Monday, June 10, 2013

Basel III or Brown-Vitter? – How the EU implements Basel III and a US alternative may look like

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.