A Brave New World: The Impact of Basel III on Canadian Banking Operations

By Stephen B. Kerr
Fasken Martineau DuMoulin LLP

It has been said that from a regulatory perspective banks historically worried about three things in the following order of importance: capital, capital and, finally, capital. Unfortunately for banks, life is becoming a little more complicated and the menu of regulatory priorities is becoming more extensive.

With the support of the G20, over the last few years the Basel Committee has created a more robust method of monitoring members' commitments to implementing its standards to improve consistency and transparency. The arrival of Basel III, the more aggressive, even petulant, younger sibling of Basel I and Basel II, has compelled the global banking industry to examine the new regulatory requirements while evaluating how these new regulations will impact operations in general and bottom lines in particular.

This article examines the advent of Basel III and its implications upon operations for banks in general and Canadian banks in particular. It will explore how Basel III's capital, leverage, liquidity and disclosure requirements will alter the landscape of Canadian banking and how these regulatory reforms may change banks' future strategies and business operations.

BASEL WHO?
Basel is a lovely city in Switzerland replete with museums, theaters and wonderful views. Not a bad place to get some chocolate either. So why then is everybody dumping on Basel these days? Well it goes back a bit and it largely has to do with banks and banking, and specifically, the Basel Committee on Banking Supervision (Basel Committee).

The Basel Committee provides recommendations on banking regulations regarding capital risk, market risk and operational risk and is responsible for strengthening the regulation, supervision and practices of banks worldwide to enhance financial stability. The Basel Committee's central and most important mandate is to promote strength among banks worldwide and establish banking standards which are developed, encouraged and issued in agreement with member countries.

The Basel Committee first created the Basel Accord, which began with the issuance of Basel I in 1988, the first systematic global attempt to regulate bank capital. Basel I focused primarily on credit risk by creating a bank asset classification system that grouped a bank's assets into five risk categories. The set of agreements comprised in Basel I was meant to ensure that financial institutions had enough capital on hand to meet obligations and absorb unexpected losses.

Basel II was issued in 2004 and introduced further capital requirements applicable to banking institutions in countries such as Canada, the United States and the United Kingdom. It was intended to strengthen the measurement and monitoring of financial institutions' capital by adopting a more risk sensitive approach to capital management. The Basel II framework was made up of three complementary pillars:

  • Pillar 1 – minimum capital requirements – established specific rules for the calculation of minimum capital for credit, market and operational risk (capital adequacy requirements).
  • Pillar 2 – supervisory review – gave regulators the power to evaluate the adequacy of the regulatory capital requirement under Pillar 1 and provided a framework for dealing with systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk. The Internal Capital Adequacy Assessment Process (ICAAP) was the result of Pillar II.
  • Pillar 3 – market discipline – complemented the minimum capital requirements and supervisory review process; through public disclosure, it allowed market discipline to become a reality. Expanded disclosure about capital and risk allowed market participants including investors, analysts, customers, other banks and rating agencies to better understand the capital adequacy and risk profile of a given institution — effectively leading to solid corporate governance.

A GLOBAL WAKE-UP CALL
It is almost impossible to be accused of hyperbole when describing the impact of the global financial crisis of 2008. Pick your most horrific-sounding adjective and it would likely fit. Arguably the worst financial crisis since the Great Depression, it shook large financial institutions to the core; banks were bailed out by national governments, stock markets declined dramatically and the housing market in some countries imploded. In many countries, economic growth became a distant memory. Significant decreases in economic activity led to a recession that lasted four years and contributed to the European sovereign-debt crisis. The possibility of total financial collapse was very real. We are five years into this mess and it will likely be another five years before we get out of it (since I am not an economist you can actually rely on this prediction).

Besides demonstrating that some bankers were marketing risky products they didn't understand and that the boards of directors of such institutions were asleep at the switch, the crisis emphasized the systemic importance of banks to national and international economies, underscored the inherent weaknesses in financial regulation around the world and slowed economic expansion in multiple sectors for the foreseeable future. The undercapitalization of many foreign banks was thrust into the spotlight. Outside of Canada, banks became insolvent and were either taken over by banking regulators or received taxpayer-funded bailouts without which insolvency was inevitable. Governments and their banking regulators criticized globally-issued forms of Tier 1 capital (i.e., other than common shares) for not effectively absorbing losses before taxpayers found themselves on the hook. At the risk of understatement, it was clear that the regulatory framework governing the global financial system needed an overhaul.

All this to say that we can therefore excuse Basel III for being the unruly younger sibling of Basel I and Basel II for the simple reason that this regulatory offspring was conceived in much more difficult times and certainly in no bed of roses.

