11

Bank Regulatory Capital

This chapter provides a detailed understanding of the calculation of bank regulatory capital. Without such understanding, it would be difficult for a strategic equity practitioner to assess the merits or weaknesses of a specific transaction. At the time of writing this chapter, the Basel III framework had just been released and the regulatory treatment of some items was still undefined. Please refer to the full text of the proposal for further details. Strategic equity transactions can be devised to:

• Enhance the capital eligibility of financial instruments.
• Reduce the impact of deduction from capital of a specific item.
• And/or, reduce the capital consumption of a specific asset.

11.1 AN OVERVIEW OF BASEL III

11.1.1 Precedent Bank Regulatory Capital Accords

In this section I will cover a brief story of the Basel accords (see Figure 11.1). During the financial crises of the 1970s and 1980s, the large banks depleted their capital levels. In 1988, the Basel Supervisors Committee intended, through the Basel Accord, to establish capital requirements aimed at protecting depositors from undue bank and systemic risk. The Accord, Basel I, provided uniform definitions for capital as well as minimum capital adequacy levels based on the riskiness of assets (a minimum of 4% for Tier 1 capital, which was mainly equity less goodwill, and 8% for the sum of Tier 1 capital and Tier 2 capital). Basel I risk measurements related almost entirely to credit risk, perceived to be the main risk incurred by banks. Capital regulations under Basel I came into effect in December 1992, after development and consultations since 1988. Basel I was amended in 1996 to introduce capital requirements to address market risk in banks’ trading books.

In 2004, banking regulators worked on a new version of the Basel accord, as Basel I was not sufficiently sensitive in measuring risk exposures. In July 2006, the Basel Committee on Banking Supervision published the “International Convergence of Capital Measurement and Capital Standards”, known as Basel II, which replaced Basel I. The supervisory objectives for Basel II were to (i) promote safety and soundness in the financial system and maintain a certain overall level of capital in the system, (ii) enhance competitive equality, (iii) constitute a more comprehensive approach to measuring risk exposures and (iv) focus on internationally active banks.

Basel II was built around three “pillars”:

• Pillar 1, called “Minimum Capital Requirements”, established the minimum amount of capital that a bank should have against its credit, market and operational risks. It provided the methodology for calculating the risk exposures in the assets of a bank's balance sheet (the “risk-weighted assets”). The capital ratio was calculated using the definition of regulatory capital and risk-weighted assets. In this chapter I will be focusing only on Pillar I.
• Pillar 2, called “Supervisory Review and Evaluation Process”, involved both banks and regulators taking a view on whether a firm should hold additional capital against risks not covered in Pillar 1. Part of the Pillar 2 process was the “Internal Capital Adequacy Assessment Process” (ICAAP), which was the bank's self-assessment of risks not captured by Pillar 1.
• Pillar 3, called “Market Discipline”, was related to market discipline and aimed to make firms more transparent by requiring them to disclosure specific, prescribed details of their risks, capital and risk management.

The unprecedented nature of the 2007–2008 financial crisis obliged the Basel Committee on Banking Supervision (BCBS) to propose an amendment to Basel II, commonly called Basel III. The new standards were to be implemented in 2013. At the heart of the new framework were more stringent capital requirements, as well as the introduction of liquidity rules.

The Capital Requirements Directive (CRD) implements Basel III in the EU and the national banking regulators then give effect to the CRD by including the requirements of the CRD in their own rulebooks. Beware that some changes to the general framework may be accepted by the CRD. The national regulators of the bank supervise it on a consolidated basis and therefore receive information on the capital adequacy of, and set capital requirements for, the bank as a whole. Individual banking subsidiaries are directly regulated by their local banking regulators, who set and monitor their capital adequacy requirements. In the United Kingdom, the banking regulator is the Financial Services Authority (FSA). In the United States, bank holding companies are regulated by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”).

11.1.2 The Capital Ratio

For each category of regulatory capital (common equity, total Tier 1, Tier 2 capital) the Basel III accord sets a minimum requirement. In other words, for each category of regulatory capital the corresponding capital ratio of a bank has to be larger than, or equal to, a required minimum. The capital ratio is calculated as follows:

11.1.3 Bank Regulatory Capital

According to Basel III, a bank's regulatory capital is divided into several categories or tiers of capital (see Figure 11.2): common equity Tier 1, additional Tier 1 capital, Tier 2 capital and two additional capital buffers. These categories try to group constituents of capital depending on their degree of permanence and loss absorbency.

Tier 1 capital is so-called because it is the best quality capital from the regulator's perspective. It includes (i) permanent shareholders’ equity, referred to as common equity Tier 1 capital, and (ii) some instruments with ability to absorb losses, referred to as additional Tier 1 capital. Tier 1 capital is aimed at absorbing losses, helping banks to “remain going concerns” (i.e., to remain solvent). Tier 2 capital, a capital with less loss absorption capability, is aimed at providing loss absorption on a “gone concern” basis (i.e., in case of insolvency of the bank) to protect depositors. The sum of Tier 1 and Tier 2 capital is called “total capital”.

In addition to Tier 1 and Tier 2 capital there are two other categories of capital. The capital conservation buffer is designed to provide banks with an extra source of capital to draw on during times of financial and/or economic stress. The countercyclical buffer is designed to protect the bank from periods of excess aggregate credit growth.

11.1.4 Risk-weighted Assets

The risk-weighted assets (RWAs) are a bank's assets and off-balance sheet items that carry credit, market, operational and/or non-counterparty risk:

• Market risk RWAs reflect the capital requirements of potential changes in the fair values of financial instruments in response to market movements inherent in both the balance sheet and the off-balance sheet items.
• Credit risk RWAs reflect the capital requirements for the possibility of a loss being incurred as the result of a borrower or counterparty failing to meet its financial obligations or as a result of deterioration in the credit quality of the borrower or counterparty.
• Operational risk RWAs reflect the capital requirements for the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
• Non-counterparty risk RWAs primarily reflect the capital requirements for premises and equipment.

RWAs are computed by adjusting each asset and off-balance sheet item for risk in order to determine a bank's real exposure to potential losses. Some assets are assigned a higher risk than others. For example, government bonds with a AAA rating are assigned a 0% weighting, meaning that a bank does not need to hold any capital to sustain these assets on its balance sheet. The riskiest assets are assigned a 1250% weighting, meaning that a bank would need to hold a substantial amount of capital to sustain these assets on its balance sheet.

Figure 11.3 illustrates the main types of balance sheet position and off-balance sheet exposure that translate into market, credit, operational and non-counterparty risk RWAs of Credit Suisse under Basel II as of 2Q2010 (in CHF billion). RWAs totalled 233 billion, while the total assets on Credit Suisse's balance sheet totalled 1,138 billion.

Banking Book vs. Trading Book

Banking operations are categorized as either banking book or trading book, and risk-weighted assets are determined accordingly. Each national regulator determines which assets are part of the trading and banking books. The regulatory definition of trading book and banking book assets generally parallels the definition of trading (i.e., assets at fair value through profit and loss) and non-trading assets under IFRS/US GAAP. However, due to specific differences between the regulatory and accounting framework, certain assets may be classified as trading book for market risk reporting purposes even though they are non-trading assets under IFRS/US GAAP. Conversely, a bank may also have assets that are assigned to the banking book even though they are trading assets under IFRS/US GAAP.

Banking book RWAs are measured by means of a hierarchy of risk weightings classified according to the nature of each asset and counterparty, taking into account any eligible collateral or guarantees. Banking book off-balance sheet items giving rise to credit, foreign exchange or interest rate risk are assigned weights appropriate to the category of the counterparty, taking into account any eligible collateral or guarantees.

Trading book RWAs are determined by taking into account market-related risks such as foreign exchange, interest rate and equity position risks and counterparty risk. Under Basel II the model used to determine the trading book RWAs was Value-at-Risk (VaR) based, with a multiplier applied by the regulator. Its output was typically for modest absolute RWA requirements. Figure 11.3 shows that Credit Suisse's RWAs for market risk were only CHF 21 billion, less than 10% of the bank's overall RWAs. The problems with this methodology were twofold: first, VaR is not a stress-loss predictor, so building a capital requirement (inherently the unexpected loss cushion) from VaR can run the risk of miscalibrating; second, the models and/or the multiplier were too optimistic, so large banks with large volatile trading books ended up holding too little regulatory capital against their trading books.

11.2 TIER 1 CAPITAL

The objective of Tier 1 capital is to absorb losses and help banks to remain going concerns (i.e., to prevent failures). There are two layers of Tier 1 capital:

• Common equity Tier 1 capital.
• Additional Tier 1 capital.

