Following news coverage can be easy. Understanding some of the terms it uses, less so. In our Flashcard series, The Atlantic explains ideas you may read about but never see spelled out. In this installment, we explain the Basel III Accord's new bank standards. In preparing this flashcard, I spoke with Richard Spillenkothen,
the former lead banking regulator for the Federal Reserve through 2006
who served on the Basel Committee when at the Fed. He is now a director
with Deloitte & Touche's Governance, Regulatory, and Risk
Strategies services practice.
The biggest news story of the day is also the hardest to understand: the new banking rules established by top bankers and regulators in Basel, known as the Basel III Accords. These new international rules designed to make banks safer could be more important than the U.S. financial regulation law passed this summer. The standards are complicated, but they should build better banks. How?
Basel III is all about capital. Capital is the amount of high quality assets a bank must hold to cushion against losses. Very simply, new rules will force banks to have more capital, higher quality capital, and more "liquid" capital. Here are five important features:
1. More Capital
The capital changes could be the most significant since the original Basel Accord was agreed to in 1988. The most vital change that Basel seeks is to force banks to hold more capital. By having a bigger cushion, banks won't be as vulnerable to losses hitting in times of economic turmoil.
The additional capital required of banks is significant. All of these new requirements come in the form of percentages, which you can think of as portions of bank assets. There are different kinds of assets that can count as capital, and they have different levels of quality. Common equity is the purest form of capital, a cushion that can absorb losses best.
Under current rules, banks are only required to hold 2.0% common equity. Under Basel III banks need an additional 2.5%, to total 7.0%, during good times. That sum can be reduced to as low as 4.5% under times of stress.
Moving to the next highest form of capital "Tier 1," adds another 1.5% of capital, and adding "Tier 2," results in another 2.0%. So in total, banks will now need 10.5% capital in normal times, or 8.0% capital in times of stress. This is much higher than what was required in the past. Here's a handy summary chart (we'll get to the "countercyclical buffer" below):
2. Better Capital
The definitions of these sorts of capital have also been tightened, to focus on higher quality assets. As already mentioned, far more of the highest quality capital -- common equity -- will be required. But the definitions of Tier 1 and Tier 2 capital are also being tweaked to be more conservative. Before, these sorts of capital included some types of assets that were not very reliable for cushioning losses during times of economic distress.
3. Bubble Busting
The new rules also contain an interesting provision to combat the ups and downs of economic cycles. Financial crises put pressure on banks' capital cushion, so there's also a measure to ensure that banks build up more padding during the upswings the protect against the downturns. That's the "countercyclical buffer" from the chart above, ranging from between 0% and 2.5%, that will be in place when the economy is hot.