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Basel 3: higher capital requirements, liquidity rules and transitional arrangements - International Law Office

International Law Office

Banking - International

Basel 3: higher capital requirements, liquidity rules and transitional arrangements

September 17 2010

Introduction
New capital requirements

Timing and transitional arrangements


Introduction

As widely expected, the oversight body of the Basel Committee announced on September 12 2010 that it has endorsed the capital and liquidity reform package originally proposed in December 2009 and amended in July 2010, known as 'Basel 3'. The Basel 3 package was proposed to ensure that the financial system cannot suffer the type of collapse and resultant economic slowdown that occurred between 2007 and 2009. It encompasses:

  • an unweighted leverage ratio;
  • two new capital buffers - a conservation buffer and a countercyclical buffer;
  • new and substantial capital charges for non-cleared derivative and other financial market transactions; and
  • significant revisions to the rules on the types of instrument that count as bank capital.

In addition to confirming that the proposed rules in the December 2009 consultation paper had been agreed, the committee announced new levels for capital ratios, which have been the subject of impact assessments and heated debates. Banks had argued that imposing excessively high capital ratios could lead to a double-dip recession; regulators countered that without robust ratios, a new crisis could soon strike. The committee has decided to increase the capital requirements substantially. However, in a concession to the fragile state of the economic recovery, the transitional arrangements announced are generous, with the full package not taking effect for eight years.

Although the impact of the Basel 3 rules on an individual bank will depend on its asset/capital base and on the relevant regulator's application of the rules, the publication of the calibrated ratios and rules is one of the most significant developments for banks since the crisis began. Banks can now focus on a future strategy to meet the combined effect of these rules, together with other recent committee-driven changes.(1) This update summarises the new calibrated Basel 3 rules and the transitional arrangements.

New capital requirements

Capital ratios and deductions
Core Tier 1/common equity
The Basel 2 rules require that a bank hold 2% of Core Tier 1 capital to risk-weighted assets. Core Tier 1 consists of ordinary shares, retained earnings and profits. The Basel 3 rules replace the concept with a tougher categorisation: 'common equity'. This basically consists of common shares plus retained income. The rules require banks to hold 4.5% of common equity.

Total Tier 1
The total Tier 1 requirement increases from 4% to 6% under Basel 3, which means that other types of Tier 1 instrument, known as additional going concern capital, can account for up to 1.5% of Tier 1 capital.

Total capital
The total minimum capital requirement remains at 8%, subject to a new capital buffer. However, 6% of capital must be Tier 1, which means that Tier 2 (which will no longer be divided into upper and lower tiers) can account for no more than 2% of capital. Tier 3, which is used solely for market risk purposes, will be removed completely.

Deductions from capital
Under Basel 3, deductions from capital must generally be made from common equity Tier 1. This requirement is stricter than the current rule, whereby a number of deductions are made from total capital. However, the July 2010 Basel 3 amendments relaxed some of the proposed deductions, allowing partial inclusion of minority interests and certain deferred tax assets and mortgage-servicing rights (rather than their deduction, which had been proposed in December 2009).

New capital buffers
Capital conservation buffer
All banks will be required to hold sufficient capital to meet the minimum capital ratios, as well as having a capital conservation buffer above the minimum 8% total capital. This buffer is set at 2.5% and must consist solely of common equity, after deductions. In effect, common equity capital must be equal to 7% of risk-weighted assets, other than in times of stress, when the buffer can be drawn down. This, therefore, represents more than a threefold increase in the existing 2% Core Tier 1 requirement. The purpose of this buffer is to ensure that banks can maintain capital levels throughout a significant downturn and that they have less discretion to deplete their capital buffers through dividend payments. Banks that do not meet this buffer will be restricted from paying dividends, buying back shares and paying discretionary employee bonuses.

Countercyclical buffer
In addition to the conservation buffer, banks may at certain times be required to hold a countercyclical buffer of up to 2.5% of capital in the form of common equity or other fully loss-absorbing capital. This buffer is a macro-prudential tool to protect banks from periods of excessive credit growth and is at the national regulators' discretion. It will therefore apply only when a national regulator considers that there is excessive credit growth in the national economy, and will be introduced as an extension of the capital conservation buffer.

