An introduction to Basel III - its

consequences for lending

Related services
Banking and finance
Introduction
What do the Basel frameworks address?
Basel III
The effect of Basel III on the costs of lending
Introduction
On 12th September, 21, the Basel !ommittee on Banking Super"ision agreed on detailed
measures to strengthen the regulation, super"ision and risk management of the banking
sector# This package of measures, known as Basel III, supplements the e$isting International
!on"ergence of !apital %easurement &ocument 'Basel II( which came into effect across the
)uropean *nion, and man+ other ,urisdictions, in 2-#
It is e$pected that Basel III will be implemented progressi"el+ across the )uropean *nion
'and elsewhere( between 21. and 21/# The implementation will re0uire a series of
directi"es and regulations to be introduced at both !ommunit+ and national le"el#
One of the main outcomes of Basel III will be a significant rise in the banking industr+1s
capital re0uirements 'and therefore, potentiall+, borrowing costs(# B+ wa+ of e$ample, some
estimates put the additional capital re0uired b+ the )uropean banking industr+ to compl+ with
Basel III at around 2 billion euros, reducing return on e0uit+ b+ up to . per
cent '%c3inse+ 21(#
This shortfall will not affect trading, corporate and retail banking e0uall+ and institutions will
presumabl+ reorganise to mitigate the cost# 4owe"er, some of the costs will be shared with
bank clients#
In this introductor+ Briefing, we recap on the e$isting Basel II framework and summarise the
main Basel III changes which gi"e rise to the increased capital re0uirement# We also
consider whether standard lending documentation allows this increased cost to be passed
on to borrowers#
We will shortl+ be publishing a more detailed briefing on the effect of Basel III on the banking
industr+#
What do the Basel frameworks address?
Capital Adequacy
The aim of Basel III is maintain banks1 sol"enc+ b+ strengthening the regulation, super"ision
and risk management of that sector# It does this b+ building on, rather than replacing, the
e$isting Basel II# In summar+, the Basel frameworks impose capital ade0uac+ re0uirements
which limit the amount of assets 'including loans( that a bank ma+ ha"e b+ reference to its
capital, so helping to ensure that losses 'including from non5performing loans( ma+ be
absorbed without pre,udicing the rights of creditors and depositors# There are two sides to
the e0uation#
On the capital side, banks must ha"e a certain amount and t+pe of capital which is
categorised based on its abilit+ to absorb losses6
a# Tier 1 is the best 0ualit+ capital 'e#g# common shares or certain 7inno"ati"e8
instruments which ha"e e0uit+5like characteristics but cost less to raise(9
b# Tier 2 'e#g# preference shares(9 and
c# Tier . which is the lowest 0ualit+ capital 'e#g# subordinated debt(#
On the asset side, a bank must calculate the "alue of all of the e$posures that it faces and
then appl+ a risk weighting depending on the t+pe of asset# In simple terms, the Basel
frameworks re0uire that a certain amount of the bank1s regulator+ capital must be allocated
'at least notionall+( to e"er+ loan ad"anced, or commitment made, b+ that bank# That
allocation therefore restricts the amount of business that a bank ma+ enter into or forces it to
raise fresh capital# Therefore, the capital ade0uac+ re0uirements of an+ loan carr+ an implicit
cost to the bank ad"ancing it# The capital ade0uac+ cost of a loan depends on the amount of
capital b+ which it has to be backed# This amount is often referred to as the capital charge#
The 8 per cent ormula
Since 1//2 'when Basel I was first implemented(, the minimum re0uirement for the e0uation
described abo"e is that a bank should ha"e total regulator+ capital 'i#e# Tier 1, Tier 2 and Tier
.( e0ual to at least - per cent of its risk5weighted assets ':W;(# - per cent is a minimum
figure6 it is possible that a bank1s regulator ma+ re0uire a higher percentage to be applied#
Basel I and Basel II
The original Basel ;ccord was relati"el+ rudimentar+ in the wa+ it allocated capital to risk#
Basel II adopted a different approach and sought to match the amount of capital re0uired to
be held b+ an institution more closel+ to the e$posures that it faces# Within that guiding idea,
the main changes introduced b+ Basel II include6
a# a more sophisticated methodolog+ for risk5weighting loans ad"anced b+ an institution
depending on6
i# the t+pe of counterpart+ 'e#g# a so"ereign as opposed to a corporate(9
ii# the counterpart+1s credit rating9 and
iii# the t+pe of risk mitigants in place 'e#g# collateral or guarantees(9
