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The Basel III Proposals, May 2010
Adrian Blundell-WignallSpecial Advisor to the OECD Secretary General for Financial Markets
Fig. 1: Basel I & Basel II
Fig 2: Problems With Basel II
• Portfolio invariance.• Single global risk factor.• Financial system “promises” are not
treated equally—regulatory arbitrage facilitated by “complete markets” in credit (the CDS market particularly).
• Pro-cyclicality.• Subjective inputs.• Unclear and inconsistent definitions.
Fig. 3: The Arbitrage Process In Complete Markets For Credit—Promises Aren’t Treated the Same
INTERESTRATE
Excess leverage& risk taken
Observed Rate as high profit Borrower BANK opportunities are CSO/CDO
are squeezedout.
Agent Spreado/heads;fees;regulation;equity; tax wedges
Observed RateInvestor
SMALL LARGE
TRANSACTION SIZESource: Ironbridge Capital/OECD
Fig. 4: Shifting the Promises
Fig. 5: The Explosion of CDS Contracts
Source: BIS
6,396 10,211
13,908
20,352
28,650
42,581
58,24457,403
41,883
36,046
133 188 243 294470
721
2,020
3,192
5,116
2,987
0
1,000
2,000
3,000
4,000
5,000
6,000
0
10 000
20 000
30 000
40 000
50 000
60 000
Dec.2004 Jun.2005 Dec.2005 Jun.2006 Dec.2006 Jun.2007 Dec.2007 Jun.2008 Dec.2008 Jun.2009
Bill
iosn
of
US
do
llars
Bill
ions
of
US
do
llars
Notional amounts outstanding
Gross market values
Fig. 6: $70.6bn Payments to AIG Counterparties ($45.7bn to EU!): Sept. 16 to 31 December 2008
(billions of US dollars) Collateral postings Payments to securities As a share of
Institution for credit default swaps* lending counterpaties** Total capital*** at end-2008
Goldman Sachs 8.1 4.8 12.9 29.1%Societe Generale 11.0 0.9 11.9 28.9%Deutsche Bank 5.4 6.4 11.9 37.4%Barclays 1.5 7.0 8.5 20.0%Merrill Lynch 4.9 1.9 6.8 77.4%Bank of America 0.7 4.5 5.2 9.1%UBS 3.3 1.7 5.0 25.2%BNP Paribas … 4.9 4.9 8.3%HSBC 0.2 3.3 3.5 5.3%[memo: Bank of America after its merger with Merrill Lynch] 12.0 [18.1%]
*Direct payments from AIG through end-2008 plus payments by Maiden Lane III, a financing entity
established by AIG and the New York Federal Reserve Bank to purchase underlying securities.
**September 18-December 12, 2008.
***Common equity net of goodwill; net of all intangible assets for Merrill Lynch and HSBC.
Source: Fed, US Treasury
Fig. 7: Basel Capital Adequacy vs Leverage Ratio & Losses---Basel is Perverse
Source: , OECD; Thomson Reuters; Bloomberg, Worldscope, Datastream. Cum. Losses Jan 2007 to mid 2009. Regulatory ratios 2006-2008 averages.
Australia
BelgiumCanada
France
Germany
Ireland
ItalyJapan
Norway
Spain
Switzerland
United Kingdom
0.0
0.5
1.0
1.5
2.0
2.5
6 7 8 9 10 11 12Wri
ted
ow
ns
& l
os
se
s/t
ota
l as
se
ts (
%)
Tier 1 ratio
Capital Adequacy Ratio (Tier 1) vs. writedowns & losses/total assets
Australia
Belgium
Canada
France
Germany
Ireland
ItalyJapan
NorwaySpain
Switzerland
United Kingdom
0.0
0.5
1.0
1.5
2.0
2.5
1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0
Wri
ted
ow
ns
& l
os
se
s/t
ota
l as
se
ts (
%)
Common equity/total assets (%)
Common equity/assets (lev. ratio) vs. writedowns & losses/assets
Fig 8: Basel III Proposed Capital Reforms
• Quality, consistency & transparency of the capital base.
• Enhance risk coverage.• Introduce a leverage ratio.• Deal with Pro-cyclicality.• Address systemic risk &
interconnectedness.
Fig 9: Basel III Best Points
• Leverage ratio notion.• Dynamic provisioning on
expected loss.• Capital buffer to ensure minima
are not violated in a crisis.• Better capital definitions.• Some improvement in
subjective inputs likely.
Fig 10: Basel III Not Dealt With
• The main issue has always been the lack of capital. Where the leverage ratio will be set.
• The RWA approach & a leverage ratio wont work well together.
• Promises will still be treated differently depending on where they sit, so regulatory arbitrage will continue.
• The framework still relies on portfolio invariance & a single global risk factor+ pillar 2 filling the holes.
Fig. 11: Not Enough Capital
Fig 12: Basel III Not Dealt With
(1)Min.CAP(RWA)=0.08*{12.5(OR+MR) + SUM[w(i)A(i)]}
(2) Min.CAP(LR)=βSUM[A(i)]
(3)Min.CAP(RWA)≤ Min.CAP(LR)NB. Setting ‘maximum’ capital
requirements via the LR and leading to distortions
Fig 13: The Liquidity Proposals
• The liquidity coverage ratio LCR, 30 day focus.
• The Net Stable Funding ratio, focusing on the liquidity characteristics of liability and asset structure.
• Other monitoring.
Fig 14: Problems with the Liquidity Proposals
• Solvent banks should manage their own liquidity with the bank payment system process & central banks having a key role—cause & effect in the crisis was from insolvency fear to liquidity.
• Bias to government bonds – crowding out lending to the private sector implications.
• Not practical—stable versus unstable funding (its all unstable in a crisis).
• Lowers returns causing banks to take on more risk.
Fig 15: Conclusions
• There are no stable risk “buckets” for weighting assets when promises in the financial system are not treated equally—risk easily transformed in complete markets for credit.
• Leverage ratio to centre stage.• Diversification issues need to be dealt with
in pillar 1 (quadratic capital penalty for deviations from benchmark).
• Treating promises equally has implications for the structure of regulatory authorities.
• And how to treat the shadow banking system.