The quality of the capital of a financial institution will become more transparent and consistent as clear European criteria have been defined. Particularly the evaluation whether hybrid capital instruments (equity and debt instruments) classify as capital has become much more stringent. Tier 1 capital will solely comprise share capital and other reserves, the definition of Tier 2 capital will have to be further harmonized within the EU, and Tier 3 capital will no longer exist. Download the brochure Capital management (PDF, 163 KB).
The maximum exposures that may be held on one counter party have been reduced. For banks this will particularly affect interbank lending, especially interbank transactions (i.e., money market transactions, derivatives and CDS). This will effectively reduce concentrations with a limited group of banks and lead to the introduction of tight restrictions within the banks to comply with these new requirements.
For banks that are active in several EU member states, a ‘Board of Supervisors’ will be set up, making the rights and responsibilities of national supervisors more explicit. This cooperation should enhance the effectiveness of supervision. The Board of Supervisors should also particularly supervise the day to day liquidity management of European banking groups.
A Leverage Ratio will be introduced for the European banks. This represents a new capital standard that indicates the ratio of the non-risk-weighted assets to the capital held. To the extent that a bank reports off-balance sheet items, on-balance sheet equivalents will have to be calculated. With a proposed calibration of 3% the Leverage Ratio will function as ‘back stop’ for lending operations.
The new capital agreement stipulates that capital must be held to mitigate the credit risk the bank is exposed to on a counterparty in an OTC derivative or in share financing transactions. Also it is encouraged to take out OTC derivatives with one central counterparty (clearing houses).
Download flyer Market Credit Valuation Adjustment, measurement and management (PDF, 125 KB).
Regulations on offering securitized products will be tightened. Basel III requires a party to have a comprehensive audit performed before investing in certain securities. The supplier of such securitized products is also obliged to retain part of the risk inherent in the underlying product.
New liquidity standards will be introduced for the short and long term. The Liquidity Coverage Ratio (LCR) will be used to measure to what extent the ‘high quality’ liquid assets of a bank are sufficient to meet its short term liability (30 days) in a relatively heavy stress scenario. For the longer term (1 year) the Net Stable Funding Ratio (NSFR) has been introduced. The NSFR calculates how the funding at banks is guaranteed, taking account of stress scenarios. This scenario will be further developed in the coming years into retail versus wholesale models.
Banks will have to raise extra capital buffers in good times. These can be used in bad times when losses are expected and banks are likely to eat into the capital buffers built up. These additions to the reserves are based on the mechanisms of capital conservation and counter cyclical buffers.
Provisions on lending portfolios will have to be formed during the expected terms of the respective loans. To facilitate this, a project has been started within the IASB to review the valuation, classification and impairment of financial instruments. To follow up on the recommendations of the Basel Committee, a new expected loss provisioning model has been introduced in the Exposure Drafts issued by the IASB, which enables forming provisions during the term of a loan (in economically prosperous times).
Capital conservation implies that banks do not simply pay out their profits to their shareholders and staff by distributing dividend and bonuses. A countercyclical buffer means that an extra capital buffer will have to be held to provide for the event that credit growth in an economy falls out of step with the economic growth.