Discuss the relationship between the capital base of banks and the 2007-2010 financial crisis and great recession.? 2) Evaluate the need for counter-cyclical capital b

Richard Ivey School of Business

The University of Western Onta.rio IVEY 910N29

BASEL 111: AN EVALUATION OF NEW BANKING REGULATIONS 1

David Blaylock wrote this case under the supe,vision of David Conklin solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation_ The afflhors may have disguised certain names and other identifying information to protect confidentiality

Richard Ivey School of Business Foundation prohibits any form of reproduction, storage or transmission without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization_ To order copies or request permission to reproduce materials, contact Ivey Publishing, Richard Ivey School of Business Foundation, The University of Western Ontario, London, Ontan·o, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mailcases@ivey_uwo.ca_

Copyright© 2010, Richard Ivey School of Business Foundation Version: 2013-03-11

INTRODUCTION

The world's biggest banks have a combined 1,730 (US$2,287 billion) gap in liquid investments that they must fill within four years, according to the Basel Committee on Banking Supervision, the intemational banking watchdog_

Under tl1e Basel III rule book, finalized by the c01mnitt.ee on Thursday, December 16, 2010, 91 of the world's biggest banks – tested in an impact assessment – also have a 577 billion capital shortfall compared Vith the ne,v 7 per cent headline number for equity tier one capital, a measure of financial strength_1

It was expected that the capital target could be achieved over tin1e from retained eamings_ For the 91 banks examined by the Basel conunittee, the combined ''tier one capital ratio" was 5_7 per cent This ratio was lower than previously calculated because the Basel III agreement disqualified certain non-equity capital from the numerator and changed the risk weightings of assets in the denominator_ Under the ne,,• rnles "any bank with less than a 7 per cent ratio will face significant restrictions on bonus and dividend pay-outs, making that the de facto minimum for most" This new 7 per cent ratio will be phased in over the period 2011-2019_ Meanwhile, some banks such as Credit Suisse, planned to issue 'coco" bonds (contingent convertible bonds)_ These bonds would conveit into equity if the bank suffered losses that

reduced its capital below specified ratios_

The new rnles also required specific ratios of liquid investments, to be achieved by 2015_ Analysts pointed to these liquidity targets as being more difficult to achieve_ Many banks would have to rely often on the inter-bank markets to achieve the liquidity ratios_ Perhaps any freezing of inter-bank markets could result in even more financial chaos than the inter-bank mad:et freezing of 2008_ A new leverage ratio target would in.dude off-balance sheet assets_ Important questions remained, including national enforcement and

' This case has been written on the basis of published sources only_ Consequently, the inte,pretation and perspectives presented in this case are not necessarily those of the Basil Committee or any of its members.

Brooke Masters and Patrick Jenkins, "Basel reveals liquidity gap for world's biggest banks,· Financial Times, December 17. 2010, p_6.

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ultimate impacts of the new Basel ill mies. Meanwhile, some nations were adding their own new regulation5, separate from Basel ill.

THE CHALLENGES IN DESIGNING INTERNATIONAL BANKING REGULATIONS

The 2007 /08 financial crisis and subsequent recession precipitated discussions on strengthening the stability of financial systems.3 Many national govemments have considered the enactment of stricter regulation of financial markets and bank liquidity. In the next few years, national and intemational ~11pervisors will implement regulatory adjustments through coordinated efforts as well as independently, causing significant changes in the banking industry.

An internationally con5istent regulatory fran1ework is desirable for the world's banking ~ystem. Increased global interconnection means that bank failures in one country can negatively influence other national economies. Governn1ents and taxpayers may suffer because of the negative con5equences from other nations' poor regulato1y practices. Internationally coordinated regulation also helps to mininlize competitive differences among national banking ~ystems. Uncoordinated policy iniplementation allows some nations a competitive advantage over those with a more restrictive regulatory framework.

