the basel capital framework: from basel i to basel iii
TRANSCRIPT
The Basel Capital Framework: From Basel I to Basel III
Presented by Leonard ChumoStrathmore University GARP Chapter Meeting14th January 2011
Agenda
1. Background
2. Basel I Framework
3. Basel II Framework
4. Proposed Basel III Framework
5. Proposed Global Liquidity Standard
6. Overview of Stress Testing
7. Proposed Next Steps for Kenya
8. Q&A
BACKGROUND
From Basel I to Basel IIIIssued Implemented
Basel I July 1988 Dec 1992
Market Risk Amendment Dec 1996 Dec 1997
Basel II June 2004 Dec 2006
Basel II Advanced Approaches
Dec 2007
Revised Securitisation andTrading Book Rules
July 2009 Dec 2011
Basel III ConsultativeDocument
Dec 2009
Basel III Nov 2010* Jan 2013 – Jan 2019
* G 20 endorsement of Basel III
The Case: Financial Crisis
Financial Contagion: Channels
Financial Institutions
Real EconomyFinancial Infrastructure
Financial Markets
Adapted from European Central Bank’s “Heat Map” Framework
Summary
Basel I
In effect since 1988Simple in applicationEasy to achieve significant capital reduction with little or no risk transfer
Basel II introduced to:Reduce regulatory arbitrage Encourage good risk management systems
Basel II
More risk sensitiveTreatment based on exposure characteristicsTakes into account quality of risk management systemPublished in June 2004
Introduced a capital charge for operational riskChange in risk management practices (ICAAP) Improved disclosures
Basel III
Introduced as a result of the financial crisisIncrease in quality and quantity of capitalGlobal liquidity standard
To be implemented over a 5 year period from 2013Macroprudential perspective
BASEL I FRAMEWORK
Basel IType of Exposure Risk Weight
OECD sovereigns 0%
OECD banks 20%
Residential mortgages 50%
SyntheticsSuper-seniorCash-collateralised mezzanineFirst loss
20%0%
100%Unfunded commitments under one year 0%
Unfunded commitments over one year 50%
Everything else 100%
OECD -> The Organisation for Economic Co-operation and Development
Immediate Impact of Basel IPositives:
Undercapitalised banks improved their capital ratios in response to Basel IThe ratio of capital to Risk Weighted Assets (RWA) for major G10 banks rose from 9.3% in 1988 to 11.2% in 1996Common definition of capital and capital adequacy globallyAn industry-wide appreciation of the concept of capital management
Negatives:Simplicity of Basel I encouraged rapid growth in products that avoided regulatory capital (364 day facilities, insurance companies selling credit wraps etc)Exacerbated the impact of a slowdown in world economic growth?
Source: Basel II- An Australian Banker’s Perspective
The Problems with Basel IUnable to distinguish between good and poor quality credit
Little impact on the risk appetite decisions of banks
Capital arbitrage opportunities supported growth in securitisation
Capital ratios (potentially) a misleading indicator of bank risk
Focused only on financial measures – lacked mechanisms to improve risk management processes
Source: Basel II- An Australian Banker’s Perspective
BASEL II FRAMEWORK
Basel II – Scope of ApplicationApplied on consolidated basis to internationally active banks
Financial activities do not include insurance
All banking and other financial activities captured through consolidation
Deduct bank’s equity and other capital investments in insurance subsidiaries
Deduct significant investments in commercial entities above materiality thresholds
Basel II – Three Pillars
Basel II Capital Accord
Set minimum acceptable capital levels
Enhanced approach for credit risks
Explicit treatment of operational risk
Market risk framework, capital definition unchanged
Bank must assess solvency versus risk profile
Supervisory review of bank’s calculations & capital strategies
Bank should hold in excess of minimum level of capital
Regulators will intervene at an early stage if capital levels deteriorate
Improved disclosure of capital structure
Improved disclosure of risk measurement and management practices
Improved disclosure of risk profile
Improved disclosure of capital adequacy
Pillar 2: Supervisory Review Process
Pillar 1: Minimum Capital Requirement
Pillar 3: Market Discipline
Adapted from: http://www.emeraldinsight.com
Approaches to Basel II – Pillar 1Basel II
Framework
Credit Risk Operational Risk Market Risk
Standardized Approach Basic Approach
Standardized Measurement
Method
Foundation – IRB Approach
Standardized Approach
Internal Models Approach (IMA)
Advanced-IRB Approach
Advanced Measurement
Approach (AMA)
IRB Internal Rating Based
Credit Risk: The Standardised ApproachClaims on AAA to AA- A+ to A- BBB+ to BBB-BB+ to B- Below B- UnratedSovereigns 0% 20% 50% 100% 150% 100%Banks - Option 1 20% 50% 100% 100% 150% 100%Banks - Option 2 20% 100% 150% 50%Bank's short-term claims - Option 2 50% 150% 20%
AAA to AA- A+ to A- BBB+ to BB- Below BB Unrated20% 50% 100% 150% 100%
Non-central government PSEs
Multilateral development banks (MDBs)
Securities firms
Corporates
Risk-weighted at national discretion, according to either option 1 or option 2 for claims on banks. May be treated as claims on sovereigns.Based on external credit assessment as set out under option 2 for claims on banks but without the possibility of using the preferential treatment for short-term claims.
