Basel, CRD, CEBS and FSA: the changing landscape of regulatory capital rules and the. impact on Tier 1 and Tier 2 capital.

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1 February 2010 Basel, CRD, CEBS and FSA: the changing landscape of regulatory capital rules and the Contents Introduction As part of the overall response of regulators to the global financial crisis, three important sets of proposals and guidelines were published in December > On 10 December 2009, the Committee of European Banking Supervisors ( CEBS ) published its Implementation Guidelines for Hybrid Capital Instruments (the CEBS Guidelines ). Pursuant to Article 63a(6) of the Capital Requirements Directive ( CRD ), as amended by the European Parliament on 6 May 2009 (the CRD Amendments ), CEBS was given the task of putting forward these guidelines for the implementation of the CRD Amendments and the convergence of supervisory practices with regard to Tier 1 hybrid instruments across EU member states. We have previously published a client note on the CRD Amendments. > On the same day, the Financial Services Authority ( FSA ) published, as part of its Consultation Paper 09/29, its proposals (the FSA Proposals ) for the implementation of the CRD provisions relating to hybrids in the UK. > Just a week later, on 17 December 2009, the Basel Committee on Banking Supervision (the Basel Committee ) published a Consultative Document entitled Strengthening the resilience of the banking sector, which contains proposals relating to bank capital designed to strengthen the quality, consistency and transparency of the regulatory capital base of banks (the Basel Proposals ). Introduction... 1 Basel Proposals Process and Overview... 1 Basel Proposals Tier 1: Common Equity... 3 Basel Proposals Tier 1 Additional Going Concern Capital... 4 CEBS Guidelines/FSA Proposals Process and Overview... 5 CEBS Guidelines/FSA Proposals Hybrid Capital 6 Permanence... 8 Flexibility of Payments.. 9 Loss Absorbency... 9 Special Purpose Vehicles Grandfathering of Non- Common Equity Tier 1 Instruments Basel Proposals Tier 2 Capital The Future This paper analyses some of the potentially far-reaching changes contained in these papers, beginning with the Basel Proposals. Basel Proposals Process and Overview The aim of the Basel Proposals is to strengthen global capital regulations with the goal of promoting a more resilient banking sector. The Basel Committee intends to complete a consultation on its proposals by April 2010 and in tandem undertake a comprehensive impact assessment of their 1 Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

2 proposals, which is to be completed before the next meeting of the Basel Committee in July Their aim is then to develop a fully-calibrated set of standards by the end of 2010, the implementation of which is to be phased in as financial conditions improve by the end of The Basel Committee is proposing, among other things, a series of measures to promote the build-up by firms of high quality counter-cyclical capital buffers in good times that can be drawn upon in periods of stress, particularly in the case of large internationally active banks. To this end, the Basel Committee is proposing that the predominant (at this stage there is no definition of what predominant means) form of Tier 1 capital must be common equity and retained earnings. The level of predominance will be decided upon on the basis of the results of the comprehensive impact assessment. The remainder of the Tier 1 capital base must be comprised of instruments ( Tier 1 Additional Going Concern Capital ) that, as well as being subordinated and having fully discretionary non-cumulative dividends or coupons, have no maturity date nor any incentive to redeem 2. The Basel Committee makes clear that innovative hybrid capital instruments with an incentive to redeem through features like step-up clauses, currently limited to 15% of the Tier 1 capital base, will be phased out 3. See further Basel Proposals Tier 1 Additional Going Concern Capital below. As discussed below (see CEBS Guidelines / FSA Proposals Hybrid Capital ), this represents a clear difference from the position under the CRD Amendments, the CEBS Guidelines and the FSA Proposals, although both CEBS and the FSA acknowledged that their respective papers would likely require amendment to reflect the final outcome on the Basel Proposals. The Basel Committee also proposes significant changes to simplify Tier 2 capital, in particular the removal of the upper and lower tiers and their replacement with a single set of criteria which resemble those currently applicable to lower Tier 2, or gone concern, capital only. See further Basel Proposals - Tier 2 Capital below. The current limitation on Tier 2 capital (50% of total Tier 1) will be removed and replaced with explicit minimum Tier 1 capital and total capital requirements. Tier 3 capital will be eliminated. The Basel Committee is also continuing to review the role of contingent capital and convertible capital instruments 4, so-called Co-Cos, both within regulatory capital minima and as buffers over the minimum requirement and will discuss this further at its next meeting in July An overview of the Basel Proposals is set out in Table 1 below Basel Proposals, paragraph 10. Basel Proposals, paragraphs 15 and 76. Basel Proposals, paragraph 15. Basal Proposals, paragraphs 16 and Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

