SUNS  4312 Thursday 29 October 1998


FINANCE: NEW BASEL GUIDELINES MAY REDUCE BANK CORPORATE GOVERNANCE

Geneva, 27 Oct (Chakravarthi Raghavan) -- The Basel Committee on Banking Supervision based at the Bank of International Settlements issued Tuesday new guidelines seemingly limiting use of innovative capital instruments to meet their capital adequacy ratios.

A press release by the committee said that at the meeting of the supervisors on 21 October, it was decided to limit acceptance of "innovative capital instruments", known in the trade as hybrid
securities issues, for inclusion in a Bank's Tier 1 capital which is used to judge capital adequacy rations.

The Basel Committee said the use of the instruments would be limited to 15 percent of the Tier 1 capital, and under very strict limitations.

However, some critics suggest that the tightening may have the perverse effect of reducing bank managements accountability to shareholders.

Under the 1988 Basel capital adequacy rules that supervisors use in overseeing banks under their jurisdictions, banks are to hold capital cushion of atleast 8 percent of their loans and investments, weighted according to the level of risks. Of this 8 percent, atleast half is to be in the form of core or Tier 1 capital - the last line of defense of a bank in absorbing losses.

In the past this core capital was to consist only of shareholders equity and retained earnings.

In recent periods, banks have been using these hybrid securities, which are seen as halfway between equity and debt, and "cheaper" to banks than equity shares in that the interest they pay can be deducted from their tax bills. Such loan capital have been for longer-durations, necessarily carrying more interest. Some experts say they have even come across cases of 100-year loans. In theory, such loans would rank lower, perhaps just above equity, in the event of a bank having to be
wound-up, and thus qualify to be nearly equity. However, clever lawyers and bank managements bending the rules could get around these.

The use of such instruments have been allowed by regulators in some European countries -- such as Germany, Italy, Portugal and Finland -- but regulators and supervisors as in the UK have taken a tougher line.

The new guidelines are expected to tighten the regulations in the countries where these instruments have been allowed, while giving the banks in jurisdictions like in the UK more leeway.

The US Federal Chairman, Alan Greenspan and the Vice-President of the New York Federal Reserve had justified their actions in orchestrating a rescue of the Long Term Capital Management Fund on the ground of systemic risks arising out of the operations of some of the world's leading banks in lending and investing in the LTCM.

Top managements would appear not to have even known the extent of the total exposure of their banks through various departmental operations. But the managements of banks that are thus at fault have been "retired" with golden handshakes and golden parachutes of compensation running
into some millions.

In the wake of such disclosures, there have been some major issues raised about corporate governance, the laxity of banking supervision and regulation in the major G-10 countries, and calls for actions to tighten up use by banks of various market instruments, the use by banks of computer generated models of value at risk, and demands for making bank managements more accountable to their shareholders.

Though the Basel supervisors announcement suggests a case of "tightening up" of regulations governing banks, the new guidelines to allow banks to include instruments they can use to meet capital requirements, may have the effect of looser corporate governance (with bank managements less accountable to their shareholders) at a time when recent disclosures about the operations of major banks (in lending and investing in hedge funds and their executives) suggest that there is
need for stricter, rather than looser, accountability of managements to their shareholders and to the central bank regulators.

In announcing the new guidelines, the Basel Supervisory Committee said its starting point was the reaffirmation that common shareholders' funds - common stock and disclosed reserves and retained earnings - should be the key elements of capital, since they allow losses to be absorbed on an ongoing basis. Since such capital allow banks to conserve resources when under stress, market judgements of capital adequacy of a bank are made on the basis of shareholders' funds, and the voting rights attached to the shares is an important source of market discipline. Hence, common shareholders' equity (with voting rights), and disclosed reserves or retained earnings should be the
predominant form of a bank's Tier 1 capital (available to meet claims in the event of insolvency).

The Basel communique said that in order to provide supervisors and market participants with sufficient information to ensure integrity of the capital is maintained, banks should periodically disclose publicly each component of the Tier 1 capital and its features.  
Also minority interests in equity accounts of consolidated subsidiaries that take the form of "Special Purpose Vehicles" (SPVs) should be included in Tier 1 capital only if the instrument meets the
requirements that all Tier 1 capital instruments need to: the SPVs are issued and fully paid, are non-cumulative, are able to absorb losses within the bank on a going-concern basis, are junior to depositors, general creditors and the subordinated debt of the bank, and are permanent.

Also required to satisfy the guidelines is that these are neither secured nor covered by a guarantee of the issuer or related entity or other arrangements that legally or economically enhance the seniority of the claims vis-a-vis the bank creditors, and callable at the initiative of the issuer only after a minimum of five years with supervisory approval and under the condition that it will be replaced with capital of the same or better.

Other conditions required to be fulfilled are: the instruments should be easily understood and publicly disclosed; their proceeds must be immediately available to the issuing bank, or if fully available only to the issuing SPV, they must be made available to the bank at a predetermined trigger point, well before a serious deterioration in the bank's financial position; the bank must have discretion over the amount and timing of distribution, subject only to prior waiver of distributions on the bank's common stock and banks having full access to waived payments; and distributions paid only out of distributable items.

The new guidelines also permit "moderate" step-ups (implying higher interest rates depending on market situations) in the instruments, in conjunction with a call option, if such step-ups occur at a minimum of 10 years after issue, and no more than one rate step-up during the life of the instrument. The step ups could be either 100 basis points (i.e. one percentage point of interest) or 50% of initial credit spread.

National supervisors, the communique said, expect banks to meet the Basel minimum capital ratios without undue reliance on innovative instruments, including those with a step-up.