Basel III: The bar is now set

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Agefi Luxembourg
 January 2011

For many, Basel reforms are the single most important regulatory restructuring that will be made in the wake of the financial crisis. This article provides an overview on how the Basel Committee prudential regulation has been reflected in the European Union, including Basel II enhancements and Basel III, and explains its transposition into Luxembourg law. It also describes the key elements of Basel III and its main challenges for the Luxembourg banking sector.

The avalanche of regulation and its Luxembourg transposition2010 will be remembered as another year of high regulatory activity. In Luxembourg, regulators have been extremely busy, transposing into national law the second and third amendments to the Capital Requirements Directives(1). The set of new directives are commonly referred as ‘Basel II enhancements’ as follows :

  • The Commission de Surveillance du Secteur Financier (CSSF) published the Circular 10/475 in July 2010, which transposes the “CRD II” directives into Luxembourg law(2). This Circular amends the CSSF 06/273 with regards to the large exposure regime and becomes effective on 31 December 2010.
  • Just before eating the turkey at Christmas, the CSSF published the Circular 10/496 (22 December 2010), transposing the “CRD III” directives(3), which introduces the trading book capital charge, re-securitization and remuneration policies, with different effective dates. This Circular also amends the Circular 06/273. Luxembourg regulators have confirmed that an updated text of the Circular 06/273 will be published in the first weeks of 2011 to facilitate its application

Basel III can be seen as the corresponding European Commission’s working document Public consultation regarding possible further amendments to the Capital Requirements Directive (February 2010), known as “CRD IV”. Countries have committed to translating the rules into national laws and regulations before January 2013, including Luxembourg. It is very important that consensus among countries continues so we get comparability and a level playing field to avoid arbitrage between financial centers.

The table underneath summarizes the abovementioned regulations.

Basel Committee

European Union

Luxembourg

Basel II

2006/48/CE and 2006/49/CECSSF 06/273

Basel II Enhancements

CRD II - 2009/27/CE, 2009/83/CE and 2009/111/CE CRD III - 2010/76/UE
CSSF 10/475 CSSF 10/496 Updated version of CSSF 06/273 in 2011

Basel III

Proposal for Directive CRD IVBefore January 2013


Key aspects of Basel III

Despite the doubts, tough negotiations and bank lobbying, the Basel Committee (the “Committee”) agreed the details of the Basel III rules(4) for the new capital and liquidity requirements in December 2010. This is a considerable achievement compared with the seven years it took to get Basel II capital adequacy framework completed. Basel III will have up to eight years to fully phase, giving more time to banks to prepare. The main documents were complemented by the results of the comprehensive quantitative impact study performed over 263 banks and an additional paper providing guidance for national authorities operating the countercyclical capital buffer.
Basel III is the successor to Basel II. The Basel II framework set out guidelines for minimum capital adequacy requirements for banks to promote the financial health and stability, with an “entity focus”. On the other hand, Basel III projects a “system focus”, considering the financial system as a whole as opposed to individual financial institutions. Mr. Nout Wellink, Chairman of the Committee, mentioned that Basel III aims at “protect financial stability and promote sustainable economic growth”, adding that “the higher levels of capital, combined with a global liquidity framework, will significantly reduce the probability and severity of banking crises in the future”. Further work is conducted by the Committee on the systemically important financial institutions (SIFIs) and the concept of contingent capital (known as ‘COCOs’).
In a nutshell, the Basel III’s aims are the following:

  • Increase the quality, quantity, and international consistency of capital;
  • Enhance risk coverage
  • Discourage excessive leverage
  • Strengthen liquidity standards
  • Reduce procyclicality
  • Address systemic risk.

Luxembourg sector is reasonably well capitalized

The text clarifies the concepts of Common Equity Tier 1, Additional Tier 1 and Tier 2 capital, abolishing definitely Tier 3 capital. Moreover, it describes the treatment of minority interests, admitting its recognition in the Common Equity only upon strict conditions. Finally, it provides a clarification on the regulatory adjustments to be applied, most of the time deducted from Common Equity Tier 1.