3 Table 1: Overview of Basel Proposals Minimum Regulatory Capital Requirement as % of riskweighted assets (R-WA) x% Total Capital (comprising Tier 1 and Tier 2 Capital) y% z% Common Equity (and retained earnings) Tier 1 Capital (comprising Common Equity and Tier 1 Additional Going-Concerm Capital) Minima for Total Capital (x% of R-WA), Tier 1 Capital (y% of R-WA) and Common Equity (including retained earnings less regulatory adjustments) (z% of R-WA, being the predominant form of Tier 1 capital) will be required. x%, y% and z% will be determined following the Basel Committee s comprehensive impact assessment. The current limitation on Tier 2 capital (that it cannot exceed Tier 1 capital) will be removed and replaced with explicit minimum Tier 1 Capital and Total Capital requirements. Basel Proposals Tier 1: Common Equity A key component of the Basel Proposals is the principle that banks risk exposures must be backed by a high quality capital base. In furtherance of that principle, the Basel Committee proposes that the predominant form of Tier 1 capital must be common shares and retained earnings 5. Later this year, the Basel Committee will put forward a system of limits applied to elements of capital which will ensure that common equity and retained earnings form a greater proportion of Tier 1 capital than is required at present (50%). Further, the Basel Committee will generally require regulatory adjustments to be applied at the level of common equity (not total Tier 1 capital) to avoid the scenario which arose during the financial crisis where some firms were able to report high Tier 1 ratios despite the fact they had low levels of tangible common equity when considered net of regulatory adjustments (e.g. goodwill). For firms which are joint stock companies, the Basel Committee points to conventional common shares and reserves as being equivalent to common equity. To ensure that all instruments included in capital as common equity truly meet the standards required by the Basel Committee, criteria for classification of instruments as common shares for regulatory capital purposes have been drawn-up 6. These criteria are generally unsurprising: the shares (or the 5 6 Basel Proposals, paragraph 15. Basel Proposals, paragraph Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

4 equivalent in non joint stock companies) must represent the most subordinated claim in liquidation; the entitlement of a holder to the residual capital on liquidation must be proportionate to its share of issued capital (i.e. there is no fixed claim, such as a liquidation preference commonly seen in preference shares); principal is perpetual; and there are no circumstances under which distributions are obligatory. However, unlike the CRD, which recognises that core Tier 1 capital could include instruments which rank pari passu with ordinary shares in a liquidation but which give preferential, non-cumulative rights to a dividend, the Basel Proposals provide that preferential dividends and distributions which are in any way tied or linked to the amount paid in at issuance are expressly not permitted to be included in the common equity capital base. Basel Proposals Tier 1 Additional Going Concern Capital This element of capital allows instruments other than common equity to be included as (the non-predominant form of) Tier 1 capital. The detailed set of criteria which an instrument will need to meet or exceed to qualify for inclusion in the Tier 1 Additional Going Concern Capital base is based on three key principles: the instrument must (a) help the firm avoid payment default through payments being discretionary; (b) help the firm avoid balance sheet insolvency by the instrument not contributing to liabilities exceeding assets; and (c) be able to bear losses while the firm remains a going concern 7. The Basel Committee considers innovative features such as step ups to have eroded the quality of Tier 1 capital 8 and as such the Basel Committee (unlike CEBS and the FSA) are proposing that 15% innovative Tier 1 capital (that is, capital with incentives to redeem) is not permitted. Some of the main criteria are set out in Table 2 below. Table 2: Criteria for inclusion in Tier 1 Additional Going Concern Capital. The main criteria include: > Subordinated to depositors, general creditors and subordinated debt (rather than having to be the most subordinated claim, as required of Common Equity which appears to allow Tier 1 Additional Going Concern Capital instruments to rank senior to common equity and pari passu with preference shares). > No maturity date; no incentives to redeem or other innovative features. > Callable at the initiative of the firm only after a minimum of five years subject to: (a) (b) (c) prior supervisory approval; the firm not creating an expectation that the call will be exercised; and the firm not exercising a call unless the called instrument is replaced with capital of the same or better quality or the firm demonstrating that its capital position is well above the minimum capital requirements after the call is exercised. > The firm must have full discretion to cancel distributions/payments. Such 7 8 Basel Proposals, paragraph 88. Basel Proposals, paragraph Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

