On 12 September 2010 the Bank for International Settlements announced that the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision ("BCBS"), had reached agreement on Basel III1.  Basel III represents a comprehensive reform of global banking regulation and will involve a substantial strengthening of bank capital requirements. 

The BCBS has also endorsed the Basel Committee's capital and liquidity reform package which was agreed on 26 July 2010.2

New Capital Requirements

Under Basel III, there will be strengthening of the quality of capital required to be held by banks.  The minimum capital ratio for common equity, which is the highest form of loss absorbing capital, will increase to 4.5% from the current level of 2%.  The Tier 1 capital ratio (which includes common equity and other qualifying financial instruments based on stricter criteria) will increase from 4% to 6%. 

Banks will also be required to hold a separate capital conservation buffer comprising 2.5% of common equity.  The intention behind this new requirement is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress.  Banks will be allowed to draw upon the buffer during such periods but, should they do so, they will face constraints on earnings distributions.  This framework is intended to reinforce the objective of sound supervision and bank governance, and address the issue of the collective failure of banks to curtail distributions such as discretionary bonuses and high dividends, even when faced with deteriorating capital positions.

A countercyclical buffer will also be implemented, according to national circumstances.   This buffer will range from 0% to 2.5% of common equity or other fully loss absorbing capital.  Its purpose is to achieve the broader macro-prudential goal of protecting the banking sector from periods of "excess aggregate credit growth".  For any given country, the countercyclical buffer will only be in effect when there is excess credit growth resulting in a system wide build up of risk.  Decisions on when economies have entered such periods will be taken by national regulators.  Once put into operation, the countercyclical buffer will be introduced as an extension of the capital conservation buffer.

The above capital requirements will be supplemented by the introduction of a non-risk based leverage ratio.  A minimum Tier 1 leverage ratio of 3% will be tested during the period from 1 January 2013 to 1 January 2017.  

Systemically Important Financial Institutions

In its announcement, the BCBS made it clear that systemically important banks will be required to hold loss absorbing capital in excess of the levels described above.  The BCBS and the Financial Stability Board continue to work together on an integrated approach to systemically important financial institutions.  This may include combinations of capital surcharges, contingent capital and bail-in debt.  A task force, chaired by Paul Tucker, Deputy Governor of the Bank of England, is working on the requirements for systemically important financial institutions and is expected to report in October, in preparation for the November 2010 G20 meeting.

Transitional Arrangements

Many of the largest banks have made substantial efforts already to increase capital levels in order to repair their balance sheets since the onset of the financial crisis.  In particular, many UK banks already hold capital levels well in excess of the current minimum regulatory requirements.  Such institutions should find the higher Basel III standards less of a stretch.  In contrast, those banks which hold too little capital are likely to have to raise new capital amounting to potentially hundreds of billions of euros over the next decade.  This issue has been recognised in the transition periods for compliance with Basel III, which are longer than many had expected.  The transitional arrangements are intended to enable banks to meet the higher capital requirements through reasonable earnings retention and capital raising, while supporting lending to the economy.   

The minimum common equity and Tier 1 requirements will be phased in between 1 January 2013 and 1 January 2015 in the following stages:

  • 1 January 2013: minimum common equity requirement rises from 2% to 3.5%, and minimum Tier 1 capital requirement rises from 4% to 4.5%. 
  • 1 January 2014: minimum common equity requirement rises to 4%, and minimum Tier 1 capital requirement rises to 5.5%.
  • 1 January 2015: minimum common equity requirement rises to 4.5%, and minimum Tier 1 capital requirement rises to 6%. 

The capital conservation buffer will be phased in from 1 January 2016, becoming fully effective on 1 January 2019.  The buffer will begin at 0.625% of risk weighted assets ("RWAs") on 1 January 2016 and will increase each subsequent year by an additional 0.625 percentage points, reaching a level of 2.5% of RWAs on 1 January 2019.  The BCBS advises that countries which experience excessive credit growth should consider accelerating the build up of the capital conservation and countercyclical buffers.  National regulators will have the discretion to impose shorter transition periods and are expected to do so where appropriate. 

Supervisory monitoring of the leverage ratio will begin on 1 January 2011.  The leverage ratio and its components will be tracked during the parallel run period, which commences on 1 January 2013 and runs until 1 January 2017.  Disclosure of the leverage ratio by individual banks will begin on 1 January 2015, and will be closely monitored.  Based on the results of the parallel run period, any final adjustments will be made in the first half of 2017.  This is with a view to migrating to a Pillar 1 treatment on 1 January 2018, based on appropriate review and calibration. 

Full details of the phase-in arrangements are set out in Annex 2 of the BCBS announcement (see www.bis.org/press/p100912b.pdf).  

Next Steps

The Basel III Accord will be presented to the Seoul G20 Leaders' summit for endorsement in November 2010.  Once the agreement has been confirmed by the G20, the European Commission will propose legislation to transpose Basel III into European Law.  The Commission intends to issue its legislative proposals, together with an in-depth impact assessment, in Q1 2011.  The legislative proposals are expected to consist of revisions to CRD 4.

Reaction

Basel III is at the core of the G20's efforts to apply lessons learnt from the global financial crisis.  Regulators have said that they hope that the changes will push banks towards less risky business strategies and ensure that they have enough reserves to withstand financial shocks, thus avoiding a repeat of the recent crisis.  Speaking about the new rules, Mr Jean-Claude Trichet, President of the European Central Bank and Chairman of the Group of Governors and Heads of Supervision, stated that the Basel III Accord represents "a fundamental strengthening of global capital standards", and that its "contribution to long-term financial stability and growth will be substantial".  Mr Nout Wellink, Chairman of the BCBS and President of the Netherlands Bank, commented 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".

Markets have generally interpreted the agreement as positive for banks with most bank shares gaining, rather than losing value.  This tends to reflect (i) the reduction of uncertainty about the shape of the proposals and (ii) the fact that the transition period is longer than some had expected. 

Overall, however, it is likely that while the new Accord may make banks sounder, it will also mean that they have less funds available to lend and will be more risk averse.  This is likely to limit the scope for economic growth, particularly in Europe, which is the most ardent supporter of the Basel Accord.  This raises the possibility that some US and Asian banks may be better placed to exploit international business opportunities in the future, if differential implementation of the Accord gives them greater scope for taking risks with their balance sheets. 

Footnotes

1  See http://www.bis.org/press/p100912.pdf
2  See http://www.bis.org/press/p100726.htm

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