Basel III and New Capital Requirements – In-Depth Look

Basel III and New Capital Requirements – In-Depth Look

Basel III and New Capital Requirements - In-Depth Look

The markets have become very sophisticated since the invention of the internet, with investors from different parts of the world able to access credit from almost any bank or lending institution. For this reason, financial institutions and markets have attracted much regulatory scrutiny. While most of the regulations were drafted years ago, some of them are being revised for the present.
We have seen the Dodd Frank regulation, the Commodities Futures Trading Commission (CFTC) 1974, Eligible Contract Participant (ECP) Requirements, and Sarbanes-Oxley Act among others, enacted to complement the existing Securities and Exchange Commission (SEC) rules, Generally Accepted Accounting Principles (GAAP), Bank for International Settlements (Basel), et al.

However, according to Sullivan & Cromwell LLP’s article, published on the Harvard Law blog, under Corporate governance and financial regulation, the Board of Governors of the Federal Reserve System (FRB) has granted its approval for publication of three notices proposing rulemaking (NPRs). These notices will substantially amend the risk-based capital rules for banks.

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This comes at a time when the countries are still recovering from the financial crises of 2008/2009. Additionally, now the European crisis is spreading across the globe.

The financial crises of 2009 were largely attributed to defaulting customers, who had acquired mortgage from banks. It is from this point of view that the proposed rules are mined, with the goal of curbing risk associated with credit lending. Along with the NPRs, is the market Risk Amendments, alias Basel II.5, which will define different methods of assessing risk exposures.

Basel III provisions propose that the application of Common Equity Tier 1 (CET1) requirements along with other revised definitions of capital and higher minimum capital ratios will be done across the board, pitting the large banks and the small (total asset value not more than $500 million) ones together. Meanwhile, the Basel I capital rules in relation to risk will be revised by Jan 1, 2015 to heighten the measurements of sensitivity to risk by adjusting the weighting categories. Currently, there are four categories, (0%, 20%, 50% and 100%), however, this will change once the new rules take effect by 2015.

The new proposed categories will not only be numerically derived, but also will possess some theoretical aspects. For instance, while the government issued securities will remain in the current 0% category, some assets exposed to high risk will be weighted as high as 600%. This category will include instruments exposed to residential mortgages and various commercial real estates.

The Implementation Process

Section 939A of the Dodd Frank Act, provides that, foreign based institutions and publicly traded companies should not be subjected to credit rating, but rather qualified to an investment grade. The implementation of NPRs and the market risk amendments would consequently affirm the implementation of this section of Dodd Frank Act for Wall Street reform and Consumer Protection. The investment grade will determine the level of exposure as illustrated by the weighted risk, which depends on whether the ‘obligor’ has the capacity to meet all principal and interest payments.

Proposed capital ratios: The revised Basel III rules feature recommendations of CET1, which require banks to maintain a minimum CET1 to risk weighted assets ratio of 4.5% by the time they are completely amortized (fully phased off). The ratio of tier one capital to risk weighted assets moves up to 6% from the current 4%, while the ratio of total capital to risk weighted assets must be at a minimum of 8%, unchanged.

Key items proposed for implementation include: components of capital, and phase-out of non-qualifying instruments, which will be phased out within four years:  75% phased out within the first year, 50% the following year, 25% the third year, and 0% in the fourth year.

However, for the small bank holding companies with less than $15 billion in total assets, the non-qualifying instruments will be phased out on a ten year straight line basis; that is 10% per annually, till 2022.

Adjustment to capital is yet another element in the proposed rulemaking. Companies will be required to get rid of accumulated other comprehensive income/loss (AOCI), while reviewing capital for regulatory purposes. This rule applies to CET1, hence affecting the proposed minimum of 4.5% ratio, to risk weighted assets. This removal will be applied at the rate of 20% per year for a period of five years, upon which, the remaining capital will reflect the actual figure as provided in the proposed regulations. The phase out process is set to begin in 2014.

Other items set for revision in this category are Differed Tax Assets (DTAs) and Investments in Non-consolidated Financial Entities, Mortgage Servicing Assets, and netting of differed tax liabilities (DTLs). Note that the asset categories listed, fall under risk assets and hence must be subjected to the various weighting categories depending on the exposures.

Additional adjustments are proposed to be implemented on leverage, capital conservation buffer, countercyclical capital buffer, Loss absorption, and introduction of a prompt corrective action among others.

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