Basel Accords Daren Warner Chief Financial Officer Basel

Basel Accords Daren Warner Chief Financial Officer

Basel – Setting the scene Basel Accords Capital Adequacy Regulation and Supervision Market Discipline

Basel – Setting the scene Basel l Mainly focused on capital requirements for banks. Basel lll Adds supervision & market discipline through the "Three Pillar" concept To be fully implemented by 2015 as it came to life after the financial crisis

Basel History

Basel History n The story behind Basel- The liquidation of Herstatt Bank n The release of Deutsche Marks to Herstatt in Frankfurt in exchange for US Dollars to be delivered to New York n Because of the time-zone differences, counterparty bank did not receive their payment as the Herstatt Bank ceased its operation

Basel l

Basel l n Establishment of Basel l n 1988 Basel Accord- the Basel Committee published a set of minimal capital requirements for banks n Mainly focused on capital requirements for banks n Focused primarily on Credit Risk, market risk was an afterthought n By 1992, Basel l was enforced by law in the G-10 [Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, UK, and the USA]

Basel l n Establishment of Basel l – Illustration of measuring capital required: Home Country Sovereign Debt Credit Assessment Risk Weights AAA to AA- 0% Corporate Debt A+ to A- BBB+ to BBBB- 20% 50% 100% Below B- 150% Unrated 100% The Accord required banks to hold minimum capital equal to 8% of their Risk-Weighted Assets (RWA) Capital Required RWA Asset class Min. 8% Risk Weights

Basel l n Establishment of Basel l – Illustration of measuring capital required: Tier One Capital + Tier Two Capital Risk Weighted Assets Shareholder Equity & Reserves Capital Adequacy Ratio (CAR) (Min 8%) Supplementary Capital Required that half of this 8% consists of Tier 1 Capital (4%)

Basel l Example Bank “X ”Assets (100 units): Cash: 10 units Bank “X” Debts: 95 units of Deposits Government bonds: 15 units Mortgage loans: 20 units Other loans: 50 units Other assets: 5 units Bank “X” Equity: 5 units Tier 1 = 3 Tier 2 = 2

Basel l Example Bank “X ” RWA = Cash = 10 * 0% = 0 Government bonds = 15 * 0% = 0 Bank “X” Debts: 95 units of Deposits Bank “X” Equity: 5 units Tier 1 = 3 Tier 2 = 2 Mortgage loans = 20 * 50% = 10 Other loans = 50 * 100% = 50 Other assets = 5 * 100% = 5 CAR= 5 / 65 = 7. 7% < min 8% Total RWA= 65 Then the CAR for Bank “X” is 8%

Basel l n Establishment of Basel l – Market Risk: Interest Rates General Market Risk • Changes in market values due to market movements Market Risk Foreign Exchange Specific Market Risk Equities • Changes in the value of an individual asset due to factors related to the issuer of the security Commodities

Basel l n Establishment of Basel l – Measurement of Market Risk: Value At Risk (VAR) A statistical measure of the potential loss for a position at a given confidence level and holding period. VAR can increase (decrease) due to: 1. Changes in the positions which (decrease) the risk on the book; or 2. Greater (lower) market volatility increase

Basel l Benefits Basel l achieved to define and increase bank capital and bank capital ratio & Relatively simple framework & Widely adopted

Basel l Operational risk was NOT considered Static measure of Default Risk Simplified calculation of potential future Counterparty Risk No recognition of the term structure or maturity of credit risk Limited differentiation of Credit Risk Basel l Pitfalls Lack of recognition of portfolio diversification effects

Basel l Impact of Basel l in the industry Emergence of Credit Derivatives First Credit Default Swap for Exxon Valdez by JP Morgan Increased divergence between Regulatory Capital and Economic Capital Basel l Consequence s Regulatory capital arbitrage through product innovation Sub-optimal lending behavior

