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Abstract

Basel III guidelines are the response of BCBS (Basel Committee on Banking Supervision) to the 2008 Crisis. It is aimed at strengthening Individual Financial Institutions as well as the overall Financial System by eliminating the weaknesses which were present in BASEL II that were revealed during the crisis.

BASEL III has a multi-dimensional impact on financial Institutions and will require associated changes to the IT systems.

This paper covers various BASEL III guidelines, and describes the “Why” and “How” different areas of IT infrastructure and systems will be impacted.

Whi

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Basel II to Basel III – The Way forward

- Rohit VM, Sudarsan Kumar, Jitendra Kumar

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BASEL III attempts to plug the loopholes present in BASEL II by recommending steps to further strengthen the overall financial system. BASEL III requires higher risk weights for risky assets bringing more assets/exposure into the umbrella of Risk Weighted Asset (RWA) calculations, prescribes a higher regulatory capital requirement and demands a very high quality of capital. It also introduces requirements to manage liquidity risk better. Finally, it introduces an additional requirement of absolute leverage ratio to take into consideration the model error which might be present in RWA calculations.

Some very fundamental assumptions by financial institutions and regulators were proven wrong during the 2008 Crisis. The business of subprime lending was based on the assumption that housing prices would keep going up. This assumption proved wrong and it triggered a chain reaction that engulfed the global financial system. This ‘crisis cycle’ is illustrated in the diagram below.

There were some incentives present in the financial system that encouraged risk taking. Transferring of risk through securitization; relying on credit ratings provided by credit rating agencies, which were paid for by the issuers; compensation of top management based on absolute growth, revenue and profit rather than risk adjusted profitability; were just some of the reasons that encouraged excessive risk taking by banks.

When subprime loan defaults started impacting the balance sheets of financial institutions, it became a systemic problem. Quarterly losses to the tune of billions of dollars by major Financial Institutions resulted in a crisis of confidence that sucked out liquidity from the financial system. At this time, the weaknesses of the BASEL II guidelines became very evident.

Exposure to risky assets in the form of subprime loans, securitization and derivatives resulted in excessive losses. The low quality and quantity of capital could not absorb these losses when systemic risk materialized. The bank’s loss absorbing capacity was affected because of their excessive leverage and their short term sources of funding made financial institutions gasping for capital when it was most difficult to raise capital.

Introduction

Excessive Risk Taking

Sub-Prime Lending

Securitization

Housing prices decline resulting in sub-prime defaults

Sub-prime defaults, Securitized assets & derivatives trading resulted in huge losses

Excessive leverage & poor capital could not absorb losses fully, demanding fresh equity infusion

Huge losses resulted in a crisis of con�dence causing liquidity to evaporate

Short term borrowing demanded fresh borrowing which failed in liquidity crisis

Firms on the verge of insolvency; threatening system failure

Governments step in to inject capital to prevent systemic failure

In stressed market situations, Credit Rating downgrades of Financial Institutions & securitized products further lowered valuations & increased losses

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The diagram below highlights where and how BASEL III changes will address the deficiencies in the ‘crisis cycle’.

In summary, the BASEL III rules will strengthen the capital reserves and introduce stringent reporting requirements that cover key risk, liquidity and leverage parameters. The BASEL III guidelines also attempt to bolster the weak links in the financial system with the introduction of Central Clearing Houses and lessen the dependency on Rating Agencies. The chart below captures the key aspects of the BASEL III guidelines that have been introduced.

CAPITAL

• Increaseincommonequityrequirementfrom2%to4.5%

• IncreaseinTier1Capital(GoingConcern)from4%to6%

• Overallcapitalwillremainthesameat8%.(WhichmeansTier2capital,orgoneconcerncapitaltoreduceto2%oftotal capital)

• Tier1Capitalcannolongerincludehybridcapitalinstrumentswithanincentivetoredeemthroughfeaturessuchasstep-up clauses. These will be phased out

• Tier3Capitalwillbeeliminated(previouslyusedformarketrisk)

RISK MANAGEMENT

• CreditValuationAdjustment(CVA)CapitalChargemustbecalculatedtocoverMark-to-MarketlossesoncounterpartyrisktoOverTheCounter(OTC)Derivatives.

