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Central bank governors and senior regulators are set to ordain that banks must have a minimum core tier one capital ratio, including a new so-called "buffer" to protect against extreme economic conditions, of 7%, I can reveal.

This is considerably lower than was wanted by the "hawks", the US, UK and Switzerland. They wanted a core tier one capital ratio of 8 to 9% including buffer, which is what British banks currently have to maintain. In fact most British banks currently have a core tier one ratio of around 10%.

But the new 7% minimum has been agreed in the face of stiff resistance from a number of countries, led by Germany, many of whose banks typically have much lower stocks of core capital in the form of equity and retained earnings - and will have great difficulty meeting the new standard.

This new international minimum was negotiated by regulatory and central banking officials in a meeting of the Basel Committee on Banking Supervision earlier this week. It is expected to be approved by the governors and senior regulators when they meet in Basle on Sunday. It will then be ratified in a final, supposedly irrevocable way by the heads of the G20 governments, at their summit in November. The 7% minimum represents a dramatic increase on the current minimum of 2%. That 2% minimum is widely seen as far too low: banks' low levels of capital relative to their assets was a major contributor to the severity of the 2008 banking crisis, as investors lost confidence in their ability to survive losses.

As they approached collapse, the capital ratios of Northern Rock and Royal Bank of Scotland fell to dangerously low levels - which is why Northern Rock was nationalized and RBS was semi-nationalized.

The point of capital is to absorb losses when loans and investments turn bad.

Although this new 7% minimum ratio of core capital (in the form of equity and retained earnings) to assets (loans and investments) as measured on a risk-weighted basis represents a significant increase, some will argue that the ratio is still too low.

One reason for this is that the absolute minimum capital ratio, without buffer, will be around 4%, or double the previous minimum.

Under the new system, if a bank's capital ratio falls below 7% or would fall below 7% when the bank is tested for financial stresses, the bank will be forced by regulators to raise new capital. And if the ratio falls below 4%, the bank will be put into "resolution" - which means that it will be taken over by regulators and wound up.

It means that banks' core capital ratios must always be above 7% in normal economic and financial conditions. But regulators would tolerate those ratios falling below 7% for short periods during economic downturns.

A senior regulator has told me that many of the biggest banks - those "too-big-to-fail" banks whose collapse would cause ruptures to the financial system - will in practice be forced to hold more than the 7% minimum.

"There will be some kind of add-on for systemically important banks," he said. So the likes of Barclays, JP Morgan, Royal Bank of Scotland, UBS and so on will in practice have to maintain core capital ratios greater than 7%.

The major concern of banks about the imposition of the higher capital ratios is that it will constrain their ability to lend in the transition period, as they build up stocks of capital - and that could undermine the global economic recovery.

The point is that there are two ways for banks to raise capital ratios: they can persuade investors to buy new shares; or they can shrink their balance sheets relative to their existing stock of capital by lending and investing less.

Because of the threat to economic growth of rapid implementation of the new capital ratios, the regulators and central bank governors are expected to give banks several years to meet the new standards.

The Basel Committee on Banking Supervision softened some of its proposed capital and liquidity rules while introducing new restrictions on how much lenders can borrow in order to rein in their risk-taking.

The panel agreed yesterday to allow certain assets, including minority stakes in other financial firms, to count as capital, according to a statement. The committee set a leverage ratio to apply to banks globally for the first time, which could become binding by 2018, pending further adjustments to the method of calculating banks’ assets.

“Even after all the compromises, the banks aren’t off the hook from tighter capital and liquidity rules,” said Frederick Cannon, chief equity strategist at New York-based Keefe, Bruyette & Woods.

France and Germany have led efforts to weaken rules proposed by the committee in December, concerned that their banks and economies won’t be able to bear the burden of tougher capital requirements until a recovery takes hold, according to bankers, regulators and lobbyists involved in the talks. The U.S., Switzerland and the U.K. have resisted those efforts. The announcement reflects the give and take between the two sides, said Barbara Matthews, managing director of BCM International Regulatory Analytics LLC in Washington.

German Concerns

Germany hasn’t signed yesterday’s preliminary agreement, said Sabine Reimer, a spokeswoman for BaFin, the country’s financial regulator.

“One country still has concerns and has reserved its position until the decisions on calibration and phase-in arrangements are finalized in September,” the committee said in a footnote to its statement.

