Basel III Accord: Where do we go from here?

Peter Went∗

October 15, 2010

Abstract
The Basel III Accord strengthens risk-based capital regulation, regulatory supervision principles
and risk management practices in the banking sector. While maintaining the micro-prudential
regulatory toolkit introduced in the previous Basel Accords that ensure the safe, sound and
prudent operations of banks, Basel III seeks to address the effects of systemic risks that globally
interconnected financial institutes propagate. On the eve of the G-20 meetings in South Korea
that are to ratify this new international framework, the paper discusses the implications this
new macro-prudential regulatory regime has on the future of banking, risk management, and
risk managers.

Keywords: Basel III Accord, Risk Management, Financial Institutions, Regulations.

JEL classification: TBD

Forthcoming in the Risk Professional, December 2010.

∗
Address: Peter Went, GARP Research Center, 111 Town Square Place Suite 1215, Jersey City, NJ 07310, USA.
Email: peter.went@garp.com Tel: 201-719-7230 Fax: 201-222-5022. The usual disclaimer applies.

Electronic copy available at: http://ssrn.com/abstract=1693622

 Basel III Accord: Where do we go from here?

Abstract

The Basel III Accord strengthens risk-based capital regulation, regulatory supervision prin-
ciples and risk management practices in the banking sector. While maintaining the micro-
prudential regulatory toolkit introduced in the previous Basel Accords that ensure the safe,
sound and prudent operations of banks, Basel III seeks to address the effects of systemic risks
that globally interconnected financial institutes propagate. On the eve of the G-20 meetings
in South Korea that are to ratify this new international framework, the paper discusses the
implications this new macro-prudential regulatory regime has on the future of banking, risk
management, and risk managers.

Never let a crisis go to waste -refining risk-based capital regulation post the financial crisis.

Each financial crisis comes with its own hard-learned lessons. The current financial crisis has

offered and continues to offer regulators, policy makers, politicians, financial institutions, and the

public ample opportunities to debate how to redesign, improve and refine the architecture of the

global financial system. The ultimate objective of regulations is clear: to reduce the likelihood that

a disruptive and devastating crisis such as this crisis would occur in the future. They should give

regulators the authority to monitor the health of individual banks and the interlinked network of

international banks, and to act decisively when weaknesses potentially threaten the health of the

system and endanger the financial system’s ability to effectively intermediate capital.

The Basel III framework is a step in this direction , not simply an incremental change or an

additional overlay to the currently existing Basel II Accord. Rather, it is a bold, broad and novel

regulatory structure that addresses the evolution of modern banking and the complex relationships

within the financial system. Unlike the two previous Basel Accords, Basel III is macroprudential

regulation. While maintaining the micro-prudential regulatory toolkit from the previous Basel pro-

posals that ensure the safe, sound and prudent operations of banks, Basel III considers the effects

Electronic copy available at: http://ssrn.com/abstract=1693622

of systemic risks that globally interconnected financial institutes propagate and seeks to address

these risks.

The proposals defining the contents of the Basel III framework evolved during the crisis that started

in 2007, and reflect the prudential regulatory lessons learned throughout the crisis. Based on these

experiences, including the success of various regulatory policies and tools used in mitigating and

resolving the effects of the crisis on the banking system and the global financial system, the Basel

Committee on Banking Supervision outlined these new regulations.

And as the G20 leaders are planning to endorse Basel III as the new global financial regulatory

framework during their meeting in South Korea in November, it is important to take a step back

to analyze the new rules negotiated by banking regulators from different countries and the impli-

cations this new regime has for the future of banking, risk management, and risk managers.

1 The main changes to the international regulation of banks

The main points of these proposals address increasing the quantity and quality of capital, expanding

capital requirements for certain types of risks, introducing globally valid liquidity standards, and

adjusting capital levels to reduce systemic risk in the global interconnected financial markets. Over

the coming 9 years, these changes will be implemented incrementally to allow regulators, banks and

the financial industry adequate time to assess the efficacy of these newly introduced regulatory tools

and to ensure that the various supervisory approaches are correctly and consistently calibrated,

implemented, and applied.

