Basel III

Nihar Raut
Amitkumar Mishra

Table of Contents
Capital regulations
CET1
Additional tier 1
Tier 2
Risk Coverage
CVA Adjustment Calculation
Wrong way risk

Capital conservational Buffer

Counter Cyclical Buffer
Liquidity Coverage Ratio
HQLA
Net Cash outflows

Monitoring tools
Contractual Maturity Mismatch
Concentration of Funding
Available Unencumbered Assets
LCR by significant currency
Market related Monitoring Tools
Net stable funding ratio
ASF
RSF

Capital Regulations
According to BIS
Total regulatory capital will consist of the sum
of the following elements:
1. Tier 1 Capital (going-concern capital)
a. Common Equity Tier 1
b. Additional Tier 1
2. Tier 2 Capital

Limitations on Capital
Common Equity Tier 1 must be at least 4.5%

of risk-weighted assets at all times.

Tier 1 Capital must be at least 6.0% of riskweighted assets at all times.
Total Capital (Tier 1 Capital plus Tier 2 Capital)
must be at least 8.0% of risk weighted assets
at all times.

CET1
Common Equity Tier 1 capital consists of the sum of the

following elements:
1.

2.
3.
4.
5.

Common shares issued by the bank that meet the criteria for
classification as common shares for regulatory purposes (or
the equivalent for non-joint stock companies);
Stock surplus (share premium) resulting from the issue of
instruments included Common Equity Tier 1;
Retained earnings
Accumulated other comprehensive income and other
disclosed reserves
Common shares issued by consolidated subsidiaries of the
bank and held by third parties (i.e. minority interest) that
meet the criteria for inclusion in Common Equity Tier 1
capital.

Additional Tier 1 capital

Additional Tier 1 capital consists of the sum of the

following elements:
Instruments issued by the bank that meet the

criteria for inclusion in Additional Tier 1 capital (and

are not included in Common Equity Tier 1);
Stock surplus (share premium) resulting from the
issue of instruments included in Additional Tier 1
capital;
Instruments issued by consolidated subsidiaries of
the bank and held by third parties that meet the
criteria for inclusion in Additional Tier 1 capital and
are not included in

Criteria for Addl. Tier 1

Issued and paid-in
Subordinated to depositors, general creditors and subordinated debt of the bank
Is neither secured nor covered by a guarantee of the issuer or related entity or

other arrangement that legally or economically enhances the seniority of the claim
vis--vis bank creditors
Is perpetual, i.e. there is no maturity date and there are no step-ups or other
incentive to redeem
May be callable at the initiative of the issuer only after a minimum of five years
Any repayment of principal (e.g. through repurchase or redemption) must be with
prior supervisory approval
The instrument cannot have a credit sensitive dividend feature, that is a
dividend/coupon that is reset periodically based in whole or in part on the banking
organisations credit standing.
The instrument cannot contribute to liabilities exceeding assets if such a balance
sheet test forms part of national insolvency law.
Instruments classified as liabilities for accounting purposes must have principal
loss Absorption

Tier 2 Capital
Tier 2 capital consists of the sum of the following

elements:
Instruments issued by the bank that meet the

criteria for inclusion in Tier 2 capital (and are not

included in Tier 1 capital);
Stock surplus (share premium) resulting from the
issue of instruments included in Tier 2 capital;
Instruments issued by consolidated subsidiaries of
the bank and held by third parties that meet the
criteria for inclusion in Tier 2 capital and are not
included in Tier 1 capital.
Certain loan loss provisions

Risk Coverage
This section addresses the changes in

computations for counter party credit risk

where there were some weaknesses.
Counterparty Credit Risk (CCR) relates to the
risk that an organization will not pay the due
amounts on a future date due to liquidity
issues or non-availability of funds or for any
other reason.

