Newsletter March 2005
Basel regulators to launch major new capital project
EU Commission moves quickly to prepare for negotiations over definition of bank capital. Controversy likely in US and Europe By Melvyn Westlake
Even before the new capital adequacy rules for banks have been finalised, regulators on the Basel Committee are gearing up for a fresh, and potentially far-reaching project that could have a significant impact on banks' capital structures. A new working group is being formed to define precisely what banks can count as their eligible capital. Whereas the capital adequacy accord - Basel II - is concerned to ensure that banks hold a sufficient quantity of capital to cover the risks in their business, the proposed new project will focus on the composition and quality of that capital.
However, fearful that financial institutions are already stretched by the implementation of Basel II, regulators are stressing that the definition of capital is a long term project that is likely to take three or four years. The Basel Committee, which effectively sets capital standards for the world banking systems, says it will not propose any changes to the definition of eligible capital until after the new risk-based capital adequacy rules are implemented at the beginning of 2008. This is assumed to mean that regulators will not seek any further rule changes until at least 2009.
So far, the new Basel working group that will undertake the definition of capital review has no formal remit or timetable, nor has the scope of the exercise been determined. It will be chaired by Paul Sharma head of the prudential risks and accounting department at the Financial Services Authority, Britain's powerful regulator, and is expected to hold its first meeting in the late summer.
However, the European Commission in Brussels, executive arm of the of the 25-member EU bloc, is sprinting out of the starting gate. It has already set its own machinery in motion with the aim of establishing a common position for the "upcoming Basel negotiations on definition of own funds," (as the definition of capital is described by Commission staff). There is a strong feeling that the EU was not well prepared during the first few years of the six-year-long Basel II negotiations, and that member countries did not speak with one voice.
Moreover, only nine of today's 25 EU members are actually represented among the 13 developed countries that comprise the Basel Committee, and there is a need to establish channels to keep the rest of the EU bloc informed about the direction of negotiations.
The Banking Advisory Committee (BAC), a Brussels group made up of finance ministry officials and chaired by a Commission official has set up a Working Group on Own Funds (WGOF). This group, chaired by Patrick Pearson, head of the Commission's banking and financial conglomerates unit, met in early March for preliminary consideration of the issues.
It plans, in turn, to ask banking supervisors to undertake a survey of what financial instruments are currently accepted as eligible bank capital in the different EU member states, and the different tax regimes for these instruments, as well as what alternative types of securities are available in the markets. This work will be carried out over the next few months by the London-based Committee of European Banking Supervisors (CEBS), whose key role is promoting supervisory convergence. The data has to been collected before more fundamental and conceptual aspects of bank capital can be considered, says Andrea Enria, CEBS secretary General. "We will be undertaking a stocktaking exercise."
However, neither European officials nor banking industry representatives want the EU process to get ahead of the negotiations in Basel. The idea is only to make an early contribution to the debate and to be able to respond in a meaningful way as negotiations evolve, EU officials insist.
European bankers and investment bankers will also be closely monitoring developments. There was said to be "standing room only" at a mid-February meeting at the British Bankers' Association in London, held to sound out bankers' views and inform officials of Britain's finance ministry about the industry's own preferred outcome from the negotiations.
Bankers are frustrated that they cannot include certain structured instruments in their Tier 1 - or core - capital, which is supposed to be a bank's highest quality capital and give it a strong defence if it hits trouble. To do this, eligible Tier 1 capital needs to incorporate features of permanence and loss absorbency.
Bankers, however, want to raise capital as cheaply as possible. And good quality equity is the dearest sort of capital. The holy grail for bankers is hybrid, or "innovative" capital that combines characteristics of both equity - and is, therefore, acceptable to regulators - and debt, which enjoys tax advantages that equity does not. In 1998, the Basel Committee ruled that "innovative" capital should be limited to 15% of a bank's Tier 1 capital.
Notorious episode
In one notorious episode in 2002, Barclays Bank and some other banks issued an instrument dubbed TONs (Tier One Notes), which had been given the green light by the Financial Services Authority. As a result of peer pressure from other members of the Basel Committee, an embarrassed FSA was forced to block any further issuance of these instruments. It was a move that infuriated many bankers and killed off the new market.
It was an episode in which "the FSA did not cover itself in glory," say bankers.
"There is a feeling that in recent times it has become much more difficult to get capital structures approved by the FSA," says Russell Deyell, head of group capital management at mortgage bank Abbey National, recently taken over by Spain's Banco Santander. "And, an attempt to put together an inventory of what is permissible elsewhere in Europe might put the FSA stance into high relief," he says rather diplomatically.
All banks want to have the lowest cost capital structure that they can get. "But we accept that there are other principles involved as well. It is just a question of where the balance lies," Deyell adds.
Another capital manager at a major bank says: "At the moment, the existing definitions of own funds are interpreted significantly differently throughout the world and even within the EU. So a benefit of the exercise might be to achieve some consistency, or at least identify where there is inconsistency in relation to such things as tax deductibility."
Principles-based approach
Bankers are heartened by the EU's approach to the matter, as set out in a paper prepared for the first meeting of the Working Group on Own Funds. "This approach is to try and devise principles as to what counts as capital, rather than specific rules," notes the banker. "The best outcome would be for regulators to devise high level principles around tax treatment of instruments, loss absorbency and so on, leaving bankers to assess for themselves whether they meet the spirit of these principles," he says. Others believe the market should decide whether a financial institution has too much or too little of a particular type of capital.
