Basel 3 Demystified

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					Incorporating Basel III Requirements
    into Bank’s Liquidity and Risk
       Management Processes
Dr. Emmanuel M. Abolo
Chairman, Riskmap Consulting Limited &
President, Risk Managers Association of Nigeria
Tel:+234 8021003297

•   Introduction
•   Basel II: The Limitations
•   Basel III: Four Major Components
•   Objectives of Basel III
•   Basel III and Bank’s Liquidity Management
     – Liquidity Coverage Ratio
     – Net Stable Funding Ratio (NSFR)
•   Incorporating Basel III into the Risk Management Process
•   Basel III Major Implementation Challenges
•   Progressive Roll Out of Basel III
•   Summary
•   Conclusion
Quotable quotes

          “Call on God, but row away from the rocks.”
                           Hunter S Thompson

 “Risk is like fire: If controlled it will help you; if uncontrolled it
                       will rise up and destroy you.”
                           Theodore Roosevelt

•   Basel III is an evolution rather than a revolution.
•   It was developed from the existing Basel II framework, and the most significant
    differences are:
     – The introduction of liquidity and leverage ratios; and
     – Enhanced minimum capital requirements.
Basel II: The Limitations

The Basel II Accord although very robust, in the wake of the recent global financial crisis, revealed weaknesses or
loopholes in its approach to risk management:
  – Macro imbalances;
  – Financial innovations - which led to unprecedented complexity in financial markets at a pace that was
      clearly unsustainable (CDs);
  – Subprime bubble - abnormal house prices in new millennium;
  – Increase in leverage;
  – Over-reliance on models e.g. use of VaR – based estimates of risk; and
  – Hard-wired procyclicality.
Risks have come from sources that Basel II did not adequately anticipate such as:
  – Collapse in market liquidity as investor confidence disappeared;
  – Deep losses in the market value of securities held by banks; and
  – Assumptions about the liquidity of financial instruments such as mortgage backed securities (MBS) that
      were based on past performance have proven to be unfounded as has the reliability of credit ratings on
      many of these MBS.
The financial crisis has also shown that at times of severe stress the inter linkages amongst banks and between
banks and other financial institutions have the potential to create a domino effect whereby seemingly safe
lenders can be put at risk by exposures to counterparties that turned out to be less safe than thought.

As a result of the foregoing, the Basel Committee on Banking Supervision (BCBS) published a revised global
standards, popularly known as Basel III
Overarching Objectives of Basel III

 To strengthen global capital       To improve the banking
 and liquidity regulation with     sector’s ability to absorb
the goal of promoting a more     shocks arising from financial
 resilient banking sector; and       and economic stress.
Specific Objectives of Basel III
•   Promote more integrated management of market and counterparty credit risk;
•   Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's
    credit rating;
•   Strengthen the capital requirements for counterparty credit exposures arising from
    banks’ derivatives, repo and securities financing transactions and raise the capital
    buffers backing these exposures;
•   Reduce procyclicality and provide additional incentives to move OTC derivative
    contracts to central counterparties;
•   Provide incentives to strengthen the risk management of counterparty credit
•   Raise counterparty credit risk management standards by including wrong-way risk;
•   Put a floor under the build-up of leverage in the banking sector;
•   Introduce additional safeguards against model risk and measurement error by
    supplementing the risk based measure with a simpler measure that is based on gross
•   Dampen any excess cyclicality of the minimum capital requirement;
•   Promote more forward looking provisions; and
•   Conserve capital to build buffers at individual banks and the banking sector that can be
    used during period of stress
Basel III: Four Major Components

1.   Quality, consistency and transparency of the capital base
     – Greater emphasis placed on the common equity component of Tier 1
     – Simplification of Tier 2
     – Elimination of Tier 3
     – Detailed regulatory capital disclosure requirements
2.   Enhancement of risk coverage through enhanced capital requirements
     for counterparty credit risk
     – Enhanced risk coverage will address issues that arise in connection
          with the use of derivatives, repos, and securities financing
3.   Changes to non-risk adjusted leverage ratio
     – This ratio will supplement the Basel II risk capital framework
4.   Measures to improve countercyclical capital framework
  Raising the Quality, Consistency, and Transparency of
  the Capital Base
Tier 1 capital
    Tier 1 capital is the core measure of a bank's financial strength from a regulator's point
    of view.
    It is composed primarily of common stock and disclosed reserves (or retained earnings),
    but may also include non-redeemable non-cumulative preferred stock.
Basel III requirements
      – The predominant form of Tier 1 capital must be common shares and retained
      – Banks must hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I
          capital (up from 4% in Basel II) of risk-weighted assets (RWA).
      – Introduction of additional capital buffers:
            • A mandatory capital conservation buffer of 2.5%; and
            • A discretionary countercyclical buffer, which allows national regulators to
               require up to another 2.5% of capital during periods of high credit growth.
      – The Basel Committee observed that banks have used innovative instruments over
          the years to generate Tier 1 capital; these are subject to stringent conditions and
          are limited to a maximum of 15% of total Tier 1 capital.
  Raising the Quality, Consistency, and Transparency of
  the Capital Base…
Tier 2 capital
    Tier 2 capital represents "supplementary capital" such as undisclosed reserves,
    revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital
    instruments, and subordinated debt.
Basel III requirements
     – Tier 2 capital instruments will be harmonized;
     – Elimination of distinction between upper and lower tier 2 capital;
     – Tier 2 capital will form up to 2% of total capital;
     – Tier 2 is limited to 100% of Tier 1, in other words Tier 2 capital cannot exceed Tier 1
     – Hybrids are instruments that have some characteristics of both debt and equity.
         Provided these are close to equity in nature, in that they are able to take losses on
         the face value without triggering a liquidation of the bank, they may be counted as
         tier 2 capital.
     – Subordinated debt is debt that ranks lower than ordinary depositors of the bank.
         Only those with a minimum original term to maturity of five years can be included
         in tier 2 capital; they must be subject to proper amortization arrangements.
  Raising the Quality, Consistency, and Transparency of
  the Capital Base…
Tier 3 capital
   These are capital held by banks to meet part of their market risks, that includes
   a greater variety of debt than tier 1 and tier 2 capitals. Tier 3 capital debts may
   include a greater number of subordinated issues, undisclosed reserves and
   general loss reserves compared to tier 2 capital.

