Changes to capital standards are rarely out of the headlines these days. Frequent announcements from Basel, Brussels and London seem to complement or overlap each other constantly. There is a high degree of confusion about what is happening, where, and when, and what changes banks and other institutions will have to make to their capital policies.  

In this article, Brett Hillis, Emma Radmore and Madeleine de Remusat outline recent developments in capital regulation. Although capital regulation is increasingly linked to other regulatory requirements, notably liquidity, operational management and remuneration policies, space does not permit this article to discuss these in detail.

Global – Basel and G-20

Basel II

Basel II has been around since 2006 or so (depending on when member countries implemented the Basel II accord agreed in 2004). Basel II was intended to overcome the shortcomings of Basel I, which was considered too simplistic and not sufficiently sensitive to risk, but the financial crisis highlighted that significant failings still remained. The Basel Committee on Banking Supervision’s (Basel Committee) agenda for strengthening the rules of Basel II included the need to address concerns that Basel II:  

  • Imposed insufficient minimum regulatory capital requirements to cover banks’ risk exposures, particularly for securitisations and market risks in the trading book
  • Did not require sufficiently good quality regulatory capital corresponding to banks’ risks (some items acceptable as capital did not in fact work to absorb losses)
  •  Lacked countercyclical capital buffers and provisions and
  •  Lacked a non-risk-based measure of regulatory capital to help contain leverage levels in the banking system.

Basel III

So Basel III set out to address these concerns, and concerns more generally raised about the banking capital requirements structure. Overall concerns included:

  • Regulation did not prevent banks becoming more and more thinly capitalised
  • A lack of trust in bank’s risk management and measurement
  • Accentuating the business cycle
  • Arguments around narrow banking and new commercial banking/ proprietary trading split
  • Some items accepted as capital did not work to absorb losses
  • Bankers’ remuneration and bonuses – where incentives were not aligned to prudent risk management
  • Capital requirements to cover “trading book” exposures were too low and did not reflect the risk that markets could become illiquid
  • Concentration risk/ large exposures exemptions and
  • Securitisation/resecuritisation.  

After broad agreement on the scope of Basel III in late 2009 and several consultations on various aspects of the changes, the Basel Committee endorsed Basel III on 12 September 2010. However, it does not intervene in structural debates around splitting proprietary trading from traditional banking activities. It sets a phased timescale for change over the next eight to nine years. Its aim is to improve:

  • The ability of the banking sector to absorb financial and economic stress-related shocks
  • Risk management and governance within banks and
  •  Banks’ transparency and disclosures.

To do this, Basel III has both macro-prudential and micro-prudential regulatory implications. The package of reforms includes:  

Increased capital requirements

  • Common equity: the minimum requirement for common equity will increase from 2 percent under Basel II to 4.5 percent under Basel III and will be subject to stricter regulatory adjustments. Additionally, there will be a new capital conservation buffer of 2.5 percent above the minimum regulatory requirement, made up of common equity. This buffer is to ensure that banks have capital to absorb losses during periods of financial stress. Banks will be able to use the buffer during these periods, the closer their ratios are to the minimum, the greater will be the constraints on earnings distributions.
  • Tier 1 capital requirement: this requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4 percent to 6 percent. However, the overall minimum capital requirement remains at 8 percent (excluding the capital conservation buffer and any countercyclical buffer).

Other micro-prudential measures

  •  Risk-based coverage: Basel III adjusts the way capital covers risks so that, for example:

– trading book exposures will be subject to a stressed VaR requirement – securitisation exposures will be subject to capital charges more consistent with those for the banking book – counterparty credit risk will be measured using stressed inputs, and banks must hold capital for mark-to-market losses associated with the deterioration of a counterparty’s credit quality and – there will be higher capital requirements for OTC activities to encourage use of central counterparties and exchanges (in line with other global and EU initiatives)

  • A global liquidity standard: many banking activities have not in the past included a pricing of liquidity risk, so the Basel Committee has decided banks should be able to withstand a 30-day system-wide liquidity shock and also generally keep robust liquidity profiles.
  • Reporting and disclosure: stronger corporate governance, stress testing, risk management and disclosure will apply as well as stronger supervision.