5 cancellation of distributions/payments must not impose restrictions on the firm except in relation to distributions to common stockholders (but see below regarding not hindering recapitalisation). > Dividends/coupons must be paid out of distributable items. > Instruments classified as liabilities must have principal loss absorption through either (i) conversion to common shares at an objective prespecified trigger point or (ii) a write-down mechanism which allocates losses to the instrument at a pre-specified trigger point. > The instrument cannot have any features that hinder recapitalisation. The criteria for Tier 1 Additional Going Concern Capital also address instruments issued indirectly via special purpose vehicles ( SPVs ). The Basel Proposals require the proceeds of such issues to be immediately available without limitation to an operating entity or the holding company in the consolidated group of the relevant firm in a form which meets or exceeds all of the other criteria for inclusion in Tier 1 Additional Going Concern Capital 9. This requirement (the rationale for which is not elaborated upon in the Basel Proposals), if it were to be implemented, may undermine many, if not all, of the traditional structuring benefits of using SPVs. The Basel Proposals also contain a rather vague reference to the intention of the Basel Committee to consider the appropriate treatment in the non-predominant element of Tier 1 capital of instruments which have tax deductible coupons 10. Again, the Basel Committee does not elaborate on what the correlation is between the tax treatment of an instrument and its regulatory qualities. The Basel Proposals, insofar as they relate to Tier 1 Additional Going Concern Capital, overlap in many respects with the CEBS Guidelines for hybrid capital and the FSA Proposals for implementing those CEBS Guidelines and the CRD Amendments in the UK. There are, however, some significant qualitative and quantitative differences. The following sections of this note focus on some of those differences which will need to be reconciled in the coming months. CEBS Guidelines/FSA Proposals Process and Overview The CRD Amendments, which are required to be transposed into national law in EU member states by 31 October 2010 and become effective by 31 December 2010, include changes to the rules regarding hybrid capital and an instruction to CEBS to bring forward the CEBS Guidelines. The FSA proposals represent the FSA s proposed way forward for implementing the CRD Amendments and the CEBS Guidelines on hybrid capital in the UK. In publishing the FSA Proposals (a week prior to the publication of the Basel Proposals), the FSA acknowledges that its proposals are only a first step towards improving the overall quality of capital and that work by the Basel Committee and others is likely to lead to further changes to the definition in capital in the medium term. That is likely to be an accurate prediction. The consultation period for the FSA Proposals ends on 10 March 2010 and the FSA expect to publish its final policy statement and its rules to implement the CRD Amendments in Q In addition, a draft directive amending the CRD is expected to be published in July this year. The draft directive may include changes in areas on which the Basel Committee is currently working, including the definition of capital. 9 Basel Proposals, paragraph 89 criterion Basel Proposals, paragraph Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

6 CEBS Guidelines/FSA Proposals Hybrid Capital The CRD Amendments permit hybrid capital to be used to meet CRD pillar 1 capital requirements for the first time expressly, albeit within a framework of new limits based on three buckets. Unlike the Basel Proposals, which have not yet been calibrated, the CEBS Guidelines and FSA Proposals are framed in terms of three buckets of non-core Tier 1 capital with maxima set at 50%, 35% and 15% of total Tier 1 capital after deductions. However, neither the CEBS Guidelines nor the FSA Proposals contain any new proposals at this stage in relation to overall levels of capital which firms should maintain. Table 3 below gives an overview of the proposed implementation of this new three-bucket hybrid capital regime. 6 Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

