For a very long time now, we’ve been wanting to write an article on this topic in order to present factually the main prudential restrictions that apply to banks or that are going to apply to them (Basel III). But the gestation of these new rules has been long, and the project has been modified and amended on numerous occasions. It seems today, nearly 5 years after the G20 Summit at Pittsburgh which was the starting point, that the main features of the future regulatory framework are stable and that we can describe them without too much of a risk of having to draft a major amendment in 3 months’ time.

The Basel Committee was set up in 1974 by the Central Banks of 10 major western countries, following the collapse of a medium-sized German bank, the Herstatt Bank, which, as a result of its over-zealous activities on the foreign exchange market, in particular with US banks, led to a temporary paralysis of the US banking system. The Basel Committee gets its name from the fact that it is hosted by the Bank for International Settlements (BIS), based in the Swiss town of Basel.

Its three aims were to improve the safety of banking systems, to establish minimum standards in terms of prudential control over banks, and to promote the harmonisation of competition among the major banks. Since it was set up, the Basel Committee has been a body which makes recommendations that only acquire legal force if they are adopted and transposed by governments into their countries’ statutes and regulations.

In 1988, an agreement was reached – called Basel I – which required banks to have a minimum of 8 in capital each time they granted 100 in loans to a company. This is the Cooke ratio, the name of the first chairman of the Basel Committee. To calculate this ratio, loans were weighted at 0% for sovereign OECD risks, at 10% for certain public sector entities, at 20% for loans to OECD banks or short-term loans for non-OECD banks and 100% for others, especially companies.

The regulatory capital requirement is a long way off the strict definition that we give it. Basel I identifies core capital (Tier 1) made up of share capital and reserves, which must represent at least 50% of regulatory capital. This first half can, in turn, be made up of up to 50% of preference shares. The other 50% of regulatory capital, called Tier 2, can also be split into two categories: perpetual instruments (Upper Tier 2) and instruments with a maturity (Lower Tier 2). In an extreme case, real capital can only make up one-quarter of regulatory capital and accordingly, 2% of risk-weighted assets. This is the capital structure with which RBS was authorised to take its share of ABN Amro in the autumn of 2007 and it is no surprise that this didn't help it much in weathering the storm that was already threatening.

Goodwill and investments in other financial institutions are deducted in the calculation of regulatory capital.

All in all, the Cooke ratio is simple but crude. It is only concerned with the solvency of a bank, leaving aside other sources of fragility such as liquidity, market or operational risks. Additionally, the way it takes credit risk into account is simplistic and is based on the borrower’s belonging to institutional categories.

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Some years later, bank collapses (Barings in 1995), trader fraud (Daïwa in 1995, Sumitomo in 1996) or state bankruptcies (Argentina in 2003) raised awareness of the limitations of the Cooke ratio and the existence of market and operational risks that it did not cover. Parallel to that, the progress of information technology means that banks are now able to better analyse the characteristics of their assets and to develop sophisticated analysis models such as the VaR (Value at Risk for market activities[1]).

Then came Basel II in 2004, which is applied mainly by European banks (since 2008) and Japanese banks (since 2007) but not by US banks, as the US regulator considers that on the basis of impact studies, Basel II would lead to reductions in regulatory capital which it held to be inopportune.

The main aim of Basel II is not to increase regulatory capital but to make it more proportionate to the risks taken and to take into account the risks overlooked by Basel I.

Basel II rests on 3 pillars:

1/ Capital requirements that are more clearly defined and that no longer only cover credit risk but also market and operational risks. The McDonough ratio succeeded the Cooke ratio. It still makes provision for a ratio of 8% of regulatory capital but accepts a more refined weighting in line with the credit risk. This is either estimated by the internal models of the largest banks (which have shown that they were able to develop reliable measurements of their credit risks over a certain period) or according to a standardised approach similar to Basel I for smaller banks. Accordingly, a loan to a company weighted at 100% under Basel I (and thus requiring 8% of capital) can, under Basel II, be weighted at 20, 50, 100 or 150% depending on its perceived risk and the guarantees taken, leading to required regulatory capital of 1.6% to 12% of its amount.

The market risk is taken into account through the flat-rate weighting of assets traded on a market according to their type (standardised approach) or according to models such as the VaR for the largest banks.

Operational risk includes the risk of fraud, computer system failure or the failure of models used, fire, etc. This risk is difficult to measure and the regulatory capital that covers it is most often estimated at a flat rate of 15% of annual income.

