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Basel 3 Capital Ratio Will Be 7% Merged

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On BBC News at Ten

So presumably UK banks can now lend more :(

http://www.bbc.co.uk/news/business-11242284

Central bank governors and senior regulators are to impose tighter restrictions on the level of assets banks must hold, the BBC has learnt.

In future, they will need a "tier one capital ratio" of at least 7%, meaning they must have $7 in their vaults for every $100 in customers' accounts.

The current requirement is just 2% in reserves and the new figure is designed to protect the world's banks in future.

The new rules were drawn up by the Basel Committee on Banking Supervision.

They are expected to be approved by the governors and senior regulators when they meet in Switzerland on Sunday, BBC business editor Robert Peston says.

It will then still need to be ratified by the head of government of the G20 group of nations at their summit in November.

Low levels of capital relative to assets were a major factor in the recent banking crisis.

Then, in 2008, both Northern Rock and Royal Bank of Scotland had dangerously small amounts as backup.

The tier one capital ratio is made up of equity and retained earnings.

The new requirement should prove little problem for UK banks, as it is in fact lower than the 8-9% ratio currently held by them.

It is also well below the 10% level that was being pushed for by the UK, the US and Switzerland.

But our business editor says there was stiff resistance to the 7% rate from some quarters, led by Germany, many of whose banks typically have much lower stocks of core capital in the form of equity and retained earnings.

He says many will have great difficulty in meeting the new standard.

The updated "Basel" rules - named after the Swiss city where the central bankers meet - will mean some banks will need to raise a lot more money from shareholders to hold against possible losses on their loans.

The rules may have the effect of limiting lending, at least in the short-term, as most banks - particularly those in Europe - have far too little capital.

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Unless more people decide to borrow, I doubt that it will make much difference. If our banks are already holding well above the minimum requirement, it's hardly likely to make much difference. It does decrease the potential for the banks to loan out much of that newly printed money, mind.

I wonder if the risk weighting on mortgages has changed too? IIRC, they were rated as low risk, which is a big part of why the banks had so many problems. The increased capital requirements will give a larger buffer in the event of crisis, but I wonder if they have reassessed risk levels too.

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Can anyone remember what it was before?

"The current requirement is just 2% in reserves and the new figure is designed to protect the world's banks in future."

I assume that is purely common stock (ie. funds provided by share holders), as I don't think we had/have any reserve requirements at all in the UK (they were voluntary). As tier 1 capital appears to represent common stock and reserves, this is an interesting point.

EDIT: It's hardly surprising our banks are well capitalised, considering we printed a load of money and bought lots of shares in them. I don't suppose the EU countries had that option with the Euro.

Edited by Traktion

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I assume that is purely common stock (ie. funds provided by share holders), as I don't think we had/have any reserve requirements at all in the UK (they were voluntary). As tier 1 capital appears to represent common stock and reserves, this is an interesting point.

I think you are confusing monetary reserves - cash assets - and capital reserves. Completely different. They are on different sides of the balance sheet.

Edited by Alan B'Stard MP

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I remember the exact moment I gave up trying to understand banking regulations.

It was when a conversation with Chef Dave (now Chef?) led me to the Comprehensive Version of Basel II. Comprehensive it might have been. Comprehensible? My aunt's ass it was. It seemed to me a document designed to confuse, muddle and embarass anybody who had not spent their entire life in the banking regulatory bubble. It certainly frightened me off.

Unless the so called Basel 3 is a return to the stone age, I suspect that talking about capital ratios is meaningless simplification.

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To save me having to reply to anybody who posts "link?" or "evidence?", here is a link relevent to the post above:

http://www.bis.org/publ/bcbs128b.pdf

Actually, it is only a link to a document outlining the second of the three pillars of Basel II, which while the substantial part (and running to 192 pages), would on its own be as usefull as a one legged stool.

If anybody wants more they can use google or something.

