Chapter 10

BANK REGULATORY CAPITAL

The capital allocation requirements of a financial institution are behind overall banking strategy. Asset allocation decisions are influenced to a great extent by the capital considerations that such allocation implies. Lower capital requirements for derivatives explain to a great extent why derivatives are used by banks and corporates instead of cash products. This is as true of the money markets as it is of the bond markets. For that reason, a book on global money markets must cover banking itself, otherwise it will be incomplete. An understanding of banking is not possible without an understanding of one of its key aspects: regulatory capital.

For instance, a key aspect of the money markets involves securitized products – for example, asset-backed commercial paper. Previously, one of the key motivations behind securitization was the requirement to obtain capital relief. This led to mortgages, trade receivables and other assets being securitized. We can see that it is vital to understand the implications of capital costs. Moreover, the issue of cost of capital must also take into account the regulatory capital implications of any asset allocation taken by a trading desk. Money market participants must know about regulatory capital issues – whether they trade CDs, bills, repos, FRNs, ABCPs – or they will not fully understand the cost of their own capital and hence return on capital.

Banking regulatory capital requirements

Banks and financial institutions are subject to a range of regulations and controls, a primary one of which is concerned with the level of capital that a bank holds and whether this level is sufficient to provide a cushion for the activities that the bank enters into. Typically, an institution is subject to the regulatory requirements of its domestic regulator, but it may also be subject to cross-border requirements such as the European Union’s capital adequacy directive.1 A capital requirements scheme proposed by a committee of central banks acting under the auspices of the Bank for International Settlements (BIS) in 1988 has been adopted universally by banks around the world. These are known as the BIS regulatory requirements or the Basel capital ratios, from the town in Switzerland where the BIS is based.2 Under the Basel requirements all cash and off-balance-sheet instruments in a bank’s portfolio are assigned a risk weighting, based on their perceived credit risk, which determines the minimum level of capital that must be set against them.

A bank’s capital is, in its simplest form, the difference between the assets and liabilities on its balance sheet, and is the property of the bank’s owners. It may be used to meet any operating losses incurred by the bank, and if such losses exceed the amount of available capital then the bank will have difficulty in repaying liabilities, which may lead to bankruptcy. However, for regulatory purposes capital is defined differently; again, in its simplest form regulatory capital is comprised of those elements in a bank’s balance sheet that are eligible for inclusion in the calculation of capital ratios. The ratio required by a regulator will be that level deemed sufficient to protect the bank’s depositors. Regulatory capital includes equity, preference shares and subordinated debt, as well as general reserves. The common element of these items is that they are all loss absorbing, whether this is on an ongoing basis or in the event of liquidation. This is crucial to regulators, who are concerned that depositors and senior creditors are repaid in full in the event of bankruptcy.

The Basel rules on regulatory capital originated in the 1980s, when there were widespread concerns that a number of large banks engaged in cross-border business were operating with insufficient capital. The regulatory authorities of the G10 group of countries established the Basel Committee on Banking Supervision. Its 1988 publication, International Convergence on Capital Management and Capital Standards, set proposals that were adopted by regulators around the world as the ‘Basel rules’. The Basel Accord was a methodology for calculating risk, weighting assets according to the type of borrower and its domicile. The Basel ratio3 set a minimum capital requirement of 8% of risk-weighted assets.

In this chapter we summarize the essential elements of the current requirements, now referred to as Basel II, and then discuss the BIS proposals now known as Basel III.

Capital adequacy requirements

The origin of the current capital adequacy rules was a desire by banking regulators to strengthen the stability of the global banking system as well as harmonize international regulations. The 1988 Basel Accord was a significant advancement in banking regulation, setting a formal standard for capitalization worldwide. It was subsequently adopted by national regulators in over 100 countries. The Basel rules have no regulatory force as such; rather, individual country regulatory regimes adopt them as a minimum required standard. This means that there are slight variations on basic Basel requirements around the world, of which the European Union’s capital adequacy directives are the best example.

Basel I rules

The BIS rules set a minimum ratio of capital to assets of 8% of the value of the assets. Assets are defined in terms of their risk, and it is weighted risk assets that are multiplied by the 8% figure. Each asset is assigned a risk weighting, which is 0% for risk-free assets such as certain country government bonds and up to 100% for the highest risk asset such as certain corporate loans. So, while a loan in the inter-bank market would be assigned a 20% weighting, a loan of exactly the same size to a corporate would receive the highest weighting of 100%.