b# special regimes to deal with areas such as pro,ect or ob,ect finance and commodities
finance9
c# alternati"e calculation methods 'the internal ratings based model( to allow
sophisticated financial institutions to use, within the super"isor+ framework, their own
models to e"aluate e$posures9 and
d# an emphasis on super"isor+ re"iew '<illar 2 in Basel II terminolog+( and disclosure
'<illar .(# The intention being that the capital re0uirements set in Basel II are
minimum le"els which will be fine tuned through dialogue with the super"isors and
disclosure#
One conse0uence of the introduction of Basel II is that the capital charge for an+ loan could
"ar+ during its life# =luctuations in the credit5rating of the borrower or the loan5to5 "alue ratio
of eligible collateral would affect the cost to the lenders of keeping the facilit+ open, as would
changes in law affecting the enforceabilit+ of the collateral# Similarl+, a change in the
regulator+ regime could also impact the risk weighting gi"en to a loan and so to its capital
charge# The 0uestion in each case is, if the capital charge for a loan changes, who should
bear the cost of the increase or take the benefit of a reduction? We deal further with this
0uestion below#
>Back to top
Basel III
;s is widel+ known, Basel III is a response b+ regulators to percei"ed weaknesses in the
e$isting Basel II framework# Whilst Basel III has a wide remit 5 including e$tensi"e, new
re0uirements for securitisations and trading 5 this note focuses on the main capital, le"erage
and li0uidit+ re0uirements#
Basic capital requirements - Tier !" # and $
The basic - per cent minimum ratio of capital to :W; remains under Basel III# 4owe"er,
whilst Tier 1 capital under Basel II could be constructed of both common e0uit+ 'e#g# ordinar+
shares in )ngland( and other capital instruments, common e0uit+ performed best in
absorbing losses throughout the crisis# The Basel !ommittee has focused on this and notes
that the minimum re0uirement currentl+ is that banks issue common e0uit+ e0ual to 2 per
cent of :W;# Basel III proposes to increase this re0uirement to ?#@ per cent of :W;, to be
phased in b+ 1 Aanuar+ 21@ at the latest#
Basel III also introduces stricter regulator+ deductions 'e#g# for minorit+ interests( for
calculating Tier 1 capital and tighter re0uirements for capital instruments which are not
common e0uit+ to form part of Tier 1 capital# On the second point, the Basel !ommittee
acknowledges that certain inno"ati"e features ha"e been introduced to Tier 1 capital o"er the
+ears 'e#g# margin step5ups( to lower the cost of raising Tier 1 capital but has stated that
those features are to be phased out#
Tier 2 capital is also to be simplified and Tier . capital is to be phased out#
Capital %uffers
In addition to strengthening Tier 1 capital, two capital buffers will be added 5 a capital
conser"ation buffer e0ual to 2#@ per cent of :W; and a counterc+clical buffer of an additional
per cent to 2#@ per cent of :W;# Both buffers must be raised through common e0uit+#
The broad basis for this proposal comes from the obser"ation that some institutions with
hea"+ losses and depleted capital from the crisis still made distributions to shareholders# The
Basel !ommittee argues that this should not occur and that banks who suffer losses should
rebuild their capital b+ retaining earnings and raising new capital# The guiding principle is to
shift the risk as much as possible from depositors to shareholders and emplo+ees of banks#
;s such, the buffers are not additional, minimum capital re0uirements# Instead, if an
institution does not ha"e the re0uired capital buffers, Basel III will restrict the institution1s
abilit+ to distribute earnings#
Of the two t+pes of buffer, the capital conser"ation buffer is intended to be large enough to
enable banks to maintain capital le"els abo"e the minimum re0uirement throughout a
significant sector5wide downturn# The counterc+clical buffer is an additional re0uirement
which will be implemented b+ national super"isors when there is e$cess credit growth in their
econom+, with the intention of dampening such credit growth#
The capital conser"ation buffer should be phased in b+ 1 Aanuar+ 21/ at the latest# The
counterc+clical buffer is still sub,ect to consultation but national super"isors are e$pected to
ha"e more discretion in implementation#
&e'erage ratio
In addition to increased risk5based capital re0uirements, Basel III introduces for the first time
a le"erage ratio# The intention is to constrain the build up of le"erage in the banking sector
with a simple metric# The current proposal b+ the Basel !ommittee is to test a le"erage ratio
