basel 3 & implication[1]
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Basel III and its implications for
banks treasurers
B. Mahapatra
Reserve Bank of India
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Outline
Introduction
Enhancement to Basel II
Building blocks of Basel III Elements of Basel III relevant for banks
treasurers
Implications of Basel III Impact on Indian banks
Conclusion
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Introduction
The Basel I 1988 capital charge for creditriska simple broad-brush approach
Amendment to Basel I 1996 to incorporate
capital charge for market risk Standardized Measurement Method (SMM)
Internal Models Approach (IMA)
Market risk capital framework Capital charge for general market risk
Capital charge for specific risk (credit risk)
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The Basel II 2004 Enhanced risk coverage
Credit
Market and
Operational risks A menu of approaches standardized to model based
with increasing complexity
Three pillar approach
The Basel II of 2004 copied and pasted the capitalcharge for market risk of Basel I amendment of1996
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As a result, the capital charge framework for
market risk did not keep pace with new
market developments and practices
Capital charge for market risk in trading book
calibrated much lower compared to banking
book positions on the assumption that
markets are liquid and positions can be woundup or hedged quickly
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Capital charge for specific risk (credit risk) in
market risk framework (trading book) was lower
than capital charge for credit risk in banking
book Lower capital charge for trading book led to
scope for capital arbitrage
Capital charge for counterparty credit risk forderivative positions also covered only the default
risk and migration risk was not captured
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The global financial crisis mostly happened in
the areas oftrading book /off balance sheet
derivatives / market risk and inadequate
liquidity risk management
Banks suffered heavy losses in their trading
book
Banks did not have adequate capital to cover
the losses
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There was heavy reliance on short term
wholesale funding
Unsustainable maturity mismatch
Insufficient liquidity assets to raise finance
during stressed period
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Enhancement to Basel II
Post- crisis, global initiatives to strengthen the
financial regulatory system
July 2009 Enhancement to Basel II mostly in
trading book
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Pillar 1 Standardized approach
Higher risk weights for CRE securitization and otherre-securitization exposures almost doubled
Bank not permitted to use any external rating ofABCP program where it had provided liquidity facilityor credit enhancement treated as unrated
Operational criteria for using external ratingsprescribed
CCF for all eligible liquidity facilities made uniform at50%, irrespective of maturity (earlier 20% CCF formaturity less than one year)
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Pillar 1 Internal models approach
Capital based on normal VaR and stressed VaR
Incremental Risk Charge (IRC) for interest rate
instruments introduced which will capture default
as well as migration risk
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Pillar 2 guidance
firm wide governance and risk management;
capturing risk of off balance sheet exposures and
securitization activities;
managing risk concentrations;
managing reputation risk and liquidity risk;
improving valuation practices; and
implementing sound stress testing practices
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Pillar 3
appropriate additional disclosures completing
enhancements in Pillars 1 and 2
Securitization exposures in trading book
Sponsorship of off balance sheet vehicles
Re-securitization exposures; and
Pipeline and warehousing risks with regard to
securitization exposures
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The Basel III
December 17, 2009 Basel Committee issued
two consultative documents:
Strengthening the resilience of the banking sector
International framework for liquidity risk
measurement, standards and monitoring
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The proposals were finalized and published
on December 16, 2010:
Basel III: A global regulatory framework for more
resilient banks and banking systems
Basel III: International framework for liquidity risk
measurement, standards and monitoring
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Objectives
Improving banking sectors ability to absorb
shocks
Reducing risk spillover to the real economy
Fundamental reforms proposed in the areas of
Micro prudential regulation at individual bank
level
Macro prudential regulation at system wide
basis
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Building Blocks of Basel III
1. Raising quality (Tier 1 6%, of which TCE - 4.5%), level(8+2.5% CCB), consistency (deductions mostly from TCE)and transparency of capital base
2. Improving/enhancing risk coverage on account ofcounterparty credit risk
3. Supplementing risk based capital requirement withleverage ratio
4. Addressing systemic risk and interconnectedness
5. Reducing pro-cyclicality and introducing countercyclical
capital buffers (0-2.5%)6. Minimum liquidity standards
We will discuss 2, 3, 4 and 6
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Improving/enhancing risk coverage on
account of counterparty credit risk
In addition to July 2009 Basel II Enhancements
Counterparty credit risk (replacement cost
value) is measured either by OEM, CEM,
Standardized Method or IMM
Banks using IMM for measuring exposure for
counterparty credit risk in derivative
transactions will be required to use stressed
inputs in Effective Expected Positive Exposure
model
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Banks using standardized approach or IRB
approach for credit risk in OTC derivatives,
must add a capital charge to cover CVA (Credit
Valuation Adjustment) risk to capture downgradation of counterparty before default in all
approaches
Capital charge for wrong way risk PD andEAD are positively correlated - in all
approaches
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Asset value correlation of 1.25 for financialfirms of $ 100 billion assets and unregulatedfinancial firms
