Basel III Framework: US/EU Comparison

Bradley Sabel is partner and co-head of the Financial Institutions Advisory & Financial Regulatory practice group at Shearman & Sterling LLP. The following post is based on a Shearman & Sterling client publication.

The US and EU rules implementing Basel III follow many aspects of Basel III closely, but there are major differences in approach in several key areas. Financial institutions have been engaged in a “race to the top” to show strong capital ratios but rules on leverage appear to be the most challenging and may require significant business restructuring. The interplay between the US and EU implementation of Basel III and the gradual “phase in” of certain rules, particularly on liquidity and leverage, will have a profound impact on the relative competitiveness of relevant US and EU financial institutions. This client publication, and the accompanying US/EU comparison and summary table, highlight points of international consistency and divergence.

Basel III establishes a new set of global standards for capital adequacy and liquidity for banking organizations. Although principally aimed at banks, these standards also apply to certain other types of financial institution (e.g., EU investment firms) as well. The Basel Committee on Banking Supervision (the “Basel Committee”) developed Basel III to supplement and, in certain respects, replace, the existing Basel II standards, the composite version of which was issued in 2006 as an update to Basel I. [1] The core elements of Basel III were finalized at the international level in 2010 and implementing rules have now been issued in 25 of the 27 jurisdictions that comprise the Basel Committee. [2]

Like Basel I and II, Basel III is not legally binding in any jurisdiction but rather is intended to form the general basis for national (or regional) rulemaking. As with Basel I and II, Basel Committee members have taken different approaches to implementing Basel III. The US and EU rules implementing Basel III differ in a number of key areas, including:

  • Treatment of capital instruments;
  • Risk weight calculation;
  • The leverage ratio;
  • Adjustments for derivative counterparty risk (the “credit valuation adjustment”);
  • References to external credit ratings; and
  • Large exposures.

Implementing rules are now in place in the US and EU, although many requirements are to be “phased in” ahead of the timetable for full implementation of Basel III by January 1, 2019. The timing of the US and EU phase-in of certain rules, such as leverage and liquidity requirements, is not consistent.

Basel I and II are widely perceived to have had various shortcomings that may have contributed to the financial crisis. The Basel Committee believes that the previous framework neither adequately accounted for risks posed by exposures to transactions such as securitizations and derivatives nor required institutions to maintain adequate levels of capital. Other perceived deficiencies included the lack of quantitative liquidity standards and the failure to take into account systemic risks associated with the build up of leverage in the financial system. In response to these shortcomings, the Basel III framework sets out quantitative and qualitative enhancements for capital adequacy, new liquidity and leverage ratio requirements, as well as other elements to help contain systemic risks.

The US and EU rules implementing Basel III, as well as the interplay between these rules, will have a profound impact on the relative competitiveness of US and EU institutions as well as the product mix that banking institutions will offer to customers and the types of debt and equity instruments sold to investors. This client publication includes a US/EU comparison table (the “US/EU Comparison Table”) comparing and contrasting the US and EU rules in the above key areas.

Basel III Implementation in the US

In July 2013, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and other bank regulatory agencies approved final rules (“Final US Rules”) that codify the US Federal regulatory agencies’ regulatory capital rules into a single, comprehensive regulatory framework. The Final US Rules implement the Basel III capital framework as well as relevant provisions of the Dodd Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). In addition, the Final US Rules replace the Basel I-based capital system that has been in place in the US. In particular, the Final US Rules, among other things:

  • Revise the definition of regulatory capital;
  • Implement new minimum requirements for Common Equity Tier 1 and an overall Tier 1 capital requirement;
  • Add a supplemental leverage ratio for “advanced approaches” banks; [3] and
  • Amend the methodology for determining risk weighted assets.

The Final US Rules were adopted largely as proposed. Notable changes from the proposed rules include:

  • Non-Advanced Approaches Banks may make a one-time election not to include most elements of “accumulated other comprehensive income” (known as “AOCI”) in regulatory capital calculations, and instead use the existing framework that excludes most AOCI from regulatory capital;
  • The proposed treatment of residential mortgages was not adopted, so the current treatment for residential mortgage exposures under the general risk-based capital rules will continue to apply. Specifically, the Final US Rules assign a 50 or 100 per cent. risk weight to exposures secured by one-to-four family residential properties;
  • The Final US Rules permanently grandfather trust-preferred securities and other non-qualifying capital instruments that were issued before May 19, 2010 in the Tier 1 capital of depository institution holding companies with total consolidated assets of less than $15 billion as of December 31, 2009; and
  • Non-Advanced Approaches banking organizations and savings and loan holding companies (“SLHCs”) must generally begin complying with the Final US Rules on January 1, 2015. Advanced Approaches banking organizations that are not SLHCs must begin complying with the Final US Rules on January 1, 2014. [4]

Basel III Implementation in the EU

The EU has implemented Basel III through two legislative acts, the Capital Requirements Regulation (“CRR”) and Capital Requirements Directive (“CRD”) (together, “CRD IV”), which were published in the Official Journal of the European Union on June 27, 2013. CRD IV consolidates the previous capital framework and amends that framework to implement Basel III.

