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Definition of capital determines Basel III impact on CUs
WASHINGTON (2/3/12)--Basel III guidelines on financial institution capital levels may have been drafted in response to the negative impact large banks made on the economic crisis, but credit unions and other financial cooperatives likely will be included in any resulting regulation. How credit unions manage member shares relative to their capital requirements could determine how significant the impact of those regulations would be.

The role shares play in defining credit union capital was the main topic of a World Council of Credit Unions (WOCCU) webinar Wednesday on recent changes to the Basel guidelines and their impact on credit unions.

Economist Glenn Westley, who has worked in the credit union and microfinance sectors, discussed changes proposed by the Basel Committee on Banking Supervision--which is part of the Bank for International Settlements in Basel, Switzerland--particularly as they relate to credit unions.

"Are credit union shares defined on the balance sheet as capital or as a liability?" Westley asked participants from seven countries who logged into Wednesday's webinar. "It depends on what you do with them."

The two-hour online event, also recorded for later viewing, looked briefly at the history of the Basel guidelines, which have become the basis for financial regulations in a growing number of countries, and the changes that have occurred since the first Basel Capital Accord in 1988. Basel I, as it was called, was developed primarily to serve as operational guidelines for large money-center banks domiciled in the Group of 10 (G-10), the world's most economically developed countries at the time. The guidelines' safe operating principles grew in popularity and eventually applied to both large and small financial institutions in more than 100 countries.

Basel I identified credit risk as the main threat to financial institution safety and soundness, and recommended that an institution must hold at least 8% of capital in risk-weighted assets, comprised of a variety of financial instruments. The committee revised its requirements for Basel II, issued in 2004, maintaining similar capital levels to protect against risk but requiring additional capital charges for operational risk (such as fraud) and market risk (such as interest rate risk).

The Basel Committee issued the Basel III capital and liquidity guidelines in December 2010 and June 2011 after the previous guidelines failed to prevent the global economic recession of the past few years. The latest guidelines revised the view of how capital standards are measured and applied, Westley said.

"In general, Basel III narrows the definition of what's acceptable and calls for more and higher quality capital than Basel II," Westley told participants.

In addition to revising capital requirements, the new guidelines propose adding a capital conservation buffer composed entirely of higher quality capital, a countercyclical buffer that comes into play if an institution's credit growth is excessive, and a leverage ratio that provides an extra layer of protection in the event of errors in financial risk models or in the values the Basel Committee assigns to risk-weighted assets.

Despite the new features, financial institution safety still comes down to a question of capital adequacy. In the case of credit unions, adequacy may hinge on how member shares are defined and how the credit union treats member access to those shares.

Credit unions must treat shares that can be redeemed by members without restriction as liabilities on the balance sheet, Westley said, explaining that members can withdraw such shares and that necessary capital can disappear when the credit union needs it most. Credit unions that can unconditionally refuse share redemption, however, can treat those shares as capital, equivalent to common equity tier 1 (CET1) capital (the capital category that also includes retained earnings) because they can remain with the credit union in times of financial duress.

"If credit union members can only redeem shares to the extent that such redemptions are fully offset by the issue of new shares to new or existing members, then the shares are CET1 capital," Westley said. "Like the issue of common equity, credit unions can count on having the full proceeds from shares sold through the end of the previous year."

To view a recording of the webinar, use the link. The webinar will be available to viewers for a fee through July.
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