On 12 September 2010, the Group of Governors and Heads of Supervision of the Basel Committee on Banking Supervision announced that they had reached agreement on measures that would fundamentally strengthen global capital standards. A key requirement under the new rules, known as Basel III, would be that banks would have to hold top quality capital totalling 7 per cent of their risk bearing assets, a significant increase from 2 per cent.
The purpose of this blog is to provide an update on the progress of the implementation of the Basel III framework. Our teams in banking and financial services will also be providing their insight into the issues as they unfold.
Basel Committee issues final elements of the reforms to raise the quality of regulatory capital
31 January 2011
The Basel Committee on Banking Supervision (BCBS) has issued a press release that sets out the minimum requirements it has developed to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss.
These requirements were endorsed by the BCBS's oversight body, the Group of Governors and Heads of Supervision, at its meeting on 10 January 2011. The BCBS reports that members of its oversight body agreed that under certain conditions, including a peer review process and disclosure, the proposal's objective could be met through a statutory resolution regime if it produces equivalent outcomes to the contractual approach.
The BCBS states that in order for an instrument issued by a bank to be included in Additional (i.e. non-common) Tier 1 or Tier 2 capital, it must meet or exceed minimum requirements set out in the annex attached to the press release. These requirements are in addition to the criteria set out in the Basel III capital rules which were published in December 2010.
Rabobank Tier 1 issue
31 January 2011
Rabobank closed this week the first Tier 1 issue following the publication of the Basel III rules in December 2010 - US$2 billion 8.37 per cent Perpetual Non-Cumulative Capital Securities. The issue was structured to be compliant with the current Dutch regulatory capital rules resulting from the EU Capital Requirements Directive 2 and is intended to be compliant with new rules once the EU Capital Requirements Directive 4 is implemented later this year following the Basel III rules.
As required in the Basel III rules, the securities contain a loss absorption feature. If Rabobank's equity capital ratio (membership certificates and retained earnings) falls below 8 per cent, accrued interest is cancelled and then the principal amount is permanently written down. These features are intended to help the mutual return to financial health.
The issue have been followed by the market with some interest in the expectation that other European banks that need to raise capital will want to do something similar.Tak Matsuda
PartnerLeonie von Schweinitz
Bank of England discussion paper raises possibility of a United Kingdom version of the Swiss Finish
28 January 2011
In a discussion paper published on 27th January, 2011, David Miles of the Bank of England monetary policy committee suggests that the minimum amount of equity capital which it is desirable for banks to hold is very much larger than banks have held in recent years and also higher than the minimum levels required by Basel III.
Basel III would require a bank to have equity capital levels equal to at least 7 per cent (when the capital conservation buffers are taken into account) of its risk-weighted assets. The Bank of England paper suggests that a far more ambitious reform would ultimately be desirable – a capital ratio which is at least twice as large as that agreed upon in Basel III.
Whilst the discussion paper reflects only the views of the authors and not necessarily those of the Bank of England, it brings closer the possibility of the implementation of a United Kingdom version of the so-called "Swiss finish": Switzerland's two largest banks (UBS and Credit Suisse) will be required to comply with a capital ratio of 19 per cent.
To a degree, this is not new: British banks have always been required to hold equity capital over and above the published minimum requirements. However, the doubling of the minima would represent a significant increase on current standards and the introduction of a global increased standard applicable to all banks would be new.
At the Seoul summit, the G20 Leaders reaffirmed their commitment to take action at both the national and international level to ensure that national authorities implement global standards in a consistent way that avoids market fragmentation, protectionism and regulatory arbitrage. However it is evident that different regulators will have varying policies as to whether capital ratios over and above those required by Basel III should be applied.
Key changes to bank regulatory capital requirements under Basel III
28 January 2011
The Basel III reforms to the banking sector regulatory framework have a number of main elements:
- revised rules for what may count as capital for regulatory purposes and increased minimum levels of capital;
- various rule changes to improve capture of bank on-and off-balance sheet risks by capital framework;
- the introduction of new minimum liquidity requirements for banks;
- the introduction of a new maximum leverage ratio requirement to impose a limit on aggregate on-and off-balance sheet risks; and
- a proposal for a higher level of capital requirements to apply to systemically important financial institutions.
"The following link is to an article on the NRG website which focuses on the first of those bullet points: Key changes to regulatory capital rules being made under Basel III,/a>".
