Basel 2 to Basel 3 Proposed Changes and Required Amendments

13th July 2011

Basel 2 to Basel 3 Proposed Changes and Required Amendments

Amendments to Basel 2
(taken from the 3 July 2009 Basel 2 papers) The changes listed below are to be brought into effect by 31.12.2011 in the EU and G20 countries. Subsidiaries of Bahraini banks in these countries will be obliged to comply with these measures even if their head offices do not.

Trading Book New stressed VaR requirement (for one year period) for banks using VaR models in the trading book New incremental risk capital charge (default & migration risk) for IRB banks Capital charges used in the banking book must be applied to securitised products in the trading book to avoid regulatory arbitrage (see page 6 of July doc) Removal of concessionary 4% RW treatment for liquid and diversified portfolios

Complex Securitisations Resecuritisations obtain higher risk weights in the banking book
AAA A+ to ABBB+ to BBBBB+ to BBB+ to unrated Securitisation Resecuritisations 20% 40% 50% 100% 100% 225% 350% 650% Deduction Deduction

No self-guarantees allowed to improve credit ratings of securities guaranteed by the bank itself when such securities are held on the banks own books

Amendments to Basel 2

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Operational criteria must be applied before banks may use above risk weights in the Basel 2 securitisation framework. Otherwise all holdings of securitisations must be deducted from capital Standard 50% CCF for liquidity facilities in the securitisation framework (no more concessionary risk weights)

Enhanced Pillar Two requirements for ICAAPs and internal controls generally This means the need for new Pillar 2 modules in the Rulebook (the CBB drafted a module called SR in 2008, but this was never released)

Enhanced Pillar Three requirements Enhanced disclosures for securitisations and credit risk mitigants

Amendments to Basel 2

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Basel 3 changes
(Paragraph references from December 2010 Basel paper)

1.

Capital Ratio

Tier One (6% of total RWAs) paragraphs 50, 53 A. Minimum common equity 4.5% of total RWAs (by 1.1.2015) after all deductions below (including unaudited/audited losses or audited profits for current period plus all eligible reserves). Paragraph 52 There are tougher requirements for Common Equity: Common shares only and must be recognised as equity by accounting standards Most subordinated claim, not fixed or capped Perpetual and never repaid outside liquidation No features that encourage buy-backs, redemption or cancellation Distributions not contractually capped or linked to amount paid in No obligatory or preferential payment of dividend (which can create a technical event of default) Issued and paid up Unsecured, unguaranteed Only issued with explicit shareholders approval May include share premium, retained earnings and p&l Deductions from common equity (full deduction by 1.1.2018) Intangibles (paragraph 67) Investments in own shares (paragraph 78) Any outstanding Tier 1 instruments that do not meet the definition of common equity (w.e.f. 1.1.2013) Minority interests in financial subsidiaries (see section G) Deferred tax assets (paragraphs 69 & 70) Mortgage servicing rights
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 Cash flow hedge reserves for items not fair valued (paragraphs 11, 71 & 72) Any shortfall of provisions to expected losses under IRB (paragraph 73) Gains on sales due to securitisation transactions (paragraph 74) Unrealised gains arising from changes in the fair value of liabilities caused by changes in the banks own credit risk/rating (paragraph 75) Defined pension fund assets and liabilities (paragraph 76) Reciprocal cross shareholdings in the capital of financial and insurance entities (paragraph 79) Investments in the capital of other financial and insurance entities where the bank owns < 10% of the issued common share capital of that entity (applies to both trading and banking book). If the aggregate of all holdings listed above exceed 10% of the banks common equity (after applying all other deductions), then the amount exceeding 10% of the concerned banks capital (of such holdings) must be deducted applying a corresponding deduction approach (i.e. common equity from common equity, tier two from tier two). Amounts below the 10% threshold will continue to be risk-weighted (paragraph 80 & 81) Investments in the capital of other financial institutions and insurance companies where the bank owns > 10% of the issued common capital of the entity (applies to trading and banking book). All such investments must be deducted (paragraphs 84 86) after above deductions where the aggregate of such investments exceeds 15% of a banks common equity. There must be full disclosure of these deductions. Any (remaining) holdings below 15% of capital will be weighted at 250% (paragraph 89).

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B.

Net Common Equity Amount A after all deductions above

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C.

