The Basel Committee on Banking Supervision (BCBS) yesterday published two consultative documents – strengthening the resilience of the banking sector and an international framework for liquidity risk – outlining its proposals for tightening bank regulation. The focus they display on capital and liquidity issues comes as no surprise (see previous blog). The committee outlined some time ago that it would seek to increase the quantity, quality and counter-cyclicality of capital and banks’ liquidity ratios.

On the capital front, the committee is proposing to improve the quality of Tier 1 capital by requiring that it is predominantly made up of equity and retained earnings. “Innovative” features on other Tier 1 securities, such as step-ups, will be phased out, and the use of call options will be regulated so that it is clear that the issuing bank is not expected to exercise the call unless it is in its own economic interests to do so. Further up the scale, Tier 2 capital will be simplified. There will only be one category of Tier 2, with characteristics broadly similar to current Lower Tier 2 capital. Tier 3 capital will be abolished. Beyond these new capital definitions, transparency will be increased, with banks forced to make disclosures including several capital ratios (e.g. Equity Tier 1, Core Tier 1 and Tangible Common Equity), a description of the main features of their capital instruments and a description of all minimum regulatory limits and their capital positions relative to them. The BCBS also proposes to alter the current minimum limits, which make the maximum level of Tier 2 capital a function of how much Tier 1 capital a bank has issued, discouraging issuance beyond the required level.

These measures – if implemented – would certainly increase banks’ quality of capital. And minimum capital ratios would rise from today’s official level, although the BCBS has declined to give an indication of the level at which the new minimum would be set. As to counter-cyclicality, the committee has come up with a novel suggestion: that banks be blocked from making “a distribution of earnings” if their capital ratios fall below a certain level. Payment suspensions would include dividends, bonuses and Tier 1 coupon payments. The Bank of England’s latest Financial Stability Report demonstrates how effective such a measure might be. It reveals that “if [UK banks’] discretionary distributions had been 20% lower per year between 2000 and 2008, banks would have generated around £75bn of additional capital – more than provided by the public sector during the crisis.” The role of CoCos – contingent capital securities such as those recently issued by Lloyds Banking Group – in the new regime will also be considered.

On another note, the Committee has also proposed two new liquidity ratios to be included in the regulatory regime. The first is a  Liquidity Coverage Ratio designed to ensure that the bank can survive a thirty-day stress scenario (by which time it is assumed that forceful action will have been prepared by management or regulators if the stress continues) defined as the stock of high quality liquid assets divided by net cash outflows over thirty days. This ratio will have to exceed 100%. The second ratio, or Net Stable Funding Ratio, aims to encourage more medium- and long-term funding by stating that the available amount of stable funding must exceed the required amount of stable funding (see p.20ff of the liquidity report). The Committee will also explore ways to limit concentration of funding from any one source.

The final (and crucial) issue addressed by the BCBS is timing. There has been considerable volatility in the markets this week – particularly in Japan – as speculation swirled that the new rules may not be implemented until after 2020. This story has been laid to rest by the Committee. It will consult on its proposals until mid-April 2010, give an update in July, and announce firm new regulations at end-2010 to be implemented by 2012. Banks will therefore need to reform themselves swiftly, though in differing ways. Euro area and Japanese banks are likely to be hit hardest by the capital requirements, while US lenders will have to amass greater liquidity. The message from the Committee is unequivocal: change is on the way and it’s coming soon.

Nicholas Smallwood, Credit Analyst

Disclaimer:

This research report is produced by Daiwa Securities Capital Markets Co., Ltd and/or its affiliates and is distributed by Daiwa Capital Markets Europe Limited in the European Union, Iceland, Liechtenstein, Norway and Switzerland. Daiwa Capital Markets Europe Limited is authorised and regulated by The Financial Services Authority and is a member of the London Stock Exchange, Chi-X, Eurex and NYSE Liffe. Daiwa Capital Markets Europe Limited and its affiliates may, from time to time, to the extent permitted by law, participate or invest in other financing transactions with the issuers of the securities referred to herein (the “Securities”), perform services for or solicit business from such issuers, and/or have a position or effect transactions in the Securities or options thereof and/or may have acted as an underwriter during the past twelve months for the issuer of such securities. In addition, employees of Daiwa Capital Markets Europe Limited and its affiliates may have positions and effect transactions in such securities or options and may serve as Directors of such issuers. Daiwa Capital Markets Europe Limited may, to the extent permitted by applicable UK law and other applicable law or regulation, effect transactions in the Securities before this material is published to recipients.

This publication is intended for investors who are not Retail Clients in the United Kingdom within the meaning of the Rules of the FSA and should not therefore be distributed to such Retail Clients in the United Kingdom. Should you enter into investment business with Daiwa Capital Markets Europe’s affiliates outside the United Kingdom, we are obliged to advise that the protection afforded by the United Kingdom regulatory system may not apply; in particular, the benefits of the Financial Services Compensation Scheme may not be available.

Daiwa Capital Markets Europe Limited has in place organisational arrangements for the prevention and avoidance of conflicts of interest. Our conflict management policy is available at http://www.uk.daiwacm.com/about-us/corporate-governance-and-regulatory. Regulatory disclosures of investment banking relationships are available at http://www.daiwausa.com/.

For more details, please contact:

Nicholas Smallwood, Credit Research
Daiwa Capital Markets Europe Limited
5 King William Street, London, EC4N 7AX

+44 (0)20 7597 8383

nicholas.smallwood@uk.daiwacm.com

For up to date Research analysis, see our blog site here.

Sign up for news/events alerts