the basel capital framework: from basel i to basel iii

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.


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


Monitoring Tools


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

the basel capital framework: from basel i to basel iii

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