The NZ Reserve Bank today published an article in the Reserve Bank Bulletin that describes the Reserve Bank’s implementation of the Basel III capital requirements. It is one of the clearest articulation of Basel III that we have read, and is recommended to those seeking to get to grips with the complexity of the evolving capital requirements. In addition, you can read our article on Basel IV (the next iteration) here.
The GFC highlighted several shortcomings in the policies and practices of some financial institutions, particularly in North America and Europe, and in the regulatory requirements for banks in respect of capital. In the lead-up to the GFC, some financial institutions were highly leveraged (that is, their assets were funded by high levels of debt as compared to equity), with capital that proved insufficient to absorb the losses that they incurred. In several countries, governments provided funds to support failing banks, effectively protecting holders of certain capital instruments from bearing losses, which came at a cost to taxpayers. The complexity of capital rules, interaction with national accounting standards, and differences in application resulted in inconsistencies in the definition of regulatory capital across jurisdictions. Further, insufficient capital was held in respect of certain risks. This made it difficult for the market to assess the true quality of banks’ regulatory capital and led some market participants to turn to simpler solvency assessment methods.
The BCBS responded with new requirements for bank capital, collectively known as Basel III, which built on the existing frameworks of Basel I and Basel II. Basel III strengthens the minimum standards for the quality and quantity of banks’ capital, and aims to reduce bank leverage and improve the risk coverage of the Basel Capital Accords. One of the purposes of Basel III is to make it more likely that banks have sufficient capital to absorb the losses they might incur, thus reducing the likelihood that a bank will fail, or that a government will be called on to use taxpayer funds to bail out a bank. Basel III also introduced an international standard on bank liquidity. Overall, these requirements increase resilience in the financial sector and reduce the probability of future systemic collapses of the financial sector.
The RBNZ Bulletin article explains the rationale behind the Basel III capital requirements, identifies and discusses their significant features, explains how the Reserve Bank has applied the requirements in New Zealand, and examines the development of the New Zealand market for instruments meeting the Basel III definition of capital.
The changes to the Capital Accord brought into effect by Basel III included: enhancing the requirements for the quality of the capital base;increasing the minimum amount of capital required to be held against risk exposures; requiring capital buffers to be built up in good times that can be drawn down in times of economic stress; introducing a leverage ratio requirement; and enhancing the risk coverage of the capital framework. Draft international minimum standards for liquidity were also proposed for the first time as part of the Basel III package. The liquidity requirements are not discussed in this article. The Basel III capital standards have been widely adopted worldwide. The Reserve Bank has largely adopted the Basel III capital requirements. As New Zealand banks were well capitalised at the time Basel III was issued, the Reserve Bank was able to put the Basel III capital requirements in place in New Zealand ahead of the timetable set by the BCBS for Basel III implementation.
