An introduction to Basel III - its consequences for lending

On 12th September, 2010, the Basel Committee on Banking Supervision agreed on detailed measures to strengthen the regulation, supervision and risk management of the banking sector. This package of measures, known as Basel III, supplements the existing International Convergence of Capital Measurement Document (Basel II) which came into effect across the European Union, and many other jurisdictions, in 2008.

It is expected that Basel III will be implemented progressively across the European Union (and elsewhere) between 2013 and 2019. The implementation will require a series of directives and regulations to be introduced at both Community and national level.

One of the main outcomes of Basel III will be a significant rise in the banking industry’s capital requirements (and therefore, potentially, borrowing costs). By way of example, some estimates put the additional capital required by the European banking industry to comply with Basel III at around 700 billion euros, reducing return on equity by up to 30 per cent (McKinsey 2010).

This shortfall will not affect trading, corporate and retail banking equally and institutions will presumably reorganise to mitigate the cost. However, some of the costs will be shared with bank clients.

In this introductory Briefing, we recap on the existing Basel II framework and summarise the main Basel III changes which give rise to the increased capital requirement. We also consider whether standard lending documentation allows this increased cost to be passed on to borrowers.

We will shortly be publishing a more detailed briefing on the effect of Basel III on the banking industry.

Capital Adequacy

The aim of Basel III is maintain banks’ solvency by strengthening the regulation, supervision and risk management of that sector. It does this by building on, rather than replacing, the existing Basel II. In summary, the Basel frameworks impose capital adequacy requirements which limit the amount of assets (including loans) that a bank may have by reference to its capital, so helping to ensure that losses (including from non-performing loans) may be absorbed without prejudicing the rights of creditors and depositors. There are two sides to the equation.

On the capital side, banks must have a certain amount and type of capital which is categorised based on its ability to absorb losses:

1. Tier 1 is the best quality capital (e.g. common shares or certain “innovative” instruments which have equity-like characteristics but cost less to raise);
2. Tier 2 (e.g. preference shares); and
3. Tier 3 which is the lowest quality capital (e.g. subordinated debt).

On the asset side, a bank must calculate the value of all of the exposures that it faces and then apply a risk weighting depending on the type of asset. In simple terms, the Basel frameworks require that a certain amount of the bank’s regulatory capital must be allocated (at least notionally) to every loan advanced, or commitment made, by that bank. That allocation therefore restricts the amount of business that a bank may enter into or forces it to raise fresh capital. Therefore, the capital adequacy requirements of any loan carry an implicit cost to the bank advancing it. The capital adequacy cost of a loan depends on the amount of capital by which it has to be backed. This amount is often referred to as the capital charge.

The 8 per cent Formula

Since 1992 (when Basel I was first implemented), the minimum requirement for the equation described above is that a bank should have total regulatory capital (i.e. Tier 1, Tier 2 and Tier 3) equal to at least 8 per cent of its risk-weighted assets (RWA). 8 per cent is a minimum figure: it is possible that a bank’s regulator may require a higher percentage to be applied.

Basel I and Basel II

The original Basel Accord was relatively rudimentary in the way it allocated capital to risk. Basel II adopted a different approach and sought to match the amount of capital required to be held by an institution more closely to the exposures that it faces. Within that guiding idea, the main changes introduced by Basel II include:

1. a more sophisticated methodology for risk-weighting loans advanced by an institution depending on:
   1. the type of counterparty (e.g. a sovereign as opposed to a corporate);
   2. the counterparty’s credit rating; and
   3. the type of risk mitigants in place (e.g. collateral or guarantees);
2. special regimes to deal with areas such as project or object finance and commodities finance;
3. alternative calculation methods (the internal ratings based model) to allow sophisticated financial institutions to use, within the supervisory framework, their own models to evaluate exposures; and
4. an emphasis on supervisory review (Pillar 2 in Basel II terminology) and disclosure (Pillar 3). The intention being that the capital requirements set in Basel II are minimum levels which will be fine tuned through dialogue with the supervisors and disclosure.

One consequence of the introduction of Basel II is that the capital charge for any loan could vary during its life. Fluctuations in the credit-rating of the borrower or the loan-to- value ratio of eligible collateral would affect the cost to the lenders of keeping the facility open, as would changes in law affecting the enforceability of the collateral. Similarly, a change in the regulatory regime could also impact the risk weighting given to a loan and so to its capital charge. The question in each case is, if the capital charge for a loan changes, who should bear the cost of the increase or take the benefit of a reduction? We deal further with this question below.

As is widely known, Basel III is a response by regulators to perceived weaknesses in the existing Basel II framework. Whilst Basel III has a wide remit - including extensive, new requirements for securitisations and trading - this note focuses on the main capital, leverage and liquidity requirements.

Basic capital requirements - Tier 1, 2 and 3

The basic 8 per cent minimum ratio of capital to RWA remains under Basel III. However, whilst Tier 1 capital under Basel II could be constructed of both common equity (e.g. ordinary shares in England) and other capital instruments, common equity performed best in absorbing losses throughout the crisis. The Basel Committee has focused on this and notes that the minimum requirement currently is that banks issue common equity equal to 2 per cent of RWA. Basel III proposes to increase this requirement to 4.5 per cent of RWA, to be phased in by 1 January 2015 at the latest.

