Basel III – an overview

23 September 2010

Charles Proctor, Oliver Irons

Introduction

Since the causes of the recent economic crisis became apparent, there has been broad recognition of the need to strengthen global capital and liquidity regulations in the banking sector.

The Group of Governors and Head of Supervision of the Basel Committee met on 26 July 2010 to agree a framework for amendments to the Basel II rules which have been in place since June 2006. The main aspects of the agreement, which were accepted on 12 September, centre on the increase in the minimum capital requirements and are set out below.

Increased Capital Requirements

Tier 1 capital

The minimum requirement for common equity (otherwise know as core Tier 1 capital) will be increased from 2% of risk weighted assets before deductions under the current rules to 4.5% after deductions. Overall Tier 1 capital (including qualifying subordinated debt instruments) will similarly increase from 4% to 6%. Both of these changes will be phased in by 1 January 2015 in accordance with the transitional arrangements discussed in more detail below.

While minimum total capital has been maintained at the Basel II level of 8%, when taken with the buffers described below, banks will effectively be required to hold a minimum capital equivalent to 10.5% of risk weighted assets once all of the ratios have been phased in by the start of 2019.

Capital buffers

In addition to the rise in the Tier 1 capital ratios, a new series of capital buffers will be introduced to further increase the minimum requirements.

The first of these is the “capital conservation buffer” which will require banks to hold a further 2.5% of core Tier 1 capital over and above the new 4.5% level which brings the total common equity requirement to the headline grabbing level of 7%.

The intention behind the capital conservation buffer is, according to the Basel Committee press release “to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress”. Banks will apparently be allowed to draw upon the buffer during such periods but the price of utilising the buffer will be a restriction of the level of permissible dividend payments. This restriction obviously has a prudential objective but it is also intended to assist banks in resisting shareholder pressure in times of deteriorating capital positions

The second is the “countercyclical buffer” which has a range of 0% to 2.5% of common equity and will be implemented “according to national circumstances”. The aim here is “to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth”. The buffer will only be in effect when there is excess credit growth that results in a “system wide build up of risk” in any given country and will operate as an extension of the capital conservation buffer.

Both the capital conservation and countercyclical buffers will be phased in from 1 January 2016 to 1 January 2019 at yearly increments of 0.625%.

Definition of capital

Given the actions taken by many banks to strengthen their common equity over the last few years the impact of the ratio increases are unlikely to be felt for some time.

It is perhaps of more significance that the Basel Committee has made the definition of capital stricter to strengthen the “quality, consistency and transparency of the regulatory capital base”.

In its consultative document entitled “Strengthening the resilience of the Banking Sector” which was issued in December 2009, the Basel Committee identified three fundamental flaws in the existing definition of capital:

1)       regulatory adjustments are not generally applied to common equity;

2)       there is no harmonised list of regulatory adjustments; and

3)       the disclosure provided by banks about their regulatory capital base is frequently deficient.

As a result, banks have been allowed to report high levels of Tier 1 capital while having low levels of common equity net of adjustments.

In order to rectify these deficiencies, and subject to a few minor concessions, the Basel Committee has adopted most of the key proposals set out in detail in the consultative documents of December 2009 to amend the definition and composition of capital.

The most significant of these proposals is the requirement for the minimum core Tier 1 capital to be measured after deduction of regulatory adjustments. The regulatory adjustments will themselves be harmonised across the various jurisdictions to ensure more consistency in their application.

The permitted make up of core Tier 1 capital is also being tightened to ensure that it consists predominantly of common shares. To this end, investments in financial institutions, mortgage servicing rights and deferred tax assets will only be allowed to form a maximum aggregate of 15% of common equity, with anything above this level being fully deducted from the calculation by the start of 2018 after a five year transition period. 

Changes are also being made to simplify Tier 2 capital, while Tier 3 capital will be abolished altogether.

Leverage ratio

The capital ratios discussed above relate to risk-based capital. Basel III intends to supplement these capital requirements with a non-risk based leverage ratio by testing a minimum Tier 1 leverage ratio of 3% from 2013 to 2017 after which adjustments will be made if necessary.

Systemically important banks

Certain banks which are considered to be too big to fail will be classed as “systemically important banks” and will be required to have loss absorbing capacity beyond the minimum standards to be introduced by Basel III. The Financial Stability Board and Basel Committee are still working on these proposals.

Transitional arrangements

Over the last few years, most banks subject to the Basel Accords have taken steps to increase the amount of capital they hold and already maintain capital above the levels required under both Basel II and the new rules. Taking the example of the UK, according to recent reports in the press, none of Britain’s largest banks had a core Tier 1 capital ratio below 9% at the end of the first half of this year which is well in excess of the 2% currently required.

As such, it appears that the increase in the capital ratios under Basel III will not require immediate action on the part of the larger financial institutions, but longer term planning will clearly be required.

In any event, the Basel Committee has agreed very generous transitional arrangements for implementing the new standards in the hope of ensuring that the rules can be adopted without reducing the levels of lending required to stimulate the uncertain global economic recovery.

Implementation of Basel III at a national level will begin on 1 January 2013 with changes phased in gradually over a period of 2 – 10 years. It should, however, be noted that the Basel Committee has given national authorities the discretion to impose shorter transition periods and have suggested that this should be done where appropriate.

A full table of the transitional arrangements for the introduction of the buffers, increased capital and leverage ratios and regulatory adjustments are set out in the table below.

Table of transitional arrangements (all dates as of 1 January)






































































































 


2011


2012


2013


2014


2015


2016


2017


2018


2019


Leverage Ratio


Supervisory monitoring


Parallel run/testing phase

1 Jan 2013 - 1 Jan 2017


Into effect


 


Minimum Common Equity Capital Ratio


2.0%


2.0%


3.5%


4.0%


4.5%


4.5%


4.5%


4.5%


4.5%


Capital Conservation Buffer


 


 


 


 


 


0.625%


1.25%


1.875%


2.50%


Minimum common equity plus capital conservation buffer


2.0%


2.0%


3.5%


4.0%


4.5%


5.125%


5.75%


6.375%


7.0%


Phase-in of deductions for regulatory adjustments


 


 


 


20%


40%


60%


80%


100%


100%


Minimum Tier 1 Capital


4.0%


4.0%


4.5%


5.5%


6.0%


6.0%


6.0%


6.0%


6.0%


Minimum Total Capital


8.0%


8.0%


8.0%


8.0%


8.0%


8.0%


8.0%


8.0%


8.0%


Minimum Total Capital plus conservation buffer


8.0%


8.0%


8.0%


8.0%


8.0%


8.625%


9.25%


9.875%


10.5%


Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital


 


 

Phased out over 10 years

     

Conclusion

In light of the current capital position of many of the major banks and the drawn out transitional arrangements granted by the Basel Committee, Basel III is unlikely to have an immediate impact on either the UK or global banking sectors. This should, however, not detract from the fact that the proposals are a step in the right direction towards safeguarding against the solvency and liquidity crisis which started with the loss of confidence in interbank lending and later spread to the rest of the economy.

Of the changes that have been discussed in this briefing, it is the revised definition of capital and the tightening of the composition of common equity, rather than the more obvious raising of capital ratios, which should have the most profound effect on the confidence the markets have in banks in the event of further economic turbulence.

More details will be required on the exact meaning of “systemically important banks” and the extent of the additional capital they will be required to hold prior to the G20 summit in November but there appears to be a broad consensus on the main proposals. It may therefore be anticipated that these proposals will be formally adopted by the end of 2010.