11.2.1 Common Equity Tier 1 Capital

The common equity component of Tier 1 capital, also referred to as “core Tier 1 capital” or “core equity capital”, is considered the highest form of loss absorbing capital. It consists of common stock (i.e., common shares) plus reserves less some deductions. Other instruments can be included which are deemed fully equivalent to common stock in terms of their capital quality as regards loss absorption and do not possess features which could cause the condition of the bank to be weakened as a going concern during periods of market stress. For example, in the rare cases where a bank issued non-voting common shares, to be included in the common equity component of Tier 1 capital, they must be identical to voting common shares of the issuing bank in all respects except the absence of voting rights.

The criteria also apply to financial institutions, such as mutual, cooperative or saving banks, that do not issue common shares. Taking into account their specific constitution and legal structure, the national supervisors apply the criteria preserving the quality of the instruments to be included in the common equity component of Tier 1 capital by requiring that the eligible instruments are deemed fully equivalent to common shares in terms of their capital quality as regards loss absorption and do not possess features which could cause the condition of the bank to be weakened as a going concern during periods of market stress.

Figure 11.4 illustrates the major components in the calculation of common equity Tier 1 capital.

Criteria Governing Instruments’ Inclusion in the Common Equity Component of Tier 1

For an instrument to be included in the common equity capital, the predominant form of Tier 1 capital, it must meet all of the following criteria:

Stock Surplus

Stock surplus (i.e., share premium) is only permitted to be included in the common equity component of Tier 1 if the shares giving rise to the stock surplus are also permitted to be included in the common equity component of Tier 1.

Banks should not be given credit in the common equity component of Tier 1 when they issue shares outside the common equity component of Tier 1 which have a low nominal value and high stock surplus. In this sense the proposal ensures that there is no loophole for including instruments other than common shares in the common equity component of Tier 1.

Minority Interests

Minority interests arise in many situations, for example the use of local partners or the partial flotation of locally incorporated subsidiaries. Under Basel III, minority interests are not fully eligible for inclusion in the common equity component of Tier 1 capital. Although minority interest absorbs losses within the subsidiary to which it relates, this exclusion is based on the premise that this capital is not fully available to support risks in the group as a whole, and that it may represent an interest in a subsidiary with little or no risk. Basel III requires the excess capital above the minimum capital requirement of a subsidiary that is a bank to be deducted in proportion to the minority interest share. This treatment is strictly available where all minority investments in the bank subsidiary solely represent genuine third-party common equity contributions to the subsidiary.

Minority interests arising from the issue of an instrument by a fully consolidated subsidiary of the bank may receive recognition in common equity Tier 1 only if:

• The instrument giving rise to the minority interest would, if issued by the bank, meet the criteria for classification as common equity Tier 1 capital.
• The subsidiary that issued the instrument is itself a bank. Any institution that is subject to the same minimum prudential standards and level of supervision as a bank may be considered a bank.
• And, the parent bank or affiliate has not entered into any arrangements to fund directly or indirectly minority investment in the subsidiary whether through an SPV or through another vehicle or arrangement.

The amount of minority interest meeting the criteria above that can be recognized is determined as follows:

• Total minority interests meeting the criteria above minus the amount of the surplus common equity Tier 1 of the subsidiary attributable to the minority shareholders.
• Surplus common equity Tier 1 of the subsidiary is calculated as the common equity Tier 1 of the subsidiary minus the lower of: (1) the minimum common equity Tier 1 requirement of the subsidiary plus the capital conservation buffer (i.e., 7.0% of risk-weighted assets) and (2) the portion of the consolidated minimum common equity Tier 1 requirement plus the capital conservation buffer (i.e., 7.0% of consolidated risk-weighted assets) that relates to the subsidiary.
• The amount of the surplus common equity Tier 1 that is attributable to the minority shareholders is calculated by multiplying the surplus common equity Tier 1 by the percentage of common equity Tier 1 that is held by minority shareholders.

In my view, the minority interest deduction reduces the incentive of banks to overcapitalize banking subsidiaries, which is against Basel III's spirit. It also creates an asymmetry between the numerator and the denominator of the capital ratio because Basel III ignores the excess capital of the subsidiary representing the minority interest at group level while the risk exposures related to this excess are fully recognized in the consolidated accounts (i.e., it does not deduct from total RWAs the quota corresponding to the excess capital related to the minority interest on the entity level).

Mandatory Convertibles and Contingent Capital Instruments

At the time this book was being written, the Basel III committee had not yet reviewed the role that contingent capital, convertible capital instruments and mandatory convertible instruments play in a regulatory capital framework.

Minimum Requirements

The minimum requirement for common equity capital is 4.5% of RWAs after the application of adjustments. However, when combined with the capital conservation buffer, the resulting common equity requirement is 7% of RWAs.

11.2.2 Additional Tier 1 Capital

Although the predominant form of Tier 1 capital must be common equity, Basel III allows instruments other than common shares to be included in another element of Tier 1 capital called “additional Tier 1” capital, also called “non-core Tier 1” capital or “contingent” capital, if they meet certain requirements. An instrument to be included in additional Tier 1 capital shall meet the following criteria:

Criteria Governing Instruments’ Inclusion in the Additional Tier 1 Capital Component

For an instrument to be included in additional Tier 1 capital, the supplementary form of Tier 1 capital, it must meet all of the following criteria:

Stock Surplus

Stock surplus (i.e., share premium) is only permitted to be included in the additional Tier 1 capital component if the instruments giving rise to the stock surplus are also permitted to be included in the additional Tier 1 capital component.

Minority Interests

Tier 1 capital instruments issued by a fully consolidated subsidiary of the bank to third-party investors (including minority interest amounts included in the calculation of common equity Tier 1 capital) may receive recognition in Tier 1 capital only if the instruments would, if issued by the bank, meet all of the criteria for classification as Tier 1 capital. The amount of this capital that will be recognized in Tier 1 will be calculated as follows:

• Total Tier 1 of the subsidiary issued to third parties minus the amount of the surplus Tier 1 of the subsidiary attributable to the third-party investors.
• Surplus Tier 1 of the subsidiary is calculated as the Tier 1 of the subsidiary minus the lower of: (1) the minimum Tier 1 requirement of the subsidiary plus the capital conservation buffer (i.e., 8.5% of risk-weighted assets) and (2) the portion of the consolidated minimum Tier 1 requirement plus the capital conservation buffer (i.e., 8.5% of consolidated risk-weighted assets) that relates to the subsidiary.
• The amount of the surplus Tier 1 that is attributable to the third-party investors is calculated by multiplying the surplus Tier 1 by the percentage of Tier 1 that is held by third-party investors.

The amount of this Tier 1 capital that is recognized in additional Tier 1 should exclude amounts already recognized in common equity Tier 1.

Deductions from Additional Tier 1 Capital

The following items must be deducted from additional Tier 1 capital:

• All of a bank's investments in its own eligible additional Tier 1 instruments, whether held directly or indirectly (unless already derecognized under the relevant accounting standards).
• Reciprocal cross holdings of Additional Tier 1 capital that are designed to artificially inflate the Additional Tier 1 capital position of a bank must be deducted in full. Banks must apply a “corresponding deduction approach” to such investments in the Additional Tier 1 capital of other banks, other financial institutions and insurance entities.

Calculation of Additional Tier 1 Capital

Figure 11.5 highlights the major components in the calculation of additional Tier 1 capital.

Minimum Requirements

The minimum Tier 1 capital, which includes common equity capital and additional Tier 1 capital, requirement is 6% of RWAs. When combined with the capital conservation buffer, the resulting Tier 1 capital requirement is 8.5% of RWAs.

11.3 TIER 2 CAPITAL

The objective of Tier 2 is to provide loss absorption on a gone-concern basis. In other words, Tier 2 capital is intended to improve the position of depositors in case of insolvency of the bank. Based on this objective, there is a minimum set of criteria for an instrument to meet or exceed in order for it to be included in Tier 2 capital.

11.3.1 Criteria for Inclusion in Tier 2 Capital

Stock Surplus

Stock surplus (i.e., share premium) is only permitted to be included in the Tier 2 capital component if the instruments giving rise to the stock surplus are also permitted to be included in the Tier 2 capital component.