• StressedparametesmustbeusedtocalculateCounterpartyCreditRisk

• EffectiveExpectedPositiveExposure(EPE)withstressedparameterstobeusedtoaddressgeneralWrong-WayRisk(WWR) and Counterparty Credit Risk

• Banksmustensurecompletetradecaptureandexposureaggregationacrossallformsofcounterpartycreditrisk(notjustOTCderivatives)atthecounterparty-specificlevelinasufficienttimeframetoconductregularstresstesting.

• Amultiplierof1.25isappliedtothecorelationparameterofallexposurestofinancialinstitutions(meetingcertaincriteria) (Asset Value Correlation - AVC)

• Additionalmarginingrequiredforilliquidderivativeexposures

• 100%riskweightforTradefinance

CAPITAL - BUFFERS

• IntroductionofCapitalConservationBuffer-2.5%ofCommonEquityTier1

• IntroductionofCounterCyclicalBuffer-0to2.5%ofRiskWeightedAssets(RWA)

Excessive Risk Taking

Sub-Prime Lending

Securitization

Housing prices decline resulting in sub-prime defaults

Sub-prime defaults, Securitized assets & derivatives trading resulted in huge losses

Excessive leverage & poor capital could not absorb losses fully, demanding fresh equity infusion

Huge losses resulted in a crisis of con�dence causing liquidity to evaporate

Short term borrowing demanded fresh borrowing which failed in liquidity crisis

Firms on the verge of insolvency; threatening system failure

Governments step in to inject capital to prevent systemic failure

In stressed market situations, Credit Rating downgrades of Financial Institutions & securitized products further lowered valuations & increased losses

Capital Conservation / Counter-cyclical bu�ers

• Less reliance on external ratings agencies

• CVA Capital Charge• Stressed Testing

• Higher quantity & quality of capital

• Leverage Ratio introduced• 100% weight for trade �nance

Correlation to �nancial institutions will carry more risk weights – to prevent systemic risks and an overall collapse

Enhanced Supervisory Review and Disclosure

Two new liquidity ratios

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LIQUIDITY • LiquidityCoverageRatio(LCR)>=100%

• NetStableFundingRatio(NSFR)>100%

LEVERAGE • LeverageRatio>=3%

RATINGAGENCIES • LowerrelianceonExternalRatingAgencies

REPORTING• Contractualmaturitymismatch

• Concentrationoffunding

• Availableunencumberedassets

• Market-relatedmonitoringtools:assetpricesandliquidity,CreditDefaultSwap(CDS)spreadsandequityprices

• LCRbycurrency

• Resultsofstresstestsshouldbeintegratedintoregularreportingtoseniormanagement

Basel III –New Requirements

IT Impact – Summary of ChangeThe architecture below represents a typical BASEL II set-up. Exposure and reference data information is extracted from multiple source systems through Extract, Transform & Load (ETL) processes and the modelling parameters – Probability ofDefault(PD),ExposureatDefault(EAD)andLossGivenDefault(LGD)are calculated. This data is stored inaRiskData-Warehouseandthenthe RWA calculations are performed on the risk data to calculate the regulatory capital requirements.

In general, a BASEL III implementation wil l require additional source systems to be included, changes to the data elements of existing source systems to be made, changes to the risk data models to be done, RWA calculations and reporting modules to comply with regulatory reporting guidelines. These changes are highlighted in the pictorial representation in the diagram.

General Ledger

Origination System

Servicing System

Collateral Mgmt.

System

Loss & Recovery System

Reference Data

External Sources

Sour

ce S

yste

m E

xtra

cts

Dat

a Q

ualit

y/CD

C

RiskDatamarts

Segment De�nition

PD, LGD, EAD

Op Risk Models

Model Validation/ Feedback

Factor Model Environment

Model Execution and Output

G/L Reconciliation RWA Calculator

Reporting Tool

ICAAP Reports

Management Reports

FFIEC 101 ReportsSt

agin

g/O

DS

Data Sources Basel II Risk EnvironmentETL Staging

Data Governance

Possible new Data marts to hold data for the measurement of Liquidity and Leverage ratios

New Sources of Data (Cash Flows) required to calculate LCR/NSFR.

