basel final

8/3/2019 Basel Final

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2011

BASEL III IMPLEMENTATION IN

BANKING SECTOR


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Term Paper

On

BASEL III implementation in banking sector

Course B-406: Central Banking: Regulations and Supervision

Submitted to:

Md. Shahidul Islam (Zahid)

Lecturer

Department of Banking

University of Dhaka

Submitted by:

Md. Zia Uddin Faruki Id # 14-083Tuhin Shubro Dey Id # 14-072Sazu Barua Id # 14-068Abu Munayem Id #14-044

Date of Submission: October 2011


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October 2011

Md. Shahidul Islam

Lecturer


University of Dhaka

Subject: Submission of Term paper on Comparative BASEL III implementation in bankingsector

Dear Sir,

Its our pleasure to prepare and submit this paper as a partial requirement of course B-406 .It willbe very helpful for us as a student of Banking to know about Basel accord supervised by BIS.

We have been able to execute our assigned task within the timeframe although the possibility ofmaking mistakes cannot be erased completely.

We hope that you will pardon us and overlook them considering that we are still learners and you

will give us the necessary suggestions that you always give for the improvement of our quality in

future.

Your faithfully

Zia Uddin Faruki

On behalf of group members

BBA Program, 14th Batch


University of Dhaka


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AACCKKNNOOWWLLEEDDGGEEMMEENNTT

Preparing the term paper on BASEL III implementation in banking sector has been a great

experience for us in light of the course 406:Central Banking: Regulations and SupervisionWe

strongly believe works like this will surely help us to have a clear concept about Basel Accordand Basel III. We express our sincere gratitude to our honorable course teacher Md. Shahidul

Islam, Lecturer, Department of Banking, University of Dhaka for his guidance, advice and giving

outline for preparing this report.

Besides, we thank our group members for their hard working, encouragement and

collaboration in the success worthy completion of this report.


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EEXXEECCUUTTIIVVEE SSUUMMMMAARRYY

BASEL III is a new global regulatory standard on bank capital adequacy and liquidity agreed bythe members of the Basel Committee on Banking Supervision. The third of the Basel Accordswas developed in a response to the deficiencies in financial regulation revealed by the globalfinancial crisis. Basel III strengthens bank capital requirements and introduces new regulatoryrequirements on bank liquidity and bank leverage. Basel III will require banks to hold 4.5% ofcommon equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) ofrisk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatorycapital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allowsnational regulators to require up to another 2.5% of capital during periods of high credit growth.In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios.The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets tocover its total net cash flows over 30 days; the Net Stable Funding Ratio requires the availableamount of stable funding to exceed the required amount of stable funding over a one-year periodof extended stress.


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BACKGROUNDOFTHE STUDY

1.0 ORIGIN OF WORK

The report is primarily originated to serve the requirements of our BBA program, which is a partof the syllabus of BBA course. It also implies the significance of theoretical knowledge of BBA

course that was gathered in the learning process as well as the application of this theoretical

knowledge in the practical field. The task of preparing the report gave us the opportunity to

observe the aforesaid concept. Through this work we become well informed about BASEL

accord and Basel III implementation in banking sector.

1.1 OBJECTIVE OF STUDY

Objectives of the study are presented below:

y To know about Basel accord supervised by BISy To know about BASEL I, II and IIIy To know about capital requirements according to BASEL accordy To know about proposed change in Basel III from Basel IIy To analyze the possible effect on banking sector from those requirements.

1.2 METHODOLOGY OF THE STUDY

We prepare this report based on secondary information available in different website. First of all

we visit different related website and gather required information. Then we analyze thoseinformation and possible effect of those requirements on banking sector.


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2.0 Introduction: The Basel Accords refer to the banking supervision Accords(recommendations on banking laws and regulations) -- Basel I and Basel II issued and Basel III -- by the Basel Committee on Banking Supervision (BCBS). They are called the Basel Accords asthe BCBS maintains its secretariat at the Bank for International Settlements in Basel, Switzerlandand the committee normally meets there. Formerly, the Basel Committee consisted of

representatives from central banks and regulatory authorities of the Group of Ten countries plusLuxembourg and Spain. Since 2009, all of the other G-20 major economies are represented, aswell as some other major banking locales such as Hong Kong and Singapore. The committeedoes not have the authority to enforce recommendations, although most member countries aswell as some other countries tend to implement the Committee's policies. This means thatrecommendations are enforced through national laws and regulations, rather than as a result ofthe committee's recommendations - thus some time may pass between recommendations andimplementation as law at the national level.

