Basel III and FSB Proposals

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1 G-20 Summit Endorses Basel Committee Proposals and Financial Stability Board Recommendations Regarding Systemically Important Financial Institutions SUMMARY At the conclusion of their summit meeting in Seoul, South Korea on November 11, 2010, the Group of Twenty Finance Ministers and Central Bank Governors (the G-20 ) endorsed the Basel Committee on Banking Supervision s Basel III bank capital and liquidity proposals, including recommended phase-in periods. The G-20 also endorsed the policy framework adopted by the Financial Stability Board (the FSB ) 1 to address the moral hazard posed by systemically important financial institutions ( SIFIs ), including through a resolution framework to ensure that all financial institutions can be resolved safely, quickly and without destabilizing the financial system and a requirement that SIFIs and initially in particular financial institutions that are globally systemic should have higher loss absorbency capacity The materials presented by the Basel Committee and the FSB at the G-20 summit meeting, to the extent made public, and the leaders declaration and related materials released at the conclusion of the meeting did not add additional detail or clarity to the many aspects of Basel III still being refined, apart from limited new insights concerning SIFIs. BACKGROUND In December 2009, the Basel Committee published two consultative documents proposing reforms to bank capital and liquidity requirements which were intended to address lessons learned from the financial crisis. 2 The December 2009 proposals were subsequently amended, 3 and on September 12, 2010 calibrated capital standards and phase-in periods for the Basel III capital and liquidity standards were announced by the Basel Committee. 4 These proposals were formally presented at the latest G-20 meeting. On a parallel track, the FSB has been developing various policy recommendations, some of which do not pertain exclusively to the banking sector, to strengthen the global financial regulatory regime New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 in the aftermath of the financial crisis. bodies. The G-20 has now endorsed key proposals of both of these DISCUSSION As proposed by the Basel Committee in September, the G-20 endorsed the Basel III capital and liquidity framework and confirmed its commitment to implement the framework starting on January 1, 2013, with phase-in to be completed by January 1, The G-20 s commitment to adopt and implement fully [the Basel III proposals] within the agreed timeframe concludes that the proposals have achieved farreaching reform of the global banking system that will markedly reduce banks incentive to take excessive risks, lower the likelihood and severity of future crises, and enable banks to withstand without extraordinary government support stresses of a magnitude associated with the recent financial crisis. In its progress report to the G-20, the FSB also explicitly notes that the Basel III countercyclical capital buffer will have to be met with common equity or other fully loss-absorbing capital. 6 The G-20 has also endorsed the FSB s proposals to reduce the moral hazard risks posed by SIFIs and to address the too-big-to-fail problem. SIFIs are firms whose disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity. The Basel Committee, in its report to the G-20 released on October 19, 2010, indicated that it would not fully address the issue of SIFIs by the end of 2010, but, instead, address the issue during the first half of next year on a timeframe that is roughly consistent with the 18-month timeframe permitted under the Dodd-Frank Act to implement Section 165(c). The FSB s SIFI framework is composed of several prongs, each of which is generally addressed by the G-20 s Seoul Summit Document reflecting the summary of its conclusions. First, the FSB has proposed measures to ensure that all financial institutions can be resolved effectively without taxpayer expense and destabilizing the financial system. According to its recommendation, each country should have a designated resolution authority with the flexibility to tailor resolution measures to the specific nature of a financial institution s activities. Such a body would also be empowered to require a financial institution to make changes to its legal and operational structure and business practices to facilitate recovery and resolution. Under the FSB s proposals, cooperation with foreign resolution authorities and sharing of information across borders is mandated, and the G-20 has specifically called upon the FSB to develop attributes of effective cross-border resolution regimes by In addition, for globally systemic SIFIs, or G-SIFIs, the G-20 has endorsed the establishment of institution-specific cooperation agreements by year-end 2011 between relevant home and host authorities that would establish the objectives and processes for cooperation in a crisis. Furthermore, the G-20 has agreed that G-SIFIs should be subject to mandatory international recovery and resolution planning, including risk profile assessments. Second, SIFIs initially and in particular G-SIFIs should be required to have higher loss absorbency capacity. This capacity would be in addition to the Basel III capital and liquidity requirements and would -2-