Strengthening collateral management andextend margining period of risk to 20 days forOTC derivatives
Increasing incentives for use of CCPscompliant with CPSS/IOSCO norms, for OTCderivatives
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Supplementing risk based capital
requirement with leverage ratio
Objectivesto supplement capital ratio incapturing risk
Numerator Tier 1 capital
Denominator on and off balance sheetexposure credit equivalent with 100% CCF, except10% CCF for unconditionally cancellable OBScommitments
Derivatives on CEM and Basel II netting basis
Collateral, guarantees or credit risk mitigation willnot reduce on balance sheet exposures
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Ratio 3%
As a Pillar 2 measure to start with but will beintegrated with Pillar 1
Leverage ratio will be tracked from January 1,2011 to see the result of the above definitionand parallel run from January 1, 2013 to 2017
and final adjustment in 2017 Disclosurefrom January 2015
As Pillar 1 ratio from January 1, 2018
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Addressing systemic risk and
interconnectedness
Capital and liquidity surcharge on SIBs/SIFIs
Activity restriction/exposure on SIBs/SIFIs
Intensive supervision of SIBs/SIFIs Asset value correlation of 1.25 for exposures
to large financial institutions and unregulated
institutions
Stricter treatment of OTC derivatives not
cleared through CCPs
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Improving loss-absorbing capacity of SIBs/SIFIs
- Contingent capital and bail-in-able debt
Orderly unwinding of SIBs/SIFIs improving
resolvabilityliving wills
International framework for liquidity
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International framework for liquidity
risk measurement, standards and
monitoring Key characteristic of the financial crisis wasinaccurate and ineffective management of
liquidity risk
Two standards/ratios proposed
Liquidity Coverage Ratio (LCR) for short term (30
days) liquidity risk management under stress
scenario Net Stable Funding Ratio (NSFR) for longer term
structural liquidity mismatches
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Liquidity Coverage Ratio (LCR)
Ensuring enough liquid assets to survive an acutestress scenario lasting for 30 days
Defined as stock of high quality liquid assets / Netcash outflow over 30 days > 100%
Stock of high quality liquid assets cash + centralbank reserves + high quality sovereign paper (also inforeign currency supporting banks operation) + state
govt., & PSE assets and high rated corporate/coveredbonds at a discount of 15% - (A)
Level 2 liquid assets with a cap of 40%
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Fundamental characteristics of liquid assets
Low credit and market risk
Ease and certainty of valuation
Low correlation with risky assets
Listed in a developed and recognized exchange
Market-related characteristics
Active and sizable market
Presence of committed market makers Low market concentration
Flight to quality
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Net Stable Funding Ratio (NSFR)
To promote medium to long term structural
funding of assets and activities
Defined as Available amount of stable funding /Required amount of stable funding > 100%
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Other monitoring tools for liquidity risk
management
Contractual maturity mismatch
Concentration of funding
Available unencumbered assets
LCR by significant currency
Market-related monitoring tools
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Implications of Basel III
Impact on economy
IIF study loss of output of 3% in G3 (US, Euro
Area and Japan) on full implementation during
2011-15 Basel Committee study likely to have modest
impact of 0.2% on GDP for each year for 4 years
for 1% increase in TCE
Similarly, for 25% increase in liquid assets, half the
impact of 1% increase in TCE
However, long term gains will be immense
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Global banks could have a gap of liquid assets
of1,730 billion - to be met in four years Global big banks could have a capital shortfall
of577 billion to meet 7% common equity
norm to be met in eight years Tier 1 capital ratio falls to 5.7% from 11.1%
under the new definition / adjustment of
capital and increase in risk coverage (RWAs) Therefore, long phase-in arrangements
(Annex1)
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Impact on Indian banks
High capital ratios at 14.4% in June 2010
which will fall to 11.7%. Tier 1 will fall from
10% to 9% and common equity from 8.5% to
7.4%
Most of deductions are already mandated by
RBI, so little impact
Most of our banks are not trading banks, sonot much increase in enhanced risk coverage
for counterparty credit risk
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Banks mostly follow a retail business model
and do not depend on wholesale funds
Whether our SLR securities can be part of
liquid assets?
Whether our liquid assets will stand the
scrutiny of fundamental characteristics and
market-related characteristics?
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Indian banks are generally not as highly
leveraged as their global counterparts
The leverage ratio of Indian banks would be
comfortable
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Banks having a huge trading book and off
balance sheet derivative exposures may be
impacted due to increased risk coverage
(capital) on account of counterparty creditrisk
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Similarly, banks having huge off balance sheet
exposures - derivatives and others - may be
impacted on account of leverage ratio
Banks depending heavily on wholesale funds
may be impacted due to the new liquidity
standards
SIBs may have further implications for capitaland liquidity surcharges and activity
restrictions
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Whether our banks can attract capital in the
form of contingent capital and bail-in able
debt at the point of non-viability or whether
our capital market will support suchinstruments?
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Conclusion
Basel Committee is undertaking a
fundamental review of the trading book
whether a particular position to be covered in
trading book or banking book and capitalrequirement
Not only sluggish growth, high unemployment
and low returns, but also more resolution willbe the New Normal
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Thank You
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