Designing global bank regulation is a complex task. Negative shocks to the financial system repeatedly uncover new problem5 in the banking industry, which regulators tl1en work to correct. International regulation has therefore become increasingly coniplex and restrictive. A more coniplicated superviso1y framework is less able to acconuuodate countries' financial differences. Predicting the effects of new regulation is difficult. Increased regulation u5ually reduces the ri5k profile of banks. However, the coinciding decrease in banks' lending may be more detrimental to the economy than any bank failures avoided in the future. A more restrictive fran1ework reduces the willingness of banks and regulators to adopt the policies for fear of lost perfonuance and reduced economic growth. Banks will enjoy a more favorable regulato1y enviroruuent in those economies that choose to reject new intemationally coordinated regulation. Systemic risk may therefore move to tl1ose financial system5 tl1at reject a more restrictive proposal.

Regulators Ill many countries look to the Basel Committee on Banking Supervision at the Bank for International Settlements for a new regulatory framework.4 The Conunittee is a gathering of national ~11pervisors fom1ed to promote cooperation in global ba11king regulation. 5 Central Bank governors of the Group of Ten countries establi5hed the Conuuittee in 1974, with the goal of mininlizing differences in hank n~gnl~tion intP.m~tion~lly Sinc.P. 197.'i, thP. C'.ommittP.P. lrns pnhlishP.rl ~n<l <listrihntP.<l ~ sP.1iP.~ of documents related to supe1visory standard5. However, the Conuuittee has no supranational autl1ority to regulate the banks in member nations. The Conuuittee's conclu5ions do not have legal force, and national regulators must independently choose to implement the Conuuittee's reconuuendation5.

The Conuuittee has focused primarily on capital adequacy 6 Capital ratios appeared to be deteriorating at many international banks in tl1e early 1980s, while global risk seemed to be increasing. The Conuuittee proceeded to publish tl1e Basel Capital Accord in 1988, conuuonly refen-ed to as Basel I. A new capital framework replaced Basel I in 2004 and was nicknamed Basel II. The most recent update con5ist5 of two

3 For the remainder of the case, the 2007/08 financial crisis will be 1eferred to as "the financial crisis.• 'For the remainder of the case, the Basel Committee on Banking Supervision will be referred to as 'The Committee.• 5 Basel Committee on Banking Supervision, "History of the Basel Committee and Its Membership~ August 2009, available at http://www.bis.org/bcbslhistory.pdf, accessed July 29, 2010. • Capital adequacy is the measure of a bank's capital base in relationship to the bank's assets.

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documents: the lntemational Framework for Liquidity Risk Measurement, Standards and Monitoring and Strengthening the Resilience of the Banking Sector.1 The Committee published the doctunents in December 2009, in response to the financial crisis. TI1e combined doctunents have been nicknamed Basel ill. Ongoing discussions have sought to determine how the new mies should be iniplemented.

Banks have been critical of the Basel ill documents. Predicting the influence of the accords is difficult, and many disagree with the Committee's dec.ision5. The financial crisis did not damage some cotu1tries as much as others, and some relatively undan1aged economies seek to maintain their current regulatory ~ystem. TI1ose who agree with the recommendatio11S often disagree with aspects of the technical methodology for calculating the various capital ratios. However, both ~11pporters and critics agree that the recommendations in Basel ill will drastically change tl1e global banking system. Tilis c.ase will outline the first two Basel Accords, evaluate the recommendation5 proposed by the Committee in the Basel ill con~1tltative documents and address the potential problems caused by financial institutions that are not regttlated tu1der the new proposals.

Some national regttlators are implementing additional regulations to coniplement the Comnlittee's capital adequacy framework. TI1iscase will exanline both the Dodd-Frank Wall Street Reform and Con5mner Protection Act implemented in the United States and the principle-based approach used by Canadian financial regttlators. The case will conclude by pointing to possible foture additions to the Basel ill framework and reconunendations.

