Basel III Capital Adequacy Accord Basel Committee on Banking Supervision 09th Sep, 2012
Contents a. 2008 Financial Crisis & the Evolution of Basel Norms b. Basel III Guidelines c. Basel II vs. Basel III – Points of Difference d. Capital Conservation Buffer & Countercyclical Buffer e. Leverage Ratio f. Liquidity Standards • Liquidity Coverage Ratio • Net Stable Funding Ratio 2
A. 2008 Financial Crisis & the Evolution of Basel Norms
The 2008 Financial Crisis in a Nutshell Deregulation of financial Large inflow of foreign services sector in the US funds Definition of Risk-Weighted Assets Leverage from the 1980s Basel II presumed that the level of capital in the system Basel II did not regulate the amount of financial was sufficien E t as ba y se c d redi on itt c s ondi categ toions rizati i o n n U of S assets and leveragD e ebt that- fibnanced anks and c i ons nstit um utio pt ns ion coul ( d ▲ ta )ke risk-weights, however new financial products spawned leading to excessively leveraged positions of banks (US Credit Bubble) (US Housing Bubble) out of securitization were highly vulnerable to systemic prior to the crisis risk which was not taken in to account while assigning risk-weights Financialization Financial Innovation (▲) Financial leverage overrides capital (equity) & ○ Mortgage Backed Securities Failure to capture off-balance sheet financial markets tend to dominate over the traditional ○ Collateralized Debt Obligations industrial economy & ag expricultu osu ral e resconomies ○ Synthetic CDOs Basel II failed to regulate key exposures such as complex trading activities, resecuritizations and expo W su eak res to & of ff-raudul balanc en e t sh under eet veh w iclri e ti s ng practice Underestimation of risk concentration Shadow Banking System (▲) ○ Financing of mortgages though off-balance sheet Mispricing of risk securitizations ○ Hedging of risks through off-balance sheet Credit Default Swaps Insufficient Risk Coverage 2008 Credit Market Crisis ○ Vulnerable to Maturity Mismatch – borrowed Risk sensitivity of financial products such as OTC short-term liquid assets to purchase long-term, An increase in TED spread to a region of 150-200 bps derivatives was incorrectly estimated under Basel II illiquid & risky assets as opposed to long-term average of around 30 bps and Counterparty Credit Risk, Liquidity Risk, ► indicating an increase of counterparty risk (default Concentration Risk, Wrong-Way Risk, etc. were not of interbank loans) adequately addressed 4
What’s wrong with Basel II…? Basel II Accentuates Procyclicality Financial Instability Failure to capture key exposures Insufficient risk (such as complex trading coverage activities, resecuritisations and exposures to off- The financial crisis balance sheet vehicles ) highlighted the need to revisit some of the risk Insufficient sensitivity assumptions high-quality underlying financial capital instruments such as OTC derivatives – prevented banks to Counterparty Risk, absorb losses as a Wrong-Way Risk and going concern Liquidity Risk 5
Basel III intends to… Increase quality of capital • Basel III intends to improve the quality of capital with the ultimate aim of improving loss- absorption capacity in both going concern & liquidity scenarios Increase quantity of capital • Basel III aims at increasing the level of capital held by banks Increase short-term liquidity coverage • Liquidity Coverage Ratio promotes short-term resilience to potential liquidity disruptions Increase stable long-term balance sheet funding • Net Stable Funding Ratio encourages banks to use stable sources to fund their activities Strengthen risk capture, notably counterparty risk • Basel III enhances risk coverage by modifying the treatment of exposures to financial institutions & the counterparty risk on derivative exposures Reduce leverage through introduction of backstop leverage ratio • Leverage Ratio is aimed at reducing the risk of a build-up of excessive leverage at the bank level as well as the systemic level 6
So does Basel III replace Basel II? Basel III guidelines are not meant to be a replacement for the Basel II guidelines. For banks to be Basel III compliant, Basel II guidelines need to be first implemented across all the pil ars and then substituted with specific recommendations of the Basel III framework. Basel II Basel III Common Tier 1 Tier 2 Common Tier 1 Tier 2 Equity Capital Capital Equity Capital Capital Minimum 2% 4% 8% 4.5% 6% 8% Requirements Capital Conservation Buffer Not applicable 2.5% Countercyclical Capital Buffer Not applicable 0% to 2.5% Leverage Ratio Not applicable Tier 1 Leverage Ratio ≥ 3% # Liquidity Coverage Not applicable Ratio ≥ 100% Net Stable Funding Not applicable Ratio ≥ 100% # The minimum level of 3% wil be tested by BCBS during the paral el run period from 01 Jan 2013 to 01 Jan 2017 7
Basel Framework Today Pillar II Pillar III Pillar I Capital Leverage Liquidity Supervisory Market Ratios Ratio Ratio Review process Discipline Capital LCR CCB Tier 1 NSFR CB Tier 2 RWA Standard IRB-F IRB-A Credit CCR CEM EPE Derivative Exposure CVA WWR Market Standard IMA Operational VAR BIA Standardized AMA Stressed VAR Updated with Basel 2.5 IRC Updated with Basel III Added in Basel III No change from Basel II 8
B. Basel III Guidelines
Building Blocks of Basel III ■ Introduces an additional Capital Conservation Buffer that can be drawn down in periods of financial stress ■ Introduces a Countercyclical Capital Buffer that ensures financial resilience of the banking sector in periods of excessive credit growth ■ Promotes more forward looking measures Countercyclical Measures Leverage Ratio Liquidity Risk Management ■ Reinforces risk-based requirements with ■ Unified minimum liquidity criteria to a simple, non-risk based “backstop” cover liquidity risk: measure based on gross exposure Basel III ■ Liquidity Coverage Ratio ■ Net Stable Funding Ratio Regulatory Capital Systemic Risk ■ Improvement of quality of Tier 1 Capital ■ Additional capital surcharges between 1- ■ Harmonized & simplified Tier 2 Capital 3.5% for systemically important financial ■ Tier 3 Capital eliminated institutions Risk Management ■ Introduction of “stressed VaR” into capital requirements ■ Capital requirements for an “Incremental Risk Charge” ■ Additional capital requirements for Counterparty Credit Risk (CVA, AVC, Wrong-Way Risk) ■ Strengthen internal credit risk processes & decrease reliance on external credit ratings 10
