Basel 3

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See also bank capital, Bank for International Settlements, Basel Committee on Banking Supervision, Basel 2, capital adequacy, liquidity and procyclicality.

Contents

Basel 3 rules published

The Basel Committee issued today the Basel III rules text, which presents the details of global regulatory standards on bank capital adequacy and liquidity agreed by the Governors and Heads of Supervision, and endorsed by the G20 Leaders at their November Seoul summit. The Committee also published the results of its comprehensive quantitative impact study (QIS).

Mr Nout Wellink, Chairman of the Basel Committee on Banking Supervision and President of the Netherlands Bank, described the Basel III Framework as "a landmark achievement that will help protect financial stability and promote sustainable economic growth. The higher levels of capital, combined with a global liquidity framework, will significantly reduce the probability and severity of banking crises in the future." He added that "with these reforms, the Basel Committee has delivered on the banking reform agenda for internationally active banks set out by the G20 Leaders at their Pittsburgh summit in September 2009".

The rules text presents the details of the Basel III Framework, which covers both microprudential and macroprudential elements. The Framework sets out higher and better-quality capital, better risk coverage, the introduction of a leverage ratio as a backstop to the risk-based requirement, measures to promote the build up of capital that can be drawn down in periods of stress, and the introduction of two global liquidity standards.

Transition and implementation

The Committee has put in place processes to ensure the rigorous and consistent global implementation of the Basel III Framework. The standards will be phased in gradually so that the banking sector can move to the higher capital and liquidity standards while supporting lending to the economy.

With respect to the leverage ratio, the Committee will use the transition period to assess whether its proposed design and calibration is appropriate over a full credit cycle and for different types of business models. Based on the results of a parallel run period, any 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.

Both the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) will be subject to an observation period and will include a review clause to address any unintended consequences.

QIS results

The Committee today released the Results of the comprehensive quantitative impact study. The Committee conducted a comprehensive QIS exercise to assess the impact of capital adequacy standards announced in July 2009 and the Basel III capital and liquidity proposals published in December 2009. A total of 263 banks from 23 Committee member jurisdictions participated in the QIS exercise. This included 94 Group 1 banks (ie those that have Tier 1 capital in excess of €3 billion, are well diversified and are internationally active) and 169 Group 2 banks (ie all other banks).

The QIS did not take into account any transitional arrangements such as the phase-in of deductions and grandfathering arrangements. Instead, the estimates presented assume full implementation of the final Basel III package, based on data as of year-end 2009. No assumptions were made about banks' profitability or behavioural responses, such as changes in bank capital or balance sheet composition, since then or in the future. For that reason the QIS results are not comparable to industry estimates, which tend to be based on forecasts and consider management actions to mitigate the impact and which incorporate analysts' estimates where information is not publicly available.

Including the effect of all changes to the definition of capital and risk-weighted assets, as well as assuming full implementation as of 31 December 2009, the average common equity Tier 1 capital ratio (CET1) of Group 1 banks was 5.7%, as compared with the new minimum requirement of 4.5%. For Group 2 banks, the average CET1 ratio stood at 7.8%. In order for all Group 1 banks in the sample to meet the new 4.5% CET1 ratio, the additional capital needed is estimated to be €165 billion. For Group 2 banks, the amount is €8 billion.

Relative to a 7% CET1 level, which includes both the 4.5% minimum requirement and the 2.5% capital conservation buffer, the Committee estimated that Group 1 banks in aggregate would have had a shortfall of €577 billion at the end of 2009. As a point of reference, for this sample of banks the sum of profits after tax and prior to distributions in 2009 was €209 billion. Group 2 banks with CET1 ratios less than 7% would have required an additional €25 billion; the sum of these banks' profits after tax and prior to distributions in 2009 was €20 billion. Since the end of 2009, banks have continued to raise their common equity capital levels through combinations of equity issuance and profit retention.

The Committee also assessed the estimated impact of the liquidity standards. Assuming banks were to make no changes to their liquidity risk profile or funding structure, as of end-2009:

  • The average LCR for Group 1 banks was 83%; the average for Group 2 banks was 98%.
  • The average NSFR for Group 1 banks was 93%; the average for Group 2 banks was 103%.

Banks have until 2015 to meet the LCR standard and until 2018 to meet the NSFR standard, which will reflect any revisions following each standard's observation period. Banks that are below the 100% required minimum thresholds can meet these standards by, for example, lengthening the term of their funding or restructuring business models which are most vulnerable to liquidity risk in periods of stress. It should be 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.

