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Basel III
James J. Okarimia
Partner at RM associatesAmsterdam 10th May 2016
Overview
Meaning of Basel III
• Why Basel III
• Aims
• Objectives
• Major Changes Implementation of the Changes
What is "Basel III":
" A global regulatory standard on:
• Bank Capital Adequacy
• Stress Testing and
• Market Liquidity Risk
Also a set of reform measures to improve
• Regulation
• Supervision
• Risk Management
Reasons for Basel III Formulation:
Failures of Basel II being:
A. Inability to strengthen financial stability.B. Insufficient capital reserve.C. Inadequate comprehensive risk management
approach.D. Lack of uniformed definition of capital
Aims & Objectives of Basel III
• To minimize the probability of recurrence of crises to greater extent.
• To improve the banking sectors ability to absorb shocks arising from financial and economic stress.
• To improve risk management and governance.
• To strengthen banks transparency and disclosures .
Targets:
• Bank‐level or micro prudential which will help raise the resilience of individual banking institutions in periods of stress.
• Macro prudential system wide risks that build up across the banking sector as well as the pro‐cyclical amplification of these risk over time.
Key Elements of Reforms
• Increasing the quality and quantity capital• Enhancing risk coverage of capital• Introducing Leverage ratio• Improving liquidity rules• Establishing additional buffers• Managing counter party risks
The three Pillars of Basel II and Basel III
9
Basel III Overview
Credit Risk
Market Risk
OperationalRisk
Capital Market Risk
Capital Definition (Tier 1, 2)
Securitisation Exposures –Banking & Trading Book Leverage
Ratio*
Stress Testing, Model Validation, Back testing
Capital Ratios
Counterparty Credit Risk
Stressed Inputs for risk models
Credit Value Adjustment (CVA) Capital Charge
Higher Capital Charge for Specific wrong way risk
Liquidity Coverage Ratio
Net Stable Funding Ratio
External Credit Ratings Capital Buffers
(Capital Conservation Buffer & Countercyclical buffer), Additional Capital -Global SIFI & Local SIFI
Liquidity Monitoring Metrics (Maturity Mismatch, Funding Concentration)
Market Risk Measures (Stressed VaR, IRC)
Capital Deductions
Basel III Implementation Framework approach
Assessment of existing Basel Implementation –Business Req,Applications, Reporting etc
GapAnalysis (B3/B2.5 vs. Current State)
Business Architecture (E2E)
Application Architecture (E2E)
Basel Current State
Assessment
Gap Analysis & Impact
Assessment
Our & Bank –Joint Activity Our Activity
Basel 2.5 & Basel3 Requirements (BCBS, Home, Host Regulator )
Impact Assessment(Systems, & Data)
Requirements& Architecture
DataRequirements
Initiative Definition
InformationArchitecture (E2E)
Define high level initiatives, their workstreams and identify dependencies
Discovery - Bank’s asset classes,Basel program current state, Risk management policy, objectives Evaluate options to
close gaps
Categorize gaps, identify/prioritizeinitiatives & workstreams
ImplementationRoadmap
Initiative 1..N &Workstreams
Functional Requirements
SystemRequirements Phases
Activities
Timelines
Estimates – Effort, Resources
Phase Deliverable
High Level Scopedefinition doc
Requirementsdocument
ImplementationRoadmap
Activities
Gap Assessment, Initiative Definition Doc
Architecture Diagram
BusinessReq. doc, Gap Analysis & Impact AssessmentReport
Establish the High level scope for Gap analysis phase
Provide inventory of Business requirements, gaps & their impact
Categorize & prioritizegaps to define initiatives, workstreams and their dependencies
Initiative 1..N &Workstreams
Capture detailed functional, system & data Requirements across initiatives & workstreams. Define To -be state business, application and Information architecture at program level
Define detailed Implementation roadmapCovering initiatives &workstreams
Phase Objective
Approach – Current State Assessment
Basel 3 – Business Architecture
Approach – Requirements & Architecture
Pillar 1:Minimum Capital Requirements
• Pillar 1 aligns the minimum capital requirements more closely to actual risks of banks economic loss
• Revised risks:
√ Credit risk√ Operational risk √ Market risk
Pillar 1:Minimum Capital Requirements(cont)
• Credit risk√ The standardised approach√ Foundation internal ratings based (IRB) approach√ Advanced IRB approach
• Operational risk √ Basic indicator approach√ Standardized approach √ Advanced measurement approach
• Market risk√ standardized approach√ internal models approach
Pillar 2:Supervisory Review Process
• Pillar 2 requires banks to think about the whole spectrum of risks they might face including those not captured at all in Pillar 1 such as interest rate risk.• Coverage in Pillar 2: √ risks that are not fully covered by Pillar 1√ Credit concentration risk√ Counterparty credit risk√ Risks that are not covered by Pillar 1√ Interest rate risk in the banking book√ Liquidity risk√ Business risk√ Stress testing
Pillar 3:Market Discipline
• Pillar 3 is designed to increase the transparency of lenders risk profile by requiring them to give details of their risk management and risk distributions.