7 Table 3: CEBS Guidelines/FSA Proposals for new categories of hybrid capital Maximum proportion of Total Tier 1 Capital (less deductions) (1) 50% (2) 50% Permanence undated no calls buybacks require regulator non-objection Flexibility of payments 35% (2) 35% 15% payments out of distributable reserves only (GENPRU A) total flexibility mandatory non payment and write off if in breach of capital resources requirement (GENPRU B) stopper should not hinder recapitalisation (de-activated when conversion occurs) immediate ACSM permitted but with write-off of any unsettled amount Loss absorbency triggers at a meaningful time and at latest if breach of capital resources requirement significant deterioration in financial / solvency condition at regulator s discretion or emergency situation at issuer s or holder s discretion. Loss absorbency mechanism conversion into preauthorised shares based on share price on original issue date Permanence undated call permitted after five years no incentive to redeem redemptions / buybacks require regulator nonobjection Flexibility of payments as 50% bucket stopper de-activated and coupons cancelled when conversion/writedown occurs Loss absorbency triggers at a meaningful time and at latest if breach of capital resources requirement or significant deterioration in financial / solvency condition Loss absorbency mechanisms either conversion into pre-authorised shares based on conversion ratio of up to 150% of initial conversion ratio or temporary or permanent writedown pari passu with common equity Permanence either undated or 30 years with lock-in* call permitted after five years moderate incentive to redeem* after 10 years if undated redemptions / buybacks require regulator nonobjection Flexibility of payments Loss absorbency triggers Loss absorbency mechanisms each as 35% bucket SPV deals 15% (2) FSA (but not CEBS) limits SPV deals to 15% * not permitted in Basel Proposals Notes: (1) Hybrid capital will be subject to a limit of 50% of Tier 1 capital after deductions. In effect, this means any deductions will be made from core Tier 1 capital whereas currently GENPRU only requires that a minimum of 50% of Tier 1 after deductions be in the form of core Tier 1 capital, which means deductions can currently be absorbed by non-core Tier 1 instruments, such as preference shares. (2) The 15%, 35% and 50% buckets are not additive. This means that both the 35% and 50% buckets represent aggregate limits and therefore if the 15% bucket is full, only a further 20% can be included in the 35% bucket, etc. 7 Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

8 As is quickly apparent from Table 3 above, there are some key features on which the CEBS Guidelines/FSA Proposals differ, qualitatively and quantitatively, from the Basel Proposals. First, the requirements set out in Basel Proposals Tier 1 Additional Going Concern Capital above that instruments must be undated and that there can be no innovative Tier 1 capital with an incentive to redeem would appear to prevent the inclusion in Tier 1 capital of the type of instrument which could have been included in the 15% bucket of Tier 1 capital under the CEBS Guidelines/FSA Proposals. Secondly, the Basel Proposals remain uncalibrated. The extent of the quantitative difference will be determined by the extent to which the Basel Committee decides to make common equity the predominant form of Tier 1 capital, which will only be decided following their comprehensive impact assessment. Whereas CEBS/FSA contemplate hybrid capital comprising up to 50% of total Tier 1 capital less deductions, the Basel Committee expressly seeks to de-couple the required amount of Tier 1 Additional Going Concern Capital from the amount of a firm s Core Tier 1 Capital. In their papers, both CEBS and FSA discuss at some length certain key features of hybrid capital, including permanence, flexibility of payments, loss absorbency and SPV structures. These are considered in turn briefly below. Permanence CEBS/FSA propose to follow the CRD and permit hybrid capital either to be undated or (unlike the Basel Committee) have a minimum maturity of 30 years. One or more calls are permitted after year 5 (year 10 if in conjunction with a moderate incentive to redeem at that time). Dated hybrids may not have any incentive to redeem. Dated hybrids or those with an incentive to redeem (as determined at the date of issue) will be limited to the 15% bucket only 11. CEBS/FSA also proposes to follow the CRD in relation to restrictions on not only redemptions but also buybacks of hybrids 12. All such redemptions or buybacks of hybrid instruments require notice to, and non-objection from, the regulators and can only be made in circumstances where either there is no adverse effect on the firm s compliance with applicable solvency and financial condition or the hybrid instrument is replaced with capital of equal or better quality. Redemptions before year 5 will generally only be allowed in specified circumstances (unforeseen, post-issue tax or regulatory events) 13. Redemption at maturity of dated hybrids may also be subject to suspension if capital, solvency and financial conditions are not satisfied. Requests to the FSA for redemptions and buybacks will be required to contain additional information, including an appropriately stressed three to five year capital plan FSA Proposals, paragraphs 3.21 and FSA Proposals, paragraphs FSA Proposals, paragraph FSA Proposals, paragraph Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

