Proposed New Capital Adequacy Rules Remodel Swiss Regulatory Capital Framework

The Federal Department of Finance recently published different proposals with respect to new rules on capital adequacy for Swiss banks, including detailed provisions aimed at mitigating the too-big-to-fail conundrum. The suggested changes strive to raise both the quality and quantity of the regulatory capital base and enhance the risk coverage of the capital framework. Whereas overall the proposed changes are welcomed insofar as they are aimed at implementing the new capital adequacy rules of the international Basel III framework, some amendments are criticizable as they would result in stricter requirements for Swiss banks than required under Basel III for no apparent good cause. In addition, the stricter capital adequacy rules for systemically important banks seem to depart from the final report of the expert commission with respect to a number of important points and, if implemented, may put significant constraints on Switzerland’s two large banks.

By René Bösch / Jonas Oggier (Reference: CapLaw-2012-2)

1) Introduction

On 24 October 2011, the Federal Department of Finance (FDF) submitted a draft of the revised Capital Adequacy Ordinance (CAO) for public consultation. Simultaneously, FINMA launched a consultation on a new circular governing eligible equity capital and on the amendments to the circulars governing market and credit risks, disclosure and risk diversification. In a subsequent separate consultation, the FDF published its proposal with respect to the introduction of a countercyclical buffer and stricter risk weightings for mortgages on residential properties. The suggested changes are mostly aimed at implementing the new capital adequacy rules of the international Basel III framework (Basel III). On 5 December 2011, the FDF started a further, separate consultation in relation to a set of new rules which are aimed at implementing the legislative changes to the Banking Act (BA) enacted by Parliament on 30 September 2011 in relation to the too-big-to-fail conundrum and which shall thus be exclusively applicable to systemically relevant banks. All consultations with respect to the CAO and the FINMA circulars ended on 16 January 2012, and the new rules are to enter into force on 1 January 2013. However, it is contemplated that the different transitory periods provided for by Basel III will (to a large extent) be reflected under the new rules. This contribution aims at providing an overview of the main novelties of the suggested new Swiss rules on capital adequacy and discussing some controversial issues.

2) Background of Proposed New Rules on Capital Adequacy

In the past, Switzerland closely implemented the international Basel framework on capital adequacy into national law, however, not without providing for stricter rules with respect to certain aspects of the capital adequacy regime applicable to Swiss banks, notably in terms of higher risk weights for certain credit positions. The implementation of more stringent rules (in particular in the form of add-ons and other special regulations) than requested under Basel III, generally known as the «Swiss finish», was primarily justified by reference to the relative and absolute importance of the financial services industry in Switzerland and the corresponding heightened risk exposure for the Swiss economy.

As a consequence of the recent economic and financial crisis, the Basel Committee substantially revised its capital adequacy framework in order to improve the resilience of the banking sector, notably by raising both the quality and quantity of the regulatory capital base and enhancing the risk coverage of the capital framework. In December 2010, the Basel Committee published the conclusions reached during the revision process in a document entitled “Basel III: A global regulatory framework for more resilient banks and banking systems” (slightly revised in June 2011). Other documents, such as the press release dated 13 January 2011 entitled “Final elements of the reforms to raise the quality of regulatory capital issued by the Basel Committee” contain further important elements of the new Basel III framework.

The proposed changes to the Swiss capital adequacy framework (i.e., the CAO and the FINMA circulars) are mostly aimed at implementing the new rules promulgated by the Basel Committee, in particular with respect to the minimum capital requirements, the capital conservation buffer and the countercyclical buffer. However, contrary to the technique of the “Swiss finish” employed hitherto, the FDF and FINMA suggest implementing the Basel III framework largely without Swiss specific conceptual modifications, merely adding Swiss specific capital buffers depending on the size of the bank to the minimum capital requirements provided for by Basel III. One important element of the current “Swiss finish” is the so-called “Swiss Standard Approach” (SSA), which was hitherto used by some banks in relation to the determination of credit risks, non-counterparty risks and large exposures. As the SSA has never been recognized on an international level, it is suggested that going forward only the Basel III compliant “International Standard Approach” shall be applied. This conceptional change, while being only one element of the “Swiss finish” to be abolished, will bring the Swiss capital adequacy framework closer to international standards and contribute to greater transparency and comparability on a cross-border level.

The suggested changes to the Swiss capital adequacy framework do not address all new policy elements promulgated by Basel III. In particular, the introduction of an unweighted leverage ratio and new liquidity minimum standards (notably the introduction of the net stable funding ratio required under Basel III) are subject to preceding monitoring periods on an international level and will only be implemented in Switzerland over the coming years (to the exception of an unweighted leverage ratio for systemically relevant banks, the implementation of which the FDF advocates substantially earlier than its introduction under Basel III; cf. Section 3.d) below).

