From Basel II to Basel III. Would Investment Banking be preferred under Basel II?

Master's Thesis 2013 48 Pages

Economics - Finance


Table of Contents

List of figures

List of tables

List of abbreviations

I. Introduction

II. Theoretical background
II.1. Review of Basel II
II.1.1. Minimum capital requirements
II.2. Review of Basel III
II.2.1. Capital requirements and buffers
II.2.2. Liquidity and funding
II.2.3. Risk coverage
II.3. Research about the impact of capital regulation

III. Impact on Investment Banking activities
III.1. Markets
III.1.1. Commodities
III.1.2. Credit
III.1.3. Equities
III.1.4. Foreign Exchange
III.1.5. Rates
III.1.6. Structured Finance
III.2. Corporate Finance
III.2.1. Mergers and Acquisitions
III.2.2. Equity Capital Markets
III.2.3. Debt Capital Markets

IV. Conclusion

V. Bibliography

List of figures

Figure 1: Liquidity Coverage Ratio

Figure 2: Composition of Holdings of Liquid Assets of Banks

Figure 3: Net Stable Funding Ratio

Figure 4: Responses to an Increase of Capital Requirements

Figure 5: Analyst Estimates of the Impact of Liquidity Proposals

Figure 6: Expected Revenue Split of Investment Banking Activities for 2013

Figure 7: Exchange traded versus OTC derivatives markets

Figure 8: Outstanding OTC Credit Derivatives (in trillions of notional dollars)

Figure 9: Impact on Selected Products

Figure 10: Banks' Debt Funding Sources by Type of Investor

Figure 11: Summary Foreign Exchange Market Evolution, 2005 - 2010

Figure 12: Outstanding OTC Derivatives (in trillions of notional dollars)

Figure 13: Corporate Finance Revenues (in billions of dollars)

Figure 14: Expected Market Share Movements of FICC for 2013

List of tables

Table 1: Risk Weight for Sovereigns

Table 2: Risk Weight for Corporate Clients

Table 3: Calibration of the Capital Framework

List of abbreviations

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I. Introduction

In the year 2007 the first bad signs appeared which predicted that something is happening in global financial markets. An asset-bubble in the US housing market started to bust and that event had generated fatal consequences not only for the US, but also for the rest of the world. Several major peaks characterize the recent financial crisis, also named subprime crisis, such as the country default of Iceland (though subprime crisis was not the main cause) or the nationalization of the mortgage corporations Freddie Mac and Fannie Mae by the US government. Certainly, no one forgets the queues of people waiting outside the branches of the British bank Northern Rock to withdraw their savings from the bank as a result of rumors about liquidity problems of this institution. Some of the biggest Investment Banks in the world experienced serious difficulties with reference to their liquidity situation and were acquired by other banks. JPMorgan Chase bought the traditional US Investment Bank Bear Stearns and Bank of America merged with the US Investment Bank Merrill Lynch. Clearly, one of the most important events in the course of the subprime crisis was the collapse of the US Investment Bank Lehman Brothers which happened on 15th September 2008.

Especially Investment Banks were hit hard by the subprime crisis and also the Investment Banking divisions of universal banks caused many issues for the whole institution. One of the main causes of the subprime crisis was identified: the Investment Banking business. The regulatory framework with reference to the banking supervisory failed in times of financial turmoil and needed to be reformed. In particular, the capital situation and liquidity profile of many banks were not adequate compared to the risks these banks were exposed to. Risks resulting from positions in the trading book (market-to-market) and risks resulting from off- balance sheet items which were not monitored by supervisory authorities needed to be emphasized. When the crisis hit, the capital requirements on the banking book were sufficiently deep to safeguard banks. The capital requirements on the trading book, however, were nowhere strong enough to absorb the losses (Dayal, 2011, p. 17). The new regulatory framework, namely Basel III, developed by the Basel Committee on Banking Supervisions which was finalized in 2011 focused on these risks. Overall, the quality and quantity of the regulatory framework should be increased and the liquidity profile of banks should be improved. Furthermore, the calculation of a bank’s risks should better reflect the true and entire risks a bank is exposed to. Banks are absolutely central to the monetary and payment system; and they are also vital to the credit system. They are leveraged; they run maturity mismatches; and their net worth is often uncertain. So they are exposed to runs, with