   Instruments such as CDS (credit default swaps) and SIV (special investment
   vehicles) are examples of tier 3 capital instruments

   Tier 3 capital instruments would be eliminated from the capital structure of
   banks by the Basel 3 accords.
Minimum Capital Requirement

The total
minimum capital
requirement is
Supplementing the Risk-based Capital Requirement
with a Leverage Ratio
 One of the underlying features of the crisis was the buildup of
 excessive on-and off-balance sheet leverage in the banking
 The Committee, therefore, is introducing a leverage ratio
 requirement that is intended to achieve the following objectives:
  – Constrain leverage in the banking sector, thus helping to
    mitigate the risk of the destabilising deleveraging processes
    which can damage the financial system and the economy;
  – Introduce additional safeguards against model risk and
    measurement error by supplementing the risk-based
    measure with a simple, transparent, independent measure of
    risk that is based on gross exposures.
   Reducing Procyclicality and Promoting Countercyclical

Basel III is promoting
                                            3                                                  • Advocating a change in the
                                                                                                 accounting standards
stronger provisioning                                             Promoting stronger             towards an expected loss
                                                                     provisioning                (EL) approach.
practices through three                                           practices (forward
related initiatives.                                                 provisioning):

                                              Achieve the
                   2                        broader macro
                                           prudential goal of
                                             protecting the
                                            banking sector
  • Banks must conduct stress               from periods of
    tests that include widening              excess credit
    credit spreads in                           growth.
    recessionary scenarios.                                                                                                   1
                                                                              Introduction of a series of
                                                                                 measures to address

                                  • Promote the conservation
                                    of capital and the build-up
                                    of adequate buffers above
                                    the minimum that can be
                                    drawn down in periods of
Basel III and Bank’s Liquidity Management

    Basel III has introduced two standards that have separate but
    complementary objectives for banks to use in liquidity management and
    for supervisors to use in liquidity risk supervision.

         1. The                     2. The Net                   Stronger
       Liquidity                      Stable                      Bank’s
       Coverage                      Funding                     Liquidity
      Ratio (LCR)                  Ratio (NSFR)                 Management

The objective is to promote     The objective is to promote
the short-term resilience of    resilience over a longer
the liquidity risk profile of   time horizon by creating
banks by ensuring that they     additional incentives for
have sufficient high-quality    banks to fund their
liquid assets to survive a      activities with more stable
significant stress scenario     sources of funding on an
lasting 30 calendar days        ongoing basis.
Liquidity Coverage Ratio

• The LCR builds on traditional liquidity “coverage ratio” methodologies
  used internally by banks to assess exposure to contingent liquidity events.
• The total net cash outflows for the scenario are to be calculated for 30
  calendar days into the future.
• The standard requires that the value of the ratio be no lower than 100%
  (i.e. the stock of high-quality liquid assets should at least equal total net
  cash outflows).
• Banks are expected to meet this requirement continuously and hold a
  stock of unencumbered, high-quality liquid assets as a defense against the
  potential onset of severe liquidity stress.
• Given the uncertain timing of outflows and inflows, banks and supervisors
  are also expected to be aware of any potential mismatches within the 30-
  day period and ensure that sufficient liquid assets are available to meet
  any cashflow gaps throughout the period.
Liquidity Coverage Ratio

 Highly prescriptive/formulaic approach; factor-based
   Stock of High-quality Liquid Assets

                  • Low credit and market risk                   • Level 1 assets can comprise
                  • Ease and certainty of                          an unlimited share of the
                    valuation                                      pool.
                  • Low correlation with risky                     • e.g. Cash, Central bank
                    assets                                           reserves and Marketable
                  • Listed on a developed and                        securities
                    recognised exchange market                   • Level 2 assets can comprise
                  • Have active outright sale or                   no more than 40% and will be
                    repurchase agreement (repo)                    subject to a 15% haircut.
                    markets at all times                           • e.g. Marketable securities,
                  • Low market concentration                         Corporate bonds and
                                                                     Covered bonds
                  • Should be central bank
Total Net Cash Outflows