Basel III – Quantitative Impact Eligible Capital Capital Ratio = Risk-weighted Assets Tier 1 Capital Leverage Ratio = ≥3% Total Exposure High-quality liquid assets Liquidity Coverage Ratio = ≥100% Total net cash outflows over the next 30 calendar days Available stable funding ≥100% Net Stable Funding Ratio = Required stable funding 11
Basel III – Qualitative Impact Impact on Individual Banks Impact on Financial System Pressure on profitability & ROE Reduced risk of a systemic banking crisis The most important implication of Basel III is an increase Enhanced capital & liquidity buffers along with enhanced in cost of lending due to increased capital requirements risk management standards & capability should reduce possibly translating in to decreased profit margins and the risk of a systemic banking crisis in the future diminishing ROE Weaker banks crowded out Reduced lending capacity With downward pressure on profit margins and increasing With increased capital requirements the lending capacity costs of compliance, weaker banks would find it difficult to of banks wil be diminished across the system possibly compete under the updated Basel framework leading to a slowdown in economic growth Change in demand from short-term Reduced investor appetite for bank to long-term funding debt and equity With the introduction of additional liquidity ratios – LCR & Should profitability margins & ROE decrease, investors NSFR – there would be a qualitative shift in the demand would be less attracted by bank debt or equity issuance from short-term to long-term funding with the consequent given that dividends are likely to be reduced to al ow firms impact on the pricing & margins that are achievable to rebuild capital bases Legal entity reorganization International Arbitrage Increased supervisory focus on proprietary trading, If national authorities implement Basel III guidelines matched with the treatment of minority investments and differently, it may lead to international regulatory arbitrage investments in financial institutions may lead to group as was observed under Basel I and Basel II reorganizations, including M&A & portfolio liquidation implementations 12 Source: Basel III: Issues and Implications – KPMG (2011)
Basel III’s Impact on Bank’s ROE – The Curves
The Basel III minimum capital requirement Lending Rate reduces the available capital with banks, bringing about a leftward shift in the bank’s S2 credit supply curve from S to S . 1 2 S
In the medium term, this would result in 1 reduced lending by banks along with in an increase in lending rates causing a decrease in demand for credit in the economy.
The interest elasticity of demand would determine the extent of decrease in demand for credit across national jurisdictions.
Overall, increased capital requirements and cost of funding would impact growth and D ROE of banks and financial institutions. Credit 13
Basel III Timeline 2011 2012 2013 2014 2015 2016 2017 2018 01 Jan 2019 Min. CE Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% Capital Conservation 0.625% 1.25% 1.875% 2.5% Buffer (CCB) Min. CE + CCB 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0% Phase-in of deductions 20% 40% 60% 80% 100% 100% from CET1 (including amounts exceeding the limit for DTAs, MSRs & financials) Min. Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% Min. Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Min. Total Capital + 8.0% 8.0% 8.0% 8.625% 9.125% 9.875% 10.5% CCB Capital instruments that Phased out over 10 year horizon beginning 2013 no longer qualify as non-core Tier 1 or Tier 2 Capital Leverage Ratio Supervisory Monitoring Paral el run: 01 Jan 2013 to 01 Jan 2017 Migration Disclosure starts 01 Jan 2015 to Pil ar 1 Liquidity Coverage Observation Introduce Ratio period begins min. std. Net Stable Funding Observation Introduce Ratio period begins min. std. 14 Source: Basel III – Design and Potential Impact – Deloitte (2010)
C. Basel II vs. Basel III – Points of Difference
Basel II vs. Basel III – Tier 1 Capital Components Basel II Basel III Common Stock & other forms of Tier 1 Common Equity issued by the bank that meets the criteria for inclusion Innovative instruments (limited to max 15%) net Stock surplus (share premium) resulting from of goodwil the issue of instruments included in Common Equity Tier 1 -- Retained earnings (including interim profit or loss) Disclosed reserves (including from minority Other comprehensive income & other interests) disclosed reserves -- Regulatory Adjustments 16 Source: bcbs189 – BIS (2011) and bcbs128 – BIS (2006)
Basel II vs. Basel III – Tier 1 Capital (Deductions) Basel II Basel III Deduction: goodwil & increase in equity from a Deduction: goodwil & all other intangibles securitization exposure - “gain-on-sale” (except mortgage servicing rights). Subject to prior supervisory approval, banks that report under local GAAP may use IFRS definition of intangible assets. Deduction: 50% of investments in other financial Deduction: Investments in the capital of institutions; 50% of securitization exposure institutions outside the regulatory scope of consolidation – 100% deduction of reciprocal cross-holding of capital; deduction of holdings exceeding 10% of bank’s common equity: “corresponding deduction approach” Deduction: Following items can be either be Deduction: Items eligible to be deducted 50% deducted 50% from Tier 1 and 50% from Tier 2 or from Tier 1 and 50% from Tier 2 or be risk be risk weighted: weighted, now have a risk weight of 1250%. • Certain securitization exposures • Certain equity exposures under the PG/LGD approach • Non-payment/ delivery on non-DvP and non-PvP transactions • Significant investments in commercial entities 17 Source: bcbs189 – BIS (2011) and bcbs128 – BIS (2006)
Basel II vs. Basel III – Additional Tier 1 Capital Components Basel II Basel III -- Instruments issued by the bank meeting the criteria for inclusion in AT 1 -- Stock surplus (share premium) resulting from instruments included in AT 1 -- Instruments issued by consolidated subsidiaries of the bank & held by third parties (i.e minority interest) that meet criteria for AT 1 -- Regulatory Adjustments Additional Tier 1 Capital was not available under Basel II 18 Source: bcbs189 – BIS (2011) and bcbs128 – BIS (2006)