Basel ll

Basel ll Establishment of Basel ll n 2004, The committee published their Basel ll n Purpose: Creating international standards about how much capital banks need to guard against the financial and operational risks n n Risks bank exposed to Amount of Capital required November 2007, Implementation of Basel ll Accord

Basel ll – 3 Pillars Basel ll Pillar 1 Minimum Capital Requirement Credit Risk Pillar 2 Supervisory Review Assesses Bank’s Capital Level Sufficiency Market Risk Operational Risk Sets out Requirements for Banks’ Capital Adequacy Pillar 3 Disclosure and Market Discipline Enhances Market Discipline through Transparency Framework

Basel ll Fundamental changes to the calculation of Regulatory Capital Calculation Unchanged Capital = Capital Adequacy Ratio Credit Risk + Market Risk + Operational Risk Changed Substantially 3 Alternative Approaches Unchanged New 3 Alternative Approaches

Basel ll Pillar 1

Basel ll – Pillar 1 Measuring Capital Requirement Credit Risk Standardised Approach Internal models for PD* Externally provided EAD* and LGD* External ratings Credit Risk Mitigation Foundation IRB Limited recognition; supervisory treatment of collateral and guarantees Advanced IRB Internal models for PD, EAD and LGD Internal estimation; including guarantees, collateral, credit derivatives Limited recognition; Supervisory treatment of collateral and guarantees Increasing complexity and data requirement *PD = Probability of Default *LGD = Loss Given Default *EAD = Exposure At Default

Basel ll – Pillar 1 Measuring Capital Requirement Market Risk Basel ll does not materially change the market risk capital charge § Capital Adequacy Directive - CAD 2; Internal model to calculate market risk capital § § Banks must seek permission to use CAD 2

Basel ll – Pillar 1 Measuring Capital Requirement Operational Risk is the risk of direct or indirect loss resulting from inadequate for failed internal processes, people and systems or from external events Operational Risk Approaches The Standardised Approach (TSA) Advanced Measurement Approaches Basic Indicator Approach (BIA)

Basel ll – Pillar 1 Measuring Capital Requirement Operational Risk Loss experience Basic Exposure Scenarios Insurance Industry loss KRI Standardised Advanced One simple calculation for all risk event types and all business lines All risk event types for each Basel-defined business line Internal Models ex. Operational Loss distribution and scenario based models Fixed percentage (currently 15%) of gross income Based upon gross income, but divided along Basel II-defined business lines and respective beta charges Firms determine their own capital charge based upon internal model

Basel ll Fundamental changes to the calculation of Regulatory Capital Calculation Unchanged Capital = Capital Adequacy Ratio Credit Risk + Market Risk + Operational Risk Changed Substantially 3 Alternative Approaches Unchanged New 3 Alternative Approaches

Basel ll Example - SCB Capital Base 2011 $million 2010 $million Total Tier 1 Capital 37, 012 34, 295 Total Tier 2 Capital 10, 499 10, 770 Risk Weighted Assets 2011 $million 2010 $million Credit Risk 220, 394 202, 333 Operational Risk 28, 762 26, 972 Market Risk 21, 354 15, 772 Total RWA 270, 510 245, 077

Basel ll Example - SCB 2011 2010 CAR= 37, 012+ 10, 499 270, 510 = 17. 6% CAR= 34, 295+ 10, 770 245, 077 = 18. 4% 17. 6% > minimum of 8% 18. 4% > minimum of 8%

Basel ll Pillar 2

Basel ll – Pillar 2 - Supervisory Review n Aims to ensure that the banks assess the capital adequacy positions relative to their overall risks n Internal Capital Adequacy Assessment Process (ICAAP) n Using Economic Capital to determine the internal capital of the bank