50%
20%
May be treated as claims on banks provided they are subject to supervisory and regulatory arrangements comparable to those of banks
Credit Risk: The Standardised Approach (2)
Category Treatment
Claims included in the regulatory retail portfolio
May be risk-weighted at 75% except past dueClaims must meet the following criteria: Orientation, product, granularity and low value to individual exposures
Claims secured by residential property
Risk-weighted at 35% Supervisors may require banks to increase these risk weights as appropriate
Claims on commercial real estate
Normally risk-weighted at 100%May receive preferential risk weight of 50%
Past due loansRisk-weighted at between 100% and 150% depending on level of provisionsDiscretion to reduce risk-weight to 50%
Higher-risk categories Risk-weighted at 150% or higherOther assets Risk-weighted at 100%Off-balance sheet items Use of credit conversion factors (CCF)
Pillar 2: Supervisory Review ProcessEnsure that banks have adequate capital to support all the risks in their business
Encourage banks to develop and use better risk management techniques
Management to develop an internal capital assessment process and set capital targets
Supervisors to evaluate how well banks are assessing their capital needs
Pillar 2: Main areas suited for treatment
ExamplesRisks considered under pillar 1 not fully captured by pillar 1 process
Credit concentration risk
Factors not taken into account by the pillar 1 process
Interest rate risk in the banking bookBusiness and strategic risk
Factors external to the bank Business cycle effects
Four Principles of Supervisory Review
1. Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital
2. Supervisors should review and evaluate banks’ internal capital adequacy assessment. Supervisors should take appropriate action if they are not satisfied with the results of this process
3. Supervisors should expect banks to operate above the minimum regulatory ratios and should have the ability to require banks to hold capital in excess of the minimum
4. Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels
Pillar 3: Market Discipline
Disclosure requirements include:
A. General disclosure principles
B. Scope of application
C. Capital structure
D. Risk exposure and assessment
Basel II and Financial Crisis : Accusations
The average level of capital required by the new discipline is inadequateThe capital accord, interacting with fair-value accounting caused remarkable lossesCapital requirements based on the Basel II regulations are cyclicalThe assessment of credit risk is delegated to non-banking institutionsWrong assumption that banks’ internal models for measuring risk exposures are superiorThe Framework provides incentives to intermediaries to deconsolidate from balance sheet some very risky exposures
Source: M.Quagliariello and F. Cannata, The role of Basel II in the subprime financial crisis: guilty or not guilty?, Jan 2009
PROPOSED BASEL III FRAMEWORK
Strengthening the capital framework
1) Raising the quality, consistency and transparency of the capital base
2) Enhancing risk coverage
3) Supplementing the risk-based capital requirement with a leverage ratio
4) Reducing procyclicality and promoting countercyclical buffers
5) Addressing systemic risk and interconnectedness
Source: Basel III: A global regulatory framework for more resilient banks and banking system, December 2010
Basel III – An Opportunity?
Platform to enhance risk management, disclosures and supervisory practices
Enhanced capital requirements and new liquidity standards will contribute to resilient financial system
Macroprudential approach will improve oversight of system-wide risks
Will reduce opportunities for capital arbitrage in certain areas and promote a level playing field
Learning from past crises to reduce the likelihood and impact of future ones
Source: Jaime Caruana, BIS, Why Basel III matters for Latin American and Caribbean financial markets, November 2010.
