An Overview of Basel III

An evolving framework for banks

November 16th 2010

Sean McNelis
Head of Hybrid Capital & Liability Management Solutions Asia-Pacific
Tel: +852 2822 4157 Email: seanmcnelis@hsbc.com.hk

The Background to Basel 3

Overview
Basel 2 focused on asset side of B/S. Basel 3 focuses mostly on liability side:

Key Changes

Focus on equity

definition of capital
liquidity

New regulations on the definition of T1 & T2 debt capital

Post the Global Financial Crisis, focus of regulation on : Longer-term / stable liquidity Leverage ratios (RWA framework cant be arbitraged)

New (higher) minimum capital requirements

Leverage ratios

Higher quality of capital (e.g. equity, CoCos, loss absorbing hybrids)

Higher quantity of capital

Liquidity ratios (LCR & NSFR)

Basel 3 & Bank Capital

Focus on core equity / Hybrids to be more equity-like

Definition of Capital

No step-ups in Tier 1 or Tier 2 capital

Upper and Lower Tier 2 distinction abolished; Tier 3 abolished

Most deductions from regulatory capital now against core equity What is the relevance of T2? Banking groups with significant DTAs, minorities, insurance subsidiaries most affected Opportunistic buy-back of hybrids at lower prices (create accounting gains)

Capital Deductions

Liability Management

Address old structures via tenders / exchange / modification UT2 Capital Final grandfathering rules under Basel 3 will be key Certain regulators & Governments (UK / Canada/ Switzerland) favour contingent capital to deal with future banking crises Debt instrument that a) converts to equity or b) is written down when the bank in crisis Limited demand from investors for the product currently Higher minimum capital ratios equity T1 ratios from 2% to 7% National regulators have discretion capital conservation buffer & countercyclical buffer

Contingent Capital

Minimum Capital Ratios

The December 2009 Basel Proposals

The Proposals

The Basel Committee on Banking Supervision (BCBS) released in December 2009 a consultation
document titled Strengthening the Resilience of the Banking Sector
Key Areas Under Review Planned Implementation Timeline

The regulatory capital

base, quality, consistency and transparency Capital requirements for counterparty credit risk Introduction of a leverage ratio Countercyclical capital framework Minimum liquidity standard

Full set of standards by the end of 2010 (on track!!)

Full implementation is aimed for by the end of 2018
2010
Consultation Period

2011-2012
(End-2010) Release of final standard Standards phased into regulatory framework

2012-2018

Steps

Aimed implementation

Basel III Consultation & Implementation Timeline

Implementation timeline runs to 2018
Jan 2013 New minimum capital requirements Aug 2010 CP on loss absorption Nov 2010 G20 meeting in Korea Dec 2010 Final T1 & T2 rules 2009 2010 Jan 2013 Amortisation of non-compliant Hybrid T1 & T2 (10% p.a.) Jan 2013 Exclusion of noncompliant common equity T1 Jan 2013 Parallel Run for leverage ratio 2011 2012 2013 2014 Jan 2016 Phase in of the capital conservation buffer 2015 2016 2017 2018

Dec 2009 consultative document titled Strengthening the resilience of the banking sector

Jan 2011 Supervisory monitoring begins for leverage ratios

Jan 2014 Jan 2015 New capital Bank level of deduction disclosure of requirements Leverage Ratio

Jan 2018 Leverage ratio as Pillar 1 test Jan 2018 Revised Net Stable Funding Ratio

Re-Defining the Capital Base

The Basel III proposals redefine the composition of regulatory capital Under the proposals: Focus on core equity Innovative Tier 1 (with step-up feature) would not be recognised Upper Tier 2 is abolished
Overview of Bank Capital Structure CHINAS CURRENT BANK CAPITAL FRAMEWORK INTERNATIONAL BANK CAPITAL FRAMEWORK Tier 3 PROPOSED BASEL III FRAMEWORK

Tier 2
Tier 2

Lower Tier 2 Contingent Capital Upper Tier 2 Hybrid Tier 1 Core Tier 1

Lower Tier 2

Upper Tier 2
Core Tier 1
Hybrid Tier 1

Innovative Tier 1 Non-Innovative Tier 1

Tier 1
Core Tier 1

Core Tier 1

Update on Basels Minimum Capital Standards (Sept 2010)

On 12 September 2010, the Basel Committee announced the new minimum capital requirements. Final rules expected in Dec 2010
Minimum Capital Requirement Capital Conservation Buffer Countercyclical Buffer

Minimum common equity ratio increases from 2% to 4.5%

Capital conservation buffer of 2.5% must be met with common equity (after regulatory adjustment)

A countercyclical buffer (0.0%~2.5%) of common equity or other loss absorbing capital will be introduced

Total Capital Total Capital 8.0% Tier 2 Common Equity (after deductions) 4.5% Hybrid Tier 1 Core Tier 1 Tier 1 Capital 6% 10.5% Tier 2 Common Equity (after deductions) 7.0% Hybrid Tier 1 Capital Conserv. Buffer Core Tier 1 Tier 1 Capital 8.5%

Total Capital Tier 2 10.5~13.0% Common Equity (after deductions) 7.0~9.5% Hybrid Tier 1 Countercyclical Buffer Capital Conserv. Buffer Core Tier 1

