FSI High-Level Meeting on the New Framework to Strengthen Financial Stability and Regulatory Priorities

Basel III: a roadmap to better banking regulation and supervision

Introduction Since 2006, it has been a long five years a challenging five years and, for both good and bad reasons, a memorable five years. On the regulatory side, much has been achieved. These policy responses to the crisis must now be implemented fully, consistently and globally. This is going to require much more work. Much of this work now shifts to the supervisory side and, as I will discuss this morning, I think we are moving in the right direction. So this morning I would like to first have a look back on where we have been and what have we learned as regulators and supervisors. Then I will examine where we are today and, finally, where we are going. Where have we been? Let us go back to 2007. What were some of the topics that were on the minds of bankers and supervisors? We were hearing quite a bit about the benefits of: Light touch regulation, The originate-to-distribute business model, Capital efficiency and optimisation, and Financial engineering and innovation. Contrary to the view held by many that this was the dawning of a new era the great moderation at the macro level there were a few people leaning against the wind. They warned of unsustainable credit growth, for instance, but their voices were drowned out by the euphoria of the times. At the micro level, few people had put together the pieces of the puzzle. Prior to the crisis, the Basel Committee had already begun work on a range of issues that would prove to be central elements to Basel III: They include stronger capital requirements for the trading book, a review of the definition of capital, a review of global liquidity supervision, stress testing, valuations and counterparty credit risk. We were also discussing other but less apparent risks to the global banking system. In a speech I gave at the Annual Risk Conference of GARP the Global Association of Risk Professionals in February 2007, I highlighted a variety of growing risks that were causing concern among Basel Committee

members. This included the originate-to-distribute model and the need to assess the pressure points that might arise if risk appetites were to reverse and liquidity conditions to deteriorate. I noted that these pressure points could take different forms and the Committees discussions gave us a good head start in developing concrete responses to them. For instance, a few of the pressure points I noted that were already on the Committees radar included: Securitisation pipeline risk and the adequacy of risk transfers, The growth of illiquid and structured risks in the trading book, Growing risk concentrations, Off-balance-sheet conduits that some day might require additional support from sponsoring banks, Trading counterparties that might demand additional financing, and The risk that market liquidity could spill over to funding liquidity. On each of these topics, the Committee subsequently revised the Basel II rules and developed supervisory guidance. So what lesson do I draw from this experience? That it is of critical importance for supervisors to be ahead of the curve to take a proactive rather than a reactive approach. Developing regulatory policy must be done on a comprehensive, wellinformed and inclusive basis. But there is also a time dimension. This was another lesson of the crisis: good regulation must be supplemented with strong and timely supervision and enforcement. The crisis also taught us or painfully reminded us of a third lesson, and that is the primacy of high quality capital. Strong capital regulation provides necessary incentives and limits on bank risk taking. But a strong capital base must be accompanied by adequate risk coverage. If a meaningful segment of a banks risks are not supported by capital, the bank remains exposed. Unfortunately, during the crisis, many banks were not protected against risks, such as complex, illiquid trading activities and off-balance sheet exposures. Strong capital and comprehensive risk coverage are not supervisory silver bullets that can cover up deficiencies in risk management or substitute for effective market discipline. The Committee, through the three pillars of Basel II, laid the foundation for the regulatory model that promotes safer banks. This framework remains valid today. Basel III is an extension of it but with critical additions, such as a leverage ratio, a macroprudential overlay and the liquidity framework. Where are we today? The Committees response to the crisis was primarily a regulatory one, although we also upgraded Pillar 2 and Pillar 3 of the capital framework. Now what is required to implement these

new rules is strong supervision. And that brings us to the present. We have come a long way in a short amount of time. But the benefits of Basel III will fall short if the framework is not implemented fully and in a consistent manner. The Committee is increasing the already substantial resources dedicated to implementation issues. In the past, the Committees Standards Implementation Group (SIG), which is chaired by Jos Mara Roldn, focused on promoting consistency in implementation of Basel II through sharing information and experiences among supervisors. Going forward, this approach will be supplemented with supervisory peer reviews and thematic reviews, to strengthen the global implementation process. It represents a significant practical and cultural shift in the way international agreements are implemented. The crisis reminded us not only of the importance of sound standards, but also underscored that these must be accompanied by stronger implementation and rigorous supervisory follow-up. Strong regulations like Basel III are only the starting point, and even this becomes ineffective without strong supervision. We have come a long way from light touch regulation to what some like to call intrusive supervision. And this means that supervisors sometimes need to take actions that are unpopular with individual banks or with prevailing public opinions. Another essential element of effective supervision is cooperation and coordination with other supervisors. Meetings like this one help promote regional communication. Let me say a few words about the global dimension of this. The Basel Committee has long been aware that some of the biggest challenges facing the banking industry relate to global, crossborder activities and the implications for global financial stability. In fact, the Committee was founded on this basis. One way we approach this challenge is through outreach with all supervisors not just Basel Committee members. At an early point during the current crisis, the Committee agreed to formalise the global dimension of its work by expanding doubling its membership. The benefits of this expansion have been immense: among others, it brings a tremendous amount of additional expertise and new perspectives to the Committees table and its working groups. It has also reinforced the legitimacy of the Committee as a truly global body. These benefits help promote goals of global financial stability. In addition, through the work of our Basel Consultative Group, we share information and ask for input on Basel Committee initiatives. This further broadens the global dialogue on supervisory issues; it also helps promote the Committees standards in a wide range of countries. Where are we going? The importance of supervisory cooperation to address global risk naturally leads me to my next topic: where are we as supervisors going? I will start with saying a few words about our work on global systemically important financial institutions or G-SIFIs. Basel III is a significant step in helping to improve the resilience and soundness of G-SIFIs. But it does not fully address the externalities or spill-over effects that these firms impose. More must be done and the Committee

has already made a proposal to the Financial Stability Board on how to identify G-SIFIs. At its June meeting the Committee will discuss the magnitude of additional loss absorbency and, in coordination with the FSB, will issue a consultative document on this important issue later this summer. Basel III also introduced a global framework for liquidity requirements, which was a major achievement of the Committee. Unlike capital requirements, we do not have extensive experience with global liquidity standards nor do we have as high quality data on bank liquidity profiles. For these reasons, we are taking a cautious approach in implementing the new requirements. We are reviewing their implications for individual banks, the banking sector, and financial markets, addressing any unintended consequences as necessary. In this regard, the Committees focus is ensuring that the calibration of the framework is appropriate. Certain aspects of the calibration will be examined and this will involve regular data collection from banks. Any adjustments should be based on additional information and rigorous analyses. Moreover, relying just on banks experiences from the crisis is not sufficient as banks and markets received massive government support. Hence, the analysis will need to include both quantitative bank experience and additional qualitative judgment. Finally, a measure of the effectiveness of Basel III might be the development of so called shadow banking. By this I mean credit intermediation that takes place outside of the traditional banking system and that involves liquidity or maturity transformation. While shadow banks perform useful functions, they can also introduce a number of risks to the broader financial system, including to banks. Clearly, it is important to address issues in the shadow banking sector but its existence should not detract from the need to strengthen the resilience of the banking system. The banking sector remains at the centre of the credit and liquidity intermediation process. This is true even in economies that are more reliant on capital markets. Moreover, significant parts of shadow banking were created, sponsored or financed by the banking sector. These include SIVs, conduits, money market mutual funds, parts of the securitisation chain, and hedge funds. Finally, much of the shadow banking sector depends on the financing and liquidity support of the banking sector. Basel III goes a long way to closing the gaps in exposure to shadow banking. Thus, stronger, consolidated banking regulation and supervision will go a significant way towards containing the risks of the shadow banking sector. These are just a few of the agenda items for the coming year. Looking ahead, there are clearly significant risks on the horizon. Promoting a strong and stable banking system that is able to act as a shock absorber rather than an amplifier of risks is essential. That, in my view, is the fundamental philosophy underlying the Basel III reforms. Conclusion