2.1 BASEL I: A set of international banking regulations put forth by the Basel Committee onBank Supervision, which set out the minimum capital requirements of financial institutions with

the goal of minimizing credit risk. Banks that operate internationally are required to maintain aminimum amount (8%) of capital based on a percent of risk-weighted assets The first accord wasthe Basel I. It was issued in 1988 and focused mainly on credit risk by creating a bank assetclassification system. This classification system grouped a bank's assets into five risk categories:0% - cash, central bank and government debt and any OECD government debt0%, 10%, 20% or 50% - public sector debt20% - development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bankdebt (under one year maturity) and non-OECD public sector debt, cash in collection50% - residential mortgages100% - private sector debt, non-OECD bank debt (maturity over a year), real estate, plant andequipment, capital instruments issued at other banks

The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-weightedassets. For example, if a bank has risk-weighted assets of $100 million, it is required to maintaincapital .2.2 BASEL II: A set of banking regulations put forth by the Basel Committee on BankSupervision, which regulates finance and banking internationally. Basel II attempts to integrateBasel capital standards with national regulations, by setting the minimum capital requirements offinancial institutions with the goal of ensuring institution liquidity.Basel II is the second of the Basel Committee on Bank Supervision's recommendations, andunlike the first accord, Basel I, where focus was mainly on credit risk, the purpose of Basel IIwas to create standards and regulations on how much capital financial institutions must have putaside. Banks need to put aside capital to reduce the risks associated with its investing and lendingpractices .2.3 BASEL III: BASEL III is a new global regulatory standard on bank capital adequacy andliquidity agreed by the members of the Basel Committee on Banking Supervision. The third ofthe Basel Accords was developed in a response to the deficiencies in financial regulationrevealed by the global financial crisis. Basel III strengthens bank capital requirements andintroduces new regulatory requirements on bank liquidity and bank leverage. Basel III willrequire banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital(up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional


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capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionarycountercyclical buffer, which allows national regulators to require up to another 2.5% of capitalduring periods of high credit growth. In addition, Basel III introduces a minimum 3% leverageratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to holdsufficient high-quality liquid assets to cover its total net cash flows over 30 days; the Net Stable

Funding Ratio requires the available amount of stable funding to exceed the required amount ofstable funding over a one-year period of extended stress.

3.0 Summary of proposed changes

First, the quality, consistency, and transparency of the capital base will be raised.

Tier 1 capital: the predominant form of Tier 1 capital must be common shares andretained earnings

Tier 2 capital instruments will be harmonized Tier 3 capital will be eliminated.

Second, the risk coverage of the capital framework will be strengthened.

Promote more integrated management of market and counterparty credit risk Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's

credit rating Strengthen the capital requirements for counterparty credit exposures arising from banks

derivatives, repo and securities financing transactions Raise the capital buffers backing these exposures Reduce procyclicality and Provide additional incentives to move OTC derivative contracts to central counterparties

(probably clearing houses) Provide incentives to strengthen the risk management of counterparty credit exposures Raise counterparty credit risk management standards also by including the wrong-way

risk

Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel IIrisk-based framework.

The Committee therefore is introducing a leverage ratio requirement that is intended toachieve the following objectives:

Put a floor under the build-up of leverage in the banking sector

Introduce additional safeguards against model risk and measurement error bysupplementing the risk based measure with a simpler measure that is based on grossexposures.

Fourth, the Committee is introducing a series of measures to promote the build up of capitalbuffers in good times that can be drawn upon in periods of stress ("Reducing procyclicality andpromoting countercyclical buffers").


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The Committee is introducing a series of measures to address procyclicality: Dampen any excess cyclicality of the minimum capital requirement; Promote more forward looking provisions; Conserve capital to build buffers at individual banks and the banking sector that can be

used in stress; and

Achieve the broader macroprudential goal of protecting the banking sector from periodsof excess credit growth. Requirement to use long term data horizons to estimate probabilities of default, downturn loss-given-default estimates, recommended in Basel II, to become mandatory Improved calibration of the risk functions, which convert loss estimates into regulatory

capital requirements. Banks must conduct stress tests that include widening credit spreads in recessionary

scenarios. Promoting stronger provisioning practices (forward looking provisioning): Advocating a change in the accounting standards towards an expected loss (EL) approach

(usually, EL amount := LGD*PD*EAD).