2/ The second pillar includes all of the risks that are not covered by the first pillar: risk of inadequate loan portfolio diversification, risk of overestimating recovery values, risk of asset/liabilities management, liquidity risk, etc. Some countries have decided to increase the flat rate of their regulatory capital requirements in this regard, such as the United Kingdom, and others have not (France, Germany).

3/ The third pillar concerns the discipline that the financial market can exercise over banks so that they communicate relevant and adequate information to investors.  Accordingly, this is mainly a list of information required.

Basel II only modifies the edges of the definition of regulatory capital.

All in all, Basel II shows progress since the amount of regulatory capital is better linked to risks taken and since market and operational risks are factored into the equation.  But this came at a price of a great deal more complexity, with a liquidity risk that is practically ignored. The events of 2008 quickly showed that the market risk had been underestimated.  It is often assessed on the basis of models based on normal law which undervalue the frequency of extreme risks[2].

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The 2008 crisis made bank regulators aware that banks were carrying too much debt, with some of their capital of a poor quality, with an inadequate liquidity buffer.

As we’ve seen, the change from Basel I to Basel II took place by specifying the method for calculating average risk-weighted assets (RWA) without changing the definition of capital. The move from Basel II to Basel III went in the opposite direction. The was little impact on the method for calculating RWA but the definition of regulatory capital was completely overhauled and it was increased in proportion to RWA. Moreover, new ratios were put in place to manage the leverage effect and regulate the liquidity of banks.

Henceforward, Basel III divides capital mainly into Common Equity Tier 1 (CET 1), which includes share capital, issue, share premiums and retained earnings. Hybrid products are tolerated on condition that they can be used from an accounting and legal point of view in order to absorb losses without having to go through the stage of liquidating the bank. As a result, most quasi-capital, which was only capital in name and which was however accepted as capital in the meaning of Basel II, is no longer considered as regulatory capital. The distinction between Upper and Lower Tier 2 has been abolished, and, de facto, the essential capital of banks must be constituted of hard core capital (CET1).

It is true that at face value, Basel III only requires a minimum of 4.5% of CET1 with a Tier 1 of 6% minimum (including CET 1) and thus Tier 2, 2% of a total of a minimum of 8% of average risk-weighted assets (RWA). But Basel III makes provision for 3 additional capital buffers also expressed as a percentage of RWA.

The first, which is mandatory, is 2.5% and is to be applied gradually between early 2016 and late 2018. As soon as a bank operates with a regulatory capital ratio that falls below 8% + 2.5% = 10.5% while remaining above 8%, its capacity to pay dividends and bonuses (which in this industry are perceived to be more important than dividends) becomes dependent on the bank regulator. This is a potential constraint and stigma which explains why banks that felt fragile or wanted to show that they were well behaved got on board early. The others had to follow suit. This is what explains today that most banks have a CET 1 of around 10%, even though this regulatory constraint is only applicable from 2019.

The second regulatory capital buffer is optional. It is in the hands of the banking regulator who can require that, during periods when the economy is doing well, banks must constitute an additional buffer of capital that can be 2.5% of RWA. This requirement will be cancelled or lessened during periods when the economy is not doing well and during which bank profits risk falling, or even turning into losses. It is clearly a counter-cyclical tool since, as the reader well knows, the amount of loans that banks can offer in the economy is directly linked to the amount of regulatory capital. Accordingly, in February 2013, the Swiss regulator imposed an additional buffer for real estate loans which it noted were overheating.

The third regulatory capital buffer only concerns the largest banks, 29 SIFIs (Systematically Important Financial Institutions) at this time, which are required to constitute, from 2016 to 2018, an additional buffer of between 1% and 3.5% of their RWA: 2.5 % for HSBC and JP Morgan; 2% for Barclays, BNP Paribas, Citi, and Deutsche Bank; 1,5 % for Bank of America, Crédit Suisse, Goldman Sachs, Crédit Agricole, etc. 1 % for Bank of China, Santander, Société Générale, etc. National regulators can impose similar mattresses on their banks even if they are not members of the group of 29 SIFIs. In this way, Denmark has imposed an additional buffer of 5% of RWA on some of its banks.

Basel III has tightened the deductibility rules for regulatory capital. From now on, most intangible assets (software, etc.) must be deducted. The same goes for gains that banks can get from valuing their debts at market value[3].