Mr Wellink noted that "the Basel III capital and liquidity standards will gradually raise the level of high-quality capital in the banking system, increase liquidity buffers and reduce unstable funding structures. The transition period provides banks with ample time to move to the new standards in a manner consistent with a sound economic recovery, while raising the safeguards in the system against economic or financial shocks". He added that in the case of the liquidity standards, "we will use the observation period for the liquidity ratios to ensure that we have their design and calibration right and that there are no unintended consequences, at either the banking sector or the broader system level".

The Basel Committee and the Financial Stability Board (FSB) are also issuing an updated report of the Macroeconomic Assessment Group which analyses the economic impact of the Basel III reforms over the transition period. The updated report and a separate press release will be issued in the coming days.

The Committee also issued today Guidance for national authorities operating the countercyclical capital buffer as a supplement to the requirements set out in the Basel III rules text. The primary aim of the countercyclical capital buffer regime is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth that have often been associated with the build-up of system-wide risk. 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.

The Committee is conducting further work on systemic banks and contingent capital in close coordination with the FSB. In the coming days, the Committee will also issue a consultation paper on the capitalisation of bank exposures to central counterparties.

Basel III Framework: US/EU Comparison

The US and EU rules implementing Basel III follow many aspects of Basel III closely, but there are major differences in approach in several key areas. Financial institutions have been engaged in a "race to the top" to show strong capital ratios but rules on leverage appear to be the most challenging and may require significant business restructuring. The interplay between the US and EU implementation of Basel III and the gradual "phase in" of certain rules, particularly on liquidity and leverage, will have a profound impact on the relative competitiveness of relevant US and EU financial institutions. This client publication, and the accompanying US/EU comparison and summary table, highlight points of international consistency and divergence.

Basel 3 requirements announced

At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a substantial strengthening of existing capital requirements and fully endorsed the agreements it reached on 26 July 2010. These capital reforms, together with the introduction of a global liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the Seoul G20 Leaders summit in November.

The Committee's package of reforms will increase the minimum common equity requirement from 2% to 4.5%. 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%. This reinforces the stronger definition of capital agreed by Governors and Heads of Supervision in July and the higher capital requirements for trading, derivative and securitisation activities to be introduced at the end of 2011.

Mr Jean-Claude Trichet, President of the European Central Bank and Chairman of the Group of Governors and Heads of Supervision, said that "the agreements reached today are a fundamental strengthening of global capital standards." He added that "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." Mr Nout Wellink, Chairman of the Basel Committee on Banking Supervision and President of the Netherlands Bank, added that "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."

Increased capital requirements

Under the agreements reached today, the minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments. 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. (Annex 1 summarises the new capital requirements.)

The Group of Governors and Heads of Supervision 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. 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 countercyclical 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 countercyclical buffer is to achieve the broader macroprudential 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 countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

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.

Systemically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams. The Basel Committee and the FSB are developing a well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt. In addition, work is continuing to strengthen resolution regimes.

The Basel Committee also recently issued a consultative document Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability. Governors and Heads of Supervision endorse the aim to strengthen the loss absorbency of non-common Tier 1 and Tier 2 capital instruments.

Transition arrangements

Since the onset of the crisis, banks have already undertaken substantial efforts to raise their capital levels. However, preliminary results of the Committee's comprehensive quantitative impact study show that as of the end of 2009, large banks will need, in the aggregate, a significant amount of additional capital to meet these new requirements. Smaller banks, which are particularly important for lending to the SME sector, for the most part already meet these higher standards.

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. The transitional arrangements, which are summarised in Annex 2, 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 (ie 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, 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.

Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer and the countercyclical buffer. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.

Banks that already meet the minimum ratio requirement during the transition period but remain below the 7% common equity target (minimum plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.

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 no longer qualify as 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 1 ;
  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.

Only those instruments issued before the date of this press release should qualify for the above transition arrangements.

Phase-in arrangements for the leverage ratio were announced in the 26 July 2010 press release of the Group of Governors and Heads of Supervision.

That is, the supervisory monitoring period will commence 1 January 2011; the parallel run period will commence 1 January 2013 and run until 1 January 2017; and disclosure of the leverage ratio and its components will start 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 net stable funding ratio (NSFR) will move to a minimum standard by 1 January 2018.