Weaknesses of Basel II
• The quality of capital.
• Pro‐cyclicality.
• Liquidity risk.
• Systemic banks.
Basel III: Strengthening the global capital framework
A. Capital reform.
B. Liquidity standards.
C. Systemic risk and interconnectedness.
A. Capital Reform
• A new definition of capital.
• Capital conservation buffer.
• Countercyclical capital buffer.
• Minimum capital standards.
A new definition of capital
Total regulatory capital will consist of the sum of the following elements:
1. Tier 1 Capital (going‐concern capital) a. Common Equity Tier 1 b. Additional Tier 1
2. Tier 2 Capital (gone‐concern capital)
• For each of the three categories above (1a, 1b and 2) there is a single set of criteria that instruments are required to meet before inclusion in the relevant category.
Capital conservation buffer
• The capital conservation buffer is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred.
• A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement.
• Outside of periods of stress, banks should hold buffers of capital above the regulatory minimum.
Countercyclical capital buffer
• The countercyclical buffer aims to ensure that banking sector capital requirements take account of the macro‐ financial environment in which banks operate.
• It will be deployed by national jurisdictions when excess aggregate credit growth is judged to be associated with a build‐up of system‐wide risk to ensure the banking system has a buffer of capital to protect it against future potential losses.
• The capital conservation buffer is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred.
Minimum capital standards
• GRC discipline has rightly
taken the center stage in top
management agenda and is
no more seen as a mere
compliance function.
• Wave of regulations (Dodd
Frank Act, Basel III/CRD IV etc)
will garner most of the Risk
attention in FSIs
• Base III/CRDIV will be
implemented in a phased
manner instead of a Big Bang
approach
B. Liquidity Standards:
1. Short‐term: Liquidity Coverage Ratio(LCR)
2. Long‐term: Net Stable Funding Ratio(NSFR)
1.Short‐term:
• The LCR is a response from Basel committee to the recent financial crisis.
• The LCR proposal requires banks to hold high quality liquid assets in order to survive in emergent stress scenario
Stock of High Quality Assets ≤ 100%Net Cash outflows over a 30 day Time Period
Short‐term: LCR
• Must be no lower than 1
• The higher the better
• High quality liquid: liquid in markets during a time of stress and, ideally, be central bank eligible.
• Banks are still expected to conduct their own stress tests to assess the level of liquidity they should hold beyond this minimum, and construct scenarios that could cause difficulties for their specific business activities.
2. Long‐Term: NSFR
• Objectives:• To promote more medium and long‐term funding activities of banking organizations.
• Ensure that the investment activities are funded by stable liabilities.
• To limit the over‐reliance on wholesale short‐term funding(money market)
Available amount of stable funding ≤ 100%Required amount of stable funding
Short‐term: NSFR
Available stable funding (ASF) is defined as the total amount of an institution’s:
• capital.• preferred stock with maturity of equal to or greater than
one year.• liabilities with effective maturities of one year or greater.
deposits and/or term deposits with maturities of less than one year that would be expected to stay with the institution for an extended period a stress event.
Required Stable Funding :
• The required amount of stable funding is calculated as the sum of the value of the assets held and funded by the institution, multiplied by a RSF factor, added to the amount of OBS activity (or potential liquidity exposure) multiplied by its associated RSF factor
Required Stable Funding : These components of required stable funding are not equally weighted.
• 100% of loans longer than one year.
• 85% of loans to retail clients with a remaining life shorter than one year.
• 50% of loans to corporate clients with a remaining life shorter than one year.
• and 20% of government and corporate bonds.
• off‐balance sheet categories are also weighted.
C. Systemic risk and interconnectedness (Counterparty risk)
• Capital incentives for using CCPs for OTC.• Higher capital for systemic derivatives.• Higher capital for inter‐financial exposures.• Contingent capital.• Capital surcharge for systemic banks.
CONCLUSION
• Basel III introduces a paradigm shift in capital and liquidity standards.
• It was constructed and agreed in relatively record time which leaves many elements unfinished.
• The final implementation date a long way off.
CONTACT
JAMES OKARIMIA Managing Partner RM AssociatesJanssoniuslaan 303528 AJ Utrechtt: +31 (0) 36 532 2399m: +31 (0) 6 2319 2655e: [email protected]
