From Basel I to Basel III and beyond

state of the play

DKF 2014
Dorothea Schfer
Munich, April 1, 2014
1 Basel I
2 Basel II and risk weighting
3 Basel III: state of the play and assessment
4 Beyond

Overview
Dorothea Schfer
From Basel I to Basel III
Basel I

1
3
Basel I
Initiation: Herstatt bankruptcy 1974
Publication of new rules 1988, Implementation: 1992,
Minimum capital requirement = amount of credit x 8 % x percentage
weight of risk class

Risk classes and percentage weights: no discredition for banks
0 % for sovereign bonds of OECD-countries (zero!)
20% for interbank credits (1 million) within OECD countries (16 000)
50% for collateralized real estate credits (40 000)
100% for other credit engagement including loans to corporations (80000)
Important elements
1
From Basel I to Basel III
Dorothea Schfer 4
Basel I
1. Common equity capital and retained earnings (core (Tier 1) capital)
2. Additional internal and external resources of the bank
(supplementary capital, long-term liabilities, specific provisions)

Tier 1 capital: core Tier 1 capital plus other instruments, e.g. non-
redeemable non-cumulative preferred stock

Loss taking: Common equity capital and retained earnings
Weird: other instruments than loss taking instruments qualify as bank
capital
Definition of capital within Basel I
1
From Basel I to Basel III
Dorothea Schfer 5
Basel I
Only four risk categories
Independency of risk weights of borrowers solvency
and liquidity
Cross-subsidization of loans and credits (good
borrowers subsidize bad borrowers)
Main critique of Basel I
1
From Basel I to Basel III
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Basel II
2
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From Basel I to Basel III

Basel II
2004: publication of Basel II framework
2007: implementation
Main elements
1. Basically no change in definition of capital
2. Introduction of individual risk weights
1. Ratings (ECAI External Credit Assessment Institution, e.g S&P, Moodys,
Fitsch)[standard approach]
2. Own calculations (bank itself assesses risk)[IRB approach]
3. Calculation of a banks required capital



Basic Overview
2
From Basel I to Basel III
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capital
x 100 % 8 % (minimum capital ratio)
credit risk + 12.5 (market risk + operational risk)
Basel II
Calculation of Risk weights: standard approach
1
From Basel I to Basel III
Dorothea Schfer 9
Credit
exposure to
Rating classes (coming from ECAI)
AAA A+ BBB+ BB+ B+ Below Without
to to to to to B- Rating
AA- A- BBB- BB- B-
Sovereign
states/central
banks (Lex EU)
0% 20% 50% 100% 150% 100%
Banks (option 1-
3): according to
the rating of the
home state
(option 1)
20% 50% 100% 150% 100%
Corporations/no
n-banks
20% 50% 100% 150% 100%
Asset Backed
Securities
20% 50% 100% 350%
1.250 %
(deductio
n from
core
capital)

Basel II
The European CRDs have introduced [] a risk weight of 0% for
exposures to Member States central government [].
[] instead of confining the zero risk weight to the standardised
approach, (the CRDs) permit a generalised zero risk weight through the
so-called IRB permanent partial use rules

IRB permanent partial use: IRB in general except for sovereign debt.
(Speech of Herv Hannoun, Deputy General Manager Bank for International Settlements, at Financial
Stability Institute High-Level Meeting Abu Dhabi, UAE, 26 October 2011 )


EU CRDs: Exposure to sovereign EU member states
2
From Basel I to Basel III
Dorothea Schfer 10
Basel II
Amount of
credit (in
million Euro)
Risk weight
(%)
Minimum
capital ratio
(%)
Mimimum
capital
Leverage
ratio
Leverage
2 5% 8% 8000 0,40% 250
50% 8% 80000 4,00% 25
Example for the calculation of minimum
capital
1
From Basel I to Basel III
Dorothea Schfer 11
Risk weight IRB approach: RW(LGD, PD, M)
Basel II
Incentives
2
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From Basel I to Basel III
1. Investing in the zero risk weight debt of EU member
states
2. Minimum risk assessment with own models
3. Investing in highly rated securities (e.g super senior
tranches of US subprime CDOs)
4. Installing off-balance sheet vehicles with no capital
requirements (continues from Basel I, no
counterbalancing regulation present)