Basel III also introduces stricter regulatory deductions (e.g. for minority interests) for calculating Tier 1 capital and tighter requirements for capital instruments which are not common equity to form part of Tier 1 capital. On the second point, the Basel Committee acknowledges that certain innovative features have been introduced to Tier 1 capital over the years (e.g. margin step-ups) to lower the cost of raising Tier 1 capital but has stated that those features are to be phased out.

Tier 2 capital is also to be simplified and Tier 3 capital is to be phased out.

Capital buffers

In addition to strengthening Tier 1 capital, two capital buffers will be added - a capital conservation buffer equal to 2.5 per cent of RWA and a countercyclical buffer of an additional 0 per cent to 2.5 per cent of RWA. Both buffers must be raised through common equity.

The broad basis for this proposal comes from the observation that some institutions with heavy losses and depleted capital from the crisis still made distributions to shareholders. The Basel Committee argues that this should not occur and that banks who suffer losses should rebuild their capital by retaining earnings and raising new capital. The guiding principle is to shift the risk as much as possible from depositors to shareholders and employees of banks.

As such, the buffers are not additional, minimum capital requirements. Instead, if an institution does not have the required capital buffers, Basel III will restrict the institution’s ability to distribute earnings.

Of the two types of buffer, the capital conservation buffer is intended to be large enough to enable banks to maintain capital levels above the minimum requirement throughout a significant sector-wide downturn. The countercyclical buffer is an additional requirement which will be implemented by national supervisors when there is excess credit growth in their economy, with the intention of dampening such credit growth.

The capital conservation buffer should be phased in by 1 January 2019 at the latest. The countercyclical buffer is still subject to consultation but national supervisors are expected to have more discretion in implementation.

Leverage ratio

In addition to increased risk-based capital requirements, Basel III introduces for the first time a leverage ratio. The intention is to constrain the build up of leverage in the banking sector with a simple metric. The current proposal by the Basel Committee is to test a leverage ratio set at 3 per cent of Tier 1 capital as part of the Pillar 2 supervisory review with a view to migrating this to a Pillar 1 requirement by 1 January 2018.

Liquidity ratios

During the crisis, a number of banks suffered from significant liquidity problems and required unprecedented state support to continue operations. Part of this risk is to be addressed by improved bank policies and oversight by board and senior management. It is also proposed to introduce two standards for the liquidity of bank assets.

The first standard is the Liquidity Coverage Ratio (LCR) to ensure that banks have sufficient liquidity to deal with severe market shocks. This requires a bank to hold sufficient high quality liquid assets that can be converted into cash to meet its cash outflows for a 30 day period in a high stress scenario specified by supervisors. The liquid assets are intended to have a low credit and market risk, be short duration and be issued in an active and large market. The stress scenario contemplated is based on a market-wide shock which leads to, amongst other things, a three notch downgrade for the bank; a run-off of a certain proportion of its retail deposits; and a loss of the bank’s access to unsecured wholesale funding.

The second standard is the Net Stable Funding Ratio (NSFR) which is intended to promote more medium and long-term funding of banks’ activities. In summary, it establishes a minimum amount of stable funding based on the liquidity characteristics of an institution’s assets and activities over a one year horizon. Stable funding in this context means capital, preferred stock and debt with maturities of more than one year and that portion of deposits with maturities of shorter than a year that would be expected to stay with the institution in a stress scenario.

The combination of (a) increased capital requirements, particularly in the common equity element of Tier 1 capital and capital buffers and (b) minimum liquidity requirements, are likely to reduce the return on equity for banks. It is unclear how different banks will address the situation but the options include reduction of rates on retail deposits; reduced staff compensation; and increased margins on products.

In the corporate lending sector, new facilities will factor the capital costs into margin where the market will bear it. However, for existing facilities, if banks are not able to recover their consequential increased costs from their borrowers, their internal rates of return will be reduced.

One of the first documentation points that we are seeing, as with Basel II, is the discussion around the increased costs clause. Market practice when negotiating loan agreements has historically been based on the principle that borrowers should indemnify lenders for the amount of any increased costs (including a reduction in the rate of return from the facility or on the lenders’ overall capital) incurred by them as a result of (a) the introduction of or any change in (or in the interpretation, administration or application of) any law or regulation or (b) compliance with any law or regulation made after the date of the relevant loan agreement.

That market practice, if continued, would result in borrowers becoming liable to indemnify lenders for the increased regulatory costs under existing facilities on the implementation of Basel III as law. Some borrowers might argue that, the principles of Basel III having been finalised, banks should have planned accordingly and the resulting reduction on returns or costs of implementation should be carved out. This was commonly the case prior to the implementation of Basel II, although banks had a much longer period of time to prepare themselves for that regime.

However, one of the major differences to the past is that the capital charge for a facility may vary during its lifetime. This started under Basel II (e.g. with the calculation of RWAs being based on credit ratings that can change over time) but there will be a significant shift in Basel III as it is progressively introduced and as countercyclical buffers and liquidity requirements are set and re-set over the life of a loan.

In this respect, the typical increased costs language is ambiguous as to whether such a change in circumstances gives the right to an indemnity notwithstanding that the framework legislation remains unaltered. There are many complicated and far-reaching issues arising from Basel III. However, parties will need to revisit the increased costs clause in standard loan documentation to make sure both lender and borrowers know how it will work in the new regime.