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TWN Info Service on Finance and Development (Dec10/03)
23 December 2010
Third World Network

Largest banks fall short of meeting Basel III capital rules
Published in SUNS #7064 dated 20 December 2010

Geneva, 17 Dec (Kanaga Raja) -- The world's largest banks, 94 of them based on their 2009 results, face a shortfall of 577 billion euros (about $700 billion) in risk-free Tier One capital to meet the new capital requirements under Basel III.

An impact study of 94 of the world's largest banks conducted by the Basel Committee on Banking Supervision (BCBS) and released on Thursday (16 December) provided this estimate.

In addition to the risk-free Tier One capital, banks also need to have about 1.75 trillion euros more to augment their liquid assets.

The Basel Committee on Banking Supervision is a committee of banking supervisory authorities which was established by the central bank Governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.

A total of 263 banks from 23 Committee member jurisdictions (out of a total of 27) participated in the study, including 94 Group 1 banks (those that have Tier 1 capital in excess of 3 billion euros, are well diversified, and are internationally active) and 169 Group 2 banks (all other banks).

The Basel III rules are being phased in. Banks have till 2019 to meet their capital ratios, while liquidity assets (to prevent a Lehman-like collapse) have to be achieved by 2015. This last can be done by the banks shedding their risky portfolios, while the capital adequacy has to be met by raising new equity capital or adding profits to reserves (instead of distributing them to shareholders).

The comprehensive quantitative impact study (QIS), conducted by the Basel Committee and released on Thursday, is aimed at ascertaining the impact of its new requirements to raise the quality and level of the capital base, to enhance risk capture, to contain excessive leverage and to introduce new liquidity standards for the global banking system - collectively referred to as "Basel III" - originally introduced in July and December 2009.

The Committee also assessed the estimated impact of the liquidity standards. Assuming banks were to make no changes to their liquidity risk profile or funding structure, as of end 2009: The average LCR (liquidity coverage ratio) for Group 1 banks was 83%, while the average for Group 2 banks was 98%; The average NSFR (net stable funding ratio) for Group 1 banks was 93%, while the average for Group 2 banks was 103%.

For the banks in the sample, QIS results show a shortfall of liquid assets of 1.73 trillion euros as of end-2009, if banks were to make no changes whatsoever to their liquidity risk profile, and a shortfall of stable funding of 2.89 trillion euros at the end of 2009, if banks were to make no changes whatsoever to their funding structure.

According to the Committee, the QIS did not take into account any transitional arrangements such as the phase-in of deductions and grand-fathering of arrangements. Instead, the estimates presented assume full implementation of the final Basel III package, based on data as of year-end 2009.

Including the effects of all changes to the definition of capital and risk-weighted assets, as well as assuming full implementation as of 31 December 2009, the average common Tier 1 capital ratio (CET1) of Group 1 banks was 5.7%, as compared with the new minimum requirement of 4.5%. For Group 2 banks, said the Committee, the average CET1 ratio stood at 7.8%.

The Committee further said that in order for all Group 1 banks in the sample to meet the new 4.5% CET1 ratio, the additional capital needed is estimated to be 165 billion euros. For Group 2 banks, the amount is 8 billion euros. Relative to a 7% CET1 level, which includes both the 4.5% minimum requirement and the 2.5% capital conservation buffer, the Committee estimated that Group 1 banks in aggregate would have had a shortfall of 577 billion euros at the end of 2009.

As a point of reference, the sum of profits after tax and prior to distributions across the same sample of Group 1 banks in 2009 was 209 billion euros. The amount of additional CET1 capital required for Group 2 banks in the QIS sample is estimated at 8 billion euros in order to reach the CET1 minimum of 4.5%. For a CET1 target level of 7%, Group 2 banks would need an additional 25 billion euros; the sum of their profits after tax and prior to distributions in 2009 was 20 billion euros.

In the results of the study, the Committee highlighted the overall change in common equity Tier 1 (CET1) capital ratios if all the Committee's final rules, both for the definition of capital and for the calculation of risk-weighted assets, were fully implemented as of 31 December 2009.

It said that Group 1 banks' average CET1 capital ratios under the new regime would have fallen by almost half from an average gross CET1 capital ratio of 11.1% to 5.7% when deductions and changes in risk-weighted assets are taken into account (a decline of 5.4 percentage points). For Group 2 banks, the new net CET1 capital ratios would decline to 7.8% from 10.7%, indicating that the measures have a considerably greater impact on the larger banks.

