In the wake of bank bailouts and other interventions adding trillions of dollars to public sector borrowing requirements and in some cases causing doubts about the ability of governments to repay their debts, policymakers swore never again and set about addressing the flaws in Basel II.
Given the time it took to agree the previous accords, there was little appetite for tearing up the framework and starting again. Basel III would be a matter of identifying and rectifying the weaknesses highlighted by the crisis.
The most obvious of these was that the level of capital, especially common equity, that banks were required to hold as a minimum was utterly inadequate to deal with a serious systemic crisis.
In the run-up to the credit crisis, banks outside the US were required to hold minimum core capital of just 2% of risk weighted assets a level that looks laughably low in retrospect, particularly given that a wide variety of instruments were included in that total, many of which failed to bear losses as was intended.
The world learned in September that in future, this ratio would rise to a bare minimum of 4.5% in practice nearly double that and consist of common equity or instruments so close as to make little difference in cost or loss absorbency.
"The Basel consultation paper is clear that in most cases core tier one capital will consist of ordinary shares for joint-stock companies," said Peter Jurdjevic, head of the capital products group at Barclays Capital in London. "Non-voting classes of shares that are the functional equivalent of ordinary shares may be eligible for inclusion in core tier one capital in limited circumstances and for non-joint stock companies, but these cases will be exceptions to the rule."
For mutuals, the tighter definition of core capital raises problems. Regulators have acknowledged the difficulties of issuing common equity, but their determination to restrict core capital means they have made few concessions.
"They are effectively either in a position where they have to offer to equity investors an instrument that is basically an ordinary share, which would result in a back-door or de facto demutualisation, or alternatively there is an instrument which doesnt convey voting control, doesnt convey economic upside, and meets the core tier one criteria," says Jurdjevic. "Its hard to imagine that instrument can be sold in large size because there isnt really a defined investor base for that kind of profile. I dont think theres an easy answer at the moment."
As a result of the Basel III process, the role of lesser quality capital has been greatly reduced non-core tier one will be limited to 1.5% and tier two capital to 2%, less than under the current rules and on a proportional basis much less so. The end result is a capital structure that is both simpler and more complicated. Gone are the myriad capital instruments of yore, replaced by ordinary shares and more homogeneous, clearly loss-bearing hybrid instruments.
Similarly, deductions from capital have become more strict and more harmonised across jurisdictions. Consequently the relative ability of banks to sustain losses as a going concern, let alone a gone concern, should be much clearer to investors.
Adding to the complexity, however, is the shift away from a binary well-capitalised/under-capitalised ratio to a more graduated capital framework. On top of the absolute minimum rests a "capital conservation buffer" set at 2.5% and comprising core capital. This buffer is designed to solve the collective action problem encountered during the crisis, whereby banks continued to distribute earnings in the form of discretionary coupons, dividends and bonuses while suffering heavy losses, for fear that they would lose ground to their competitors. In future, banks will be increasingly restricted from making such distributions as they eat into their buffer.
Finally, banks will have to hold up to 2.5% of additional common equity "or other fully loss absorbing capital" as a counter-cyclical capital buffer. The actual level will depend on the decisions made by regulators in the jurisdictions to which the firm has exposure. If a bank is concentrated in one country where the regulator has imposed the full buffer because it deems credit to be strongly outpacing the economy, it will have to hold 2.5%. Conversely, a bank operating solely in a country at the bottom of the credit cycle will not have to hold anything in its buffer. In practice, geographically diversified banks are likely to fall somewhere in the middle.
"The direction of travel appears to be clear," says Steven Penketh, head of capital issuance and securitisation at Barclays Bank in London. "The capital structure of the future will comprise equity core tier one, with an overlay of tier one and tier two that are likely to require contingent loss absorbing features at prescribed trigger points."
Issue and be dammed
Banks have been given a long timetable to transition to their new capital structures Basel III wont fully fall into place until 2023, although elements kick in from 2013. But the delay in setting the calibration and deciding on rules for grandfathering of existing capital instruments has left financial institutions in a something of a quandary. For several years, they have known they will need to raise capital, yet other than expensive equity, they did not know precisely what would count.
"Given that the rules for new generation [instruments] have not yet been finalised, this places potential issuers in a difficult position," wrote Fitch in response to the September announcement from Basel. "Either they structure the instruments to the most conservative level of the current proposals (and pay the necessary premium for the extremely high potential loss-absorption) or they undertake a less conservative (and cheaper) structure and run the risk of losing the transition benefits. In the face of similar cut-off dates in the past, it has ultimately been down to national regulators to guide their banks as to what they will accept during this transition period."
Faced with this uncertainty, many have gone ahead and issued under the existing rules, accepting they may have to call the instruments at a later date. Overall volumes, however, have been much lower.
"Tier one that doesnt get grandfathered or start to amortise will have none of the loss absorbency features that would qualify it as lower tier two did," says Matt Carter, head of bond origination at Royal Bank of Scotland in London. "The question for issuers to my mind is: How do they view the price of this tier one debt? Do they view it as cheap senior funding, because thats all its going to give you? It increases the likelihood that issuers will call all of their tier one debt at the first instance, because it has very little place in the capital structure going forward."
Part of the reason that banks have been reluctant to goldplate their capital issuance is that the new loss-absorbency features are unattractive to the traditional investor base for bank capital, and may even result in the loss of tax deductibility, a key cost driver for hybrid capital. Until they knew exactly how much they would need to raise and whether it could be met from retained earnings, it made little sense for most institutions to pay the cost of establishing a new investor base.