1.1 The quality and quantity of capital

The new framework simplifies the regulatory capital definition, and by extension harmonizes glob-

ally the various types of financial instruments that can become eligible for inclusion when computing

3
regulatory capital adequacy. Tier 1 capital is fully loss absorbent regulatory capital on a going-

concern basis. The new definition of Tier 2 capital is streamlined, removing the distinction between

upper and lower tiers, and is expected to bear losses on a contingency basis, or gone-concern basis

in case of insolvency. Tier 3 capital is abolished.

The quantity of capital is increased by emphasizing the crucial role core equity capital plays in

absorbing losses and providing banks an essential capital base. The core equity capital regulatory

requirement is raised from the current 2% to 4.5%, and the Tier 1 capital requirement is raised from

4% to 6%. Banks have 5 years to implement these changes, which also disallows the inclusion of

certain non-common equity instruments that no longer qualify as regulatory capital. Additionally,

by 2019 the proposals call for an additional capital conservation buffer funded by common equity

to absorb losses during periods of financial and economic stress. When this buffer falls below 2.5%,

the bank’s ability to distribute earnings through the payment of dividends to its shareholders and

discretionary bonuses to its employees is limited until the buffer is restored. Effectively, these pro-

posals demand the common equity ratio of 7% and bringing the total regulatory capital requirement

to 10.5%.

The crisis emphasized the pro-cyclical nature of risk-based capital requirements. During good

times, when underwriting practices are generous, credit volumes can easily become excessive. Dur-

ing bad times, when underwriting practices are stringent, credit is hard to secure. Credit losses

reduce the amount of available capital, and the value of mark-to-market credit products is highly

sensitive to the volatility patterns of the markets. These disequilibria can deepen the effects of an

economic contraction and may further propagate banking and economic crises. The new rules in-

troduce a complex framework for creating, implementing, and releasing the countercyclical capital

buffer, ranging between 0% and 2.5%. This fully loss-absorbing capital should protect the banking

sector, at a national level, from periods of excessive credit volumes. By increasing capital require-

ments during such periods, the potentially devastating effects of a system-wide buildup of risk are

counterbalanced. Furthermore, the Committee will promote more forward-looking provisions based

on expected losses.

4
1.2 Fully loss-absorbent contingent capital

The proposals further call for making all financial instruments qualified to fulfill regulatory capital

requirements as fully loss-absorbing at specific trigger events. When a bank receives an injection of

public sector capital, support or guarantee to ensure its continuing viability, or when it writes-off

or converts capital to maintain its future viability, these yet to be finalized rules call for forced

conversion of non-debt capital into fully loss bearing equity capital. Consequently, market partici-

pants and investors have the incentive to conduct more thorough due diligence to identify, prior to

a crisis, banks that are more likely to forcibly convert debt into loss-absorbing equity.

1.3 Risk-invariant leverage ratio

To supplement the broader risk capital requirements and the increased regulatory capital levels,

the Basel Committee also sets forward a new risk-invariant leverage ratio to act as a backstop to

the traditional risk based capital requirements. Starting 2015, an initial minimum Tier 1 leverage

ratio of 3% will be implemented and assessed during a 5 year parallel run period, before subjecting

this regulatory metric for further review and calibration in anticipation of full inclusion as a Pillar

1 capital requirement.

1.4 Liquidity

Typically, banks fail from the combination of substantial credit losses and limited or disappearing

liquidity to adequately fund their assets during times of stress. Consequently, regulators have con-

sidered access to adequate funding and liquidity levels crucial for the long-term stability of each

bank. Hereto, international banking regulations did not have global liquidity standards, or con-

sistent regulatory monitoring in cross-border supervisory oversight. The new short term Liquidity

Cover Ratio, to be implemented starting 2015, focuses on the ability to maintain adequate liquidity

coverage for extreme stress conditions of up to 30 days. This will be complemented by a longer-term

structural Net Stable Funding Ratio, to be implemented by 2018, that relates the long-term and

stable sources of funding to the liquidity characteristics of on- and off-balance sheet.