3) Overview of Proposed New Rules on Capital Adequacy

The following sections outline some of the main novelties proposed by the FDF and FINMA. These changes are contemplated to be implemented by way of amendments to the existing CAO (Draft-CAO or D-CAO) and to the circulars governing market and credit risks, disclosure and risk diversification, as well as through the enactment of a new circular governing eligible equity capital.

a) New Rules Regarding Eligible Capital

The proposed new Swiss rules reflect the new regulatory capital structure promulgated by Basel III. Pursuant to article 16 (1) D-CAO, total regulatory capital will be composed of tier 1 capital (going-concern capital; T1) and tier 2 capital (gone-concern capital; T2). Tier 1 capital is further divided into common equity tier 1 (CET1) and additional tier 1 capital (AT1). Tier 2 capital will no longer be subdivided into lower tier 2 and upper tier 2 capital, and the currently existing tier 3 capital will no longer be eligible for regulatory capital purposes.

CET1, which is mainly composed of paid-in corporate capital, open reserves (including share premiums), reserves for general bank risks and retained earnings (article 19 (1) D-CAO), remains largely unchanged as compared to the existing definition of common equity, save for a few clarifications. By way of example, it is suggested to specify that preference shares (Vorzugsaktien) and participation certificates (Partizipationsscheine) may qualify as CET1 if, inter alia, they hold no privilege whatsoever over common shares (cf. article 21 (2) D-CAO), and that the endowment capital of cantonal banks may only be eligible for regulatory capital purposes if a possible maturity of such capital is solely destined to re-determine the capital conditions (cf. article 22 D-CAO).

In certain ways, AT1 is the successor category of hybrid tier 1 capital under the existing CAO (cf. article 19 CAO). In the recent financial and economic crisis, hybrid tier 1 capital was—for a variety of reasons—much less loss-absorbing than originally intended. As a result, capital instruments will need to fulfill stricter requirements in order to qualify as AT1 under the Draft-CAO. Typical eligible instruments will be corporate capital instruments such as preference shares and participation certificates if they cannot qualify as CET1, as well as certain debt instruments (cf. article 24 D-CAO).

Compared to the existing hybrid tier 1 capital, AT1-compliant instruments which are classified as liabilities for accounting purposes (i.e., not preference shares or participation certificates) need to have principal loss absorption at a pre-specified trigger point, but at the latest upon falling below a CET1-threshold of 5.125% of risk-weighted assets (RWA), through either (i) conversion into common equity or (ii) a write-down mechanism which allocates losses to the instrument, in each case after decision of the FINMA (cf. article 24 (1) (f) D-CAO). In addition, the terms and conditions of AT1 instruments must have a provision that requires such instruments to be either written off or converted into common equity at the point of non-viability (PONV), which is defined as the earlier of (i) the moment shortly before a public sector capital injection or equivalent support in favour of the bank or (ii) FINMA deeming such write-off or conversion to be necessary (cf. article 26 D-CAO). Therefore, AT1 instruments which are classified as liabilities for accounting purposes will need to provide for two different conversion or write-off triggers: the pre-specified trigger of article 24 (1) (f) D-CAO (the AT1-Trigger) and the PONV-trigger of article 26 D-CAO (the PONV-Trigger). The PONV-Trigger serves as some sort of backstop trigger in case the AT1-Trigger is not activated. Both of these loss-absorption mechanisms are based upon Basel III requirements, however, the Draft-CAO seems to depart from the Basel III framework in a number of ways, notably by giving FINMA greater latitude of judgment than strictly necessary.

The draft FINMA circular 2013/x governing eligible equity capital (D-CEEC) provides that a partial write-down upon the triggering of both the AT1-Trigger and the PONVTrigger will be possible (no 6.19 D-CEEC). However, only the maximum write-down amount will be eligible for regulatory capital purposes in such case (no 6.20 D-CEEC). The terms and conditions of AT1 instruments may also provide for a so-called “write-up feature”, in order that investors may participate in an improvement of the bank’s condition after the successful implementation of a write-down, by way of an increase of the nominal amount of their claim which was previously (partly or entirely) written down (cf. no 6.27 and 6.28 D-CEEC). Such a write-up feature, which may potentially enable banks to raise capital at better terms without prejudice from a regulatory standpoint, may in our view be implemented in the form of participating loan features or profit certificates (Genussscheine) or by way of issuing warrants entitling to subscribe for shares at beneficial terms.

T2 instruments are similar to AT1 instruments, but are subject to less stringent regulatory conditions (e.g., minimum maturity of only five years compared to unlimited duration of AT1 instruments). T2 instruments are required to provide for a PONV-trigger identical to the PONV-Trigger for AT1 instruments (cf. article 27 (3) D-CAO).