Much of the issuance so far that has had an eye to the future for instance Lloydss issue of contingent capital has come in the form of exchange offers, taking advantage of depressed prices for subordinated debt and little prospect of coupon payments. Other banks which are under state aid restrictions may follow suit, given that they will lose capital eligibility for many instruments at their call date but may not be allowed to redeem the notes.
"Liability management where there is a discount to par that you can book as a gain to core tier one, will certainly be a feature of these securities," says Gordon Taylor, head of FIG origination for Northern Europe at RBS in London. "The national capital injections are exempt, so to the extent that the regulator looks at the tier two position around non-call, for example, as part of the regulatory capital regime, there might be some extra flexibility there."
Still up for grabs is the question of how much additional capital systemically important institutions will need to hold, and what form it will take. Despite being identified as a central weakness of the existing framework, it is among the last to be addressed by the Basel process and most national regulators Switzerlands special rules for Credit Suisse and UBS being an obvious exception.
Septembers agreement on capital ratios included only the briefest of mentions of tougher rules for systemic firms, saying that it "could include combinations of capital surcharges, contingent capital and bail-in debt".
The announcement raised more question than it answered, and not just because the amount of capital was left for a later date. Bail-in debt, where senior creditors take a haircut or a conversion ahead of bankruptcy has been much discussed but without any direction as to how it would operate in practice most particularly whether all senior debt would be included or just a subset.
"Bail-in debt is a difficult concept for investors to grasp, frankly," says Taylor. "You can foresee a situation for example where bail-in debt is part of senior debt, and that could in some situations exacerbate a bank as it sees its liquidity dry up in the short term, because investors are obviously frightened that their senior debt, which up that point ranked pari passu with depositors, could be part of a bail-in. You could see that exacerbating the non-viability of the institution right at the point it needs a stable funding platform. The queues outside Northern Rock were perhaps a stark example of that."
In late August, Germanys cabinet approved a draft law on bank restructurings which included bail-in language for all new debt, but the practicalities remain unclear. At first bail-ins would form part of a voluntary restructuring process, but if this fails, regulator BaFin can step in and force a resolution.
"The debt for equity swap or contribution of debt creditors to the crisis cannot be done without consent but consent can be replaced by majority voting," says Marc Benzler, a capital markets partner at Clifford Chance. "Also, it might be difficult to designate the respective classes of creditors and how they are grouped."
The European Union is expected to put forward similar proposals on creditor haircuts as part of legislation for a harmonised crisis management framework in October.
The market remains sceptical, however, that mandatory bail-ins for senior debt are viable, given the lack of investor appetite.
"I dont see bail-ins happening," says David Soanes, head of FIG for EMEA and deputy global head of GCM at UBS in London. "I dont think therell be a big enough market for bail-in senior debt securities so I dont think it will happen. With loss bearing hybrid capital youre a little bit more in that sphere, because the scale of what you need to produce under the new rules is quite small relative to the scale funding in general, and its an investor base thats already deciding to take additional risk. Making hybrid capital more equity-like isnt anathema to an awful lot of investors, its just a question of what they charge for it. With senior debt youre trying to be as far away from having equity returns and equity risk as possible. Its like having ice cream with your fish it just doesnt go."
Investors assessment of systemically important institutions will also be affected by changes to insolvency regimes. Here more progress has been made, although policymakers seem to have abandoned any hope of a truly integrated cross-border insolvency process. The changes made in many jurisdictions, however, share several key features, designed to make it easier for large firms to fail in a relatively orderly fashion, limited the need for taxpayer support.
Several jurisdictions, including the UK, USA and Germany, have passed legislation giving policymakers greater power to step in at an early stage and break up failing institutions, in some cases even when they are not insured, deposit-taking institutions. The European Commission has called for a harmonised resolution regime for banks in Europe, backed by a pan-European fund financed by a levy on the sector. Even the commission, however, acknowledges that political difficulties of such a plan and has settled on a network of funds in member states as a medium term goal.
Changes to capital rules will also affect banks as investors in their own debt, most notably in the area of securitisation. Pre-crisis, banks and their affiliated structured investment vehicles made up a very large proportion of the investor base for asset backed securities and their low funding and capital costs meant that securitisation became an extremely cheap funding source for banks.
A combination of the credit crisis, gross leverage ratio under Basel III and tweaks to the asset side of capital rules will put an end to that dynamic, however.
"The investor base demographic for senior bank funding has changed beyond all recognition," says Carter. "Clearly the Basel I world of banks buying each others paper is gone. The world of SIVs who were big buyers particularly of triple-A RMBS is gone.
"Banks are effectively having to fund themselves by selling to asset managers and pension funds, which is clearly the same audience that corporate and governments are targeting as well. Banks have been fortunate this year in that corporate issuance in the eurozone is down 50% so there hasnt been competing supply, but it does mean that banks will be looking at every tool in the funding cabinet."
Tightened rules on the trading book mean that banks can no longer hold large quantities of ABS, only holding capital against market risk. In Europe, bank investors will have to perform extensive credit analysis to avoid punitive risk weightings on their securitisation positions and will only be able to invest in securitisations where originators have retained at least 5% of the risk.Meanwhile the gross leverage ratio, due to come into force in 2018, will reduce the incentive to hold large volumes of triple-A rated assets the bulk of securitised debt and is designed to prevent firms from building up large off-balance sheet exposures along the lines of SIVs. Securitisation established its once central role as a funding tool on the back of banks explicit and hidden leverage forced deleveraging of the banking system will relegate securitisation to a much smaller role until real money picks up the slack.