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Bank capital and Basel III: a (really) short guide

September 12th, 2010 |  Published in Economics, finance and the financial markets

12 September 2010 — For the curious but uninitiated, we thought this very brief primer prepared by our colleagues at the Financial Times would help you understand bank capital, Basel III and all that.

What is bank capital?   It is the funds – traditionally a mix of equity and debt – that banks have to hold in reserve to support their business. Bank capital has been in the spotlight since the financial crisis began.

How is it measured?  The two capital ratios that banks routinely cite are the tier one capital ratio and a subset of that – the core tier one capital ratio, also called the equity tier one ratio. Tier one is essentially top-notch capital, with core tier one a subset comprising the best of the best. There is also tier two capital, consisting largely of subordinated debt, but that is gradually becoming irrelevant for regulatory purposes.

The Basel Committee on Banking Supervision, whose Basel III rules form the basis for global bank regulation, is focused on the core tier one ratio, which, like the Americans, it refers to as the equity tier one ratio. It essentially will consist of only equity and retained profits.

How are the ratios calculated?  A bank’s capital is measured against its risk-weighted assets – essentially a bank’s total assets recalculated to a smaller number to reflect the relatively low-risk nature of some. The average bank today probably has a core tier one ratio of about 7 or 8 per cent, compared with a regulatory minimum of 2 per cent, and a tier one ratio of 9 or 10 per cent, compared with a 4 per cent minimum.

So the new requirement for a 7 per cent core tier one ratio will be a breeze for most banks?  Well, it certainly won’t be as much of a stretch as many banks originally feared. But for banks that are only marginally above it, or expect to be by the end of 2018 when the phase-in period ends, there could be issues. That is because both elements of the ratio are being toughened – what qualifies as core tier one capital is being narrowed to exclude lower-quality instruments. Previously accepted forms of top-notch capital, such as deferred tax assets, are being phased out. The weightings applied to banks’ assets will rise in many cases, amplifying the ratio’s denominator.

This is all a result of the financial crisis, right?  Right. In the financial crisis many highly geared banks with a lot of non-equity (such as hybrid debt) in their capital structures were left looking very weak because losses burnt through their relatively thin equity cushions quickly.

For that reason, investors have increasingly been interested in how strong banks’ core tier one ratios are. To an extent, regulators are just catching up with the market.

Copyright The Financial Times Limited 2010


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