Although the new Basel III requirements do not start to come into force until January 2013, banks and other financial institutions covered by Basel III will undoubtedly want any new capital instruments they issue to be Basel III compliant. Pending clarification of the new rules many banks have been putting off capital issuance. However, following publication of Basel III capital requirements in December 2010 and January 2011, and in the light of the high levels of subordinated debt capital securities in particular which are scheduled for redemption in 2011 and 2012, many banks will now be planning issuance of Basel III compliant securities, and indeed the first of these issues are already coming to market, with Rabobank issuing a preliminary prospectus for a proposed Additional Tier 1 issue of perpetual capital securities on 19 January.
Basel III: Treatment of deferred tax assets
28 January 2011
One change proposed by Basel III which will have a significant impact on banks' regulatory capital is in the treatment of deferred tax assets.
Deferred tax assets are one of the most arcane aspects of accounting but they arise because of differences in the way in which a company prepares its financial accounts and its tax accounts. If a company makes a loss it will have no tax charge. However in many countries, including the UK, tax laws will allow the company to carry forward the loss and offset it against its profits in future years thus reducing its tax liability in the future. Where it is probable that there will be profits in the future against which the loss can be set, the company is allowed to recognise the future tax saving as a deferred tax asset in its accounts in the year in which the loss is incurred.
Under Basel II these deferred tax assets can be included in Tier 1 Capital. In one sense, because it reflects a reduced future payment obligation, there is no risk associated with the asset. The difficulty with this approach however is that the recognition of deferred tax assets is an exercise in judgment as to the probability of future profits and the period over which they are expected to arise. Taking that into account, deferred tax assets are not realisable in circumstances of financial stress.
The financial crisis lead to a massive increase in tax losses suffered by banks and in the corresponding deferred tax assets shown in their accounts. According to Fitch, on average deferred tax assets represent 10.7 per cent of the equity of US banks. In 2009, Citibank had $38 billion of deferred tax assets of which $13 billion counted in Tier 1 Capital. Deferred tax assets represent 20 per cent of UBS equity and Santander, Unicredit and BNP hold deferred tax assets of 15.8 billion 10.2 billion and 10.1 billion euros respectively.
Under Basel III it is proposed that deferred tax assets whose recognition depends on the realisation of profits in the future should be deducted from Tier 1 Capital and the reduction made good from another source. At least some banks base their estimation of future profitability over an 8 year period which suggests that some tax losses currently recognised as deferred tax assets will still be outstanding when Basel III comes into operation.
Basel III: Risk-weighting of letters of credit in trade finance
24 January 2011
Buried deep in the Basel III text is the provision relating to off-balance sheet items. Trade letters of credit are found in a list between standby letters of credit and failed transactions and unsettled securities. Strange bedfellows indeed.
These are off balance sheet items, and, to quote the text.
It is difficult to understand how a documentary credit, which is only payable if documents are presented which represent goods, and over which the bank then has a pledge, can be treated as "significant leverage" and treated the same way as a standby letter of credit, which is effectively an uncovered guarantee.
Of course, documentary letters of credit can be used as leverage tools, but surely we are sophisticated enough to deal with that, and not impose regulatory capital burdens on normal trade transactions.
The next steps in the Basel III process
20 January 2011
The Basel Committee on Banking Supervision (BCBS) has published a speech given by its chairman, Nout Wellink. Mr Wellink's speech is entitled Basel III and beyond.
In his speech Mr Wellink calls on the Basel III rules to be implemented in a timely and globally consistent manner. All BCBS member countries now have to begin the process of translating the Basel III rules text into national regulations and legislation to meet the 2013 deadline.
Mr Wellink states that Basel III is the core regulatory response to problems revealed by the financial crisis but new rules and standards are not enough. The next critical task relates to better and more intrusive supervision at the global level. For that purpose the BCBS' implementation group will conduct follow up and thematic peer reviews. Areas of focus will include common interpretation of standards and potential areas for regulatory arbitrage. The BCBS will also follow up to review implementation by banks and supervisors in areas like stress testing and sound liquidity risk management.
In parallel to the BCBS' focus on implementation its future work programme will cover the following areas:
- The observation of certain elements of Basel III.
- Further development of supervisory standards.
- Efforts to improve supervisory practices and cross-border bank resolution practices.
In relation to developing supervisory standards Mr Willink states that policy development work continues on the market risk rules, systemically important banks, the reliance on external ratings and large exposures. More generally, the BCBS will be taking a very close look at how banks arrive at their measures of exposure, how they risk weight their assets and how they engage in risk mitigation activities. Another high priority for the BCBS will be its work on systemically important banks, in collaboration with the Financial Stability Board. The BCBS has developed a provisional methodology that includes both quantitative and qualitative indicators to identify systemically important banks at the global level. The BCBS is also examining the magnitude of additional loss absorbency that global systemically important banks should have, which could be met through some combination of common equity, contingent capital and bail-in debt.