Overall, the package is phased in up to 2019; however, for the phase out of some capital instruments it is 2023. The phase in of the deductions from capital is necessary given the huge effect of deducting most deferred tax assets (DTAs) and many minority interests. The prolonged phase out (over a 10-year period starting in 2013) of those capital instruments no longer allowed as non-core Tier 1 or Tier 2 will also help to reduce the transition effects. The table enclosed provides a simplified view on the Basel III framework timeline.

The quantitative impact study published by the Committee collected on a voluntary basis banking data as of 31 December 2009. The study evidences that the Common Equity Tier 1 ratio (CET1) for group 1 banks)(5) equals to 5.7%, and for the group 2 equals to 7.8%, where Basel III minimum requirements are set at 4.5%. In other words, banks will have to raise €165 billion and €8 billion for group 1 and group 2 respectively. If this calculation is done including the capital conservation buffer equal to 2.5%, then the group 1 presents a shortfall of €537 billion and the group 2 a shortfall of €20 billion.

These figures need to be taken as an indication for Luxembourg: one Luxembourg bank out of 263 banks participated directly in the survey. A recent survey made by the Banque Centrale du Luxembourg (BCL)(6) using also data from CSSF, shows that Luxembourg sector is reasonably well capitalized following the current Basel II regime. The average solvency ratio equals to 19.7% at the end of December 2009, which is an increase of 3.4% from the previous year. Additionally, the Tier 1 ratio also increased from 14.1% in December 2008 to 17.4% in December 2009. Nevertheless, the efforts and resources requested by Basel III will be substantial and will impact the solvency ratio figure.

…But further efforts will need to be made to enhance the risk coverage

The Committee is proposing to strengthen the capital requirements for counterparty credit risk exposures arising from derivatives, repos, and securities financing activities, in addition to the trading book and securities reforms requested by CSSF Circular 10/496. The main requirements included are the following:

  • Banks will have clear incentives for using central counterparties to clear OTC derivatives as the bank’s collateral and exposures to central counterparties will be subject to a low risk weight, proposed at 2%
  • Banks using the internal modeling approach)(7) will have to determine their capital requirement for counterparty credit risk using stressed inputs, an approach similar to that introduced for market risk in the trading book. Additional quantitative and qualitative standards are required for collateral management for banks also using internal modeling
  • Banks will also be subject to a capital charge for mark-to-market losses (i.e. credit valuation adjustment – CVA risk) associated to deterioration in the credit worthiness of a counterparty
  • To address systemic risk of the financial sector, the Committee requires raising the risk weights on exposures to financial institutions relative to the non-financial corporate sector, as financial exposures are more highly correlated than non-financial ones

On the top of these changes, the Committee is raising the standards regarding the treatment of wrong-way risk, for instance cases where the exposure increases when the credit quality of the counterparty deteriorates. Finally, the text envisages the strengthening of stress testing, back testing and model validation techniques, as have occurred for other type of risks.

According to the Luxembourg country report published by the International Monetary Fund (IMF))(8) in June 2010 “there is a substantial variation in the internal rating-based (IRB) estimates across banks, and their limited sensitivity to the current downturn, suggests that banks may be underestimating risks”. This report calls for closer analysis in coordination with Luxembourg supervisors. The recent announcement of Standard & Poor’s about its proposal to revise its credit rating methodology, whereby almost 50% of the banks might be downgraded, will put additional pressure on Luxembourg banks to demonstrate the appropriate risk coverage of their capital framework.

… And further deleveraging will be required

As one of the underlying features of the crisis was the excessive on- and off-balance sheet leverage in the banking system, the Committee introduced the leverage ratio as a “supplementary measure” to the capital requirements. The leverage ratio is currently only deployed in the US, Canada and Switzerland.

The leverage ratio relates the bank capital to total balance sheet assets or exposure. Therefore, it is not risk-weighted, raising strong banking concerns, included ABBL. In the final text, the Committee has clarified its introduction as a “simple, transparent, non-risk based” measure “that is calibrated to act as supplementary measure to the risk-based capital requirements”.