5
1.5 Appropriately risk-weighted assets

The proposals raise capital requirements in the banking book. During the financial crisis expe-

riences with resecuritization transactions, where a securitized instrument becomes the underlying

asset of another securitized product, suggest that these sophisticated structures are particularly

dependent on the availability of liquidity. To reflect these experiences, the proposals increase the

capital requirements by adjusting the risk weight of resecuritization exposures in relation to the

securitization exposures, by harmonizing some credit conversion factors for specific liquidity facili-

ties associated with securitization and market disruption lines, by demanding more rigorous credit

analysis of externally rated securitization exposures, and by prohibiting the recognition of ratings

that reflect guarantees or other support provided by banks.

To provide further stability to the financial system, the proposals also call for enhanced counter-

party credit risk practices, including higher Pillar 1 capital requirements determined by stress tests.

These capital charges account for the effects of deteriorating credit quality on transactions with

counterparties. Further, the proposals emphasize the need for more robust collateral management

practices, and increased capital requirements for exposures to large financial firms. Importantly, the

proposals also increase incentives to execute OTC-transactions through centralized clearinghouses.

The largest impact on the trading book comes from the introduction of the stressed market VaR

requirement for banks that use the Internal Models Approach. Extending the market risk capi-

tal requirement by calculating a stressed VaR, banks replicate VaR during periods of stress. By

expanding market risk capital requirements to account for periods of stress, the procyclicality of

market risk capital requirement is reduced. According to the Quantitative Impact Study, this

change in capital requirement beyond the existing VaR estimate (using data from the most recent

one-year period) and the stressed VaR for a one-year period of significant stress is likely to increase

the capital requirements 3 - 4 times. Moreover, an Incremental Risk Capital Charge (IRC) is in-

troduced to complement the new VaR framework by incorporating the effects of credit migration,

widening of credit spreads and loss of liquidity.

6
To improve market discipline through increased transparency, the Basel Committee also proposes

the implementation of deeper and broader disclosure standards to ensure that market participants

have an increased ability to better assess the risks other banks may pose. These proposals comple-

ment and support changes in capital levels, capital requirements, and liquidity standards.

2 The likely impact on banking

Basel III combines risk-based capital and liquidity standards to reduce the potentially devastating

effects of a global and systemic banking crisis, and impact the availability, price and volume of

credit. The significance of this impact on the economy is difficult to predict as the final result de-

pends on the individual and joint effects of several intertwined factors, some of which are discussed

below.

First, to meet the new liquidity standards, banks will have to increase the amount of low-yielding

liquid assets on their balance sheet by divesting less liquid and higher yielding assets. The net

effect is reduced earnings yield, which should reduce the earnings of the individual banks and the

profitability of the banking sector in aggregate.

Second, to fulfill the capital requirements, banks are likely to raise new capital, issue new types of

financial instruments, and repurchase or otherwise unwind financial instruments that the new rules

make ineligible for purposes of regulatory capital. Increasing the demand for equity capital should

bid up both the price and the required return on capital. Apart from selling new equity, banks

can also raise equity by reducing dividend payouts to shareholders and moderate compensation

practices. However, with more equity capital to meet regulatory mandates, bank leverage declines,

reducing equity risk premiums, capital costs, and funding expenses.

Third, to satisfy the new and higher capital requirements, particularly through the risk-invariant

leverage ratio, banks may have to reduce the exposures with comparatively higher risk weights.

7
This would likely reduce the banking sector in its ability to effectively and efficiently intermediate

credit, including contingent products.

