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Asia Banking and Projects 

Basel III: a short guide  

01 October 2010

Edward Chan, a Partner in our London Banking team, was recently the guest speaker at the Asia Pacific Loan Market Association (APLMA), specially convened seminar on the proposed revisions and additions to the Basel II capital adequacy regime (the proposals being collectively referred to as Basel III). This was held in Hong Kong on September 13, 2010. He has also recently authored an article for the APLMA's newsletter (Autumn 2010, Issue No. 38) on this topic. 

We set out below the article as it appeared in the APLMA Newsletter:

Background

In the aftermath of the financial crisis, the Basel Committee on Banking Supervision proposed some major revisions and additions to the existing Basel II capital adequacy regime in December 2009 in two consultation papers entitled “Strengthening the resilience of the banking sector” and “International framework for liquidity risk measurement, standards and monitoring”.

These proposals, collectively referred to as Basel III, form part of the global regulatory response to the crisis and will be endorsed by the G-20 group of finance ministers and central bank governors.  These reforms are intended to promote a more resilient banking sector and to improve the sector’s ability to absorb shocks arising from financial stress (thereby reducing the risk of any spillover effect from the financial sector into the real economy).

The proposed package of reforms seek:

  • to improve the quality of capital;
  • to increase risk weightings for derivatives and repos;
  • to introduce a leverage ratio;
  • to address pro-cyclicality;
  • to improve liquidity management; and
  • to deal with risks posed by systemically important financial institutions.

In relation to each of these key areas of reform:

Capital

The Basel Committee identified a reduction in the quality of bank capital.  Under the current regime, Tier 1 capital had moved too far away from common equity.  Consequently, banks could report high Tier 1 ratios while holding as little as 2% common equity to risk-weighted assets.  Pursuant to the Basel Committee’s proposals:  

  • Tier 1 capital:  Tier 1 capital will increase to 6% of risk-weighted assets by 1 January 2015 (up from the current level of 4%).
  • Common equity:  Common equity will need to form the predominant part of Tier 1 capital and must reach 3.5% of risk-weighted assets by 1 January 2013, 4% by 1 January 2014 and 4.5% by 1 January 2015 (up from the current level of 2%).  Only ordinary shares and retained income will qualify as “common equity”, making this more restrictive than the current concept of “Core Tier 1”.
  • Additional going concern capital:  The remainder of Tier 1 capital (representing up to 1.5% of risk-weighted assets) can be made up of "additional going concern capital”.  This is broader than common shares but there are strict criteria on loss absorbency and other features.   
  • Other tiers of capital:  Tier 2 capital will be simplified and will no longer be sub-divided into upper and lower Tier 2 capital.  Tier 3 will be phased out completely.
  • Grandfathering:  Capital instruments which do not meet the criteria for inclusion in the common equity element of Tier 1 capital cannot count as such from 1 January 2013, subject to an exception for non-joint stock companies whose Core Tier 1 will be grandfathered on a declining basis over a longer period provided certain conditions are met.  There are a number of other grandfathering provisions.  
  • Conversion/write-off:  In addition, the Basel Committee has recently issued a consultation paper on a requirement for all regulatory capital instruments to have a conversion/write-off  mechanism so that subordinated debt-holders incur losses (together with the shareholders) when a bank is rescued or close to insolvency.  This is known as a “bail-in”.  In its recent paper on the loss absorbency of capital instruments, the Basel Committee focused on a number of other characteristics that makes regulatory capital sufficiently loss absorbent, which could mean many current Tier 2 instruments fail to meet these criteria.
  • Deductions from capital:  One of the more controversial aspects of the reform package was the increased scope of deductions, including deferred tax assets, minority interests, goodwill and other intangibles.  The deduction rules have been relaxed quite considerably by the Basel Committee in July 2010, but deductions will still generally have to be made from common equity Tier 1, rather than the total of Tier 1 and 2 which is currently the case.  The deductions will be phased in, increasing by 20% over a four year period between 1 January 2015 and 31 December 2018.  There will be harmonisation of deductions across jurisdictions.

Risk weightings

The Basel Committee noted that, whilst the trading books of banks suffered substantial losses in the recent crisis, the amount of capital held against trading book risks was minimal. 

The Basel Committee had, in July 2009, announced certain measures (referred to as Basel II enhancements) which prescribed increased capital charges for securitisations and credit-related trading book assets.  These are due to come into effect in December 2011.

The Basel III measures seek to strengthen the requirements for counterparty credit risk exposures arising from derivatives, repos, securities financing transactions and related activities.  These include:

  • a stressed counterparty risk capital charge based on stressed inputs;
  • a capital charge for credit value adjustment risk (risk associated with deterioration in a counterparty’s creditworthiness);
  • a capital charge for specific wrong way risk (where exposure to a counterparty is positively correlated with the probability of default of that counterparty);
  • incentives to use central counterparties to clear over-the-counter (OTC) derivatives;
  • an interconnectedness multiplier of 1.5% will also be applied to exposures to large regulated firms (with assets of at least US$100bn) and all non-regulated firms; and
  • tougher collateral, valuation, margining and stress-testing requirements.

These capital charges are designed to price risk more accurately which, in turn, will require banks to hold more capital to support trading book activities.  It is unclear when these changes to the current rules will become in force, but it is possible that it could be as early as the end of 2011.

Leverage ratio

A leverage ratio (which is the ratio of a bank’s capital to its total exposures) will be introduced.  This ratio is intended to prevent an undercapitalised bank from growing too large as it limits how much that bank can borrow relative to its capital base.

