Wednesday, July 28, 2010

BASEL III - nerdy finance stuff you don't care about

So a friend asked me to write up a post on the BASEL bank regulations which i thought i'd crosspost here.

The Basel Accords are a set of international banking regulations which were created by the BASEL Committee, made up of members of the Group of 10 (G10) nations to provide regulatory consistency and stability for banks worldwide. BASEL I was triggered by the collapse of 2 major banks in 1974, Franklin National Bank and Bankhaus Herstatt. The first BASEL accords were published in 1988 and enactred in the G10 in 1992. This coherent, unified regulatory code increased confidence and transparency for banking across borders and also promoted competition by ensuring similar costs and requirements across the globe. The BASEL committee does not possess any direct regulatory authority, and its up to individual nations to enact and enforce the BASEL standards. In the US, for example, the recent financial reform legislation contained language to automatically adopt the requirements of BASEL III, which is being negotiated currently.
One of the most important and highly debated issues in the currently BASEL III negotiations is capital requirements. Capital requirements are regulations controlling the ratio of a bank’s capital to its risk weighted assets. This basically means banks much be able to absorb the unexpected loss of value to risky assets (think subprime mortgage loans, MBS’s, etc) with cash or highly liquid, non-risky assets they have. To be more specific:

“To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have aTier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. -

Tier 1 capital refers to shareholder equity, retained profits, and some other assets. Tier 2 capital is undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt. (whatever the hell those are).
The big problem with the current capital requirements as defined by BASEL II is that it just doesn’t include lots of risky assets. These assets are called “off balance sheet”. This was apparently partially adressed in BASEL II but not implemented in the US till 2007, after the bubble was built on the back of overleveraged banks and other financial institutions with short term financing (often as short as overnight on REPO markets). But even after 2007, there remained the possibility to hide risky assets in off-balance sheet entities. Here’s an excerpt from a research paper explaining how a bank could take securitized MBS’s and hide them to circumvent the capital requirements, thus increasing leverage and risk for the institution and increasing the possibility of default and bankruptcy.

“One way to understand where and why possible frictions might have occurred is
to consider an idealized securitization transaction whereby the originator, bound by
capital adequacy rules, sells a pool of assets to an off-balance-sheet entity. What is of
critical importance, however, is the issue exactly what kind of an off-balance sheet
entity takes control over the assets. It may be a special purpose vehicle (SPV), i.e. what
Gorton and Souleles (2005) call a bankruptcy remote, “robot firm,” with no employees,
no physical existence, and no capacity to make substantial economic decisions. SPVs
typically carry out predefined tasks of tranching pools of receivables obtained from the
originator into asset-backed securities which are then sold on the market in much the
same way as described above. Alternatively, the originating bank could set up an offbalance-
sheet conduit called structured investment vehicle (SIV), a physically existing,
managed and leveraged financial company whose purpose will be to undertake arbitrage
by buying long-term fixed-income assets from its sponsors to fund them with short-term
liabilities such as asset-backed commercial paper (ABCP).
As Shin (2008) astutely observes, the critical difference between SPVs and SIVs
stems from the fact that selling a loan is entirely different from issuing liabilities against
it. While the former – to the extent that loans are indeed passed down the chain –
contributes to spreading credit risk around the whole economic system, the latter keeps
it concentrated around the very bank that originates the loans and only hides it from the
regulators. As recognized by the IMF (2008, p. 69) in one of its latest reports on global
financial stability:
…SIVs and commercial paper conduits, are entities that allow financial institutions
to transfer risk off their balance sheet and permit exposures to remain mostly
undisclosed to regulators and investors; to improve the liquidity of loans through
securitization; to generate fee income; and to achieve relief from regulatory capital

So banks don’t want these requirements because it limits their ability to leverage and take risk and thus make tons of money. The biggest banks in particular believe they will not be allowed to fail and even if they are, the executives will still be rich and taxpayers or investors will take the hit. And the latest news is that the latest draft of BASEL III is watered down, weak tea.

“Early reports suggest that the final draft accord — agreed to by everyone except Germany so far — largely caved in on its definition of capital, which will allow banks a lot more leeway to skirt the new rules. It also, as expected, allows a long transition period before the new rules take effect. In return, it mandates a minimum leverage ratio. This would be great news except that the new minimum is 3%, or 33:1”-

And that’s that.

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