Enhancing Quality of Capital Under Basel III
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1 Enhancing Quality of Capital Under Basel III Ahmad El Radi METAC Banking Supervision Advisor August 2014 Beirut, Lebanon 1
2 Misconception on Basel III Basel III somehow replaces Basel II Basel III complements Basel II and Basel I. 2
3 What did Basel III Introduce Enhancing the quality, consistency, and transparency of the capital base; Strengthening the risk coverage of the capital framework; Introducing a leverage ratio to supplement the risk-based capital; and Reducing pro cyclicality and promoting countercyclical buffers; 3
4 What did Basel III Introduce Promoting the build-up of capital buffers that can be used in periods of stresses as countercyclical capital framework and emphasizing a more forward looking provisioning process based on expected losses; Addressing systemic risk and interconnectedness. 4
5 What did Basel III Introduce 1. Liquidity Coverage Ratio 2. Net Stable Funding Ratio 3. Monitoring tools 5
6 What did Basel III Introduce Giving more importance and emphasis on Common Equity and Retained Earnings; Deducting regulatory adjustments (such as goodwill, shortage in provisions, deferred taxes, etc ) from the amount of common equity instead of deducting them from total Tier 1 capital or the combination of Tier 1 and Tier 2; Eliminating Tier 3 capital, assigned to cover market risk; Unifying the elements of Tier 2 capital across jurisdictions; Limiting sub-categories of Tier 1 and Tier 2 capital. 6
7 Macro prudential Regulation Micro prudential Regulation Basel III Leverage Ratio New Liquidity Framework 7
8 Changes to the Definition of Capital The quality and consistency of the common equity element of Tier 1 capital is significantly improved, and the regulatory adjustments is generally apply to this element (common equity) To ensure their quality and consistency, common shares will need to meet a set of entry criteria before being permitted to be included in the predominant form of Tier 1 capital. 8
9 Changes to the Definition of Capital The required features for instruments to be included in Tier 1 capital, outside of the common equity element, is strengthened. - The elements / instruments to be included in Tier 1 capital should be sufficiently loss absorbent on a going-concern basis; i.e.: (i) subordinated; (ii) have fully optional non-cumulative dividends or coupons; and (iii) neither have a maturity date nor an incentive to redeem. - Innovative instruments which was limited to 15% of Tier 1 capital was phased out. 9
10 Changes to the Definition of Capital Tier 2 became more simplified. There is one set of entry criteria, and no sub-categories of Tier 2 - All Tier 2 capital will need to meet the minimum standard of being subordinated to depositors and general creditors and have an original maturity of at least 5 years. 10
11 Changes to the Definition of Capital Tier 3 is abolished - To ensure that capital used to meet market risks requirements has the same quality of capital used to meet credit risk and operational risk requirements. 11
12 Changes to the Definition of Capital The transparency of capital is improved. 12 Banks should disclose the following: - A full reconciliation of regulatory capital elements; - Separate disclosure of all regulatory adjustments; - A description of all limits and minima, identifying the positive and negative elements of capital to which the limits and minima apply; - A description of the main features of capital instruments issued; - Ratios involving components of regulatory capital such as Equity Tier 1, Core Tier 1 or Tangible Common Equity ratios, with a comprehensive explanation of how these ratios are calculated (only for banks which disclose such ratios) The full terms and conditions of all instruments included in regulatory capital should be disclosed on the bank s website.
13 Changes to the Definition of Capital The system of limits applied to elements of capital is revised to ensure that common equity forms a greater proportion of Tier 1 than is permitted in Basel II. - Separate explicit minima is established for the common equity component of Tier 1 (after the application of regulatory adjustments), total Tier 1 and total capital. - The predominant form of Tier 1 must be its common equity component (after the application of regulatory adjustments). - The current limitation on Tier 2 capital (it cannot exceed Tier 1) is removed. 13
14 Structure of Regulatory Capital Total regulatory capital consists of the sum of the following elements: Elements of Capital 1. Tier 1 Capital (going-concern capital) a) Common Equity b) Additional Going-Concern Capital 2. Tier 2 Capital (gone-concern capital) Each of the above capital elements must meet a set of certain criteria before inclusion in the relevant category. 14
15 Common Equity Tier 1 Common Equity Tier 1 capital consists of the sum of the following elements: Common shares issued by the bank; Stock surplus (share premium) resulting from the issue of instruments included Common Equity Tier 1; Retained earnings; Accumulated other comprehensive income and other disclosed reserves; Common shares issued by consolidated subsidiaries of the bank and held by third parties (i.e minority interest) that meet the criteria for inclusion in Common Equity Tier 1 capital; and 15 Regulatory adjustments applied in the calculation of Common Equity Tier 1.
