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A committee of central bankers and financial regulators has agreed new rules to prevent a repeat of the global financial crisis.
The Group of Central Bank Governors and Heads of Supervision, the oversight body of the Basel Committee on Baning Supervision, on Sunday agreed to substantially raise the amount of capital that banks must set aside against potential losses.
Internationally active banks must now hold a minimum 7% of assets as total common equity. This includes a special "capital conservation buffer" of 2.5% to withstand future periods of stress in the financial markets. The minimum requirement for common equity, which is highest form of loss absorbing capital, was raised to 4.5% from 2%.
Furthermore, the Tier 1 capital requirement, which includes common equity and other qualifying financial instruments, will be raised to 6% from 4%. A countercyclical buffer in the range of 0%-2.5% if common equity will also be implemented according to national circumstances to protect the banking sector from excess credit growth.
The rules will come into effect on January 1, 2013, by when banks are expected to set a 3.5% of assets aside as minimum common equity and meet the Tier 1 capital requirements. These will be gradually phased in over the next decade so that banks can adjust to the new rules.
If common equity levels fall below the minimum levels, regulators could force banks to hold back more of their earnings in reserves and suspend dividend payments and loan portfolios.
Further, a liquidity coverage ratio would be intorduced on January 1, 2015, following an observation period starting next year.
European Central Bank President Jean-Claude Trichet described the agreement as "a fundamental strengthening of global capital standards."
"Their contribution to long-term financial stability and growth will be substantial. The transition arrangements will enable banks to meet the new standards while supporting the economic recovery," he said.
"Currently the majority of European banks will have no problem to meet the new requirements," said Eleonore Lamberty of ING Credit Research. "For the handful of banks that would find it more difficult, the very lengthy implementation period ensures that any capital shortfalls can be addressed, possibly through retained earnings."
"The industry wide expectation of significant capital raising exercises has hereby become much less compelling."
The U.S. Federal Reserve welcomed the new rules as a "significant strengthening" in prudential standards for large and internationally active banks. "The agreement represents a significant step forward in reducing the incidence and severity of future financial crises, providing for a more stable banking system that is less prone to excessive risk-taking, and better able to absorb losses while continuing to perform its essential function of providing credit to creditworthy households and businesses," it said.
The British Bankers' Association said though the changes are good from a stability perspective, but they add billions to the fixed operating cost of a bank. "The consequence is that inevitably the cost of credit - the price the borrower pays for money - will rise. The cheap money era is over," said Angela Knight, chief executive of the group.
The Basel Committee, which works under the Bank for International Settlements, now has to get the new rules ratified by leaders at the November G20 summit in Seoul.
Headquartered in Basel, Switzerland, the BIS was established in 1930 in the aftermath of the Great Depression and consists of members from 27 central banks around the world.
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