Basel III, the latest Accord, is the response of the BCBS to the 2008 GFC. The BSBC’s assessment of the risk factors that amplified the crisis is the fact that banks were highly leveraged with inadequate liquidity buffers, they engaged in poor governance and risk management, and some set up inappropriate incentives structures (BIS, 2015b). The purpose of Basel III was to adjust banks’ capital requirements at a level that would absorb
unexpected shocks. The phase-in implementation started in January 2013 and full implementation is expected in January 2019.
In summary, Basel III renewed the MRCR but more specifically defined the regulatory capital in insisting on a higher quality of Tier 1 capital and repealing Tier 3. It also introduced a conservation buffer ratio, a countercyclical buffer ratio, a leverage ratio, a liquidity coverage ratio and net stable funding ratio as follows:
- Total Capital Ratio = Regulatory Capital / Risk-weighted Assets = 8% - Conservation buffer = 2.5% of Risk-weighted assets (from 2016) - Countercyclical capital buffer = 0 to 2.5% of Risk-weighted assets
- Leverage Ratio (LR) = Capital measure19 / Exposure measure20
>=3%
- Liquidity Coverage Ratio (LCR) = Unencumbered stock of high quality
liquid assets21 / Total net cash outflows22 over 30 days of significant stress
period >= 100%
19 Capital measure is the Tier 1 capital of the risk-based capital framework
20A bank’s total exposure measure is the sum of the following exposures: (a) on-balance sheet exposures; (b)
derivative exposures; (c) securities financing transaction (SFT) exposures; and (d) off-balance sheet (OBS) items.
21 At least 60% level 1 assets (cash, central bank reserve, sovereign debt qualifying for a 0% risk weight under the Basel
II SDA for credit risk) and no more than 40% level 2 assets (sovereign debt qualifying for a 20% risk weight under the Basel II SDA for credit risk and corporate bonds and covered bonds of at least AA- rating
22 Net cash outflows is Total expected cash outflows minus Total expected cash inflows during the 30 days of stress
period.
Basel III Capital
- Net Stable Funding Ratio (NSFR) = Available amount of stable funding23 /
Required amount of stable funding >= 100%
Under the SD approach, revised and published in July 2016 (BIS, 2016b), general RWAs are 0%, 20%, 50%, 100% and 150%. For residential mortgage loans, the BCBS reduced the dependency on rating agencies and distributed the risk weights as follows:
1- Cases where repayment are not materially dependent on cash flows generated by the property LTV≤40% 40%<LTV≤60 % 60%<LTV≤80 % 80%<LTV≤90 % 90%<LTV≤100% LTV>100% Risk Weights 25% 30% 35% 45% 55% 75% for individuals 85% for SMEs
LTV (loan-to-value ratio) = Amount loan24 / Value of the property25
Source: (BIS, 2016b)
2- Cases where repayment are materially dependent on cash flows generated by the property
LTV≤60% 60%<LTV≤80% LTV>90%
Risk Weights 70% 90% 120%
Source: (BIS, 2016b)
23 Portion of capital and liabilities expected to be reliable over one year
24 Outstanding loan amount + undrawn committed amount of the mortgage loan 25 Appraised independently
3- Cases that do not meet the requirements of the framework have a 150% risk weight.
With regards to IRB approach, a consultative document was issued in March 2016 on “Reducing variations in the credit risk-weighted assets – constraints on the use of internal model approaches”. The revised version has not yet been published.
The BCBS also revised the Basel III securitisation framework but the new version is scheduled to come into effect only in 2018. For this reason, it is not in the scope of this study and will not be presented further. However, it is worth noticing the Basel III design distinguishes the internal ratings-based approach, the external ratings-based approach and the standardised approach. The choice now depends on the information available/analysis/estimations of banks and no more on the bank’s role in the securitisation process or the credit risk approach used for the underlying exposures (BIS, 2016a).
2.1.3.1. RCA persists in Basel III, at least for now
Basel III (2010), published following the GFC, has unfortunately not addressed the Basel II risk-weighted assets calculations problems (Petersen & Mukuddem-Petersen, 2014). RCA may continue to occur. Among the reasons pointed out, the fact that banks still have
the latitude to use a combination of approaches in the calculation of their RWA maintains the state of flux (Le Leslé & Avramova, 2012). Berg, Gehra, & Kunisch (2011) pointed out the discrepancies between the RWAs in banks’ credit risk (loans book) and market risk (trading book, ex: bonds). They demonstrated that, given a similar risk profile, under Basel I and Basel II, the asset correlation parameter (the degree of systematic risk given by the regulator), lead to 30% to 50% more capital requirements for corporate loans exposures than in the trading business. They believe this RCA opportunity will be repeated under Basel III in view of the fact that asset correlation is provided by the regulators for loans exposures and determined by banks for the trading business (Berg, Gehra, & Kunisch, 2011).
Blundell-Wignall & Atkinson (2010) described a case where bank A lends some money to a company through a bond acquisition. To this type of loan, the Accord allocates 100% risk weight. Bank A can then buy a Credit Default Swap from bank B on the bond. Because of the move of the promise from bank A to bank B, there is a shift of risk weight of the loans from 100% to 20%. In definitive, bank A will now determine its regulatory capital based on 20% risk weight instead of 100%.
In conclusion, as noticed by Haldane (2012), the granularity of the Basel risk weights opens doors for ‘near-limitless’ arbitrage.
Section 2.2. Theoretical perspective
Financial regulation and supervision are meant for i) microeconomic stability, ii) consumers or investors’ protection and proper behaviour, and iii) efficiency and competition (Giorgio & Noia, 2001). Regulation is justified by banks’ balance sheet opaqueness. However, regulations have become more and more complex. Subsequently, opaqueness and complexity cause asymmetry of information. This is an appropriate canal for regulatory arbitrage. Regulatory arbitrage is for the banking sector what inefficiencies are for the financial market (Fleischer, 2010). An efficient market is a market in which prices always fully reflect all available information (Fama, 1969). Fama (1969) also reported from Niederhoffer & Osborne (1966) and Scholes' (1969) works that two groups of actors actually have monopolistic access to information: the specialists on major security exchanges and the corporation insiders. This lack of information homogeneity among participants of the financial market is commonly termed asymmetry of information or principal-agent problem26. Similarly, in the banking sector, information asymmetry is for
example reflected in the difference between the economic capital and the regulatory capital defined in the Basel Accords regulation.
26 The principal agent problem is a situation where for example a person (the agent) acts in the interest of another (the
principal). The problem is, they both hold different information and different incentives. It is thus difficult for the principal to have control over the agent’s action. This is where moral hazard (hidden action) and adverse selection (hidden information) occur (Alexander, 2006).
Looking at banks’ behaviour under regulatory pressure (capital requirements) and the impact on their stability, AT and IT perspectives provide complementary interesting insights to assist the researcher in examining the relationship between the regulator and banks at the micro and macro levels. Because these theories focus on the pivotal concepts of asymmetry information (with sub-concepts of moral hazard27 and adverse selection28),
principal-agent problem and outcome uncertainty from the former and legitimacy from the latter, it is believed that they override the usefulness of other theories as they are perfectly aligned with the subject of this research.