Capital Ratios and Deductions: Core Tier 1/common Equity

Introduction
As widely expected, the oversight body of the Basel Committee announced on September 12
2010 that it has endorsed the capital and liquidity reform package originally proposed in
December 2009 and amended in July 2010, known as 'Basel 3'. The Basel 3 package was
proposed to ensure that the financial system cannot suffer the type of collapse and resultant
economic slowdown that occurred between 2007 and 2009. It encompasses:
 an unweighted leverage ratio;

 two new capital buffers - a conservation buffer and a countercyclical buffer;
 new and substantial capital charges for non-cleared derivative and other financial market
transactions; and
 significant revisions to the rules on the types of instrument that count as bank capital.
In addition to confirming that the proposed rules in the December 2009 consultation paper had
been agreed, the committee announced new levels for capital ratios, which have been the subject
of impact assessments and heated debates. Banks had argued that imposing excessively high
capital ratios could lead to a double-dip recession; regulators countered that without robust
ratios, a new crisis could soon strike. The committee has decided to increase the capital
requirements substantially. However, in a concession to the fragile state of the economic
recovery, the transitional arrangements announced are generous, with the full package not taking
effect for eight years.
Although the impact of the Basel 3 rules on an individual bank will depend on its asset/capital
base and on the relevant regulator's application of the rules, the publication of the calibrated
ratios and rules is one of the most significant developments for banks since the crisis began.
Banks can now focus on a future strategy to meet the combined effect of these rules, together
with other recent committee-driven changes.(1) This update summarises the new calibrated Basel
3 rules and the transitional arrangements.
New capital requirements
Capital ratios and deductions

Core Tier 1/common equity
The Basel 2 rules require that a bank hold 2% of Core Tier 1 capital to risk-weighted assets. Core
Tier 1 consists of ordinary shares, retained earnings and profits. The Basel 3 rules replace the
concept with a tougher categorisation: 'common equity'. This basically consists of common
shares plus retained income. The rules require banks to hold 4.5% of common equity.
Total Tier 1
The total Tier 1 requirement increases from 4% to 6% under Basel 3, which means that other
types of Tier 1 instrument, known as additional going concern capital, can account for up to
1.5% of Tier 1 capital.
Total capital
The total minimum capital requirement remains at 8%, subject to a new capital buffer. However,
6% of capital must be Tier 1, which means that Tier 2 (which will no longer be divided into
upper and lower tiers) can account for no more than 2% of capital. Tier 3, which is used solely
for market risk purposes, will be removed completely.
Deductions from capital

Under Basel 3, deductions from capital must generally be made from common equity Tier 1.
This requirement is stricter than the current rule, whereby a number of deductions are made from
total capital. However, the July 2010 Basel 3 amendments relaxed some of the proposed
deductions, allowing partial inclusion of minority interests and certain deferred tax assets and
mortgage-servicing rights (rather than their deduction, which had been proposed in December
2009).
New capital buffers

Capital conservation buffer
All banks will be required to hold sufficient capital to meet the minimum capital ratios, as well
as having a capital conservation buffer above the minimum 8% total capital. This buffer is set at
2.5% and must consist solely of common equity, after deductions. In effect, common equity
capital must be equal to 7% of risk-weighted assets, other than in times of stress, when the buffer
can be drawn down. This, therefore, represents more than a threefold increase in the existing 2%
Core Tier 1 requirement. The purpose of this buffer is to ensure that banks can maintain capital
levels throughout a significant downturn and that they have less discretion to deplete their capital
buffers through dividend payments. Banks that do not meet this buffer will be restricted from
paying dividends, buying back shares and paying discretionary employee bonuses.
Countercyclical buffer
In addition to the conservation buffer, banks may at certain times be required to hold a
countercyclical buffer of up to 2.5% of capital in the form of common equity or other fully loss-
absorbing capital. This buffer is a macro-prudential tool to protect banks from periods of
excessive credit growth and is at the national regulators' discretion. It will therefore apply only
when a national regulator considers that there is excessive credit growth in the national economy,
and will be introduced as an extension of the capital conservation buffer.
Leverage ratio
While banks in the United States have been subject to a leverage ratio for some time, this tool
has never previously been part of the Basel regulatory framework. The committee has agreed to
test an unweighted ratio of 3% over a transition period. It has made a number of changes to
features of the ratio as they were set out in its July 2010 revisions; among other things, it allows
netting based on the Basel 2 rules.
Systemically important banks

