Basel III – Higher Capital Requirements for Banks

On September 12, 2010, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced the agreements reached in connection with the new rules (known as Basel III) required to strengthen the resilience of banks and the global banking system.

Basel III addresses a number of issues related to the banks’ capital requirements including the following: (i) raising the quality of capital to ensure banks are better able to absorb losses, (ii) raising the level of the minimum capital requirements, and (iii) promoting the build-up of capital buffers in good times that can be drawn down in periods of stress, including both a capital conservation buffer and a counter-cyclical buffer to protect the banking sector from periods of excessive growth. 

For Basel III to apply to Canadian banks, the new rules will have to be implemented by the Office of Superintendent of Financial Institutions Canada (OSFI), expected in 2011.  Although the Canadian banks weathered the financial crisis relatively well compared to their international peers and some of the new capital requirements under Basel III are in line with those that the Canadian banks are currently subject to under the current Canadian rules, the Basel III capital rules will likely result in the Canadian banks being required to raise more capital.  Below is a brief overview of the Basel III capital requirements.

What Constitutes Capital?

Basel III provides a new definition of capital, a key element of which is the greater focus on common equity (the highest quality component of a bank’s capital). 

Tier 1 Capital

Tier 1 capital will, among other things, need to be subordinated to depositors and general creditors, have fully discretionary non-cumulative dividends or coupons and have neither a maturity date nor an incentive to redeem. Common shares and non-cumulative, perpetual preferred shares (as currently structured in Canada) would be compliant with the new rules.  The “innovative instruments” issued by the Canadian banks which currently qualify as Tier 1 capital would not be compliant with Basel III. 

Tier 2 Capital

Tier 2 capital will be simplified – there will be only one set of Tier 2 capital (rather than Tier 2A and Tier 2B under the current rules).  Tier 2 capital will need to meet the minimum standard of being subordinated to depositors and general creditors and have an original maturity of at least five years.  Subordinated debt issuances will not be compliant where they contain a step-up feature, other incentives to redeem, or provide for redemption in the first five years.   

Tier 3 Capital

Tier 3 capital will be eliminated.

Phasing Out Existing Capital Instruments

It is likely that the capital instruments issued by the Canadian banks before December 17, 2009 (i.e., the date of publication of the Consultative Document “Strengthening the resilience of the banking sector” published by the Basel Committee) will be grandfathered under the new rules.  However, Basel III proposes that such capital instruments will be phased out over 10 years beginning in 2013.

Raising the Level of Capital

Basel III also raises the levels of capital requirements for banks.  The minimum requirement for common equity, the highest form of loss-absorbing capital, will be raised from the current 2% level to 4.5% (before factoring in the capital conservation buffer).  The level of Tier 1 capital (which includes common equity and other qualifying financial instruments whose inclusion will be based on stricter criteria) will increase from 4% to 6% (before factoring in the capital conservation buffer).  These new requirements are expected to be phased in over a period of five years beginning in 2013.

In Canada, the current requirements (minimum tier 1 capital ratio of 4% and total capital ratio of 8%) are already higher than the requirements under Basel II.  We expect that Basel III would set a floor for the Canadian capital requirements and these new requirements would likely be higher than required under Basel III.

Capital Buffers

Under the new rules, the banks will be required to hold capital conservation buffers comprising common equity of 2.5%.  The philosophy is that banks will be required to build up buffers in good times that can be drawn down in periods of stress.  During these periods of financial stress (as banks’ capital levels move closer to the minimum requirements level), this conservation buffer will restrict the banks’ discretionary distributions (e.g., bonuses and higher dividends).

In addition, Basel III has also proposed a counter-cyclical buffer within a range of 0 to 2.5% comprised of common equity or other fully loss absorbing capital, which will be implemented according to national circumstances.  This buffer will only be in effect when there is excess credit growth that is resulting in a system-wide build up of risk.

Contingent Capital 

One of the proposals that has been debated by the Basel Committee and various national regulators relates to the idea of contingent capital.  The contingent capital of a bank would be a security that converts into common equity of that bank when that bank is in serious trouble.  This conversion would occur before the bank goes into insolvency or liquidation. For example, the trigger event could be when the relevant government has decided to inject public sector capital to rescue the bank.  From a taxpayer’s perspective, the idea of contingent capital is appealing as the holders of a bank’s capital instruments (both Tier 1 and Tier 2 capital) would have their securities converted into common shares, thus reducing the amount of government-injected capital required to rescue the bank.  Although OSFI is a strong supporter of this idea, whether contingent capital will be accepted by other members of G20 and the details of how contingent capital would work remain open points.