Basel II vs. Basel III – Tier 2 Capital Components Basel II Basel III ( Limited to a max of 100% of Tier 1 ) ( No max limit on Tier 2 capital ) Undisclosed reserves Instruments issued by the bank meeting the criteria for inclusion in Tier 2 Asset revaluation reserves (latent gains on Stock surplus (share premium) resulting from unrealized securities are subject to a discount of the issue of instruments 50%) General provisions / loan-loss reserves (limited General provisions / loan-loss reserves held to max of 1.25% of RWA) against future, presently unidentified losses (limited to a max 1.25% of credit RWA calculated under standardized approach) Hybrid capital instruments (unsecured, Total eligible provisions minus total expected subordinated, fully paid-up, not redeemable) loss amount (limited to max 0.6% of credit RWA calculated under IRB approach) Subordinated debt (limited to a max of 50% of Instruments issued by consolidated subsidiaries Tier 1 capital) of the bank & held by third parties (i.e minority interests) that meet the criteria for Tier 2 Deduction: 50% of investments in other financial Regulatory adjustments institutions; 50% of securitization exposure Hybrid capital instruments have been removed from Tier 2 Capital definition under Basel III 19 Source: bcbs189 – BIS (2011) and bcbs128 – BIS (2006)
Basel II vs. Basel III – Tier 3 Capital Components Basel II Basel III ( Limited to a max of 250% of Tier 1 ) -- Short-term subordinated debt (at the discretion -- of the national authority for the sole purpose of meeting capital requirements for market risks) Tier 3 Capital has been removed from the regulatory capital under Basel III 20 Source: bcbs189 – BIS (2011) and bcbs128 – BIS (2006)
Criteria for Inclusion – Key Aspects Common Equity Tier 1 Additional Tier 1 Tier 2 ISSUER 1. General • Bank • Bank • Bank • Fully-consolidated subsidiary • Consolidated subsidiary of bank • Consolidated subsidiary of of bank meeting conditions meeting conditions below bank meeting conditions below below • Special purpose vehicle (SPV) • Special purpose vehicle meeting conditions below (SPV) meeting conditions below 2. Subsidiary • Held by third parties • Held by third parties • Held by third parties Issuers • Common equity, if issued by • Instrument, if issued by bank, • Instrument, if issued by bank, bank, would qualify as Tier 1 would qualify as Tier 1 capital in would qualify as Tier 1 or Tier 2 Common Equity in al respects al respects capital in al respects • Subsidiary is itself a bank • Amount recognized limited to • Amount recognized limited to • Amount recognized limited total amount of Tier 1 capital of total amount of total capital of to total amount of common subsidiary minus surplus subsidiary minus surplus equity of subsidiary minus attributable to third party investors attributable to third party surplus attributable to minority (if any) (surplus calculated as investors (if any) (surplus shareholders (if any) (surplus lower of (i) minimum Tier 1 calculated as lower of (i) calculated as lower of (i) requirement of subsidiary plus minimum total capital minimum Tier 1 Common capital buffer (i.e., 8.5% of risk requirement of subsidiary plus Equity requirement of weighted assets) and (ii) portion capital buffer (i.e., 10.5% of risk subsidiary plus capital buffer of consolidated minimum Tier 1 weighted assets) and (i ) portion (i.e., 7.0% of risk weighted requirement plus capital buffer of consolidated minimum Tier 1 assets) and (i ) portion of relating to subsidiary) requirement plus capital buffer consolidated minimum Tier 1 • Excludes any instrument relating to subsidiary) requirement plus capital buffer recognized as Tier 1 CE • Excludes any instruments relating to subsidiary) recognized as Tier 1 CE or Tier 1 Additional Capital 21 Source: Regulatory Capital Reform under Basel III – Latham & Watkins (2011)
Criteria for Inclusion – Key Aspects (Cont’d) Common Equity Tier 1 Additional Tier 1 Tier 2 ISSUER 3. SPV Issuers • Proceeds of instrument issued • Proceeds of instrument issued by SPV must be immediately by SPV must be immediately available without limitation to available without limitation to operating entity or holding operating entity or holding company in form meeting or company in form meeting or exceeding al other criteria for exceeding al other criteria for inclusion in Tier 1 Additional inclusion in Tier 2 Capital Capital 4. Source of • Neither bank nor related party • Neither bank nor related party funds over which bank exercises control over which bank exercises or significant influence can have control or significant influence purchased instrument, nor can can have purchased instrument, bank directly or indirectly have nor can bank directly or funded purchase of instrument indirectly have funded purchase of instrument 22 Source: Regulatory Capital Reform under Basel III – Latham & Watkins (2011)
Criteria for Inclusion – Key Aspects (Cont’d) Common Equity Tier 1 Additional Tier 1 Tier 2 TERM 1. In general Perpetual • Perpetual • Minimum original maturity of • No step-ups or other at least 5 years incentives to redeem • Recognition in regulatory capital in remaining 5 years before maturity amortized on straight-line basis • No step-ups or other incentives to redeem (an option to cal after 5 years but prior to start of amortization period, without creating expectation of cal , is not incentive to redeem) 2. Redemption • Principal perpetual & never • Repayment of principal (e.g. • Investor must have no rights / Repayment repaid outside of liquidation through repurchase or to accelerate repayment of • Discretionary repurchases & redemption) only with prior future scheduled payments other discretionary means of supervisory approval (coupon or principal), except in effectively reducing capital • Instrument cannot have bankruptcy and liquidation permitted if al owable under features hindering national law recapitalization, such as provisions requiring issuer to compensate investors if new instrument issued at lower price during specified time frame 23 Source: Regulatory Capital Reform under Basel III – Latham & Watkins (2011)
Criteria for Inclusion – Key Aspects (Cont’d) Common Equity Tier 1 Additional Tier 1 Tier 2 TERM 3. Cal • Cal able at initiative of issuer • Cal able at initiative of issuer only after minimum of five years: only after minimum of five years: a. To exercise cal option bank a. To exercise cal option bank must receive prior supervisory must receive prior supervisory approval; and approval; and b. Bank must not do anything b. Bank must not do anything creating expectation that cal wil creating expectation that cal wil be exercised; and be exercised; and c. Bank must not exercise call c. Bank must not exercise call unless: unless: i. bank replaces called i. bank replaces called instrument with capital of same or instrument with capital of same or better quality and replacement better quality and replacement done at conditions sustainable for done at conditions sustainable for income capacity of bank income capacity of bank (replacement must be concurrent (replacement must be concurrent with cal , not after); or with cal , not after); or i . bank demonstrates that i . bank demonstrates that capital position well above capital position well above minimum capital requirement after minimum capital requirement cal exercised (“minimum” after cal exercised (“minimum” requirement refers to national law requirement refers to national law not Basel III rules) not Basel III rules) 24 Source: Regulatory Capital Reform under Basel III – Latham & Watkins (2011)