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Unfortunately the whole concept of capital ratio based lending is deeply flawed. What good is the capital level if the asset side is composed of make believe assets.

Here's a good piece from Bloomberg that neatly describes the problem:

The bit in bold highlights the main point.

How GM Made $30 Billion Appear Out of Thin Air: Jonathan Weil

By Jonathan Weil - Sep 9, 2010 2:00 AM GMT Thu Sep 09 01:00:00 GMT 201

It will be a long time before General Motors Co. can shake the stigma of being called Government Motors. Here’s another nickname for the bailed-out automaker: Goodwill Motors. Sometimes the wackiest accounting results are the ones driven by the accounting rules themselves. Consider this: How could it be that one of GM’s most valuable assets, listed at $30.2 billion, is the intangible asset known as goodwill, when it’s been only a little more than a year since the company emerged from Chapter 11 bankruptcy protection?

That’s the amount GM said its goodwill was worth on the June 30 balance sheet it filed last month as part of the registration statement for its planned initial public offering. By comparison, GM said its total equity was $23.9 billion. So without the goodwill, which isn’t saleable, the company’s equity would be negative. This is hardly a sign of robust financial strength.

GM listed its goodwill at zero a year earlier. It’s as if a $30.2 billion asset suddenly materialized out of thin air. In the upside-down world that is GM’s balance sheet, that’s exactly what happened.

Indeed, the company’s goodwill supposedly is worth more than its property, plant and equipment, which GM listed at $18.1 billion. The amount is about eight times the $3.5 billion GM is paying to buy AmeriCredit Corp., the subprime auto lender. Another twist: GM said its goodwill would have been worth less had its creditworthiness been better. Talk about a head- scratcher. (More on this later.)

Not Normal

This isn’t the way goodwill normally works. Usually it comes about when one company buys another company. The acquirer records the other company’s net assets on its books at their fair market value. It then records the difference between the purchase price and the net assets it bought as goodwill.

The origins of GM’s goodwill are more convoluted. Shortly after it filed for bankruptcy last year, GM applied what’s known as “fresh-start” financial reporting, used by companies in Chapter 11. Through its reorganization, GM initially slashed its liabilities by about $93.4 billion, or 44 percent. Under fresh- start reporting, though, GM’s assets rose by $34.6 billion, or 33 percent, mainly because of the increase to goodwill.

GM’s explanation? The company said it wouldn’t have registered any goodwill under fresh-start reporting if it had booked all its identifiable assets and liabilities at their fair market values. However, GM recorded some of its liabilities at amounts that exceeded fair value, primarily related to employee benefits. The company said the decision was in accordance with U.S. accounting standards on the subject.

Funky Numbers

The difference between those liabilities’ carrying amounts and fair values gave rise to goodwill. The bigger the difference, the more goodwill GM booked. In other instances, GM said it recorded certain tax assets at less than their fair value, which also resulted in goodwill.

On the liabilities side, for example, GM said the fair values were lower than the carrying amounts on its balance sheet because it used higher discount rates to calculate the fair value figures. The higher discount rates took GM’s own risk of default into account, which drove the fair values lower.

Here’s where it gets really funky. If GM’s creditworthiness improves, this would reduce the difference between the liabilities’ fair values and carrying amounts. Put another way, GM said, the goodwill balance implied by that spread would decline. That could make GM’s goodwill vulnerable to writedowns in future periods, which would reduce earnings.

Unexpected Outcome

A similar effect would ensue on the asset side if GM’s long-term profit forecasts improved. Under that scenario, GM could recognize higher tax assets and bring their carrying amount closer to fair value, narrowing the spread between them.

So, to sum up, the stronger and more creditworthy GM becomes, the less its goodwill assets may be worth in the future. An intuitive outcome, this is not.

There’s a broader storyline here. Normally when companies go public, they’re supposed to be prepared from a business and financial-reporting standpoint to take on the responsibilities of public ownership. GM’s IPO, of course, is a much different animal. Taxpayers already own most of the company. Now the government is trying to unload its 61 percent stake back onto the investing public, though it may take years before the government can sell it completely.

