Macroprudential Regulation andBasel III

Amarendra Mohan

www.cafral.org.in

Agenda

• Macroprudential regulation

– Why?

– What?

• Systemic Risk

• Basel III implementation

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Why?

• The story of the Queen…..

Systemic risk

“ The risk of disruption of financial services that is

(i) caused by an impairment of all or parts of the financial

system, &

(ii) has the potential to have serious negative consequences

for the real economy”

IMF/BIS/FSB paper Oct 2009

Can lead to costly Financial Crises –

• Credit flows stop

• Products do not get made

• People lose their jobs

• Effects on the economy can last for a long time, maybe

forever

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Why are we concerned? Severe & persistent real costs of financial crises

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- Level of real output in UK, Euro Area and USA remains significantly below its pre-crisis path, even after 5 years since the crisis started.

- In cumulative terms, crisis-induced output losses have so far reached almost 60% of annual pre-crisis GDP in UK, over 40% in Euro-area and over 30 % in the US.

Source: David Aikman, Andrew G. Haldane and Sujit Kapadia, “Operationalising a Macroprudential Regime: Goals, Tools and Open Issues”, BANCO DE ESPAÑA ESTABILIDAD FINANCIERA, NÚM. 24, May 2013

UK

USA

Euro Area

Index: 2004=100

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Microprudential vs Macroprudential Approach

Microprudential Macroprudential

Focuslimit distress of

individual institutions

limit financial system-

wide distress

Key Objective

consumer

(investor/depositor)

protection

avoid output (GDP)

costs linked to

financial instability

Correlations and

common exposures

across institutions

useful to understand critical

Calibration of

prudential controls

in terms of risks of

individual institutions;

bottom-up

in terms of system-

wide risk;

top-down*As defined, the two perspectives are intentionally stylised in order to highlight two orientations that coexist in current prudential frameworks

**Adapted from Borio, C (2003): “Towards a macroprudential framework for financial supervision and regulation?”, CESifo Economic Studies,

vol 49, no 2/2003, pp 181–216. Also available as BIS Working Papers, no 128, Basel, February.

7Source: IMF, Key Aspects of Macroprudential Policy, 2013

Macroprudential Policy and Other Public Policies: The Context

Financial System Vulnerabilities: Which are the right questions to ask?

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Macroprudential Policy

Macroprudential: Macro and Prudential

Objective:

• to limit systemic risk – the risk of widespread disruptions to the provision of financial services that have serious negative consequences for the economy at large

Scope:

• Focus -financial system as a whole (including the interactions between financial & real sectors) as opposed to individual components (that take rest of the system as given)

Instruments and associated governance:

• Use of primarily prudential tools calibrated to target the sources of systemic risk.

• Any non-prudential tools that are part of the framework need to clearly target systemic risk.

Source: FSB, IMF, BIS, “Macroprudential Policy Tools and Frameworks- Progress Report to G20” 27 Oct 2011

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Systemic Risk: Time and Structural Dimension

Time Dimension

Arrows denote size of exposures

LDB- Large Domestic Bank, SDB-Small Domestic Bank, MF- Mutual Fund, IC-Ins Co., GB-Global BankONB- Other Non-Banks

A Video or a Movie –

how risks evolve over

a period of time

A Still Picture

- How risks appear at

a point in time

Adapted from IMF

The financial cycle is different from the business cycle

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The financial and business cycles in the United States

1 The financial cycle as measured by frequency-based (bandpass) filters capturing medium-term cycles in real credit, the credit-to-GDP

ratio and real house prices. 2 The business cycle as measured by a frequency-based (bandpass) filter capturing fluctuations in real GDP

over a period from one to eight years.

Source: M Drehmann, C Borio and K Tsatsaronis, “Characterising the financial cycle: don’t lose sight of the medium term!”, BIS Working

Papers, no 380, June 2012.

Mapping Tools to Objectives: Time Dimension

Countercyclical

Capital buffer

Sectoral Tools

(Sectoral capital req,

LTV, DTI limits)

Overexposure to funding

shocks

Resilience to Shocks

Excessive Credit Growth

Sectoral vulnerabilities to:

(Asset prices, Ex rates, Inttrates)

Liquidity Tools

Source: IMF

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Capital and Capital Buffers

1. Good quality Brakes & Airbags

2. Safe distance – perfect driving conditions (normal times)

3. Safe distance – driving in a snow storm

(not normal, market/ financial stress)

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The Capital Buffers

1. Capital Conservation Buffer

Establishes buffer above the

minimum requirement - banks to

build capital buffers in good times (by

reducing discretionary distributions of

earnings)

Draw down buffers during stress

Strengthens ability to withstand

adverse environments, Greater

resilience going into a downturn,

Reduces procyclicality

Requirement: CET1 = 2.5% of RWA

Constraints imposed if CET1 ratio

falls within buffer range:

– On the distribution of dividends,

on bonuses and share buybacks

Supervisory discretion to impose

time limits on banks operating within

the buffer range

2. Countercyclical Capital Buffer

To protect banking sector from periods of excessive aggregate credit growth (private sector credit-to-GDP gap) often associated with system-wide risk

Not about solvency of a bank in first instance (covered by min. capital req.)

