On December 16, 2010, the Basel Committee on Banking Supervision (the “Basel Committee”) released the “final” text of its reforms to strengthen global capital and liquidity rules in order to create a more resilient banking industry. (As discussed in more detail below, additional guidance remains to be provided with respect to systemically important financial institutions.) These reforms, which are known as the “Basel III Framework,” are set out in two documents: “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” and “Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring.” The Basel III Framework, which addresses issues revealed by the crisis, is intended to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, thereby reducing the risk of spillover from the financial sector to the real economy.
The Basel III Framework is intended to strengthen the regulatory capital framework by, among other things: (i) raising the quality, consistency and transparency of the capital base; (ii) reducing procyclicality and promoting countercyclical buffers; (iii) enhancing risk coverage; (iv) supplementing the risk-based capital requirement with a leverage ratio; and (v) introducing a global liquidity standard.
The following is a summary of many of the key components of the Basel III Framework.
I. Raising the Quality, Consistency and Transparency of the Capital Base
Definition of Capital. The Basel Committee has proposed revising the definition of capital to, among other things, simplify and harmonize regulatory capital across jurisdictions. The Basel III Framework also demonstrates a greater focus on common equity, the highest quality component of a bank’s capital, and the goal of ensuring that Tier 1 capital can help a bank remain a going concern.
Under the Basel III Framework, and subject to certain transition periods discussed below, Common Equity Tier 1 capital must be at least 4.5% of risk-weighted assets at all times. For those banking organizations that issue common shares, this category generally must consist of common shares and retained earnings.
Tier 1 capital, which consists of Common Equity Tier 1 capital and Additional Tier 1 capital, must be at least 6.0% of risk-weighted assets. In order to qualify as Additional Tier 1 capital, an instrument must be able to help a bank remain a going concern. For example, in order to qualify as Additional Tier 1 capital, an instrument must, among other requirements: (a) be subordinated to depositors, general creditors and subordinated debt of the bank; (b) be perpetual (i.e., have no maturity date and no step-ups or other incentives to redeem); (c) be callable at the initiative of the issuer only after a minimum of five years, with prior supervisory approval; (d) have its principal repayable only with prior supervisory approval; (e) be fully discretionary with respect to the banking organization’s ability to cancel distributions/payments on dividends/coupons; and (f) not have a credit sensitive dividend feature.
An instrument that does not qualify as Tier 1 capital may nevertheless qualify as Tier 2 capital (or “gone-concern capital”) if it, among other things: (a) is subordinated to depositors and general creditors; (b) has a minimum original maturity of at least five years, with no incentives to redeem; (c) is callable at the initiative of the issuer only after a minimum of five years, with prior supervisory approval; (d) does not give investors rights to accelerate the repayment of future scheduled payments (coupon or principal), except in bankruptcy and liquidation; and (e) does not have a credit sensitive dividend feature.
The Basel III Framework also provides that certain items must be deducted or derecognized from capital (generally from the calculation of Common Equity Tier 1 capital), including the following: (1) goodwill and all other intangibles; (2) deferred tax assets that rely on future profitability of the banking organization in order to be realized; and (3) any increase in equity capital resulting from a securitization transaction. Furthermore, certain items, such as (i) significant investments in the common shares of unconsolidated financial institutions, (ii) mortgage servicing rights, and (iii) deferred tax assets that arise from temporary differences, receive only limited recognition (both on an individual and an aggregate basis) when calculating Common Equity Tier 1 capital.
Disclosures. In order to improve the transparency of regulatory capital and improve market discipline, the Basel III Framework requires banking organizations to make a number of disclosures. For example, banking organizations must provide a full reconciliation of all regulatory capital elements back to the balance sheet in its audited financial statements and must make a separate disclosure of all regulatory adjustments and the items not deducted from Common Equity Tier 1 capital. Banking organizations are also required to make available on their websites the full terms and conditions of all instruments included in regulatory capital. The Basel Committee noted that they will issue more detailed disclosure requirements in 2011.
Transition Arrangements. The Basel III Framework includes transitional arrangements for implementing the new capital standards in order to help ensure that the banking sector can meet such higher capital standards through reasonable earnings retention and capital raising, while still supporting lending to the economy.
As of January 1, 2013, banking organizations will be required to meet the following new minimum requirements: (a) 3.5% Common Equity Tier 1 capital; (b) 4.5% Tier 1 capital. The minimum Common Equity Tier 1 and Tier 1 requirements would then be phased-in over the following 2 years, with full implementation (i.e., a 4.5% Common Equity Tier 1 minimum and a 6.0% Tier 1 minimum) effective January 1, 2015. The total capital requirement will remain at the existing level of 8.0%, and therefore will not need to be phased-in.
