Basel Accords Daren Warner Chief Financial Officer.
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Transcript of Basel Accords Daren Warner Chief Financial Officer.
Basel
Accords
Capital Adequacy
Market Discipline
Regulation and
Supervision
Basel – Setting the scene
Basel lMainly focused on capital requirements for banks.
Basel llAdds supervision & market
discipline through the "Three Pillar" concept
Basel lllTo be fully implemented by 2015
as it came to life after the financial crisis
Basel – Setting the scene
Basel History
The story behind Basel- The liquidation of Herstatt Bank
The release of Deutsche Marks to Herstatt in Frankfurt in exchange for US Dollars to be delivered to New York
Because of the time-zone differences, counterparty bank did not receive their payment as the Herstatt Bank ceased its operation
Basel l
Establishment of Basel l
1988 Basel Accord- the Basel Committee published a set of minimal capital requirements for banks
Mainly focused on capital requirements for banks
Focused primarily on Credit Risk, market risk was an afterthought
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
Establishment of Basel l – Illustration of measuring capital required:
The Accord required banks to hold minimum capital equal to 8% of their Risk-Weighted Assets (RWA)
Capital Required RWA
Credit Assessment
AAA to AA-
A+ to A- BBB+ to BBB-
BB+ to B-
Below B-
Unrated
Risk Weights 0% 20% 50% 100% 150% 100%
Min. 8%
Asset class Risk Weights
Home Country Sovereign Debt
Corporate Debt
Basel l
Establishment of Basel l – Illustration of measuring capital required:
Tier One Capital + Tier Two Capital
Risk Weighted Assets Capital Adequacy Ratio
(CAR) (Min 8%)
Shareholder Equity & Reserves
Supplementary Capital
Required that half of this
8% consists of Tier 1 Capital (4%)
Example
Bank “X ”Assets (100 units):
Cash: 10 units
Government bonds: 15 units
Mortgage loans: 20 units
Other loans: 50 units
Other assets: 5 units
Bank “X” Debts:95 units of Deposits
Bank “X” Equity: 5 unitsTier 1 = 3Tier 2 = 2
Basel l
Example
Bank “X ” RWA =
Cash = 10 * 0% = 0
Government bonds = 15 * 0% = 0
Mortgage loans = 20 * 50% = 10
Other loans = 50 * 100% = 50
Other assets = 5 * 100% = 5
Bank “X” Debts:95 units of Deposits
Bank “X” Equity: 5 unitsTier 1 = 3Tier 2 = 2
Total RWA= 65
CAR= 5 / 65 = 7.7% < min 8%
Then the CAR for Bank “X” is 8%
Basel l
Basel l
Establishment of Basel l – Market Risk:
General Market Risk
• Changes in market values due to market movements
Specific Market Risk
• Changes in the value of an individual asset due to factors related to the issuer of the security
Foreign Exchange
Interest Rates
Commodities
Equities
Market Risk
Basel l
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 increase (decrease) the risk on the book; or
2. Greater (lower) market volatility
Basel l
Basel l Benefits
Basel l achieved to define and increase bank capital and bank capital ratio
Relatively simple framework
Widely adopted
&
&
Relatively simple framework
Basel l
Basel l Pitfalls
Limited differentiation of
Credit Risk
No recognition of the term structure
or maturity of credit risk
Operational risk was NOT
considered
Static measure of Default Risk
Simplified calculation of
potential future Counterparty Risk
Lack of recognition of portfolio
diversification effects
Basel l
Impact of Basel l in the industry
Basel l
Consequences
Emergence of Credit Derivatives First Credit Default Swap for Exxon Valdez by
JP Morgan
Increased divergence between Regulatory Capital and Economic
Capital Sub-optimal lending behavior
Regulatory capital arbitrage through product innovation
Basel ll
Establishment of Basel ll
2004,The committee published their Basel ll
Purpose: Creating international standards about how much capital banks need to guard against the financial and operational risks
November 2007, Implementation of Basel ll Accord
Risks bank exposed to Amount of Capital required
Basel ll – 3 Pillars
Basel ll
Pillar 1 Minimum Capital
Requirement
Pillar 2 Supervisory Review
Pillar 3 Disclosure and Market
Discipline
Assesses Bank’s Capital Level Sufficiency
Sets out Requirements for
Banks’ Capital Adequacy
Enhances Market Discipline through
Transparency Framework
Credit Risk
Market Risk
Operational Risk
Basel ll
Fundamental changes to the calculation of Regulatory Capital
Regulatory Capital Calculation
Unchanged
Unchanged
Unchanged
=
Credit Risk
Capital Capital Adequacy Ratio
ChangedSubstantially
3 Alternative Approaches
New
3 AlternativeApproaches
Market Risk Operational Risk + +
Basel ll – Pillar 1
Increasing complexity and data requirement
Standardised Approach
Limited recognition;
supervisory treatment
of collateral and
guarantees
Credit Risk Mitigation
External ratings
Foundation IRB
Internal models for PD*
Externally provided EAD*
and LGD*
Limited recognition;
Supervisory treatment of
collateral and guarantees
Advanced IRB
Internal models for PD,
EAD and LGD
Internal estimation; including
guarantees, collateral, credit
derivatives
Measuring Capital Requirement Credit Risk
*PD = Probability of Default *LGD = Loss Given Default *EAD = Exposure At Default
Measuring Capital Requirement Market Risk
Basel ll – Pillar 1
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 CAD2
Measuring Capital Requirement Operational Risk
Basel ll – Pillar 1
Operational Risk is the risk of direct or indirect loss resulting from inadequate for failed internal processes, people and systems or from external events
Basic Indicator Approach (BIA)
Advanced Measurement Approaches
The Standardised
Approach (TSA)
Operational Risk Approaches
Fixed percentage (currently 15%) of gross income
Exposure
Scenarios
Insurance
KRI
Industry loss
Loss experience
Basic Advanced
Based upon gross income, but divided along Basel II-defined business lines and respective beta charges
Standardised
Firms determine their own capital charge based upon internal model
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
Measuring Capital Requirement Operational Risk
Basel ll – Pillar 1
Basel ll
