Banks’ regulations are a key element to understand banks behaviour and their influence on the markets. This paper aims to go through the evolution of the Basel Accords, with a focus on banks’ capital requirements.
From Basel I to Basel IV
The Basel Committee on Banking Supervision (BCBS), founded in 1974, is the global standard setter for the prudential regulation of banks. Its goal is to achieve cooperation on banking supervisory matters and enhance financial stability.
The first accord, Basel I, was reached in 1988 and its main pillar was capital adequacy, a minimum ratio of capital to risk-weighted assets (RWAs), called the Cooke ratio.
Due to the evolution of the sector and to some shortcomings of Basel I, in 1999 the BCBS delivered Basel II. This second framework was based on three pillars:
- Capital adequacy
- Regulatory supervision, rules for the regulators
- Disclosure, regarding market discipline
Basel I and II soon appeared to be too weak to assure financial stability, mostly during the 2007-2008 financial crisis.
In 2010 Basel III came along with stricter requirements:
- Stronger requirements for common equity
- Liquidity ratio
- Leverage ratio
At the roots of banks’ capital requirements are to be found regulatory capital and risk-weighted assets (RWAs). The problem was lying behind the discretionary calculation of RWAs that was bringing a wide variation of values across banks that could not be explained only by their portfolio’s risk.
In 2017 the committee decided to deliver reforms to Basel III, which are called by the industry “Basel IV”, to be implemented by January the 1st 2022. The main goal was to restore the framework’s credibility.
Variables impacting banks’ capital requirements
The Capital ratio is a fundamental element of the Basel framework, it is the amount of regulatory capital divided by the amount of risk-weighted assets:
The grater is the amount of risk-weighted assets, the more capital is needed.
- Basel III – Regulatory capital
Basel III was mainly focused on the fine tuning of the Regulatory Capital, the numerator of the capital ratio. Banks fund their investments with both capital and debt, however capital can absorb losses, reducing at the same time the probability of default. Regulatory capital absorbs losses in going and gone concern:
- Common equity tier 1 (CET1): common shares, retained earnings and other reserves. It is the highest quality of regulatory capital and it absorbs losses immediately.
- Additional tier 1 (AT1): capital instruments with no fixed maturity. It provides loss absorption on a going-concern basis.
- Tier 2 (T2): subordinated debt and general loan-loss reserves. It is a gone-concern capital, in other words only in case of the bank failure it absorbs losses before depositors and general creditors.
Figure 1 shows the specified minimum level banks must maintain of CET1, Tier 1 and Total capital, with each level set as percentage of RWAs.
- Basel IV – Risk-weighted assets and Output Floor
Basel 2017’s reforms concentrate on the RWAs, the denominator of the capital ratio.
Banks’ assets typically include cash, securities and loans where each type of asset has different risk characteristics with different risk weights.
Due to the variation in the calculation of the RWAs (standardized or with internal models), the incomparability between banks capital ratios was undermining the confidence in capital requirement.
Moreover, the committee believed that the use of internal models could become an incentive to minimize risk weights when applied to set minimum capital requirements. Additionally, certain types of assets cannot be modelled correctly using internal models.
The 2017 revision addresses specifically to this shortcoming; it aims at restoring the credibility in calculation of RWAs through:
- Enhancing the robustness and risk sensitivity of the standardized approach
- Constraining and placing limits to the use of internal model approaches
Standardized approach and Internal ratings-based approach
Most banks use the standardized approach (SA) for credit risk, under this method supervisors set risk weights banks must apply to their exposures to determine RWAs.
The reform updated the SA by:
- Improving its granularity and risk sensitivity, while keeping the approach sufficiently simple; e.g. residential mortgages: instead of assigning a flat risk weight, weights are set depending on the loan-to-value;
- Reducing banks’ mechanistic reliance on credit ratings by requiring enough due diligence when using external ratings.
On the other hand, internal rating-based (IRB) approach for credit risk allows banks, under certain conditions, to use their internal models to estimate credit risk and, consequently, relative RWAs. There are two IRB approaches:
- Advanced IRB, which allows banks to estimate probability of default (PD), loss-given default (LGD), exposure at default (EAD) and maturity of an exposure;
- Foundation IRB, which removes the two important sources of RWAs variability as it applies fixed values to the LGD and EAD parameters.
As Figure 2 shows, the BSBC decided to remove the option of A-IRB, except for specialised lending; moreover, for equity exposures no IRB approach can be used. When IRB approaches are retained the committee has chosen to set minimum levels on the PD and other inputs.
A new Output Floor
The revision of the SA provides the basis for a revised output floor to internally modelled capital requirements which is another key point of Basel IV’s framework. The revised output floor limits the amount of capital benefit a bank can obtain from its use of internal models. More specifically banks’ calculation of RWAs using internal models cannot fall below 72,5% of the risk weighted assets computed by the standard approach, in other words this output floor limits the benefit banks can obtain from using internal models to 27,5%.
Impact of the final framework
In August 2019 the European Banking Authority (EBA) published a quantitative impact assessment of the last Basel framework. The results show an expected increase in minimum required capital around 24,4% (average EU); however, this result is largely driven by large and systematically important institutions, whereas it is limited for medium and small banks.
The capital increase reflects the intentions of the committee in tightening the framework for the new targeted categories of exposures considered riskier.
The impact of the framework depends on the specific structure of the banking market and current regional regulation, as a matter of fact US banks will probably experience a much lower increase in capital requirements mostly because most of them do not use an internal rating-based approach.
On a global level the new Basel reform will not lead to a significant increase in capital requirements.
Author: Silvia Monge