In its efforts to improve supervisory practices and cross-border bank resolution the BCBS is currently assessing implementation by its member countries of recommendations made by its Cross-border Bank Resolution Group. Mr Willink also mentions that the BCBS intends to revise the Core Principles for Effective Banking Supervision in 2011.
LMA Note on the Increased Costs Clause
17 January 2011
The LMA has issued advice on negotiating the Increased Costs clause in its recommended forms of facility agreement in the light of the Basel III Accord. These pro-formas contain a footnote suggesting language for use where it is considered appropriate to exclude Basel II from the scope of the Increased Costs clause. As Basel II has now been implemented (at least within the EU) and as the indemnification under the Increased Costs clause relates to changes in law, it may be thought that this exclusion is now superfluous. However, there is still plenty of scope for changes in the way that the Basel II legislation is interpreted or applied.
The LMA's advice arises from a concern that, by agreeing to the suggested Basel II exclusion, banks might inadvertently also exclude from the scope of that clause any increased cost arising from the implementation of Basel III. This could happen where, when legislation for Basel III is introduced, it is consolidated with the existing Basel II legislation so that the definition of Basel II also captures the subsequent Accord.
Perhaps more fundamental is the question of the circumstances in which any bank will be able to recover its increased regulatory costs under current facility documentation. We have all been told that Basel III will make lending more expensive and, in due course, banks will factor the added expense into their interest calculations. However, can they recover this under existing documentation?
Banks and borrowers need to consider what circumstances might give rise to an increased lending cost as a consequence of the implementation of the Basel Accords and who should take the risk of that cost in each case. For example, the cost of maintaining a facility might be affected (amongst other things) by:
- the enactment of legislation giving effect to the Basel III Accord;
- its progressive implementation between now and 2018;
- the introduction of the capital conservation and countercyclical buffers;
- any variation of either of the Basel accords, including anything carried out under the "to be agreed" provisions (for example in respect of strategically important financial institutions);
- a change (whether in law or otherwise) which affects the risk-weighting of a particular loan; or
- any change in the risk-weighting approach adopted by a particular bank.
Whether any such cost could be claimed by a lender under a particular facility would depend on the exact drafting of the clause: it is not just a change in law but also a change in its interpretation or application which is covered. The lenders will also need to establish the amount of the increased cost and refer it back to the particular loan - this may not be an easy thing to do.
17 January 2011
As part of the wider measures being ushered in to strengthen regulation and risk within the banking system, Basel III rules outline the definitions for contingent capital instruments, otherwise known as "CoCos" which will be considered part of a Bank's Tier 1 Capital. The key feature of these hybrid securities setting them apart from existing convertible bonds is the ability to convert from debt to equity upon the occurrence of a defined regulatory trigger point namely, under Basel III rules, if the financial institution in question allows its capital to fall below the defined ratio/threshold.
Conceptually CoCos have been well received, both by Banks and Regulators in the context of the widespread calls following the financial crisis for capital adequacy solutions to be innovative and designed with a "going concern approach" in mind. Unlike other bail in solutions which increase uncertainty and the scale of loss for all institutional investors, CoCos are intended to be a more bespoke solution, aimed only at those investors who are able to bear the risk of capital adequacy thresholds being breached. It is this high risk profile that has raised broader questions within the market as to exactly who will buy the instruments. In a report recently produced by Standard and Poor it is argued that traditional bond buyers such as life & pension funds may be reticent to invest in the instruments by virtue of the contingent element ultimately meaning greater risk. S&P believe Hedge Funds may be interested in purchasing CoCos, however the level of appetite for the instruments is uncertain with previous deals involving the issue of CoCos such as by Lloyds Banking Group not considered a genuine test of demand thus far. In view of the proposed Solvency II rules CoCos may be considered particularly attractive for the insurance sector.
Basel Committee publishes Basel III rules text
The Basel Committee on Banking Supervision (BCBS) has issued the Basel III rules text, which presents the details of global regulatory standards on bank capital adequacy and liquidity agreed by the Governors and Heads of Supervision, and endorsed by the G20 leaders at their November Seoul summit.
The BCBS is raising the resilience of the banking sector by strengthening the regulatory capital framework, building on the three pillars of the Basel II framework. The reforms raise both the quality and quantity of the regulatory capital base and enhance the risk coverage of the capital framework. They are underpinned by a leverage ratio that serves as a backstop to the risk-based capital measures, are intended to constrain excess leverage in the banking system and provide an extra layer of protection against model risk and measurement error. Also, the BCBS is introducing a number of macro-prudential elements into the capital framework to help contain systemic risks arising from pro-cyclicality and from the interconnectedness of financial institutions.
