average ROE of Europe’s four major banks. Thus it is safe to say that by measuring these two variables resulted in a not an effective way of critiquing Basel III’s effectiveness on the macro-economic status of the EU.

5.0 Conclusion

In response to the overall results generated in section 4.0, a conclusion regarding the possible effectiveness of Basel III, compared to previous capital requirements laid out by Basel II can now be formulated. The research question aims in answering the two objectives earlier mentioned in the introduction:

i) Has credit risk been mitigated and safeguarded properly within GSIB’s capital structures?



ii) What are the possible effects on the whole economy in Europe, since Basel III’s implementation?

In response to objective ii), recent changes in the capital accord concerning Basel III have resulted in a tightening of credit conditions within the whole economy, causing the net level of borrowing credit to remain at a low rate over the last four years. This observation regarding credit being less distributed to the economy is also supported by the results linked to the decrease in profitability for banks (4.2.1 and 4.2.2).

Economic Indicators used in this research, thus show a general trend expressed by the GSIB’s, showing that ROE and revenues have decreased on average. More over, the focus on GSIBs has been selectively chosen in order to show the reader the severe changes that these banks have been subject to since the implementation of Basel III, exhibiting that the bigger the bank’s capital structures, the higher capital requirements they will have to adopt.

With banks not resulting profitable it is important to understand the implications this will have on the economy as a whole. Having read various newspaper articles treating the same argument, in many cases it was said that; what is bad for banks is also bad for businesses and consumer borrowers. Expanding on this conclusion would consider then the effects caused by credit contractions. When credit contractions appear to intensify, the automatic response of the economy is the increase in defaults, which at the same time would result either in: banks increasing their cost of credit lending, or raising new equity: options considered to be the most expensive ways to raise capital in order to cover losses.In response to objective ii), Basel III has caused a disruption in credit availability within many industries, including the banking system, affecting ultimately loan prices to increase, and thus making borrowing less available. Empirical data expressed in section 4.2.3, supports this macro-economic trend



by showing that credit provisions have been shrinking within the financial statements of the selected GSIB’s.

Since credit lending has become more expensive, banks are now facing a difficult dilemma where they must stimulate their client’s trust. Many argue that increasing prices in the loan market is an encumbrance for the economy, and for banks to overprice their primary activity would highly unrecommendable, especially given the current status of the global economy which is at the end of its economic cycle. In respect to objective i) Basel III does improve significantly the conditions for banks to identify, and calculate their levels of credit risk. This is mainly thanks to the improvement in quality of capital, and to the supplementary upgraded mechanisms implemented to cover expected losses, and at the same time ensuring appropriate liquidity and leverage both in short and long term.

The minimum capital ratios have increased since the implementation of Basel III, strengthening the banks overall exposure to credit risk, thus developing a defence system, which will be activated in case of another recession or credit crunch. Basel III also treats credit risk as an ongoing concern, showing continuous research and proposals in the attempt of mitigating this risk factor. An example of this ongoing concern, would be the regulation of retail credit lines, affecting the distribution oh high quality streams of credit cards, which until now where seen within the banking system as “unconditionally cancellable commitments”, well now with Basel III’, these services will also be subject to. Real life events signalling this event would be the resignation of Visa’s CEO Charlie Scharf, which will be replaced by a former American Express president, Alfred F. Kelly, announced on December 1st 2016, (Bloomberg, 2016).

Focusing on Europe’s banking performance, it is evident that banking industry is crossing a fragile five-year period, where returns, revenues and new investment opportunities are always more selective requiring always higher



costs. With the implementation of Basel III , Europe’s GSIBs, have suffered this regulatory change, especially since the regional economy is much more dependent on bank’s performance. European banks are more leveraged than US banks because European corporations do not have such easy access to the bond capital market and thus rely entirely on the banking system in order to interact with it.

Basel III promised to improve the overall internal governance within the banking system, thus improving systemic risk. Corporate bank leaders who have always gained from the industry, are now facing smaller salaries, Consequently, events concerning resignations, such as the ones taken by HSBC’s CEO, but also Well’s Fargo, can be considered warning signs, reflecting the difficult situation that has developed in terms of accepting the Basel III’s reforms.

Finally, it is important to praise the efficiency and importance with which Basel III has frame worked the banking system, applying stricter rules, and tightening parameters in terms of capital adequacy. The banking system has always had a reputation for its ruthlessness and arrogance so far, but with Basel III the culture is changing, meaning that if it will be the case, banks will be fined and left to fail if they don’t follow the new banking regulatory framework, and examples of this capital regime put into practice can be supported by following the cases of Deutsche Bank, or even Montepaschi di Siena Bank (Italian national bank), which hasn’t passed the summer stress tests conducted by the BCBS, and is now facing its third recapitalization, caused by its negative capital resulted after the stress test. Personally I think that Basel III will secure the banking industry by 2020, and that with the slow but steady economic recovery being expressed globally, these parallel forces will allow credit risk will be calculated more accurately causing a decrease in loan prices, and increasing investor’s confidence, but also reinforcing and stimulating other industries which constitute the backbone of today’s economy.



6.0 AppendixTable 1.0: Phase in arrangements 2013-2019 of Basel III. Source: bis.org, 2016



Table 2.0: Phase in arrangements of completed post-crisis reforms. Source: bis.org



Table 3.0: Basel III, The three pillar phase approach. Source: bis.org



Table 4.0: Asset category for Required Stable Funding Factor. Source: bis.org



Table 5.0: Presentation of Findings of GSIB’s in the EU. Source: Morningstar.com, OECD.org)

- All calculations conducted and processed using Microsoft Excel programme have be using the fixed current exchange rates, dated for the 16/11/16



Table 5.1 Real GDP Growth in Europe’s individual countries. Source OECD.org



7.0 Annex: Official Regent’s University of London Document: Application for Ethical Approval for Proposed Research



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ARTCLES & NEWSPAPER ARTICLES / BLOGS:

1. Grant Rogers. (2016) LinkedIn: The Impact of New Basel III Regulations

on Banks and Credit Availability, (accessed 23rd September 2016),

https://www.linkedin.com/pulse/impact-new-basel-iii-regulations-banks-



credit-august-8-grant-rogers?articleId=8143240240696195552

2. The Data Team. (2016): European Economic Guide, The Economist, 16th

November, http://www.economist.com/blogs/graphicdetail/2016/11/daily-

chart-10?fsrc=scn/fb/te/bl/ed/

3. Shotter, J. (2016): Deutsche chief John Cryan says bank rules benefit only

U.S only, Financial Times, November 18th, FT,

https://www.ft.com/content/7cd5c10e-ad89-11e6-ba7d-76378e4fef24

4. Wolf, M. (2016): Deutsche bank offers a tough lesson in risk, Financial

Times, October 5th,FT.
