Question

A regional bank hires you for advice on the basel III impact of its new strategy. the bank is restructuring its asset portfolio by selling a portion of its treasury portfolio and raising its allocation to commercial loans by the same amount. Explain the anticipated directional impact of the portfolio shift on the bank's capital, leverage and liquidity ratios.

Answer 1

Basel III is an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector. The Basel Committee on Banking Supervision published the first version of Basel III in late 2009, giving banks approximately three years to satisfy all requirements. Largely in response to the credit crisis, banks are required to maintain proper leverage ratios and meet certain minimum capital requirements.

KEY TAKEAWAYS

• Basel III is an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector.
• Basel III is part of the continuous effort to enhance the banking regulatory framework.
• Basel III was published in 2009, largely in response to the credit crisis associated with the Great Recession.

Minimum Capital Requirements

Basel III introduced tighter capital requirements in comparison to Basel I and Basel II. Banks' regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is subdivided into Common Equity Tier 1 and additional Tier 1 capital. The distinction is important because security instruments included in Tier 1 capital have the highest level of subordination. Common Equity Tier 1 capital includes equity instruments that have discretionary dividends and no maturity, while additional Tier 1 capital comprises securities that are subordinated to most subordinated debt, have no maturity, and their dividends can be cancelled at any time. Tier 2 capital consists of unsecured subordinated debt with an original maturity of at least five years.

Basel III left the guidelines for risk-weighted assets largely unchanged from Basel II. Risk-weighted assets represent a bank's assets weighted by coefficients of risk set forth by Basel III. The higher the credit risk of an asset, the higher its risk weight. Basel III uses credit ratings of certain assets to establish their risk coefficients.

In comparison to Basel II, Basel III strengthened regulatory capital ratios, which are computed as a percent of risk-weighted assets. In particular, Basel III increased minimum Common Equity Tier 1 capital from 4% to 4.5%, and minimum Tier 1 capital from 4% to 6%. The overall regulatory capital was left unchanged at 8%.

Countercyclical Measures

Basel III introduced new requirements with respect to regulatory capital for large banks to cushion against cyclical changes on their balance sheets. During credit expansion, banks have to set aside additional capital, while during the credit contraction, capital requirements can be loosened. The new guidelines also introduced the bucketing method, in which banks are grouped according to their size, complexity and importance to the overall economy. Systematically important banks are subject to higher capital requirements.

Leverage and Liquidity Measures

Additionally, Basel III introduced leverage and liquidity requirements to safeguard against excessive borrowings and ensure that banks have sufficient liquidity during financial stress. In particular, the leverage ratio, computed as Tier 1 capital divided by the total of on and off-balance assets less intangible assets, was capped at 3%.