Basel ll – Pillar 2 Internal Capital Adequacy Assessment Process (ICAAP) An internal process for assessing the level and quality of capital resources Required to support: • current and projected risk profile of exposures • stress events and scenarios • strategic management buffer ICAAP should be embedded into the bank’s management process Supervisory Review & Evaluation Process (SREP) Under SREP, the regulator will review: • exposures to all material risk • adequacy of risk management • adequacy of capital resources • integration into business decisions • management understanding of risk and capital

Basel ll – Pillar 2 What is Economic Capital? Prudent banking standards recommend that a bank hold enough capital to cushion against large losses that might bankrupt the firm n Economic Capital is an estimate of the level of capital that an entity requires to operate its business with a desired target solvency level n As risk is related to capital we need to find the optimum balance between risk, reward and equity Portfolio Risk Economic Capital Low Leverage High Economic capital Credit Worse Quality Better n

Basel ll Pillar 3

Basel ll – Pillar 3 - Disclosure and Market Discipline n Enhanced Market discipline through transparency framework n Market disclosure: – – n capital structure risk management policies and practices risk profile capital adequacy Discusses the role of materiality of information, frequency of disclosures and the issue of proprietary or confidential information

Basel ll – Pillar 3 - Disclosure and Market Discipline n Pillar 3 disclosures will be published on the Group website and its location will be referenced in the Annual Report and Accounts n Firms are exempt from disclosing information which is: – Immaterial – Proprietary; public sharing would undermine Group’s competitive position – Confidential information; information where we have binding agreements to the effect with customers/counterparties

Basel ll SCB Position For SCB Group the Basel II regime started on 1 January 2008

SCB Position Pillar 1 Credit Risk IRB Market Risk SCB have permission to use CAD 2 SCB measures VAR at 97. 5% confidence level, 1 day holding period Operational Risk TSA & AMA is Regularly reviewed

SCB Position Pillar 2 SCB has used Economic Capital (EC) model widely and more rigorously The Economic Capital model for the Bank was the ROARC (Return on Allocated Risk Capital) Economic Capital = Credit Risk Capital+ Market Risk Capital + Operational Risk Capital

SCB Position Pillar 3 SC Group will publish Pillar 3 disclosures once a calendar year (at least) in tandem with the annual accounts cycle Disclosures will be required for SC Group and its significant subsidiaries Market risk Capital Operational risk Capital Equities in the non-trading book Interest rate risk in the nontrading book Securitisation Credit risk mitigation Quantitative and qualitative disclosures constitute Risk management objectives and policies Credit and dilution Risk Capital resources and capital assessment Standardised credit risk Counterparty credit risk IRB credit risk

Basel ll The impact of the financial crisis on Basel ll n The recent global financial crisis has revealed weaknesses in the whole approach to risk management that has been developed through the Basel II process n Basel II did not adequately anticipate some risks such as a collapse in market liquidity as investor confidence disappeared and deep losses in the market value of securities held by banks

Basel ll Synopsis § Is much more complex than Basel I § Relies on high quality, accurate data § Makes regulatory capital closer to economic capital § Emphasizes risk quality § Will make RWA and capital much more volatile § Needs a definite change in the risk culture

Basel lll

Basel lll n Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector n Aims to improve and strengthen banking sector’s : § Ability to absorb shocks arising from financial and economic stress § Risk management and governance § Transparency and disclosures

Basel lll n Basel lll – attempts to encourage banks to hold larger percentages of Government Bonds to provide a riskless safety net should they run into liquidity problems Does Holding large percentage of Government Bonds REALLY save the bank from Bankruptcy ? Example: Holding of Italian debt (20% riskweighting) bankrupted MF Global in the space of a week!

