A set of slides discussing the Basel III financial reform proposals and the need to regulate bank capital

1. Economics for your Classroom from
Ed Dolan’s Econ Blog
Financial Reform: What is
Basel III and Why Should We
Regulate Bank Capital?
Revised March 2013
Munsterplatz, Basel, Switzerland
Photo source:
http://commons.wikimedia.org/wiki/File:Munsterplatz,_Basel,_Switzerland.jpg
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2. What is Bank Capital?
A bank balance sheet records the financial condition of the bank
 Assets are the income-producing items the bank owns, like loans
 Liabilities are what it owes—its sources of funds, like deposits
 By definition, capital equals assets minus liabilities
In banking, the term capital is used instead of the terms net worth or equity that
are often used in other areas of accounting. These terms are synonyms.
Revised version March 2013 Ed Dolan’s Econ Blog

3. Why Banks Need Capital
 Banks need capital for protection in case
of losses on loans or other assets
 Suppose a borrower defaults on a $50,000
loan, reducing total assets
 The bank still owes depositors $900,000
 After the loan loss, capital (assets minus
liabilities) falls by the amount of the loss
 If capital falls to zero or below . . .
 the bank’s assets are no longer enough to
cover what it owes depositors
 It is insolvent and must cease operations
 Its shareholders stand to lose everything
they have invested
Revised version March 2013 Ed Dolan’s Econ Blog

4. More Leverage Means More Risk
 A bank with less capital in relation to its
assets is said to have higher leverage
 High leverage puts a bank at greater risk
of insolvency
 Example
 The low-leverage bank (top) could survive
up to $500,000 in loan losses
 The higher-leverage bank (bottom) would
become insolvent after just $100,000 of
loan losses
Revised version March 2013 Ed Dolan’s Econ Blog

5. But More Leverage Also Means Higher Returns
More leverage means higher risk, but also
higher returns for shareholders if the
bank remains solvent
 Assume interest received from loans to
be 10% and interest paid on deposits to
be 8%
 Shareholders’ return is the difference
between income and cost of deposits
 With capital at 50% of assets (top),
shareholders’ rate of return on their
invested capital is 12%
 With capital at 10% of assets (bottom),
shareholders’ rate of return increases to
28%
Revised version March 2013 Ed Dolan’s Econ Blog

6. Regulators vs. Bankers’ Preferences for Leverage
 Varying the degree of leverage
creates a tradeoff for shareholders
between risk of insolvency and rate of
return
 Bank regulators, who are concerned
about the spillover effects that bank
failures have on the rest of the
economy, tend to prefer less risk, less
leverage, and more capital than do
bank managers
 To limit risk to the financial system,
regulators set minimum standards for
bank capital
Revised version March 2013 Ed Dolan’s Econ Blog

7. Who Regulates Bank Capital?
 Bank regulators of individual countries
do not act alone in setting rules for
bank capital. They coordinate their
capital regulation through the Basel
Committee on Bank Supervision
 The Committee meets at the, Bank for
International Settlements (BIS), an
international organization, founded in
1930, that fosters monetary and Munsterplatz, Basel, Switzerland
financial cooperation and acts as a Photo source:
http://commons.wikimedia.org/wiki/File:Munsterplatz,_Basel,_Switzerland.jpg
bank for central banks
Revised version March 2013 Ed Dolan’s Econ Blog

8. The Basel Accords
 The Basel Committee periodically issues
“accords” that set out international standards
for bank capital as well as other bank
regulations
 The first Basel Accords, now called Basel I,
were issued in 1988
 They were replaced by a new set of
Photo source:
standards, Basel II, in 2004. http://upload.wikimedia.org/wikipedia/commons/e/e4/Glo
be.png
Revised version March 2013 Ed Dolan’s Econ Blog