The Draft-CAO stipulates that AT1 and T2 instruments issued before 12 September 2010 will be phased-out over a period of ten years, leading to a yearly reduction in regulatory capital recognition of 10% (article 125c (3) D-CAO). Instruments issued between 12 September 2010 and 31 December 2011 will also be phased-out over the same period, provided that they qualify as regulatory capital instruments under the new rules except for the inclusion of a PONV-trigger (article 125c (4) D-CAO). Instruments issued after 1 January 2012 need to fulfill all requirements under the new rules in order to qualify as regulatory capital instruments and specifically need to include the PONVtrigger (cf. article 125c (2) D-CAO). The proposed implementation schedule of the Basel III rules is criticizable, as the PONV-trigger requirement has to be implemented by Swiss banks one year ahead of the Basel III schedule (according to which implementation only starts in January 2013). Hence, since 1 January 2012 Swiss banks are required to issue instruments containing PONV-triggers, which may lead to competitive disadvantages in terms of financing costs compared to foreign banks.

With respect to reductions applicable to eligible capital instruments, the new rules (generally implemented from Basel III) focus on eliminating non loss-absorbing capital elements from regulatory capital eligibility (e.g., deferred tax assets, which only become loss-absorbing if the bank generates profits in the future, which by definition is uncertain).

b) New Rules Regarding Required Capital

The proposed new Swiss rules on capital adequacy reflect the calibration of the minimum capital requirements under Basel III. Therefore, Swiss banks after expiry of the transitory period in December 2018 will have to comply with a minimum CET1 ratio of 4.5% of RWA, a T1 ratio of 6% of RWA and a total regulatory capital ratio of 8% of RWA (article 33 (3bis) D-CAO), although FINMA will require add-ons depending on the size of the bank as is already the case under current law (article 34 D-CAO).

Based on the new Basel III rules, the introduction of a capital conservation buffer is contemplated, which would require Swiss banks to permanently hold additional CET1 of 2.5% of RWA (article 33a D-CAO). If a bank’s CET1 ratio temporarily falls into this buffer range by reason of unexpected and special circumstances (such as a crisis of the international or Swiss financial system), FINMA will set the bank a deadline after expiry of which the buffer will need to have been restored. It is worthwile noting that the implementation of the capital conservation buffer in Switzerland seems to conceptually depart from the Basel III rules. Under Basel III, banks will be able to conduct business as normal when their capital levels fall into the conservation range as they experience losses, since only certain constraints will be imposed on banks with respect to distributions (e.g., limitations on dividend and discretionary bonus payments). The Basel Committee explicitly did not want to impose constraints that would be so restrictive as to result in the buffer range being viewed as establishing a new minimum capital requirement. However, the suggested Swiss approach would de facto result in the establishment of such a new minimum capital requirement (i.e., 7% CET1 of RWA), as banks falling into the conservation range will need to demonstrate the existence of “unexpected and special circumstances”, which proof may be hard to come by in practice.

Furthermore, the FDF suggests introducing a countercyclical buffer aimed at (i) improving the resilience of the banking sector in times of excessive credit growth and (ii) limiting excessive credit growth. According to the proposed new legislation, a CET1 buffer of a maximum of 2.5% of RWA in Switzerland could be activated by the Federal Council on an as-needed basis upon request by the Swiss National Bank (article 33b (2) D-CAO). If a bank’s CET1 ratio falls into the buffer range as determined by the Federal Council, FINMA will set the bank a deadline after expiry of which the buffer will need to have been restored. Similar to the capital conservation buffer, this results in the establishment of a criticizable) new minimum capital requirement of 9.5% CET1 of RWA (i.e., the sum of the minimum capital requirement, capital conservation buffer and countercyclical buffer). It is planned that the provisions regarding the countercyclical buffer shall enter into force on 1 March 2012 (although in a slightly less extensive form) in order to enable the Federal Council to already activate the buffer in 2012 if need be, compared to a coming into effect in January 2013 as provided by Basel III. The introduction of a countercyclical buffer, with the at least implicitly understood aim of being a directive measure (Lenkungsmassnahme), raises questions with respect to its constitutionality and whether the BA provides a sufficient legal basis for that undertaking.

