Basel III: The Capital Challenge

In December 2010, after months of negotiation, the Basel Committee issued the long-awaited Basel III. The text, which was agreed by the governors and heads of supervision together with a quantitative impact study (QIS), details the standards on bank capital adequacy and liquidity and will form the basis of Capital Requirements Directive 4 (CRD 4) European reforms, which will become mandatory for European banks and investment firms caught within the scope of Markets in Financial Instruments Directive (MiFID).

Under the Basel III rules, banks will need to hold a greater amount of high-quality capital that must be capable of fully absorbing losses at the point of non-viability. Also included in the rules are:

  • Provision for better coverage of risk, especially for capital market activities, including a proposed 2% risk weighting for exposures to central counterparties (previously 0%).
  • An internationally harmonised 3% leverage ratio (to be tested under observation) to constrain excessive risk taking and to serve as a backstop to the risk-based capital requirements.
  • Capital buffers to promote the build-up of capital that can be drawn down in periods of stress, which appear to only be able to be met by common equity Tier 1 capital and not by loss absorbing Tier 1 capital.
  • The introduction of the liquidity coverage ratio (LCR), including an LCR minimum floor, intended to ensure that banks can pay their obligations falling due over a period of acute short-term stress (30 days). The LCR can be made up of a stock of high-quality liquid assets, including sovereign bonds and supranational bonds under certain conditions. Forty percent of it can be made up of ‘level 2 assets’ (e.g. non-bank corporate bonds and covered bonds subject to a minimum -AAA rating or equivalent internal rating) subject to a minimum 15% haircut.
  • The introduction of the net stable funding ratio (NSFR) intended to ensure that banks have sources of funding which they can access to meet obligations falling due over the longer term.

These rules, as a package of measures for reform, are accompanied by requirements covering stronger standards for supervision, public disclosures and risk management (including rules relating to enhanced corporate governance and the need for stress testing), together with rules relating to central clearing and disclosure of over-the-counter (OTC) transactions.

Built into the rules are long transitional periods that have been introduced with the intention of gradually raising capital and liquidity standards in order to permit banks to move to the higher capital and liquidity standards while supporting lending to the economy. The rules will take effect gradually over six years from 2013 onwards. However, there will be strong pressure for banks to meet the requirements prior to the transitional periods.

There are also grandfathering provisions built in so that hybrid instruments issued prior to 2013, which will not meet the loss absorbency test in place from 2013, can count towards a pool of instruments which will get grandfathered and amortised from 2013, for example.

The QIS states that the world’s largest 94 international banks will need to raise €577bn, based on figures at the end of 2009, in order to meet the minimum 7% Tier 1 capital ratio (4.5% minimum requirement and 2.5% capital buffer) required for banks to be free from restrictions on bonuses and dividends. British banks currently meet the requirement more effectively than European banks.

In addition, these banks that had an average LCR of 83% and average NSFR of 93% as of the end of 2009 will need to raise them to 100% by 2015 in respect of the LCR and by 2018 in respect of the NSFR. They will need to do this either by lengthening the terms of their funding or restructuring their business models, which are most vulnerable to liquidity risk in periods of stress. These figures may look harmless but the Basel Committee has said that under the NSFR these banks had an €2.89 trillion shortfall based on data as at the end of 2009, assuming that they made no changes to their funding structure.

The fact that the QIS is based on 2009 figures is unhelpful, because they are effectively a year out of date. In addition, the figures in the QIS do not include the additional amounts of capital and loss absorbency buffers required by banks (as yet unknown but expected to be disclosed mid 2011) on the basis that they will fall within the definition of a systematically important financial institution (SIFI), together with the cost of measures addressing contingent capital and bail-in-able debt.

Holding higher capital and complying with the requirements in the rules will be costly for banks. They will either raise money through capitalisations or through retaining profits and by reducing lending. Banks will also pass on the additional costs to end-users wherever possible by, for example, increasing interest rates on loans to borrowers. As a result, the cost of loans will be higher and the increased costs provision in loan agreements will be much negotiated.

Harmonised Implementation Needed

What will happen with implementation? It is important that Europe does not implement stricter rules than other G20 countries, for example Asia and the US, as some banks – such as those in Spain, Italy and Portugal – will be struggling even to meet the agreed requirements and it will adversely affect competition in Europe. In addition, while it is unlikely that the UK will be able to gold plate if the EU decides not to impose stricter rules once the CRD is implemented, the country should ensure that it does not impose stricter rules during the transitional period as this will adversely affect competition in the UK.

It is also important that a proportionate approach is taken with respect to implementation in Europe for investment firms to ensure they are not adversely affected by reforms designed to tackle the banking crisis.


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