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.
This is good for two reasons. First, this will slow banks' lending during upswings in comparison to their capital, to guard against runaway lending. Second, if a bubble has been created, and it pops, there will be additional cushion to absorb the resulting losses. At the peak of economic cycles, banks will have a buffer of up to 9.5% of common equity -- the highest quality capital -- to fall back on. Currently the amount required is just 2.0%.
4. Better Liquidity
Another problem during economic turmoil is liquidity -- the ability to turn your assets into cash. The credit crunch was a major problem because liquidity "dried up," banks couldn't unload their assets or make their payments, and many large banks need government assistance to survive. Basel III will be the first time regulators would have a numerical standard for liquidity. The new rules require banks to have enough high quality liquid assets to cover cash outflows over a 30-day stress period. These assets would include very liquid assets like government securities.
Finally, the new rules provide a clear timeline for when and how these changes should be implemented. The process will be quite gradual, not in full effect until 2019. But the implementation will be done in a very smart way, providing benchmarks within the process to ensure that banks are on the way to full compliance, with some preliminary standards needing to be met starting in 2013. It's likely the market will push banks to implement the new standards faster than Basel III requires.
The debate for more bank capital has become pretty quiet over the past several years. While some argue that banks shouldn't have high capital standards, so they can be free to lend more money, the financial crisis did a good job of silencing most critics of stricter capital requirements. These days, market participants, policymakers, and economists broadly agree that higher capital requirements are probably a pretty good idea. Of course, the specifics are not as easily defined.
The other controversial piece, is how long you provide banks. Financial institutions argue they need a long period to slowly acquire additional capital, so not to disrupt the markets.The long implementation timeline that Basel III provides should serve to quiet those worries. Banks are given a great deal of time to acquire additional capital, and rework their business models accordingly. But some who are worried about bank stability at the low capital limits currently in place think the timeline should be more aggressive.
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