Minority Interests

Total capital instruments (i.e., Tier 1 and Tier 2 capital instruments) issued by a fully consolidated subsidiary of the bank to third-party investors (including amounts included in the calculation of Tier 1 capital) may receive recognition in total capital only if the instruments would, if issued by the bank, meet all of the criteria for classification as Tier 1 or Tier 2 capital. The amount of this capital that will be recognized in consolidated total capital is calculated as follows:

• Total capital instruments of the subsidiary issued to third parties minus the amount of the surplus total capital of the subsidiary attributable to the third-party investors.
• Surplus total capital of the subsidiary is calculated as the total capital of the subsidiary minus the lower of: (1) the minimum total capital requirement of the subsidiary plus the capital conservation buffer (i.e., 10.5% of risk-weighted assets) and (2) the portion of the consolidated minimum total capital requirement plus the capital conservation buffer (i.e., 10.5% of consolidated risk-weighted assets) that relates to the subsidiary.
• The amount of the surplus total capital that is attributable to the third-party investors is calculated by multiplying the surplus total capital by the percentage of total capital that is held by third-party investors.

The amount of this total capital that is recognized in Tier 2 must exclude amounts recognized in common equity Tier 1 and amounts recognized in additional Tier 1.

Where capital has been issued to third parties out of an SPV, none of this capital can be included in common equity Tier 1. However, such capital can be included in consolidated additional Tier 1 or Tier 2 and treated as if the bank itself had issued the capital directly to the third parties only if it meets all the relevant entry criteria and the only asset of the SPV is its investment in the capital of the bank in a form that meets or exceeds all the relevant entry criteria (as required by criterion 14 for additional Tier 1 and criterion 9 for Tier 2). In cases where the capital has been issued to third parties through an SPV via a fully consolidated subsidiary of the bank, such capital may, subject to the requirements of this paragraph, be treated as if the subsidiary itself had issued it directly to the third parties and may be included in the bank's consolidated additional Tier 1 or Tier 2 in accordance with the treatment outlined for minority interests.

Additional Inclusions in Tier 2 Capital

The following items can be included in Tier 2 capital:

• For banks using the standardized approach to credit risk, provisions or loan-loss reserves held against future, presently unidentified losses. The inclusion is limited to a maximum of 1.25% of credit risk-weighted risk assets calculated under the standardized approach. Provisions ascribed to identify deterioration of particular assets or known liabilities, whether individual or grouped are excluded.
• Excess of total provisions over the total expected loss under the internal ratings-based (IRB) approach. The inclusion is limited to a maximum of 0.6% of credit risk-weighted risk assets calculated under the IRB approach. At national supervisor discretion, a limit lower than 0.6% may be applied.

Deductions from Tier 2 Capital

The following items must be deducted from additional Tier 1 capital:

• All of a bank's investments in its own eligible Tier 2 instruments, whether held directly or indirectly (unless already derecognized under the relevant accounting standards).
• Reciprocal cross holdings of Tier 2 capital that are designed to artificially inflate the Tier 2 capital position of a bank must be deducted in full. Banks must apply a “corresponding deduction approach” to such investments in the Tier 2 capital of other banks, other financial institutions and insurance entities.

Calculation of Tier 2 Capital

Figure 11.6 highlights the major components in the calculation of Tier 2 capital.

Minimum Requirements

Total risk-based capital, which includes Tier 1 and Tier 2 capital, is 8% of RWAs. However, when combined with the capital conservation buffer, the resulting total risk-based capital requirement is 10.5% of RWAs.

11.3.2 Trigger Conditions for Hybrid Instruments

The terms and conditions of all non-common Tier 1 and Tier 2 instruments issued by an internationally active bank must have a provision that requires such instruments, at the option of the relevant authority, to either be written off or converted into common equity upon the occurrence of the trigger event unless:

• The governing jurisdiction of the bank has in place laws that (i) require such Tier 1 and Tier 2 instruments to be written off upon such event, or (ii) otherwise require such instruments to fully absorb losses before tax payers are exposed to loss.
• A peer group review confirms that the jurisdiction conforms with the previous clause.
• And, it is disclosed by the relevant regulator and by the issuing bank, in issuance documents going forward, that such instruments are subject to loss under clause (i).

Other conditions that have to be met are the following:

11.4 DEDUCTIONS FROM COMMON EQUITY TIER 1 CAPITAL

In order to ensure that capital is available to absorb losses, some adjustments are required to either (i) avoid double counting of capital or (ii) exclude elements of the equity section of a bank that are uncertain. The main regulatory capital deductions from common equity capital are the following:

• Goodwill and intangible assets (except mortgage servicing rights).
• Deferred tax assets that rely on future profitability.
• Cash flow hedge reserve.
• Shortfall of the stock of provisions to expected losses.
• Gain on sale related to securitization transactions.
• Cumulative gains and losses on own liabilities.
• Defined benefit pension assets and liabilities.
• Treasury stock.
• Reciprocal holdings in unconsolidated financial entities.
• Less than 10% holdings in unconsolidated financial entities.
• Significant holdings in unconsolidated financial entities.
• Combined deduction of significant investments in unconsolidated financial entities, MSRs and DTAs.

11.4.1 Goodwill and Other Intangible Assets (Except Mortgage Servicing Rights)

Basel III requires the deduction from common equity of goodwill and other intangibles, excluding mortgage servicing rights, including any goodwill included in the valuation of significant investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation. The amount deducted should be net of any associated deferred tax liability which would be extinguished if the intangible asset becomes impaired or derecognized under the relevant accounting standards. Goodwill is created as part of a purchase price allocation. Basel III allows using IFRS in determining the level of intangible assets if national GAAP results in a wider range of assets being classified as intangible.

The proposed deduction addresses the high degree of uncertainty that intangible assets would have a positive realizable value in periods of stress or insolvency. Part of the reason for subtracting goodwill is to ensure acquisitive banks do not have an advantage over organically grown banks with the same real assets and liabilities.

11.4.2 Deferred Tax Assets

The treatment of deferred tax assets (DTAs) is quite complex. In this section I will try to briefly give a bit of color on why DTAs take place.

An Overview of DTAs According to IAS 12

According to IAS 12, DTAs can be classified as follows:

• DTAs resulting from timing differences. To be covered below.
• DTAs resulting from the carry forward of unused tax losses. This type of DTA represents a claim against tax authorities to reduce the tax on future profits due to net operating losses (NOLs). It arises where a bank incurs losses and there is insufficient other income against which the losses can be offset. IAS 12 requires that DTAs on unused tax losses may only be recognized to the extent that it is probable that future taxable profits will be available against which the unused tax losses can be utilized. Where a DTA arises from a NOL carried forward, the DTA has independent value and is not solely dependent on future profits from existing operations to be monetized. For example, simple additional equity from a legal entity perspective can be transferred to the jurisdiction to earn out the NOL, and a number of jurisdictions permit the transfer of the business to a new owner.
• DTAs resulting from the carry forward of unused tax credits. This type of DTA arises if the bank qualifies for tax credits, those tax credits have not been able to be applied to the taxes payable in the current period and the tax authorities permit a carry forward of such unused tax credits into future years. The accounting treatment is similar to DTAs resulting from the carry forward of unused tax losses. However, the tax credits may be subject to the satisfaction of specific requirements, and therefore, the recoverability testing of DTAs on unused tax credits is in most instances more difficult than for unused tax losses.
• DTAs representing current tax assets. These DTAs can result from a tax loss carry back or from a prepayment. They represent an existing claim against the fiscal authorities which is usually paid as soon as certain formal requirements are fulfilled (e.g., filing a tax return or an application).

A DTA resulting from timing differences (also referred to as “temporary differences”) arises where there is a timing mismatch between the taxation of income/expense and the period in which the income/expense is recorded in the financial statements.

• A timing difference between accounting and tax systems arising from income being recognized for tax purposes before it is recognized for accounting purposes. This can arise from external or intra-group transactions. The DTA is in effect a prepayment to the tax authorities of an expense that will later be recognized for accounting purposes. One driver of this type of DTA is a prepaid interest.
• A timing difference between accounting and tax systems arising from expenses being recognized for accounting purposes before they are recognized for tax purposes. The position will automatically reverse through the passage of time. One driver of this type of DTA is the recognition of fair market value losses. In this case, the position will reverse either when the market value recovers or when the losses are crystallized for tax purposes. The existence of this type of DTA does not imply that the bank has incurred losses, instead it may represent a tax accounting concept designed to deal with differences in the timing of expense recognition between the financial statements and for tax purposes. For example, many tax systems only permit a deduction of loan-loss provisions upon actual realization of those losses; whereas the deduction for accounting arises at the time the provision is made. Another example of this type of DTA arises when a bank records an expense for deferred compensation in the financial statements over the vesting period (say, years 1 to 3) while this expense may not be deductible for tax purposes until the compensation is delivered (say, year 4). In this case, a DTA would be recorded in years 1 to 3 in respect of the future tax deduction that would be available for the deferred compensation expense.