PAST BASEL ACCORDS

Basel I

The document titled International Convergence of Capital Measurement and Capital Standards was tl1e Conu11ittee's first major publication on capital adequacy.8 Banks' capital ratio is the ratio of banks' capital to on-balance sheet risk-weighted assets. TI1e Co11u11ittee reconunended a nlininuun capital ratio of 8 per cent. Basel I focused primarily on credit risk and ~11ggested appropriate risk weights for different kinds of loans and asset5. For example, government debt and cash received a weight of zero. Loans secured by mortgages received a 50 per cent weighting, and private-sector loans received a 100 per cent weighting. Basel I applied a general definition of capital that was easily integrated into most national regulation5. All member cotmtries introduced the framework, as did ahnost all otl1er cotmtries that host international banks.

Basel II is a revised version of the 1988 doctunent.9 The updated doctunent seeks to in1prove risk cak.ulation in capital measurement by introducing three pillars. The first pillar expand5 on the nlininuun capital requirements proposed in Basel I by introducing a system that is based on external credit ratings. For example, government debt from a cotu1try with a single-A credit rating would receive a 20 per cent risk weight, whereas a triple-A rated government would maintain a zero weighting. High-risk assets could receive weightings of more than 100 per cent. Alternatively, banks that received superviso1y approval

7 Basel Committee on Banking SupeNision, ·consultative Document: Strengthening the Resilience of the Banking Sector,· December 2009, available at http:l/www.bis.org/publ/ bcbs164.pdf, accessed August 7, 2010. 8 Basel Committee on Banking SupeNision, "International Convergence of Capital Measurement and Capital Standards,• 1988, available at http://www.bis.org!publl bcbsc111.pdf, accessed August 10, 2010. • Basel Committee on Banking Supervision, 'International Convergence of Capital Measurement and Capital Standards, A Revised Framework~ 2006, available at http://www.bis.org!publlbcbs128.htm, accessed August 7, 2010.

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could measure credit risk u5iilg an internal ratiilg framework outlined in Basel II. The first pillar also promotes the use of Value at Risk (VaR) to measure market, credit and operational risk.10 The second pillar recommends that supeivisors evaluate a bank's capital level in relation to the bank's risk profile to promote early regulator iiltervention. The third pillar encourages greater transparency of banks' holdiilgs.

Some recommendations proposed in Basel II may have increased systemic risk. The Committee iilcreased unifomlity in risk aversion, relied heavily on credit rating agencies and encouraged procydical behavior. 11

Imposiilg standardized, risk-based capital reqtlirements limits financial i.n5titutions' ability to iildependently define tl1eir risk aversion. Banks have greater difficulty selling tl1eir risky assets in a time of crisis when prices begiil to fall because other finm are unable to accept a higher level of risk.12 Minimtuu capital requirements c.an therefore decrease market liquidity and iilcrease systenlic risk.

Measuring tl1e minimum capital reqtlirements on the basis of evaluations by credit rating agencies and iiltemal rating systems may also exacerbate a crisis. 13 Credit rating agencies are unregulated, and ratiilgs can vaiy substantially between agencies. Directiilg ba!lks to monitoring their holdings on the basis of a rating agency's assessments may cause banks to unknowingly increase tl1eir risk profile if agencies base their analysis on mistaken asstuuptions or metl1odologies. Banks' iilternal risk models are complex and based on assumption5 tl1at proved untrue during the recent crisis.14 Dependence on iiltemal and external risk modeling also promotes procyc.lical behavior because ratings are procyc.lical.15 Ratiilgs strengthen iil stable period5 and lower dtu'ing period5 of crisis. Procyclical behavior iilcreases systenlic risk by increasing the probability of bank failure from tu1expected crises and discouraging lending dtu'ing downturn5.