   The term total net cash outflows = Total expected cash outflows - Total
   expected cash inflows (in the specified stress scenario for the subsequent
   30 calendar days)

    – Total expected cash outflows are calculated by multiplying the outstanding
      balances of various categories or types of liabilities and off-balance sheet
      commitments by the rates at which they are expected to run off or be drawn
    – Total expected cash inflows are calculated by multiplying the outstanding
      balances of various categories of contractual receivables by the rates at which
      they are expected to flow in under the scenario up to an aggregate cap of 75%
      of total expected cash outflows.

• Banks will not be permitted to double count items – i.e. if an asset has
  been included as part of the “stock of high-quality liquid assets” (i.e. the
  numerator), the assets cannot also be counted as cash inflows.
 Net Stable Funding Ratio (NSFR)

• The NSFR builds on traditional “net liquid asset” and “cash capital”
  methodologies used widely by internationally active banking organisations,
  bank analysts and rating agencies.

• “Stable funding” is defined as the portion of those types and amounts of
  equity and liability financing expected to be reliable sources of funds over a
  one-year time horizon under conditions of extended stress.

• For the purposes of this standard, extended borrowing from central bank
  lending facilities outside regular open market operations are not considered
  in this ratio in order not to create a reliance on the central bank as a source
  of funding.
Net Stable Funding Ratio (NSFR)
Incorporating Basel III into the Risk Management
Process - A New Risk Mgt Culture
• Basel III will affect the way that banks address the management of risk and
  finance. The new regime seeks much greater integration of the finance
  and risk management functions.

• This will probably drive the convergence of the responsibilities of CFOs
  and CROs in delivering the strategic objectives of the business. However,
  the adoption of a more rigorous regulatory stance might be hampered by
  a reliance on multiple data silos and by a separation of powers between
  those who are responsible for finance and those who manage risk.

• The new emphasis on risk management that is inherent in Basel III
  requires the introduction or evolution of a risk management framework
  that is as robust as the existing finance management infrastructures. As
  well as being a regulatory regime, Basel III in many ways provides a
  framework for true enterprise risk management, which involves covering
  all risks to the business.
Incorporating Basel III into the Risk Management
Process - Data Management
•   The data management requirements of Basel III are significant. For the bank, the
    regulator, and the wider market to get an accurate picture of the bank’s position,
    the data must be accurate, up to date, and consistent.
•   To deliver compliance against Basel III, all banks must now ensure that risk teams
    have quick and easy access to centralized, clean, and accurate data. This data must
    reflect their bank’s credit, market, concentration, operational, and liquidity risk.
•   All banks will also need to calculate the enhanced capital, new liquidity ratios, and
    new leverage ratios to be in a position to start reporting to local supervisors—in
    the multiple formats that the various national regulators require—starting as early
    as 2013.
•   Delivering this objective effectively is difficult if the data is dispersed across
    different silos. Furthermore, the data must be carefully defined and managed to
    ensure that it delivers the correct ratio calculations for capital adequacy, leverage,
    and liquidity every time. This requirement, combined with the significantly greater
    reporting requirements of Basel III—in terms of granularity and frequency—means
    that the effort required to manage data within Basel III is greater than ever.
Incorporating Basel III into the Risk Management
Process - Stress Testing

• Stress testing—the ability to understand the impact of significant
  market events on the key ratios—receives greater significance
  under Basel III.
• Stress testing will be required more often, performed across more
  data, and delivered in more depth. It will take longer, it will require
  more effort.
• Placing all the data in a central repository will allow banks to run a
  wide array of complex stress tests that meet the needs of the
  business - to deliver insight and also meet the needs of the
  regulator - to deliver compliance.
Basel III Major Implementation Challenges
Basel III Major Implementation Challenges
Progressive Roll Out of Basel III

                                                                   Measure have been
The quality,                                  The risk-based
                                                                  introduced to reduce
consistency and                             capital requirement                             Systemic risk and
                       The risk coverage                            procyclicality and
transparency of the                               has been                                interconnectedness
                      has been enhanced                                  promote
capital base has                           supplemented with a                           have been addressed
been raised                                    leverage ratio

• Basel III is an opportunity as well as a challenge for banks. It can provide a
  solid foundation for the next developments in the banking sector, and it
  can ensure that past excesses are avoided.
• Designed to substantially raise the quality, quantity and international
  consistency of bank capital and liquidity; constrain the build up of leverage
  and maturity mismatches; and introduce capital buffers above the
  minimum requirements that can be drawn upon in bad times.
• Basel III will buttress confidence in credit institutions and promote
  financial stability. With the new rules, banks face a much more demanding
  regulatory environment. There are uncertainties about the actual costs of
  these measures in the medium term, and because of this I find it very
  appropriate the Basel Committee has phased them in over several years.
  Banks will have adequate time to adapt, while at the same time providing
  adequate credit to the economy.
Thank You