The CRR will enter into force from January 1, 2014 and as a “regulation” it will be directly applicable in the legal systems of all EU Member States without the need for transposition at the Member State level. This contrasts to the previous framework which used directives only, which rely upon national implementation measures of Member States. The aim is to create a “single rulebook” which applies equally to all Member States and minimizes the scope for variations across Member States. The CRR addresses the quantity and quality of capital required (impacting the regulatory capital base of many institutions as certain outstanding instruments no longer qualify as regulatory capital), liquidity, counterparty credit risk, and leverage.

The CRD requires Member States to promulgate compliant national legislation by December 31, 2013. A directive, unlike a regulation, gives Member States a certain amount of discretion to implement EU requirements in a form and manner that is suitable to them. The CRD contains provisions addressing prudential supervision and the new capital conservation and counter cyclical capital buffers, as well as certain areas not covered by Basel III, but which the EU nevertheless wishes to implement, including requirements relating to corporate governance, sanctions, regulation of variable remuneration and measures to reduce reliance on external credit ratings.

The European Banking Authority (the “EBA”) will play a new role in implementing Basel III in the EU, a matter historically dealt with largely by national regulators. Certain provisions in CRD IV mandate the EBA to develop and publish technical standards to “flesh out” certain parts of CRD IV. The EBA has already produced a number of consultation papers containing final draft technical standards, such as in relation to own funds requirements and credit risk adjustment.

As with the EU’s implementation of Basel II, CRD IV generally applies to all credit institutions (such as banks and building societies) and also to investment firms (which generally encompasses broker dealer businesses). Therefore, broadly all financial institutions in the EU are subject to the new Basel III regime, with a much wider scope than that applicable in the US. However, EU firms providing investment advice and/or executing brokerage services only and which do not hold client monies will, as under previous legislation, be exempt under CRD IV. In addition, firms that are subject to CRD IV but engage predominantly in advising and arranging activities are not subject to much of the CRD IV regime by virtue of the limited credit and market risks assumed by such firms. Also, EU financial institutions can select whether to be subject to the Standardized Approach or obtain permission to be subject to the Internal Ratings Based (“IRB”) Approach (which is equivalent to the Advanced Approach in the US).

Highlights: Points of Comparison

Despite a degree of commonality in the US and EU implementation of Basel III, there is significant divergence in some respects which may give rise to certain arbitrage opportunities.

