In October 2011, the Swiss legislator published a proposal for the implementation of the regulatory framework known as "Basel III", as applicable to Swiss banks. The new regulatory capital requirements will enter into force on 1 January 2013, with an implementation period extending to the end of 2018.

1. OVERVIEW

1.1 Key Features of the New Capital Regime

The new capital regime aims at achieving a higher resilience of banks to losses compared to the regime under the Basel II framework. This shall be achieved, inter alia, by ensuring that banks have access to sufficient capital of "good quality" for absorbing losses in a "going concern" context.

The size of required total capital (without taking into account the equity capital buffer and the countercyclical buffer) has not been changed, and remains at 8% of risk-weighted assets.

However, the composition of such capital changes significantly. Banks must now hold Common Equity Tier 1 (CET1) capital of 4.5% of risk-weighted assets (previously 2%) and they may hold additional Tier 1 capital of up to 1.5% and Tier 2 capital of up to 2% of risk-weighted assets.

In addition, banks must create a capital buffer in the form of CET1 capital of 2.5% of risk-weighted assets, which leads to a total CET1 capital of 7% of risk-weighted assets. Under certain credit market circumstances, a countercyclical buffer of up to 2.5% of additional CET1 capital may temporarily apply to all categories of banks, where required for macro-prudential reasons. This countercyclical buffer aims at improving the resilience of the banking sector during phases of excessive credit growth. The respective rules entered into force on 1 July 2012.

Basel III minimum capital requirements:

In line with the Basel III framework (Basel III: A global regulatory framework for more resilient banks and banking systems), all Swiss banks organised as stock corporations – not only banks of systemic importance within the meaning of the too-big-to-fail legislation – may (for the purposes of establishing sufficient AT1 and T2 capital) make use of the newly created capital instruments included in the Banking Act as part of the too-big-to-fail legislation. Such new capital instruments include bonds with a write-off feature, reserve capital, and convertible capital.

1.2 Adding "Swiss Specific Buffers" to the Basel III Requirements

The requirements of the Basel III framework (including minimum capital requirements, capital buffers, and where necessary, macro-prudentially motivated countercyclical buffers) are supplemented by additional capital requirements introduced by FINMA Circular 2011/02 (Additional Swiss Requirements). The regulation set out in FINMA Circular 2011/02 entered into force on 1 July 2011 and shall remain applicable also post-implementation of Basel III.

In its Circular 2011/02, FINMA requires, depending on the size and importance of the bank, an additional capital buffer in addition to the requirements of the Basel III framework of up to 1% of risk-weighted assets (applicable only to banks that are not of systemic importance).

"The new legislation implementing Basel III aims at both improving the quality of components of regulatory capital and reducing the sub-divisions that were made

1.3 Formal Implementation

The Basel III framework is implemented in Switzerland through an amendment of the Capital Adequacy Ordinance (CAO), as well as through an amendment of various FINMA Circulars and the release of new FINMA Circulars.

2. COMPONENTS OF REGULATORY CAPITAL

2.1 Eligible Capital

The CAO (pre-implementation of Basel III) includes three types of regulatory capital (Tier 1, Tier 2 and Tier 3). Tier 1 capital is sub-divided into actual core capital and innovative core capital. Tier 2 capital is sub-divided into upper Tier 2 and lower Tier 2 capital. Tier 3 capital includes other forms of qualifying additional capital. The new legislation implementing Basel III aims at both improving the quality of components of regulatory capital and reducing the subdivisions that were made in the legislation so far.

The new legislation implementing Basel III aims at both improving the quality of components of regulatory capital and reducing the sub-divisions that were made in the legislation so far.

2.2 Common Equity Tier 1 (CET1) Capital

Pursuant to Art. 21 et seq. of the revised Capital Adequacy Ordinance (rev-CAO), and as already required by the Basel II framework, CET1 capital includes actually paid-in capital, disclosed reserves, provisions for general banking risks, earnings carried forward and current earnings after deduction of the expected proportion of CET1 capital to be distributed.

In order to qualify as CET1 capital, share capital must not include preferential rights (e.g. in a liquidation scenario). Therefore, any share capital in the form of preferred shares or preferred non-voting shares would not be eligible as CET1 capital.

2.3 Additional Tier 1 (AT1) Capital

Additional Tier 1 (AT1) capital can be issued in the form of an equity or debt instrument.

Pursuant to Art. 20 of the rev-CAO, AT1 capital must be subordinated to any non-subordinated debt, it must be completely paid in or created internally, may not be financed through loans granted by the bank, and must neither be subject to a set-off with claims of the bank nor be secured by assets of the bank. Furthermore, pursuant to Art. 27 of the rev-CAO, such capital may neither have a fixed term nor may it be issued with an expectation that it will be repaid early. Such capital may be repaid after five years at the earliest, and only at the bank's initiative and with the consent of FINMA. Dividends or interest may only be paid in respect of such capital if reserves are available, provided that it must be at the bank's discretion whether any such payments are made. In addition, payments to investors may neither be linked to the creditworthiness of the bank nor subject to a step-up mechanic. Also, AT 1 capital must not have any feature that could hinder a rights offering made by the bank.

Moreover, according to Art. 27 (3) of the rev-CAO, if the CET1 capital has fallen below a level of 5.125% of the total capital or, if reached earlier, upon the occurrence of any other pre-determined trigger event, FINMA may require that AT1 capital in the form of a debt instrument (i.e. excluding AT1 capital in the form of preferred shares or preferred non-voting shares) be converted to CET1 capital or that a write-off be triggered for such debt in an amount as required to be in compliance with the required regulatory capital ratios. Such loss absorption must be provided for in the terms and conditions of the AT1 instruments.

