The Basel Committee on Banking Supervision on December 16, 2010 released the final text of the Basel III rules. On January 13, 2011, the Basel Committee issued final elements of proposed reforms to raise the quality of regulatory capital. Certain aspects of the Basel framework and in particular the timing of its implementation are subject to national discretion. On February 1, 2011, the regulator responsible for the solvency of Canadian banks and other deposit taking institutions ("DTI's"), the Office of the Superintendent of Financial Institutions ("OSFI"), issued its action plan for the implementation of the Basel III Capital Adequacy and Liquidity Requirements in Canada. Subsequently on February 4, 2011, OSFI issued a draft Advisory concerning contingent capital and a release relating to non-qualifying capital instruments. Further to our previous communications on Basel III, this Bulletin summarizes both the Basel III rules and OSFI's indication as to how these rules will be interpreted and enforced in Canada.
The Basel III Rules
The Basel Committee on Banking Supervision has stated that Basel III attempts to: (i) improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source; (ii) improve risk management and governance; and (iii) strengthen transparency in disclosures. The rules text sets out in greater detail the standards for global regulatory oversight as agreed to by the Governors and Heads of Supervision and endorsed by the G20 leaders at their summit in Seoul, South Korea on November 11-12, 2010. They require DTI's to maintain higher minimum levels of capital, to improve the quality of their capital and impose on them a new leverage constraint as well as two new liquidity standards.
These capital, leverage and liquidity standards are to be phased in over years to allow for observation to ensure that these changes are not detrimental to the banking industry, specifically, or more generally, the national economies in which these rules will be implemented.
The Basel rules introduce a new minimum common equity capital ratio or core capital requirement. DTI's will be required to hold (as of January 1, 2015) Tier 1 common equity equal to 4.5% of its risk weighted assets. Minimum Tier 1 capital, which will include common equity Tier 1 and additional Tier 1 capital, will be required to be (as of January 1, 2015) 6% of a DTI's risk weighted assets. Total (i.e. Tier 1 and Tier 2) capital which a DTI will be required to hold, or its minimum total capital ratio, will remain at 8.0% of its risk-weighted assets. The concept of Tier 3 capital is being eliminated.
In addition to the above requirements, Basel III has also introduced a capital conservation buffer which is intended to assist in absorbing losses during stress periods. It must consist entirely of common equity and will be phased in commencing January 1, 2016. By January 1, 2019 DTI's will be required to have an additional 2.5% of common equity Tier I capital over and above its 4.5% minimum resulting in a total common equity requirement of 7%, a minimum Tier 1 capital requirement of 8.5% and a minimum total capital ratio of 10.5%. If it does not have the common equity to comply with this buffer requirement, the DTI will be permitted to conduct business as normal but its ability to pay dividends and discretionary bonuses or engage in share repurchases will be restricted.
Basel III introduces a separate counter-cyclical buffer requirement of up to 2.5% of additional common equity intended to protect a country's financial system from the adverse consequences of excess aggregate credit growth. This is a discretionary buffer requirement which could at any time be imposed at a national level by OSFI. If the full amount of the counter-cyclical buffer is added in, a DTI's common equity Tier 1 capital increases to 9.5%, its Tier 1 capital increases to 11% and its total capital increases to 13%.
Basel III clarifies the capital treatment of minority, or non-controlling, interests and other capital issued out of consolidated subsidiaries and held by third parties. It also discusses in detail certain regulatory adjustments to be applied in the calculation of regulatory capital (and common equity Tier 1 in particular).
Finally, the capital requirements of certain DTI activities are increased under Basel III. In July 2009, the Basel Committee significantly raised the capital obligations relating to DTI's trading book and complex securitization exposures. Basel III concentrates on counterparty credit risk ("CCR"), namely, the risk that a counterparty to a material transaction could default or otherwise be unable to honour its obligations prior to the settlement of the transaction. The focus is on derivatives, repo, and securities finance activities. DTI's will be required to determine their capital requirement in relation to CCR using stressed inputs and will be subject to a capital charge for potential mark to market losses (as opposed to outright defaults) associated with a deterioration in the credit worthiness of a counterparty.