Potential moderating effect on credit cycle (Potential positive side benefit, not primary objective)

Extends capital conservation buffer (i.e. to be met with CET1 capital)

Buffer range between 0 - 2.5% of RWA

– Deployed during build-up phase of system-wide risk

– Deactivated when system-wide risk dissipates

Pre-announce decisions to raise buffer levels by up to 12 months

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Individual bank minimum capital conservation standards

CET1 RatioMinimum Capital

Conservation Ratios(% of earnings)

> 7% 0%

> 6.375% - 7% 40%

> 5.75% - 6.375% 60%

> 5.125% - 5.75% 80%

> 4.5% - 5.125% 100%

Conservation requirements: An illustration

Minimum4.5%

Conservation Buffer2.5%

Bank B6.8%

Bank A9%

Bank C4.7%

Requirement Hypothetical banks

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CCB and Credit to GDP Gap

0

1.25

2.5

3.75

0 2 4 6 8 10 12

Credit to GDP gap (%)

CCB

(% of RWA)

Buffer

L H

Example: Suppose the GAP = 6%

CCB= [(6 – 2) / 8] x 2.5 = 1.25

CCB= 0 if credit/GDP gap is equal to/below 2, CCB =2.5 if

credit/GDP gap is equal to/above 10%. For credit/GDP gap between 2 and 10 percent the buffer is calculated as 2.5/8 times the value of the credit/GDP gap exceeding 2 per cent.

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16

Capital buffers: An illustration

Cycle-neutral

Buffer

2.5% CET 1

Time

Minimum requirement (hard floor)

Time-varying

buffer

Capital Level

Capital Conservation Buffer

4.5% CET 1

7.0% CET 1

(4.5+2.5)

Desired level

9.5% CET 1

(4.5+2.5+2.5)

Countercyclical

Capital Buffer

2.5%

CET 1

Release: also important-(London Taxi)

India: Countercyclical capital buffer

• Credit-to-GDP gap for CCCB framework can have limitations for

emerging economies

• In a structurally transforming economy with rapid upward mobility,

growth in credit demand will expand faster than GDP growth:

– shift from services to manufacturing where the credit intensity is

higher per unit of GDP

– need to double India’s investment in infrastructure which will

place enormous demand on credit

– financial inclusion programme will bring millions of low income

households into formal banking system with almost all of them

needing credit.

• Lower threshold (L=3%), Basel (2%)

• Higher threshold (H=15%), Basel (10%)

• Sectoral approach also to be used

Statistically relevant indicators:

• Incremental C-D ratio for a moving period of 3 years

• Predictor of overheating of credit market, high correlation

with credit-to-GDP gap and Gross NPA growth; lag of over

12 months

• Industrial Outlook (IO) survey

• Quarterly covering 2000 manufacturing companies,

negative correlation with Gross NPA growth but not with the

Gap; lag of over 12 months

• Interest Coverage Ratio of corporate sector

• high correlation with credit-to-GDP gap but not GNPA

• Considered but not found suitable: Stock price, Gold price

• Promising but inadequate data points as of now: House Price

Index, Credit Condition Survey

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India: Supplementary Indicators

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Structural Dimension: Mapping Tools to Objectives

SIB Capital

Surcharge

Sectoral Tools within

financial System

(RW, large exposure limits)

Increased Resilience of

G-SIFIs

Liquidity Tools

Changes to market

infrastructures

Reduce excessive

exposures within the

system

- Funding Market

- Derivatives Market

IMF: June 2013

Source: IMF

The New Vocabulary

• SIFIs – Systemically Important Financial Institutions

• SIMIs – Systemically Important Markets & Infrastructures

• FMIs – Financial Market Infrastructures

• SIBs – Systematically Important Banks

• G-SIFIs/ G-SIBs – Global SIFIs/ Global SIBs

• D-SIFIs/ D-SIBs – Domestic SIFIs/ Domestic SIBs

• RRP – Recovery and Resolution Plan

• Living Wills

• HLA – Higher Loss Absorbency for D-SIBs/G-SIBs relative to

Basel III requirements for internationally active banks

• Systemicity …..