Additional Going Concern Capital paragraph 54 and 13 January 2011 Annex There are enhanced criteria for classification as additional Going Concern Capital Issued & paid up Subordinated to depositors, general creditors and subordinated debt Not secured or guaranteed Perpetual and no step-ups or other incentives to redeem Callable only at initiative of issuer after minimum 5 years, subject to prior supervisory approval Documentation should not create the expectation of a call by the issuer Call cannot be made without bank concurrently replacing capital without issuance of capital of same or better quality, and capital must be well above minimum required capital level Coupon payments must be discretionary Cancellation of payments must not constitute an event of default Cancellation of payments must not put restrictions on the bank Dividend only payable out of distributable items No credit sensitive dividend payment features Must be convertible at the option of the supervisory authority to common equity or to be written down in value (e.g. by reducing the amount repaid at call point), or contain a write-down feature which allocates losses to the instrument before tax payers are exposed to loss* (see bullet point below) Issuer and connected counterparties may not have purchased the instrument, nor can the bank have funded the purchase of the instrument No compensation features if other similar instruments are subsequently issued at a lower price Proceeds must be immediately available without limitation (e.g. from an SPV that is part of the consolidated group) May include share premium

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 The convertibility feature above must be supported by a law (not a directive) that the instrument must be written off/down or fully absorb losses before tax payers (i.e. the Government) are exposed to loss. Furthermore, there must be a peer group review to confirm that such laws are in place and both the bank and the regulator (in issuing documents) disclose that these instruments are loss-bearing. Only common stock may be issued to instrument holders (i.e. no payment of cash or other compensation may be given) if a trigger event (see bullet point below) occurs. The bank must have all approvals to issue common equity to the amount required should a trigger event occur. A trigger event is the earlier of: (1) a decision that a write-off (without which the bank would be unviable) is necessary, as determined by the supervisor; or (2) the decision to make a public sector injection of capital (or equivalent support) without which the bank would have become unviable (as determined by the supervisor). Deduct investment in own shares. Deduct holdings of such instruments issued by other financial and insurance entities which do not exceed 10% of the investees capital, but which in aggregate exceed 10% of the concerned banks capital (paragraph 80). All instruments issued after 1 January 2013 must meet the above criteria to be included in regulatory capital. Instruments issued prior to 1 January 2013 that do not meet the criteria above will be phased out from 1 January 2013 (90% cap in 2013, reducing by 10% per annum). Instruments with early calls or step-ups will not generally be recognised as regulatory capital.

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D.

Total Tier One Capital Item B plus item C

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E.

Tier Two Capital (i.e. gone concern capital) paragraphs 57 & 58 and 13 January Annex

There are simplified and tougher requirements for Tier 2: Issued and paid in Subordinated to depositors and general creditors Unsecured and not guaranteed Minimum maturity of 5 years with straight line amortisation over last five years to maturity No redemption incentives Callable only at the initiative of issuer after minimum of five years Early calls subject to prior supervisory approval No expectation of early calls to be created by the documentation Calls may not be exercised unless capital of the same or better quality is issued concurrently and the issuer demonstrates its capital is well above minimum required Investors may not accelerate the repayment of payments (except in bankruptcy or liquidation) No credit sensitive dividend feature The issuer and its related parties may not have purchased or funded the purchase of the instrument Proceeds must be immediately available without limitation (where raised by an SPV that is part of the consolidated group)

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Interim unaudited profits for the current period will still be allowed Expected loss approach to provisioning still under review, but general provisions up to 1.25% of credit risk weighted assets (i.e. not including operational risk or market risk charges) paragraphs 60 61 Includes stock surplus (i.e. premium) Deduct holdings of own Tier 2 capital Must be convertible at the option of the supervisory authority to common equity or to be written down in value (e.g. by reducing the amount repaid at call point), or contain a write-down feature which allocates losses to the instrument before tax payers are exposed to loss* (see bullet point below) The convertibility feature above must be supported by a law (not a directive) that the instrument must be written off/down or fully absorb losses before tax payers (i.e. the Government) are exposed to loss. Furthermore, there must be a peer group review to confirm that such laws are in place and both the bank and the regulator (in issuing documents) disclose that these instruments are loss-bearing. Only common stock may be issued to instrument holders (i.e. no payment of cash or other compensation may be given) if a trigger event (see bullet point below) occurs. The bank must have all approvals to issue common equity to the amount required should a trigger event occur. A trigger event is the earlier of: (1) a decision that a write-off (without which the bank would be unviable) is necessary, as determined by the supervisor; or (2) the decision to make a public sector injection of capital (or equivalent support) without which the bank would have become unviable (as determined by the supervisor). All instruments issued after 1 January 2013 must meet the above criteria to be included in regulatory capital. Instruments issued prior to 1 January 2013 that do not meet the criteria above will be phased out from 1 January 2013 (90% cap in 2013, reducing by 10% per annum). Instruments with early calls or step-ups will not generally be recognised as regulatory capital.
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Basel 3 changes