Formally, the BIS requirements are set in terms of the type of capital that is being set aside against assets. International regulation (and UK practice) defines the following types of capital for a bank:

• Tier 1 – perpetual capital, capable of absorbing loss through the non-payment of a dividend. This is shareholders’ equity and also non-cumulative preference shares.
• Upper Tier 2 – this is also perpetual capital, subordinated in repayment to other creditors; it may include, for example, undated bonds such as building society PIBS, and other irredeemable subordinated debt.
• Lower Tier 2 – this is capital that is subordinated in repayment to other creditors, such as long-dated subordinated bonds.

The level of capital requirement is given by:

(10.1)

The ratios in equation (10.1) therefore set minimum levels. A bank’s risk-adjusted exposure is cash risk-adjusted exposure together with risk-adjusted off-balance-sheet exposure. For cash products on the banking book, capital charge calculation (risk-adjusted exposure) is given by:

calculated for each instrument.

The sum of the exposures is taken. Firms may use netting or portfolio modelling to reduce the total principal value.

Capital requirements for off-balance-sheet instruments are lower because for these instruments the principal is rarely at risk. Interest rate derivatives such as forward rate agreements (FRAs) of less than 1 year’s maturity have no capital requirement at all, while a long-term currency swap requires capital of between 0.08% and 0.2% of the nominal principal.

The BIS makes a distinction between banking book transactions as caried out by retail and commercial banks (primarily deposits and lending) and trading book transactions as carried out by investment banks and securities houses. Capital treatment differs between banking and trading books.

A primer on Basel II

The Basel II rules were published in final form in June 2004.4 This chapter concentrates on the essentials behind the main rulings contained in the BIS document – these are important from an ALM strategist’s point of view.

The aim of Basel II was to align economic and regulatory capital more closely than Basel I. It introduces three different approaches that a bank can adopt to achieve this: the standardized approach, which is not far removed from the current Basel I framework but which applies more risk-weighting categories and uses formal credit ratings; and the foundation and advanced internal-ratings-based (IRB) approaches, which are more complex and allow for a bank to use its own risk models and risk exposure data in line with the Basel II framework. Implementation of the new rules should result in changes in certain bank and ALM activity, with certain products and sectors seeing greater activity and other areas less, as capital is realigned and banks seek to meet adjusted target rates of return.

Overview

Given that the primary objective behind Basel II is to better align economic with regulatory capital, we conclude that banking activity exhibiting low economic risk will attract a low capital charge. Such activity might include residential mortgages and high-grade corporate lending. By the same token, business that previously was of interest to banks because regulatory treatment seemed less onerous than perceived economic risk, such as low-rated securitization tranches and non-OECD country lending, should become less attractive. Following this logic, banks that have a high proportion of lower risk business, such as commercial and retail banks, will find that their capital charge has reduced. The model-based approaches – the foundation and advanced IRB – require less capital to be held compared with the standardized approach. Implanting these approaches will call for a large investment in risk management models and internal data systems – something only the larger banks can afford. Thus, an advantage is presented to large banks over small banks straight away.

Three-pillar approach

The cornerstone of the Basel II rules is the three-pillar approach. These are minimum capital requirements, supervisory review and market discipline. A general description of them follows.

Minimum capital requirements. The objective of these is to produce a closer link between economic and regulatory capital. The underlying idea is to remove any possibility of regulatory capital arbitrage, which was common under Basel I. There is a more tailored regime, with more specific targeting of individual credits rather than the broad-brush approach of Basel I which targeted whole asset classes. An example of this was the 20% risk weighting given to OECD country banks, which meant some low-rated banks required the same capital set-aside as very highly rated banks. The 100% risk weighting for all corporates, regardless of their credit quality or country of incorporation, was another example of this. Also under this pillar was a more contentious issue, a new capital charge for operational risk. This would cover the risk of IT breakdown as well as risks such as fraud and trading irregularity.

The definition of bank capital remains as it was under Basel 1, and the minimum capital ratios of 4% for Tier 1 and 8% for total capital also remain in place. So, Pillar 1 – and Basel II as a whole – is concerned only with the denominator of the capital ratio calculation as established under Basel 1 – not the numerator which remains unchanged.5

Supervisory review process. This is the focus of Pillar 2 and covers national regulators’ reviews of bank capital assessment models. It describes the process by which the regulator sets minimum capital requirements that exceed those outlined in Pillar 1, with the exact requirements being a function of the risk profile of each bank. Banks must also assess their credit concentration risks and stress-test them under various conditions.