spillovers to the rest of the system and the economy more widely (Tucker, 2010, p. 1). As Investment Banking activities were identified as one of the main causes of the subprime crisis it is highly interesting to investigate how these activities are affected by the new regulatory framework. For the future of global financial markets it is essential to know if Investment Banking would be preferred under Basel II, which Investment Banking activities may benefit and which may suffer from Basel III. With this examination concerning the impact of these regulative reforms it is possible to estimate how the banking sector may look like in the future with regard to Investment Banking.

This paper is separated into a theoretical part and an advanced part. The theoretical part consists of important reviews of Basel II and Basel III. In addition to that, the theoretical part highlights important research findings both about capital regulation in general and about capital regulation with a focus on the impact of Basel III. The advanced part deals with the impact of Basel III on certain Investment Banking activities and is divided into markets activities and corporate finance activities. The paper is completed by a broad conclusion in order to answer the question if Investment Banking would be preferred under the old or the new Basel capital accord.

II. Theoretical background

The first part of this paper establishes the theoretical framework of the whole thesis, and it is essential to understand these theoretical foundations in order to answer the question stated in the title. It reviews both Basel II and Basel III with an emphasis on their impact on Investment Banking activities. In addition, the last chapter of the first part highlights important research findings about the general effects of capital regulation and the specific effects of the regulative reforms of Basel III.

II.1. Review of Basel II

The final version concerning the framework of Basel II was published in June 2004 and replaced Basel I established in 1988. The main critique of Basel I is that due to its characteristic of being rather static it encouraged misallocation of regulatory capital in the global financial system. Under Basel I the amount of regulatory capital needed to back up a credit was just depending on the type of borrower, e.g. corporate client or sovereign client, regardless of the creditworthiness a borrower has. As the cost of capital resulting from the required amount of regulatory capital to support the credit depended solely on the type of borrower, and as typically borrowers with a lower creditworthiness pay a higher interest rate, banks were encouraged to lend to customers with a lower instead of a higher creditworthiness (within a category of borrowers). Basel II tries to amend this wrong incentive by requiring higher levels of regulatory capital for high risk borrowers (Dierick, 2005). Therefore Basel II downsizes the gap between regulatory capital and economic capital. Regulatory capital is the one needed to fulfill the regulatory capital requirements defined by the supervisory authority and economic capital is the one held by the bank to cover the true risk of its balance sheet. The three complementary pillars of Basel II are explained in the following.

II.1.1. Minimum capital requirements

The minimum total capital ratio which a bank has to maintain at all times is 8% and is calculated by the amount of regulatory capital the bank has divided by the sum of riskweighted assets of the bank’s balance sheet. It is also called the first pillar of Basel II.

Regulatory capital

The regulatory capital of a bank has three components, core capital (Tier 1), supplementary capital (Tier 2) and short term subordinated debt covering market risk (Tier 3). Tier 1 capital is the key element of regulatory capital as it is transparent and a major source for other financial market players to examine if a bank’s capital is adequate or not. Tier 1 capital consists of two elements, equity capital (issued and fully paid shares) and disclosed reserves (the bank’s own funds). Tier 2 capital consists of undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid debt capital instruments and subordinated term debt. Undisclosed reserves, also named ‘hidden reserves’, are unpublished items but already booked through the profit and loss account and accepted by the supervisory authority.

Revaluation reserves occur if a bank owns securities booked (Banking book) at historic prices and these historic prices deviate from current market prices. General loan-loss reserves are reserves which are set aside against potential losses which may occur in the future but are not yet identified. Hybrid debt capital instruments can only be included to Tier 2 capital if they have similar characteristics to equity; in particular they need to support losses on an ongoing time horizon without a liquidation component connected to a certain trigger event. Only subordinated term debt, with an original maturity greater than five years, may be included in Tier 2 capital but with a cap of 50% of the existing core capital and an adequate amortization schedule until the instrument matures, meaning that without prolonging the subordinated term debt it decreases (amortizes) over time. The capital needed to cover market risks principally consists of Tier 1 and Tier 2 capital. In addition to that, short term subordinated debt may be added to cover market risks. The cap of Tier 3 capital to cover market risks depends on the supervisory authority of a country and may differ across countries.

