Measuring Risk: Basel III and Capital Adequacy

Banks are currently preparing for Basel III's higher capital requirements. Speculation about the impact these changes could have are widespread throughout the markets. Given the implications of the Basel III agreements it is imperative to understand the strengths and weaknesses of the new standards.

In addition, it is important for investors to note that Standard & Poor’s (S&P) will continue making assessments according to its Risk Adjusted Capital Framework (RACF). Developed, like Basel III, to address the problems found in Basel II, the RACF is S&P’s independently developed primary metric for assessing capital adequacy in financial institutions.

Basel III

The Basel III agreements are focused on strengthening the liquidity and capital adequacy of financial institutions. Over the course of their implementation, the minimum common equity regulatory capital ratio will gradually increase to 7% in 2019 from its current 2%. Banks will also be subject to a variable countercyclical buffer set by national authorities of up to 250 basis points (bps). However, despite some improvements, S&P believes Basel II’s difficulties in relation to comparability between regulatory national ratios will persist under Basel III.

Despite Basel III ratios being subject to numerous assumptions, some banks have started to estimate them. A sample of these banks reveals that the average risk adjust capital ratio after diversification is comparable to the common equity tier 1 (CET1) ratio estimated under Basel III. There is, however, significant volatility around this average. Higher levels of operational risk have the potential to translate into higher charges from regulators.

S&P believes that asset managers' operational risk has increased significantly during the past decade. In particular, we apply a heavier capital charge for cash and money-market funds to reflect the financial support many independent asset managers (or parent banking companies) might provide to their funds. RAC ratio already addresses some enhancements of Basel III

Trading-book market-risk capital requirement will triple under “Basel II.5”

Banks in most mature markets, including the US, will have to increase their regulatory capital requirements with regard to the trading book at year-end 2011. Overall, S&P is of the opinion that the average capital requirements for market risk in the trading book will triple with the implementation of these increased requirements (“Basel II.5”). S&P believes reported Basel II.5 ratios will begin to converge to our RAC ratio. As the stress value at risk and the incremental risk charge metrics become publicly available, we expect the improved disclosure to help market participants' analysis of trading-book market risks.

Comparability issues will persist under Basel III

The Basel recommendations are not planned to be implemented according to a single blueprint. Instead, each country will have the right to exercise its own national discretions. This opens up the possibility of "goldplating" (i.e., adding rules from local regulators) when translating the recommendations from the Basel Committee on Banking Supervision (BCBS) into local regulation.

Even within the same jurisdiction, we expect differences in regulatory risk weights to remain as much driven by differences in banks' risk profiles as by variation in the methodology and models they use to assess the risk weights.

By contrast, the RACF has its own globally consistent definition of capital and risk-weighted assets. A significant part of Basel III is devoted to raising the quality, consistency, and transparency of the capital base. However, S&P  expects this to neutralize only some, not all, of the national discretions affecting the numerators of the capital ratios.

Concentration matters

The RACF embeds explicit adjustments for concentration and diversification of credit, market, operational, and insurance risks. The range of concentration and diversification adjustments are extremely varied and significantly affect the RAC ratio for most banks.

On the contrary, the Basel formula and hence Basel risk-weighted assets assume infinite granularity of the exposures and does not make any adjustment for institution specific concentration or diversification.
 
Basel III is a step in the right direction, but not yet a solution

While it is a move towards comparability in regulatory capital ratios, Basel III appears only to be a step. The statement made by the Basel Committee in 2005, in relation to Basel II, still holds true – “Basel is not a destination but a journey.”