On April 14, 2013, the
European Parliament has decided on the rules implementing Basel III
in the European Union. They will take the form of a regulation,
entailing direct application in all EU member states. Even though the
legislative process is not formally finished yet, you can consider
the regulation as almost final. Opening the document causes a shock:
1,276 pages! I admit that it is the longest word-document I have ever
seen.
Just a few days later, on
April 24, US Senators Brown and Vitter have proposed a new banking
regulation for the US. And, guess what, the document is only 24 pages
long!
What is going on here?
In short, Basel III rules
are based on risk-weighted assets (For a bank, lending to a rich is
not as risky as lending to a poor.) whereas Brown-Vitter does not
differentiate the risk profile of a bank's assets.
Capital
requirements under Basel III
The core of the Basel III
regulation is capital requirements. Other components (large exposure
regime, liquidity coverage requirements, and leverage ratio) play a
minor role.
The regulation says that
banks must meet three capital requirements:
- Common equity tier 1 ratio ≥ 4.5 %
- Tier 1 capital ratio ≥ 6 %
- Total capital ratio ≥ 8 %
All three ratios have the
same denominator – risk weighted assets. The idea here is that you
(or, more precisely, your computers) look at every group of assets on
the bank's balance sheet and decide how likely it is that the client
will pay. If your client is good (international organizations,
reliable governments, etc.) you forget about the asset (0 % or other
low %); if your client is very bad (low-rated corporates etc.) you
will count your asset several times (for example 200 %). The reason
for the inverse relationship is that risk-weighted assets constitute
the denominator – the higher they are the lower the ratio.
The numerator changes:
- Most prudent is the common equity tier 1 ratio which counts only equity.
- The tier 1 capital ratio is somewhat in the middle because it counts not only equity but also financial instruments between equity and debt.
- The total capital ratio is the most lax ratio because it adds some additional debt instruments.
You can find a more
detailed presentation of the Basel III rules here. “More
detailed” is relative however – you can read entire books about
Basel III if you want....
Capital
requirements under Brown-Vitter
The Brown-Vitter Bill
introduces equity capital requirements as follows:
Additional risk-based
capital requirements remain possible for financial institutions with
more than 20 BUSD in Total Consolidated Assets, in order to prevent
investment in excessive amounts of riskier assets.
With regards to Basel
III, the Brown-Vitter Bill is categorical: “The Board, the
Corporation, and the Comptroller of the Currency shall be prohibited
from any further implementation of any rules of the Federal banking
agencies regarding Basel III […]”.
At first glance, the
proposal of the US senators seems obviously wrong. Two banks might
hold assets of completely different risk profiles and, nevertheless,
be treated exactly the same way. However, when I compare the US
proposal with Basel III, I am wondering what is better:
- A conceptually correct but 1,276 pages long regulation that almost nobody can understand and which has more room for interpretation than you can possibly imagine?
- An oversimplified and 24 pages long regulation that everybody can follow?
As oftentimes, the right
answer is probably somewhere in the middle. Let's wait and see what
the US will adopt in the end.
Resources:
- For a critic of the Brown-Vitter Bill, you can read Davis Polk – Brown-Vitter Bill, Commentary and Analysis – April 30, 2013. The article contains many additional references.