Fluffy Balance Sheet

At this point, GM’s balance sheet remains loaded with fluff, as the goodwill illustrates. GM said its August deliveries were down 25 percent from a year earlier, so it’s not as if business is booming. Moreover, GM disclosed that it still has material weaknesses in its internal controls, which is a fancy way of saying it doesn’t have the necessary systems in place to ensure its financial reporting is accurate.

This being the political season, the Obama administration has made clear that it wants GM to complete the IPO this year, so the president can claim a policy success. It’s bad enough GM needed a taxpayer bailout. What would be worse is taking the company public again prematurely.

This much is certain: The next time GM wants to create $30 billion out of nothing, it won’t be so easy.

(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)

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"The current requirement is just 2% in reserves and the new figure is designed to protect the world's banks in future."

I assume that is purely common stock (ie. funds provided by share holders), as I don't think we had/have any reserve requirements at all in the UK (they were voluntary). As tier 1 capital appears to represent common stock and reserves, this is an interesting point.

EDIT: It's hardly surprising our banks are well capitalised, considering we printed a load of money and bought lots of shares in them. I don't suppose the EU countries had that option with the Euro.

Banks were well capitalised before the crunch...only in their own shite. BoE has lent against that shite real capital that has devalued MY labour.

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Unfortunately the whole concept of capital ratio based lending is deeply flawed. What good is the capital level if the asset side is composed of make believe assets.

Here's a good piece from Bloomberg that neatly describes the problem:

The bit in bold highlights the main point.

Can I use goodwill to pay off my mortgage?

I have lots of it and it appears very valuable.

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What good is the capital level if the asset side is composed of make believe assets.

I've done a bit of work on Basel II implementation, in layman's terms the principal problems with the accord was that it was a political guideline and not based on orthodox economic statistical theory.

There was way too much leeway for abuse of the purpose of such legislation and Basel III isn't looking much better. 7% is not a figure that will make the European banking system more stable, it’s a figure that will keep the wave of bank failures to affordable levels. Its all too little, too late.

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I think you are confusing monetary reserves - cash assets - and capital reserves. Completely different. They are on different sides of the balance sheet.

You're right - I just did a bit of reading about the capital account.

So, the banks basically need to hold 7% as cash (capital) reserves against which losses would be deducted, rather than paying out all of this cash as dividends (or other expenditure), then having little cover against write downs?

If so, then this means that the bank is less likely to need to rattle the tin for more capital (issuing more shares) to avoid going bankrupt? Presumably, it means that the shares holders will be given a smaller dividend too, along with lower wages/expendature, as more of the profit has to be retained as capital reserves?

Edited by Traktion

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Unfortunately the whole concept of capital ratio based lending is deeply flawed. What good is the capital level if the asset side is composed of make believe assets.

Here's a good piece from Bloomberg that neatly describes the problem:

The bit in bold highlights the main point.

IIRC, the Basel rules also define various risk weightings for various assets. I doubt they are sufficient for the sort of financial innovation which we have had over the last decade though.

TBH, the idea that the Basel Accords can be followed, thus producing safe banks does seem flawed. It seems to be an attempt to make something inherently unstable, stable, which the financial crisis proved was this was a false security.

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You're right - I just did a bit of reading about the capital account.

So, the banks basically need to hold 7% as cash (capital) reserves against which losses would be deducted, rather than paying out all of this cash as dividends (or other expenditure), then having little cover against write downs?

reserves?

Not quite. Capital is not money when referencing a balance sheet.

It's the residual claim on bank value (assets) once the normal liabilities are taken into account.

Once side are the assets - the other side are the claims on the value of those assets - normal liabilities and capital claims.

There isn't a capital account - there are accounts of type capital. A fair few in fact - and not to be confused with bank account or money in the classical sense. These are balance sheet accounts.