Basel III seeks to respond to what was seen as an excessive build up of on and off balance sheet leverage in the banking system immediately prior to the financial crisis. Unlike Canada where OSFI has for many years imposed a constraint in the form of an assets to capital multiple ("ACM") of twenty times subject to adjustment, the majority of Basel countries did not pre Basel III have a leverage constraint. Basel III contemplates a minimum leverage ratio of 3% for a parallel run period from 2013 to 2017, that is, Tier 1 capital (although data will also be collected on common equity Tier 1 and total regulatory capital) equal to the sum of on balance sheet non-derivative exposures, repurchase agreements and securities finance, derivatives and off-balance sheet items. Depending on the results, the leverage ratio will be adjusted and made effective in 2018.
Global banks outside Canada in particular, notwithstanding adequate capital levels, often suffered badly from liquidity issues during the financial crisis. Basel III prescribes two minimum standards for funding of liquidity, the first to promote short-term resilience of a DTI's liquidity risk profile and the second to promote resilience over a longer term horizon. These minimum standards are the liquidity coverage ratio ("LCR") and the net stable funding ratio ("NSFR"). The LCR requires DTI's to maintain sufficient unencumbered high quality liquid assets to offset 100% of the net cash outflows they could encounter under an acute short term (i.e. 30 day) stress scenario. The NSFR is a longer-term (i.e. one year) test under less severe circumstances. It aims to limit over-reliance on short-term wholesale funding during the times of buoyant market liquidity. The NSFR requires DTI's to maintain secure medium and long term funding to respond to the liquidity characteristics of their assets including their contingent liquidity needs arising from its off balance sheet assets over a one year period. Both the LCR and the NSFR are subject to an observation period in order to deal with any unintended consequences.
Quality of Capital and Non-Qualifying Instruments
Basel III imposes stricter standards on the quality of capital. In its January 13, 2011 release, Basel imposed certain minimum requirements to ensure the loss absorbency of all classes of capital of a DTI at the point of its non-viability. The intent is to ensure that all classes of capital instruments fully absorb losses at the point of non-viability of the DTI before taxpayers through capital injections or otherwise are exposed to loss.
Basel III requires that the terms and conditions of all non-common Tier 1 and Tier 2 instruments, through a statutory or contractual approach, include a provision whereby the instrument is either written off or converted into common equity of the DTI upon the occurrence of a trigger event at the point of non-viability. This is referred to as a non-viability contingent capital ("NVCC") requirement. As a result of these and other changes in the definition of capital, beginning January 1, 2013 DTI's will have capital that no longer qualifies in the calculation of regulatory capital. The phase-out of non-qualifying capital commences at a rate of 10% each year over a period of ten years beginning January 1, 2013 when recognition of these instruments for capital purposes will be capped at 90% and from that date declining by 10% in each successive year until the cap is at 0% in 2022. The cap is applied separately for Tier 1 and Tier 2 instruments.
OSFI Guideline – Basel III Action Plan
The Basel III rules require implementation by the Basel member countries with effect from January 1, 2013. OSFI in its action plan for the implementation of Basel III announced and/or confirmed the following.
First, OSFI will revise capital adequacy guidelines A and A-1 and related reporting forms and instructions accordingly, will consider whether there is the need for additional guidance on disclosure requirements, and will establish domestic interpretations of the capital rules text in the near future. In this vein OSFI confirmed that, after a consultation process to be undertaken in 2011, this new regulatory guidance should be in place before the end of 2012 for implementation in the first fiscal quarter of 2013.
Second, OSFI expects that its minimum capital requirements will follow the Basel III transition plan and that DTI's will be expected to have in place internal capital plans and targets that will enable them to meet these new capital requirements. In addition, OSFI indicates that those DTI's that have already met the minimum common equity capital ratio requirement during the transition period but remain below the 7% common equity Tier 1 target test (that is the minimum common equity capital ratio plus the capital conservation buffer) should maintain prudent earnings retention policies and avoid any actions that weaken their capital position.
Third, the new Basel III rules will require DTI's to migrate from the current OSFI ACM to the Basel III international leverage ratio in 2018. OSFI indicated that it does not expect to consult the industry on the implementation of the Basel III leverage ratio or develop timing and mechanisms for the change from its ACM to the new Basel ratio until the Basel III ratio has been substantially finalized.