Let me now bring my remarks to a close. The recent financial crisis resulted in a strong and some say a bold regulatory response. But it also taught us some valuable lessons, such as the need for supervisors to get ahead of the curve through strong risk analysis and assessment. But we also know that once a regulatory response is formulated, it must be implemented in a full and timely manner. We also were reminded of the unassailable importance of strong capital and liquidity buffers in the face of rapid financial innovation and uncertainty. The regulatory response to the crisis has been developed. Now we as supervisors must ensure that Basel III and all relevant standards are implemented. We will be judged on our capacity to meet this objective. This process will sometimes require unpopular actions and decisions but we must press on with resolution and determination. It will also require even more cooperation and coordination with our supervisory counterparts in other jurisdictions. As regulators and supervisors, it is our responsibility to ensure that the standards are implemented both in form and in the spirit in which they were intended. Looking to the future, we are well on our way to developing a framework to address the risks arising from G-SIFIs. The Committee is also carefully monitoring a variety of aspects related to the Basel III liquidity framework and will adjust the standards if necessary. Shadow banking is another important risk area that warrants careful analysis.

Conference on Basel III Financial Stability Institute Basel 6 April 2011 Basel III: Stronger Banks and a More Resilient Financial System Stefan Walter Secretary General, Basel Committee on Banking Supervision I. Introduction Thank you for the opportunity to speak to you this morning about Basel III. It is has now been three and a half years since the global financial crisis began. The banking sector and financial system have now been stabilised. But this required unprecedented public sector interventions. Despite the severity of the crisis, we are already seeing signs that its lessons are beginning to fade. At the same time, there are still significant risks on the horizons, while key reforms still need to be carried through if we are to achieve a truly stable banking and financial system. I would like to begin this morning by recalling the damaging effects of the crisis and why the Basel III reforms are central to promoting financial stability. I will then briefly outline the key reforms that comprise Basel III. Finally, I will focus on what still needs to be done to ensure longer-term stability. In particular, I will discuss the need for global and consistent implementation of the Basel III reform package and the ongoing work to address the risks of systemic banking institutions. II. Motivation for Basel III reforms A. Damaging effects of banking crises There is a wide body of evidence that the most severe economic crises are associated with banking sector distress. While there is variation in findings across studies, the Basel Committees long-term economic impact study found that the central estimate in the economics literature is that banking crises result in losses in economic output equal to about 60% of precrisis GDP.1 Why are banking crises so damaging? Banks are highly leveraged institutions and are at the centre of the credit intermediation process. In addition, credit and maturity transformation functions are vulnerable to liquidity runs and loss of confidence. A destabilised banking system affects the provision of credit and liquidity to the broader economy and ultimately leads to lost economic output. In the most recent phase of the crisis there has also been significant spillover of risk between the banking sector and sovereigns. Governments in a number of industrialised countries had to increase their debt in order to stabilise their banking systems and economies. As a result, debt-to-GDP ratios in a number of economies increased by as much as 10-25 percentage points. It therefore is clear that the economic benefits of raising the resilience of the banking sector to shocks are immense.

B. Frequency of banking crises The costs of banking crises are extremely high but, unfortunately, the frequency has been as well. Since 1985, there have been over 30 banking crises in Basel Committee-member

countries. Roughly, this corresponds to a 5% probability of a Basel Committee member country facing a crisis in any given year a one in 20 chance, which is unacceptably high. [See Table 2] Many countries may not have been the cause of the current crisis, but they have been affected by the global fall out. Moreover, history has shown that banking crises have occurred in all regions of the world, affecting all major business lines and asset classes. Moreover, there tend to be a common set of features that seem to repeat themselves in various combinations from banking crisis to banking crisis. These include: Excess liquidity chasing yields Too much credit and weak underwriting standards Underpricing of risk, and Excess leverage In the current crisis, these recurring trends were magnified by: Weak bank governance practices, including in the area of compensation Poor transparency of the risks at financial institutions and in complex products Risk management and supervision focused on individual institutions instead of also at the system level Procyclicality of financial markets propagated through a variety of channels, and Moral hazard from too-big-too-fail, interconnected financial institutions. C. Benefits of tighter regulation through Basel III exceed the costs The objective of the Basel III reforms is to reduce the probability and severity of future crises. This will involve some costs arising from stronger regulatory capital and liquidity requirements and more intense and intrusive supervision. But our analysis and that of many others has found the benefits to society well exceed the costs to individual institutions. The Committees longterm economic impact analysis found that capital and liquidity requirements could be increased well above current minimum levels while still achieving positive net economic benefits. [see These findings are not surprising. It is widely accepted that prudent fiscal and monetary policies are the cornerstones of financial stability and sustainable economic growth. Indeed, maintaining conservative fiscal and inflation policies involve a cost they result in potentially lower shortterm economic growth, which is offset by more sustainable long-term growth. Increasing stability of the banking and financial system involves a similar trade-off, where the costs are more than offset by the long-term gain. In particular, it is difficult to imagine a country that can maintain sustainable growth on the foundation of a weak banking system III. Key features of the Basel III reform package The Basel III framework is the cornerstone of the G20 regulatory reform agenda and the final Basel Committee rules were issued at the end of last year. This development is the result of an unprecedented process of coordination across 27 countries. Compared to Basel II, it was also

achieved in record time, less than two years. The next step, which is just as critical as the policy development, is implementation. The full potential of Basel III will only be achieved if all Committee-member countries and regions work within the global process, and fully implement the minimum standards. Some countries may choose to implement higher standards to address risks particular to their national contexts. This has always been an option under Basel I and II, and it will remain the case under Basel III. Why is Basel III fundamentally different from Basel I and Basel II? First, it is more comprehensive in its scope and, second, it combines micro- and macro-prudential reforms to address both institution and system level risks. On the microprudential side, these reforms mean: A significant increase in risk coverage, with a focus on areas that were most problematic during the crisis, that is trading book exposures, counterparty credit risk, and securitisation activities; A fundamental tightening of the definition of capital, with a strong focus on common equity. At the same time, this represents a move away from complex hybrid instruments, which did not prove to be loss absorbing in periods of stress. We also introduced requirements that all capital instruments must absorb losses at the point of non-viability, which was not the case in the crisis; The introduction of a leverage ratio to serve as a backstop to the risk-based framework; The introduction of global liquidity standards to address short-term and long-term liquidity mismatches; and Enhancements to Pillar 2s supervisory review process and Pillar 3s market discipline, particularly for trading and securitisation activities. In addition, a unique feature of Basel III is the introduction of macroprudential elements into the capital framework. This includes: Standards that promote the build-up of capital buffers in good times that can be drawn down in periods of stress, as well as clear capital conservation requirements to prevent the inappropriate distribution of capital; The leverage ratio also has system-wide benefits by preventing the excessive build-up of debt across the banking system during boom times. To minimise the transition costs, the Basel III requirements will be phased in gradually as of 1 January 2013. I would now like to say a few words in particular about two of the newer elements of the regulatory framework, namely the liquidity standards and the leverage ratio. As mentioned, excess leverage and weak liquidity profiles of banks were at the core of the crisis, and they therefore represent a critical part of the Basel III framework going forward. A. The Liquidity Framework There is broad support for the liquidity framework introduced by the Committee. Banks and other market participants already use methods similar to the Liquidity Coverage Ratio (LCR)

