Basel 3 capital requirements - overview and critical evaluation

Table of content

II. Table of figures

III. List of abbreviations

1. Introduction

2. Historical Development
2.1. Basel I
2.2. Basel II

3. Basel III
3.1. 8% Total and 13% Potential Capital Ratio
3.1.1. Tier 1 capital (excluding Buffers)
3.1.2. Tier 2 capital
3.1.3. Buffer implementation
3.2. Leverage Ratio
3.3. Step-by-Step Implementation

4. Shortcomings
4.1. Shifting promises
4.2. Increasing Product Costs
4.3. Decreasing GDP growth
4.4. Critics from a personal point of view

5. Conclusion

IV. Appendix

V. References

II. Table of figures

Figure 1: Total equity rates in US Commercial banks from 1840-

Figure 2: Distribution of minimum capital requirement under Basel II

Figure 3: 8 percent Total Capital and potential 13 percent Capital Ratio

Figure 4: how banks should save money when they use their conversation buffer

Figure 5: Implementation process of Basel III

Figure 6: Example of possible “shifting promises” under Basel III

Figure 7: changing total product costs in different banking sectors

Figure 8: How the changing capital requirements will change the development of GDP

Figure 9: comparison of GDP growth between the Eurozone and other countries

III. List of abbreviations

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1. Introduction

The implementation of capital requirements in the banking sector is done by the Basel Committee of Banking Supervision. Historically, these requirements got upgraded step-by-step to prevent high risk in this sector. Although, this was the aim of all Basel accords, the last financial crisis has shown us the shortcomings that they still have.

This paper is divided in to three main parts where each has some subdivisions:

Firstly, one will get a basic overview about the history of the whole Basel Accord. The implementation of the new Basel III capital requirements was not that easy and was not a work of only a few days. It started quite early in the mid-70s with the foundation of the Basel Committee. During the years the Basel accord was enhanced a lot of times until the latest version was presented in 2010.

Secondly, there is an in-depth explanation of the whole capital requirements under Basel III. One will see the changes between the requirements under Basel II and III. Especially the division of Tier 1 and 2 capital has changed dramatically. Additionally, there is an exact explanation of different types of money sources which can be used as Tier 1 or 2 capital. Essential new types of capital are the two Buffers that are going to be implemented under Basel III – Countercyclical and Conversation Buffer.

Thirdly, there are also some discussions going on with Basel III. Although, the higher capital requirements make the banking sector safer, there are a few shortcomings for the whole economy. One will see three main shortcomings, which are often discussed by researchers. Additionally, one finds a part where I explain my personal critics about the new Basel III capital requirements.

Finally, at the end of this paper one will get a short conclusion about the content of the whole paper. After reading all parts one should be able to understand the system of Basel, including all its Pros and Cons.

2. Historical Development

Generally, the banking regulations of Basel I, II and III are made by the Basel Committee on Banking Supervision (BCBS). This Committee was founded in 1974 by the G-10 with the intention to provide a forum of discussion, make the coordination between national supervisors easier and to improve the overall supervisory standards that should lead to a better financial stabilization. Meanwhile it consists of more states and has its’ headquarter in Basel. The decisions which are made in the Basel Committee have no legal status and are therefore not obligatory under international law. In its early stages, the aim was that all banks which are internationally active have to implement some rules which are made by the Basel Committee (Basel I, II and III). Meanwhile, these rules should be implemented by all banks around the world to guarantee a stable financial environment. One reason behind this is that the increasing globalisation crosslinks the business of banks all around the world. Hence, the Basel Committee decided to implement the first Basel Accord which introduced the first capital requirements for the banking system.^[1]

2.1. Basel I

To understand why the implementation of Basel I was necessary one has to understand how the business of a bank works. Basically, banks get money from their clients in form of deposits. This short term deposits can then be used to give loans to clients. Normally, these clients have to pay a higher interest rate on their long term loans in comparison with the interest rate they get from short term deposits. The difference between these interest rates is the main profit of a bank. Therefore, it is the main problem for a bank if clients cannot payback their loans or if the banks do not get enough deposits to maintain their loan business. Generally, such situations are not that harmful as long as a bank has enough equity to absorb its losses. The lower the amount of equity compared to its total assets is, the higher is the risk that the bank will face a liquidity problem. The liquidation of the German Herstatt bank was a major signal that showed how important it is to have enough equity, to maintain in the banking business.^[2]

In an US study of Berger et. al. it is shown that the overall equity rate, as a percentage of total assets, has decreased sharply since 1840. Especially, one can see a very low rate beginning in the mid-70s. Figure 1 gives a detailed overview of the development of equity in the US banking business.

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Figure 1: Total equity rates in US Commercial banks from 1840-1990^[3]

There was a decline in the equity ratio from 55 down to 5 percent. The BCBS argued that banks are not able to maintain their business during a crisis, when they only have such low equity ratios. Hence, they implemented Basel I in the year 1988. One of the goals of this rule was to get a higher stability in the banking system. Additionally, it was encouraged that all banks have the same minimum amount of equity to make it possible that there are no distortions of competition. Under Basel I there was also the first definition of Tier 1 and 2 capital, which is also used in the latest version of Basel Accords. Tier 1 and 2 capital are different forms of equity which are hold by a bank. By definition, a bank has to hold a minimum of 8 percent of its risk weighted Assets (RWAs) in form of equity under Basel I. For the calculation under the Basel I version from 1988 there was only credit risk which was taken into account.^[4]

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^[1] BCBS

^[2] King et. Al. (2011)

^[3] Berger et. Al. (1995), p.402

^[4] Basel I (1998)