  • Impact of the Dodd-Frank Act: The Dodd-Frank Act introduced several capital-related provisions unique to US financial institutions that are inconsistent with, and stricter than, the Basel III framework. For example:
    • Regulatory Capital Base: As described in greater detail in the US/EU Comparison Table, the criteria for capital instruments to qualify as regulatory capital differ from—and are stricter than—existing qualification standards. Accordingly, groups subject to the new rules should evaluate outstanding instruments against the new qualification standards and phase out schedules. In this regard, the Dodd-Frank Act: (i) requires an accelerated three year phase out schedule for certain “hybrid” capital instruments issued by large US banks that would no longer count as regulatory capital or as the same type of capital, (ii) provides permanent grandfathering treatment for certain capital investments made by the US government in banks that would not otherwise qualify, and (iii) requires mandatory deduction from capital of investments in hedge funds and private equity funds “organized and offered” by US banking entities in accordance with the Volcker Rule.
    • Removal of References to External Credit Ratings: The financial crisis highlighted the risks of over-reliance on external credit ratings which are dominated by a small pool of credit rating agencies. Several changes to US asset risk weightings were driven by the Dodd-Frank Act requirement to remove from US regulations reliance on external credit ratings (e.g., in the context of investments in securitized assets or sovereign debt). Final US Rules offer several alternatives to use of these ratings. For example, the Organization for Economic Cooperation and Development (“OECD”) “country risk classification” codes are used for purposes of determining risk weights of exposures to non-US sovereigns and non-US banks. Similarly, and in line with G20 commitments, [5] CRD IV contains provisions designed to reduce over-reliance on external ratings, requiring financial institutions to strengthen their own credit risk assessment and not to rely solely and mechanistically on external credit ratings. For example, institutions with a material number of exposures in a given portfolio will be required to develop internal ratings for that portfolio and to use external ratings to benchmark the resulting capital requirements to their internal credit opinions. If the internal credit opinion shows that the external ratings are by comparison too favorable, then Pillar II discretion should be used to require the holding of additional capital in respect of these risks (Articles 135 and 136 CRR). In its June 2013 publication on new rules on credit ratings (“MEMO/13/571”), the European Commission referred to US rules which require the removal of reference to credit ratings in legislation and indicated that the EU would adopt a cautious approach by abolishing references to credit ratings in EU legislation by January 1, 2020, only once appropriate alternatives have been identified and implemented.
    • Collins Amendment Capital Floor: The so-called Collins Amendment of the Dodd-Frank Act (Section 171) prevents Advanced Approaches Banks from having minimum capital requirements below the general risk-based capital requirements. As a result, a non-US bank employing the Advanced Approaches of Basel III and pursuing a strategy of lower risk loans and investment grade assets may enjoy a competitive advantage over US institutions, as the capital floor imposed under the Collins Amendment would eliminate any ultimate capital relief large US banks may otherwise obtain under the internal models approach of Basel III.
  • New Risk Weight Calculations Included as Part of the US Basel III Rules: The Final US Rules would significantly modify risk weighted asset calculations under the “Standardized Approach”, effective January 2015. On the other hand, the EU has not effected a wholesale change to asset risk weightings. Changes in the relative capital charges applied to assets held by US institutions, as compared to those applied in the EU, would change the competitive dynamic between institutions located in those jurisdictions and potentially introduce opportunities for arbitrage.
  • Leverage Ratio Implementation: The Basel III leverage ratio is a non-risk-based ratio which includes off-balance sheet exposures and is intended to complement capital requirements by acting as a backstop to risk-based capital requirements. In the US, Advanced Approaches Banks will be required to comply with the Basel III leverage ratio standards (3 per cent.), as well as the existing Tier 1 capital-to-assets leverage ratio (generally 4 per cent.). Further, the Federal Reserve, the Federal Deposit Insurance Corporation (“FDIC”), and the Office of the Comptroller of the Currency (“OCC”) have, separately from Basel III, proposed an “enhanced supplementary leverage ratio” for the largest banking organizations. If adopted, this enhanced supplementary leverage ratio would make the US version of Basel III even stricter than the Final US Rules. Under this proposal, covered bank holding companies would be required to maintain a supplementary Basel III-based leverage ratio of at least 5 per cent. in order to avoid restrictions on capital distributions and discretionary bonus payments. In addition, insured depository institution subsidiaries of those covered bank holding companies would be required to maintain a leverage ratio of 6 per cent. to be considered “well capitalized” under the applicable prompt corrective action framework. In the EU, the leverage ratio has not been introduced outright as a binding requirement, but as a Pillar II measure (i.e., the national regulator will determine whether or not the leverage ratio of a particular institution is too high and whether the institution should hold more capital as a consequence). In the EU, credit institutions and investment firms must calculate their leverage ratios from January 1, 2014 and report them to national regulators from January 1, 2015. The leverage ratio may be introduced as a binding measure in 2018, following the Basel Committee review and calibration of leverage ratio requirements in the first half of 2017.
  • The Credit Valuation Adjustment: The credit valuation adjustment (“CVA”) for derivatives trades covers mark-to-market losses on expected counterparty risk. In the EU, corporates, sovereigns, and pension funds are exempt from the new CVA charge. US banks are concerned that the absence of a similar exemption in the US rules gives an unfair pricing advantage to banks trading within the EU which are not required to hold capital against similar exposures. Other critics have argued that the CVA exemption is inconsistent with aims to achieve globally harmonized prudential requirements. Some EU Member States are reportedly considering imposing a Pillar II capital add-on to compensate for the CVA exemption.
  • Super-equivalence: The implementation of Basel III in the EU was delayed as a result of political disagreement between EU Member States over the ability of a Member State to impose higher capital requirements than applicable under CRD IV, (i.e., by “gold-plating”). The final CRD IV position is to prohibit super-equivalent standards being imposed by Member States. The rationale for this restriction is that there would otherwise be regulatory arbitrage, with risky activities migrating to Member States with lower capital and liquidity requirements. Member States may, however, increase the capital ratio by use of the countercyclical, systemic risk, and the global and systemic institution buffers. As noted above in the context of the CVA exemption, Pillar II discretionary powers have the potential to undermine the objective of EU-wide uniform capital requirements. As demonstrated by the proposed enhanced supplemental leverage ratio and the lack of a CVA exemption in the Final US Rules, the US Federal banking regulators have determined to adopt more stringent rules in certain instances.
  • Large Exposures: The CRR contains requirements on large exposures relating to the reporting and calculation of own funds requirements for large exposures in the trading book. These requirements do not materially differ from pre-existing EU rules on large exposures in the Banking Consolidation Directive (2006/48/EC). This is an area that is subject to change in the near future. In its March 2013 proposal for a new large exposures framework for measuring and controlling risks associated with the failure of a large counterparty (the “Large Exposures Proposal”), the Basel Committee expressed concern that while existing Basel rules recognise the need for banks to limit the size of their exposures in relation to their capital, existing rules fail to explain in sufficient detail the methodology by which banks should measure and aggregate their exposures to large counterparties. The Large Exposures Proposal would supplement rather than replace existing rules. The key points to note are that: (i) a large exposure to a counterparty would arise if an institution’s exposure to a counterparty or group of connected counterparties amounts to 5 per cent. (under CRD IV this is currently 10 per cent.) or more of a bank’s eligible capital base, and (ii) exposures to a counterparty or group of connected counterparties would be prohibited if 25 per cent. or more of a bank’s Common Equity Tier 1 or Tier 1 capital is exposed towards the counterparty or group of connected counterparties (under CRD IV banks are currently limited to exposures of 25 per cent. of total regulatory capital). Banks would be prohibited from using their internal methodologies for calculating exposures. Further, the Large Exposures Proposal contains special rules for certain defined entities including sovereigns, central counterparties, and global systemically important banks (“G-SIBs”). The Basel Committee intends to introduce new rules to regulate large exposures following a review of responses to the Large Exposures Proposal consultation, which closed on June 28, 2013. In the US, in December 2011, the Federal Reserve proposed a single counterparty credit exposure limit for large US banking holding companies, and issued a similar proposal for foreign banking organizations in December 2012, in each case, as a part of the Federal Reserve’s proposed enhanced prudential standards under Section 165 of the Dodd-Frank Act. If these proposals are adopted, the US large exposures regime would differ from the Large Exposures Proposal in a number of ways.
  • Other Considerations:
    • The new rules require that banks in the US and EU have in place adequate procedures and resources (including data and systems) to comply with the range of capital, liquidity, leverage, and counterparty requirements. The costs of implementation of the rules are likely to have a substantial impact on the regulatory costs of systemically important institutions and relative costs for small firms also could be significant.
    • Market participants and regulators have expressed concerns that differences in international accounting standards could lead to competitive advantages or disadvantages.
    • The Final US Rules do not address the Basel III liquidity requirements. The US requirements are being left for a future proposal that regulators have said will be issued after the Basel Committee has finalized its approach in this area. The US Federal Reserve Board Governor, Daniel Tarullo, has called for the liquidity requirements to be eased. In contrast, the EU rules incorporate the Basel III liquidity standard. [6]
    • Additional Basel III and other requirements—including the capital “surcharge” for G-SIBs and a minimum equity and long-term debt requirement for the largest US banking organizations—are also expected to be implemented in the US through subsequent rulemakings over the next couple of years.