The leverage ratio is still generating a lot of debate: the regulatory capital is risk-based while the leverage ratio is non-risk-based; hence apples will be compared with pears. The good news for the Luxembourg banking community is that transition arrangements are clarified and the regulators agreed on performing any final adjustments needed before migrating to a Pillar 1 on 1 January 2018. The transition period will comprise 2 periods:

  • During the supervisory period, which commences on 1 January 2011, the regulators will focus on developing templates to track in a consistent manner the underlying components
  • During the parallel run, which started on 1 January 2010 till 1 January 2017, the leverage ratio and its components will be tracked and banks will be required to calculate the leverage ratio using the definitions of capital and total exposure described in the text. The Committee will start testing during the paralel run minimum Tier 1 leverage ratio of 2.8% for group 1 and 3.8% for group 2 banks and perform any final adjustments needed before migrating to a Pillar 1 on 1 January 2018. So there is still room for changes

As the IMF country report for Luxembourg highlights, despite high capital adequacy ratios in Luxembourg banking system, “leverage ratios are high and disperse, prompting questions regarding the suitability of the structure of risk weights and their level”. This report calls for closer analysis in estimating the bank risks and finds appropriate the CSSF’s decisions of capital add-ons as prudential measure.

Coping with liquidity standards will be one of the greatest challenge among Luxembourg banks

The Basel III framework is introducing two liquidity ratios: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR).

Regarding the LCR, the Committee provides a definition of high-quality liquid assets, differentiating between level 1 assets (0% haircut) and level 2 assets (15% haircut). The eligibility of level 2 will depend on both credit ratings and additional qualitative and quantitative criteria. The Committee will test these criteria during the observation period to determine the appropriate indicators to be used i.e. volume, bid-ask spread, turn-over, etc. The Committee is also introducing a special treatment for jurisdictions with insufficient liquid assets and will analyze different options during the observation period.

Regarding the NSFR, the final text is very much in line with the original proposal. A point of attention regarding the off-balance sheet categories is that national regulators can specify the risk factor of certain contingent funding obligations. Luxembourg regulators will require additional reporting to calibrate appropriately this factor.

As there are still several open points, the Committee will conduct an additional quantitative impact study regarding the liquidity standards using data from year-end 2010 and mid-year 2011. The Committee has echoed the strong concerns of the banking industry and the text clearly proposes to include revisions for both ratios if this proves necessary in the light of analysis conducted and the data collected during the observation period.

The liquidity ratios observation period and transitional arrangements timelines are as follows:

  • For the LCR, the observation period stars on 1 January 2011 and will be introduced, including any revisions, on 1 January 2015. It is worth noting that some of the specific issues to be closely monitored will be the treatment of liquidity lines to non-financial corporates, the additional quantitative and qualitative criteria for level 2 assets eligibility and term deposits.
  • For the NSFR, the observation period begins also on 1 January 2011)(9) and it will be introduced, including any revisions, on 1 January 2018.

Finally, the Committee requests the implementation of liquidity monitoring tools such as contractual maturity mismatching, concentration of funding, available unencumbered assets, market-related monitoring tools, and computation of LCR per currency. These standards complement the CSSF Circular 09/403 and the BCL Règlement 2009/No 4 referring to liquidity risk management surveillance.

It is clear that there will be rigorous monitoring on the LCR and the NSFR over the transition period, and Luxembourg banks will have to move quickly to engineer appropriate systems, generate data and implement robust liquidity risk management techniques in order to meet the abovementioned requirements. For some banks, spreadsheets will not be longer sufficient and raising the right skills and knowledge will not be a one-day job. Most probable, some banks will need to review their funding model and balance-sheet strategy, impacting their business operating model at local and at group level.

Reducing procyclicality is likely to increase the risk-weighted assets of Luxembourg banks

The Committee proposes introducing corrective measures to reflect the changes in economic cycles. The timeline shows the phase-in arrangements.The main proposals are as follows:

  • Reduce excess of cyclicality in the minimum capital requirements by introduction longer periods (point-in-time vs. through-the-cycles methodologies for credit and counterparty risk)
  • Supporting the International Accounting Standards Board’s (IASB’s) initiative, the Committee is advocating for forward looking provisioning based on expected losses, which captures actual losses more transparently, and is less pro-cyclical than the current “incurred losses” provisioning model
  • Conserve capital to build buffers at individual banks that can be used in period of stress. A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement, i.e. CET1 must be used first to meet the requirements before contributing to the capital conservation buffer. The Committee also introduces elements to the restrictions on earnings distribution
  • Introduce the countercyclical buffer to reflect the specific circumstances of national economies. The Committee has also calibrated the countercyclical buffer within a range of 0%-2.5% of risk-weighted assets. The Committee leaves the door open to national authorities to implement addition macroprudential tools, including a buffer in excess of 2.5% for banks in their jurisdiction; however, the international reciprocity provisions set out by Basel III will treat the maximum of the countercyclical buffer as 2.5%. The ball in now in Luxembourg’s regulators field