The Committee will put in place rigorous reporting processes to monitor the ratios during the transition period and will continue to review the implications of these standards for financial markets, credit extension and economic growth, addressing unintended consequences as necessary.

The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. It seeks to promote and strengthen supervisory and risk management practices globally. The Committee comprises representatives from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.

The Group of Central Bank Governors and Heads of Supervision is the governing body of the Basel Committee and is comprised of central bank governors and (non-central bank) heads of supervision from member countries. The Committee's Secretariat is based at the Bank for International Settlements in Basel, Switzerland.

Basel 3 short term liquidity rule argreed

Global banking supervisors agreed on Tuesday to phase in the introduction of a key new global standard on lenders' minimum short-term funding cover, handing further relief to a sector facing a hefty funding gap.

The Basel Committee of banking supervisors and central bankers from 27 countries met on Tuesday in South Korea, which is hosting the Group of 20 leading countries that had called for tougher capital and liquidity requirements in response to the financial crisis.

The committee had already agreed to a soft phase-in for its net stable funding ratio, which covers a bank's longer-term liquidity. That measure will be tested from 2012 and become mandatory in January 2018.

On Tuesday the committee said it would also have a softer phase-in for its liquidity coverage ratio (LCR), which will require a bank to hold enough highly liquid assets, mainly government bonds, to cover 30 days of net cash outflows.

The LCR observation period will start next year but the committee still wants the rule to become a minimum global standard in January 2015.

Introducing an observation period and review clauses gives the committee more leeway to make big changes on the way.

"There are elements of these ratios which we will study during this observation period because these requirements are brand new - that's the reason for this change," the Chairman of the Basel Committee on Banking Supervision Nout Wellink told a news conference in Seoul.

Limiting potential liquidity problems was a major lesson of the financial crisis, Bundesbank President Axel Weber said.

Legal experts said banks will have to stock up on government bonds, in competition with insurers who face their own tougher requirements in Europe under new Solvency II rules.

"It is essential that assets like highly rated corporate or Pfandbrief covered bonds also be eligible," Weber said.

While a phase-in of the LCR had been expected, bankers welcomed confirmation of the observation periods.

Consultancy PWC said the Basel Committee had made a sensible move as it was difficult to forecast what impact the new liquidity rules will have on bank lending.

The Bundesbank's Weber said the burden of adjustment to the new rules would vary across countries and could affect lending in Germany, but that a broad credit crunch is not expected.

The Basel Committee also said it would finalise by year-end its proposal on the use of contingent capital, also known as CoCos, bail-in bonds and other non-equity loss-absorbent instruments to pad out a bank's capital requirements.

Wellink said the Basel members would then decide how to make these banks better equipped to absorb losses by March 2011 and later draw up specific rules.

Basel 3 commentary

Basel 2 becomes Basel 3

Background

As we reported in our bulletin "More, More, More: A Summary of the Basel Proposals,"1 in December 2009, the Basel Committee on Banking Supervision ("BCBS") published two consultative documents proposing significant reforms to the Basel II framework.2 These relate to, among other things, the definition of capital, the treatment of counterparty credit risk, the introduction of a leverage ratio and the imposition of global liquidity standards (the "December 2009 Proposal").3

Following an extensive consultation process during which many concerns were raised as to the scope and effect of the December 2009 Proposal, including concerns that many banks and financial institutions may be unable to function with the increased capital and liquidity requirements (at least until there is a significant economic recovery), BCBS announced on 26 July 2010 that its oversight body had reached agreement on proposed capital and liquidity reforms. It also announced that it intended to finalise the calibration and phase-in arrangements for the reforms at a meeting in September 2010.

On 16 July 2010, BCBS also published its countercyclical buffer proposals for public consultation, which will continue until 10 September 2010.4 Part of these proposals was outlined in the December 2009 Proposal.

Although the proposals in its July 2010 papers do not alter the overall thrust of the December 2009 Proposal in relation to capital and liquidity requirements, they do include some important modifications and softening of some of BCBS's earlier proposals, including substantially deferring the transitional period for the global minimum Tier 1 leverage ratio and the net stable funding ratio. Details of the new BCBS proposals were published in an Annex to its 26 July announcement (the "Annex").5 We summarise the key features below.

