WMTT Data Management Briefing Document

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DEMYSTIFYING THE REGULATORY LANDSCAPE BASEL III
/ ACCOUNTINGJohann Kruger CA (SA), CFAIFRS
and Financial Risk Management Consultant Lloyds
Bank Corporate Markets11th November 2011
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The Changing Regulatory Environment
Basel 2.5 (2011) and Basel III (2013)
OTC derivatives, EMIR (2012/13)
Volcker Rule Swaps push-out
Securitisation controls skin in the game
MiFID II, Retail Distribution Review
Solvency II
Source Oliver Wyman
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BASEL III BANK CAPITAL
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Basel Committee Background

• Basel Committee for Banking Supervision
• Functions
• Basel Committee provides a forum for regular
  cooperation on banking supervisory matters.
• Over recent years, it has developed increasingly
  into a standard-setting body on all aspects of
  banking supervision.
• Membership
• Senior officials responsible for banking
  supervision or financial stability issues in
• Central banks, and Authorities with formal
  responsibility for the prudential supervision of
  banking business where this is not the central
  bank (e.g. FSA in the UK).
• Chairman
• Stefan Ingves, President of the Netherlands
  Sveriges Riksbank.
• Secretariat
• Secretary General Stefan Walter, supported by a
  staff of 14.

Source Bank for International Settlements web
site http//www.bis.org/about/factbcbs.htm
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Basel III Committee Member Countries

• Argentina
• Australia
• Belgium
• Brazil
• Canada
• China
• France
• Germany
• Hong Kong SAR
• India
• Indonesia
• Italy
• Japan
• United States

• Korea
• Luxembourg
• Mexico
• Netherlands
• Russia
• Saudi Arabia
• Singapore
• South Africa
• Spain
• Sweden
• Switzerland
• Turkey
• United Kingdom

Source Bank for International Settlements web
site http//www.bis.org/about/factbcbs.htm
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Basel III Sub-Committees

• Standards Implementation Group
• Policy Development Group
• Accounting Task Force
• Basel Consultative Group

Source Bank for International Settlements web
site http//www.bis.org/about/factbcbs.htm
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Basel III Brief Summary

• Capital requirements
• Quality of capital
• definition 14 criteria mainly focusing on
  loss-absorbency
• proportion of common equity from 3.5 to 4.5
  by 2015
• Increase in of capital more for SIFIs
• RWA measurement

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Basel III Brief Summary

• Liquidity and leverage
• Liquidity coverage ratio (Minimum std by 2015)
• Net Stable Funding ratio (Minimum std by 2018)
• So what?
• Net effect higher cost of doing business not
  necessarily offset by lower cost of capital
• Impact of Solvency II on insurers higher capital
  charge for holding equities and bank paper
• Impact of pension fund de-risking lower demand
  for bank equities higher demand for debt
  securities

Basel III are only guidelines, local regulators
may enforce higher requirements However, draft EU
legislation limits potential for higher
requirements than Basel III
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Phased Implementation Market Response

• Phased regulatory transition is likely to be
  overtaken by market considerations
• Analysts and the market already differentiate the
  sector on a pro forma Basel III basis
• This will drive early implementation of measures
  to respond to new requirements

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EBA Announcement 26 October 2011

• Term funding guarantee scheme
• Banks access to term funding (ECB focuses on
  short term funding)
• EU Commission, ECB, EIB to urgently explore
  options for achieving this objective
• New capital requirements
• 9 CET minimum
• After deducting MTM on sovereign debt as at 30
  September2011
• Note the French 10yr yield was 2.6 on 30
  September, but is now above 3
• Banks to submit plans by 2011
• Banks to meet requirement by 30 June 2012
• EBA estimates circa 106bn required
• Issues
• Lack of investor appetite for bank shares
• Significant shrinkage of bank balance sheets,
  possibly contributing to recession

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Basel III What Impact For Derivatives Pricing?

• Key variables impacting the extent of the
  increase in RWA requirement in relation to
  unexpected losses
• Counterparty credit quality
• Maturity
• Expected exposure (market movements and funding
  position)
• Type of instrument (Rates / FX / Commodities)

Based on latest Basel Proposals (latest
publication in June 2011) and, subject to change
as the regulations are finalised for the EU and
the Netherlands, and depending on expected
exposure assumptions
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Basel III What Impact For Derivatives Pricing?

• Overall increase in charges at typically 2 x,
  but could be several times for long dated credit
  intensive trades
• AA to A counterparties
• typically single digit basis points on regular
  vanilla interest rate instruments and
• double digit increases in costs for XCCY swaps
  and commodity hedges
• BB to BBB counterparties
• low double digit basis points on vanilla
  interest rate instruments and
• possibly large double digit increases in costs
  for XCCY swaps and commodity hedges
• General Increase in Capital Requirements Phased
  in From 2013
• Increase in RWA for OTC Derivatives Big Bang
  Effect on 1 Jan 2013 inc Existing Pfolio

Based on latest Basel Proposals (latest
publication in June 2011) and, subject to change
as the regulations are finalised for the EU and
the Netherlands, and depending on expected
exposure assumptions
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Basel III What Impact For Derivatives Pricing?

