Basel Committee Proposes Strengthening Bank Capital and Liquidity Regulation

On December 17, 2009, the Basel Committee issued two consultative documents proposing reforms to bank capital and liquidity regulation, which are intended to address lessons learned from the financial crisis that began in 2007. [1] The document titled Strengthening the Resilience of the Banking Sector proposes fundamental, although in many respects anticipated, changes to bank capital requirements. The document titled International Framework for Liquidity Risk Measurement, Standards and Monitoring proposes specific liquidity tests that, although similar in many respects to tests historically applied by banks and regulators for management and supervisory purposes, going forward would be required by regulation.

The proposals in the first document, which we refer to as the “capital proposals”, would significantly revise – and, as described by the consultative document, simplify – the definitions of Tier 1 Capital and Tier 2 Capital, with the most significant changes being to Tier 1 Capital. Among other things, the proposals would disqualify innovative capital instruments – including U.S.-style trust preferred securities and other instruments that effectively pay cumulative distributions, and in many cases are debt for tax purposes – from Tier 1 Capital status. They would also re-emphasize that Common Equity is the “predominant” component of Tier 1 Capital by (i) adding a minimum Common Equity to risk-weighted assets ratio, with the ratio itself to be determined based on the outcome of an impact study that the Committee is conducting, and (ii) requiring that goodwill, general intangibles and certain other items that currently must be deducted from Tier 1 Capital instead be deducted from Common Equity as a component of Tier 1 Capital. This approach could have a significant impact on acquisitions in which goodwill arises.

The proposals in the second document, which we refer to as the “liquidity proposals”, impose two measures of liquidity risk exposure, one based on a 30-day time horizon and the other addressing longer term structural liquidity mismatches over a one-year time period.

Comments on both proposals are due by April 16, 2010, with the expectation that the Committee will release a “fully calibrated, comprehensive set of proposals” by December 31, 2010 and final provisions will be implemented by December 31, 2012. [2] The U.S. bank regulators have urged comment on the proposals. Ultimate implementation in individual countries is subject to the discretion of the bank regulators in those countries, and the regulations or guidelines actually adopted in particular jurisdictions may, of course, differ from the Basel Committee’s proposals.

The proposals in their entirety are quite detailed and specific in some areas (the components of regulatory capital, for example) and merely conceptual in others, with details yet to be developed (the new leverage ratio, for example). They inevitably require close analysis by banking organizations – both banks and bank holding companies – that will be affected, because of their potentially profound effect on the banking industry and individual organizations. [3] We have outlined below only key components of the proposals.

Capital Proposals

The capital proposals have four key elements:

• raising the quality, consistency and transparency of the capital base;
• strengthening the risk coverage of the capital framework, particularly with respect to counterparty credit risk exposures arising from derivatives, repos and securities financing activities;
• introducing a leverage ratio requirement as an international standard; [4] and
• measures to promote the build-up of capital buffers in good times that can be drawn upon during periods of stress, introducing a countercyclical component designed to address the concern that existing capital requirements are procyclical – that is, they encourage reducing capital buffers in good times, when capital could more easily be raised, and increasing capital buffers in times of distress, when access to the capital markets may be limited or they may effectively be closed.

The Capital Base

When the Basel committee adopted Basel II, it expressly chose not to address or change the components of capital, reserving that task for a later date. The capital proposals now do that. Tier 1 Capital would be defined to have just two components – “Common Equity” and “Tier 1 Additional Going Concern Capital”. For banks that are joint stock companies, common shares (and, except in rare circumstances, only voting common shares) and related capital and surplus will be the sole form of qualifying Common Equity. Common Equity must satisfy each of 14 criteria. These criteria include:

• the instrument is perpetual and, apart from dividends, never repaid outside of liquidation;
• the bank does nothing to create an expectation at issuance that the instrument would be bought back, redeemed or cancelled;
• distributions are not preferential to any other legal or contractual obligation;
• the instrument takes the first and proportionately greatest share of any losses as they occur; and
• the paid-in amount is recognized as equity capital (and not as a liability) for purposes of determining balance sheet insolvency.

