Basel Committee Publishes Consultative Document Proposing Changes to Exposure Measure and Disclosure Requirements SUMMARY On June 26, 2013, the Basel Committee on Banking Supervision (the Basel Committee ) published for comment a consultative document (the Proposal ) which proposes significant revisions to the leverage ratio as presented in the original Basel III framework initially adopted in December 2010 and revised in June 2011 (the Original Basel III Framework ). 1 In particular, the Basel Committee is proposing modifications to the denominator of the leverage ratio (defined in the Proposal as the Exposure Measure ) that for many banks will increase its amount. 2 Changes to the Exposure Measure include: specification of a broad scope of consolidation for the inclusion of exposures; clarification of the general treatment of derivatives and related collateral; enhanced treatment of written credit derivatives, which is the Proposal s term for a credit derivative (that is, a credit default swap or total return swap) viewed from the perspective of the seller as opposed to the buyer of credit protection; and enhanced treatment of Securities Financing Transactions ( SFTs ). The Original Basel III Framework provided a transition period for the leverage ratio commencing on January 1, 2011, and specified that the Basel Committee would use the transition period to assess both whether the initial 3% calibration is appropriate over a full credit cycle and for different types of business models and whether a wider definition of exposures and an offsetting adjustment in the calibration would better achieve the objectives of the leverage ratio. 3 The Proposal appears to expand significantly the xposure easure particularly the provisions dealing with credit derivatives and SFTs without any suggestion that any change in the 3% calibration would be offsetting. To the contrary, the Proposal states that the Basel Committee will continue to test a minimum requirement of 3% for the leverage ratio during the period ending January 1, 2017, leaving unanswered the question of whether any recalibration New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
would be an increase or a decrease. 4 In addition, the Proposal also indicates that the Basel Committee will also continue to collect data during the transition period to track the impact of using total regulatory capital or Common quity Tier 1 as the [numerator of the leverage ratio]. 5 Consistent with the Original Basel III Framework, banks must publicly disclose their Basel III leverage ratio starting January 1, 2015. The Proposal substantially expands on the Original Basel III Framework s leverage disclosure provisions by outlining particular public disclosure requirements, including completion of a summary comparison table, a common disclosure template, and a reconciliation requirement, as well as other disclosures. Comments on the Proposal are due by September 20, 2013. EXPOSURE MEASURE The Basel III leverage ratio is defined as Tier 1 capital, defined in paragraphs 49 to 96 of the Original Basel III Framework, 6 divided by the Exposure Measure, with the ratio expressed as a percentage. Calculations are based on the three-month average of leverage ratios over a particular quarter. 7 From January 1, 2013 to January 1, 2017, the Basel Committee will require a minimum 3% leverage ratio. 8 As noted above, the Basel Committee has indicated that it will continue to test the minimum requirement of 3%. 9 The Proposal seeks to modify the Exposure Measure by providing additional guidance regarding the calculation and measurement of exposures that must be included in the Exposure Measure. In particular, the Proposal focuses on two main elements of the Exposure Measure: the scope of consolidation and general measurement principles, with only the latter likely to be significant for most U.S. banks. Scope of Consolidation To ensure consistency within the leverage ratio framework, the Proposal identifies certain items which should be deducted from or included in capital when determining the xposure easure. When a bank s investment in the capital of another entity (referred to as an investee in the Proposal) is included within the Tier 1 capital of the bank (apparently meaning not deducted from the bank s Tier 1 capital) and the investee is within the scope of regulatory or accounting consolidation under the Basel II Framework, the investee s assets and other exposures must be included in the bank s Exposure Measure. 10 In such a scenario, banks may offset the on- and off-balance sheet exposures of entities in the scope of consolidation to avoid double counting. 11 The Original Basel III Framework contemplates that a bank may have an investment in an investee that results in consolidation for regulatory accounting purposes but whose assets, for purposes of calculating consolidated risk-weighted assets of the bank, are excluded. The Proposal, like the Original Basel III Framework, 12 accomodates this circumstance. Generally speaking, however, it will not apply to U.S. banks, because the common circumstance for U.S. banks where the assets of an investee are consolidated for U.S. GAAP purposes but not included in the bank s -2-
