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12 Part 2: The First Pillar - Minimum Capital Requirements

I. Calculation of minimum capital requirements

40. Part 2 presents the calculation of the total minimum capital requirements for credit,

market and operational risk. The capital ratio is calculated using the definition of regulatory capital and risk-weighted assets. The total capital ratio must be no lower than 8%. Tier 2 capital is limited to 100% of Tier 1 capital.

A. Regulatory capital

41. The definition of eligible regulatory capital, as outlined in the 1988 Accord and

clarified in the 27 October 1998 press release on "Instruments eligible for inclusion in Tier 1 capital", remains in place except for the modifications in paragraphs 37 to 39 and 43. The definition is outlined in paragraphs 49 (i) to 49 (xviii) and in Annex Ia.

42. Under the standardised approach to credit risk, general provisions, as explained in

paragraphs 381 to 383, can be included in Tier 2 capital subject to the limit of 1.25% of risk- weighted assets.

43. Under the internal ratings-based (IRB) approach, the treatment of the 1988 Accord

to include general provisions (or general loan-loss reserves) in Tier 2 capital is withdrawn. Banks using the IRB approach for securitisation exposures or the PD/LGD approach for equity exposures must first deduct the EL amounts subject to the corresponding conditions in paragraphs 563 and 386, respectively. Banks using the IRB approach for other asset classes must compare (i) the amount of total eligible provisions, as defined in paragraph 380, with (ii) the total expected losses amount as calculated within the IRB approach and defined in paragraph 375. Where the total expected loss amount exceeds total eligible provisions, banks must deduct the difference. Deduction must be on the basis of 50% from Tier 1 and

50% from Tier 2. Where the total expected loss amount is less than total eligible provisions,

as explained in paragraphs 380 to 383, banks may recognise the difference in Tier 2 capital up to a maximum of 0.6% of credit risk-weighted assets. At national discretion, a limit lower than 0.6% may be applied.

B. Risk-weighted assets

44. Total risk-weighted assets are determined by multiplying the capital requirements for

market risk and operational risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of

8%) and adding the resulting figures to the sum of risk-weighted assets for credit risk. The

Committee applies a scaling factor in order to broadly maintain the aggregate level of minimum capital requirements, while also providing incentives to adopt the more advanced risk-sensitive approaches of the Framework. 11

The scaling factor is applied to the risk-

weighted asset amounts for credit risk assessed under the IRB approach. 11

The current best estimate of the scaling factor is 1.06. National authorities will continue to monitor capital

requirements during the implementation period of this Framework. Moreover, the Committee will monitor

national experiences with this Framework. 13

C. Transitional arrangements

45. For banks using the IRB approach for credit risk or the Advanced Measurement

Approaches (AMA) for operational risk, there will be a capital floor following implementation of this Framework. Banks must calculate the difference between (i) the floor as defined in paragraph 46 and (ii) the amount as calculated according to paragraph 47. If the floor amount is larger, banks are required to add 12.5 times the difference to risk-weighted assets.

46. The capital floor is based on application of the 1988 Accord. It is derived by applying

an adjustment factor to the following amount: (i) 8% of the risk-weighted assets, (ii) plus Tier

1 and Tier 2 deductions, and (iii) less the amount of general provisions that may be

recognised in Tier 2. The adjustment factor for banks using the foundation IRB approach for the year beginning year-end 2006 is 95%. The adjustment factor for banks using (i) either the foundation and/or advanced IRB approaches, and/or (ii) the AMA for the year beginning year-end 2007 is 90%, and for the year beginning year-end 2008 is 80%. The following table illustrates the application of the adjustment factors. Additional transitional arrangements including parallel calculation are set out in paragraphs 263 to 269.

From year-end

2005 From year-end

2006 From year-end

2007 From year-end

2008

Foundation IRB

approach 12

Parallel

calculation 95% 90% 80%

Advanced

approaches for credit and/or operational risk Parallel calculation or impact studies Parallel calculation 90% 80%

47. In the years in which the floor applies, banks must also calculate (i) 8% of total risk-

weighted assets as calculated under this Framework, (ii) less the difference between total provisions and expected loss amount as described in Section III.G (see paragraphs 374 to

386), and (iii) plus other Tier 1 and Tier 2 deductions. Where a bank uses the standardised

approach to credit risk for any portion of its exposures, it also needs to exclude general provisions that may be recognised in Tier 2 for that portion from the amount calculated according to the first sentence of this paragraph.

