Basel III and its implications for banks

Prof. Babu V Kristu Jayanti College

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

Introduction
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)

 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

 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

 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

 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

 There was heavy reliance on short term wholesale funding

Unsustainable maturity mismatch

Insufficient liquidity assets to raise finance during stressed period

Enhancement to Basel II
Post- crisis, global initiatives to strengthen the financial regulatory system

July 2009 Enhancement to Basel II mostly in trading book

 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)

 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

 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

 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

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

 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

 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

Building Blocks of Basel III

1. 2. 3. 4. 5. 6. Raising quality (Tier 1 6%, of which TCE - 4.5%), level (8+2.5% 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 (02.5%) Minimum liquidity standards We will discuss 2, 3, 4 and 6

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

 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

 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

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

 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

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

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

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

 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 > 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%

 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

 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 > 100%

 Other monitoring tools for liquidity risk management

Contractual maturity mismatch
Concentration of funding Available unencumbered assets LCR by significant currency Market-related monitoring tools

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

 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)

Impact on Indian banks

High capital ratios at 14.4% in June 2010 which will fall to 11.7%. Tier 1 will fall from 10% to 9% and common equity from 8.5% to 7.4% Most of deductions are already mandated by RBI, so little impact Most of our banks are not trading banks, so not much increase in enhanced risk coverage for counterparty credit risk

 Banks mostly follow a retail business model and do not depend on wholesale funds

Whether our SLR securities can be part of liquid assets?

Whether our liquid assets will stand the scrutiny of fundamental characteristics and market-related characteristics?

 Indian banks are generally not as highly leveraged as their global counterparts

The leverage ratio of Indian banks would be comfortable

 Banks having a huge trading book and off balance sheet derivative exposures may be impacted due to increased risk coverage (capital) on account of counterparty credit risk

 Similarly, banks having huge off balance sheet exposures - derivatives and others - may be impacted on account of leverage ratio Banks depending heavily on wholesale funds may be impacted due to the new liquidity standards SIBs may have further implications for capital and liquidity surcharges and activity restrictions

 Whether our banks can attract capital in the form of contingent capital and bail-in able debt at the point of non-viability or whether our capital market will support such instruments?

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

 Thank You