A BRAVE NEW WORLD
The Basel Committee announced the third installment of the Basel Accord in December 2010 in response to the deficiencies in financial regulation revealed by the worldwide economic collapse. Aimed at more strictly regulating banks and strengthening the global banking system, the new framework hopes to create a financial system that is better equipped to weather financial and economic pressure and help ensure a financial future with fewer (unpleasant) surprises. The regulatory rules set out in Basel III include higher minimum capital requirements, new capital conservation and countercyclical buffers, revised risk-based capital measures, a new leverage ratio and two liquidity standards.

On February 1, 2011, Canada's Office of the Superintendent of Financial Institutions (OSFI) issued its own action plan for the implementation of Basel III in Canada. As Canadian banks are among the most well capitalized, well managed and well regulated in the world (and aided of course by a more conservative and risk-averse Canadian business culture coupled with a more stable housing market), they are well positioned, particularly when compared to most foreign financial institutions, to absorb these regulatory imperatives. This has allowed OSFI to mandate an accelerated adoption of Basel III in Canada.

THE JOYS OF CAPITAL
Basel III introduces a new minimum common equity capital ratio (or core capital requirement). Effective January 1, 2015, deposit-taking institutions such as banks and trust and loan companies (commonly referred to as DTIs — but let's keep life simple and just call them “banks”) will be required to hold Tier 1 common equity equal to 4.5 per cent of their risk-weighted assets. Minimum Tier 1 capital, which will include common equity Tier 1 and additional Tier 1 capital, will be required to be 6 per cent of a bank's risk weighted assets. Total (i.e., Tier 1 and Tier 2) capital, which a bank will be required to hold, or its minimum total capital ratio, will remain at 8.0 per cent of its risk-weighted assets. The concept of Tier 3 capital is being eliminated.

In addition to the above requirements, Basel III has also introduced a capital conservation buffer intended to assist in absorbing losses during stress periods. It must consist entirely of common equity and will be phased in commencing January 1, 2016. By January 1, 2019, banks will be required to have an additional 2.5 per cent of common equity Tier I capital over and above their 4.5 per cent minimum, resulting in a total common equity requirement of 7 per cent; a minimum Tier 1 capital requirement of 8.5 per cent; and a minimum total capital ratio of 10.5 per cent. If a bank does not have the common equity to comply with this buffer requirement, it will be permitted to conduct business as usual but its ability to pay dividends and discretionary bonuses or engage in share repurchases will be restricted.

Basel III introduces a separate counter-cyclical buffer requirement of up to 2.5 per cent of additional common equity intended to protect a country's financial system from the adverse consequences of excess aggregate credit growth. This discretionary buffer requirement could, at any time, be imposed at a national level by OSFI. If the full amount of the counter-cyclical buffer is added in, a bank's common equity Tier 1 capital increases to 9.5 per cent, its Tier 1 capital increases to 11 per cent and its total capital increases to 13 per cent. Still with me?

Basel III also clarifies the capital treatment of minority, or non-controlling, interests and other capital issued out of consolidated subsidiaries and held by third parties. It also discusses in detail certain regulatory adjustments to be applied in the calculation of regulatory capital (and common equity Tier 1 in particular).

Finally, the capital requirements of certain bank activities are increased under Basel III. The Basel Committee significantly raised the capital obligations relating to a bank's trading book and complex securitization exposures. Basel III concentrates on counterparty credit risk (CCR), namely, the risk that a counterparty to a material transaction could default or otherwise be unable to honor its obligations prior to the settlement of the transaction. The focus is on derivatives, repo and securities finance activities. Banks will be required to determine their capital requirement in relation to CCR using stressed inputs and will be subject to a capital charge for potential mark to market losses (as opposed to outright defaults) associated with a deterioration in the credit worthiness of a counterparty.

Clearly, the quantity of capital still matters and retains a very prominent place on the regulatory menu, but it is no longer just quantity that matters as quality of capital is becoming increasingly important.

SKIN IN THE GAME
During the recent financial crisis, a number of non-Canadian distressed banks were rescued by capital injections from the public sector. In response, on January 13, 2011, the Basel Committee issued requirements to ensure that all classes of capital instruments can fully absorb losses at the point of non-viability. More specifically, all non-common Tier 1 and Tier 2 instruments intended for inclusion for purposes of regulatory capital must either contractually or statutorily include a provision whereby the instrument is either written off or converted into common equity at the point of non-viability before taxpayer dollars are used to bailout a bank; transferring costs first to investors of contingent capital, who will absorb losses. A taxpayer may be excused for asking why this was not always the case. Maybe one day we will get an answer to that question.