Risk-weighted assets - Credit Risk

Under Basel II banks have the choice between two possibilities to calculate the credit risk of their balance sheet. Either a bank uses the standardized approach or the internal ratings-based approach (IRB). In the standardized approach the credit risk is calculated in a standardized way by using ratings from international rating agencies. Certainly, before a bank may use a rating from an international rating agency to determine the risk weights the agency needs to be approved by the supervisory authority.

The following two tables demonstrate how the risk-weighted assets are calculated in the

standardized approach for sovereigns and corporate clients.

Table 1: Risk Weight for Sovereigns

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For instance, bonds issued by sovereigns with the best rating from an approved international rating agency, at least AA-, have a risk weight of 0%. That means that a bank does not have to hold any Tier 1, Tier 2 or Tier 3 capital to cover the credit risk resulting from the issuer. Thus, sovereign bonds of high quality are classified as the typical risk free asset.

Under Basel I all exposure to the corporate sector was weighted with 100% no matter what creditworthiness a corporate client has. As already discussed, Basel I set wrong incentives with regard to lending activities of banks. The standardized approach under Basel II differentiates the creditworthiness of borrowers, e.g. borrowers of the corporate sector.

Table 2: Risk Weight for Corporate Clients

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The table shows that even a loan to the best rated corporate client has to be supported with capital. But more important is that the weakness of Basel I is solved. The additional interest gains resulting from a loan to a corporate client with a lower creditworthiness compared to a corporate client with a higher creditworthiness are equalized as a higher amount of regulatory capital is needed to support a loan to a low-rated corporate client.

Under the standardized approach off-balance sheet items are converted into an equivalent credit exposure by using a certain credit conversion factor. For maturities smaller than one year the factor is 20% and above one year the factor is 50% (BIS, 2006). In addition, banks need to calculate counterparty credit risk resulting from over the counter (OTC) derivatives, repos and other transactions in the trading book. These risk weights which are used to calculate the capital requirement have to be consistent in the banking book and in the trading book.

Banks have several possibilities to mitigate credit risk and thus to decrease their capital needs concerning the risk in their balance sheets. Credit exposure may get collateralized e.g. a borrower may deposit cash or securities as collateral for a loan. Furthermore, borrowers often favor loan guarantees given by a third party as collateral since no liquidity is needed for this type of collateral as long as borrowers pay back the loan accordingly. In addition to that, banks may buy credit derivatives such as credit default swaps (CDS) to offset credit risk.

Under the IRB approach banks need their own estimates of risk weights to calculate their capital requirements. However, the precondition is that the supervisory authority approves the internal calculation model concerning the determination of the risk weights. Primarily, the IRB approach consists of four components to calculate the credit risk: The probability of default, the loss given default, the exposure at default and the effective maturity. The probability of default calculates the probability that the borrower defaults within one year. The loss given default indicates what percentage of the original nominal value of the credit is lost if the borrower defaults. The exposure at default is equal to the outstanding debt of the borrower in nominal terms and the effective maturity indicates the maturity of the loan. With these estimations the expected and the unexpected loss is calculated. While a bank has to book risk-provisions against the expected loss the calculated unexpected loss has to be backed up by capital of the bank. Under the IRB approach, the required minimum capital is based on the probability distribution of losses due to the default risk in a portfolio or loans or other financial instruments. The IRB model further assumes a 99.9% confidence level (Dierick, 2005, p. 13).

