The New Capital and Liquidity Proposals –...

The New Capital and Liquidity Proposals – Implications for Banks and their SupervisorsTenth Annual International Seminar on Policy Challenges for the Financial Sector

Andrew CrossManaging Director, Risk Management3rd June 2010

Disclaimer

The author makes no representation as to the accuracy or completeness of the

information provided.

The views expressed here are those of the author, and do not necessarily represent

those of Credit Suisse Group.

Agenda

From Basel 2 to Basel 3

Regulatory Change Overview

Introduction

What Next ?

IntroductionKey Challenge: How to balance competing goals ?

– Addressing known weaknesses in current financial system– Supporting economic recovery– Improving resilience of global financial system to future shocks– Avoid crisis of confidence in key countries / sectors whilst making change

Estimated impacts are very material for European Banks1

– Capital: €600- €1,000Bn of new capital European banks to comply with capital proposals– Ratios: T1 ratios could fall 2.26%– Long term funding: €3,500-5,500Bn of new LT funding to comply with liquidity proposals– Earnings: Impact on European bank earnings ~€250 Bn (~37% 2012E); RoE drops 4-5%

Key Implementation Issues– Timing/Transition: clarity on transition timeframe is crucial to reduce uncertainty (2012-

17?)– Global implementation: key that proposals go live in most G20 at same time in similar

form– Use Pillar 2: progress can be achieved by including key measures like leverage and

liquidity under Pillar 2 – this will allow improved understanding of impacts and adaption of measures

– Key design issues: crucial BCBS address most critical design issues this year e.g. CVA, liquidity definitions, treatment of deductions (main points from comments and QIS)

1. Sources: Credit Suisse, McKinsey

Agenda



Introduction

What Next ?

Regulatory Change: Where’s it all coming from ?

SystemicRisk

FSB led: Compensation, credit growth, banking system risk, cross border resolution, global standardsNon FSB led: capital, procyclicality, risk management, accountingLocal (US/EU/National): OTC derivatives - market structures / central clearing, business model (e.g. “Volcker rule”), regulatory structure (US: Fed role, EU: new EBA), SIFIs(“TBTF”)

FSB

Key InitiativesFocus Overview of Regulatory Change Agenda

Led by

Loca

l

“MA

CR

O”

CapitalRisk Capture

Leverage

Basel 2: Trading BookStressed VaR and Incremental Risk Charge (default/migration)Securitisation positions

Basel 3: Capital / Risk Capture / LeverageMore restrictive definition of capitalMore demanding capital ratios; bigger capital buffersHigher capital charges for counterparty risk e.g. CVAFormal leverage ratio constraint

Liquidity RiskBasel 3: New minimum quantitative liquidity standards

Liquidity Coverage Ratio to survive a 1 month stressNet Stable Funding Ratio requires longer term funding sources

BC

BS

“MIC

RO

”

OtherRegulatory: Increased supervision intensityTax: compensation, trading activity, resolution fundsLocal/SSG: Focus on infrastructure, resilience and controls Lo

cal

Loca

l

BASEL 3

Tier 2

Basel 3 Changes in ContextBasel 3 proposals are more far reaching than all change seen to date

Available Capital

Required Capital

CapitalBuffer

LeverageRatio Disclosure

Capital Related Constraints Liquidity Disclosure

Basel 2:Trading Book

SecuritisationsIRC

Stressed VAR

Liquidity

RetailLoans

Core Basel 2

OperationalRisk

Ope

ratio

-na

lRis

k

DerivativesSecuredFinance

Commercial Loans

Pillar 2Capital Buffer

DisclosureRWA

calculation

Pillar 1 Pillar 2 Pillar 3

Pre Basel 2

Tier 1

Cre

dit R

isk

Ban

king

Boo

k

Mar

ket R

isk

Trad

ing

Boo

k

VAR

Fixed assetsTier 2Tier 3

Basel 3

Liquidity Coverage

Ratio

Net stable Funding

Ratio

Liquidity

CVA

Procyclical Capital Buffer

GlobalLeverage

Ratio

LeverageRatio

Tier 1Deductions

Tier 3Abolished

Tier 2Restrictions

Industry Impact of Basel Change Agenda

Trading Book Improvements

Stressed VaR/IRC: in full implementation modeSecuritisation rules: flawed and will damage credit supply in key areas eg residential mortgages

