Economics, Commerce and Trade Management: An International Journal (ECTIJ)
Basel II to Basel III – The Way Forward
1. White Paper
Basel II to Basel III – The Way forward
- Rohit VM, Sudarsan Kumar, Jitendra Kumar
Abstract
Basel III guidelines are the response of BCBS (Basel Committee on Banking Supervision) to the 2008 Crisis. It is aimed at
strengthening Individual Financial Institutions as well as the overall Financial System by eliminating the weaknesses which
were present in BASEL II that were revealed during the crisis.
BASEL III has a multi-dimensional impact on financial Institutions and will require associated changes to the IT systems.
This paper covers various BASEL III guidelines, and describes the “Why” and “How” different areas of IT infrastructure and
systems will be impacted.
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2. Introduction
Some very fundamental assumptions by financial institutions and regulators were proven wrong during the 2008 Crisis. The business
of subprime lending was based on the assumption that housing prices would keep going up. This assumption proved wrong and it
triggered a chain reaction that engulfed the global financial system. This ‘crisis cycle’ is illustrated in the diagram below.
There were some incentives present in the financial system that encouraged risk taking. Transferring of risk through securitization; relying on
credit ratings provided by credit rating agencies, which were paid for by the issuers; compensation of top management based on absolute
growth, revenue and profit rather than risk adjusted profitability; were just some of the reasons that encouraged excessive risk taking by banks.
When subprime loan defaults started impacting the balance sheets of financial institutions, it became a systemic problem. Quarterly
losses to the tune of billions of dollars by major Financial Institutions resulted in a crisis of confidence that sucked out liquidity from the
financial system. At this time, the weaknesses of the BASEL II guidelines became very evident.
Exposure to risky assets in the form of subprime loans, securitization and derivatives resulted in excessive losses. The low quality and
quantity of capital could not absorb these losses when systemic risk materialized. The bank’s loss absorbing capacity was affected
because of their excessive leverage and their short term sources of funding made financial institutions gasping for capital when it was
most difficult to raise capital.
Sub-Prime Sub-prime defaults, Excessive leverage &
Lending Housing prices Securitized assets & poor capital could not
decline resulting in derivatives trading absorb losses fully,
sub-prime defaults resulted in huge demanding fresh
Securitization losses equity infusion
Excessive Risk Taking In stressed market situations, Credit
Rating downgrades of Financial
Institutions & securitized products
further lowered valuations &
increased losses
Governments step in Firms on the verge of Short term borrowing Huge losses resulted
to inject capital to insolvency; demanded fresh in a crisis of
prevent systemic threatening system borrowing which confidence causing
failure failure failed in liquidity crisis liquidity to evaporate
BASEL III attempts to plug the loopholes present in BASEL II by recommending steps to further strengthen the overall financial system. BASEL
III requires higher risk weights for risky assets bringing more assets/exposure into the umbrella of Risk Weighted Asset (RWA) calculations,
prescribes a higher regulatory capital requirement and demands a very high quality of capital. It also introduces requirements to manage
liquidity risk better. Finally, it introduces an additional requirement of absolute leverage ratio to take into consideration the model error
which might be present in RWA calculations.
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3. The diagram below highlights where and how BASEL III changes will address the deficiencies in the ‘crisis cycle’.
• Higher quantity & quality of
Capital Conservation / • Less reliance on external
capital
Counter-cyclical buffers ratings agencies
• Leverage Ratio introduced
• CVA Capital Charge
• 100% weight for trade finance
• Stressed Testing
Sub-Prime Sub-prime defaults, Excessive leverage &
Lending Housing prices Securitized assets & poor capital could not
decline resulting in derivatives trading absorb losses fully,
sub-prime defaults resulted in huge demanding fresh
Securitization losses equity infusion
In stressed market situations,
Excessive Risk Taking Credit Rating downgrades of
Correlation to financial institutions
Financial Institutions &
will carry more risk weights – to
prevent systemic risks and an securitized products further
overall collapse lowered valuations &
increased losses
Governments step in Firms on the verge of Short term borrowing Huge losses resulted
to inject capital to insolvency; demanded fresh in a crisis of
prevent systemic threatening system borrowing which confidence causing
failure failure failed in liquidity crisis liquidity to evaporate
Enhanced Supervisory Two new liquidity
Review and Disclosure ratios
In summary, the BASEL III rules will strengthen the capital reserves and introduce stringent reporting requirements that cover key risk, liquidity and
leverage parameters. The BASEL III guidelines also attempt to bolster the weak links in the financial system with the introduction of Central Clearing
Houses and lessen the dependency on Rating Agencies. The chart below captures the key aspects of the BASEL III guidelines that have been introduced.
