The latest round of the Basel accords centres on the introduction of higher capital requirements for banks. Intended to be implemented gradually, the impact of these recommendations has been the subject of considerable speculation on the capital markets.
As a metric for the measurement of risk, the new Basel III standards have their merits and weaknesses. In this regard, a useful comparison can be made with Standard & Poor’s (S&P) Risk Adjusted Capital Framework (RACF). The RACF is S&P’s primary metric for assessing capital adequacy in financial institutions. It was designed, like Basel III, to address some of the problems identified in Basel II, in particular issues of comparability between regulatory national ratios. Although Basel III represents an advance on Basel II, in S&P’s opinion, these issues are likely to persist.
As a result, S&P will continue to employ the RACF when undertaking credit assessments. Although the RACF and Basel III have similar goals in terms of measuring risk, it is important for financial professionals to bear in mind that they are different instruments, and as such generate different understandings of risk. Compliance with Basel III standards will not in itself determine credit ratings apportioned by S&P.
Basel III: Strengths and Weaknesses
The focus of Basel III is on improving the liquidity and capital adequacy of financial institutions. Basel III will see the minimum common equity regulatory capital ratio be raised from its current 2% to 7% by 2019. Financial institutions will also be required to enact a variable countercyclical buffer that will be set by national authorities at a rate of up to 250 basis points (bps). The buffer will work by enabling regulators to raise capital requirements during periods when credit is perceived to be expanding faster than gross domestic product (GDP). Conversely, during times of low liquidity, regulators are able to decrease or suspend the buffer, in order to free up capital within the system.
The intent is to ensure banks boost their capital reserves during periods of growth, instead of being forced to find a means of obtaining liquidity at the other end of the cycle. Furthermore, institutions regarded as of systemic importance will also be subject to increased strictures, and required to hold an additional capital buffer. The exact details regarding this extra buffer have yet to be specified but this could amount to up to 300 bps in several mature markets.
Currently, while calculations regarding the Basel III standards must be subject to a number of assumptions, a number of banks have started to calculate their expected ratios. A sample of these banks reveals that the average risk-adjusted capital ratio after diversification is comparable to the common equity Tier 1 (CET1) ratio estimated under Basel III. On the other hand, significant volatility exists around this average. In relation to US trust banks, for example, Basel III estimates are 3-5% higher than the averages generated by the RAC ratio.
This is a significant discrepancy, given that increased levels of operational risk are liable to translate into heavier charges from regulators. S&P believes that over the last decade, the operational risk handled by asset managers has grown markedly. In order to account for this change S&P apply a heavier capital charge for cash and money-market funds. This is meant to reflect the likelihood of independent asset managers and their parent banking companies providing financial support to their funds, if required.
Increase in Capital Requirements for Trading Book Risk
Banks in mature markets, including the US, will be required by the Basel standards to substantially increase the capital requirements on their trade book market risk by the end of 2011.
Nicknamed ‘Basel II.5’ by the market, these augmented capital requirements require higher charges for securitisation exposures, the introduction of a ‘stressed’ value-at-risk (VaR) and an ‘incremental risk charge’ (IRC). Already, Swiss banks have been implementing the Basel II.5 procedures, since the beginning of the year, for Swiss Financial Market Supervisory Authority (FINMA) regulatory purposes.
In S&P’s opinion the result of the transition from Basel II to Basel II.5 will be a tripling of the average capital requirements for market risk in the trading book. This increase is already accounted for in the RACF ratio, which since its creation has featured a capital charge for trading-book market risk three to four times higher than regulatory charges derived from VaR models.
S&P expects reported Basel II.5 ratios will begin to converge to our RACF ratio, as a consequence of the stress VaR and the IRC metrics becoming openly available. This will assist market participants’ analysis of trading-book market risks. However, even after regulators put the new trading-book regime into action, S&P anticipates the capital charge in the RACF ratio to remain higher than the charge under Basel II.5.
Continuing Issues with Comparability
The Basel recommendations were not designed to be implemented according to a single blueprint. Instead each country will retain the authority to implement its own national discretions. This opens the door to the possibility of ‘goldplating’ when translating the recommendations into local regulations. As an example of the discrepancies that divergent local regulations can generate, the Commonwealth Bank of Australia’s (CBA) Tier 1 capital ratio as of December 2010 would be 13.5% under Financial Services Authority (FSA) rules instead of 9.7% under the Australian rules. The Australian rules impose a minimum 20% loss given default compared with 10% in most other countries, including the UK.
This difference alone drives about 40% of the impact on the pro-forma CBA Tier 1 capital ratio. This is despite the underlying risk being the same under both regulatory systems.
This issue is not limited to differences between national regulatory systems. S&P expects differences to emerge even within the same jurisdictions, as variances in regulatory risk weights are caused as much by differences in banks’ risk profiles as by variation in the methodology and models they employ to establish the risk weights. The UK FSA conducted a study on 13 banks. It revealed, given the same underlying risk, extraordinarily divergent estimates of probabilities of default. The most conservative bank estimated a probability of default for corporate obligors rated A that was fully 10 times higher than the estimate provided by the most aggressive one.
Raising the Quality of the Capital Base
A central focus of Basel III was on improving the transparency and consistency of the capital base. In the opinion of S&P this is likely to have an effect in neutralising some of the effects of the national discretions affecting the numerators of the capital ratios. However, the inadequacies in the design of the Basel III system mean that these problems will persist.
In contrast the RACF was devised on the basis of a globally consistent definition of both capital and risk-weighted assets. In contrast to the Basel III standards, therefore, the RACF provides S&P with the ability to conduct risk-analysis across jurisdictions and geographies on a consistent and coherent basis.
It is important to remember that regulators in national jurisdictions, tasked with implementing Basel III may be more conservative than S&P on some factors (e.g. deducting minority interests and deferred tax assets) and less on others (e.g. risk weighting significant minority financial institution holdings).
Handling the Concentration of Credit
The RACF includes explicit adjustments for the concentration and diversification of credit, market, operational, and insurance risks. These adjustments are designed to capture four different components:
- Single-name concentrations in the corporate portfolio.
- Industry-sector concentration or diversification of the corporate portfolio.
- Geographic concentration or diversification of the credit risk and equity risk-weighted assets.
- Concentration or diversification of business lines and risk types.
Each of the adjustments except the single-name can be positive (i.e. increase the risk-weighted assets) or negative (i.e. a benefit) depending on the bank. As shown by the considerable variance among the simple averages, the medians, and the weighted averages, the range of concentration and diversification adjustments are extremely diverse and significantly affect the RAC ratio for most banks.
This is very different from the Basel formula, which does not make an adjustment for institution-specific concentration or diversification.
Additionally, Basel risk-weighted assets assume infinite granularity of risk exposures. The second pillar of Basel does require banks to undertake an internal capital-adequacy assessment that regulators will then review. However, this assessment is not explicitly included in Pillar I risk-weighted assets.
Basel III a Step Forwards, But Improvements Still to be Made
It is certainly the case that there is a strong willingness among regulators to enhance the consistency of Basel implementation worldwide. However, S&P does anticipate material national discretions to remain. Consequently, Basel III will continue to maintain some of the marked discrepancies in Basel Tier 1 capital ratio computations. As a result, the multiple methodologies and approaches of the Basel framework, alongside the dependence on internal models, will continue to complicate comparisons of Basel III ratios.
While, therefore, Basel III may be thought of as an improvement on previous versions of the accords, a number of deficiencies remain. S&P anticipate the legacy of Basel III being as a part of a continued, on-going evolution in regulatory risk management.