Edited by Alan B'Stard MP

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You're right - I just did a bit of reading about the capital account.

So, the banks basically need to hold 7% as cash (capital) reserves against which losses would be deducted, rather than paying out all of this cash as dividends (or other expenditure), then having little cover against write downs?

If so, then this means that the bank is less likely to need to rattle the tin for more capital (issuing more shares) to avoid going bankrupt? Presumably, it means that the shares holders will be given a smaller dividend too, along with lower wages/expendature, as more of the profit has to be retained as capital reserves?

Here's a good link to bank balance sheets:

Calculated risk

Peter.

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Here's a good link to bank balance sheets:

Calculated risk

Peter.

Not all liabilities are the same. The second diagram shows three categories of liabilities: 1) Long term bank debt, 2) commercial paper (called CP, this is less than 270 days duration, and usually much shorter), and 3) FDIC insured deposits.

I'm not sure this chap understand capital. It is a liability too. He needs a 4)

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I'm not sure this chap understand capital. It is a liability too. He needs a 4)

Surely the classic equation is:

Assets = Capital + Liabilities

which suggests that capital differs from liabilities.

Capital is the amount of money investors put into the bank plus any retained earnings. Liabilities is the money the bank borrows from depositors or other sources

Liabilities have to be paid back, but capital doesn't (so it's not a liability in the common sense meaning of the term),

Peter.

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Surely the classic equation is:

Assets = Capital + Liabilities

which suggests that capital differs from liabilities.

Liabilities have to be paid back, but capital doesn't (so it's not a liability in the common sense meaning of the term),

Peter.

The "company" is an incorporated body - a mythical personage. It starts its life with nothing. Investors provide money to the bank. The bank now owes these monies to those investors. It is a liability for the personage - and recorded as such.

How could assets = capital + liabilities ever be true if it wasn't the case?

The capital (aka equity) is the liquidation valuation for the bank investors - and the liquidated assets would (in theory) be returned to them in such an instance.

Edited by Alan B'Stard MP

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Not quite. Capital is not money when referencing a balance sheet.

It's the residual claim on bank value (assets) once the normal liabilities are taken into account.

Once side are the assets - the other side are the claims on the value of those assets - normal liabilities and capital claims.

There isn't a capital account - there are accounts of type capital. A fair few in fact - and not to be confused with bank account or money in the classical sense. These are balance sheet accounts.

Thanks again for the information - you really are a mine of it! :)

Would my assertion that there would be less expenditure still be correct, if they are having to accumulate more capital or does it mean they need to issue more shares to raise capital?

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Thanks again for the information - you really are a mine of it! :)

Would my assertion that there would be less expenditure still be correct, if they are having to accumulate more capital or does it mean they need to issue more shares to raise capital?

Let me read your assertion again !

But with regards to raising capital - yes they would need to issue shares. Issue more shares - capital liabilities up - receive more cash - assets go up.

Of course they can cut their expenditure - which will show up in earnings. Earnings (not money - but a valuation / claim) can be distributed to shareholders in the form of more capital liabilities - or retained.

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The "company" is an incorporated body - a mythical personage. It starts its life with nothing. Investors provide money to the bank. The bank now owes these monies to those investors. It is a liability for the personage - and recorded as such.

How could assets = capital + liabilities ever be true if it wasn't the case?

The capital (aka equity) is the liquidation valuation for the bank investors - and would be returned to them in such an instance.

But while the personage "lives", there is no way for the investors to get the money is there? The capital only goes to the investors when the personage dies, so it's not a liability of the bank as such, because it is never liable for the money?

Peter.

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But while the personage "lives", there is no way for the investors to get the money is there? The capital only goes to the investors when the personage dies, so it's not a liability of the bank as such, because it is never liable for the money?

Peter.

Stock market.

Self-terminate !

You would expect investors to invest for the income. If the company is not listed - and the investor wants out - he will have to negotiate.

Aren't share certificates negotiable documents?

Edited by Alan B'Stard MP

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