Certainly, there is every prospect of the Basel capital definition negotiations becoming controversial. The capital quality of Japanese banks, for example, is frequently criticised in the US. Struggling Japanese banks have been allowed by Tokyo supervisors to include so-called tax deferred assets (TDAs) in Tier 1 capital to an exceptional degree. TDAs represent claims against tax on future earnings. In the case of some major Japanese banks, TDAs have represented over 70% of all Tier 1 capital in recent years, and they still remain quite a large element for some banks. By contrast, in the US, such assets are not allowed to account for more than 10%.
Bankers in the US and Europe note that the original 1988 Basel I accord, which first set international capital standards, had its roots in a perception that Japanese and French banks were under-capitalised and thus competing unfairly.
What remains undecided is how extensive should be the scope of the Basel capital definition review. According to the paper prepared for EU own funds working group meeting in early March, the choice is between, on the one hand, "pursuing only minor necessary changes to the existing setting, bringing the definition of own funds up to date, and making it sufficiently flexible; and, on the other hand, starting a more challenging and profound reform of the definition of own funds with the aim of creating a new setting in which it may be easier to accommodate future market developments."
Limiting the scope of the Basel review is likely to be difficult, however, even if that were the preferred approach. As one close observer notes: "in constructing the capital structure of a bank, it isn't just regulation that is driving the choices.
Five parameters
It is also tax considerations, stock exchange listing rules, accounting considerations, and the treatment of financial instruments by the credit rating agencies. The problem for the banks is that they have to operate within these five parameters. Once they have optimised their capital structure for one of these parameters, they discover it will not work for one or more of the others."
The WGOF paper also sees potential conflict between future regulatory capital definitions and accounting standards. It suggests the working group considers "the relationship between the criteria for recognition and measurement of items for accounting purposes, and the criteria for the eligibility of instruments as own funds..." In the past, there has been a reliance on accounting standards when identifying own funds for prudential purposes. The paper suggests in may be time to consider a "wider independence" between the two.
Apart from the rapid development of new structured financial instruments in the capital markets, and the divergences of regulatory practice around the world, there are other factors making the Basel review necessary. One results from changes agreed in the Basel II capital adequacy accord. The decision to calculate regulatory capital against only unexpected losses instead of both expected and unexpected losses, and the related changes in the treatment of provisions, will also alter the relationship between Tier 1 capital and Tier 2 capital, which comprises significant elements of subordinated debt.
Scrap Tier 2?
There has, anyway, always been a weakness in the rule that says Tier 2 capital cannot be greater than Tier 1. If a bank gets into trouble and its Tier 1 capital starts being eroded, this will lead to a similar reduction in Tier 2 (assuming that Tier 2 is already at its maximum level). So, a bank in difficulties gets a double whammy, explains a capital markets practitioner.
Credit rating agencies and US banks tend to pay little attention to Tier 2 capital, anyway. And, more radical bankers suggest that Tier 2 ought to be scrapped altogether, in favour of a single Tier for total capital, perhaps with restrictions on the allowable proportions of some classes of securities.
Although nothing has apparently been ruled out of the Basel capital definition review, regulators note that Tiers 1 and 2 are recognised for certain purposes in the Basel II capital adequacy accord, and this could make it difficult to take such a radical course.
The use of hybrid instruments in the US is no less controversial. There appears to have been a fierce disagreement between Washington regulatory agencies over Trust preferred securities. At the beginning of March, the Federal Reserve Board issued a final rule confirming that these securities can be included in the Tier 1 capital of bank holding companies (BHCs). This appears to be in the teeth of oppositions from the Federal Deposit Insurance Corporation (FDIC), which believes trust preferred securities should be relegated to the Tier 2 capital division. In an unusually caustic letter to Alan Greenspan, chairman of the Federal Reserve System, the Corporation's chairman Donald Powell, says "The unilateral decision of an important bank regulator such as the Federal Reserve to depart from established prudential standards is of concern to the FDIC."
Trust preferred securities are undated cumulative preferred securities issued out of a special purpose entity (SPE), usually in the form of a trust. In essence the bank holding company sets up a SPE, which issues the securities to the investors, and provides the proceeds back to the BHC in exchange for debt. Some 820 BHCs have issued $77 billion of worth of trust preferred securities since 1996 when the Fed first permitted them. These securities are tax efficient because payments on them are tax deductible, unlike dividends on directly issued preferred shares.
Final rule
The final Fed rule allows BHCs to "explicitly" include outstanding and prospective issuance of these securities in their Tier 1 capital. However, the Fed will also subject these instruments and other "restricted core capital elements" to tighter quantitative limits within Tier 1, and more stringent qualitative standards. Trust preferred securities and other restricted elements will continue to be limited to 25% ceiling within Tier 1. A lower ceiling of 15% will be set for internationally active BHCs. Previously this 15% ceiling had only been a recommendation not a firm rule.
BHCs have been given five years to comply with the revised quantitative and qualitative standards.
Much of what is in the final rule is unchanged from the Fed's proposal of last May (see June issue of Global Risk Regulator), when public comments were sought. The Federal Reserve notes that, of the 38 comment letters received, the letter from the FDIC is the only one to oppose the rule. For its part, however, the FDIC does not pull its punches. "Trust preferred securities do not provide the degree of capital support that is consistent with their receiving the Tier 1 designation that is reserved for high-quality capital instruments," writes Chairman Powell. "We are also concerned that the Federal Reserve has, in effect, used its exclusive authority over BHC capital requirements to confer a competitive advantage on BHC subsidiaries relative to stand-alone banks," Powell adds.
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