48. Should problems emerge during this period, the Committee will seek to take

appropriate measures to address them, and, in particular, will be prepared to keep the floors in place beyond 2009 if necessary.

49. The Committee believes it is appropriate for supervisors to apply prudential floors to

banks that adopt the IRB approach for credit risk and/or the AMA for operational risk following year-end 2008. For banks that do not complete the transition to these approaches in the years specified in paragraph 46, the Committee believes it is appropriate for supervisors to continue to apply prudential floors - similar to those of paragraph 46 - to provide time to ensure that individual bank implementations of the advanced approaches are sound. However, the Committee recognises that floors based on the 1988 Accord will become increasingly impractical to implement over time and therefore believes that supervisors should have the flexibility to develop appropriate bank-by-bank floors that are 12 The foundation IRB approach includes the IRB approach to retail. 14 consistent with the principles outlined in this paragraph, subject to full disclosure of the nature of the floors adopted. Such floors may be based on the approach the bank was using before adoption of the IRB approach and/or AMA.

Ia. The constituents of capital

A. Core capital (basic equity or Tier 1)

49(i). The Committee considers that the key element of capital on which the main

emphasis should be placed is equity capital 13 and disclosed reserves. This key element of capital is the only element common to all countries' banking systems; it is wholly visible in the published accounts and is the basis on which most market judgements of capital adequacy are made; and it has a crucial bearing on profit margins and a bank's ability to compete. This emphasis on equity capital and disclosed reserves reflects the importance the Committee attaches to securing an appropriate quality, and the level, of the total capital resources maintained by major banks.

49(ii). Notwithstanding this emphasis, the member countries of the Committee also

consider that there are a number of other important and legitimate constituents of a bank's capital base which may be included within the system of measurement (subject to certain conditions set out in paragraphs 49(iv) to 49(xii) below).

49(iii). The Committee has therefore concluded that capital, for supervisory purposes,

should be defined in two tiers in a way which will have the effect of requiring at least 50% of a bank's capital base to consist of a core element comprised of equity capital and published reserves from post-tax retained earnings (Tier 1). The other elements of capital (supplementary capital) will be admitted into Tier 2 limited to 100% of Tier 1. These supplementary capital elements and the particular conditions attaching to their inclusion in the capital base are set out in paragraphs 49(iv) to 49(xii) below and in more detail in Annex

1a. Each of these elements may be included or not included by national authorities at their

discretion in the light of their national accounting and supervisory regulations.

B. Supplementary capital (Tier 2)

1. Undisclosed reserves

49(iv). Unpublished or hidden reserves may be constituted in various ways according to

differing legal and accounting regimes in member countries. Under this heading are included only reserves which, though unpublished, have been passed through the profit and loss account and which are accepted by the bank's supervisory authorities. They may be inherently of the same intrinsic quality as published retained earnings, but, in the context of an internationally agreed minimum standard, their lack of transparency, together with the fact that many countries do not recognise undisclosed reserves, either as an accepted accounting concept or as a legitimate element of capital, argue for excluding them from the core equity capital element. 13 Issued and fully paid ordinary shares/common stock and non-cumulative perpetual preferred stock (but excluding cumulative preferred stock). 15

2. Revaluation reserves

49(v). Some countries, under their national regulatory or accounting arrangements, allow

certain assets to be revalued to reflect their current value, or something closer to their current value than historic cost, and the resultant revaluation reserves to be included in the capital base. Such revaluations can arise in two ways: (a) from a formal revaluation, carried through to the balance sheets of banks' own premises; or (b) from a notional addition to capital of hidden values which arise from the practice of holding securities in the balance sheet valued at historic costs. Such reserves may be included within supplementary capital provided that the assets are considered by the supervisory authority to be prudently valued, fully reflecting the possibility of price fluctuations and forced sale.

