Thursday, 23 September 2010

Basel 3 - Financial Stability....but at what cost??

The much awaited recommendations from the Basel Committee on new capital standards were announced on 12th September 2010. The immediate market reaction was a sigh of relief with bank stocks staging a smart rally on the back of a much diluted set of provisions with a longer implementation timeline.
Is this a case of too little too late as some have implied or a pragmatic compromise between maintaining financial stability and ensuring robust economic growth? Let’s examine the key provisions of the proposed regulations to assess its impact on the banking sector and consequently on credit costs / credit availability.

I. Minimum capital requirements – more than 3 fold increase to core equity

The minimum capital 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 regulatory adjustments. This increase will be phased in to apply from Jan 1, 2015.

In addition to the above, the committee recommended a 2.5% of additional core equity capital as a conservation buffer above the regulatory minimum taking the aggregate minimum core equity required to 7%. The conservation buffer is also phased in to apply from Jan 1, 2016 and will come into full effect from Jan 1, 2019.

Certain regulatory deductions (material holdings, deferred tax assets, mortgage servicing rights etc) that are currently applied to tier 1 capital and/or tier 2 capital or treated as RWA will now be deducted from Core equity capital. This will also be progressively phased in over a five year period commencing 2014.

Phasing-in effect:

Minimum core equity
Conservation buffer

Total core equity
Min. total capital incl. buffer
Phasing in of other deductions from core T1

Counter cyclical buffer
In addition the regulator can specify a counter cyclical buffer of up to 2.5% of fully loss absorbing capital for macro prudential objectives

Regulatory buffers, provisions, and cyclicality of the minimum

The capital conservation buffer should be available to absorb banking sector losses conditional on a plausibly severe stressed financial and economic environment. The countercyclical buffer would extend the capital conservation range during periods of excess credit growth, or other indicators deemed appropriate by supervisors for their national contexts. Both buffers could be run down to absorb losses during a period of stress.
Deductions from Core Tier 1
  • Minority interest - The excess capital above the minimum of a subsidiary that is a bank will be deducted in proportion to the minority interest share.
  • Investments in other financial institutions - The gross long positions may be deducted net of short and the proposals now include an underwriting exemption.
Minority interest in a banking subsidiary is strictly excluded from the parent bank’s common equity if the parent bank or affiliate has entered into any arrangements to fund directly or indirectly minority investment in the subsidiary whether through an SPV or through another vehicle or arrangement.

Other deductions
The other deductions from Common Equity Tier 1 are: goodwill and other intangibles (excluding Mortgage Servicing Rights), Deferred Tax Assets, investments in own shares, other investments in financial institutions, shortfall of provision to expected losses, cash flow hedge reserve, cumulative changes in own credit risk and pension fund assets.

The following items may each receive limited recognition when calculating the common equity component of Tier 1, with recognition capped at 10% of the bank’s common equity component:
  • Significant investments in the common shares of unconsolidated financial institutions (banks, insurance and other financial entities). “Significant” means more than 10% of the issued share capital;
  • Mortgage servicing rights (MSRs); and
  • Deferred tax assets (DTAs) that arise from timing differences.
A bank must deduct the amount by which the aggregate of the three items above exceeds 15% of its common equity component of Tier 1.

The combined effect of the above is shown below:
II. Qualifying non core tier 1 and tier 2 capital, transition arrangements

Capital instruments that do not meet qualifying criteria for inclusions in non-core tier 1 capital (i.e no incentive to redeem, full loss absorption capacity, full discretion on coupon payments etc) will be progressively phased out at an amortization rate of 10% p.a. effective Jan 1, 2013 to the earliest call date after which it will fully be derecognised if not called.

Only one type of tier 2 capital and the terms will have no incentive to redeem (i.e. no step-ups in coupons).

III. Leverage Ratios

A. Definition of the leverage ratio
The Committee is proposing a minimum Tier 1 leverage ratio of 3% during the parallel run period. While there is a strong consensus to base the leverage ratio on the new definition of Tier 1 capital, the Committee will also track the impact of using total capital and tangible common equity.
Off-balance-sheet (OBS) items, use uniform credit conversion factors (CCFs), with a 10% CCF for unconditionally cancellable OBS commitments (subject to further review to ensure that the 10% CCF is appropriately conservative based on historical experience).
Derivatives (including credit derivatives), apply Basel II netting plus a simple measure of potential future exposure based on the standardised factors of the current exposure method.