16 Criteria for classification as common shares for regulatory capital purposes 1. Represents the most subordinated claim in liquidation of the bank. 2. Entitled to a claim on the residual assets after all senior claims have been repaid in liquidation. 3. Principal is perpetual and never repaid outside of liquidation. 4. The bank does nothing to create an expectation at issuance that the instrument will be bought back, redeemed or cancelled. 5. Distributions are paid out of distributable items (retained earnings included). The level of distributions is not subject to a contractual cap. 16
17 Criteria for classification as common shares for regulatory capital purposes 6. There are no circumstances under which the distributions are obligatory. Non payment is therefore not an event of default. 7. Distributions are paid only after all legal and contractual obligations have been met and payments on more senior capital instruments have been made. 8. It is the issued capital that takes the first and proportionately greatest share of any losses as they occur. Each instrument absorbs losses on a going concern basis. 17
18 Criteria for classification as common shares for regulatory capital purposes 9. The paid-in amount is recognized as equity capital (i.e not recognized as a liability) for determining balance sheet insolvency. 10. The paid-in amount is classified as equity under the relevant accounting standards. 11. It is directly issued and paid-in and the bank can not directly or indirectly have funded the purchase of the instrument. 18
19 Criteria for classification as common shares for regulatory capital purposes 12. The paid-in amount is neither secured nor covered by a guarantee of the issuer or related entity or subject to any other arrangement that legally or economically enhances the seniority of the claim. 13. It is only issued with the approval of the owners of the issuing bank, either given directly by the owners or, if permitted by applicable law, given by the Board of Directors or by other persons duly authorized by the owners. 14. It is clearly and separately disclosed on the bank s balance sheet. 19
20 Additional Tier 1 capital Instruments issued by the bank that meet the criteria for inclusion in Additional Tier 1 capital (and are not included in Common Equity Tier 1); Stock surplus (share premium) resulting from the issue of instruments included in Additional Tier 1 capital; Instruments issued by consolidated subsidiaries of the bank and held by third parties (minority interest) that meet the criteria for inclusion in Additional Tier 1 capital and are not included in Common Equity Tier 1.; and Regulatory adjustments applied in the calculation of Additional Tier 1 Capital 20
21 Criteria for inclusion in Additional Tier 1 capital 1. Issued and paid-in; 2. Subordinated to depositors, general creditors and subordinated debt of the bank; 3. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis bank creditors; 4. Is perpetual, i.e. there is no maturity date and there are no step-ups or other incentives to redeem. 21
22 Criteria for inclusion in Additional Tier 1 capital 5. May be callable at the initiative of the issuer only after a minimum of five years: a) To exercise a call option a bank must receive prior supervisory approval; and b) A bank must not do anything which creates an expectation that the call will be exercised; and c) Banks must not exercise a call unless: i. They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank; or ii. The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised. 6. Any repayment of principal (e.g. through repurchase or redemption) must be with prior supervisory approval and banks should not assume or create market expectations that supervisory approval will be given; 22
23 Criteria for inclusion in Additional Tier 1 capital 7. Dividend/coupon discretion: a) the bank must have full discretion at all times to cancel distributions/payments; b) cancellation of discretionary payments must not be an event of default; c) banks must have full access to cancelled payments to meet obligations as they fall due; d) cancellation of distributions/payments must not impose restrictions on the bank except in relation to distributions to common stockholders. 23
24 Criteria for inclusion in Additional Tier 1 capital 8. Dividends/coupons must be paid out of distributable items; 9. The instrument cannot have a credit sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organization s credit standing. 10. The instrument cannot contribute to liabilities exceeding assets if such a balance sheet test forms part of national insolvency law. 24
25 Criteria for inclusion in Additional Tier 1 capital Instruments classified as liabilities for accounting purposes must have principal loss absorption through either (i) conversion to common shares at an objective pre-specified trigger point or (ii) a writedown mechanism which allocates losses to the instrument at a pre-specified trigger point. The writedown will have the following effects: a. Reduce the claim of the instrument in liquidation; b. Reduce the amount re-paid when a call is exercised; and c. Partially or fully reduce coupon/dividend payments on the instrument.