Definition of Capital

Whilst retaining most of the proposals relating to definition of capital in the December 2009 Proposal, BCBS has agreed to relax some of its requirements in relation to regulatory adjustments to be applied to the common equity component of Tier 1:

  • Minority interests: A limited prudential recognition of the minority interest in a subsidiary bank will be permitted, allowing the parent bank to deduct the excess capital above a minimum level in proportion to the minority interest share. Previously there could be no recognition of such minority interests. It is stated, however, that no such recognition will be permitted where the parent bank or an affiliate has entered into any arrangements to fund, directly or indirectly, other minority investments in the subsidiary including through an SPV or other vehicle.
  • Investments in other financial institutions: BCBS has discarded the previous restrictions on allowing net short positions to be deducted from long positions in calculating the deduction for unconsolidated investments only if the short positions involve no counterparty risk. An underwriting exemption will also be included. The requirement to deduct unconsolidated investments in financial institutions above certain minimum thresholds will continue to apply.
  • Intangible assets (e.g., software): An optional IFRS treatment will be allowed in determining the level of intangible assets if applying the relevant national GAAP would result in a wider range of assets being classified as intangible.
  • Significant investments (i.e., more than 10%) in the common shares of unconsolidated financial institutions; mortgage servicing rights; and deferred tax assets arising from timing differences: When calculating a bank's common equity component of Tier 1 capital, a limited recognition is now permitted in relation to these three items, capped in each case at 10% of the bank's common equity component. Such recognition in relation to these items in the aggregate is further limited to 15% of the bank's common equity component of Tier 1 capital (as calculated prior to the deduction of these items but after all other relevant deductions). In the December 2009 Proposal all of these items were subject to a full deduction.
Counterparty Credit Risk

Various technical changes are proposed in relation to calculating counterparty credit risk including:

  • relaxing the provisions relating to recognition of hedging arrangements;
  • raising the threshold at which an asset value correlation adjustment will be made from US$25 billion to US$100 billion;
  • subjecting banks' mark-to-market and collateral exposures to a central counterparty to a "modest" risk weight. "Modest" is not * defined for these purposes but it is indicated as likely to be in the 1 to 3% range. The December 2009 Proposal had suggested there would be a zero risk weighting in these circumstances; and
  • eliminating the 5x multiplier in calculating the credit valuation adjustment ("CVA") proposed in the December 2009 Proposal.
Leverage Ratio

Although the introduction of leverage ratio was announced in the December 2009 Proposal, many of the details remained unclear. Some further details are given in the Annex.

BCBS states that its aim is to develop a simple, transparent, nonrisk-based measure that is calibrated to act a supplement to the risk-based requirements. In calculating the ratio it is proposed that off-balance sheet items be subject to uniform credit conversion factors, which are not specified, although a 10% credit conversion factor is proposed for unconditionally cancellable off-balance sheet items. It is proposed that derivatives be converted to a "loan equivalent amount" by applying existing netting rules (which were not envisaged in the December 2009 Proposal) together with a measure of potential future exposure based on the standardised factors of the current exposure method.

It is proposed that the minimum Tier 1 leverage ratio be set at 3% which will be tested during a "parallel run" period between 2013 and 2017. Bank level disclosure of the leverage ratio and its components will commence in January 2015. A "supervisory monitoring period" will commence on 1 January 2011 which will focus on developing templates to consistently track the underlying components of the definition of the ratio and the resulting ratio. It is indicated that the leverage ratio will not become a binding requirement until at least the beginning of 2018.

BCBS notes that there is a strong consensus to base the leverage ratio on the new definition of Tier 1 capital, but states it will also track the impact of the ratio using total capital and tangible common equity as the numerator.

In the December 2009 Proposal, BSBC stated that it was considering alternative treatments for more complex items, such as securitisations, repurchase agreements, derivatives and off-balance sheet items. Save to the limited extent mentioned above, these issues are not considered further in the Annex.

Pro-cyclicality and Countercyclical Buffers

BCBS refers in the Annex to its consultative document of 16 July 2010 (with comments due by 10 September 2010) setting out its proposals for a countercyclical buffer proposal. Details of the proposed conservation buffer proposal were set out in the December 2009 Proposal and have not been amended. BCBS intends to finalise both proposals by the end of 2010.

