25. Fundamental Principle for
Management & Supervision of
Liquidity Risk
A bank should:
Be responsible for the sound management of liquidity risk
Establish a robust liquidity risk management framework
Assess the adequacy of both a bank's liquidity risk
management framework and its liquidity position
Take prompt action if a bank is deficient
Protect depositors and to limit potential damage to the
financial system.
29. TRANSITION OF LCR
AND NSFR
Phase-in:
1 January 2015 -> LCR requirement of 60%
+ 10% each year to reach 100 per cent on 1
January 2019.
APRA is not proposing to adopt this phase-in
arrangement for the LCR.
NSFR does not come into effect until 1 January
2018
30. EXPECTED IMPACT ON
ECONOMY
Financial markets
0 Steeper yield curves
0 Lower yields for instruments qualifying as a part of
the liquidity buffer
0 LCR used to fund government budget deficits post GFC.
The new liquidity rules are likely to
0 increase interest rates and
0 reduce available liquidity
Thus putting pressure on interest margins
Notas do Editor
Hi Everyone! So today we’re going to do a presentation on the Basel III
First, we’re going to recap on the history of the Basel accords.Second, we’re going to provide a short intro into what Basel III is.Next, we will look at what changes would be introduced as part of the Basel III.And Lastly we will look at the implementation by APRA.
The BIS (Bank for International Settlements), whichtakes an active interest in the stability of the international financial system, implemented the original Basel Agreement, AKA Basel I on the first of January 1993. The 1988 Basel Agreement primarily focused on credit risk and appropriate Risk Weighting of Assets. However, market risk was later incorporated into risk-based capital (in the form of an add-on to the percent ratio for credit risk exposure) through a revision in 1996. The next most important change was the ‘new Basel Accord or Agreement’ of 2006 AKA Basel II which introduced three mutually reinforcing pillars of capital regulation in banks.As shown in the next slide… Pillar 1…
Pillar 1 covers regulatory minimum capital requirements for credit, market and operationalrisk. Banks are required to maintain a minimum risk‐based capital ratio of 8.00 percent. Capital is categorised as either Tier 1 capital, upper Tier 2 capital or lower Tier 2 capital. At least half of a bank’s capital requirement must be held in Tier 1 capital.As part of the calculation process, risk weights are applied to balance‐sheet assets using risk weights set by the regulator. These weights may be based on the counterparty to an asset or on an external rating provided by an approved credit rating agency. Off‐balance‐sheet items are converted to a balance‐sheet equivalent using credit conversion factors before applying the risk weights. (Within each of these risk categories banks have a choice of applying a standardised approach or an internal approach to measuring their capital requirement. Subject to approval from the bank supervisor, an internal approach method allows a bank to use its own risk management models.)Pillar 2 targets regulatory supervisory review which BIS stressed as a critical complement to minimum capital requirements.(Includes four basic principles: (1) the assessment of total capital requirements by a bank, (2) the review of capital levels and the monitoring of banks’ compliance by supervisors, (3) the ability of a supervisor to increase the capital requirement of a bank, and (4) the intervention of a supervisor at an early stage to maintain capital levels.)Pillar 3 focuses on market discipline through transparency and disclosure requirements on capital structure, risk exposures and capital adequacy. (Banks are required to provide information and data on a periodic basis to the supervisor. Some of these reports may be made public.)As you can see, this second accord aimed to promote safety and soundness in the financial system by allocating capital in organisations to accurately reflect risk. It also greatly extended the first, especially with the increased focus on market and operational risk and the formation of the three pillars. Through APRA, Australiaimplemented the Basel II Framework on 1 January 2008.
The most recent update to the Basel Accords is its third installment known as Basel III which was first agreed upon in 2010 through an international agreement between 27 countries. Basel III was developed in response to the deficiencies in financial regulation as revealed by the GFC [especially related tothe loss of confidence in the solvency, capital adequacyand liquidity of banking institutions]. The overall objectives of the Basel III reforms is to increase stability and liquidity in global financial markets. Basel III is supposed to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.Basel III may be described essentially as Basel II plus the lessons learned from the market crisis.
There are two major elements involved with Basel III and these are Capital Requirements & Liquidity.
