Regulation: Banks digest the meaning of Basle III

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By:
Hamish Risk
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Capital regulators tighten rules; Banks required to set aside more capital

José María Roldán, the head of banking supervision at Banco de España and chairman of a key Basle Committee sub-group, proclaimed that as then unpublished revised bank capital regulations would be nothing less than a "regulatory tsunami".

Roldán has warned about the impact of new Basle guidelines

You had been warned. In December, José María Roldán, the head of banking supervision at Banco de España and chairman of a key Basle Committee sub-group, proclaimed that as then unpublished revised bank capital regulations would be nothing less than a "regulatory tsunami". And so they have proved to be. The long-awaited revised bank capital rules from the Basle Committee on Banking Supervision, now dubbed Basle III, were released as the banks wound down for Christmas, and the industry is only now fully digesting what it will mean.

Broadly speaking they entail profound changes for the way banks ration and employ capital. That will be felt most by banks with large investment banking activities, institutions that rely heavily on hybrid instruments to prop up bank capital, those that apply leverage to their trading activities, and institutions whose funding programmes are weighted towards wholesale debt markets. In short, it strikes at the heart of many of the weak links exposed by the financial crisis.

The proposals aren’t set in stone and will enter a relatively short consultation period finishing at the end of the year, with full implementation tabled by the end of 2012. That’s in marked contrast to the previous capital accord, Basle II, which began its consultation in 2001 and ended it in 2005, only for it to become effectively obsolete when implementation coincided with the financial crisis.

Stability-cost balance

Alessandra Mongiardino, a senior credit officer at Moody’s Investors Service, says: "2010 will certainly be a year of intense lobbying by the banks. The outstanding issue is striking the appropriate balance between the goal of increased financial stability and the potential costs and repercussions on the real economy."

The key challenge for the Basle Committee will be the implementation of a global standard across all jurisdictions, because the recommendations still need the agreement of national bank regulators. Indeed, the ink had barely dried on the Basle document before the Banca d’Italia released a statement saying alternative options would be considered on a number of issues relevant to the Italian banks. It should also be noted that the US still hasn’t implemented Basle II for the majority of its banks.

At the heart of the proposals is a drive to improve the quality of bank capital. One of the key criticisms as the crisis played out was that the quality of banks’ capital wasn’t sufficiently high when losses materialized, while core capital measures lacked harmonization and disclosure of regulatory capital bases was deficient. To that end, ordinary common shares and retained earnings, less regulatory deductions, will become the predominant form of tier 1 capital, the regulators’ gold standard.

That is likely to be felt in the hybrid capital markets, where convertible debt securities were supposed to perform the role of equity in certain situations but didn’t, and could be now outlawed as tier 1 capital. That is, unless they have provisions that give discretion to suspend dividends and coupons and are non-dilutive to equity. Interestingly, just how regulators will treat the new vogue of hybrid capital, so-called contingent convertible instruments, or CoCos, seen as a panacea to the hybrid capital weakness, isn’t completely clear in the proposals. More clarity will come in the summer, the Basle Committee says.

Ancillary buffers

Complementing the new tier 1 criteria, Basle III is adding ancillary buffers, given the lessons from the boom-bust that characterized the banking sector over the past decade. Counterparty risk will attract higher charges, particularly for complex instruments such as bespoke derivatives, which should hit investment banks harder. In addition, banks will be required to hold buffers of capital above the regulatory minimum. That will limit "generous distributions" to shareholders and employees, as well as share buybacks. For example, if a bank were to suffer losses that caused its capital to fall below a minimum requirement equal to 50% of the bank’s required "capital conservation range" the bank would be required to conserve a given percentage of its earnings in the following financial year. Another provision is the introduction of a leverage ratio, whereby a minimum level of capital as a percentage of gross exposures is put in place, irrespective of the relevant risks of the portfolio. Critics are quick to point out that it proved ineffective in the US, where it had already been in place.

How much capital?

What all this implies for how much capital banks will need to raise to meet the requirements will be determined by the success or failure of the consultation period, depending on what side of the fence you sit on.

Credit Suisse analyst Daniel Davies reckons the new rules might cost European banks €139 billion by the time implementation is complete, and says some will be better placed than others. "Danske Bank, DnB NOR, Santander, Standard Chartered and UBS offer a significant amount of excess capital pro forma under Basle III, while on the contrary French and UK banks do not feature well," he says. "These banks will have to either convince market participants that they can operate with relatively lower tier 1 ratios, or act decisively in order to improve their solvency.’’