Basel III and its implications for banks treasurers

Basel III and its implications for banks’ treasurers B. Mahapatra Reserve Bank of India

Outline Introduction Enhancement to Basel II Building blocks of Basel III Elements of Basel III relevant for banks’ treasurers • Implications of Basel III • Impact on Indian banks • Conclusion • •

Introduction • The Basel I – 1988 – capital charge for credit risk – a simple “broad-brush” approach • Amendment to Basel I – 1996 – to incorporate capital charge for market risk – Standardized Measurement Method (SMM) – Internal Models Approach (IMA) • Market risk capital framework – Capital charge for general market risk – Capital charge for specific risk (credit risk)

• The Basel II – 2004 – Enhanced risk coverage • Credit • Market and • Operational risks – A menu of approaches – standardized to model based with increasing complexity – Three pillar approach • The Basel II of 2004 copied and pasted the capital charge for market risk of Basel I amendment of 1996

• As a result, the capital charge framework for market risk did not keep pace with new market developments and practices • Capital charge for market risk in trading book calibrated much lower compared to banking book positions on the assumption that markets are liquid and positions can be wound up or hedged quickly

• Capital charge for specific risk (credit risk) in market risk framework (trading book) was lower than capital charge for credit risk in banking book • Lower capital charge for trading book led to scope for capital arbitrage • Capital charge for counterparty credit risk for derivative positions also covered only the default risk and migration risk was not captured

• The global financial crisis mostly happened in the areas of trading book /off balance sheet derivatives / market risk and inadequate liquidity risk management • Banks suffered heavy losses in their trading book • Banks did not have adequate capital to cover the losses

• There was heavy reliance on short term wholesale funding • Unsustainable maturity mismatch • Insufficient liquidity assets to raise finance during stressed period

Enhancement to Basel II • Post- crisis, global initiatives to strengthen the financial regulatory system • July 2009 Enhancement to Basel II – mostly in trading book

• Pillar 1 – Standardized approach – Higher risk weights for CRE securitization and other re-securitization exposures – almost doubled – Bank not permitted to use any external rating of ABCP program where it had provided liquidity facility or credit enhancement – treated as unrated – Operational criteria for using external ratings prescribed – CCF for all eligible liquidity facilities made uniform at 50%, irrespective of maturity (earlier 20% CCF for maturity less than one year)

• Pillar 1 – Internal models approach – Capital based on normal Va. R and stressed Va. R – Incremental Risk Charge (IRC) for interest rate instruments introduced which will capture default as well as migration risk

• Pillar 2 guidance – firm wide governance and risk management; – capturing risk of off balance sheet exposures and securitization activities; – managing risk concentrations; – managing reputation risk and liquidity risk; – improving valuation practices; and – implementing sound stress testing practices

• Pillar 3 – appropriate additional disclosures completing enhancements in Pillars 1 and 2 • • Securitization exposures in trading book Sponsorship of off balance sheet vehicles Re-securitization exposures; and Pipeline and warehousing risks with regard to securitization exposures

The Basel III • December 17, 2009 Basel Committee issued two consultative documents: – Strengthening the resilience of the banking sector – International framework for liquidity risk measurement, standards and monitoring

• The proposals were finalized and published on December 16, 2010: – Basel III: A global regulatory framework for more resilient banks and banking systems – Basel III: International framework for liquidity risk measurement, standards and monitoring

• Objectives – Improving banking sector’s ability to absorb shocks – Reducing risk spillover to the real economy • Fundamental reforms proposed in the areas of – Micro prudential regulation – at individual bank level – Macro prudential regulation – at system wide basis

Building Blocks of Basel III 1. Raising quality (Tier 1 – 6%, of which TCE - 4. 5%), level (8+2. 5% CCB), consistency (deductions mostly from TCE) and transparency of capital base 2. Improving/enhancing risk coverage on account of counterparty credit risk 3. Supplementing risk based capital requirement with leverage ratio 4. Addressing systemic risk and interconnectedness 5. Reducing pro-cyclicality and introducing countercyclical capital buffers (0 -2. 5%) 6. Minimum liquidity standards • We will discuss 2, 3, 4 and 6

Improving/enhancing risk coverage on account of counterparty credit risk • In addition to July 2009 Basel II Enhancements • Counterparty credit risk (replacement cost value) is measured either by OEM, CEM, Standardized Method or IMM • Banks using IMM for measuring exposure for counterparty credit risk in derivative transactions will be required to use stressed inputs in Effective Expected Positive Exposure model

• Banks using standardized approach or IRB approach for credit risk in OTC derivatives, must add a capital charge to cover CVA (Credit Valuation Adjustment) risk – to capture down gradation of counterparty before default in all approaches • Capital charge for “wrong way” risk – PD and EAD are positively correlated - in all approaches

• Asset value correlation of 1. 25 for financial firms of $ 100 billion assets and unregulated financial firms • Strengthening collateral management and extend margining period of risk to 20 days for OTC derivatives • Increasing incentives for use of CCPs compliant with CPSS/IOSCO norms, for OTC derivatives

