Alert December 21, 2010

Basel Committee Issues Final Basel III Rules and Publishes Results of its Quantitative Impact Study

The Basel Committee on Banking Supervision (the “Basel Committee”) issued the final version of its new Basel III capital rules on December 16, 2010.  Basel III is intended to protect financial stability and promote sustainable economic growth by setting out higher and better capital requirements, requiring better risk coverage, introducing a leverage ratio as a backstop to the risk-based requirement, instituting measures to promote the build up of capital that can be drawn down in periods of stress, and introducing a global liquidity framework.  In particular, the December 16, 2010 release provides details on the application of the two new liquidity standards under Basel III, the Liquidity Coverage Ratio (“LCR”) and the Net Stable Funding Ratio (“NSFR”).  Future editions of the Alert will provide additional information regarding the details of the LCR and the NSFR, as well as the remainder of the final Basel III rules.

The Basel Committee also released on December 16, 2010 the results of its comprehensive quantitative impact study (“QIS”) regarding the Basel III capital standards announced in July 2009 and the capital and liquidity proposals released in December 2009.  A total of 263 banks from 23 jurisdictions participated in the QIS, including 94 “Group 1 banks” (i.e., those banks with Tier 1 capital in excess of €3 billion (approximately $4 billion) that are considered well diversified and internationally active) and 169 Group 2 banks (i.e., all other banks).  The QIS did not take into account any transitional arrangements and instead assumed full implementation of the final Basel III rules, based on data as of year-end 2009.  Furthermore, the QIS did not take into account banks’ profitability or behavioral responses, such as changes in bank capital or balance sheet composition.

Including the effect of all changes to the definition of capital and risk-weighted assets, as well as assuming full implementation as of December 31, 2009, the average common equity Tier 1 capital ratio (“CET1”) of Group 1 banks was 5.7%, and the average CET1 of Group 2 banks was 7.8%.  The new minimum CET1 requirement under Basel III is 4.5%, plus a 2.5% capital conservation buffer, for a total of 7%.  The Basel Committee estimated that Group 1 banks in the aggregate would have had a shortfall of €577 billion (approximately $760 billion) from such requirement at the end of 2009.  Group 2 banks with CET1 ratios less than 7% would have required an additional €25 billion (approximately $33 billion).

With respect to the new liquidity requirements, the average LCR for Group 1 banks was 83%, while the average for Group 2 banks was 98%.  The average NSFR for Group 1 banks was 93%, and the average for Group 2 banks was 103%.  Banks will have until 2015 to meet the 100% LCR requirement, and until 2018 to meet the 100% NSFR requirement.  The Basel Committee noted that banks that are below the 100% required minimum thresholds can meet these standards by lengthening the term of their funding or restructuring business models.  Banks may also increase their holdings of liquid assets.  The Basel Committee also noted that the shortfalls in the LCR and the NSFR are not additive, as decreasing the shortfall in one standard may also result in a decrease in the shortfall in the other standard.

The QIS results also showed Group 1 banks having a weighted average leverage ratio of 2.8% at the end of 2009, and Group 2 banks having a weighted average leverage ratio of 3.8%.

The Basel Committee also published additional guidance for national authorities operating the countercyclical capital buffer, which is intended to protect the banking sector from periods of excess aggregate credit growth that have often been associated with the build-up of system-wide risk.  The Basel Committee noted that “in addition to providing guidance for national authorities, this document should help banks understand and anticipate the buffer decisions in the jurisdictions to which they have credit exposures.”  For additional information regarding the Basel III countercyclical capital buffer, please see the July 20, 2010 Alert.

Finally, the Basel Committee reiterated that it is continuing work related to systemic banks and contingent capital in coordination with the Financial Stability Board, and that it expects to issue a consultation paper on the capitalization of bank exposures to central counterparties soon.  The Alert will continue to monitor further developments and provide updates on material developments as they occur.