Procyclicality of EPE measurement

One of the items not addressed under Basel II was the

procyclicality of the EPE measure. In other words, the risk of

counterparty default increases when the market conditions
become worse. It has a direct linkage to market conditions. The
guideline therefore specifies that the EPE computation must
take the maximum of the following:
RWA from EPE calculated with current historical covariance.
RWA from EPE calculated with historical covariance aligned to
the stressed period used to calibrate Stressed Value at Risk
(VaR).
This will ensure that the RWA takes into account stressed
market conditions or current conditions, whichever is worse and
thus make it a conservative estimate.

Additional Credit Value Adjustment

(CVA) Charge
While MTM was a factor in computing the total exposure for

off-balance sheet future settlement instruments, the capital

was insufficient to cover the profit and loss impact because
of MTM variances.
This charge is not required for transactions involving a
central counterparty like an exchange and not required for
SFT transactions unless the supervisor determines that the
banks losses from SFT credit value adjustments are
material.
This additional CVA risk capital charge is the standalone
market risk charge calculated on the set of CVAs for all OTC
counterparties. The CVA charge computation varies on the
option chosen by the bank for computing counterparty risks


Where

is the time of the revaluation time bucket, starting from =0.

is the longest contractual maturity across the netting sets

with the counterparty.

is the credit spread of the counterparty at tenor ti, used to
calculate the CVA of the counterparty
is the loss given default of the counterparty and should be
based on the spread of a market instrument of the
counterparty
is the expected exposure to the counterparty at revaluation
time
Di is the default risk-free discount factor at time where D0 =
1

When a bank does not have the required approvals to calculate a CVA capital

charge

for its counterparties, the bank must calculate a portfolio capital

charge using the above formula where

h is the one-year risk horizon (in units of a year), h = 1.
is the weight applicable to counterparty i.
EAD is the exposure at default of counterparty i (summed across its netting
sets), including the effect of collateral as per IMM.
is the effective maturity of the transactions with counterparty i.
is the notional of purchased single name CDS hedges (summed if more than
one position) referencing counterparty i, and used to hedge CVA risk.
is the full notional of one or more index CDS of purchased protection, used
to hedge CVA risk.
is the weight applicable to index hedges
is the maturity of the hedge instrument with notional
is the maturity of the index hedge ind. In case of more than one index
hedge position, it is the notional weighted average maturity.

Wrong way risk

Wrong way risk occurs when exposure by a bank to counterparty is adversely

correlated with the credit quality of that counter-party. In other words,

exposure is high to a counterparty whose creditworthiness is decreasing
General Wrong Way Risks (GWWR) relate to risks in the macro economic
conditions and not specific to a counterparty. Like the current economic
scenario of high interest rates and higher probability of default is general in
the market. There are no specific capital charges for general wrong way risk.

Specific Wrong Way Risks (SWWR) arises on specific transaction

e.g. they arise through poorly structured transactions, for example those
collateralized by own or related party shares.
For transactions with specific wrong way risk, Basel guidelines recommend
the following treatment
Assign

maximum remaining loss to EAD for credit default swaps with SWWR.
Assign EAD for equity derivatives with SWWR commensurate with an assumption
that the counterparty is in default.
Apply 100% LGD.

Collateralized Counterparties and

margin period of risk
Requirement: Increase margin period of risk where:
There is a history of large, prolonged disputes with counterparty.
There is one or more complex or illiquid products in the portfolio.
There are more than 5,000 trades in the portfolio.
For portfolios with > 5,000 trades, the supervisory floor for the

period of risk is 20-days.

Where one or more complex/illiquid products exist in the
portfolio, a supervisory floor for the period or risk is 20-days.
Where firms have had more than two large margin call
disputes (to be calibrated) in the last two quarters that have
lasted more than the applicable base period of risk, then
banks must double the supervisory floor for that netting-set
for the next two quarters.

Capital Conservation
Buffer
Outside of periods of stress, banks should hold

buffers of capital above the regulatory minimum.

When buffers have been drawn down, one way
banks should look to rebuild them is through
reducing discretionary distributions of earnings.
This could include reducing dividend payments,
share-backs and staff bonus payments. Banks
may also choose to raise new capital from the
private sector as an alternative to conserving
internally generated capital.