Basel III Reform
Capital ratio = Capital Risk-weighted assets
New capital ratios• Common equity• Tier 1• Total capital• Capital conservation
buffer
Enhancing risk coverage• Securitisation products• Trading book• Counterparty credit risk
Raising the quality of capital• Focus on common equity• Stricter criteria for Tier 1• Harmonised deductions
from capital
Macroprudential overlay
Leverage ratio
Mitigating procyclicality• Countercyclical buffer
Mitigating systemic risk(work in progress)
• Systemic capital surcharge for SIFIs
• Contingent capital• Bail-in debt• OTC derivatives
Source: Herve Hannoun, The Basel III Capital Framework: a decisive breakthrough
Basel III Phase- in Arrangements2011 2012 2013 2014 2015 2016 2017 2018 2019
Leverage ratio Supervisory monitoring
Parallel run 1 Jan 2013 –1 Jan 2017. Disclosure
from 1.1.2015
To Pillar
1
Min. common equity ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Capital conservation buffer 0.625 1.25 1.875 2.50
Min. common equity plus capital conservation buffer 3.5 4.0 4.5 5.125 5.75 6.375 7.0
Phase-in of deduction from CET1 20 40 60 80 100 100
Minimum Tier 1 Capital 4.5 5.5 6.0 6.0 6.0 6.0 6.0
Minimum Total Capital 8.0 8.0 8.0 8.0 8.0 8.0 8.0
Minimum total capital plus conservation buffer 8.0 8.0 8.0 8.625 9.25 9.875 10.5
Liquidity coverage ratio A B
Net stable funding ratio A B
A -> Observation period begins
B -> Introduce minimum standard
Liquidity Proposal
Two liquidity risk metrics as “regulatory standards”
Four regulatory monitoring tools to track liquidity
Underscore the importance of holding high quality liquid assets as the need for contingency planning for stress scenarios
A short-term (30-day) ratio - Liquidity coverage ratio (LCR)
A longer-term (one-year) “structural” ratio – Net Stable Funding Ratio (NSFR)
Provide greater consistency in cross-border supervisory oversight, in liquidity management
Contractual Maturity Mismatch
Funding Concentration
Available Unencumbered Assets
Market-Related Monitoring Tools
Source: GARP, Basel III Accord: Where do we go from here?
Revised Framework for Trading book and Securitisation
12-month stressed VaR capital chargeIncremental risk capital charge in credit sensitive positions under VaRSimilar treatment for trading and banking book securitisationHigher risk weights for resecuritisation Higher CCFs for S-T liquidity facilities to OBS conduits and SIVsMore rigorous own risk analysis
Strengthened Supervisory GuidanceArea GuidanceLiquidity RiskManagement
September 2008: Principles for Sound Liquidity Risk Management and Supervision
Valuation Practices April 2009: Supervisory guidance for assessing banks’ financial instrument fair value practices
Stress Testing May 2009: Principles for sound stress testing practices and supervision.
Sound Compensation Practices
January 2010: Compensation Principles and StandardsAssessment MethodologyOctober 2010: Consultation Document on the Range of Methodologies for Risk and Performance Alignment of Remuneration
Corporate Governance
October 2010: set of principles for enhancing sound corporate governance practices at banking organisations.
Supervisory Colleges
October 2010: Good Practice Principles on Supervisory Colleges.
Pillar 2: Risk Management and Supervision
Firm-wide governance and risk management
Capturing of risks of OBS exposures and securitisation activities
Managing risk concentrations
Incentives for banks to better manage risk and return over the long-term
Sound compensation practices
Systemic Oversight and Pillar 2
Leverage in the banking system as a whole
Systemic capital charge on SIFIs
Countercyclical capital charge
Interconnectedness via OTC derivatives
Stress testing and risk modelling addressing tail risks
Concentration risk
Large exposuresSource: Herve Hannoun The Basel III Capital Framework: a decisive breakthrough, November 2010
Future WorkEffort TimelineFundamental review of the trading book
To be completed by end of 2011
Ratings and securitisation To be completed by end of 2011Systemically important banks Develop by end of 2010 a provisional
methodology for SIFI at the global levelA study of additional loss absorbency by mid-2011
Contingent capital Complete review by mid-2011Cross-border bank resolution To build on 2010 report and recommendations
of the cross-border bank resolution group
Review of core principles for effective bank supervision
To initiate a revision of core principles at the beginning of 2011
Large exposure The committee currently reviewing rules in place across different jurisdictions
Standards implementation A pilot review to be undertaken in 2011
PROPOSED GLOBAL LIQUIDITY STANDARD
Regulatory StandardsTwo (2) standards (LCR & NSFR) with separate but complementary objectivesLCR is aimed at promoting the S-T resilience to survive a stress scenario lasting 30 daysThe NSFR has a time horizon of 1 year and is aimed at capturing structural issuesShould be implemented consistently by supervisors around the worldMust be supplemented by supervisory assessments of other aspects in line with sound principles.
Source: Basel III: International framework for liquidity risk measurement, standards and monitoring, December 2010
Stress Test Scenarios1) Run-off of a proportion of retail deposits2) A partial loss of unsecured wholesale funding
capacity3) A partial loss of secured, S-T financing4) Additional contractual outflows that would arise from a
downgrade (by up to 3 notches)5) Increase in market volatilities that impact the quality
of collateral6) Unscheduled draws on committed but unused credit
and liquidity facilities7) Potential need to buy back debt or honour non-
contractual obligations to mitigate reputational risk.