Four, to protect the banking industry from periods of excessive credit growth that historically

is associated with the emergence of asset and credit bubbles, the counter-cyclical capital buffer

aims to reduce excess credit creation. During periods of excessive credit creation, regulators may

trigger the need for replenishing this capital buffer, which reduces the trajectory of balance sheet

growth and acts as a balancing factor.

Five, to implement these wide-ranging changes, the Basel III proposals provide a lengthy im-

plementation window, which may reduce the overall capital costs for banks. As the stability of the

banking system is slowly restored and the costs of the bailout are discounted, costs of raising and

employing capital should decline, which, by extension, should reduce the cost of credit costs.

Six, to strengthen the resiliency of the banking system through increased capital levels and capital

coverage, substantial government infusions in the banking system would become less likely. This

would reduce the risk premium in the banking system as the potential burden of another series of

another large scale government capital injections would decline.

At the end, the question remains: do the positive effects of reduced risk premium in the bank-

ing system sufficiently compensate for the increased equity capital costs, lower leverage and prof-

itability? By reducing leverage in banks, both risk sensitive deposit insurance premium levels, and

wholesale and interbank funding costs would likely decline. Whether aggregate effect of lowering

these two funding costs would offset the potentially higher equity capital costs and the foregone

yield demanded by high liquidity assets remains to be seen.

8
3 The likely impact on risk management

The new proposals embrace several approaches to improve risk management practices at banks,

including increased use of stress tests, more sophisticated models to account for various risks and

greater emphasis on the cyclical nature of banking.

All these proposals impact the Internal Capital Adequacy Assessment Process (ICAAP), strengthen

internal risk governance, and cement the role of risk management in senior management with the

increased independence of the Chief Risk Officer (CRO). In its proposals, the Committee empha-

sizes the independence of the CRO from individual business lines and suggests that the CRO should

report directly to the chief executive and the bank’s board of directors.

Learning from the crisis, supervisory focus will increase on various specific risk management ar-

eas, including the emergence of embedded risk concentrations throughout the asset and liability

base of banks. The financial crisis demonstrated that securitization transactions with the same

counterparty create on-balance sheet positions with off-balance sheet liabilities, and can create risk

management problems, which also have reputational implications. As the proposals emphasize the

need to incorporate the results of various stress tests in the computation of the regulatory capital

requirements, stress testing emerges as a core risk management and regulatory instrument. More-

over, given the potential role contingent capital can play in supporting the survival and the ongoing

viability of a bank in duress, the nature of stress tests change as well. Accordingly, stress tests

should also consider the dynamic effects on regulatory capital, thus the (in)ability of the bank’s

own capital to absorb losses.

Additionally, with the introduction of global liquidity standards, risk management will have to

identify, measure, and control liquidity risks and further integrate liquidity risk management when

managing credit, market, and operational risks. Assessing the risks of intraday liquidity positions,

managing counterparty credit and bilateral exposures - particularly when considering complex se-

curitized and other products - will require banks to design and implement early warning indicators.

By integrating various risk management activities ranging from credit risk, through funding risk,

9
to counterparty credit risk, the increasing convergence of risk management process and practices

directly emerges from these proposals.

Finally, the more stringent capital requirements would increase the demands on the more effective

use of all available bank capital, which emphasizes the role of both capital and risk management.

4 The likely impact on risk managers

The integration of risk management practices impacts the governance role of risk managers by

highlighting the crucial role the CRO and risk managers play in the successful governance of finan-

cial institutions. The visibility of risk managers is likely to increase through all levels of the bank

as the proposals encourage the risk function to highlight risk concentrations and violations of risk

appetite limits to senior management and the board risk management.

Risk managers will also face new and exciting challenges. For instance, for market risk man-

agers these proposals offer several interesting and intellectually stimulating challenges. Apart from

incorporating a stressed market risk capital requirement for market risk, the proposals call for the

computation of an IRC and the development of VaR models that better incorporate the effects of

correlations, nonlinearities, and liquidity.