and the Net Stable Funding Ratio (NSFR). Many of the issues that have been raised pertaining to these requirements revolve around the calibration of the ratios, rather than the conceptual basis of the framework. It is important to emphasise the Committees goal in establishing the liquidity framework: to require banks to withstand more severe shocks than they had been able to in the past, thus reducing the need for such massive public sector liquidity support in future episodes of stress. The success of the framework should not be measured in terms of whether it will have zero cost. Instead, the better measure of success is whether the framework corrects pre-crisis extremes at acceptable costs. Banks that take on excessive liquidity risk should be penalised under the new framework, while sound business models should continue to thrive. With these objectives in mind, the Committee will use the observation period to review the implications of the standards for individual banks, the banking sector, and financial markets, addressing any unintended consequences as necessary. In this regard, the Committees focus is now on ensuring that the calibration of the framework is appropriate. Certain aspects of the calibration will be examined and this will involve regular data collection from banks. Any adjustments should be based on additional information and rigorous analyses. Moreover, relying just on banks experiences from the crisis is not sufficient, as it embeds a high level of government support of banks and markets. Hence, the analysis will need to include both quantitative bank experience and additional qualitative judgement. It is worth emphasising that a number of effects of the framework are indeed intended. For example, with regard to the pool of liquid assets, the rules are meant to promote changes in behaviour. Contrary to popular perception, they are not about promoting the hoarding of government debt, but about creating incentives to reduce risky liquidity profiles. This can be achieved, for example, by pushing out the average term of funding or increasing the share of stable funds. In other cases, banks did not price liquidity appropriately throughout the firm, and correcting risk management deficiencies will in turn improve liquidity profiles. In fact, the initial response we have observed in some countries that have already implemented comparable liquidity ratios suggest that these are the types of strategies that are being pursued. Also contrary to what many have claimed, the new standards should help promote greater diversification of the pool of liquid assets held by banks. Bank holdings of liquid assets continue to be dominated by exposures to sovereigns, central banks and zero percent risk-weighted public sector entities. These assets comprised 85% of banks liquid assets according to the Committees most recent quantitative impact study. By recognising high quality corporate and covered bonds subject to a limit the liquidity framework will help promote a further diversification of the liquid asset pool. B. The Leverage Ratio Many banks entered the crisis with excessive leverage. This increased the probability of bank failures. It also exacerbated the effects of the crisis on broader financial markets as many banks rushed to de-leverage once the crisis hit. The objective of the leverage ratio is to serve as a back-stop to the risk-based measure. The Committees calibration work shows that bank leverage was a highly statistically significant discriminator between banks that ultimately failed or required government capital injections during the crisis and those that did not. Moreover, at the height of the crisis, the market gravitated towards simple leverage based measures to compare banks. [see Table 4] The leverage ratio also serves a macroprudential purpose. We have seen during this and prior crises the cyclical movement of leverage at the system-wide level. Leverage, which tends to

build up prior to crisis periods, is subsequently unwound when a crisis occurs. This cyclical aspect exacerbates both the upswing phase and the downturn. In addition, what can appear to be very low risk assets at the institution level can ultimately create incentives for the build-up of risks at the broader system level. The leverage ratio serves to limit excessive concentrations in such asset classes. [see Table 5] As with the liquidity framework, the Committee has a process in place to assess the impact of the leverage ratio on business models. It will take actions if necessary to make sure that the design of the leverage ratio will achieve its objectives. As I stressed earlier, it is important that all countries and regions continue to work within this global process. What still needs to be done to ensure longer-term banking sector and economic stability? Over the past three years, much has been achieved by the global regulatory community to respond to the crisis. This policy work is now substantially complete. But to ensure longer-term banking sector and economic stability, consistent and timely global implementation of Basel III is critical. In addition, a key remaining area of policy development work is focused on dealing with systemically important banks (SIBs). Finally, we will also need to stay attuned to bank-like risks that emerge in the shadow banking sector. V. Implementation of Basel III The Committee has put in place mechanisms to help ensure more consistent implementation of its standards. This applies not only to Basel III but to other global standards agreed by the Committee. The efforts of the Committee are reinforced through additional institutional arrangements introduced at the level of the Financial Stability Board (FSB) and the G20. Going forward, the Committees Standards Implementation Group will play a critical role in conducting thematic peer reviews of member countries implementation of standards and sound practices. Implementation involves not only introduction of the standards in legal form, but also rigorous and robust review and validation by supervisors. We therefore are also introducing processes to ensure the integrity of key elements of the framework. An example of this is the review of banks risk weightings, which should include the use of test portfolio exercises. As we have painfully learned from the recent crisis, the failure to implement Basel III in a globally consistent way will again lead to a competitive race to the bottom and increase the risk of another crisis down the road. VI. Addressing the Too-Big-To-Fail (TBTF) problem During the crisis, the failure or impairment of certain banks sent shocks through the financial system. This had an adverse knock-on effect on the real economy. Supervisors and relevant authorities had limited options to prevent or contain problems effecting individual firms and this led to wider financial instability. As a consequence, public sector intervention to restore financial stability during the crisis was necessary, as was the massive scale of these responses. The fallout from the crisis underscores the need to put in place additional measures to reduce the likelihood and severity of problems emerging at systemic banking institutions. The Committee, in close cooperation with the FSB is working to address the financial system externalities created by Systemically Important Banks (SIBs). To achieve this broad objective, policy tools are being designed to: Reduce the probability as well as the impact of an SIB failure;