Tier Three (Abolished).

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F.

Total Capital (w.e.f. 1.1.2015) This is the sum of D and E above. Banks must have a Minimum ratio of 8%, of which 6% must be Tier One. Remaining 2% can be met by Tier 2 (paragraph 50)

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G. Minority Interests (paragraph 62) Minority interests in the common equity Tier One of a fully consolidated subsidiary may receive recognition in Common Equity Tier One if: The instruments meet all the criteria for common equity The subsidiary is a bank (i.e. not an SPV) The subsidiary has a surplus above its minimum Tier One capital requirements The surplus is added after deducting: a) the lower of the required minimum common equity Tier One plus its capital conservation buffer; or the proportion of consolidated minimum common equity Tier One plus the capital conservation buffer that relates to the subsidiary; and b) the amount of surplus Common Equity Tier One attributable to the minority shareholders. Minority interests attributable to other Tier One and Tier Two Capital instruments will be allowed under similar conditions (see paragraphs 63 and 64). Capital issued by SPVs can be included in consolidated Additional Tier One and Tier Two capital, but not in Common Equity (paragraph 65).

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H. Countercyclical Buffers (0-2.5% of RWAs) The size of the Buffer is set by the regulator and must take account of macroeconomic environment in which the bank(s) operate. This may mean that wholesale banks and retail banks will legitimately have different buffers Although each jurisdiction must decide for itself on the extent of the buffer, there are references and principles to follow (FSD of the CBB will have to be involved to apply individual buffers or the CBB may simply impose an industry wide percentage) The buffer is a function of the weighted average of capital buffer addons applied in each jurisdiction where the bank has exposure (this process could potentially be very complex for some banks) The countercyclical buffer would increase the 2.5% capital conservation buffer (see next page) by up to an additional 2.5% during periods of excessive credit growth Buffer can be released when the released capital would absorb losses in the system that pare a threat to financial stability Banks will be forced to conserve earnings where the buffer is below that required by the supervisor (paragraph 147)

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J.

Capital Conservation Buffer (2.5% of RWAs) Capital in excess of minimum to be used in times of stress (2.5% - must be common equity) Constraint on dividends, share buybacks and bonuses (subject to 100% conservation ratio (paragraph 131) if CET1 below 5.125% and sliding conservation scale up to 7% CET1 ratio) Phased in from 1.1.2016 to 1.1.2019

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K. New Risk Weightings A 1,250% Risk Weight will apply for the following items: Securitisation (and resecuritisations) exposures B+ or below Certain Equity exposures under the PD/LGD approach Non-payment/delivery on non Delivery versus payment transactions Significant investments in commercial entities (above 15% of capital base) paragraph 90

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2.

Leverage Ratio Based on Tier One Capital only (but subject to review) Off-balance sheet items subject to uniform 10% CCF All derivatives will be subject to Basel 2 netting plus PFE Minimum 3% ratio (w.e.f. 1.1.2018) i.e.

Tier One Capital . Unweighted on-balance sheet + 10% off-balance sheet assets Disclosure of the leverage ratio will start w.e.f. 1.1.2015 Calculation will be on an average basis over the reporting quarter

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3.

Counterparty credit risk (paragraph 98 onward) Stressed inputs to be used Elements of counterparty risk charges are related to MTM losses as a result of the fall in the credit worthiness of a counterparty Collateral and margining requirements strengthened Increase in risk weights on financial institutions An additional capital charge (the CVA)

These changes only apply to banks using the internal model method.

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4.