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Assessing Systemic Importance

• Systemically Important Financial Institutions (SIFIs)

Financial institutions whose distress or disorderly failure would

cause significant disruption to the wider financial system and

economic activity

• Global SIFIs (G-SIFIs)

… significant dislocations in the global financial system

and adverse economic consequences across a range of

countries

• Do Banks only give rise to systemic risk?

Source- Reducing the moral hazard posed by systemically important financial institutions –

FSB Recommendations and Time Lines, 20 October 2010.

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SIBs: The Policy Framework

Probability of Failure

1.Higher Loss Absorbency • Addl. CET1 • CoCos (high trigger)

2.SIE: Sup Intensity & Eff. Enhanced Sup expectations-

• Risk management functions• RDA & RR • Risk governance • Internal controls

Impact of Failure

1.Recovery & Resolution Plan

• Bail-in Debt

2.Resolvability Assessments

3.Resolution Authority

4.Crisis Management Groups

TBTF Subsidy

Reduce Moral Hazard

EISIB= EInon-SIB

PD x LGD = PD x LGD

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G-SIBs – Assessment Methodology

Supervisory Judgement

Indicator-based

Measurement Approach

Peer Review Process

+

+

Global Systemic BanksAdditional Capital

Requirements

Magnitude of Higher Loss

Absorbency

Bucketing approach

Instruments to meet

Additional Loss

absorbency

Indicator Based Measurement Approach

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5 Categories, each

20% weight

12 Individual Indicators Indicator

weights

Denominators: end-2013

G-SIB exercise (Euro)

Cross-jurisdictional

activity (20%)

Cross-jurisdictional claims 10% 15,800,934,260,979

Cross-jurisdictional liabilities 10% 14,093,660,568,019

Size (20%) Total exposures as per Basel III

Leverage ratio20% 66,313,252,232,943

Interconnectedness

(20%)

Intra-financial system assets 6.67% 7,717,965,931,836

Intra-financial system liabilities 6.67% 7,830,851,966,370

Securities outstanding (Nov 2011- wholesale funding ratio,

now under Ancillary Indicator)

6.67% 10,836,237,185,460

Substitutability/

financial institution

infrastructure (20%)

(2013: CAP–

500bps)

Assets under custody 6.67% 100,011,715,645,358

Payments activity 6.67% 1,850,754,573,909,200

Underwritten transactions in debt

and equity markets 6.67% 4,487,480,557,423

Complexity (20%) Notional amount of Over The

Counter (OTC) derivatives 6.67% 639,987,527,203,752

Level 3 assets 6.67% 595,404,598,635

Trading and available-for-sale

securities (July 2013- excluding HQLA)

6.67% 3,310,507,132,019

Bucketing Approach & HLA Requirement – Nov 2013

Bucket Score range* Higher loss absorbency requirement

(Common equity as % of RWA)

5 (empty) 530-629 3.5%

4 430-529 2.5%

3 330-429 2.0%

2 230-329 1.5%

1 130-229 1.0%

*cut-off score for end-2012 exercise- 130 bp, equal bucket sizes at 100 bps. Scores -average of five category sub-scores,

with substitutability/infrastructure capped at 500 bps. Bucket thresholds & the cap fixed for at least end-2013, ‘14 & ‘15.

• Avoid a fixed list (moral hazard, no incentives to reduce systemic relevance)

• continuous function (better on theoretical grounds), difficult to justify in

practice. Equal sized buckets imply a linear function – higher capital for

higher measure of systemic risk

• 4 buckets + 1 empty on top. If the top bucket is filled, then add a new empty

one (incentive to reduce systemic importance)

Nov 2014 List of 30 G-SIBs (29 in 2013, 28 in 2012)

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Bucket G-SIBs in alphabetical order within each bucket

5(3.5%)

Empty

4(2.5%)

HSBC, JP Morgan Chase

3(2.0%)

Barclays, BNP Paribas, Citigroup, Deutsche Bank

2(1.5%)

Bank of America, Credit Suisse, Goldman Sachs, Mitsubishi UFJ FG, Morgan Stanley,, Royal Bank of Scotland

1(1.0%)

