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The Basel ii Accord
From the Basel ii Compliance Professionals Association (BCPA)
the largest association of Basel ii Professionals in the world

The constituents of capital

A. Core capital (basic equity or Tier 1)

49(i). The Committee considers that the key element of capital on which the main emphasis should be placed is equity capital * and disclosed reserves.

This key element of capital is the only element common to all countries' banking systems; it is wholly visible in the published accounts and is the basis on which most market judgements of capital adequacy are made; and it has a crucial bearing on profit margins and a bank's ability to compete.

This emphasis on equity capital and disclosed reserves reflects the importance the Committee attaches to securing an appropriate quality, and the level, of the total capital resources maintained by major banks.

* 13 Issued and fully paid ordinary shares/common stock and non-cumulative perpetual preferred stock (but excluding cumulative preferred stock).

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

49(iii). The Committee has therefore concluded that capital, for supervisory purposes, should be defined in two tiers in a way which will have the effect of requiring at least 50% of a bank's capital base to consist of a core element comprised of equity capital and published reserves from post-tax retained earnings (Tier 1).

The other elements of capital (supplementary capital) will be admitted into Tier 2 limited to 100% of Tier 1.

These supplementary capital elements and the particular conditions attaching to their inclusion in the capital base are set out in paragraphs 49(iv) to 49(xii) below and in more detail in Annex 1a.

Each of these elements may be included or not included by national authorities at their discretion in the light of their national accounting and supervisory regulations.

B. Supplementary capital (Tier 2)

1. Undisclosed reserves

49(iv). Unpublished or hidden reserves may be constituted in various ways according to differing legal and accounting regimes in member countries.

Under this heading are included only reserves which, though unpublished, have been passed through the profit and loss account and which are accepted by the bank's supervisory authorities.

They may be inherently of the same intrinsic quality as published retained earnings, but, in the context of an internationally agreed minimum standard, their lack of transparency, together with the fact that many countries do not recognise undisclosed reserves, either as an accepted accounting concept or as a legitimate element of capital, argue for excluding them from the
core equity capital element.

2.  Revaluation reserves

49(v). Some countries, under their national regulatory or accounting arrangements, allow certain assets to be revalued to reflect their current value, or something closer to their current value than historic cost, and the resultant revaluation reserves to be included in the capital base.

Such revaluations can arise in two ways:

(a) from a formal revaluation, carried through to the balance sheets of banks' own premises; or

(b) from a notional addition to capital of hidden values which arise from the practice of holding securities in the balance sheet valued at historic costs.

Such reserves may be included within supplementary capital provided that the assets are considered by the supervisory authority to be prudently valued, fully reflecting the possibility of price fluctuations and forced sale.

49(vi). Alternative (b) in paragraph 49(v) above is relevant to those banks whose balance sheets traditionally include very substantial amounts of equities held in their portfolio at historic cost but which can be, and on occasions are, realised at current prices and used to offset losses.

The Committee considers these "latent" revaluation reserves can be included among supplementary elements of capital since they can be used to absorb losses on a going-concern basis, provided they are subject to a substantial discount in order to reflect concerns both about market volatility and about the tax charge which would arise were such cases to be realised.

A discount of 55% on the difference between the historic cost book value and market value is agreed to be appropriate in the light of these considerations. The Committee considered, but rejected, the proposition that latent reserves arising in respect of
the undervaluation of banks' premises should also be included within the definition of supplementary capital.

3. General provisions/general loan-loss reserves

49(vii). General provisions or general loan-loss reserves are created against the possibility of losses not yet identified. Where they do not reflect a known deterioration in the valuation of particular assets, these reserves qualify for inclusion in Tier 2 capital.

Where, however, provisions or reserves have been created against identified losses or in respect of an identified deterioration in the value of any asset or group of subsets of assets, they are not freely available to meet unidentified losses which may subsequently arise elsewhere in the portfolio and do not possess an essential characteristic of capital.

Such provisions or reserves should therefore not be included in the capital base.

49(viii). The supervisory authorities represented on the Committee undertake to ensure that the supervisory process takes due account of any identified deterioration in value.

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

49(ix). This would mean that all elements in general provisions or general loan-loss reserves designed to protect a bank from identified deterioration in the quality of specific assets (whether foreign or domestic) should be ineligible for inclusion in capital.

In particular, elements that reflect identified deterioration in assets subject to country risk, in real estate lending and in other problem sectors would be excluded from capital.

49(x). General provisions/general loan-loss reserves that qualify for inclusion in Tier 2 under the terms described above do so subject to a limit of

(a) 1.25 percentage points of weighted risk assets to the extent a bank uses the Standardised Approach for credit risk; and

(b) 0.6 percentage points of credit risk-weighted assets in accordance with paragraph 43 to the extent a bank uses the IRB Approach for credit risk.

4. Hybrid debt capital instruments

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

Each of these has particular features which can be considered to affect its quality as capital.

It has been agreed that, where these instruments have close similarities to equity, in particular when they are able to support losses on an on-going basis without triggering liquidation, they may be included in supplementary capital.

In addition to perpetual preference shares carrying a cumulative fixed charge, the following instruments, for example, may qualify for inclusion: long-term preferred shares in Canada, titres participatifs and titres subordonnés à durée indéterminée in France, Genussscheine in Germany, perpetual debt instruments in the United Kingdom and mandatory convertible debt instruments in the United States.

The qualifying criteria for such instruments are set out in Annex 1a.