Reduce the cost to the public sector should a decision be made to intervene; and Level the playing field by reducing too-big-to-fail competitive advantages in funding markets. The Committee has developed a methodology that embodies the key components of systemic importance. These are size, interconnectedness, substitutability, global activity and complexity. The methodology can serve as a basis for the differentiated treatment of systemic institutions without needing to specify a fixed list of such institutions. Common equity is the key when it comes to going concern capital as it is available to absorb losses with certainty, thus reducing the probability of failure. The Committee also continues to study the role that going-concern contingent capital could play in its framework for SIBs. Strong resolution and recovery frameworks play a critical role in reducing the impact of failure by facilitating the orderly wind-down of a global bank. In this context, the Committee is reviewing the role that bail-in debt could play in complementing Tier 2 capital to provide additional resources that can mitigate the systemic impact of banks at the point of non-viability. The Committees work on systemically important banks is part of the broader effort of the Financial Stability Board (FSB) to address the risks posed by SIFIs. The Committee is working closely with the FSB through this process, and expects to consult on proposals to address the risks of globally systemic banks around the middle of the year. VII. Shadow Banking The final area where further work is needed is shadow banking. Shadow banking was a key mechanism through which the crisis was propagated. SIVs, money market mutual funds, the securitisation process, and bank liquidity lines to off-balance-sheet exposures all served to amplify the impact of the crisis on banks. While it is clearly important to address issues in the shadow banking sector, its existence should not detract from the fundamental need to strengthen the resilience of the banking system itself. The banking sector remains at the centre of the credit and liquidity intermediation process. This is true even in economies that are more reliant on capital markets. Moreover, significant parts of shadow banking were created, sponsored or financed by the banking sector and these include SIVs, ABCP conduits, MMMFs, certain securitisation structures, and hedge funds. Finally, much of the shadow banking sector depends on the financing and liquidity support of the banking sector. Basel III goes a long way to closing the gaps in exposure to shadow banking. It does this in several ways: by addressing the capital treatment for liquidity lines to SIVs and other types of off-balance sheet conduits; by addressing counterparty credit risk; by including off-balance sheet exposures in the Basel III leverage ratio; and by incorporating a range of contractual and reputational risks arising from the shadow banking sector into the liquidity regulatory and supervisory standards. Thus, stronger, consolidated banking regulation and supervision will go a significant way towards containing the risks of the shadow banking sector.

In addition, to the extent that bank-like risks emerge in the shadow banking sector, they should also be addressed directly. Supervisors should take a system-wide perspective on the credit intermediation process. To the extent that bank-like functions are carried out in the shadow banking sector and pose broader systemic risks, they should be subject to appropriate regulation, supervision, and disclosure. In particularly this is the case where activities combine credit intermediation, maturity or liquidity transformation, and leverage. The FSB, the Basel Committee and the Joint Forum of Banking, Securities, and Insurance Supervisors will monitor developments closely and promote appropriate responses as circumstances dictate. VIII. Other Basel Committee initiatives The Committee is also conducting a fundamental review of the trading book. It is fundamental in the sense that it will help inform basic questions such as how to address the line between the banking and the trading book and how to improve upon the current VAR based framework for measuring trading risks. We will consult on this issue as the work progresses, which I expect will be around the end of this year Other issues on the Committees agenda include further work on cross-border bank resolution issues and updating of large exposure standards, as well as a revision of the Core Principles for Effective Banking Supervision. It is critical that we incorporate the lessons of the crisis into a revised set of Core Principles, which will serve as the basis for enhanced country level reviews through the IMF and World Bank. IX. Conclusion The policy work for developing the Basel III framework has for the most part been completed. The reforms are significant and bring together micro and macro lessons of the crisis. The Committee has now moved to the next phase: implementation. One of the regulatory lessons of the crisis is that it is critical that all countries and regions now follow the global implementation process. By definition, it will be hard to predict the cause of the next crisis. Many risks are still looming on the horizon, and all countries need to continue the process of building their capacity to absorb shocks whatever the source. The banking sector s shock absorbing capacity must be much stronger than it has been in the past, and the implementation of our standards must be more globally consistent and robust

Basel III: towards a safer financial system

Speech by Mr Jaime Caruana
General Manager of the Bank for International Settlements

at the 3rd Santander International Banking Conference Madrid, 15 September 2010

Introduction Today I would like to review the agreement recently reached in Basel to strengthen financial regulation. As you know, a long series of international meetings was just held at the BIS. On 12 September, the Group of Governors and Heads of Supervision, the Basel Committees governing body, announced higher global minimum capital standards for commercial banks. This followed the agreement reached in July regarding the overall design of the capital and liquidity reform package. Together, these reforms are referred to as Basel III. Basel III represents a fundamental strengthening in some cases, a radical overhaul of global capital standards. Together with the introduction of global liquidity standards, the new capital standards deliver on the core of the global financial reform agenda, and will be presented to the Seoul G20 Leaders Summit in November. As significant as this past weekends agreement was, it was neither the beginning nor the culmination of the Basel Committees reform programme. Significant progress had already been achieved since the start of the financial crisis in 2007, and there is still more work to do. So Basel III is a key part, but not the only part, of the much wider agenda coordinated by the Financial Stability Board to build a safer financial system and ensure its resilience to periods of stress. I should caution, however, that better regulation is critical but not enough. It is just one piece of the puzzle. The promotion of financial stability requires a broad policy framework, of which prudential policy is only one element. The BIS has been a consistent and long-standing advocate of the essential role played by macroeconomic policies, both monetary and fiscal, as an important element in fostering financial stability. A third key ingredient is market discipline: the crisis has reaffirmed the importance of effective bank supervision to ensure full implementation of prudential policies, to avoid moral hazard posed by too-big-to-fail institutions, and to promote strong risk management practices and appropriate disclosure. And, of course, the financial industry and here I am referring to banks, shareholders, investors and other market participants is an integral piece of the puzzle too. The crisis revealed a number of shortcomings related to governance, risk management, due diligence, etc that the private sector itself needs to address. Needless to say, international cooperation is the foundation on which all of these elements stand. Indeed, a key feature of the G20 process is the premium put on the universal adherence to the goals of financial stability and sustainable economic growth. It is important to note that the Basel III regulatory standards have been developed by the Basel Committees global community of 27 member jurisdictions represented by 44 central banks and supervisory authorities.

Now let me turn to the key features of the new capital standards under Basel III. At the risk of oversimplifying what are rather complex issues, I would like to stress today that the implementation of Basel III will: (1) considerably increase the quality of banks capital; (2) significantly increase the required level of their capital; (3) reduce systemic risk; and (4) allow sufficient time for a smooth transition to the new regime. 1. Better capital quality First, Basel III will considerably increase the quality of bank capital. This crucial feature tends to be forgotten because observers are mainly focusing on the level of regulatory capital required by Basel III. Certainly, the agreement reached on 12 September on calibration of the new standards has attracted a great deal of attention, and rightly so. But it was the July agreement on the design of the framework that paved the way for its calibration. The new definition of capital is every bit as significant as the increased level of capital, and was an essential step in the process: it was imperative to define capital adequately before setting its level. Higher capital quality means more loss-absorbing capacity, which in turn means that banks will be stronger, allowing them to better withstand periods of stress. What are the new capital requirements? A key element is the greater focus on what is called common equity, ie the highest-quality component of a banks capital. Under current standards, as you know, banks have to hold at least half of their regulatory capital as Tier 1 capital. The remainder is made up of other items of lower loss-absorbing capacity. In addition, half of Tier 1 capital must be common equity. Other Tier 1 capital is also high-quality relative to other elements of the capital structure, but not of the same calibre as common shares and retained earnings. The sharper focus on common equity means that the Basel III framework puts greater emphasis on the minimum requirement for higher-quality capital. Moreover, the definition of common equity also called core capital is now stricter. Under the present system, certain types of assets of questionable quality are already deducted from the capital base (ie Tier 1 and Tier 2 capital). Under Basel III, these deductions will be more stringent since they will be applied directly to common equity. This represents a substantial strengthening of the definition of the highest-quality part of banks capital. And, going one step further, the definition of Tier 1 capital has also been strengthened to include common equity and other qualifying financial instruments based on strict criteria. By strengthening the quality of capital, Basel III will lead to a substantial improvement in the loss-absorbing capacity of banks. Under Basel II, the ratios for the minimum requirements for common equity and Tier 1 capital were 2% and 4%, respectively. According to the new definition of capital, these ratios are now equivalent to around 1% and 2%, respectively, for an average internationally active bank. The new rules mean that, everything being equal, banks will need to increase their common equity capital to meet minimum requirements. 1. More capital But better capital is not enough. As the financial crisis painfully revealed, we need more capital in the banking sector. This is the aim of the higher capital requirements recently agreed by the Basel Committees governing body.