The tests for recognition of DTAs under IAS 12 are notably stringent. DTAs are only recognized to the extent that it is probable that sufficient taxable profit will be available against which unused tax credits and deductible temporary differences can be utilized. In particular, the accounting standard requires detailed profit projections to prove the ability to earn out the DTA. For example, in the case of an entity which has incurred losses, there is a high evidentiary hurdle to be overcome before DTAs can be recognized, even where there is a long or indefinite future period available for utilization of those tax losses.

Basel III Treatment of DTAs

Basel III makes a distinction between (i) deferred tax assets arising from timing differences, (ii) DTAs which rely on future profitability of the bank to be realized and (iii) DTAs which do not rely on the future profitability of the bank to be realized.

DTAs arising from timing differences receive limited recognition, subject to the threshold deduction treatment. Their recognition is capped at 10% of the bank's common equity Tier 1 capital, with an aggregate limit for DTAs, mortgage servicing rights and significant investments in unconsolidated financial entities of 15%. This combined deduction is covered later.

DTAs which rely on future profitability of the bank to be realized are fully deducted from common equity Tier 1 capital. Deferred tax assets may be netted with associated deferred tax liabilities (DTLs) only if the DTAs and DTLs relate to taxes levied by the same taxation authority and offsetting is permitted by the relevant taxation authority. The DTLs permitted to be netted against DTAs must exclude amounts that have been netted against the deduction of goodwill, intangibles and defined benefit pension assets, and must be allocated on a pro rata basis between DTAs subject to the threshold deduction treatment and DTAs that are to be deducted in full. This deduction requirement addresses the concern that undue reliance on these assets is not appropriate for prudential purposes, as they may provide no protection to depositors or governmental deposit insurance funds in insolvency and can be suddenly written off in a period of stress.

DTAs which do not rely on the future profitability of the bank to be realized are assigned the relevant sovereign risk weighting.

In reality, where a bank has been operating for a number of years, it will typically have a core level of timing differences which will continue in existence from year to year. This arises, in the case of deferred compensation for example, due to the DTA being reduced through share deliveries, while at the same time being increased as a result of new awards being expensed in the financial statements. Even a constantly profitable entity will typically have a core amount of DTAs arising from timing differences which will persist from year to year. This means that the bank would be constantly deducing these DTAs from common equity Tier 1.

11.4.3 Cash Flow Hedge Reserve

Under IAS 39/IFRS9 there is a component of the shareholders’ equity section called the “cash flow hedge reserve”. This component primarily includes the fair value of derivatives used to hedge assets, liabilities or future highly probable commitments.

Basel III requires the deduction of the positive and the addition of negative cash flow hedge reserve from the common equity component of Tier 1 where it relates to the hedging of items that are not fair valued on the balance sheet (including projected cash flows). This requirement tries to remove the element which gives rise to artificial volatility in shareholders’ equity, as in this case the reserve only reflects one half of the picture, the fair value of the derivative but not the changes in fair value of the hedged future cash flow.

11.4.4 Shortfall of the Stock of Provisions to Expected Losses

Basel III requires a full deduction from the common equity component of Tier 1 capital of any shortfall of the stock of provisions to expected losses under the IRB approach. The full amount is deducted and is not reduced by any tax effects that could be expected to occur if provisions were to rise to the level of expected losses. This deduction is aimed at safeguarding a level playing field, avoiding that a bank with a low stock of provisions shows more Tier 1 capital, which could discourage banks from provisioning in excess of IRB's expected losses.

11.4.5 Gain-on-sale Related to Securitization Transactions

Basel III requires a full deduction from the common equity component of Tier 1 capital of any increase in equity capital resulting from a securitization transaction, such as that associated with expected future margin income (FMI) resulting in a gain-on-sale.

11.4.6 Gains and Losses on Fair Valued Own Liabilities due to Changes in Own Credit Risk

Basel III requires the deduction from common equity capital of all unrealized gains and losses that have resulted from changes in the fair value of liabilities that are due to changes in the bank's own credit risk.

11.4.7 Defined Benefit Pension Fund Assets and Liabilities

A defined benefit pension scheme is one where the level of pension payments that the employee will receive upon retirement are predefined – generally they are defined as a percentage of final salary, with that percentage depending on length of service. In most cases these schemes are “funded”, i.e., pensioners receive their pension payments from a separate fund (often a trust) rather than directly from the company. The fund is built up over time with the employer, and in some cases the employee, making regular contributions to the fund over the employee's working life. In effect, with a defined benefit scheme the employer is taking the risk: the employee is entitled to a guaranteed pension income and the employer's contributions to the fund are likely to vary over time to reflect changing actuarial assumptions and investment performance.

Pension Assets

A pension fund is merely a collection of financial assets. Most pension funds invest in a mix of equities, bonds and other assets such as property or private equity. These assets can be valued either at market value (with the value of the fund fluctuating as markets rise and fall) or at actuarial values (normally based on the PV of expected future dividends).

Pension Liabilities

Banks operating defined benefit schemes have made a commitment to pay pensions to past and current employees. An employee's pension entitlement is typically based on a percentage of final salary multiplied by years of service. The actual amount paid out by the pension fund over time will therefore depend on salary levels, staff turnover, mortality rates, inflation rates and other assumptions. While some of these variables – such as pay increases – are under the employer's control, others – such as mortality rates and inflation – are clearly not.

Accounting Treatment under IAS 19 of Defined Benefit Plans

Under IAS 19, the net defined benefit liability is recorded in the statement of financial position as:

IAS 19 recognizes all changes in the value of the defined benefit obligation and in the value of plan assets in the financial statements in the period in which they occur. The changes in the net defined benefit liability (asset) are split into the following components:

• Service costs: recognized in P&L.
• Net interest income or expense: recognized in P&L as part of finance costs.
• Remeasurements of the net defined benefit liability (asset), including actuarial gains and losses: recognized in other comprehensive income (OCI).

Treatment under Basel III

Basel III applies no filter to net defined benefit pension fund liabilities. In other words, Basel III fully recognizes, as included on the balance sheet, liabilities arising from defined benefit pension funds in the calculation of the common equity component of Tier 1.

Additionally, Basel III requires the deduction of the value of each net defined benefit pension fund asset from the common equity component of Tier 1, net of any associated deferred tax liability which would be extinguished if the asset should become impaired or derecognized under the relevant accounting standards. Assets in the fund to which the bank has unrestricted and unfettered access can, with supervisory approval, offset the deduction. Such offsetting assets should be given the risk weight they would receive if they were owned directly by the bank.

The requirement for pension fund assets to be deducted from the common equity component of Tier 1 addresses the concern that assets arising from pension funds may not be capable of being withdrawn and used for the protection of depositors and other creditors of a bank, and thus, their only value stems from a reduction in future payments into the fund. Basel III allows for banks to reduce the deduction of the asset if they can address these concerns and show that the assets can be easily and promptly withdrawn from the fund. In my view, this deduction provides an incentive for banks to minimize the overfunding of pension funds or even accept underfunding, increasing pensions’ risk.

11.4.8 Treasury Stock

In order to prevent capital arbitrage, Basel III requires the deduction from the common equity component of Tier 1 capital of direct and indirect holdings of own common shares, unless already derecognized under the relevant accounting standards. This also applies to shares held in the trading book. The objective of the deduction for holdings in own shares is to prevent double counting of a bank's capital. In addition:

• Any own stock which the bank could be contractually obliged to purchase should be deducted from its common equity Tier 1 capital.
• Basel III allows the netting of long positions in own shares with short positions, only if the short positions involve no counterparty risk.
• Banks should look through holdings of index securities to deduct exposures to own shares. In other words, if the bank stock happens to be a constituent of an index on which the bank has a long position, the bank has to deduct the part of the index position that corresponds to the bank stock. However, gross long positions in own shares resulting from holdings of index securities may be netted against short positions in own shares resulting from short positions in the same underlying index. In such cases the short positions may involve counterparty risk (which will be subject to the relevant counterparty credit risk charge).

Basel III considers it necessary to apply prudential filters to cash-settled derivatives on own shares.

I do not agree with the requirement to look through index securities, as own shares embedded in index securities do not reduce the risk-bearing capacity of a bank. The requirement, in my opinion, does not reflect the true risk position of these securities as they are mostly entered as part of the bank's market-making activities. A capital reduction of own shares embedded in an index security would put index member banks at a disadvantage to banks not represented in an index. Besides, the risk of such index trades is typically managed through banks’ trading books and, as such, is subject to market risk capital requirements. Overlaying an additional deduction risks overstating capital requirements.