On February 4, 2011, OSFI published a draft advisory discussing its expectations regarding non-viable contingent capital. OSFI subsequently released its final Advisory on Non-Viability Contingent Capital (NVCC) on August 16, 2011, marking the latest development in Canada's implementation of Basel III. The Advisory provides that capital instruments, other than common shares, issued by banks must, in order to qualify as regulatory capital (which is the whole point after all), contain a feature providing for automatic conversion to common shares upon the occurrence of a trigger event. Effective January 1, 2013, all Tier 1 and Tier 2 capital instruments issued by banks other than common shares must comply with the principles set out in the Advisory.

To satisfy OSFI's NVCC requirements, a capital instrument of a Canadian bank, including a Canadian subsidiary of a foreign bank, must: (a) have a clause requiring a full and permanent conversion into common shares of the bank upon a trigger event; and (b) meet all other criteria for inclusion as tier capital as specified by Basel III.

Under Basel III, all non-common capital instruments issued after January 1, 2013, must include NVCC features. Those without NVCC features will be phased out according to the timeline set out in Basel III. The aggregate amount of a bank's outstanding non-qualifying capital instruments will be determined at that time. Recognition of these instruments for capital purposes will be capped at 90 per cent from that date, with the cap reducing by a further 10 per cent of the original base in each subsequent year. Canadian banks have indicated that, with rare exception, they will be able, solely though par redemptions, to reduce non-qualifying capital in compliance with the Basel III phase out schedule.

BIGGER ISN'T ALWAYS BETTER
In March 2013, OSFI designated all six of Canada's largest domestic banks (Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada, and The Toronto-Dominion Bank — the “Big Six”) as domestic systemically important banks (D-SIBs). Basel III has finalized twelve principles to assess and create higher loss absorbency for D-SIBs.

Aimed at limiting the likelihood of failure, D-SIBs will be subject to a one per cent risk-weighted capital surcharge starting January 1, 2016, in addition to the Common Equity Tier 1 ratio of seven per cent they already have to hold as protection against financial instability, which increases their relative cost of doing business and puts even more pressure on return on equity (ROE). It is not anticipated, however, that these Canadian banks will be designated as global systemically important banks (G-SIBs) that would have more significant capital requirements. Like winning the prize for most improved player at the end of a season, being designated a G-SIB isn't a prize anybody really wants.

The Big Six will also have to comply with continued supervisory intensity and enhanced disclosure requirements. These enhanced disclosure requirements are the equivalent of a Distant Early Warning (DEW) Line for Canada's banking sector, a radar system of sorts, to provide initial warning to both banks and regulators of looming financial and economic stress. In addition, an increased emphasis on timely and accurate disclosure will result in greater transparency, with a focus on Tier 1 capital and, less so than is currently the case, on Tier 2 capital.

While this regulatory DEW Line benefits the greater economy by reducing the risk of spillover from the financial sector in the event of a disruption, it adds to an already hefty regulatory burden for banks in Canada.

TIMES ARE A CHANGING
Much of the foregoing relates to capital, but as will become clear, Basel III is a beast with more than one head.

Basel III seeks to respond to what was seen as an excessive buildup of on- and off-balance sheet leverage in the banking system immediately prior to the financial crisis. Unlike Canada, where OSFI has for many years imposed a leverage constraint in the form of an assets to capital multiple (ACM) of 20 times subject to adjustment, many Basel Committee member countries did not have a leverage constraint (or a leverage constraint as conservative as Canada's) prior to Basel III.

The Basel Committee is in the process of finalizing a leverage ratio requirement whereby Tier 1 capital must equal at least three per cent of on- and off-balance sheet exposures with a projected implementation of early 2018. Once the Basel III leverage ratio has been substantially finalized, changes to Canada's ACM will be made, if necessary. In the meantime, Canadian banks are expected to meet the ACM test and to operate at or below their authorized multiple on a continuous basis.

A NOVEL IDEA
As I keep telling my kids financial health is not just about assets, it is also about how quickly those assets can be converted into cash or, put another way, liquidity. Basel III imposes new liquidity requirements for banks in the form of two new ratios: liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). Accordingly, Banks are required to maintain high quality liquid assets to cover 100 per cent of net cash outflows that could be encountered under certain stress scenarios (LCR) and maintain a minimum amount of secure medium and long term funding based on the liquidity characteristics of their assets over one year (NSFR). From a Canadian regulatory perspective, it is this new emphasis on liquidity that is truly novel. This is the case not only for the banks but also for OSFI, as it struggles to understand these new requirements and how they will be measured.

In this new regulatory reality, Canadian banks will need to adjust to robust liquidity tests. Some banks in Canada will dispose of non-core banking assets or those that are too illiquid (not to mention capital intensive) as they are forced to comply with the new Basel III liquidity requirements.