risk-weighted assets no longer occurs (that circumstance being so-called Section 20 securities subsidiaries, established in compliance with Section 20 of the Glass-Steagall Act prior to the repeal of that provision by the Gramm-Leach-Biley Act). For investees outside the scope of regulatory and accounting consolidation, only the investment in the capital of the investee (the carrying value) should be included in the Exposure Measure. 13 Measurement Principles The Exposure Measure is the sum of the following exposures: (i) on-balance sheet exposures, (ii) derivative exposures, (iii) SFT exposures, and (iv) other off-balance sheet exposures. 14 The Proposal provides for the specific treatment of each type of exposure. 1. On-Balance Sheet Exposures In calculating on-balance sheet exposures, banks must include all on-balance sheet assets [emphasis in original] in their Exposure Measure. This includes on-balance sheet derivative collateral and collateral for SFTs. 15 However, on-balance sheet assets deducted from Tier 1 capital, defined in paragraphs 66 to 89 of the Original Basel III Framework, should not be included in the Exposure Measure. 16 In addition, liability items (for example, gains/losses due to changes in the bank s own credit risk on fair-valued liabilities) may not be deducted from the Exposure Measure. 17 2. Derivative Exposures The Proposal s treatment of the xposure easure for derivatives has two components: (i) those applicable to all derivatives (for example, interest rate and foreign exchange swaps as well as credit derivatives) and (ii) supplemental provisions adding an additional component to the Exposure Measure for written credit derivatives (that is, as explained above, the xposure easure for credit protection sellers). The Exposure Measure for all derivatives captures the two types of derivatives exposure: (i) exposure arising from the underlying of the contract and (ii) a counterparty credit risk exposure. 18 Derivative exposures must be calculated as the replacement cost ( RC ) for the current exposure plus an add-on for potential future exposure applying regulatory bilateral netting rules and adjusting the exposure amount for the related collateral. 19 In the context of a single derivative exposure, RC is defined as the replacement cost of the contract (obtained by marking-to-market), where the contract has a positive value. 20 The addon is defined as an amount for potential future credit exposure over the remaining life of the contract calculated by applying an add-on factor to the notional principal amount of the derivative. 21 The add-on factors are included in tables set forth in Annex 1 to the Proposal. The add-on factors for interest rates, foreign exchange and gold, equities, precious metals except gold, and other commodities are unchanged from existing capital standards (under both the general risk-based capital rules and the advanced approaches rules, albeit applied against exposure at default, or AD, in the case of the -3-
advanced approaches rules) with the add-on factors determined by the interplay between the remaining maturity of the derivative and the type of derivative. Existing general risk-based capital rules do not include specific add-on factors for credit derivatives, but the advanced approaches rules do, and Annex 1 uses those add-on factors. The add-on factors do not key off of the remaining term but instead key off of (i) whether the bank is the protection buyer or protection seller and (ii) the nature of the reference obligation, with the Proposal requiring higher add-on factors for non-qualifying reference obligations than for qualifying reference obligations. Qualifying reference obligations are defined as those that are rated investment-grade by at least two credit rating agencies as specified by the national authority, rated investment-grade by one rating agency, and not less than investment-grade by any other rating agency, or, subject to supervisory approval, unrated but deemed to be of comparable investment quality by the reporting bank (provided that the issuer of the reference obligation has securities listed on a recognized stock exchange). Because Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act precludes the use of external credit ratings in the U.S. banking agencies regulations, implementation of these provisions in the United States will require adjustment, likely replacing the Proposal s use of external ratings with the approach taken by the agencies in the Capital NPRs and their existing rules for defining investment grade as a measure that does not rely on external ratings. Derivative exposures are adjusted to reflect regulatory bilateral netting rules or collateral received in connection with derivative contracts, including, for example, by stating that collateral received may not be netted against derivatives exposures whether or not netting is permitted under the bank s operative accounting or risk based framework. 