Differences between Basel II and Basel IIl

Differences between Basel II and Basel IIl Basel lll – Capital Ratio n Upward adjustments to the Tier 1 Capital Ratio (4% to 6%) Stages of implementation: 1 Jan 2013: 4. 5% 1 Jan 2014: 5. 5% 1 Jan 2015: 6%

Differences between Basel II and Basel IIl Basel lll – Minimum Common Equity Requirement n Increase in the minimum Tier 1 Common Equity requirement (2% to 4. 5%): Stages of implementation: 1 Jan 2013: 3. 5% 1 Jan 2014: 4% 1 Jan 2015: 4. 5%

Differences between Basel II and Basel lll – Capital Buffers Create capital buffers in good times that can absorb losses during periods of financial and economic stress Capital Conservation Buffer Countercyclical Buffer • To absorb banking sector losses exclusively with common equity • 2. 5% added to the minimum ratios • To extends capital conversion range during periods of excess credit growth • Up to 2. 5% added to the minimum ratios

Differences between Basel II and Basel IIl Basel lll – Leverage Ratio Common Equity & Reserves Tier 1 Capital Exposure ≥ 3% Balance sheet exposures excluding derivatives, net of specific provisions and valuation adjustments § To prevent the build-up of excessive on and off-balance sheet leverage in the banking system § A ‘simple’, non-risk based, ‘backstop’ measure § To be calculated as an average over the quarter § Banks will be required to disclose in January 2015

Differences between Basel II and Basel IIl Basel lll – Liquidity Ratios – Liquidity Coverage Ratio (LCR) Stock of High Quality Liquid Assets Net Cash Outflows over the next 30 calendar days ≥ 100% Cash/ Central Bank Reserves/ Sovereign & Supra-national bonds/ Corporate and Covered Bonds rated AAn Ensure that a bank has sufficient high quality unencumbered liquid assets to enable it to survive a short term (30 calendar day) period of significantly severe stress n To be introduced in 1 January 2015

Differences between Basel II and Basel IIl Basel lll – Liquidity Ratios – Net Stable Funding Ratio (NSFR) Available Amount of Stable funding Required Amount of Stable funding ≥ 100% n To promote resiliency over longer-term time horizons by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing structural basis. The Net Stable Funding Ratio has been developed to capture structural issues related to funding choices n To be introduced in 1 January 2015

Basel lll – Target Capital Ratios by 1/1/2018) Minimum Common Equity (after deductions) Tier 1 Capital Total Capital 4. 5% 6% 8% Same as Basel ll Capital Conservation Buffer 2. 5% Minimum Plus Conservation Buffer 7% 8. 5% 10. 5% Countercyclical capital buffer 0% - 2. 5% 0 – 2. 5% Upper end of minimum capital 9. 5% 11% 13%

Basel lll – IFRS Vs FASB Difficulty in comparing between capital requirement for US Banks and Non-US Banks; n A significant amount of assets ($4 Trillion) does not appear on the balance sheet of USD banks due to netting off derivatives transactions that is allowed as per the US accounting rules n Due to differences in reporting standard in US and IAS; its difficult to compare the financials of US and non-US banks particularly pertaining to netting off derivatives and reporting of mortgage backed securities n US Banks will have lower capital requirement than Non-US Banks n

Basel lll Summary § Hold more capital § Better quality capital § Carry more liquid assets § Limit bank’s leverage § Build up capital buffers § Emphasis on Liquidity § Regulation, Regulation & Regulation

Regulation Examples

Basel l, lll

Differences between Basel l, lll Basel l • Considers only Market and Credit Risk • Minimum level of capital is based on a single risk weight for each of a limited number of asset classes Basel ll • Considers Market, Credit, Operational Risks • 3 Pillars: • Minimum Capital Requirement • Supervisory Review Process • Disclosure and Market Discipline Basel lll • Enhancement of the 3 Pillars of Basel ll • Liquidity & leverage Management: • Liquidity Coverage Ratio (LCR) • Net Stable Funding Ratio (NSFR) • Leverage Ratio

Summary n Basel I increased the overall level of capital in financial markets n Basel II aims to redistribute capital with the overall capital maintained at the same level on an average, but with a more efficient allocation of capital n Basel lll has a target to increase the government bond share in the banks capital and solve their liquidity problems

Q&A