Tier 1 Additional Going Concern Capital is also defined by reference to 14 criteria (albeit different from the criteria for Common Equity). These criteria include:

• the instrument is subordinated to depositors, general creditors and subordinated debt of the bank;
• the instrument is perpetual, with no maturity date and no incentives to redeem;
• the instrument may be redeemable at the option of the issuer only after a minimum of five years, and any optional redemption (i) is subject to prior supervisory approval and (ii) may occur only if the bank either (x) replaces the called instrument with capital of the same or better quality or (y) demonstrates that its capital position is well above the capital requirements after the optional redemption option is exercised;
• the bank must have full discretion at all times to cancel, and not merely defer, distributions/payments (that is, no cumulative dividends). This criterion would prohibit inclusion of (i) cumulative preferred stock, which is currently permitted as a component of Tier 1 Capital for U.S. bank holding companies, subject to limitations, and (ii), along with other criteria, U.S.-style trust preferred securities and other innovative capital elements that are effectively cumulative;
• the instrument cannot have a credit sensitive dividend feature;
• cancellation of distributions/payments must not impose restrictions on the bank except in relation to distributions to common stockholders;
• the instrument cannot contribute to liabilities exceeding assets if such a balance sheet test forms part of national insolvency law;
• instruments classified as liabilities must have principal loss absorption through either (i) conversion to common shares at an objective pre-specified trigger point or (ii) a write-down mechanism which allocates losses to the instrument at a pre-specified trigger point;
• the instrument cannot have any features that hinder recapitalization, “such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified timeframe.” This criterion would prohibit so-called “reset” or “down-round” provisions of the type that have been included in the documents for some capital issuances during the recent financial crisis; and
• if the instrument is issued by a special purpose vehicle as opposed to an operating entity of the holding company in the consolidated group, the proceeds must be immediately available without limitation to an operating entity or the holding company in a form which meets or exceeds the other criteria for inclusion in Tier 1 Additional Going Concern Capital. Although not further addressed in the capital proposals, this standard implies that the special purpose vehicle must apply the proceeds of the security it issues to purchase from an operating entity or the holding company a security that is Tier 1 Capital (as opposed to remitting proceeds as a dividend or consideration for a purchase of assets).

The capital proposals define Tier 2 Capital by reference to nine criteria, generally consistent with existing standards for securities included in Tier 2 Capital. These criteria include:

• the instrument must have a minimum original maturity of at least five years, with the capital credit amortizing on a straight-line basis in the five years before maturity, and must include no incentives to redeem. Although the proposals do not comment further on this standard, bank regulators historically have taken the view that a step-up in coupon (or other feature creating an incentive to redeem) combined with a redemption right may effectively be a maturity date;
• the instrument must not be redeemable at the option of the issuer for at least five years after initial issuance, with the other conditions to optional redemption similar to those for Tier 1 Additional Going Concern Capital;
• the investor may have no acceleration rights, except in bankruptcy and liquidation;
• the instrument cannot have a credit sensitive dividend/distribution feature;
• if the instrument is not issued by an operating entity or the holding company in the consolidated group, its proceeds must be immediately available without limitation to an operating entity or the holding company in a form which meets or exceeds the other criteria for inclusion in Tier 2 Capital. As in the case of the similar standard for Tier 1 Additional Going Concern Capital, this standard implies that the special purpose vehicle must apply the proceeds of the security it issues to purchase from an operating entity or the holding company a security that is Tier 2 Capital (as opposed to remitting proceeds as a dividend or consideration for a purchase of assets).

Notably, the capital proposals do not include in Tier 2 Capital any components for items that are not securities. Most importantly, they do not include in Tier 2 Capital any portion of the allowance for loan and lease losses, or ALLL. Nor do they specifically comment on the failure to include any amount of the ALLL. Under existing standards, the ALLL may be included in Tier 2 Capital, subject to a limit of 1.25% of risk-weighted assets. This could have the procyclical impact of discouraging the building of strong ALLLs.

