Basel II to Basel III – The Practical & Technical Challenges

Edwin Yuen

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Overview of Basel II Capital Framework International standard for capital adequacy that assesses all aspects of risks comprehensively

DISCLOSE

Basel II Capital Accord

Pillar I Minimum Capital Requirements

• Risk based capital measurement (e.g. PD, LGD, EAD, etc)

• Organization and process change in credit application and approval process for independent credit risk control

Pillar II Supervisory Review

• Capital management/ planning

• Align capital allocation to risk-return performance goals

• Supervisory discretion to impose higher capital requirements

Pillar III Market Discipline

• Transparency and disclosure on risk management process (qualitative) and measurement (quantitative) under Basel II parameters

Goals: Strengthen safety & soundness of the financial system

MANAGE MEASURE

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Basel II Regulatory Capital Calculation

Capital Requirements = Exposure x Risk Weight x 8%

Standardised Approach

• Risk weights determined by external credit ratings

Foundation IRB* Approach

• Determined by internally estimated Probability of Default (PD)

• Regulatory prescription for Loss Given Default (LGD), Exposure At Default (EAD) & Maturity (M)

Advanced IRB* Approach

• Determined by internally estimated PD, LGD, EAD & M

Increasing Complexity & Risk Sensitivity

* IRB = Internal Ratings-Based

CREDIT RWA

MINIMUM REGULATORY CAPITAL

MARKET RWA + OPS RWA + ≥ 8%

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Basel III Basel III essentially introduces changes in 3 key areas

Higher effective minimum capital requirements:

i) higher core equity and Tier 1 capital requirement

ii) additional capital conservation and countercyclical buffers

Additional capital requirements and higher risk weights for: i) counterparty credit risk exposures arising from derivatives, repurchase

and securitization activities (preference for central clearing houses, which receive low risk weight of 2%)

ii) trading book exposure through imposition of additional stressed VaR capital charge (i.e., volatility experienced during a period of significant financial stress)

More stringent criteria on sources of funds qualifying as eligible capital.

Mandated adjustments/deductions to certain specified assets that lack loss absorption capacity when determining core equity capital

Capital Requirements

Liquidity Requirements New minimum liquidity ratios to ensure that banks

are able to cope with temporary liquidity disruptions as well as maintain adequate long-term stable funding for their assets

Leverage Constraints New leverage ratio to prevent excessive leveraging

by banks

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Basel III - Capital Requirements Capital Ratio =

Capital Supply

Risk Weighted Assets Tier 1 Capital

Common equity and retained earnings to be the pre-dominant form of Tier 1 capital:

• Minimum Common Equity increased to 4.5% (from 2% under B2)

• Minimum Total Tier 1 Capital increased to 6% (from 4% under B2)

Total Capital (including Tier 2 but before buffers) retained at 8% New Capital Conservation Buffer Requirement

• New requirement of 2.5% Capital Conservation Buffer, to be met by Common Equity

New Counter-cyclical Capital Buffer • Additional 0%- 2.5% Common Equity

capital buffer requirement during periods of excessive credit growth

New for Systemically Important Financial Institutions (SIFI)

• Additional capital requirement buffer of 1-2.5% for SIFIs

Types of Funds that meet Capital Requirement will be tightened

• Deduction from Core Equity Capital of components that have no Loss-Absorption Capacity

• More stringent criteria for inclusion as Tier 1 and Tier 2 capital, such as: No step-ups or other

incentives to redeem Tier 1 instruments must share

in losses of bank at a pre-specified trigger point

Increased Risk Weighted Assets • Besides capital required for market

risk based on normal VaR, additional capital is required on stressed VaR based on a continuous 12-month period of significant financial stress.

• Higher capital requirement for securitization in both the banking and trading book.

• Capital required for counterparty credit exposures arising from banks’ derivatives, repo and securities transactions, including mark-to-market losses on expected counterparty credit risk (Credit Valuation Adjustments).

