Basel Committee sets higher global capital standards for banks

The group of central bankers and regulators who oversee the Basel Committee on Banking Supervision has announced new capital and liquidity rules for banks to strengthen their resilience against future financial shocks. Kanaga Raja examines this new package of reforms known as Basel III.

THE Group of Governors and Heads of Supervision of the Basel Committee on Banking Supervision (BCBS) on 12 September announced a package of reforms aimed at strengthening substantially the existing capital requirements of banks, in order for them to be able to successfully withstand future financial and banking crises.

The package of reforms, referred to as Basel III, would amongst others increase the minimum common equity requirement of banks, the highest form of loss-absorbing capital, from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments.

In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress, bringing the total common equity requirements to 7%.

National implementation by member countries of the new standards begins on 1 January 2013.

Amongst others, banks will be required to meet the new minimum requirements in relation to risk-weighted assets as of 1 January 2013. The minimum common equity and Tier 1 requirements will be phased in between 1 January 2013 and 1 January 2015.

Furthermore, the regulatory adjustments would be fully deducted from common equity by 1 January 2018, while the capital conservation buffer will be phased in between 1 January 2016 and year end 2018, becoming fully effective on 1 January 2019.

'Fundamental strengthening'

A press release issued by the Basel Committee quoted Jean-Claude Trichet, President of the European Central Bank and Chairman of the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee, as saying that 'the agreements reached today are a fundamental strengthening of global capital standards'.

He added: 'Their contribution to long-term financial stability and growth will be substantial. The transition arrangements will enable banks to meet the new standards while supporting the economic recovery.'

'The combination of a much stronger definition of capital, higher minimum requirements and the introduction of new capital buffers will ensure that banks are better able to withstand periods of economic and financial stress, therefore supporting economic growth,' said Nout Wellink, Chairman of the Basel Committee and President of the Netherlands Bank.

[The Basel Group took up in the 1980s the setting up of global capital standards, and negotiated and reached an accord of principles and rules in 1988, known now as Basel I, which came into force in 1992. Very soon, some of its inadequacies, particularly on issues relating to 'securitisation' etc, became evident. Even the Basel Group became seized of this, there was the so-called Asian financial crisis in 1997, and its aftermath.

[The Basel Committee, which had taken revision of Basel I, issued its first proposals in 1999, and after a series of further clarifications and proposals, Basel II was agreed among the key countries, to be brought into force by countries after a one-year transition. The entry into force of Basel II in the case of the United States (where there were four different regulatory authorities for different kinds of banking institutions) was further delayed and became effective only in 2008. By then, the United States had found itself in the midst of the worst financial crisis.

[The crisis though brought into clearer focus the inadequacies as well as the need for further tightening and clarification, and the work on Basel III had begun. A clearer picture emerged by December 2009, and these have now been agreed upon and issued on 12 September, and it is to be considered by the leaders of the Group of 20 (G20) major economies and agreed upon at their Seoul summit in November.]

In a press release also issued on 12 September, the Board of Governors of the US Federal Reserve System, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation voiced their active support for the Group of Governors and Heads of Supervision and the Basel Committee to increase the quality, quantity and international consistency of capital, to strengthen liquidity standards, to discourage excessive leverage and risk-taking, and to reduce pro-cyclicality in regulatory requirements.

The US federal banking agencies added that 'the agreement reached represents a significant step forward in reducing the incidence and severity of future financial crises, providing for a more stable banking system that is less prone to excessive risk-taking, and better able to absorb losses while continuing to perform its essential function of providing credit to creditworthy households and businesses.'

The new standards

The Group of Governors and Heads of Supervision of the Basel Committee fully endorsed the agreements that it had reached on 26 July 2010. (It had left some crucial details to be agreed on in September.)

Back in July, Germany was the sole member out of the 27 member countries of the Basel Committee that had reserved its position until the decisions on calibration and phase-in arrangements were finalised in September.

According to media reports, Germany signed on to the agreement on 12 September. Media reports also quoted analysts as saying that most US banks are already in compliance with the new standards, but that some European banks would have to raise additional capital to meet the new requirements, either by not paying out dividends to shareholders or by issuing new stock.

