Canada: Basel Committee Releases Basel III Rules Text

The Basel Committee yesterday issued the Basel III rules text, which contains details of the global regulatory standards for bank capital adequacy and liquidity agreed to by the Governors and Heads of Supervision (GHOS) and endorsed by the G20 leaders at their November Seoul summit. The Committee also published the results of its comprehensive quantitative impact study.

The rules text is consistent with the September 12 agreement reached by GHOS on capital, but includes some important clarifications and further details on the operation of the new requirements.

This bulletin highlights some of the more important clarifications related to deductions from capital and the transition provisions relating to non-qualifying capital instruments.

The rules text does not include the additional entry criteria relating to "gone concern" or non-viability contingent capital (NVCC) features that are expected to be required for all non-common capital instruments at a future date. These criteria are expected to be approved at the GHOS meeting in January 2011 and will then be added to the Basel III rules text. In addition, the Basel Committee continued to indicate that systemically important banks should have additional loss-absorbing capacity beyond the minimum requirements set out in Basel III; this capacity could include a combination of capital surcharges, contingent capital and bail-in debt. The Committee, working with the Financial Stability Board, intends to make some proposals in this regard in the first half of 2011.

Significant Clarifications and Additional Details

Minority (non-controlling) interests and other capital issued by consolidated subsidiaries that is held by third parties

As previously announced, minority interests arising from the issue of common shares to third parties by a fully consolidated banking subsidiary may be recognized as common equity at the parent bank level (i) if the instruments otherwise qualify; and (ii) only to the extent of the minimum capital requirements of that subsidiary. The rules text also provides that non-common tier 1 and tier 2 capital instruments will be afforded similar treatment in a banking subsidiary and other consolidated non-bank subsidiaries. More detail is also provided for the determination of the minimum capital requirements of a banking subsidiary, and a helpful illustrative example is included in Annex 3 to the rules text.

Portfolio investments in capital instruments of other financial institutions

As previously proposed, investments held by banks in capital instruments of other banks and financial and insurance entities must be deducted using the "corresponding deduction approach" for each component of capital to the extent that the aggregate of these investments exceeds 10% of the corresponding capital component of the bank. Investments for this purpose include direct, indirect and synthetic holdings of capital (including the relevant portion held through any index securities), in both the banking book and the net long positions in the trading book.¹ However, investments in non-capital instruments (e.g., senior debt instruments) are not included and underwriting positions held for five working days or less can also be excluded from the calculation.

Minority investments and non-consolidated (for regulatory purposes) subsidiaries

If a bank owns more than 10% of the issued common shares of any financial institution that does not consolidate for regulatory capital purposes, the amount of the investment must, generally, also be deducted using the corresponding deduction approach. However, as set out in the September agreement, instead of a full deduction, these investments may receive limited recognition in the calculation of the common equity tier 1 capital up to 10% of the bank's common share equity. However, these investments – when aggregated with mortgage servicing rights and deferred tax assets that arise from temporary differences – must continue to be deducted on a phased basis commencing on January 1, 2013, to the extent that the aggregate of the three items exceeds 15% of the common share equity.

Treatment of non-qualifying capital instruments

As previously announced, capital instruments that no longer qualify as capital will be phased out beginning January 1, 2013. Recognition of these instruments will be capped at 90% of the aggregate amount outstanding on that date, with the cap reducing by 10 percentage points in each subsequent year. The calculation of the cap will be applied to non-common tier 1 and tier 2 capital separately and will refer to the total amount of instruments outstanding that no longer meet the relevant criteria. If an instrument is redeemed after January 1, 2013, the nominal amount serving as the base will not be reduced. Therefore, through an orderly redemption of non-qualifying capital after 2013, banks should be able to significantly mitigate the amount of any capital "haircut" that will be required under these transition rules. In addition, in general,² an instrument that has a call or a step-up, and that is not called at its effective maturity date, will continue to be recognized as that tier of capital, provided that it subsequently meets the new criteria for that type of capital. However, if it does not meet the new criteria and is not called, it will generally be fully derecognized from that tier of capital on January 1, 2013 or on its effective maturity date.

The Office of the Superintendent of Financial Institutions (OSFI) indicated, in a letter to banks yesterday, that since the Basel III rules currently provide that the cap on non-qualifying capital will be applied to tier 1 and tier 2 capital instruments separately and refers to the total amount of non-qualifying capital, the finalization of the rules related to NVCC may affect the operation of the cap on tier 1 and tier 2 nonqualifying instruments. In addition, OSFI indicated that when the NVCC requirements have been finalized, it intends to issue guidance clarifying the phasing out of all non-qualifying instruments and stating its expectations regarding the rights of redemption under regulatory event clauses.

Capital Conservation Buffer

The rules text also provides additional clarification on the operation of the capital conservation buffer. In particular, earnings will be defined as distributable profits calculated after the tax that would have been reported had none of the distributions been paid. In addition, a bank that does not have positive earnings and has a common tier 1 ratio of less than 7% would be restricted from making any distributions. The rules text indicates that the framework is intended to be applied at a consolidated level, although national supervisors have the option of applying a regime at a solo level to conserve resources in a particular part of the group. Finally, the rules text indicates that, in normal times, banks should not choose to operate in the buffer range simply to compete with other banks and win market share. To ensure that this does not happen, supervisors have the additional discretion to impose time limits on banks operating within the buffer range on a case-by-case basis.

Countercyclical Capital Buffer

Despite growing controversy,³ yesterday the Committee also issued Guidance for national authorities operating the countercyclical capital buffer as a supplement to the requirements set out in the Basel III rules text. The primary aim of the countercyclical capital buffer regime is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth that have often been associated with the buildup of system-wide risk. In addition to providing guidance for national authorities, the Guidance is intended to help banks understand and anticipate the buffer decisions in the jurisdictions to which they have credit exposures. The Basel rules text also indicates that the Basel Committee is further reviewing whether the countercyclical capital charge must be satisfied by common equity tier 1 or whether it could also be satisfied with other fully loss-absorbing capital (and, if so, what form that would take).

Footnotes

1 Investments in capital instruments of the bank will need to be fully deducted, calculated in a similar manner.

2 Important specific transition issues depend on when the instrument is callable or has a step-up.

3 For example, Nick Le Pan, former OSFI Superintendent and a former vice chairman of the Basel Committee, has been quoted as follows:

"We ... have not proven we can forecast turning points in the credit cycle with a reasonable degree of accuracy. So implementing the buffer will likely act as a permanently higher minimum, and will detract from, not support financial stability."

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