July 28, 2017    7 minute read

What are the Key Differences Between the Basel Agreements?

Reigning in the Banks    July 28, 2017    7 minute read

What are the Key Differences Between the Basel Agreements?

The Basel Committee on banking supervision is a consultative international body, established in 1974 by the central banks of the G10 countries. Its aim is to define rules for banking supervision to ensure stability to the global financial system. The Basel Committee has no legislative power but makes proposals that should be implemented within the individual national systems.

Basel I

In 1988 the Committee reached an initial agreement on minimum capital requirements of banks (the capital had to be at least 8% of loans to customers), with the aim of limiting the very “aggressive” behaviour of some lenders, free to act in the little-regulated jurisdictions. If the equity available was insufficient, one was supposed to reduce loans to customers or have less risky ones. However, it had the following limits:

  • There was no differentiation of risk measures for the same type of customers;
  • “operational risks” were not considered;
  • portfolio diversification is not considered as a tool of risk reduction;
  • the maturity of the loan was not considered.

Basel II

From the limits of Basel I, began the process of revision of the first agreement, leading to the drafting, in June 1999, of an initial consultation document, open to comments from individual countries, banking associations and scholars. On 28 June 2004, the Committee approved the final version of the agreement, which entered into force on 1.1.2008. The new arrangement was described as an architecture based on three pillars constituting a unitary and integrated system. The pillars were the following:

  1. Capital requirements,  the criteria for calculating minimum capital requirements are redefined, reforming the rule of 8%: making it more sensitive to the risk of individual loans allowing for opinions (“rating”) assigned by the Bank considering the so called ” operational risk “(fraud, earthquake, computer crash, etc.);
  2. Supervisory review, this pillar aimed to increase the powers of the supervisory authorities that should ensure, in addition to the minimum requirements based on purely mathematical calculation, even the application by credit institutions of organizational policies and procedures for risk measurement and government;
  3. Market discipline, the agreement obligated financial institutions to provide more information to the market, to ensure that the investing public could verify clearly and transparently, the conditions of risk and capital requirements of individual banks. Therefore, the market would punish the banks considered too risky, demanding higher rates or refusing to fund them.

Basel II implied that the financing costs for a company were increasingly tied to ratings of borrowers of money. This meant that the financial costs necessarily passed through an increase in capitalization, and a consequent, an improvement of corporate rating.

Basel III

Basel III was a set of new rules on banking supervision released as a response to the financial crisis of 2008. On 12 September 2010 the Governors and heads of G20 supervisors endorsed the Basel Committee’s proposals, which were submitted to the heads of State and Government in November 2010 in Seoul. The objective pursued with this reform was to prevent excessive risk-taking by operators, making the financial system more robust and to establish a uniform playfield among the numerous financial institutions. There were five areas of intervention:

  1. Introduction of minimum liquidity standards (Liquidity Coverage Ratio and Net Stable Funding Ratio);
  2. Introduction of the definition of regulatory capital together with the establishment of higher capital requirements (Common Equity, common stock plus retained earnings, are increased from  2% to 4.5% and Tier 1, Common Equity + other financial instruments,  is increased from the current 4% to 6%);
  3. Best coverage of market risk and counterparty risks (the Basel Committee has proposed changes to increase the capacity of the capital requirements to capture market and counterparty risks to avoid an underestimation of actual risks inherent in the processing activity of non-financial instruments, particularly complex and trading activities);
  4. Reducing the level of financial leverage (it established a minimum requirement of capital, Tier 1, that banks must hold compared to total assets, non-risk-weighted, on and off-balance sheet, and be neutral to the different accounting rules);
  5. Countercyclical measures to reduce the “procyclicality” of the prudential rules (these measures were meant to reduce the procyclicality of prudential rules, in fact, the banks would hold capital resources in excess of the minimum, called a conservation buffer, equal to 2.5% of the common equity in relation to the assets at risk).

The “philosophy” of Basel 3 was simple: all transactions that a bank made (sale of securities, lending, etc.) involved risks, and therefore, potential losses. The higher risk, the greater the amount of money that the Bank would set aside to protect itself, and they could not use it in any way.

Basel IV?

It has to be said that the innovations introduced with Basel III made much more complex the regulatory framework whose basic philosophy remained, however, unchanged. The possibility that the fruits of financial innovation would undermine the efficacy in the future, with consequent risks of new crises, was not necessarily averted.

What was supposed to be the intent of all only a “review” of the rules laid down by Basel 3, actually seems to have become in effect a new regulation of the banking system already renamed Basel IV. It has to be remembered that the Basel 3 rules have forced banks to recapitalize for over €520bn between 2011 and 2015 to meet the requirements of capital strengthened after the financial crisis.

The new proposals by the Basel Committee, according to preliminary analysis, could result in an increase of 55% of the ratio CET1 asset compared to the current requirements. Also, as another possible addition to the already existing rules of Basilea, there seems to be the possibility to cancel the possibility for banks to use internal models to calculate operational risk, for fear that they may not be able to effectively identify risk. All European banks have formed a tight front against new rules that Basel IV might introduce soon.

Delays

But this is not as fast as it may seem: in fact, the governing body of the Basel Committee was supposed to put the final point on the reform of the Basel III rules over the weekend of January 7 and 8  2017. In doing so, the GHOS (Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision) would approve definitively a draft proposal examined in a meeting held in late November in Santiago, Chile.

In a statement released, the GHOS has eventually stopped everything and thrown the ball forward; arguing that more time is needed to complete some work. Also, they did not provide any indication of the date on which will be held the future meeting of the committee. One of the reasons that might explain the freezing of the reform is the fact that the Basel Committee is waiting to understand what the new US administration is willing to do.

Conclusion

The new American President has never made any secret of wanting to change the rules for investment banks and American financial companies and reviewing the Obama administration’s reforms. Between banks (and supervisory authorities) of the old continent and the US the level of confrontation remains high. The subject of the dispute, in particular, is the revision of internal rating models, with which banks calculate the riskiness of their assets and capital to set aside accordingly.

The widespread fear is that Basel IV prudential requests increases for European banks, and force institutes to a give a new squeeze to credit. According to estimates by the European Banking Federation, Basel IV could lead to a capital shortage over €860bn. Not exactly good news at a time when national economies and investment bank support is becoming more and more essential.

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