1. Capital - Regime Changes
1.1 Basel III and CRD IV
Basel III is a global package of reforms setting out international standards of capital adequacy and makes changes to the existing Basel II framework. It has come about in response to the financial crisis.
Basel III is aimed at internationally active banks, whereas CRD IV, which implements Basel III in the EU (and repeals the existing Capital Adequacy Directive), also extends coverage of the new capital regime to credit institutions (an undertaking, the business of which is to receive deposits or other repayable funds from the public and to grant credits for its own account) and investment funds (basically firms which fall into the scope of the EU Markets and Financial Instruments Directive (2004/39) MIFID) excepting a small number of investment firms, whether such firms are international or not.
1.2 CRD IV, CRR and the Regulators
CRD IV is a new directive incorporating a regulation, namely the Capital Requirements Regulation which applies directly to every EU member state (rather than the Directive which must be transposed into national law). CRD IV addresses supervisory powers and prudential requirements and its main aim is to provide a "single rulebook' across the EU that will cover regulatory capital, the definition of capital, risk weighting, corporate governance and penalties.
CRD IV is on top of other reforms in relation to banks such as Liikenen, Vickers, banking , the UK Financial Services (Banking Reform) Bill etc. Also CRD IV is not the last word on capital requirements, nor is it likely that the amount of capital that firms will have to hold will be reduced.
In the UK the regulatory bodies, the PRA and the FCA, are subject to the rules and will be
applying them to relevant firms in the UK. National regulators will have little scope in interpreting the rules, they are broadly stuck with the words on the page. For all practical purposes the rules are already in force.
The new rules were published in the Official Journal of the European Parliament on 27 June 2013 and will come into effect from January 2014. The EU Commission has set out grandfathering arrangements for existing capital instruments in the transitional provisions for the regulation.
2. Capital requirements
What constitutes qualifying capital will become more restricted. Risk weightings will increase and the overall ratios to be met will go up. The base requirements for common equity will increase from 2% to 4.5%. The requirement for total Tier 1 capital will increase from 4.5% to 6%. Additional buffers will be introduced (for example, an additional buffer for globally systemically important banks) and a capital conservation buffer and these buffers are largely to be met out of equity.
In addition, the amendments introduce new prudential requirements in the form of the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR).
Core Tier 1 ratios measure equity capital as a proportion of a bank's assets. Certain hybrid instruments currently recognised as Tier 1 capital will no longer be treated as such. Until now, banks have used "internal models" to calculate their risk-weighted assets, thereby reducing their capital requirements (giving them considerable discretion). However the new regime is pushing banks to use standardised risk weightings rather than internally modelled ones.
3. Leverage Ratio
In order to curtail a bank's total indebtedness, a leverage ratio of 3% is proposed, preventing given borrowing from being more than 33 times a bank's Tier 1 capital. Under the leverage ratio only Tier 1 capital will qualify.
This is being introduced to contain the build-up of leverage in the banking sector and restrict the level of indebtedness. It will eventually be a 100% requirement, but it is to be phased in, starting at 60% in 2015 reaching 100% on 1 January 2018. Under the LCR, the institution must have a stock of high-quality liquid assets (those assets that can be converted into cash to meet liquidity needs (net cash outflows) for a 30-day period under a severe stress scenario which is at least equal to the total net outflows. For example, highly liquid assets will include instruments such as government bonds. If a bank enters into a commitment of 100 capable of being called in the next 30 days, it must 100 in terms of liquidity on day one.
Illiquid long-term assets must be funded by long-term liabilities, meaning liabilities of more than 12 months. Under NSFR, institutions must structure their funding so that the amount of long-term funding is at least equal to their illiquid assets (if you need long exposures, you need long-term assets e.g. bonds). The type of funding will depend on the type of asset held. Off-balance sheet exposures and/or activities pursued by the institution – the regulation is trying to limit the extent to which the institution can rely on debt which is less than 12 months. The NSFR is not directly covered by CRD IV, but will be the subject of further legislation proposed by 31 December 2016