FINANCIAL INSTITUTIONS ENERGY INFRASTRUCTURE AND COMMODITIES TRANSPORT TECHNOLOGY

Basel III – Capital Requirements and Leverage Ratios

Kenneth Gray Consultant Norton Rose LLP April 2011 AGENDA

• Introduction to the Accords • Definitions of Capital • Levels of Capital • Leverage Ratios • Implications for trade

Introduction to

Purpose • To harmonise capital adequacy regimes • By ensuring have sufficient capital to absorb losses from non-performing loans and other trading activities

History –

• Basel 1 (1988) • Capital ≥ 8% x Weighted Assets (RWA) • Most loans had 100% risk weighting • Performance bonds/Standby LCs had a conversion factor (CCF) of 50% • -term self-liquidating contingent liabilities had a CCF of 10% • Superseded by Basel II (2004) History – Basel II

• Came into force in EU in 2008 • Maintains basic 8% formula • Plus supervisory review process • Introduces more sophisticated risk-weighting calculations • Standardised Approach • Foundation and Advanced Internal Ratings Based Approaches • CCF for documentary LCs increased to 20%

Weaknesses revealed by Financial Crisis • According to Basel Committee: – excessive on- and off-balance sheet leverage in banking sector – procyclical deleveraging had occurred – level and quality of capital base had been eroded – insufficient liquidity buffers – high interconnectedness of systemic institutions Basel III

• Agreed in principle by in September 2010 • Requirement for global and simultaneous implementation • Seoul announcement expressly acknowledged the specificities of trade finance • Texts published by BCBS in December 2010 • “A global regulatory framework for more resilient banks and banking systems” • “International Framework for measurement, standards and monitoring” Basel III - Timing

• Commission to publish directive (CRD 4) by June 2011 • CRD 4 may be a consolidating directive/regulation • Member State governments may need to legislate thereafter • Phased introduction between 2013 and 2018

Basel III - Aims

• Increase quantity, quality and transparency of capital • Harmonised definition of regulatory capital • Strengthen capital requirements for counterparty credit exposures • Introduce a backstop unweighted leverage ratio supplementary to Basel II • Addresses procyclicality • Introduces a global liquidity standard • Capital must be able to absorb losses if becomes non-viable What is Regulatory Capital?

• Common Equity Tier 1 • Common shares, share premium, retained earnings, certain reserves, Additional Tier 1 • Equity reserves, non-controlling interests, certain products • Tier 2 – Subordinated with over five years’ maturity • Coco bonds/bail-in bonds etc..,

Minimum Levels of Capital

2011 2018 (Basel II) (Basel III fully implemented) Equity 2% 4.5% (but see later for additional requirements) Hybrid Tier 1 2% 1.5% Capital Tier 2 4% 2.0% Total 8% 8% Capital Buffers

• Capital Conservation Buffer • 2.5% of common equity • To withstand future periods of stress • Restrictions on dividends, bonus payments, share buybacks if not met Capital Buffers

• Countercyclical capital buffers • 2.5% of common equity • Implemented where there is excess growth in any state • Total minimum capital may be 13% • Of which 9.5% must be common equity Further Increases to Minimum Levels of Capital • The “Swiss Finish” increases minima to 19% • Of which 9% can be held by CoCos • FSA has suggested optimal levels of capital in the United Kingdom would be 15-20% • May be an additional charge for systemically important financial institutions Additional Equity – CoCos and Bail-In Bonds • CoCos • “Going Concern” contingent capital • Min $926bn to be issued in next decade* • Designed to contain financial stress • Contractual, not regulatory, conversion trigger point • May result in change of control • Difficult investment for certain institutions who can’t hold equity

* estimate Additional Equity – CoCos and Bail-In Bonds • Bail-In Bonds • “Gone Concern” regulatory capital • Absorbs losses at point of non-viability • A regulatory resolution tool • High levels of discretion to regulators as to trigger point • To what should bail-ins apply?

CoCos and Bail-In Bonds Issues • Pricing: – Rabobank bonds: 8.375% – CoCos: 7.875% • When is the trigger point? – Capital, regulator or market-based? • Risk of contagion Non-Risk Based Leverage Ratio • Basic risk-weighting formula remains in place • In addition, beginning in 2013: • ≥ 3% x {non risk-weighted assets* + off-balance sheet exposures} • *i.e. assume all the bank’s assets have a risk- weighting of 100% • Reduces the attraction of super-secured lending (export , covered bonds, trade finance)

Liquidity

• Liquidity Coverage Ratio • Net Stable Funding Ratio • LCR designed to establish a minimum of high level liquid resources sufficient to meet acute stress-testing lasting for a month • NSFR incentivises banks to fund illiquid assets with stable funding Effect of Basel III on Trade Finance • Does requirement for more capital necessarily lead to greater lending costs? • Modigliani Miller • Might lead to banks concentrating on core areas • Other less regulated entities might step in Effect of Basel III on Trade Finance • Trade Finance Specificities (ICC/ADB survey results) • Average maturity 155 Days • Less than 0.02% default rate • OBS transactions have a default rate of 0.005% • LGD of 40% Effect of Basel III on Trade Finance

• Off balance sheet items (OBS), including documentary LCs), “are a source of potentially significant leverage” • CCF for certain OBS is increased to 100% • Risk charge for counterparty increases the cost of interbank dealing • Different rules for export credits

Effect of Basel III on Trade Finance • Introduction of one year maturity floor • Average tenor = 115 days • Capital requirements are tripled • N.B. Several jurisdictions have indicated they will not implement this Effect of Basel III on Trade Finance • Risk weighting • A counterparty can have no better credit than its sovereign • Overall non-risk based leverage ratio Effect of Basel III on Trade Finance • Net Stable Funding Ratio • Incentivises banks to fund long term assets from stable sources • Monitoring tool to 2018 • All illiquid securities and loans over one year needs to be funded from prescribed stable sources • May make short term funding more attractive

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FINANCIAL INSTITUTIONS ENERGY INFRASTRUCTURE AND COMMODITIES TRANSPORT TECHNOLOGY