Conclusion

Basel III arguably represents the most important international response to the financial crisis. Divergences in approach between the US and the EU follow, among other reasons, as a result of the prior, hard-wired constraints imposed by Dodd-Frank in the US and fraught political negotiations in the EU in the run-up to implementation. The breadth and impact of the relative cost advantages stemming from divergence in the rules will differ by asset class. Despite implementation of Basel III in the US and EU, many rules are to be “phased-in” over the coming years and in the US regulators are expected to propose future rulemakings in the areas of capital and liquidity. As a result, the resulting scope of the competitive differences may not become entirely clear for some time.

Endnotes:

[1] The Basel Committee is an international supervisory group in which banking supervisors from the US, the UK, and 25 other nations participate.
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[2] Basel Committee report: “G20 Monitoring and Implementing of Basel III Regulatory Reforms,” August 2013.
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[3] US banking groups with consolidated assets of at least $250 billion or consolidated total on-balance sheet foreign exposures of at least $10 billion qualify as “Advanced Approaches Banks”.
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[4] The Final US Rules do not apply to the following SLHCs: top-tier SLHCs that are insurance underwriting companies, top-tier SLHCs that held 25% or more of total consolidated assets in subsidiaries that are insurance underwriting companies (excluding assets associated with insurance for credit risk) as of June 30, of the previous calendar year, and, top-tier SLHCs that are grandfathered unitary SLHCs that derived 50% or more of total consolidated assets or 50% or more of total revenues on an enterprise wide basis from non-financial activities as of June 30 of the previous calendar year. Other SLHCs are covered by the rule and are referred to in this client publication as “covered SLHCs.”
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[5] The Financial Stability Board issued a progress report to the G20 on August 29, 2013 (“Credit Rating Agencies: Reducing Reliance and Strengthening Oversight”), containing a “roadmap” for national and supra-national authorities to amend existing rules, guidance and encourage reporting and disclosure of credit risk assessment procedures and strategy, aimed at ending the mechanistic reliance on external credit ratings.
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[6] Basel III rules on liquidity, in particular, in relation to the “net stable funding ratio” liquidity buffer, are subject to possible change in the future, as discussed in the Basel Committee report “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools”, January 2013.
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