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.
In implementing Basel III, OSFI has made a number of important changes to the previously issued version of the guideline which will affect the way that Canadian banks and other deposit taking institutions (“DTIs”) determine capital adequacy. This bulletin provides a brief overview of some of the changes implemented in the Final Guideline, including changes with respect to structured products as well as the calculation of market risk.
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.
The assets to capital multiple is calculated by dividing an institution’s total assets (including items considered “off-balance sheet”) by the total of its adjusted net Tier 1 Capital and adjusted Tier 2 Capital (as defined in Chapter 2 of the Final Guideline). For a more detailed discussion of Tier 1 and Tier 2 capital, refer to Davis’ previous bulletin of May 2012 on this subject. As a general rule, total assets should be no greater than 20 times capital, though there are exceptions to this standard ratio (see Final Guideline, Chapter 2).
To calculate an institution’s risk-based capital ratio, it is first necessary to determine the total of its “risk-weighted assets”, (rather than “total assets” as used to establish the asset to capital multiple). An institution’s total risk-weighted assets are determined by multiplying the capital requirements for market risk and operational risk by 12.5 and adding the resulting figures to the risk-weighted assets for credit risk. To calculate the risk-capital ratio, the institution’s total capital is divided by its risk-weighted assets. The resulting percentage gives some idea as to the relative capital strength of the institution, taking into account the risks to which its various assets are exposed. The minimum risk-based capital ratio permitted by the Final Guideline is 8%.
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.
- the Final Guideline has been revised to include the Basel III minimum and target capital levels, as well as the asset to capital multiple calculation described above. The standards for calculation of capital instruments have been made more onerous, as have been the requirements with respect to mandated regulatory adjustments. For credit risk, new risk weights have been introduced for use in calculations made under the standardized approach. Notably, the use of unsolicited ratings for assets that constitute sovereign exposures (subject to certain conditions) is now permitted.
- The most significant changes with respect to settlement and counterparty risk (chapter 4) are the introduction of a new capital charge for credit valuation adjustment instability and new capital requirements for exposure to central counterparties. The range of eligible guarantors in the context of mitigating credit risk has been limited, and greater detail has been given with respect to determination of the materiality threshold for equity exposures which may be excluded from the internal ratings based (“IRB”) calculation of credit risk.
- Finally, regarding structured products, changes have been included which incorporate the Basel III requirement for 50/50 deductions to move to a 1250% risk-weight, which is discussed in greater detail below.
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.
Securitization exposures subject to the 1250% risk-weight include credit-enhancing interest-only strips (net of any increase in equity capital resulting from securitized transactions), investments in securitization exposures with short term ratings below A-3/P-3/R-3 or which are unrated, and below-investment-grade retained securitization exposures. Originating banks and entities divided by credit risk calculation methods (i.e. the standardized approach or the model approach) have different categories of securitization exposures to which the 1250% risk-weight applies.
The calculation of market risk, as discussed in “Chapter 9 – Market Risk” of the Final Guideline, also reflects the shift to a 1250% risk-weight as described above. Institutions are required to monitor the level of risk against which capital requirements are applied. The capital requirement in the context of market risk is determined either by adding the sum of all capital charges for market risk, as calculated using the standardized approach, or by the measure of market risk derived from the model approach (or a mixture of the two). It is in the calculation of the capital charges where the 1250% risk-weight is relevant. Incorporation of this new risk-weight into the calculation has the potential to greatly affect the capital requirements of which institutions must be mindful.
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.
If you have any questions concerning this bulletin, please contact the authors or any member of the Davis LLP Banking & Financial Services Group.