Criteria for Inclusion – Key Aspects (Cont’d) Common Equity Tier 1 Additional Tier 1 Tier 2 TERM 4. No • Bank does nothing to create • Bank should not assume or • Bank must not do anything Expectation expectation at issuance that create market expectation that creating expectation that cal wil instrument wil be bought back, supervisory approval for be exercised redeemed or cancel ed nor do repayment of principal wil be statutory or contractual terms given provide any feature which might give rise to such expectation DISTRIBUTIONS / COUPONS 1. Source • Distributions paid out of • Dividends/ coupons paid out distributable items of distributable items • Level of distributions not in any way tied or linked to amount paid in at issuance and not subject to cap (except to extent bank unable to pay distributions exceeding level of distributable items) 25 Source: Regulatory Capital Reform under Basel III – Latham & Watkins (2011)
Criteria for Inclusion – Key Aspects (Cont’d) Common Equity Tier 1 Additional Tier 1 Tier 2 DISTRIBUTIONS / COUPONS 2. No • No circumstances under • Dividends/ coupons • Investor must have no rights Obligation which distributions obligatory discretion: to accelerate repayment of • Non-payment not event of a) Bank must have full future scheduled payments default discretion at al times (coupon or principal), except in to cancel distributions/ bankruptcy and liquidation payments b) Cancel ation of discretionary payments must not be event of default c) Banks must have full access to cancel ed payments to meet obligations as they fall due d) Cancel ation of distributions/ payments must not impose restrictions on bank except in relation to distributions to common stockholders 26 Source: Regulatory Capital Reform under Basel III – Latham & Watkins (2011)
Criteria for Inclusion – Key Aspects (Cont’d) Common Equity Tier 1 Additional Tier 1 Tier 2 DISTRIBUTIONS / COUPONS 3. Priority • Distributions paid only after al legal and contractual obligations met and payments on more senior capital instruments made • No preferential distributions, including in respect of other elements classified as highest quality issued capital 4. Margin • Instrument may not have a • Instrument may not have a adjustment credit sensitive dividend feature, credit sensitive dividend feature, i.e., dividend/ coupon reset i.e., dividend/ coupon reset periodically based in whole or periodical y based in whole or part on bank’s current credit part on bank’s current credit standing standing SUBORDINATION 1. Priority • Most subordinated claim in • Subordinated to depositors , • Subordinated to depositors , liquidation of bank general creditors and general creditors of bank • Entitled to claim of residual subordinated debt of bank assets proportional with share of issued capital after al senior claims repaid in liquidation 27 Source: Regulatory Capital Reform under Basel III – Latham & Watkins (2011)
Criteria for Inclusion – Key Aspects (Cont’d) Common Equity Tier 1 Additional Tier 1 Tier 2 SUBORDINATION 2. Loss • Takes first and proportionately • Instruments classified as liabilities Absorbency greatest share of any losses as must have principal loss absorption occur through either • Within highest quality capital; a) conversion to common shares at absorbs losses on going-concern objective pre-specified trigger point basis proportionately and pari or passu with all others b) Write-down mechanism al ocating losses to instrument at pre- specified trigger point Write-down wil have the fol owing effects c) reduce claim of instrument in liquidation, d) Reduce amount re-paid when cal is exercised, and e) Partially or ful y reduce coupon/ dividend payments on instrument 3. Equity-like • Paid-in amount recognized as • Instrument can’t contribute to nature equity capital for determining liabilities exceeding assets if balance sheet insolvency balance sheet test forms part of • Paid-in amount classified as national insolvency law equity under relevant accounting standards 28 Source: Regulatory Capital Reform under Basel III – Latham & Watkins (2011)
Criteria for Inclusion – Key Aspects (Cont’d) Common Equity Tier 1 Additional Tier 1 Tier 2 SUBORDINATION 4. Security • Neither secured nor covered by • Neither secured nor covered by • Neither secured nor guarantee of issuer or related guarantee of issuer or related covered by guarantee of entity or subject to other entity or other arrangement legally issuer or related entity or arrangement legally or or economically enhancing other arrangement legally economically enhancing seniority seniority of claim vis-à-vis bank or economically of claim creditors enhancing seniority of claim vis-à-vis depositors and general bank creditors 29 Source: Regulatory Capital Reform under Basel III – Latham & Watkins (2011)
D. Capital Conservation Buffer & Countercyclical Buffer
Buffers Comparison Capital Conservation Buffer Countercyclical Capital Buffer 2.5% of RWA 0% - 2.5% of RWA Fixed Variable Objective is to build capital buffers outside periods Objective is to dampen excessive credit growth in of stress which can be drawn down as losses are the economy to ensure capital levels in the incurred banking sector Non-discretionary – disclosed buffer Discretionary – buffer requirement is decided by requirements national authorities Pre-determined set of consequences for banks Pre-determined set of consequences for banks that do not meet the buffer requirements that do not meet the buffer requirements similar to that of Capital Conservation Buffer Implemented as it is and sits on top of the Implemented as an extension to the Capital Common Equity Tier 1 capital requirements Conservation Buffer -- National authorities pre-announce the decision to raise the buffer requirements by up to 12 months 31
Capital Conservation Buffer – Objective
The Capital Conservation Buffer is intended to ‘promote the conservation of capital and the build-up of adequate buffers above the minimum that can be drawn down in periods of stress.’