Enhanced public disclosure. Pillar 3 requires banks to publish their risk-weighting calculations, capital breakdown and capital adequacy.

Approaches to credit risk

The Basel II rules can be implemented under three alternative approaches: standardized, foundation IRB and advanced IRB. These can be briefly described as follows:

• Standardized approach. The most straightforward to apply, with risk weights being assigned according to asset class or formal credit ratings. The assets are described as residential mortgages, corporate loans, and so on.
• Foundation IRB. Under the foundation IRB approach, capital calculation is made after the bank itself sets default probabilities for each class of assets. The bank assigns probabilities of default (PD) to each asset class, or each asset in accordance with credit rating. Using the Basel II guidelines it then sets parameters for loss given default (LGD), exposure at default (EAD) and maturity (M). These inputs are then used to calculate the risk weights for each asset class using the Basel II capital calculation formula. Foundation IRB may be used as a stepping stone before implementation of the advanced IRB methodology, or retained as the calculation method in its own right.
• Advanced IRB. Under the advanced IRB approach, a bank will calculate risk weights using its own parameters, which are arrived at from its own default data and internal models.

Under the IRB approach banks may use their own data, though –significantly – it must include data for PD, LGD and EAD. Their own model can be used to calculate risk weights, which is then adjusted by a scaling factor. In practice, this means a scaling factor of 1.06 will be applied. Note that a bank must adopt the same approach for both its banking book and its trading book.

The majority of banks, especially those outside Europe, are expected to employ the standardized approach. Smaller banks with extensive retail and mortgage business are also expected to adopt the standardized approach. Only the largest banks are expected to adopt the advanced IRB approach, which requires significant investment in internal systems. Banks that wish to implement the advanced IRB approach must seek supervisory approval of their systems and models from their national regulator.

Operational risk

Basel II introduced a capital set-aside to cover operational risk – a contentious departure from the requirements of Basel I. Banks are required to calculate a capital charge for operational risk, separate from the capital charge for credit risk. Each approach has its own calculation method. The general calculation is that a bank must apply 15% of its average revenue over the last 3 years – revenue is defined as net interest income (NII) plus non-interest income.6 Under the standardized approach a bank may calculate its own level of operational risk, per business line, and apply the capital charge based on this risk exposure. The charge itself can then lie within a 12% to 18% range, rather than the uniform 15% level.

Under the advanced IRB approach a bank will calculate its own operational risk level and then apply its own capital charge, under BIS guidelines of course. This enables a bank to set lower operational risk charges for certain business lines, where it can show that risk exposure is lower.

Table 10.1 is a summary of the main differences between Basel I and II by asset class. Certain sectors, such as residential mortgages and high-credit-rated corporate lending, gain substantially under the new regime, whereas some businesses such as fund management, which previously attracted no charge, now carry an operational risk charge.

Table 10.1 Comparison of regime change from Basel I to Basel II risk weights

Impact on specific sectors

To illustrate Basel II further, we consider it with regard to specific selected asset classes. One can gain some idea of the objectives of the new rules by looking at their impact on different business lines. We review sovereigns first, followed by bank assets, structured finance securities, corporates and credit derivatives.

Sovereign business

As was the case with all asset classes, the treatment of sovereign debt under Basel I was very simple. Sovereigns were divided into OECD and non-OECD debt.7 OECD sovereign debt was risk-weighted at 0%, while non-OECD sovereigns were risk-weighted at 100%. Under Basel II there is a deeper distinction, with risk-weighting assigned by credit rating (under the standardized approach). This is shown in Table 10.2.

Table 10.2 Basel II sovereign debt risk weightings (standardized approach)

The IRB approaches use banks’ own internal measures of risk. Under the standardized approach, formal credit ratings from external credit assessment institutions (ECAIs) assume a high importance. The BIS document describing Basel II states that if a country carries a rating each from S&P’s, Moody’s and Fitch’s, and one of these is lower than the other two, then the higher can be assumed. For a bank holding the debt of a country like China (which is rated A/A2/A) this rule has no impact; however, for a bank holding the debt of Malaysia (which is rated A/BBB/A), this is significant. It means that the bank can take the two higher ratings, which enable it to apply a 20% risk weighting. This is considerable compared with a Basel I weighting of 100%.