In the December 2009 Proposal, BCBS stated that the four key objectives of introducing countercyclical buffers were:

  • dampening any excess cyclicality of the minimum capital requirement;
  • promoting more forward-looking provisions;
  • conserving capital to build buffers at individual banks and the banking sector to be used in times of stress; and
  • achieving the broader macroprudential goal of protecting the banking sector from periods of excess credit growth.

In the Annex, BCBS states that the capital conservation buffer should be available to absorb losses during a period of severe stress whilst the countercyclical buffer would extend the capital conservation range during periods of excess credit growth (or other appropriate national indicators).

Through a quantitative impact study, BCBS is considering ways to mitigate cyclicality, by adjusting for the compression of probability of default estimates in the internal ratings-based ("IRB") approach during benign credit conditions through the use of probability of default estimates in an economic downturn.

The following points are worth noting from BCBS's 16 July 2010 consultative document:

  • The primary aim of the countercyclical buffer is stated to be to achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth associated with system-wide risk build-up and to ensure that the banking sector in aggregate has the capital on hand to help maintain the flow of credit in the economy without its solvency being questioned in times of financial stress. It is hoped the buffer may also temper the build-up phase of the cycle in the first place by raising the cost of credit and dampening demand.
  • Each jurisdiction will be given the discretion to set the countercyclical buffer as an add-on to the minimum buffer range established by the conservation buffer. Add-on decisions would be pre-announced by 12 months to give banks time to meet the additional capital requirements before they take effect.
  • Add-ons will be subject to an upper limit and will only be in effect when there is evidence of excess credit growth that is resulting in a build-up of system-wide risk. There will be no add-ons at any other times.
  • Internationally active banks will look at the geographic location of their credit exposure and calculate their buffer add-ons for each exposure by reference to the applicable buffer in the jurisdiction where such exposure is located. Such arrangements will require jurisdictional reciprocity and sharing of information. The interaction between the home authority of the relevant bank and host authorities in which it operates are stated to be an area still under consideration by BCBS.
  • To assist each jurisdiction in setting its buffers and to ensure international consistency, a methodology will be established together with a set of principles.
  • To assist relevant authorities in operating the buffer and communicating decisions, it is proposed that the buffer framework be implemented through a combination of minimum standards in setting the buffer and disclosing information and best practice guidance setting out recommendations on how authorities can best promote accountability and transparency over buffer decisions.
  • To ensure consistency with the minimum capital requirements, individual banks should ensure that their buffer add-ons are calculated with at least the same frequency as their minimum capital requirements.
  • BCBS intends to maintain a website collating the prevailing buffer add-ons in effect in each jurisdiction.
Systemic Banks, Contingent Capital and Capital Surcharge

In addition to the proposed reforms to the trading book, securitisation, counterparty credit risk and exposure to other financials, BCBS proposes the following measures to address systemic risk:

  • "Gone concern" proposal: BCBS will issue for consultation a "gone concern" proposal that requires capital instruments to be written off or converted to common shares, at the option of the regulator, if the issuer bank becomes financially troubled.
  • "Going concern" proposal: Having reviewed an issues paper on the use of contingent capital to make up the capital buffers, BCBS will review a proposal for the treatment of "going concern" contingent capital at its December 2010 meeting.
  • "Guided discretion" approach: BCBS will further develop the "guided discretion" approach to integrate the capital surcharge into the Financial Stability Board's initiative on systemically important financial institutions (where contingent capital may have a role).
Global Liquidity Standards

The December 2009 Proposal set out proposals for two liquidity ratios: a short-term liquidity cover ratio aimed at ensuring banks maintain 30 days' liquidity coverage for extreme stress conditions and a longer-term net stable funding ratio by reference to the amount of "longer-term, stable sources of funding" (at least one year) relative to the "liquidity profiles" of the assets funded and the off-balance sheet exposures.

Liquidity coverage ratio

Various changes to the detailed calculation of "liquid assets" and other elements of the ratio have been proposed. These changes include treating commitments of sovereigns and central banks in a manner similar to non-financial corporates and requiring that all assets in the liquidity pool for the definition of liquid assets be managed as part of the pool and be subject to operational requirements (to be finalised by the end of this year) and introducing a "level 2" of liquid assets which can comprise up to 40% of the pool.

Net stable funding ratio

BSBC states that it remains committed to introducing a net stable funding ratio but that the proposals for its calibration set out in the December 2009 Proposal require significant modification. It states that it is considering, in particular, amending the calibrations relating to retail and SME deposits, mortgages and off-balance sheet commitments. A modified proposal will be produced for consultation by the end of 2010.