22 adjustments. The Proposal and its Annex further detail the appropriate In addition, the Proposal adds to the Exposure Measure with respect to a bank s written credit derivatives a component calculated to reflect the bank s credit exposure to the reference entities. It does this by requiring that the full effective notional value referenced by a written credit derivative must be incorporated into the Exposure Measure, subject to reductions by the effective notional amount of a purchased credit derivative on the same reference name and level of seniority 23 if the remaining maturity of the purchased credit derivative is equal to or greater than the remaining maturity of the written credit derivative. 24 3. Securities Financing Transaction Exposures SFTs must also be included in the Exposure Measure. The Exposure Measure for SFTs when the bank is acting as principal is calculated as the sum of (i) gross SFT assets recognized for accounting purposes (with (x) no recognition of accounting netting of cash payables against cash receivables as is currently permitted under U.S. GAAP and IFRS, and (y) the removal of the value of securities received in an SFT and recognized as an asset by the transferor if the transferor has the right to hypothecate but has not done so ) and (ii) a measure of counterparty credit risk calculated as current exposure without an add-on for potential future exposure. 25-4-
This calculation is subject to important exceptions and nuances. First, where sale accounting is achieved under the operative accounting framework, all sales-related accounting entries must be reversed, and the bank s exposure must be calculated as if the SFT had been treated as a financing transaction under the accounting framework (the sum of steps (i) and (ii) above). 26 Additionally, when a bank acts as an agent in an SFT and provides an indemnity or guarantee to only one of the two parties involved for any difference between the value of the security or cash the party has lent and the value of the collateral the borrower has borrowed, an amount for the agent bank s potential exposure is added to the Exposure Measure in its leverage ratio but is calculated using only step (ii) above. 27 4. Other Off-Balance Sheet Exposures Consistent with the Original Basel III Framework, banks must factor off-balance sheet exposures into their Exposure Measure, including commitments (including liquidity facilities), unconditionally cancellable commitments, direct credit substitutes, acceptances, standby letters of credit, trade letters of credit, failed transactions and unsettled securities. 28 Banks must apply a uniform 100% credit conversion factor ( CCF ) in calculating these off-balance sheet items (except for unconditionally cancellable commitments, which are subject to a CCF of 10%). 29 DISCLOSURE REQUIREMENTS In the Proposal, the Basel Committee emphasizes the importance of consistent and common disclosure across banks to allow market participants to compare the capital adequacy of banks across jurisdictions and to reconcile leverage ratio disclosures with banks published financial statements from period to period. 30 Accordingly, internationally active banks across Basel-member jurisdictions must publish their leverage ratio using common templates. 31 Implementation Timing and Logistics of Disclosure Starting January 1, 2015, disclosures generally must be published with the same frequency and at the same time as a bank s financial statements. 32 However, the Basel III leverage ratio, the Tier 1 capital measure (numerator), the Exposure Measure (denominator) and the end-of-quarter leverage ratio must comply with Pillar 3 requirements and in any event be publicly disclosed on a quarterly basis even if the bank otherwise publishes financial statements on a semi-annual basis. 33 Banks financial statements must include the required disclosures or provide a direct link to the completed disclosures on their website or on publicly available regulatory reports. 34 In addition, banks must maintain an on-going archive of all reconciliation templates, disclosure templates and explanatory tables relating to prior reporting periods on their websites or through publicly available regulatory reports. 35 Templates and Tables To ensure consistency across jurisdictions, banks are required to use standardized tables and templates for their disclosures. 36 The Basel Committee developed the summary comparison table, common -5-