A key element of Basel III is an increase of the minimum common equity requirement to 4.5%. This is much higher than the minimum ratio of 2% under Basel II, which, as I said, is more like 1% for an average representative bank when one measures common capital under the new, stronger definition. Similarly, the Tier 1 minimum capital requirement will be increased to 6%. This ratio has to be compared to a minimum ratio of 4% under the present standards. Banks will also be required to hold a capital conservation buffer of 2.5% of common equity to withstand future periods of stress. The consequences of not meeting this requirement are direct: the closer a banks capital level gets to the minimum requirement, the more constrained its earnings distribution (eg dividend payments, share buybacks and bonuses) will be until capital is replenished. This will help ensure that capital remains available to support the banks ongoing business operations during times of stress. Thus, during normal periods the total common equity requirements for banks will be effectively brought to at least 7%. Such an increase will also be complemented by additional countercyclical buffers, to which I will come back in a moment. So far I have discussed only the level of capital, ie the numerator of the capital ratios. But it is important not to lose sight of the asset base against which capital is compared. Significant progress has been achieved on this front. In 2009, the Basel Committee increased the capital required for trading book and complex structured products; the higher requirements will be introduced by no later than end-2011. Lastly, these risk-based capital requirement measures will be supplemented by a non-riskbased leverage ratio, which will help contain the build-up of excessive leverage in the system, serve as a backstop to the risk-based requirements and address model risk. It has been agreed to test a minimum Tier 1 leverage ratio of 3% that is, the ratio of Tier 1 capital (calculated using the new, stronger Basel III definition) to the banks total non-weighted assets plus offbalance sheet exposures during a preliminary period that will begin in January 2013. This test will allow the Basel Committee to monitor how banks actual leverage ratios evolve during the economic cycle, the impact this can have on their business models, and how risk-based requirements and an overall leverage ratio interact. In short, the new global capital standard for banks will increase substantially in the coming years. Let me emphasise that these standards set a floor for the actual level of banks capital. As before, it is important to ensure that banks hold sufficient capital above the minimum levels, depending on their risk profile, business models, prevailing economic conditions, etc. The possibility for national supervisors to require a more stringent capital base under Pillar II as well as a more rapid implantation of the standards will therefore continue to be a key element in the new Basel III rules. 1. A macroprudential overlay to tackle system-wide risks The third essential element of the new regulatory capital framework is that it provides what might be called a macroprudential overlay to deal with systemic risk, that is, the risk of financial system disruptions that can destabilise the macroeconomy. To be sure, better capitalised individual banks will lead to a stronger banking system, but this firm-specific approach by itself may not be sufficient. This is because the risk posed to the system is greater than the sum of the risks faced by individual institutions, as has been particularly evident during the financial crisis that started in 2007. At the BIS, we believe that two key tasks must be pursued to effectively limit systemic risk. The first is to reduce procyclicality, that is, the financial systems tendency to amplify the ups and downs of the real economy. The second task is to

take account of the interlinkages and common exposures among financial institutions, especially for those deemed systemically important. Basel III thus represents a fundamental turning point in the design of financial regulation. The conscious need to supplement the micro level of financial supervision with the macroprudential dimension is something that, I think, has for the first time found expression in financial regulation. On the procyclicality aspect, Basel III will promote the build-up of buffers in good times that can be drawn down in periods of stress. First, as I already noted, the new common equity requirement is 7%. This new higher level includes the capital conservation buffer of 2.5%, and will ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of stress without going below the minimum capital requirements. This will reduce the possibility of a self-reinforcing adverse cycle of losses and credit cutbacks as compared with previous arrangements. Second, a key element of the Basel III rules to limit procyclicality will be the countercyclical capital buffer, which has been calibrated in a range of 02.5%. This countercyclical buffer would build up during periods of rapid aggregate credit growth if, in the judgment of national authorities, this growth is aggravating system-wide risk. Conversely, the capital held in this buffer could be released in the downturn of the cycle. This would, for instance, reduce the risk that available credit could be constrained by regulatory capital requirements. The intention is thus to mitigate procyclicality and attenuate the impact of the ups and downs of the financial cycle. Apart from addressing procyclicality, Basel III will also allow for a better handling of the systemic risk due to the interlinkages and common exposures across individual institutions. The key principle in this context is to ensure that the standards are calibrated with respect to the contribution that each institution makes to the system as a whole, not just with respect to its riskiness on a standalone basis. The FSB and the Basel Committee are exploring several measures to deal with these systemically important financial institutions (SIFIs). Under the Basel III framework, it has been agreed that these institutions should have loss-absorbing capacity beyond the common standards. Work is still under way to delineate the modalities for addressing systemic risk, but one possibility would be to allow national authorities to establish a systemic capital surcharge for SIFIs. The new Basel III package encompasses specific macroprudential tools that national supervisory authorities can use to establish targeted capital requirements in order to deal with systemic risk both over time and across institutions. From this perspective, Basel III provides an anchor for the development of a fully fledged and strong macroprudential framework that takes account of these two dimensions of systemic risk. 1. Transition arrangements These tightened definitions of capital, significantly higher minimum ratios and the introduction of a macroprudential overlay represent what has been described by some as a historic remake of banking regulations. At the same time, the Basel Committee, its governing body and the G20 Leaders have consistently stated that the reforms will be introduced in a way that does not impede the recovery of the real economy. In addition, time is needed to translate the new internationally agreed standards into national legislation. In this spirit, the Governors and Heads of Supervision also announced on 12 September a set of transitional arrangements for the new standards. As I have already noted, national authorities can, and in fact should, impose higher

standards if deemed appropriate in the local circumstances and prevailing economic conditions; similarly, they can impose shorter transition periods where appropriate. The new, strengthened definition of capital will be phased in over five years: the requirements will be introduced in 2013 and fully implemented by the end of 2017. In addition, existing public sector capital injections will be grandfathered until the end of 2017. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over 10 years beginning 1 January 2013. Turning to the minimum capital requirements, the higher minimums for common equity and Tier 1 capital will be phased in beginning in 2013, and will become effective at the beginning of 2015. The schedule will be as follows:1 The minimum common equity and Tier 1 requirements will increase from the current 2% and 4% levels to 3.5% and 4.5%, respectively, at the beginning of 2013. The minimum common equity and Tier 1 requirements will be 4% and 5.5%, respectively, starting in 2014. The final requirements for common equity and Tier 1 capital will be 4.5% and 6%, respectively, beginning in 2015. The 2.5% capital conservation buffer, which will be comprised of common equity and is in addition to the 4.5% minimum requirement, will be phased in progressively starting on 1 January 2016, and will become fully effective by 1 January 2019. Finally, the leverage ratio will also be phased in. The test (the so-called parallel run period) will begin in 2013 and run until 2017, with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on review and appropriate calibration. Conclusion I am sure you will agree with me that the new Basel III package is a very important milestone. The international community is very grateful to Nout Wellink, Chairman of the Basel Committee, Jean-Claude Trichet, Chairman of the Group of Governors and Heads of Supervision, and Mario Draghi, Chairman of the Financial Stability Board: they have all been instrumental in ensuring the success of this endeavour and of the broader financial regulatory agenda. Much has already been achieved to strengthen the financial system, and of course a great deal of work remains to be done to implement internationally agreed standards in all jurisdictions. Central banks and financial supervisory authorities are dedicated to this goal, and will benefit from the full support of the BIS and the international groupings it hosts in Basel. Today I have focused my comments on the new capital standards. Another important aspect of Basel III is the introduction of new global minimum liquidity standards, which is particularly significant because no such international standards currently exist: The Committees liquidity coverage ratio, which will be introduced on 1 January 2015, will promote banks short-term resilience to potential liquidity disruptions. It will require banks to hold a buffer of high-quality liquid assets sufficient to deal with the cash outflows encountered in an acute short-term stress scenario as specified by supervisors. The other minimum liquidity standard introduced by Basel III is the net stable funding ratio. This requirement, which will be introduced as a minimum standard by 1 January 2018, will address

