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BirdsEye View

basel proposals on bank capital structure
Just when you thought the Basel accords were dead (recall Basel 1, Basel 2 and 1a, all of which were shot down after years of deliberation and consternation), the Basel Committee on Banking Supervision issued two documents in December which, if accepted, will have profound implications on our banking system.
 
Considering Basel’s past track record, I wouldn’t start agitating over these two documents yet. At the same time, given the global dissatisfaction with the world-wide instability of the financial system, this initiative MIGT grow legs better than its predecessors.
 
The two documents, entitled “Strengthening the Resilience of the Banking Sector” and “International Framework of Liquidity Risk measurement, Standards and Monitoring”, aim to accomplish the following:
 
·                     Improve the quality of bank capital
·                     Strengthen capital requirements against counter-party risk
·                     Expand capital buffer to absorb extraordinary shocks to the system by looking forward instead of backward
·                     Add a leverage ratio to the Basel II risk-based capital framework
 
US banks should vociferously comment upon these documents as they propose major changes to many key ratios:
 
·                     Definition of Tier 1 capital
·                     Imposition on a minimum common equity to risk-weighted-assets ratio
·                     Shifting loan loss reserve methodology from looking backwards (historical loss as the basis for ALLL) to forward looking (expected loss)
·                     Addition of off-balance-sheet assets to the calculation of average assets and risk weighted assets
·                     Limiting netting of exposures (another burden on asset calculation)
·                     Deduction of ALL intangibles, including mortgage servicing rights (MSRs) and core deposit intangibles (goodwill) from common equity
·                     New liquidity standard for international banks that includes a 30-day liquidity coverage ratio and a longer-term structural liquidity ratio (and, if you’re a fully domestic bank, don’t relax yet; you and I know how such requirements end up spreading to other segments of the industry)
 
While the ultimate objective behind these documents is noble – stability of the global financial system – the devil is, as always, in the details. Below are some of these details:
 
  1. Trust preferred securities and other debt-like capital instruments be phased out as Tier 1 capital such that only common equity and non-cumulative perpetual preferred would be considered tier 1 capital.
  2. Common equity must comprise the majority of Tier 1 capital. This will be ensured by adding a minimum common equity to risk weighted assets ratio, with common equity defined as:
    1. Minus any stock surplus paid for by non-common shares
    2. Plus/Minus unrealized gains or losses
    3. Minus goodwill and other intangibles net of any deferred tax liability (THIS WILL HAVE A HUGE IMPACT ON ACQUISITIONS OF BANK DEPOSITS)
    4. Minus deferred tax assets dependent on future earnings
    5. Minus investment in treasury stock
    6. Minus minority interests (for Tier 1 capital only)
    7. Minus investments in other banks’ capital instruments in whichever form of capital that investment occurred (tier 1, tier 2, risk-based etc.)
    8. Minus any shortfall in the loan loss revision that results from the changes in loan loss methodology
 
Tier1 capital obviously has many more restrictions under the newly proposed guidelines than in the past, but Tier2 capital has some relaxations, most notably the elimination of limits on the amount of subordinated debt or trust preferred securities that could count as Tier2 capital.
 
There are many proposed changes. The most impactful appear to be:
 
·                     Disallowance of trust preferred securities and other debt-like hybrids as Tier1capital
·                     Requirement that preferred stock be able to absorb losses to count as Tier1 capital
·                     Minimum common equity to risk weighted assets ratio (even more draconian since assets previously excluded (netted, off balance sheet and securitized assets) will be added back to risk based assets
·                     Unlimited debt to be included in Tier2 capital
·                     Deduction from Tier1capital of all intangibles including forward-looking tax deferred assets, OTTI write-downs, expected loss provisioning if below required levels and goodwill
·                     Capital buffer against expected loan losses and rapid growth before allowing discretionary capital contributions
 
Bottom line: keep an eye on developments as they occur. The way I see it, this is a sign of things to come, but many of the specific measures contained herein will go the way previous Basel measures did – nowhere.