As mentioned, the capital proposals reiterate that the “predominant form” of Tier 1 Capital must be common shares and retained earnings. Although the proposals do not specify a measure of predominance (by percentage or otherwise), they reinforce the predominance standard by (i) adding a minimum Common Equity to risk-weighted assets ratio, with the ratio itself to be determined based on the outcome of an impact study that the Committee is conducting, and (ii) specifying that certain items that existing capital regulations require be deducted from Tier 1 Capital instead must be specifically deducted from the Common Equity component of Tier 1 Capital, implicitly for purposes of the predominance test. Those items include goodwill and deferred tax assets which rely on future profitability of the bank, in each case net of any associated deferred tax liability. [5]

The capital proposals also specify that other intangibles must be deducted from the Common Equity component of Tier 1 Capital, again implicitly for purposes of the predominance test. Basel I as initially adopted in 1987 does not specifically address whether or the extent to which specifically identifiable intangible assets other than goodwill – for example certain servicing rights – may be included in (that is, not deducted as “lesser” assets from) components of capital. The risk-based capital regulations and guidelines adopted by national regulators in many countries do. For example, the U.S. federal bank regulatory agencies permit readily marketable mortgage servicing assets, non-mortgage servicing assets and purchased credit-card relationships to be included (that is not deducted) from Tier 1 Capital, subject to a number of specific limitations.

Minority interests will not be eligible for inclusion in the Common Equity component of Tier 1 Capital but will be eligible for inclusion in Tier 1 Additional Going Concern Capital and Tier 2 Capital.

The capital proposals leave open the possibility that the Basel Committee will recommend changes to the existing required levels of minimum capital – 4% Tier 1 Capital to risk-weighted assets and 8% Total Capital to risk-weighted assets. The consultative document contemplates that the Basel Committee will initiate a comprehensive impact assessment of the proposed enhancements, including as an “anchor of this analysis” the impact of the changes to the definition of capital, and that analysis will set the foundation for determining whether any adjustment will be required to the overall basic requirements. As noted above, the proposals also include a minimum Common Equity to risk-weighted assets ratio requirement to be determined after such impact assessment.

Other matters of note with respect to the proposed changes in the components of capital include the following:

• The capital proposals do not include specific provisions concerning convertible instruments or “contingent capital” – that is, capital instruments that are issued as fixed income securities but convert to common shares if specific events (which may include a systemic risk determination by a governmental authority or an event specific to the issuer, such as falling out of capital compliance) occur. The proposals simply note that the Basel Committee continues to review the role these instruments should play in a regulatory capital framework.
• As noted above, hybrid securities and other innovative capital instruments of the type that have been issued in large volume since the mid-1990s (many of which are debt for tax purposes) generally will not qualify as Tier 1 Capital. Going forward, the capital proposals specify that they will be “phased out.” However, the proposals do not specify a grandfathering period and instead comment that “the Committee will consider appropriate transitional and grandfathering arrangements.”
• The proposals specify that no adjustment should be applied to remove from the Common Equity component of Tier 1 Capital unrealized gains or losses recognized on the balance sheet. They go on to note the concern that “the existing policy adopted in certain jurisdictions of filtering out certain unrealized losses” has undermined confidence in Tier 1 Capital. This would appear to have the consequence in the United States, for example, that write-downs of available for sale securities recorded in accumulated other comprehensive income or loss, which currently are included as a positive or negative number, as applicable, within shareholders’ equity but disregarded for purposes of regulatory capital measures, would no longer be disregarded in calculating the Common Equity component of capital, at least for purposes of the predominance test.
• Similarly, for banks that adopt mark-to-market accounting for their own liabilities, the capital proposals would preclude filtering out from the Common Equity component of Tier 1 Capital all gains or losses resulting from changes in the fair value of liabilities which are due to changes in the bank’s own credit risk.
• Historically, capital regulations have addressed the components of capital as support for a bank as a going concern. The capital proposals draw a distinction between Tier 1 Capital, which is referred to in parenthetical references as “going-concern capital”, and Tier 2 Capital, which is referred to in parenthetical references as “gone-concern capital” – that is, capital that acts as support for depositors in receivership, bankruptcy or liquidation but has less of a role in preserving the bank as a going concern.
• The capital proposals would eliminate Tier 3 Capital as a component of regulatory capital. [6] The proposals explain the elimination of Tier 3 Capital as a step to ensure that market risks are met with the same quality of capital as credit and operational risks.