set at . per cent of Tier 1 capital as part of the <illar 2 super"isor+ re"iew with a "iew to
migrating this to a <illar 1 re0uirement b+ 1 Aanuar+ 21-#
&iquidity ratios
&uring the crisis, a number of banks suffered from significant li0uidit+ problems and re0uired
unprecedented state support to continue operations# <art of this risk is to be addressed b+
impro"ed bank policies and o"ersight b+ board and senior management# It is also proposed
to introduce two standards for the li0uidit+ of bank assets#
The first standard is the Bi0uidit+ !o"erage :atio 'B!:( to ensure that banks ha"e sufficient
li0uidit+ to deal with se"ere market shocks# This re0uires a bank to hold sufficient high 0ualit+
li0uid assets that can be con"erted into cash to meet its cash outflows for a . da+ period in
a high stress scenario specified b+ super"isors# The li0uid assets are intended to ha"e a low
credit and market risk, be short duration and be issued in an acti"e and large market# The
stress scenario contemplated is based on a market5wide shock which leads to, amongst
other things, a three notch downgrade for the bank9 a run5off of a certain proportion of its
retail deposits9 and a loss of the bank1s access to unsecured wholesale funding#
The second standard is the Cet Stable =unding :atio 'CS=:( which is intended to promote
more medium and long5term funding of banks1 acti"ities# In summar+, it establishes a
minimum amount of stable funding based on the li0uidit+ characteristics of an institution1s
assets and acti"ities o"er a one +ear horiDon# Stable funding in this conte$t means capital,
preferred stock and debt with maturities of more than one +ear and that portion of deposits
with maturities of shorter than a +ear that would be e$pected to sta+ with the institution in a
stress scenario#
>Back to top
The effect of Basel III on the costs of lending
The combination of 'a( increased capital re0uirements, particularl+ in the common e0uit+
element of Tier 1 capital and capital buffers and 'b( minimum li0uidit+ re0uirements, are likel+
to reduce the return on e0uit+ for banks# It is unclear how different banks will address the
situation but the options include reduction of rates on retail deposits9 reduced staff
compensation9 and increased margins on products#
In the corporate lending sector, new facilities will factor the capital costs into margin where
the market will bear it# 4owe"er, for e$isting facilities, if banks are not able to reco"er their
conse0uential increased costs from their borrowers, their internal rates of return will be
reduced#
One of the first documentation points that we are seeing, as with Basel II, is the discussion
around the increased costs clause# %arket practice when negotiating loan agreements has
historicall+ been based on the principle that borrowers should indemnif+ lenders for the
amount of an+ increased costs 'including a reduction in the rate of return from the facilit+ or
on the lenders1 o"erall capital( incurred b+ them as a result of 'a( the introduction of or an+
change in 'or in the interpretation, administration or application of( an+ law or regulation or
'b( compliance with an+ law or regulation made after the date of the rele"ant loan
agreement#
That market practice, if continued, would result in borrowers becoming liable to indemnif+
lenders for the increased regulator+ costs under e$isting facilities on the implementation of
Basel III as law# Some borrowers might argue that, the principles of Basel III ha"ing been
finalised, banks should ha"e planned accordingl+ and the resulting reduction on returns or
costs of implementation should be car"ed out# This was commonl+ the case prior to the
implementation of Basel II, although banks had a much longer period of time to prepare
themsel"es for that regime#
4owe"er, one of the ma,or differences to the past is that the capital charge for a facilit+ ma+
"ar+ during its lifetime# This started under Basel II 'e#g# with the calculation of :W;s being
based on credit ratings that can change o"er time( but there will be a significant shift in Basel
III as it is progressi"el+ introduced and as counterc+clical buffers and li0uidit+ re0uirements
are set and re5set o"er the life of a loan#
In this respect, the t+pical increased costs language is ambiguous as to whether such a
change in circumstances gi"es the right to an indemnit+ notwithstanding that the framework
legislation remains unaltered# There are man+ complicated and far5reaching issues arising
from Basel III# 4owe"er, parties will need to re"isit the increased costs clause in standard
loan documentation to make sure both lender and borrowers know how it will work in the
new regime#