Basel III: An Evaluation of New

Banking Regulations
Submitted by:
Amar Sneh 245
Kavya Rangineni 265
Seerat Gupta 284
Arjit Gupta 307
Divyanshu Jain 312
Rachit Mundhra - 327
 The Global Financial Crisis
Less reliance on external ratings
Capital Conservation / Higher quantity & quality of capital
agencies
Leverage Ratio introduced
Counter-cyclical buffers CVA Capital Charge
100% weight for trade finance
Stressed Testing

Excessive Risk Taking

Housing prices Sub-prime defaults, Excessively levered &
Incentives:
decline resulting in Securitized assets & poorly capitalized
Securitization sub-prime defaults
Sub-Prime derivatives trading banks could not
Sub prime lending Lending
resulted in huge absorb losses
losses
Securitization

In stressed market situations, Credit Rating

Correlation to financial institutions
downgrades of Financial
will carry more risk weights to
prevent systemic risks and an Institutions & securitized products
further lowered valuations & increased losses
overall collapse

Governments step in to Short term borrowing & Huge losses resulted in a

Firms on the verge of confidence crisis causing
inject capital to refinancing failure led to
insolvency; liquidity dry-up
prevent systemic liquidity crisis
Threats of system
failure
failure

Enhanced Supervisory Liquidity Coverage Ratios (LCR)

Review and Disclosure Net Stable Funding Ratio (NSFR)
 International Banking Regulations
Increased global interconnection means that a banks failure in one country can negatively
influence other national economies
Competitive differences and poor regulatory practices among national banking systems can lead
to governments and taxpayers of other countries to suffer

Need for an internationally consistent regulatory framework for the worlds banking system
Challenges in designing international banking regulations

International regulation has become increasingly complex and restrictive due to negative shocks
repeatedly uncovering new problems in the banking industry
Increased regulation usually reduces the risk profile of the banks but predicting the effects of the
new regulation is difficult
A highly restrictive framework reduces the willingness banks to adopt policies for fear of lost
performance
Decrease in banks lending may be more detrimental to the economy than any bank failures
avoided in the future
Systematic risk may move to the financial systems that reject a more restrictive proposal
 Basel Committee
Formed with the goal of minimising differences in bank regulation internationally
Established by the Central Bank governors of a group of 10 countries in 1974
The committees conclusions do not have a legal force and the national regulators must choose
to implement the committees recommendations independently

1988 First basel capital accord published known as Basel 1

2004 New capital framework replaced Basel 1 and was known as Basel 2
2009 In response to the financial crisis, 2 new documents were submitted together named as
Basel 3
 Basel 1

First major publication on Capital Adequacy: International Convergence of Capital Measurement

and Capital Standards
Set up an international 'minimum' amount of capital that banks should hold. Minimum Capital
Ratio of 8%
The set of agreement- mainly focuses on
risks to banks
the financial system
To ensure that financial institutions
have enough capital on account to meet obligations
absorb unexpected losses.

Focused on credit risk and appropriate weights to different kinds of loans and assets
 Basel II features
Seeks to improve risk calculation in capital measurement
Introduced three pillars:
Introduced system based on external credit ratings

Pillar I Banks could measure credit risk with supervisory approval

Outlined internal rating framework
Promoted use of Value at Risk (VaR)

Pillar II Recommends supervisors evaluate a banks capital level with risk profile
Ensures early regulator intervention

Pillar III Encourages greater transparency of banks holdings

 Basel II limitations

Banks have greater Increased

systematic risk
difficulty in selling risky
assets in time of crisis

Imposed standardized,
Uniformity in risk risk based capital
aversion
requirement limits

Rating agencies are

Relied heavily on
unregulated; ratings credit rating
vary among agencies agencies

Dependence on
Encouraged pro- internal and external
cyclical behavior
risk modeling
 Capital requirement: Basel III
Countercyclical buffer
Capital conservation buffer
Tier II
Additional tier I
Common Equity Tier I
Classification of
Capital: Basel III
0-2.5%
Total Regulatory Capital
2.5%
2%
Tier I Capital Tier II Capital
1.5%
8% Total Capital
Paid up Capital + Retained Undisclosed reserve
6% Tier I capital Earnings = Core Capital Revaluation reserve
4.5% General Reserves Loan loss provisions
Hybrid capital Instruments
Dated Sub-debts
 BASEL III
Improving the capital base
Recommendation to raise the quality, consistency and transparency of banks capital base while reducing
required capital ratio to 7%
To declare common equity and retained earnings as the predominant form of Tier 1 capital

Strengths-
Defined level of common equity will be maintained
Improvement in banks ability to absorb losses during crisis
Encourage investors and other banks to trust a banks reported capital ratio
Weaknesses-
Limited demand for banks common equity from investors
Issuance of common stock at favorable terms will lead to higher cost of capital
To maintain minimum high-quality capital to total RWA ratio banks will be forced to reduce total assets
 Leverage Ratio
Inclusion of leverage ratio to supplement the risk-based capital requirements of Basel II
Leverage Ratio = high-quality capital / on- and off-balance sheet assets
Goals of Leverage ratio are:
To limit banks leverage
To discourage rapid deleveraging that may destabilizes the overall economy
To calculate exposure, high-quality assets, total repurchase agreements and securitizations should be
included and netting should be disallowed
A minimum 3% of Tier 1 leverage ratio is proposed
Strengths-
It increases transparency by supplementing risk-based model with a broader model
Identify banks that are operating radically different from their peers
Monitors the off-balance sheet leverage
Weaknesses-
Focus can shift to higher-risk assets as all assets will be equally weighed
Allowing ratio to be broad can lead to overstating the potential risk can make identification of outliers
difficult
 Countercyclical Capital Buffer
Maintenance of a capital buffer above the
regulatory capital requirement
Created in the time of stable economy to
absorb losses in the time of crisis
Acts as a check on excessive leverage and
unwarranted lending during expansionary
phase
Regulators restricts capital eroding actions of
banks when the buffer is wiped out
Only problem it further reduces the capital
base
Alternative Proposals
IMF proposed flat tax on all banks, insurance
companies and hedge funds
Another proposal was tax on profit
The funds will either be pooled into a
centralized capital buffer or become part of
government revenue as a pledge to support in
future distress
Rejected because of Moral Hazard problem,
hence Countercyclical Buffer
 Counterparty Credit Risk
CCR: risk that the opposite party will not honor the contract
Basel II estimate based on historical data
Basel III estimate based on worst case scenario
A multiplier of 1.25 is to be applied when calculating the correlation between asset
value and economy
Zero risk assigned to contracts settled through clearinghouse or exchanges to
incentivize banks to shift OTC derivatives to ETP
Intermediaries like exchange will increase cost of transaction and end user will suffer
 Liquidity ratios
Aims to improve banks resilience to liquidity problems in the market
Two liquidity ratios intended to monitor both short-term and long-term scenarios

