The Basel III Proposals, May 2010

Adrian Blundell-WignallSpecial Advisor to the OECD Secretary General for Financial Markets

Fig. 1: Basel I & Basel II

Fig 2: Problems With Basel II

• Portfolio invariance.• Single global risk factor.• Financial system “promises” are not

treated equally—regulatory arbitrage facilitated by “complete markets” in credit (the CDS market particularly).

• Pro-cyclicality.• Subjective inputs.• Unclear and inconsistent definitions.

Fig. 3: The Arbitrage Process In Complete Markets For Credit—Promises Aren’t Treated the Same

INTERESTRATE

Excess leverage& risk taken

Observed Rate as high profit Borrower BANK opportunities are CSO/CDO

are squeezedout.

Agent Spreado/heads;fees;regulation;equity; tax wedges

Observed RateInvestor

SMALL LARGE

TRANSACTION SIZESource: Ironbridge Capital/OECD

Fig. 4: Shifting the Promises

Fig. 5: The Explosion of CDS Contracts

Source: BIS

6,396 10,211

13,908

20,352

28,650

42,581

58,24457,403

41,883

36,046

133 188 243 294470

721

2,020

3,192

5,116

2,987

0

1,000

2,000

3,000

4,000

5,000

6,000

0

10 000

20 000

30 000

40 000

50 000

60 000

Dec.2004 Jun.2005 Dec.2005 Jun.2006 Dec.2006 Jun.2007 Dec.2007 Jun.2008 Dec.2008 Jun.2009

Bill

iosn

of

US

do

llars

Bill

ions

of

US

do

llars

Notional amounts outstanding

Gross market values

Fig. 6: $70.6bn Payments to AIG Counterparties ($45.7bn to EU!): Sept. 16 to 31 December 2008

(billions of US dollars) Collateral postings Payments to securities As a share of

Institution for credit default swaps* lending counterpaties** Total capital*** at end-2008

Goldman Sachs 8.1 4.8 12.9 29.1%Societe Generale 11.0 0.9 11.9 28.9%Deutsche Bank 5.4 6.4 11.9 37.4%Barclays 1.5 7.0 8.5 20.0%Merrill Lynch 4.9 1.9 6.8 77.4%Bank of America 0.7 4.5 5.2 9.1%UBS 3.3 1.7 5.0 25.2%BNP Paribas … 4.9 4.9 8.3%HSBC 0.2 3.3 3.5 5.3%[memo: Bank of America after its merger with Merrill Lynch] 12.0 [18.1%]

*Direct payments from AIG through end-2008 plus payments by Maiden Lane III, a financing entity

established by AIG and the New York Federal Reserve Bank to purchase underlying securities.

**September 18-December 12, 2008.

***Common equity net of goodwill; net of all intangible assets for Merrill Lynch and HSBC.

Source: Fed, US Treasury

Fig. 7: Basel Capital Adequacy vs Leverage Ratio & Losses---Basel is Perverse

Source: , OECD; Thomson Reuters; Bloomberg, Worldscope, Datastream. Cum. Losses Jan 2007 to mid 2009. Regulatory ratios 2006-2008 averages.

Australia

BelgiumCanada

France

Germany

Ireland

ItalyJapan

Norway

Spain

Switzerland

United Kingdom

0.0

0.5

1.0

1.5

2.0

2.5

6 7 8 9 10 11 12Wri

ted

ow

ns

& l

os

se

s/t

ota

l as

se

ts (

%)

Tier 1 ratio

Capital Adequacy Ratio (Tier 1) vs. writedowns & losses/total assets

Australia

Belgium

Canada

France

Germany

Ireland

ItalyJapan

NorwaySpain

Switzerland

United Kingdom

0.0

0.5

1.0

1.5

2.0

2.5

1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0

Wri

ted

ow

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& l

os

se

s/t

ota

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ts (

%)

Common equity/total assets (%)

Common equity/assets (lev. ratio) vs. writedowns & losses/assets

Fig 8: Basel III Proposed Capital Reforms

• Quality, consistency & transparency of the capital base.

• Enhance risk coverage.• Introduce a leverage ratio.• Deal with Pro-cyclicality.• Address systemic risk &

interconnectedness.

Fig 9: Basel III Best Points

• Leverage ratio notion.• Dynamic provisioning on

expected loss.• Capital buffer to ensure minima

are not violated in a crisis.• Better capital definitions.• Some improvement in

subjective inputs likely.

Fig 10: Basel III Not Dealt With

• The main issue has always been the lack of capital. Where the leverage ratio will be set.

• The RWA approach & a leverage ratio wont work well together.

• Promises will still be treated differently depending on where they sit, so regulatory arbitrage will continue.

• The framework still relies on portfolio invariance & a single global risk factor+ pillar 2 filling the holes.

Fig. 11: Not Enough Capital

Fig 12: Basel III Not Dealt With

(1)Min.CAP(RWA)=0.08*{12.5(OR+MR) + SUM[w(i)A(i)]}

(2) Min.CAP(LR)=βSUM[A(i)]

(3)Min.CAP(RWA)≤ Min.CAP(LR)NB. Setting ‘maximum’ capital

requirements via the LR and leading to distortions

Fig 13: The Liquidity Proposals

• The liquidity coverage ratio LCR, 30 day focus.

• The Net Stable Funding ratio, focusing on the liquidity characteristics of liability and asset structure.

• Other monitoring.

Fig 14: Problems with the Liquidity Proposals

• Solvent banks should manage their own liquidity with the bank payment system process & central banks having a key role—cause & effect in the crisis was from insolvency fear to liquidity.

• Bias to government bonds – crowding out lending to the private sector implications.

• Not practical—stable versus unstable funding (its all unstable in a crisis).

• Lowers returns causing banks to take on more risk.

Fig 15: Conclusions

• There are no stable risk “buckets” for weighting assets when promises in the financial system are not treated equally—risk easily transformed in complete markets for credit.

• Leverage ratio to centre stage.• Diversification issues need to be dealt with

in pillar 1 (quadratic capital penalty for deviations from benchmark).

• Treating promises equally has implications for the structure of regulatory authorities.

• And how to treat the shadow banking system.