• Increase in common equity requirement from 2% to 4.5%
• Increase in Tier 1 Capital (Going Concern) from 4% to 6%
CAPITAL
• Overall capital will remain the same at 8%. (Which means Tier 2 capital, or gone concern capital to reduce to 2% of
total capital)
• Tier 1 Capital can no longer include hybrid capital instruments with an incentive to redeem through features such as
step-up clauses. These will be phased out
• Tier 3 Capital will be eliminated (previously used for market risk)
CAPITAL -
• Introduction of Capital Conservation Buffer - 2.5% of Common Equity Tier 1
BUFFERS
• Introduction of Counter Cyclical Buffer - 0 to 2.5% of Risk Weighted Assets (RWA)
• Credit Valuation Adjustment (CVA) Capital Charge must be calculated to cover Mark-to-Market losses on counterparty
risk to Over The Counter (OTC) Derivatives.
RISK • Stressed parametes must be used to calculate Counterparty Credit Risk
MANAGEMENT • Effective Expected Positive Exposure (EPE) with stressed parameters to be used to address general Wrong-Way Risk
(WWR) and Counterparty Credit Risk
• Banks must ensure complete trade capture and exposure aggregation across all forms of counterparty credit risk (not
just OTC derivatives) at the counterparty-specific level in a sufficient time frame to conduct regular stress testing.
• A multiplier of 1.25 is applied to the corelation parameter of all exposures to financial institutions (meeting certain
criteria) (Asset Value Correlation - AVC)
• Additional margining required for illiquid derivative exposures
• 100% risk weight for Trade finance
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4. LIQUIDITY • Liquidity Coverage Ratio (LCR) >= 100%
• Net Stable Funding Ratio (NSFR) > 100%
LEVERAGE
• Leverage Ratio >= 3%
• Contractual maturity mismatch
REPORTING • Concentration of funding
• Available unencumbered assets
• Market-related monitoring tools: asset prices and liquidity, Credit Default Swap (CDS) spreads and equity prices
• LCR by currency
• Results of stress tests should be integrated into regular reporting to senior management
RATING
AGENCIES • Lower reliance on External Rating Agencies
Basel III –New Requirements
IT Impact – Summary of Change
The architecture below represents
New Sources of Data Updated Models will incorporate RWA Calculation will change
a typical BASEL II set-up. Exposure new sources of capital (new data because of the new data
(Cash Flows) required to
and reference data information calculate LCR/NSFR. fields) and stressed parameters fields and new risk weights
is extracted from multiple source
systems through Extract, Transform Data Sources ETL Staging Basel II Risk Environment RWA Calculation and Reporting
& Load (ETL) processes and the
Origination
modelling parameters – Probability System
Risk
of Default (PD), Exposure at Default Datamarts
(EAD) and Loss Given Default (LGD) Servicing
System
G/L Reconciliation RWA Calculator
are calculated. This data is stored
in a Risk Data-Warehouse and then Factor Model Environment
Source System Extracts
Collateral
Mgmt .
Data Quality/CDC
Reporting Tool
the RWA calculations are performed System
Staging/ODS
Segment
Definition
on the risk data to calculate the Loss &
Recovery PD, LGD,
regulatory capital requirements. System EAD
FFIEC 101
Reports
In general, a BASEL III implementation Reference Op Risk
Models
Data
ICAAP
will require additional source Reports
systems to be included, changes External
Model Validation/ Feedback
Sources
to the data elements of existing Management
Reports
source systems to be made, changes Model Execution and Output
to the risk data models to be done, General
Ledger
RWA calculations and reporting Data Governance
modules to comply with regulatory
reporting guidelines. These changes Data Governance across the system
are highlighted in the pictorial
representation in the diagram. New Reports 6. Market-related monitoring tools: asset
Possible new Data marts to hold 1. LSR, NSFR prices and liquidity, CDS spreads, equity
data for the measurement of 2. Leverage prices, institution specific information
Liquidity and Leverage ratios 3. Contractual maturity mismatch related to the ability of the institution to
4. Concentration of funding fund itself in various wholesale markets
5. Available unencumbered assets 7. LCR by currency
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5. BASEL III’s IT impact can be further understood by looking at its impact on each of the areas separately. The table below lists the impact
expected in different areas of implementation and also lists some of the challenges that will be encountered while implementing them.
Infrastructure Risk
Risk Data RWA Regulatory
and Data Modeling and
Identification Calculation Reporting
Management Quantification
Some new sources • The new liquidity • The formulas used • Changes will be • The reporting
of data that would ratios that Basel III in the calculation required at the systems will have
need to interact with introduces (LCR and of PD, LGD, EAD will risk engines to to be enhanced to
the Basel framework NSFR), will entail change due to the accommodate the cater to the new
include: the creation of need to incorporate new buffers (Counter reports mentioned
• Asset Liability new Liquidity Risk stressed parameters Cyclical, Capital in Basel III
Management (ALM) Data Marts to hold and to also reflect Conservation).
• The existing reports
systems relevant Data a higher EAD value
• It will also need will also be modified
for counterparties
• Cash Flow • Use of Stressed to accommodate to reflect liquidity,
where specific
IMPACT
Management parameters as well the new Risk leverage and CVA,
Wrong Way Risk
systems as calculating CVA Weights assigned besides the new
(WWR) has been
• Existing Liquidity for counterparty to derivatives, trade capital structure
identified.
Risk Management credit risks will need finance products
• Subsidiary reporting
systems huge amounts of as well as account
requirements will be
historical data, which for exposures to
• Data from Central augmented.
may require the use financial institutions.