Supplementing risk based capital requirement with leverage ratio • Objectives – to supplement capital ratio in capturing risk • Numerator – Tier 1 capital • Denominator – on and off balance sheet exposure credit equivalent with 100% CCF, except 10% CCF for unconditionally cancellable OBS commitments • Derivatives on CEM and Basel II netting basis • Collateral, guarantees or credit risk mitigation will not reduce on balance sheet exposures

• Ratio – 3% • As a Pillar 2 measure to start with but will be integrated with Pillar 1 • Leverage ratio will be tracked from January 1, 2011 to see the result of the above definition and parallel run from January 1, 2013 to 2017 and final adjustment in 2017 – Disclosure from January 2015 • As Pillar 1 ratio from January 1, 2018

Addressing systemic risk and interconnectedness Capital and liquidity surcharge on SIBs/SIFIs Activity restriction/exposure on SIBs/SIFIs Intensive supervision of SIBs/SIFIs Asset value correlation of 1. 25 for exposures to large financial institutions and unregulated institutions • Stricter treatment of OTC derivatives not cleared through CCPs • •

• Improving loss-absorbing capacity of SIBs/SIFIs - Contingent capital and bail-in-able debt • Orderly unwinding of SIBs/SIFIs – improving resolvability – “living wills”

International framework for liquidity risk measurement, standards and monitoring • Key characteristic of the financial crisis was inaccurate and ineffective management of liquidity risk • Two standards/ratios proposed – Liquidity Coverage Ratio (LCR) for short term (30 days) liquidity risk management under stress scenario – Net Stable Funding Ratio (NSFR) for longer term structural liquidity mismatches

• Liquidity Coverage Ratio (LCR) – Ensuring enough liquid assets to survive an acute stress scenario lasting for 30 days – Defined as stock of high quality liquid assets / Net cash outflow over 30 days > 100% – Stock of high quality liquid assets – cash + central bank reserves + high quality sovereign paper (also in foreign currency supporting bank’s operation) + state govt. , & PSE assets and high rated corporate/covered bonds at a discount of 15% - (A) – Level 2 liquid assets with a cap of 40%

• Fundamental characteristics of liquid assets – Low credit and market risk – Ease and certainty of valuation – Low correlation with risky assets – Listed in a developed and recognized exchange • Market-related characteristics – Active and sizable market – Presence of committed market makers – Low market concentration – Flight to quality

• Net Stable Funding Ratio (NSFR) – To promote medium to long term structural funding of assets and activities – Defined as Available amount of stable funding / Required amount of stable funding > 100%

• Other monitoring tools for liquidity risk management – Contractual maturity mismatch – Concentration of funding – Available unencumbered assets – LCR by significant currency – Market-related monitoring tools

Implications of Basel III • Impact on economy – IIF study – loss of output of 3% in G 3 (US, Euro Area and Japan) on full implementation during 2011 -15 – Basel Committee study – likely to have modest impact of 0. 2% on GDP for each year for 4 years for 1% increase in TCE – Similarly, for 25% increase in liquid assets, half the impact of 1% increase in TCE – However, long term gains will be immense

• Global banks could have a gap of liquid assets of € 1, 730 billion - to be met in four years • Global big banks could have a capital shortfall of € 577 billion to meet 7% common equity norm – to be met in eight years • Tier 1 capital ratio falls to 5. 7% from 11. 1% under the new definition / adjustment of capital and increase in risk coverage (RWAs) • Therefore, long phase-in arrangements (Annex 1)

Impact on Indian banks • High capital ratios at 14. 4% in June 2010 which will fall to 11. 7%. Tier 1 will fall from 10% to 9% and common equity from 8. 5% to 7. 4% • Most of deductions are already mandated by RBI, so little impact • Most of our banks are not trading banks, so not much increase in enhanced risk coverage for counterparty credit risk

• Banks mostly follow a retail business model and do not depend on wholesale funds • Whether our SLR securities can be part of liquid assets? • Whether our liquid assets will stand the scrutiny of fundamental characteristics and market-related characteristics?

• Indian banks are generally not as highly leveraged as their global counterparts • The leverage ratio of Indian banks would be comfortable

• Banks having a huge trading book and off balance sheet derivative exposures may be impacted due to increased risk coverage (capital) on account of counterparty credit risk

• Similarly, banks having huge off balance sheet exposures - derivatives and others - may be impacted on account of leverage ratio • Banks depending heavily on wholesale funds may be impacted due to the new liquidity standards • SIBs may have further implications for capital and liquidity surcharges and activity restrictions

• Whether our banks can attract capital in the form of contingent capital and bail-in able debt at the point of non-viability or whether our capital market will support such instruments?

Conclusion • Basel Committee is undertaking a fundamental review of the trading book – whether a particular position to be covered in trading book or banking book and capital requirement • Not only sluggish growth, high unemployment and low returns, but also more resolution will be the “New Normal”

• Thank You