Basel II
Consequence
2
Dorothea Schfer 13


From Basel I to Basel III
1. Growing of total assets without additional capital
2. Bank got bigger and bigger
3. Excessive leverage and extremely low leverage
ratios
4. Expansion of off-balance sheet vehicles

Basel II
Basis for such incentives

Leverage effet in combination with bonuses which are linked to the return
on equity

2
From Basel I to Basel III
Dorothea Schfer 14
return
return on equity
return on assets
interest rate
debt/equity
If equity capital is fixed more debt brings the bank managers in the desired
direction
Basel II

Trends in banking after introduction of risk
weighting
Leverage (multiple of equity capital) and ratio of risk-
weighted and total assets of the four largest banks in UK



2
From Basel I to Basel III

Dorothea Schfer 15
30
35
40
45
50
55
15
20
25
30
35
2000 2001 2002 2003 2004 2005 2006 2007 2008
Hebel (100 Prozent/Leverage Ratio
in Prozent) (linke Skala)
risikogewichtete
Aktiva/Bilanzsumme in Prozent
(rechte Skala)
Leverage (left-
hand axis)
Risk-
weighted
assets to total
assets (right-
hand axis) in
%
Basel II
Acceleration of a ongoing trend? Leverage Ratio of
Deutsche Bank (1870-1914)
2
From Basel I to Basel III
Dorothea Schfer 16
Basel II
Leverage Ratio of Deutsche Bank (1924-1942)
2
From Basel I to Basel III
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Basel II
Total assets and capital of Deutsche Bank
(billion)(1952-2011)
2
From Basel I to Basel III
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Basel II
Leverage Ratio of Deutsche Bank (1952-2011)
2
From Basel I to Basel III
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Trend till 2019?
Basel II
More anectotic evidence: the Swedish real estate case
2
Dorothea Schfer 20
When the Basel 2 accord came into effect in Sweden in 2007, Swedens
largest mortgage lenders were authorized by FI to use internal models to
calculate the risk weights in their credit exposures. The result of the
introduction of the models was that risk weights for Swedish mortgages
dropped sharply, and many of the largest players now have average risk
weights down at around 5 per cent for these exposures. This can be
compared to risk weights of 50 per cent in the regulations applicable until
2007 the Basel 1. (Finansinspektionen Memorandum Nov 26, 2012)


From Basel I to Basel III
Basel II
More anectotic evidence: the Swedish real estate case
2
Dorothea Schfer 21
When the Basel 2 accord came into effect in Sweden in 2007, Swedens
largest mortgage lenders were authorized by FI to use internal models to
calculate the risk weights in their credit exposures. The result of the
introduction of the models was that risk weights for Swedish mortgages
dropped sharply, and many of the largest players now have average risk
weights down at around 5 per cent for these exposures. This can be
compared to risk weights of 50 per cent in the regulations applicable until
2007 the Basel 1. (Finansinspektionen Memorandum Nov 26, 2012)


From Basel I to Basel III
Basel II
Summer stress test of EBA in 2011



Starke Hebelung der Bankbilanzen groer Banken

2
From Basel I to Basel III
Dorothea Schfer
22
10 largest German banks (in million Euro)
Source: DIW Berlin, own calculations on the basis of published stress test data.
Lever
age
Ratio
in %
If a leverage
ratio of 5% is
required
Cap
required(left)/
additional cap
needed right
(million Euro)
Basel II
Ongoing: high leverage in banks balance sheets





2
From Basel I to Basel III
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IMF Financial Stability Report 2012
Basel II
The zero risk weight approach for EU member states fires
back
2
Dorothea Schfer 24


From Basel I to Basel III
Dramatic loss of value
of large proportion of
EU-banks assets
because of
downgrading

Investors lost
confidence in solvency
of banks
(and of states)
AAA
AA
A
BBB
BB
B
CCC
CC
C
SD
01.01.2009 16.05.2010 28.09.2011 09.02.2013
Rating steps
01.01.2009 - 01.09.2013

