September 2010 / Special Issue
The release of Basel III agreement over the weekend has been welcomed by financial markets but also caused many organizations wondering about the impact of the accord. To aid credit unions and their regulators understand what Basel III will mean for them we've issued this special issue of the Global Regulatory Update.
Dave Grace, Vice President, WOCCU
Basel III Finalised: Governors and Heads of Supervision Agree on Reform of Banking Standards
On September 12 the Basel Committee's Group of Governors and Heads of Supervision reached an agreement on reforming the Basel capital framework, thereby paving the way for a reform of the definition of permissible capital and introducing additional capital requirements.
The Basel II framework, introduced in 2004, required financial institutions to hold a percentage of risk weighted assets as regulatory capital to cover exposures arising from credit, operational and market risks. The framework, however, proved insufficient with regards to ensuring high levels and quality of capital and preventing banks from building up excessive on- and off-balance sheet leverage. These shortcomings reinforced the instability of the whole system during the most recent financial crisis. Basel III is expected to address these shortcomings: it will tighten the definition of regulatory capital and introduce new capital requirements in the form of buffers.
As a major achievement for the cooperative sector, the World Council of Credit Unions (WOCCU), together with other organisations representing cooperatives, have secured that ownership shares of non-joint stock companies, i.e. cooperatives, will in the future be recognised as Tier 1 capital, if they meet the criteria of Tier 1 capital.
More concretely, some of the key changes of Basel III include:
Capital requirements: While total capital requirements will remain at 8%, over next 8 years the minimum common equity capital requirement will be enhanced from currently 2% to 4.5% and the minimum Tier 1 requirement from 4% to 6%.
Quality of capital: Basel III applies a stricter definition as to what qualifies as Tier 1 capital - in the future the predominant part of Tier 1 must consist of common shares and retained earnings. For the first time cooperative shares will be recognised as Tier 1 capital under the condition that they meet the requirements for common shares (e.g. are risk-absorbing - see criteria below).
Transition periods: The new requirements will be gradually phased in over a period of five years. As a first step, by January 1, 2013 institutions will need to raise their common equity and minimum Tier 1 to 3.5% and 4.5%, respectively. By January 1, 2015 the new levels of 4.5% for common equity and 6% for Tier 1 will need to be achieved.
Capital conservation buffer: Credit institutions will be required to build up capital conservation buffers which the institution can draw on in times of financial and economic stress. The capital buffer consists of 2.5% common equity and will be gradually phased in: on January 1, 2016 institutions will be required for the first time to hold 0.625% capital conservation buffer; the full buffer of 2.5% will need to be implemented by January 1, 2019 at the very latest. In case the capital conservation buffer is not met, no dividends can be paid out.
Countercyclical buffer: When risks of a credit bubble arise, supervisors can require a capital add-on in the form of a (macroeconomic) counter-cyclical buffer. According to the risk, this can vary within the range of 0%-2.5% and must be provided for in the form of common equity or other fully absorbing capital. The purpose of the countercyclical buffer will be to dampen excessive credit growth with a view to avoiding the build-up of system-wide risk.
Leverage ratio: Additionally to the capital requirements, a 3% non-risk based leverage ratio in the form of Tier 1 capital will be required as of 2019.
Systemically relevant institutions: While the Basel Committee decided that systemically important institutions will need to hold additional loss absorbing capital, no final conclusions on the amounts have yet been reached.
At their next meeting in November 2010 (to be held in the Republic of Korea), G-20 leaders are expected to formally adopt the Basel III standards.
WOCCU generally welcomes the new rules and sees benefits arising for credit unions from the new definition of Tier 1 capital and a more level playing field with banks in terms of the amount and quality of regulatory capital. Some jurisdictions have already decided not to subject credit unions to the countercyclical capital buffer given that they generally do not present systemic risk.
Mid-October WOCCU will be hosting a webinar for its members and credit union supervisors to provide more information on Basel III by hearing from Mr. Karl Cordewener, Deputy Secretary General of the Basel Committee. Details on Basel III webinar dates and registration will be sent out shortly.
Tier 1 Capital Criteria: For Common Shares to be Classified as Tier 1 Capital They Will:
- Represent the most subordinated claim in liquidation of the financial institution.
Be entitled to a claim of the residual assets that is proportional with its share of issued capital, after all senior claims have been repaid in liquidation (i.e., has an unlimited and variable claim, not a fixed or capped claim). This can be adopted for national discretion based on a cooperative structure.
- The principal is perpetual and never repaid outside of liquidation (setting aside discretionary repurchases or other means of effectively reducing capital in a discretionary manner that is allowable under national law). This can be adopted for national discretion based on a cooperative structure.
- The financial institution does nothing to create an expectation at issuance that the instrument will be bought back, redeemed or cancelled nor do the statutory or contractual terms provide any feature which might give rise to such an expectation.
- Distributions are paid out of distributable items (retained earnings included). The level of distributions are not in any way tied or linked to the amount paid in at issuance and are not subject to a cap (except to the extent that a bank is unable to pay distributions that exceed the level of distributable items).
- There are no circumstances under which the distributions are obligatory. Non payment is therefore not an event of default.
- Distributions are paid only after all legal and contractual obligation have been met and payments on more senior capital instruments have been made. This means that there are no preferential distributions, including in respect of other elements classified as the highest quality issued capital.
- It is the issued capital that takes the first and proportionately greatest share of any losses as they occur. Within the highest quality capital, each instrument absorbs losses on a going concern basis proportionately and pari passu with all the others.
- The paid in amount is recognized as equity capital (i.e., not recognized as a liability) for determining balance sheet insolvency.
- The paid in amount is classified as equity under the relevant accounting standards.
- It is directly issued and paid-up.
- The paid in amount is neither secured nor covered by a guarantee of the issuer or related entity or subject to any other arrangement that legally or economically enhances the seniority of the claim.
- It is only issued with the approval of the owners of the issuing bank, either given directly by the owners or, if permitted by applicable law, given by the Board of Directors or by other persons duly authorized by the owners.
- It is clearly and separately disclosed on the bank's balance sheet.