Additional macro-prudential provisions

  • Countercyclical buffer: members can apply an additional new countercyclical buffer within a range of 0 percent to 2.5 percent made up of common equity or other “fully loss absorbing capital”. The purpose of the countercyclical buffer is to protect the banking sector from periods when there is increased credit growth which may result in increased levels of systemic risk. Banks will be required to increase the levels of their capital during these periods of growth to provide a buffer to any accompanying increase in systemic risk. The relevant national regulator or central bank will set this buffer.
  • Non-risk-based leverage ratio: this will complement the rest of the Basel III measures and will be a back-stop to them. A minimum leverage ratio of 3 percent will be tested over a trial period, and make appropriate adjustments following the trial.
  • Additional loss absorbing capacity for global systemically important financial institutions (G-SIFIs): in line with other initiatives to address the risk of “too-big-to-fail” and paying particular attention to global organisations, Basel III will require G-SIFIs that are banks to have additional capacity to absorb losses.

National implementation should start from the beginning of 2013 when new requirements in relation to risk-weighted assets will apply. The new common equity and Tier 1 requirements will phase in between 2013 and 2015 (although the total 8 percent total capital requirement will remain constant, banks can meet the difference between it and the Tier 1 requirement with Tier 2 and higher forms of capital). The capital conservation buffer will phase in between 2016 and 2018. Capital instruments that no longer qualify as common equity Tier 1 capital will be excluded from its scope from January 2013 although some that meet set conditions may be phased out more gradually.  

Reaction to Basel III Basel III has been welcomed in all quarters. Specifically, the Financial Stability Board and the G-20 endorsed it at the November 2010 Seoul Summit and called on all members to implement it within the set timescales. The EU outlined the action it would take to fit Basel III within the EU regulatory structure (see below).  

European – how many CRDs?

Meanwhile in Brussels, amendments to the two original Capital Requirements Directives (commonly  eferred to as one legislative instrument (CRD)) of 2006 come thick and fast. The CRD implemented the Basel II capital framework. However, in order to try to address the weaknesses identified by the financial crisis amendments have been made to the CRD by two further Capital Requirements Directives: CRD2 and CRD3.  

CRD2

The amendments arising from CRD2, adopted in 2009, were aimed at:

  • Hybrid capital: improving the quality of firms’ capital by establishing clear EU-wide criteria for assessing the eligibility of “hybrid” capital to be counted as a bank’s “own funds” for Tier 1 capital purposes
  •  Large exposures: improving how banks manage large exposures by restricting lending beyond a certain limit to any one party
  •  Securitisation: improving the risk management of securitisation, including prohibiting firms from investing in a securitisation unless the originator retains an economic interest of at least 5 percent (“skin in the game”) and
  • Cross-border supervision: improving the supervision of cross-border banking groups by establishing ‘colleges of supervisors’ for banking groups that operate in multiple EU countries. CRD 2 required Member States to bring into force implementing measures by 31 December 2010. We discuss the UK’s implementation below.

CRD3

CRD3 has been long in the making. It was finally adopted by the European Council in October 2010 and is aimed at:

  • Trading book and re-securitisations:strengthening capital requirements for the trading book and for re-securitisation and broadening disclosure of exposure to securitisation risks and
  • Ensuring that remuneration policies in the banking sector do not generate unacceptable levels of risk.

In order to achieve these aims CRD3 sets higher and reinforced capital requirements for certain assets that banks hold in the trading book and for resecuritisation instruments (these instruments carry higher risks due to their complexity and sensitivity to losses and banks will be required to assess their trading books in a way that better reflects potential losses that result from adverse movement in the markets). It increases disclosure requirements in several areas, including securitisation exposures in the trading book and sponsorship of off-balancesheet exposures. Additionally, it imposes a binding obligation on credit institutions and investment firms to have remuneration policies and practices that are consistent with and promote sound and effective risk management and brings remuneration policies within the scope of supervisory review, so that supervisors have the power to require firms to take measures to rectify any problems that they may identify.

