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The Basel 3 "safety net" - higher capital requirements, new liquidity rules and transitional arrangements confirmed 

14 September 2010

1. Introduction

As widely anticipated, the oversight body of the Basel Committee announced on Sunday 12th September that it endorsed the capital and liquidity reform package originally proposed in December 2009 and amended in July 2010, otherwise known as "Basel 3".  The Basel 3 package was proposed to ensure the financial system cannot suffer the same type of collapse and resultant economic slowdown that occurred in 2007-2009 and it encompasses:

  • an unweighted leverage ratio;
  • two new capital buffers - conservation and counter-cyclical;
  • new and substantial capital charges for non-cleared derivative and other financial market transactions; and
  • major revisions to the rules on what types of instrument count as banks' capital.

In addition to confirming that the proposed rules detailed in the December 2009 Consultation Paper had been agreed, the Committee also announced new levels for capital ratios, which have been the subject of much heated discussion, debate and impact assessments.  Banks had argued that imposing too high capital ratios would lead to a possible double-dip recession, while regulators countered that, without robust ratios, a new crisis could occur in the near future.  While the Committee has clearly decided to increase the capital requirements quite substantially, in a concession to the fragile economic recovery the transitional arrangements announced are generous, with the full package not taking effect for 8 years.

Despite the longer implementation timetable, banks will now need to consider both the impact of the new quality of capital rules on their current capital base, as well as the increase in capital that certain assets (such as repos and derivatives) will require. While the impact of the Basel 3 rules on any individual bank will still depend upon how the relevant regulator applies the rules in practice and the asset/capital base of the particular bank, the publication of the calibrated ratios and rules is one of the most important developments for banks since the crisis began.  Taken together with other recent Committee driven changes (which, in part, have resulted in the capital related amendments to the Capital Requirements Directive (“CRD”) in Europe referred to as CRD 2 and CRD 3), Banks can now focus on future strategy to meet the combined effect of these rules. Set out below is a summary of both the new calibrated Basel 3 rules and the transitional arrangements.

2. New capital requirements

Capital ratios (and deductions)

  • Core Tier 1/common equity - currently the Basel 2 rules require that a bank holds 2% of Core Tier 1 capital (to risk weighted assets).  Core Tier 1 consists of ordinary shares, retained earnings and profits. The Basel 3 rules replace the concept of Core Tier 1 with a tougher categorisation of “common equity”, basically common shares plus retained income, and require banks to hold 4.5% of common equity.
  • Total Tier 1 - increases from the current 4% to 6% under Basel 3, which means that other types of Tier 1 instruments, known as additional going concern capital, can account for up to 1.5% of Tier 1 capital.
  • Total capital - the total minimum capital requirement remains at 8% (subject to the new capital buffer described below).  However, as 6% of capital must be Tier 1, this means Tier 2 (which will no longer be divided into upper and lower Tier 2) can only account for 2% of capital.  Tier 3, which currently is used solely for market risk purposes, is removed completely.
  • Deductions from capital - deductions from capital must generally be made from common equity Tier 1 under Basel 3.  This is tougher than the current rules, where a number of deductions are made from total capital. However, the July 2010 Basel 3 amendments did relax some of the proposed deductions, allowing partial inclusion of minority interests and certain deferred tax assets and mortgage servicing rights (rather than their deduction which had been proposed in December 2009).

New capital buffers

  • Capital conservation buffer - all banks will be required to hold sufficient capital to meet the minimum capital ratios detailed above, as well as have a "capital conservation buffer" above the minimum 8% total capital. This buffer is set at 2.5% and must be made up solely of common equity, after deductions. The impact of this requirement is that effectively common equity capital must be equal to 7% of risk-weighted assets other than in times of stress when the buffer can be drawn down. This, therefore, represents more than a three fold increase in the current 2% Core Tier 1 requirement. The purpose of this buffer is to ensure that banks can maintain capital levels throughout a significant downturn and that they have less discretion to deplete their capital buffers through dividend payments.  Banks that do not meet this buffer will be restricted from paying dividends, buying back shares and paying discretionary employee bonuses.
  • Counter-cyclical buffer - in addition to the conservation buffer, banks may at certain times be required to hold a counter-cyclical buffer of up to 2.5% of capital, in the form of common equity or other fully loss absorbing capital. This buffer is a macro-prudential tool to protect banks from periods of excessive credit growth and is at the national regulators’ discretion. It will therefore only apply when a national regulator thinks that there is excessive credit growth in the national economy and will be introduced as an extension of the capital conservation buffer.