Liquidity Liquidity Coverage Ratio 30 day stressed funding scenario set by supervisor dictates level of high quality liquid assets to be held at all times (w.e.f. 1.1.2015) Net Stable Funding Ratio (w.e.f. 1.1.2018)

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5.

New Disclosure Requirements (paragraph 91 93) Full reconciliation of all regulatory capital elements to the balance sheet Separate disclosure of all regulatory adjustments Disclosure of all capital limits and minima Description of main features of capital instruments Disclosure of Equity Tier One ratio as well as other capital ratios (Tier One, Total) Any transitional provisions

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Summary of Basel 3

1.

Raise Quality of Capital Base Raise Quality of Common Equity (2013). Abolish Innovative Instruments from Tier One and only allow Going Concern/Loss Participating Tier One instruments (2013). Additional deductions from Tier One (2014 onward). Simplify and toughen Tier Two Capital (2013). Only limited inclusion of non-equity elements in Tier One.

2.

Enhanced capital charges for securitisation and off-balance sheet exposures (December 2011) July 2009 securitisation and trading book requirements. New counterparty credit risk charges and requirements.

3.

New 3% Leverage Ratio (2015) Based on Tier One Capital only. Will include off-balance sheet exposures at 10% CCF.

4.

New Liquidity Standards Liquidity Coverage Ratio (2015). Net Stable Funding Ratio (2018).

5.

New Capital Buffers Capital conservation buffer (2.5% of RWAs starting 2016 2019). Countercyclical buffer (0-2.5% of RWAs no set date). Also forward looking provisioning may play a role (expected loss approach to be explored).

Summary of Basel 3

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Revised Basel 3 Capital Components and Capital Adequacy Calculation Step-by-step

The items below the revised components of eligible regulatory capital. 1. Common Equity plus disclosed reserves (using new criteria in 17/12/2009 Basel Paper) including unaudited or audited losses and including audited profits for the current period unrealised gains to be included at 45% as previously or at CBB discretion Regulatory Deductions from Common Equity: a) Deduction of minority interests in subsidiaries (no longer included in Common Equity assume worst case). b) Deduction of goodwill and all other intangibles. c) Deduction of any deferred tax assets (should normally only apply to foreign subsidiaries). d) Deduction of any investments in own shares (treasury stock), any own share purchases funded by the bank (e.g. employee stock incentive programs). e) Deduction of investments in the capital of financial institutions (including banking and insurance and investment business institutions). This deduction will include all holdings of common equity in other financial institutions which are less than 10% of the concerned financial institutions capital (above a 10% threshold for the reporting bank). The full amount of such holdings (above the 10% own funds threshold) must be deducted from the reporting banks common equity. Secondly, the holdings of all common stock in all other financial institutions above 10% of the investees capital must be aggregated (after performing the above deduction). Where the aggregate of any such holdings exceeds 15% of the reporting banks common equity, then the amount over 15% of the reporting banks common equity
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2.

must be deducted. Note that these deductions will apply irrespective of the location of the exposure in the trading book or in the banking book. 3. 4. Common Equity after regulatory deductions (Item 1 less item 2) Additional Going Concern Capital (using new criteria for most banks this should be a zero item, but certain preference shares or other loss-bearing instruments may be included here subject to the new Basel limits) Total Tier One Capital (Item 3 plus item 4 but subject to cap) Tier Two Capital (subject to 2% cap and using new conditions) Total Eligible Capital (Item 5 plus item 6) Risk-Weighted Assets Calculate total risk weighted assets for the banking book, the trading book and operational risk as under existing PIR/Rulebook requirements, but note that all significant investments in commercial entities above 15% of capital base must be risk-weighted at 1,250%. Assume no grandfathering of concessions. 9. Calculation of Capital Ratios Calculate the following ratios: a) Common Equity Capital Ratio (Item 3 divided by item 8) b) Tier One Capital Ratio (Item 5 divided by item 8) c) Total Capital Ratio (item 7 divided by item 8) For the solo capital adequacy calculation, all shareholdings in subsidiaries must be deducted from common equity in addition to the deductions made in item 2e) above. Also all risk-weighted assets of subsidiaries for items 7 and 8 above must be deducted from the risk-weighted asset base of the reporting bank, prior to calculation of the solo capital ratios.

5. 6. 7. 8.

Revised Basel 3

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