funding mismatches and provide incentives for banks to use stable sources to fund their activities. There is currently great diversity in global liquidity risk management and national liquidity supervision regimes. The Committee will therefore adopt rigorous reporting processes to monitor the ratios during the transition period to ensure the standards behave and interact as intended. Basel III thus provides a combination of capital and liquidity standards that will help increase the resilience of the financial sector in the face of stress. But before ending, I would like to emphasise these four key points: First, the new Basel III package affords the financial industry more clarity on the regulatory front. In todays still challenging economic and financial conditions, uncertainty is the enemy. Removing regulatory uncertainty can contribute importantly to the ongoing recovery. Second, the new Basel III package combines enhancements at both the micro- and the macroprudential level. The new standards improve on the Basel II framework at the micro level of individual financial institutions, especially by strengthening the level and quality of capital. But Basel III also has a macroprudential overlay to promote the greater stability of the financial system as a whole. The aim is to establish appropriate capital schemes to address the procyclicality of the financial system and to deal with systemic risk. The countercyclical capital buffer will be activated by national authorities within the general guidance provided by an international agreement, depending on circumstances in specific jurisdictions. Tools will be available to limit systemic risk, and this will surely put a premium on effective supervision within jurisdictions, as well as on international peer reviews of local arrangements to ensure their international consistency. Last but certainly not least, the foundation of a sound macroprudential framework has now been laid. Third, there will be an appropriately long transition period. The new definition of capital, higher risk weights and increased minimum requirements will entail a significant amount of additional capital. The agreed transitional arrangements will help ensure that the banking sector can meet the higher capital standards through reasonable earnings retention and capital-raising, while still supporting the flow of new lending to the economy. Fourth, we must avoid complacency. True, the financial industry will have time to adapt so as to both maintain an adequate supply of credit for the economy and repair balance sheets. Banks and supervisors alike will have to redouble their efforts to foster behavioural changes to ensure a sustained global recovery from the deep financial crisis. From this perspective, it goes without saying that those banks that already meet the minimum standards but do not meet the conservation buffer should apply the conservation principle. In other words, they should do their best to satisfy the conservation buffer requirement as soon as reasonably possible. Supervisors, for their part, must remain vigilant and actively promote a transition to the new standards as bank-specific and broader economic conditions warrant. I should point out that market discipline also plays an important role in guarding against complacency.

Basel III For Global Banks: Third Time's The Charm?

March 4, 2010

In December 2009, the Basel Committee on Banking Supervision published two consultative documents which set out proposals to strengthen the capitalization and liquidity of the global banking sector. The proposals have been widely dubbed "Basel III" because they would be the third edition of the minimum standards applied by regulators to internationally active banks. The consultative documents are a response to the significant pressure exerted on banks' balance sheets by the extremely testing economic and market conditions of the past three years. In Standard & Poor's Ratings Services' view, the severe stress experienced by the global banking industry during this period has empowered the regulatory community to propose more stringent requirements than it has previously felt able to apply. If their final form is reasonably close to the consultative version, the Basel III proposals are likely to extend the scope of the balance sheet strengthening measures already initiated by many banks, and potentially trigger fundamental changes in business models and product pricing. In this sense, they could mark one of the most significant developments in banking regulation since the original Basel Accord was introduced in 1988. We anticipate a prolonged transition period and significant grandfathering arrangements to cushion the immediate impact of Basel III implementation on the banking system and, by extension, the real economy. Standard & Poor's is broadly supportive of the Basel III proposals. In general, we consider that they are a sensibleresponse to shortcomings in the current regulatory approach that were highlighted by the recent downturn. We see the essence of the capital proposals as being consistent with our in-house analytical tools, such as our risk-adjusted capital framework (RACF). We developed the RACF and our own definitions of bank capital because we consider that the value of existing regulatory ratios is undermined by methodological weaknesses and by inconsistencies in application by national regulators. While Basel III has the potential to address some of these issues, the comparability of regulatory ratios would still be blurred by differences between banks' internal rating models and by the availability of various options to assess identical risks. Equally, we do not expect Basel III to resolve all of the differences in approach between national regulators. We note that the U.S., for example, has been slower than other major countries in its implementation of Basel 2, and we consider that similar variations are likely under Basel III. The European Commission has recently launched a consultation process on the legislative changes required to implement capital and liquidity reforms in the European Union, and we note that its proposals are closely aligned with those of the Basel Committee. The Basel III liquidity proposals represent the first attempt by international regulators to introduce harmonized minimum standards, which is a long overdue development in our view. Some national regulators have already overhauled their liquidity regimes in light of recent events, and the Basel III proposals appear to build on the best practices in these approaches. We view positively the strong improvement in transparency and the emphasis placed on market discipline in the various elements of the Basel III proposals. To date, we believe the disclosure provided by banks regarding regulatory capital measures has frequently been deficient.We are currently reviewing the detail of the Basel III consultative documents, and we intend to publish more extensive