Risk Coverage

The capital proposals designed to strengthen risk coverage are focused on the two internal-ratings based approaches in Basel II (and not on Basel I or, with limited exceptions, the standardized approach in Basel II). The recommendations address:

• a determination that the regulatory capital treatment for counterparty credit risk was insufficient in a number of areas, including:
  • failure to incorporate into the capital framework “wrong-way risk” – that is, an exposure to a counterparty that is adversely correlated with the credit quality of that counterparty (for example, in Basel II terminology, a circumstance where the product of exposure at default (EAD) and probability of default (PD) increases as counterparty risk deteriorates);
  • the failure to fully account for market value losses short of default with respect to counterparties;
  • the failure to recognize the degree to which large institutions are interconnected;
  • the fact that the close-out period for replacing trades with a counterparty may extend for a longer period than is captured by the existing capital calculations;
  • the destabilizing effect of margin calls, sometimes precipitating defaults;
  • the failure to use central counterparties to clear trades; and
  • the failure to recognize that securitizations have much more price volatility than corporate exposures; and
• shortcomings in banks’ risk management of counterparty credit exposures, including:
  • insufficient back-testing techniques;
  • insufficient stress testing;
  • failure to recognize exposure to wrong-way risk, particularly with respect to financial guarantors; and
  • use of insufficient multipliers to determine exposure at default.

The Basel Committee’s proposals to address these concerns include:

• implementing an explicit charge for specific wrong-way risk;
• applying a multiplier of 1.25 to the asset value correlation of exposures to large regulated financial firms (with assets of at least $25 billion) and to all exposures to unregulated firms, regardless of size;
• extending the margin period of risk to 20 days for OTC derivatives and securities financing transactions netting sets that are large (that is, over 5,000 trades), have illiquid collateral, or represent hard-to-replace derivatives;
• requiring that the data used to calculate expected exposures to counterparties include a period of stress;
• incorporating a simple capital add-on to better capture credit valuation adjustments that recognizes a clearly defined set of hedges;
• updating the simplified assumptions (referred to as the “shortcut method”) that currently may be used by some banks to model exposures;
• implementing various improvements in the calculation of EAD to promote more robust collateral management practices (for example, failure to address the risk of downgrade triggers and the inability of some banks to model collateral jointly with exposures) and in the operations and risk analysis supporting the collateral management process (for example, re-use of collateral);
• creating a separate supervisory haircut category for repo-style transactions using securitization collateral and prohibit resecuritizations as eligible financial collateral for regulatory capital treatment purposes;
• increasing incentives to use central counterparties for OTC derivatives;
• enhancing counterparty credit risk management requirements by (i) addressing general wrong-way risk, (ii) making the qualitative requirements for stress testing more explicit, (iii) revising the model validation standards and (iv) issuing supervisory guidance for sound-back testing of counterparty credit risk exposure; and
• placing additional constraints on banks’ own estimates of multiples used to determine exposure of default.

Leverage Ratio

The existing Basel Accords – Basel I and Basel II – do not include a simple leverage ratio (that is, a capital requirement where the denominator is total assets, perhaps subject to adjustments, as opposed to risk-weighted assets). By contrast, the capital regulations and guidelines of the U.S. federal bank regulatory agencies do include such a leverage ratio requirement, calculated as Tier 1 Capital divided by average total consolidated assets for the relevant period, less goodwill and certain other deductions (with a stated minimum for the strongest institutions being 3.0% and for most other institutions and purposes being 4.0%, although regulatory pronouncements and practice indicate that maintenance of a higher ratio – at least 5.0% – is generally expected). Earlier this year the Basel Committee announced its intention to introduce a leverage ratio as a supplemental measure to the risk-based ratio of Basel II. The capital proposals discuss at length considerations that the Basel Committee will address in devising the three principal components of a leverage ratio – that is, (i) the numerator, (ii) the denominator, and (iii) the minimum percentage requirement for the ratio. However, at this point, pending completion of impact studies to be conducted during the first half of 2010, they do not include a specific definitive proposal on any of the three components.

As to the numerator in the leverage ratio (referred to as the “capital measure”), the proposals state that a “high quality measure of capital” will be used, but leave open the possibility that it could be limited to the Common Equity component of Tier 1 Capital or, alternatively, could be either Tier 1 Capital in its entirety (including Tier 1 Additional Going Concern Capital) or Total Capital (that is, Tier 1 Capital plus Tier 2 Capital).

