Friday, September 10, 2010

BASEL III – What does it mean?

The purpose of Basel II (recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision), which was initially published in June 2004, was to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face.

In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability

Even though the European banks and most banks in the global markets have implemented the Basel II rules, analyzed the risk exposure and the value at risk, the financial crisis revealed that the capitalization and liquidity of many banks is not enough. Financial institutions like the Hypo Real Estate in Germany, RBS in UK or Fannie Mae in the US had to be saved by the governments because their reserves were not sufficient to cover for the credit losses and massive depreciations on toxic assets.

The main goal of the Basel committee is to prevent the next financial crisis. Hence the members of the committee came to an understanding (on September 7, 2010) to keep a tighter rein on the banks. Those new regulations will constitute the third accord of the Basel Committee on Banking Supervision, also known as BASEL III.

While the chairmen of the central banks and financial supervision organizations of 27 countries will have the final saying (they will meet on Sunday, September 12), the core elements of the new regulations are known:

  • Minimum quotas for the Core-Tier-1 capital of publicly traded corporations which – according to the plans – in the future, will only consist of ordinary shares and revenue reserves.
  • Special rules apply for savings, cooperative, and regional banks, which are not publicly traded corporations. Under certain criteria’s (e.g. profit-and-loss distribution) certificates and silent participations can be added to the Core-Tier-1.
  • The required core capital ratio is expected to be 6%.
  • In addition, BASEL III will probably dictate the installation of two capital buffers for financial distress, each in the amount of 2%. The Basel Committee suggests a leverage ratio of 3%. This means the balance sheet total can only be 33 times larger than the core capital, i.e. the raising capital is limited.

What does that mean for the financial institutions and the economy?
The banks have to hold out a capital reserve of 10% and can only raise limited amounts of capital in the market. To give you an example: for the top 10 German banks alone this means an increased demand of more than $ 130 billion. In addition, if the banks in Germany want to do their business to the current extend in the future, they need to increase their capital base considerably. If that does not work out, the granting of credits in Germany could decline dramatically, probably in the range of $ 1300 billion (according to the banking association). Therefore the Basel Committee wants to install the deficit limit only for a test. It will not become binding before 2018.

In any way, it will have a negative impact on the economic growth in Europe, the USA and other markets. The banks have to redesign/enhance their risk models and analyze their equity ratios and liquidity risk more closely.

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