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Legal Update

Basel III Capital and Liquidity Reforms Modified but Remain Largely Intact

3 August 2010
Mayer Brown Legal Update

On July 26, 2010, the Group of Governors and Heads of Supervision (Governors), the oversight body of the Basel Committee on Banking Supervision (Committee), announced “broad agreement” on the final terms of the Committee’s far-reaching “Basel III” package of capital and liquidity reforms proposed in December 2009.1 Although the overall structure and most of the key elements of the Basel III reforms remain intact, the Governors’ summary of the agreement reflects modifications in several key areas, including the definition of capital, the treatment of counterparty credit risk, elements of the new global leverage ratio, new regulatory capital buffers, mitigation of systemic risk and the new global liquidity standards. Critical details relating to calibration and the implementation schedule for the Basel III reforms, which will have a significant impact on both US and non-US financial institutions, are expected to be announced at the next Governors’ meeting in September 2010, ahead of the November 2010 G-20 summit in Seoul.

In a related development, the Committee on July 16 released for comment a detailed proposal for the new “countercyclical capital buffer,” which together with the “capital conservation buffer” described in the December 2009 capital reform proposal, is scheduled to be finalized by year-end 2010 and included as part of the Basel III reforms.

Broad Agreement on Basel III Terms

Generally speaking, the Committee agreed to retain the key elements of the December 2009 capital and liquidity proposals while including several specific modifications and clarifications, as well as delaying substantially the phase-in periods for the global minimum tier 1 leverage ratio and the “net stable funding ratio.” Key modifications to the original Basel III proposal include:2

  • Definition of Capital. The Committee will now permit limited inclusion in the common equity component of tier 1 capital of (i) significant (i.e., more than 10 percent) investments in the common shares of unconsolidated financial institutions; (ii) mortgage servicing rights; and (iii) deferred tax assets based on timing differences. Each of these elements would be limited to 10 percent of common equity, and in the aggregate could not exceed 15 percent of common equity. This represents a change from the December 2009 proposal, which would have required full deduction for these items. The Committee also will permit some as-yet unspecified “prudent recognition” of minority interests in consolidated bank subsidiaries (although other minority interests must be deducted), and permit use of IFRS rather than national GAAP in determining the types of intangible assets that must be deducted.

  • Leverage Ratio. The agreement retains the proposed minimum tier 1 leverage ratio, which has been tentatively set at 3 percent. However, the Committee will begin testing the 3 percent leverage ratio during a “parallel run” period from 2013 to 2017, with bank-level disclosure of the leverage ratio beginning in 2015. The leverage ratio is not scheduled to become a binding requirement until January 1, 2018. Although there is a “strong consensus” for using the new definition of tier 1 capital as the numerator for the leverage ratio, the Committee repeated its plans to track the impact of using total capital and tangible common equity as the relevant measures. Derivatives would be included based on the current exposure method under Basel II, but, in a departure from the December proposal, netting would be recognized. Finally, certain off-balance sheet items would be converted to on-balance sheet equivalents using uniform (but as-yet unspecified) credit conversion factors (CCFs), with a 10 percent CCF for unconditionally cancellable commitments.

  • Counterparty Credit Risk (CCR). Modifications have been made to the calculation of the additional capital charges for CCR arising out of derivatives, repurchase agreement and securities lending exposures, including broader recognition of hedging and elimination of a punitive multiplier in calculating the “credit valuation adjustment.”

  • Contingent Capital. The Committee will continue to assess and is expected to publish detailed proposals regarding (i) a requirement that contractual terms of certain capital instruments permit a regulator to write-off the instrument or convert it to common equity in the event of insolvency, and (ii) the use of contingent capital to meet a portion of the capital buffers (described below).

  • Liquidity Requirements. Implementation of the net stable funding ratio, which is designed to promote more medium- and long-term funding of the assets and activities of banks over a one-year time horizon, will be delayed until at least 2018, and a modified proposal will be issued for public comment by year-end 2010. Changes also were made to the calibration of the stress scenario and definition of qualifying liquid assets under the liquidity coverage ratio proposal.

Countercyclical Capital Buffer Proposal

The countercyclical capital buffer, issued for comment on July 16,3 would be an additional capital buffer (structured as an “add-on” to the capital conservation buffer)4 that is intended to encourage the increase of bank capital during “bubble” periods when excess credit growth is determined to be associated with a buildup of systemic risk. The proposal includes a methodology, based on the ratio of credit-to-GDP in individual countries, which is intended to promote international consistency in deciding when to trigger use of the countercyclical capital buffer. When a national authority determines that excessive credit growth is contributing to systemic risk, banks operating in that jurisdiction would be required to hold this additional capital. The Committee expects that the countercyclical capital buffer would be deployed infrequently, perhaps as rarely as once every 10 to 20 years in a given jurisdiction.

Comments on this proposal are due to the Committee by September 10, 2010.

Conclusion

The recent pronouncements appear designed largely to signal that the Committee remains on track for adoption of far-reaching capital changes by year-end 2010. Although the most recent pronouncements provide some welcome modifications and clarifications, many of the key details, including of course the ultimate “calibration” decisions, have yet to be announced. In addition, once adopted by the Committee, these Basel III changes will have to be adapted and applied by national authorities. As a result, the process of adopting and assessing the impact of Basel III will continue for some time.

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1. In reaching their agreement, the Governors considered comments received on the Committee’s detailed December 2009 capital and liquidity proposals—which together have been colloquially referred to as “Basel III”— as well as the results of the Quantitative Impact Study (QIS) called for in those proposals. For detailed information about the December 2009 capital reform proposal, please see our update, available at: https://www.mayerbrown.com/publications/article.asp?id=8416&nid=6.
Notwithstanding the expression of “broad agreement” on the final terms of Basel III, Germany has continued to express concerns about the package and has “reserved its position” until final details on calibration and phase-in arrangements are released in September.
2. A press release announcing the Governors’ agreement, together with a seven page Annex containing a summary of their agreed-upon modifications to the original Basel III proposals, is available at: http://www.bis.org/press/p100726.htm.
3. A copy of the countercyclical capital buffer proposal is available at: http://www.bis.org/publ/bcbs172.pdf?noframes=1.
4. The capital conservation buffer generally will consist of a buffer range above minimum tier 1 capital requirements. As a bank’s capital falls into the buffer range and approaches the minimum requirement, the bank would be subject to increasing restrictions on distributions (conversely, a bank that maintains capital in excess of the buffer range or at its high end would enjoy greater discretion with respect to distributions). Both the capital conservation buffer and the countercyclical capital buffer are expected to be finalized by year-end 2010 and included in the final Basel III reforms.

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