The financial crisis has led to significant changes in funding strategies and comprehensive reform of bank oversight. What changes have been made in German law and what do the tighter liquidity rules mean for financial institutions?
The necessary legislation is supposed to be in place in all G20 member states by the end of 2012. For EU, the European Commission published the EU Regulation "Capital Requirements Regulation" (CCR-E) and the EU Directive "Capital Requirements Directive" (CRD IV-E) in July 2011 to implement the Basel III regulations in national law.
In Germany, adopting CRD IV-E requirements has meant substantial changes to the KWG (German Banking Act) and its subsidiary regulations. The federal government proposed an implementation act to implement CRD IV on 22 August 2012, but the legislative details are still being worked out.
On 11 October, the German banking industry submitted extensive comments on the proposed legislation and pushed to move the implementation to 2014. The first hearing on the bill took place in Bundestag on 18 October. It is expected that the CRD IV Implementation Act and the new regulations in the Banking Act will be passed this year. In the meanwhile, we are waiting for the direction that German law will take. For Basel III, it is of paramount importance that the mandatory regulations be implemented identically across the world at the same time, since otherwise, significant competitive inequalities might arise in the international financial market. By October of this year, only 8 of the 27 member states had issued their final regulations for the implementation of Basel III.
The G20 countries have committed themselves to global implementation of Basel III to strengthen the resilience of the banking system. This includes the areas of regulation described below.
Strengthening of solvency through higher quality and quantity of equity capital
The central element of Basel III is the major overhaul of the structure and transferability of core capital and the increase of the minimum capital from 8 per cent previously to 13 per cent. Tier 3 capital is completely eliminated from the calculations and the previous split of supplemental Tier 2 capital (to satisfy creditors' claims) has been abandoned. Tier 1 capital (to cover ongoing losses) is divided into common equity and additional core capital. It is essential that the allocation to capital groups now be based on strict criteria that take into account durability, loss participation and subordination. In particular, the net positions are significantly expanded. These include goodwill, intangible assets and financial investments.
Basel III provides for the gradual increase in core capital (see chart on the next page). The minimum capital requirement of 8 per cent will shift by 2015 from the current 4 per cent of core capital to 6 per cent. From 2016, further capital conservation buffers of 2.5 per cent must be built. In addition, national oversight boards can require a further buffer of up to 2.5 % depending on the current economic situation. The minimum capital requirements can rise up to 13 per cent; for banks important to the global system, a surcharge can be added.
Introduction of a Leverage Ratio
The excessive debt of credit institutions contributed to the financial crisis according to a study of the Basel Committee. A debt ratio is intended to limit the excessive debt.
It will be calculated each quarter on the basis of average monthly values. These are calculated as the ratio of Tier 1 core capital divided by the sum of assets both on and off the balance sheet. Items off the balance sheet shall be counted in full whereas the financial institution is charged only 10 per cent. The proportion of core capital must be at least three per cent according to preliminary information in CRR-E.
From 2013, the leverage ratio must be reported regularly. After reviewing the impact and amounts, these figures will then be set as binding limits from 2018.
It should be noted that the "modified balance sheet equity ratio" introduced in 2009 into the German Banking Act to achieve the same purpose is calculated differently than the new CRD IV leverage ratio. It is therefore proposed by the German banking industry to dispense with the old figure in the German CRD IV Implementation Act.
Introduction of stronger Minimum Liquidity Standards
The aim of the new regulations is to ensure short-term liquidity of financial institutions even when subject to stress and to ensure long-term funding. The standards redefined in Basel III are adopted in CRR and replace existing national guidelines for liquidity.
Net Stable Funding Ratio – NSFR
The introduction of the structural liquidity ratio () shows the long-term stable funding in relation to the expected long-term funding needs. This concept corresponds to the "golden rule of banking."
The available stable funding is the sum of all liabilities weighted with an available stable funding (ASF) factor. The factor varies from 0 to 100 per cent: Equity is, for example, set at 100 per cent, private deposits at 90 per cent and government deposits at only 50 per cent. There are also weighted RSF (Required Stable Funding) factors for refinancing.
Liquidity Coverage Ratio – LCR
By introducing the liquidity coverage ratio (LCR) a target is created for a bank's liquidity buffer in relation to its cash outflows in the next 30 days.
The stress scenarios take into account bank-specific and systemic crises as well as downgrades of up to three rating levels by rating agencies.
For the cash outflows, customer groups are modelled with different flow rates. Private customers and small businesses have an outflow rate of 5 to 10 per cent; larger companies, central banks and public bodies have cash outflows of 75 per cent and banks are assumed to have an outflow rate of 100 per cent.
From 2013, the LCR is to be reported within the observation period and from 2015, compliance with it will be mandatory. Measures to control the LCR is a very topical issue and require a high level of detail and data quality due to cash flow-based metrics reporting, which in turn will require more changes to IT systems and dashboards.
For compliance with the ratios refinancing and bond issues will become more difficult in the future. For short-term deposits (excluding retail investors and small businesses) have high flow rates and bank outflows do not count for the liquidity buffer. Therefore, they are less likely to be in demand by other banks.
New financial market strategies will emerge in which the use of eligible commercial loans can play an important role in the funding strategy. A major effect can be achieved by redirecting the liquidity buffer. The shift of securities due by the end of 2014 or targeted treatment of repurchase agreements (with maturities of over 30 days, repos with the central bank or the government) should be tested. Furthermore, tighter controls on the percentage increase in deposits will have to be taken into consideration for different customer groups. These include increasing retail investment and reducing bank deposits.
An analysis of the profitability of the financial institution based on the new liquidity rules is required and can result in an adjustment of the funding strategy and shifting of the liquidity buffer. The on-going monitoring phase is to be used to implement and refine the control measures. A good preparation is the basis for fulfilling the new regulatory requirements and will also strengthen the financial institution in the European and international market.
This creates confidence for existing customers and opens up new sales opportunities.