9 The FSA do not expect buybacks of hybrids to occur within the first five years of their issue unless they are being replaced with capital of the same or higher quality 15. No more than one step-up is allowed during the life of a hybrid instrument and even if it has already occurred the instrument will at all times remain in the 15% bucket 16. Flexibility of Payments Both the CEBS Guidelines and the FSA Proposals contain provisions 17 : > to make payment of coupons on hybrids conditional on the existence of distributable reserves 18 ; > designed to ensure dividend stoppers should not hinder recapitalisations 19 ; > specifying that all coupons on hybrids must be capable of being cancelled by the firm (for an unlimited period and on a non-cumulative basis) and in some cases (e.g. a breach of capital resources requirements or at the initiative of the FSA) must be cancelled 20 ; and > specifying the scope for satisfaction of hybrid coupons by use of an immediate ACSM 21. Both CEBS and the FSA are putting forward stringent requirements around the use of ACSMs to settle coupons. The FSA Proposals limit the use of an ACSM to circumstances when the firm is in compliance with its capital resources requirements, the deferred coupon is satisfied without delay using newly-issued core Tier 1 capital with an aggregate fair value no greater than the deferred coupon in question, the firm has no obligation to find subscribers for such new capital and should the realised value of the new capital be less than the relevant deferred coupon, the firm has no obligation to issue further new capital 22. Loss Absorbency Both CEBS and the FSA emphasise loss absorbency as the most important characteristic of capital and it will no longer be sufficient for capital instruments to achieve that by a combination of winding-up subordination and coupon discretion. Principal loss absorbency is also required 23. In addition, the terms must not hinder a recapitalisation. Both CEBS and the FSA cite two possible methods to achieve this: conversion into common equity and/or (in the case of the 35% and 15% buckets each) principal write-down. In order to qualify for the 50% bucket, the applicable conversion price must be no lower than the share price at the time of issue of the hybrid 24. The proposals do not elaborate in detail how this price may be adjusted for dilutive 15 FSA Proposals, paragraph FSA Proposals, paragraph FSA Proposals, paragraph GENPRU A. 19 GENPRU A. 20 GENPRU B. 21 GENPRU GENPRU C and D. 23 FSA Proposals, paragraph FSA Proposals, paragraph Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

10 corporate events or movements in any applicable foreign exchange rates. This conversion ratio means that investors in this category of hybrid will be contingently exposed to downside risk pari passu with holders of ordinary shares. In order to qualify for the 15% and 35% buckets, the applicable conversion ratio must be no more than 150% of the initial value of the hybrid divided by the share price at the time of issue of the hybrid 25. Both CEBS and the FSA also put forward temporary or permanent principal write down as an acceptable form of on-going loss-absorption. From the point the write-down trigger is reached, CEBS and the FSA consider the relative subordination between core and hybrids is effectively switched off 26 and hybrids and core Tier 1 capital should absorb losses on a pari passu basis. There are provisions to permit any write down to be reversed out of future profits also on a pari passu basis with core Tier 1 capital. No coupon can be paid on hybrids while they are written down and during that period dividend stoppers must also be de-activated 27. The FSA proposes that the trigger for conversion/write down of all hybrids should be at the latest where a significant deterioration in the firm s financial or solvency condition is reasonably foreseeable or on a breach of capital requirements. For the 50% bucket, an additional trigger of either the regulator s discretion or an emergency situation is proposed 28. Special Purpose Vehicles The FSA has proposed that the UK should be superequivalent to the CEBS Proposals in the area of hybrid capital issued through SPVs 29. The FSA s stated rationale for this is that capital instruments should be simple and therefore a 15% limit on SPV issue will mitigate potential legal and operational risk inherent in SPV structures 30. A 15% limit is more restrictive than both the CRD and CEBS Guidelines and the FSA has not spelled out the specific legal and operational risks about which it says it is concerned. The FSA is also proposing that SPVs should generally be established in the UK (not offshore in places such as Jersey or Delaware) 31. The potential significance of this proposal in a UK context is that SPV structures, which have historically been one important way of achieving a tax deduction for hybrid capital, may, depending on how the regulatory landscape, including the Basel Proposals (see discussion above under Basel Proposals - Tier 1 Additional Going Concern Capital around restrictions on indirect issues through SPVs), ultimately changes, represent the only prospect of structuring tax-deductible hybrid capital and as a consequence UK banks will be limited to a maximum of 15%, whereas banks in other jurisdictions may be able to structure tax-deductible hybrids beyond this level. Grandfathering of Non-Common Equity Tier 1 Instruments Although the Basel Committee has expressed its intention to introduce the Basel Proposals in a manner that does not prove disruptive, it only refers to 25 FSA Proposals, paragraph FSA Proposals, paragraph FSA Proposals, paragraph FSA Proposals, paragraph FSA Proposals, paragraph FSA Proposals, paragraph FSA Proposals, paragraph Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