It also states that it will carry out an "observation phase" to test the effect of the ratio and that its current timetable for introducing the ratio as a minimum standard is 1 January 2018.

Effect of the Proposals and Next Steps

As indicated above, there are still aspects of the proposals that require further clarification although, in most cases, BCBS has indicated that it intends to publish full details of the proposals by the end of 2010.

Although the main elements of the December 2009 Proposal remain intact, there has been a significant softening of some the proposals, including allowing recognition of some items in calculating Tier 1 capital that were previously excluded, including minority interests in consolidated bank subsidiaries, a relaxation of some of the calculations of capital charges for counterparty credit risk in relation to derivatives and repo transactions.

It is still intended that the bulk of the proposals will be implemented by the end of 2012. However, the time frame for some important elements of the proposals, notably the introduction of the leverage ratio and net stable funding ratio, has been deferred until at least the start of 2018.

Basel Committee estimates new rules would have minimal impact on growth

The Basel Committee on Banking Supervision rebuffed complaints from banks that proposed regulations would damage economic growth, saying the impact would be “modest.”

The committee estimated in a report today the new rules would trim 0.38 percent from gross domestic product in the U.S., euro area and Japan after four-and-a-half years. That’s about an eighth of the 3.1 percent reduction foreseen by the Institute of International Finance, an industry group, over five years.

The study follows suggestions from banks including Deutsche Bank AG and Bank of America Corp. that a rush to regulate may force them to cut lending, jeopardizing the economic recovery. The committee is seeking to frame the debate as the Group of 20 nations face a November deadline for outlining new rules after the worst financial crisis since the 1930s.

“The economic benefits of the proposed reforms are substantial and need to be considered alongside the analysis of the costs,” said Nout Wellink, the chairman of the Basel Committee, in the statement. “These benefits result not only from a stronger banking system in the long run, but also from greater confidence in the stability of the financial system.”

Over a longer time span, the positive effects of rules requiring banks to raise the quality and quantity of capital and liquidity reserves will outweigh the costs by increasing the soundness of the financial system and reducing the probability of another banking crisis, the committee said.

Banking Study

At stake for banks is the potential need to raise as much as $375 billion in fresh capital, according to estimates by analysts at UBS AG. Banks worldwide have written down more than $1.8 trillion since the credit crisis started in 2007, according to data compiled by Bloomberg.

Today’s report counters a June study from the Washington- based IIF, which concluded the rules would also translate into about 9.7 million fewer jobs than would otherwise be the case, with the euro region hit the hardest. The organization represents more than 400 financial companies in more than 70 countries.

Such warnings have found some support among governments in Europe, where bank lending plays a bigger role in the economy than in the U.S., whose companies rely more on markets for finance. Germany has declined to agree to the Basel panel’s new rules until their impact is gauged, the country’s financial regulator BaFin said July 27.

The tricky bits

"... The most important bit of reform is the international set of rules known as “Basel 3”, which will govern the capital and liquidity buffers banks carry. It is here that the most vicious and least public skirmish between banks and their regulators is taking place.

The Basel club of bank supervisors put out proposals in December, which aim to boost capital and get banks to wean themselves off short-term funding. In the submissions they have made in response, banks have been critical. Although they claim to accept the objective of raising safety buffers, banks argue that any big changes will impede economic growth. Many also say that the Basel club’s timetable, which is to have the proposals finalised by this year and implemented by late 2012, is unrealistic.

Some complaints will be brushed aside. During the crisis there was a total loss of confidence in banks’ capital standards, with most investors resorting to more basic accounting information to measure solvency. It is for this reason that Basel 3 is likely, however much the banks squeal, to take a firm line on excluding low-quality instruments such as preference shares from core capital. Likewise, few can seriously object to its demand that banks hold enough liquid assets to withstand a severe, month-long liquidity shock.

The tricky bits will be setting the absolute level of capital that is needed in the system and defining a tolerable amount of short-term funding. The Basel club has not articulated a vision of how big the buffers should be. But its instincts are pragmatic—Stefan Walter, the secretary-general of the Basel Committee, says the aim is “a balanced package where the costs will be phased to avoid economic disruption and the benefits will be substantial.”