BASEL Ill

Improving the Capital Base

Sununa,y

Basel m recommends raisiilg the quality, con5istency and transparency of banks' capital base, while reducing the required capital ratio to 7 per cent. The prim~ adjustment is to dec.lare conuuon eqtlity and retained earnings as the predominant forn1 of Tier 1 capital. 6 Past capital regulation did not require banks to hold a defined level ofconuuon equity and it set Ii.nuts only on total Tier 1 capital and total capital. 17For

10 Value at Risk measures the worst expected loss over a period on the basis of a given probability and assuming normal market conditions. 11 Procyclical behavior is the tendency of banks to react predictably to business cycle fluctuations. Procyclical banks over/end or hold less capital during expansionary periods and attempt to under/end or hold more capital during recessionary periods. 12 Jon Danielsson et al., 'An Academic Response to Basel II~ LSE Financial Markets Group Special Paper Series, Special Paper No. 130, May 31, 2001, available at htlpf/www.bis.org/ bcbslcalfmg.pdf, accessed August 24, 2010. 13 Robert C. Pozen, Too Big to Save?: How to Fix the U.S. Financial System, Wiley, Hoboken, NJ, 2010, p. 144. " Sheila Bair, "Remarks by FDIC [Federal Deposit Insurance Corporation] Chair Sheila Bair to the Institute of International Bankers Annual Washington Conference, Washington, DC,• March 2, 2009, available at http://www.fdic.govlnewslnewslspeecheslarchives/2009/ spmar0209.html, accessed August 3, 2010. 15 Jon Danielsson et al., 'An Academic Response to Basel II~ LSE Financial Markets Group Special Paper Series, Special Paper No. 130, May 31, 2001, p 15, available at http/lwww.bis.org/bcbslca/fmg.pdf, accessed August 24, 2010. 1 • Tier 1 capital is a bank's core capital base. Basel II defines Tier 1 capital as equity capital and disclosed reseNes. Equity

capital includes common stock and non-cumulative preferred stock. Non-cumulative preferred stock dividends do not accumulate if left unpaid, whereas cumulative preferred stock dividends accumulate. Disclosed reseNes refer primarily to retained earnings. 17 Tier 2 capital is supplementary capital. Tier 2 capital consists of reseNes other than those included in Tier 1 capital that are accepted by a bank's regulatory authority. Tier 2 capital may include hybrid (debt and equity combination) instruments and subordinated debt (debt that ranks lower than ordinary bank depositors).

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example, Bas,el II stated only that banks must maintain all 8 per cent minimum capital base composed of at least 50 per cent Tier 1 capital. Banks could have held as little as 2 per cent of assets ill common equity without breaking regulatory sta11dards.18 Banks could therefore maintain adequate capital ratios but hold the majority of capital in preferred stock or supplementary capital.

The highest quality capital component is common equity because it is subordinate to all other types of ftmdillg, in1mediately absorbs losses and has no maturity elate. Any assets included in Tier 1 capital that are not common equity must be able to absorb losses effectively.

Stremrths

Many banks failed to maintain a high-quality capital base prior to the crisis. Banks stmggled to rebuild their capital as the crisis worsened because investors, tULsure about the quality of banks' assets, were hesita11t to hold bank equity. Heavy losses and writedowns incurred during the crisis reduced banks' retained earnings component of Tier 1 capital. Many investors therefore distmsted reported measures of Tier 1 capital reserves because it was difficult to observe which banks held sufficient common stock to withstand the crisis. Attaining ~11fficie11t capital was difficult a11d required govemment ~11ppo1t. Increasing the a11101111t of common equity will improve banks' ability to absorb losses during difficult periods. Banks with more Tier 1 capital and greater reliance on deposits received higher rettmis during the crisis.19 Greater common equity requirements will also encourage investors and other banks to trust a bank's repo1ied capital ratios.

