Opinion

Felix Salmon

The other bits of Basel III

By Felix Salmon
September 14, 2010

All the headlines about Basel III have concentrated on the new core Tier 1 capital requirements — the amount of pure equity and retained earnings that banks are going to have to have going forward. It was banks’ core equity which proved woefully insufficient during the crisis — hardly a surprise, when the Basel II requirement for it was just 2% — and it’s core equity which has seen the biggest beefing up under Basel III, all the way to 7%.

But Melvyn Westlake reckons that there might be a bigger story here in the total capital requirements under Basel III, including not only core Tier 1 capital but everything, up to and including Tier 2. Westlake knows what he’s talking about: he works for Global Risk Regulator magazine, the trade journal which covers all these issues in enormous detail on a permanent basis. Here’s what he just sent me via email:

I would suggest that the Basel Committee intends that Tier 2 capital will have a much more significant role than in the past. It is not absolutely clear what instruments will qualify for Tier 2 in the future, but they will certainly have to be loss absorbing, possibly in a “going concern” situation as well as a “gone concern” situation.

He also notes what the Basel Committee itself has said:

During the recent financial crisis a number of distressed banks were rescued by the public sector injecting funds in the form of common equity and other forms of Tier 1 capital. This had the effect of supporting not only depositors but also the investors in regulatory capital instruments. Consequently, Tier 2 capital instruments (mainly subordinated debt), and in some cases non-common Tier 1 instruments, did not absorb losses incurred by certain large internationally-active banks that would have failed had the public sector not provided support.

It’s going to take a while (something over a decade, most likely) to fully make the switch from the current grab-bag of instruments which count as Tier 2 capital to a much safer system where holders of Tier 2 capital can and will take losses in the event that a bank comes close to failing. So far, the market in contingent convertible securities is nascent at best, and no one really understands how or whether it will evolve — maybe banks will find it easier to just issue equity instead.

But in any case, the new Tier 2 capital requirement of 10.5% is an important number: it basically means that if any bank does need a bailout, its subordinated bondholders are going to be the first to do the bailing out, rather than the government. And it should give some reassurance to the people worried about leverage, too. After all, if you calculate leverage ratios using total capital rather than just equity, they’re likely to come down substantially. And that’s without taking into account the new liquidity restrictions. Lehman’s biggest failure was in liquidity management; the new Basel rules will, if they work, stop another Lehman from happening again. The capital rules are aimed not at preventing another Lehman, but rather at shoring up the global commercial-banking system. Which is just as important.

Comments
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What is it that will decide when subordinated bondholders do the “bailing out”? I would think ideally you have a sort of prepackaged bankruptcy where the shareholders are told, “sorry”, control (election of directors, fiduciary duty, etc.) passes to Tier 2, and Tier 2 is told, “You don’t get your money back, but you get what you can squeeze out of the carcass. Enjoy!”, and they get to wind it down or figure out how to (gradually?) recapitalize it so that it’s compliant with Basel III. Presumably how different securities in the grab bag get to make relative claims on the carcass would be spelled out as part of issuing the securities; what I’d like, though, would be a way to trigger this bankruptcy event short of the sort of equitable insolvency that often means that those assets have already been squandered. How do you protect the actual residual claimants from whomever might think they’re (still/already) the residual claimants?

Posted by dWj | Report as abusive
 

dWj: The latest proposal from Basel in August, which came as a bit of a surprise to the market, was that all eligible capital instruments should have automatic writedown/conversion features which are triggered by the injection of public funds or a determination by the regulator that the bank would not be viable without the conversion. The idea being that this forestalls bankruptcy unless losses exceed all capital, not just equity.

Posted by GingerYellow | Report as abusive
 

Thanks, GingerYellow. I got married in August, which may or may not be related to my having missed that.

Posted by dWj | Report as abusive
 

Felix,

Let me say that you should get some kind of medal for your coverage of the whole basel proceedings… just awesome!

The issue in this post, risk weighting assets, to me is more of a rating agency problem and furthermore an audit problem than it is a Basel problem. In my mind the rating agencies no longer exist. I do a 10 minute balance sheet / cashflow statement review of every corporate bond I buy now.

The biggest problem left in the system is the for profit auditors. When a billion dollar publicly traded company like Satyam can mistate their cash on hand and get their auditors to sign off on their annual reports… I still can’t even get my arms around that. To me that’s the next step in the re-regulation process. There are less than 10,000 public companies in the US… I don’t see why a goverment agency like the IRS couldn’t grow their existing auditing function overtime to the point that every listed company was audited every year. At this point I would trust those numbers more than numbers signed off on by a for profit auditor.

keep up the great reporting Felix!

Posted by y2kurtus | Report as abusive
 

Yes, Tier 2 capital is different now.

Criteria for inclusion in Tier 2 Capital

1. Issued and paid-in

2. Subordinated to depositors and general creditors of the bank

3. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis depositors and general bank creditors

4. Maturity:

a. minimum original maturity of at least five years

b. recognition in regulatory capital in the remaining five years before maturity will be amortised on a straight line basis

c. there are no step-ups or other incentives to redeem

5. May be callable at the initiative of the issuer only after a minimum of five years:

a. To exercise a call option a bank must receive prior supervisory approval;

b. A bank must not do anything that creates an expectation that the call will be exercised; and

c. Banks must not exercise a call unless:

i. They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank; or

ii. The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.

6. The investor must have no rights to accelerate the repayment of future scheduled payments (coupon or principal), except in bankruptcy and liquidation.

7. The instrument cannot have a credit sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organisation’s credit standing.

8. Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument, nor can the bank directly or indirectly have funded the purchase of the instrument

9. If the instrument is not issued out of an operating entity or the holding company in the consolidated group (eg a special purpose vehicle – “SPV”), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Tier 2 Capital

George Lekatis
http://www.basel-iii-association.com

Posted by George_Lekatis | Report as abusive
 

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