Liquidity Coverage Ratio (LCR)

Short term Metric
Ratio of high quality assets to net
cash outflows over 30-day period
Should be equal to or greater than 1
and quality assets must be highly
liquid
Defines banks ability to remain
solvent for a month under stress
scenario
Net Stable Funding Ratio
Medium and Long-term Metric
Ratio of Available stable funding to the
amount of stable funding required to
cover all illiquid assets and securities held
Should remain above 1
Stable funding includes equity and
liabilities financing
Liquidity Ratios Strengths and weaknesses
Strengths
LCR ensures maintenance of high quality
assets by banks
30-day period is enough to resolve
liquidity crisis
LCR excludes both bank debt and
insurance firm debt from high quality
assets to counteract interconnectedness
of financial system
Sets an international minimum standard
and requires more detailed analysis of
each bank to improve the quality of
leverage
Weaknesses
Increase the cost and decrease the
availability of credit
Available funding may not be sufficient
to meet required NSFR
Rush to obtain stable funding can lead to
mispricing
Reduce liquidity as bank debt is not high
quality asset
May create liquid asset shortage and
large concentration of risk
Could affect the interbank lending
market
 BASEL III - Exceptions
Country Exclusion
Recommendations are not legal binding
Countries choice whether to reject the proposal or indefinitely delay the
implementation
Faced criticism of including the norms according to banking practices of USA & Europe
and not of emerging economies
Shift of systematic risk from Western banking system to developing countries
Non-Banking Financial Institutions
May shift the risk directly or indirectly to non-bank institutions
May shift business to non-regulated institutions because of high operating costs for
banks
Greater concentration of financial services in hands of unregulated institutions may
increase systematic risk
 National Regulations
USA Dodd Frank Wall Street Reform and Consumer Protection Act , Signed on July 21, 2010

Seeks to: Consumer Protection Act -

End taxpayer bailouts
Monitor compensation practices
Limit proprietary trading
Regulate non-banking financial
institutions
To prevent deceptive financial
products and practices
Protect investors and consumers by
increasing oversight of lending and
financial services practices

Volcker Rule
Banned proprietary trading by commercial banks
Commercial bank cannot own or invest in a hedge fund and a private equity fund
 National Regulations
Canada Principle based Approach EU - A New International Regulatory Framework

General frameworks to guide banks

compliance
Focus on quality and individual stress test
OSFI allows banks to
choose their own
analytical tools to
manage liquidity
risks
Tools differ based on
the banks size of
funding and diversity
A new EU Banking
Union
Providing assistance to
individual banks during
difficulties
Basel Committee
Earlier largest banks,
rule based approach
but recent proposals to
defined the metrics
include all banks
and risk factors to be
used
Encouraged banks to
circumvent certain
rules

As a result Canada performed better during the financial crisis

 Conclusions
The proposal to raise the quality of banks capital base will allow banks to better absorb shocks
Leverage ratio is an important addition to restrict banks from holding too much leverage
Decision to limit counterparty credit risk will decrease bank interconnectedness
Liquidity ratios will decrease reliance in short term funding

Possible additions to the Basel Framework

Internationally Coordinated framework for continuous stress testing
Coco bonds which would automatically become shares in case of specific ratios being
breached
Avoid defining a specific level for counter-cyclical buffers, since any bank reaching that buffer
might cause panic among investors
 Recent RBI norms
Inclusion of value of property while calculating Tier-I or core capital base
45% of property value to be counted
Bank should be able to sell the property readily at its own will
No legal impediment in selling the property
Valuation should be obtained from two independent valuers, at least once in every three years
Foreign currency translation reserves can be considered as CET-I capital
This will be reckoned at 25% discount
Gains arising out of setting off the losses at a later date can be counted as Tier-I capital, up
to 10%
Deferred tax assets to be counted while calculating Tier-I capital
Changes will unlock INR 35,000 crore for PSBs and INR 5,000 crore for private banks
Indian banks need to maintain CAR of 9%, in addition to a capital conservation buffer of
2.5%
 Bank wise CAR- March 2015

Source: http://dbie.rbi.org.in/DBIE/dbie.rbi?site=publications#!4
 Emergence of Basel IV
Additional capital and liquidity requirements
Higher minimum leverage ratio
Less reliance on internal models
Revised standardized approaches (in particular for credit risk)
Capital floor and the trading book
Linking of asset quality review and stress testing
Pillar 2 capital add-ons
Liquidity requirements
More disclosure
It will increase banks RWAs significantly

Source: https://www.kpmg.com/IM/en/IssuesAndInsights/ArticlesPublications/Documents/basel-4-revisited-2015.pdf