Basel iii capital adequacy accord

Basel III Capital Adequacy Accord
Basel Committee on Banking Supervision
09th Sep, 2012

Contents

a. 2008 Financial Crisis & the Evolution of Basel Norms
b. Basel III Guidelines
c. Basel II vs. Basel III – Points of Difference
d. Capital Conservation Buffer & Countercyclical Buffer
e. Leverage Ratio
f. Liquidity Standards
• Liquidity Coverage Ratio
• Net Stable Funding Ratio

2

A. 2008 Financial Crisis & the Evolution of Basel Norms

The 2008 Financial Crisis in a Nutshell

Deregulation of financial Large inflow of foreign
services sector in the US funds
Definition of Risk-Weighted Assets
from the 1980s
Leverage
Basel II presumed that the level of capital in the system Basel II did not regulate the amount of financial
was sufficientEasy credit categorization of assets and
based on its conditions in US leverage that banks and institutions could(▲)
Debt-financed consumption take
risk-weights, however new financial products spawned leading to excessively leveraged positions of banks
out of securitization were Credit Bubble)
(US highly vulnerable to systemic prior to the crisis Housing Bubble)
(US
risk which was not taken in to account while assigning
risk-weights

Financialization Financial Innovation (▲)
○ Mortgage Backed Securities
Failureleverage overrides capitaltraditional&industrial
Financial (equity) financial
to capture off-balance sheet
markets tend to dominate over the ○ Collateralized Debt Obligations
exposures
economy & agricultural economies ○ Synthetic CDOs
Basel II failed to regulate key exposures such as
complex trading activities, resecuritizations and
exposures to off-balance sheet vehicles
Weak & fraudulent underwriting practice

Underestimation of risk concentration Shadow Banking System (▲)
Mispricing of risk ○ Financing of mortgages though off-balance sheet
securitizations
○ Hedging of risks through off-balance sheet Credit
Default Swaps
2008 Credit Market Crisis
Insufficient Risk Coverage
○ Vulnerable to Maturity Mismatch –such as OTC
Risk sensitivity of financial products borrowed
short-term liquid incorrectly estimated under Basel II
derivatives was assets to purchase long-term,
An increase in TED spread to a region of 150-200 bps illiquid & risky assets
as opposed to long-term average of around 30 bps ► and Counterparty Credit Risk, Liquidity Risk,
indicating an increase of counterparty risk (default of Concentration Risk, Wrong-Way Risk, etc. were not
interbank loans) adequately addressed

4

What‟s wrong with Basel II…?

Basel II
Accentuates Procyclicality Financial
Instability

Failure to capture key
exposures
Insufficient risk (such as complex trading
activities, resecuritisations
coverage and exposures to off-
The financial crisis balance sheet vehicles )
highlighted the need to
revisit some of the risk
Insufficient sensitivity assumptions
high-quality underlying financial
instruments such as
capital OTC derivatives –
prevented banks to Counterparty Risk,
absorb losses as a Wrong-Way Risk and
going concern Liquidity Risk

5

Basel III intends to…

Increase quality of capital
• Basel III intends to improve the quality of capital with the ultimate aim of improving loss-
absorption capacity in both going concern & liquidity scenarios

Increase quantity of capital
• Basel III aims at increasing the level of capital held by banks

Increase short-term liquidity coverage
• Liquidity Coverage Ratio promotes short-term resilience to potential liquidity disruptions

Increase stable long-term balance sheet funding
• Net Stable Funding Ratio encourages banks to use stable sources to fund their activities

Strengthen risk capture, notably counterparty risk
• Basel III enhances risk coverage by modifying the treatment of exposures to financial
institutions & the counterparty risk on derivative exposures

Reduce leverage through introduction of backstop leverage ratio
• Leverage Ratio is aimed at reducing the risk of a build-up of excessive leverage at the bank
level as well as the systemic level

6

So does Basel III replace Basel II?

Basel III guidelines are not meant to be a replacement for the Basel II guidelines. For banks to be Basel III
compliant, Basel II guidelines need to be first implemented across all the pillars and then substituted with
specific recommendations of the Basel III framework.

Basel II Basel III
Common Tier 1 Tier 2 Common Tier 1 Tier 2
Equity Capital Capital Equity Capital Capital
Minimum
2% 4% 8% 4.5% 6% 8%
Requirements
Capital
Not applicable 2.5%
Conservation Buffer
Countercyclical
Not applicable 0% to 2.5%
Capital Buffer

Leverage Ratio Not applicable Tier 1 Leverage Ratio ≥ 3% #

Liquidity Coverage Not applicable
≥ 100%
Ratio
Net Stable Funding Not applicable
≥ 100%
Ratio

# The minimum level of 3% will be tested by BCBS during the parallel run period from 01 Jan 2013 to 01 Jan 2017

7

Basel Framework Today

Pillar II Pillar III
Pillar I Capital Leverage Liquidity
Supervisory Market
Ratios Ratio Ratio
Review process Discipline

Capital LCR
CCB
Tier 1 NSFR
CB
Tier 2

RWA Standard IRB-F IRB-A

Credit
CCR CEM EPE
Derivative Exposure

Market CVA WWR

Standard IMA
Operational
BIA Standardized AMA VAR

Stressed VAR
Updated with Basel 2.5
IRC
Updated with Basel III Added in Basel III No change from Basel II

8

Building Blocks of Basel III

■ Introduces an additional Capital Conservation Buffer that can be
drawn down in periods of financial stress
■ Introduces a Countercyclical Capital Buffer that ensures financial
resilience of the banking sector in periods of excessive credit growth
■ Promotes more forward looking measures

