Regulatory capital - implications of proposed new Basel III regime

March 2011

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Introduction

The Basel III reforms to the regulatory framework for the banking sector are not yet set in stone - a number of proposals have been flagged by the Basel Committee as being subject to continuing consideration. However, following publication in December of two Basel III documents: A global regulatory framework for more resilient banks and banking systems  and  International framework for liquidity risk measurement, standards and monitoring, and the subsequent issue of a press release in January setting out requirements to ensure that capital instruments are structured to fully absorb losses at the time the relevant institution becomes non-viable, the nature of the new regime has now become rather clearer. This short article highlights and comments on certain key changes to regulatory capital requirements being introduced under Basel III from a building society perspective.

Building societies current position

Building society regulatory capital currently comprises predominantly members’ reserves, permanent interest bearing shares (PIBS) and subordinated debt. Members’ reserves constitute core Tier 1 capital under the UK regime which implements existing Basel requirements, PIBS constitute non-core Tier 1 capital and subordinated debt constitutes lower Tier 2 capital. Members’ reserves are the main source of high quality capital for the building society sector, comprising approximately 85 per cent of total Tier 1 capital.

In recent years, and particularly since the onset of the global financial crisis in 2007, an issue which has received considerable attention (including from the Government-convened expert group advising on strategic issues affecting building societies) is how building societies may be able to generate capital which is recognised as core Tier 1, other than from profits retained as members’ reserves. This issue now needs to be considered through the lens of Basel III requirements, alongside consideration of the implications of Basel III for PIBS-type instruments and subordinated debt.

It is worth emphasizing that the Basel Committee has focussed primarily on banks which are joint stock companies in settling the terms of Basel III and as a result certain eligibility criteria and other terms are less well-suited to mutuals such as building societies than to banks. The Basel Committee has acknowledged that it is appropriate for the specific constitution and legal structure of mutuals to be taken into account in applying Basel III to them and effectively it is being left to national regulators, and in the case of EU member states the European Commission in implementing Basel III through the CRD4 Capital Requirements Directive-related legislation, to determine exactly how the new requirements will be applied to mutuals. To date only the Basel Committee has published its Basel III requirements and accordingly comments below relate to the Basel Committee publications.

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Key regulatory capital changes under Basel III

Increased requirement for the highest quality category of capital

In conjunction with modifying the qualifying criteria applicable to this category of capital, the Basel Committee is renaming it, with the term Common Equity Tier 1 replacing core Tier 1. Nevertheless, despite the changes members’ reserves will continue to qualify for and will be the predominant constituent of Common Equity Tier 1 for building societies.

Until now, under the Basel regime this highest quality category of capital was required as a minimum to constitute 2 per cent of a financial institution’s risk weighted assets (with total regulatory capital comprising at least 8 per cent of the institution’s risk weighted assets). Under the new regime this required minimum percentage will increase: to 3.5 per cent of risk weighted assets by January 2013 and to 4.5 per cent by January 2015.

In addition, under the new regime only Common Equity Tier 1 will count towards satisfying the new capital conservation buffer requirement being phased in from January 2016 and reaching its final level of 2.5 per cent of risk weighted assets in January 2019. (The effect of the capital conservation buffer requirement is to impose restrictions on making distributions out of capital until the required capital conservation buffer is in place). No Common Equity Tier 1 which is taken into account as regulatory capital forming part of the required 8 per cent of risk weighted assets may be included as part of the capital conservation buffer.

Moreover, if a national regulator decides that there is excess aggregate credit growth in its jurisdiction and accordingly imposes a national countercyclical buffer requirement (as an extension to the capital conservation buffer), then under current proposals this countercyclical buffer (of up to a further 2.5 per cent of risk weighted assets) is also to be met solely with Common Equity Tier 1. The Basel Committee has however said that it is still reviewing whether to permit other fully loss absorbing capital to count towards this countercyclical buffer.

Accordingly, by January 2019 financial institutions will be strongly incentivised by Basel III regulation to have Common Equity Tier 1 capital comprising at least 7 per cent of risk weighted assets (and total regulatory capital of at least 10.5 per cent of risk weighted assets); and these percentages will be higher again if, in relation to a particular jurisdiction, a countercyclical buffer requirement is then also in effect. Moreover, these are only Basel III prescribed minimum percentages. National regulator requirements for individual institutions may well be substantially higher.

Logically, this increased level of requirement for the highest quality category of capital may be expected to increase the importance for building societies of being able to generate Common Equity Tier 1 capital other than from profits retained as members’ reserves. However, currently it is unclear exactly what the requirements will be in relation to building societies when Basel III is implemented in the EU and the UK and consequently it is unclear whether it will be practicable to structure an instrument which will qualify as Common Equity Tier 1 and which will also be attractive to investors. Devising an instrument which is marketable to external investors has of course been problematic under the existing Basel regime. So whereas the West Bromwich Building Society was able to issue deferred shares with limited profit participation rights which qualified as core Tier 1 capital, these shares were not issued to new investors and to date there has been no example of core Tier 1 capital being issued to new building society investors.

