Alert August 03, 2010

Broad Agreement Reached on Basel III Capital and Liquidity Reform Package

The Basel Committee on Banking Supervision (the “BCBS”) announced that the central bank governors and heads of banking supervision agencies from the BCBS’s member countries reached “broad agreement on the overall design of the capital and liquidity reform package,” including the definition of capital, the treatment of counterparty credit risk, the leverage ratio, and the global liquidity standard.  The BCBS expects to finalize proposed capital buffers by the end of 2010, and the governors and heads of supervision agreed to finalize the capital set-aside requirements (i.e., the percentage of risk-weighted assets required to be held) and phase-in arrangements at their next meeting in September, 2010.  The BCBS also announced that it will publicly issue its economic impact assessment in August, 2010.

The BCBS noted that “one country still has concerns and has reserved its position until the decisions” on the final figures for the capital set-aside and the phase-in arrangements are decided in September, 2010.  Germany’s central bank, the Bundesbank, and its financial regulator, BaFin, later confirmed that Germany was the holdout, largely due to concerns regarding the definition of capital and how much capital a bank will be required to hold to meet Basel III criteria.  In particular, Germany is reportedly seeking greater recognition of “silent participations” in savings banks, which are nonvoting shares, including government loans, that buffer bank capital positions.

A brief description of a number of the modifications agreed to by the governors and heads of supervision follows.

Definition of Capital

The BCBS retained most of the definition of capital proposals set out in its December 2009 consultative package, but noted that it had concluded that “certain deductions could have potentially adverse consequences for particular business models and provisioning practices, and may not appropriately take into account evidence of realizable valuations during periods of extreme stress.”  Accordingly, a number of changes were agreed upon, including the following:

  • The BCBS will now allow “some prudent recognition of the minority interest supporting the risks of a subsidiary that is a bank,” while “excess capital above the minimum of a subsidiary that is a bank will be deducted in proportion to the minority interest share.”
  • The BCBS agreed to eliminate a counterparty credit restriction (which provided that gross long positions of unconsolidated investments in financial institutions could be deducted net of short positions only if the short positions involved no counterparty risk) on hedging of financial institution investments and to include an underwriting exemption.
  • Instead of requiring a full deduction of (1) significant investments (more than 10% of the issued share capital) in the common shares of unconsolidated financial institutions, (2) mortgage servicing rights, and (3) deferred tax assets, as proposed in December 2009, each such item may receive recognition up to 10% of a bank’s common equity component of Tier 1 capital.  A bank must deduct the amount by which the aggregate of these three items exceeds 15% of its common equity component of Tier 1, with the items included in the 15% aggregate limit being subject to full disclosure.

Counterparty Credit Risk

The BCBS also announced a number of modifications to “the treatment of counterparty credit risk, including the bond equivalent approach to calculating the credit valuation adjustment (CVA).”  These modifications include:

  • Modifying the bond equivalent approach to address hedging, risk capture, effective maturity and double counting;
  • Eliminating the 5x multiplier that was originally proposed to address the excessive calibration of the CVA;
  • Keeping the asset value correlation adjustment at 25%, but raising the threshold from $25 billion to $100 billion; and
  • Subjecting banks’ mark-to-market and collateral exposures to a central counterparty to a modest risk weight (in the 1-3% range).

Leverage Ratio

The BCBS agreed on a number of changes on the design and calibration for the leverage ratio, which will be calculated as an average over the quarter.  For off-balance sheet items, the BCBS agreed to use uniform credit conversion factors (“CCFs”), with a 10% CCF for unconditionally cancellable off-balance sheet commitments, subject to further review to ensure that the 10% CCF is appropriately conservative based on historical experience.  With respect to all derivatives (including credit derivatives), Basel II netting plus a simple measure of potential future exposure will be applied.