analysis of them before the comment period ends on April 16, 2010. At this early stage, we do not expect that Basel III, once implemented, would likely have a material impact on our bank ratings, which are partly predicated on capitalization being strengthened before governments reduce their support of the banking system. We will, of course, revisit this conclusion as the Basel III proposals move closer to their final form. Over time, the Basel III regime might have a positive influence on our bank ratings, at least the stand-alone credit profiles, if it contributes to greater resilience to future shocks and the industry is able to transition smoothly to the strengthened capital and liquidity requirements. The Basel III proposals are unlikely to be the last word on reforms of the banking industry following the credit crunch. While there appears to be international agreement that the banking industry must maintain stronger capital and liquidity reserves, we do not observe a broad consensus among governments and regulators about the need for, or design of, structural changes. The Basel III consultative documents raise the prospect of capital and liquidity surcharges for systemically important institutions, and the proposals on counterparty credit risk are partly intended to address the "interconnectedness" of the financial system. The Basel Committee intends these initiatives to contribute to the wider debate on the risks of systemically important banks. Discussions on such structural issues appear likely to continue for some time. Overview Of The Basel III Capital Proposals The paragraphs below summarize what we see as the key components of the proposals for enhancing the regulatory capital framework. The consultative document is divided into four broad themes: 1. Improving the quality and consistency of regulatory capital A primary goal of the Basel Committee is to increase the quality and global consistency of regulatory capital and to standardize the required deductions and adjustments. It intends that Tier 1 capital should enable each bank to remain a going concern, with Tier 2 capital recategorized as a "gone concern" reserve to protect depositors in the event of insolvency, and Tier 3 capital abolished altogether. In addition, it states that Tier 1 capital should predominantly comprise common equity and retained earnings, with a tighter definition of common equity. The Basel Committee proposes the introduction of much stricter criteria on the inclusion of hybrid instruments, notably the requirement for coupons to be noncumulative and fully discretionary and for principal to be available to absorb losses on an ongoing basis, either through principal writedown or conversion into common equity. This stance accords with our recent criteria refinement, which highlighted that we will give only minimal equity content in our Adjusted Total Equity (ATE) and Total Adjusted Capital (TAC) capital measures to certain types of hybrids that do not provide sufficient flexibility to defer coupons (see "Assumptions: Clarification Of The Equity Content Categories Used For Bank And Insurance Hybrid Instruments With Restricted Ability To Defer Payments," published Feb. 9, 2010 on RatingsDirect). The Basel III proposals are likely to make hybrid Tier 1 capital more equity-like and homogeneous, with a higher likelihood of coupons on future hybrids being cancelled in periods of stress. Furthermore, the Basel Committee proposes to phase out so-called

innovative Tier 1 instruments with embedded incentives to redeem, such as coupon step-ups. Overall, investors in hybrids eligible within future Tier 1 capital are expected to bear more risks, both in terms of loss absorption and the potential absence of redemption. As stated in our criteria, heightened risk of nonpayment or deferral leads us to assign lower ratings to hybrid issues. We would therefore adjust our hybrid ratings to take account of regulatory changes that make such instruments more likely to absorb losses. We welcome the proposal to strengthen and simplify the capital structure of banks. Recent experience has shown us that the co-existence of multiple classes of regulatory capital instruments has sometimes had unintendedconsequences in terms of the flexibility to defer coupons and the predictability of banks' behavior. Furthermore, some regulatory capital instruments such as nondeferrable Tier 2 and Tier 3 issues had minimal equity content, and therefore we have not included them in our capital measures. The consultative document lists a number of items that must be adjusted for in common equity, including minority interests in consolidated subsidiaries, unrealized losses on balance sheet assets, cashflow hedge reserves, goodwill and other intangibles, net tax loss carryforwards, defined-benefit pension fund deficits, investments in unconsolidated subsidiaries such as insurance businesses, and any shortfall in loan loss provisions relative to expected losses. The proposals also call for improved disclosure of regulatory capital calculations to enhance transparency and aid reconciliations with accounting data. These proposals represent a significant tightening and harmonization of regulatory capital requirements. It appears, for example, that few existing Tier 1 hybrid instruments would qualify for continued inclusion in Tier 1, absent a grandfathering arrangement. In addition, the list of capital adjustments is more comprehensive than the rules currently applied of any major national regulator. The proposal that these items should be deducted from common equity rather than a broader capital measure is very exacting. However, it addresses one of the weaknesses of the current regime, where capital needs of certain activities, particularly nonbanking businesses such as insurance, were partly or entirely covered by subordinated debt which did not absorb losses on a going-concern basis. Given the complexity of capital requirements for financial conglomerates, it remains to be seen if this more demanding rule will be implemented in a consistent manner in all jurisdictions. We believe the required Basel III deductions would likely have a significant impact on most banks, with certain institutions and sectors particularly affected. For example, the requirement to fully deduct pension fund deficits mirrors our existing approach, but would be much tougher than the regulatory adjustment currently applied in the U.K., where banks' employee pension schemes tend to be relatively large. In the RACF, we already reflect most, but not all, of the proposed Basel III capital deductions either in the calculation of ATE and TAC or in one-for-one capital charges in Standard & Poor's risk-weighted assets. A notable difference in our approach relates to minority interests in consolidated subsidiaries, which we would deduct only if the subsidiary were a nonfinancial entity such as a property or industrial company or a special purpose vehicle. We regard the Basel III proposal to deduct all minority interests as asymmetric

and overly conservative. Other differences relate, for instance, to the deduction of any shortfall in loan loss provisions relative to expected losses, or to the deduction of a number of equity stakes such as industrial holdings over a particular threshold. Although we would welcome more stringent and consistent deduction requirements, we consider that some of the proposed changes in regulatory deductions (for items such as tax loss carryforwards or unrealized losses) would likely exacerbate procyclicality, which is already a problem under the current Basel 2 regime. We note that the Basel III proposals advocate capital buffers to address this (see below for details). The full consequences of these definitional changes cannot be accurately quantified until the Basel Committee has determined the minimum capital ratios that banks must maintain. It is undertaking an impact study during the first half of 2010 to calibrate the required minima, which would be applied at three different levels (common equity, Tier 1, and total regulatory capital). Since the effect of the Basel III proposals is likely to be material, we expect an extended transition period, significant grandfathering of existing capital instruments, and/or other regulatory adjustments to ease the impact on the sector and the wider economy. Still, the banking industry might well need to conserve capital--through constrained dividends, for example--and some institutions might decide to adapt their business models-through selected disposals, for example--in response to the new rules. 2. Increased capital requirements on certain counterparty credit risks To augment previously-announced increases in market risk capital charges which take effect at year-end 2010, the Basel III proposals contain a number of measures that would significantly raise capital requirements for trading-related counterparty risks. These changes are intended to address deficiencies in the Basel 2 methodology that were highlighted by the recent period of acute market volatility. In summary, the proposals in the Basel III consultative document call for: the use of stressed inputs in the calculation of potential future counterparty exposures; the introduction of a capital charge against potential mark-to-market losses arising from deteriorating counterparty creditworthiness short of actual default; an increase in the correlation assumptions for exposures to other financial institutions, with embedded incentives to move over-the-counter (OTC) trading to central counterparties and exchanges; and increased capital charges in certain other areas, such as wrong way risk (which arises when the probability of default and the exposure at default are positively correlated, as banks experienced, for example, in the case of asset-backed securities hedged with monolines). Clearly, the proposed strengthening of the counterparty risk capital charge would have the greatest impact on banks with large capital markets activities. Our preliminary estimate is that the counterparty risk charge could increase very significantly from the current level, with the main driver being the proposed introduction of a Pillar 1 value-at-risk charge on counterparty valuation adjustments. In general, we consider that the proposed changes are a reasonable response to recent events. For example, our own assessment of asset correlation between financial institutions had indicated that the levels assumed in Basel 2 (12%-24%) were too low in times of stress. The potential implications for the smooth functioning of the interbank market require further consideration, however.

