This past December, the Basel Committee on Banking Supervision (BCBS) finalised the Basel III international regulatory capital and liquidity accord with major revisions urged by the World Council of Credit Unions (WOCCU) to reduce regulatory burdens on Canadian credit unions. The Basel committee spent the past seven years fine-tuning the Basel III standard, which was first issued in 2010, to ensure that it helped reduce risks posed to the financial system by large banks without creating unintended consequences for smaller, less complex institutions. WOCCU engaged the Basel committee at every opportunity during this process to help ensure that the final version of Basel III would include a new, proportional regulatory approach that reduces credit unions’ capital requirements and compliance costs.
One significant victory for credit unions in the final version of Basel III is reduced capital requirements for loans to small and medium-enterprises (SMEs). Basel III expands Basel II’s “regulatory retail” category to treat most loans to SMEs — defined as businesses with annual revenue up to about $80 million per year — as having the same 75 percent of face value risk-weight that Basel II accorded to consumer loans and loans to very small businesses such as sole proprietorships. Basel III’s expansion of the regulatory retail category to include loans to SMEs will reduce the capital that Canadian credit unions must hold against most business loans by 25 percent.
Basel III’s revised capital requirements for mortgages are another bright spot for credit unions. Mortgage loans with a 100 percent guarantee from a Canadian federal government-sponsored entity, such as the Canada Mortgage and Housing Corporation, will likely continue to be treated as a zero-percent risk to the credit union. As well, credit unions holding non-guaranteed, owner-occupied residential mortgage loans with at least 20 percent equity will be able to reduce the capital held against these loans by between 14 to 43 percent per loan.
Second-home and investment-property mortgages will receive the same risk-based capital treatment as owner-occupied residential loans unless more than 50 percent of the money the borrower will need to pay the loan comes from rental income. Other investment property mortgages with at least 20 percent equity will have risk ratings between 30 and 45 percent of face value under the final version of Basel III. This is a significant concession won by WOCCU compared to the committee’s original proposal, which, had it been finalised, would have required credit unions to hold approximately twice as much capital against investment-property mortgages.
The final version of Basel III also reduces most credit unions’ operational risk reserves. While Basel II typically required credit unions to establish an operational risk reserve equal to 15 percent of the institution’s annual net revenue, Basel III establishes three marginal rates for operational risk reserves that are similar to progressive income tax systems where higher earners pay higher marginal tax rates. For Basel III’s operational risk reserves, credit unions with annual net revenue of less than $1.6 billion a year will now usually have operational risk reserves based on the lowest marginal rate, which is roughly 12 percent relative to the credit union’s annual net revenue. Basel III will therefore reduce most credit unions’ operational risk reserves by up to one-fifth, compared to Basel II.
Large banks, however, are not so lucky. As urged by WOCCU, the final version of Basel III increases large banks’ capital requirements and levels the regulatory playing field by establishing a capital “output floor” that prohibits large banks from reducing their capital requirements significantly below what a similarly sized credit union’s regulatory capital requirement would be.
The final version of Basel III issued this past December is a major improvement for credit unions. Canadian credit unions should ultimately save billions of dollars under these new Basel III capital requirements once the standard takes effect starting in January. ◊