Basel Committee announces higher capital ratios

Banking observers had previously suggested that the full Basel III package of capital and liquidity reforms proposed could reduce returns on equity in the sector by up to a third.

The global banking sector must therefore have breathed a sigh of relief on September 12, when the Basel Committee of Banking Supervisors (BCBS) announced their latest proposals for a reformed capital and liquidity regime.

What are the new minimum requirements?

The BCBS agreement includes:
• a tightened definition of capital, including a focus on common equity
• increased minimum capital ratios
• an additional non-risk weighted leverage ratio to be met
• proposals for capital conservation and counter cyclical buffers
• additional capital surcharges for systemic banks
• a global liquidity standard to ensure sufficient liquid assets to cover short term outflows in times of stress.

The new minimum requirement will be split between a core requirement and a ‘conservation buffer’ which can be accessed in times of stress. Key requirements in the agreement are:
• increases in minimum common equity requirements from 2 percent now to 4.5 percent by 1 January 2015
• a capital conservation buffer ultimately reaching 2.5 percent giving a cumulative, ongoing minimum common equity requirement of 7 percent, and a minimum total capital requirement of 10.5 percent
• additional deductions from capital, which further reduce capital available to support assets will be phased in from 2014 to 2018.
 

What do these proposals mean for banks?

While the headline figure of seven percent in ongoing minimum common equity requirement remains, getting there may become more challenging. This is due to a tighter definition of qualifying capital, increased capital requirements against trading book assets, and higher deductions from capital.

(1) Further capital ‘add-ons’: National regulators can impose up to 2.5 percent as a further ‘counter cyclical’ capital requirement. Further capital requirements are likely for ‘systemically significant banks.’ Levied at the supervisor’s discretion, this could mean considerable scope for variation between jurisdictions and banks.

There is also a new requirement for a minimum leverage ratio of three percent. Many banks may choose to build in additional buffers. Dipping into the conservation buffer may allow regulators to impose restrictions on bonus and earnings distributions.

(2) Lead times can be misleading: The proposed timing may also be an issue, and banks should be taking steps now to position themselves for compliance.

Many of the new proposals will take effect earlier than the implementation dates of 2018 and 2019. There are also some pre-implementation requirements for supervision and disclosure, which means the pressure on banks to comply will start earlier.

In the transitional period, banks below the seven percent capital level will need to ‘maintain prudent earnings retention policies.’ This gives regulators a lever on bonuses and distributions from 2013 or earlier.

(3) ‘Known unknowns’: Much is being left to national discretion, even as the Basel Committee has now achieved wider international agreement.

Final proposals to address the additional risk posed by ‘systemically significant institutions’ are still being studied by the Basel Committee, and the Financial Stability Board. This could still add result in capital and compliance burdens for institutions.

Calibration of the liquidity coverage ratio and net stable funding ratio are subject to lengthy observation periods with minimum standards proposed for 2015 and 2018 respectively, and could have another substantial impact on bank funding and strategy.

It is not all about capital

Basel 3 is underpinned by risk models quantifying risk on which the capital requirements are based. While banks review their capital strategy, they should anticipate anticipated regulatory calls for continued improvements to risk management and risk models.

The implementation of Basel III will be phased with first requirements taking effect in January 2013. Planning should start early to facilitate the operational information and technology changes required for plans to be put in motion. Only then can banks implement the required changes and while retaining the flexibility to accommodate future changes.

The Basel capital and liquidity reforms will now be presented to the Seoul G20 Leaders summit this week. Different adoption and implementation agendas in different jurisdictions are still possible and these could complicate preparation and compliance for many cross-border firms.