• Our calculations show the following effect on
  some standard transactions in terms of multiples
  applied to credit spreads

A A BBB BBB BB BB
Aggressive Conservative Aggressive Conservative Aggressive Conservative
Receive fixed GBP, pay floating GBP 5yr 1.6x 2.3x 1.4x 1.7x 1.4x 2.3x
Receive fixed GBP, pay floating GBP 10yr Receive Fixed GBP, pay Fixed USD 5yr XCCY 2.4x 1.8x 3.0x 2.3x 1.8x 1.4x 2.1x 1.7x 2.0x 1.5x 2.5x 1.8x
Receive Fixed GBP, pay Fixed USD 10yr XCCY 2.5x 2.8x 1.9x 2.1x 2.1x 2.3x
Receive Fixed GBP, pay Floating USD 10yr XCCY 2.4x 2.8x 1.8x 2.0x 2.0x 2.3x
FX Fwd 1yr 100m Buy USD, sell GBP 1.8x 1.8x 1.3x 1.3x 1.3x 1.3x
For example, we recently looked at a 20-year
cross currency swap for a good credit (single A)
and the running cost was calculated as 50 basis
points.
Based on latest Basel Proposals (latest
publication in June 2011) and, subject to change
as the regulations are finalised for the UK, and
depending on expected exposure assumptions
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What then shall we do? (1)

• Unintended consequences
• Costs for corporate hedgers could be prohibitive
  especially accessing foreign capital markets
• Posting collateral and exposure to unacceptable
  levels of cash flow risk putting the real
  economy at risk
• Discouraging hedging by corporates, who represent
  less than 15 of the market volume
• What then shall we do?
• Cease to hedge
• Greater use of natural hedges
• Greater use of purchased options
• Credit breaks
• Deal with ignorant banks/Do as much as possible
  hedging while the market is behind the curve
• If all else fails, collateralise or clear
  centrally (if possible)
• Lobby the Basel Committee in relation to OCT
  derivatives used to manage corporate risk

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What then shall we do? (2)

• More Efficient Use of Capital by Banks
• RWA reporting
• Collateral management
• Counterparty risk exposure management
• Product mix/innovation
• Caps/ Swaptions /LLS
• Margin funding
• Collateral transformation
• Synthetic margin swaps
• Borrow from the capital markets (insurance
  companies pension funds)
• Securitisations ratings for derivatives
  (especially useful if super-senior)

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Basel III Recent Developments

• Basel guidance incorporated into proposed
  regulation and directive (CRD IV)
• Main capital requirements, including CVA RWA on
  OTC derivatives included as regulation
  therefore NO flexibility at national level
• Any lobbying by corporates must now be directed
  towards the European process and timing is
  critical CVA RWA is of particular concern
• Countercyclical buffer requirement included as
  directive
• Increasing media attention to conflicting
  requirements of Solvency II and Basel III , i.e.
• requirement for more capital and longer dated
  funding for banks vs
• higher capital charges for such instruments on
  insurance company balance sheets
• Australia to adopt 2 years early
• China to require higher than Basel III minimum
  for its banks

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ACCOUNTING
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IFRS for SMEs

• 74 jurisdictions have either adopted the IFRS or
  stated a plan to adopt within three years
• In Europe, reception has been cool
• Adopted Bosnia Macedonia
• Available for use Switzerland
• Planned UK, Ireland
• Others are studying it
• Netherlands no plans to adopt

Excluding charities and small companies as
defined in company law, current proposed
requirement is for years beginning on/after 1
July 2013.
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IFRS 9 Finally a principles based standard

• IFRS 9 Overhaul of Financial Instruments
  Accounting (including derivatives)
• IAS 39 replacement why?
• Three phases
• Classification
• General hedge accounting model portfolio
  hedging of interest rate risk
• Impairment
• Convergence

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IFRS 9 Finally a principles based standard

• The good news
• 80125 corridor disappears
• Retrospective test disappears continue to
  recognise all ineffectiveness
• Hedge accounting for option time value
• Rebalancing allowed
• Component hedging for non-financial items
• Derivative on derivative rule (NIH interest rate
  hedging)
• Alignment with true risk management process

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IFRS 9 Finally a principles based standard

• The bad news
• Voluntary de-designation possibly prohibited
• Delays
• EU endorsement process

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Option time value behaviour PL behaviour

• Example USD Revenue buy GBP call vs. cylinder
  (add sold GBP put)
• Which causes most volatility?

Time value behaviour at inception in relation to
spot movement (assume static vega and theta) If
vega increases expansion of peak/trough As time
passes (for constant vega) contraction of
peak/trough
Gain
A
Put strike (sold)
0
Call strike (bought)
X-axis GBPUSD FX rate
B
Potential volatility of the call A Potential
volatility of the cylinder AB
Loss
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Accounting Current Issues

• IFRS 13 Fair Value Measurement
• Single standard
• Similar to FAS 157 (and text currently in IAS 39
  AG)
• Credit valuation adjustments for corporates
• IFRS 10, 11, 12 Consolidation, joint
  arrangements, disclosures of interests in other
  entities
• IAS 19 Post employment benefits

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Accounting Current Issues

• Exposure draft Capitalisation of operating
  leases
• Increase in net debt
• Earlier recognition of expenses
• Impact on service contract
• Increased disclosures
• Onerous systems requirements
• Exposure draft Accounting for insurance
  activities
• IFRS and US GAAP conversion

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Strategic Financial Reporting Issues
The analysis of financial reporting policies
among FTSE 100 companies shows that they use
non-IFRS profit numbers extensively to
communicate performance to shareholders
FTSE 100 Financial Reporting Policies ( of total
companies surveyed)
Financial reporting policy Financial reporting policy
that use non-IFRS profit measures to communicate performance to shareholders that use non-IFRS profit measures to communicate performance to shareholders
that adjust for non-cash volatility from IAS 39 that adjust for non-cash volatility from IAS 39
that present the information on the face of the Income Statement that present the information on the face of the Income Statement
Results by accounting firm
BDO Stoy Hayward (1)
Deloitte (19)
Ernst Young (12)
KPMG (17)
PwC (31)
1
79
53
40
2
0
44
83
33
58
46
77
57
84
Data gathered from a sampling of 80 FTSE 100
non-financial corporates Data as of December
2010 based on latest published annual reports
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