Member States had to implement the CRD3 changes on remuneration (and some others) by 1 January 2011. The rest of the changes must be implemented by 31 December 2011.  

CRD4 Changes to the CRD are not to end with CRD3, however. In February 2010 the Commission published its consultation on CRD4. The consultation closed on 16 April 2010 and sought views on proposed changes in the following areas:

  • Liquidity standards: introducing liquidity standards that include a liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio
  • Further improving capital: raising the quality, consistency and transparency of the capital base
  • Leverage ratio: introducing a leverage ratio as a supplement to the Basel II framework
  • Capital against specific risks: strengthening capital requirements for counterparty credit risk arising from derivatives, repos and securities financing activities
  • Countercyclical requirements: developing a countercyclical capital framework
  • SIFIs: introducing appropriate measures to deal with systemically important institutions; and
  • Single rulebook: the need for specific prudential requirements for certain areas of business in the context of creating a single rulebook.

The changes reflect both activities in Basel (which has continued to develop along these lines) and commitments made by G-20 leaders in London and Pittsburgh during 2009 as regards building high quality capital, strengthening risk coverage, mitigating pro-cyclicality, discouraging leverage as well as strengthening liquidity risk requirements and forwardlooking provisioning for credit losses.

The Commission will consult again on CRD4 in the first quarter of 2011.  

Reaction to Basel III and CRD 4 Whilst the proposals in the consultation have been broadly welcomed there are reservations in some quarters. EBIC, an association of European banking associations including EBF, has raised its concerns about some of the CRD4 (and hence Basel III) proposals, especially the leverage ratio. It is worried the changes will disproportionately affect some businesses which were strong during the crisis and move away from “risk sensitiveness”. It believes the Basel model on which the proposals are based are biased against the classical banking model of intermediation and that European banks, where this model is prominent, could suffer competitive disadvantages as a result. EBIC believes a second round of consultation is needed after the carrying out of quantitative impact studies. BBA, ISDA and the AFME in their joint response to the proposals would also welcome a further round of consultation after quantitative impact studies planned by the Basel Committee and the Commission take place.

UK – has FSA caught up? The transposition of the CRD reforms is split between HM Treasury and FSA. FSA is responsible for implementing the majority of the amendments, in the form of revisions to the existing provisions in the Handbook. HM Treasury implements changes that require amendments to FSMA or secondary legislation.  

HM Treasury In January 2010 HM Treasury issued a paper addressing the CRD2 issues where the FSA does not have powers to make the necessary amendments, such as provisions intended to improve the supervision of cross-border banking groups and to take account of the Credit Rating Agencies Regulation. At the end of October, it made regulations which impose new requirements on FSA in respect of cross-border supervision of banks.  

FSA

Most of the measures required to implement CRD2 and CRD3 were set out in FSA Consultation Paper CP09/29 and the follow-up Consultation Paper CP10/17.  

FSA’s proposed approach on implementing the CRD2 and CRD3 rule changes concentrates on following core areas, which are covered to varying extents by both Directives:

  • Hybrid capital
  • Large exposures
  • Securitisation and
  • Prudent valuation.

CRD2

Amendments to FSA’s rules relating to liquidity risk management already came into force on 1 October 2010. The remainder took effect from the start of 31 December 2010 (after significant technical debate over whether they could instead take effect at the end of that day, or from 1 January 2011) .

FSA’s proposals for implementing CRD2 essentially involved the following:

