Basel Committee Agrees Capital Rules

by Ulrika Lomas, LawAndTax-News.com, Brussels

30 July 2010

The Group of Governors and Heads of Supervision (GGHS), the oversight body of the Basel Committee on Banking Supervision, has reached broad agreement on the overall design of the banking capital and liquidity reform package.

The GGHS said it is "deeply committed" to increasing the quality, quantity, and international consistency of capital, to strengthen liquidity standards, to discourage excessive leverage and risk taking, and reduce pro-cyclicality, in the global banking system. In particular, the reform package includes the definition of capital, the treatment of counterparty credit risk, the leverage ratio, and the global liquidity standard.

The calibration and phase-in arrangements of the reforms will be finalised at the next meeting of the GGHS in September. One country, believed to be Germany, still has some concerns on the package, and has reserved its position until then.

The Basel Committee retained most of the definition of capital proposals set out in the December 2009 consultative package. However, it concluded that certain deductions could have potentially adverse consequences for particular bank business models and provisioning practices, and may not appropriately take into account evidence of realisable valuations during periods of extreme stress.

Therefore, for example, while the requirement that unconsolidated investments in financial institutions be fully deducted when the holdings exceed certain thresholds has been retained, investments of more than 10% in the shares of unconsolidated financial institutions (banks, insurance and other financial entities) may receive limited recognition when calculating the common equity component of Tier 1 capital, with recognition capped at 15% of a bank’s own common equity component.

With regard to the leverage ratio, the Committee reaffirmed that the objective is to develop a simple, transparent, non-risk based measure that is calibrated to act as a credible supplementary measure to the risk based requirements. It would apply uniform credit conversion factors for off-balance sheet (OBS) items and, for all derivatives (including credit derivatives), apply netting plus a simple measure of potential future exposure, to ensure that all derivatives are converted in a consistent manner to a “loan equivalent” amount.

It was said that the Committee’s approach would thereby result in a strong treatment for OBS items, and would also strengthen the treatment of derivatives relative to a purely accounting based measure.

The transition period will be divided into three sections. Firstly, there will be a supervisory monitoring period, commencing on January 1, 2011, before the Committee proposes to test a minimum Tier 1 capital against risk-weighted assets leverage ratio of 3% during a parallel run period from January 1, 2013 and January 1, 2017. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a full treatment on January 1, 2018.

The Committee will use the parallel run period to assess whether the proposed design and calibration is appropriate over a full credit cycle and for different types of business models. This assessment will include consideration of whether a wider definition of exposures and an offsetting adjustment in the calibration would better achieve the objectives of the ratio.

While there is a strong consensus to base the leverage ratio on the new definition of Tier 1 capital, the Committee also will track the impact of using total capital and tangible common equity.

Jean-Claude Trichet, President of the European Central Bank and Chairman of the GGHS, said that "the agreements reached today are a landmark achievement to strengthen banking sector resilience in a manner that reflects the key lessons of the crisis." He emphasised that "the GGHS have ensured that the reforms are rigorous and promote the long term stability of the banking system.”

Nout Wellink, Chairman of the Basel Committee and President of the Netherlands Bank added that "a strong banking sector is a necessary condition for sustainable economic growth." He added that "many banks have already made substantial strides in strengthening their capital and liquidity base. The phase-in arrangements will enable the banking sector to meet the new standards through reasonable earnings retention and capital-raising."

Most banks appear to have welcomed the proposed regulations, which both they and the markets had feared could have been worse. It was reported that the banking authorities in some countries, particularly France and Germany, had resisted more stringent regulations while their banks were still recovering from the financial crisis and while they were concerned that banks would be unable to continue lending through the nascent economic recovery. The introduction of a long transition period has helped in that respect.

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