Basel 3 is an update to the Basel Accords that aims to strengthen bank capital requirements and introduce new regulatory requirements on bank liquidity and leverage. Key changes include tighter definitions of Tier 1 capital, a leverage ratio, countercyclical capital buffers, and new liquidity standards. The goals are to promote a more resilient banking system and reduce risk of financial crises. Basel 3 also seeks to address procyclicality concerns by promoting capital conservation and countercyclical buffers.

1. BASEL 3
By : Khawar Nehal
CEO
Applied Technology Research Center
Khawar.nehal@atrc.net.pk

2. What is Basel 3 ?
Basel 3 is an update to the Basel Accords.

3. What is in Basel 3 ?
➢ Tighter definitions of Tier 1 capital. That means
banks must hold 4.5% by January 2015, then a
further 2.5%, totaling 7%.
➢ The introduction of a leverage ratio.
➢ A framework for counter-cyclical capital buffers
➢ Measures to limit counterparty credit risk
➢ Short and medium-term quantitative liquidity
ratios.

4. Why Basel 3 ?
To respond to the lack of adequate controls in
financial institutions, which led to lax checks in the
lending by banks, the Basel Committee on
Banking Supervision (BCBS) has come up with
updates to their guidelines for capital and banking
regulations.

5. How BCBS puts it.
This consultative document presents the Basel
Committee's proposals to strengthen global
capital and liquidity regulations with the goal of
promoting a more resilient banking sector. The
objective of the Basel Committee's reform
package is to improve the banking sector's ability
to absorb shocks arising from financial and
economic stress, whatever the source, thus
reducing the risk of spillover from the financial
sector to the real economy.

6. Tier 1 Capital
Tier 1 capital: the predominant form of Tier 1
capital must be common shares and retained
earnings.
Tier 1 capital is considered the more reliable form
of capital, which comprises the most junior
(subordinated) securities issued by the firm.
These include equity and qualifying perpetual
preferred stock.

7. Tier 1 Capital
Tier 1 capital is the core measure of a bank's
financial strength from a regulator's point of view.
It is composed of core capital, which consists
primarily of common stock and disclosed reserves
(or retained earnings), but may also include non-
redeemable non-cumulative preferred stock.

8. Tier 1 Capital
Capital in this sense is related to, but different from, the
accounting concept of shareholders' equity.
Both tier 1 and tier 2 capital were first defined in the Basel
I capital accord and remained substantially the same in
the replacement Basel II accord.
Tier 2 capital is senior to Tier 1, but subordinate to
deposits and the deposit insurer's claims. These include
preferred stock with fixed maturities and long-term debt
with minimum maturities of over five years.

9. Tier 1 Capital
Each country's banking regulator, however, has some discretion
over how differing financial instruments may count in a capital
calculation. This is appropriate, as the legal framework varies in
different legal systems.
The theoretical reason for holding capital is that it should
provide protection against unexpected losses.
Note that this is not the same as expected losses which are
covered by provisions, reserves and current year profits. In
Basel I agreement, Tier 1 capital is a minimum of 4% ownership
equity but investors generally require a ratio of 10%.

10. Tier 1 Capital Ratio
The Tier 1 capital ratio is the ratio of a bank's core equity capital
to its total risk-weighted assets. The Tier 1 risk based capital
ratio is the ratio of a bank's core (equity capital) to its total risk-
weighted assets. Risk-weighted assets are the total of all assets
held by the bank which are weighted for credit risk according to
a formula determined by the Regulator (usually the country's
central bank). Most central banks follow the Bank for
International Settlements (BIS) guidelines in setting formulas for
asset risk weights. Assets like cash and coins usually have zero
risk weight, while debentures might have a risk weight of 100%.

11. Tier 1 Capital Ratio
A good definition of Tier 1 capital is that it includes
equity capital and disclosed reserves, where
equity capital includes instruments that can't be
redeemed at the option of the holder (meaning
that the owner of the shares cannot decide on his
own that he wants to withdraw the money he
invested and so cannot leave the bank without the
risk coverage). Reserves are held by the bank,
and are thus money that no one but the bank can
have an influence on.

12. Tier 1 Capital Ratio
Tier 1 capital is seen as a metric of a bank's ability
to sustain future losses. It is the way to track how
much risk any particular bank is taking on, in
terms of dollars held per dollars loaned out.
A 10% Tier 1 capital ratio may approximate but
does not mean that a bank is holding in its vaults
$1 for every $10 that a customer has in their
account balance. The ratio looks across the
columns of the balance sheet. The $10 that the
customer has deposited is a liability of the bank.

