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The Actuary The magazine of the Institute & Faculty of Actuaries

Banking - Basel III made simple

What is Basel III?
The new ‘Basel III’ regulatory framework for banks is set to radically impact the post-credit- crisis banking landscape. The proposed rules suggest that capital requirements for bancassurers will rise; however, the impact may be less than first envisaged.

The Basel Committee sets the framework for international banking regulation and its proposals have been implemented by almost all Organisation for Economic Cooperation and Development countries over the last two decades. The last incarnation of the supervisory framework (Basel II) was the backdrop for regulation and capital calculations in the period leading up to the credit crisis. Since then, many amendments to regulatory approaches have been suggested, and some already implemented unilaterally. In December 2009 the Committee published a proposal for new international rules, known as Basel III. These were clarified and amended in July 2010, including changes and delays for some of the more contentious issues.

What does Basel III entail?
Basel III contains five main changes:
1) Raising the quality, consistency and transparency of the capital base: a new measure of high-quality capital (common equity Tier 1) is specified, which excludes most hybrid capital instruments. Also, the treatment of accounting issues is made more restrictive, for example, cross holdings, minority interests and deferred tax assets.

2) Introduction of a global liquidity standard: Basel I and II focused almost exclusively on capital, particularly under the explicit capital requirement calculations. In contrast, Basel III specifies a calculation and limits for two new ratios:
a) The Liquidity Coverage Ratio specifies a minimum size for the portfolio of liquid assets that banks must hold to cover short periods of liquidity stress.
b) The Net Stable Funding Ratio ensures that long-term assets are to be funded with longterm liabilities. This will result in a significant change to the funding profiles of many banks and the delay of full implementation reflects the potential macro-economic impact.

3) Extending and re-weighting risk coverage: Banks use risk-weighted assets (RWAs) to measure risk and capital requirements. The RWA calculations have been extended to include a set of credit risks that caused significant losses through the crisis.

RWAs now explicitly cover ‘wrong-way’ risk (this is where the credit quality of the counterparty is correlated to the instrument) and collateral value adjustments (the impact of counterparty credit quality on the price of an instrument).

4) Introduction of a leverage ratio: A non-risk-adjusted leverage ratio has been designed and will be calibrated over a period of parallel run.

5) Measures to dampen pro-cyclicality: The broad aim is to dampen the pro-cyclical nature of capital requirements. Various approaches are considered including new calculation methodology for RWAs, increased supervisory review and imposition of counter-cyclical buffers and changes to credit-provisioning methodology.

While there is support for the direction of the proposals, the specifics and the implementation schedule have been subject to much debate and lobbying. To some extent, the amendments proposed in July 2010 were a reaction to this pressure. The minutiae of specific proposals have a major impact for individual banks, which industry analysts are currently assessing. The proposals are being reconsidered and rules drafted, and the timing and scope are expected to be further clarified before the end of the year. It is expected that further changes to the proposals will be made, but the broad framework will remain as it is.

What are the main implications of Basel III?
The top three implications for the banking industry are already clear:
1) Capital requirements will increase: The calibration of the new ‘common equity Tier 1’ ratio is still up for grabs, but there is little doubt that the result will be higher capital requirements for almost all institutions.
2) Funding rules will damage profitability: Restrictions on liquidity profiles will raise the cost of longer-term funding, and the return on equity ‘drag’ from larger liquidity buffers will be significant.
3) The economics of trading businesses will be less favourable: Capital and funding requirements for investment banking activities will be significantly more conservative, and are likely to lead to banks exiting or radically re-pricing some businesses.

There are further implications for bancassurers. Under the revised Basel III proposals, bancassurers will not gain credit for equity invested in insurance subsidiaries if this exceeds 10% of the bank’s common equity tier 1. For banks with large insurance subsidiaries as a proportion of the group, this is a material reduction from Basel II.

Although the rules are not yet set, at the time of writing many bancassurers across Europe have already begun to consider ownership of their insurers. However, the complete sale of insurance subsidiaries would be a stark option. Under the current proposals, there are options to redesign ownership and capital structures that can mitigate a portion of the capital impact. We expect many bancassurers to pursue this route. However, this is a significant financial and operational change for insurers embedded within banks, with Solvency II also being implemented.


James Mackintosh is a senior manager and Matt Gosden is a partner at Oliver Wyman