At yesterday’s 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. In addition the central bankers fully endorsed the agreements reached in July this year. Under the agreements, the minimum requirement for common equity will be raised from the current 2% level to 4.5%. The Tier 1 capital requirement will increase from 4% to 6%.
“Their contribution to long-term financial stability and growth will be substantial.”
In stores January 2011 (Limited Edition)
According to the press release, “systemically important banks” should have loss absorbing capacity beyond the standards announced Sunday, and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams. The Basel Committee and the FSB are also developing an integrated approach to the “systemically important” financial institutions which could include combination of capital surcharges, contingent capital and bail-in debt.
However, which banks that are regarded as “systemically important” are yet to be determined.
But even more interesting will be the list of banks that are “systemically unimportant.”
One might also wonder what the bankers mean by “a higher form of capital”…
“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 securitization activities to be introduced at the end of 2011,” Bank of International Settlements writes in its statement.
After its meeting on Sunday, The Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a 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,” Bank of International Settlements says in the press release.
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 securitization activities to be introduced at the end of 2011.
Contribution To Stability And Growth
Mr. Jean-Claude Trichet, President of the European Central Bank and Chairman of the Group of Governors and Heads of Supervision, says that “the agreements reached today are a fundamental strengthening of global capital standards.” Adding 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, adds 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.”
Under the agreements reached Sunday, 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.
The central bankers agree that the capital conservation buffer is a the regulatory minimum requirement and must 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,” BIS says.
This is described as “sound supervision.”
National Countercyclical Buffers
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,” BIS adds.
Systemically important – Or Not?
“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 central bankers informs.
The Basel Committee and the FSB are also developing an integrated approach to systemically important financial institutions which could include a combination of capital surcharges, contingent capital and bail-in debt, according to the statement.
In addition, work is continuing to strengthen resolution regimes.
The Keeley Triangle
The Basel Committee on Banking Supervision have recently issued a consultative document proposal to ensure the loss absorbency of regulatory capital at the “point of non-viability.”
The point of non-viability refers to the contingency that a bank becomes unable to support itself in the private market such that it needs rescuing by the public sector, rather than in the narrow sense of insolvency or liquidation.
BCBS have considered three different options which could help ensure that, as a pre-condition of being treated as regulatory capital, an instrument (in particular a Tier 2 instrument) is capable of bearing loss at the point of non-viability:
Option 1: Developing national and international bank resolution frameworks that enable losses to be allocated to all capital instruments issued by internationally active banks that have reached the point of non-viability.
Option 2: Identifying systemically important banks and prohibiting them from including Tier 2 instruments in their regulatory capital.
Option 3: Mandating that all regulatory capital instruments include a mechanism in their terms and conditions that ensures they will take a loss at the point of non-viability.
BCBS ultimately chose to propose Option 3.
Option 1 was regarded as unrealistic in the short term, due to the need to achieve convergence of national insolvency laws and bank resolution regimes.
Option 2 would entail the practical difficulty of trying to identify systemically important banks, which itself gives rise to possible moral hazard issues and, therefore, would probably mean prohibiting all banks from including Tier 2 instruments in their regulatory capital, to the detriment of smaller, non-systemically important banks.
Here’s a copy of the proposal.
The Transition Arrangements
Since the onset of the crisis, banks have already undertaken substantial efforts to raise their capital levels, BIS points out.
Adding that the 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, according to the statement.
The Governors and Heads of Supervision have agreed on transitional arrangements for implementing the new standards to 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 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):
o 3.5% common equity/RWAs;
o 4.5% Tier 1 capital/RWAs, and
o 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.
A Higher Form of Capital
The usual capital structure
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.
“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.”
Here’s the full statement from Bank of International Settlements.
Annex 1: Calibration of the Capital Framework
Annex 2: Phase-in arrangements
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