Weaknesses

The Committee's proposals will increase a bank's amotmt and cost of capital. Investors have a limited demand for banks' common equity. Forcing banks to hold substantially more conuuon stock will require issuance at increasingly favorable temis to attract more investors. Global capital may be insufficient for banks to recapitalize according to the new rules, without incurring higher costs.20 Some a11alysts and regulators worry that the world has a limited amount of "safe assets," particularly high-quality govenuuent and coiporate bonds. The increased cost of capital will increase borrowing costs for retail and commercial customers, since banks will attempt to recuperate increased operating costs by charging greater interest on their loruis. Banks must maintain a mininuuu ratio of !ugh-quality capital to total risk-weighted assets. Brulks may be forced to reduce total assets, including [oruis below the levels they could achieve in the absence of Basel ill. The Cruiadiru1 Brulkers Association wanis that requiring banks to hold too much capital may be as damaging to the world economy as allowing banks to operate with too little c.apital.21 The Institute of Intemational Finance predicts that Basel ill could decrease potential gross domestic product

18 Basel Committee on Banking Supervision, 'Consultative Document: International Framework for Liquidity Risk Measurement, Standards and Monitoring,• December 2009, p. 4, available at http:l/www.bis.org!publlbcbs165.pdf, accessed August 8, 2010. 10 Andrea Beltratti and Rene M. Stutz, Why Did Some Banks Perform Better during the Credit Crisis? A Cross-Count,y Study of the Impact of Governance and Regulation,• Finance Working Paper No. 254/2009, European Corporate Governance Institute, 2009, p. 21, available at http://www.ecgi.orglwplwp_id.php?id=386, accessed August 26, 2010. 20 Canadian Bankers Association, 'CBA Comments on the Basel Committee's Consultative Document 'Strengthening the Resilience of the Banking Sector,m April 16, 2010, p. 3, available at http:l/www.bis.org!publlbcbs1651cbac.pdf, accessed August 9, 2010. 21 Ibid., p. 1.

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(GDP) growth by 3 per cent and decrease the number of available jobs by 10 million in the United States, the European Union and Japan.22

Leverage Ratio

Su11una1y

The Committee recommends supplementing the risk-based capital requirements of Basel II with a leverage ratio.23 TI1e leverage ratio is based on a bank's total exposure. It is expected to protect against model risks and measurement errors.24 TI1e munerator of the leverage ratio is composed of high-quality capital and the denominator includes both on-balance sheet and off-balance sheet assets.25 The goals of the leverage ratio are to limit banks' leverage and discourage rapid deleveraging that may destabilize the overall economy.26

The proposal recommends that high-quality assets, total repurchase agreements and sec.uritizations be included in the calculation of exposure while disallowing nettinf!"27 In a July 26, 2010 statement the Committee proposed a minimum Tier 1 leverage ratio of 3 per cent. 8

Stremrths

The leverage ratio provides a 11011-risk-basedmeasure. As previou5ly mentioned, Basel II iniposes a mininuun capital requirement u5ing a ratio of high-quality capital to risk-weighted assets. Risk is