Agricultural Bank of China (new addition in 2014), Bank of China, Bank of New York Mellon, BBVA, Groupe BPCE, Group Credit Agricole, Industrial & Commercial Bank of China Ltd, ING Bank, Mizuho FG, Nordea, Santander, Societe Generale, Standard Chartered, State Street, Sumitomo Mitsui FG, UBS, UnicreditGroup, Wells Fargo,

Source: FSB “Update of list of G-SIBs”, Nov 2014

D-SIBs – The Indian Framework

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Category (weight) Indicator Indicator weight

Size (40%) Exposure Measure for Basel III Leverage Ratio 40%

Interconnectedness(20%)

Intra Financial System Assets 6.67%

Intra Financial System Liabilities 6.67%

Securities Outstanding 6.67%

Substitutability(20%)

Assets Under Custody 6.67%

INR Payments using RTGS & NEFT 6.67%

Underwritten transactions in debt & equity markets

6.67%

Complexity(20%)

Notional Amount of OTC Derivatives 6.67%

Cross Jurisdictional Liabilities 6.67%

Securities under HFT & AFS categories 6.67%

India: Bucketing for DSIBs

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Bucket HLA (Additional CET 1 as % of RWA)

5 (Empty) 1.00%

4 0.80%

3 0.60%

2 0.40%

1 0.20%

Hong Kong: D-SIB Framework FEB 2015

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Factor Quantitative Indicator Indicator weighting

Size (50%) Total Assets 50%

Interconnectedness (25%)

Interconnectedness within the banking system: Balances with and from banks (bothcomponents weighted 6.25% each)

12.5%

Interconnectedness with the financial system: Loans to financial concerns

12.5%

Substitutability/financial institution infrastructure (25%)

Deposits from customers 12.5%

Loans and advances to customers 12.5%

Basel III: Regulatory capital ……

CRAR

Basel II 13.33%

Basel III 12.60%

Basel III capital requirements

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Basel III Capital and buffers

Common Equity Tier 1

after deductions

Addl

Tier 1

Tier 1

capital

Tier 2

capital

Total

capital

Level Total (1) (2) 3=(1+2) 4 (3+4)

Minimum 4.5% 4.5% 1.5% 6% 2.0% 8.0%

Conservation

buffer

2.5% 7.0% 1.5% 8.5% 2.0% 10.5%

Countercyclical

buffer range

0-2.5% 9.5% 1.5% 11% 2.0% 13.0%

G-SIB Buffer

(D-SIB Buffer

could be more)

0-2.5%

(empty top

bucket of

3.5%)

12% 1.5% 13.5% 2.0% 15.5%

Pre-Basel III minimum common equity = 2%, Min Tier 1= 4%

8% under Basel I ≠ 8% under Basel II ≠ 8% under Basel III

Adequacy of Regulatory Capital

Multiple approaches to determining adequacy of regulatory capital:

• Risk weighted capital requirements: capital primarily based on a historical assessment of risk in each asset class

• Stress Tests and capital planning: banks resilient to future adverse scenarios (US- CET1 Ratio- 4.5%, Tier 1 -6%, Total ratio-8%, Tier

1 leverage ratio of 4%, under baseline and stressful conditions over a planning horizon of 9 quarters)

• Leverage Ratio: in proportion to exposures regardless of their risk to guard against understatement of risk

UK: Proposed Leverage Ratios

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BOE Leverage

requirement

Coverage Proposed calibration

1. Minimum Leverage

Ratio Requirement

All banks/building societies,

investment firms

3%

2. Supplementary

Leverage ratio buffer

G-SIBs and other major

domestic UK banks/building

societies

35% of the corresponding

risk-weighted systemic

buffer rates

3. Countercyclical

leverage ratio buffer

(CCLB)

All banks/building societies,

investment firms

35% of the risk-weighted

countercyclical capital

buffer rate

- Buffer requirements -CET1 capital

- 35% conversion factor – ratio of 3% min leverage req & 8.5% Tier 1 capital req. including

CCB (4.5% CET1, 1.5% Addl T1, 2.5% CCB). (3/8.5=0.35, or 35%)

- capital measure — numerator of leverage ratio — CET1 75%, AT1 upto 25% (1.5/6=0.25)

Final Remarks: Macroprudential Frameworks

• One of the key innovations of Basel III: macroprudential

regulation

• But macroprudential approach is not a panacea…

• “The key to success is blend ambition with humility – ambition to

put in place frameworks that are capable of constraining financial

booms and to use the tools vigorously; humility to recognise that

limitations in what the frameworks can achieve on their own.”

• “….Macroprudential frameworks must be part of the answer, but

they cannot be the whole answer (in taming financial booms and

busts).”

Claudio Borio

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Thank You