An effective if simple illustration of the new regime can be given as follows: consider a bank holding two bonds, each of USD10 million nominal, issued by South Africa and South Korea, respectively. Under Basel I – taking the minimum 8% capital requirement – the capital charges for each are

Under Basel II’s standardized approach the charges are

So, in this stylized example the impact is quite significant. The makeup of government bond portfolios in banks will be reviewed and heavily influenced by each sovereign credit ECAI. As capital charges rise for certain borrowers compared with others, those sovereigns that suffer an adverse impact in terms of the capital that a bank investor is required to hold against them may find their issuance yields rise. It is not necessarily emerging market sovereigns that will be so impacted. Italy is currently rated at A by S&P’s (although it is rated Aa2 by Moody’s and AA by Fitch’s). If one of the other agencies also effects a downgrade to Italian sovereign debt, then such debt will lose its 0% risk weighting under Basel II’s standardized approach rules. This point also highlights the advantage of adopting IRB rules. Under foundation IRB, countries such as Italy and Greece, which will or may attract a 20% weighting under the standardized approach, will probably be weighted at 0% under banks’ own PD values for sovereign debt. However, there is no doubt that higher rated non-OECD sovereigns will gain under Basel II and may well see their bond yields spread narrow. Less clearcut, but still a strong possibility, is that lower rated OECD members will see their debt attract a higher charge.

Description of calculation

Although we are describing the calculation for sovereign assets here, much of the calculation framework for Basel II is the same for corporates. Under Basel II the standardized approach applies risk weights in accordance with asset credit rating, as shown in Table 10.2. Under the IRB approach banks that meet minimum specified requirements and have obtained their regulator’s approval can use their internal estimates of risk parameters to determine their capital requirements. These parameters are

• Probability of default (PD). This is key to the IRB approach. It is the 1-year probability that an obligor will default.
• Loss given default (LGD). This is a measure of the expected average loss that a bank will suffer per unit of asset or exposure in the event of counterparty default. Whereas a borrower can only have one credit rating and hence only one PD, different sets of exposure to the same borrower may have different LGDs – for example, if one exposure is collateralized and another is not.
• Exposure at default (EAD). This is a measure of the extent to which a bank is exposed to a counterparty in the event of the latter’s default. For cash transactions, this amount is the nominal amount of the exposure. For derivative transactions and transactions with variable drawdown options, a credit conversion factor is applied to convert notional amounts to nominal values.
• Maturity (M). Generally speaking, longer dated loans represent higher credit risk. Up to a point, the longer the maturity of an exposure the higher the probability of decrease in its credit quality, hence the higher the PD. Somewhat counterintuitively, this effect is higher for better rated entities, because the higher the credit rating the greater the number of downward categories, short of default, there are for the entity to migrate to. Hence, the risk weight in terms of M is actually higher.

Foundation IRB. A bank adopting this approach may use its internal credit risk-scoring model to estimate PD,8 but must use BIS-prescribed LCG, EAD and M values. Senior unsecured claims on corporates, sovereigns and banks are assigned a 45% LGD; subordinated unsecured borrowings are assigned a 75% LGD. There is an assigned value of 2.5 for M. For EAD a credit conversion factor of 75% is applied for undrawn liquidity facilities and unused credit lines.

Advanced IRB. Banks that implement the advanced IRB approach will use their own values for PD, EAD and LGD and calculate their own M value. Because national regulatory authorities will also be setting their own prescribed levels for these parameters, adopting the advanced approach will be beneficial for banks that believe their own estimates will be lower than those of the regulator. The calculation of M is dependent on the cashflows of actual assets on the book. Generally, if the M value is below 2.5 then the risk weight will be lower under the advanced approach than under the foundation approach. If M lies above 2.5 then the opposite is true. The maximum value for M is 5.0.

Formulae. For all assets not in default, the formulae for calculating risk weights and capital requirements under both the foundation and advanced approaches are:

(10.2)

(10.3)

(10.4)

where

and

The formula for is saying that – ignoring correlation and maturity factors – the capital requirement represents the difference between loss under the worst case scenario (assumed to be an event with a probability less than 0.1%) and expected loss (given by PD × LGD).