13. Tier 1 Capital Ratio
The bank must have started with some equity
capital, say $2. The ratio requires that we
investigate what the bank does with those $12
(equity of $2 plus deposit of $10). If the bank
lends $9 and invests $3 in Treasury securities, the
question whether the Bank complies with its
capital requirements will depend on the risk-
adjusted asset-value of the claim against the
borrower for $9 that the bank holds.

14. Tier 1 Capital Ratio
If the risk-adjusted value of that is 90% or $8.10,
then (assuming the $3 Treasury deposit is valued
at 100%) the bank's risk-adjusted assets would be
$11.10, implying a Tier 1 capital requirement of
$1.10. The bank's liabilities are $10. Subtracted
from $11.10, they leave Tier 1 capital of $1.10, so
the bank is in compliance, albeit barely.

15. Tier 1 Capital Ratio
Some call the loan of $9 that the bank was able to
make in these circumstances fiat money because it
creates the appearance that more money is in
circulation than was issued by the central bank. In this
example, the most that the central bank could have
issued would be the $2 equity plus the $10 deposit, yet
the borrower together with the depositor, believe they
can purchase $19 of goods and the bank's equity
holders believe they hold equity of $2. Thus, even in an
economy of specie or hard money, fiat money will exist
to the extent permitted by bank regulation.

16. Tier 2 Capital
Tier 2 capital is a measure of a bank's financial
strength with regard to the second most reliable
form of financial capital from a regulatory point of
view.
The forms of banking capital were largely
standardized in the Basel I accord, issued by the
Basel Committee on Banking Supervision and left
untouched by the Basel II accord. National
regulators of most countries around the world have
implemented these standards in local legislation.

17. Tier 2 Capital classifications
There are several classifications of tier 2 capital.
In the Basel I Accord, tier 2 capital is composed of
supplementary capital, which is categorized as
undisclosed reserves, revaluation reserves,
general provisions, hybrid instruments and
subordinated term debt. Supplementary capital
can be considered tier 2 capital up to an amount
equal to that of the core capital.

18. Core capital
Core capital is another term for Tier 1 capital.

19. Tier 3 Capital
Tertiary capital held by banks to meet part of their market
risks, that includes a greater variety of debt than tier 1
and tier 2 capitals. Tier 3 capital debts may include a
greater number of subordinated issues, undisclosed
reserves and general loss reserves compared to tier 2
capital.
Tier 3 capital is used to support market risk, commodities
risk and foreign currency risk. To qualify as tier 3 capital,
assets must be limited to 250% of a banks tier 1 capital,
be unsecured, subordinated and have a minimum
maturity of two years.

20. Changes Proposed in Basel III
First, the quality, consistency, and transparency of
the capital base will be raised.
➢ Tier 1 capital: the predominant form of Tier 1
capital must be common shares and retained
earnings
➢ Tier 2 capital instruments will be harmonised
➢ Tier 3 capital will be eliminated.

21. Changes in risk coverage
Second, the risk coverage of the capital framework will be strengthened.
➢ Strengthen the capital requirements for counterparty credit exposures
arising from banks’ derivatives, repo and securities financing
transactions
➢ Raise the capital buffers backing these exposures
➢ Reduce procyclicality and
➢ Provide additional incentives to move OTC derivative contracts to
central counterparties (probably clearing houses)
➢ Provide incentives to strengthen the risk management of counterparty
credit exposures

22. Changes : Leverage ratio
Third, the Committee will introduce a leverage ratio as a supplementary
measure to the Basel II risk-based framework.
➢ The Committee therefore is introducing a leverage ratio requirement
that is intended to achieve the following objectives:
➢ Put a floor under the build-up of leverage in the banking sector
➢ Introduce additional safeguards against model risk and
measurement error by supplementing the risk based measure with
a simpler measure that is based on gross exposures.

23. Changes : Capital build up
Fourth, the Committee is introducing a series of measures to
promote the build up of capital buffers in good times that can
be drawn upon in periods of stress ("Reducing procyclicality
and promoting countercyclical buffers").
* The Committee is introducing a series of measures to
address procyclicality:
o Dampen any excess cyclicality of the minimum capital
requirement;
o Promote more forward looking provisions;
o Conserve capital to build buffers at individual banks
and the banking sector that can be used in stress; and

24. Procyclicality
Procyclical is a term used in economics to describe how
an economic quantity is related to economic fluctuations.
It is the opposite of countercyclical. However, it has more
than one meaning.
In business cycle theory and finance, any economic
quantity that is positively correlated with the overall state
of the economy is said to be procyclical. That is, any
quantity that tends to increase when the overall economy
is growing is classified as procyclical. Quantities that tend
to increase when the overall economy is slowing down
are classified as 'countercyclical'.

