what is basel iii and why should we regulate bank capital
DESCRIPTION
A set of slides discussing the Basel III financial reform proposals and the need to regulate bank capitalTRANSCRIPT
Economics for your Classroom fromEd Dolan’s Econ Blog
Financial Reform: What is Basel III and Why Should We
Regulate Bank Capital?Revised March 2013
Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.
Munsterplatz, Basel, SwitzerlandPhoto source: http://commons.wikimedia.org/wiki/File:Munsterplatz,_Basel,_Switzerland.jpg
What is Bank Capital?
A bank balance sheet records the financial condition of the bank Assets are the income-producing items the bank owns, like loans Liabilities are what it owes—its sources of funds, like deposits By definition, capital equals assets minus liabilities
Revised version March 2013 Ed Dolan’s Econ Blog
In banking, the term capital is used instead of the terms net worth or equity that are often used in other areas of accounting. These terms are synonyms.
Why Banks Need Capital
Banks need capital for protection in case of losses on loans or other assets
Suppose a borrower defaults on a $50,000 loan, reducing total assets
The bank still owes depositors $900,000 After the loan loss, capital (assets minus
liabilities) falls by the amount of the loss If capital falls to zero or below . . .
the bank’s assets are no longer enough to cover what it owes depositors
It is insolvent and must cease operations Its shareholders stand to lose everything
they have invested
Revised version March 2013 Ed Dolan’s Econ Blog
More Leverage Means More Risk
A bank with less capital in relation to its assets is said to have higher leverage
High leverage puts a bank at greater risk of insolvency
ExampleThe low-leverage bank (top) could survive
up to $500,000 in loan lossesThe higher-leverage bank (bottom) would
become insolvent after just $100,000 of loan losses
Revised version March 2013 Ed Dolan’s Econ Blog
But More Leverage Also Means Higher Returns
More leverage means higher risk, but also higher returns for shareholders if the bank remains solvent
Assume interest received from loans to be 10% and interest paid on deposits to be 8%
Shareholders’ return is the difference between income and cost of depositsWith capital at 50% of assets (top),
shareholders’ rate of return on their invested capital is 12%
With capital at 10% of assets (bottom), shareholders’ rate of return increases to 28%
Revised version March 2013 Ed Dolan’s Econ Blog
Regulators vs. Bankers’ Preferences for Leverage
Varying the degree of leverage creates a tradeoff for shareholders between risk of insolvency and rate of return
Bank regulators, who are concerned about the spillover effects that bank failures have on the rest of the economy, tend to prefer less risk, less leverage, and more capital than do bank managers
To limit risk to the financial system, regulators set minimum standards for bank capital
Revised version March 2013 Ed Dolan’s Econ Blog
Who Regulates Bank Capital?
Bank regulators of individual countries do not act alone in setting rules for bank capital. They coordinate their capital regulation through the Basel Committee on Bank Supervision
The Committee meets at the, Bank for International Settlements (BIS), an international organization, founded in 1930, that fosters monetary and financial cooperation and acts as a bank for central banks
Revised version March 2013 Ed Dolan’s Econ Blog
Munsterplatz, Basel, SwitzerlandPhoto source: http://commons.wikimedia.org/wiki/File:Munsterplatz,_Basel,_Switzerland.jpg
The Basel Accords
The Basel Committee periodically issues “accords” that set out international standards for bank capital as well as other bank regulations
The first Basel Accords, now called Basel I, were issued in 1988
They were replaced by a new set of standards, Basel II, in 2004.