A key destabilising factor during the recent financial and economic crisis was that major on- and off-balance sheet risks, as well as derivative related exposures, were not adequately captured by the capital framework. By introducing measures to strengthen the capital requirements for counterparty credit exposures arising from banks’ derivatives, repo and securities financing activities, the proposed new Swiss rules strive to implement the adjustments developed under Basel III for Switzerland. In particular, counterparty credit risks will need to be assessed using stressed inputs (article 45 D-CAO), and banks will be subject to a capital charge for potential mark-to-market losses associated with a deterioriation in the creditworthiness of a derivatives counterparty (article 41a D-CAO; no 392 et seq. draft circular 2008/19 governing credit risks (D-CGCR)). Further, stricter requirements for collateral management and margining are proposed (no 115.1 et seq. D-CGCR) and claims against central counterparties in relation to derivatives and repo activities will be attributed a risk weight of 2% instead of 0% (article 56–56a D-CAO; no 399 et seq. D-CGCR).

c) New Rules Regarding Large Exposures

The proposed new Swiss rules on capital adequacy (cf. articles 83 et seq. D-CAO) also provide for various stricter requirements with respect to large exposures (Klumpenrisiken), some of which are outlined hereafter. First, as the Swiss standard approach shall be deleted (cf. Section 2) above), a risk-weighted determination of the required capital in relation to the coverage of large exposures will no longer be accepted. Under the new rules, the 25% maximum limit on large exposures (article 86 D-CAO) will need to be complied with on an unweighted basis, in accordance with the “International Standard Approach”. This conceptual change has an important effect in particular on interbank claims, which hitherto typically were attributed a risk weight of only 25% (compared to 100% under the new approach), leading to substantially stricter requirements in particular for banks with eligible capital higher than CHF 250 million. Further, to date, internal claims against adequately regulated group companies in principle were not subject to the rules regarding large exposures. FINMA believes that this broad exemption is no longer justified, as claims among group companies are not necessarily less risk prone than claims against third parties. For instance, foreign regulators tend to preemptively block assets of a troubled banking group in their respective jurisdictions, which may result in a Swiss-based lending entity not being able to recover its assets located in group companies abroad. It is therefore suggested that cross-border claims against group companies shall be limited to the extent necessary to ensure that the Swiss entity does not fall into bankruptcy in case of a failure of the foreign entity (cf. article 89 D-CAO). Finally, the privileged maximum limits on large exposures (up to 100% instead of 25%) applicable to small and medium banks with respect to claims against other banks and securities dealers will no longer be available with respect to claims against Swiss or foreign systemically important banks (article 115a D-CAO). This change aims at inducing small and medium banks to reduce their credit exposure towards systemically important banks and to achieve higher diversification.

d) Additional Rules for Systemically Important Banks

The Basel Committee has only recently published additional policy measures aimed at addressing negative externalities posed by global systemically important financial institutions, which measures are planned to be phased-in between 2016 and 2018. On 5 December 2011, the FDF launched a consultation in relation to a set of new rules which shall be exclusively applicable to systemically important banks (SIBs). These new rules are to enter into force on 1 January 2013, i.e., before the new Basel III rules will become effective.

Swiss SIBs (currently only UBS and Credit Suisse) will be required to comply with substantially stricter capital adequacy rules compared to non-systemically important banks. The capital adequacy rules for SIBs will be composed of three components: (1) a basic capital requirement in CET1 of 4.5% of the institution’s RWA (article 123e D-CAO), (2) a capital conservation buffer of 8.5% of RWA that must be satisfied with CET1 in the amount of 5.5% of RWA and may be satisfied by CoCo’s in the amount of up to 3% of RWA (article 123f D-CAO), and (3) a variable progressive component depending on the degree of systemic importance of the respective financial institution (article 123g D-CAO).

To a large extent, the proposed new rules for SIBs are based on the compromise reached by the expert commission on too-big-to-fail (in which UBS and Credit Suisse were represented) in its final report dated 30 September 2010. However, the FDF in its suggested amendments to the CAO seems to depart from the final report of the expert commission with respect to certain important points. For instance, the progressive component (article 123h D-CAO) seems to rely on a different basis for calibration compared to the proposals of the expert commission, without adjustment of the actual calibration of the progressive component. It should be ensured that given this new calibration, total capital requirements for SIBs will not be higher than 19% of RWA upon introduction of the new rules, in accordance with the compromise reached by the expert commission and parliamentary debates. Furthermore, the FDF proposes the introduction of an unweighted leverage ratio for SIBs as early as 2013 (article 123j et seq. D-CAO), notwithstanding the fact that the introduction of the leverage ratio is subject to preceding monitoring periods under Basel III. Both the expert commission and Parliament agreed that the leverage ratio should result in capital requirements slightly below the requirements according to the risk-weighted rules at the time of implementation, and not be a further constraining element under normal circumstances. The new rules put forward by the FDF should reflect this core principle in order to ensure that the calibration of the leverage ratio does not lead to total capital requirements higher than 19% of RWA. Finally, the FDF proposes the introduction of stricter requirements for SIBs than for non-SIBs with respect to the rules on large exposures (Klumpenrisiken) (article 123m D-CAO). Given that the issue of large exposures is not a toobig-to-fail specific problem and that the expert commission did not deem it necessary to suggest stricter rules in this respect, a tightening of the rules on large exposures for SIBs does not prima facie seem to be justified.