26 Criteria for inclusion in Additional Tier 1 capital 12. Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument, nor can the bank directly or indirectly have funded the purchase of the instrument; 13. The instrument cannot have any features that hinder recapitalisation, such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified time frame; 14. If the instrument is not issued out of an operating entity or the holding company in the consolidated group (eg a special purpose vehicle SPV ), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Additional Tier 1 capital. 26
27 Tier 2 capital Instruments issued by the bank that meet the criteria for inclusion in Tier 2 capital (and are not included in Tier 1 capital) i.e. non-perpetual preferred shares with minimum maturity of at least five years; Stock surplus (share premium) resulting from the issue of instruments included in Tier 2 capital; Instruments issued by consolidated subsidiaries of the bank and held by third parties (i.e. minority interest), that meet the criteria for inclusion in Tier 2 capital and are not included in Tier 1 capital. 27
28 Tier 2 capital Certain loan loss provisions (for banks using the standardized approach which are held against unidentified losses); General provision (limited to 1.25 percent of credit risk-weighted assets calculated under the standardized approach) Regulatory adjustments applied in the calculation of Tier 2 Capital. 28
29 Types of Preferred Shares (P.S) Cumulative P.S: Dividends not paid in a given year will be cumulated, they are considered as arrears. They are not listed among liabilities. Callable P.S: Call provision: The issuing corporation can repurchase the shares from the P.S holders at a stipulated call price. 29
30 Types of Preferred Shares (P.S) Convertible P.S: Conversion privilege which entitles the P.S holders to exchange their shares for common shares in a stipulated ratio. A convertible P.S holders has a greater assurance of regular dividends in addition to the privilege s/he has of the conversion privilege. 30
31 Common Shares Vs. Preferred Shares Common Shares: Voting rights; Share in profits: Dividends (not specified); Preemptive rights to subscribe for additional shares, thus allowing shareholders to maintain their percentages of ownership. Share in the distribution of remaining assets after paying all obligations and liabilities, when the bank is liquidated. 31
32 Common Shares Vs. Preferred Shares Preferred Shares: No voting rights; Receive predefined dividends amounts before any dividend is paid to common shares; Dividend is usually stated as a fixed amount per share or as a certain percentage of the P.S par value. Holders of P.S have no assurance that they will always receive the indicated dividend; Paying dividends is subject to the decision of the board of 32 directors.
33 Criteria for inclusion in Tier 2 Capital 1. Issued and paid-in 2. Subordinated to depositors and general creditors of the bank 3. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-àvis depositors and general bank creditors; 33
34 Criteria for inclusion in Tier 2 Capital 4. Maturity: a. minimum original maturity of at least five years; b. recognition in regulatory capital in the remaining five years before maturity will be amortised on a straight line basis; c. there are no step-ups or other incentives to redeem. 34
35 Criteria for inclusion in Tier 2 Capital May be callable at the initiative of the issuer only after a minimum of five years: a. To exercise a call option a bank must receive prior supervisory approval; b. A bank must not do anything that creates an expectation that the call will be exercised; and c. Banks must not exercise a call unless: i. They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank; or ii. The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.