11.4.9 Reciprocal Stakes in Unconsolidated Financial Companies

All holdings of common equity capital which form part of a reciprocal cross holding agreement with unconsolidated financial companies (including insurance entities) or are investments in affiliated institutions (e.g., sister companies) are deducted in full from common equity capital on a corresponding basis.

11.4.10 Less than 10% Stakes in Unconsolidated Financial Companies

The regulatory adjustment described in this section applies to investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation and where the bank does not own more than 10% of the issued common share capital of the entity. In addition:

• Investments include direct, indirect and synthetic holdings of capital instruments. Indirect holdings are exposures or parts of exposures that, if a direct holding loses its value, will result in a loss to the bank substantially equivalent to the loss in value of the direct holding. For example, banks should look through holdings of index securities to determine their underlying holdings of capital. If banks find it operationally burdensome to look through and monitor their exact exposure to the capital of other financial institutions as a result of their holdings of index securities, national authorities may permit banks, subject to prior supervisory approval, to use a conservative estimate.
• Holdings in both the banking book and trading book are to be included. Capital includes common stock and all other types of cash and synthetic capital instruments (e.g., subordinated debt). It is the net long position that is to be included (i.e., the gross long position net of short positions in the same underlying exposure where the maturity of the short position either matches the maturity of the long position or has a residual maturity of at least one year).
• Underwriting positions held for five working days or less can be excluded. Underwriting positions held for longer than five working days must be included.
• If the capital instrument for the entity in which the bank has invested does not meet the criteria for common equity Tier 1, additional Tier 1, or Tier 2 capital of the bank, the capital is to be considered common shares for the purposes of this regulatory adjustment. If the investment is issued out of a regulated financial entity and not included in regulatory capital in the relevant sector of the financial entity, it is not required to be deducted.
• National discretion applies to allow banks, with prior supervisory approval, to exclude temporarily certain investments where these have been made in the context of resolving or providing financial assistance to reorganize a distressed institution.

If the total of all holdings listed above in aggregate exceeds 10% of the bank's common equity (after applying all other regulatory adjustments in full listed prior to this one), then the amount above 10% is required to be deducted, applying a corresponding deduction approach. The same reasoning is followed to compute the deduction for Tier 1 capital and total capital by summing the total holdings of Tier 1 capital and total capital respectively. This means the deduction should be applied to the same component of capital for which the capital would qualify if it was issued by the bank itself. Accordingly, the amount to be deducted from common equity should be calculated as the total of all holdings which in aggregate exceed 10% of the bank's common equity (as per above) multiplied by the common equity holdings as a percentage of the total capital holdings. This would result in a common equity deduction which corresponds to the proportion of total capital holdings held in common equity. Similarly, the amount to be deducted from additional Tier 1 capital should be calculated as the total of all holdings which in aggregate exceed 10% of the bank's common equity (as per above) multiplied by the additional Tier 1 capital holdings as a percentage of the total capital holdings. The amount to be deducted from Tier 2 capital should be calculated as the total of all holdings which in aggregate exceed 10% of the bank's common equity (as per above) multiplied by the Tier 2 capital holdings as a percentage of the total capital holdings.

If, under the corresponding deduction approach, a bank is required to make a deduction from a particular tier of capital and it does not have enough of that tier of capital to satisfy that deduction, the shortfall will be deducted from the next higher tier of capital (e.g., if a bank does not have enough additional Tier 1 capital to satisfy the deduction, the shortfall will be deducted from common equity Tier 1).

Amounts below the threshold, which are not deducted, are risk weighted. Thus, instruments in the trading book are treated as per the market risk rules and instruments in the banking book should be treated as per the internal ratings-based approach or the standardized approach (as applicable). For the application of risk weighting the amount of the holdings must be allocated on a pro rata basis between those below and those above the threshold.

11.4.11 Significant Stakes in Unconsolidated Financial Companies

Banks use equity investments in other financial institutions to expand internationally, diversify their exposure to domestic markets and leverage local market expertise without the strategic and operational risks associated with acquisitions or building their own infrastructure in an unfamiliar market. Basel III allows a limited recognition of investments in financial sector entities, including insurance entities, which are outside the regulatory scope of consolidation to be deducted under certain conditions, to avoid double counting of capital. Full deduction of minority stakes in other financial institutions would have been overly punitive as it would have meant that these exposures had zero value in stressed going and gone-concern situations. Like any other investment, minority investments in other financial institutions can be sold to raise equity in a stressed scenario.

The regulatory adjustment described in this section applies to investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation where the bank owns more than 10% of the issued common share capital of the issuing entity or where the entity is an affiliate of the bank. Investments in entities that are outside the scope of regulatory consolidation refer to investments in entities that have not been consolidated at all or have not been consolidated in such a way as to result in their assets being included in the calculation of consolidated risk-weighted assets of the group. An affiliate of a bank is defined as a company that controls, or is controlled by, or is under common control with, the bank. Control of a company is defined as (1) ownership, control, or holding with power to vote 20% or more of a class of voting securities of the company; or (2) consolidation of the company for financial reporting purposes. In addition:

• Investments include direct, indirect and synthetic holdings of capital instruments. For example, banks should look through holdings of index securities to determine their underlying holdings of capital. If banks find it operationally burdensome to look through and monitor their exact exposure to the capital of other financial institutions as a result of their holdings of index securities, national authorities may permit banks, subject to prior supervisory approval, to use a conservative estimate.
• Holdings in both the banking book and trading book are to be included. Capital includes common stock and all other types of cash and synthetic capital instruments (e.g., subordinated debt). It is the net long position that is to be included (i.e., the gross long position net of short positions in the same underlying exposure where the maturity of the short position either matches the maturity of the long position or has a residual maturity of at least one year).
• Underwriting positions held for five working days or less can be excluded. Underwriting positions held for longer than five working days must be included.
• If the capital instrument of the entity in which the bank has invested does not meet the criteria for common equity Tier 1, additional Tier 1, or Tier 2 capital of the bank, the capital is to be considered common shares for the purposes of this regulatory adjustment. If the investment is issued out of a regulated financial entity and not included in regulatory capital in the relevant sector of the financial entity, it is not required to be deducted.
• National discretion applies to allow banks, with prior supervisory approval, to exclude temporarily certain investments where these have been made in the context of resolving or providing financial assistance to reorganize a distressed institution.

All investments included above that are not common shares must be fully deducted following a corresponding deduction approach. This means the deduction should be applied to the same tier of capital for which the capital would qualify if it was issued by the bank itself. If the bank is required to make a deduction from a particular tier of capital and it does not have enough of that tier of capital to satisfy that deduction, the shortfall will be deducted from the next higher tier of capital (e.g., if a bank does not have enough additional Tier 1 capital to satisfy the deduction, the shortfall will be deducted from common equity Tier 1).

Investments included above that are common shares will be subject to the threshold treatment described in the next section.

In my opinion, the need to look through indirect positions embedded in index securities is flawed. Many banks actively trade equities and index securities as part of their market-making activities, not to make strategic investments in other financial institutions. Furthermore, holdings of index positions do not create regulatory capital in a financial institution which is a member of the index. Hence, a capital deduction is not justified. Furthermore, a capital deduction of certain portions of an index product, which are hedged by a corresponding short position, results in an asymmetric risk position between the decomposed index product (capital deduction) and the hedge (RWA on that part of the hedge which refers to the capital deduction of the underlying asset). As a result, a fully hedged position is treated with a capital deduction and RWAs. Without the capital deduction, the net RWA on the fully hedged position is zero.

Also, there is no consistency with the treatment of unrealized gains on those participations. An increase in the market value of a participation in a financial entity may lead to a larger reduction from common equity.

11.4.12 Combined Deduction of Significant Investments in Unconsolidated Financial Entities, MSRs and DTAs

Instead of a full deduction, the following items may each receive limited recognition (see Figure 11.7) when calculating the common equity component of Tier 1, with recognition capped at 10% of the bank's common equity component (after applying all previous deductions):

• Significant investments (i.e., more than 10% of the issued share capital) in the common shares of unconsolidated financial institutions (including insurance activities).
• Mortgage servicing rights.
• DTAs arising from timing differences.