Fifth, the Committee is introducing a global minimum liquidity standard for internationallyactive banks that includes a 30-day liquidity coverage ratio requirement underpinned by alonger-term structural liquidity ratio called the Net Stable Funding Ratio.

The Committee also is reviewing the need for additional capital, liquidity or other supervisorymeasures to reduce the externalities created by systemically important institutions.

As on Sept 2010, Proposed Basel III norms ask for ratios as: 7-9.5%(4.5% +2.5%(conservationbuffer) + 0-2.5%(seasonal buffer)) for Common equity and 8.5-11% for tier 1 cap and 10.5 to 13for total capital (Proposed Basel III Guidelines: A Credit Positive for Indian Banks)'

3.1 Datelines to meet BASEL III requirements:

Capital Requirements

2013Minimum capital requirements: Start of the gradual phasing-in of the higher minimum

capital requirements.

2015Minimum capital requirements: Higher minimum capital requirements are fully

implemented.

2016 Conservation buffer: Start of the gradual phasing-in of the conservation buffer.

2019 Conservation buffer: The conservation buffer is fully implemented.

Leverage Ratio

2011Supervisory monitoring: Developing templates to track the leverage ratio and theunderlying components.

2013Parallel run I: The leverage ratio and its components will be tracked by supervisors but notdisclosed and not mandatory.


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2015Parallel run II: The leverage ratio and its components will be tracked and disclosed but notmandatory.

2017Final adjustments: Based on the results of the parallel run period, any final adjustments tothe leverage ratio.

2018

Mandatory requirement: The leverage ratio will become a mandatory part of Basel III

requirements.

Liquidity Requirements

2011Observation period: Developing templates and supervisory monitoring of the liquidityratios.

2015 Introduction of the LCR: Introduction of the Liquidity Coverage Ratio (LCR).

2018 Introduction of the NSFR: Introduction of the Net Stable Funding Ratio (NSFR).

4.0 Transition Basel II to Basel III:

A. Tier 1 Capital

A1. BASEL II:Tier 1 capital ratio = 4%Core Tier 1 capital ratio = 2%

The difference between the total capital requirement of 8.0% and the Tier 1 requirement can bemet with Tier 2 capital.

A2. BASEL III:Tier 1 Capital Ratio = 6%Core Tier 1 Capital Ratio (Common Equity after deductions) = 4.5%

Core Tier 1 Capital Ratio (Common Equity after deductions) before 2013 = 2%, 1st January2013 = 3.5%, 1st January 2014 = 4%, 1st January 2015 = 4.5%

The difference between the total capital requirement of 8.0% and the Tier 1 requirement can bemet with Tier 2 capital.

B. Capital Conservation Buffer

B1. BASEL II:There is no capital conservation buffer.

B2. BASEL III:Banks will be required to hold a capital conservation buffer of 2.5% to withstand future periodsof stress bringing the total common equity requirements to 7%.


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Capital Conservation Buffer of 2.5 percent, on top of Tier 1 capital, will be met with commonequity, after the application of deductions.

Capital Conservation Buffer before 2016 = 0%, 1st January 2016 = 0.625%, 1st January 2017 =1.25%, 1st January 2018 = 1.875%, 1st January 2019 = 2.5%

The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital thatcan be used to absorb losses during periods of financial and economic stress. While banks areallowed to draw on the buffer during such periods of stress, the closer their regulatory capitalratios approach the minimum requirement, the greater the constraints on earnings distributions.

C. Countercyclical Capital Buffer

C1. BASEL II:There is no Countercyclical Capital Buffer

C2. BASEL III:A countercyclical buffer within a range of 0% 2.5% of common equity or other fully lossabsorbing capital will be implemented according to national circumstances.

Banks that have a capital ratio that is less than 2.5%, will face restrictions on payouts ofdividends, share buybacks and bonuses.

The buffer will be phased in from January 2016 and will be fully effective in January 2019.

Countercyclical Capital Buffer before 2016 = 0%, 1st January 2016 = 0.625%, 1st January 2017= 1.25%, 1st January 2018 = 1.875%, 1st January 2019 = 2.5%

D. Capital for Systemically Important Banks only

D1. BASEL II:There is no Capital for Systemically Important Banks

D2. BASEL III:Systemically important banks should have loss absorbing capacity beyond the standardsannounced today and work continues on this issue in the Financial Stability Board and relevantBasel Committee work streams.

The Basel Committee and the FSB are developing a well integrated approach to systemicallyimportant financial institutions which could include combinations of capital surcharges,contingent capital and bail-in debt.

