Basel III rules published - White & Case

Insight: Regulatory
January 2011
Basel III rules published
On 16 December 2010, the Basel Committee on Banking
Supervision (Basel Committee) published many of the Basel III
rules. 1 These set out the details of the new global capital and
liquidity standards for banks developed by the Basel Committee
and endorsed in principle by the G20 Leaders at their November
summit in Seoul. This note provides a high-level overview of the
main Basel III capital and liquidity requirements and the timeline
for implementation.
1. Increasing the quantity and enhancing the quality of capital
Basel III will both increase risk-weighted capital requirements and superimpose a non-riskweighted
leverage ratio. These quantitative capital requirements will be reinforced by
more stringent qualitative capital standards. These combined measures are summarised
below.
(i) Minimum capital requirements
Minimum common equity (the highest quality component of Tier 1 capital) as a percentage
of risk-weighted assets will increase from 2% under Basel II to 4.5% under Basel III.
Minimum Tier 1 capital as a percentage of risk-weighted assets will be raised from 4% to
6%. Minimum total capital (including both Tier 1 and Tier 2 capital) as a percentage of
risk-weighted assets will remain notionally the same at 8%.
At the same time, the different regulatory capital instruments will need to meet tighter
criteria. Innovative hybrid capital with incentives to redeem which may currently count
towards Tier 1 capital will be phased out over time. Tier 2 capital instruments will be
harmonised. Tier 3 capital, previously available to cover market risks, will be eliminated.
In addition, regulatory adjustments will have to be deducted in most cases from common
equity rather than from any Tier 1 or from a combination of Tier 1 and Tier 2 capital. This
will make it harder to meet the proposed quantitative capital requirements.
(ii) Capital conservation buffer
In good times, a capital conservation buffer of 2.5% of common equity Tier 1 will be held
on top of the minimum capital requirements, bringing the total common equity capital
requirements to 7%. In times of stress, banks can draw on the buffer provided that, if
they do so, earnings distributions such as bonuses and dividends are limited.
1 Basel Committee on Banking Supervision, “Basel III: A global regulatory framework for more resilient banks and
banking systems” (http://bis.org/publ/bcbs189.pdf) and “Basel III: International framework for liquidity risk
measurement, standards and monitoring” (http://bis.org/publ/bcbs188.pdf), 16 December 2010.
For more information please contact:
Carmen Reynolds, London
+ 44 20 7532 1421
creynolds@whitecase.com
Dr. Dennis Heuer, Frankfurt
+ 49 69 29994 1576
dheuer@whitecase.com
Jonathan Weinberg, Prague
+ 420 255 771 111
jweinberg@whitecase.com
Duane Wall, New York
+ 1 212 819 8453
dwall@whitecase.com
Ernest (Ernie) T. Patrikis, New York
+ 1 212 819 8200
epatrikis@whitecase.com
Kate Andrews, London
+ 44 20 7532 1249
kandrews@whitecase.com
Susanne Leitterstorf, London
+ 44 20 7532 1349
sleitterstorf@whitecase.com
This publication is prepared for the general information of
our clients and other interested persons. It is not, and does
not attempt to be, comprehensive in nature. Due to the
general nature of its content, it should not be regarded as
legal advice.

Basel III rules published
(iii) Countercyclical capital buffer
This additional buffer of up to 2.5% of common equity Tier 1 or other fully loss-absorbing capital will have to be built up in periods of rapid
aggregate credit growth which, in the opinion of national authorities, aggravates system-wide risk. The countercyclical capital buffer can
be released during a downturn and, if in effect, would be an extension of the capital conservation buffer.
(iv) Additional requirements for systemically important financial institutions
Systemically important financial institutions could be subject to additional requirements reflecting the greater risks to financial stability that
their failure would present. Work on this will continue in 2011 and areas under consideration may include capital surcharges and the
introduction of contingent capital or “bail-in” debt.
(v) Leverage ratio
A non-risk-weighted minimum leverage ratio of Tier 1 capital to total exposures (including on-balance sheet and off-balance sheet items)
will be introduced to address concerns about leverage in the financial system and back up the risk-based requirements outlined above,
which may be affected by modelling errors. A minimum ratio of 3% will be tested.
Comparison of Basel II and proposed Basel III capital requirements
The table below provides an overview of the differences between the Basel II and the proposed Basel III quantitative capital
requirements. As a result of the revised qualitative capital standards the real impact of the proposed changes will be greater than these
quantitative requirements might otherwise suggest.
2. Enhancing risk coverage
The minimum common equity, Tier 1 and total capital requirements are calculated relative to risk-weighted assets. Under Basel III,
risk-weighted assets will increase as a result of enhanced risk coverage in relation to capital market activities. Besides, Basel III aims to
address certain concerns about the reliance on external credit ratings when determining risk-weights.
Higher capital requirements for trading and securitisation activities
In July 2009, the Basel Committee announced, among other things, higher capital requirements for trading and securitisation activities.
The trading book reforms will, among other things, introduce new risk weights to better capture risks in trading portfolios. The
securitisation reforms also include an increase in the risk-weighting of certain securitisations and resecuritisation exposures.
Capital requirements for certain counterparty credit risk exposures
Basel III will enhance capital requirements and risk management standards for counterparty credit risk exposures arising from derivatives,
repos and securities financing activities. The aim is to reduce the risk of transmission of shocks between financial institutions whilst also
creating incentives to move OTC derivative exposures to central counterparties and exchanges. The measures include, for example, the
use of stressed inputs to determine capital requirements for counterparty credit default risk and a capital charge for mark-to-market losses
associated with a deterioration in the credit worthiness of counterparties.
External credit ratings in the Basel III framework
Basel III contains measures in relation to the use of external credit ratings in the capital framework. Amongst other things, Basel III will
incorporate elements of the International Organization of Securities Commissions’ (IOSCO) Code of Fundamentals for Credit Rating
Agencies and require banks to carry out internal assessments of externally rated securitisation exposures.
2
Basel II Basel III
Common Equity Tier 1 Capital Total Capital Common Equity Tier 1 Capital Total Capital
Minimum requirements 2.0% 4.0% 8.0% 4.5% 6.0% 8.0%
Additional capital
conservation buffer
Not applicable 2.5%
Additional countercyclical
buffer range
Not applicable 0%-2.5% 2
Additional requirements
for systemically important
financial institutions
Not applicable May be added to the other risk-weighted requirements
Leverage ratio Not applicable May in effect add to the risk-weighted requirements
2 Common equity or other fully loss-absorbing capital