The financial crisis showed that not all institutions heldsufficient capital and that the capital was sometimes of poor quality and not available to absorb losses as they materialized.As a result of this, there are four important changes with regard to capital in the new Basel III accord.There are the minimum capital requirements, non-allowable capital, new capital buffers and the leverage ratio.---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Capital RequirementsBasel III plans to increase the quality, consistency and transparency of capital.The minimum level for total capital will remain at 8% as per Basel II…However, by 2015 Basel III will require banks to hold 4.5% of common equity (common shares + retained earnings) (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of "risk-weighted assets" (RWA) after the full rollout which can be seen from this graph.Non-allowable CapitalTier 3 capital (available to cover market risk) is being eliminated. Innovative hybrid capital instruments with an incentive to redeem will be phased out. The phase-out period is 2013–21.A new stricter approach to the inclusion of minority interests within consolidated capital is being introduced.New Capital BuffersBasel III has introduced "additional capital buffers”, this includes: (i) a "mandatory capital conservation buffer" of 2.5% of CET1 which will bring the total CET1 to 7% and (ii) a "discretionary counter-cyclical buffer", which would allow national regulators to provideup to another 2.5% of capital during periods of high credit growth.The mandatory capital conservation buffer will be built up in “good times” and can be drawn upon in “bad times” and capital distribution constraints will be imposed on any bank not fully meeting the capital conservation buffer.Leverage Ratio >> SHOW EXAMPLEA leverage ratio will be introduced as a supplementary measure to the Basel II risk-based framework. The leverage ratio is calculated by dividing Tier 1 capital by the bank's average total consolidated assets.The ratio will require a minimum percentage of Tier 1 to gross on and off-balance-sheet assets. By 2018, the leverage ratio will become mandatory under Basel III & banks are expected to maintain a leverage ratio in excess of 3%.
The first one we’re going to cover is the new Capital Requirements
Capital RequirementsSo… Basel III plans to increase the quality, consistency and transparency of capital. & how will we do this?The minimum level for total capital will remain at 8% as per Basel II…However, by 2015 Basel III will require banks to hold 4.5% of common equity (common shares + retained earnings) (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of "risk-weighted assets" (RWA) after the full rollout which can be seen from this graph.The reason for this increase, especially in common equity is because regulators view these as the most effective type of capital, as it can directly absorb any losses.
With regards to the Non-allowable Capital, basically, Tier 3 capital (available to cover market risk) is being eliminated. Innovative hybrid capital instruments with an incentive to redeem will be phased out. The phase-out period is 2013–21.A new stricter approach to the inclusion of minority interests within consolidated capital is being introduced.
New Capital Buffers
As you can see from the graph,Basel III has introduced "additional capital buffers”, this includes: (i) a "mandatory capital conservation buffer" of 2.5% of CET1 which will bring the total CET1 to 7% and (ii) a "discretionary counter-cyclical buffer", which would allow national regulators to provideup to another 2.5% of capital during periods of high credit growth.The mandatory capital conservation buffer will be built up in “good times” and can be drawn upon in “bad times” and capital distribution constraints will be imposed on any bank not fully meeting the capital conservation buffer.The capital conservation buffer basically enhances the coverage of risk by ensuring that institutions are able to absorb losses in stress periods lasting for a number of years.European Commission (2011):The countercyclical capital buffer is introduced to “achieve the broader macro-prudential goal of protecting the banking sector and the real economy from the system-wide risks[ stemming from the boom-bust evolution in aggregate credit growth] and more generally from any other structural variables and from the exposure of the banking sector to any other risk factors related to risks to financial stability.”
This graph shows a final comparison in terms of capital between Basel II and Basel IIISo… as you can see, the proportion of tier 1 capital has increased and the extra buffers allow for increased security.
So the last part of Capital I am going to discuss is the new Leverage Ratio.Leverage Ratio >> SHOW EXAMPLE?
To prevent an excessive build-up of leverage on institutions’ balance sheets, Basel III introduces a non-risk-based leverage ratio to supplement the risk-based capital framework of Basel II.The leverage ratio is calculated by dividing Tier 1 capital by the bank's average total consolidated assets.The denominator (exposure measure) should be the sum of the exposure values of all assets and off-balance sheet items not deducted from the calculation of Tier 1 capital.The ratio will require a minimum percentage of Tier 1 to gross on and off-balance-sheet assets. By 2018, the leverage ratio will become mandatory under Basel III & banks are expected to maintain a leverage ratio in excess of 3%.
Basel III has introduced two required liquidity ratios: LCR & NSFRThe Basel III liquidity framework introduces two new minimum global standards:• a 30-day Liquidity Coverage Ratio (LCR) to address an acute stress scenarios• a Net Stable Funding Ratio (NSFR) to encourage longer-term funding resilience.
Basel III has introduced two required liquidity ratios: LCR & NSFRThe Basel III liquidity framework introduces two new minimum global standards:• a 30-day Liquidity Coverage Ratio (LCR) to address an acute stress scenarios• a Net Stable Funding Ratio (NSFR) to encourage longer-term funding resilience.