Total Regulatory Capital Ratio = [Tier 1 Capital Ratio] + [Capital Conservation Buffer] +[Countercyclical Capital Buffer] + [Capital for Systemically Important Banks]Increased capital requirements


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4.1 Details analysis of BASEL III requirements: Under the agreements reached, the minimumrequirement for common equity, the highest form of loss absorbing capital, will be raised fromthe current 2% level, before the application of regulatory adjustments, to 4.5% after theapplication of stricter adjustments.

This will be phased in by 1 January 2015.

The Tier 1 capital requirement, which includes common equity and other qualifying financialinstruments based on stricter criteria, will increase from 4% to 6% over the same period.

The Group of Governors and Heads of Supervision also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met withcommon equity, after the application of deductions. The purpose of the conservation buffer is toensure that banks maintain a buffer of capital that can be used to absorb losses during periods offinancial and economic stress. While banks are allowed to draw on the buffer during suchperiods of stress, the closer their regulatory capital ratios approach the minimum requirement,

the greater the constraints on earnings distributions. This framework will reinforce the objectiveof sound supervision and bank governance and address the collective action problem that has prevented some banks from curtailing distributions such as discretionary bonuses and highdividends, even in the face of deteriorating capital positions.

A countercyclical buffer within a range of 0% 2.5% of common equity or other fully lossabsorbing capital will be implemented according to national circumstances. The purpose of thecountercyclical buffer is to achieve the broader macroprudential goal of protecting the bankingsector from periods of excess aggregate credit growth. For any given country, this buffer willonly be in effect when there is excess credit growth that is resulting in a system wide build up ofrisk. The countercyclical buffer, when in effect, would be introduced as an extension of theconservation buffer range. These capital requirements are supplemented by a non-risk-basedleverage ratio that will serve as a backstop to the risk-based measures described above.

In July, Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of3% during the parallel run period. Based on the results of the parallel run period, any finaladjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1treatment on 1 January 2018 based on appropriate review and calibration. Systemically important banks should have loss absorbing capacity beyond the standards announced today and workcontinues on this issue in the Financial Stability Board and relevant Basel Committee workstreams. The Basel Committee and the FSB are developing a well integrated approach tosystemically important financial institutions which could include combinations of capitalsurcharges, contingent capital and bail-in debt. In addition, work is continuing to strengthenresolution regimes. The Basel Committee also recently issued a consultative document Proposalto ensure the loss absorbency of regulatory capital at the point of non-viability. Governors andHeads of Supervision endorse the aim to strengthen the loss absorbency of non-common Tier 1and Tier 2 capital instruments.

4.2 Transition arrangements


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Since the onset of the crisis, banks have already undertaken substantial efforts to raise theircapital levels. However, preliminary results of the Committees comprehensive quantitativeimpact study show that as of the end of 2009, large banks will need, in the aggregate, asignificant amount of additional capital to meet these new requirements. Smaller banks, which

are particularly important for lending to the SME sector, for the most part already meet thesehigher standards. The Governors and Heads of Supervision also agreed on transitionalarrangements for implementing the new standards. These will help ensure that the banking sectorcan meet the higher capital standards through reasonable earnings retention and capital raising,while still supporting lending to the economy.

The transitional arrangements include:1. National implementation by member countries will begin on 1 January 2013.

Member countries must translate the rules into national laws and regulations before this date.

As of 1 January 2013, banks will be required to meet the following new minimum requirementsin relation to risk-weighted assets (RWAs):

3.5% common equity/RWAs;

4.5% Tier 1 capital/RWAs, and

8.0% total capital/RWAs.

The minimum common equity and Tier 1 requirements will be phased in between 1 January2013 and 1 January 2015.

On 1 January 2013, the minimum common equity requirement will rise from the current 2%level to 3.5%.

The Tier 1 capital requirement will rise from 4% to 4.5%.

On 1 January 2014, banks will have to meet a 4% minimum common equity requirement and aTier 1 requirement of 5.5%.

On 1 January 2015, banks will have to meet the 4.5% common equity and the 6% Tier 1requirements.

The total capital requirement remains at the existing level of 8.0% and so does not need to bephased in.

The difference between the total capital requirement of 8.0% and the Tier 1 requirement can bemet with Tier 2 and higher forms of capital.


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2. The regulatory adjustments (ie deductions and prudential filters), including amounts above theaggregate 15% limit for investments in financial institutions, mortgage servicing rights, anddeferred tax assets from timing differences, would be fully deducted from common equity by 1January 2018.

