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Incorporating Basel III Requirements
into Bank’s Liquidity and Risk
Management Processes
By
Dr. Emmanuel M. Abolo
Chairman, Riskmap Consulting Limited &
President, Risk Managers Association of Nigeria
Tel:+234 8021003297
e-mail: info@riskmapgroup.com
aboloemma@gmail.com
Contents
• 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
Introduction
• 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
exposures;
• 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
exposures;
• 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
capital
– 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
arrangements
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
earnings
– 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
capital
– 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
8%
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
system.
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;
and
– 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
Buffers
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
looking
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
procyclicality:
• Promote the conservation
of capital and the build-up
of adequate buffers above
the minimum that can be
drawn down in periods of
stress.
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
Characteristics
Composition
• 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
eligible
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
down.
– 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
Summary
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
countercyclical
been raised leverage ratio
buffers
Conclusion
• 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
Questions
