Amid considerable international publicity, the Basel Committee on Banking Supervision’s1 oversight body, the Group of Governors and Heads of Supervision, on Sunday, September 12, 2010, announced a strengthening of existing bank capital requirements and also endorsed a proposal issued last July for an additional countercyclical capital buffer2. These two developments, along with a new global liquidity standard, will now be presented to a November Summit meeting of leaders of the G20 countries.  

The day after the announcement stocks of the largest U.S. bank holding companies reacted favorably, possibly reflecting relief that the new standards were not as severe or impending as previously thought. However, the chairman of the FDIC commented that the new standards are not as high as “many of us” would have liked.3  

As reflected below, the announcement essentially consisted of the release of numbers, but did not explain the basis of how the numbers were reached.  

Minimum Common Equity Ratio

These reforms would eventually require banks to maintain a minimum ratio of common equity to risk-weighted assets of 4.5%, phasing in by January 1, 2015 (3.5% by January 1, 2013; 4% by January 1, 2014). Simultaneously, the broader Tier 1 minimum capital ratio, which includes not only common equity but also certain preferred stock and minority investment in consolidated subsidiaries, would also increase from 4% to 6% by January 1, 2015. Increasing the minimum amount of common equity required to support risk-weighted assets reflects the strong perception on the part of bank regulators that ability to absorb loss is the most important function of capital, and common equity provides the greatest ability to absorb loss.  

“Capital Conservation Buffer”

In addition, banks would be required, by January 1, 2019, to hold a so-called “capital conservation buffer” of 2.5%, phasing in beginning on January 1, 2016, when a 0.625% buffer would be required (1.25% by January 1, 2017; 1.875% by January 1, 2018; and 2.5% by January 1, 2019).  

The capital conservation buffer is to be met with common equity and, thus, would appear to be essentially, for all practical purposes, a further increase of the minimum common equity requirement.

Dividends

Banks that have not met the 7% common equity plus buffer target, are expected to maintain “prudent earnings retention policies” to meet the target as soon as reasonably possible. Banks would be permitted to pay dividends on the common stock that provides the capital conservation buffer, but the buffer is to absorb losses in times of stress, and, thus, banks may be constrained from paying dividends on that capital stock if capital ratios are dropping.  

Total Common Equity

The effect of this, of course, would be to impose a total common equity (plus buffer) to risk-weighted assets ratio of 7% by January 1, 2019 (phasing in at 3.5 % by January 1, 2013; 4% by January 1, 2014; 4.5% by January 1, 2015; 5.125% by January 1, 2016; 5.75% by January 1, 2017; 6.375% by January 1, 2018; and 7% by January 1, 2019).  

Transition

The transition periods, which do not commence until more than two years from now and then run for six years, are intended to blunt criticism that imposing higher capital standards on banks today would blunt the current slow international economic recovery. However, some have suggested that these new requirements could well be obsolete by the time—more than eight years from now— that they go into full effect.  

Although many banks have raised substantial amounts of capital since the financial crisis4 and reports are that the four largest U.S. banks already exceed the new ratios, a Basel study suggests that, in order to meet the new capital requirements, large banks will need to raise substantial amounts of capital. Ironically, many smaller banks already meet the new standards. The transition period is expected to enable banks to raise capital ratios through earnings retention and asset reduction, as well as traditional capital raises.  

January 1, 2013

By January 1, 2013, all banks would be expected to have ratios of 3.5% common equity to risk-weighted assets, 4.5% Tier 1 capital to risk-weighted assets, and 8% total capital to risk-weighted assets. Bank regulators would have to change their national rules before that date.  

Phase-In

Click here to see the phase-in schedule that would be followed.

Other Basel Capital Developments

Furthering this trend toward higher bank capital requirements, the Group of Governors and Heads of Supervision last July agreed to tighten the definitions of what constitutes capital and common equity5, and higher capital requirements for trading, derivative, and securitization activities are scheduled to be introduced at the end of 2011. Last July, the Group also agreed to test a non-riskbased minimum Tier 1 leverage ratio of 3% from January 1, 2013 to January 1, 2017 with adjustments carried out in the first half of 2017.  

The Committee also is working on other concepts that would impact large systemically important financial institutions (not just banks), such as capital surcharges, contingent capital, and “bail-in debt.” Details of these developments could be very significant, but are lacking. The Committee also recently released a proposal to strengthen the loss absorbency of non-common Tier 1 and Tier 2 capital instruments.  

Countercyclical Buffer

The September 12 announcement also mentions yet another capital buffer, a so-called “countercyclical buffer” of up to 2.5% of common equity, not to be confused with the new 2.5% “capital conservation buffer.” Implementation of this in any given country is expected to be a function of national economic circumstances; it is expected to be countercyclical, protecting banks from periods of excess growth of credit. For any given country, the countercyclical buffer will only be in effect when there is excess credit growth leading to a build-up of risk. The announcement provided no details as to when or how this would be phased in.

Conclusion

It is beginning to seem like capital has become to policy makers the new patent medicine that will cure all ills. The “medicine” is incorporated in new Basel III and the recently-enacted comprehensive financial regulatory reform legislation which provides for additional capital requirements for systemically important non-bank financial firms and higher capital requirements for swap dealers and major swap participants. While some cynics suggest that capital does not prevent many bank failures—since capital can be quickly wiped out as assets go bad (or as examiners express concern about them even if they do not really go bad) and capital cannot protect against the rare liquidity failure— requirements for higher levels of common equity do have the effect of reducing and limiting leverage. While that may adversely effect profitability, it may do wonders in reducing risk.