Of course, the correlation parameter is key because the defaults of different obligors are not independent of each other. General macroeconomic factors impact all obligors, more so for higher rated entities (on the assumption that lower rated firms are more likely to experience difficulty due to firm-specific issues rather than the general state of the economy). The correlation parameter value in the formula lies between 0.12 and 0.24; the value increases from 0.12 for entities as their credit rating increases. The maturity adjustment factor is a correction to allow for the fact that the tenor of the exposure will be shorter or longer than the benchmark value of 2.5.

The standard formula given here is not used for assets in default. For such exposures the capital requirement is given by

where expected loss PD×LGD is the bank’s best estimate. This estimate is used to calculate loan loss provision and setoff charges for each asset in default.

Example illustration9

To help illustrate the new calculation rules, and as an indication of how capital requirements can be significantly different under Basel II than under Basel I, we present a stylized example of two sovereign assets. Imagine that a bank holds the following two sovereign bonds:

• USD100 million	Turkey 10-year, rated BB
• USD100 million	Malaysia 10-year, rated A

Under Basel I the regulatory capital requirement for this portfolio is zero for the Turkey bond, because the country is an OECD member, and USD8 million for the Malaysia bond which is 100% risk weighted. However, under Basel II this requirement changes, with the exact calculation being dependent on the approach being adopted.

Standardized approach. Under the standardized approach, the ratings of each sovereign bond determine its risk weighting.10 So, the capital calculation is

• Turkey	USD4 million
Malaysia	USD1.6 million

This highlights a general point on the impact of Basel II compared with Basel I: under the simple standardized approach, asset portfolios that gain include those of highly rated non-OECD obligations such as China, Chile, Hong Kong and South Africa, while portfolios that would suffer higher capital charges would include OECD member countries that are lower rated, such as Mexico, Poland, Slovakia, South Korea and, as shown here, Turkey. In our example, the holding of Turkey sovereign bonds suffers a significant increase in capital charge, while the holding of Malaysia sovereign bonds benefits from a much-reduced requirement.

Foundation IRB. For this example we extract statistical data from debt market prices in January 2006 (see Table 10.3). As far as PD values are concerned, these are unnecessarily severe; rating agency PD values for both countries would be nearer to zero.11 However, the illustration works better using our unrealistic estimates, which produce the risk weights shown in Table 10.3. The M and LGD values are those prescribed in the BIS document for use in the foundation approach.

Table 10.3 Calculation parameters

Using calculated risk weights, we produce a capital requirement of

• Turkey	USD5.1 million
• Malaysia	USD3.3 million

So, under foundation IRB we have a still-higher capital charge for Turkey and a lower requirement for Malaysia. Note that our calculation, using market data from 2006, produced different results from the BIS’s example calculation released at the time of the final draft.

Advanced IRB. Under the advanced IRB approach, as Malaysia has a lower PD value its impact is, somewhat counter-intuitively, greater over a longer period than Turkey’s. This produces a greater increase in capital charge for a 10-year exposure for Malaysia than for Turkey. The risk weight for Malaysia rises from 41% to 66%, while that for Turkey rises from 66% to 100%.

Note that the values arrived under advanced IRB are heavily influenced by the PD, M and LGD parameters used. Significant differences in results can emerge based on what values are assigned for these inputs. For example, rating agency PDs often differ greatly from credit default swap-implied PD values. In the case of sovereign exposures – because PDs can assume zero value – the choice of which number to use is significant.

Bank assets

For bank ALM strategy purposes, this is perhaps the most important asset class to assess with respect to the impact of Basel II. Banks are significant holders of short-term and medium-term bank-issued debt and will look to rebalance liquidity portfolios for any types of assets that are adversely affected under the new rules.12

Note that Basel II does not redefine (nor seek to redefine) bank ‘capital’. The definition of Tier 1 and Tier 2 capital remains the same as under Basel I. So, a bank holding another bank’s capital instruments must continue to observe specific rules, although in practice there might be a possibility of more favourable treatment in practice under the IRB approach. Essentially, a holding of bank capital in the form of equity or subordinated debt by another bank, which is greater than the equivalent of 10% of the holding bank’s own capital, is deducted from the holding bank’s capital base or risk-weighted at 100%. In other words, a minimum of 8% capital would have to be held against an asset comprised of bank capital, whether this is Tier 1 equity, upper Tier 2 or lower Tier 2 subordinated debt. Under the IRB approach in Basel II, there is no specific new treatment for bank capital, but applying the IRB rules may result in some bank capital being risk-weighted at lower than 100%. We can see how this may well be the case where the instrument is issued by a strongly rated bank.