Outside of period of stress, banks should hold buffers of capital above the regulatory minimum.
When buffers have been drawn down, banks should rebuild them through: Reducing discretionary distribution of earnings (reducing dividend payouts, share-backs, staff nous payments) Raising ne w capital from the private sector
In the absence of raising capital in the private sector, the share of earnings retained by banks for the purpose of rebuilding their capital buffers should increase the nearer their capital levels are to the minimum capital requirement.
The framework reduces the discretion of banks which have depleted their capital buffers to engage in ‘unacceptable’ practices like: Using future predictions of recovery as justification for maintaining generous distribution to shareholders, other capital providers and employees Using the distribution of capital as a way to signal their financial strength 32
Capital Conservation Buffer – The Framework
A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement. Capital distribution constraints wil be imposed on a bank when capital levels fall within this range.
Banks wil be able to conduct business as normal when their capital levels fall in to the conservation range as they experience losses. The constraints imposed only relate to distributions, not the operation of the bank.
The distribution constraints imposed on banks when their capital levels fall into the range increases as the banks’ capital levels approach the minimum requirements.
The Basel Committee does not wish to impose the constraints for entering the range that would be so restrictive as to result in the range being viewed as establishing a new capital requirement. 33
Capital Conservation Buffer – Mechanics For example, a bank with a CET 1 capital ratio in the range of 5.125% to 5.75% is required to conserve 80% of its earnings in the subsequent financial year (i.e payout no more than 20% in terms of dividends, share buybacks and discretionary bonus payments). Individual bank minimum capital conservation standards Common Equity Tier 1 Ratio Minimum Capital Conservation Ratios (expressed as a percentage of earnings) Within 1st quartile of buffer (4.5% - 5.125%) 100% Within 2nd quartile of buffer (> 5.125% - 5.75%) 80% Within 3rd quartile of buffer (> 5.75% - 6.375%) 60% Within 4th quartile of buffer (> 6.375% - 7%) 40% Above top of buffer (> 7%) 0% 34 Source: bcbs189 – BIS (2011)
Capital Conservation Buffer – Other Key Aspects & Timeline
Items considered to be distributions include dividends and share buybacks, discretionary payments on other Tier 1 capital instruments and discretionary bonus payments to staff.
Earnings are defined as distributable profits calculated prior to the deduction of elements subject to the restriction on distributions. Earnings are calculated after the tax which would have been reported had none of the distributable items been paid.
The Capital Conservation Buffer framework should be applied at the consolidated level, i.e restrictions would be imposed on distributions out of the consolidated group. National supervisors would have the option of applying the regime at the solo level to conserve resources in specific parts of the group.
Banks should not choose in normal times to compete with other banks and win market share. To ensure that this does not happen, supervisors have the additional discretion to impose time limits on banks operating within the buffer range on a case-by-case basis.
The Capital Conservation Buffer wil be phased in between 01 Jan 2016 and year end 2018 becoming fully effective on 01 Jan 2019. It wil begin at 0.625% of RWAs on 01 Jan 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 01 Jan 2019. 2016 2017 2018 2019 Capital Conservation Buffer 0.625% 1.25% 1.875% 2.5% 35
Capital Conservation Buffer – Impact on Regulatory Capital Regulatory Capital 12% 10% 8% Tier 2 Other Tier 1 6% CET1 + CCB 4% 2% 0% Basel II Basel III 36
Countercyclical Buffer – Objective
The countercyclical buffer aims to ‘ensure that the banking sector in aggregate has the capital on hand to help maintain the flow of credit in the economy without its solvency being questioned’.
‘It wil 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 objective behind countercyclical buffer is to dampen excessive credit growth when national regulatory authorities judge the credit-to-GDP ratio is deviating from the trend.
The buffer for internationally active banks wil be a weighted average of the buffers deployed across all national jurisdictions to which they have credit exposures.
Banks would be subject to restrictions on distributions if they do not meet the buffer requirements as mandated by the regulatory authority.