Counterparties for
of new data marts/
data related to Over-
databases to store
The-Counter (OTC)
such information.
derivatives.
• Identifying the right • A single data • Consultants having • The system should • Understanding
Data Elements. This load with all the experience in be configured to the new reporting
would require a attributes required Stress Testing, provide Group Data, requirements
good knowledge of for market, CCR, Analytics, and Solo Data, Basel I,
• Bringing out
accounting systems RWA, economic general knowledge II and III data on
CHALLENGES
synergies across
as well as knowledge capital and liquidity about the business demand.
stakeholders and
of the various risk should be of Banks will be
consolidating the
reports required by extracted from required to identify
reporting platform.
Basel III. source systems. and stress the
• Identifying required parameters.
• As a result, DQ
sources and data checks will be • Model validation
requirements for rigorous. should be a focus
different legislations. area.
DATA GOVERNANCE
• Put in place a rigorous and scalable Data Governance framework (People + Process + Technology)
• Align source systems’ data quality capabilities to meet Fit For Purpose norms
• End-to-end audit capability from source system data to final output calculation may be a challenge in Basel III because of the many
new source systems interacting with the reporting systems.
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6. BASEL III Implementation Approach
A BASEL III Implementation will require a core team to co-ordinate with multiple track owners who would be responsible for making changes
to the applications and systems that they manage. Ideally, a BASEL III Project Management Office (PMO) will be responsible for initial impact
assessment, identifying multiple tracks within the overall program, co-ordinating and monitoring the overall execution and reporting to
the senior management.
Impact Analysis
Strategy & Solution Maintenance &
& Track Implementation
Roadmap Definition Support
Segregation
• Program roadmap • Define individual • Product evaluation (if • Application • Ongoing
definition tracks within the required) customization and enhancements
• High level plan program • Architecture design build • Maintenance and user
• Establish current state • Impact analysis • Data analysis & • Data quality testing support
of compliance and requirement modeling • Functional testing • Platform migration
documentation
• PMO process • Technical design • Regression testing
definitions for change • Identify
• Data feed design • Non-functional
management, dependencies, risks
• Data sourcing and ETL testing
communication and assumptions
• Data sufficiency • Defect management
management and • Detail level planning
analysis and reporting
reporting for individual tracks
• Identify key • Identify the critical • Platform
stakeholders path Development
• Kick-off meeting with
all stakeholders
Basel III Implementation Timeline
Since the BASEL III requirements bring in critical buffers and significant capital outlays, the key aspects of the BASEL III guidelines will be
implemented in phases from January 2013 through 2018. This should give banks enough time to review their financial preparedness and
also enhance their operational and reporting capabilities.
PHASE IN ARRANGEMENTS
(Shading indicated transition periods - all dates are as of 1 January)
As of
2011 2012 2013 2014 2015 2016 2017 2018
1 Janurary 2019
Supervisory Parallel run 1 Jan 2013 - 1 Jan 2017 Migration
Legerage Ratio
Monitoring Disclosure starts 1 Jan 2015 to Pillar 1
Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50%
Minimum Common Equity Plus Capital
3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
Conservation Buffer
Phase-in of deductions from CET1 (including amounts
20% 40% 60% 80% 100% 100%
exceeding the limit for DTAs, MSRs and Financials)
Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Minimum Total Capital plus Conservation Buffer 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%
Capital Instruments that no longer qualify as non-core
Phased out over 10 year horizon beginning 2013
Tier 1 capital or Tier 2 capital
Introduce
Observation
Liquidity Coverage Ratio Minimum
Period Begins
Standard
Introduce
Observation
Net Stable Funding Ratio Minimum
Period Begins
Standard
Source - The website for the Bank for International Settlements - http://www.bis.org/bcbs/basel3.htm
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7. Conclusion
BASEL III guidelines attempt to plug the gaps identified in BASEL
II. However, the world economy and financial markets are dynamic
and evolving ecosystems with many forces in play. Consequently,
financial regulations will keep on evolving. The intensity of regulatory
interventions is expected to increase in the future and the importance
of risk management is expected to further move up in the priority of
board members and top management.
It is therefore imperative that a BASEL III implementation is planned and
designed with a high degree of scalability to support future changes in
regulation. A BASEL III implementation should be taken as an opportunity
to remove a silo based approach to risk management and move towards
a reliable and scalable enterprise wide risk management system.
For such intent to be successful, an early start and preparation are
essential so that enough due diligence goes into laying down the
foundations of a strong risk management system.
About the Authors
Jitendra Kumar is a Principal Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys.
He has over 15 years of experience and has completed CFA level I & II from the CFA institute, USA.
He can be reached at Jitendrakumar@infosys.com
Sudarsan Kumar is a Senior Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys.
He has over 4 years of risk and compliance experience with data warehousing in Basel II.
He can be reached at Sudarsan_Kumar@infosys.com
Rohit VM is a Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. His current
focus is on Basel III. Rohit earned his Post Graduate Diploma in General Management (PGDGM) from XLRI, Jamshedpur.
He can be reached at Rohit_V02@infosys.com
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