The BCBS recognises that strong capital requirements are a necessary condition for banking sector stability but are not sufficient on their own. The BCBS believes that a strong liquidity base reinforced through robust supervisory standards is of equal importance. To date, there have been no internationally harmonised standards in this area. The BCBS is therefore introducing internationally harmonised global liquidity standards. As with the global capital standards, the liquidity standards will establish minimum requirements and will promote an international level playing field to help prevent a competitive race to the bottom.
The BCBS is introducing transitional arrangements to implement the new standards that help ensure that the banking sector can meet the higher capital standards through reasonable earnings retention and capital raising, while still supporting lending to the economy. The transitional arrangements are described in the Basel III liquidity rules text document.
After an observation period beginning in 2011, the Liquidity Coverage Ratio (LCR) will be introduced on 1 January 2015. The Net Stable Funding Ratio (NSFR) will move to a minimum standard by 1 January 2018. The BCBS will put in place reporting processes to monitor the ratios during the transition period and will continue to review the implications of these standards for financial markets, credit extension and economic growth, addressing unintended consequences as necessary. Both the LCR and the NSFR will be subject to an observation period and will include a review clause to address any unintended consequences.
The BCBS has also published a document entitled Guidance for national authorities operating the countercyclical capital buffer. This document sets out the procedures and guidance for national authorities operating the countercyclical capital buffer regime. It sets out what is required of the national authorities responsible for operating the countercyclical buffer regime, the principles that they should follow in making buffer decisions and the calculation of the common buffer guide that will feed into buffer decisions across jurisdictions. In addition to providing guidance for national authorities, the document should also help banks to understand and anticipate the buffer decisions in the jurisdictions to which they have credit exposures.
The BCBS has also released a report which sets out the results of the comprehensive quantitative impact study. The quantitative impact study (QIS) was conducted to ascertain the impact of the new requirements.
Basel Committee announcement - December 2010
On 30 November and 1 December 2010 the Basel Committee on Banking Supervision (the Committee) agreed on the details of the Basel III rules text, and announced that it expects to publish the Basel III rules by the end of 2010. As an accompaniment to the Basel III rules, the Committee will also publish a summary of the results of its comprehensive quantitative impact study (QIS), which, along with the Committee's economic impact assessment analysis, was an important factor in the design and detail of the Basel III framework.
The Committee has also announced that the liquidity coverage ratio and the net stable funding ratio, included as part of the Basel III rules on global regulatory standards on capital adequacy and liquidity, will be subject to an observation period and will include a review clause to address any unintended consequences.
The Committee further announced that, on issues related to globally systemic banking institutions, it will publish:
- A paper on a qualitative and quantitative methodology by which national authorities can assess the global systemic importance of financial institutions. The Committee will send this paper to the Financial Stability Board (FSB) by the end of 2010.
- A study of the magnitude of additional loss absorbency that global systemically important banks should have. The Committee intends to publish this paper by mid-2011.
- A review to assess the extent of going-concern loss absorbency that could be provided by different instruments. The Committee plans to publish this paper by mid-2011.
In addition before the end of 2010 the Committee will issue a consultation on the rules for the capitalisation of bank exposures to central counterparties. It will also conduct an impact study on the proposed rules with the goal of finalising them in 2011.
Report on the December 2010 meeting of the Basel Committee on Banking Supervision
G20 summit in Seoul - consistent implementation required
At the Seoul summit the G20 Leaders reaffirmed their commitment to take action at both the national and international level to raise regulatory standards and to ensure that national authorities implement global standards in a consistent way that avoids market fragmentation, protectionism and regulatory arbitrage. In particular the G20 Leaders confirmed that they would fully implement the new Basel III framework.
The European Commissioner for the Internal Market and Services, Michel Barnier, has issued a press statement welcoming the G20 Leaders' support of the Basel III framework. However, Barnier emphasised the need for the new framework to be consistently implemented across the globe, stating that "The Commission attaches the utmost importance to an international level playing field. If these new rules are going to work properly, it is imperative that all jurisdictions implement them at the same time, and in a consistent manner, in the EU and beyond."
The Commission has confirmed that in March 2011 it will table the necessary legislative proposals to transpose Basel III into EU law. Legislation will take the form of a revision of the Capital Requirements Directive (CRD IV).
Head of Financial institutions
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