On 1 January 2013, a bank must deduct the amount by which the aggregate of the three items above exceeds 15% of its common equity component of Tier 1 (calculated prior to the deduction of these items but after application of all other regulatory adjustments applied in the calculation of common equity Tier 1). As of 1 January 2018, the calculation of the 15% limit will be subject to the following treatment: the amount of the three items that remains recognized after the application of all regulatory adjustments must not exceed 15% of the common equity Tier 1 capital, calculated after all regulatory adjustments.

The amount of the three items not deducted in the calculation of common equity Tier 1 will be risk weighted at 250%.

Mortgage Servicing Rights

Mortgage servicing rights are financial assets associated with a set of legal documents. There is an active market for mortgage servicing and sale is possible on both a going and gone-concern basis. These assets are typically hedged for prepayment risk. Payments to mortgage services are the highest priority claim on interest distributions in a securitization structure.

11.4.13 Basel II 50/50 Deductions

In relation to certain assets, Basel II required deductions to be made 50% from Tier 1 and 50% from Tier 2, or gave banks the option of applying a 1250% risk weight. The 50:50 deductions complicated the definition of capital, particularly in the application of the limits. Basel III requires that these assets receive a 1250% risk weight. These assets include:

• Certain securitization exposures.
• Certain equity exposures under the PD/LGD approach.
• Non-payment/delivery on non-DvP and non-PvP transactions.
• Significant investments in commercial entities.

11.5 OTHER CAPITAL BUFFERS

The holding of capital buffers over regulatory minimum levels is a necessary and standard practice of well-run banks. Outside periods of stress, Basel III requires banks to hold buffers of capital above the regulatory minima. Basel III considers two types of capital buffer, the capital conservation buffer and the countercyclical buffer.

11.5.1 Capital Conservation Buffer

The capital conservation buffer is designed to provide banks with an extra source of capital that can be drawn on during times of financial and economic stress. The philosophy behind the capital conservation buffer is to create a capital cushion during “good times” that can absorb shocks in periods of stress.

The target capital conservation buffer is at 2.5% of RWAs and must consist of common equity Tier 1 instruments. While banks are allowed to draw on this buffer during periods of stress, the more of the buffer that is drawn by a bank (i.e., as the buffer is depleted), the greater the restrictions that will be imposed on it in respect of earnings distributions such as dividends, share buybacks and discretionary employee bonuses. Basel III imposes minimum capital conservation ratios for entering the range, as shown in the table below. For example, a bank with a CET1 capital ratio in the range of 5.125–5.75% is required to conserve 80% of its earnings in the subsequent financial year (i.e., pay out no more than 20% in terms of dividends, share buybacks and discretionary bonus payments). If the bank wants to make payments in excess of the constraints imposed by this regime, it would have the option of raising capital in the private sector equal to the amount above the constraint which it wishes to distribute. This would be discussed with the bank's supervisor as part of the capital planning process.

The common equity Tier 1 ratio includes amounts used to meet the 4.5% minimum common equity Tier 1 requirement, but excludes any additional common equity Tier 1 needed to meet the 6% Tier 1 and 8% total capital requirements. For example, a bank with 8% common equity Tier 1 and no additional Tier 1 or Tier 2 capital would meet all minimum capital requirements, but would have a zero conservation buffer and therefore be subject to the 100% constraint on capital distributions.

Common equity Tier 1 ratio	Minimum capital conservation ratio
4.5–5.125%	100%
>5.125–5.75%	80%
>5.75–6.375%	60%
>6.375–7.0%	40%
>7.0%	0%

Set out below are a number of other key aspects of the requirements.

• Elements subject to the restriction on distributions: Items considered to be distributions include dividends and share buybacks, discretionary payments on other Tier 1 capital instruments and discretionary bonus payments to staff. Payments that do not result in a depletion of common equity Tier 1, which may for example include certain scrip dividends, are not considered distributions.
• Definition of earnings: Earnings are defined as distributable profits calculated prior to the deduction of elements subject to the restriction on distributions. Earnings are calculated after the tax which would have been reported had none of the distributable items been paid. As such, any tax impacts of making such distributions are reversed out. Where a bank does not have positive earnings and has a common equity Tier 1 ratio less than 7%, it would be restricted from making positive net distributions.
• Solo or consolidated application: The framework should be applied at the consolidated level, i.e., restrictions would be imposed on distributions out of the consolidated group. National supervisors would have the option of applying the regime at the solo level to conserve resources in specific parts of the group.
• Additional supervisory discretion: Although the buffer must be capable of being drawn down, banks should not choose in normal times to operate in the buffer range simply to compete with other banks and win market share. To ensure that this does not happen, supervisors have the additional discretion to impose time limits on banks operating within the buffer range on a case-by-case basis. In any case, supervisors should ensure that the capital plans of banks seek to rebuild buffers over an appropriate timeframe.

The capital conservation buffer will be phased in between 1 January 2016 and year-end 2018, becoming fully effective on 1 January 2019. It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625%, to reach its final level of 2.5% of RWAs on 1 January 2019.

11.5.2 Countercyclical Buffer

In addition to the capital conservation buffer described above, Basel III also requires a countercyclical capital buffer, a range of 0–2.5% of common equity or other fully loss absorbing capital, which is implemented in accordance with national circumstances. Typically, downturns in the banking sector are preceded by periods of excessive growth. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system-wide build-up of risk. The buffer can be drawn on by the banks during these periods of excess credit.

Basel III recommends that countries experiencing excessive credit growth consider accelerating the build-up of the capital conservation buffer and the countercyclical buffer. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.

The countercyclical buffer regime consists of the following elements:

• National authorities will monitor credit growth and other indicators that may signal a build-up of system-wide risk and make assessments of whether credit growth is excessive and is leading to the build-up of system-wide risk. Based on this assessment they will put in place a countercyclical buffer requirement when circumstances warrant. This requirement will be released when system-wide risk crystallizes or dissipates.
• Internationally active banks will look at the geographic location of their private sector credit exposures and calculate their bank-specific countercyclical capital buffer requirement as a weighted average of the requirements that are being applied in jurisdictions to which they have credit exposures.
• The countercyclical buffer requirement to which a bank is subject will extend the size of the capital conservation buffer. Banks will be subject to restrictions on distributions if they do not meet the requirement.

Each Basel Committee member jurisdiction will identify an authority with the responsibility to make decisions on the size of the countercyclical capital buffer. If the relevant national authority judges a period of excess credit growth to be leading to the build-up of system-wide risk, they will consider, together with any other macroprudential tools at their disposal, putting in place a countercyclical buffer requirement. This will vary between zero and 2.5% of risk-weighted assets, depending on their judgment as to the extent of the build-up of system-wide risk.

Banks will be subject to a countercyclical buffer that varies between zero and 2.5% to total risk-weighted assets. The buffer that will apply to each bank will reflect the geographic composition of its portfolio of credit exposures. Banks must meet this buffer with common equity Tier 1 or other fully loss absorbing capital or be subject to the restrictions on distributions. As with the capital conservation buffer, the framework is applied at the consolidated level. In addition, national supervisors may apply the regime at the solo level to conserve resources in specific parts of the group. The table below shows the minimum capital conservation ratios a bank must meet at various levels of the common equity Tier 1 capital. The common equity Tier 1 ratio includes amounts used to meet the 4.5% minimum common equity Tier 1 requirement, but excludes any additional common equity Tier 1 needed to meet the 6% Tier 1 and 8% total capital requirements. For example, a bank with 8% common equity Tier 1 and no additional Tier 1 or Tier 2 capital would meet all minimum capital requirements, but would have a zero countercyclical buffer and therefore be subject to the 100% constraint on capital distributions.

Common equity Tier 1 ratio	Minimum capital conservation ratio (% of earnings)
Within 1st quartile of buffer	100%
Within 2nd quartile of buffer	80%
Within 3rd quartile of buffer	60%
Within 4th quartile of buffer	40%
Above top of buffer	0%

11.6 TRANSITIONAL ARRANGEMENTS

While applicable from 1 January 2013, Basel III would be implemented with a long phase-in period.

11.6.1 Transitional Period

Regarding regulatory deductions, the Basel Committee introduced a transitional period between 2014 and 2018 before the full deductibility. The regulatory adjustments would be fully deducted from common equity by 1 January 2018.

Phase-in arrangements (all dates are as of 1 January):

The regulatory adjustments (i.e., deductions and prudential filters), including amounts above the aggregate 15% limit for investments in financial institutions, mortgage servicing rights and deferred tax assets from timing differences, would be fully deducted from common equity by 1 January 2018. In particular, the regulatory adjustments will begin at 20% of the required deductions from common equity on 1 January 2014, 40% on 1 January 2015, 60% on 1 January 2016, 80% on 1 January 2017, and reach 100% on 1 January 2018. During this transition period, the remainder not deducted from common equity will continue to be subject to existing national treatments.

