Basel Committee on Banking Supervision Publishes Revised Capital Framework and Phase-In Periods.

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At a meeting on September 12, 2010, the oversight body of the Basel Committee on Banking Supervision (the "Basel Committee"), announced the calibration of a revised capital framework ("Basel III") for major banking institutions, as well as the transition and phase-in roadmap for the revised capital rules. These bank capital reforms will be presented for formal adoption at the G20 Finance Ministers and Central Bank Governors summit to be held in Seoul on November 11 and 12, 2010. National implementation by member countries, including Canada, would begin on January 1, 2013, with member countries translating the rules into national laws and regulations before this date.

This new bank regulatory capital framework will be phased-in, as described below, over an eight-year period in total. Once fully implemented on January 1, 2019, Basel III will subject banking institutions to the following capital requirements:

  • a minimum requirement for common equity, the highest form of loss-absorbing capital, of 4.5% (increased from 2%), which together with the "capital conservation buffer" of 2.5% referred to below, would bring the total common equity requirement to 7%;
  • a Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, of 6% (increased from 4%); and
  • a new "capital conservation buffer" to be calibrated at 2.5% and be met with common equity, after the application of deductions, and which buffer is to be above the minimum requirements, including the unchanged minimum total capital ratio of 8%.  

The Basel Committee also announced that a "countercyclical buffer" within a range of 0% - 2.5% of common equity (or other fully loss absorbing capital) will be implemented according to "national circumstances". This countercyclical buffer, when in effect, would be introduced as an extension of the capital conservation buffer range. For any given country, this buffer would only be in effect when there is excess credit growth resulting in a system-wide build-up of risk, as determined by the applicable regulator in the relevant jurisdiction using macroeconomic tools. Under the Basel Committee's previously published proposals regarding countercyclical capital buffers, the add-on buffer would be set at zero during normal macroeconomic conditions, with the Basel Committee expecting the buffer to be imposed infrequently, perhaps once every 10 to 20 years.

In addition, the Basel Committee's announcement states that "systemically important banks" should have loss absorbing capacity beyond the Basel III standards, and that the Basel Committee is pursuing workstreams with the intention of developing a well-integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt. In addition, it is stated, without further elaboration, that "work is continuing to strengthen resolution regimes".

Phase-in and Transition

National implementation of Basel III by member countries, including Canada, would begin on January 1, 2013, with member countries translating the rules into national laws and regulations before this date. As of January 1, 2013, banks will be required to meet the following new minimum requirements in relation to risk-weighted assets ("RWAs"):

  • 3.5% commonequity/RWAs;
  • 4.5% Tier1 capital/RWAs; and
  • 8.0% totalcapital/RWAs.

The minimum common equity and Tier 1 requirements will be phased-in between January 1, 2013 and January 1, 2015. On January 1, 2014, banks will have to meet a 4% minimum common equity requirement and a Tier 1 requirement of 5.5%. On January 1, 2015, banks will have to meet the 4.5% common equity and the 6% Tier 1 requirements.

The 8% total capital requirement remains unchanged and so does not need to be phased in. The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 and so-called "higher forms" of capital.

The capital conservation buffer will be phased-in between January 1, 2016 and January 1, 2019. It will begin at 0.625% of RWAs on January 1, 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on January 1, 2019. National authorities, such as the Office of the Superintendent of Financial Institutions ("OSFI"), have the discretion to impose shorter transition periods. The purpose of the conservation buffer is to ensure that banking institutions maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks banking institutions will be allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on their earnings distributions.

The regulatory adjustments to common equity, including amounts above the specified limits for investments in financial institutions, mortgage servicing rights, and deferred tax assets from timing differences, would be fully deducted from common equity over a phase-in period through to January 1, 2018. During this transition period, the remainder not deducted from common equity will continue to be subject to existing national treatment.

Banks that already meet the minimum ratio requirement during the transition period, but remain below the 7% common equity target (minimum plus the capital conservation buffer), should maintain prudent earnings retention policies with a view to meeting the capital conservation buffer as soon as reasonably possible.

The release also outlines the timeline for the grandfathering and sunset of existing public sector capital injections and capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital.

Other Ratios

The monitoring period for supervising global leverage ratios will commence on January 1, 2011, and the parallel run period for the new minimum Tier 1 leverage ratio of 3% will commence January 1, 2013 and run until January 1, 2017. Based on the results of the parallel run period, any final adjustments will be carried out in the first half of 2017 with a view to migrating this leverage ratio to a Pillar 1 treatment on January 1, 2018, based on appropriate review and calibration. Disclosure of the leverage ratio and its components will start January 1, 2015, although the release does not provide specifics with respect to these disclosure requirements.

The September 12, 2010 release also confirms, without further elaboration, that, after an observation period beginning in 2011, the liquidity coverage ratio (LCR) will be introduced on January 1, 2015, and the revised net stable funding ratio (NSFR) will move to a minimum standard by January 1, 2018.

Certain Conclusions and Issues

The Basel III capital framework has the stated goal of strengthening global capital standards and contributing to long-term financial stability and growth, and has, for the most part, been received positively worldwide, including by Bank of Canada Governor Mark Carney, who has stated that the economic case for higher capital requirements for banks is compelling. Through the combination of a revised definition of capital, higher minimum requirements and the introduction of new capital buffers, these revised bank regulatory capital standards are designed to ensure that banks are better able to withstand periods of economic and financial stress.

Although the Basel III requirements appear to impose, in the aggregate, capital ratios that are currently met or exceeded by the major Canadian banking institutions, the revised capital framework will require a close review of the composition of each banks' regulatory capital. In addition, it remains to be seen whether regulators, including OSFI, will expect banking institutions to maintain capital levels in excess of the Basel III standards. It is noteworthy, however, that upon the publication of the Basel III release, OSFI announced that it will no longer require Canadian banks, bank holding companies and trust and loan companies to be subject to the increased conservatism in capital management announced late in 2008.

The Basel Committee also announced that it will put in place rigorous reporting processes to monitor the ratios during the transition period and will continue to review the implications of these standards for financial markets, credit extension and economic growth, addressing unintended consequences as necessary. The release, however, provides no further details or follow-up roadmap regarding the framework for this reporting and monitoring.

Moreover, significant questions remain regarding the Basel Committee's pending approach to systemically important financial institutions, including in respect of capital surcharges, contingent capital and bail-in debt, as well as in respect of resolution regimes. These questions are only compounded by similar regulatory action to be taken in the United States (including in respect of foreign banks, bank holding companies and financial institutions) under the Dodd-Frank Wall Street Reform and Consumer Protection Act.