Basel Basics: A First Step in Putting the Three-Tiered Credit Union System's Capital to Better Use
There are two kinds of people in this world. No, not regulators and the rest of us. But those who pay close attention to the recent discourse regarding risk-based capital and actually know what it means; and everybody else. The talk also frequently includes references to the Basel II accords. As an advocate for the corporate credit union system, I have recently joined others in an attempt to increase my learning curve on what is arguably the most significant financial trend facing credit unions and the way they do business. In the coming months, ultimately I'd like to be able to answer the following question: Is there a way the credit union system can put its capital to better use for the sake of its members? Credit unions have an abundance of capital in the three-tiered credit union system. When members place funds in their credit union, the credit union is required to have at least 7% of such funds in the form of capital. If the credit union has excess liquidity, many of those same dollars go to a corporate credit union, which also has to have capital sequestered on those same dollars. Then, as corporates make investments in the third-tier of the credit union system, U.S. Central reserves maintains capital on the same dollars. Altogether, by the time a member's money is fully embedded in the system, there is at least 10%, if not 15% capital securing that money. All such percentages are not risk adjusted. Now we have to look at whether Basel II offers credit unions a more efficient way of managing capital reserves. As a beginner in this educational process, I humbly offer you my version of "Basel Basics." The first important term related to this entire discussion is risk-based capital. Risk-based capital as defined by Investor Dictionary.com reads: One of three capital standards adopted for savings institutions in 1989. The standard is designed to require savings institutions to hold more capital for higher-risk assets. The value of each asset is weighted according to its risk and then capital is calculated at a fixed percent of each risk-weighted asset. The standard adopted in 1989 was 8% of risk-weighted assets (Tier I is 4% and Tier II is 8%). So, what is Basel II? Central bankers from a core group of Western countries established the Basel Committee on Banking Supervision in 1974 in order to reduce the risk of a global banking collapse. Basel II is an outgrowth of previous work done by the committee and represents a brand new capital accord. Committee membership now includes representatives from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States. The committee takes its name from Basel, Switzerland, where it has its headquarters. Although the Committee does not have the power to make law, bank supervisory bodies in most western economies generally implement its recommendations and supervisory standards. As proposed, Basel II is based on three so-called regulatory pillars: minimum capital requirements, supervisory review of capital adequacy and effective disclosure requirements. As to minimum capital requirements, there would still be a ratio like we have today. However, the assets would be risk-weighted prior to the calculation of the ratio. Cash on hand carries little risk as do instruments backed by the federal government. Correspondingly, riskier investments would require a higher rating weighting. The overall thought is that the amount of capital ultimately dictated by the risk-based ratio formula would be a more exact measure of risk facing the institution. Another pillar is supervision. This pillar of Basel II aims to encourage financial institutions to adopt better risk management practices by having them consider and plan for those risks not captured in their capital ratio. These risks may include those that arise as part of the general economic cycle, as well as business and strategic risk. The risks also may include catastrophic event risk, operational risk and loss of reputation risk. The risks contemplated under this heading are in some respects more subjective or institution-specific than those under the first pillar. Additionally, the second pillar requires supervisory agencies to review and evaluate a bank's internal capital adequacy assessments and strategies. The third and last pillar is public disclosure. In keeping with the changes in corporate due diligence and governance, Basel II wishes to promote supervision by means of its third pillar of market discipline. The Committee considers that requiring financial institutions to disclose to the market detailed information on their capital ratios and risk exposures would engender this discipline. In terms of credit unions, where investment portfolios are required to be very safe as it is, adopting a risk-based approach similar to Basel II there may be an opportunity to liberate some of the generous amounts of capital currently held. Putting that now free capital to better use would greatly serve members. Credit unions have a great tradition of offering competitive financial services and it is incumbent upon the movement to keep abreast of trends that could further serve its members. In the coming months, we will continue to hear more about risk-based capital, the particulars of Basel II and ideas for other risk-based capital regimes. It remains to be seen what kind of impact a new capital formula could have on financial strategies for credit unions.