As to the denominator in the calculation, the capital proposals indicate that the starting point will be “the accounting measure of exposure” (that is, the applicable GAAP), but likely with adjustments. Possible adjustments include:

• even in jurisdictions where accounting and regulatory netting is otherwise permitted for mutual exposures, disregarding netting and applying a gross measure of exposures, or alternatively, and in order to accommodate inconsistency in approaches to netting across jurisdictions, applying a common set of regulatory netting rules as currently set out in Basel II;
• including all on-balance sheet assets, including high quality liquid assets (although the proposals note that the committee will assess the impact of possibly excluding high-quality liquid assets that qualify for the liquidity proposal as described below);
• disallowing netting in repo-style transactions;
• likely following GAAP with respect to securitizations, but collecting data and evaluating the impact of expected accounting changes (for example, in the United States, the changes to FAS No. 140 and FIN 46(R) made by FAS Nos. 166 and 167, which starting January 1, 2010 for most sellers/sponsors will cause many securitizations to be taken onto the financial statements of the related sellers/sponsors), and considering as an alternative approach including a bank’s entire managed portfolio of securitizations;
• when a bank sells credit protection using a credit derivative (for example, a credit default swap) and is effectively providing a guarantee, converting the exposure to an asset equivalent applying a 100% conversion factor, but, consistent with the gross measure of exposure referred to in the first bullet point above, not permitting netting of other credit derivatives with the same counterparty; and
• including in the denominator off balance sheet items that, under the Basel II standards, are treated as asset equivalents, applying a 100% credit conversion factor.

In Basel terminology, “Pillar 3” is the disclosure pillar of the capital regime. The capital proposals note that the Basel Committee will require rigorous Pillar 3 disclosures with respect to the leverage ratio and ultimately will include a disclosure template setting out the components required in the calculation.

As to the minimum required leverage ratio (expressed as a percentage), the capital proposals do not suggest or even discuss a particular percentage. They note that “the ratio will be calibrated to constrain the build-up of leverage in the banking sector, hoping to avoid destabilizing de-leveraging processes which can damage the broader financial system and the economy.”

Procyclicality

Bank regulators have noted even prior to the current crisis the tendency of capital levels to decline during good times, partly because of lower estimates of probability of default and, consequently, loss. The Basel Committee notes that it is conducting two specific impact studies on possible measures to reduce procyclicality. It also makes several specific proposals.

The two measures that are the subject of impact studies are:

• a proposal that, in calculating exposures, banks use the highest average probability of default (PD) estimate applied by the bank historically to each of its exposure classes as a proxy for a downturn PD, as opposed to PD estimates based on the long-term data horizons currently provided for in Basel II; and
• a proposal that banks use an average of historic PD estimates for each exposure class.

The specific proposals do not correspond to the impact studies. The first specific proposal is to promote stronger provisioning practices through three related initiatives. The initiatives are:

• advocating a change in accounting standards toward an expected loss approach;
• updating supervisory guidance to be consistent with the move to such an expected loss approach; and
• addressing disincentives to provisioning in the regulatory capital framework.

A second specific proposal is to establish a capital “buffer” above the minimum capital requirements and require that, if a bank’s capital level fall within the buffer range, the bank be limited in making dividends and other distributions (including share buybacks and discretionary bonus payments) depending upon where in the buffer range the bank falls. The capital proposals include a table of illustrative numbers, presented with a cautionary note that they “do not represent a view on relative or absolute levels, as the proposal still needs to be calibrated.” As an example, however, if a bank suffers losses such that its capital level falls to a level above the minimum requirement equal to 30% of the size of the capital buffer, then the bank will be required to conserve 80% of its earnings in the subsequent financial year by being required to pay out no more than 20% of its earnings in dividends, share buybacks and discretionary bonus payments. Depending on the circumstances of the individual institutions, this could have a significant effect on compensation structure.

The proposals outline a framework but leave open for development, including through the comment process, key aspects of the proposal, including (i) calibration (that is, percentage requirements), (ii) the type of capital required to comprise the buffer, and (iii) the elements subject to restriction on distributions (perhaps beyond ordinary dividends and share buybacks and discretionary bonus payments).

The Basel Committee notes, in discussing the buffer proposal, that it is in the process of reviewing a regime which would adjust the capital buffer range when there are signs that credit has grown to excessive levels. The notion is to use the buffer concept as a means to restrain excessive credit growth. The capital proposals note that the concept is at an early stage of development and, as a consequence, outline it only conceptually.

