Basel 3: Capital Conservation Buffer Will Improve Preferred Share Quality

I posted a brief note on Basel 3 when it was announced on the weekend … here are some more thoughts.

The press release states:

. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%.

The Group of Governors and Heads of Supervision also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity, after the application of deductions. The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions. This framework will reinforce the objective of sound supervision and bank governance and address the collective action problem that has prevented some banks from curtailing distributions such as discretionary bonuses and high dividends, even in the face of deteriorating capital positions.

  • The capital conservation buffer will be phased in between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019. It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019. Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer and the countercyclical buffer. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.
  • Banks that already meet the minimum ratio requirement during the transition period but remain below the 7% common equity target (minimum plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.

The American Enterprise Institute, quite rightly, considers this rather vague:

Third, the SFRC believes that both the capital conservation buffer and countercyclical buffer are insufficient to protect against sudden shocks. The proposal also suggests that enforcement of the capital conservation buffer may be unduly lenient. Rather than prohibiting distributions of earnings as the buffer is approached, the GGHS announcement indicates that there will only be some restriction on the size of such payouts. Permitting a payout of capital when a firm’s capital cushion is declining toward a critical threshold makes little economic sense.

I’ve seen a lot of lot of generalities about the constraints to be placed on banks when they are in the buffer zone, but no informed opinions, which makes me feel a little better about not having been able to find a schedule of restrictions on the BIS web-site.

However, it does appear – on the basis of what unfounded, uninformed and entirely speculative inferences I can make from the available documents – that banks will still be paying common dividends while in the buffer zone, although the amount of these dividends may be restricted. Who knows, there might be forced reductions but I think paying a penny will be OK. And if they pay common dividends, they have to pay the preferred dividends. So that’s a good thing, and from the perspective of safety the additional buffer will simply be that much more common equity between preferreds and a harsh environment.

The Globe story on the issue mentioned Eric Helleiner:

Nevertheless, the banker’s argument about the economic impact of new regulations got the authorities’ attention. Financial institutions won’t face higher capital standards until Jan. 1, 2013, a delay that seems “kind of long” and is probably “where some of the political compromises are coming in,” said Eric Helleiner, the Waterloo, Ont.-based Centre for International Governance and Innovation’s chair in political economy, who has written several articles about Basel III.

So I looked him up. Those interested in international bureaucracy may wish to review his publications.

There is euphoria over Basel 3:

Canadian banks said Monday they expect to be able to adopt new Basel III rules for maintaining reserve capital with little trouble, meaning dividend hikes and share buybacks could be on the way once Canada’s banking regulator gives the go-ahead.

“Based on our first read, we’re encouraged by the announcement and feel very comfortable in meeting these standards within the established timelines, given where our capital ratios stand today,” Janice Fukakusa, chief financial officer of Royal Bank of Canada, (RY-T54.601.102.06%) said at the Barclays Financial Services Conference in New York.

Her comments were echoed by other Canadian banks presenting at the conference.

Rod Giles, a spokesman for OSFI, told Reuters in an e-mail that the regulator will soon issue an advisory to the nation’s big banks providing more clarity on its expectations for future capital outlays.

Bank officials with the clout to hire ex-regulators will be in a far better position to judge the effect of the accord on Canadian regulation than any investor scum, so I won’t speculate too much about the final rules. I suspect, however, that OSFI’s ‘more capital is always better’ mind-set will result in a certain extra capital requirement over and above the global minimum. After all, if it tacks another 20bp on the price of Canadian mortgages, who cares?

Update: Within minutes of the “Publish” button being clicked, OSFI issued Interim Capital Expectations for Banks, Bank Holding Companies, Trust and Loan Companies (collectively, Deposit taking institutions or “DTIs”):

In light of the recent international developments providing greater certainty as to the reform of capital rules, until this Advisory is withdrawn or amended, OSFI expects sound capital management by DTIs, as set out in its guidance, but will no longer require the increased conservatism in capital management announced late in 2008.

As part of sound capital management, and in response to the continuing uncertainty caused by regulatory reform, DTIs must be able to demonstrate on request, both continually and prior to any transaction that may negatively impact their capital levels:

  • that they have prudent internal capital targets that incorporate:
    • the impact of the most recent regulatory reform information from the BCBS, GHOS and OSFI;
    • expected market requirements arising from such reforms; and
    • the impact of any such proposed transaction;
  • via an up-to-date capital plan, prepared in accordance with OSFI’s guidance on Internal Capital Adequacy Assessment Program (ICAAP)7, that they would have sufficient capital to meet their internal capital targets at all times while taking into account:
    • current regulatory requirements and the most recent regulatory reform information from the BCBS, GHOS and OSFI;
    • the full transition period required to implement such reforms;
    • due consideration of possible alternatives related to finalizing such reforms; and
    • due consideration of remote but plausible business scenarios that may adversely affect their ability to comply with current and reformed regulatory rules.

Please note that this Advisory repeals the October 2008 Advisory titled Normal Course Issuer Bids in the Current Environment.

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