Basel III

1. Introduction Post-crisis, the Basel Committee on Banking Supervision (BCBS) has taken a number of initiatives with the objectives to (i) improve banking sectors ability to absorb shocks and (ii) reduce risk spillover to the real economy. The fundamental reforms proposed were in the areas of (i) micro-prudential regulation at individual bank level and (ii) macro-prudential regulation on system-wide basis. These reform measures are popularly referred to as Basel III, in line with earlier reform measures called Basel I and Basel II. 2. July 2009 enhancements / revisions The initial effect of the crisis was, inter alia, traced to inadequate capital for the securitization portfolio in trading books of banks and inappropriate risk management on a firm wide basis and inadequacies in sound liquidity management. Therefore, as an immediate response to the crisis, the Basel Committee, in July 2009, issued three documents, viz., (i) Enhancement to Basel II Framework; (ii) Revisions to the Basel II Market Risk framework; and (iii) Guidelines for Computing Capital Charge for Incremental Risk in Trading Book, intended to strengthen the Basel II Framework and respond to lessons learnt from the crisis. These enhancements / revisions are mostly in the area of capital for market risk in the securitization portfolio in trading books of banks. The market risk capital under the VaR-based internal models approach with 10day liquidity horizon was reinforced with a stressed-VaR capital, with a view to take care of illiquidity of positions which had no market. Further firm-wide liquidity risk management practices were strengthened. These enhancements / revisions to Basel II are required to be implemented by banks from December 2011. Banks in India have adopted the simpler standardized/basic approaches under Basel II. Therefore, wherever those enhancements and revisions were applicable to standardized/basic approaches, appropriate guidelines were issued to banks in February 2010. 3. December 2009 consultative documents and modifications in July and September 2010 Press releases On December 17, 2009, the Basel Committee issued two consultative documents, viz., (i) Strengthening the resilience of the banking sector (mostly by strengthening bank capital) and (ii) International framework for liquidity risk measurement, standards and monitoring for comments by April 16, 2010. The Basel Committee also conducted a Comprehensive Quantitative Impact Study (CQIS) on these reform measures. Taking into account the comments received; the results of the CQIS; assessments of the economic impact over the transition and the long run economic benefits and costs, the Basel Committee issued Press releases on July 26, and September 12, 2010 indicating the shape of the regulatory measures. The Press releases covered certain modifications to the baseline proposals made in December 17, 2009 documents. 4. Improving the quality, consistency, risk coverage and transparency of capital 4.1. Quality of capital The proposals require that the features for instruments to be included in Tier 1 capital outside the common equity element will be strengthened. Tier 1 capital should fulfill the criteria that bank will

remain as a going concern. Tier 2 capitals will be simplified and there will be only one set of entry criteria, removing sub-categories of Tier 2 capital. Tier 2 capitals will be required to absorb losses like in gone concern. Tier 3 capital will be abolished. 4.2. Consistency of capital The regulatory deductions / adjustments to capital varied across jurisdictions. Some jurisdictions made adjustments / deductions to common equity, while some others to either Tier 1 capital or 50% to Tier 1 capital and 50% to Tier 2 capital. With a view to improving the quality of common equity and also consistency of regulatory adjustments / deductions, it has been proposed that most of the deductions will be from common equity. The important proposals in this regard are: (i) share premium of preference shares will not be admissible as common equity; (ii) deduction from capital in respect of shortfall in provisions to expected losses under IRB approach should be made from common equity component of Tier 1 capital; (iii) cumulative gains or losses due to change in own credit risk on fair valued financial liabilities should be filtered out from common equity; (iv) shortfall in defined benefit pension fund should be deducted from common equity, (v) certain regulatory adjustments which required to be deducted 50% from Tier 1 and 50% from Tier 2 capital, will receive 1250% risk weight, etc. However, some recognition has been granted in regard to minority interest in subsidiaries, investments in capital of certain banking, financial and insurance entities which are outside the regulatory scope of consolidation, goodwill and other intangibles, and deferred tax assets. The deductions from common equity Tier 1 capital will commence from January 1, 2014, with 20% requirement over a five year period ending December 2018. 4.3. Improving the risk coverage of capital At present, the counterparty credit risk in the trading book covers only the default of the counterparty. The reform package proposes a Credit Value Adjustment (CVA) which captures deterioration in the credit worthiness of a counterparty due to down-gradation, in addition to default risk. The Basel Committee also proposes to better capture the risk of interconnectedness among larger financial firms (defined as assets of $ 100 billion) by prescribing an asset value correlation adjustment at 25% and increasing the incentive for using CCPs for OTC derivatives (but prescribing a small risk weight for CCPs, in 1-3% range, so that banks remain cognizant that CCP exposures are not risk free). 