25. Procyclicality
Gross Domestic Product (GDP) is an example of a
procyclical economic indicator. Many stock prices
are also procyclical, because they tend to
increase when the economy is growing quickly.
Unemployment is an example of a countercyclical
economic indicator.

26. Procyclicality :Meaning in policy making
Procyclical has a different meaning in the context
of economic policy. In this context, it refers to any
aspect of economic policy that could magnify
economic or financial fluctuations. An economic
policy that is believed to decrease fluctuations is
called countercyclical.

27. Procyclicality :Meaning in policy making
In particular, the financial regulations of the Basel
II Accord have been criticized for their possible
procyclicality. The accord requires banks to
increase their capital ratios when they face greater
risks. Unfortunately, this may require them to lend
less during a recession or a credit crunch, which
could aggravate the downturn. A similar criticism
has been directed at fair value accounting rules.

28. Countercyclical
Countercyclical is a term used in economics to
describe how an economic quantity is related to
economic fluctuations. It is the opposite of
procyclical. However, it has more than one
meaning.

29. Countercyclical :
Meaning in policy making
An economic or financial policy is called
'countercyclical' (or sometimes 'activist') if it works
against the cyclical tendencies in the economy.
That is, countercyclical policies are ones that cool
down the economy when it is in an upswing, and
stimulate the economy when it is in a downturn.

30. Countercyclical :
Meaning in policy making
Keynesian economics advocates the use of
automatic and discretionary countercyclical
policies to lessen the impact of the business cycle.
One example of an automatically countercyclical
fiscal policy is progressive taxation. By taxing a
larger proportion of income when the economy
expands, a progressive tax tends to decrease
demand when the economy is booming, thus
reining in the boom.

31. Countercyclical :
Meaning in policy making
Other schools of economic thought, such as
monetarism and new classical macroeconomics,
hold that countercyclical policies may be
counterproductive or destabilizing, and therefore
favor a laissez-faire fiscal policy as a better
method for maintaining an overall robust
economy.

32. Changes : Capital build up
* Achieve the broader macroprudential goal of protecting
the banking sector from periods of excess credit growth.
o Requirement to use long term data horizons to
estimate probabilities of default,
o downturn loss-given-default estimates, recommended
in Basel II, to become mandatory
o Improved calibration of the risk functions, which
convert loss estimates into regulatory capital requirements.
o Banks must conduct stress tests that include
widening credit spreads in recessionary scenarios.

33. Macroprudential Analysis
A method of economic analysis that evaluates the
health, soundness and vulnerabilities of a
financial system.
Macroprudential analysis looks at the health of the
underlying financial institutions in the system and
performs stress tests and scenario analysis to
help determine the system's sensitivity to
economic shocks.

34. Macroprudential Analysis
Macroeconomic and market data are also
reviewed to determine the health of the current
system. The analysis also focuses on qualitative
data related to financial institutions' frameworks
and the regulatory environment to get an
additional sense of the strength and vulnerabilities
in the system.

35. Changes : Capital build up
➢ Promoting stronger provisioning
practices (forward looking
provisioning):
➢ Advocating a change in the
accounting standards towards an
expected loss (EL) approach
(usually,
EL amount := LGD*PD*EAD).

36. Changes : Minimum capital
Fifth, the Committee is introducing a global
minimum liquidity standard for internationally active
banks that includes a 30-day liquidity coverage ratio
requirement underpinned by a longer-term structural
liquidity ratio.
The Committee also is reviewing the need for
additional capital, liquidity or other supervisory
measures to reduce the externalities created by
systemically important institutions.

37. Externalities
In economics, an externality (or
transaction spillover) is a cost or benefit,
not transmitted through prices, incurred by
a party who did not agree to the action
causing the cost or benefit.
A benefit in this case is called a positive
externality or external benefit, while a cost
is called a negative externality or external
cost.

38. Summary
It is hoped that the BASEL 3 updates
shall guide the banks to control their lax
lending practices.
The good option is to have better
training and testing in the Human
resources departments so that all bank
employees can be trained and made
aware of such practices.

39. Summary
If you would like to get consultants and trainers for
your employees, then please feel free to contact
us.
Regards,
Khawar Nehal
Applied Technology Research Center.
Contact : http://atrc.net.pk