3 be drawn, depending on national circumstances, from a menu of viable alternatives and could be achieved by some combination of capital surcharges, contingent capital and bail-in debt. With respect to G-SIFIs, the FSB is also considering liquidity surcharges and tighter large exposure restrictions, levies and other structural measures. Notably, the G-20 summit declaration endorsing the FSB s approach toward SIFIs and G-SIFIs does not explicitly mention capital surcharges while specifically endorsing further development of contingent capital instruments. It is unclear whether such omission by the G-20 was deliberate. Drawing on relevant qualitative and quantitative indicators, the FSB in conjunction with other institutions is expected to determine by mid-2011 those institutions to which the FSB recommendations for G-SIFIs will initially apply based on a Basel Committee methodology that is currently being devised. The Basel Committee is also expected to complete a study by mid-2011 of the magnitude of additional loss absorbency that G-SIFIs should have, along with an assessment of the extent of necessary going-concern loss absorbency. The FSB, in consultation with the Basel Committee, will recommend an additional degree of G-SIFI loss absorbency, and the instruments by which these can be met, by December The FSB proposals with respect to SIFIs and G-SIFIs also include recommendations concerning: greater regulatory oversight through increased intensity and effectiveness of national and international supervisory efforts; improving the robustness of core financial markets infrastructure, such as payment and securities settlement and the clearing of OTC derivatives through central counterparties; and other supplementary measures based on national circumstances. OBSERVATIONS AND IMPLICATIONS The Basel Committee has substantial work to do before its scheduled release at year-end of the definitive Basel III framework. Although some aspects of Basel III are settled (most importantly, the calibrations for capital ratios and the implementation schedule), others likely will be subject to important refinements (for example, the conversion factors applied to off balance sheet commitments under the proposed leverage ratio, the treatment of liquidity facilities under the leverage ratio and the liquidity coverage ratio, and a variety of aspects of the liquidity coverage ratio more generally). Moreover, it is clear that the FSB proposals towards SIFIs and G-SIFIs remain a work in progress. In connection therewith, the FSB and the Basel Committee will need to resolve a wide variety of issues, including: the criteria that will be used to classify financial institutions as a SIFI and/or G-SIFI, and the process/discretion that may be used by regulators when classifying an institution as such; what, if any, will be the differences between the treatment of G-SIFIs in particular and SIFIs more generally; whether the identity of the SIFIs and G-SIFIs will be disclosed; the exact mechanism or mix of mechanisms (surcharges, contingent capital, bail-in debt, etc.) by which extra loss abosrbency for SIFIs and G-SIFIs will be achieved; the specific terms of contingent capital and bail-in debt instruments; and -3-

4 how to harmonize national legal regimes with respect to systemic resolution of SIFIs and G-SIFIs. Given the wide ranging nature of the FSB s proposals, such questions will be subject to extensive discussions and negotiations among the member states of the Basel Committee, the FSB and the G-20. ENDNOTES The FSB was established in April 2009 by the G-20. It is the successor to the Financial Stability Forum founded in 1999 by the G7 Finance Ministers. Among other tasks, the FSB is mandated with assessing vulnerabilities affecting the financial system, promoting coordination and information exchange among relevant authorities, monitoring and advising on market developments and their implications for regulatory policy and advising on and monitoring best practice in meeting regulatory standards. See S&C s memo to clients, dated December 28, 2009, entitled Bank Capital and Liquidity Requirements: Basel Committee Issues Proposals to Strengthen Bank Capital and Liquidity Regulation, for a description of the Basel Committee s capital and liquidity proposals as initially released in December See S&C s memo to clients, dated July 28, 2010, entitled Bank Capital and Liquidity Requirements: Basel Committee Oversight Body Announces Amendments to December 2009 Basel III Proposals to Strengthen Bank Capital and Liquidity Regulation, for a description of the amendments announced on July 26, 2010 to the Basel Committee s capital and liquidity proposals. See S&C s memo to clients, dated September 13, 2010, entitled Basel III Capital and Liquidity Standards: Basel Committee Calibrates Capital Standards and Establishes Phase-in Periods for Capital and Liquidity Standards. Ahead of the November G-20 meeting, the Committee announced that it had reached an agreement on key details of the proposed liquidity coverage ratio (the LCR ). It also confirmed that implementation of both the LCR and net stable funding ratio will include an observation period that will include a mechanism to review the implementation and, if necessary, adjust for unintended consequences. The Committee has announced that all elements of the standards, both on the capital side and the liquidity side, will be finalized and adopted by the Committee by December 31, See S&C s memo to clients, dated July 28, 2010, entitled Basel III Capital Proposals: Basel Committee Issues Countercyclical Capital Buffer Proposal for more information on the countercyclical capital buffer proposal. * * * Copyright Sullivan & Cromwell LLP

5 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 700 lawyers on four continents, with four offices in the United States, including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish ( ; rishj@sullcrom.com) or Alison Alifano ( ; alifanoa@sullcrom.com) in our New York office. CONTACTS New York Whitney A. Chatterjee chatterjeew@sullcrom.com H. Rodgin Cohen cohenhr@sullcrom.com Elizabeth T. Davy davye@sullcrom.com Mitchell S. Eitel eitelm@sullcrom.com Michael T. Escue escuem@sullcrom.com C. Andrew Gerlach gerlacha@sullcrom.com Andrew R. Gladin gladina@sullcrom.com Wendy M. Goldberg goldbergw@sullcrom.com Erik D. Lindauer lindauere@sullcrom.com Mark J. Menting mentingm@sullcrom.com Camille L. Orme ormec@sullcrom.com Donald J. Toumey toumeyd@sullcrom.com Marc R. Trevino trevinom@sullcrom.com Mark J. Welshimer welshimerm@sullcrom.com Michael M. Wiseman wisemanm@sullcrom.com Washington, D.C. Andrew S. Baer baera@sullcrom.com Eric J. Kadel, Jr kadelej@sullcrom.com William F. Kroener III kroenerw@sullcrom.com J. Virgil Mattingly mattinglyv@sullcrom.com Andrea R. Tokheim tokheima@sullcrom.com -5-

6 Samuel R. Woodall III Los Angeles Patrick S. Brown Stanley F. Farrar Tokyo Keiji Hatano NY12532:

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