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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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