Basel Committee to look at Tier 1 capital quality

The Basel Committee on Banking Supervision is preparing radical changes to its rules on capital quality, including a 'soft target' of 75% for equity capital - up from 50% today - and the possible abolition of two-tier capital, according to a senior regulator.

As things stand, 50% of Tier 1 capital is supposed to qualify as 'core' equity, which is permanent, absorbs losses and gives the issuer freedom on whether to pay dividends. The rest can comprise various types of hybrid instruments, which are currently subject to a patchwork of national laws. European reforms were intended to harmonise those laws, but the crisis has prompted a focus on more fundamental questions.

"It's not about the Basel Committee versus Europe - it is yesterday's problems versus today's problems," says the regulator. "When we started this work, it was focused on hybrid instruments, but what's happening now is a much more fundamental review of what capital really is, what it's for, and what features of capital we need to see."

The boldest idea currently under discussion would be the inclusion of an anti-cyclical element to the capital regime. In the current crisis, capital requirements have increased at a time when capital is hardest to raise, intensifying the pressure on banks. Evidently, regulators have been paying attention. There is "strong support" within the Basel Committee for a plan to keep the minimum core equity requirement at 50% but to have it float upwards to a target of 75% when times are good, the regulator says. In other words, banks would be expected to make hay when the sun shines, building a large buffer of the very best quality capital,then be allowed to wind that down as the organisation suffers losses.

Thibaut Adam, head of capital markets structuring at BNP Paribas in London, says it is an interesting approach, but one that comes with problems: "The chief question would be about timing - who would decide when we were in good times or bad?"

A second bold change could be the abolition of Tier 2 capital. The regulator argues that because these instruments only absorb losses in a bankruptcy situation - and because the crisis has shown that large, systemically important banks are too big to fail - Tier 2 capital has become completely irrelevant. "If an instrument only has loss-absorbing capacity in an event that will never happen, then it has no loss-absorbing capacity for the purposes of Basel II. If these lower-quality instruments don't count for regulatory purposes, then banks will have little incentive to use them," he says.

The result will be a greater need for capital that has the same qualities as core equity. However, bankers argue that investors don't want to buy capital that is both permanent and would get written down by losses. One compromise might be to create fixed-term notes that are loss-absorbing. The regulator isn't impressed: "If there is a term limit, it obviously makes the hybrids more debt-like. It is hard to say where this dilemma will end up, but I refuse to believe banks will never be in a position to issue equity capital. Banks will have to issue these capital instruments, and ultimately there will be investors willing to buy them. It all depends on the pricing."

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