Finally, OSFI confirmed that it will need to amend its liquidity Guideline B-6 in order to introduce new minimum quantitative standards for liquidity risk in time for the implementation of the LCR at the beginning of 2015 and the NSFR at the beginning of 2018. To do this, OSFI intends to commence in 2011 a public consultation process on a revised Guideline B-6 and its interim guidance dated January 23, 2009.
OSFI Advisories – NVCC and Non-Qualifying Instruments
In its February 4, 2011 draft Advisory concerning contingent capital, OSFI discussed Basel's requirements concerning loss absorption at the point of non-viability and NVCC. The draft Advisory sets out a number of criteria that must be met if a DTI's capital is to satisfy the NVCC requirement, failing which it will become non-qualifying capital for regulatory purposes.
In Canada the contractual terms of the capital instrument will be required to provide for it to be converted into common shares on the occurrence of a trigger event. An acceptable trigger event is defined as one of two events only, namely: (i) either the Superintendent of Financial Institutions (the "Superintendent") determines that the DTI has ceased to be viable and after taking into account the required conversion the Superintendent considers it reasonably likely that viability will be restored; or (ii) the federal or a provincial government in Canada announces that a DTI has accepted a capital injection from the government without which the DTI would have been determined by the Superintendent to be non-viable. Conversion will not be permitted to constitute a default under the instrument and commercially reasonable efforts must be undertaken to ensure that conversion does not constitute a default under any other agreement pertaining to the DTI. The instrument will be required to include a trust arrangement for the holding of common shares post conversion on behalf of any party who is legally prohibited from holding such shares.
OSFI has suggested that DTI's who currently have outstanding non-common capital instruments which do not comply with the Basel III provisions (including its NVCC requirement) should consider amending the terms of these capital instruments to make them compliant, which may not be practical, or develop new instruments and distribute them to existing holders through, for example, an exchange offer.
Concerning the treatment of non-qualifying capital instruments, OSFI confirmed that it intends to wholly adopt the Basel III rules which affect the eligibility of instruments for inclusion in regulatory capital and provide for a transition and phase-out period for capital instruments that do not meet the Basel III requirements. To the maximum extent possible, DTI's are to give effect to the legitimate expectations of holders of capital instruments and to redeem non-qualifying instruments at their regular par redemption date and embark on open market purchases minimizing reliance on a redemption due to a regulatory event. Although not worded identically in each instrument, a regulatory event redemption is a contractual provision which allows the DTI issuer to redeem the instrument if the DTI is no longer permitted to treat the instrument as capital for regulatory purposes.
The non-qualifying capital cap in any year may, but need not, be met in part by a voluntary exclusion of an amount of non-qualifying instruments from available regulatory capital. OSFI expects DTI's to forecast if they will need to use a regulatory event redemption to comply with the declining cap and if the forecast is yes to disclose to the public a schedule of such redemptions. If, on the other hand, the forecast is no it must disclose to the public that it need not redeem any instruments through using a regulatory event redemption.
Subsequent to the release of the February 4, 2011 draft Advisory, Canadian banks have indicated that, with two long dated exceptions, they will be able to reduce their non-qualifying capital in compliance with the Basel III phase-out schedule through par redemptions and without reliance on regulatory event redemptions.
Quite apart from its direct (capital and other) costs, the implications of Basel III are far-reaching for Canadian DTI's. While Canadian DTI's are generally well capitalized, each DTI will have to carefully consider how these new rules will impact on the type of capital they raise; their outstanding innovative capital and other capital instruments which will no longer qualify as Tier 1 or Tier 2 capital; the businesses they carry on; the investments they make and the assets they hold; the nature of the acquisitions they make (and perhaps more importantly, how they are financed); and, not to be forgotten, the scale and extent of their distributions to shareholders whether by share buybacks, dividends or return of capital. While at present they are only being applied in Canada with respect to DTI's, OSFI in its February 4, 2011 draft Advisory has indicated that, after consultation, it will determine how and to what extent the Basel III rule changes will be applied to life insurance companies, insurance holding companies, federally regulated property and casualty insurance companies, and cooperative credit associations.