Final Guideline for Basel III Implementation Now in Effect
Davis LLP Banking & Financial Services Bulletin
May 6, 2013
The Office of the Superintendent of Financial Institutions (“OSFI”) issued the ‘final’ version of its Capital Adequacy Requirements Guideline (the “Final Guideline”) in response to the reforms adopted by the Basel Committee on Banking Supervision (“BCBS”) in December 2012. These reforms, commonly known as “Basel III”, are intended to strengthen global capital adequacy rules and encourage greater resilience in the banking sector. The Final Guideline came into effect on January 1, 2013, with the exception of provisions governing Credit Valuation Adjustment, which come into effect on January 1, 2014. Capitalized phrases used in this bulletin and not otherwise defined are terms of art in the Final Guideline, which is accessible here.
Capital Adequacy: General Concepts
Banks and other DTIs are required by the OSFI to maintain, on a continuous basis, a minimum asset to capital ratio. There are two calculations used to establish an institution’s capital adequacy: the assets to capital multiple, and a risk-based capital ratio. The former provides an overall assessment of the sufficiency of an institution’s capital; the latter is used to weigh assets according to their vulnerability to credit risk, operational risk, and market risk.
Final Guideline: Basic Changes
The Final Guideline departs from previous versions both in structure and content. Most immediately apparent is the consolidation of the guideline, formerly made up of two volumes (a simplified approach to capital adequacy calculations applicable to certain institutions in one volume; the remaining calculation approaches in the other, following the format of Basel II), into one. The numbers from the original BCBS text are no longer used to order the document, but rather paragraphs and sections are numbered sequentially. A new chapter (Chapter 4 - Settlement and Counterparty Risk) has been added, made up of what were Annex 3 and Annex 4 to Chapter 3 - Credit Risk - Standardized Approach, as well as sections of what was previously Chapter 8 (now Chapter 9) - Market Risk. This new Chapter 4 focuses to a significant extent on the rules surrounding credit derivative instruments, possibly on account of the rapid growth of the global CDS market at the time Basel III was in development, and the role credit derivatives played in the financial crisis.
Final Guideline: Specific Changes
In the move from Basel II to Basel III, the method for calculating operational risk is unchanged. Similarly, the Basel II standards are still used in the Final Guideline as the basis for establishing market risk; there are however several noteworthy adjustments relevant to the calculation of market risk.
Calculation of Market Risk
Previously, a 50% deduction from regulatory capital was a required adjustment for exposure to structured products. Basel III has introduced a new approach. Going forward, most securitization exposures will be risk-weighted at 12.5:1 or 1250%. Equity exposures determined under the PD/LGD approach (see Chapter 6 of the Final Guideline), and significant investments in commercial and equity exposures, as well as major investments in commercial entities, will also be subject to the 1250% risk-weight. Chapter 7 permits certain exceptions: the most senior exposure in a securitization, exposures in a second-loss position or better in some ABCP programs, and eligible liquidity facilities, are all exempt from the 1250% risk-weight requirement.
New Application of Dealer Exception
A further important change to “Chapter 9 - Market Risk” was made with respect to the new application of the dealer exception. Generally, positions held in an institution’s own eligible regulatory capital instruments are deducted from total capital. As well, positions in other institutions’ eligible regulatory capital instruments, or in intangible assets, will be treated the same way as assets held in the banking book. A dealer exception to these rules may now be granted when an institution demonstrates to OSFI that it is an ‘active market maker’. The exception applies to holdings of other DTI capital and would allow that institution to treat those holdings as being held in the trading book. It should be noted however, that this exception will apply only to positions in other financial institution’s regulatory capital instruments, and only on positions which are not in excess of the 10% limit on non-significant investments in capital of banks, financial, and insurance entities as described in Chapter 2 of the Final Guideline.
While retaining much of the content of Basel II, the Final Guideline introduces several important changes of which banks and other DTIs must be aware. Although the changes from the preliminary guideline may appear minor, the Basel III scheme on the whole is a departure from the now-familiar approach of Basel II. It is important that banks and DTIs in Canada be both fully aware of the Final Guideline and comfortable with the Basel III regime.