Short-term debt

The new rules for short-term bank debt can be summarized as follows:

• Debts of 1-year maturity or less are assigned a 20% risk weighting assuming they are rated at A-1/P-1.13 Short-term bank debt rated at A-2/P-2 is assigned a 50% weighting while A-3/P-3 paper is weighted at 100%.
• Very-short-term debt of 3-month maturity or less that is unrated, but whose issuer has a long-term rating equivalent to A-3/P-3, will be rated at 20%.

Essentially, it is apparent that virtually all short-term bank paper will continue to be rated at 20%, which is unchanged from the Basel I regime. The preferential treatment of very-short-term debt, which enables even low-rated (A-3/P-3) assets to be weighted at 20%, is prescribed in Option 2 of the standardized approach to bank debt (see Example 10.1). It is not available under Option 1, so banks that are required to adopt the latter by their national regulator will not have this flexibility. Under Option 1 short-term assets will be rated at 20%, 50% and 100% for A-1/P-1, A-2/P-2 and A-3/P-3 ratings, respectively. In the event that a sovereign or bank has three ratings, the two highest ratings will apply. Table 10.4 summarizes Option 1 and Option 2 risk weights.

Table 10.4 Basel II bank debt capital charge Options 1 and 2

We can identify certain anomalies that may arise under this two-alternative ruling. For all assets of over 3-month maturity, there is a clear difference at the BBB to BBB rating band. Under Option 1 a bank in that rating range would be 100% risk-weighted, whereas under Option 2 it would carry only a 50% risk-weighting. Another potential anomaly is a BBB-rated bank incorporated in an A-rated country: under Option 1 it would carry a 50% weighting, compared with a 100% weighting under Option 2. Note also the preferential treatment for very-short-term bank debt under Option 2.

From Table 10.4 we conclude that banks of lower credit rating but who are incorporated in a highly rated country would benefit from adopting Option 1, while in the converse case Option 2 would be advantageous.14 Note that the UK’s FSA regulatory agency has stated that Option 2 is the more risk sensitive of the two approaches and should be the one that is used.15

IRB approach

The procedure for applying IRB rules in both foundation and advanced forms for bank assets is virtually identical to that used for sovereign assets. The only significant difference is that a minimum value of 0.03% for the PD parameter must be applied for bank assets when calculating the risk weighting. If applying foundation IRB, a bank may use its own internal credit analysis results when estimating the PD parameter (subject to the 0.03% minimum), while values for the EAD, LGD and M parameters are set in the BIS guidelines. Senior unsecured bank debt is assigned a 45% LGD value, with subordinated unsecured debt given a 75% LGD level. The value for M is 2.5. If applying advanced IRB, a bank may use its own internally calculated values for PD, EAD, LGD and M.

Repo agreements and securities lending

A 0% risk weight is applied to an exposure that is collateralized under a repo agreement if the counterparty is a ‘core market participant’; otherwise, the risk weight is 10%. This assumes that (i) the loan and the collateral are denominated in the same currency, (ii) the position is marked-to-market on a daily basis and margin taken where necessary and (iii) the transaction takes place under a standard legal agreement such as a GMRA.

Any other collateralized exposure is also risk-weighted at 0%, provided that the collateral is in the form of cash or sovereign debt issued by a country that is also risk-weighted at 0% under the standardized approach and there is a haircut of at least 20%.

Derivative positions

Banks are the largest users of off-balance-sheet derivatives such as swaps. Under Basel I banks calculated the credit exposure arising from derivatives trading using the ‘current exposure’ method, which entailed taking the mark-to-market value of each position and basing exposure on that. Basel II continues essentially with this approach. The counterparty charge for derivatives transactions is given by:

where

Note that this only applies to over-the-counter (OTC) derivative contracts – not exchange-traded ones, for which no counterparty charge is required. Equation (10.5) shows that a bank will obtain capital relief for any of its derivatives trades that are collateralized by the counterparty.

Corporate and retail lending

The area of corporate and retail lending saw some of the biggest impacts of Basel II. This is important for ALM practitioners to be aware of because corporate lending is, in many cases, the largest proportion of a bank’s balance sheet. Many commentators have remarked that stronger rated corporates will seek greater disintermediation, while banks may find it attractive to lend to unrated or low-rated corporates rather than middle-rated corporates. As noted elsewhere, although a full assessment should wait until at least a year after implementation, we present here some basic considerations for the ALM strategist.