The committee has stated that systemically important banks should be subject to higher capital
requirements than those in the Basel 3 package. Work continues on the proposals. Options
include capital surcharges, contingent capital and bail-in-debt.
Liquidity rules
The new liquidity coverage ratio and net stable funding ratio will be introduced in accordance
with the timing detailed below. The committee made a number of revisions to the components of
both these ratios in the July 2010 revisions.
Increased capital requirements for derivatives and repos

The December 2009 proposals contained a number of provisions that would have substantially
increased the capital requirements for counterparty credit exposures arising from banks' non-
cleared repo and securities and derivatives financing operations. These proposals, which were
substantially revised in July 2010, are not mentioned in the September press release. This may be
because the timing for implementation needs to be coordinated with the European Commission,
which is due to announce its proposals on the treatment of derivatives imminently.
Timing and transitional arrangements
Taking into account the continued fragility of global economic growth, the recent statement sets
out highly detailed transitional arrangements.
Common equity, Tier 1, total capital and national implementation

The new capital ratios will be phased in. National implementation must begin on January 1 2013,
by which date banks should have 3.5% common equity, 4.5% Tier 1 capital and 8% total capital.
In 2014 this increases to 4% common equity and 5.5% Tier 1 capital. The full ratios (ie, 4.5%
common equity and 6% Tier 1 capital) apply from January 2015.
Grandfathering of existing capital instruments

Capital instruments which do not meet the criteria for inclusion in the common equity element of
Tier 1 cannot count as common equity from January 1 2013. However, certain instruments issued
by non-joint stock companies which are Core Tier 1 at present will be grandfathered on a
declining basis over a longer period. Certain conditions apply, including the provision that such
instruments be treated as equity under prevailing accounting standards. Capital instruments that
no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a
10-year period starting on January 1 2013. Their recognition will be capped at 90%, to be
reduced by 10% each year. Instruments with an incentive to redeem will be phased out at their
effective maturity date. Only instruments issued before September 12 2010 qualify for the
transitional arrangements. Existing public-sector capital injections are grandfathered until
January 1 2018.
Regulatory deductions
Deductions will be phased in. Initially, 20% of the required deductions from common equity will
apply by January 1 2014, to be increased by 20% a year thereafter until 100% of the deductions
are made from common equity by January 1 2018.
Capital buffers
The capital conservation buffer will be phased in at 0.625% on January 1 2016 and will reach
2.5% by January 1 2019. The committee also states that banks which meet their general ratios,
but remain below the 7% common equity target during the transition period, should "maintain
prudent earnings" so as to meet the buffer as soon as possible. It is unclear exactly what this
means and whether the requirement catches banks that comply with the transitional capital buffer
phase in requirements over the period until January 1 2019, but do not meet the 7% requirement
until that date - it appears to do so.
Leverage ratio
The 3% ratio requirement will run parallel from January 1 2013 to 2017. The committee will
track the ratio, its component factors and impact over this period and will require bank-level
disclosure of the ratio and its factors from January 1 2015. Based on the results of the parallel
run, final adjustments to the ratio will made in the first half of 2017 and it will be fully effective
from January 1 2018.
Liquidity ratios
The liquidity coverage ratio will be introduced on January 1 2015. The net stable funding ratio
will apply as a minimum standard from January 1 2018.
For further information on this topic please contact Benedict James, Edward Chan, Carson
Welsh or Richard Levy at Linklaters LLP by telephone (+44 20 7456 2000) or by fax (+44 20
7456 2222) or by email (benedict.james@linklaters.com, edward.chan@linklaters.com,
carson.welsh@linklaters.com or richard.levy@linklaters.com).
Endnotes
These, in part, have resulted in the capital-related amendments to the EU Capital

(1)
Requirements Directive in Europe.

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Introduction

 an unweighted leverage ratio;

New capital requirements

Capital ratios and deductions

Deductions from capital

New capital buffers

Systemically important banks

Increased capital requirements for derivatives and repos

Timing and transitional arrangements

Common equity, Tier 1, total capital and national implementation

Grandfathering of existing capital instruments

These, in part, have resulted in the capital-related amendments to the EU Capital

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