Background
One of the main reasons giving rise to the severe economic and financial crisis in 2007 (“Crisis”) was deterioration of the level and quality of the capital base, accompanied by excessive on and off-balance sheet leverage built up by the banking sectors of many jurisdictions. In response to this problem, the Basel Committee on Banking Supervision (“Basel Committee”), of which the Hong Kong Monetary Authority (“HKMA”) is a member, established regulatory frameworks for worldwide banking sectors. Following the enhancements to Basel II issued in July 2009, the Basel Committee issued the Basel III framework on regulatory capital and liquidity standards (“Basel III”) in December 2010. The objectives of Basel III include:

1.         improving the banking sector’s ability to absorb shocks caused by financial and economic stress,

2.         reducing the risks of any transmission of shocks from the banking sector to the economy through increasing the level, quality and transparency of banks’ capital base as well as the risk coverage of the capital framework.

This article will focus on the Basel III requirements on the capital and leverage of banks. 

Raising the quality, consistency and transparency of the risk-based capital base and strengthening capital standards

Changes to rules on what qualify as capital
Under the old definition of capital, Tier 1 capital may move too far away from common equity. Banks could report high Tier 1 ratios while having a weak tangible common equity ratio as low as 2% (net of regulatory deductions) when measured against risk-weighted assets. However, the regulatory deductions might be inconsistently applied across jurisdictions.

The old definition also consisted of various elements with a complex set of minimums and maximums for each element, rendering it difficult to determine the availability of capital for potential losses. To address the problem, Basel III provides a new definition of capital.

The new definition of capital is twofold.

The first component is Tier 1 capital, which absorbs losses on a “going concern” basis (i.e. the financial institution is solvent). The principal form of Tier 1 capital is common shares and retained earnings (“Core Tier 1”). The remaining Tier 1 capital comprises instruments that are subordinated, that have fully discretionary non-cumulative dividends or coupons and have neither a maturity date nor an incentive to redeem, such as certain preference shares. Innovative capital instruments, currently limited to 15% of Tier 1 capital, will be phased out.

The second component is Tier 2 capital, which absorbs losses on a “gone concern” basis (i.e. after insolvency and upon liquidation). Subordinated debt is a typical example of Tier 2 capital. Tier 3 capital covering a portion of a bank’s market risk capital charge of Basel II will be eliminated from the calculation of capital base. The definitions of Tier 1 and Tier 2 capital have been incorporated into sections 37 to 40 of the Banking Capital Rules (Cap.155L) (“BCR”).

The regulatory adjustments applied in the calculation of Core Tier 1 are also harmonized under Basel III. Items such as (i) goodwill and other intangibles, (ii) deferred tax assets (such as relating to allowance for credit losses, unused tax losses, and unused tax credit) netted with deferred tax liabilities only if the deferred tax assets and deferred tax liabilities relate to taxes levied by the same tax authority and offsetting is permitted by the relevant tax authority, (iii) cash flow hedge reserve that relates to the hedging of items that are not fair-valued on the balance sheet, (iv) (if the Authorized Institution uses the internal rating-based approach for calculating credit risk for non-securitization exposures as set out in Part 6 of the BCR) the amount of the excess of the total expected loss amount over the total eligible provisions, will be excluded from the calculation of Core Tier 1. Such regulatory adjustments have been implemented in Hong Kong by section 43 of the BCR.

The Basel Committee advocates the use of the expected loss approach mentioned in point (iv) in the last paragraph with the goal of improving the usefulness and relevance of financial reporting information for stakeholders, including prudential regulators. The expected loss approach includes the requirement of the use of long term data horizons to estimate probabilities of default, and downturn loss-given-default estimates to convert loss estimates into regulatory capital requirement.

Pursuant to section 43 of the BCR, cumulative losses arising from holding of land and buildings below the depreciated cost value will be excluded from the calculation of Core Tier 1. Unrealised gains on the revaluation of properties held for investment or own-use are required to be excluded from Core Tier 1, but may be included in Tier 2 capital, subject to 55% haircut but the cap that the amount of unrealized gains to be included in supplemental capital cannot exceed the amount included in this item in a given Authorized Institution’s supplementary capital as at 31 December 1998 will no longer apply.

