What You Need to Know About Basel III
Sam Chandan Sept. 30, 2010, 3:01 p.m.
Meeting earlier this month, the Group of Governors and Heads of Supervision of the Bank of International Settlements announced its endorsement of the Basel Committee’s July agreement on bank capital reforms, in time for presentation at November’s G20 summit.
The confirmation of the Basel III effort by central bankers was greeted with relief by the banking community and by investors. The provisions of the new accord are less stringent than originally anticipated. Similarly, the extended implementation time frame set by the Basel Committee affords banks considerable leeway in working toward higher capital requirements. Bank stocks in the United States and Europe rallied the day after the announcements in Switzerland, signaling the accord’s limited impact on the near- and medium-term outlook for the sector.
Under the terms of the Basel III framework, banks’ minimum total capital, the definition of which has been in play throughout this process, rises sharply, from 2 percent to 7 percent of risk-adjusted assets. Supplemented by a conservation buffer intended to help institutions absorb losses during periods of unusual financial stress, capital rises further. An additional countercyclical buffer will range from 0 percent to 2.5 percent, according to country-specific circumstances and in support of “macroprudential” goals in constraining the growth of credit.
Why 2.5 and not 3 percent? At play is the art of politics as much as any science of risk management. Exact numbers aside, the Basel Committee believes that the changes support its goal of reducing the pro-cyclicality of credit by improving the quality and quantity of banks’ capital cushions. Still, few changes will be immediate. A phase-in period begins in 2013. The common equity requirements come into force in 2015; the additional buffer, in 2019.
AS COMPARED TO the antecedent Basel II accord, the new framework has been negotiated far more quickly, is far simpler and reflects agreement among a larger number of participants. And while the Basel Committee has been keen to focus attention on the need for countercyclical capital buffers, these differences in the two accords highlight shifting regulatory priorities over time as well.
Basel II, which has never been fully implemented, may have allowed banks using more advanced risk metrics to reduce their capital levels. It is widely expected that Basel III, on the other hand, will curtail banks’ discretion. Capital requirements, while higher, will be generally less sensitive to the risk-taking activities of lenders.
Laying the groundwork for the shift in perspective, the Financial Stability Board and Basel Committee released a separate report in August outlining the macroeconomic implications of a stricter capital and liquidity framework. On net, the report concludes that “… the benefits of higher capital and liquidity requirements accrue from reducing the probability of financial crisis and the output losses associated with such crises.”
Agreement on Basel III has not been effortless. Apart from resistance from banks, regulators from Australia and Canada, where the banking systems have been more stable through the financial crisis, are perceived as less enthusiastic about the new accord. Germany was the only participating nation to withhold its support during the July meetings, where the reforms were nailed down. Among the large advanced economies, French, German and Spanish banks are viewed as having the most to do in meeting new capital requirements.
Basel III’s extended implementation time frame is a controversial concession designed to avoid an abrupt deleveraging across the pond. In the United States, on the other hand, the largest institutions already meet the new requirements. The updated thresholds will not fundamentally alter their profit calculus, but they are impactful. JPMorgan, for example, has estimated that its risk-weighted assets will rise by approximately 25 percent.
IN A PRELIMINARY assessment of Basel III’s implications for commercial real estate, new risk calculations could exert a drag on the reemerging securitization market. It is unclear if the higher costs are commensurate with any quantifiable assessment of risk. Separately, there is an open question about whether small borrowers will be disproportionately impacted by higher loan costs. But there are ample tools that domestic regulators have at their disposal–should they wish to use them–to offset any observable and negative impact on small businesses and small commercial real estate borrowers.
For the time being, Basel III offers debt-hungry commercial real estate investors in the United States no cause for alarm. Nor do domestic banks have much to fear. As part of its balancing act, the new accord has little that might undercut the basic incentives to lend or to borrow, or that will require American banks to undertake suboptimally timed new capital-raising.
The Sept. 12 announcement of higher global minimum capital standards by the Group of Governors and Heads of Supervision, along with details of the capital framework and phase-in arrangements, is available from the Bank of International Settlements at http://bit.ly/90fpjg.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.