Today, the Basel Committee on Banking Supervision of the Bank of International Settlements (BCBS) issued a proposed consultative document entitled “Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability” which proposes that all regulatory capital instruments be able to absorb losses in the event the issuing bank reaches the point of non-viability. This is a supplemental proposal to the BCBS’s December 2009 consultative document entitled “Strengthening the resilience of the banking sector." The BCBS states that it believes this proposal will reduce the risk of moral hazard, noted by some finance officials as a key underlying cause of the financial crisis.

BCBS notes that, during the financial crisis, infusions of common equity and certain other forms of Tier 1 capital were a common tool used by governments to rescue distressed banks. This had the effect of supporting not only the depositors at those distressed banks, but also the investors in other regulatory capital instruments. Consequently, Tier 2 capital instruments, such as subordinated debt, did not absorb losses incurred by certain large internationally-active banks that would have failed had the public sector not provided support.

As a result, the BCBS believes that the contractual terms of capital instruments must allow them to be written off or converted to common shares in the event a bank is unable to support itself in the private market absent conversion. The “trigger event” for such conversion would be the earlier of (1) the decision to make a public sector injection of capital, or equivalent support, without which the bank would have become non-viable, as determined by the relevant authority, or (2) a decision that a write-off, without which the bank would become non-viable, is necessary, as determined by the relevant authority. The issuance of any new shares as a result of the trigger would have to occur prior to any public sector injection of capital so that such capital is not diluted.

After issuance of the December 2009 consultative document, in late July 2010, the Governors and Heads of Supervision, the oversight body of BCBS, announced it had reached a broad consensus on the overall design of the capital and liquidity reform package. Comments to the loss absorbency consultative document are requested by October 1, 2010, prior to the G-20 Leaders summit in Seoul on November 11-12, 2010, at which time the final report, which will reflect the fully calibrated global capital and liquidity standards, will be delivered.