• Enhanced stress testing to address “wrong-way risk”

• Higher risk weights for exposures to large regulated financial institutions (assets ≥ USD100 billion) and all unregulated financial institutions

• Larger haircuts for illiquid collateral and collateral of counterparties with large number of transactions outstanding

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Basel III – Phase-in Implementation

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Basel III – Final Status as of January 2019

Tier 1 : Common

Equity

Tier 1 : Other

Minimum Tier 1 Capital : 6% of RWA

Minimum Total Capital: 8% of RWA

Minimum Common Equity : 4.5% of RWA

Tier 1 : Common

Equity

Tier 2

Tier 1 : Other

Capital Conservation

Buffer

Capital Conservation Buffer: 2.5% of RWA

Counter Cyclical Capital

Buffer

Buffer range: 0% to 2.5% of RWA

Minimum Capital before buffers: 8%

Minimum Capital after buffers: Conservation: 10.5% & Counter cyclical: up to 13%

Tier 2

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Basel III - Capital Requirements Capital Conservation Framework • Objective - The Capital Conservation Framework ensures that banks build up capital buffers outside

stress periods that will be available when losses occur • 2 components:-

• Capital Conservation Buffer established at a minimum of 2.5% of RWA above the minimum Tier 1 regulatory requirement of 4.5% and must be comprised of common equity

• Capital Conservation Ratios constraints discretionary distributions of earnings eg dividends, share buy-backs and staff bonus payments etc by banks:-

Common Equity Tier 1 Ratio % of Earnings to be Retained

4.5% - 5.125% (within 1st quartile of buffer) 100%

> 5.125% - 5.75% (within 2nd quartile of buffer) 80%

> 5.75% - 6.375% (within 3rd quartile of buffer) 60%

> 6.375% - 7.0% (within 4th quartile of buffer) 40%

> 7.0% (above top of buffer) 0%

For example, a bank with Tier 1 capital ratio of 5.125% to 5.75% is required to conserve 80% of its earnings in subsequent financial year (ie no more than 20% payout in dividends, share buybacks and/or discretionary bonus).

4.5%

6.375% 5.75% 5.125% 4.5%

7.5%

1%

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Basel III Capital Requirements Countercyclical Buffer • Objective - The Countercyclical Buffer protects banking sector from periods of excess aggregate credit

growth that results in system-wide risk. While minimum capital requirement and capital conservation buffer ensure individual banks remain solvent during stress periods, Countercyclical Buffer ensures credit will be available to the economy without fear on solvency of the banking system.

• Countercyclical buffer consists of:

• National regulators will be monitoring credit growth to assess any excessive credit growth that could result in system-wide risk.

• Regulator will assess whether the Countercyclical Buffer increases over time (within the range of 0% - 2.5% of RWA).

• This requirement will be released when system-wide risk occurs. • Increase in Countercyclical Buffer will be pre-announced with 12 prior notice for implementation while

reduction could take effect immediately.

• For international banking operations, Host regulator will set applicable buffer requirement based on the credit expansion of banks in that jurisdiction.

• Home regulator will ensure that their banks maintain such buffers based on their credit expansion in that location.

• Banks will be subject to countercyclical buffer that varies between 0% - 2.5% of total risk weighted assets. Banks must meet this buffer with Common Equity Tier 1.

• The credit to GDP ratio is common reference for regulators to determine level of Countercyclical Buffer.

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Basel III Capital Requirements Countercyclical Buffer (contd.)

Countercyclical Buffer will operate together with the Capital Conservation Buffer to constraint on the discretionary distributions of earnings eg dividends, share buy-backs and staff bonus payments etc in banks. E.g. a countercyclical buffer of 2.5%, the total buffer would be 5% and the constraints are:-

Common Equity Tier 1 Ratio % of Earnings to be Retained

4.5% - 5.75% (within 1st quartile of buffer) 100%

> 5.75% - 7.0% (within 2nd quartile of buffer) 80%

> 7.0% - 8.25% (within 3rd quartile of buffer) 60%

> 8.25% - 9.5% (within 4th quartile of buffer) 40%

> 9.5% (above top of buffer) 0%

For example, a bank with a Tier 1 capital ratio in the range of 5.75% to 7.0% is required to conserve 80% of its earnings in the subsequent financial year (ie payout no more than 20% in terms of dividends, share buybacks and discretionary bonus payments).

4.5%

8.25% 7% 5.75% 4.5%

9.5%

2%

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Detailed Basel III Capital Requirements

Capital Ratio Limits and Minimums

Common Equity Tier 1

Total Tier 1 Capital

(inclusive of Other Tier 1 Capital)

Total Capital

(inclusive of Tier 2 capital)

Minimum 4.5% 6.0% 8.0%

Conservation Buffer 2.5%

Minimum + Conservation Buffer 7.0% 8.5% 10.5%

Countercyclical Buffer range 0% - 2.5%

Minimum + Both Buffers 7.0% - 9.5% 8.5% - 11% 10.5% - 13.0%

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Basel III Capital Requirements Increased RWA - Counterparty Credit Risk

