Basel III v Dodd-Frank: What Does it mean for US Banks

January 2011

Banking

Kevin F Barnard — Arnold & Porter LLP

Alan W Avery — Arnold & Porter LLP

On 11 November 2010, during their summit meeting in Seoul, South Korea, the Group of Twenty Finance Ministers and Central Bank Governors (known as the G-20) formally endorsed the Basel Committee on Banking Supervisions proposals for capital and liquidity requirements for banking institutions. The Basel Committee had announced an agreement on these higher capital standards on 12 September 2010.

These higher capital standards are part of what the Basel Committee has called the core of the global financial reform agenda. This agenda, commonly referred to as Basel III, was introduced in December 2009, when the Basel Committee published its consultative proposals for global capital and liquidity standards. On 26 July 2010, the Basel Committee reached general agreement on the proposed capital and liquidity reforms. The Basel Committees September actions finalised the capital ratio requirements and the phase-in arrangements.

Even though it was endorsed by the G-20, Basel III will not be legally binding in itself. The Basel III standards will need to be implemented by the regulatory authorities of member countries by statute or regulation. Member countries are expected to issue laws or regulations to implement Basel III by 1 January 2013, when the first benchmark in the phase-in period is scheduled to be achieved. It is expected that the US federal banking agencies will implement Basel III. In a joint press release expressing support for Basel III, the US federal banking agencies expressed their collective view that it sets the stage for key regulatory changes to strengthen the capital and liquidity of international active banking organisations in the United States and around the world.

On 21 July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was signed into law by President Obama. The Dodd-Frank Act which represents the most sweeping overhaul of the US financial sector since the Great Depression contains several provisions relating to capital requirements for US banking institutions. For example, the so-called Collins Amendment requires US regulators to impose more stringent capital requirements on US institutions. Although Basel III and the Dodd-Frank Act have similar objectives, there are differences in the capital requirements imposed by Dodd-Frank and the standards proposed under Basel III. There are also important differences in the implementation schedules. These differences will lead to uncertainties for US institutions until the federal financial regulatory agencies work out how to resolve them in the implementation process.

Enhanced Standards Under Basel III

Basel III requires more capital, and higher quality capital than the Basel II framework. It does so by increasing the regulatory capital ratios, narrowing the definition of capital, and requiring capital buffers. Basel III will also impose a leverage ratio and liquidity standards, although the specific quantitative requirements for those measures have yet to be finalised.

Increased Regulatory Capital Requirements

Basel III reflects a strong emphasis on common equity, and it also requires a corresponding increase in Tier 1 capital. The minimum common equity requirement is set at 4.5 per cent under Basel III, which is up from the current minimum of 2 per cent. The minimum Tier 1 capital requirement will increase from 4 per cent to 6 per cent under Basel III. These new requirements will also be phased in by 1 January 2015, with the phase-in period beginning on 1 January 2013. The minimum total capital requirement remains at 8 per cent under Basel III. These ratios are all based on risk-weighted assets.

Stronger Definition Of Capital

Basel III not only requires higher capital ratios, but also applies stricter definitions and adjustments to the components of capital.

As noted above, Basel III requires a banking institution to hold more common equity. Basel III further requires a banking institution to take certain deductions from its common equity. The required deductions from common equity will be phased in starting on 1 January 2014, and the requirements will be fully implemented on 1 January 2018.

Under Basel III, a capital instrument must be perpetual (ie, with no maturity date and no incentive to redeem) to qualify for inclusion in Tier 1 capital. As a result, trust preferred securities and preferred stock issued to the US Department of the Treasury under the Troubled Asset Relief Program (TARP) likely would not qualify for inclusion in Tier 1 capital under the Basel III definition. However, there is also a phase-in schedule for the new definition of Tier 1 capital. Existing public sector capital injections such as the TARP preferred stock will be grandfathered until 1 January 2018. For other capital instruments that will no longer qualify as non-common equity Tier 1 capital, the required deduction of such instruments will be phased in over a ten-year period, beginning in 1 January 2013. The same phase-in schedule applies to capital instruments that would no longer qualify for inclusion in Tier 2 capital under Basel III, although it is less apparent which instruments would fall into this category, at least with respect to instruments widely used in the US.

Capital Buffer Requirements

Basel III requires a capital conservation buffer in addition to the regulatory capital ratios discussed above. It also envisions a countercyclical buffer requirement that member countries could considering adopting.

Under Basel III, a banking institution will be required to maintain a capital conservation buffer of 2.5 per cent, which must be in the form of common equity. A banking institution may reduce this buffer (but not below zero) during periods of financial and economic stress, but as the buffer diminishes, the institution will operate under greater constraints on earnings distributions, including not only dividends but also discretionary compensation payments. The capital conservation buffer will be phased in after the higher minimum regulatory capital requirements are already in effect. Specifically, it will start at 0.625 per cent on 1 January 2016 and increase incrementally each year to 2.5 per cent by 1 January 2019.