4.4. Transparency of capital base The transparency of capital base will be improved, with all elements of capital required to be disclosed along with a detailed reconciliation to the reported accounts. 4.5. Total capital requirement The total capital requirement of 8% to risk-weighted assets will remain unchanged. However, the system of limits applied to elements of capital has been revised to ensure that common equity forms a greater proportion of Tier 1 capital than is permitted at present. The current limitation on Tier 2 capital that it cannot exceed Tier 1 capital has been removed and replaced with explicit minimum core common equity requirement of 4.5% (after the application of stricter regulatory adjustments). This will be phased in by January 1, 2015. The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6% over the same period. Thus, the Tier 2 capital elements will be capped at a maximum of 2%. 4.6. Phase in period
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The minimum common equity and Tier 1 and total capital requirements will be phased in between January 1, 2013 and January 1, 2015, as furnished below: January 1, 2013 Minimum common 3.5% equity ratio Minimum Tier 1 4.5% capital Minimum total capital 8.0% January 1, 2014 4% 5.5% 8.0% January 1, 2015 4.5% 6% 8.0%

4.7 Capital conservation buffer Apart from the above, banks will be required to hold a capital conservation buffer of 2.5% in the form of common equity to withstand future periods of stress bringing the total common equity requirement of 7%. The capital conservation buffer in the form of common equity will be phased in over a period of four years in a uniform manner of 0.625% per year, commencing from January 1, 2016. 4.8 Countercyclical capital buffer Further, a countercyclical capital buffer within a range of 0 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of countercyclical capital buffer is to achieve the broader macro-prudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system-wide build up of risk. The countercyclical capital buffer, when in effect, would be introduced as an extension of the conservation buffer range. 5. Leverage ratio 5.1 Definition The capital requirements will be supplemented by a non-risk based leverage ratio which is proposed to be calibrated with a Tier 1 leverage ratio of 3% (the Basel Committee will further explore to track a leverage ratio using total capital and tangible common equity). The ratio will be captured with all assets and off balance sheet (OBS) items at their credit conversion factors [with 10% CCF for unconditionally cancellable OBS commitments (subject to further review)] and derivatives with Basel II netting and a simple measure of potential future exposure ensuring that all derivatives are converted in a consistent manner to a loan equivalent amount. The ratio will be calculated as an average over the quarter. 5.2 Tracking and date of implementation The leverage ratio will be tracked by supervisors commencing from January 1, 2011 to track underlying components of the agreed definition and the resulting ratio. There will be a parallel run commencing from January 1, 2013 till January 1, 2017, when leverage ratio and its components will be tracked. Banks will be required to disclose the ratio from January 1, 2015. Based on the results of the parallel run, final adjustments will be carried out in first half of 2017 with a view to migrating to Pillar 1 treatment from January 1, 2018, based on appropriate review and calibration. 6. Mitigating cyclicality
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The December 2009 proposal included possible approaches including using downturn PDs in IRB approach during benign credit conditions. 7. Forward looking provisioning The Basel Committee is in close dialogue with the IASB in developing a forward looking expected loss based provisioning system in place of the present incurred loss based provisioning. 8. Systemic banks, contingent capital and capital surcharge With a view to mitigating systemic risk, the Basel Committee, in addition to the countercyclical capital buffer mentioned in para 4.8, the Basel Committee is working on a proposal for capital surcharge for systemically important financial institutions (SIFIs) or banks (SIBs). For this purpose, the Basel Committee has proposed a capital instrument whose contractual terms will allow them at the option of the regulatory authority to be written off or converted into common equity in the event that a bank is unable to support itself in the private market in the absence of such conversions. The Committee has issued a consultation paper for such gone concern capital. The Committee will also further review use of contingent capital as going concern capital in December 2010. The Committee is reviewing development of the guided discretion approach for capital and liquidity surcharge for systemically important financial institutions and contingent capital could play an important role in meeting any systemic surcharge requirements. 9. Global liquidity standards In December 2009, the Basel Committee had proposed a short term (30 days of stress period) liquidity coverage ratio and a structural long term net stable funding ratio. 