That hasn’t stopped the banks fighting their corner. Their main lobbying body, the Institute of International Finance, will release a report on June 10th that can be relied on to paint an apocalyptic picture of the economic cost of Basel 3. Later this year the Basel club will publish its own assessment, which should be less alarming.

On capital there is room for compromise. The happy secret of Western banking is that the system in aggregate now has lots of capital (see chart) relative to the net losses experienced over the crisis. The kind of erosion of capital forecast by the Federal Reserve’s stress tests last year, for example, has simply not materialised. That means the Basel club can legitimately argue that banks in aggregate do not need to raise much new capital. It can focus instead on fixing loopholes and finding ways to close outlier banks that lose far more money than the average.

Where Basel 3 will almost certainly have to retreat is in its proposal to force banks significantly to cut their structural reliance on short-term funding. Credit Suisse reckons the regulators’ proposed “net stable funding ratio” would require European banks to raise €1.3 trillion ($1.6 trillion) of long-term funding. Even over the course of several years, finding enough deposits or issuing enough bonds to meet that requirement is a hair-raising prospect—not least because of regulators’ parallel efforts to remove the implicit guarantee that bank creditors still enjoy."

Basel discusses progress on reforms and issues new proposal

In meetings held Wednesday and yesterday, the Basel Committee on Banking Supervision reviewed various items in order to develop recommendations for its package of regulatory reforms, including the structure of the capital and liquidity frameworks, comments on its December 2009 consultation package, results of its comprehensive quantitative impact study (QIS) and its economic impact assessment analyses.

Later this month, the Committee will present its concrete recommendations for the definition of capital, the treatment of counterparty credit risk, and leverage ratios, conservation buffers and liquidity ratios to the Committee’s oversight body, the Group of Central Bank Governors and Heads of Supervision.

The Committee also commenced a countercyclical capital buffer proposal, with a September 10, 2010 deadline for comments. This proposal addresses the objectives set forth by the Committee to “conserve capital to build buffers at individual banks and the banking sector that can be used in stress” and to “achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth.” The proposal discusses how the proposed buffers would operate in practice, and also describes various proposed elements, including how bank-specific buffers might be calculated, selecting authority to operate the buffer, and the treatment of surplus when the buffer returns to zero. The countercyclical buffer would be imposed when national authorities believe that excess aggregate credit growth is associated with a build-up of system-wide risk.

Finally, the Committee said it plan to issue a proposal with respect to the role of “gone concern” contingent capital in the regulatory capital framework in the near future.

Basel Committee making "significant progress" on reforms

The Basel Committee on Banking Supervision said Friday it had made "significant progress" at a meeting this week designed to hammer out tougher rules on banks' capital and the size of their liquidity buffers.

The committee, composed of global regulators and central bankers, said it has developed concrete recommendations for completing its reforms of these rules, which will be reviewed by its oversight body—the Group of Central Bank Governors and Heads of Supervision—later this month.

"The committee made significant progress at its meeting and remains fully on track to deliver a complete package of capital and liquidity reforms, including design and calibration, in time for the November 2010 G20 Leaders Summit in Seoul," said Nout Wellink, chairman of the Basel Committee.

The committee met in the Swiss town of Basel on Wednesday and Thursday to debate how to frame these new rules without discouraging banks from lending at a time of fragile economic recovery. Regulators and central bankers from 27 countries also tussled over a range of issues relating to these reforms, such as how to craft and operate a leverage ratio which would place a limit on how much banks can borrow.

The Basel Committee said last year it would draw up new rules to improve the overall quality of banks' capital, boost their cash pools, create an acceptable ratio for borrowing and force them to accumulate capital during economic booms by the end of 2010. The rules would then come into effect in 2012 when, it is hoped, the global economy will have stabilized

The committee also plans to introduce new rules governing the amount of capital banks need to hold against their trading activities and investment in securitization deals by the end of 2011.

Some financial institutions and regulatory experts didn't believe the Basel committee would be able to produce a set of finalized rules, backed by an assessment of their impact on economic growth, by the end of this year.

"A lot of the pushback the committee has been getting has been on the basis that they can't possibly have analyzed the data fully and come up with quantitative limits in the time available, but I think what they seem to be saying is 'yes, we will'," said Simon Gleeson, a partner in the financial regulatory group at law firm Clifford Chance in London.

The Basel Committee said it reviewed at this week's meeting the results of its impact study, although these aren't expected to be published until September or October, according to a person familiar with the matter.

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