Basel III capital requirements’ impact on bonuses

The Bank for International Settlements (BIS) Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a strengthening of bank capital requirements on 12 September 2010 that may impact banker bonuses.

The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. It seeks to promote and strengthen supervisory and risk management practices globally. The Committee comprises representatives from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.

Under the new requirements (expressed as a % of risk weighted assets):

  • The minimum standard for common equity (core Tier 1 capital) has been increased from 2% (before the application of regulatory adjustments) to a minimum of 4.5% (after the application of stricter adjustments)

  • The minimum for Tier 1 capital in general has been raised to 6%

  • The minimum for Tier 2 capital remains at 8%

  • In addition, there is a capital conservation buffer of 2.5%, which means banks will need a minimum of 7% common equity, 8.5% Tier 1 capital and 10.5% Tier 2 capital. While banks are allowed to draw on the buffer during periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions.

  • A countercyclical capital buffer of a maximum further 2.5% kicks in when credit in an economy is growing faster than the economy itself. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. The level of this buffer will be set by national regulators, rather than by the BIS and, when in effect, would be introduced as an extension of the conservation buffer range. If it is enforced to the maximum, when the economy is booming banks will require reserves of 9.5% common equity, 11% Tier 1 capital and 13% Tier 2 capital.

  • The BIS further indicated that systemically important banks should have loss absorbing capacity beyond these standards, which suggests that the biggest banks will require significantly more capital than indicated here

  • The phased introduction of the new requirements commences from 1 January 2013, with a core Tier 1 requirement of 3.5%, rising to 4.5% in 2015

  • The whole of the new structure is to be phased in by 1 January 2019

  • Other key parts of the Basel III regime include the liquidity coverage ratio that is to be introduced in 2015 and the net stable funding ration in 2018

Since the onset of the crisis, banks have already undertaken substantial efforts to raise their capital levels. However, preliminary results of the Committee’s comprehensive quantitative impact study show that as of the end of 2009, large banks will need, in the aggregate, a significant amount of additional capital to meet these new requirements.

It is interesting that the Committee claimed that smaller banks, which are particularly important for lending to the SME sector, for the most part already meet these higher standards. From where we sit, the smaller banks have lower reserves of tier 1 capital, and in the well-supervised countries like Australia and Canada, are facing cost pressures in sourcing external funding as a result.

In effect, the new Basel accord indicates that bank leverage up to 20x common equity is ok. Lehman would have passed this test.

This framework will prevent banks from dishing out bonuses as high as in the recent past in times of plenty (i.e. during cyclical asset booms).

Will the new requirements have an impact on bonuses? In theory they should, as banks squirrel away retained earnings in lieu of paying dividends to shore up their equity base. While measures of performance for bonuses at the top banker level differ, they all effectively come down to returns on equity. Bonuses can be expected to shrink as ROE falls, particularly for smaller banks, and banks that engage in trading, derivative and securitisation activities, given the higher capital requirements that will be introduced for such activities at the end of 2011 (and which have resulted in banks such as Goldman Sachs and certain local players exiting trading activities on their own book).

Basel III also does not appear to explicitly recognise the impact that significant bonus deferral can have for capital adequacy requirements. Currently bonus deferral is required by guidelines or regulations in effect or about to come into effect in most OECD countries. Australias came into effect via APRA guidelines on 1 April 2010 (see HERE). As was pointed out recently in testimony to the US House Financial Services Committee by a Brookings Institution economist (see HERE) :

“Large firms that implement aggressive holdbacks can boost by billions of dollars the capital they have available to buffer against a major shock.”

However, in relatively high growth economies such as Australia where opportunity exceeds credit supply, the higher costs of credit are likely to be passed on without too much of a dent in bank returns and hence bonuses for the larger banks.

Todays bankers will have retired by the time the new rules are fully operational from 1 January 2019, and a new generation of post-gen Y bankers will have been weaned on a bonus starvation diet. OK, we exaggerate a bit. And maybe not so much in Australia. Australian banks already meet these requirements. Assuming APRA does not set its standards too much higher, we will get an idea of the bonus impact in the next three years or so.

Full details of the Basel III requirements are available at the BIS site HERE.

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