3. In particular, the regulatory adjustments will begin at 20% of the required deductions fromcommon equity on 1 January 2014, 40% on 1 January 2015, 60% on 1 January 2016, 80% on 1January 2017, and reach 100% on 1 January 2018.

During this transition period, the remainder not deducted from common equity will continue tobe subject to existing national treatments.

4. The capital conservation buffer will be phased in between 1 January 2016 and year end 2018becoming fully effective on 1 January 2019.

It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an

additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019.Countries that experience excessive credit growth should consider accelerating the build up ofthe capital conservation buffer and the countercyclical buffer. National authorities have thediscretion to impose shorter transition periods and should do so where appropriate.

5. Banks that already meet the minimum ratio requirement during the transition period butremain below the 7% common equity target (minimum plus conservation buffer) should maintainprudent earnings retention policies with a view to meeting the conservation buffer as soon asreasonably possible.

6. Existing public sector capital injections will be grandfathered until 1 January 2018.

Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capitalwill be phased out over a 10 year horizon beginning 1 January 2013. Fixing the base at thenominal amount of such instruments outstanding on 1 January 2013, their recognition will becapped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in eachsubsequent year. In addition, instruments with an incentive to be redeemed will be phased out attheir effective maturity date.

7. Capital instruments that do not meet the criteria for inclusion in common equity Tier 1 will beexcluded from common equity Tier 1 as of 1 January 2013.

However, instruments meeting the following three conditions will be phased out over the samehorizon described in the previous bullet point:

(1) they are issued by a non-joint stock company;

(2) they are treated as equity under the prevailing accounting standards; and


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(3) they receive unlimited recognition as part of Tier 1 capital under current national bankinglaw.

8. Only those instruments issued before the date of this press release should qualify for the abovetransition arrangements.

Phase-in arrangements for the leverage ratio were announced in the 26 July 2010 press release ofthe Group of Governors and Heads of Supervision. That is, the supervisory monitoring periodwill commence 1 January 2011; the parallel run period will commence 1 January 2013 and rununtil 1 January 2017; and disclosure of the leverage ratio and its components will start 1 January2015. Based on the results of the parallel run period, any final adjustments will be carried out inthe first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based onappropriate review and calibration. After an observation period beginning in 2011, the liquiditycoverage ratio (LCR) will be introduced on 1 January 2015. The revised net stable funding ratio(NSFR) will move to a minimum standard by 1 January 2018.The Committee will put in place rigorous reporting processes to monitor the ratios during the

transition period and will continue to review the implications of these standards for financialmarkets, credit extension and economic growth, addressing unintended consequences asnecessary.The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. It seeks to promote and strengthen supervisory and riskmanagement practices globally.The Committee comprises representatives from Argentina, Australia, Belgium, Brazil, Canada,China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg,Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden,Switzerland, Turkey, the United Kingdom and the United States.

The Group of Central Bank Governors and Heads of Supervision is the governing body of theBasel Committee and is comprised of central bank governors and (non-central bank) heads ofsupervision from member countries. The Committees Secretariat is based at the Bank forInternational Settlements in Basel, Switzerland.


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Each Basel Committee member jurisdiction will identify an authority with the responsibility tomake decisions on the size of the countercyclical capital buffer. If the relevant national authorityjudges a period of excess credit growth to be leading to the build up of system-wide risk, theywill consider, together with any other macro prudential tools at their disposal, putting in place acountercyclical buffer requirement. This will vary between zero and 2.5% of risk weighted

assets, depending on their judgment as to the extent of the build up of system-wide risk.

5.0Conclusion:BASEL III is a new global regulatory standard on bank capital adequacy andliquidity agreed by the members of the Basel Committee on Banking Supervision. The third ofthe Basel Accords was developed in a response to the deficiencies in financial regulationrevealed by the global financial crisis. Basel III strengthens bank capital requirements andintroduces new regulatory requirements on bank liquidity and bank leverage. Basel III willrequire banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital(up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additionalcapital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionarycountercyclical buffer, which allows national regulators to require up to another 2.5% of capitalduring periods of high credit growth. In addition, Basel III introduces a minimum 3% leverageratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to holdsufficient high-quality liquid assets to cover its total net cash flows over 30 days; the Net StableFunding Ratio requires the available amount of stable funding to exceed the required amount ofstable funding over a one-year period of extended stress.


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6.0 References:

1. www.bangladesh-bank.org2. www.bis.org3. www.wikipedia.org4. www.investopedia.org

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