Leverage ratio
While banks in the United States have been subject to a leverage ratio for some time, this tool has never previously been part of the Basel regulatory framework. The committee has agreed to test an unweighted ratio of 3% over a transition period. It has made a number of changes to features of the ratio as they were set out in its July 2010 revisions; among other things, it allows netting based on the Basel 2 rules.

Systemically important banks
The committee has stated that systemically important banks should be subject to higher capital requirements than those in the Basel 3 package. Work continues on the proposals. Options include capital surcharges, contingent capital and bail-in-debt.

Liquidity rules
The new liquidity coverage ratio and net stable funding ratio will be introduced in accordance with the timing detailed below. The committee made a number of revisions to the components of both these ratios in the July 2010 revisions.

Increased capital requirements for derivatives and repos
The December 2009 proposals contained a number of provisions that would have substantially increased the capital requirements for counterparty credit exposures arising from banks' non-cleared repo and securities and derivatives financing operations. These proposals, which were substantially revised in July 2010, are not mentioned in the September press release. This may be because the timing for implementation needs to be coordinated with the European Commission, which is due to announce its proposals on the treatment of derivatives imminently.

Timing and transitional arrangements

Taking into account the continued fragility of global economic growth, the recent statement sets out highly detailed transitional arrangements.

Common equity, Tier 1, total capital and national implementation
The new capital ratios will be phased in. National implementation must begin on January 1 2013, by which date banks should have 3.5% common equity, 4.5% Tier 1 capital and 8% total capital. In 2014 this increases to 4% common equity and 5.5% Tier 1 capital. The full ratios (ie, 4.5% common equity and 6% Tier 1 capital) apply from January 2015.

Grandfathering of existing capital instruments
Capital instruments which do not meet the criteria for inclusion in the common equity element of Tier 1 cannot count as common equity from January 1 2013. However, certain instruments issued by non-joint stock companies which are Core Tier 1 at present will be grandfathered on a declining basis over a longer period. Certain conditions apply, including the provision that such instruments be treated as equity under prevailing accounting standards. 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 period starting on January 1 2013. Their recognition will be capped at 90%, to be reduced by 10% each year. Instruments with an incentive to redeem will be phased out at their effective maturity date. Only instruments issued before September 12 2010 qualify for the transitional arrangements. Existing public-sector capital injections are grandfathered until January 1 2018.

Regulatory deductions
Deductions will be phased in. Initially, 20% of the required deductions from common equity will apply by January 1 2014, to be increased by 20% a year thereafter until 100% of the deductions are made from common equity by January 1 2018.

Capital buffers
The capital conservation buffer will be phased in at 0.625% on January 1 2016 and will reach 2.5% by January 1 2019. The committee also states that banks which meet their general ratios, but remain below the 7% common equity target during the transition period, should "maintain prudent earnings" so as to meet the buffer as soon as possible. It is unclear exactly what this means and whether the requirement catches banks that comply with the transitional capital buffer phase in requirements over the period until January 1 2019, but do not meet the 7% requirement until that date - it appears to do so.

Leverage ratio
The 3% ratio requirement will run parallel from January 1 2013 to 2017. The committee will track the ratio, its component factors and impact over this period and will require bank-level disclosure of the ratio and its factors from January 1 2015. Based on the results of the parallel run, final adjustments to the ratio will made in the first half of 2017 and it will be fully effective from January 1 2018.

Liquidity ratios
The liquidity coverage ratio will be introduced on January 1 2015. The net stable funding ratio will apply as a minimum standard from January 1 2018.

For further information on this topic please contact Benedict James, Edward Chan, Carson Welsh or Richard Levy at Linklaters LLP by telephone (+44 20 7456 2000) or by fax (+44 20 7456 2222) or by email (benedict.james@linklaters.com, , carson.welsh@linklaters.com or richard.levy@linklaters.com).

Endnotes

(1) These, in part, have resulted in the capital-related amendments to the EU Capital Requirements Directive in Europe.


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