Basel III Throws Down the Gauntlet!

The Basel III Committee on Banking Supervision decided last year to stop counting most hybrid securities as Tier 1 capital. They claimed it was because they didn't provide a buffer for losses in 2008. They meant to say it was because they shouldn't be counted as Tier 1 capital because that was a ruse.

Basel III is concerned with the banking securities known as Trust-Preferred Securities because they were treated as capital (equity/own funds) rather than debt for regulatory purposes. This gave the banks favorable tax, accounting and credit treatment, without providing any real capital to the bank.

This is because except from a regulatory point of view they were treated as debt which essentially meant that they were taxed like debt obligations i.e. interest payments are deductible. If they had been treated as true capital they would have to pay dividends, which are taxable. There are other advantages-all of which accrue to the issuing banks.

About the only disadvantage to the banks is that they are more expensive to issue as they are subordinated to all of the issuer's other debt. Because of the willingness of the rating agencies to play along with the concept investors bought them in droves. It was another example of being offered something that looked too cheap to be true which was half correct.

They didn't have the risk of equity and were supposed to fit neatly into a debt
portfolio investment. In 2008 they traded more like equity than debt. Now under Basel III these securities will be required to include triggers that force bank to convert hybrids into common stock, or write them off to avert collapse.

The intention is to have securities which are defined as capital actually function as capital. The immediate, and expected response of the bank lobby is that these triggers, which will be enforceable by national authorities will "politicise" the products meaning that the pricing of these instruments will have to incorporate politics!

First of all every investment has a political risk component. It's part of the uncertainty accompanying an investment decision. Playing the politics card in this instance is an insult. The banks have been happily bailed out-by political decisions-Goldman Sachs and Morgan Stanley even became banks to benefit. Now the governments are looking to ensure they don't have to do it again.

In today's announcement the committee noted that “All classes of capital instruments” must “fully absorb losses at the point of non-viability before taxpayers are exposed to loss".

The underlying message would seem to foreshadow that in the future bondholders too will be held to account.

Touche