Capital Definition

Capital definition: need practical grand fathering rulesDeductions: many critical problems affecting different markets eg MIs in developing countries, DTAs in Japan

CapitalRatios

Core ratios: unclear where new levels will be set given changes in other areas eg capital defn, RWAsSystemic add-on: not clear who is lead, FSB or BCBSConservation buffer: need CoCos to manage this

Liquidity Risk Improvements

LCR (1mth): liquid asset definition is too narrowNSFR (1yr): disincentivises >1yr lending to retail, SME and corporates

RiskCapture

Cpty credit risk: must calibrate incentive for CCPsCVA: approach is confused hybrid of MR/CR; calibration is wrong (x10)

Bas

el 2

Bas

el 3

Material for IBsSec rules have

uncertain outcomes

Industry Impact1

Large impacts for many banks unless

changes made

Lack of clarity at present makes

planning difficult

CVA needs major rework

NSFR needs major rethink as impacts

many product areas

Highlights of industry concernsFocus

Leverage Ratio

Equity definition: double impact from tighter capital defnB/S definition: ultra conservative defn causes major issues eg ignores netting and add back of sold CDS

Likely to be binding constraint for many banks

Significant impact on some market

participants / product sectors

Significant impact on whole financial

system

Moderate impacton some market

participants / product sectors

1. Impact ahead of any 2010 updates to current proposals

Agenda



Introduction

What Next ?

Basel 2: Trading Book Changes - Summary

Additional measure of “Stressed VaR” – in addition to current VaR; “Stressed VaR” wont decrease as market volatility dropsIncremental risk charge “IRC” – additional capital charge for default and migration risk on assets held in trading bookWhole raft of new rules on treatment of securitisation assets incl:

Definitions of originating, sponsoring and investing banksDefinitions on credit risk transferDefined treatment for each type of securitisation (incl. liquidity facilities)Definitions on credit risk assessments for securitisation positionsGuidelines on the applicable methodologies for determining minimum regulatory capital for securitisations

Key measures

Overall Objective

Increase capital held against the trading book (in line with banking book)Reduce procyclicality of trading book capitalAddress issues concerning securitisation assets

Driver of change

Trading book deemed under capitalised

VaR is quite procyclical with capital requirement reduced in benign marketsSecuritisation assets not properly captured in current capital framework

Crisis experience: severe market losses in TB well above capital held

Basel 2: Trading Book Changes - Assessment

Stressed VaR – No material change expectedIncremental Risk Charge – No material change expectedSecuritisation – Material change needed, unclear whether feasible

Likelihood of change

Key Issues

IRC: unrealistic expectations on IRC models design and operation

Securitisation: Double counting of long and short positions

Securitisation: Irrational treatment of net shorts

Securitisation: Treatment of correlation tradingOverall: concerns on consistent timing of implementation (EU/US)

Industry Comment

Industry in “implementation mode” for stressed VaR and IRCMaterial uncertainty on securitisation treatment likely to disrupt credit to some key product segments eg residential mortgages

Basel 3: Capital Definition - Summary

“Common Equity” must be the “predominant” part of Tier 1 Capital - includes unrealised gains & losses (e.g. AFS reserves); excludes minority interestsRemainder of Tier 1 is “Additional Going Concern Capital” i.e. preference shares & hybrids (non-cumulative, no step up, no stock-settlement) Step-up Hybrid Tier 1, all Upper Tier 2 and Tier 3 disappear: grandfathering of all obsolete instruments to be determined post impact studyContingent capital: application and conditions will be considered in July 2010Capital Deductions to be entirely from Common Equity, no longer split across Tier 1 and Tier 2Expected Loss minus provisions (IRB); certain ABS; Deferred Tax Assets; Employee pension contribution assets (defined benefit schemes)

Key measures

Overall Objective

Raising the quantity and quality of Tier 1 capitalHarmonising capital constituents and deductions among BIS countriesImprove transparency of capital make-up

Driver of change

Many capital instruments didn’t act as loss absorbers on a going concern basisCapital deductions materially inconsistent across jurisdictionsWeak transparency on constituents of capital base

Crisis experience: market loss confidence in T1 measures of capital

Basel 3: Capital Definition - Assessment

T1 definition (largely common equity) – No material change expectedT1 deductions: Minority Interests – Possibly a mistake, likely to changeT1 deductions: Insurance Subs – Unclear, probably wont change materiallyT1 deductions: DTAs – Change needed but no clear path; conflicting goals between pro-cyclical effects and US/EU level playing field


Key Issues

Capital requirement from participations in banking/finance/insurance securities?Identify securitisation positions attracting RW 1,250% (doubling Tier 1 deduction)Identify any positive AFS reserves (newly recognised as Tier 1)?Deferred Tax Assets: which of them will deduct from core Tier 1?Future compliance of existing capital instruments (prefs, hybrids, Tier 2)?

Industry Comment

Strong push back on current proposals as “procyclical” and “counterproductive”Need grandfathering and transitions arrangementsNeed local treatments, especially in Emerging MarketsDeductions are too aggressivePromoting contingent capital

Basel 3: Capital Ratios - Summary

Minimum capital ratios (to be set after impact study): Going Concern – two measures: (i) Common Equity / RWA, (ii) Tier 1 Capital / RWA Gone Concern: Total Capital (= Tier 1 Capital + Tier 2 Capital) / RWA

Additional, quantitative, cyclically-adjusted Capital Buffers required: falling into the buffer range causes regulatory impositions including restrictions on discretionary distributions (dividends, buybacks, hybrid payments) and compensation Forward-looking and dynamic provisioning, and other changes to reduce pro-cyclicality

Key measures

Overall Objective

Raising capital levels across the industryReduce pro-cyclicalityConserve capital and prevent excessive credit growth

Driver of change

Capital levels not sufficient for crisis timesCapital framework too pro-cyclical i.e. capital materially reduced in good times

Crisis experience: current capital framework inadequate

Basel 3: Capital Ratios - Assessment

Minimum levels – Unclear on how will be calibratedCapital conservation – Proposals agreed in outline but challenges remain e.g. difficult to mesh with US PCA1 regime; expect use of CoCos for this bufferMinimise procyclicality – Proposals still undeveloped; need more detail hereForward looking provisions – Though commitment to concept, many details still open; strong conflicts with accounting


Key Issues

Current T1/Total minimums of 4%/8% driven towards 6%/10%Combined with definition of capital changes drives towards 8% core equity“Big banks” may need more e.g. 9% Procyclical buffers will be more again e.g. 10%Buffers will restrict management flexibility on distributions, business growth, compensation

Industry Comment

Proposals results in double counting between capital and provisioningSupports forward looking provisioning, but needs consistent accountingMust avoid rigid capital buffersStrong focus on Pillar 2 mechanisms

1. PCA: Prompt Corrective Action

Basel 3: Risk Coverage - Summary

Strengthening risk capture to resolve weak aspects of Basel II revealed in the crisis, notably counterparty risks between banks

Increase in RW of exposures to banks and other financialsIncrease in RWA for derivative counterparty risk (“CVA”)

Possible reduction in RW of exposures to central clearing counterparties (CCPs)On top of substantial increases in RWAs for Trading Book assets and securitisations announced in July 2009 (to be implemented YE 2010)Possible changes to PD inputs to reduce pro-cyclicality of RWs

Key measures

Overall Objective

Increase RWA for counterparty credit riskIntroduce capital charge for CVA

Driver of change

Counterparty defaults / deteriorations coincident with high market volatilityMTM losses on counterparty credit risk were material (mainly US GAAP banks)Large FIs were connected at time of crisis

Crisis experience: counterparty credit risk undercapitalised

Basel 3: Risk Coverage - Assessment

“Stressed EPE” – No material change expectedIncreased RWAs for large FIs – No material change expectedCVA – Principle of charge agreed; methodology and calibration likely to be reviewed and changed given severe over calibration is current draft


Key Issues

RWA impact from exposures to banks/financials (e.g. derivative trading)RWA impact of EPE changes to derivative counterparty risk calcs (large FIs) Significant RWA implied by CVA capital chargePotential RWA reduction from clearing Corporate Bank hedges with CCPsRWA impact of July 2009 Trading Book changes (incl. securitisations)

Industry Comment

No need for “stressed EPE” as covered under existing Pillar 2 testsNo strong evidence for increasing RWAs for large FIsEffective penalty for OTC trades will be distortiveCVA charge needs significant recalibration and redesign eg use VaR framework

Basel 3: Leverage Ratio - Summary

Introducing a leverage ratio as a supplementary measure to the Basel II risk-based ratios. Minimum % ratio to be decided post impact study Capital Measure = regulatory capital definition – either Common Equity or Tier 1 Capital, decided post impact studyAsset (Exposure) Measure = accounting assets plus assets per “worse of” IFRS and US GAAP treatment

Plus certain off-balance sheet items (e.g. lending commitments, guarantees, written CDS protection) at their full notional amountNo offset of collateral in CSAs, repos, or other agreementsNo netting allowed between transactions with a single counterparty even within master agreements (derivatives, repos)

Key measures

Overall Objective

Introduce non risk weighted capital constraintReduce leverage in system

Driver of change

Leverage was a cause of issues at many troubled banksRisk based regimes missed build up of leverage

Crisis experience: leverage was a major contributor to the crisis

Basel 3: Leverage Ratio - Assessment

Some form of leverage ration – Agreed in principle by BCBSDefinition of capital – Some discussion, likely to be core capitalDefinition of “Assets” – Difficult to estimate how much change in definition will be made in 2010Calibration of constraint – Not yet specified, so allows some flexibility –current definitions drive big banks to 1%-2%


Key Issues

Leverage ratio could become the dominant capital constraintSignificant increases in assets from:

removing netting & collateral for derivatives and reposincluding cash with central banksincluding guarantees and CDS sold at notional

Significantly more penal than current US or CH approaches

Industry Comment

Industy keen that leverage ratio is under Pillar 2 – allowing regulator/firm flexibility to setting constraintUse Tier 1 as definition of capital“Unreasonable” to not recognise netting; include CDS as using “Current Exposure Measure”Propose exclude “High quality liquid assets” from Assets

Basel 3: Liquidity Proposals - Summary

Introducing a global minimum liquidity standard for internationally active banksLiquidity Coverage Ratio (“LCR”) to ensure a bank has sufficient high quality liquid resources to survive an acute stress scenario (1 month)Net Stable Funding Ratio (“NSFR”) to promote longer term stability by incentivising banks to access longer term stable funding sources

Four monitoring measures: (i) Contractual Maturity Mismatch, (ii) Concentration of Funding, (iii) Available Unencumbered Assets and (iv) Market-related Monitoring tools

Key measures

Overall Objective

Introduce quantitative liquidity constraintsAddress known liquidity issues at many institutions

Driver of change

Liquidity was a cause of issues at many troubled banksLack of clear standards reduced ability of regulators to challenge firms

Crisis experience: liquidity risk was a major contributor to the crisis

Basel 3: Liquidity Proposals - Assessment

Short term liquidity constraint (LCR) – Agreed in principle, definition still under reviewLCR design – Key decision needed on inclusion of agency, corporate bonds, covered bonds (with haircuts)Medium term liquidity constraint – Agreed in principleNSFR design – Focus will be on factors applied to funding sources


Key Issues

Significant impact on liquidity portfolio if based on government securities onlyLarge change in term structure of debt funding re. NSFR ratioNew requirements for undrawn commitments (e.g. liquidity facilities)Penalises over reliance on funding from wholesale marketsPenalises banks with mortgage portfolios greater than their deposit bases

Industry Comment

LCR – liquid assets definition is too narrow; should be more risk basedNSFR - will dramatically restrict provision of credit and liquidity to economyLikely to be pro-cyclical as maturities reduce as a crisis developsNational implementations likely to result in “trapped liquidity”

Agenda



Introduction

What Next ?

The measures should be coherent and correlate to the public policy goals

Cumulative effects matter and should be taken into consideration

International coordination is required in order to avoid regulatory arbitrage

Switzerland's competitiveness as a financial center must be taken into consideration

Cost-benefit analysis of regulations is required and should influenceoutcomes

Principle-based regulation enables banks to meet regulatory requirements flexibly and efficiently Su

cces

sful

regu

latio

n1

2

3

4

5

6

These principles correspond in large part to Article 7, para. 2 of the Swiss Financial Market Supervisory Act (FINMAG)

Principles for Successful Regulation: A Swiss View

Switzerland:Full compliance by 2012Aggressive scheduleSwiss finishFlexible legislative process

EU:Formal full implementation (CRD4)Currently, strong political backing to change agendaUnclear if political backlash if capital/liquidity impact too material eg GermanyNational implementations may vary according to local practices eg France

Asia Pacific:Implementation country by country Key Asian countries now full BCBS membersExpect wide divergence on timings and scope of implementationsFull adoption likely in Japan, Singapore, HK

US:Not yet on Basel IIHighly politicised implementationLikely to be delayed beyond 2012Major push back / local treatment of leverage, liquidity

Basel 3: Likely Global RolloutCanada:

Full implementationLikely on schedule for 2012

UK:Proactive implementer of new rulesLikely full compliance by 2012Strong push of UK view of subs

BCBS members:Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.

LatAm:Implementation country by country Key LatAm countries now full BCBS membersExpect wide divergence on timings and scope of implementations

Milder StricterLater Earlier

Deviation from int'l. consensus

- Time + - Substance +

Regulatory Change: Some lessons from Switzerland

Leverage ratio

Greater risk management

Higher capital adequacy requirements

Stricter liquidity management

Transparency, stricter accounting policies

Emergency planning for system-relevant areas

Strengthened deposit protection

Size restrictions/splitting up of big banks

New compensation systems

Central clearing counterparties for OTC derivatives

Regulated liquidation procedure

Changes proposed /under discussion Examples

Mandatory compensation rules for banking sector starting in 2010

SNB and politics considered size reduction at early stage, dynamic in international discussionSharp increase in liquidity maintenance from mid-2010 plannedLeverage ratio introduced in SwitzerlandCapital adequacy requirements for major banks 50% to 100% and even more above Basel II requirementsSignificant increase in frequency and intensity of interactions with supervisionFederal Council expert committee report on systemic risks (fall 2010)Proposal on deposit protection with CHF 10 billion ex-ante fundsPr

oces

sing

Liqu

idity

/Cap

ital

Bus

ines

s

What’s best way to make progress ?PRIORITISE

– Basel II learning point: many of proposals are only fully understood now 3yrs post go live– Current change agenda is too large and complex to deliver by 2012– BCBS need to set out timescale and transition approach – this will allow more review and

assessment of impacts– Prediction: G20 timeframe and BCBS too vested in current package likely to result

in over ambitious and unrealistic implementation plan

COMMUNICATION– Current rhetoric from regulators and industry is too confrontational to facilitate good

consensus– Proper debate can get overwhelmed with positioning on both sides– If BCBS can set out a more positive tone to change agenda then industry will engage– Prediction: difficult to change tone on both sides, particularly in current political

environment

LEVEL PLAYING FIELD – WHAT DOES GOOD LOOK LIKE ?– Need real clarity on level of coordination across jurisdictions– Arguably clarity is greater goal than consistency per se– Prediction: very difficult to bring US change programme in line with global agenda

Some Advice on “Change”

Advice for regulatorsAll change is not growth, as all movement is not forward

Advice for industryIt is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change

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© Copyright 2010

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