Regulatory adjustments will begin at 20% of the required adjustments to Common Equity Tier 1 on January 1, 2014, and increase in 20% increments each year, reaching 100% on January 1, 2018. The same transition approach will apply to deductions from Additional Tier 1 and Tier 2 capital.
In addition, capital instruments that no longer qualify as Additional Tier 1 or Tier 2 capital will be subject to a gradual phase-out beginning on January 1, 2013. Specifically, their recognition will be capped at 90% from January 1, 2013, with the cap reducing by 10% in each subsequent year. Furthermore, existing public sector capital injections will be grandfathered until January 1, 2018.
II. Reducing Procyclicality and Promoting Countercyclical Buffers
The Basel III Framework introduces a regime to promote the conservation of capital and the build-up of adequate buffers above the minimum that can be drawn down in periods of stress. In particular, the Basel III Framework includes provisions for a capital conservation buffer and a countercyclical buffer.
Capital Conservation Buffer. The Basel III Framework provides for a capital conservation buffer of 2.5% of risk-weighted assets to be established above the regulatory minimum capital requirement. This buffer, which is designed to ensure that banking organizations build up capital buffers outside periods of stress that can be drawn down as losses are incurred, must be met with Common Equity Tier 1 capital.
Banking organizations that fail to maintain this buffer will be able to conduct business as usual, but will be subject to constraints on distributions (such as dividends, share buy-backs and bonuses). These distribution constraints will increase as a banking organization’s capital level approaches the minimum requirements. The Basel Committee noted that the constraints imposed on banks with capital levels at the top of the range would be minimal because it does not want to impose constraints for entering the buffer range that would be so restrictive as to result in the range being viewed as establishing a new minimum capital requirement. However, it remains to be seen how the market generally will view banking organizations that fall into the capital conservation buffer range.
The capital conservation buffer will be phased in beginning January 1, 2016 (at 0.625%) and increase each subsequent year by an additional 0.625 percentage points, to reach its full implementation level of 2.5% on January 1, 2019. The Basel Committee notes that banking organizations that already meet the minimum ratio requirement during the transition period but remain below the 7% Common Equity Tier 1 target (which includes the 4.5% minimum requirement plus the 2.5% capital conservation buffer) should aim to meet the conservation buffer as soon as reasonably possible.
Countercyclical Buffer. The Basel III Framework also incorporates a countercyclical buffer to be deployed by national supervisors when they determine that their jurisdiction is experiencing excess aggregate credit growth. It is expected that jurisdictions are likely to only need to deploy such a buffer on an infrequent basis (perhaps as infrequently as once every 10 to 20 years). An internationally active banking organization’s buffer would effectively be equal to a weighted average of the buffer add-ons applied in the jurisdictions to which it has exposures. Accordingly, internationally active banking organizations will likely find themselves subject to a small buffer on a more frequent basis, since credit cycles are not always highly correlated across jurisdictions.
The countercyclical buffer will vary between 0% and 2.5% of risk weighted assets, depending on the extent of the build up of system-wide risk, and must be met with Common Equity Tier 1 “or other fully loss absorbing capital.” (The Basel Committee noted that it is still reviewing the question of permitting other fully loss absorbing capital beyond Common Equity Tier 1 and what form it would take.) The buffer would act as an extension of the capital conservation buffer range, thereby subjecting banking organizations to restrictions on distributions if they do not meet the requirement.
In general, a jurisdiction would inform banking organizations up to 12 months in advance of its decision to raise the countercyclical buffer level in order to give them time to meet the additional capital requirements. Reductions in the countercyclical buffer would take effect immediately to help reduce the risk that the supply of credit would be constrained by such a buffer.
The countercyclical buffer regime will be phased-in with the capital conservation buffer beginning on January 1, 2016. The maximum countercyclical buffer requirement would be 0.625% on January 1, 2016, with a possible increase each subsequent year by an additional 0.625 percentage points, potentially reaching a final maximum level of 2.5% on January 1, 2019. Countries that experience excessive credit growth during the transition period may consider accelerating the build up of the capital conservation buffer and the countercyclical buffer.
III. Enhancing Risk Coverage
In addition to raising the quality and level of the capital base, the Basel III Framework also reforms the counterparty credit risk (“CCR”) framework to try to ensure that all material risks are being captured. These reforms are expected to raise capital requirements for the trading book and complex securitization exposures, which were a major source of losses for many internationally active banks. The Basel III Framework also introduces measures to strengthen the capital requirements for counterparty credit exposures arising from banking organizations’ derivatives, repo and securities financing activities, with the intention of raising capital buffers backing these exposures, reducing procyclicality, and providing additional incentives to move OTC derivative contracts to central counterparties.
