SPECIAL REPORT I THE CAPITAL CHALLENGE
Basel
redefines
capital
T
For community he sleepy town of Basel, Swit-
zerland, seems an unlikely
banks, the third source for radical changes
to the global banking environment.
time around for Best known as a pharmaceutical
the global rules headquarters, it is also home to the
Bank for International Settlements,
may be less sponsor of the Basel Committee on
Banking Supervision. The commit-
"the charm" than tee sets international standards for
cause for alarm the conduct and risk management
of a wide range of bank activities,
including standards for appropriate
levels of capital to be held against
risks of those activities.
By Mary Frances Monroe
The committee's most recent pre-
vious pronouncement on regula-
tory capital—dubbed Basel II—was
applied in the U.S. only to large,
internationally active banks. Thus
the Basel Committee has not been
on the radar of most community
NOVEMBER 2010 I ABA BANKING JOURNAL I 33
banks since adoption of Basel I in
1988. That changed in September
when the committee announced a
fundamental redefinition of capi-
tal as well as heightened standards
intended to apply to all banks. For
many, the changes will force revi-
sions to capital plans and, for some,
require new sources of equity capital.
Bumpy road from I to III
Current capital rules applied to
U.S. banks and bank holding com-
panies are based on the Basel I
accord, which started the risk-sen-
sitive approach to capital require-
ments. Exposures on and off the
balance sheet were classified into
broad categories of credit risk.
Over time, Basel I was criticized
for being insufficiently granular in
its assignment of assets to risk cat-
 SPECIAL REPORT THE CAPITAL CHALLENGE
egories. Exposures with very dif-
ferent risk profiles would be slot-
ted into the same risk bucket.
The committee sought to improve
the risk sensitivity of Basel I and
embarked on a multi-year upgrade.
Basel II was adopted in 2004 as
a more risk-sensitive measure that
employed banks' own estimates of
risk in determining minimum capi-
tal requirements. When the Basel
Committee adopted Basel II, U.S.
federal banking agencies decided to
adopt only the advanced approach-
es that apply to certain internation-
ally active banking organizations.
Others could opt-in voluntarily.
After adoption of Basel II, some
committee members expressed con-
cerns about the perceived expan-
siveness of the definition of capital.
Concerns centered around the
ability of certain instruments includ-
ed in Tier 1 capital to absorb loss
on a going-concern basis. To discuss
these concerns, a working group was
formed to review the definition of
capital. The lengthy deliberations of
this group infiuenced significantly
the consultative paper released in
December 2009—"Strengthening
the resilience of the banking sec-
tor." That paper proposed a sub-
stantial narrowing of the types of
instruments that could be includ-
ed in Tier 1 ; a stronger reliance on
common shareholders' equity; and
a very aggressive increase in capital
requirements —all with a goal of
implementation by yearend 2012.
In response to comments filed
by banks, trade groups—including
ABA—and others, some onerous
provisions were revised. The result-
ing agreement, released in Septem-
ber, is known as "Basel III." It was
expected to be formally endorsed at
the November meeting of the G-20.
Basel Ml in brief
Space constraints allow only an
overview of Basel III. The frame-
34 I ABA BANKING JOURNAL I NOVEMBER 2010
work increases capital requirements
and limits the types of instruments
that can be included in Tier 1.
While it represents a moderation
of the most onerous provisions of
the consultative paper, the impact
should not be underestimated.
Basel III requires a minimum com-
mon equity capital ratio of 4.5%
of risk-weighted assets by Jan. 1,
2015, plus adoption of a capital
conservation buffer equal to com-
mon equity in the amount of an
additional 2.5% of risk-weighted
assets by Jan. 1, 2019.
Basel III also limits the types of
instruments that can be included
in Tier 1 capital to common share-
holders' equity plus a limited "sin
bucket" that is capped at 15% of
common equity in the aggregate
and 10% of common equity for any
one component. The "sin buck-
et" consists of mortgage servicing
rights, deferred tax assets that arise
from timing differences, and signifi-
cant (more than 10%) investments
in the common shares of unconsoli-
dated financial institutions. The first
two categories of assets are more
commonly held by U.S. banks;
the investments in unconsolidated
financial institutions are more com-
mon in Europe. Amounts of these
restricted assets in excess of the
10% and 15% caps are deducted
from common equity over a phase-
out period from 2013 to 2018.
Basel III provides for a phase-in
of the minimum common equity
capital ratio, the capital conservation
buffer, and the Tier 1 capital require-
ment, as set forth in the nearby chart.
The minimum total capital require-
ment (minus the buffer) remains at
8% of risk-weighted assets.
Basel III also provides for a lever-
age ratio in recognition of the role
that high levels of overall leverage
contributed to the recent financial
crisis. However, the leverage ratio
under Basel III is very different
from the leverage ratio to which
U.S. banks have long been subject;
the Basel III leverage ratio includes
off-balance sheet exposures. The
leverage ratio will be the subject of
a supervisory monitoring period
from January 2011 followed by a
parallel run period from January
2013, with banks required to report
their leverage ratios from Janu-
ary 2015. Based on the results of
the parallel run, adjustments may
be made to the leverage ratio in
the first half of 2017, with a view
towards implementing a leverage
requirement effective January 2018.
Impact on community banks
A common misperception among
some bankers is that Basel III is of
concern only to large, internation-
ally active banks. ABA has been
active in dispelling that. Basel III is
a fundamental redefinition of capital.
It places common stockholders' equity
in the overwhelmingly predominant
position in capital structures.
Implementation of Basel III for
U.S. banks will depend on the fed-
eral banking agencies. They will
issue a notice of proposed rulemak-
ing later this year or early next year.
While it's not possible to say with
certainty how Basel III will be imple-
mented, here is what ABA expects:
• Banks will be urged to meet
the fully phased-in common equity
capital ratio plus capital conserva-
tion buffer of 7% of risk-weight-
ed assets and the total capital plus
conservation buffer ratio of 10.5%
sooner rather than later.
• Banks with significant credit
concentrations including, but not
limited to, commercial real estate,
should expect to maintain capital
ratios above the fully phased-in
minimum requirements.
• Trust preferred and cumulative
preferred securities that have long
been issued by bank holding com-
panies will no longer count as Tier 1
Phase-in arrangements for Basel III
(White blocks indicate transition periods—all dates are as of Jan. l)