22 The Institute of lntemational Finance represents more than 400 of the world's largest banks. David Keefe, ·usRegulator Says Basel Capital Rules Still Tight~ Global Risk Regulator, July 31, 2010. 23 Bank leverage is the use of funding borrowed from depositors or purchased on the market to finance interest-bearing assets, primarily loans. Banks seek a profit by investing depositor funds in loans at rates high enough fo cover capital costs and operating expenses. A leverage ratio compares a bank's leverage to its capital level. 24 Current exposure is the Joss that would be incurred today if a counterparty tailed to honor its contract. Credit risk or credit exposure is the risk that a counterparty will fail to pay back the full amount that is owed at the scheduled time or anytime in the future. A counterparty is the opposing party in a financial transaction, such as a security trade or Joan. 25 On-balance sheet leverage is leverage incurred from financial transactions renected on the balance sheet according to accounting standards. Off-balance sheet transactions are financial transactions that are not observable on the balance sheet of the financial institution conducting the transaction. Financial derivatives such as futures contracts are included in off-balance sheet transactions. Off-balance sheet leverage is therefore leverage that is not renected on the balance sheet, usually because the leveraging is part of a financial derivative transaction. 26 The economy can be destabilized by a Joss spiral. A Joss spiral occurs when leveraged investors' assetsdrop in value and their net worth declines very quickly because of leverage. For example, an investor may buy $100 million worth of assets on a 10 per cent margin. The investor therefore finances the investment with only $10 million of his or her own capital and borrows the remaining $90 million. The leverage ratio is 10 to 1 assetsto capital or 9 to 1 debt to capital. Consider the asset value dropping to $95 million. The investors original $10 million in capital has been reduced to $5 million. The investor is forced to reduce the position to $50 million to maintain the leverage ratio of 10, meaning that the investor must sell $45 million worth of assets at a tower price than when he or she originally bought the asset. The sale further decreases prices and induces more selling to create a spiral of declining asset value. 27 Repurchase agreements are contracts to sell and tater repurchase securities at a pre-specified date and price. Securitization involves compiling assetsinto new securities backed by the underlying assets and the assets' cash flows. Netting is the offsetting of positions by trading partners to reduce a large number of individual positions into a smaller number of positions. Committee on Payment and SeWement Systems,A Glossary of Terms Used in Payments and Settlement Sysiems•,March 2003, available at http:llwww.bis.org/publlcpssOOb.pdf, accessed August 10, 2010. 28 The recommended leverage ratio is based on the Committee's more limited definition of cap1al and more broad definition of assets,including off-balance sheet assets. The minimum Tier 1 leverage ratio of 3 per cent means that banks must hOfd at least 3 per cent of their total assets in Tier 1 capital, or a bank's total assetsc<1nnot be more than 33 times its Tier 1 capital. Bcse/ Committee on Banking Supervision, "Annex•, July 26, 2010, available at http:// www.bis.org/press/p100726/annex.pdf, accessed August 9, 2010.

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quantified through financ.ial modeling and dependenc.e 011 credit rating agenc.ies. The leverage ratio inc.reases tra115parenc.y by supplementing the risk-based models with a broader model that does not distinguish between low-risk and high-risk asset5. The ratio can help to identify banks that are operating radic.ally different from their peers, particularly in regard to off-balance sheet activities.29

The primaiy strength of the leverage ratio is the monitoring of off-balance sheet leverage. Brulks heavily expru1ded both 011-balru1cesheet ru1d off-balru1ce sheet leverage prior to the fi11ru1cialcrisis. The bru1ki11g ~ystem maintained strong capital ratios while significantly inc.reasing leverage. Brulks were therefore able to expru1d their risk profile without exceeding regulat0ty limits. For exan1ple, Lehman Brothers boasted a Tier 1 capital ratio of 11 per cent just five days before the finn's collapse. However, Lehman Brothers reported a leverage ratio of30.7 to 1 in the compru1y's 2007 ruumal report.30

Weaknesses

Strict implementation of a leverage ratio may have tulintended co11Seque11ces. Assigning too much impo1iance to a leverage ratio could incent banks to focus more on higher-risk assets with !}feater potential retums than on low-risk assets with lower yield because all assets are equally weighted. 1 Allowing the ratio to be too broad may also cotmteract the significance of the ratio by overstating potential risks ru1d therefore making the identification of outliers more difficult.

Counter-Cyclical Capital Buffers

Summa1y

The Conunittee proposes the maintenance of capital buffers dtu111g stable periods to absorb losses dtu111g period5 of stress. A capital buffer is a range defined above the regulato1y mi.11i.11uu11 capital requirement to protect against losses. Cotu1ter-cyc.lical capital buffers reqtlire brulks to hold capital greater than the regulatory mi.ninuun dm111g periods of stability in order to ~1uvive dw111g a sudden industry downturn. Regu

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