Handbook of Basel III Capital

Enhancing Bank Capital in Practice

Juan Ramirez

• Publisher: Wiley
• Year: 2016
• ISBN:
  9781119330899
• Edition: 1
• Topic: Commerce
• Subtopic: Finance

A deeper examination of Basel III for more effective capital enhancement

The Handbook of Basel III Capital – Enhancing Bank Capital in Practice delves deep into the principles underpinning the capital dimension of Basel III to provide a more advanced understanding of real-world implementation. Going beyond the simple overview or model, this book merges theory with practice to help practitioners work more effectively within the regulatory framework, and utilise the complex rules to more effectively allocate and enhance capital. A European perspective covers the CRD IV directive and associated guidance, but practitioners across all jurisdictions will find value in the strategic approach to decisions surrounding business lines and assets; an emphasis on analysis urges banks to shed unattractive positions and channel capital toward opportunities that actually fit their risk and return profile. Real-world cases demonstrate successful capital initiatives as models for implementation, and in-depth guidance on Basel III rules equips practitioners to more effectively utilise this complex regulatory treatment.

The specifics of Basel III implementation vary, but the underlying principles are effective around the world. This book expands upon existing guidance to provide a deeper working knowledge of Basel III utility, and the insight to use it effectively.

• Improve asset quality and risk and return profiles
• Adopt a strategic approach to capital allocation
• Compare Basel III implementation varies across jurisdictions
• Examine successful capital enhancement initiatives from around the world

There is a popular misconception about Basel III being extremely conservative and a deterrent to investors seeking attractive returns. In reality, Basel III presents both the opportunity and a framework for banks to improve their assets and enhance overall capital – the key factor is a true, comprehensive understanding of the regulatory mechanisms. The Handbook of Basel III Capital – Enhancing Bank Capital in Practice provides advanced guidance for advanced practitioners, and real-world implementation insight.

Chapter 1
Overview of Basel III

Bank executives are in a difficult position. On the one hand their shareholders require an attractive return on their investment. On the other hand, banking supervisors require these entities to hold a substantial amount of expensive capital. As a result, banks need capital‐efficient business models to prosper.

Banking regulators and supervisors are in a difficult position as well. Excessively conservative capital requirements may lessen banks' appetite for lending, endangering economic growth. Excessively light capital requirements may weaken the resilience of the banking sector and cause deep economic crises.

1.1 INTRODUCTION TO BASEL III

Basel III's main set of recommendations were issued by the Basel Committee on Banking Supervision (BCBS) in December 2010 (revised June 2011) and titled Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems.

It is important to note that the BCBS does not establish laws, regulations or rules for any financial institution directly. It merely acts in an advisory capacity. It is up to each country's specific lawmakers and regulators to enact whatever portions of the recommendations they deem appropriate that would apply to financial institutions being supervised by the country's regulator.

1.1.1 Basel III, CRR, CRD IV

With a view to implementing the agreements of Basel III and harmonising banking solvency regulations across the European Union as a whole, in June 2013 the European Parliament and the Council of the European Union adopted the following legislation:

• Capital Requirements Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 (hereinafter the “CRD IV”), on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC. CRD IV entered into force in the EU on 1 January 2014; and
• Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 (hereinafter the “CRR”).

National banking regulators then give effect to the CRD by including the requirements of the CRD in their own rulebooks. The national regulators of the bank supervises it on a consolidated basis and therefore receives information on the capital adequacy of, and sets capital requirements for, the bank as a whole. Individual banking subsidiaries are directly regulated by their local banking regulators, who set and monitor their capital adequacy requirements.

• In Germany, the banking regulator is the Bundesanstalt für Finanzdienstleistungsaufsicht (“BaFin”).
• In Switzerland, the banking regulator is the Swiss National Bank (“SNB”).
• In the United Kingdom, the banking regulator is the Prudential Regulation Authority (“PRA”).
• In the United States, bank holding companies are regulated by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board” or “FSB”).

1.1.2 A Brief History of the Basel Accords

Global standards for bank capital are a relatively recent innovation, with an evolution along three phases (see Figure 1.1).

FIGURE 1.1 Bank regulatory capital accords

During the financial crises of the 1970s and 1980s the large banks depleted their capital levels. In 1988 the Basel Supervisors Committee intended, through the Basel Accord, to establish capital requirements aimed at protecting depositors from undue bank and systemic risk. The Accord, Basel I, provided uniform definitions for capital as well as minimum capital adequacy levels based on the riskiness of assets (a minimum of 4% for Tier 1 capital, which was mainly equity less goodwill, and 8% for the sum of Tier 1 capital and Tier 2 capital). Basel I was relatively simple; risk measurements related almost entirely to credit risk, perceived to be the main risk incurred by banks. Capital regulations under Basel I came into effect in December 1992, after development and consultations since 1988. Basel I was amended in 1996 to introduce capital requirements to addressing market risk in banks' trading books.

In 2004, banking regulators worked on a new version of the Basel accord, as Basel I was not sufficiently sensitive in measuring risk exposures. In July 2006, the Basel Committee on Banking Supervision published International Convergence of Capital Measurement and Capital Standards, known as Basel II, which replaced Basel I. The supervisory objectives for Basel II were to (i) promote safety and soundness in the financial system and maintain a certain overall level of capital in the system, (ii) enhance competitive equality, (iii) constitute a more comprehensive approach to measuring risk exposures and (iv) focus on internationally active banks.

The unprecedented nature of the 2007–08 financial crisis obliged the Basel Committee on Banking Supervision (BCBS) to propose an amendment to Basel II, commonly called Basel III. Basel III introduced significant changes in the prudential regulatory regime applicable to banks, including increased minimum capital ratios, changes to the definition of capital and the calculation of risk‐weighted assets, and the introduction of new measures relating to leverage, liquidity and funding.

1.1.3 Accounting vs. Regulatory Objectives

It is important to make clear that the accounting and regulatory objectives are not fully aligned. The aim of accounting financial statements is the provision of information about the financial position, performance, cash flow and changes in the financial position of an entity that is useful for making economic decisions to a range of users, including existing and potential investors, lenders, employees and the general public.

The main objective of prudential regulation is to promote a resilient banking sector or, in other words, to improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.

1.2 EXPECTED AND UNEXPECTED CREDIT LOSSES AND BANK CAPITAL

Let us assume that a bank provided a loan to a client. The worst case one could imagine would be that the client defaults and that, as a consequence, the bank losses the entire loaned amount. This event is rather unlikely and requiring the bank to hold capital for the entire loan would be excessively conservative and the bank is likely to pass the cost of the capit...