  • Hybrid capital: improving the quality of firms’ capital by establishing clear criteria for assessing the eligibility of hybrid capital to be counted as part of a firm’s overall capital. FSA rules now include a definition of hybrid capital and explain its permitted uses. They specify the features that hybrid capital must have regarding permanence, flexibility of payments and loss absorbency to be eligible as tier one capital. FSA received several comments on its consultative proposals, including concerns over its proposed treatment of SPV investments, but it implemented its proposals largely unchanged, although it acknowledged it would review the rules at a later stage, possibly in view of CRD4 implementation.
  •  Large exposures: enhancing the management of large exposures by restricting a firm’s lending beyond a certain limit to any one party. FSA’s supervisory approach has focused on intragroup relations. FSA has confirmed it will use the available exemption so the rules do not apply to limited licence and limited activity firms. Following responses to consultation, it will not set a lower limit for smaller firms with exposures to other institutions, an option CRD2 provided when abolishing the inter-bank exemption.
  •  Securitisations: improving the risk management of securitisation, including a requirement to ensure that a firm does not invest in a securitisation unless the originator retains an economic interest; so called “skin in the game”. FSA has also made some technical amendments that clarify how firms can show they have transferred credit risk off their balance sheets. FSA consulted on changes from CRD2 and the (then) likely text of CRD3, and will not feed back fully on its proposals nor finalise its rules until it has considered the final text of CRD3. The rules it has now made that are not likely to be affected by the CRD3 analysis include the new reporting and waiver rules.
  • Trading book valuations: changes to the requirements for market risk under the different permitted calculation models. Again, to a large extent FSA’s proposals are affected by CRD3 and so are even now not final, but its intention is to: – To introduce a stressed VaR measure – To introduce an IRC model for debt instruments – To apply the standardised method to securitisations and – To introduce an all price risks measure for the correlation trading portfolio.
  • Extending the prudent valuation framework to all fair valued positions: respondents had mixed views on some of FSA’s proposals, but were generally supportive of its proposals in relation to the IRB approach and treatment of counterparty, credit, position and operational risks and risk mitigation.

Nearly all changes are now final, and FSA has warned firms of the need carefully to assess some of the knock-on effects of the rules that took effect at the start of 31 December 2010. It consulted further on changes to core tier 1 capital, operational risk, large exposures and certain 0 percent credit risk weightings, mainly in the light of CEBS advice, but the results of this further consultation have not yet been published.

CRD 3 Most of the CRD 3 amendments are required to be implemented by 31 December 2011, with the exception of the rules on remuneration which came into effect on 1 January 2011. This article does not address the remuneration rules, many of which had been anticipated by FSA and the remainder of which will took effect for the beginning of 2011 as required.

In respect of the remainder of CRD3, FSA has consulted on the implementation of the following changes to its rules:

  • Strengthening the capital requirements for the trading book to ensure that a firm’s assessment of the risks connected with its trading book better reflects the potential losses from adverse market movements in stressed conditions
  • Imposing higher capital requirements for resecuritisations to make sure that firms take proper account of the risks of investing in such complex financial products and
  • Upgrading disclosure standards to increase market confidence.

Much of the detail of FSA’s proposals has been covered above, under CRD2, and FSA published a policy statement in late December 2010, following CEBS’ final guidelines on remuneration policies and practices. There were inevitably some tight timescales to be met, especially for the CRD3 provisions that had to take effect from 1 January 2011.

CRD 4 The FSA has not yet taken any steps to implement CRD4 (which is at a consultative stage only). It has however announced its intention to publish a consultation paper (“Strengthening capital standards 4”) but the publication date is yet to be decided. The implications of all this Clearly there is a lot for banks to take in. There have been reactions to global and European moves from many associations, and a few pleas to FSA. We have seen:

  • Initial stock-market reaction relief that the regime is not even tougher
  • Fear that it will increase capital requirements significantly
  • Realisation that it will require banks to raise more equity/retain more profits
  • Understanding it will mean lower returns on capital
  • Query over whether bank equity will be perceived as less risky?
  • Acceptance there will be higher capital requirements for traded products/resecuritisations
  • Concern that regulators have not properly taken into account the cumulative effect and cost of all the reform measures.

And, of course, the Basel Committee is not advocating changes to the structure of banking, although governments are, most notably of course the UK. Also, Basel III does not go all the way. For example:

  • Much detail remains to be worked out for the leverage ratio
  • The additional requirements for systemically important banks are not yet clear and
  • The world is moving, slowly but surely, towards a regulatory system where there is greater emphasis on centralisation and central decision making  

So, dear Prudence, greet the brand new day … but look around, because more change will come.