The US Federal Reserve Bank has elements of private ownership whereas the NZ Reserve Bank is 100% owned by the Government of New Zealand. In my opinion is does an excellent job. Although inflation is currently too low.
In 1988 the Basel Committee (BCBS) developed the original Basel Capital Accord which is now known as Basel I. Basel I provided an approach for defining capital and measuring risk-weighted assets and introduced a minimum capital ratio requirement of 8 percent. The calculation of risk-weighted assets differentiated between the risks that a bank faced, by using a simple system of different risk-weights applied to different classes of assets that the bank held. Over the next two decades banking continued to evolve. Concerns grew over time about the ability of Basel I to account for evident types of new risk in the areas of derivatives and certain hedge fund activities. This evolution resulted in the BCBS adding capital requirements for market risk to Basel I in 1996.
It then released Basel II in 2004. Basel II built on the Basel I framework by improving on the calculation of a bank’s risk-weighted assets and explicitly identifying operational risk as a separate type of risk. Capital requirements for market & operational risk can be converted into risk-weight equivalent amounts and hence compared with risk-weighted assets for credit risk exposures, thus creating the concept of risk-weighted exposures. In the wake of the Global Financial Crisis it became apparent that there were some shortcomings (for systemically important Banks: the S.I.B’s) in the Basel Capital Accord in place at the time, known as Basel II.
Basel III - The Main Changes are the New Rules for the Level and Definition of Capital.
In December 2010 the BCBS issued a package of enhancements, known as Basel III, to strengthen the international standards for the regulation and supervision of bank capital. The changes to the Capital Accord brought into effect by Basel III included: enhancing the requirements for the quality of the capital base; increasing the minimum amount of capital required to be held against risk exposures; requiring capital buffers to be built up in good times that can be drawn down in times of economic stress; introducing a leverage ratio requirement; and enhancing the risk coverage of the capital framework. At the time of writing, the BCBS has completed its last stage of consultations for this. Basel III now provides for enhanced risk coverage in some areas.
The Capital Ratios
Different capital ratios are defined for each tier of capital - Equity, Tier 1 and Tier 2 as follows:
Source: RBNZ Bulletin
• The Common Equity Tier 1 (CET1) Capital Ratio is the ratio of CET1 Capital to risk-weighted exposures;
• The Tier 1 Capital Ratio is the ratio of Tier 1 Capital to risk-weighted exposures;
• The total Capital Ratio is the ratio of Total Capital (Tier 1 plus Tier 2 capital) to risk-weighted exposures.
This is how the Basel III – as well as the incoming Basel IV - risk-weighted exposures are a measure of the risk of loss that the bank faces, and includes the following categories of risk:
• Credit Risk, which refers to the risk that a borrower or other counterparty to a contract with the bank defaults on their obligation (which is an asset of the bank);
• Operational Risk, which is the risk of loss arising from inadequate or failed internal processes or systems, or from wrong-doing or errors by executives or employees;
• Market Risk, which is the risk of loss on financial instruments held for trading purposes arising from movements in market prices.
Calculating risk-weighted assets provides a measure of the credit risk. Risk weighted assets are calculated by assigning a risk-weight to each of the bank’s assets, where the risk-weight reflects the riskiness of the asset, and multiplying the value of the asset by the risk-weight. Risk-weights are either those specified in the Basel capital standard - the standardised approach, or are calculated by the bank using its own internal risk models, the old internal models-based approach now phasing out. Higher risk-weights are applied to riskier assets requiring more capital to be held against them. In this way the Basel III & IV rules provide risk-adjusted capital levels.
The Buffers
Basel III introduced the capital conservation buffer, and also a countercyclical buffer. The conservation buffer, which applies at all times, is an additional amount of common equity equal to 2.5 percent of risk-weighted exposures
The Buffers are designed such that banks build up financial resources in good times that can be drawn down in times of financial stress - without giving rise to a regulatory breach – as there is no breach if a bank’s capital ratio falls below the minimum ratio requirement plus the buffer ratio, as long as it remains above the minimum ratio requirement. However, in this situation a bank’s distributions on ordinary shares and Tier 1 instruments are limited. If no countercyclical buffer is in place, the limits in the following table apply (the NZ Reserve Bank has followed the Basel approach here). So these are real disincentives for a non-complying Bank and its Board.
Source: RBNZ Bulletin
The Qualifying Instruments
Basel III sets requirements that instruments must comply with to be classified within a given category of capital. In many cases these requirements are principles-based, rather than prescriptive. Ordinary shares are the strongest form of capital, followed by Tier 1 capital and then Tier 2 capital. These attributes are described below. The Reserve Bank has implemented the Basel III requirements for each of these elements of capital quality.
There are some transition arrangements in the Reserve Bank’s regime. Banks may continue to recognise, until 1 January 2018, a portion of instruments that qualified as capital under the previous rules, but do not qualify under the Reserve Bank’s Basel III rules as they are phased in. The amount recognised has been reducing in value annually, at a rate of 20 percent a year. A market for Basel III-compliant instruments has been developing in New Zealand and banks have found sufficient demand to allow them to issue these instruments. This market is likely to develop over the coming years with further capital issues by Banks. By way of comparison those hybrid bonds issued by the big 4 aussie Banks 3 years ago have now become non-qualifying capital under Basel III’s final phase.
Conclusion
The Reserve Bank requirements largely align with the Basel III text, the most significant departure being that the Reserve Bank has not implemented a Leverage Ratio. The Reserve Bank requirements also largely align with APRA’s requirements (The Australian Banking Regulator) which makes sense to me.
In the next GFC event all Banks will have to – and be able to – bail themselves out. Not the taxpayers (Bail In).
In my opinion one of the best aspects of Basel III is that the “Credit Ratings” given by international Agencies such as Standard & Poors, Fitch et al are absolutely meaningless. They are given no credibility at all under Basel. No longer is there self-regulation endorsed by these external agencies. Each individual Bank must comply with the Buffers, Capital & other Ratio’s by holding Qualifying Capital Instruments set down by the Basel Committee.
Over the years and when I was very young I would often ask senior Bankers I met on my travels around the world the question “where does the money come from?” and the answer was often quipped out: the “Gnomes of Zurich”.
So well done to the Gnomes of Zurich.
In positions of immense power and control they have done a highly commendable job tackling a colossal problem … on the most critical component of the global system. They’ve kept it strong.
