Most people believe the Basel III capital rules are buttoned up. International regulators worked hard, agreed in December to impose tough standards and then gave bankers eight years to meet them.
But the reality is something much less concrete. There are some big unanswered questions facing regulators, and in turn, bankers.
The acting comptroller, John Walsh, used a sewing analogy to describe where things stand.
"Basel III represents both a layering on, and a revision of" the existing, hard-fought regulatory capital rules," Walsh said in a recent speech. "You will not be surprised to learn that all of this does not fit together seamlessly. In fact, we will be ripping out seams and redesigning this garment for years to come."
That's a bit of hyperbole, as few expect foundational changes to Basel III. The minimum ratios are set and common equity is the new king. But interviews with officials at the three banking agencies reveal several areas where their work continues: incorporating Basel III into both Prompt Corrective Action (PCA)and the U.S. leverage ratio; designing a capital surcharge on the largest financial firms; figuring out what role, if any, contingent capital and bail-in debt should play.
The PCA was mandated by a law enacted after the savings and loan crisis in 1991. As a bank's regulatory capital slides, regulators are to impose increasingly stern sanctions, such as suspending dividends or limiting growth. Once equity capital hits 2%, PCA requires the institution be seized.
Only that 2% figure is written into law. The rest of the thresholds triggering regulatory actions were set by the agencies, and now they plan to revise those thresholds to bring PCA in line with Basel III.
In simple terms that means PCA — widely considered a failure — could actually gain some teeth.
No one, not even the regulators, knows yet what the revised PCA system will look like, but it's a fair bet the threshold to avoid any regulatory sanctions may rise to 6% Tier 1 capital from the current 4%. It's also likely PCA will gain a common equity component, perhaps set at 4.5% of risk-weighted assets.
That's because Basel III starts with a common equity floor of 4.5%. It then adds a layer called a conservation cushion, which is 2.5%. That brings the minimum to 7%.
Regulators are still debating whether to add a countercyclical buffer of 2.5% that would be built up in good times. A surcharge for large firms may be added as well, which would bring regulatory capital requirements to something over 9%.
The agencies hope to propose rules implementing Basel III here over the summer and aim to include the PCA update in that effort. The Dodd-Frank Act extended PCA to holding companies, so that, too, will be worked into the proposal.
The U.S. has long also used a leverage ratio, and currently U.S. banks must hold Tier 1 capital equal to 5% of their on-balance-sheet assets. But Basel III tells banks to hold 3% against both on- and off-balance-sheet assets. So the question for U.S. regulators is whether to stand pat, adopt both or move to the international standard. Officials at the three banking agencies do not agree on the best route forward.
"That is going to be one of the toughest issues in the next round of Basel III implementation in the U.S.," said Karen Shaw Petrou, the co-founder and managing partner of Federal Financial Analytics in Washington.
One more wrinkle: In the U.S. the leverage ratio is hard and fast; in Basel III enforcement is subject to the regulators' discretion.
"If you fall below 5% in the U.S., bad things happen," Petrou said. "So while you just get a tough talking-to in the EU, here PCA kicks in."
The last set of questions addresses the role of contingent capital and bail-in debt.
Neither would replace common equity, but could serve as a supplement, most likely as a way to meet legislative demands for large financial companies to hold an extra cushion of capital.
There is no common definition of either term, but both are forms of debt that would convert to equity when some triggering event occurred. The difference between the two is the trigger on bail-in debt would likely be much lower than on contingent capital, known as Cocos.
For instance, creditors who owned bail-in debt might face conversion when the bank was at death's door, while a Coco holder's stake might be converted when the company's stock price slipped below $10 a share. The two forms would have very different terms and prices.
Deciding the triggers, who should set them and who would determine when they had been breached are some of questions vexing regulators. There are also tax issues — it is really debt and thus deductible? — and accounting issues.
A Basel task force is studying Cocos and the Financial Stability Board has a group focused on bail-in debt. They aim to complete their work by midsummer. Here in the U.S., Dodd-Frank mandates that the Financial Stability Oversight Council produce a report on Cocos by mid-2012, but regulators expect to have it done earlier so they can have some influence with their international counterparts.
Dodd-Frank does not mandate that Cocos be used here, only that regulators weigh the pros and cons.
If regulators do decide to move ahead, it's a good bet there would be some regulatory standards for these debt sales. Not every term, but at least the broad outlines to ensure some consistency.
What regulators like about these debt instruments is that capital could be raised quickly. Conversion is triggered and, viola, a bank has raised capital.
Richard J. Herring, co-director of the Wharton Financial Institutions Center at the University of Pennsylvania, said Cocos should appeal to well-run banks because it would be much less expensive than issuing stock.
"As long as the issuer has confidence that they are going to stay above the trigger, it's just like debt," Herring said.
And Cocos could impose more market discipline on financial firms — the debtholders would train an eagle eye on the issuers and the firms themselves would have a huge incentive to address problems early to avoid the dilution that would occur by tripping a trigger, Herring said.
But other experts said the market has already rejected Cocos. "The Coco idea hit the cold, cruel world of investors who said no thank you," Petrou said. (Only a few banks have issued Cocos, and none in the U.S.)
U.S. regulators would love it if Cocos worked out, but most remain unconvinced and pessimistic.
"This gets to a fundamental point — what are we trying to accomplish and how does contingent capital get us there?" a senior federal regulator said. "Does it accomplish anything common equity doesn't?"
Regulators may be even less impressed by bail-in debt, with some saying Dodd-Frank's prohibition on bailing out financial companies makes the question of using it here moot.
But this may not be a dead issue, because at least one agency is convinced a public-sector bailout is not a condition for triggering bail-in debt. (A condition of the interviews was an agreement not to reveal which agency said what.)
Of course these are just the capital parts of Basel III still requiring attention. A new liquidity standard is still being ironed out and even with the massive shift to common equity few people think capital alone can prevent the next crisis. It must be coupled with a tough resolution process, which regulators are also hard at work on.