Fundamental changes to the calculation of Regulatory Capital
Regulatory Capital Calculation
Unchanged
Unchanged
Unchanged
=
Credit Risk
Capital Capital Adequacy Ratio
ChangedSubstantially
3 Alternative Approaches
New
3 AlternativeApproaches
Market Risk Operational Risk + +
Example - SCBCapital 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
CAR= 37,012+ 10,499 270,510
= 17.6%
CAR= 34,295+ 10,770 245,077
= 18.4%
2011 2010
17.6% > minimum of 8% 18.4% > minimum of 8%
Basel ll
Basel ll – Pillar 2
Aims to ensure that the banks assess the capital adequacy positions relative to their overall risks
Internal Capital Adequacy Assessment Process (ICAAP)
Using Economic Capital to determine the internal capital of the bank
Pillar 2- Supervisory Review
Basel ll – Pillar 2
Pillar 2
Internal Capital Adequacy Assessment Process
(ICAAP)
Supervisory Review & Evaluation Process
(SREP)
An internal process for assessingthe 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
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
Prudent banking standards recommend that a bank hold enough capital to cushion against large losses that might bankrupt the firm
Economic Capital is an estimate of the level of capital that an entity requires to operate its business with a desired target solvency level
As risk is related to capital we need to find the optimum balance between risk, reward and equity
Cre
dit
Wor
se
Q
ual
ity
B
ette
r
Low Leverage High
Portfolio Risk
Economic Capital
Econom
ic capital
What is Economic Capital?
Basel ll – Pillar 2
Enhanced Market discipline through transparency framework
Market disclosure:– 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
Pillar 3- Disclosure and Market Discipline
Pillar 3 disclosures will be published on the Group website and its location will be referenced in the Annual Report and Accounts
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 – Pillar 3
Pillar 3- Disclosure and Market Discipline
Credit RiskIRB
Market RiskSCB have permission to
use CAD2 SCB measures VAR at
97.5% confidence level, 1 day holding period
Operational Risk TSA
&
AMA is Regularly reviewed
Pillar 1
SCB Position
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
Pillar 2
SCB Position
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
Quantitative and qualitative
disclosures constitute
Pillar 3
Risk management objectives and policies
Credit and dilution Risk
Capital resources and capital assessment
Standardised credit risk
Counterparty credit risk
IRB credit risk
Market risk Capital
Operational risk Capital
Equities in the non-trading
book
Interest rate risk in the non-
trading book
SecuritisationCredit risk mitigation
SCB Position
The recent global financial crisis has revealed weaknesses in the whole approach to risk management that has been developed through the Basel II process
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
The impact of the financial crisis on Basel ll
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 ll
Basel ll Synopsis
Basel lll
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
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 – attempts to encourage banks to hold larger percentages of Government Bonds to provide a riskless safety net should they run into liquidity problems
Basel lll
Does Holding large percentage of Government Bonds REALLY save the bank
from Bankruptcy ?
Example: Holding of Italian debt (20% risk-
weighting) bankrupted MF Global in the space of a week!
Differences between Basel II and Basel IIl
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%
Basel lll – Capital Ratio
Differences between Basel II and Basel IIl
Basel lll – Minimum Common Equity Requirement
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
Basel lll – Capital Buffers
Create capital buffers in good times that can absorb losses during periods of financial and economic stress
• To absorb banking sector losses exclusively with common equity
• 2.5% added to the minimum ratiosCapital Conservation
Buffer
• To extends capital conversion range during periods of excess credit growth
• Up to 2.5% added to the minimum ratiosCountercyclical Buffer
Differences between Basel II and Basel IIl
Basel lll – Leverage Ratio
Tier 1 Capital Exposure ≥ 3%
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
Common Equity & Reserves
Balance sheet exposures excluding derivatives, net of specific provisionsand valuation adjustments
Differences between Basel II and Basel IIl
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
To be introduced in 1 January 2015
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 AA-
Differences between Basel II and Basel IIl
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
To be introduced in 1 January 2015
Basel lll – Liquidity Ratios – Net Stable Funding Ratio (NSFR)
Available Amount of Stable funding Required Amount of Stable funding ≥ 100%
Basel lll
Common Equity (after deductions)
Tier 1 Capital Total Capital
Minimum 4.5% 6% 8%
Capital Conservation Buffer
2.5% 2.5% 2.5%
Minimum Plus Conservation Buffer
7% 8.5% 10.5%
Countercyclical capital buffer
0% - 2.5% 0% - 2.5% 0 – 2.5%
Upper end of minimum capital
9.5% 11% 13%
Basel lll – Target Capital Ratios by 1/1/2018)
Same as Basel ll
Basel lll – IFRS Vs FASB
Difficulty in comparing between capital requirement for US Banks and Non-US Banks;
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
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
US Banks will have lower capital requirement than Non-US Banks
Hold more capital
Better quality capital
Carry more liquid assets
Limit bank’s leverage
Build up capital buffers
Emphasis on Liquidity
Basel lll
Basel lll Summary
Regulation, Regulation & Regulation
Differences between Basel l, ll, 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
Basel I increased the overall level of capital in financial markets
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
Basel lll has a target to increase the government bond share in the banks capital and solve their liquidity problems