It noted that these declines are mainly attributable to the new definition of capital deductions and filters not previously applied at the common equity level of Tier 1 capital in most jurisdictions (numerator) and to a lesser but still significant extent to increases in risk-weighted assets (denominator).

Under the Basel III framework, the minimum requirement for CET1, the highest form of loss absorbing capital, will be raised to 4.5% after the application of stricter adjustments. This minimum CET1 capital ratio will be phased in by 1 January 2015. Further, a capital conservation buffer above the regulatory minimum requirement was calibrated at 2.5% and will have to be met with common equity, after the application of deductions, by 1 January 2019.

The Committee provided information on the additional amount of capital that Group 1 and Group 2 banks would need between 31 December 2009 and 2019 to meet the target CET1 capital under Basel III, assuming a fully phased-in target CET1 requirement as at the end of 2009.

Assuming a fully phased-in risk-based capital requirement, the amount of additional CET1 capital required for Group 1 banks in the QIS sample to meet the 4.5% CET1 minimum requirement is 165 billion euros. For Group 2 banks, of which the coverage is considerably smaller, the shortfall is estimated at 8 billion euros. For a CET1 target of 7%, Group 1 banks would need an additional 577 billion euros and Group 2 banks in the QIS sample would need an additional 25 billion euros.

The Committee said that no assumptions have been made about banks' profitability or behavioural responses, such as changes in bank capital or balance sheet composition, since end-2009 or in the future. For this reason, it said that the QIS results are not comparable to current industry estimates, which tend to be based on forecasts and consider management actions to mitigate the impact, as well as incorporate estimates where information is not publicly available.

For Group 1 banks, the change in net CET1 capital compared to gross CET1 capital amounts to -41.3%. With an average change of -24.7%, the impact is smaller for Group 2 banks as compared to their Group 1 counterparts. The decline in both groups' Tier 1 and total capital is more modest and largely due to changes in capital instrument eligibility.

On the issue of risk-weighted assets attributable to the introduction of Basel III, the Committee found that overall risk-weighted assets increase by 23.0% for Group 1 banks. The main drivers of this increase are charges against counter-party credit risk and trading book exposures.

Accordingly, it added, banks that have significant exposures in these areas influence the average increase in risk-weighted assets heavily. Some banks also experience a larger-than-average increase in risk-weighted assets due to securitisation exposures in their banking book. Since Group 2 banks are less affected by the revised counter-party credit risk and trading book rules, risk-weighted assets increase by an average of just 4.0%.

As regards counter-party credit risk, the Committee pointed out that the calculation uses a modified version of the December 2009 proposed bond equivalent CVA (credit valuation adjustment) charge and a threshold of US$100 billion for applying the increased asset value correlation parameter to regulated financial institution exposures. The number of banks included in the counter-party credit risk (CCR) analysis is smaller than the number taking part in the QIS, as CCR is relevant only to banks engaged in OTC (over-the-counter) derivatives activities or securities financing transactions (SFTs).

Based on the sample banks included in this analysis, the Committee said that the new CCR requirements resulted in an 11.0% average increase in credit risk-weighted assets for Group 1 banks and a significantly smaller 1.1% increase in credit risk-weighted assets for Group 2 banks. The increase relative to overall risk-weighted assets is 7.6% for Group 1 banks and 0.3% for Group 2 banks.

The Committee introduced several Pillar 1 enhancements to the Basel II securitisation banking book framework in July 2009. Specifically, higher risk weights were introduced for re-securitisation exposures and credit conversion factors for short-term liquidity facilities to off-balance sheet conduits were increased. The effect of these enhancements was captured in the scope of the QIS data collection.

For Group 1 banks, the revised treatment of securitisations would increase overall risk-weighted assets by 1.7%. As expected, the overall change in risk-weighted assets for Group 2 banks (a 0.1% increase) was very modest overall. Importantly, these changes do not reflect the transition from a deduction to a risk-weighting treatment for securitisation exposures in some jurisdictions. Such effects have been attributed to changes in the definition of capital, said the Committee.

Regarding the leverage ratio, the Committee found that the average leverage ratio is 2.8% and 3.8% for Group 1 and Group 2 banks, respectively, indicating that large banks are considerably more leveraged than smaller banks (a bank with a high level of leverage will have a low leverage ratio). Independent of the risk-based ratio, approximately 42% of the Group 1 banks and 20% of the Group 2 banks in the sample would have been constrained by a 3% leverage ratio as of 31 December 2009 assuming the new definition of Tier 1 capital was already in place.