Updated Models will incorporate new sources of capital (new data �elds) and stressed parameters

RWA Calculation will change because of the new data �elds and new risk weights

Data Governance across the system

New Reports1. LSR, NSFR2. Leverage3. Contractual maturity mismatch4. Concentration of funding5. Available unencumbered assets

6. Market-related monitoring tools: asset prices and liquidity, CDS spreads, equity prices, institution speci�c information related to the ability of the institution to fund itself in various wholesale markets

7. LCR by currency

RWA Calculation and Reporting

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BASEL III’s IT impact can be further understood by looking at its impact on each of the areas separately. The table below lists the impact expected in different areas of implementation and also lists some of the challenges that will be encountered while implementing them.

Some new sources of data that would need to interact with the Basel framework include:

• AssetLiabilityManagement (ALM) systems

• CashFlowManagement systems

• ExistingLiquidityRisk Management systems

• DatafromCentralCounterparties for datarelatedtoOver-The-Counter(OTC)derivatives.

• Thenewliquidityratios that Basel III introduces (LCR and NSFR), will entail the creation of new Liquidity Risk DataMartstoholdrelevantData

• UseofStressedparameters as well as calculating CVA for counterparty credit risks will need huge amounts of historical data, which may require the use of new data marts/databases to store such information.

• Theformulasusedin the calculation ofPD,LGD,EADwillchange due to the need to incorporate stressed parameters and to also reflect ahigherEADvaluefor counterparties where specific Wrong Way Risk (WWR) has been identified.

• Changeswillberequired at the risk engines to accommodate the new buffers (Counter Cyclical, Capital Conservation).

• Itwillalsoneedto accommodate the new Risk Weights assigned to derivatives, trade finance products as well as account for exposures to financial institutions.

• Thereportingsystems will have to be enhanced to cater to the new reports mentioned in Basel III

• Theexistingreportswill also be modified to reflect liquidity, leverage and CVA, besides the new capital structure

• Subsidiaryreportingrequirements will be augmented.

IMPA

CT

• IdentifyingtherightDataElements.Thiswould require a good knowledge of accounting systems as well as knowledge of the various reports required by Basel III.

• Identifyingsources and data requirements for different legislations.

• Asingledataload with all the attributes required for market, CCR, RWA, economic capital and liquidity risk should be extracted from source systems.

• Asaresult,DQchecks will be rigorous.

• Consultantshavingexperience in Stress Testing, Analytics, and general knowledge about the business of Banks will be required to identify and stress the required parameters.

• Modelvalidationshould be a focus area.

• Thesystemshouldbe configured to provideGroupData,SoloData,BaselI,II and III data on demand.

• Understandingthe new reporting requirements

• Bringingoutsynergies across stakeholders and consolidating the reporting platform.

CH

ALL

ENG

ES

• PutinplacearigorousandscalableDataGovernanceframework(People+Process+Technology)

• Alignsourcesystems’dataqualitycapabilitiestomeetFitForPurposenorms

• End-to-endauditcapabilityfromsourcesystemdatatofinaloutputcalculationmaybeachallengeinBaselIIIbecauseofthemanynew source systems interacting with the reporting systems.

DAT

A G

OV

ERN

AN

CE

Risk Data Identification

RWA Calculation

Regulatory Reporting

Infrastructure and Data Management

Risk Modeling and Quantification

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BASEL III Implementation Approach A BASEL III Implementation will require a core team to co-ordinate with multiple track owners who would be responsible for making changes totheapplicationsandsystemsthattheymanage.Ideally,aBASELIIIProjectManagementOffice(PMO)willberesponsibleforinitialimpactassessment, identifying multiple tracks within the overall program, co-ordinating and monitoring the overall execution and reporting to the senior management.