36 Criteria for inclusion in Tier 2 Capital 6. The investor must have no rights to accelerate the repayment of future scheduled payments (coupon or principal), except in bankruptcy and liquidation. 7. The instrument cannot have a credit sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organization's credit standing. 8. Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument, nor can the bank directly or indirectly have funded the purchase of the instrument; 36
37 Criteria for inclusion in Tier 2 Capital 9. If the instrument is not issued out of an operating entity or the holding company in the consolidated group (e.g a special purpose vehicle SPV ), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Tier 2 Capital. 37
38 Adjustments 1. (Share of minority interest in the surplus paid over the required capital). Minority Interest arising from the issue of capital instruments by a fully consolidated subsidiary. 2. Net unrealized gains and losses resulting from changes in the fair value of liabilities due to its own credit risk variations. 3. Investment in own shares (treasury shares). 4. Goodwill and other intangible assets. 5. Net assets of pension funds. 38
39 Adjustments 6. Deferred tax assets (DTA) that are recognized but rely on future profitability and are yet to be realized. 7. Cash flow hedge reserves that are not reported at fair value. 8. Shortfall of the stock of provisions to expected losses. 9. Gain on sale related to securitization transactions. 10. Investment in the capital of banking and financial entities. 11. Reciprocal cross-holding in the capital of banking, and financial entities (full deduction) 39
40 Explanation of regulatory adjustments 1. To deduct the share of minority interest in the surplus over the minimum required total capital of the subsidiary RWA. Example: Bank (x) owns 70% of another Bank (y) s shares capital, while the remaining shares (30%) are owned by minority interest. Bank (y) total capital is 100 and its RWA is 800. The minimum required capital is 10.5% (8% plus 2.5% conservation buffer). So, the minimum required capital is: 800 x 10.5%= 84. Then the surplus in Bank (y) s capital is 16 (100-84). The share of minority interest in this surplus is 16 x 30%= 4.8 To be deducted from the total capital:
41 Explanation of regulatory adjustments 2. Net unrealized gains and losses on issued bonds or similar instruments should be deducted from the total eligible capital. In case the bond s price decreases in the market, the bank should reflect this decrease in its eligible capital. Unrealized gain on instruments classified as Other Comprehensive Income, such as: interim profit and loss as to be verified by external auditors. 6. The recorded tax payable as prepaid expense shall be deducted from the eligible capital. Deferred Tax Assets are amount paid in advance which have the effect of reducing the amount of income tax payable in subsequent periods and which are therefore recognized as assets. 41
42 Explanation of regulatory adjustments 9. Gain on sale from a securitization transaction, which was treated as profit and consequently added to capital, shall be deducted from the CAR calculation. The residual part of the securitization transaction which was not sold, shall be risk weighted by 1250%. 10. If the bank owns less than 10% of the issued common shares of the entity, the investment amount will be risk weighted, whereby the instruments in the trading book will be treated under market risk rules and those in the banking book will be treated as per the standardized approach of the credit risk. 42
43 Explanation of regulatory adjustments 10. While in case the bank owns more than 10% of the issued common shares of the entity, then the investment amount shall be fully deducted from the eligible capital even of the investment does not fall under the definition of common equity. The deduction should follow the corresponding deduction approach; i.e. the deduction should be applied to the same component of capital for which the capital would qualify if it were issued by the bank itself. 43
44 Basel III vs. Basel II Tier 1 Capital Tier 1 capital ratio is pegged at 6%, with core Tier 1 at 4.5%. Implementation started in January 2013, when core Tier 1 rose from 2% to 3.5%, with full phase-in of the Tier 1 rules by January Basel III Basel II Banks are required to have a Tier 1 capital ratio of 4%, with half of that, or 2%, are core Tier 1 in the form of top quality capital such as retained earnings. 44
45 Basel III vs. Basel II Capital Conservation Buffer Capital conservation buffer of 2.5% that will sit on top of Tier 1 capital, is introduced Any bank whose capital ratio fails to stay above the buffer faces restrictions by supervisors on payouts such as dividends and bonuses. The new buffer will have to be composed of common equity, after the application of deductions Basel II No capital conservation buffer The buffer will be phased in from January 2016 and will be fully effective in January Basel III 45
46 Basel III vs. Basel II Countercyclical Capital Buffer Set at 0-2.5% of common equity Basel II No global standard on this type of buffer Basel III 46
47 Basel III vs. Basel II Leverage Ratio Put a cap on buildup of leverage in the banking sector Introduce extra safeguard A leverage ratio of 3% of Tier 1. Basel III Basel II Not Applicable 47
48 48 Transitional Arrangements
49 Gradual adoption till January 1 st 2019 Total capital + CB + CCB 15.5% Total capital + CB 13.0% Total capital 10.5% Tier1 capital 8.0% 4.5% 6.0% C.E.T1 Additional tier1 capital Tier2 capital Conservation Buffer (CB) Countercyclical buffer (CCB) Systematically Important Financial Institutions (SIFI)
50 50
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