An alternative possible approach to generate Common Equity Tier 1 may be for a building society to issue debt which upon the occurrence of a trigger event - e.g. linked to capital ratios - is written down, with a principal amount equal to the write-down being retained and so increasing Common Equity Tier 1 reserves. This kind of contingent capital security has been issued by Rabobank, itself a mutual, in 2010 and 2011, but Rabobank has a very high credit rating and it remains unproven whether there will be investor demand for similar securities issued by lower rated entities or in the UK building societies sector.

More restrictive approach to what may qualify as regulatory capital

The categories of regulatory capital which will exist under Basel III in addition to Common Equity Tier 1 will be Additional Tier 1 and Tier 2. Common Equity Tier 1 and Additional Tier 1 will be required under Basel III to constitute by January 2015 in aggregate at least 6 per cent of risk weighted assets and total Tier 1 and Tier 2 capital will be required to constitute by the same date at least 8 per cent of risk weighted assets.

The criteria which must be satisfied in order for securities to qualify as regulatory capital have been thoroughly reviewed by the Basel Committee with a view to addressing perceived weaknesses identified during the financial crisis and have been made materially more restrictive in various ways, including in particular:

No step-ups or other incentives to redeem will be permitted to be included in a Tier 2 or Additional Tier 1 capital instrument.

This change will impact on both PIBS and subordinated debt where it has until now been common to provide for a step-up after a specified number of years in the coupon rate payable, effectively giving investors comfort that the issuer would exercise a call option to redeem the securities immediately before the step-up becomes effective. Instruments containing a step-up in rate or any other incentive to redeem will not qualify as regulatory capital under Basel III.

All Tier 1 and Tier 2 capital instruments must contain provisions to ensure that losses are fully absorbed by the instrument at the point of non-viability.

This requirement has been introduced in light of the fact that during the financial crisis a number of distressed financial institutions were rescued through the injection of public funds and this had the effect that Tier 2 capital instruments (mainly subordinated debt) and in some cases Tier 1 instruments did not contribute to absorbing the losses which had been incurred - which they would have done had these institutions been allowed to fail rather than rescued.

More specifically, the requirement is that all Additional Tier 1 and Tier 2 instruments must (unless the governing jurisdiction of the financial institution achieves the same result by operation of law) have a provision that requires such instruments, at the option of the regulator, to either be written off or converted into an instrument qualifying as common equity upon the earlier of (1) a decision that a write-off, without which the institution would become non-viable, is necessary, and (2) a decision to make a public sector injection of capital, or provide equivalent support, without which the institution would have become non-viable.

This is a major new requirement for regulatory capital instruments. The Basel Committee had previously flagged that additional loss absorption requirements would be introduced, but it is only since the January 2011 press release on this that this requirement has been clarified for banks. In relation to building societies, further clarification regarding how the loss absorption requirement will be applied will be provided once the terms of EU and UK implementing legislation are published. However, it is prudent to assume that a loss absorption requirement will apply to any future issues of PIBS or subordinated debt intended to qualify as regulatory capital under Basel III. The marketability of building society instruments containing such a feature is unproven and clearly this is a potential issue in relation to the new requirements, but nevertheless it appears that instruments will going forward have to contain one of these features in order to qualify as regulatory capital under Basel III.

In relation to Additional Tier 1 instruments, the financial institution must have a full discretion at all times to cancel coupon payments.

The Basel Committee regards certain provisions, which have in the past been permitted to be included in the terms of non-core Tier 1 instruments, as inconsistent with the relevant financial institution having a full discretion to cancel and accordingly these are now prohibited, these being:

  • a “dividend pusher” provision - this refers to a provision which imposes an obligation on an institution to make a coupon payment on an instrument if it has made a payment on another (typically more junior) capital instrument or share;
  • a requirement for an institution to make a distribution/payment in kind where it elects not to pay in cash - e.g. satisfying the coupon payment obligation through an issue of shares.

Payment in kind provisions have in the past been included in the terms of PIBS issues - these will not be permissible in future.

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Basel III implementation period and transitional provisions

The new capital requirements are being phased in from January 2013 and will be fully in effect only from January 2019. This 6 year phasing in period will help banks and building societies, in particular as they will be able to use retained profits over a number of years to help meet any additional requirements for Common Equity Tier 1 arising under Basel III.

Capital instruments issued before 12 September 2010 which do not qualify as Additional Tier 1 capital or Tier 2 capital under Basel III will be phased out beginning January 2013. This phasing out will take place over a period of up to 10 years with capital recognition being reduced by 10 per cent a year during this period, subject to the instrument remaining outstanding and subject in certain circumstances to no call date occurring in respect of the instrument. Capital instruments issued on or after 12 September 2010 (the date on which the Basel III capital requirements were first announced) will be fully de-recognised on 1 January 2013.

Both the reduced role for Additional Tier 1 and Tier 2 capital instruments under the Basel III regime and the extended phasing out period for instruments which cease to qualify under Basel III will operate to reduce to some extent the volumes of compliant Additional Tier 1 and Tier 2 instruments which financial institutions will have to issue in the coming years in order to comply with regulatory requirements. However, redemptions will have the opposite effect where redeemed capital securities need to be replaced. What is clear is that following the Basel III-related publications in December and January regulatory capital requirements are now sufficiently certain for financial institutions to be seeking, with the approval of their regulators, to issue new capital securities which are Basel III compliant, and we are already starting to see this with recent ground-breaking issues by Rabobank and Credit Suisse.

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