11.6.2 Capital Instruments Failing Criteria for Eligibility in Capital

Capital instruments that fail to meet the criteria for eligibility in equity capital, and that have been issued before July 2010.

Existing public sector capital injections will be grandfathered until 1 January 2018. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a 10-year horizon beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year, as shown in the table below. In addition, instruments with an incentive to be redeemed will be phased out at their effective maturity date.

All capital instruments that do not meet the criteria for inclusion in common equity Tier 1 will be excluded from common equity Tier 1 beginning 2013. However, instruments meeting the following three conditions will be phased out over a period until 2022:

• They are issued by a non-joint stock company.
• They are treated as equity under the prevailing accounting standards.
• They receive unlimited recognition as part of Tier 1 capital under current national banking law.

11.7 LEVERAGE RATIO

One of the causes of the 2007–2008 financial crisis was the build-up of excessive balance sheet leverage in the banking system, despite meeting their capital requirements. It was only when the banks were forced by market conditions to reduce their leverage that the financial system increased the downward pressure on asset prices. This exacerbated the decline in bank capital. To prevent the excessive deleveraging from happening again, Basel III introduced a leverage ratio. This ratio was designed to put a cap on the build-up of leverage in the banking system as well as introducing additional safeguards against model risk and measurement errors. The leverage ratio is a simple, transparent, non-risk-weighted measure, calculated as an average over the quarter:

A key point is the calculation of restated balance sheet assets (referred to as “exposure” by Basel III). It should generally follow the accounting measure of the exposure.

• For on-balance sheet, non-derivative exposures are net of specific provisions and valuation adjustments (e.g., credit valuation adjustments).
• Physical or financial collateral, guarantees or credit risk mitigation purchased is not allowed to reduce on-balance sheet exposures.
• Netting of loans and deposits is not allowed.

On-balance sheet assets are included using the accounting recognition. In addition:

• Repurchase agreements, reverse repurchase agreements, security lending and borrowing, and margin lending transactions, where the value of the transactions depends on the market valuations and the transactions are often subject to margin agreements, are included using their accounting measure of exposure and the regulatory netting rules based on the Basel II framework (except the rules for cross-product netting).
• Derivatives, including credit derivatives, are included using (i) their accounting measure of exposure, plus (ii) an add-on for potential future exposure calculated according to the current exposure method as identified in the Basel II framework (this ensures that all derivatives are converted in a consistent manner to a “loan equivalent” amount) and (iii) the regulatory netting rules based on the Basel II framework (except the rules for cross-product netting).
• For off-balance sheet (OBS) items, banks use uniform 100% credit conversion factors (CCFs), except a 10% CCF to be applied to unconditionally cancellable OBS commitments. This requirement puts OBS items (e.g., liquidity facilities, unconditionally cancellable commitments, direct credit substitutes, acceptances, standby letters of credit, trade letters of credit, failed transactions and unsettled securities) in the same position as loans. In my view this requirement is overly conservative as significant amounts of off-balance sheet exposures are never drawn and indeed some are arguably not commitments, if unconditionally cancellable.
• Deductions from the measure of Tier 1 capital must also be deducted from balance sheet asset calculations.

The Basel Committee agreed to test a minimum Tier 1 leverage ratio of 3% during the period from 1 January 2013 until 1 January 2017 (“the parallel run period”). Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

11.8 LIQUIDITY COVERAGE RATIO

Banks experienced severe liquidity problems during the 2007–2008 financial crisis, despite meeting their capital requirements. Basel III requires banks to hold a pool of highly liquid assets which is sufficient to maintain the forecasted net cash outflows over a 30-day period, under stress assumptions (see Figure 11.8). This requirement tries to improve a bank's resilience against potential short-term liquidity shortages. The ratio is calculated as follows:

Assets are considered “highly liquid” if they can be quickly converted into cash at almost no loss.

All assets in the liquidity pool must be managed as part of that pool and are subject to operational requirements. The assets must be available for the treasurer of the bank, unencumbered and freely available to group entities (see Basel III framework for a more detailed calculation of the liquidity coverage items).

Stock of highly liquid assets	Factor
Level 1 assets: Cash, central bank deposits, public sector, supranational securities with active repo market and with 0% risk weighting*	100%
Level 2 assets: Sovereign, central bank and PPE assets qualifying for 20% risk weighting. High-quality corporate and covered bonds with rating ≥ AA–	85%
*Including domestic sovereign debt for non-0% risk-weighted sovereigns, issued in foreign currency, to the extent that this currency matches the currency needs of the bank's operations in that jurisdiction.

Therefore, equities are not part of the high-quality liquid assets.

The denominator, “net cash outflows over a 30-day period”, is calculated as follows:

The list to calculate the cash outflows over a 30-day time period is quite extensive and I would prefer the reader to refer to the actual Basel III document.

The next table briefly summarizes the items to calculate the cash inflows and their associated available stable funding (ASF) factors.

Cash inflows over a 30-day stress period	Factor
Reverse repos and securities borrowing, with Level 1 assets as collateral	0%
Reverse repos and securities borrowing, with Level 2 assets as collateral	15%
Reverse repos and securities borrowing, with Level 3 assets as collateral	100%
Credit or liquidity facilities	0%
Operational deposits held at other financial institutions	0%
Deposits held at centralized institution of a network of cooperative banks	0% of the qualyifying deposits with the centralized institution
Amounts receivable from retail counterparties	50%
Amounts receivable from non-financial wholesale counterparties, from transactions other than those listed above	50%
Amounts receivable from financial institutions, from transactions other than those listed above	100%
Net derivative receivables	100%
Other contractual inflows (e.g., contractual payments from derivatives)	National supervisor discretion

The liquidity ratio would be effective in 2015 after an observation period.

11.9 NET STABLE FUNDING RATIO

Basel III requires a minimum amount of funding that is expected to be stable over a one-year time horizon based on liquidity risk factors assigned to assets and off-balance sheet exposures. This requirement provides incentives for banks to use stable sources to fund banks’ balance sheets, off-balance sheet exposures and capital markets activities, therefore reducing the refinancing risks of a bank. The net stable funding ratio (NSFR) establishes the minimum amount of stable funding based on the liquidity characteristics of a bank's assets and activities over a more than one-year horizon. In other words, a bank must hold at least an amount of long-term (i.e., more than one year) funding equal to its long-term (i.e., more than one year) assets. The ratio is calculated as follows:

The numerator is calculated by summing a bank's liabilities, weighted by their degree of permanence. The next table briefly summarizes the specific liabilities and their associated required stable funding (RSF) factors.

Available amount of stable funding		Factor
Equity	Tier 1 and Tier 2 capital, other preferred stock and capital > 1 year	100%
Long-term funding	Long-term debt and deposits ≥ 1 year	100%
Stable deposits < 1 year	Retail customers and SMEs, according to LCR definition	90%
Less stable deposits < 1 year	Retail customers and SMEs, according to LCR definition	80%
Wholesale funding < 1 year	Non-financial corporates, central banks, supranationals and PSEs	50%
Other	All other liabilities and equity not included above	0%

Basel III considers that short-term deposits are rapidly gained, likely through high rates offered, and are treated as “less stable” by the guidelines. This is especially the case with wholesale deposits.

The denominator is calculated by summing a bank's assets, weighted by their degree of permanence. The next table briefly summarizes the specific assets and their associated RSF factors.

Required amount of stable funding		Factor
Fully liquid	Cash, short-term unsecured liquid instruments < 1 year, securities < 1 year, matched book positions (securities with exactly offsetting reverse repo), non-renewable loans to financials < 1 year	0%
Highly liquid	Sovereign, central bank, supranational debt with 0% risk weighting under Basel II standardized approach	5%
Very liquid	Unencumbered senior corporate and covered bonds ≥ 1 year, rated at least AA– Sovereign, central bank and PSE debt ≥ 1 year with 20% risk weighting	20%
Liquid	Unencumbered senior corporate and covered bonds ≥ 1 year, rated from A+ to A– Unencumbered listed equity securities Gold Corporate, sovereign, central bank and PSE loans < 1 year	50%
Less liquid	Unencumbered residential mortgages and other unencumbered loans (excluding loans to financial institutions ≥ 1 year with ≤ 35% risk weighting under Basel II standardized approach)	65%
Almost illiquid	Other retail and SME loans < 1 year	85%
Illiquid	All other assets	100%
Off-balance sheet positions	Undrawn amount of committed credit lines, liquidity facilities	5%
	Other contingent obligations	National supervisor discretion

The liquidity ratio will be effective in 2018 after an observation period.