49(vi). Alternative (b) in paragraph 49(v) above is relevant to those banks whose balance

sheets traditionally include very substantial amounts of equities held in their portfolio at historic cost but which can be, and on occasions are, realised at current prices and used to offset losses. The Committee considers these "latent" revaluation reserves can be included among supplementary elements of capital since they can be used to absorb losses on a going-concern basis, provided they are subject to a substantial discount in order to reflect concerns both about market volatility and about the tax charge which would arise were such cases to be realised. A discount of 55% on the difference between the historic cost book value and market value is agreed to be appropriate in the light of these considerations. The Committee considered, but rejected, the proposition that latent reserves arising in respect of the undervaluation of banks' premises should also be included within the definition of supplementary capital.

3. General provisions/general loan-loss reserves

49(vii). General provisions or general loan-loss reserves are created against the possibility

of losses not yet identified. Where they do not reflect a known deterioration in the valuation of particular assets, these reserves qualify for inclusion in Tier 2 capital. Where, however, provisions or reserves have been created against identified losses or in respect of an identified deterioration in the value of any asset or group of subsets of assets, they are not freely available to meet unidentified losses which may subsequently arise elsewhere in the portfolio and do not possess an essential characteristic of capital. Such provisions or reserves should therefore not be included in the capital base.

49(viii). The supervisory authorities represented on the Committee undertake to ensure that

the supervisory process takes due account of any identified deterioration in value. They will also ensure that general provisions or general loan-loss reserves will only be included in capital if they are not intended to deal with the deterioration of particular assets, whether individual or grouped.

49(ix). This would mean that all elements in general provisions or general loan-loss

reserves designed to protect a bank from identified deterioration in the quality of specific assets (whether foreign or domestic) should be ineligible for inclusion in capital. In particular, elements that reflect identified deterioration in assets subject to country risk, in real estate lending and in other problem sectors would be excluded from capital.

49(x). General provisions/general loan-loss reserves that qualify for inclusion in Tier 2

under the terms described above do so subject to a limit of 16 (a) 1.25 percentage points of weighted risk assets to the extent a bank uses the

Standardised Approach for credit risk; and

(b) 0.6 percentage points of credit risk-weighted assets in accordance with paragraph

43 to the extent a bank uses the IRB Approach for credit risk.

4. Hybrid debt capital instruments

49(xi). In this category fall a number of capital instruments which combine certain

characteristics of equity and certain characteristics of debt. Each of these has particular features which can be considered to affect its quality as capital. It has been agreed that, where these instruments have close similarities to equity, in particular when they are able to support losses on an on-going basis without triggering liquidation, they may be included in supplementary capital. In addition to perpetual preference shares carrying a cumulative fixed charge, the following instruments, for example, may qualify for inclusion: long-term preferred

shares in Canada, titres participatifs and titres subordonnés à durée indéterminée in France,

Genussscheine in Germany, perpetual debt instruments in the United Kingdom and mandatory convertible debt instruments in the United States. The qualifying criteria for such instruments are set out in Annex 1a.

5. Subordinated term debt

49(xii). The Committee is agreed that subordinated term debt instruments have significant

deficiencies as constituents of capital in view of their fixed maturity and inability to absorb losses except in a liquidation. These deficiencies justify an additional restriction on the amount of such debt capital which is eligible for inclusion within the capital base. Consequently, it has been concluded that subordinated term debt instruments with a minimum original term to maturity of over five years may be included within the supplementary elements of capital, but only to a maximum of 50% of the core capital element and subject to adequate amortisation arrangements. C. Short-term subordinated debt covering market risk (Tier 3)

49(xiii). The principal form of eligible capital to cover market risks consists of shareholders'