Corporate assets

The simple 100% risk weight for corporate lending that applied under Basel I has been discarded. In its place is the ratings-based methodology for the standardized approach shown in Table 10.5. Under the foundation IRB approach the capital charge reduces for higher rated corporates, so that AA-rated companies – previously rated 100% under Basel I – are now around 15%. The class of assets termed ‘small- and medium-sized enterprises’ (SMEs) also gained under Basel II when compared with non-SME corporates; under the IRB approach it is expected that the weighting will be approximately 20% lower for small SMEs.16

Table 10.5 Basel II standardized approach: corporate risk weights

Rating	Risk weight (%)
AAA to AA	20
A to A	50
BBB to BB	100
Below BB	150
Unrated	100
Source: BIS.

Retail asset risk weighting under Basel II was 75% in the standardized approach, compared with 100% under Basel I. Residential mortgage risk weighting will decrease from 50% to 35%; under the IRB method they are expected to fall from this to around 15%. Thus, banks with large pools of residential mortgages gained in capital charge terms compared with non-mortgage banks.

Corporate assets – the standardized approach

Under the blanket 100% risk weighting of Basel I, banks had a greater incentive, somewhat perversely, to lend to lower rated corporates because this resulted in higher return on capital. This anomaly is better addressed under Basel IIIn the standardized approach the obligor’s formal credit rating determines capital charge risk weighting. Broadly, the only unchanged case is corporates rated from BBB to BB which remain at 100%. All other corporates have changed risk weights. Banks that adopt the standardized approach then have little incentive to lend to entities in this rating category, whereas they have an incentive to lend to undated corporates compared with those rated below BB. An unrated corporate will have no incentive to apply for a credit rating unless this is likely to be better than BBB, as the lending rate may be prohibitive.

Corporate assets – the IRB approaches

Banks implementing the foundation IRB methodology are allowed to use their internal credit risk models to estimate the PD values for each obligor;17 the values for the LGD, EAD and M parameters are prescribed by the BIS. Under the advanced IRB a bank may use its own estimates of all four parameters.

Illustration using a hypothetical example

We use a simple example to illustrate the impact of Basel II. Consider a bank lending to two entities:

• a utility company rated AA;
• an industrial company rated BB.

Under Basel I a loan of USD10 million to each company would each attract a minimum capital charge of USD800,000.00. Under the standardized approach of Basel II the charge for the loan to the utility company would be USD160,000, while the requirement for the industrial company would be unchanged at USD800,000.

Under the foundation approach, the bank would use its PD value to calculate the risk weighting; assuming the calculation came to 15% for the utility company the capital charge would now be USD120,000. Again, we assume the risk weight for the industrial company was worked out as 95%; this leads to a capital charge of USD760,000. Risk weight values under the advanced IRB would use the bank’s internal data for all calculation parameters, but may well be higher for the industrial company, making this asset an even more expensive one when compared with the Basel I regime.

Basel III

In September 2010 the Basel Committee for Banking Supervision (BCBS), which comprises the regulators and central bankers of 27 countries, released details of the new banking regulatory capital rules, which were termed Basel III. The rules require banks to hold a higher amount of core Tier 1 capital than was required under the Basel I and II regimes.

The main provisions of Basel III are as follows:

• the minimum level of core Tier 1 capital to be 4.5% of risk-weighted assets – this compares with the 2% level required under the Basel II accord;
• a ‘capital conservation’ buffer of 2.5% will also be required, as protection against periods of economic and financial stress;
• there will be a Tier 1 ‘leverage ratio’ of 3%.

Although this additional reserve is not compulsory, a bank that does not put it in place will be restricted from paying dividends to shareholders; therefore, for practical purposes the minimum Tier 1 capital ratio is actually 7%.

In addition, a ‘countercyclical’ capital buffer of up to 2.5% will be allowable, with national regulators having the authority to impose this requirement when they deem it necessary, as a response to overheating markets.

The definition of core Tier 1 capital is also being simplified under Basel III; going forward, it will comprise only equity, retained reserves and undated preference shares. Tier 2 has also been simplified and will only comprise preferred shares, hybrid subordinated debt and long-term subordinated debt without incentive to redeem (such as step-up coupons).

The timeline for implementation is January 2015, with the capital conservation buffer not required until January 2019.

