|Basel III redefines capital (November 2010)|
The third time around for the global rules may be less “the charm” than cause for alarm. An ABA expert shows what the new rules will mean for all banks.
For community banks, the third time around for the global rules may be less “the charm” than cause for alarm
By Mary Frances Monroe
The sleepy town of Basel, Switzerland, seems an unlikely source for radical changes to the global banking environment. Best known as a pharmaceutical headquarters, it is also home to the Bank for International Settlements, sponsor of the Basel Committee on Banking Supervision. The committee sets international standards for the conduct and risk management of a wide range of bank activities, including standards for appropriate levels of capital to be held against risks of those activities.
The committee’s most recent previous pronouncement on regulatory capital—dubbed Basel II—was applied in the U.S. only to large, internationally active banks. Thus the Basel Committee has not been on the radar of most community banks since adoption of Basel I in 1988. That changed in September when the committee announced a fundamental redefinition of capital as well as heightened standards intended to apply to all banks. For many, the changes will force revisions to capital plans and, for some, require new sources of equity capital.
Bumpy road from I to III
Current capital rules applied to U.S. banks and bank holding companies are based on the Basel I accord, which started the risk-sensitive approach to capital requirements. Exposures on and off the balance sheet were classified into broad categories of credit risk.
Over time, Basel I was criticized for being insufficiently granular in its assignment of assets to risk categories. Exposures with very different risk profiles would be slotted into the same risk bucket. The committee sought to improve the risk sensitivity of Basel I and embarked on a multi-year upgrade.
Basel II was adopted in 2004 as a more risk-sensitive measure that employed banks’ own estimates of risk in determining minimum capital requirements. When the Basel Committee adopted Basel II, U.S. federal banking agencies decided to adopt only the advanced approaches that apply to certain internationally active banking organizations. Others could opt-in voluntarily.
After adoption of Basel II, some committee members expressed concerns about the perceived expansiveness of the definition of capital.
Concerns centered around the ability of certain instruments included in Tier 1 capital to absorb loss on a going-concern basis. To discuss these concerns, a working group was formed to review the definition of capital. The lengthy deliberations of this group influenced significantly the consultative paper released in December 2009—”Strengthening the resilience of the banking sector.” That paper proposed a substantial narrowing of the types of instruments that could be included in Tier 1; a stronger reliance on common shareholders’ equity; and a very aggressive increase in capital requirements —all with a goal of implementation by yearend 2012.
In response to comments filed by banks, trade groups—including ABA—and others, some onerous provisions were revised. The resulting agreement, released in September, is known as “Basel III.” It was expected to be formally endorsed at the November meeting of the G-20.
Basel III in brief
Space constraints allow only an overview of Basel III. The framework increases capital requirements and limits the types of instruments that can be included in Tier 1. While it represents a moderation of the most onerous provisions of the consultative paper, the impact should not be underestimated. Basel III requires a minimum common equity capital ratio of 4.5% of risk-weighted assets by Jan. 1, 2015, plus adoption of a capital conservation buffer equal to common equity in the amount of an additional 2.5% of risk-weighted assets by Jan. 1, 2019.
Basel III also limits the types of instruments that can be included in Tier 1 capital to common shareholders’ equity plus a limited “sin bucket” that is capped at 15% of common equity in the aggregate and 10% of common equity for any one component. The “sin bucket” consists of mortgage servicing rights, deferred tax assets that arise from timing differences, and significant (more than 10%) investments in the common shares of unconsolidated financial institutions. The first two categories of assets are more commonly held by U.S. banks; the investments in unconsolidated financial institutions are more common in Europe. Amounts of these restricted assets in excess of the 10% and 15% caps are deducted from common equity over a phase-out period from 2013 to 2018.
Basel III provides for a phase-in of the minimum common equity capital ratio, the capital conservation buffer, and the Tier 1 capital requirement, as set forth in the nearby chart. The minimum total capital requirement (minus the buffer) remains at 8% of risk-weighted assets.
Basel III also provides for a leverage ratio in recognition of the role that high levels of overall leverage contributed to the recent financial crisis. However, the leverage ratio under Basel III is very different from the leverage ratio to which U.S. banks have long been subject; the Basel III leverage ratio includes off-balance sheet exposures. The leverage ratio will be the subject of a supervisory monitoring period from January 2011 followed by a parallel run period from January 2013, with banks required to report their leverage ratios from January 2015. Based on the results of the parallel run, adjustments may be made to the leverage ratio in the first half of 2017, with a view towards implementing a leverage requirement effective January 2018.
Impact on community banks
A common misperception among some bankers is that Basel III is of concern only to large, internationally active banks. ABA has been active in dispelling that. Basel III is a fundamental redefinition of capital. It places common stockholders’ equity in the overwhelmingly predominant position in capital structures.
Implementation of Basel III for U.S. banks will depend on the federal banking agencies. They will issue a notice of proposed rulemaking later this year or early next year.
While it’s not possible to say with certainty how Basel III will be implemented, here is what ABA expects:
• Banks will be urged to meet the fully phased-in common equity capital ratio plus capital conservation buffer of 7% of risk-weighted assets and the total capital plus conservation buffer ratio of 10.5% sooner rather than later.
• Banks with significant credit concentrations including, but not limited to, commercial real estate, should expect to maintain capital ratios above the fully phased-in minimum requirements.
• Trust preferred and cumulative preferred securities that have long been issued by bank holding companies will no longer count as Tier 1 capital under Basel III, as well as the Dodd-Frank Act. (The Act makes certain exceptions for smaller bank holding companies, but continued use of trust preferred as a funding vehicle for such companies is at odds with Basel III. This likely will be addressed in the rulemaking.)
• The current leverage ratio requirement should remain in effect, with agencies migrating to a new leverage ratio that includes off-balance-sheet exposures. Whether this will replace existing requirements or be added to it remains to be seen.
What about liquidity?
The Basel Committee published a consultative paper on liquidity metrics at the end of 2009. The proposal would have established a short-term (30-day) liquidity coverage ratio and a longer-term (one year) net stable funding ratio that would require banks to hold sufficient liquid assets to deal with the cash outflows associated with an acute stress scenario. Widespread criticism of the proposal plus the timing of the sovereign debt crisis coincided neatly to reflect the proposal’s shortcomings. As a result, the committee decided to take more time to study liquidity metrics and to delay introducing a short-term ratio until 2015 and a longer-term ratio until 2018.
This is not to say that heightened liquidity standards will not be applied for several years. Basel member countries have committed to “rigorous reporting processes to monitor the ratios” during the intervening years. In the U.S., expect examiners to increase their scrutiny and, at least informally, use various metrics to benchmark banks’ liquidity positions.
Banks can also expect increased focus on liquidity contingency plans. These plans should provide for a range of options for raising new liquidity based on escalating stress events, both bank-specific and market-wide, as well as a combination of market and idiosyncratic stresses. The lack of final committee action on liquidity doesn’t mean banks can rest; the liquidity crisis remains top-of-mind among regulators.
To assist banks with their planning, ABA will be rolling out a revised liquidity toolkit later this year. •
The electronic version of this article available at: http://www.nxtbook.com/nxtbooks/sb/ababj1110/index.php?startid=32
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