All in all, banks are required, de facto, to have a minimum of 10.5% of their RWA in regulatory capital, of which a minimum of 7% in CET, 1.5% in Tier 1 capital and 2% in Tier 2. Most banks cover the majority of their regulatory capital in CET 1, i.e. with real capital.

Let’s take the example of BNP Paribas, which has never been an undercapitalised bank. We estimate its 2008 RWA, in the meaning of Basel III at around €820bn for 2008 CET 1 equity capital of €29bn, i.e. a ratio of 3.5%. In 2013, RWAs are, in the meaning of Basel III, €627bn, or a drop of one-quarter, for CET 1 equity capital of €65bn (up by 125%), i.e. a ratio of 10.3%. In this case, one euro of RWA thus requires around 3 times more regulatory capital under Basel III than under Basel II (and in this case, without taking account of the SIFI surcharge which only applies from 2016).

And that’s the story for solvency ratios.

The complexity of weighting banks assets in line with the perception of their risks and the observation of weighting practices that differ from bank to bank for the same asset, have raised suspicions, in particular of the US regulator, and have resulted in the encouragement of a solvency ratio on an non-weighted basis.  Basel III has taken it back in the form of a leverage ratio which is calculated like the ratio of Tier 1 capital to the total on the bank’s balance sheet and off its balance sheet items[4]. This should not be lower than 3% from 2018, but it is already being applied in practice. Accordingly, the Bank of England forced Barclays in the summer of 2013 to carry out a capital increase in order to improve its leverage ratio.

In reaction Basel II's virtual failure to deal with the crucial issue of liquidity, Basel III introduces two liquidity ratios. The first is a short-term liquidity ratio, the liquidity coverage ratio (LCR) which aims to enable banks to withstand, over at least 30 days, massive withdrawals by individual and corporate depositors, thanks to a stock of assets that can be easily sold and are very low risk. The ratio is thus calculated like the division of the second by the first, and must be at least 100%. Sixty percent of the assets taken into account are liquidities and government securities, and for the balance, the bonds of listed companies that are rated at least AA-, or riskier listed securities for 15%.

The second liquidity ratio restricts the ability of banks to use short-term resources (less than one year) to finance long-term undertakings (more than one year), i.e. limit their capacity to carry out transformations which is one of their economic fundamentals, but also the principal source of their collapse (Northern Rock, Dexia, etc.).

This ratio, called the Net Stable Funding Ratio (NSFR) is calculated as the ratio of available stable financings to required stable financings and must be higher than 100%. Its calculation method is still being discussed but should be broadly as follows.

Available stable funding is mainly made up of: all regulatory capital and loans or deposits of more than one year, 90 or 95% of individual and SME overnight deposits and deposits with an agreed maturity of less than one year, 50% of deposits of less than one year of large corporations, governments, public entities, and interbank loans of between 6 months and one year.

Required stable funding is mainly made up of: fixed assets, assets provided as a guarantee, loans to banks of more than one year, loans in arrears; 5% of securities issued by a government, a public entity or a central bank; 15% of bonds or commercial papers of companies rated at least AA–; 50% of loans of at least one year to individuals, companies, bonds or commercial paper of companies rated between A+ and BBB–, property bonds rated at least AA, loans of between 6 months and one year to other banks; 65% of mortgage loans of more than one year; and 85% of loans of more than one year to companies or individuals.

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In some ways, Basel III is evidence of the pragmatism of central bankers. They have understood that many banks had become too big[5]  for governments to have the financial resources to be able to bail them out in the future, that they would always be one innovation ahead of them, and that it would be very difficult to modify their culture which is geared towards risk-taking during economic booms. So failing all else, the central banks may as well ensure that banks are highly capitalised in order to enable them to absorb heavy losses without going bust, and to introduce restraints on liquidity, the second usual source of collapse. The future will tell if the restraints have been sufficient to avoid the occurrence of systemic crises.

From mid-2000 to mid-2008, the €/$ exchange rate fluctuated between 0.8 and 1.6. From mid-2008 to mid-2011 the exchange rate never went below 1.2 or above 1.6. And since mid-2011, the band has narrowed to 1.2 to 1.4:

Unsurprisingly for our readers well versed in option pricing[1], values of at the money 12 month € /$ calls are down: from around 7 % early 2000 to less than 3% today:

The cost of getting a protection against an adverse move of the $ again the €, while being in a position to benefit from $ weakness, has never been so low. This is nothing more than the consequence of a currency risk that has never been so small. What will happen in the future is quite another question and this is the reason why financial hedging instruments exist! Let’s meet again in one or two years’ time to talk about the near future. once it will have become part of the past!

