Deus Ex Macchiato

From the Committee, edited down for brevity:

The Committee retained most of the definition of capital proposals set out in the December 2009 consultative package. However, it concluded that certain deductions could have potentially adverse consequences and may not appropriately take into account evidence of realisable valuations during periods of extreme stress. Therefore, the following amendments to the December 2009 proposal have been agreed.

Definition of capital

The Committee will allow some prudent recognition of the minority interest supporting the risks of a subsidiary that is a bank. The excess capital above the minimum of a subsidiary that is a bank will be deducted in proportion to the minority interest share.

The December 2009 reform package required that unconsolidated investments in financial institutions be deducted when the holdings exceed certain thresholds. These thresholds continue to apply. The December paper also stated that gross long positions may be deducted net of short positions only if the short positions involve no counterparty risk. The Committee agreed to eliminate this counterparty credit restriction on hedging of financial institution investments and to include an underwriting exemption.

Instead of a full deduction, the following items may each receive limited recognition when calculating the common equity component of Tier 1, with recognition capped at 10% of the bank’s common equity component:

• Significant investments in the common shares of unconsolidated financial institutions. “Significant” means more than 10% of the issued share capital;

• Mortgage servicing rights (MSRs); and
• Deferred tax assets (DTAs) that arise from timing differences.

A bank must deduct the amount by which the aggregate of the three items above exceeds 15% of its common equity component of Tier 1.

Counterparty credit risk

The Committee is making the following modification to the treatment of counterparty credit risk, including the bond equivalent approach to calculating the credit valuation adjustment (CVA):

• Modify the bond equivalent approach to address hedging, risk capture, effective maturity and double counting;

• To address the excessive calibration of the CVA, eliminate the 5x multiplier that was proposed in December 2009;
• Keep the asset value correlation adjustment at 25% to reflect the inherent higher risk of exposures to other financial entities and to help address the interconnectedness issue, but raise the threshold from $25 billion to $100 billion; and
• Banks’ mark-to-market and collateral exposures to a central counterparty (CCP) should be subject to a modest risk weight, for example in the 1-3% range, so that banks remain cognisant that CCP exposures are not risk free.

Leverage Ratio
The Committee agreed on the following design and calibration for the leverage ratio, which would serve as the basis for testing during the parallel run period:

• For off-balance-sheet (OBS) items, use uniform credit conversion factors (CCFs), with a 10% CCF for unconditionally cancellable OBS commitments (subject to further review).

• For all derivatives (including credit derivatives), apply Basel II netting plus a simple measure of potential future exposure based on the standardised factors of the current exposure method.
• The leverage ratio will be calculated as an average over the quarter.

When it comes to the calibration, the Committee is proposing to test a minimum Tier 1 leverage ratio of 3% during the parallel run period.

The parallel run period commences 1 January 2013 and runs until 1 January 2017. During this period, the leverage ratio and its components will be tracked, including its behaviour relative to the risk based requirement. Bank level disclosure of the leverage ratio and its components will start 1 January 2015.

Procyclicality, systemically important financial institutions, and the net stable funding ratio have all been kicked into the long grass, with further proposals at the end of the year (i.e. past the G20 Basel 3 deadline of November).

The Liquidity coverage ratio stays, but with some recalibration:

• Retail and SME deposits: Lower the run-off rate floors to 5% (stable) and 10% (less stable), respectively (from 7.5% and 15%). These numbers are floors and jurisdictions are expected to develop additional buckets with higher run-off rates as necessary.

• Operational activities with financial institution counterparties: Introduce a 25% outflow bucket for custody and clearing and settlement activities, as well as selected cash management activities.
• Deposits from domestic sovereigns, central banks, and public sector entities (PSEs):
  • For unsecured funding, treat all (both domestic and foreign) sovereigns, central banks and PSEs as corporates (ie with a 75% roll-off rate), rather than as financial institutions with a 100% roll-off rate.

  • For secured funding backed by assets that would not be included in the stock of liquid assets, assume a 25% roll-off of funding.
• Undrawn commitments: Lower retail and SME credit lines from 10% to 5%. Treat sovereigns, central banks, and PSEs similar to non-financial corporates, with a 10% run-off for credit lines and a 100% run-off for liquidity lines.
• Inflows: Rather than leave it to bank discretion to determine the percentage of “planned” net inflows, establish a concrete harmonised treatment in the standard that reflects supervisory assumptions.
• Definition of liquid assets: All assets in the liquidity pool must be managed as part of that pool and are subject to operational requirements. The December 2009 proposal outlined that the assets must be available for the treasurer of the bank, unencumbered, and freely available to group entities. The Committee will finalise these operational requirements by the end of this year.

  As part of the narrow definition of liquid assets, allow the inclusion of domestic sovereign debt for non-0% risk weighted sovereigns, issued in foreign currency, to the extent that this currency matches the currency needs of the bank’s operations in that jurisdiction.

• Introduce a “Level 2” of liquid assets with a cap that allows up to 40% of the stock to be made up of these assets.
  • Include (with a 15% haircut) government and PSE assets qualifying for the 20% risk weighting under Basel II’s standardised approach for credit risk, as well as high quality non-financial corporate and covered bonds not issued by the bank itself (eg rated AA- and above), also with a 15% haircut.

  • Utilise both ratings and additional criteria as outlined in the December proposal (bid-ask spreads, price volatility, etc) to determine eligibility.
• Develop standards for review at the September 2010 BCBS meeting for jurisdictions which do not have sufficient Level 1 assets to meet the standard.

Posted in: Basel, Regulation by David /