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Basel III capital standards agreed

 

13 September 2010

New capital standards agreed by the Basel Committee.  

On 12 September 2010 the Basel Committee agreed the final level of global capital standards for banks - the most long-awaited part of the Basel III reform. Under the new rules, banks will be required to hold at least 7% of common equity, which is over three times higher than the existing minimum level. Banks will be required to hold:

  • 4.5% of common equity to meet the core Tier 1 capital requirement; and
  • further 2.5% of common equity to meet the capital conservation buffer requirement.

The impact of the increase of the minimum level of common equity from 2% to 7% should be assessed in combination with the rest of the Basel III reform, including new trading book requirements, a new leverage ratio and minimum liquidity requirements. Despite these significant changes, press reports suggest that most internationally active banks are expected to meet the Basel III requirements without the need to raise further capital. However, it may still be too early for banks to relax as the Basel Committee has stated that "systemically important banks" should have loss absorbing capacity above the 7% level of common equity. Whilst it is currently an open question whether the Basel Committee will have an appetite for further raising the threshold for common equity for systemically important banks, work continues on the part of the Financial Stability Board (the FSB) and various Basel Committee work streams with a view to developing an integrated approach to regulation of systemically important financial institutions. Options include a new resolution regimes, capital surcharges, contingent capital and bail-in debt.

Banks will also be subject to a so called countercyclical buffer requirement within a range of 0% - 2.5% of common equity or other fully loss absorbing capital (endorsed by the relevant national regulator). Details of this requirement are still being finalised.

To mitigate the potential economic impact of these new requirements, the new level of capital standards will be implemented gradually between January 2013 and January 2019. We note that this is not consistent with the transition requirements proposed under CRD II and, therefore, amendments to CRD II (which were significantly more generous) will be expected.

The minimum capital requirement for common equity will be raised from the current 2% level, before the application of regulatory adjustments. This will be phased in by 1 January 2015 (see below for details).

The total Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter loss absorbency criteria, will increase from 4% to 6% over the same period. Failure to meet this requirement will result in restrictions of a bank's ability to pay dividends and discretionary bonuses.

The capital conservation buffer above the regulatory minimum requirement will be calibrated at 2.5% and will be met with common equity, after the application of deductions. Failure to meet this requirement will result in restrictions of a bank's ability to pay dividends and discretionary bonuses.

The Basel Committee reiterated its commitment to introduce another capital buffer designed to prevent the build-up of credit bubbles, a so called countercyclical buffer. The countercyclical buffer will be within a range of 0% - 2.5% of common equity or other fully loss absorbing capital (to be implemented according to national circumstances). Details of this requirement are yet to be finalised.

The Basel Committee also confirmed its intention to introduce the leverage ratio as set out in the announcement by the Bank Committee on 26 July 2010.

The Basel Committee made it clear that systemically important banks should have loss absorbing capacity above the 7% level. This statement refers to the ongoing work by the Basel Committee and the Financial Services Board which is designed to further strengthen the resilience of the financial system through a series of measures, including capital surcharges, bail-in and a new resolution regime for systemically important banks.

Transitional arrangements and grandfathering of existing capital instruments

National implementation by member countries will begin on 1 January 2013. Member countries must translate the rules into national laws and regulations before this date.

1) Capital ratio

As of 1 January 2013, banks will be required to meet the following new minimum requirements in relation to risk-weighted assets (RWAs):

  • 3.5% common equity/RWAs;
  • 4.5% Tier 1 capital/RWAs, and
  • 8.0% total capital/RWAs.

The minimum common equity and Tier 1 requirements will be phased in between 1 January 2013 and 1 January 2015:

  • on 1 January 2013, the minimum common equity requirement will rise from the current 2% level to 3.5%. The Tier 1 capital requirement will rise from 4% to 4.5%;
  • on 1 January 2014, the minimum common equity requirement will rise to meet a 4% minimum common equity requirement and the Tier 1 requirement will rise to 5.5%; and
  • on 1 January 2015, the minimum common equity requirement will rise to 4.5% common equity and the Tier 1 requirement will rise to 6%.

