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Executive Summary

The global banking standards enshrined in Basel III go into effect by 2013 for new capital standards and 2015 for new liquidity standards.  Well before those dates, however, it will become essential for bank directors and executives to have a working understanding of the new Basel III standards that apply to their institution in order to be able to assist in the development and monitoring of a bank capital/liquidity plan that satisfies applicable U.S. standards.  This article gives a rundown of the essential terms and requirements of Basel III and offers questions directors can ask to help get their bank ready for it.

Background on Basel III

Basel III updates and revises significantly the current international bank capital accords (so-called “Basel I” and “Basel II”).  The changes are principally designed to:

• increase the capacity of banks to absorb losses and shocks to funding;
• introduce a more “macro-prudential”  orientation to capital requirements through measures such as a capital surcharge for systemically-important institutions; and
• provide for greater transparency through detailed disclosures of regulatory capital.

The Basel Committee on Banking Supervision (the “Basel Committee”) continued to refine Basel III during 2011 and plans to make further technical adjustments, especially relating to the new liquidity requirements described below.

Capital and liquidity standards consistent with Basel III will be formally implemented in the United States through a series of rulemakings.  The U.S. bank agencies intend to issue a notice of proposed rulemaking during the first quarter of 2012 and a final rule later in the year that would implement the Basel III capital reforms. The capital surcharge for the largest banks and liquidity standards are expected to be implemented through subsequent rulemakings.

The United States’ selective implementation of Basel II—generally applying the rules only to the very largest institutions—illustrates how the United States may implement only certain aspects of Basel III and/or impose the requirements on only certain institutions (in particular, the large, internationally active institutions).  Indeed, the U.S. bank agencies are required under the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) to impose stricter capital requirements on large U.S. banking groups (those with at least $50 billion in assets) than smaller ones.  Nonetheless, even community banks are likely to face more stringent capital requirements as a result of Basel III, whether through a greater emphasis on common equity (i.e., rather than other forms of regulatory capital such as preferred stock or subordinated debt) and/or possible higher minimum requirements.

While many key details will remain uncertain until the United States issues its final rules, bank directors should be prepared to ask management and advisors questions about the anticipated impact of Basel III for the institution.  In many cases, these may include questions similar to the following:

Key Questions

Will we have to raise more capital when Basel III starts to be phased in, and what type of capital?  Will the market be able to absorb any offering by us as well as other banks in the same boat?

Basel III’s multi-year implementation timeline (from 2013 to 2019) was designed to allow banks to build up capital slowly and organically.  Of course, in practice, this may not always be possible (e.g., insufficient earnings to make up the capital deficiency and/or market pressure to comply with Basel III’s capital ratios before the deadlines set out in Basel III).  Regulators will generally expect impacted banks to develop a realistic plan for satisfying the new requirements, which may include issuing new stock/debt instruments that qualify as regulatory capital and/or other viable alternatives (which may include, e.g., the reduction of assets).

Qualifying Types of Capital: Basel III tightens minimum requirements for inclusion in the capital base.  Permissible capital is divided into the following three categories, summarized below—from the highest “quality” to the lowest—in very broad terms:

• Common Equity Tier 1:  ordinary common shares and retained earnings
• Additional Tier 1 Capital:  perpetual preferred stock where the issuer has complete discretion to cancel distributions/payments on the instruments (e.g., cumulative trust preferred instruments will no longer qualify).
• Tier 2 Capital:  subordinated debt with a minimum original maturity of at least five years

Basel III establishes technical qualification criteria for each category.  Existing financial instruments issued prior to September 2010 that will no longer qualify as capital will generally be phased out from the issuer’s regulatory capital over time by 2023.  Instruments issued after that date are generally deducted from the capital base as appropriate upon implementation of Basel III.  U.S. rules in this regard may diverge from those established under Basel III.  For example, under the Dodd-Frank Act, U.S. institutions with less than $15 billion in assets may continue to count cumulative trust preferred securities issued prior to May 19, 2010 as Tier 1 capital, whereas Basel III does not provide for this grandfathering.

New Minimum Capital Requirements: 

Basel III will increase:

• the Common Equity Tier 1 component of the capital base from 2.0 percent of risk-weighted assets (“RWAs”) to 3.5 percent by 2013 and 4.5 percent by 2015; and the overall Tier 1 risk-based capital requirement (composed of Common Equity Tier 1 and
• Additional Tier 1 capital) to 6 percent when fully phased in by 2015, from the current 4 percent minimum. The broader total risk-based capital requirement (composed of overall Tier 1 and Tier 2 capital) will remain at 8 percent.

As a practical matter, most banks covered by Basel III will seek to maintain, at a minimum, the following risk-based capital ratios by 2019 in order to avoid the imposition of restrictions on dividend payouts, share buybacks and bonuses. (Institutions seeking so-called “well-capitalized” status under U.S. law may be required to hold even higher levels of capital):

• Common Equity Tier 1: 7.0 percent (2.0 percent today)
• Tier 1 Capital: 8.5 percent (4 percent today)
• Total Capital: 10.5 percent (8 percent today)

Basel III also calls for a new minimum non-risk adjusted Tier 1 “leverage ratio” (to be implemented starting in 2018), similar to the existing requirement under U.S. law, but including some off-balance sheet exposures.

Will the risk weighting of assets and off-balance-sheet items change?  If so, what will be the effect on our capital requirements?  Do we need to reduce any particular type of asset because of the changes?

