Basel Committee endorses new rules on bank instruments

MANILA, Philippines - The Basel Committee has issued last week the minimum requirements to ensure that all classes of banks’ capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss.

The committee’s oversight body, the Group of Governors and heads of supervision, endorsed the requirements during its Jan. 10 meeting.

Members agreed that under certain conditions, including a peer review process and disclosure, the proposal’s objective could be met through a statutory resolution regime if it produces equivalent outcomes to the contractual approach.

During the financial crisis, a number of distressed banks were rescued by the public sector by injecting funds in the form of common equity and other forms of Tier 1 capital.

“While this had the effect of supporting depositors, it also meant that Tier 2 capital instruments (mainly subordinated debt), and in some cases Tier 1 instruments, did not absorb losses incurred by certain large internationally-active banks that would have failed had the public sector not provided support,” the committee said in a press statement.

In order for an instrument issued by a bank to be included in additional (i.e. non-common) Tier 1 or in Tier 2 capital, it must meet or exceed minimum requirements to ensure loss absorbency at the point of non-viability.

These requirements are in addition to the criteria detailed in the Basel III capital rules that were published in December 2010.

The minimum requirements to ensure loss absorbency at the point of non-viability include scope and post trigger instrument, trigger event, group treatment, and transitional arrangements.

Scope and post trigger instrument

1. The terms and conditions of all non-common Tier 1 and Tier 2 instruments issued by an internationally active bank must have a provision that requires such instruments, at the option of the relevant authority, to either be written off or converted into common equity upon the occurrence of the trigger event.

2. Any compensation paid to the instrument holders as a result of the write-off must be paid immediately in the form of common stock (or its equivalent in the case of non-joint stock companies).

3. The issuing bank must maintain at all times all prior authorization necessary to immediately issue the relevant number of shares specified in the instrument’s terms and conditions should the trigger event occur.

Trigger event

The trigger event is the earlier of: 

1. A decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority; and

2. the decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable, as determined by the relevant authority.

The issuance of any new shares as a result of the trigger event must occur prior to any public sector injection of capital so that the capital provided by the public sector is not diluted.

Group treatment

The relevant jurisdiction in determining the trigger event is the jurisdiction in which the capital is being given recognition for regulatory purposes.

Therefore, where an issuing bank is part of a wider banking group and if the issuing bank wishes the instrument to be included in the consolidated group’s capital in addition to its solo capital, the terms and conditions must specify an additional trigger event.

This trigger event is the earlier of: (1) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority in the home jurisdiction; and (2) the decision to make a public sector injection of capital, or equivalent support, in the jurisdiction of the consolidated supervisor, without which the firm receiving the support would have become non-viable, as determined by the relevant authority in that jurisdiction.

Any common stock paid as compensation to the holders of the instrument must be common stock of either the issuing bank or of the parent company of the consolidated group (including any successor in resolution).

Transitional arrangements

Instruments issued on or after Jan. 1, 2013 must meet the criteria set out above to be included in regulatory capital. Instruments issued prior to Jan. 1, 2013 that do not meet the criteria set out above, but that meet all of the entry criteria for Additional Tier 1 or Tier 2 capital set out in Basel III: A global regulatory framework for more resilient banks and banking systems, will be considered as an “instrument that no longer qualifies as additional Tier 1 or Tier 2 and will be phased out from Jan. 1, 2013.