Source: Basel III: International framework for liquidity risk measurement, standards and monitoring, December 2010
Characteristics of Liquid Assets
Fundamental Characteristics Market-Related Characteristics
Low credit and market risk
Ease and certainty of valuation
Low correlation with risky assets
Listed on a developed and recognized exchange market
Active and sizeable market
Presence of committed market markers
Low market concentration
Flight to quality
Source: Basel III: International framework for liquidity risk measurement, standards and monitoring, December 2010
Monitoring Tools
Source: Basel III: International framework for liquidity risk measurement, standards and monitoring, December 2010
Contractualmaturity mismatch
Contractual cash and security outflows from on- and off-BS items, mapped to defined time bands based on maturities
Concentration of funding
Funding liabilities sourced from each significant counterparty or from each significant product/instrument
List of asset and liability amounts by significant currencyAvailable unencumberedassets
That are marketable as collateral in secondary markets and/or eligible for central banks’ standing facilities
LCR by significantcurrency
FX LCR -> stock of high-quality liquid assets in each currency Over Total net cash outflows over a 30-day period in each currency.
Market-relatedmonitoring tools
Market-wide information, information on the financial sector and bank-specific information
OVERVIEW OF STRESS TESTING
Stress Testing DefinitionCEBS CP12
Stress testing is a risk management technique used to evaluate the potential effects on an institutions financial condition of a specific event and/or movement in a set of financial variables. The traditional focus of stress testing relates to exceptional but plausible events.
BCGFS (2000)
A generic term describing various techniques used by financial firms to gauge their potential vulnerability to exceptional but plausible events.
* CEBS – Committee of European Banking Supervisors** BCGFS – BIS Committee of the Global Financial System
Financial Turmoil: Lessons LearnNeed buy-in from top management.Stress for liquidity and capital for off balance sheet VIE.Link scenarios and business practices.Seek economist’s help to create meaningful scenarios.Prolonged stress periods require detailed assessment of second order effects.Wider granularity is a better.Improve liquidity stress testing in a systematic crisis.Nothing is impossible.
Source: Presentation by Kapo Yuen – Federal Reserve Bank of New York
Scope of Stress Testing Exercise
1) Residential mortgages 2) Commercial mortgages3) Personal and unsecured loans4) Investment portfolio5) Interbank exposures6) Off-Balance sheet positions
The stress testing exercise should assess the impact of the identified shock on profitability,
capital position and liquidity
Examples of Stress Test Scenarios
Changes in real estate prices (value of collaterals): EL = PD*LGD*EAD*M
Increase in defaults rates : PD = f (u, ∆i)
Shift and/or twist in the yield curve – net interest impact and repricing impact
Distortion in the interbank market
Rating downgrade – increased cost of funding
Examples of Stress Test Scenarios (cont.)Run on bank and fire sale of assets
Changes in value of investments – MTM losses
Micro and macro contagion
Rogue trading
Geopolitical developmentsUse reverse stress tests to mitigate against the risk of
using non-stringent stress scenarios. The test could be for events that could wipe out all capital or the whole PnL
Managing Capital Adequacy under Pillar II
Stress Scenario
Stressed Macro
Economic Factors
Credit Risk
Market risk
Operational Risk
Business Risk
Integrated Scenario
effectStress Risk Capital
& Change in EL/Earnings
Available Capital
Current Risk Capital Capital Safety
Cushion (Shock Absorber)
Earnings Retention and Dividend Policy
Planned Growth and Risk Taking
Pro-cyclicality Management
Capital Management Framework
Source: Standard and Poor’s
Integrated Stress Testing Framework
PROPOSED NEXT STEPS FOR KENYA
The Way Forward for Kenya
Full Implementation of Risk-Based Supervision Full compliance with Core Principles for Effective Banking SupervisionIntroduction of some elements of Basel II and Basel III (ICAAP and Stress Testing)Consolidated supervision and supervisory collegesMacroprudential surveillance led by a body similar to Financial Stability Oversight Council (FSOC)Integrated financial sector supervisory body modeled around FSA or APRA
The Way Forward for Kenya (cont.)Supervision to focus mainly on consumer protection High standards on corporate governance Zero tolerance on failure of systemically importance financial institutions (SIFI)Financial sector crisis management planAssessment of events that may trigger contagion within the financial sectorCredit assessment/rating system and collateral registryPush towards efficient interaction between financial regulatory, monetary and fiscal policies
Q&A