Although we agree with the underlying concepts, we see calibration issues with the Pillar 1 value-at-risk charge on credit valuation adjustments, and believe that this should be reviewed in the Basel Committee's impact study. 3. Introduction of a leverage ratio Leverage ratios are already applied to banks in certain countries, such as the U.S., and other national regulators, such as Switzerland's FINMA, have announced plans to introduce similar measures as a response to the recent crisis. The Basel III proposals would, if implemented, introduce a consistent leverage ratio measure for all internationally active banks. The consultative document indicates that this measure would initially be a Pillar 2 monitoring tool, but could ultimately become a Pillar 1 requirement. The document sets out a number of options for the calculation of the numerator and denominator of the ratio. Both are positioned relatively conservatively in our opinion. The numerator is intended to be a high quality capital measure, which suggests that it will be either common equity or Tier 1. For the denominator, the consultative document indicates that netting of repurchase agreement (repo) and derivative contracts might not be recognized. For many banks, this would make a substantial difference to the leverage ratio outcome, similar to the existing balance sheet gross-up under International Financial Reporting Standards (IFRS) relative to U.S. generally accepted accounting principles (GAAP). The Basel Committee will also consider whether to include short credit derivative positions and several off-balance-sheet items at their notional values, which would also have a significant impact in many cases. In our view, since excessive leverage was evidently a contributory factor to the stress experienced by the banking sector since 2007, the introduction of a consistent leverage ratio measure could usefully complement risk-adjusted regulatory capital metrics and help to identify outliers. In our view, the effectiveness of the Basel III proposal will crucially depend on the final definition of the leverage ratio. If poorly calibrated, it could lead to outcomes that might be seen as undesirable from a broader perspective, such as a reduction in liquidity in the repo market as banks reduce their portfolios to manage the leverage ratio calculation. The introduction of a measure of adjusted assets that eliminates inconsistencies between accounting standards would facilitate cross-regional comparisons, even beyond its particular use in a leverage ratio. However, an excessively wide definition of adjusted "gross" assets could make such information less relevant and potentially misleading. 4. Addressing procyclicality Perhaps the most innovative section of the consultative document is the proposals to address procyclicality. We have consistently highlighted the procyclicality bias of Basel 2, and we consider that, without countervailing measures, this problem would likely be exacerbated by the Basel III proposals regarding the definition of capital. We sought to mitigate procyclicality in our RACF methodology by calibrating the capital charges to stress scenarios. The Basel Committee intends to evaluate a number of options to address procyclicality, including: the use of a noncyclical probability of default proxy in internal rating models; encouragement for provisioning policies to move to a forward-looking expected loss methodology rather than the incurred loss approach currently applied under IFRS and U.S. GAAP;

and the introduction of capital buffers that would be proactively adjusted to take account of macroeconomic factors. The most ground-breaking proposal in our view is a mechanistic framework that would require the conservation of Tier 1 capital via restrictions on dividends, share buybacks, and discretionary bonuses if a bank's capitalization falls within specified ranges above its minimum regulatory requirement. These proposals to address procyclicality sit alongside other macroprudential tools currently under consideration by regulators and governments. Their collective aim is to address potentially detrimental trends such as rising leverage, lending growth, and liquidity mismatches before they become excessive. Some regulators already have the power to adjust minimum capital requirements and require changes in underwriting criteria, but their track records in applying these powers have been mixed, partly we believe because they appeared reluctant to penalize their domestic banks relative to international competitors. The recent stress experienced by the banking sector has strengthened regulators' resolve, but time will tell whether this is maintained in the long term. The proposed capital conservation framework is an interesting idea in our view, but requires detailed calibration, as the consultative document itself points out. The framework has been designed to address the collective action problem that may have occurred in the banking sector in the run-up to the crisis, when some institutions may have considered reducing distributions to staff and/or shareholders, but ultimately decided against such a move due to concerns that competitors would not follow suit. Depending on the calibration, the practical result of the framework might be that the regulatory capitalization targeted by banks is the level at which they have complete discretion over bonus and dividend payments. The capital conservation framework is additionally aimed at assigning a more predictable loss absorption role to hybrid Tier 1 capital instruments on a going-concern basis and changing the market perception of the relative likelihood of nonpayment. As stated in our criteria, heightened risk of nonpayment or deferral leads us to assign lower ratings to hybrid issues, and we would therefore adjust these ratings to take account of regulatory changes that made such instruments more likely to absorb losses. Overview Of The Basel III Liquidity Proposals The Basel Committee published a separate consultative document in December 2009 regarding new international standards for liquidity management and monitoring. Specifically, the document proposes two complementary metrics that are intended to encapsulate banks' short-term liquidity and structural funding positions: The short-term liquidity metric--named the liquidity coverage ratio in the consultative document-would require banks to maintain high quality, unencumbered assets in excess of their stressed cash outflows over a 30day time horizon. The document proposes several possible definitions of the numerator and

denominator, including the haircuts to be applied to eligible liquid assets and the stressed outflow assumptions for each category of liabilities and off-balance-sheet commitments. The structural funding metric--named the net stable funding ratio--effectively assesses the behavioral maturity of each side of the balance sheet over a one-year horizon. More particularly, haircuts are applied to each category of assets and liabilities according to their expected stability through a stress scenario, and the available stable funding must exceed the required stable funding. We regard the proposed introduction of internationally-consistent minimum liquidity standards as a positive step. We view the time horizon assumed in each ratio as relatively short, however, particularly for more highly rated institutions, which we would expect to target a longer survival period. The 30-day horizon used in the liquidity coverage ratio appears to have been borrowed from the established stress test standard for U.S. broker dealers.Although we believe this ratio would provide a better basis to compare banks than existing published liquidity metrics, the prolonged liquidity crunch of late 2008 and early 2009 demonstrates that financial institutions need to be able to function in a stress scenario for longer than 30 days. The consultative document proposes other monitoring tools to assess liquidity over different time horizons, but it is unclear whether these would be applied as consistently as the liquidity coverage ratio. We also consider that the categories put forward in the consultative document for banks' liquidity sources and uses have not yet been precisely defined, and could usefully be more granular and nuanced. The chosen definition of liquid assets could lead to distortions in the markets for eligible and non-eligible securities. The consultative document does not make firm recommendations on important practical aspects of the proposed liquidity regime, such as the frequency of calculation, the depth of public disclosure, and the scope of application. For example, the document indicates that banks would report only on a consolidated basis, which might not be sufficient for large, global banks with major liquidity requirements in multiple currencies and regions. Although we would not advocate a regulatory regime which required banks to lock up material liquidity pools in individual jurisdictions, thereby constraining the fungibility of resources across each group, we believe that banks should demonstrate that they can channel funds to individual legal entities on a timely basis. Transparency We view positively the strong improvement in transparency and the emphasis placed on market discipline in the various elements of the Basel III proposals. We agree with the Basel Committee's view that the disclosure provided by banks regarding regulatory capital measures has frequently been deficient to date. The proposals would notably require a published reconciliation of regulatory capital measures to the financial statements, the separate disclosure of all regulatory adjustments, the identification of all limits applied, and the description of the main features of hybrid capital instruments. The committee intends to require rigorous Pillar 3 disclosures on other components of the proposals, such as the computation of the leverage ratio. Given the differences

in accounting treatments across jurisdictions, for instance between IFRS and U.S. GAAP, Standard & Poor's is supportive of these additional disclosures that would facilitate comparison of financial metrics between jurisdictions. Next Steps We intend to review the Basel III consultative documents in further detail and publish more extensive analysis of them before the comment period ends on April 16, 2010. The Basel Committee plans to publish the final rules by year-end 2010, with implementation scheduled for year-end 2012. As stated earlier, we expect an extended transition period with significant grandfathering arrangements to manage the risk that the global economic recovery could be jeopardized if banks are forced to focus on balance sheet strengthening at the expense of their core functions.