Sumitomo Mitsui Financial Group Inc., Japan’s second- largest bank by market value, led banks higher in Tokyo after the committee agreed to allow some deferred tax assets to be counted as capital. The nation’s banks and regulators had fought against excluding deferred tax assets.

“The Basel Committee’s easing of restrictions gives investors a reason to take another look at Japanese banks, which have been cheap recently,” said Mitsushige Akino, who oversees about $450 million in assets in Tokyo at Ichiyoshi Investment Management Co.

Sumitomo Mitsui rose 2.8 percent to 2,587 yen at the 3 p.m. close of trading in Tokyo. Mitsubishi UFJ Financial Group Inc., the country’s largest bank, gained 2.5 percent and Mizuho Financial Group Inc. climbed 2.2 percent.

‘Making Concessions’

“They’re definitely making concessions on the definition of capital and the liquidity ratios,” said BCM International’s Matthews, who used to lobby the committee on behalf of banks. “Those were necessary to convince the Germans to accept the leverage ratio. But even though we see a lot of concessions, there are also limits to the concessions. So this isn’t fully caving in.”

The Basel committee, which represents central banks and regulators in 27 nations and sets capital standards for banks worldwide, was asked by Group of 20 leaders to draft rules after the worst financial crisis in 70 years.

Yesterday’s agreements were announced after a meeting of the group of governors and heads of supervision, which oversees the committee’s work. While the committee narrowed differences when it met two weeks ago in Basel, it left most of the final decisions to its board, members said.

The board said some of its proposals might not be completed by the end of this year, the deadline set by the G-20. Liquidity requirements for how much cash and cashable securities banks need to hold against their longer-term liabilities and counter- cyclical buffers, which would raise minimum capital requirements in times of faster economic growth, have to be worked on longer, the board said.

Lobby Efforts

European banks lobbied against the proposed exclusion of minority interests that banks hold in other financial institutions. Japan fought the hardest against the elimination of deferred tax assets, past losses that lenders use to offset tax charges in future years. The U.S. has opposed removing mortgage-servicing rights, contracts to collect payments, which are unique to U.S. banks.

The compromise announced yesterday would allow a bank to count part of a stake it owns in another financial firm in relation to the risk the capital is supposed to cover at the entity in which it invested. Deferred tax assets and mortgage- servicing rights would be included in capital up to a limit. The total for all three could not exceed 15 percent of a lender’s common equity.

While the capital ratios allow banks to assign weights to assets based on their risks, the new leverage figure considers all assets without a risk assessment. The committee initially set it at 3 percent -- meaning a bank’s total assets cannot be more than 33 times its Tier 1 capital, which includes securities that could help a lender cover unexpected losses.

Level Playing Field

The new rule also defines how assets are tallied, so as to level the playing field between different accounting standards and bring off-balance-sheet items into the calculation. The ratio will be tested from 2013 until 2017, and banks would be required to start publishing their individual leverage figures starting in 2015.

Bankers including Deutsche Bank AG Chief Executive Officer Josef Ackermann and HSBC Holdings Plc Chairman Stephen Green have said that the new rules may force banks to reduce lending, potentially limiting economic growth.

While yesterday’s announcement resolved several issues, many areas of contention, such as the actual minimum capital ratios that will be set, remain outstanding, said KBW’s Cannon.

“The definition of capital had to be finalized before the numbers can be put on, but there are still many moving parts,” said Cannon, whose research firm specializes in financial companies. The committee is planning to present a final package of reforms to the G-20 leaders meeting in Seoul in November.

Risk-Weighted Assets

Banks currently need to hold capital equal to a minimum of 8 percent of risk-weighted assets. Half of that must be Tier 1, and half of the Tier 1 needs to be common stock. Both Tier 1 and common-equity ratios will be increased, Cannon and other analysts expect. The Basel committee is also revising how the risk weighting will be done.

Like the leverage ratio, the liquidity rules are new to the Basel standards. The liquidity coverage ratio sets the amount of cash that needs to be held by a lender against any payment coming due within a month, while the net stable funding ratio considers liabilities up to 12 months.

The committee announced several modifications to the definition of liquid assets and of how to measure the safety of different types of funding. Government deposits will now be considered the same as corporate cash put in a bank, instead of treated as other banks’ money as originally proposed. Bank deposits are seen as less stable.

The changes should please banks, said Cannon.

“They compromised more on the short-term ratio than we were expecting,” he said.