Lecture 6c: The Basel III

1
Lecture 6c The Basel III Implications
2
Outline

• Introduction
• Enhancement to Basel II
• Building blocks of Basel III
• Elements of Basel III relevant for banks
  treasurers
• Implications of Basel III
• Impact on Indian banks
• Conclusion

3
Basel I

• The Basel I 1988 capital charge for credit
  risk a simple broad-brush approach
• Amendment to Basel I 1996 to incorporate
  capital charge for market risk
• Standardized Measurement Method (SMM)
• Internal Models Approach (IMA)
• Market risk capital framework
• Capital charge for general market risk
• Capital charge for specific risk (credit risk)

4
Basel II

• The Basel II 2004
• Enhanced risk coverage
• Credit
• Market and
• Operational risks
• A menu of approaches standardized to model
  based with increasing complexity
• Three pillar approach
• The Basel II of 2004 copied and pasted the
  capital charge for market risk of Basel I
  amendment of 1996

5

• As a result, the capital charge framework for
  market risk did not keep pace with new market
  developments and practices
• Capital charge for market risk in trading book
  calibrated much lower compared to banking book
  positions on the assumption that markets are
  liquid and positions can be wound up or hedged
  quickly

6

• Capital charge for specific risk (credit risk) in
  market risk framework (trading book) was lower
  than capital charge for credit risk in banking
  book
• Lower capital charge for trading book led to
  scope for capital arbitrage
• Capital charge for counterparty credit risk for
  derivative positions also covered only the
  default risk and migration risk was not captured

7

• The global financial crisis mostly happened in
  the areas of trading book /off balance sheet
  derivatives / market risk and inadequate
  liquidity risk management
• Banks suffered heavy losses in their trading book
• Banks did not have adequate capital to cover the
  losses

8

• There was heavy reliance on short term wholesale
  funding
• Unsustainable maturity mismatch
• Insufficient liquidity assets to raise finance
  during stressed period

9
Enhancement to Basel II

• Post- crisis, global initiatives to strengthen
  the financial regulatory system
• July 2009 Enhancement to Basel II mostly in
  trading book

10

• Pillar 1 Standardized approach
• Higher risk weights for CRE securitization and
  other re-securitization exposures almost
  doubled
• Bank not permitted to use any external rating of
  ABCP program where it had provided liquidity
  facility or credit enhancement treated as
  unrated
• Operational criteria for using external ratings
  prescribed
• CCF for all eligible liquidity facilities made
  uniform at 50, irrespective of maturity (earlier
  20 CCF for maturity less than one year)

11

• Pillar 1 Internal models approach
• Capital based on normal VaR and stressed VaR
• Incremental Risk Charge (IRC) for interest rate
  instruments introduced which will capture default
  as well as migration risk

12

• Pillar 2 guidance
• firm wide governance and risk management
• capturing risk of off balance sheet exposures and
  securitization activities
• managing risk concentrations
• managing reputation risk and liquidity risk
• improving valuation practices and
• implementing sound stress testing practices

13

• Pillar 3
• appropriate additional disclosures completing
  enhancements in Pillars 1 and 2
• Securitization exposures in trading book
• Sponsorship of off balance sheet vehicles
• Re-securitization exposures and
• Pipeline and warehousing risks with regard to
  securitization exposures

14
The Basel III

• December 17, 2009 Basel Committee issued two
  consultative documents
• Strengthening the resilience of the banking
  sector
• International framework for liquidity risk
  measurement, standards and monitoring

15

• The proposals were finalized and published on
  December 16, 2010
• Basel III A global regulatory framework for more
  resilient banks and banking systems
• Basel III International framework for liquidity
  risk measurement, standards and monitoring

16

• Objectives
• Improving banking sectors ability to absorb
  shocks
• Reducing risk spillover to the real economy
• Fundamental reforms proposed in the areas of
• Micro prudential regulation at individual bank
  level
• Macro prudential regulation at system wide
  basis

17
Building Blocks of Basel III

• Raising quality (Tier 1 6, of which TCE -
  4.5), level (82.5 CCB), consistency
  (deductions mostly from TCE) and transparency of
  capital base
• Improving/enhancing risk coverage on account of
  counterparty credit risk
• Supplementing risk based capital requirement with
  leverage ratio
• Addressing systemic risk and interconnectedness
• Reducing pro-cyclicality and introducing
  countercyclical capital buffers (0-2.5)
• Minimum liquidity standards
• We will discuss 2, 3, 4 and 6

18
Improving/enhancing risk coverage on account of
counterparty credit risk

• In addition to July 2009 Basel II Enhancements
• Counterparty credit risk (replacement cost value)
  is measured either by OEM, CEM, Standardized
  Method or IMM
• Banks using IMM for measuring exposure for
  counterparty credit risk in derivative
  transactions will be required to use stressed
  inputs in Effective Expected Positive Exposure
  model