The buffer wil vary between zero and 2.5% of risk weighted assets, depending on the judgment of the relevant national authority. 37
Countercyclical Buffer – Mechanics
Since the Countercyclical Buffer is implemented as an extension of the Capital Conservation Buffer (2.5%), a hypothetical Countercyclical Buffer requirement of 2% implies that the bank would need to maintain a capital ratio of 9% failing which restriction on distribution of earnings would be applicable. 4.5% (CE Tier 1) + 4.5% (Conservation Buffer + Countercyclical Buffer) = 9% Individual bank minimum capital conservation charges, when a bank is subject to a 2% Countercyclical Buffer requirement Common Equity Tier 1 Minimum Capital Conservation Ratios (expressed as a percentage of earnings) Within 1st quartile of buffer (4.5% - 5.625%) 100% Within 2nd quartile of buffer (>5.625% - 6.75%) 80% Within 3rd quartile of buffer (>6.75% - 7.875%) 60% Within 4th quartile of buffer (>7.875% – 9%) 40% Above top of buffer (> 9%) 0% 38 Source: bcbs189 – BIS (2011)
The BIS document titled ‘Guidance for national authorities operating the countercyclical capital buffer’, delineates the principles that national regulatory authorities have agreed to follow in making buffer decisions.
To give banks time to adjust to a new buffer level, a period of up to 12 months would be given after the announcement of the decision by the concerned regulatory authority. Decision to reduce the buffer level would take effect immediately post-announcement.
The countercyclical buffer regime wil be phased-in in parallel with the capital conservation buffer between 01 Jan 2016 and year end 2018 becoming fully effective on 01 Jan 2019.
The maximum countercyclical buffer requirement will begin at 0.625% of RWAs on 01 Jan 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final maximum of 2.5% of RWAs on 01 Jan 2019. 2016 2017 2018 2019
Countries C that oun tex erper c i ycenc li e cal ex B c ufes f s er ive credit grow 0. th s 625% hould consi 1. der 25% accelerat 1. ing the 875% build up 2. of 5% the capital conservation buffer and the countercyclical buffer. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.
In addition, jurisdictions may choose to implement larger countercyclical buffer requirements. In such cases the reciprocity provisions of the regime wil not apply to the additional amounts or earlier time- frames. 39
Credit-to-GDP Guide to determine Countercyclical Buffer Guidance for national authorities operating the Countercyclical Capital Buffer
National authorities are urged to take countercyclical capital buffer decisions on a quarterly or more frequent basis.
Basel Committee believes that national authorities should implement a communication strategy that provides regular updates on their assessment of macro financial situation and the prospects for potential buffer actions. This would promote accountability and sound decision-making while allowing banks and their stakeholders to prepare for buffer decisions.
The capital surplus created when the countercyclical buffer is returned to zero should be unfettered. i.e there are no restrictions on distributions when the buffer is turned off. Credit-to-GDP Guide
National authorities can determine the buffer add-on by the following 3 steps: 1. Calculate the aggregate private sector credit-to-GDP ratio 2. Calculate the credit-to-GDP gap (the gap between the ratio and its trend) 3. Transform the credit-to-GDP gap in to the guide buffer add-on 40
Credit-to-GDP Guide to determine Countercyclical Buffer (cont’d) 1. Calculating the credit-to-GDP ratio The credit-to-GDP ratio in period t for each country is calculated as: RATIO = CREDIT / GDP Х 100% t t t GDP is domestic GDP and CREDIT is a broad measure of credit to the private, non-financial sector t t in period t. Both GDP and CREDIT are in nominal terms and on a quarterly frequency. 2. Calculating the credit-to-GDP gap The credit-to-GDP ratio is compared to its long term trend. If the credit-to-GDP ratio is significantly above its trend (i.e there is a large positive gap) then this is an indication that credit may have grown to excessive levels relative to GDP. The gap (GAP) in period t for each country is calculated as the actual credit-to-GDP ratio minus its long-term trend (TREND): GAP = RATIO – TREND t t t TREND is a simple way of approximating something that can be seen as a sustainable average of ratio of credit-to-GDP based on the historical experience of the given economy. It is established using the Hodrick-Prescott filter which tends to give higher weights to more recent observations. 41
Credit-to-GDP Guide to determine Countercyclical Buffer (cont’d) 3. Transforming the credit-to-GDP gap into the guide buffer add-on
The size of the buffer add-on (VB ) (in percent of risk-weighted assets) is zero when GAP is below a t t certain threshold (L). It then increases with the GAP until the buffer reaches its maximum level t (VB ) when the GAP exceeds an upper threshold H. max Basel Committee on Banking Supervision’s analysis has found that an adjustment factor based on L=2 and H=10 provides a reasonable and robust specification based on historical banking crises. For example, when the credit-to-GDP ratio is 2 percentage points or less above its long term trend, the buffer add-on (VBt) wil be 0%. Similarly, when the credit-to-GDP ratio exceeds its long term trend by 10 percentage points or more, the buffer add-on wil be 2.5% of risk weighted assets. 42
E. Leverage Ratio
Prior to the financial crisis of 2007, many financial institutions and banks had built up excessive on- and off-balance sheet leverage which were not accurately accounted for in the risk-based capital ratios.
LR is a secondary measure that is to be used alongside Basel II risk-based capital ratios.