Framework
A capital conservation buffer of 2.5%,

comprised of Common Equity Tier 1, is

established above the regulatory minimum
capital requirement.
The distribution constraints imposed on banks
when their capital levels fall into the range
increase as the banks capital levels approach
the minimum requirements

Counter Cyclical Buffer

The countercyclical buffer aims to ensure that

banking sector capital requirements take

account of the macro-financial environment in
which banks operate.
It will be deployed by national jurisdictions
when excess aggregate credit growth is
judged to be associated with a build-up of
system-wide risk to ensure the banking
system has a buffer of capital to protect it
against future potential losses.

Bank specific countercyclical

buffer
Banks will be subject to a countercyclical

buffer that varies between zero and 2.5% to

total risk weighted assets.
The buffer that will apply to each bank will
reflect the geographic composition of its
portfolio of credit exposures.
Banks must meet this buffer with Common
Equity Tier 1 or other fully loss absorbing
capital.

Liquidity Coverage
Ratio(LCR)
Objective: To ensure bank maintains HQLA

that can be converted in cash to meet its

funding need over next 30 days under highly
stressed scenarios.
LCR = Stock of HQLA/ Total net cash outflows
over next 30 calendar days .
In absence of financial stress ratio should be
>=100%
What are HQLA? What are net cash outflows?

Stock of HQLA
Assets are considered to be HQLA if they can be easily and

immediately converted into cash at little or no loss of value.

Characteristics of HQLA:
Low Risk: Low duration, legal , inflation, foreign exchange risk.
Ease and certainty on valuation (Formula, inputs, standardised)
Low correlation with risky assets
Listed on a developed and recognised exchange.
Active market size(active sale or repo, low spread, high trading

volume, robust market place, diverse market participants)

Low volatility.
Flight to quality (Market moves to these assets in stressed
conditions)

HQLAs are generally eligible at central banks intraday liquidity

needs.

Operational Requirement of HQLA

Bank should periodically monetize

representative proportion of HQLA to

demonstrate and test its characteristics.
Assets should be unencumbered.
Several other requirements w.r.t. control,
mobilizing the asset, rehypothecation.

Diversification of HQLA
Level 1: Unlimited share of the pool and are not subject to a haircut.
Coins and Bank notes, central bank reserves(which can be drawn down in times of
stress), marketable securities representing claims on or guaranteed by sovereigns,
central banks, BIS, IMF, ECB or multilateral dev bank.
Level 2 : Comprise no more than 40% of the overall stock after haircuts(15%)

have been applied.

Level 2A:
Marketable securities representing claims on or guaranteed by sovereigns(proven

record of haircut not exceeding 10%)

Corporate debt securities and Covered bonds(AA- or higher)
or higher)(proven record of haircut not more than 10% )

Level 2B
Residential mortgage backed securities(RMBS)(proven record of maximum haircut of
20%)(25% haircut applied)
Corporate debt(50% haircut)(Rating of A+ to BBB-)(Not issued by financial institution)
Equities (Not issued by financial institution, major stock exchange, proven record of
maximum decline not more than 40% and haircut not more than 40%)

Net cash outflows

Total Net cash outflows over the next 30 calendar days = Outflows Min

(Inflows; 75 percent of outflows) i.e. 25% of outflows must always be

covered by HQLA.
Inflows:
Inflows considered must be cash based and accruals and other non-cash based

income should be excluded.

Interest on placements
Dividends and interest on securities/bonds/equity
Fees from Fee based products
Any other inflows like rents and other income

Outflows:
Run down on liabilities(Stable deposit =3%, Less stable deposit =10%,

unsecured wholesale funding callable in 30 days varies from 5% to 100%)

Secured Funding (Level 1, 2A, 2B with run down rate varying from 0% to 100%)
Operational Expenses for the next 30 days
Additional interests on borrowings because of stressed conditions.