Basel III also recommends a countercyclical buffer. Each member country may choose to require this buffer according to national circumstances. If implemented, the buffer would be in the range of 0 per cent to 2.5 per cent of common equity or other fully loss absorbing capital. It would be an extension of the capital conservation buffer, and therefore, it would not directly increase the minimum regulatory capital requirements. The countercyclical buffer would be in effect only when there is excess credit growth that is resulting in a system-wide build-up of risk. The Basel Committee did not specify a phase-in period for the countercyclical buffer, presumably because it is a discretionary measure.

Leverage Ratio

While US financial regulatory agencies have imposed a minimum leverage ratio requirement on US banks for many years, previous Basel capital standards have not included a minimum leverage ratio. This will change with Basel III. The supervisory monitoring period will commence on 1 January 2011. A parallel run period, during which banking institutions will calculate their leverage ratios for review by the regulators but will not be subject to a formal leverage ratio requirement, will run from 1 January 2013 to 1 January 2017, and it is currently proposed that a 3 per cent Tier 1 leverage ratio be tested during that period. A banking institution will be expected to disclose its leverage ratio (including the components of the ratio) starting on 1 January 2015. The Basel Committee proposes to finalise a leverage ratio requirement in the first half of 2017, with the goal of making it a formal regulatory capital requirement on 1 January 2018.

Differences Between Basel III and the Dodd-Frank Act

Basel III will have a significant impact US banking institutions. The magnitude of that impact will largely depend on how Basel III is implemented in the US through regulations prescribed by the federal banking agencies and how these regulations interact with those adopted pursuant to the Dodd-Frank Act. The Dodd-Frank Act has a number of provisions that conflict with Basel IIIs requirements.

Interaction with the Collins Amendment

An example of these conflicting capital requirements relates to the Collins Amendment, which is found in section 171 of the Dodd-Frank Act. There is significant uncertainty as to how Basel III will interact with the Collins Amendment, which requires that the US federal banking agencies prescribe minimum leverage capital requirements and minimum risk-based capital requirements on a consolidated basis for insured depository institutions, bank holding companies, savings and loan holding companies, and non-bank financial companies supervised by the Federal Reserve. It may be that the requirements established under the Collins Amendment exceed the Basel III standards (it is highly unlikely they would be less stringent). For example, regulations to implement the Collins Amendment may assign higher risk-weightings to certain assets than Basel III requires, and thus increase capital requirements for US banking institutions.

Furthermore, while both Basel III and the Collins Amendment eliminate Tier 1 capital treatment for trust preferred securities, the two regimes have considerably different transition periods. Under the Collins Amendment, for US depository institution holding companies with total consolidated assets of US$15 billion or more, the requirement to exclude trust preferred securities issued before 19 May 2010 from Tier 1 capital will be phased in over a period of three years, beginning on 1 January 2013. Under Basel III, the requirement to exclude trust preferred securities from Tier 1 capital will be phased in over a ten-year period beginning on the same date. On the other hand, under the Collins Amendment, trust preferred securities issued before 19 May 2010 by bank holding companies with consolidated assets of less than US$15 billion in consolidated assets as of 31 December 2009 are grandfathered as Tier 1 capital, while Basel III has no such exception. Given the divergent measures, it is possible then that the shorter transition period in the Collins Amendment may prevail in the US implementation process. As a result, US institutions could find themselves in the worst of both worlds, with the substantially shorter transition phase of the Dodd-Frank Act but without the benefit of the statutes grandfathering.

Use of Rating Agencies

Another important difference between Basel III and the Dodd-Frank Act relates to the role of rating agencies. As was the case with its predecessor Basel II, Basel IIIs framework for risk-weighting of certain types of securities relies heavily on credit rating agencies published ratings for such securities for determining the riskiness of the securities and therefore the amount of capital banks must hold against them. However, reflecting criticism of credit rating agencies for giving mortgage-backed securities investment-grade ratings they didnt deserve and thereby arguably contributing to the US housing bubble, section 939A of the Dodd-Frank Act requires US regulatory agencies to remove all references to credit ratings of securities from their rules. Section 939A effectively prohibits the use of credit rating agencies in the rules to implement new capital standards for US banking institutions. The US regulatory agencies are in the process of developing alternatives to the use of rating agencies, but public comments by the regulators suggest that this will be a significant and time-consuming undertaking. The need for an alternative approach will seriously complicate the implementation of new capital standards in the US. Possible results could be that the US delays implementation of new capital standards and that the resulting new standards could be significantly different that those implemented in other countries because of differences in risk weighting frameworks.

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These are a few of the important differences between Basel III and the regulatory capital provisions of the Dodd-Frank Act. How the US regulatory agencies resolve these and other conflicts will determine whether and to what extent US institutions will have competitive advantages or disadvantages as compared to their international competitors when it comes to raising and maintaining the capital necessary to meet the emerging regulatory capital standards. In addition, differences in how Basel III is implemented in the US and how it is implemented in other countries that result from the US regulatory agencies resolution of these and other conflicts could create opportunities for Basel III arbitrage. Efforts to arbitrage previous Basel capital rules are looked to by many as having facilitated the development of the complex shadow banking system that became a significant source of unregulated risk during the recent financial crisis.