11 doing so in relation to instruments which have been issued by banks prior to the publication of [the Basel Proposals on 17 December 2009] 32. If this is interpreted as meaning that there may not be grandfathering procedures put in place for instruments issued on or after 17 December 2009 and before the Basel Proposals (which are, after all, at this stage just proposals published for consultation) are finalised and adopted, there will clearly be an increase in the uncertainty in the Tier 1 capital raising market. In Europe, member states are required to implement the CRD Amendments/CEBS Guidelines into national law by 31 October 2010 and to apply them from 1 January However, hybrid Tier 1 capital instruments issued until 31 December 2010 which comply with current requirements for innovative Tier 1 capital (GENPRU in the UK) (but not with the new hybrid eligibility criteria as set out in the CRD Amendments/CEBS Guidelines) were to benefit from grandfathering arrangements for 10 years after 31 December 2010 (and in decreasing proportions thereafter until 2040) 33. This created a window (from 6 May 2009 (the date of the CRD Amendments) to 31 December 2010 (the day before implementation of the CRD Amendments)) during which banks would have been able to issue GENPRUcompliant innovative Tier 1 capital and benefit from grandfathering. While declaring its intention to grandfather instruments issued prior to 17 December 2009, the Basel Proposals are silent with respect to the treatment of Tier 1 hybrids issued on or after 17 December 2009 and before implementation of the Basel recommendations (expected to occur by the end of ) which comply with either GENPRU requirements for innovative Tier 1 capital or the CRD Amendments/CEBS Guidelines/FSA Proposals in relation to hybrids but which do not comply with the requirements of Tier 1 Additional Going Concern Capital. If such instruments were not to be grandfathered, this would mean that, until implementation of the Basel recommendations at the end of 2012 (or whenever the Basel recommendations are actually implemented), firms will face uncertainty. Currently, the Basel Proposals are only proposals put forward for consultation and which may therefore be amended in light of that consultation and the outcome of the Basel Committee s comprehensive impact assessment which may not be for many months yet. Until the Basel Proposals are more settled and put forward as final recommendations, it may during the interim period be difficult for firms to proceed with non-common equity Tier 1 issuance without some greater comfort from the Basel Committee or their national regulators on either those final recommendations or more generous grandfathering provisions. The longer that interim period persists, the longer firms may be unable to issue hybrid capital with confidence and that may of itself be detrimental to the market and to some firms. There is, however, a possibility that the Basel Proposals have been drafted in such a way as to still allow the Basel Committee to be able to consider 32 Basel Proposals, paragraph It should be noted that the grandfathering provisions under the CRD Amendments are not entirely free from ambiguity. Article 154(9) of the CRD Amendments refers to instruments which have been deemed equivalent to innovative tier one capital by 31 December 2010 (rather than simply referring to innovative Tier 1 instruments in issue by 31 December 2010) being grandfathered, and the same Article also states that [CEBS] shall monitor, until 31 December 2010, the issuance of these instruments. These drafting details have led some in the market to conclude that the grandfathering provisions in the CRD Amendments may not be automatic and that there may be some regulatory discretion as to whether innovative tier one instruments will be grandfathered. The FSA Proposals are also ambiguous, stating that an instrument may be grandfathered if, as at 31 December 2010, the firm included it, and was entitled to include it, in its capital resources as non-innovative or innovative tier one capital. 34 Basel Proposals, paragraphs 10 and Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