5. Subordinated term debt

49(xii). The Committee is agreed that subordinated term debt instruments have significant deficiencies as constituents of capital in view of their fixed maturity and inability to absorb losses except in a liquidation.

These deficiencies justify an additional restriction on the amount of such debt capital which is eligible for inclusion within the capital base.

Consequently, it has been concluded that subordinated term debt instruments with a minimum original term to maturity of over five years may be included within the supplementary elements of capital, but only to a maximum of 50% of the core capital element and subject to adequate amortisation arrangements.

C. Short-term subordinated debt covering market risk (Tier 3)

49(xiii). The principal form of eligible capital to cover market risks consists of shareholders’ equity and retained earnings (Tier 1 capital) and supplementary capital (Tier 2 capital) as defined in paragraphs 49(i) to 49(xii).

But banks may also, at the discretion of their national authority, employ a third tier of capital (“Tier 3”), consisting of short-term subordinated debt as defined in paragraph 49(xiv) below for the sole purpose of meeting a proportion of the capital requirements for market risks, subject to the following conditions:

• Banks will be entitled to use Tier 3 capital solely to support market risks as defined in paragraphs 709 to 718(Lxix). This means that any capital requirement arising in respect of credit and counterparty risk in the terms of this Framework, including the credit counterparty risk in respect of OTCs and SFTs in both trading and banking books, needs to be met by the existing definition of capital base set out in paragraphs 49(i) to 49(xii) above (i.e. Tiers 1 and 2);

Tier 3 capital will be limited to 250% of a bank’s Tier 1 capital that is required to support market risks.

This means that a minimum of about 28½% of market risks needs to be supported by Tier 1 capital that is not required to support risks in the remainder of the book;

• Tier 2 elements may be substituted for Tier 3 up to the same limit of 250% in so far as the overall limits set out in paragraph 49(iii) above are not breached, that is to say eligible Tier 2 capital may not exceed total Tier 1 capital, and long-term
subordinated debt may not exceed 50% of Tier 1 capital;

• In addition, since the Committee believes that Tier 3 capital is only appropriate to meet market risk, a significant number of member countries are in favour of retaining the principle in the present Framework that Tier 1 capital should represent at least
half of total eligible capital, i.e. that the sum total of Tier 2 plus Tier 3 capital should not exceed total Tier 1.

However, the Committee has decided that any decision whether or not to apply such a rule should be a matter for national discretion.

Some member countries may keep the constraint, except in cases where banking activities are proportionately very small.

Additionally, national authorities will have discretion to refuse the use of short-term subordinated debt for individual banks or for their banking systems generally.

49(xiv). For short-term subordinated debt to be eligible as Tier 3 capital, it needs, if circumstances demand, to be capable of becoming part of a bank’s permanent capital and thus be available to absorb losses in the event of insolvency. It must, therefore, at a minimum:

• be unsecured, subordinated and fully paid up;

• have an original maturity of at least two years;

• not be repayable before the agreed repayment date unless the supervisory authority agrees;

• be subject to a lock-in clause which stipulates that neither interest nor principal may be paid (even at maturity) if such payment means that the bank falls below or remains below its minimum capital requirement.

D. Deductions from capital

49(xv). It has been concluded that the following deductions should be made from the capital base for the purpose of calculating the risk-weighted capital ratio.

The deductions will consist of:

(i) Goodwill, as a deduction from Tier 1 capital elements;

(ii) Increase in equity capital resulting from a securitisation exposure, as a deduction from Tier 1 capital elements, pursuant to paragraph 562 below;

(iii) Investments in subsidiaries engaged in banking and financial activities which are not consolidated in national systems.

The normal practice will be to consolidate subsidiaries for the purpose of assessing the capital adequacy of banking groups.
Where this is not done, deduction is essential to prevent the multiple use of the same capital resources in different parts of the group.

The deduction for such investments will be made in accordance with paragraph 37 above.

The assets representing the investments in subsidiary companies whose capital had been deducted from that of the parent would not be included in total assets for the purposes of computing the ratio.

49(xvi). The Committee carefully considered the possibility of requiring deduction of banks' holdings of capital issued by other banks or deposit-taking institutions, whether in the form of equity or of other capital instruments.

Several G-10 supervisory authorities currently require such a deduction to be made in order to discourage the banking system as a whole from creating cross-holdings of capital, rather than drawing capital from outside investors.

The Committee is very conscious that such double-gearing (or "double-leveraging") can have systemic dangers for the banking system by making it more vulnerable to the rapid transmission of problems from one institution to another and some members consider these dangers justify a policy of full deduction of such holdings.

49(xvii). Despite these concerns, however, the Committee as a whole is not presently in favour of a general policy of deducting all holdings of other banks' capital, on the grounds that to do so could impede certain significant and desirable changes taking place in the structure of domestic banking systems.

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

(a) Individual supervisory authorities should be free at their discretion to apply a policy of deduction, either for all holdings of other banks' capital, or for holdings which exceed material limits in relation to the holding bank's capital or the issuing bank's
capital, or on a case-by-case basis;

(b) Where no deduction is applied, banks' holdings of other banks' capital instruments will bear a weight of 100%;

(c) The Committee considers that reciprocal cross-holdings of bank capital artificially designed to inflate the capital position of the banks will be deducted for capital adequacy purposes;

(d) The Committee will closely monitor the degree of double-gearing in the international banking system and does not preclude the possibility of introducing constraints at a later date.

For this purpose, supervisory authorities intend to ensure that adequate statistics are made available to enable them and the Committee to monitor the development of banks' holdings of other banks' equity and debt instruments which rank as capital under the present agreement.  

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