For example, the Basel III Framework includes the following risk coverage reforms:
Requires banking organizations to determine their capital requirement for CCR using stressed inputs.
Requires banking organizations to add a capital charge to cover the risk of mark-to-market losses (i.e., credit valuation adjustment risk) associated with a deterioration in the credit worthiness of a counterparty.
Raises CCR management standards for the treatment of “wrong-way risk” (i.e., cases where the exposure increases when the credit quality of the counterparty deteriorates).
Applies an asset value correlation multiplier of 1.25 to exposures to certain financial institutions.
Strengthens standards for collateral management and initial margining (including by increasing the margin period of risk for certain netting sets of OTC derivatives and repo-style transactions).
Subjects banking organizations’ mark-to-market and collateral exposures to a qualifying central counterparty to a modest risk weight, currently proposed at 2%. (The Basel Committee noted that it separately will issue for public consultation a set of rules relating to the capitalization of bank exposures to central counterparties, with such standards to be finalized during 2011.)
Enhances the stress testing and backtesting requirements for banking organizations using the internal model method under Basel II.
IV. Leverage Ratio
The Basel III Framework introduces a simple, transparent, non-risk based leverage ratio in order to constrain the build-up of leverage in the banking sector. The basis of calculation will be the average of the monthly leverage ratio over the quarter based on the definitions of capital (the capital measure) and total exposure (the exposure measure). The Basel III Framework proposes to test a minimum Tier 1 leverage ratio of 3% during a parallel run period from January 1, 2013 to January 1, 2017.
The capital measure for the leverage ratio will be based on the new definition of Tier 1 capital as set out in the Basel III Framework. The Basel Committee noted that it will also collect data during the transition period to track the impact of using total regulatory capital and Common Equity Tier 1 capital.
The exposure measure should generally follow the accounting measure of exposures and will capture both on-balance sheet and certain off-balance sheet items (including certain derivatives transactions, securities financing transactions, and commitments).
The transition period for the leverage ratio will commence with a supervisory monitoring period beginning January 1, 2011. As noted above, a parallel run period will run from January 1, 2013 until January 1, 2017. Banking organization level disclosure will start on January 1, 2015. Based on the results of the parallel run period, any final adjustments to the leverage ratio will be carried out in the first half of 2017, with a view to full implementation on January 1, 2018.
V. Global Liquidity Standards
The Basel III Framework introduces two minimum standards for funding liquidity in order to achieve two separate but complementary objectives. Specifically, the Liquidity Coverage Ratio (“LCR”) was designed to promote short-term resilience of a banking organization’s liquidity risk profile by ensuring that it maintains an adequate level of unencumbered, high‑quality liquid assets to survive a significant stress scenario lasting for 30 days. The Net Stable Funding Ratio (“NSFR”) was developed to promote resilience over a longer time horizon by establishing a minimum acceptable amount of stable funding based on the liquidity characteristics of an institution’s assets and activities over a one year horizon.
Liquid Coverage Ratio. The LCR builds on traditional liquidity “coverage ratio” methodologies used internally by banks to assess exposure to contingent liquidity events. Pursuant to the LCR, a banking organization’s ratio of “stock of high-quality liquid assets” to “total net cash outflows over the next 30 calendar days” must be at least 100% (i.e., the stock of high-quality liquid assets must at least equal total net cash outflows) under a prescribed short-term stress scenario that incorporates many of the shocks experienced during the recent financial crisis.
As indicated above, the numerator of the LCR is the “stock of high quality liquid assets,” and under the LCR banks must hold a sufficient stock of unencumbered high-quality liquid assets. In order to qualify as a “high-quality liquid asset,” an asset should be liquid in markets during a time of stress (i.e., easily and immediately converted into cash at little or no loss of value) and, ideally, be eligible at central banks for intraday liquidity needs and overnight liquidity facilities.
The LCR separates assets that can be included in the stock into two categories: “Level 1” assets and “Level 2” assets. Level 1 assets, which are limited to the highest quality liquid assets (such as cash, certain central bank reserves, and certain marketable securities representing claims on or guaranteed by sovereigns or central banks), may comprise an unlimited share of the pool of high-quality liquid assets and are not subject to a haircut. Level 2 assets, which include somewhat lower quality assets than those eligible to be Level 1 assets, may comprise no more than 40% of the overall stock, after applying a minimum 15% haircut to the current market value of each such Level 2 asset.
