Alert July 21, 2009

Basel Committee Announces Basel II Capital Framework Enhancements

The Basel Committee on Banking Supervision (the “BCBS”) announced that it has approved a number of measures to enhance the Basel II capital framework (“Basel II”) and to strengthen the rules governing trading book capital.  These measures are part of the BCBS’s broader program to strengthen the regulatory capital framework in response to the financial crisis that began in 2007 by introducing new standards to: (1) promote the build-up of capital buffers that can be drawn down in periods of stress; (2) strengthen the quality of bank capital; and (3) introduce a leverage ratio as a backstop to Basel II.  The BCBS is also taking measures to mitigate any excess cyclicality of the minimum capital requirements and to promote a more forward-looking approach.  The BCBS intends to issue a consultative paper on this broader program by the first quarter of 2010.

Under the approved Basel II enhancements, the BCBS is strengthening the treatment for certain securitizations in Pillar 1 (regarding minimum capital requirements) of Basel II.  The BCBS is introducing higher risk weights for resecuritization exposures (so-called collateralized debt obligations of asset-backed securities) to better reflect the risk of such products, and is raising the credit conversion factor for short term liquidity facilities to off-balance sheet conduits.  In addition, the BCBS is requiring that banks conduct more rigorous credit analyses of externally rated securitization exposures in order to ensure that banks perform their own due diligence and do not simply rely on rating agency credit ratings.

Furthermore, the BCBS is issuing supplemental guidance under Pillar 2 (the supervisory review process) of Basel II.  This supplemental guidance “addresses the flaws in risk management practices revealed” by the financial crisis.  More specifically, these proposed measures address: firm-wide governance and risk management; capturing the risk of off-balance sheet exposures and securitization activities; managing risk concentrations; providing incentives for banks to better manage risk and returns over the long term; and sound compensation practices.  The supplemental guidance also incorporates the FSF Principles for Sound Compensation Practices issued by the Financial Stability Board (formerly known as the Financial Stability Forum) in April 2009.

The BCBS has also proposed measures to enhance Basel II’s Pillar 3 (regarding market discipline) by strengthening disclosure requirements in several important areas, including: securitization exposures in the trading book; sponsorship of off-balance sheet vehicles; resecuritization exposures; and pipeline and warehousing risks with regard to securitization exposures.  The BCBS noted that these “additional disclosure requirements will help reduce market uncertainties about the strength of banks’ balance sheets related to capital market activities.”

The BCBS expects banks and supervisors to begin immediately to implement the Pillar 2 guidance, while the new Pillar 1 capital requirements and Pillar 3 disclosures are expected to be implemented no later than December 31, 2010.  In the meantime, the BCBS agreed to keep in place the Basel I capital floors, which required banks to set aside capital equivalent to 8% of an institution’s risk-weighted assets, beyond the end of 2009.

With respect to the revisions to the trading book rules, which will take effect at the end of 2010, the BCBS announced the introduction of higher capital requirements, including the implementation of an incremental risk capital charge (which includes default risk as well as migration risk) for unsecuritized credit products, to capture the credit risk of complex trading activities and reduce the incentive for regulatory arbitrage between the banking and trading books.  The proposed measures also include a stressed value-at-risk (VaR) requirement, which the BCBS “believes will help dampen the cyclicality of the minimum regulatory capital framework.”

The proposed enhancements to Basel II have not yet been implemented by the federal banking agencies in the US.  Once implemented, they will apply only to “core banks” required to adopt Basel II in the US and those banking institutions that opt-in to applying Basel II in the US.  A US depository institution is a core bank if it (1) has consolidated total assets of $250 billion or more on year-end regulatory reports, (2) has consolidated total on-balance sheet foreign exposure of $10 billion or more at the most recent year-end, or (3) is a subsidiary of another depository institution or bank holding company that is a core or opt-in bank.  Similarly, a US-chartered bank holding company is a core bank if the bank holding company either (i) meets the consolidated asset thresholds described above for banks (excluding from the $250 billion asset calculation assets of insurance underwriting subsidiaries), or (ii) has a subsidiary bank that is a core or opt-in bank.