Liquidity Proposals

The liquidity proposals have three key elements:

• a “Liquidity Coverage Ratio” designed to ensure that a bank maintains an adequate level of unencumbered, high-quality assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors;
• a “Net Stable Funding Ratio” designed to promote more medium and long-term funding of the assets and activities of banks over a one-year time horizon; and
• a set of common metrics – referred to as “monitoring tools” – that the Basel Committee indicates should be considered as the minimum types of information that banks should report to supervisors, as applicable, and supervisors should use in monitoring the liquidity risk profiles of supervised entities.

The liquidity proposals indicate that compliance with the Liquidity Coverage Ratio, the Net Stable Funding Ratio and the monitoring tools would be mandatory for all internationally active banks. [7] Nevertheless, the proposals note that these ratios and monitoring tools may be used for other banks and for any subset of subsidiaries of internationally active banks that supervisors may choose. They do not address regulatory sanctions that may be applied for non-compliance.

Liquidity Coverage Ratio

The Liquidity Coverage Ratio is defined as the ratio, for a bank, of its “stock of high quality liquid assets” divided by a measure of its “net cash outflows over a 30-day time period”. The standard requires that the ratio be no lower than 100%. Both the numerator and denominator are defined in a way intended to insure that sufficient liquid assets are available to meet any cash flow gaps throughout a 30-day period following an acute liquidity stress scenario that is assumed to involve:

• a three-notch downgrade in the bank’s public rating;
• run-off of a proportion of retail deposits;
• a loss of unsecured wholesale funding capacity and reductions of potential sources of secured funding on a term basis;
• loss of secured, short-term financing transactions for all but high-quality liquid assets;
• increases in market volatilities that impact the quality of collateral or potential future exposures of derivative positions and thus require larger collateral haircuts or additional collateral;
• unscheduled draws on all the bank’s committed but unused credit and liquidity facilities; and
• the need for the bank to fund balance sheet growth arising from non-contractual obligations honored in the interest of mitigating reputational risk.

High quality liquid assets for purposes of the numerator are intended to meet four fundamental characteristics (low credit and market risk, ease and certainty of valuation, low correlation with risky assets, and listed on a developed and recognized exchange market) and four market-related characteristics (active and sizeable market, presence of committed market makers, low market concentration, and flight to quality considerations). The Basel Committee has determined that the only assets that meet these characteristics are:

• cash;
• central bank reserves, to the extent that they can be drawn down in times of stress;
• marketable securities representing claims on or claims guaranteed by sovereigns, central banks, noncentral government public sector entities, the Bank for International Settlements, the International Monetary Fund, the European Commission, and certain multi-lateral development banks that meet specified criteria; and
• government or central bank debt issued in domestic currencies by the country in which the liquidity risk is being taken or the bank’s home country.

The Basel Committee indicated that is also gathering data on corporate bonds and covered bonds and, subject to limitations (likely to include haircuts of 20% to 40% even if other criteria are satisfied) it will consider whether these instruments may be included.

Net cash outflows is defined, for purposes of the denominator in the Liquidity Coverage Ratio, as “cumulative expected cash outflows minus cumulative expected cash inflows arising in the specified stress scenario in the time period under consideration.” The liquidity proposals include very detailed provisions with respect to cash outflows and inflows. The approach, generally described, is to identify a cash source and then apply a “factor” to the proportion of the cash source that is expected to be paid out (referred to as a “run-off factor”) or received in the relevant period. The run-off factors range from 7.5% to 100%, with, as examples, 7.5% applying to “stable” retail deposits and the “stable” portion of unsecured wholesale funding provided by small business customers; 15% to less stable retail deposits and less stable unsecured wholesale funding provided by small business customers; 25% to unsecured wholesale funding provided by non-financial corporate customers, sovereigns, central banks and public entities where the related deposits are demonstrated to be needed for the entities’ operational purposes; 75% to other unsecured wholesale funding provided by non-financial corporate customers; and 100% to unsecured wholesale funding provided by other legal entity customers, including financial institutions (which are specified to include banks, securities firms, insurance companies and multilateral development banks). The net cash outflow provisions assume 100% loss of any funding to the bank from assetbacked commercial paper conduits, securities investment vehicles and similar facilities. They also assume that committed credit and liquidity facilities extended to clients will be drawn over specified ranges – for example, 10% for retail customers and 100% for non-financial corporate customers.