Basel III Implementation Timeline Since the BASEL III requirements bring in critical buffers and significant capital outlays, the key aspects of the BASEL III guidelines will be implementedinphasesfromJanuary2013through2018.Thisshouldgivebanksenoughtimetoreviewtheirfinancialpreparednessandalso enhance their operational and reporting capabilities.

Source - The website for the Bank for International Settlements - http://www.bis.org/bcbs/basel3.htm

• Programroadmapdefinition

• Highlevelplan

• Establishcurrentstateof compliance

• PMOprocessdefinitions for change management, communication management and reporting

• Identifykeystakeholders

• Kick-offmeetingwithall stakeholders

• Defineindividualtracks within the program

• Impactanalysisand requirement documentation

• Identifydependencies, risks and assumptions

• Detaillevelplanningfor individual tracks

• Identifythecriticalpath

• Productevaluation(ifrequired)

• Architecturedesign

• Dataanalysis&modeling

• Technicaldesign

• Datafeeddesign

• DatasourcingandETL

• Datasufficiencyanalysis

• PlatformDevelopment

• Applicationcustomization and build

• Dataqualitytesting

• Functionaltesting

• Regressiontesting

• Non-functionaltesting

• Defectmanagementand reporting

• Ongoingenhancements

• Maintenanceandusersupport

• Platformmigration

Strategy & Roadmap Implementation Maintenance &

Support

Impact Analysis & Track Segregation

Solution Definition

PHASEINARRANGEMENTS(Shadingindicatedtransitionperiods-alldatesareasof1January)

2011 2012 2013 2014 2015 2016 2017 2018 As of 1Janurary2019

Legerage Ratio Supervisory Monitoring

Parallelrun1Jan2013-1Jan2017 Disclosurestarts1Jan2015

Migration toPillar1

Minimum Common Equity Capital 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%

Minimum Common Equity Plus Capital Conservation Buffer 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%

Phase-inofdeductionsfromCET1(includingamountsexceedingthelimitforDTAs,MSRsandFinancials) 20% 40% 60% 80% 100% 100%

MinimumTier1Capital 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%

Capital Instruments that no longer qualify as non-core Tier1capitalorTier2capital Phasedoutover10yearhorizonbeginning2013

Liquidity Coverage Ratio ObservationPeriod Begins

Introduce Minimum Standard

Net Stable Funding Ratio ObservationPeriod Begins

Introduce Minimum Standard

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About the AuthorsJitendra Kumar is a Principal Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. Hehasover15yearsofexperienceandhascompletedCFAlevelI&IIfromtheCFAinstitute,USA.

He can be reached at Jitendrakumar@infosys.com

Sudarsan Kumar is a Senior Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. Hehasover4yearsofriskandcomplianceexperiencewithdatawarehousinginBaselII.

He can be reached at Sudarsan_Kumar@infosys.com

Rohit VM is a Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. His current focusisonBaselIII.RohitearnedhisPostGraduateDiplomainGeneralManagement(PGDGM)fromXLRI,Jamshedpur.

He can be reached at Rohit_V02@infosys.com

ConclusionBASEL III guidelines attempt to plug the gaps identified in BASEL II. However, the world economy and financial markets are dynamic and evolving ecosystems with many forces in play. Consequently, financial regulations will keep on evolving. The intensity of regulatory interventions is expected to increase in the future and the importance of risk management is expected to further move up in the priority of board members and top management.

It is therefore imperative that a BASEL III implementation is planned and designed with a high degree of scalability to support future changes in regulation. A BASEL III implementation should be taken as an opportunity to remove a silo based approach to risk management and move towards a reliable and scalable enterprise wide risk management system.

For such intent to be successful, an early start and preparation are essential so that enough due diligence goes into laying down the foundations of a strong risk management system.

© 2012 Infosys Limited, Bangalore, India. Infosys believes the information in this publication is accurate as of its publication date; such information is subject to change without notice. Infosys acknowledges the proprietary rights of the trademarks and product names of other companies mentioned in this document.

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