The friendly and ever-so-precise tones of Peter Went, VP Banking Risk Management Program at the Global Association of Risk Professionals (GARP), have been moderating a cavalcade of panellists over the past couple years. When the chance arose to attend his solo webinar on July 17, 2012, we leapt at the opportunity.

Went,  co-author of five books on financial risk management, spoke about risk-based capital requirements and how the Basel III Accord redefines and increases the quality and quantity of these requirements. His presentation was divided into three parts: capital under Basel III, US implementation of Basel III capital rules, and the macroeconomic impact of the Basel III changes.

This posting focusses on only the first part, and that was in fact the lion’s share of his presentation. The banking world has already been through Basel I, Basel II and even “Basel II.5” so “capital” has been thought about in banking as long and hard as car chases have been thought about in Hollywood.

Went described changes to capital occurring in five areas under Basel III:  the quality and level of capital requirements; the capital loss absorption at the point of non-viability; the definition of SIFIs (Systemically Important Financial Institutions); the capital conservation buffer; and countercyclical capital.

The capital increase due to Basel III changes, Went remarked, has been estimated to be “on the order of $1.1 trillion.” Estimates by the Basel Committee on Banking Supervision – the international coordinating authority under whose auspices the Basel Accords are developed by central bankers representing the major global economies – suggest that the capital shortfall may be substantially lower. Fortunately, Basel III implementation will occur over a very long time frame, with the last round of changes slated for January 1, 2019. Hence it may be possible that the banks could raise the necessary capital funds by relying on their internally generated funds – without having to resort to the capital markets.

The purpose of Basel III is to raise the quantity and quality of capital reserves in the financial system. Thus, Tier 3 capital is being phased out and  financial instruments that fail to qualify for the complex loss absorbency requirements will be phased out and “derecognized.”  This further increases the demands on banks to raise additional capital.

Went drew a distinction between the two types of loss-absorbent capital that the new framework introduces. The primary type is “going concern” such as shareholders’ equity. The secondary type is “gone concern” such as short-term debt.  Overall, he cautioned, there is a “substantial increase in the level of capital” needed to fulfill capital requirements under Basel III—as high as 18.5 percent to 20 percent in the case of the most stringent national standards, if the countercyclical buffer and SIFI surcharge are included.

Tier 1 Capital

Went touched briefly on the very detailed rules for components of Tier 1 capital. For example, common equity is defined as being subordinate to all other types of contractual funding, with fully discretionary dividend payments, and is thus the highest quality component of capital. A bank may add “innovative” Tier 1 capital to supplement its core capital, including hybrid instruments such as convertible preferred shares. However, several innovative Tier 1 instruments will be phased out such as cumulative preferred stock, step-up instruments, and trust preferred stock. In a nutshell, said Went, Tier 1 capital has “moved toward tangible common equity.”

Tier 2 Capital

Tier 2 capital may be thought of as “gone concern” because this is capital existing after an instrument has been declared insolvent and “unviable.” This capital absorbs losses before depositors bear the final brunt.

Loss-Absorbing Requirements

A trigger event—not necessarily the bankruptcy of the financial institution, but when an injection of public capital—occurs. This signals that non-debt capital must be converted to loss-bearing equity capital. This must occur before the injection of public-sector capital, support, or guarantees.

Secondarily loss-absorbent instruments are “quite challenging to value,” said Went. The instruments are designed to meet loss absorbency requirements to ensure that critical business and systemic functions can continue to operate during a crisis on an interim basis. In fact, “a steady stream of instruments has been issued.” Citing three examples from Lloyds, Rabobank, and Credit Suisse, Went remarked there was increased complexity in both the instruments and the specification of trigger events.

As biologists have observed for the past 150 years, as systems evolve, complexity increases. Although financial instruments are the product of human invention, they, too, obey this tendency.

Part 2 of this posting summarizes Went’s comments on US implementation and macroeconomic considerations of Basel III. ª

The webinar presentation slides can be found at: IIIE260E41ABB06F733340658FF&text_language_id=en&playerwidth=1000&playerheight=650&overwritelobby=y&eventuserid=65577848&contenttype=A&mediametricsessionid=54053351&mediametricid=895222&usercd=65577848&mode=launch#

The trillion-dollar bill image is from the website: