Course 14. Capital Adequacy

Outline

(1) About BIS (establishment)

(2) Mission

(3) Basel Committees

(4) Basel Capital Accord (Basel I, II, III)

(5) Recent regulatory incentives

Micro vs Macro prudentiality

Liquidity risk

Systemic risk

(1) About BIS (establishment)

One Bank to Rule Them All

(2) Mission

The mission of the BIS is to serve central banks in their

pursuit of monetary and financial stability & foster

international cooperation by:

fostering discussion and facilitating collaboration among

central banks;

supporting dialogue with other authorities that are

responsible for promoting financial stability;

carrying out research and policy analysis on issues of

relevance for monetary and financial stability;

acting as a prime counterparty for central banks in their

financial transactions.

(3) Basel Committees

The Basel Committee on Banking Supervision (BCBS);

The Committee on the Global Financial System (CGFS);

The Committee on Payments and Market Infrastructures

(CPMI);

The Markets Committee;

The Central Bank Governance Forum;

The Irving Fisher Committee on Central Bank

Statistics (IFC).

(3) Basel Committees

BIS hosts three groups that have their own legal

personality:

the Financial Stability Board (FSB);

the International Association of Deposit Insurers (IADI); and

the International Association of Insurance Supervisors (IAIS).

(3) Basel Committee on Banking

Supervision (BCBS)

(3) BCBS regulations

(4)Basel Capital Accord

What is Basel Accord?

Basel Accord I: In 1988 BCBS published a set of minimal capital requirements for internationally active banks based on credit risk; updated in 1996 to cover market risk.

Basel Accord II was issued by BCBS in 2004 to address shortcomings in the treatment of credit risk and incorporated operational risk. It is based on three pillars.

• minimum capital requirements;

• supervisory review practices;

• market discipline.

(4) Basel Capital Accord

Basel II Accord

(4) Basel Capital Accord

Basel II Accord

Capital Adequacy Ratio

Cooke Ratio=Capital / Risk Weighted Assets ≥ 8%

=> Capital = min 8% * Risk Weighted Assets

Definition of Capital

Capital= Core Capital + Supplementary Capital

CORE & SUPPLEMENTARY CAPITAL

1) Core Capital (Tier I Capital)

i) Paid Up Capital

ii) Disclosed Reserves (General and Legal Reserves)

2) Supplementary Capital (Tier II Capital)

i) General Loan-loss Provisions

ii) Undisclosed Reserves (other provisions against

probable losses)

iii) Asset Revaluation Reserves

iv) Subordinated Term Debt (5+ years maturity)

v) Hybrid (debt/equity) instruments

RISK WEIGHT CATEGORIES IN BASEL-I (1)

0% Risk Weight: Cash, Claims on central governments and central banks denominated in national currency and funded in that currency

20% Risk Weight: Claims on multilateral development banks and claims guaranteed or collateralized by securities issued by such banks

50% Risk Weight: Loans fully securitized by mortgage on residential property that is or will be occupied by the borrower or that is rented.

100% Risk Weight: Claims on the private sector

(4) Basel Capital Accord

Deficiencies of Basel II Accord

• Market risk • not robust to extreme and unforeseen market variations

• Liquidity risk • do not addressed

• Isolated risk (micro) • no consideration of the probability and cost of bank failures

and their impact on the system as a whole

(5) Recent regulatory incentives

Entire system risk vs Isolated risk

Macroprudential vs Microprudential regulation

(5) Recent regulatory incentives

Basel III

bank-level, or microprudential, regulation, which will

help raise the resilience of individual banking institutions

to periods of stress

Liquidity risk (new!)

macroprudential, system wide risks that can build up

across the banking sector as well as the procyclical

amplification of these risks over time.

Systemic risk (new!)

(4) Recent regulatory incentives

Identifying SIFIs: how?

TBTF:“Too Big To Fail” TITF: “Too Interconnected To Fail”

=> TITBAF: “Too Important To Be Allowed To Fail”

(4) Recent regulatory incentives

Identifying SIFIs: methodology

The Basel method

The market method

Static risk indicators

=> balance-sheet & off-balance-sheet

items

• international activity (20%);

• size (20%);

• interconnections (20%);

• substitutability (20%);

• complexity (20%).

Dynamic risk indicators

=> market variables

• contagion effects

Bank i → System

• macroeconomic shocks

System → Bank i

!!! Negative externalities: fire sales, liquidity spirals, haircuts (margins),

losses (trading portfolio), undercapitalization

(4) Recent regulatory incentives

Global Systemically Important Banks (29 GSIB-s)

Source: BIS, 2015

(4) Recent regulatory incentives

Domestic SIFIs (Romania)

Source: NBR (2015)

Conclusions

The importance of BIS:

major improvement in capital regulation ;

enhance safety and soundness of the banking system,

but a lot of challenges in the implementation ;

less incentives for regulatory arbitrage ;

better risk management by institutions.

Thank you!