Basel III Capital Standards Are Announced

Basel III Capital Standards Are Announced

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On September 12, 2010, the G-10 Governors and Heads of Supervision ("GHOS") announced their agreement on a new capital proposal, commonly referred to as Basel III. This proposal will be presented to the G-20 nations at their meeting in South Korea in November, where adoption is widely anticipated. If this occurs, it will then be up to each G-20 nation to adopt these rules (or variations of them) over the next few months, or, more likely, years. Basel III seeks to raise the capital standards applicable to all G-20 banks. In connection with these capital standards, global liquidity standards (not described here) also will be proposed in the future. As formulated, Basel III would apply only to banking entities, and it has been criticized in some quarters as not applying to the "shadow banking system" of nonbanks engaged in financial activities that are the functional equivalent of banking. Others believe that similar requirements may be extended in the future to other types of financial entities by some, if not all, G-20 countries (for example, in the United States, to insurance companies and systemically important financial institutions).

In order to obtain the agreement of all the G-20 countries, a lengthy phase-in period was adopted, with implementation of the new standards not beginning until 2013 and the full requirements not in place until January 1, 2019. This should provide sufficient time and opportunity for banks subject to Basel III to raise the required capital, while not diminishing their ability to provide credit to their borrowers at a particularly critical time for the financial markets. Following this Summary are Annex I (setting forth the capital requirements and buffers) and Annex II (showing how the capital requirements will phase in from now through January 1, 2019) from the G-10 capital announcement.

Three measures of capital will be established: Common Equity (4.5%), Tier 1 Capital (6%), and Total Capital (8%). Although the first two ratios will begin to be implemented in 2013, they will not be fully in place until 2015. The Total Capital ratio will remain at the current required level of 8%. In addition to these three ratios, a Capital Conservation Buffer (2.5%) will be required, phasing in beginning in 2016 and fully in place by 2019. The Capital Conservation Buffer will consist of Common Equity. By 2019, banks must have a Common Equity plus Conservation Buffer of 7% and a Total Capital plus Conservation Buffer of 10.5%. The premise behind the Conservation Buffer is that a bank can draw down on it in times of financial and economic stress. However, the closer the banks' regulatory capital ratios approach the minimum requirement, the greater the constraints that will be put on earnings distributions, such as dividends and executive compensation, thus establishing strong incentives for banks to maintain the buffer.

The combined figure of 7% Common Equity plus Conservation Buffer contrasts with the current Basel II requirement of 2% Common Equity. These capital measures represent a stronger reliance on core equity capital and, even for Tier 1 Capital, regulatory adjustments are restricted and financial instruments that make up Tier 1 Capital are based on stricter criteria. One exception to these more stringent requirements is that existing public sector capital injections will be counted as Tier 1 Capital for a phase-in period.

The Basel III proposal will not be phased in as quickly, or be as comprehensive, as some nations might have wished. Several measures that were backed by the United States and the United Kingdom were not adopted as hard requirements at the outset, but will be studied, monitored and may be introduced later, including leverage and liquidity ratios and additional loss-absorbing capacity for systemically significant banks. Examples of this include a Tier 1 leverage requirement (Tier 1 Capital to book asset ratio), which is anticipated initially to be monitored, added (at a level of 3%) as a parallel test run in 2013, disclosed as of 2015, then added as a required ratio as of 2018. Also, a liquidity coverage ratio initially will be the subject of observation only, with a minimum standard to be introduced in 2015. A countercyclical buffer (in a range of 0-2.5%) may be adopted on an individual country basis. This buffer would be required in addition to other capital requirements during times of economic expansion and could be drawn upon in times of economic contraction. Finally, the GHOS continues to work on the development of additional measures to improve the loss-absorbing capacity of systemically important financial institutions to address "too big to fail" concerns.

U.S. regulators are supportive of the Basel III effort. In a press release dated September 12, 2010, U.S. banking regulators called the Basel III agreement "a significant step forward in reducing the incidence and severity of future financial crises, providing for a more stable banking system that is less prone to excessive risk-taking, and better able to absorb losses while continuing to perform its essential function of providing credit to creditworthy households and businesses." Nonetheless, U.S. regulators expressed their desire for higher standards, including measures to deal with the "too big to fail" problem, pointedly stating that the Dodd-Frank Act "requires the establishment of more stringent prudential standards, including higher capital and liquidity requirements for large, interconnected financial institutions." EU regulators also have endorsed the overall package. They have, however, expressed concern that adjustments may be required in implementing leverage limits (e.g., French banks have historically operated with higher leverage); liquidity rules (e.g., to recognize covered bonds, which are widespread in Germany and other EU member countries); and the definition of capital (where lenders such as cooperative banks cannot easily increase equity by issuing shares).

Annex 1

Annex 2

Contributors