As of the time of writing, Basel III had not made any modifications to the process of assigning risk weightings to assets. This remains identical to the methodology implemented under Basel II.

Initial impact

The Basel III rules are possibly more onerous for banks than a first reading might suggest, particularly when the Tier 1 capital ratio is taken together with the proposals for a leverage ratio and liquidity buffers. However, although banks will need to hold more high-quality capital, they have been allowed a long-transition phase to implement the new requirements. They will need to hold common equity to the value of 4.5% of their assets by the start of 2015, up from the current 2%. Beyond that, by January 2019 banks will need to hold a 2.5% capital conservation buffer of common equity. The rationale of the buffer is that it is just that – a buffer that can be run down during periods of market stress, without hitting the regulatory reserve and thus preserving the bank as a going concern. The total requirement comprises the common equity ratio of 7% stated above. This is a considerable increase on the previous minimum of 2%.

In addition, the BCBS is introducing new rules from 2012 that demand a more onerous capital regime for trading activities and securitized assets held on the trading book. This is expected to be three times the level required against banking book assets. Large systemically important banks will, at a point in the future, face a capital surcharge on top of the standard requirements.

A more problematic area of the new rules is the countercyclical buffer. If regulators believe that banks are in the midst of a credit bubble they may levy a countercyclical buffer of up to 2.5% of assets, which will be made up of common stock or other equally loss-absorbing instruments.

The Tier 1 leverage ratio of 3% will limit banks to lending 33 times their capital, a significantly lower value than that observed by some banks leading up to the financial crash. This represents a cap on bank risk irrespective of the impact from higher capital numbers. Although this limit is not due to be introduced until 2018, banks will need to disclose the level to the market from 2015 onwards.

BIBLIOGRAPHY

BIS (1988) International Convergence of Capital Measurement and Capital Standards, Basel Committee on Banking Regulations and Supervisory Practice, July.

Fabozzi, F. and Choudhry, M. (Eds) (2004) The Handbook of European Fixed Income Securities, John Wiley & Sons, Inc.

FSA (2008) Consultation Paper 189.

Gup, B. (2004) The New Basel Capital Accord, Thomson Corporation, New York.

1 In the UK, banking regulation is now the responsibility of the FSA, which took over from the Bank of England in 1998. In the US, banking supervision is conducted by the Federal Reserve; it is common for the central bank to be a country’s domestic banking regulator.

2 BIS (1988) International Convergence of Capital Measurement and Capital Standards, Basel Committee on Banking Regulations and Supervisory Practice, July.

3 Also known as the ‘Cooke ratio’ after the Chairman of the Basel Committee at the time, Peter Cooke.

4 The actual title of the document, published by the Basel Committee on Banking Supervision of the Bank for International Settlements on 26 June 2004, is International Convergence of Capital Measurements and Capital Standards.

5 There is a slight change to the numerator in the ratio under Basel II in circumstances where deductions of capital for certain asset classes must be made, but this will not apply to all banks.

6 Some national regulators have specified that a bank may take average volume of business, such as volume of assets, over the last 3 years rather than revenues.

7 The member countries of the Organization for Economic Cooperation and Development (OECD) are Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovakia, South Korea, Spain, Sweden, Switzerland, Turkey, the UK and the US.

8 There is a minimum level of 0.03% specified by BIS for corporates and banks.

9 The author thanks Rameez Saboowala for his assistance with gathering data for use in this section.

10 In our example there is one uniform rating for each exposure. Very broadly speaking, if a sovereign or other entity is rated differently across different agencies, the lower rating applies.

11 This is significant: at a zero PD there would be a zero capital requirement because there is no minimum level of PD for sovereign exposures. For corporate exposures, a minimum floor PD applies irrespective of rating.

12 Banks hold a large part of their liquidity book in short-term bank debt such as certificates of deposit (CDs), commercial paper (CP) and floating rate notes (FRNs).

13 Note that the highest S&P short-term rating is A-1, while the highest Moody’s short-term rating is P-1.

14 Note that rating agencies do not rate a corporate entity, including a bank, at a higher rating than the rating of its country of incorporation (although an equivalent rating is possible). Hence, such banks are rare beasts.

15 Consultation Paper 189, FSA.

16 An SME is defined for Basel II purposes as a corporate with annual sales of EUR50 million or less.

17 There is a BIS-imposed minimum PD of 0.03%.