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Banks have had more than two years to peruse the Basel III prudential rules since they were finalised in December 2010, but the impact of one footnote – which transfers the volatility of huge, previously exempt bond portfolios into bank capital numbers – is only now beginning to sink in.
Paragraph 52 of Basel III lists what banks must include in common equity Tier I. This number, when divided by risk-weighted assets, produces the all-important common equity Tier I ratio, which is subject to a new 4.5 per cent minimum plus a range of add-ons that are expected to establish an effective industry standard of around 10 per cent for larger banks.
One of the elements that has to go into common equity Tier I is accumulated other comprehensive income (AOCI), which contains the unrealised gains and losses of available-for-sale (AFS) securities, along with pension costs and cashflow hedges that are not included in the profit-and-loss statement.
Before Basel III, unrealised gains and losses on AFS debt securities were filtered out of common equity Tier I – but a 58-word footnote to paragraph 52 removes this filter, and those provisions were copied into US proposals implementing Basel III in June 2012.
Cue uproar. Regulators were swamped with 1,200 comment letters – many attacking the change in the treatment of AFS securities – and on November 9, regulators announced an unspecified delay in plans to implement the rules: “When I talk to people in the US, they say the removal of the AOCI filter is the biggest single issue the industry is lobbying over in terms of financial regulation”, says Peter Sime, head of risk and research with the International Swaps and Derivatives Association.
It’s not hard to see why. “The elimination of the AOCI filter is an issue for the entire banking industry – large and small and everything in between”, says David Wagner, head of finance affairs at industry group The Clearing House in New York.
The price of the securities can, of course, move around for other reasons, and there was a glimpse of the future in BAML’s fourth-quarter earnings presentation, in which the bank reported a $1.3 billion after-tax decline in its common equity Tier I under Basel III due to unrealised losses on AFS debt securities.
This, say US banks, will force them to hold an additional capital buffer and could also prompt them to change their hedging strategies – they may hold fewer interest rate-sensitive assets, or take existing bonds out of AFS, and apply the held-to-maturity classification that would insulate them from capital but prevent them from being traded. In turn, that could affect demand for government bonds or the liquidity of the market – and it’s an issue that is already worrying some issuers, particularly because Basel III also contains new liquidity rules that will encourage banks to increase their holdings of sovereign debt.
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