General wrong-way risk arises when PD of counterparties is positively correlated with general market risk factors, e.g., defaults and deterioration in credit-worthiness of trading counterparties occur when market volatilities, and thus counterparty exposures, are higher than usual, i.e, as PD increases, EAD of counterparties also increases

Use more conservative estimate of EAD by requiring use of stressed parameters (volatilities, correlations) in the calculation of effective EPE

• Max [Effective effective positive exposure (EPE) using current market data (most recent 3 year period), Effective

EPE using 3 year period that includes the 1 year stressed period used for the stressed VaR calculation in market risk]

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Basel III Capital Requirements Increased RWA - Counterparty Credit Risk

Asset values of financial institutions were more correlated than those of non-financial firms

Asset value correlations for financial institutions were 25% higher than for non-financial firms

Therefore, a multiplier of 1.25 to be applied to the correlation used in Basel formula for credit risk capital for exposures to financial institutions with assets of at least US$25 billion and other unregulated entities such as hedge funds and financial guarantors

Currently, 12% to 24%, to be increased to 15% to 30%

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Basel III Capital Requirements Increased RWA - Off-balance Sheet Exposures and Securitisation Risk

Increasing risk weights for re-securitization exposures

A securitization exposure in which the risk associated with an underlying pool of exposures is tranched and at least one of the underlying exposures is a securitization exposure

Percentage increase in risk weight is higher for better rated tranches

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Basel III Capital Requirements Increased RWA - Stressed VaR Added to Market Risk Capital Computation

Market Risk Capital Charge

= Max (VaRt,mc x 1/60ΣVaRt-i) + Max (sVaRt, ms x 1/60ΣsVaRt-i)

Will increase market risk capital requirements substantially

• Where • VaRt = previous day’s VaR • VaRt-i = VaR calculated i business days earlier • sVaRt = previous day’s stressed VaR • sVaRt-i = sVaR calculated i business days earlier • mc and ms = multiplication factor, typically set at the 3 times floor prescribed

by Basel. (However, could be up to 4 depending on backtesting results).

• sVaR is based on 10-day, 99th percentile, one-tailed confidence interval VaR measure of current portfolio, with model inputs calibrated to historical data from period of significant stress – e.g.,12 month 2007/2008 stress period

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Basel III – Leverage Ratio • Basel 3 introduces the Leverage Ratio to constrain the accumulation of leverage in

the banking sector. The ratio would prevent the subsequent deleveraging processes, which damage the broader financial system and the economy.

• The Leverage Ratio constraint is defined as follows:-

Tier 1 Capital

Total Exposure > 3%

Capital Measure • Based on the new B3 definition of Tier 1 capital. • Items that are deducted completely from capital

do not contribute to leverage, and should therefore also be deducted from the measure of exposure.

Exposure Measure • The exposure measure for the leverage ratio follow accounting measure of

exposure: • on-balance sheet, non-derivative exposures are net of specific

provisions and valuation adjustments (eg credit valuation adjustments); • Off-balance sheet items (eg commitments, unconditionally cancellable

commitments, direct credit substitutes, acceptances, standby letters of credit, trade letters of credit, failed transactions and unsettled securities) are subject to a credit conversion factor (CCF) of 100%, i.e, full notional value is included as exposure. Commitments that are unconditionally cancellable at any time by the bank without prior notice attract a CCF of 10%.

• physical or financial collateral, guarantees or credit risk mitigation purchased not allowed to reduce on-balance sheet exposures;

• netting of loans and deposits is not allowed

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Liquidity Risk:

HKMA Implementation - LM-2

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Overview of Basel III Timeline – HKMA issued in January 2012 Consultation Paper to the Industry on Basel III Implementation Timetable

Capital Base

Leverage Ratio

Liquidity standard and monitoring metrics

Counterparty Credit Risk (CCR)

HKMA is currently considering the feasibility of advance method (EAD) adoption and the enhancement to CCR capital framework *

Forward Looking Loss Provisioning

HKMA awaiting BCBS and IAS to decide the approach for Banks in HK.