11.10 CASE STUDY: CALCULATION OF MINORITY INTERESTS

In this section I will cover an example of how capital related to minority interests is allocated to the capital of the consolidated bank. This example is highly simplified, but provides an understanding of how a subsidiary contributes to the regulatory consolidated capital. Let us assume that Bank P is the parent bank, and that it has a sole subsidiary called Bank S. Figure 11.9 highlights the stand-alone balance sheets of each bank and the consolidated balance sheet (CET1: common equity Tier 1, AT1: additional Tier 1 and T2: Tier 2).

Let us assume that Bank S's RWAs are 400. The first step is to calculate the minimum capital requirements for Bank S, including the capital conservation buffer. Bank S's surplus capital has been calculated for description purposes only:

The second step is to calculate the amount of the capital issued by Bank S to third parties that is included in the consolidated capital:

Thus, if we look at Bank S's total Tier 1 capital, we can see that only the minimum requirement attributed to third parties was included in the consolidated total Tier 1 capital (see Figure 11.10). In other words, the surplus total Tier 1 capital issued to third parties was excluded from consolidated total Tier 1 capital.

The third step is to calculate the components of Bank S's capital to be included in the consolidated regulatory capital [all data taken directly from column (h) in the previous table]:

The last step is to calculate the consolidated regulatory capital:

11.11 CASE STUDY: CREATING MINORITY INTERESTS

An interesting way to create capital under Basel II was to add minority interests that were not deducted from common equity Tier 1 capital. Although feasible under Basel II, the transaction described herein does not work under Basel III. However, I have included it to show an interesting strategic equity technique (see Figure 11.11).

Let us assume that a bank called SmallBank has a stake in a corporate, called ABC, worth EUR 500 million. The transaction is implemented along the following steps:

The strategy just covered is a very preliminary version of the transaction. It faces the following drawbacks:

Figure 11.12 illustrates the consolidated balance sheet of SmallBank after implementing the transaction, ignoring the fair valuing of the derivative. The transaction generated EUR 200 million of minority interests.

11.12 CASE STUDY: REDUCING RISK WEIGHTING

Let us assume that SmallBank has an asset in the banking book that has a high risk weighting (i.e., it highly consumes capital) that is worth EUR 200 million. The transaction is implemented along the following steps (see Figure 11.13):

At maturity of the derivative, the flows would be the following:

What if SmallBank does not exercise its call option? The SPV would then sell the asset onto the market. Let us assume that the proceeds of the disposal are EUR 150 million. The SPV would then redeem the bond, paying Gigabank EUR 150 million. Simultaneously, under the derivative SmallBank would pay to Gigabank EUR 50 million, corresponding to the difference between the bond EUR 200 million face value and its EUR 150 million market value.

As a result, SmallBank has switched an asset held in its banking book for a derivative held in its trading book. If the capital consumption of the derivative is much lower than that of the asset, SmallBank would maintain the same economic exposure to the asset but with a much lower risk weighting. The major drawback of this solution is that the derivative is marked-to-market through P&L, potentially increasing the volatility of SmallBank's P&L statement.

11.13 CASE STUDY: RELEASING COMMON EQUITY

Let us assume that in May 20X1 SmallBank has 30 million treasury shares, representing 2.4% of its share capital. These shares will be distributed to shareholders as a scrip dividend in July 20X1. The average acquisition price of these shares is EUR 6.00, therefore deducting the owners’ equity section of SmallBank by EUR 180 million (= 30 million × 6.00). Let us assume further that SmallBank shares are trading at EUR 7.00. Thus, the shares have a market value of EUR 210 million (= 30 million × 7.00). The transaction is implemented along the following steps (see Figure 11.14):

At the end of June 20X1, SmallBank reported its regulatory capital ratios. Ignoring the change in fair value of the collar, SmallBank would have the following impacts in its common equity capital:

• The sale of the treasury shares would release EUR 210 million capital.
• The tax liability would reduce EUR 9 million from capital.

As a result, SmallBank has released EUR 201 million (= 210 million – 9 million) common equity capital.

At expiry, prior to July's dividend distribution, there are three scenarios:

• SmallBank's share price is greater than, or equal to, EUR 7.25. SmallBank exercises the call, receiving 30 million own shares and paying EUR 217.5 million (= 30 million × 7.25).
• SmallBank's share price is greater than EUR 6.75 and lower than EUR 7.25. Neither option is exercised. SmallBank buys 30 million own shares in the market.
• SmallBank's share price is lower than, or equal to, EUR 6.75. Gigabank exercises the put option, giving SmallBank 30 million shares and receiving EUR 202.5 million (= 30 million × 6.75).

Alternative with a Deep-in-the-money Call

The major drawback of the previous strategy was the P&L impact due to changes in the fair value of the collar. An alternative strategy uses a deep-in-the-money call rather than a collar. For example, let us assume that SmallBank bought a call with the following terms:

• Underlying: SmallBank common stock
• Number of options: 30 million
• Settlement: Physical settlement only
• Maturity: July 20X1 (just prior to the dividend distribution date), spread over several dates to reduce the gamma risk upon expiry
• SmallBank buys a call with strike EUR 5.60 (i.e., 80% of the then prevailing share price)
• Premium: EUR 1.54 (i.e., 22% of the then prevailing share price) per share, or a total of EUR 46.2 million
• Delta of the call: 90% (i.e., 27 million shares)

As the call could only be settled by SmallBank receiving the underlying shares, it was treated as an equity instrument, and therefore, no fair valuing was required after inception. The EUR 46.2 million premium was recognized in equity, reducing the amount of common equity capital. At the end of June 20X1, SmallBank reported its regulatory capital ratios. The transaction had the following impacts in its common equity capital:

• The sale of the treasury shares released EUR 210 million capital.
• The tax liability reduced capital by EUR 9 million.
• The purchase of the call reduced capital by EUR 46.2 million.

As a result, SmallBank released EUR 154.8 million (= 210 million – 9 million – 46.2 million) common equity capital by implementing this transaction.

11.14 CASE STUDY: REDUCING AN UNCONSOLIDATED FINANCIAL STAKE

Let us assume that SmallBank has a 13% stake in another bank, called RegionalBank. Under Basel III rules, SmallBank is heavily penalized if it holds a stake greater than 10% of the issued capital of RegionalBank. 3% of RegionalBank represents EUR 400 million. A po-tential transaction can be implemented along the following steps (see Figure 11.15):

The main drawbacks of the transaction are as follows:

11.15 CASE STUDY: COMMERZBANK'S CAPITAL STRUCTURE ENHANCEMENT WITH CREDIT SUISSE

On 13 January 2011, Commerzbank implemented a transaction to enhance its common equity Tier 1 capital. Under the new Basel III requirements, hybrid instruments could not contribute to a bank's common equity Tier 1 capital. Commerzbank exchanged hybrid instruments for cash and simultaneously new shares were issued, resulting in contribution in kind. The transaction was executed with Credit Suisse's collaboration and it comprised the following steps (see Figure 11.16):

The transaction equalled a contribution in kind of a portion of the bank's TPS in exchange for the issue of new shares. Under Basel III the TPS would be eligible for additional Tier 1 capital, but not for common equity Tier 1 capital. The proceeds of the placement of the new shares determined the amount of TPS purchasable by the bank. As a result, a maximum of EUR 625 million of TPS was purchased. The allocation of the funds between the TPS was determined in accordance with the order of priority outlined in the table. TPS with the same rank in the order of priority were pro-rated equally.

The transaction had no significant impact on Commerzbank's Tier 1 capital ratio, but it resulted in an increase of its common equity Tier 1 capital. Let us assume that all the first two types of TPS were tendered for EUR 314 million (= 170 million + 144 million), and that the remaining EUR 311 million amount was distributed pro-rata to the remaining TPS, to fill the EUR 625 million target:

The effect on common equity Tier 1 capital was an increase of EUR 1,057 million (= 625 million + 432 million), as follows:

• By issuing new shares, Commerzbank increased its common equity Tier 1 capital by EUR 625 million, the issue proceeds.
• By buying the TPS at a discount to their issue price, Commerzbank booked a gain of EUR 432 million.

The effect on additional Tier 1 capital was a reduction of EUR 1,004 million (see previous table). As a result, Tier 1 capital was almost unchanged, increasing by only 53 million (= 1,057 million – 1,004 million).