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17 Jan 2011

Overview of Basel III - minimum capital requirements and global liquidity standards

by Andrew Jinks, Louise McCoach, Alex Chernishev, Eugene Bong, Joshua Knuckey

Going-concern and gone-concern capital

Under Basel III the total capital a bank is required to hold is 8.0% of its risk-weighted assets. Total capital is divided into two broad categories: Tier I capital and Tier II capital. Broadly speaking, Tier I capital is capital that is available to absorb losses on a "going-concern" basis, or capital that can be depleted without placing the bank into insolvency, administration or liquidation. Tier II capital is capital that can absorb losses on a "gone-concern" basis, or capital that absorbs losses in insolvency prior to depositors losing any money.

Tier I capital

Tier I capital is in turn comprised of both Common Equity Tier I capital and Additional Tier I capital. Common Equity Tier I capital is the purest form of capital and includes common shares and retained earnings. The required ratio of Common Equity Tier 1 capital to risk-weighted assets will go up from 2% to 4.5% under Basel III. This percentage will also be more difficult to meet as Basel III have introduced stricter regulatory adjustments. These new capital requirements will be progressively phased in between 1 January 2013 and 1 January 2015.

Additional Tier I capital mainly consists of instruments issued by the bank which are able to meet specific criteria (and are not included in Common Equity Tier I capital). Basel III has introduced stricter criteria for determining what constitutes Additional Tier I capital in order to ensure these instruments absorb losses of a bank on a going-concern basis.

In addition, the minimum total Tier I capital requirement will increase from 4% to 6% under Basel III and will be progressively phased in between 1 January 2013 and 1 January 2015.

Capital conservation buffer

Basel III has also introduced a capital conservation buffer which requires an additional 2.5% of Common Equity Tier I capital to be held over and above the absolute minimum requirements. This buffer is intended to be available to be drawn down during periods of stress. If the buffer falls below 2.5%, constraints on a bank's ability to distribute earnings will be progressively applied on a sliding scale.

Counter-cyclic capital buffer

A separate counter-cyclical buffer has also been introduced to ensure that the banking sector's capital requirements take account of the macro-economic environment in which banks operate. This buffer will range between 0 to 2.5% of a bank's risk-weighted assets and will be determined by the relevant regulator in each jurisdiction. The regulator will determine the level of the buffer according to its perception of the systemic risk that has built up in the banking system as a result of excess credit growth.

Leverage ratio

The Basel Committee has also introduced a new non risk-weighted leverage ratio to prevent banks building-up excessive on- and off-balance sheet leverage. The Basel Committee is currently testing a minimum Tier 1 leverage ratio of 3% of bank exposure, which generally follows the accounting measure of exposure.

Global liquidity standards

The Basel Committee has also introduced new global liquidity standards. These standards have been introduced to ensure that banks have sufficient liquid assets to survive acute and longer-term stress scenarios.

Systemically important banks

The Basel Committee has also proposals in place to require systemically important banks to have loss-absorbing capacity beyond the minimum standards. Work on this issue is continuing and the Basel Committee has not yet stated what banks will be considered systemically important.

 

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.