S w 910N29 BASEL III: AN EVALUATION OF NEW BANKING REGULATIONS1
David Blaylock wrote this case under the supervision of David Conklin solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality.
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INTRODUCTION
The world’s biggest banks have a combined 1,730 (US$2,287 billion) gap in liquid investments that they must fill within four years, according to the Basel Committee on
Banking Supervision, the international banking watchdog.
Under the Basel III rule book, finalized by the committee on Thursday, December 16,
2010, 91 of the world’s biggest banks — tested in an impact assessment — also have a
577 billion capital shortfall compared with the new 7 per cent headline number for equity tier one capital, a measure of financial strength. 2
It was expected that the capital target could be achieved over time from retained earnings. For the 91 banks examined by the Basel committee, the combined “tier one capital ratio” was 5.7 per cent. This ratio was lower than previously calculated because the Basel III agreement disqualified certain non-equity capital from the numerator and changed the risk weightings of assets in the denominator. Under the new rules “any bank with less than a 7 per cent ratio will face significant restrictions on bonus and dividend pay-outs, making that the de facto minimum for most.” This new 7 per cent ratio will be phased in over the period 2011-2019. Meanwhile, some banks such as Credit Suisse, planned to issue “coco” bonds
(contingent convertible bonds). These bonds would convert into equity if the bank suffered losses that reduced its capital below specified ratios.
The new rules also required specific ratios of liquid investments, to be achieved by 2015. Analysts pointed to these liquidity targets as being more difficult to achieve. Many banks would have to rely often on the inter-bank markets to achieve the liquidity ratios. Perhaps any freezing of inter-bank markets could result in even more financial chaos than the inter-bank market freezing of 2008. A new leverage ratio target would include off-balance sheet assets. Important questions remained, including national enforcement and
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This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives presented in this case are not necessarily those of the Basil Committee or any of its members. Brooke Masters and Patrick Jenkins, “Basel reveals liquidity gap for world’s biggest banks,” Financial Times, December 17,
2010, p.6.
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ultimate impacts of the new Basel III rules. Meanwhile, some nations were adding their own new regulations, separate from Basel III.
THE CHALLENGES IN DESIGNING INTERNATIONAL BANKING REGULATIONS
The 2007/08 financial crisis and subsequent recession precipitated discussions on strengthening the 3 stability of financial systems. Many national governments have considered the enactment of stricter regulation of financial markets and bank liquidity. In the next few years, national and international supervisors will implement regulatory adjustments through coordinated efforts as well as independently, causing significant changes in the banking industry.
An internationally consistent regulatory framework is desirable for the world’s banking system. Increased global interconnection means that bank failures in one country can negatively influence other national economies. Governments and taxpayers may suffer because of the negative consequences from other nations’ poor regulatory practices. Internationally coordinated regulation also helps to minimize competitive differences among national banking systems. Uncoordinated policy implementation allows some nations a competitive advantage over those with a more restrictive regulatory framework.

Designing global bank regulation is a complex task. Negative shocks to the financial system repeatedly uncover new problems in the banking industry, which regulators then work to correct. International regulation has therefore become increasingly complex and restrictive. A more complicated supervisory framework is less able to accommodate countries’ financial differences. Predicting the effects of new regulation is difficult. Increased regulation usually reduces the risk profile of banks. However, the coinciding decrease in banks’ lending may be more detrimental to the economy than any bank failures avoided in the future. A more restrictive framework reduces the willingness of banks and regulators to adopt the policies for fear of lost performance and reduced economic growth. Banks will enjoy a more favorable regulatory environment in those economies that choose to reject new internationally coordinated regulation. Systemic risk may therefore move to those financial systems that reject a more restrictive proposal. Regulators in many countries look to the Basel Committee on Banking Supervision at the Bank for
International Settlements for a new regulatory framework.
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The Committee is a gathering of national Central Bank governors of the supervisors formed to promote cooperation in global banking regulation.
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Group of Ten countries established the Committee in 1974, with the goal of minimizing differences in bank regulation internationally. Since 1975, the Committee has published and distributed a series of documents related to supervisory standards. However, the Committee has no supranational authority to regulate the banks in member nations. The Committee’s conclusions do not have legal force, and national regulators must independently choose to implement the Committee’s recommendations.