B. Transition to the leverage ratio
The supervisory monitoring period commences 1 January 2011. The parallel run period commences 1 January 2013 and runs until 1 January 2017. 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.

IV. Liquidity

A. Liquidity coverage ratio (LCR)

The stock of liquid assets should be higher than the projected liquidity outflow over a 30 day time period.

Definition of liquid assets: The proposal outline that the assets must be available for the treasurer of the bank, unencumbered, and freely available to group entities. As part of the narrow definition of liquid assets, the proposal allow for the inclusion of domestic sovereign debt for non-0% risk weighted sovereigns, issued in foreign currency, to the extent that this currency matches the currency needs of the bank’s operations in that jurisdiction.

Allow Level 2 of liquid assets with a cap that allows up to 40% of the stock to be made up of these assets. Include (with a 15% haircut) government and PSE assets qualifying for the 20% risk weighting under Basel II’s standardised approach for credit risk, as well as high quality non-financial corporate and covered bonds not issued by the bank itself (eg rated AA- and above), also with a 15% haircut.

Retail and SME deposits: Lower the run-off rate floors to 5% (stable) and 10% (less stable), respectively. These numbers are floors and jurisdictions are expected to develop additional buckets with higher run-off rates as necessary.

Operational activities with financial institution counterparties: Introduce a 25% outflow bucket for custody and clearing and settlement activities, as well as selected cash management activities.

Deposits from domestic sovereigns, central banks, and public sector entities:
For unsecured funding, treat all (both domestic and foreign) sovereigns, central banks and PSEs as corporates (ie with a 75% roll-off rate), rather than as financial institutions with a 100% roll-off rate.

For secured funding backed by assets that would not be included in the stock of liquid assets, assume a 25% roll-off of funding.

Secured funding: Only recognise roll-over of transactions backed by liquidity buffer eligible assets.
Undrawn commitments: Lower retail and SME credit lines from 10% to 5%. Treat sovereigns, central banks, and PSEs similar to non-financial corporates, with a 10% run-off for credit lines and a 100% run-off for liquidity lines.

Inflows: Rather than leave it to the bank’s discretion to determine the percentage of “planned” net inflows, establish a concrete harmonised treatment in the standard that reflects supervisory assumptions.
B. Net stable funding ratio (NSFR)
The main concerns related to the calibration of the standard and the relative incentives across business models, in particular retail versus wholesale. A number of adjustments are under consideration.

V. Counterparty credit risk

The Committee is making modification to the treatment of counterparty credit risk, including the bond equivalent approach to calculating the credit valuation adjustment (CVA). The bond equivalent approach will be amended to address hedging, risk capture, effective maturity and double counting. To address the excessive calibration of the CVA, the 5x multiplier that was proposed in December 2009 will be eliminated. More advanced alternatives to the bond equivalent approach could be considered as part of the fundamental review of the trading book.

Banks’ mark-to-market and collateral exposures to a central counterparty (CCP) should be subject to a modest risk weight, for example in the 1-3% range, so that banks remain cognisant that CCP exposures are not risk free.

VI. Systemic banks, contingent capital and a capital surcharge

In addition to the reforms to the trading book, securitisation, counterparty credit risk and exposures to other financials, the Group of Governors and Heads of Supervision agreed to include the following elements in its reform package to help address systemic risk:
The Basel Committee has developed a proposal based on a requirement that the contractual terms of capital instruments will allow them at the option of the regulatory authority to be written-off or converted to common shares in the event that a bank is unable to support itself in the private market in the absence of such conversions. At its July meeting, the Committee agreed to issue for consultation such a “gone concern” proposal that requires capital to convert at the point of non-viability.

It also reviewed an issues paper on the use of contingent capital for meeting a portion of the capital buffers. The Committee will review a fleshed-out proposal for the treatment of “going concern” contingent capital at its December 2010 meeting.


The short term implications are muted as the implementation timeline is phased over 8 years to ensure that economic growth is not threatened. But the combined impact of the above proposals will have significant long term implication for bank profitability, availability of credit, cost of credit and would challenge the current wholesale bank model (GS, MS, GE Capital etc)…..

While attempting to make the financial sector stable, the central bankers are driving the insurance premium too high for the banks and its customers. It remains to be seen when they would be rushing into Basel 4 to address the adverse impact of Basel 3 on credit availability and credit costs.

A more effective deterrent would have been to make bank’s board personally liable for negligence and mismanagement! That would, in my opinion, lead to good governance standards….more than any amount of rules can ever achieve!!

Any takers????????