The proposals also call for a capital charge to capture default, credit migration risk, credit spread

risk and liquidity effects in the trading book and sets the IRC requirements at the 99.9% confidence

interval over a capital horizon of one year and specifically considering the liquidity horizons appli-

cable to individual trading positions. Specific liquidation floors, ranging for one month for equities

to one year for resecuritization exposures complicate modeling.

As these new the regulatory guidelines require a constant risk level for the set one-year capital

horizon, the practical implication from a risk management and risk measurement perspective is

that holdings subject to the IRC, would need to be appropriately rebalanced during the one-year

10
period to maintain a constant level of risk over the horizon. Further modeling challenges in the

new IRC framework relate to the finer calibration of the effects of concentration in the portfolio,

the impact of hedging, possible maturity mismatches, and the non-linear impact of option features.

To meet these and other risk management challenges such as jointly considering both valuation

and risk factors in risk assessment, and to successfully ascend to their increased governance roles,

risk managers are destined to face substantially higher educational standards and more demanding

training requirements in the future.

5 Possible flashpoints

The Basel III proposals also address concerns caused by the procyclical amplification of finan-

cial shocks throughout the banking system that characterized the financial crisis, and introduce a

number of measures to make the global banking system more resilient to effects caused by mark-

to-market accounting standards and margining practices. Overall, through these proposals, the

Basel Committee seeks to promote broader macroprudential strength that periods of excess credit

growth propagate.

While these proposals address the broad financial reform agenda, its impact fails to extend beyond

banks. The shadow banking system - hedge funds, unregulated investment funds and insurance

companies - is a significant provider of credit and user of services provided by banks. Basel III

does not regulate the activities of these entities including their leverage, risk management practices,

liquidity levels, and risk appetite etc. Many countries are still implementing the Basel II rules; we

are yet to learn when they will be able to turn their attention to the Basel III framework. More-

over, the implementation of Basel III hinges on the nature of these proposals: similar to the two

preceding Accords, these international agreements between central bankers and banking regulators

do not directly bind regulators or banks on a national level. Unless there is the political power to

enact legislation that incorporates these proposals into the national regulatory framework, these

rules may remain toothless.

11
Basel III cannot address the problems caused by regulatory arbitrage: to attract banks and to cre-

ate viable financial centers, national governments can choose not to implement these international

risk-based capital standards. And as regulations become more onerous, the incentives increase to

instantaneously move capital from countries with oppressive supervision to countries with a more

relaxed approach to financial regulation.

With internationally active banks increasingly interrelated through their trading, payment, and

settlement activities, the Basel Committee has emphasized the need for practical approaches to as-

sess the importance of individual banks to the stability of the global financial system. Importantly

and as the collapse of Lehman Brothers demonstrated, the impact of collapsing systemically signif-

icant banks is devastating on counterparties with their complex interrelationships. Consequently,

the Committee is evaluating potential capital surcharges and liquidity requirements for systemically

important banks together with calls for potentially increased regulatory scrutiny of their activities.

Thus, that group of banks that local - or supranational -supervisors will deem to be systemically

important is expected to hold more capital and liquidity while facing increasing risk management

requirements and regulatory oversight of their activities.

And as the proposals continue to encourage banks to use clear OTC derivatives transactions through

centralized counterparties and exchanges, the role these entities play in the financial infrastructure

is likely to increase. As centralized counterparties are designed to reduce systemic risks by guaran-

teeing that trades are executed as intended, the strength of risk and collateral management practices

at these entities should evolve as a regulatory priority in the coming years as these systemically

important entities assume a more integrated and central role in the financial system.

Basel III is a new step in financial system regulation: its long-term success depends on the political

will to implement these broad-based macro-prudential principles. We cannot let this crisis go to

waste, and refrain from reforming those components in the financial system that failed.

12