Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Basel III: The German (or rather Sinn) Finish

I have blogged about the Swiss Finish and the British Finish that add (or threaten to add) large layers of capital requirements for banks on top of the Basel III minimum. Now, one of Germany’s most influential economists, Hans-Werner Sinn, has come out with proposals that are equally far reaching. My impression is that the German political establishment has been opposed to higher capital requirements, but this could change if the peripheral sovereign crisis necessitates a large bail out of German banks. So Sinn’s proposals are interesting:

After the Basel III system for bank regulation, a Basel IV system is needed in which the risk weights for sovereign debt are to be raised from zero to the level for mid-sized companies.

Common equity (core capital plus balance-sheet ratio) is to be increased by 50% with respect to Basel III.

Sinn does not elaborate on these points which come at the fag end of a long list of (highly controversial) recommendations on how to rescue the euro. There is therefore some ambiguity about what exactly he means. Basel III demands common equity of 4.5% plus a capital conservation buffer of 2.5% plus an extra capital requirement of up to 2.5% for Global Systemically Important Banks (G-SIBs) plus a counter cyclical buffer of up to 2.5%. This leaves us with a range of 7% to 12%. If we take the mid point of 9.5% (for example, a big G-SIB at a point in the business cycle where the counter cyclical buffer is zero) and apply a 50% increase to this, we end up at 14.25%. Since Basel III also requires non equity capital of 3.5%, the total capital requirement would be 17.75%. This is a little below the Swiss and British finish in the aggregate, but it has more of higher quality (equity) capital.

Sinn’s proposal for increasing risk weights is also effectively an increase in bank capital requirements. I am quite in agreement with the idea that we should not distinguish between sovereign exposures and corporate exposures when it comes to risk weights. Other classes of assets with low risk weights (for example, exposures to central counter parties) also need to be revisited. Sinn’s proposal attacks the risk weight problem in another way by applying a 50% increase to the balance sheet leverage ratio which essentially measures the ratio of capital to unweighted assets. Basel III requires a minimum leverage ratio of 3% (assets can be 33 times capital); if this ratio is pushed up to 4.5%, assets will be limited to 22 times capital. For the leverage ratio, Basel III uses tier one capital; it is not clear whether Sinn wants this to be entirely in the form of equity capital.

Basel III was in some ways a victory for the big global banks (though they are still trying to water it down to whatever extent they can), but it appears to me that the real battle lies beyond Basel III. And perhaps, the banks are gradually losing this battle. So many different groups of people coming at it from different perspectives are ending up with very similar banker-unfriendly numbers on minimum bank capital.


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