The Committee has focused primarily on capital adequacy. Capital ratios appeared to be deteriorating at 6 many international banks in the early 1980s, while global risk seemed to be increasing. The Committee proceeded to publish the Basel Capital Accord in 1988, commonly referred to as Basel I. A new capital framework replaced Basel I in 2004 and was nicknamed Basel II. The most recent update consists of two
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For the remainder of the case, the 2007/08 financial crisis will be referred to as “the financial crisis.”
For the remainder of the case, the Basel Committee on Banking Supervision will be referred to as “The Committee.”
Basel Committee on Banking Supervision, “History of the Basel Committee and Its Membership”, August 2009, available at http://www.bis.org/bcbs/history.pdf, accessed July 29, 2010.
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Capital adequacy is the measure of a bank’s capital base in relationship to the bank’s assets.
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documents: the International Framework for Liquidity Risk Measurement, Standards and Monitoring and
Strengthening the Resilience of the Banking Sector.
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The Committee published the documents in December
2009, in response to the financial crisis. The combined documents have been nicknamed Basel III.
Ongoing discussions have sought to determine how the new rules should be implemented.
Banks have been critical of the Basel III documents. Predicting the influence of the accords is difficult, and many disagree with the Committee’s decisions. The financial crisis did not damage some countries as much as others, and some relatively undamaged economies seek to maintain their current regulatory system. Those who agree with the recommendations often disagree with aspects of the technical methodology for calculating the various capital ratios. However, both supporters and critics agree that the recommendations in Basel III will drastically change the global banking system. This case will outline the first two Basel Accords, evaluate the recommendations proposed by the Committee in the Basel III consultative documents and address the potential problems caused by financial institutions that are not regulated under the new proposals.
Some national regulators are implementing additional regulations to complement the Committee’s capital adequacy framework. This case will examine both the Dodd-Frank Wall Street Reform and Consumer
Protection Act implemented in the United States and the principle-based approach used by Canadian financial regulators. The case will conclude by pointing to possible future additions to the Basel III framework and recommendations.
PAST BASEL ACCORDS
Basel I
The document titled International Convergence of Capital Measurement and Capital Standards was the 8
Committee’s first major publication on capital adequacy. Banks’ capital ratio is the ratio of banks’ capital to on-balance sheet risk-weighted assets. The Committee recommended a minimum capital ratio of 8 per cent. Basel I focused primarily on credit risk and suggested appropriate risk weights for different kinds of loans and assets. For example, government debt and cash received a weight of zero. Loans secured by mortgages received a 50 per cent weighting, and private-sector loans received a 100 per cent weighting.
Basel I applied a general definition of capital that was easily integrated into most national regulations. All member countries introduced the framework, as did almost all other countries that host international banks.
Basel II
Basel II is a revised version of the 1988 document. The updated document seeks to improve risk 9 calculation in capital measurement by introducing three pillars. The first pillar expands on the minimum capital requirements proposed in Basel I by introducing a system that is based on external credit ratings.
For example, government debt from a country with a single-A credit rating would receive a 20 per cent risk weight, whereas a triple-A rated government would maintain a zero weighting. High-risk assets could receive weightings of more than 100 per cent. Alternatively, banks that received supervisory approval
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Basel Committee on Banking Supervision, “Consultative Document: Strengthening the Resilience of the Banking Sector,”
December 2009, available at http://www.bis.org/publ/ bcbs164.pdf, accessed August 7, 2010. Basel Committee on Banking Supervision, “International Convergence of Capital Measurement and Capital Standards,”
1988, available at http://www.bis.org/publ/ bcbsc111.pdf, accessed August 10, 2010. Basel Committee on Banking Supervision, “International Convergence of Capital Measurement and Capital Standards, A
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Revised Framework”, 2006, available at http:// www.bis.org/publ/bcbs128.htm, accessed August 7, 2010.
This document is authorized for use only by Jerry Parwada at HE OTHER until November 2014. Copying or posting is an infringement of copyright. Permissions@hbsp.harvard.edu or 617.783.7860.