With respect to cash inflows, the proposals assume that banks will receive 100% of all performing contractual wholesale cash inflows, but that maturing reverse repos or securities lending agreements will be rolled over and will not give rise to any cash inflows where the bank is the “lender” (for example, a true repo) but will not be rolled-over and, accordingly, will involve a cash outflow where the bank is the borrower (that is, a reverse repo).

Net Stable Funding Ratio

The Net Stable Funding Ratio is defined as the ratio, for a bank, of its “available amount of stable funding” divided by its “required amount of stable funding”. The standard requires that the ratio be no lower than 100%. The standard is designed to ensure that investment banking inventories, off-balance sheet exposures, securitization pipelines and other assets and activities are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles. Generally described, the numerator in the ratio – “available stable funding” – is calculated by applying to designated items on the right side of the balance sheet (that is, items that are sources of funding) a factor – called an “ASF factor” – ranging from 100% to 0% depending upon the particular equity or liability component, with the factor reflecting stability of funding. Similarly, the denominator in the ratio – the required amount of stable funding – is calculated by applying to each asset on the left side of the balance sheet and certain off-balance sheet commitments (that is, items requiring funding) a specific required stable funding factor – called an “RSF factor” – reflecting the amount of the particular item that supervisors believe should be supported with stable funding.

More specifically, with respect to the numerator in the ratio:

• available stable funding is defined as the total amount of a bank’s (i) capital, (ii) preferred stock with a maturity of one year or more, (iii) liabilities with effective maturities of one year or more, and (iv) that portion of “stable” non-maturity deposits and/or term deposits with maturities of less than one year that would be expected to stay with the bank for an extended period in an idiosyncratic stress event; and
• the ASF factors range from 100% to 0%, with the more stable funding sources having higher ASF factors (and, accordingly, contributing more to meeting the minimum 100% requirement). For example, Tier 1 Capital and Tier 2 Capital are assigned 100% ASF factors, “stable” retail deposits an 85% ASF factor, “less stable” retail deposits a 70% ASF factor, certain wholesale funding and deposits of non-financial corporate customers a 50% ASF factor, and other liabilities and equity categories a 0% ASF factor.

With respect to the denominator in the ratio:

• the required amount of stable funding is calculated as the sum of the value of assets held, after converting certain off-balance sheet exposures to asset equivalents, multiplied by a specified RSF factor;
• the RSF factors range from 0% to 100%, with assets requiring a less stable funding source having lower RSF factors (and, accordingly, contributing more to meeting the minimum 100% requirement). For example, cash and money market instruments are assigned a 0% RSF factor, unencumbered marketable securities with maturities of one year or more and representing claims on sovereigns a 5% RSF factor, unencumbered AA corporate bonds with maturities of one year or more a 20% RSF factor, gold a 50% RSF factor, loans to retail clients having a maturity of less than one year an 85% RSF factor, and all other assets a 100% RSF factor.

Monitoring Tools

The liquidity proposals outline four monitoring tools, or “metrics”, that are described, together with the ratios described above, as being intended to “provide the cornerstone of information which aid[s] supervisors in assessing the liquidity risk of a bank.” The metrics address:

• contractual maturity mismatch;
• concentration of funding;
• available unencumbered assets; and
• market-related monitoring tools.

Contractual Maturity

This metric is defined as “contractual cash and security inflows and outflows from all on- and off-balance sheet items, mapped to defined time bands based on their respective maturities.” The proposal leaves it to national supervisors to define the precise time buckets but recites that possibilities include requesting the cash flow mismatch to be constructed for overnight, 7 day, 14 day, 1, 2, 3 and 6 months, and 1, 3, 5 and beyond 5 year buckets.

Concentration of Funding

This metric requires three items:

• calculation of the ratio of funding liabilities sourced from each significant counterparty to the bank’s “balance sheet total” (which appears to mean total liabilities as opposed to total liabilities plus shareholders’ equity);
• calculation of the ratio of funding liabilities sourced from each significant product/instrument to the bank’s balance sheet total; and
• a list of asset and liability amounts by significant currency.