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*CCR capital framework enhancements may including: •Imposition of capital charges for marked to market loses •Use of stress input for capital calculation •Asset value correlation multiplier for exposures to large regulated financial institutions and unregulated financial institutions •Strengthen risk management standards (model validation, stress-testing, collateral management and margining requirements) •Further enhancements to capitalisation of bank exposures to central counterparties

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Liquidity Requirements

Liquidity Coverage Ratio • Objective: To promote short-term resiliency of liquidity profile of banks

• Aims to ensure that banks maintain adequate level of unencumbered,

high quality assets that can be converted to cash to meet liquidity needs:-

• for a 30-day time horizon • under an acute liquidity stress scenario

• Definition:

Stock of high quality liquid assets Net cash outflows over a 30-day time period

High Quality Liquid Assets (Sovereign Bonds, Central Banks, Certain Corp

Bonds)

Net Cash Outflows = Deposit outflow, credit lines drawdown – Debt Amortization

≥ 100%

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Liquidity Coverage Ratio – Implemented by 2015 Stocks of High quality liquid assets

•Level 1 assets (no Haircut): Central Bank reserves, sovereign bonds in domestic currency, domestic sovereign bonds in foreign currency, cash

•Level 2 assets (haircut applies) can be up to 40% of stock of liquid assets - At 15% haircut government/PSE assets qualifying for 20% Basel II Risk Wt - At 15% haircut, (AA- Rating or better) corporate bonds

Cash Outflows Retail deposits (demand deposit and term deposit with maturity < 30 days) - min 5% run-off for stable retail deposits

- min 10% run-off for less stable retail deposits - 0% run-off for term deposit with residual maturity > 30 days

Unsecured Wholesale Funding - min 5% run-off for stable SME deposit

- min 10% run-off for less stable SME deposit - 25% run-off for legal entities with operational relationship Secured Funding - 15% run-off for secured funding transactions backed by Level 2 assets

- 25% run-off for secured funding transactions backed by assets not eligible for stock of high liquid assets

Cash Inflows Level 1 Assets – 0% inflow assuming reverse REPO or Securities borrowing agreements secured by Level 1 assets will be rolled-over and not result in any cash inflow Level 2 Assets – 15% cash inflow due to reduction of funds extended against collateral. All other Assets – 100% cash inflow assuming that bank not roll-over maturing reverse REPO or securities borrowing agreements

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Liquidity Requirements

Net Stable Funding Ratio

• Objective: To promote more medium and long-term funding of assets and activities of banks

• Aims to limit over-reliance on wholesale funding and establish a minimum acceptable amount of stable funding over a one year horizon

• Definition:

Available stable funding Required stable funding

> 100%

Available Stable Funding = Deposits, Equity, Wholesale Funding, other liabilities Required Stable Funding = Marketable securities/credits, off-balance sheet assets

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Net Stable Funding Ratio Minimum Standard Implemented by 2018 Available Stable Funding (Source)

• 100% Tier 1 and Tier 2 capital • 100% Liabilities with maturities > 1 year • 90% Stable retail and SME deposits (non-maturity or residual maturity < 1 year) • 80% less stable retail and SME deposits • 50% unsecured wholesale funding

Required Stable Funding (Use)

-100% loans with maturity >1 year -85% retail or SME loans with maturity < 1 year -65% residential mortgages qualifying for 35% Basel II RW -50% corporate loans with maturity < 1 year, gold, unencumbered listed equity or Senior unsecured corporate bonds (A+ to A- rating) > 1 year -5% Off-B/S Undrawn committed credit and liquidity facilities -5% debt issued/guaranteed by sovereigns, central banks -0% cash, inter-bank, securities with effective maturity < 1 year, non-renewable loans < 1 year

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Liquidity Risk Approach

Contractual Cashflow ● Cashflows with relatively certain timing and amount under contractual

obligations

Non-contractual Cashflow – customer behaviour ● Customer behaviour (deposit run-off, drawdown of unused credit lines)

Non-contractual Cashflow – Market Factor ● Market price of collaterals and market rates that affects margin calls,

roll-over rates, REPO, OTC derivatives

Model developed to predict non-contractual cashflow due to customer behaviour and market factors

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Practical and Technical Challenges

Historical Time Series Data for Liquidity Modeling ● Availability, accuracy and structure of data ● Data quality check Data analysis Data gaps Data cleansing

Fund Transfer Pricing ● BCBS Principle 4 in Principle of Sound Liquidity Management ● HKMA LM-2 Sound Systems & Controls for Liquidity Risk Mgt ● Cost and Benefit Allocation for Liquidity Management.

Practical Use of LM in Risk Management ● Contribute to Setting Risk Appetite in Bank ● Data base used for LM-2 regulatory reporting will support internal reporting

for efficient governance, monitoring of liquidity in Bank, contributing to enhancing limit management, liquidity position management, and liquidity buffer management.

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Thank you