From an M&A perspective, the liquidity requirements embedded in Basel III will place a large premium on highly liquid and capital favorable assets. All banks will have to reassess their investments in order to shed those that: (a) aren't core to the business of banking; (b) are capital intensive and/or illiquid; or (c) are in regions where such institutions don't want to be (i.e., foreign regulatory traps). They will have to examine their current business lines and investments and ask why they are in a particular business in light of this new regulatory environment. Canadian banks' non-core banking asset divestitures will no doubt create buying opportunities for certain strategic buyers and private equity investors. While the proliferation of divestitures will become a reality, the future may also see these institutions seek out highly liquid assets and look further afield for term deposits and similar types of assets. As Canadian banks revisit their business models, a bigger focus on return on capital and liquidity and an emphasis on capital reallocation based on revised (and tighter) risk weighting (another neat way for regulators to increase capital requirements) and risk assessment concerns will shift their acquisitions and divestitures activities. Canadian banks will not necessarily be simply sellers, however. As a result of capital, liquidity and leverage requirements, non-Canadian global banks (such as those in Europe) will be required to scrap certain activities, giving Canadian banks some attractive acquisition opportunities.

Overall, the emphasis on retail banking and the necessary incentivizing of longer term deposits will help banks fulfill their liquidity requirements and long term funding issues. However, Canadian banks may find it more challenging to manage liquidity-risk than capital, and depending on their exposure to the American market, they will be significantly affected by non-Basel III considerations including Dodd-Frank and Volcker in the United States.

WHERE DO WE GO FROM HERE?
There is no question that the Basel III reforms will impact Canadian banks' strategies and business operations and possibly profitability by increasing the quantity, quality and transparency of capital and negatively impacting ROE. The potential for a growing divide between economic capital and regulatory capital could fuel the fire between banks and their regulators. The diminished emphasis on total capital and increased emphasis on Common Equity Tier 1, commonly referred to as “CET1” (and pronounced “cety”) may result in Canadian banks focusing on assets that are more capital friendly. Accordingly, the landscape of Canadian banking could change significantly.

Quite apart from its direct (capital and other) costs, the implications of Basel III (and for the Big Six as a result of their D-SIB designations) are far reaching for Canadian banks. While they are generally well-capitalized, each bank will have to carefully consider how these new rules will impact the type of capital they raise; their outstanding innovative capital and other capital instruments that will no longer qualify as Tier 1 or Tier 2 capital; the businesses they carry on; the investments they make and the assets they hold; the nature of the acquisitions they make (and perhaps more importantly, how they are financed); their costs and overall margins and profitability; and, not to be forgotten, the scale and extent of their distributions to shareholders whether by share buybacks, dividends or return of capital.

Banks may have to simplify or, in some cases, collapse legal structures and consider branch alternatives in foreign jurisdictions in order to ease capital strain. Canadian banks will also have to measure their exposure to foreign regulatory conditions. Let's not forget that to varying degrees Canadian banks have a significant presence in foreign markets. For Canadian banks it is not simply an issue of the evolving Canadian regulatory context but also what is happening internationally.

Basel III's increased complexity combined with a lack of regulatory consistency across countries will require very significant investment in tools and personnel necessary to effectively manage change. As Canadian banks work toward realigning their operational priorities, the push to enhance liquidity models and stress testing will require newer and more sophisticated tools necessary for better modeling, measuring and liquidity risk management. In short, sophisticated compliance expertise will be in high demand.

Better data administration, new and improved systems and highly trained personnel will become critical components of a bank's operations. Banks will have to streamline reporting both up and across institutions. Board and senior management time will be increasingly consumed with capital and liquidity concerns. There will be a greater premium on risk management and appropriate governance and the regulatory importance of the Chief Risk Officer's role will only continue to increase.

CONCLUDING THOUGHTS
The global financial crisis revealed significant flaws in the banking sector, resulting in the failure or taxpayer rescue of a number of non-Canadian distressed banks. Basel III's global framework aims to improve the resilience of banks and banking systems in the event of financial and economic stress, before taxpayers are stuck footing another enormous bill.

Banks in Canada are in a good position to adopt Basel III; they are strongly capitalized and have existing and sophisticated leverage models, excellent risk management capabilities, advanced and robust compliance and well-developed recovery plans. Canadian banks will find it easier to deal with the new liquidity requirements thanks to their historical emphasis on retail banking. That said it will come at a cost. In addition, managing liquidity is a novel regulatory innovation which will require Canadian banks (not to mention OSFI) to examine their balance sheets more closely.

Basel III, its requirements involving capital, liquidity, leverage and governance and its implications, both intended and unintended, represents one of the most significant regulatory developments affecting the banking industry in recent memory. It will dramatically impact the ways in which banks in Canada are managed and do business. It should be an interesting ride for shareholders, regulators, employees and customers alike. Of course, by the time it is all figured out, there will be a Basel IV to worry about. Perhaps by then I will have finally visited Basel and seen what all the fuss is about.