The Basel III Challenge For Banks: Why Extra Capital Requirements?

The Financial Stability Board (FSB) released an updated list of  global systemically important banks (G-SIBs) last week. ((Update of group of global systemically important banks, FSB Press Releases, Nov 1 2012)) The list in itself shows quite obvious changes reflecting the developments since last November 2011 when the previous list was released – three banks (Lloyds, Commerzbank & Dexia) were left out because of restructuring/shrinking asset-bases, and two new ones (Standard Chartered & BBVA) were added to account for their growing importance. But the thing actually being talked about in detail since the release is FSB’s allocation of these 29 banks among the various “additional loss absorbency-level buckets” – the various levels of extra capital these banks are expected to hold above the mandated minimum.

In this series of articles we attempt to shed some light on the rationale behind capital requirement guidelines, the allocation of individual banks into these buckets, and the overall impact on their operations. But most importantly, we will try to elaborate on how it impacts us as both bank customers and investors.

The Need For Tighter Regulation

Following the global economic recession, the biggest concern among financial regulators was to ensure that the biggest and most important banks do not buckle under economic pressure the way they did in 2008 when governments were forced to step in and pump in billions of taxpayer dollars to bail-out them out. The concept of a bank acting as the economic backbone of a region or a nation led to the larger idea of banks which are systemically important on the global scale – the G-SIBs.

The FSB, backed by the G20 nations, is charged with overseeing the financial condition of the world’s largest bank – with specific focus on identifying G-SIBs and coming up with ways to making them more robust. As the biggest global banks are extremely diversified in their operations, and as splitting their traditional lending business from the more volatile investment banking operations comes with a long list of issues, the most acceptable solution for the regulators and the banks was to increase the amount of capital they hold.

So What Is This Capital Surcharge All About?

The reason behind forcing banks to retain a percent of their total capital sounds simple enough – if the bank has enough capital reserves, then it should be better off in times of an economic crisis. But then, how much of capital set aside is really enough for a bank? Clearly, one figure would not be suitable for all banks. After all, the ‘biggest’ banks differ from each other radically in terms of their business models, geographical diversification, quality of asset base, and a plethora of such factors. And if one sets an arbitrarily high limit for the capital figure, then the banks would have that much lower cash to lend out to customers – impairing economic development.

The solution came in the form of a minimum capital requirement that should be applicable to all banks, with an additional capital surcharge for individual banks seen as systemically important globally. In Sept 2010, an accord about the minimum level of capital requirement was reached at 7%. And the surcharge applicable was to be one of 5 values: 1%, 1.5%, 2%, 2.5% and 3.5%.

Of these, the highest surcharge of 3.5% was proposed as a deterrent to an extremely large-sized bank from growing any further, and thankfully no bank currently falls in this bucket. As for the other proposed buckets, the FSB rated the G-SIBs based on their inter-connectedness, size, complexity, global reach, and even the ability of other firms to take over their functions in the event of their failure to come up with this list:

So, if a bank falls in Bucket 4 – like Citigroup (NYSE:C) or JPMorgan Chase (NYSE:JPM) – then it is mandatory for it to hold an additional 2.5% in capital over and above the 7% base minimum, or a total of 9.5%. And this proportion of the total assets set aside will also need to meet the more stringent classification of assets laid out under the Basel III norms to ensure that these assets in themselves do not lose substantial value in the event of a downturn.

But Are These Surcharge Figures Final?

The surcharges mentioned above are applicable to the banks up to next November, when the list will be updated again to incorporate any changes/developments over the period. The actual implementation of the capital requirements would begin in 2016, based on the list as it stands after yet another iteration in November 2014. The current list is more of an indicator to banks to start shoring up their capital reserves – giving them ample time before the requirements actually kick-in.

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