basel 3 & implication[1]

8/2/2019 Basel 3 & Implication[1]

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Basel III and its implications for

banks treasurers

B. Mahapatra

Reserve Bank of India


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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


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Introduction

The Basel I 1988 capital charge for creditriska 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)


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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 capitalcharge for market risk of Basel I amendment of1996


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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 woundup or hedged quickly


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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 forderivative positions also covered only the default

risk and migration risk was not captured


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The global financial crisis mostly happened in

the areas oftrading 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


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There was heavy reliance on short term

wholesale funding

Unsustainable maturity mismatch

Insufficient liquidity assets to raise finance

during stressed period


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Enhancement to Basel II

Post- crisis, global initiatives to strengthen the

financial regulatory system

July 2009 Enhancement to Basel II mostly in

trading book


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Pillar 1 Standardized approach

Higher risk weights for CRE securitization and otherre-securitization exposures almost doubled

Bank not permitted to use any external rating ofABCP program where it had provided liquidity facilityor credit enhancement treated as unrated

Operational criteria for using external ratingsprescribed

CCF for all eligible liquidity facilities made uniform at50%, irrespective of maturity (earlier 20% CCF formaturity less than one year)


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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


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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


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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


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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


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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


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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


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Building Blocks of Basel III

1. 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

2. Improving/enhancing risk coverage on account ofcounterparty credit risk

3. Supplementing risk based capital requirement withleverage ratio

4. Addressing systemic risk and interconnectedness

5. Reducing pro-cyclicality and introducing countercyclical

capital buffers (0-2.5%)6. Minimum liquidity standards

We will discuss 2, 3, 4 and 6


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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


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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 downgradation of counterparty before default in all

approaches

Capital charge for wrong way risk PD andEAD are positively correlated - in all

approaches


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Asset value correlation of 1.25 for financialfirms of $ 100 billion assets and unregulatedfinancial firms

Strengthening collateral management andextend margining period of risk to 20 days forOTC derivatives

Increasing incentives for use of CCPscompliant with CPSS/IOSCO norms, for OTCderivatives


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Supplementing risk based capital

requirement with leverage ratio

Objectivesto supplement capital ratio incapturing risk

Numerator Tier 1 capital

Denominator on and off balance sheetexposure credit equivalent with 100% CCF, except10% CCF for unconditionally cancellable OBScommitments

Derivatives on CEM and Basel II netting basis

Collateral, guarantees or credit risk mitigation willnot reduce on balance sheet exposures


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Ratio 3%

As a Pillar 2 measure to start with but will beintegrated with Pillar 1

Leverage ratio will be tracked from January 1,2011 to see the result of the above definitionand parallel run from January 1, 2013 to 2017

and final adjustment in 2017 Disclosurefrom January 2015

As Pillar 1 ratio from January 1, 2018


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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


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Improving loss-absorbing capacity of SIBs/SIFIs

- Contingent capital and bail-in-able debt

Orderly unwinding of SIBs/SIFIs improving

resolvabilityliving wills

International framework for liquidity


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International framework for liquidity

risk measurement, standards and

monitoring Key characteristic of the financial crisis wasinaccurate 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


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Liquidity Coverage Ratio (LCR)

Ensuring enough liquid assets to survive an acutestress scenario lasting for 30 days

Defined as stock of high quality liquid assets / Netcash outflow over 30 days > 100%

Stock of high quality liquid assets cash + centralbank reserves + high quality sovereign paper (also inforeign currency supporting banks operation) + state

govt., & PSE assets and high rated corporate/coveredbonds at a discount of 15% - (A)

Level 2 liquid assets with a cap of 40%


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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


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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%


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Other monitoring tools for liquidity risk

management

Contractual maturity mismatch

Concentration of funding

Available unencumbered assets

LCR by significant currency

Market-related monitoring tools


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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


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Global banks could have a gap of liquid assets

of1,730 billion - to be met in four years Global big banks could have a capital shortfall

of577 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)


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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, sonot much increase in enhanced risk coverage

for counterparty credit risk


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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?


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Indian banks are generally not as highly

leveraged as their global counterparts

The leverage ratio of Indian banks would be

comfortable


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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 creditrisk


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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 capitaland liquidity surcharges and activity

restrictions


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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 suchinstruments?


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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 capitalrequirement

Not only sluggish growth, high unemployment

and low returns, but also more resolution willbe the New Normal


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Thank You

basel 3 & implication[1]

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