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Basel II and Basel III Give Global Banks New Underpinnings for Diverse Economies

GC Headline, 20 July 11: "The Australian Prudential Regulation Authority has written a letter to banks seeking information on how they intend to meet new Basel II requirements for securitization that commence January 2012."


Basel II
Basel II was initiated in 2004, when world banks realized how precarious their position had become in a declining economy and a three-pronged Accord addressed 1.) new capital standards, 2.) enhanced supervision and 3.) increased market discipline through public disclosures.

With the deadline fast approaching, banks will be expected to have the new rules actively in place in compliance with the Accords.

NEW RULES: The Standardized Approach to New Capital Standards

New risk assessment rules recognize that counter parties within the same loan category can present far different risks that demand a dedicated exercise of regulations that pronounce greater weight to the credit rating of the borrower. Credit ratings are assigned risk weight by an external rating agency accredited by satisfying the descriptions outlined in the Basel II Accord.


With the focus on Risk Assessment Criteria, the Accord outlined risk assessment according to borrower categories:

• When applied to corporations risk assessment can be as low as 20% and peaks at 150% for a "BB-" rating.
• Risk assessment for individuals and small businesses can be weighted at 75%, provided the bank's portfolio is diverse enough as outlined in the Accord profile.
• Residential real estate changed from 50% in Basel I to 35% in Basel II
• Commercial real estate, with property collateral, was rated at a 100% risk with a regulatory discretion granted to office, multipurpose commercial and multifamily residential properties at 50%, subject to qualifying limits.

• Sovereign governments and central banks face a rating regimen similar to corporations from 0% to 150% according to a rating agency.

A choice of one option to apply to their international banking system is granted to countries:
1. one risk rating below the country's risk weight
2. a credit assessment score awarded by external rating agency, with lower rates for
short-term obligations

The remaining risk management included Off-Balance Sheet items such as
• Commitments
• Securities Lending
• Letters of Credit
with Credit Risk Mitigation addressing collateral by using a reevaluation of exposure every six months.

Operational Risk
Under the rubric of a Standardized Approach Basel II Accord requires:
1. A Basic Indicator Approach with an operational risk set at 15% of the institution's net positive annual gross income
or
2. A Standardized Approach that divides a bank's eight business lines gross income, multiplied by a specified factor, ranging from 12% to 18%.

Advanced Measurement Approach
Risk capital charge is determined by using the bank's internal operational risk measurement system, with a limitation of recognition by third party insurance not to exceed 20% of the total operational risk capital charge.

Banks will be required to comply with these new regulations or face the possibility of closing their doors.

Basel III
In March of 2010, Standard and Poor published a while paper titled, "Basel III for Global Banks: Third Time's the Charm?" in which they reviewed the latest Accord put forward to tighten international banking regulations. They are "broadly supportive" of the proposals.

S & P predicts the impact of Basel III will affect the world economy with fundamental changes in business models and product pricing, however resulting in a "prolonged transition period with significant grandfathering arrangements" to cushion the effect.

In assessing the response to Basel II, S & P notes that the U.S. has lagged behind other countries in adopting the proposals, while the European Commission had recently responded with legislative changes toward proposed reforms in the European Union.

Liquidity protocols are being adopted and Basel III proposals support these standards of practice.
Although Basel III goes a long way toward improving practices, S & P does not predict a change in the structural design among the systemically important institutions, while the counter-party credit risk does seem to address the "interconnectedness" of the financial system. Structural issues will be in debate for a protracted time.


In their Overview, Standard and Poor summarizes the Basel III consultative document by referencing these liquidity proposals, which they view as having a positive effect on the regulatory capital structure:
1. Improve the quality and consistency of regulatory capital
2. Increase capital requirements on certain counter-party credit risks

3. Introduction of a leverage ratio
4. Address procyclicality


Overview of the Basel III Liquidity Proposals
Two short-term proposals were published separately by the Basel Committee to introduce standards for liquidity management and monitoring:
1. Named the Liquidity Coverage Ratio, the first standard would require banks to maintain high quality, unencumbered assets in excess of their stressed cash outflows over a 30-day time horizon.
2. Named the Net Stable funding ratio the second standard effectively assesses the behavioral maturity on each side of the balance sheet over a one-year horizon.
S & P regarded these propositions as positive steps, although they question the 30-day horizon and suggest that they would expect institutions should be able to survive over a longer period.

Transparency
The strong improvement in transparency is viewed positively and S & P agrees with the committee's view that disclosure has frequently been deficient to date. They step in and recommend a series of statements to further clarify global banks' status.

In short, suffice it to say that Basel II and III are dedicated to protecting international banking liquidity by focusing efforts toward tightening their parameters for risk management and liquidity. However, S & P predicts an extended transition period in the course of "managing risk—that the global economic recovery could be jeopardized if banks are forced to focus on balance sheet strengthening at the expense of their core functions."
Reference: Standard & Poor's "Global Credit Portal – RatingsDirect" article "Basel III for Global Banks: Third Time's The Charm?" by Richard Eames, et al.

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