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Tuesday, November 2, 2010

The Status of the Basel III Capital Adequacy Accord

Walter W. Eubanks
Specialist in Financial Economics

The new Basel Capital Adequacy Accord (Basel III) is of concern to Congress mainly because it could put U.S. financial institutions at a competitive disadvantage in world financial markets. The Basel capital accord is an agreement among countries’ central banks and bank supervisory authorities on the amount of capital banks must hold as a cushion against losses and insolvency. Higher capital requirements constrain bank lending and profitability. The accords are not treaties. Member countries may modify the agreement to suite their financial regulatory structures. The concern is that Basel III might be in conflict with the new capital requirements U.S. regulators are implementing under the Dodd-Frank Act (P.L. 111-203). Basel III was the central focus of the discussion at the September 22, 2010, House Committee on Financial Services hearing on international regulatory issues relevant to the implementation of the Dodd-Frank Act. A day after member central bank governors approved the quantitative capital requirements of Basel III, Senate Banking Committee Chairman Christopher Dodd issued a statement warning of the potential for international regulatory arbitrage in implementing Basel III.

The first Basel accord was adopted in 1988 and is credited with providing stability to the international banking system. Banking regulators in the United States and other countries developed Basel II in 2004 because Basel I was not sufficiently sensitive in measuring risk exposures. By 2006, the European Union implemented Basel II. U.S. banking regulators issued the final rules for the implementation of the Basel II on December 7, 2007, and published the final regulations for implementing Basel II on April 1, 2008. At the time, the United States was in the most severe economic recession in more than 70 years. Federal regulatory agencies turned their attention to stabilizing the financial system, and Basel II was never fully implemented.

Basel III would make significant changes in bank regulatory capital requirements. It would increase the amount of common tangible equity held as minimum regulatory capital because common equity improves loss absorbency. Tangible common equity consists of bank shares and retained earnings. This increase is a significant change in regulatory capital requirements because many assets that are being used as regulatory capital would have to be converted to common tangible equity. By 2015, more than half of the total regulatory capital would be composed of common tangible equity capital. Common tangible equity will also be used in a new conservation capital buffer. This capital conservation buffer is to ensure that banks build up capital outside periods of financial stress that can be drawn down when losses are incurred. The minimum total capital plus conservation buffer would be 10.5% of risk-weighted asset in January 1, 2019, which is 2.5% higher than the current minimum requirement. If another element, the countercyclical capital buffer, is fully added, the minimum total capital requirement would be 13% of riskweighted assets. This would be a remarkable increase in capital requirement from current levels. Very few U.S. banks were able to maintain 13% of risk-weighted assets at the highest level of U.S. bank profitability. At that time, the average total equity capital ratio was 10.52%.

This report follows the basic elements of the Basel III documents on the types of capital requirements and their phase-in schedule, which were approved by the Basel member central bank governors on September 12, 2010. The elements are the new definition of Tier 1 capital, the minimum common equity capital, the capital conservation buffer, countercyclical capital bufferliquidity coverage ratio, global leverage ratio, and wind-down government capital injections. The report concludes with some implications drawn from its content.

Date of Report: October 28, 2010
Number of Pages: 16
Order Number: R41467
Price: $29.95

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