A “significant counterparty” is defined as a single counterparty or group of affected or affiliated counterparties accounting in aggregate for more than 1% of the bank’s total liabilities. Similarly, a “significant instrument/product” is defined as a single instrument/product or group of similar instruments/products which in aggregate amount to more than 1% of the bank’s total liabilities, and a “significant currency” is defined as liabilities denominated in a single currency, which in aggregate amount to more than 1% of the bank’s total liabilities. The proposal includes a statement that each metric should be reported separately for time horizons of less than one month, 1-to-3 months, 3-to-6 months, 6-to-12 months, and for longer than 12 months. It is not clear how such time buckets apply to what appear to be point-in-time calculations.

Available Unencumbered Assets

Available unencumbered assets are defined as “unencumbered assets that are marketable as collateral in secondary markets and/or eligible for central banks’ standing facilities.” This metric is only informational. The proposals recite that, for an asset to be counted in this metric, the bank must have already put in place operational procedures needed to monetize the asset.

Market-Related Monitoring Tools

This metric, which also appears to be informational, relates to early warning indicators in monitoring potential liquidity difficulties at banks. It includes market-wide information (for example, equity prices and spreads in debt markets generally), information on the financial sector (for example, equity and debt market information for the financial sector broadly and for specific subsets of the financial sector, including indices), and bank-specific information (for example, information on the equity prices of the specific bank or credit default swaps spreads for the bank).

Concluding Observations

In view of the severity of the recent financial crisis, we believe it unlikely that the Basel Committee’s implementation of the proposals will involve the prolonged period of delay and postponement that marked the adoption of Basel II. Regardless of the derivation of the adage that “a crisis is a terrible thing to waste,” it is likely to inform the Committee’s deliberations. Moreover, we believe that national regulators will begin to implement at least certain of the recommendations as a supervisory matter, particularly if there is any slippage in timing by the Committee.

Endnotes

[1] The Basel Committee on Banking Supervision is a committee of banking supervisory authorities which was established by the central bank Governors of the Group of Ten countries in 1975. The base risk-based capital guidelines initially adopted by bank regulators in the Organization for Economic Co-operation and Development are based upon the Basel Committee’s December 1987 consultative paper titled “Proposals for International Convergence of Capital Measurement and Capital Standards”, often referred to as “Basel I”. In June 2006 the Basel Committee released a comprehensive new accord titled “International Convergence of Capital Measurement and Capital Standards – A Revised Framework”, often referred to as “Basel II”. Although Basel II has three approaches – a standardized approach and two advanced approaches, the United States regulators have adopted only the most advanced approach, referred to as the internal ratings-based approach, or “IRB”, and have applied it only to so-called core banking organizations that have either more than $250 billion in assets or $10 billion in foreign exposures.
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[2] Comments should be submitted either by e-mail to [email protected] or in writing to Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements, CH-4002 Basel, Switzerland.
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[3] Although the consultative document on capital uses the term “bank”, it defines the term “bank” consistently with Basel II, to mean any “bank, banking group or other entity (for example, holding company) whose capital is being measured”.
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[4] The capital guidelines of the United States bank regulatory agencies already include a leverage ratio. Other jurisdictions historically have not, and an explicit leverage ratio is not a component of Basel I or Basel II in their current forms.
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[5] The treatment of deferred tax assets historically has varied considerably among jurisdictions. The risk-based capital guidelines applicable to United States banks have, since 1995, required that deferred tax assets that depend upon future taxable income be deducted from Tier 1 Capital to the extent they exceed the lesser of the amount that the bank expects to realize within one year and 10% of Tier 1 Capital.
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[6] Tier 3 Capital was added as a permitted component of capital, maintainable against market risk, pursuant to the Basel Committee’s 1996 paper titled “Amendment to the Capital Accord to Incorporate Market Risks”. Generally described, Tier 3 Capital consists of short-term subordinated debt (minimum maturity of two years) that is not redeemable before maturity without approval by the relevant regulator and is subject to various other limitations on payments depending upon capital compliance. Few, if any, U.S. banks issued Tier 3 Capital, largely because it would not qualify as debt for U.S. federal income tax purposes.
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[7] The term “internationally active banks” is not defined. The U.S. federal bank regulatory agencies have defined the term to mean, for purposes of their versions of Basel II, banking organizations with either $250 billion or more of total assets for $10 billion or more of foreign exposures.
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