Risk- weighted assets - Operational risk

Risk or potential loss resulting from failed internal processes, serious mistakes from employees, a breakdown of IT-systems or from a natural disaster is called operational risk. Under Basel I it was not required to hold capital against operational risk. That changed under Basel II. Banks had several possibilities to calculate their operational risk. The standard approach divided a bank into different business lines and each business line had a certain beta-factor measuring the operational risk. Investment Banking activities obtained the highest one. The advanced measurement approach is quite similar to the IRB approach. A bank could use its own operational risk measurement system if the system and the model behind it were approved by the supervisory authority.

Risk- weighted assets - Market risk

Market risk is defined as the risk of losses in on and off balance sheet positions arising from movements in market prices. The risks subject to this capital requirement are the risks that refer to interest related instruments and equities in the trading book as well as foreign exchange and commodity risk throughout the bank (BIS, 2006, p. 157).

II.1.2. Supervisory review process

While the minimum capital requirements examine a more quantitative approach, the supervisory review process is the qualitative complement. Four key principles established by the Basel Committee on Banking Supervision clarify the qualitative approach of the second pillar of Basel II:

1. Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels (BIS, 2006, p. 205).
2. Supervisors should review and evaluate banks ’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process (BIS, 2006, p. 209).
3. Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum (BIS, 2006, p. 211).
4. Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored (BIS, 2006, p. 212).

The overall ambition of the supervisory review process is an active dialogue and a constant interaction between a bank and its supervisory authority. Under the supervisory review process bank management is obliged to develop an internal capital assessment process in order to evaluate if further capital is needed in addition to the core minimum requirements to support risks beyond the first pillar. A bank management needs to assess if capital is sufficient with respect to its individual business strategy. For instance, such a strategy could be a concentration of certain Investment Banking activities like proprietary trading at the expense of traditional banking activities such as loan-deposit business. Another risk might occur if a bank management concentrates on one type of client segment e.g. lending to ship owners. If the whole maritime industry gets into difficulties a bank may face additional risks due to risk concentration in its loan book and thus needs to preserve more capital. Furthermore, the supervisory review process requires banks to monitor the interest rate related risk in the banking book which is not covered in the minimum capital requirements of the first pillar.

III.1.3. Market discipline

Under the third pillar banks are required to publish information concerning their business strategy, risk profile, capital structure and the management of the banks’ risk. Based on the published information other financial market participants are able to evaluate the sustainability of a bank. If these market participants decide that a business strategy is wrong then market pressure may push a banks’ management to change the business strategy. Thus, the third pillar of Basel II represents the self-correcting ability of the market. Banks are obliged to disclose separately information about credit, market and operational risk. As credit risk is a major source for assessing the risk profile banks need to publish data on the portfolio structure, major types of credit exposure, as well as the geographical and the industry- specific-sector distribution of impaired loans. In addition to that, information concerning credit mitigation of the bank has to be provided. If banks are using the IRB approach to calculate credit risk they are requested to publish sufficient details on their internal calculation model so that other financial market participants may back test and stress test the model. Finally, the interest rate risk in the banking book needs to be published (Dierick, 2005).

II.2. Review of Basel III

Basel II was never really adopted as the recent financial crisis with the fall of Lehman Brothers prevented a successful implementation in banks across the world. In July 2009 the Basel committee already developed and published Basel 2.5 which predominantly concentrates on market risk in the trading book and securitization exposures. As the crisis has shown, during times with financial turmoil banks with a huge trading book may get undercapitalized very fast and Basel 2.5 intended to boost capital to back up market risk (Blundell-Wignall, 2010). The main objectives behind Basel III are to strengthen global capital and liquidity regulation with the goal of promoting a more resilient banking sector as it is essentially needed for sustainable growth in the economy. Basel III also has a macro prudential view as risks in the financial system as a whole can be dangerous and have been unattended under Basel II (BIS, 2011). The core aspects of Basel III are reforms concerning capital and funding as it specifies new capital definition and ratios and introduces new funding ratios (Härle, 2010). Some key objectives affected the finalized reform extremely. Banks should be incentivized to use central counterparties (CCP) for the clearing instead of bilateral, OTC trades while derivatives business and trading activities should be more capital intensive. Furthermore, interconnected exposure of the financial sector and liquidity measures should penalize the reliance on short term funding. The following chapters highlight the three pillars of Basel III more in detail consisting of capital requirements and buffers, liquidity and funding, as well as risk coverage.