Revised version March 2013 Ed Dolan’s Econ Blog
Photo source: http://upload.wikimedia.org/wikipedia/commons/e/e4/Globe.png
Failure of the Basel Accords
Unfortunately, Basel II failed to prevent the global financial crisis that began in 2007
Government rescues of failed or failing banks like Citibank (US), RBS (UK), and Fortis (EU) cost taxpayers billions of dollars, pounds, and euros
Failure of the Basel II standards can be traced to two major problems:They allowed banks to overstate their
true amount of capitalThey allowed banks to understate the
risks to which they were exposed
Revised version March 2013 Ed Dolan’s Econ Blog
Photo source: http://commons.wikimedia.org/wiki/File:Citibank_Tower.JPG
Tangible Common Equity
Many observers think that the simplest measure of capital, called tangible common equity (TCE), is also the most accurate for measuring a bank’s exposure to risk
Tangible assets include only those like loans, securities, and buildings that could be sold by a failing firm to help pay its obligations
Equity capital equals tangible assets minus liabilities. It measures shareholder funds that are first in line to absorb risk in case of failure
Revised version March 2013 Ed Dolan’s Econ Blog
The ratio of tangible common equity to tangible assets to equity capital provides a measure of a bank’s exposure to risk. With a TCE ratio of 2%, this bank is solvent but its leverage and risk of failure are high
Regulatory Capital
Basel II regulations did not use TCE to measure risk. Instead, instead they used the ratio of regulatory capital to risk-weighted assets
Both the numerator and denominator differ from the tangible common equity concept
Regulatory Capital
Risk-Weighted Assets
Revised version March 2013 Ed Dolan’s Econ Blog
Regulatory Capital
Regulatory capital increases the numerator of a bank’s capital ratio in two ways compared with TCE
First, it counts certain intangible assets like goodwill and tax loss assets that contribute to possible future profits but could not be sold by a failing firm to raise cash
Second, it counts both common equity and hybrid capital (such as preferred stock) that is a mixture of debt and equity. Hybrid capital is a less reliable cushion against loss than common equity
Regulatory capital ratio = 100,000/1,050,000 = 9.5%, compared to tangible common equity of 2%
Revised version March 2013 Ed Dolan’s Econ Blog
Risk-Weighted Assets: Example
For the denominator of the capital ratio, Basel II did not count all assets at full value
Instead, assets were assigned risk weights according to their ratings
Examples of the weights:AAA rated assets = 20%A rated assets = 50%BBB rated assets = 100%
Revised version March 2013 Ed Dolan’s Econ Blog
Regulatory Capital vs. TCE
In short, under Basel II regulatory capital tended to understate the leverage of bank balance sheets
A bank might have tangible assets of 1,000,000 and tangible common equity of 20,000, giving a TCE ratio of 2%
The same bank might have risk-weighted assets of just 500,000 and regulatory capital of 50,000, giving a regulatory capital ratio of 10%
Data in this chart compare regulatory capital ratios to TCE ratios for banks in Europe and the US just before the 2008 financial crisis
Revised version March 2013 Ed Dolan’s Econ Blog
Trying Again: Basel III
In an attempt to fix the problems of Basel III, regulators have reached a new agreement, known as Basel III
Proposed improvements include:A better measurement of capital, closer to
tangible common equity (but not exactly)Requirements for banks to build extra
capital reserves if early warning signs show abnormal credit growth or asset price bubbles
Building of The Bank for International SettlementsPhoto source: http://commons.wikimedia.org/wiki/File:BIZ_Basel_002.jpg
Revised version March 2013 Ed Dolan’s Econ Blog
Will Basel III Succeed?
Now the hard work has begun of translating the general principles of Basel III into specific regulations
Preliminary proposals were tough, but banks are lobbying hard to weaken them
Some observers are already starting to fear that Basel III regulations will once again be too easy on banks, laying the basis for another global financial crisis a few years down the road
Revised version March 2013 Ed Dolan’s Econ Blog
Related slideshow: More on Financial Regulation and Basel III: Regulating Bank Liquidity
Click here to learn more about Ed Dolan’s Econ texts
For more slideshows and commentary, follow Ed Dolan’s Econ Blog
Like this slideshow? Share it on Twitter
Follow @DolanEcon on Twitter