12 grandfathering GENPRU- or CRD Amendments/CEBS Guidelines/FSA Proposal-compliant hybrid Tier 1 instruments issued on or after 17 December 2009 which are not also Tier 1 Additional Going Concern Capital-compliant. The sentence immediately following the sentence referring only to the grandfathering of instruments issued before 17 December 2009 states as follows: The impact assessment [scheduled to occur during the first half of 2010] will be used to consider recommendations for an appropriate grandfathering period for instruments and an appropriate phase in period for the new capital standards (emphasis added) 35. One interpretation of this sentence is that the term grandfathering period refers only to the length of time for which the securities will be grandfathered. Another interpretation is that the term also refers to the period during which securities can be issued and still benefit from grandfathering provisions. If the latter, broader, interpretation is adopted, then the reference to instruments, rather than only to instruments issued before 17 December 2009, may mean the Basel Committee is open to the idea of grandfathering instruments issued on or after 17 December 2009 if this is warranted by the comprehensive impact assessment. The input of market participants in the consultation process may be an important factor in the decision the Basel Committee eventually takes in this regard. After all, elsewhere in the Basel Proposals the Basel Committee states that appropriate grandfathering arrangements will be established to ensure that this process is completed without aggravating near term stress. 36 Basel Proposals Tier 2 Capital Although the main focus of the Basel Proposals is on Tier 1 capital, significant changes are also being proposed to Tier 2 capital. The upper and lower subcategories of Tier 2 capital are to be eliminated. Instead, there will be one set of entry criteria 37. All Tier 2 capital will be more akin to what is now described as lower Tier 2 capital than upper Tier 2 capital, because the Basel Committee is proposing that Tier 2 capital should correspond to capital which absorbs losses on a gone concern basis 38 whereas, under current GENPRU requirements, upper Tier 2 capital instruments must absorb losses on a going concern basis. Therefore, the requirements for Tier 2 capital in the Basel Proposals 39 read like current requirements for lower Tier 2 capital, as described in Table 4 below. Table 4: Criteria for inclusion in Tier 2 Capital. The main criteria include: > Subordinated to depositors and general creditors. > Minimum original maturity of at least 5 years, no incentives to redeem. > Recognition in regulatory capital in the remaining 5 years before maturity will be amortised on a straight line basis. > Callable at the initiative of the firm only after a minimum of 5 years subject to: (a) (b) prior supervisory approval; the firm not creating an expectation that the call will be exercised; 35 Basel Proposals, paragraph Basel Proposals, paragraph Basel Proposals, paragraphs 72 and Basel Proposals, paragraph Basel Proposals, paragraph Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

13 (c) and the firm not exercising a call unless the called instrument is replaced with capital of the same or better quality or the firm demonstrating that its capital position is well above the minimum capital requirements after the call is exercised. > The investor must have no rights to accelerate the repayment of future scheduled payments (coupon or principal) except in liquidation. The combination of the proposal requiring 5-year straight-line amortisation of regulatory recognition prior to maturity and the proposals prohibiting incentives to redeem or the creation of any expectation that a call will be exercised significantly reduces the attractiveness of classic Tier 2 capital structures, such as, say, 30 non-call 10 instruments, which allowed the full principal amount of the instrument to be counted for regulatory capital purposes until the first call date, at which point a step-up gave investors some comfort that the call would be exercised. Making all of Tier 2 capital gone concern capital only may at first appear to be at odds with the general move towards enhancing the quality of bank regulatory capital. However, the Basel Proposals are clear that the Basel Committee will calibrate the minimum requirements for the overall level of capital, Tier 1 capital, and the predominant form of Tier 1 capital as part of the impact assessment 40. The Basel Committee refers to its calibration work in 2010 and states that as part of this the system of limits applied to elements of capital will be revised. It continues,.the current limitation on Tier 2 capital ([that] it cannot exceed Tier 1) will be removed and replaced with explicit minimum Tier 1 and total capital requirements. 41 It is likely that the calibration work in 2010 will result in significantly higher levels of going concern capital in the form of Tier 1 only, with a reduced (gone-concern only) role for Tier 2 capital. The Future The recent papers from the Basel Committee, CEBS and the FSA demonstrate the significant changes to the bank capital regulatory landscape which lie ahead. There are clearly many common strands to the papers: the bottom line of them all being firms will be required to have more, and better quality, capital. There are, however, some important differences between the Basel Proposals and the CEBS/FSA position which will need to be reconciled in the coming months. In particular, the status of innovative and dated Tier 1 capital and the manner in which capital requirements are to be calibrated. The proposals also raise interesting questions around tax and investor appetite for hybrid instruments which have robust conversion and write down features. There will be a lot of devil in the detail with those features. Although in their respective proposals, the FSA and CEBS stress the need for both the mechanism for conversion/write down and the trigger point at which such conversion/write down occurs to be clearly defined, legally certain and transparent, none of the proposals yet set out the level of detail necessary to achieve this. 40 Basel Proposals, paragraph Basel Proposals, paragraph Basel, CEBS, CRD and FSA: the changing landscape of regulatory capital rules and the

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