II.2.1. Capital requirements and buffers

The main objective of the first pillar of Basel III is to enhance the quality as well as the quantity of regulatory capital. For the Basel committee it is critical that global banks are backed by a high quality capital base (BIS, 2011).

Regulatory capital and buffers

The capital base under Basel III solely consists of Tier 1 and Tier 2 capital to improve the quality of capital. Tier 3 capital known under Basel II to support market risk is eliminated. Tier 1 capital consists of Common Equity Tier 1 capital (CET1) and Additional Tier 1 capital. CET1 items are e.g. common shares issued by the bank, retained earnings or other disclosed reserves. Additional Tier 1 capital items are instruments issued by the bank which are paid in and subordinated to depositors, to general creditors and to subordinated debt of the bank. For instance, some types of certificates belong to Additional Tier 1 capital which has no maturity date and no incentives to redeem. Tier 2 capital items are instruments by the bank which are also paid in, subordinated to depositors and, in contrast to Additional Tier 1 capital, just subordinated to general creditors of the bank. One important criterion is that the instrument may not be covered by a guarantee of the issuer or a third party e.g. a sovereign. The original maturity has to be at least five years and the investor may not have rights to accelerate the redemption of the instrument. Overall, the regulatory capital needs to have the feature of loss absorbing in a case of emergency.

The idea behind the capital conservation buffer is that banks are required to hold CET1 capital in addition to the minimum capital requirements which should be building up in periods outside of financial turmoil. The buffer is introduced in order to ensure that banks maintain the minimum capital requirements at all times. The countercyclical buffer aims to ensure that the capital requirements of the banking sector take account of the macro-financial environment in which banks operate (BIS, 2011). Due to the interconnection within the banking industry a downturn or a financial turmoil may hit the whole industry at once, especially in periods of excess credit growth. Supervisory authorities determine how much countercyclical buffer banks have to hold depending on several monitored indicators such as credit growth, housing prices or system-wide risks. The following table gives an overview about the capital requirements and buffers under Basel III.

Table 3: Calibration of the Capital Framework

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The minimum CET1 capital is 4.5% expressed in terms of total risk-weighted assets. Together

with the Additional Tier 1 capital and Tier 2 capital the total capital ratio needs to be at least 8%. By including the conservation buffer all ratios are lifted up by 2.5%, meaning that the total capital ratio (Tier 1 + Tier 2) is at least 10.5%. Depending on the observations of the supervisory authority the countercyclical buffer may get lifted up by a maximum of 2.5%, meaning that in the end a total capital ratio of 13% may be required.

Risk- weighted assets

Basel III and Basel II are similar in the way how to calculate risk-weighted assets in order to determine the required Tier 1 and Tier 2 capital. Like under Basel II credit risk, market risk and operational risk is calculated separately although some amendments concerning the related models have been made. Furthermore, banks may either use the standardized approach or the IRB approach to calculate total risk-weighted assets of the balance sheet. In contrast to Basel II, under Basel III market risk for extreme events needs to be calculated. Banks are required to calculate a so called stressed value at risk based on a 10-day, one sided 99 percent confidence interval (Al-Darwish, 2011). An additional capital charge may be required depending on the stressed value at risk.

Besides that, if a bank is classified as a systemically important financial institution (SIFI) then the bank is subject to an additional capital charge under Basel III. The rate of the additional charge ranges from 1% to 2.5% (Al-Darwish, 2011, p. 35).

II.2.2. Liquidity and funding

The second pillar of Basel III deals with the introduction of new ratios to improve the liquidity and funding situation of banks. It consists of the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). During the financial crisis many banks faced serious liquidity and funding issues when many financial markets participants liquidated their positions in debt issued by banks with the main objective to overweight cash and to reduce portfolio risk. In addition to that, many investors stopped to renew maturing debt instruments issued by banks which enhanced the difficulty for banks to manage their liquidity situation properly.



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Title: From Basel II to Basel III. Would Investment Banking be preferred under Basel II?