Basel III tool kit

Author: | Published: 24 Apr 2015
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Latin American countries’ adoption of Basel III is leading to the rise of AT1s as a financing tool for banks, as well as an investment vehicle for international funds

The maxim that banking should be commercial and that tax payers should not have to pay for the cost of failure underpins the spirit of Basel III, a set of guidelines published in 2010 as result of the 2008 financial crisis.The most important takeaways of the Basel III guidelines can be summarised as:

1) a stricter definition of capital (removing intangibles, for example);

2) higher capital requirements for all institutions that will take into account the need for buffers (for capital conservation, countercyclical measures with additional requirements for institutions deemed domestic systemically important banks);

3) the creation of liquidity ratios to ensure that banks remain liquid in times of stress;

4) leverage ratios that recognise the need to take into account risk weighted assets; and,

5) the modification of tier 1 and tier 2 securities structures for greater flexibility in recapitalising banks, therefore reducing the dependency on public funds in cases where those banks have capital problems.

As regulators across the globe continue to assess the best approach to implementation, Latin American banks and regulators have had the good fortune of being in a position of strength to deal with the roll out. Relatively speaking, Latin America has been one of the most conservative regions when it comes to regulatory frameworks, particularly in terms of capital requirements. Lessons learnt on the back of years of experience in crisis and volatility management have resulted in some of these countries having certain Basel III equivalent requirements in place even before the new guidelines were laid out. As a result, Latin American banks are generally well prepared, and sufficiently capitalised, to take on the new regime.

Unsurprisingly, Latin America's three largest economies, Argentina, Brazil and Mexico, all of whom are members of the Basel Committee on Banking Supervision (BCBS), were the first countries to advance in this matter. Since these are by definition guidelines, each particular jurisdiction needs to analyse and implement the framework while taking into consideration the intricacies of their financial systems. For this important reason, the implementation – in most countries – came in stages and in many cases, allowed for several years for banks to become fully compliant with the new requirements. In accordance with Basel III, these measures were put in place to reduce the initial burden of the new regulations. Nevertheless, in a region that continues to grow, credit expansion will evidently result in a greater need for capital.

"Latin America has been one of the most conservative regions when it comes to regulatory frameworks, particularly in terms of capital requirements"

An interesting development to note is the birth of a new generation of capital securities which will become an important component of bank capital in the years to come. Additional Tier 1 instruments (AT1) are fixed income instruments that contain equity-like features which therefore qualify as capital from a regulatory perspective. Similar to equity, AT1s are perpetual instruments and therefore do not have a contractual maturity (some jurisdictions, like Peru, also accept longer tenors, for example 60 years). They are also subordinated to senior debt and have the ability to cancel coupon payments, which is akin to the instances where a company does not pay dividends to stockholders when it doesn't have distributable profits. It is also comparable in terms of how it corresponds to the loss of market value of a financial institution experiencing capital or liquidity constraints, as these securities require stricter loss absorbing features than their predecessors.

These changes will allow for these instruments to become what is referred to as 'going concern' versus 'gone concern', which basically reflects the flexibility that these instruments provide a bank in terms of giving time to allow the bank to recover. In practical terms, these bonds are written down (or in some cases written off) on the bank's balance sheet when the institution breaches a certain capital ratio or when the regulator determines it has reached what is denominated the point of non-viability (PONV). Non-viability usually refers to the point where the regulator believes an institution either needs to receive a public injection of capital (bail-out) or when it has to trigger loss-absorbing measures to remain viable. In the terms we described above, it is the point before it goes from going concern to gone concern.

Alternatively, the instruments can be converted into ordinary shares, although at the point of conversion the ordinary shares will most likely hold very little value. For example, if an institution breaches the 5.125% limit of their common equity ratio (CET1), the regulatory measure of the purest form of capital, or if the regulator decides it has reached its PONV, a bank will automatically trigger the loss-absorbing feature in all their AT1 perpetuals (certain regulators have chosen not to incorporate capital triggers for loss-absorption keeping it to a question of PONV). An investor will therefore either lose its claim to the bond, partially or fully, or receive some kind of equity stake in the financial institution. The financial institution has now reduced its debt burden (principal and interest) and fortified its capital base (by creating equity as a result of not needing to return this debt or as a result of conversion of the debt), thereby relieving the stress on its balance sheet.

Tier 2 features

Under Basel III, Tier 2 instruments – which have defined maturities and obligatory coupons – will also need to include loss absorbing language similar to AT1 perpetuals, which would allow regulators to write down, write off, or convert into equity these instruments at the PONV.

"The noticeable increase in supply of these securities is evidence that investors across the globe have been eager to participate in AT1 perpetuals"

Despite the inherent risks, the noticeable increase in supply of these securities is evidence that investors across the globe have been eager to participate in AT1 perpetuals. In 2014 alone there was $120.9 billion of AT1 perpetual issuance worldwide, a dramatic increase from the $45 billion in 2013 (source: Dealogic). For certain credits, usually each country's national champions, investors see the potential loss-absorbing outcome as tail risk and are happy to receive the extra return that these instruments carry. Although it may vary by region and rating, these perpetual securities may yield 300-400 basis points (bps) above senior securities. Conversely, issuers benefit from the capital recognition and tax benefits these instruments provide, and in many cases, are able to execute a capital injection around 300-400 bps below their cost of equity. This is not to mention the added benefit that this alternative does not dilute its shareholders. This is why AT1 perpetuals are regarded as a cost-effective way to fortify a bank's capital structure.

The recognition of how this benefits banks and the investor community has resulted in many Latin American countries establishing the framework for these securities as part of their Basel III implementation. While Brazil and Mexico are fully up and running (Banco do Brasil was the first Latin American bank, in fact the first emerging market bank, to issue a Basel III-compliant AT1 perpetual security), many others are quickly getting their regulatory frameworks in place. Peru, for example, is working on adapting its outstanding perpetual regulations to comply with Basel III requirements. Colombia has recently issued a decree to admit perpetual securities as part of a bank's capital. This is considered to be the first step in the framework that would allow for AT1 perpetuals for the first time in this country's history. Finally, Chile is considering changing its banking law, to allow its financial institutions to have access to this new and effective form of capital.

Basel III implementation is a continuing process. Basel III guidelines are intended to make banks in Latin America and across the globe resilient, and above all, safer. How Latin America has adapted and built on its position of financial strength is a fine example of the region's ability to adapt and continue to grow.

About the author

Rodrigo Gonzalez
Executive director and regional head of debt capital markets, Americas
Standard Chartered Bank

Rodrigo Gonzalez is the Americas head of debt capital markets for Standard Chartered Bank. Since joining the bank in New York in 2010, he has been pivotal in building out the bank's Latin Americas debt capital markets capabilities. He oversaw a series of noteworthy Tier 1 and Tier 2 transactions for leading banks across the region (including Banco do Brasil, Bradesco, Itau and COFIDE), which further consolidated Standard Chartered's leadership position as a hybrid capital and Basel III specialist. Rodrigo joined the bank from Dresdner Kleinwort where he was part of the debt capital markets team covering Latin American corporates and banks.