Greece Ireland Italy Portugal Spain
Source: Christopher F. Baum & Margarita Karpava &
Dorothea Schfer & Andreas Stephan, 2013. "Credit Rating
Agency Downgrades and the Eurozone Sovereign Debt
Crises," Boston College Working Papers in Economics 841,
From Basel I to Basel III
Dorothea Schfer 25
-500
0
500
1000
1500
2000
2500
3000
3500
4000
Spreads Sovereign Bonds 2000 2014: losses in value until
summer 2012
Frankreich
Italien
Portugal
Irland
Griechenland
Spanien
Hans-Helmut Kotz und Dorothea Schfer (2014), Rating-Agenturen:
Fehlbar und berfordert. In: Schfer D, Semmler W. and Young B. (Ed.), Nachhaltige Europische
Konsolidierungspolitik

Basel II
Conclusion for Basel II




2
From Basel I to Basel III
Dorothea Schfer 26
Risk weights in Basel II

have enabled banks to get larger and larger without increasing the amount of
loss-absorbing equity capital,

made banks more vulnerable,

have contributed to the European financial crisis
because of the short distance of many large European banks to default
and
the therefore high probability that sovereign EU/Euro member states
have to accumulate more debt in order to help their banks

In addition: lobby groups use risk weights to fight for lower ones (e.g. sme loans,
real estate loans, energy investments). This may decrease credit costs on the
micro level but decreases stability on the macro level (race to the bottom)
Basel III
Is it the answer to these problems?
3
Dorothea Schfer 27
From Basel I to Basel III

Basel III
Important elements
3
From Basel I to Basel III

Dorothea Schfer 28
Narrower definition of eligible capital (focus: loss absorption)
Increase of capital requirements
Banks in general
Global systemically (Sifis), domestic systemically important
financial institutions
Leverage ratio
Still dominant: risk weighting is basis for capital requirements
Struggle with US about role of rating agencies
Basel III
Important elements
3
From Basel I to Basel III

Dorothea Schfer 29
Liquidity coverage ratio and net stable funding ratio
Liquidity for 30 day of stress (recently postponed 2015 to
2019)
NSFR: fighting of maturity mismatch (goal: liquid for one
year)
Payment rules (bonus systems)
(CRD IV: EUP and EUC struggle)

Basel III
Capital requirements
3
From Basel I to Basel III

Dorothea Schfer 30
Core capital (Common equity and retained earnings)
Banks in general (7 %, including max. CCB: 9.5 %)
from 2% to 4.5%
capital conservation buffer: 2.5 % (supervisory authorities impose
constraints)
Counter cylical buffer (CCB) from 0 to 2.5 %
Sifis: on top between 1% and 2.5 % (depends on
importance) + 1% in addition for the highest class Sifis (in
discussion)
Reminder: Tier 1 capital ratio of German banks 11.9 % (IMF)



Basel III
Capital requirements
3
From Basel I to Basel III

Dorothea Schfer 31
CRD IV: EUP and EUC struggle about eligibility of additional
buffers (Sweden, UK)

EUP: fear of competitive advantage for buffer countries

Weird because for years lower capital requirements than the
strong Basel II rules were labelled as competitive advantage
(e.g. German banks complained a lot about US bank not
following the Basel II rules)


Basel III
Capital requirements
3
From Basel I to Basel III

Dorothea Schfer 32
Leverage ratio : 3 percent in 2019
Too low for large banks
it implies a leverage of 33 x the required capital,
no constraint for the growth in size (no constraint for mh)
Required capital is broader defined than the core capital,
therefore: required core leverage ratio is actually lower
Too late
Not exactly clear: mandatory or only ratio for observation






Basel III
Final remark
3
From Basel I to Basel III

Dorothea Schfer 33
Basel III is not the answer to the identified problems
It does not effectively constrain the leveraged growth model
of banks
It does not effectively constrain the banks discretion about
the risk weighting and the capital requirements
It does not effectively remove the managements incentive
to build on the leveraged growth model
Limitation of the moral hazard (mh) problem of Sifis: highly
questionable


Vielen Dank fr Ihre Aufmerksamkeit.
DIW Berlin Deutsches Institut
fr Wirtschaftsforschung e.V.
Mohrenstrae 58, 10117 Berlin
www.diw.de

Thanks for your attention