19

• Banks using standardized approach or IRB approach
  for credit risk in OTC derivatives, must add a
  capital charge to cover CVA (Credit Valuation
  Adjustment) risk to capture down gradation of
  counterparty before default in all approaches
• Capital charge for wrong way risk PD and EAD
  are positively correlated - in all approaches

20

• Asset value correlation of 1.25 for financial
  firms of 100 billion assets and unregulated
  financial firms
• Strengthening collateral management and extend
  margining period of risk to 20 days for OTC
  derivatives
• Increasing incentives for use of CCPs compliant
  with CPSS/IOSCO norms, for OTC derivatives

21
Supplementing risk based capital requirement with
leverage ratio

• Objectives to supplement capital ratio in
  capturing risk
• Numerator Tier 1 capital
• Denominator on and off balance sheet exposure
  credit equivalent with 100 CCF, except 10 CCF
  for unconditionally cancellable OBS commitments
• Derivatives on CEM and Basel II netting basis
• Collateral, guarantees or credit risk mitigation
  will not reduce on balance sheet exposures

22

• Ratio 3
• As a Pillar 2 measure to start with but will be
  integrated with Pillar 1
• Leverage ratio will be tracked from January 1,
  2011 to see the result of the above definition
  and parallel run from January 1, 2013 to 2017 and
  final adjustment in 2017 Disclosure from
  January 2015
• As Pillar 1 ratio from January 1, 2018

23
Addressing systemic risk and interconnectedness

• Capital and liquidity surcharge on SIBs/SIFIs
• Activity restriction/exposure on SIBs/SIFIs
• Intensive supervision of SIBs/SIFIs
• Asset value correlation of 1.25 for exposures to
  large financial institutions and unregulated
  institutions
• Stricter treatment of OTC derivatives not cleared
  through CCPs

24

• Improving loss-absorbing capacity of SIBs/SIFIs -
  Contingent capital and bail-in-able debt
• Orderly unwinding of SIBs/SIFIs improving
  resolvability living wills

25
International framework for liquidity risk
measurement, standards and monitoring

• Key characteristic of the financial crisis was
  inaccurate and ineffective management of
  liquidity risk
• Two standards/ratios proposed
• Liquidity Coverage Ratio (LCR) for short term (30
  days) liquidity risk management under stress
  scenario
• Net Stable Funding Ratio (NSFR) for longer term
  structural liquidity mismatches

26

• Liquidity Coverage Ratio (LCR)
• Ensuring enough liquid assets to survive an acute
  stress scenario lasting for 30 days
• Defined as stock of high quality liquid assets /
  Net cash outflow over 30 days gt 100
• Stock of high quality liquid assets cash
  central bank reserves high quality sovereign
  paper (also in foreign currency supporting banks
  operation) state govt., PSE assets and high
  rated corporate/covered bonds at a discount of
  15 - (A)
• Level 2 liquid assets with a cap of 40

27

• Fundamental characteristics of liquid assets
• Low credit and market risk
• Ease and certainty of valuation
• Low correlation with risky assets
• Listed in a developed and recognized exchange
• Market-related characteristics
• Active and sizable market
• Presence of committed market makers
• Low market concentration
• Flight to quality

28

• Net Stable Funding Ratio (NSFR)
• To promote medium to long term structural funding
  of assets and activities
• Defined as Available amount of stable funding /
  Required amount of stable funding gt 100

29

• Other monitoring tools for liquidity risk
  management
• Contractual maturity mismatch
• Concentration of funding
• Available unencumbered assets
• LCR by significant currency
• Market-related monitoring tools

30
Implications of Basel III

• Impact on economy
• IIF study loss of output of 3 in G3 (US, Euro
  Area and Japan) on full implementation during
  2011-15
• Basel Committee study likely to have modest
  impact of 0.2 on GDP for each year for 4 years
  for 1 increase in TCE
• Similarly, for 25 increase in liquid assets,
  half the impact of 1 increase in TCE
• However, long term gains will be immense

31

• Global banks could have a gap of liquid assets of
  1,730 billion - to be met in four years
• Global big banks could have a capital shortfall
  of 577 billion to meet 7 common equity norm
  to be met in eight years
• Tier 1 capital ratio falls to 5.7 from 11.1
  under the new definition / adjustment of capital
  and increase in risk coverage (RWAs)
• Therefore, long phase-in arrangements (Annex1)

32
(No Transcript)
33
Conclusion

• Basel Committee is undertaking a fundamental
  review of the trading book whether a particular
  position to be covered in trading book or banking
  book and capital requirement
• Not only sluggish growth, high unemployment and
  low returns, but also more resolution will be the
  New Normal