According to the Basel Committee press release, under the agreements reached on 12 September, the minimum requirement for common equity will increase from 2% to 4.5%. This will be phased in by 1 January 2015.

The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6% over the same period.

It was also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity, after the application of deductions.

According to the press release, the purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions.

This framework will reinforce the objective of sound supervision and bank governance and address the collective action problem that has prevented some banks from curtailing distributions such as discretionary bonuses and high dividends, even in the face of deteriorating capital positions.

A counter-cyclical buffer within a range of 0%-2.5% of common equity or other fully loss-absorbing capital will be implemented according to national circumstances. The purpose of the counter-cyclical buffer is to achieve the broader macro-prudential goal of protecting the banking sector from periods of excess aggregate credit growth.

For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system-wide build-up of risk. The counter-cyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

According to the press release, these capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described above.

In July, Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3% during the parallel run period. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

The Governors and Heads of Supervision also agreed on transitional arrangements for implementing the new standards. These will help ensure that the banking sector can meet the higher capital standards through reasonable earnings retention and capital raising, while still supporting lending to the economy.

Transitional arrangements

According to the Basel Committee press release, the transitional arrangements include:

* National implementation by member countries will begin on 1 January 2013. Member countries must translate the rules into national laws and regulations before this date. As of 1 January 2013, banks will be required to meet the following new minimum requirements in relation to risk-weighted assets (RWAs): 3.5% common equity/RWAs; 4.5% Tier 1 capital/RWAs, and 8.0% total capital/RWAs.

The minimum common equity and Tier 1 requirements will be phased in between 1 January 2013 and 1 January 2015. On 1 January 2013, the minimum common equity requirement will rise from the current 2% level to 3.5%. The Tier 1 capital requirement will rise from 4% to 4.5%. On 1 January 2014, banks will have to meet a 4% minimum common equity requirement and a Tier 1 requirement of 5.5%. On 1 January 2015, banks will have to meet the 4.5% common equity and the 6% Tier 1 requirements.

The total capital requirement remains at the existing level of 8.0% and so does not need to be phased in. The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 and higher forms of capital.

* The regulatory adjustments (i.e. deductions and prudential filters), including amounts above the aggregate 15% limit for investments in financial institutions, mortgage servicing rights, and deferred tax assets from timing differences, would be fully deducted from common equity by 1 January 2018.

In particular, says the press release, the regulatory adjustments will begin at 20% of the required deductions from common equity on 1 January 2014, 40% on 1 January 2015, 60% on 1 January 2016, 80% on 1 January 2017, and reach 100% on 1 January 2018. During this transition period, the remainder not deducted from common equity will continue to be subject to existing national treatments.

*   The capital conservation buffer will be phased in between 1 January 2016 and year end 2018, becoming fully effective on 1 January 2019. It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.

*  Existing public sector capital injections will be grandfathered until 1 January 2018. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a 10-year horizon beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year. In addition, instruments with an incentive to be redeemed will be phased out at their effective maturity date.

*  Capital instruments that do not meet the criteria for inclusion in common equity Tier 1 will be excluded from common equity Tier 1 as of 1 January 2013. However, instruments meeting the following three conditions will be phased out over the same horizon described in the previous bullet point: (1) they are issued by a non-joint stock company; (2) they are treated as equity under the prevailing accounting standards; and (3) they receive unlimited recognition as part of Tier 1 capital under current national banking law.

According to the press release, the phase-in arrangements for the leverage ratio were announced on 26 July, whereby the supervisory monitoring period will commence on 1 January 2011, and the parallel run period will commence on 1 January 2013 and run until 1 January 2017.

The disclosure of the leverage ratio and its components will start on 1 January 2015. Based on the results of the parallel run period, any final adjustments will be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

After an observation period beginning in 2011, the liquidity coverage ratio (LCR) will be introduced on 1 January 2015. The revised new stable funding ratio (NSFR) will move to a minimum standard by 1 January 2018, said the press release.         

Kanaga Raja is the Editor of the South-North Development Monitor (SUNS), which is published by the Third World Network. This article is reproduced from SUNS (No. 6996, 14 September 2010).

*Third World Resurgence No. 240/241, August-September 2010, pp 7-9