On the question of liquidity, the Committee said it has further strengthened its liquidity framework by developing two minimum standards for funding liquidity. One of the standards is a 30-day liquidity coverage ratio (LCR) which is intended to promote short-term resilience to potential liquidity disruptions. The liquidity coverage ratio was designed to require global banks to have sufficient high-quality liquid assets to withstand a stressed 30-day funding scenario specified by supervisors.

The LCR denominator is comprised of cash outflows less cash inflows that are expected to occur in a severe stress scenario, while the numerator consists of a stock of unencumbered, high quality liquid assets that must be available to cover any net outflow.

The Committee noted that 169 Group 1 and Group 2 banks provided sufficient data in the follow-up data collection exercise to calculate the LCR according to the final rules. The average LCR was 83% for Group 1 banks and 98% for Group 2 banks. For the banks in the sample, QIS results show a shortfall of liquid assets of 1.73 trillion euros as of end-2009, if banks were to make no changes whatsoever to their liquidity risk profile.

"This number is only reflective of the aggregate shortfall for banks that are below the 100% requirement and does not reflect surplus liquid assets at banks above the 100% requirement. Banks that are below the 100% required minimum have until 2015 to meet the standard by scaling back business activities which are most vulnerable to a significant short-term liquidity shock or by lengthening the term of their funding beyond thirty days. Banks may also increase their holdings of liquid assets."

The second standard is the net stable funding ratio (NSFR), a longer-term structural ratio to address liquidity mismatches and provide incentives for banks to use stable sources to fund their activities. The NSFR for Group 1 banks is 93% on average. For Group 2 banks, the average NSFR is higher than that of the Group 1 sample at 103%.

The Committee said that 166 Group 1 and Group 2 banks provided sufficient data in the follow-up data collection exercise to calculate the NSFR according to the final proposals - 43% of these banks already meet or exceed the minimum NSFR requirement, with 67% of them at an NSFR of 85% or above.

QIS results show that banks in the sample had a shortfall of stable funding of 2.89 trillion euros at the end of 2009, if banks were to make no changes whatsoever to their funding structure.

The Committee said: "This number is only reflective of the aggregate shortfall for banks that are below the 100% NSFR requirement and does not reflect any surplus stable funding at banks above the 100% requirement. Banks that are below the 100% required minimum have until 2018 to meet the standard and can take a number of measures to do so, including by lengthening the term of their funding, reducing maturity mismatch, or scaling back activities which are most vulnerable to liquidity risk in periods of stress."

"It should be noted that the shortfalls in the LCR and the NSFR are not additive, as decreasing the shortfall in one standard may result in a similar decrease in the shortfall of the other standard, depending on the steps taken to decrease the shortfall," it added.

The Chairman of the Basel Committee and President of the Netherlands Bank, Mr Nout Wellink noted that "the Basel III capital and liquidity standards will gradually raise the level of high-quality capital in the banking system, increase liquidity buffers and reduce unstable funding structures. The transition period provides banks with ample time to move to the new standards in a manner consistent with a sound economic recovery, while raising the safeguards in the system against economic or financial shocks."

He added that in the case of the liquidity standards, "we will use the observation period for the liquidity ratios to ensure that we have their design and calibration right and that there are no unintended consequences, at either the banking sector or the broader system level."

Meanwhile, the Committee also issued the Basel III rules text that outlines the details and time-lines of global regulatory standards on bank capital adequacy and liquidity. The rules text presents the details of the Basel III Framework, which covers both micro-prudential and macro-prudential elements.

According to the Committee, the Framework sets out higher and better-quality capital, better risk coverage, the introduction of a leverage ratio as a backstop to the risk-based requirement, measures to promote the build-up of capital that can be drawn down in periods of stress, and the introduction of two global liquidity standards.

Mr Wellink described the Basel III Framework as "a landmark achievement that will help protect financial stability and promote sustainable economic growth. The higher levels of capital, combined with a global liquidity framework, will significantly reduce the probability and severity of banking crises in the future."

He added: "With these reforms, the Basel Committee has delivered on the banking reform agenda for internationally active banks set out by the G20 Leaders at their Pittsburgh summit in September 2009."

On the issue of transition and implementation, the Committee said that it has put in place processes to ensure the rigorous and consistent global implementation of the Basel III Framework. The standards will be phased in gradually so that the banking sector can move to the higher capital and liquidity standards while supporting lending to the economy.

With respect to the leverage ratio, the Committee said that it will use the transition period to assess whether its proposed design and calibration is appropriate over a full credit cycle and for different types of business models. Based on the results of a parallel run period, any adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration, it added.

Both the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) will be subject to an observation period and will include a review clause to address any unintended consequences, it said further. +

 


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