Effect of Basel III

Effect of Basel III

The existing rules require a capital adequacy ratio of 8% to the RWAs. Rules allow Tier 1 capital at a minimum of 4% of RWAs i.e., 50% of total capital and Tier 2 capital comprising of debt instruments of medium term maturity of at least 5 years at a maximum of 4% of RWAs. Tier 3 capital with short maturity of at least 2 years can also support Tier 2 capital to some extent. Common equity in Tier 1 capital can be as low as 2% of RWAs.

Innovative features such as step-up option are allowed in capital instruments. The regulatory adjustments to capital are effected both at Tier 1 and Tier 2 capital in equal measure. The existing definition of capital is, thus, flawed. Capital is not only deficient in quality equity capital, but also contains elements of debt which do not support the bank as a going concern. In subprime crisis, big banks entered the crisis with insufficient level and quality of capital.

Under Basel III, Tier 1 capital will be the predominant form of regulatory capital. It will be minimum 75% of the total capital of 8%, i.e., 6%, as against 4% now. Within Tier 1 capital, common equity will be the predominant form of capital. It will be minimum 75% of the Tier 1 capital requirement of 6%, i.e., 4%, from the existing level of 2%. You may observe that the meaning of “predominant” portion of common equity in Tier 1 capital and Tier 1 capital portion in total capital (Tier 1 plus Tier 2) as 50% under Basel I and II has under gone a change to 75% under Basel III, improving the overall level of high quality capital in the banks.

To my mind the most revolutionary feature of Basel III in this regard is to ensure that public sector rescue of non-viable, but still functioning banks, does not entail absorption of losses by the tax-payers while leaving the non-common equity capital providers unscathed. Therefore, under Basel III, the terms and conditions of all non-common Tier 1 and Tier 2 instruments issued by banks will have a provision that requires such instruments, at the option of the relevant authority, to be either written off or converted into common equity upon the bank being adjudged by the supervisory authority as having approached or approaching the point of non-viability.

Additionally, innovative features in non-equity capital instruments are no longer acceptable. Tier 3 capital has also been completely abolished. The regulatory adjustments or deductions from capital presently applied at 50% to Tier 1 capital and 50% to Tier 2 capital will now be 100% from the common equity Tier 1 capital. To improve market discipline, all elements of capital are required to be disclosed along with a detailed reconciliation to the reported accounts. These requirements will be implemented uniformly across all jurisdictions and the consistency in application will be ensured by the Basel Committee through a peer review process.

Thus, the definition of capital in terms of its quality, quantity, consistency and transparency will improve under Basel III.

Minimum capital levels will rise to as high as 11.5%, from 9%, by 2019. \

These ratios will be fully implemented by March 31, 2018.