Basel 3: No Material change in bank ratings for S&P...at this stage

Basel 3: No Material change in bank ratings for S&P...at this stage

On March, 4th 2010, S&P published a short document on Basel 3 titled
“Basel 3 for global banks: third time's the charm?” S&P broadly views

Basel 3 to result in stronger resilience -- Samson Jackuel

Basel 3 proposals as positive. Stronger quality and consistency of
regulatory capital, increased capital requirements on some
counterparties, better transparency and the implementation of a
leverage ratio will strengthen banks' resilience to new shocks and
improve comparison across banks. The introduction of liquidity ratios
provides additional early warning signals to regulators and investors. It
also brings greater international harmonisation. At this stage of the
review of Basel 3 consultative document, the agency does not expect
the implementation of Basel 3 proposals to materially affect banks'
ratings.

The objective of Basel 3 is to strengthen and harmonise the global capital
framework. Basel 3 has thus introduced a proposal that requires Total Tier 1
Capital to be principally composed of pure equity i.e. common equity and
retained earnings. Besides, instead of the current complex capital structure
which comes under six level of subordination ( Core Tier 1 capital, noninnovative

Common equity as the largest component of Total Tier 1 Capital -- Samson Jackuel

hybrid Tier 1 capital, innovative Tier 1 capital, upper Tier 2 capital,
lower Tier 2 capital and Tier 3 capital), the framework is now simplified, split
into three categories:
i) Core Tier 1 (common equity and retained earnings only), ii) Additional going
concern Tier 1 capital (instruments which are subordinated, have noncumulative
dividends/coupons and are fully discretionary, bear no maturity
date as well as no incentive to redeem), iii) Tier 2 capital (minimum 5 year
paper and UT2 and LT2 to form a single Tier 2 category).
Basel 3 also set an harmonised list of regulatory adjustments, that applies to
all Basel Committee countries. According to the proposals, deductions should
be made directly on common equity instead of Total Tier 1 capital or Total
Capital (Tier 1 capital + Tier 2 capital).

For a better capital allocation, Basel 3 suggests banks to capture risks by
implementing stress tests assessing the evolution of their counterparty
exposures. It also recommends an additional capital charge against mark-tomarket

Enhanced assessment of counterparty risk and capital charges -- Samson Jackuel

losses. Last but not least, the enhancement of the risk coverage also
addresses the issue of the systemic risk caused by the interconnection of
financial groups and increases the risk weights on financial institutions versus
non-financial corporates.

Basel 3 tackles the deficiency of the disclosures as regard to banks'
regulatory capital. It recommends banks to be required to provide i) a full
reconciliation of all regulatory capital elements backed by the balance sheet in
the audited financial statements, ii) a separate disclosure of all regulatory
adjustments, iii) a description of all limits and minima, iiii) a description of the
main features of capital instrument issued, iiiii) a comprehensive explanation
of how ratios involving components of regulatory capital are calculated.

Basel 3 also intends to supplement the risk based capital requirements with a

Additional disclosures to allow reconciliation of regulatory capital calculation and balance sheet items -- Samson Jackuel

leverage ratio, which will be simple, transparent and based on gross
exposures. At this stage the component of the ratio still needs to be clarified.
However, the numerator of the leverage ratio should include high quality
capital i.e. common equity. The denominator could be adjusted assets. No
level for this ratio has been provided for now.




Given the key role of liquidity issue in the ongoing global financial crisis, Basel
3 developed two liquidity internationally consistent standards for banks'
liquidity:

The Liquidity Coverage Ratio (LCR) measures the stock of liquid assets
available to cover the net cash outflows over a 30 days period. This ratio must
be greater than 100%. Liquid assets encompass i)cash, ii) central bank
reserves that can be drawn in times of stress, iii) marketable securities
guaranteed by sovereigns, central banks, non-central government public
sector entities, the BIS, the IMF, the European Commission...iiii) government
or central bank debt issued in domestic currencies. Net cash outflows
represent the net liquidity gap under a stress scenario taking into account an
increased probability of cash withdrawal.

The Net Stable Funding Ratio (NSFR) is a long term gauge that calculates
over a one-year horizon and under stress scenarii the coverage of required
amount of stable funding by available amount of stable funding. This ratio
(Available amount of stable funding/ Required amount of stable funding) has
to be at least equal to 100%. According to Basel 3 proposals, the available
amount of stable funding includes i) capital, ii) preferred stock with maturity at
least equal to one year, iii) liabilities with minimum effective maturities of one
year, iiii) non-maturity deposits and/or less than one-year term deposits that
would be expected to stay for an extended period in a idiosyncratic stress
event. In line with Basel 3 proposals, the required amount of stable funding is
obtained by assigning a Required Stable Funding factor (RSF) to the assets
and off-balance sheet (OBS) exposure of an institution. In other terms, the
principle is similar to risk weighting the assets but in this case it comes to
liquidity weighing the assets and OBS.

Although S&P is supportive of Basel 3, the agency stresses some
shortcomings of the proposals compared with its in-house Risk-Adjusted
Capital Framework (RACF).

The agency views some of Basel 3 proposals related to regulatory capital as

Some shortcomings of Basel 3 by S&P -- Samson Jackuel

“overly conservative”. For instance, S&P only deducts minority interests in
consolidated subsidiaries if the latter are non-financial companies or special
purpose vehicles. S&P also underlines the increased procyclicality that may
result from the deduction of any shortfall between loan loss provisions and
expected losses. As to the liquidity ratio, S&P highlights that the 30-day time
horizon for the stress test is relatively short taking into account the duration of
the liquidity crunch we have been experiencing since late 2008. Besides S&P
underscores the likelihood of distortion in the market between eligible and
non-eligible securities due to the chosen definition of liquid assets.

Although the fully calibrated standards are to be set by the end of 2010 and

Towards a reshaping of business models and deep changes in the industry -- Samson Jackuel

be implemented by the end of 2012, we believe the regulatory changes
highlighted above are to deeply remodel the industry. The reform is to affect
banks' capital structure and modify their funding costs. This, coupled with new
counterparty risk assessment should transform the composition of the balance
sheet. In other words, the regulatory storm will inevitably compel some banks
to transform their business models and is likely to create opportunities for
merger and acquisitions.

Samson Jakuel