Application issues for

LCR
Frequency of calculation and reporting.
Atleast monthly and with operational potential to report
weekly or daily.
Scope of application
Should be applied across all international active banks and

its subsets and should be applied consistently.

There might be differences in home/host liquidity
requirment and treatment of liquidity transfer restrictions.

Currencies
Banks and supervisors cannot assume that currencies will

remain transferable and convertible in a stress period,

even for currencies that in normal times are freely
transferable and highly convertible.

Monitoring Tools
To measure the liquidity health of the banks.
They are as good as standards as regulators

will demand the data on periodic basis.

Contractual Maturity Mismatch
Concentration of Funding
Available Unencumbered Assets
LCR by significant currency
Market related Monitoring Tools

Contractual Maturity Mismatch:

Objective: Helps identify gaps in funds flow

based on mismatch of contract expiry dates

within a specified period(overnight
to 5 years).
Should include all on and off balance sheet items.
Non-Maturing A&L should
be reported separately.
Assumptions:
No rollover.
Seperately report the customer collateral
received. Reporting also in rehypothecation.

Concentration of funding
Objective: To identify those sources of wholesale funding

that are of such significance that withdrawal of this

funding could trigger liquidity problems.
Encourages diversification of funding sources.
3 metric computations:
A. Funding liabilities sourced from each significant

counterparty as a % of total liabilities Threshold 1%

B. Funding liabilities sourced from each significant
product/instrument as a % of total liabilities Threshold 1%
C. List of asset and liability amounts by significant currency
Threshold 5%

Available Unencumbered Assets

( An asset or property that is free and clear of any encumbrances such as creditor claims
or liens.)

Objective: Provide supervisors with data on the

quantity and key characteristics of unencumbered

assets which can be used as collateral to raise
additional HQLA or secured funding in secondary
market and available unencumbered assets that are
eligible for central banks standing facilities.
Bank should report amount, type and location of AUA.
In addition, it should report the estimated haircut that
secondary market or relevant central bank would
require on the asset.

LCR by significant currency

Objective: LCR by currency will give an indication of the
banks preparedness to meet obligations in each currency.
Foreign Currency LCR = Stock of High Quality Liquid Assets
in each significant currency / Total net cash outflows over a
30 day time period in each significant currency.
Outflows must be net of any foreign exchange hedges.
A currency is significant if aggregate liabilities in that
currency > 5%.
No global defined minimum required threshold.
The ratio should be high for currency in which bank raises
most of its funds in foreign currency market.

Market Related Monitoring Tools

Objective: High frequency market data with little or no
time lag can be used as early warning indicators in
monitoring potential liquidity difficulties at banks.
Market wide information : Information related to but not
limited to equity prices(Overall market, sub-indices) in
related exchanges, debt market(monet market, medium
term notes, Long term debt, govt bond markets, Credit
default spread indices etc) Foreign exchange markets,
commodities markets and indices related to specific
products.
Information on financial sector
Bank specific information

Net Stable Funding Ratio

The NSFR is defined as the amount of available stable

funding relative to the amount of required stable

funding.
NSFR => Available amount of stable funding/Required
amount of stable funding.
Should be >= 100% on ongoing basis.
It complements the LCR and ensures that banks
balance their liquidity profiles over short term without
ignoring medium to long term requirements
Should be reported atleast quaterly.
What classifies as Available stable funding and Required
stable funding?

Available Stable
Funding(ASF)

ASF =

ASF Factor x Components of ASF

categories

Required Stable Funding(RSF)

RSF =

RSF Factor x Components of RSF

categories

Application issues of NSFR:

Frequency of calculation and reporting Should be reported
quaterly with minimal time lags.
Scope of application To all internationally active bank and also on
their subsets to ensure greater consistency and level playing field
between domestic and cross border bank.

Implementation timeline

References
Basel III : A global regulatory framework for more resilient banks and banking systems
Bank for International Settlement
Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools
- Bank for
International Settlement(BIS).
Basel III: The net stable funding ratio : Bank for International Settlement(BIS).
White paper on Basel III : An easy to understand summary iCreate Software