3. Introducing liquidity requirements
A combination of (i) a minimum liquidity coverage ratio to enhance short-term cash flow resilience and (ii) a structural minimum net stable
funding ratio to encourage banks to better match the liquidity profile of their assets and liabilities are to be introduced.
Liquidity coverage ratio
The liquidity coverage ratio is designed to promote short term liquidity resilience and compares the stock of high quality liquid assets held
by a bank to its net cash outflows during a hypothetical 30-day severe stress scenario. The liquidity coverage ratio will be set at a
minimum of 100%, requiring high quality liquid assets to fully cover the net cash outflows in such a scenario. The liquidity coverage ratio
needs to be maintained at all times.
High quality liquid assets need to meet certain criteria. Some assets, for example cash and central bank reserves that can be drawn
down in times of stress, qualify in their entirety. Certain other assets can be taken into account up to a limit and subject to a haircut.
Net cash outflows equal cash outflows minus cash inflows, where cash inflows are capped at 75% of outflows, thus limiting a bank’s
reliance on anticipated inflows to meet the liquidity requirements. Weightings are given to different types of inflows and outflows to
reflect the speed at which they are expected to become available or to be withdrawn in the stress scenario.
Net stable funding ratio
The net stable funding ratio aims to promote resilience over a longer term horizon and incentivise banks to fund their activities with more
stable sources of funding on an ongoing basis. The ratio compares the longer term stable funding available to a bank to the stable funding
it requires over a one year period of extended stress and will be set at a minimum of 100%, meaning that available stable funding will
have to fully match required stable funding. The minimum net stable funding ratio needs to be met at all times.
Stable funding includes that share of certain types of equity and debt finance which is expected to be reliably available over the one year
stress scenario. How much stable funding is required depends on the liquidity risk profiles of an institution’s assets and off-balance sheet
exposures. Weightings are assigned to such assets and exposures to reflect the amount of the item which supervisors believe should be
supported by stable funding.
4. Timeline
The higher capital requirements for trading and securitisation activities are expected to be implemented at the end of 2011. Other Basel III
measures are to be phased in gradually from 1 January 2013, as set out in the table below: 2
2011 2012 2013 2014 2015 2016 2017 2018
As of
1 January
2019
Minimum common equity 2.0% 2.0% 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Minimum Tier 1 capital 4.0% 4.0% 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
Minimum total capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Capital conservation
buffer
0.625% 1.25% 1.875% 2.50%
Countercyclical buffer ≤ 0.625% ≤ 1.25 ≤ 1.875 ≤ 2.50%
Leverage ratio Supervisory monitoring Initially set at 3% during observation period from 1 January 2013 to The plan is to migrate to
1 January 2017; any final adjustments in first half of 2017
Pillar 1 treatment on
1 January 2018
Capital instruments that
Either excluded from 1 January 2013 or, if they meet certain criteria, phased out over 10 years
no longer qualify as
common equity
starting with 2013
Capital instruments that
Phased out over 10 years starting with 2013 (though existing public sector capital injections will
no longer qualify as
non-common equity Tier 1
capital or Tier 2 capital
be grandfathered until 1 January 2018)
Phase in of regulatory
adjustments
20% 40% 60% 80% 100% 100%
Liquidity coverage ratio
(LCR)
Observation period Minimum standard applies
Net stable funding ratio
(NFR)
Observation period Minimum standard applies
2 See also Basel Committee on Banking Supervision, “Basel III: A global regulatory framework for more
resilient banks and banking systems”, Annex 4, 16 December 2010, http://bis.org/publ/bcbs189.pdf.
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Concluding remarks
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The aim of the Basel III capital and liquidity standards is to make banks more resilient. However, Basel III also imposes costs on banks,
reducing the returns that they can earn on their assets and increasing their cost of capital. It is to be expected that banks will seek to
pass these costs on to their customers to the extent possible.
The capital structure of many financial institutions looks set to change as a result of Basel III. Some banks have already embarked on
core capital raising exercises which have helped to secure their capital adequacy ratios. It seems quite possible that more will follow.
Alternative or additional ways to meet the Basel III standards include retention of earnings or the reduction of risk-weighted assets
through sales and/or a shift in the kinds of business undertaken by an institution.
Banks face some uncertainty about how Basel III will be implemented across countries. National authorities may have some discretion as
to how widely they apply the Basel III requirements and are also required to exercise judgement when determining the level of the
countercyclical buffer to be held by banks in different circumstances. National authorities may impose more stringent capital and liquidity
standards than prescribed by Basel III.
In the European Union, Basel III will be implemented as part of a set of amendments to the Capital Requirements Directive (CRD) referred to
as CRD IV (with the exception of the trading book and securitisation reforms covered already by earlier CRD amendments). The draft
legislation for CRD IV is due to be published in the latter part of this year. Difficulties may emerge if particular countries delay implementation,
as can happen with the adoption of international standards.
Attorney advertising, prior results do not guarantee a similar outcome.