The BCBS is proposing to test a minimum Tier 1 leverage ratio of 3% during a parallel run period that will begin on January 1, 2013 and run through January 1, 2017.  Banks will be required to begin disclosing their individual leverage ratio figures on January 1, 2015.  Based on the results of this parallel run, any final adjustments would be carried out in the first half of 2017, with full implementation beginning on January 1, 2018.  The BCBS noted that while there is a “strong consensus to base the leverage ratio on the new definition of Tier 1 capital, the [BCBS] also will track the impact of using total capital and tangible common equity.”

Contingent Capital

At its July, 2010 meeting, the BCBS agreed to issue for consultation a “gone concern” proposal that requires capital to convert at the point of non-viability.  The BCBS will also review a “fleshed-out proposal” for the treatment of “going concern” contingent capital at its December 2010 meeting with a progress report in September 2010.

Global Liquidity Standard

The governors and heads of supervision endorsed a number of revisions to the liquidity coverage ratio (“LCR”), which is designed to ensure that banks have sufficient high quality liquid resources to survive an acute stress scenario lasting for one month, with respect to the definition of liquid assets and how to measure the safety of different types of funding.  These revisions include:

  • Retail and Small and Medium Sized Enterprise (“SME”) deposits: lowering the run-off rate floors to 5% (stable) and 10% (less stable), respectively, from 7.5% and 15%;
  • Operational activities with financial institution counterparties: introducing a 25% outflow bucket for custody and clearing and settlement activities, as well as selected cash management activities;
  • Deposits from domestic sovereigns, central banks, and public sector entities (“PSEs”): for unsecured funding, all sovereigns, central banks and PSEs will be treated as corporates (with a 75% roll-off rate), rather than as financial institutions with a 100% roll-off rate; for secured funding backed by assets that would not be included in the stock of liquid assets, a 25% roll-off of funding will be used;
  • Secured funding: only recognizing roll-over of transactions backed by liquidity buffer eligible assets;
  • Undrawn commitments: retail and SME credit lines will be lowered from 10% to 5%, and sovereigns, central banks, and PSEs will be treated similar to non-financial corporates with a 10% run-off for credit lines and a 100% run-off for liquidity lines;
  • Inflows: rather than leaving it to bank discretion to determine the percentage of “planned” net inflows, a concrete harmonized treatment will be established; and
  • Definition of liquid assets: all assets in the liquidity pool must be managed as part of that pool and are subject to operational requirements; the BCBS will also allow the inclusion of domestic sovereign debt for non-0% risk weighted sovereigns, issued in foreign currency, to the extent that this currency matches the currency needs of the bank’s operations in that jurisdiction; and will introduce a “Level 2” of liquid assets with a cap that allows up to 40% of the stock to be made up of these assets – including (with a 15% haircut) government and PSE assets qualifying for the 20% risk weighting under Basel II’s standardized approach for credit risk, and high quality non-financial corporate and covered bonds not issued by the bank itself.

The BCBS also noted that it remains committed to the introduction of the net stable funding ratio (“NSFR”) as “a longer term structural complement to the LCR.”  However, the initial NSFR proposal is being significantly modified with a number of adjustments under consideration, including: (i) raising the Available Stable Funding factor for stable and less stable retail and SME deposits from 85% and 70% to 90% and 80%, respectively; (ii) lowering the Required Stable Funding factor to 65% for residential mortgages and other loans that would qualify for the 35% or better risk weight under Basel II’s standardized approach; and (iii) lowering the extent to which off-balance sheet commitments would need to be pre-funded, by lowering the previous requirement of 10% stable funding to 5% required stable funding.  The BCBS noted that it will carry out an “observation phase” before finalizing and introducing the revised NSFR as a minimum standard by January 1, 2018.

Upon being finalized by the BCBS, the Basel III provisions will still need to be implemented in the U.S. by the federal banking agencies, which could result in changes from the international agreement.  In this regard, we note that Senator Christopher Dodd and Representative Barney Frank are each expected to hold hearings on the Basel III process amid reported concerns from some legislators that the proposed rules will be too weak.

The Alert will continue to monitor this area and provide updates on material developments as they occur.