Basel III changes the current risk weightings of several types of assets and exposures.  New higher risk weights (i.e., an upwards adjustment to the capital charge associated with a particular asset)—together with the tighter qualification rules for capital instruments—make Basel’s III minimum capital requirements more difficult to achieve than they even appear based on the new percentages alone.  Assets/positions subject to more stringent capital treatment under Basel III include:

• CDOs (collateralized debt obligations)/securitizations
• OTC (over-the-counter) derivatives transactions
• Trading book positions, which, very generally, refer to positions in financial instruments taken principally for the purpose of selling in the near term or as an accommodation to a customer. (Proposed rules effectively implementing what is often referred to as “Basel 2.5” addressing  capital charges for trading book positions were issued by the U.S. federal bank agencies in January and December 2011.  These rules would only apply to banking institutions with gross trading assets and liabilities equal to (i) $1 billion or more, or (ii) 10 percent of the institution’s total consolidated assets.)
• Exposures to certain large or unregulated financial institutions, e.g., as part of trade finance or other transactions
• Mortgage-servicing rights (there are new limits on the amount of these rights and certain other assets that can be counted as regulatory capital)

Given the significant increase in the minimum capital requirements, Basel III will create greater incentives for institutions to invest in assets with lower-risk weights such as U.S. government securities.  It will also lead many banks to reassess whether yields generated by asset classes continue to justify their capital costs and to evaluate the legal/financial implications of unwinding or selling assets or businesses.

When will liquidity requirements become effective, and what will they be?

Minimum quantitative liquidity requirements are new to the Basel framework (and will be new to the U.S. capital adequacy framework).  Specifically, there are two new requirements:

• “Liquidity Coverage Ratio” requirement: Banks will be required starting in 2015 to maintain a specified minimum amount of cash and/or certain other high quality, liquid assets to cover “net cash outflows” in a hypothetical 30-day liquidity crisis.
• “Net Stable Funding Ratio” requirement: Banks will be required by 2018 to maintain a specified minimum amount of “stable funding” (e.g., Tier1 and 2 regulatory capital instruments, deposits  and long term funding) in relation to the bank’s illiquid assets to address funding needs over a stressed one-year period.

The assumptions and weightings built into the liquidity requirement calculations will create a new set of considerations for banks mapping out business plans and product pricing strategies. (i.e., How much liquidity or long term funding, as the case may be, will have to be set aside for a particular type of bank asset/exposure?) The rules could especially impact the cost of providing products with high liquidity charges such as committed credit facilities to financial institutions and committed back-stop liquidity facilities.  The rules will only be completed at the international and U.S. levels following observation and review periods, and thus, it is generally expected that adjustment will be made to the current version of the requirements.

How may Basel III impact our ability to grow organically and/or through new acquisitions?

Organic expansion and/or acquisitions could be made more costly from a capital perspective by possibly triggering:

• a “systemic risk” surcharge (or a higher surcharge) above the minimum capital requirements, and/or
• the application of new requirements, assuming  that U.S. bank regulators selectively apply certain of the Basel III reforms based on criteria such as bank size.

The Basel III systemic risk surcharge (to be implemented under Basel III over a three-year period commencing in 2016) will be based on a sliding scale from 1 percent to 2.5 percent of common equity and will apply to banks identified as so-called global systemically important banks (“G-SIBs”); a further 3.5 percent surcharge could be used to discourage further growth.  The amount of the Basel III surcharge to be applied will be based on several factors such as the G-SIB’s size, interconnectedness, lack of substitutes or financial institution infrastructure for services provided, global cross-jurisdictional activity and complexity.  An initial list of 28 G-SIBs (including eight U.S. institutions) subject to the surcharge was released in early November of 2011.  The list will be revisited in 2014 prior to the scheduled implementation of the G-SIB surcharge in 2016.

As noted above, U.S. law requires U.S. bank holding companies with assets of at least $50 billion to be subject to more stringent capital requirements than those that apply to smaller institutions.  Companies outside of the G-SIB category, but meeting the $50 billion threshold, will not necessarily be subject to the capital surcharge. However,  under final rules issued by the Federal Reserve in November, any U.S.  bank holding company meeting this threshold will be subject to stress tests and be required to submit a detailed nine-quarter capital plan demonstrating the company can maintain minimum required capital ratios and a Common Equity Tier 1 ratio greater than 5 percent under both expected and stressed conditions.

Conclusion

Federal Reserve Governor Daniel Tarullo has recently reassured the U.S. banking industry that the proposed phase-in of the Basel III capital rules from 2013 to 2019 will be followed, and not accelerated, in the United States.  Nonetheless, large U.S. banks—generally those with over $50 billion in assets—will be expected to steadily improve their capital ratios if they have not yet met the fully phased-in Basel III requirements.  Moreover, the Federal Reserve may disallow a bank’s proposed payment of dividends where it is unable to demonstrate an ability to readily and without difficulty meet the new capital requirements, including all transition targets, on time.  These recent pronouncements underscore the importance of serious Basel III-related planning at this time.  This is especially true for large institutions, several of which have begun taking steps such as shedding assets subject to high capital charges in preparation for Basel III.

In coming months, we should see the issuance of new rules and additional guidance on Basel III implementation clarifying regulatory expectations for U.S. banking institutions, including smaller, less complex U.S. banks.  Directors and executives should closely monitor regulatory as well as market developments to ensure that their institution’s capital and liquidity plans are in line with both applicable U.S. regulatory standards as well as market demands.