Leverage ratio

While banks in the US have been subject to a leverage ratio for some time, this tool had never previously been part of the Basel regulatory framework.  The Committee has now agreed to test over a transition period (see "Timing and transitional arrangements” section below) an unweighted ratio of 3%. The Committee made a number of changes to features of the ratio in its July 2010 revisions, including allowing netting based on the Basel 2 rules.

Systemically important banks

The Committee states that systemically important banks should be subject to higher capital requirements than those in the Basel 3 package. Work continues on firm proposals. Options include capital surcharges, contingent capital and bail-in-debt.

Liquidity rules

The new liquidity coverage ratio and net stable funding ratio will be introduced in accordance with the timing detailed below. The Committee made a number of revisions to the components of both these ratios in the July 2010 revisions.

Increased capital requirements for derivatives, repos etc

The December 2009 Basel 3 proposals contained a number of proposals to substantially increase the capital requirements for counterparty credit exposures arising from banks non-cleared repo and securities and derivatives financing operations. These proposals, which were revised quite substantially in July 2010 are not mentioned at all in the September press release. This may be because the timing for implementation has to be co-ordinated with the European Commission which is due to announce its own proposals on the treatment of derivatives imminently.

3. Timing and transitional arrangements

Taking into account the continued fragility of global economic growth, there are very detailed transitional arrangements which are summarised below.

Common equity, Tier one, total capital and national implementation - the new capital ratios will be phased in gradually. National implementation must begin on 1 January 2013. At 1st January 2013, banks should have 3.5% common equity, 4.5% Tier 1 capital and 8% Total capital. In 2014, this increases to 4% common equity and 5.5% Tier 1. The full ratios must be in force by January 2015, namely 4.5% common equity and 6% Tier 1.

Grandfathering of existing capital instruments - capital instruments which do not meet the criteria for inclusion in the common equity element of Tier 1 cannot count as common equity from 1 January 2013. However, certain instruments issued by non-joint stock companies which currently are Core Tier 1 will be grandfathered on a declining basis over a longer period subject to specified conditions, including that they are treated as equity under prevailing accounting standards. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a ten year period, starting on 1st January 2013. On this date, their recognition will be capped at 90%, reducing 10% each year.  Instruments with an incentive to redeem will be phased out at their effective maturity date. Only instruments issued before 12 September 2010 qualify for the transitional arrangements. Existing public sector capital injections are grandfathered until 1 January 2018.

Regulatory deductions - deductions will be phased in, with  20% of the required deductions from common equity applying by 1 January 2014 and increasing 20% per year thereafter until 100% of the deductions are made from common equity by 1 January 2018.

Capital buffers - the capital conservation buffer will be phased in at 0.625% on 1 January 2016 and will reach 2.5% by 1 January 2019.  The Committee also states that Banks which meet their general ratios but remain below the target 7% common equity during the transition period should "maintain prudent earnings" so as to meet the buffer as soon as possible. It is unclear exactly what this means and whether it catches Banks which comply with the transitional capital buffer phase in requirements over the period until 1 January 2019 but do not meet the 7% requirement until that date, but it is thought that it does.

Leverage ratio - the 3% ratio requirement will parallel run from 1 January 2013 to 2017 meaning that the Committee will track the ratio, its component factors and impact over this period and will require Bank level disclosure of the ratio and its factors from 1 January 2015. Based on the results of the parallel run, final adjustments to the ratio will carried out in the first half of 2017 and it will be fully effective from 1st January 2018.

Liquidity ratios - the liquidity coverage ratio will be introduced on 1 January 2015, while the net stable funding ratio will apply as a minimum standard from 1 January 2018.

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