The liquidity coverage ratio (LCR) will prescribe the quantity of high-quality liquid assets a bank must have at any given time. Assets get a "liquidity" based weighting varying from 100% for government bonds and cash to weightings of 0-50% for corporate bond.It aims to ensure that each institution maintains an adequate level of unencumbered, high-quality assets that can be converted into cash to meet its liquidity needs for 30 days under a specified acute liquidity stress. The purpose of this ratio is to promote resilience to potential liquidity disruptions over a 30-day horizon and ensure banks have sufficient unencumbered, high quality liquid assets to offset the net cash outflows they could encounter under an acute short-term stress scenario including:significant downgrade of credit ratingpartial loss of depositsloss of unsecured wholesale funding, andincreases in derivative collateral calls and substantial calls on contractual and non-contractual off-balance sheet exposures including committed credit card and liquidity facilities.NOTE: S-T
This slide shows you a breakdown of what composes of the numerator and denominator.High quality liquid assets may be classified as level 1 and level 2.Level 1 comprises of cash, central bank reservesLevel 2 comprises of corporate bonds of credit rating AA-, covered bonds AA-The net cash outflow is the cumulative expected cash outflow minus cumulative expected cash inflow over a 30-designated-day period (using specified stresses)
Basel III has introduced two required liquidity ratios: LCR & NSFRThe Basel III liquidity framework introduces two new minimum global standards:• a 30-day Liquidity Coverage Ratio (LCR) to address an acute stress scenarios• a Net Stable Funding Ratio (NSFR) to encourage longer-term funding resilience.
The net stable funding ratio (NSFR) is designed to provide incentives for banks to seek more stable forms of funding. It is a longer-term structural liquidity ratio, requiring a minimum amount of stable sources of funding at an ADI relative to the liquidity profiles of the assets, as well as the potential for contingent liquidity needs arising from off-balance sheet commitments, over a one year horizon.Itrequires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.It aims to limit overreliance on short-term wholesale funding during times of buoyant market liquidity and encourage better assessment of liquidity risk across all on- and off-balance sheet items.[100% of illiquid assets need to be backed with stable funding, but this is 65% for qualifying residential mortgages ]NOTE: L-T
OBSERVATION PERIODS: develop templates & collect information on the effectiveness of the liquidity ratiosBy 2019, banks are expected to have 100% LCR
Basel III has introduced two required liquidity ratios: LCR & NSFRThe Basel III liquidity framework introduces two new minimum global standards:• a 30-day Liquidity Coverage Ratio (LCR) to address an acute stress scenarios• a Net Stable Funding Ratio (NSFR) to encourage longer-term funding resilience.
A bank is responsible for the sound management of liquidity risk. A bank should establish a robust liquidity risk management framework that ensures it maintains sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources. Supervisors should assess the adequacy of both a bank's liquidity risk management framework and its liquidity position and should take prompt action if a bank is deficient in either area in order to protect depositors and to limit potential damage to the financial system.
ADI authorised deposit taking institu
CET1 = Common equity Tier 1T1 Tier 1The Basel Committee has set out detailed transitional arrangements for the implementation of Basel III framework, as outlined in the table above.
Similarly on the implementation of Basel III in Australia, the same minimum requirements are to be met.However, APRA has taken a different approach to implementing the Basel III framework. APRA has expressed that a transitioning process is not necessary – as highlighted in our slide above, it shows that APRA requires ADIs to implement the revised regulatory adjustments in full from 1 January 2013 and the capital conservation buffer in full from 1 January 2016.Under the phase-out arrangements, recognition of capital instruments that no longer qualify as non common equity Tier 1 capital or Tier 2 capital will be capped at 90 per cent from 1 January 2013, with the caps reducing by 10 percentage points in each subsequent year.APRA proposes to adopt the Basel III phase-out arrangements for all noncomplying instruments. Outstanding noncomplying instruments will be required to be phased-out no later than their first available call date, where one exists APRA expects ADIs to replace this capital with fully complying instruments and to have effective capital management plans for this purpose.APRA is of the view that, taking into account the transition allowance for capital instruments that no longer qualify as Tier 1 and Tier 2, ADIs should be able to meet the minimum Basel III requirement of a Common Equity Tier 1 ratio (including the capital conservation buffer) of seven per cent by 1 January 2016.Banks would have to be 100 per cent compliant with LCR rules under Basel III by 2015
The Basel Committee allows for a phase-in of the a LCR. The phase-in involves a minimum LCR requirement of 60 per cent on 1 January 2015, increasing by 10 percentage points each year to reach 100 per cent on 1 January 2019. However, APRA is not proposing to adopt the phase-in arrangement for the LCR and proposes to introduce the LCR in full from 1 January 2015APRA believes that meeting that timetable will confirm the improvement in liquidity risk management by ADIs and will send a strong message about the soundness of the Australian banking system. The Basel Committee is continuing to review the NSFR, which does not come into effect until 1 January 2018.
Financial markets will be impacted, such as steeper yield curves due to an increase in demand for instruments at the long-end, lower yields for instruments qualifying as a part of the liquidity buffer, and LCR used to fund government budget deficits post GFC. In conclusion, the new liquidity rules are likely to increase interest rates and reduce available liquidity in the interbank money market, which in this environment of increased demand for deposits will put another pressure on interest margins.
Overall Basel III will strengthen global capital rules to promote a more resilient global banking system.END OF PRESENTATION