Tier 1 Capital 8.5~11.0%

0.0~2.5% 2.5%

2.5%

New Definition for Hybrid Tier 1 Instruments

The biggest impact of the proposed new Basel rules is likely to stem from the removal of stepups, more stringent requirements for coupon discretion as well as a stronger form of principal loss absorption

Tier 2

Features No step-ups Non-cumulative Loss absorption

Resolution regimes

Contingent Capital
Hybrid Tier 1 Core Tier 1

Bail in

T1 hybrids more equity-like

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New Definition for Tier 2 Instruments

With the exception of the removal of step-ups, the proposed Tier 2 rules are in many respects similar to existing Tier 2 rules. Debate on adding non-viability triggers continues

Tier 2 Contingent Capital Hybrid Tier 1 Core Tier 1

Features
No step-ups

Loss absorption at the point of non-viability

Resolution regimes

Bail in

T2 debt more risky for investors

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Latest Proposals On Regulatory Capital Loss Absorption

The Basel Committee issued a consultative document titled Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non-Viability on Aug 19 2010
Regulatory Capital Loss Absorbency

All non-common equity bank regulatory capital instruments (including Tier 2 and Hybrid Tier 1 capital) should be capable of absorbing losses in the event that a bank is unable to support itself in the private market, through:
Permanent write-down of principal; or Conversion to equity Rationale Many regulatory capital instruments do not absorb losses in gone-concern situations During the Global Financial Crisis, banks capital instruments have not taken losses in many circumstances (even where the Government invested in the bank) Basel Proposed Solution Gone-concern loss absorbency would continue to work through subordination in liquidation for failed banks The regulatory authority has the option to require non-common equity regulatory capital instruments to be permanently written-off or converted into common shares

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Introduction of a Leverage Ratio by 2018

Objectives Put a floor under the build-up of leverage in the banking sector Provide additional backstop against model risk and measurement errors Stop arbitraging of RWA approach Key Idea
Migrating leverage ratio from a Pillar 3 to a Pillar 1 treatment based on future review and calibration
Basel II
Pillar 1
Min. Capital Req.

Pillar 2
Supervisory Review Process

Pillar 3

Market Discipline

BCBS Original Proposals Latest Review The Leverage Ratio is designed as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment Netting is not allowed Certain Off-Balance Sheet items should be included using a flat 100% Credit Conversion Factor

Key Amendments (vs. Dec09 Proposals) Proposed minimum 3% (i.e. 33 times leverage) to be tested, based on new definition of Tier 1 capital Calculated as an average over a quarter For all derivatives netting is allowed 10% Credit Conversion Factors for Off-Balance Sheet items
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A role for Hybrid Capital in the Future?

Banks tend to use subordinated debt to enhance RoE, whilst meeting reg. requirements Tax deductible equity will continue to make sense for banks
Regulatory Capital Non-Dilutive

Can be recognised by regulators as Tier 1 or Tier 2 in calculating the issuing banks capital adequacy, depending on local regulations
Structured as a fixed-income instrument without voting rights and thus is non-dilutive to existing shareholders (other than where equity conversion is included) Lower cost of capital due to its quasi-equity nature and tax benefits More favorable WACC compared to the use of pure equity capital Expansion of possible sources of regulatory capital Diversification of investor base (issue in foreign currency) Tax deduction on interest is a key driver of issuance

Lower Cost Diversificatio n Tax Benefits

Equity Credit

Equity credit from rating agencies in financial analysis

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Existing Bank Capital Framework in Asia-Pacific

Timeline of introducing Hybrid Tier 1 regulations

Dec. 1998 Mar 1999 Sep 1999 Sep 2001 Dec 2002 Japan Thailand Australia Hong Kong Korea

Oct. 2003 May 2004 Dec 2004 Dec 2005 Jan 2006 Taiwan Singapore Malaysia Philippines India

China

Lower Tier 2

Upper Tier 2

Hybrid Tier 1

Capital regulations are well developed across the Asia-Pacific region

Basel 3 will lead to changes in the definition of capital in the region

China will be in a position to adopt the new Basel 3 capital rules allowing banks to issue the new generation of instruments across the capital spectrum
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The role for Contingent Capital?

Basel review has also identified the merits of contingent capital Switzerland, Canada and the UK are big proponents of contingent capital as a useful tool to re-capitalise banks in any future financial crisis The Swiss proposals consider the use of contingent capital for up to 9% of RWAs The Basel Committee will consult further on contingent capital before July 2011 What is Contingent

An instrument that can be converted into a higher form of capital (or equity) It allows an issuer to pre-secure higher quality regulatory capital for a future date and to avoid execution uncertainty Can be generated by e.g. issuing a senior or subordinated bond which embeds a conversion option into a higher tier of capital (often equity)
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Capital?

Forms of Contingent Capital

Examples of structuring alternatives
Senior debt / Tier 2 instrument exchangeable into a Tier 1 capital bond (hybrid capital) at any time at the issuers full option. The terms of the Tier 1 instruments are pre-defined at the launch, however the coupon can be reset upon exchange (examples Deutsche Bank UT2 / T1 contingent capital transaction) Senior debt / Tier 2 where principal is permanently written down based on a trigger event (example Rabobank) Senior debt / Tier 2 instrument exchangeable into equity based on a pre-defined trigger. The number of shares / share price on exchange is set out at the time of issuance of the bond (example Lloyds ECNs) Risk management tool

Optimization of balance sheet

Contingent Capital

Cost-efficient funding

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Q&A
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Disclaimer
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