The results of the quantitative impact study of December 2010 evidence that the risk-weighted assets would increase by 23.0% for group 1 banks, mainly due to the charges against counterparty credit risk and trading book exposures. Group 2 banks are less affected by these measures as their risk-weighted assets would only increase by an average of 4.0%. Nevertheless, let’s not forget that only one Luxembourg bank participated in the survey, therefore tailor-made analysis should be performed to assess more accurate impact on the Luxembourg sector.

…Further regulation expected for systemically important financial institutions

Regulators are planning to request additional capital for banks deemed to present a threat to the financial system if they fail. The aim is to design an integrated approach to deal with the riskiest 30 or 40 so-called “SIFIs” and ensure that they have additional loss-absorbing capacity.

The Committee and the Financial Stability Board are developing an approach integrated by combinations of capital surcharges, contingent capital and bail-in debt. The concept of contingent capital and bail-in debt is not rejected by the banking industry. Indeed, such instruments are viewed by some as potentially useful in helping firms cope during periods of stress. It is the capital surcharge that is strongly opposed as it might create two-tier banks. It is possible that for a trial period at least, the additional loss-absorbing buffer will be treated as a Pillar 2 measure, which provides for some supervisory discretion, rather than as a binding Pillar 1 measure.

Conclusion

It is going to be a very long path to implementation of Basel III and it is uncertain how the funding markets will respond to this enormous demand for capital from banks. It is clear, however, that banks wishing to remain attractive to investors in the capital markets will have to move quickly to implement the requirements

The bar is now set and Luxembourg banks should start, if not done yet, a deep and exhaustive Basel III impact assessment on their main activities and current portfolios, and develop adequate action plans and roadmaps to cope with all the new requirements ahead in the most competitive way. Banks will need also to position themselves within their respective groups and rethink their overall business model in the light of the new regulatory requirements.

The cost of implementation of Basel III should not be disregarded. At entity level, new prudential standards and reporting, upgraded applications, additional skilled resources and enhanced risk management techniques will need to be implemented. At macro level, the final report issued in December 2010 by the Macroeconomic Assessment Group (MAG))(10) highlights a minor impact in the aggregated GDP; nevertheless, no Luxembourg model was submitted to the MAG. The bankers’ global voice representing more than 400 financial firms, the Washington-based Institute of International Finance (IIF), is more pessimistic and foresees that the Euro area would feel the largest impact from new Basel proposals as the growth could be cut by 0.5% per year from 2010 to 2015.

Coping with Basel III will be far from being just a regulatory exercise. Additional risk management techniques will need to be developed and business models may need to be rebuilt. Despite the costs, the implementation of proper risk management techniques linked with appropriate strategic thinking can contribute to generate further competitive advantage and increase the reputation of the banks in the financial arena. As the proverb says: “qui va sano, va piano”. Now countdown begins… So bankers … ready, steady, go!



(1) Directives 2006/48/CE and 2006/49/CE
(2) Directives 2009/27/CE, 2009/83/CE and 2009/111/EC
(3) Directive 2010/76/EU
(4) Basel III : A global regulatory framework for more resilient banks and banking systems, BCBS, December 2010 and Basel III: International framework for liquidity risk measurement, standards and monitoring, BCBS, December 2010
(5) Group 1 banks are those that have Tier 1 capital in excess of €3 billion, are well diversified, and are internationally active. All other banks are considered group 2 banks.
(6) Revue de Stabilité Financière 2010 (May 2010)
(7) Basel II framework definition
(8) IMF – Country Report No 10/161 (June 2010)
(9) It is a year earlier than suggested by the Basel Committee in its announcement of 12 September 2010.
(10) The MAG was established in February 2010 by the Financial Stability Board and the Basel Committee to assess the macroeconomic implications of Basel III reforms