The denominator of the LCR (total net cash outflows) equals the total expected cash outflows minus total expected cash inflows in the specified stress scenario for the subsequent 30 days. Total expected cash outflows are calculated by multiplying the outstanding balances of various types of liabilities and off-balance sheet commitments by rates at which they are expected to run off or be drawn down. (For example, “stable” retail deposits generally would have a run-off rate of 5% while unsecured wholesale funding provided by most non-financial corporate customers would have a run-off rate of 75%).
Total expected cash inflows are calculated by multiplying the outstanding balances of various categories of contractual receivables by the rates at which they are expected to flow in under the specified stress scenario, up to an aggregate cap of 75% of total expected cash outflows. When considering its available cash inflows, a banking organization should only include contractual inflows from outstanding exposures that are fully performing and for which the banking organization has no reason to expect a default within the 30-day time horizon. The scenario does not consider inflows from committed credit or liquidity facilities from other institutions in order to reduce the risk of liquidity shortages at one bank causing shortages at other banks. For most transactions, though, whether secured or unsecured, the inflow rate will be determined by the counterparty.
Net Stable Funding Ratio. The NSFR builds on traditional “net liquid asset” and “cash capital” methodologies widely used by internationally active banking organizations, bank analysts and rating agencies. Pursuant to the NSFR, a banking organization’s “Available amount of stable funding” (“ASF”) must be greater than its “Required amount of stable funding” (“RSF”). “Stable funding” is defined as “the portion of those types and amounts of equity and liability financing expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress.”
ASF is defined as the total amount of a banking organization’s: (a) capital; (b) preferred stock with maturity of at least one year; (c) liabilities with effective maturities of at least one year; and (d) that portion of non-maturity deposits, term deposits, and/or wholesale funding with maturities of less than one year that would be expected to stay with the banking organization for an extended period in an idiosyncratic stress event. Each category of ASF is assigned an “ASF factor” of between 0% and 100%, with less stable funding sources receiving a higher factor. The amount assigned to each category is then multiplied by the appropriate ASF factor, and the total ASF is the sum of the weighted amounts.
The amount of stable funding required for a particular banking organization depends on the broad characteristics of the liquidity profiles of its assets, off-balance sheet exposures and other activities. The RSF is calculated as the sum of the value of the assets held and funded by the banking organization and the amount of off-balance sheet activity (or potential liquidity exposure), multiplied by a specific required RSF factor assigned to each particular asset type or off-balance sheet category. Assets that are considered more liquid in the applicable stressed environment receive lower RSF factors (and therefore require less stable funding).
Frequency of Calculation and Reporting. Banking organizations are expected to meet the requirements of the LCR and NSFR continuously. The LCR should be reported at least monthly, and more frequently in stressed situations (at the discretion of the applicable supervisor). The NSFR should be calculated and reported at least quarterly.
Transitional arrangements. Both the LCR and the NSFR will be subject to an observation period beginning in 2011 which will be used to monitor the implications of these standards and address any unintended consequences. In order to give banking organizations time to develop their reporting systems, reporting to supervisors will first be expected by January 1, 2012. The LCR will be introduced on January 1, 2015, and the NSFR will become a minimum standard by January 1, 2018.
Monitoring Tools. In addition to the LCR and NSFR standards, the Basel III Framework notes that the following metrics can be used by supervisors as consistent monitoring tools: (1) contractual maturity mismatch; (2) concentration of funding; (3) available unencumbered assets; (4) LCR by significant currency; and (5) market-related monitoring tools.
VI. Systemically Important Financial Institutions
The Basel Committee has stated that systemically important financial institutions (“SIFIs”) should have loss absorbing capacity beyond the minimum standards, but has not yet provided specific details. In connection with the release of the Basel III Framework, the Basel Committee noted that it is continuing to work with the Financial Stability Board in developing an integrated approach to SIFIs which could include combinations of capital surcharges, contingent capital and bail-in debt. The Basel Committee is also developing a proposal on a methodology (which would comprise both quantitative and qualitative indicators) to assess the systemic importance of financial institutions at a global level. Additional information with respect to SIFIs is expected to be provided in 2011.
VII. U.S. Implementation
It is important to note that the Basel III Framework is not self-executing, but rather needs to be adopted by the U.S. federal banking regulators in order to become effective in the U.S. While Treasury Secretary Geithner and the U.S. federal banking regulators have all expressed support for Basel III, the timing and scope of its implementation, as well as any potential modifications or adjustments that may result during the implementation process, are not yet known.
The Alert will continue to monitor and report on important developments in this area.