Credit Risk Measurement, Leverage Ratios, and Basel III: Proposed Basel III Leverage and Supplementary Leverage Ratios

Credit Risk Measurement, Leverage Ratios, and Basel III: Proposed Basel III Leverage and Supplementary Leverage Ratios

Copyright: © 2018 |Pages: 31
DOI: 10.4018/978-1-5225-4131-8.ch006

Abstract

The Basel III Leverage Ratio, as originally agreed upon in December 2010, has recently undergone revisions and updates – both in relation to those proposed by the Basel Committee on Banking Supervision – as well as proposals introduced in the United States. Whilst recent proposals have been introduced by the Basel Committee to improve, particularly, the denominator component of the Leverage Ratio, new requirements have been introduced in the U.S to upgrade and increase these ratios, and it is those updates which relate to the Basel III Supplementary Leverage Ratio that have primarily generated a lot of interests. This is attributed not only to concerns that many subsidiaries of US Bank Holding Companies (BHCs) will find it cumbersome to meet such requirements, but also to potential or possible increases in regulatory capital arbitrage: a phenomenon which plagued the era of the original 1988 Basel Capital Accord and which also partially provided impetus for the introduction of Basel II. This paper is aimed at providing an analysis of the recent updates which have taken place in respect of the Basel III Leverage Ratio and the Basel III Supplementary Leverage Ratio – both in respect of recent amendments introduced by the Basel Committee and proposals introduced in the United States. As well as highlighting and addressing gaps which exist in the literature relating to liquidity risks, corporate governance and information asymmetries, by way of reference to pre-dominant based dispersed ownership systems and structures, as well as concentrated ownership systems and structures, this paper will also consider the consequences – as well as the impact - which the U.S Leverage ratios could have on Basel III. There are ongoing debates in relation to revision by the Basel Committee, as well as the most recent U.S proposals to update Basel III Leverage ratios and whilst these revisions have been welcomed to a large extent, in view of the need to address Tier One capital requirements and exposure criteria, there is every likelihood, indication, as well as tendency that many global systemically important banks (GSIBS), and particularly their subsidiaries, will resort to capital arbitrage. What is likely to be the impact of the recent proposals in the U.S.? The recent U.S proposals are certainly very encouraging and should also serve as impetus for other jurisdictions to adopt a pro-active approach – particularly where existing ratios or standards appear to be inadequate. This paper also adopts the approach of evaluating the causes and consequences of the most recent updates by the Basel Committee, as well as those revisions which have taken place in the U.S, by attempting to balance the merits of the respective legislative updates and proposals. The value of adopting leverage ratios as a supplementary regulatory tool will also be illustrated by way of reference to the impact of the recent legislative changes on risk taking activities, as well as the need to also supplement capital adequacy requirements with the Basel Leverage ratios and the Basel liquidity standards.
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Introduction

The first consultative paper on a new capital adequacy framework, which was issued by the Basel Committee on Banking Supervision, introduced the “three pillar” model which encompasses the minimum capital requirements, supervisory review and market discipline – “as a lever to strengthen disclosure and encourage safe and sound banking practices” (BIS, 1999a). As well as the criticism related to the fact that it rewarded risk lending, the fact that “capital requirements were just reasonably related to banks’ risk taking activities and that the credit exposure requirement was the same regardless of the credit rating of the borrower,” (Saidenberg & Schuermann, 2003) a general criticism of Basel I relates to the fact that it promoted capital arbitrage. Such capital arbitrage being attributed to its wide risk categories which provided banks with the liberty to “arbitrage between their economic assessment of risk and the regulatory capital requirements” (BIS, 1999b).

“Regulatory capital arbitrage,” a practice which involves banks “using securitization to alter the profile of their book” usually produces the effect of making bank's capital ratios appear inflated (BIS, 1999b).1 Four identified types of capital arbitrage are: cherry picking, securitization with partial recourse, remote origination and indirect credit (BIS, 1999b).

The Second Consultative Paper, issued by the Basel Committee in January 2001, introduced the two Internal Ratings Based (IRB) methodologies – the Foundational IRB and the Advanced IRB methodologies. The Internal Ratings Based approach to capital requirements for credit risk, not only relies significantly on the internal assessment carried out by a bank, in relation to counterparties and exposures, but is also geared towards the achievement of two primary goals, namely2: “additional risk sensitivity” and “incentive compatibility.”

Basel II is premised on a three-level approach which permits banks to select from three models, namely: the basic standardized model, the IRB foundation approach and the advanced ratings approach. According to the Consultative Document on Standard Approach to Credit Risk (BIS, 2001b), capital requirements under the standardized approach are considered to be more synchronized and in harmony with the principal elements of banking risk – owing to the introduction of more differentiated risk weights and a broader recognition of techniques which are applied in mitigating risk whilst such techniques attempt to avoid undue complexity. As a result, capital ratios generated through the standardized approach, should adapt more to present and actual risks encountered by banks, than was the case previously.

Under Pillar One minimum capital requirements, operational risk is to be corroborated by capital. Measurement approaches for operational risk can be found in the Capital Requirements Directive (CRD) and there are three broad approaches to the capital assessment of operational risk which are as follows:

  • Basic Indicator Approaches

  • Standardized Approaches

  • Internal Measurement Approach

The developments and evolution across the Basel Capital Accords have illustrated their focus to address prevailing financial risks at the time, their focus on the regulation of complex financial instruments such as hedge funds, the pro cyclical nature of risks and the need to mitigate occurrences related to regulatory capital arbitrage. The era of Basel III has also witnessed the introduction of liquidity standards – these being the first of their kind, However the need to address off balance sheet instruments, complex derivative products, exposures of various kinds – and particularly those exposures relating to derivatives, off balance sheet and leverage, as well as those risks attributed to non-bank institutions, continually constitute a vital focal point.

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