9. Failure of the Basel Accords
 Unfortunately, Basel II failed to
prevent the global financial crisis that
began in 2007
 Government rescues of failed or
failing banks like Citibank (US), RBS
(UK), and Fortis (EU) cost taxpayers
billions of dollars, pounds, and euros
 Failure of the Basel II standards can
be traced to two major problems:
 They allowed banks to overstate their
true amount of capital
 They allowed banks to understate the
risks to which they were exposed Photo source: http://commons.wikimedia.org/wiki/File:Citibank_Tower.JPG
Revised version March 2013 Ed Dolan’s Econ Blog

10. Tangible Common Equity
 Many observers think that the
simplest measure of capital, called
tangible common equity (TCE), is
also the most accurate for measuring
a bank’s exposure to risk
 Tangible assets include only those
like loans, securities, and buildings
that could be sold by a failing firm to
help pay its obligations The ratio of tangible common equity
to tangible assets to equity capital
 Equity capital equals tangible assets provides a measure of a bank’s
minus liabilities. It measures exposure to risk. With a TCE ratio
shareholder funds that are first in line of 2%, this bank is solvent but its
leverage and risk of failure are high
to absorb risk in case of failure
Revised version March 2013 Ed Dolan’s Econ Blog

11. Regulatory Capital
 Basel II regulations did not use TCE
to measure risk. Instead, instead they
Regulatory Capital
used the ratio of regulatory capital
to risk-weighted assets
Risk-Weighted Assets
 Both the numerator and denominator
differ from the tangible common
equity concept
Revised version March 2013 Ed Dolan’s Econ Blog

12. Regulatory Capital
 Regulatory capital increases the
numerator of a bank’s capital ratio in
two ways compared with TCE
 First, it counts certain intangible
assets like goodwill and tax loss
assets that contribute to possible
future profits but could not be sold by
a failing firm to raise cash
 Second, it counts both common
equity and hybrid capital (such as
preferred stock) that is a mixture of
Regulatory capital ratio =
debt and equity. Hybrid capital is a 100,000/1,050,000 = 9.5%,
less reliable cushion against loss than compared to tangible common
common equity equity of 2%
Revised version March 2013 Ed Dolan’s Econ Blog

13. Risk-Weighted Assets: Example
 For the denominator of the capital
ratio, Basel II did not count all assets
at full value
 Instead, assets were assigned risk
weights according to their ratings
 Examples of the weights:
 AAA rated assets = 20%
 A rated assets = 50%
 BBB rated assets = 100%
Revised version March 2013 Ed Dolan’s Econ Blog

14. Regulatory Capital vs. TCE
Data in this chart compare regulatory
 In short, under Basel II regulatory capital ratios to TCE ratios for banks
capital tended to understate the in Europe and the US just before the
2008 financial crisis
leverage of bank balance sheets
 A bank might have tangible assets
of 1,000,000 and tangible common
equity of 20,000, giving a TCE
ratio of 2%
 The same bank might have risk-
weighted assets of just 500,000
and regulatory capital of 50,000,
giving a regulatory capital ratio of
10%
Revised version March 2013 Ed Dolan’s Econ Blog

15. Trying Again: Basel III
 In an attempt to fix the problems of Basel
III, regulators have reached a new
agreement, known as Basel III
 Proposed improvements include:
 A better measurement of capital, closer to
tangible common equity (but not exactly)
 Requirements for banks to build extra
capital reserves if early warning signs show
abnormal credit growth or asset price
bubbles
Building of The Bank for
International Settlements
Photo source:
http://commons.wikimedia.org/wiki/File:BIZ_Basel_002.jpg
Revised version March 2013 Ed Dolan’s Econ Blog

16. Will Basel III Succeed?
 Now the hard work has begun of
translating the general principles of
Basel III into specific regulations
 Preliminary proposals were tough, but
banks are lobbying hard to weaken
them
 Some observers are already starting
to fear that Basel III regulations will
once again be too easy on banks,
laying the basis for another global
financial crisis a few years down the
road
Revised version March 2013 Ed Dolan’s Econ Blog

17. Related slideshow:
More on Financial Regulation and Basel III: Regulating Bank Liquidity
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