LR would ‘…constrain the build-up of leverage in the banking sector, helping to avoid destabilizing deleveraging processes which can damage the broader financial system and the economy’ Calculation Simple arithmetic mean of the monthly leverage ratio over the quarter Scope of application Solo, consolidated and sub-consolidated level Disclosure Disclosure of the key elements of the leverage ratio under Pil ar 3 Introduction Planned for 01 Jan 2018 Transition period • 01 Jan 2011: Start supervisory monitoring period (development of templates) • 01 Jan 2013-2017: Parallel run (leverage ratio & its components wil be tracked, including its behavior relative to the risk based requirement) • 01 Jan 2015: Disclosure of the leverage ratio by banks • First half of 2017: Final adjustments • 01 Jan 2018: Migration to Pil ar 1 treatment 44
LR is not intended to be a binding instrument at this stage but as an “additional feature that can be applied on individual banks at the discretion of supervisory authorities with a view to migrating to a binding (Pillar 1) measure in 2018, based on appropriate review and calibration.” Tier 1 Capital Leverage Ratio = ≥3% Total Exposure Sum of the exposure values of all assets and off-balance sheet items not deducted from the calculation of Tier 1 capital. Exposure measure generally follows accounting measure. For off-balance sheet items, a specific credit risk adjustment of 10% generally applies for undrawn credit facilities (this may be cancel ed unconditionally at any time without notice), and 100% for al other off-balance sheet items.
Within the disclosure requirements, the following information should be reported:
A breakdown of the total exposure method
A description of the processes used to manage the risk of excessive leverage
A description of the factors that had an impact on the leverage ratio during the period to which the disclosed leverage ratio refers 45
F. Liquidity Standards
Liquidity Standards – A Comparison Liquidity Coverage Ratio Net Stable Funding Ratio Introduction 01 Jan 2015; observation period starting 01 Jan 2018; under observation until then 01 Jan 2013 Goal To promote short-term resilience of a To promote long-term resilience of banks bank’s liquidity profile such that it by requiring a sustainable maturity survives a “significant stress scenario” structure for assets and liabilities by lasting for 30 days creating incentives to use more stable funding sources Horizon 30 days 1 year Scope of Level of individual institution (with legal Level of individual institution (with legal Application personality) personality) Reporting Monthly with the operational capacity to Quarterly increase the frequency to weekly or even daily in stressed situations Disclosure Disclosure of LCR under Pil ar 3 Disclosure of NSFR under Pil ar 3 47 Source: Basel III Handbook – Accenture
Liquidity Coverage Ratio
LCR is aimed at ensuring that banks have adequate, high-quality liquid assets to survive a short- term stress scenario and is defined as: Stock of high-quality liquid assets Total net cash outflows over the next 30 calendar days ≥ 100%
LCR has two components: Value of the stock of high-quality liquid assets in stressed conditions; and Total net cash outflows over the next 30 calendar days = Outflows - Min [Inflows; 75% of Outflows] 48
Liquidity Coverage Ratio High-quality liquid assets “Level 1” assets Cash; transferrable assets of extremely high liquidity & credit quality (Min. of 60% of liquid assets) “Level 2” assets Transferrable assets that are of high liquidity & credit quality (Max. 40% of liquid assets; market value; haircut of min. 15%) ≥100% Liquidity outflows Liquidity inflows • Retail deposits (5-10%) • Monies due from non-financial • Other liabilities coming customer (5-10%) due during next 30 days • Secured lending & capital market (0-100%) driven transactions (0-100%) • Collateral other than • Undrawn credit & liquidity facilities “level 1 assets” (15-20%) (0%) • Credit & liquidity facilities • Specified payables & receivables (5-100%) expected over the 30 day horizon Liquidity outflows are calculated (100%) by multiplying the assets with the • Liquid assets (0%) specified “run-off” factors • L iN q ew uidit i y s i s nfuance lows ar of e obl calcu ilgat ate i dons by ( m 0% ultip )lying the assets with the specified inflow factor Total net cash outflows over the next 30 calendar days 49 Source: Basel III Handbook – Accenture
What is a liquid asset? Liquid Asset # Cash and deposits held with central banks Level 1 assets can comprise an which can be withdrawn in times of stress unlimited share of the pool, are Level 1 Transferrable assets that are of extremely held at market value and are not high liquidity and credit quality Asset subject to a haircut under the LCR. Transferrable assets representing claims on or guaranteed by the central govt. of a ≥ 60% of the liquid assets. Member State or a third country if the institution incurs a liquidity risk in that Member State or third country that covers by holding those liquid assets Level 2 assets are subject to a Level 2 Transferrable assets that are of high liquidity cap of 40% of all liquid assets and Asset and credit quality subject to 15% haircut. Fundamental Characteristic Market Characteristic Low credit and market risk Active and sizable market Ease and certainty of valuation Presence of committed market matters Low correlation with risky assets Low market concentration Listed on developed and recognized exchange market Investors show tendency to move into asset during systemic crisis # Source: Basel III Handbook – Accenture 50
High quality liquid assets High Quality Liquid Asset Not High Quality Liquid Asset Not issued by the institution itself or its parent or Assets issued by a credit institution unless they subsidiary institutions or another subsidiary of its fulfill one of the following conditions: parent financial holding company a) They are bonds eligible for treatment as covered bonds Eligible collateral in normal times for intraday b) The credit institution has been set up and is liquidity needs & overnight liquidity facilities of a sponsored by a Member State central or regional govt. and the asset is guaranteed by central bank in a Member State or if, the liquid that govt. and used to fund promotional loans assets are held to meet liquidity outflows in the granted on a non-competitive, not-for-profit currency of a third country, or of the central bank basis in order to promote its public policy of that third country objectives The price can be determined by a formula that is Assets issued by any of the following: easy to calculate based on publicly available a) An investment firm inputs and doesn’t depend on strong assumptions b) An insurance undertaking as is typically the case for structured or exotic c) A financial holding company products d) A mixed-activity holding company e) Any other entity that performs one or more of the activities listed in Annex I of the Directive Listed on a recognized exchange as its main business (eg. financial leasing; acceptance of deposits and other mutual Tradable on active outright sale or repurchase recognition) agreement with a large and diverse number of market participants, a high trading volume and market depth and breadth 51 Source: Basel III Handbook – Accenture