With Simon Gueguen – Lecturer-researcher at the University of Paris Dauphine

Credit default swaps (CDS) have had a bad press.  The principle of these credit derivative instruments is to enable the purchaser to transfer a default risk to which it is exposed to the seller, in exchange for a regular cash flow[1]. They have sometimes been accused of encouraging the spread of the financial crisis, without any causal link having been clearly established.

In the last issue of the Vernimmen Newsletter, we discussed an article that showed that the subprimes crisis was probably a crisis provoked by a demand shock, rather than a crisis of the financial system or linked to financial innovations.  The article that we present this month[2] shows that CDSs have virtuous effects on the financing of companies and encourage investments in the real economy.

Saretto and Tookes studied the consequences of the existence of a CDS market for non-financial US companies on the S&P500 index, between 2002 and 2010. Their intuition is that CDSs encourage financing for the following reasons:

• Although there is a separation between the potential supplier of credit and the party that agrees to bear the risk, the existence of CDSs make it possible to increase the number of investors on the side of the credit offer;

• Institutional investors subject to capital adequacy requirements (Basle II, Solvency II) enjoy a reduction of these requirements when they cover their credit positions with the purchase of CDSs, which means that they can lend more;

• Banks may use CDSs to provide credit to companies with the aim of establishing a long-term commercial relationship, without any credit risk;

• Even before the lender buys CDSs, the existence of such a market offers it a way out of its risk and this anticipated effect may encourage the lender to lend more.

A previous study, quoted in the article[3], showed that the impact of CDS market on the cost of lending was barely perceptible.  The Saretto and Tookes article shows that there is however an impact, but that this covers the quantity of loans agreed (increase in financial leverage) and the maturity of the debt (a non-price element of the debt contract). According to the empirical results, the introduction of a CDS market:

• Increases financial leverage measured in market value (measured as the ratio of the total amount of debt to the total value of the company) by 3.1 percentage points, or 19% of the average amount of the leverage (16%);

• Increases the maturity of the debt by around one year (according to test specifications), which is very significant economically (the average maturity of debt in the sample is 8.68 years).

Finally, Saretto and Tookes show that the effects are increased in the event of credit rationing.  To summarise, CDSs help companies to find credit, especially in periods of crises.

   Because that would be mixing apples and oranges!

Looking at return on equity is a way of measuring the company's performance. Either these returns are book returns (ROE) or they are financial returns.

If they are book returns (ROE), we take the company’s net earnings that go to its shareholders (they’re free to pay them out in the form of dividends or to reinvest them in the company) over to the company’s equity which was contributed by the shareholders, or left at their disposal in the form of past net earnings that were not paid out in dividends. So we answer the question: by how much did this company, over a given financial year, increase the funds that were entrusted to it? However, these book returns, calculated over a year, are really quite theoretical for shareholders as they only really get their hands on them if, at the end of the period, the company is liquidated without cost, which is fortunately a rare occurrence.

Nevertheless, they are not of no interest because, compared with returns required by the shareholder, they can be used to measure value created or destroyed over the year[1].

In order to make up for its rather theoretical nature, we can calculate its financial equivalent which only takes into account the cash flows effectively paid out or collected over a given period, not necessarily the year but the period during which the share was held by the investor. It is the capitalisation rate that makes it possible to equalise the initial value of the share and the value of possible dividends paid in the meantime with the current value of the share. This is the IRR (internal rate of return) in terms of investment choice that is called TSR  (total shareholder return[2]) in this case. It answers the question:  what rate of return did I effectively enjoy over the period during which I held the share?

The ROE and TSR generally diverge. Accordingly, in 2013, the SBF 120 increased by around 20% dividends reinvested compared with 15% for book return on equity. But if fell to 15% in 2011, when return on equity were very positive. Over a long period, or even over a very long period, the two should converge.

So, bringing net earnings, an accounting aggregate, to the value of equity (market cap.) and not the book value of equity in an improbable effort to synthesise, makes no sense. In the vast majority of these cases, shareholders don't get their hands on net earnings. Accordingly, there is no reason to divide net earnings by the current value of the investment which is the value of equity. At the very most, what would be measured by this ratio is the inverse of the P/E ratio (value of equity / net earnings), but a fat lot of good that would do us!