2.4 Tier 2 (T2) Capital

Pursuant to Art. 30 of the rev-CAO, T2 capital must meet the general requirements applicable to equity capital pursuant to Art. 20 of the rev-CAO that also apply to Tier 1 capital (as set out above in respect of AT1 capital). Such T2 capital must have an initial maturity of at least five years and may not be subject to incentives for the bank to repay the T2 capital. As with AT1 capital, T2 capital may only be repaid after five years at the earliest, and only at the bank's initiative and with the consent of FINMA. Any step-up mechanic increasing the amounts due to investors prior to maturity is not allowed.

3. LOSS ABSORPTION

3.1 Background

Under the revised regulatory capital regime, the concept of "loss absorption" applies mandatorily to AT1 and T2 capital. The new regime differentiates between loss absorption under the aspect of continuation of bank operations ("going concern") and loss absorption at a point in time when insolvency is imminent ("gone concern").

3.2 Loss Absorption in a "Going Concern" (AT1 Capital)

AT1 capital in the form of debt must take its share in losses upon the occurrence of a pre-determined trigger event, at the latest, however, when the level of the CET1 capital has fallen below a threshold of 5.125% of the total capital. Such loss absorption must take place either through a write-off or a conversion into CET1.

3.3 Loss Absorption in a "Gone Concern" (AT1 and T2 Capital)

Sharing losses when insolvency is imminent ("loss absorption at the point of non-viability" or "PONV") is regulated by Art. 29 of the rev-CAO. Imminent insolvency means that the bank will likely be able to survive if the PONV consequences are triggered. Loss absorption is triggered at the latest prior to accepting government aid, or if FINMA considers it necessary. FINMA is given more room for discretion in initiating loss absorption in a "gone concern" than in a "going concern". It is not necessary that the bank becomes subject to restructuring proceedings for a PONV to be triggered.

"Under the revised regulatory capital regime, "loss absorption" applies mandatorily 3.4 Comparison of Swiss and Basel III Rules

While the PONV feature under the Basel III rules only applies mandatorily to "internationally active" banks, the Swiss rules according to the rev-CAO do not distinguish between "internationally active" banks and other banks. The PONV features therefore apply to all Swiss banks.

4. ENHANCEMENT OF THE CAPITAL BASIS

4.1 Background

In the context of the too-big-to-fail debate, the Swiss Parliament approved, in its fall session in 2011, provisions applicable to banks of systemic importance. In addition, provisions regarding the creation of new capital instruments, which are available for all banks (i.e. not only banks of systemic importance) were adopted. Such new capital instruments include bonds with a write-off feature, reserve capital and convertible capital. These provisions took effect on 1 March 2012.

4.2 Bonds with a Write-Off Feature

Bonds with a write-off feature may be used for loss absorption in "going concern" or "gone concern" situations. The terms and conditions of the bonds must describe the trigger mechanism, which must be approved by FINMA.

4.3 Reserve Capital

Reserve capital serves the purpose of enabling the bank to raise new capital. It is not a capital instrument that may be used to absorb existing losses in the context of the "loss absorption" mechanics discussed above.

The new provisions on reserve capital only apply to banks and not to other stock corporations. However, reserve capital operates similarly to authorized capital that may be issued by any joint stock corporation. Just like authorized capital, reserve capital is created by a resolution of the shareholders meeting amending the articles of association, thereby enabling the board of directors of a bank to raise capital quickly when necessary. In order to grant to the board of directors as much flexibility as possible, the provisions on reserve capital allow the issuance of new shares at a discount to the market price, provided that this is in the interest of the bank with respect to a swift and complete placement of the new shares.

While authorized capital is available for only two years and is limited in terms of size to 50% of the issued capital, such limitations do not apply to reserve capital of banks. However, reserve capital may not be paid up with the bank's own funds.

4.4 Convertible Capital

Convertible capital of banks as specified in the new provisions of the Banking Act is akin to conditional capital that may be issued by any joint stock corporation. However, there are substantial differences to be highlighted.

The issuance of convertible capital must be based on a resolution passed by a shareholders meeting amending the articles of association. Such resolution gives to the board of directors the power to decide when and how to issue such convertible capital.

As opposed to conditional capital, the conversion of convertible capital into shares or non-voting shares is not instigated by the investor, but it is triggered by an event determined beforehand. Such convertible capital may be used for purposes of loss absorption in "going concern" and "gone concern" situations. The terms and conditions of the bonds must describe the trigger mechanism and the issuance must be approved by FINMA.

If a trigger event occurs, the board of directors must carry out the conversion into shares or non-voting shares by means of a publically notarized resolution. The capital increase must then be entered into the commercial register without delay.

5. TRANSITIONAL PRO VISIONS

Between 1 January 2013 and 31 December 2022, Tier 1 capital or Tier 2 capital issued under the pre-Basel III regime and instruments complying with the post-Basel III regime may both be used under certain conditions. However, Tier 3 capital pursuant to the pre-Basel III regime is not eligible as of the entering into force of the new regulatory capital requirements.

6. CONCLUSIONS

Under the Basel III framework as it is scheduled to be implemented in Switzerland through the rev-CAO, the revised capital requirements lead to the result that Swiss banks will require more CET1 capital compared to the regime pre- Basel III.

To the extent that part of the minimum capital requirements are satisfied with AT1 capital or T2 capital, such capital instruments require a bespoke tailoring of certain features in order to be recognized for the purposes of the rev-CAO (e.g. including the PONV feature).

The transitional provisions of the rev-CAO recognize for a limited duration Additional Tier 1 Capital or Tier 2 Capital issued under the pre-Basel III regime, provided that any such capital instruments issued as of 1 January 2012 must be fully compliant with the requirements of the rev-CAO in order to be recognized (with the inclusion of a PONV feature).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.