2011 2012 2013 2014 2015 2016 2017 2018 As of

Jan. 1 2019

Leverage Ratio Supervisory Parallel run )an. 1, 2013 - )an. 1, 2017 Migration to
monitoring Disclosure starts )an. 1, 2015 Pillan

Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50%
Minimum common equity plus capital
3.5% 4.0% 4.5% 5.125% 575% 6.375% 7.0%
conservation buffer

Phase-in of deductions from CETi

(including amounts exceeding the 20% 40% 60% 80% 100% 100%
limit for DTAs, MSRs and financiáis)

Minimuníi Tier l Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Minimum Total Capital plus
8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%
Conservation Buffer

Capital instruments that no longer qualify

Phased out over 10 year horizon beginning 2013
as non-core Tier l capital or Tier 2 capital

Liquidity coverage ratio Observation Introduce

period minimum
begins standard

Net stable funding ratio Observation Introduce

period minimum
begins standard

Source: Basel Committee On Banking Supervision

capital under Basel III, as well as the
Dodd-Frank Act. (The Act makes
certain exceptions for smaller bank
holding companies, but continued
use of trust preferred as a funding
vehicle for such companies is at
odds with Basel III. Tbis likely will
be addressed in the rulemaking.)
• The current leverage ratio
requirement should remain in effect,
with agencies migrating to a new
leverage ratio that includes off-bal-
ance-sheet exposures. Whether this
will replace existing requirements or
be added to it remains to be seen.
What about liquidity?
The Basel Gommittee published a
consultative paper on liquidity met-
rics at the end of 2009. The propos-
al would have established a short-
term (30-day) liquidity coverage
ratio and a longer-term (one year)
net stable funding ratio that would
require banks to hold sufficient liq-
uid assets to deal with the cash out-
fiows associated with an acute stress
scenario. Widespread criticism of
the proposal plus the timing of the
sovereign debt crisis coincided neat-
ly to refiect the proposal's short-
comings. As a result, tbe committee
decided to take more time to study
liquidity metrics and to delay intro-
ducing a short-term ratio until 2015
and a longer-term ratio until 2018.
This is not to say that heightened
liquidity standards will not be applied
for several years. Basel member coun-
tries have committed to "rigorous
reporting processes to monitor the
ratios" during the intervening years.
In the U.S., expect examiners to
increase their scrutiny and, at least
informally, use various metrics to
benchmark banks' liquidity positions.
Banks can also expect increased
focus on liquidity contingency plans.
These plans should provide for a
range of options for raising new
liquidity based on escalating stress
events, both bank-specific and mar-
ket-wide, as well as a combination
of market and idiosyncratic stresses.
The lack of final committee action
on liquidity doesn't mean banks can
rest; the liquidity crisis remains top-
of-mind among regulators.
To assist banks with their planning,
ABA will be rolling out a revised
liquidity toolkit later this year. •
Mary Frances Monroe, vice-president,
ABA's Office of Regulatory Policy, chairs its
Capital Working Group. To participate, con-
tact her at mmonroe@aba.com

NOVEMBER 2010 I ABA BANKING JOURNAL I 35

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