Basel III: Capital Requirements for Banks and the ECB

Much has been said about the Basel Committees ambition to create a regulatory framework that will be resilient enough to withstand and contain another Lehman Brothers scenario. Remember, before extending and deepening the regulations put on banks in order to make them more resilient to short term funding problems, the regulation known as Basel II proved to be completely impotent in dealing with the ”unlikely” happening and large financial institutions fell as dominoes.

So what to do? More of the same, of course.

Basel III has taken Basel II one step further in its requirements for banks to load up more equity for each unit of risk-weighted assets (RWA) outstanding. We will spare the reader too much of the details and instead try to simplify by presenting Basel III in a couple of key concepts:

Pillar 1

a)     Capital. Under Basel III capital is defined as Common Equity Tier 1 (CET1), additional Tier 1 and Tier 2. CET1 will have reach 4.5% of RWA under Basel III; Tier 1 6% and Total Capital (CET1+T1+T2) 8% of RWA at all times. There are also requirements of hybrid capital that can be converted to common equity whenever the regulator deems it necessary. In order to alleviate the inability of hybrid to be converted in 2008 banks must create a capital conservation buffer that will have through retained earnings. Note the regulator can cut dividends to boost the conservation buffer. In addition a countercyclical buffer must be put together at the call of regulator.

b)     Risk coverage. Basel III will attempt to force banks to keep capital reserves for securitized assets that the bank is involved in, as well as posting more capital for each unit of assets on its trading book.

c)      Containing leverage. It is still being discussed whether to include a non-risk weighted leverage ratio on top of the other capital requirements. We will come back to why both banks and governments will be extremely unwilling to do this.

Pillar 2

Risk management and supervision. This is the kind of mumbo jumbo that a good team of lawyers will make sure will never be implemented in the way that the designers of Basel III envisioned. Regardless, good governance and keeping control of the actions of the people in the organisation might seem as self-evident. But history has proven it otherwise.

Pillar 3

Market discipline. Will force banks to be more open in disclosure of its off balance sheet exposures, structured investment vehicles (SIV) and other off-balance sheet constructs used to spin off capital consuming assets and other holdings. Regulator will most likely be interested in having a more comprehensive discussion around how capital ratios are will be calculated in order to minimise regulatory arbitrage and risk-weight adaption.

Quick summary of the three pillars: lawyers and accountants wettest dream.

All of the above is to be implemented gradually up until 2019. Now, we have extensively tried to show the readers of this blog that growth – in the eyes of Keynesians and Monetarists – is inflation; in other words, expanding fiduciary credit. In a world with little or no real growth, but strong nominal growth through credit expansions – Basel III seem to be a contradiction the Keynesians and Monetarist will dread!

Today`s economy desperately tries to deflate excess debt and not to mention the asset price inflation that is wholly made by the Fed – expanding credit (RWA) conserving cash  and boosting capital all at the same time is simply contradictory. How can this be solved?

Well, neither the banks nor the politbureau of monetary policy in Europe, the ECB, are stupid. Or at least we don’t think they are!

The banks will ceterius paribus, cut lending down to the marginal project and look for strong arbitrages which are pretty much guaranteed by the ECB. The ECB will make this happen. They call it LTRO, or long term refinancing operations and outright market transactions (OMT). We call it forced redistribution through money printing – some say /təˈmeɪtoʊz/ some say /təˈmɑːtoʊz/

Our money masters seem to be of the opinion that they can ”fuck small and medium sized companies, but for the love of God, make sure they fund capital consuming governments”.

Said and done – welcome on-board LTRO and OMT. LTRO is a programme were the ECB aims at ”improving the transmission mechanism in the Eurozone”, or in other words – create the interest rate decided by central planners in Frankfurt, at any price. This involved loans to European banks of €1 trillion with a maturity of three years. When that did not work, another programme was launched – Outright Monetary Transactions (OMT) – opening up for the ECB to buy government debt flat-out, and in essence drive down yields.

This is very important. By doling out fixed (low) rate three year loans and telling banks that they can earn a fat profit by buying insolvent government debt, two problems are fixed simultaneously:

  1. Spanish and Italian governments receive an implicit bailout from Frankfurt,
  2. European banks are on track to earn enough retained earnings to meet CET1 requirements far earlier than 2019. This ratio is also met by reweighting balance sheets from holding more government paper (with a very low risk weight) on the expense on corporate- and commercial loans (with a high risk weight).

Concluding remarks

As usual, the problems facing our masters are solved by inflation. Yes, we see capital magically rise in the banking sector (see chart below), but this ”capital” is perversely enough a product of capital consumption!

Think about that for seventeen more seconds and be baffled with the bullshit that we are presented. War is peace, liberal is fascist and capital is consumption. Welcome to the new new normal.

EZ Banking Liabilities

Source: European Central Bank (ECB), own calculations

 

 

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