2) Deductions

The regulatory adjustments (ie deductions and prudential filters), including amounts above the aggregate 15% limit for investments in financial institutions, mortgage servicing rights, and deferred tax assets from timing differences, will be fully deducted from common equity by 1 January 2018 and will be phased in as follows:

  • the regulatory adjustments will begin at 20% of the required deductions from common equity on 1 January 2014;
  • 40% on 1 January 2015;
  • 60% on 1 January 2016;
  • 80% on 1 January 2017; and
  • reach 100% on 1 January 2018.

During this transition period, the remainder not deducted from common equity will continue to be subject to existing national treatments.

3) Capital conservation buffer

The capital conservation buffer will be phased in between 1 January 2016 and year end 2018, becoming fully effective on 1 January 2019. It will be phased in, so that it will be:

  • 0.625% of RWAs on 1 January 2016; and
  • increased each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019.

National authorities will have the discretion to impose shorter transition periods and are encouraged to do so where appropriate.

4) Existing public sector capital injections

Existing public sector capital injections will be grandfathered until 1 January 2018. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a 10 year horizon beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year. In addition, instruments with an incentive to be redeemed will be phased out at their effective maturity date.

5) Capital instruments that no longer qualify as common equity Tier 1

Capital instruments that no longer qualify as common equity Tier 1 will be excluded from common equity Tier 1 as of 1 January 2013. However, instruments meeting the following three conditions will be phased out over the same horizon described under paragraph 4 above:

  • they are issued by a non-joint stock company;
  • they are treated as equity under the prevailing accounting standards; and
  • they receive unlimited recognition as part of Tier 1 capital under current national banking law.

Only those instruments issued before 12 September 2010 will qualify for the transition arrangements numbered 4 and 5.

6) Leverage ratio

The phase-in arrangements for the leverage ratio announced in the 26 July 2010 announcement have been confirmed:

  • the supervisory monitoring period will commence 1 January 2011;
  • the parallel run period will commence 1 January 2013 and run until 1 January 2017; and
  • disclosure of the leverage ratio and its components will start 1 January 2015.

Based on the results of the parallel run period, any final adjustments will be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

7) Liquidity coverage ratio and net stable funding ratio

After an observation period beginning in 2011, the liquidity coverage ratio will be introduced on 1 January 2015.

The revised net stable funding ratio will move to a minimum standard by 1 January 2018

Conclusion

It may be too early for either the industry or the Basel Committee to claim victory over the finalised global capital standards for banks as the work to strengthen the financial system still continues. In particular, the Basel Committee is still working on the proposal to increase loss absorbency of regulatory capital, which is open for consultation until 1 October 2010. When implemented, this proposal may substantially restrict banks' flexibility in respect of capital instruments making it more difficult and costly for banks to raise capital if needed. This should be viewed in combination with new more restrictive requirements for capital deductions which will limit the extent to which banks can rely on minority interests, deferred tax assets and mortgage servicing rights. The cumulative effect of the new loss absorbency criteria and the new stricter requirements in respect of capital deductions will mean that it will be significantly more expensive for banks to raise even the same amount of capital, let alone a triple amount of that.

Whilst the Basel Committee announced its intention to allow "some prudent recognition" of minority interests and relax some other controversial parts of the Basel III proposal in its 26 July 2010 announcement, details of the finalised agreement on deductions and other parts of the Basel III reform, including the credit valuation adjustment, have not been released and it is impossible at this stage to predict the overall impact of the Basel III reform on banks' capital.

These details are expected to be released as part of the complete Basel III package of capital and liquidity reform to be published in time for the G20 Leaders' Summit in Seoul, South Korea on 11-12 November 2010. However, further proposals are expected before the end of 2010, including on contingent capital instruments and the net stable funding ratio. Those proposals and the rest of the capital and liquidity reform introduced by the Basel Committee will need to be separately agreed between the EU member states and the European Parliament and then transposed into national law in each member state. In the past the EU has demonstrated its utmost commitment to introduce draft European law to implement the Basel III proposals promptly. There is no reason to believe that the EU will not be as quick this time.

 

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