The focus of new definition of capital on tangible common equity, the element with the greatest loss-absorbing capacity, enhances the quality of banks’ capital base, and the harmonization of regulatory adjustments applied in the calculation of Core Tier 1 helps achieve consistency in the definition of capital across jurisdictions. Banks are also required to provide full disclosure and reconciliation of all capital elements under Basel III, thus achieving transparency of the capital base.

Three minimum capital adequacy ratios
Apart from raising the quality, consistency and transparency of the capital base of banks, Basel III also strengthens capital standards by introducing the following three minimum capital adequacy ratios:

1.         banks should hold a minimum of 4.5% of risk-weighted assets in Core Tier 1 at all times, increasing from the ratio of 2% under Basel II;

2.         Tier 1 capital must be at least 6.0% of risk weighted assets at all times; and

3.         Total capital (Tier 1 capital plus Tier 2 capital) must be at least 8.0% of risk-weighted assets at all times.

These enhanced capital standards improve banks’ ability to absorb losses during both normal times and times of financial and economic stress. In Hong Kong, sections 3A to 3D of the Banking Capital (Amendment) Rules 2012 incorporate these three minimum capital adequacy ratios. Section 3B of the BCR provides for the full implementation of all the three ratios after 1 January 2015.

Supplementing the risk-based capital requirement with a leverage ratio
Leading up to the Crisis, there was a build-up of undue on- and off-balance sheet leverage in the banking systems. Many banks reported strong risk based capital ratios while building up high levels of leverage. When the financial crisis was most severe, banks were forced to deleverage that accelerated the cycle of decrease of asset price, aggravation of losses and decline in bank capital, and contraction of availability of bank credit.   

In order to address the problem, Basel III introduces a simple and non-risk-based leverage ratio to supplement the risk-based capital requirement. The objectives of such leverage ratio are to deter the build-up of leverage by banks and to reinforce the risk based capital requirements with a non-risk based “backstop” measure.

The leverage ratio is a measure of a bank’s Tier 1 capital net of any regulatory adjustments applicable to Tier 1 capital divided by accounting measure of its total exposure consisting of all on-balance sheet and off-balance sheet exposures plus derivatives.

In respect of on-balance sheet exposures, while they include all on-balance sheet assets, liability items including gains/losses on fair-valued liabilities due to changes in the Authorized Institution’s own credit risks must not be deducted from calculation. For derivatives, the exposure measure shall consist of the sum of (i) the positive value of the derivatives, and (ii) the counterparty default risk exposure, which is calculated by multiplying the notional amount of the contract by the appropriate credit conversion factor. The latter is a variable depending on the existence of a valid bilateral netting agreement between the institution and the counterparty and the nature of the financial derivative contract. For off-balance sheet exposures, including acceptance and standby letters of credit, will be converted with a flat 100% credit conversion factor unless they are unconditionally cancellable.

According to the “Leverage Ratio Framework” issued by HKMA on 9 May 2014, the Basel Committee on Banking Supervision implementation timeline provides for a parallel run period for the leverage ratio commencing on 1 January 2013 and continues until 1 January 2017. According to the Basel Committee, the leverage ratio and its components will be tracked during the parallel run period. Banks are required to calculate their leverage ratio using the definitions of capital and total exposure. Based on the results of the parallel run period, the Basel Committee will then make necessary adjustments to the definition and calibration of the leverage ratio by 2017, with a view to incorporating it as a Pillar 1 requirement, i.e. minimum regulatory capital requirement, under Basel III in 1 January 2018. During the parallel run period, a testing minimum leverage ratio of 3% will be applied.

Public disclosure of the leverage ratio will start on 1 January 2015.

Implementation
The HKMA is committed to implementing the Basel III framework in accordance with the timetable proposed by the Basel Committee, which expects its members to begin the implementation from 1 January 2013 in phases, with full implementation by 1 January 2019.

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.