equity and retained earnings (Tier 1 capital) and supplementary capital (Tier 2 capital) as defined in paragraphs 49(i) to 49(xii). But banks may also, at the discretion of their national authority, employ a third tier of capital ("Tier 3"), consisting of short-term subordinated debt as defined in paragraph 49(xiv) below for the sole purpose of meeting a proportion of the capital requirements for market risks, subject to the following conditions: Banks will be entitled to use Tier 3 capital solely to support market risks as defined in paragraphs 709 to 718( Lxix). This means that any capital requirement arising in respect of credit and counterparty risk in the terms of this Framework, including the credit counterparty risk in respect of OTCs and SFTs in both trading and banking books, needs to be met by the existing definition of capital base set out in paragraphs 49(i) to 49(xii) above (i.e. Tiers 1 and 2); Tier 3 capital will be limited to 250% of a bank's Tier 1 capital that is required to support market risks. This means that a minimum of about 28½% of market risks needs to be supported by Tier 1 capital that is not required to support risks in the remainder of the book; 17 Tier 2 elements may be substituted for Tier 3 up to the same limit of 250% in so far as the overall limits set out in paragraph 49(iii) above are not breached, that is to say eligible Tier 2 capital may not exceed total Tier 1 capital, and long-term subordinated debt may not exceed 50% of Tier 1 capital; In addition, since the Committee believes that Tier 3 capital is only appropriate to meet market risk, a significant number of member countries are in favour of retaining the principle in the present Framework that Tier 1 capital should represent at least half of total eligible capital, i.e. that the sum total of Tier 2 plus Tier 3 capital should not exceed total Tier 1. However, the Committee has decided that any decision whether or not to apply such a rule should be a matter for national discretion. Some member countries may keep the constraint, except in cases where banking activities are proportionately very small. Additionally, national authorities will have discretion to refuse the use of short-term subordinated debt for individual banks or for their banking systems generally.

49(xiv). For short-term subordinated debt to be eligible as Tier 3 capital, it needs, if

circumstances demand, to be capable of becoming part of a bank's permanent capital and thus be available to absorb losses in the event of insolvency. It must, therefore, at a minimum: be unsecured, subordinated and fully paid up; have an original maturity of at least two years; not be repayable before the agreed repayment date unless the supervisory authority agrees; be subject to a lock-in clause which stipulates that neither interest nor principal may be paid (even at maturity) if such payment means that the bank falls below or remains below its minimum capital requirement.

D. Deductions from capital

49(xv). It has been concluded that the following deductions should be made from the capital

base for the purpose of calculating the risk-weighted capital ratio. The deductions will consist of: (i) Goodwill, as a deduction from Tier 1 capital elements; (ii) Increase in equity capital resulting from a securitisation exposure, as a deduction from Tier 1 capital elements, pursuant to paragraph 562 below; (iii) Investments in subsidiaries engaged in banking and financial activities which are not consolidated in national systems. The normal practice will be to consolidate subsidiaries for the purpose of assessing the capital adequacy of banking groups. Where this is not done, deduction is essential to prevent the multiple use of the same capital resources in different parts of the group. The deduction for such investments will be made in accordance with paragraph 37 above. The assets representing the investments in subsidiary companies whose capital had been deducted from that of the parent would not be included in total assets for the purposes of computing the ratio. 18

49(xvi). The Committee carefully considered the possibility of requiring deduction of banks'

holdings of capital issued by other banks or deposit-taking institutions, whether in the form of equity or of other capital instruments. Several G-10 supervisory authorities currently require such a deduction to be made in order to discourage the banking system as a whole from creating cross-holdings of capital, rather than drawing capital from outside investors. The Committee is very conscious that such double-gearing (or "double-leveraging") can have systemic dangers for the banking system by making it more vulnerable to the rapid transmission of problems from one institution to another and some members consider these dangers justify a policy of full deduction of such holdings.

49(xvii). Despite these concerns, however, the Committee as a whole is not presently in

favour of a general policy of deducting all holdings of other banks' capital, on the grounds that to do so could impede certain significant and desirable changes taking place in the structure of domestic banking systems.

49(xviii). The Committee has nonetheless agreed that:

(a) Individual supervisory authorities should be free at their discretion to apply a policy of deduction, either for all holdings of other banks' capital, or for holdings which exceed material limits in relation to the holding bank's capital or the issuing bank's capital, or on a case-by-case basis; (b) Where no deduction is applied, banks' holdings of other banks' capital instruments will bear a weight of 100%; (c) The Committee considers that reciprocal cross-holdings of bank capital artificially designed to inflate the capital position of the banks will be deducted for capital adequacy purposes; (d) The Committee will closely monitor the degree of double-gearing in the international banking system and does not preclude the possibility of introducing constraints at a later date. For this purpose, supervisory authorities intend to ensure that adequate statistics are made available to enable them and the Committee to monitor the development of banks' holdings of other banks' equity and debt instruments which rank as capital under the present agreement. 19

II. Credit Risk - The Standardised Approach

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