Treasury Practice

Basel III in numbers

Published: Feb 2011

The regulations set out in Basel III mean that banks will have to maintain more robust capital reserves and equity buffers than they do at present. The accords, which were passed by the G20 last November, build on the principles established in Basel I and II. Treasurers now need more than a passing acquaintance with these ratios because their banks’ willingness to deal with them will be a direct function of their Basel numbers.

Basel I applied a simple principle to a bank’s assets: each class of asset was given a uniform risk weighting. Basel II took a more nuanced approach, but the principle remained the same. The rating applied to the asset was determined by the bank’s internal rating and by the credit rating assigned to it by an agency. Under Basel III, the minimum level of capital that a bank will have to hold against the assets on its balance sheet – the capital adequacy ratio – will depend on the risk profiles, or weightings, of those assets.

The capital adequacy ratio (CAR)

\(\mathrm{CAR}= \frac{\mathrm{Tier\:1\:capital}\: + \:Tier\:2\:capital}{Risk\: weighted\: assets\:RWAs}\)
Under Basel III, CAR will remain at 8% until 2016 rising to 10.5% by 2019. Banks will have to maintain a minimum common equity ratio of 4.5% (plus the conservation buffer of 2.5%) and a Tier 1 capital ratio of 6% (8.5% including the buffer). Total capital (Tier 1 plus Tier 2) must be 8% (10.5% including the buffer). This is an increase on Basel II but because the CAR is a function of risk weighted assets, not total assets, it still allows banks to build up significant leverage. Even a AAA-rated CDO, catalyst for the banking crisis, under the new regime is only 20% risk weighted and so generates a capital charge of 20% of 8% – a mere 1.6%.

The Basel III rules lay out two other ratios: the liquidity ratio and the net stable funding ratio.

Liquidity coverage ratio (LCR)

Should a run on the bank occur, or should the market be otherwise ‘dislocated’, the committee has established a ratio that it hopes will keep the banks afloat. The liquidity coverage ratio is used by banks to determine the amount of capital they will need “under an acute stress liquidity scenario”.

\(LCR = \frac{stock \:  of \:  high \:  quality \:  liquid \: assets}{Net \: cash \: outflows \: over \: a \: 30 \: day \: time \:period}\)

High quality assets include government and covered bonds. Under Basel III, banks are required to maintain a minimum liquid coverage ratio of 100%.

Net stable funding ratio (NSFR)

The Basel Committee hopes that the net stable funding ratio (NSFR) will make banks think longer-term. The ratio was therefore devised to allow banks to establish ‘more medium and long-term funding of the assets and activities’. It is defined as:

\(NSFR =\frac{ available \:  amount \:  of \: stable \: funding} {\: required \: amount \: of \: stable \: funding } \)

Again, banks are required to maintain a minimum NSFR of 100%.

The measure seeks to quantify the proportion of structural term assets which are funded by stable funding, including customer deposits, long-term wholesale funding and equity.

The left-hand side of the ratio represents the sources of core bank funding, that is Tier 1 and Tier 2 capital, ‘stable’ retail deposits with a maturity of less than a year, and 50% of large corporate deposits with a maturity of less than a year.

The right-hand side of the equation is calculated as the weighted sum of the assets that sit on a bank’s balance sheet. They include cash (risk weighted 0%), liquid securities (5%), corporate bonds (20%), other corporate bonds (50%) and retail loans with a maturity of less than a year (80%).

This ratio is of particular interest to the corporate treasurer as according to one analyst’s calculations, it adds €1.1 trillion to the European banking sector’s funding requirements, with the consequent impact on the corporate market.

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