The leverage ratio will be set at 3% of common equity for the “parallel run” period from 2013 to 2017.  Based on the results from the parallel run, this ration may be adjusted and will become fully effective at the start of 2018.  Total exposures for this purpose will include all on-balance sheet exposures (measured gross without taking any collateral into account) and off balance sheet items.

Pro-cyclicality

Measures to deal with the inherent pro-cyclicality of Basel II regime will be introduced, under which banks are in effect required to hold less capital in an upturn and more in a downturn, thus exacerbating losses that flow through into the real economy.  To address any such pro-cyclicality,the Basel Committee has proposed the following:

  • Capital conservation range:  Each bank will be required to create a capital buffer equal to 2.5% of risk-weighted assets, beyond minimum capital requirements, which it can draw down in a downturn.  This buffer is to be made up of common equity only and must be maintained at all times.  If a bank’s capital falls within this capital conservation range, that bank will face restrictions on paying dividends or returning capital to shareholders and on paying bonuses to employees.  This buffer will be phased in gradually between 1 January 2016, when it starts at 0.625% and 1 January 2019, when it reaches 2.5%.
  • Counter-cyclical buffer:  In addition, banks may be required at certain times to hold a further counter-cyclical buffer.  This buffer, which can range from 0% to 2.5% of risk-weighted assets, will be set by the relevant national regulator (acting in its sole discretion) and is intended to be a macro-prudential tool to protect banks from excessive credit growth.  The counter-cyclical buffer will be met with Tier 1 capital.
  • PD measurement:  Banks using an internal ratings based (IRB) approach will need to use either the highest average of probability of default (PD) of each exposure class or an average of historic PD estimates.
  • Expected loss provisioning:  Banks will make provisions for expected credit losses before there is evidence of impairment in relation to the relevant assets.  This is to encourage provisioning to start earlier in the economic cycle and, over time, to “smooth” the recognition of provisions.

Liquidity

The Basel III documents proposed two new quantitative tests, the short-term liquidity coverage ratio (“LCR”) and the longer term net stable funding ratio (“NSFR”), together with the adoption of minimum standards and metrics for monitoring liquidity risk on an internationally harmonised basis.

LCR:  The LCR is designed to ensure that a bank has sufficient high quality unencumbered assets to enable it to survive a short-term (30-day) period of acute stress.  To meet the LCR,banks will be required to hold a larger buffer of specified assets. 

Certain contingent obligations, such as undrawn committed liquidity and credit facilities (the scope of which are currently unclear as a result of inexact drafting), can require up to 100% liquidity coverage. 

An observation period will begin in 2011, while the LCR will be fully effective on 1 January 2015.

NSFR:  The NSFR test considers the robustness of a bank’s funding position (based on that bank’s assets and activities) over a one-year period during which it is subject to an institution-specific stress of which there is public awareness and which results in specific impacts (for instance, a three-notch credit rating downgrade). 

Effectively, the NSFR will require Banks to increase longer-term funding, particularly for illiquid assets and off-balance sheet exposures, securitisation structures and other assets which during the economic crisis proved be a significant liquidity drain in times of stress.  It does this by requiring a bank to value a certain proportion of each asset as illiquid and against which “stable” (or “sticky”) funding must be held.  

Implementation will be delayed until 1 January 2018 after a monitoring period (which itself could result in further changes).

Systemically important financial institutions

In its September 2010 press release, the Basel Committee announced that “systemically important banks” should have “loss absorbing capacity beyond the standards announced today”.  The Basel Committee and the Financial Stability Board are jointly developing an approach to this issue (and have been for quite a while which appears to show the difficulty in reaching consensus), which could include combinations of capital surcharges, contingent capital and debt bail-in. However, given the raft of other proposals the Committee is currently developing, this issuer appears to have been given a “back-seat” at the moment.  The Basel Committee has not appeared to focus at all on the idea of breaking up large banks, or restricting retail deposit taking banks from certain risky activities (such as the US Volker rule).

Timing

The details of Basel III are to be finalised by the end of 2010 and be presented to the G20 during the summit in Seoul.  Taking into account the continued fragility of global economic growth, there are detailed transitional arrangements for each of the reform proposals.  Capital ratios will not be in full force until 2015, leverage and liquidity rules will not be fully effective until 2018 and capital buffers will not be fully implemented until 2019.

Issues to consider

The Basel Committee’s proposals should prompt a bank to consider the following strategic consequences:

  • whether or not a bank needs (or is able) to raise further capital (and, in particular, common equity) in order to meet the new capital ratios and buffers;
  • whether or not the bank will need to conserve capital (for instance, by hiving-off or reducing business areas which are capital-hungry);
  • whether or not the bank will need to de-leverage or otherwise reduce its balance sheet;
  • the constraints arising from having to hold liquid assets to meet the LCR;
  • whether or not it is able to obtain sufficient amounts of longer-term stable financing;
  • the impact of wider regulatory reform (for instance, Dodd-Frank in the US and the Vickers Commission in the UK); and
  • given the impact of various regulatory proposals on a bank’s competitors, what opportunities a better-capitalised or better-funded bank will have to acquire businesses and assets.

Taken together, these strategic issues are likely to go to the heart of what a bank will look like in the post-Basel III world (not only in terms of its own size, shape and business mix but also its competitive position relative to other banks and financial institutions).

Your Contacts

Edward Chan
Partner
+44 20 7456 4320
edward.chan@linklaters.com

Umesh Kumar
Partner
+852 2842 4894
umesh.kumar@linklaters.com

Trevor Clark
Partner
+852 2901 5223
trevor.clark@linklaters.com

Carl Fernandes
Partner
+852 2842 4186
carl.fernandes@linklaters.com

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