9.1 Liquidity coverage ratio (LCR) 9.1.1 Definition of liquid assets The LCR is the ratio between the stocks of high quality liquid assets to net cash outflows over a short term horizon of 30 days under acute stress scenario, and should be at least 100%. The Committee proposes to finalize the operational requirements for treating assets as liquid by end of this year. The proposal outlines that the assets must be available for the treasurer of the bank, unencumbered, and freely available to group entities. The Committee also proposes to allow non-0% risk weighted foreign currency sovereign debt as liquid asset, to the extent that this currency matches the needs of the banks operation in that jurisdiction. The Committee also proposes to introduce a Level 2 liquid asset with a cap of 40% of the stock of liquid assets. 9.1.2 Phase in period After an observation period beginning January 1, 2011, the LCR will be introduced on January 1, 2015. 9.2 Net stable funding ratio (NSFR) The NFSR is the ratio between available amounts of stable funding, like capital and other long term liabilities over one year, and required amount of stable funding, weighted by a factor, and should be at least 100%. The Committee is seized of developing longer term structural complement of LCR and proposes to modify and further calibration of the December 2009 proposal, depending upon the business models of banks, i.e., retail versus wholesale. The
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introduction of the revised NSFR as a minimum standard will be by January 1, 2018. The Committee will issue a set of proposals by the end of this year and carry out an observation phase till the introduction of the standard in 2018. 10. Impact on the economy While the additional capital and liquidity requirements will involve large and permanent benefits by raising the stability of the system and promoting more sustainable growth, there inevitably would be a trade off by way of lower growth which has implications for employment. A study by the Institute of International Finance (IIF), the association of banks, estimates that there will be a loss of 3 per cent in the combined GDP of the G3 i.e. US, Euro zone and Japan during the period 2011-15 on full implementation of the Basel proposals. However, the Basel Committees studies reveals that the transition to stronger capital and liquidity standards is likely to have a modest impact on aggregate output. If higher requirements are phased in over a period of four years, each one percentage point increase in banks capital ratio of tangible common equity to RWA will lead to a decline in the level of GDP relative to its baseline path by about 0.20% after implementation is completed, i.e., the impact on GDP will be 0.04% per annum over a four and half year period. Similarly, a 25% increase in liquid asset holding is found to have an output effect less than half that associated with a one-percentage point increase in capital ratios. The study reveals that there is clear long term economic benefit from increasing capital and liquidity requirements from their current levels in order to raise the safety and soundness of the global banking system. Therefore, with a view to reducing the immediate impact on aggregate output, the Basel Committee has phased in the regulatory measures over a long time horizon so that the fragile recovery process is not affected on account of enhanced regulatory standards. A comprehensive chart of phase in time is given in the Annex. 11. Assessment It has been commented that the Basel Committee has given long latitude to banks to comply with the capital and liquidity standards, by diluting some of the baseline proposal of December 2009 and extended phase in, going up to 2019. However, it should be seen in perspective that given the present health of banks balance sheets and the fragile economic recovery, it would not have been possible for banks to achieve more stringent standards with a short time, without impeding economic growth. It is therefore better to be right than to be in a hurry. Secondly, it is expected that banks while complying with the new standards will incur additional cost in raising capital with the risk absorption features and maintaining high quality liquid assets (which would be low yielding) and reducing reliance on wholesale funding. Banks may pass on the additional cost to their customers, particularly to SME customers, thereby making the cost of borrowing high for them. Thirdly, by focusing on increased standards for the banks, there will be regulatory arbitrage by moving business to non-banks. The reform in regulation in other segments of financial sector is therefore important and should be pursued with vigour. Fourth, the priorities for the emerging economies may be different from the advanced economies. It is the advanced economies which created the crisis because of their lax regulation and supervision. Tightening regulation and supervision by them is justifiable. The emerging economies would like to improve financial inclusion and penetration in their jurisdictions and the additional burden of the new regulatory standards may divert their focus and impede their efforts in this regard.
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Finally, the Basel Committee has addressed the issue of macro-prudential regulation and systemic risk management in a limited way. Each jurisdiction will have to create structures and institutional arrangements for system-wide approach to risk management for maintaining financial stability.