High quality liquid assets – operational requirements To be considered as high quality liquid assets items have to fulfil several operational requirements: They are appropriately diversified “Level 1 assets” should not be less than 60% of the liquid assets They are legally and practically readily available at any time during the next 30 days to be liquidated via outright sale or repurchase agreements in order to meet obligations coming due The liquid assets are controlled by a liquidity management function A portion of the liquid assets is periodically and at least annually liquidated via outright sale or repurchase agreements for the following purposes: o To test the access to the market for these assets o To test the effectiveness of its processes for the liquidation of assets o To test the usability of the assets o To minimize the risk of negative signaling during a period of stress Price risks associated with the assets may be hedged but the liquid assets are subject to appropriate internal arrangements that ensure that they will not be used in other ongoing operations, including hedging or other trading strategies; providing credit enhancements in structured transactions; to cover the operational costs The denomination of the liquid assets is consistent with the distribution by currency of liquidity outflows after the deduction of capped inflows 52
Liquidity Coverage Ratio – Stress Conditions Scenarios The stress scenarios envisaged for LCR incorporates many of the shocks experienced during the 2008 financial crisis at a systemic level as well as the idiosyncratic level (institution specific level):
The run off of a proportion of retail deposits
A partial loss of unsecured wholesale funding capacity
A partial loss of secured, short-term financing with certain collateral and counterparties
Contractual outflows that would arise from a downgrade in the bank’s public credit rating by up to and including 3 notches, including collateral posting requirements
Increase in market volatilities that impact the quality of collateral or potential future exposure of derivative positions
Unscheduled draws on committed but unused credit and liquidity facilities
The potential need to buy back debt or honor non-contractual obligations in the interest of mitigating reputational risk 53
Net Stable Funding Ratio
The objective of NSFR is to promote more medium and long-term funding of the assets and activities of banking organizations.
Institutions are required to maintain a sound funding structure over one year in an extended firm- specific stress scenario.
Assets currently funded and any contingent obligations to fund must be matched to a certain extent by sources of stable funding.
NSFR is designed to act as a minimum enforcement mechanism to complement the LCR and reinforce other supervisory efforts by promoting structural changes in the liquidity risk profiles of institutions away from short-term funding mismatches and toward more stable, longer-term funding of assets and business activities.
It aims to limit over-reliance on short-term wholesale funding during times of buoyant market liquidity and encourage better assessment of liquidity risk across all on- and off-balance sheet items. Available stable funding ≥100% Net Stable Funding Ratio = Required stable funding 54
Available stable funding ASF Factor Items 100% • Tier 1 & 2 capital • Preferred stock not included in Tier 2 capital with maturity ≥ 1 year • Secured & unsecured borrowings & liabilities with effective remaining maturities ≥ 1 year 90% • “Stable” non-maturity (demand) deposits and/or term deposits with residual maturity < 1 year 80% • “Less stable” non-maturity (demand) deposits and/or term deposits with residual maturity < 1 year 50% * Unsecured wholesale funding, non-maturity deposits and/or term deposits with a residual maturity < 1 year, provided by non-financial corporates, sovereigns, central banks, MDBs and PSEs 0% • Al other liabilities and equity categories not included in the above categories Available stable funding ≥100% Net Stable Funding Ratio = Required stable funding 55 Source: Basel III Handbook – Accenture
Required stable funding Available stable funding ≥100% Net Stable Funding Ratio = Required stable funding RSF Factor Items 0% • Cash • Unencumbered short-term unsecured instruments & transactions with outstanding maturities < 1 yr • Unencumbered securities with stated remaining maturities < 1 year with no embedded options • Unencumbered securities held where the institution has an offsetting reverse repurchase transaction • Unencumbered loans to financial entities with effective remaining maturities < 1 year that are not renewable and for which the lender has an irrevocable right to cal 5% • Unencumbered marketable securities with residual maturities of one year or greater representing claims on or claims guaranteed by sovereigns, central banks, BIS, IMF, EC, non-central government PSEs or multilateral development banks that are assigned a 0% risk-weight under the Basel II standardized approach, provided that active repo or sale-markets exist for these securities 20% • Unencumbered corporate bonds or covered bonds rated AA- or higher with residual maturities 1 yr satisfying all of the conditions for Level 2 assets in the LCR • Unencumbered marketable securities with residual maturities 1 year representing claims on or claims guaranteed by sovereigns, central banks, non-central government PSEs that are assigned a 20% risk-weight under the Basel II standardized approach, provided that they meet all of the conditions for Level 2 assets in the LCR 56 Source: Basel III Handbook – Accenture
Required stable funding (cont’d) Available stable funding ≥100% Net Stable Funding Ratio = Required stable funding RSF Factor Items 50% • Gold • Unencumbered equity securities, not issued by financial institutions or their affiliates, listed on a recognized exchange and included in a large cap market index • Unencumbered corporate bonds and covered bonds that are central bank eligible and are not issued by financial institutions 65% • Unencumbered residential mortgages of any maturity that would qualify for the 35% or lower risk- weight under Basel II Standardized Approach • Other unencumbered loans, excluding loans to financial institutions, with a remaining maturity ≥ 1 yr, that would qualify for the 35% or lower risk-weight under Basel II Standardized Approach for credit risk 85% • Unencumbered loans to retail customers and SME (as defined in the LCR) having a remaining maturity < 1 year 100% • All other assets not included in the above categories 57 Source: Basel III Handbook – Accenture