disclosure template and explanatory table for these purposes. The summary comparison table compares total accounting assets to total ratio exposures to provide an introductory overview of the main differences. 37 The common disclosure template provides the breakdown of the main leverage ratio regulatory items incorporating all on- and off-balance sheet exposures (all values are end-of-period) and, in the last row, the reconciliation of the leverage ratio from its end-of-period value to its average of monthend value. 38 The Proposal details the particular line items required by each table or template. In addition, banks must reconcile their leverage ratio disclosures and financial statements by disclosing the source of material differences between on-balance sheet exposures in the common disclosure template and on-balance sheet assets in their financial statements. 39 Banks are required to explain the key drivers of material changes in their Basel III leverage ratio observed from the end of the previous reporting period to the end of the current reporting period. 40 INTERPLAY WITH U.S. DEVELOPMENTS The agencies notices of proposed rulemaking implementing the Basel III framework were initially released in June 2012 and published in the Federal Register on August 30, 2012. Their notices of proposed rulemaking included a leverage ratio based on the Original Basel III Framework (including with a 3% calibration), and made it applicable only to advanced approaches banks (that is, those with $250 billion or more in total consolidated assets or $10 billion or more in foreign exposures). The agencies are expected to publish final rules implementing Basel III for U.S. banks within the next several weeks. There has been substantial discussion among the U.S. banking agencies and other policy makers in the United States concerning the role of the leverage ratio as a regulatory capital measure and its calibration. On April 24, 2013, Senators Sherrod Brown and David Vitter introduced in the United States Senate a bill (S. 798) that would require the agencies to apply a leverage ratio of not less than 8% to banks with more than $50 billion in total consolidated assets and not less than 15% to banks with at least $500 billion in total consolidated assets. The approach the U.S. banking agencies will take with respect to the Basel III leverage ratio in the final rules expected to be adopted within the next several weeks, or a re-proposal for comment of the Basel III leverage ratio as a new notice of proposed rulemaking (including whether they will propose to increase the minimum ratio to a calibration higher than 3% notwithstanding that the Basel Committee has not yet done so), is unknown as of today. However, it is likely that the agencies approach in any event will incorporate aspects of the Proposal. * * * Copyright Sullivan & Cromwell LLP 2013-6-
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 ENDNOTES Paragraphs 151 to 167 of the Original Basel III Framework outline the current version of the leverage ratio framework. See Basel Committee on Banking Supervision, Revised Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems Revised Version (Jun. 2011), available at www.bis.org/publ/bcbs189.htm (the Original Basel III Framework ). For additional information on the Basel III framework, please refer to our Memorandum to clients, dated December 31, 2010, Basel III Capital and Liquidity Framework: Basel Committee Issues Final Revisions to International Regulation of Bank Capital and Liquidity. Basel Committee on Banking Supervision, Consultative Document: Revised Basel III Leverage Ratio Framework and Disclosure Requirements (Jun. 2013), available at www.bis.org/publ/bcbs251.htm. The Original Basel III Framework at 165. The Proposal at 7. Id. at 9. Basel Committee on Banking Supervision, Revised Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems Revised Version (Jun. 2011), available at www.bis.org/publ/bcbs189.htm. The Proposal at 6. Id. at 7. Id. Id. at 11; The Basel II Framework, defining the scope of regulatory consolidation, is available at www.bis.org/publ/bcbs128.htm. The Proposal at 14. The Original Basel III Framework at 84 and fn. 29. Id. at 13. Id. at 18. Id. at 19. Id. at 20. Id. at 21. In addition, physical or financial collateral, guarantees or credit risk mitigation purchased are not allowed to reduce on-balance sheet exposure as a general matter. Id. at 17. Id. at 22. Id. at 23. Id. at 24. Id. at 24. Id. at 27. In addition, the xposure easure must be grossed up by the amount of any derivatives collateral provided where the provision of that collateral reduce[s] on balance sheet assets under the operative framework. as is the case in certain circumstances under U.S. GAAP. Id. at 28. The Basel Committee has similarly proposed to restrict offsetting of exposures with different seniorities in other contexts, most recently in its proposed framework for measuring and controlling large exposures. Basel Committee on Banking Supervision, Consultative Document: Supervisory Framework for Measuring and Controlling Large Exposures (Mar. 2013), available at www.bis.org/press/p130326.htm. -7-
ENDNOTES (CONTINUED) 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 The Proposal at 31. Id. at 35. Id. at 36. Id. at 37-38. Id. at 40. Id. at 41-42. Id. at 44. Id. at 45. Id. at 47, 48. Id. at 49. Id. at 50. Id. at 51. The Proposal specifically warns that banks should not adjust the common disclosure template. However, modifications may be permissible to take account of language differences and to reduce the reporting of unnecessary information. Id. at 63. Id. at 55. Id. at 56-58. Id. at 59. Id. at 60. -8-
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