Countercyclical Measures

Leverage Ratio Liquidity Risk Management
■ Reinforces risk-based requirements with ■ Unified minimum liquidity criteria to
a simple, non-risk based “backstop” cover liquidity risk:
measure based on gross exposure Basel III ■ Liquidity Coverage Ratio
■ Net Stable Funding Ratio

Regulatory Capital Systemic Risk
■ Improvement of quality of Tier 1 Capital ■ Additional capital surcharges between 1-
■ Harmonized & simplified Tier 2 Capital 3.5% for systemically important financial
■ Tier 3 Capital eliminated institutions

Risk Management
■ Introduction of “stressed VaR” into capital requirements
■ Capital requirements for an “Incremental Risk Charge”
■ Additional capital requirements for Counterparty Credit Risk (CVA,
AVC, Wrong-Way Risk)
■ Strengthen internal credit risk processes & decrease reliance on
external credit ratings

10

Basel III – Quantitative Impact

Eligible Capital
Capital Ratio =
Risk-weighted Assets

Tier 1 Capital
Leverage Ratio = ≥ 3%
Total Exposure

High-quality liquid assets
Liquidity Coverage Ratio = ≥ 100%
Total net cash outflows over
the next 30 calendar days

Available stable funding
Net Stable Funding Ratio = ≥ 100%
Required stable funding

11

Basel III – Qualitative Impact

Impact on Individual Banks Impact on Financial System

Pressure on profitability & ROE Reduced risk of a systemic banking crisis
The most important implication of Basel III is an increase Enhanced capital & liquidity buffers along with enhanced
in cost of lending due to increased capital requirements risk management standards & capability should reduce the
possibly translating in to decreased profit margins and risk of a systemic banking crisis in the future
diminishing ROE

Weaker banks crowded out Reduced lending capacity
With downward pressure on profit margins and increasing With increased capital requirements the lending capacity
costs of compliance, weaker banks would find it difficult to of banks will be diminished across the system possibly
compete under the updated Basel framework leading to a slowdown in economic growth

Change in demand from short-term Reduced investor appetite for bank
to long-term funding debt and equity
With the introduction of additional liquidity ratios – LCR & Should profitability margins & ROE decrease, investors
NSFR – there would be a qualitative shift in the demand would be less attracted by bank debt or equity issuance
from short-term to long-term funding with the consequent given that dividends are likely to be reduced to allow firms
impact on the pricing & margins that are achievable to rebuild capital bases

Legal entity reorganization International Arbitrage
Increased supervisory focus on proprietary trading, If national authorities implement Basel III guidelines
matched with the treatment of minority investments and differently, it may lead to international regulatory arbitrage
investments in financial institutions may lead to group as was observed under Basel I and Basel II
reorganizations, including M&A & portfolio liquidation implementations

Source: Basel III: Issues and Implications – KPMG (2011) 12

Basel III‟s Impact on Bank‟s ROE – The Curves

 The Basel III minimum capital requirement
Lending Rate reduces the available capital with banks,
bringing about a leftward shift in the bank‟s
S2 credit supply curve from S1 to S2.
S1  In the medium term, this would result in
reduced lending by banks along with in an
increase in lending rates causing a
decrease in demand for credit in the
economy.

 The interest elasticity of demand would
determine the extent of decrease in demand
for credit across national jurisdictions.

 Overall, increased capital requirements and
D cost of funding would impact growth and
Credit ROE of banks and financial institutions.

13

Basel III Timeline

2011 2012 2013 2014 2015 2016 2017 2018 01 Jan
2019
Min. CE Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%

Capital Conservation 0.625% 1.25% 1.875% 2.5%
Buffer (CCB)
Min. CE + CCB 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%

Phase-in of deductions 20% 40% 60% 80% 100% 100%
from CET1 (including
amounts exceeding the
limit for DTAs, MSRs &
financials)
Min. Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%

Min. Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%

Min. Total Capital + 8.0% 8.0% 8.0% 8.625% 9.125% 9.875% 10.5%
CCB
Capital instruments that Phased out over 10 year horizon beginning 2013
no longer qualify as
non-core Tier 1 or Tier
2 Capital
Leverage Ratio Supervisory Monitoring Parallel run: 01 Jan 2013 to 01 Jan 2017 Migration
Disclosure starts 01 Jan 2015 to Pillar 1
Liquidity Coverage Observation Introduce
Ratio period begins min. std.
Net Stable Funding Observation Introduce
Ratio period begins min. std.

Source: Basel III – Design and Potential Impact – Deloitte (2010) 14

C. Basel II vs. Basel III – Points of Difference

Basel II vs. Basel III – Tier 1 Capital Components

Basel II Basel III
Common Stock & other forms of Tier 1 Common Equity issued by the bank that meets
the criteria for inclusion
Innovative instruments (limited to max 15%) net Stock surplus (share premium) resulting from the
of goodwill issue of instruments included in Common Equity
Tier 1
-- Retained earnings (including interim profit or
loss)
Disclosed reserves (including from minority Other comprehensive income & other
interests) disclosed reserves
-- Regulatory Adjustments

Source: bcbs189 – BIS (2011) and bcbs128 – BIS (2006) 16

Basel II vs. Basel III – Tier 1 Capital (Deductions)

Basel II Basel III
Deduction: goodwill & increase in equity from a Deduction: goodwill & all other intangibles
securitization exposure - “gain-on-sale” (except mortgage servicing rights).
Subject to prior supervisory approval, banks that
report under local GAAP may use IFRS definition
of intangible assets.
Deduction: 50% of investments in other financial Deduction: Investments in the capital of
institutions; 50% of securitization exposure institutions outside the regulatory scope of
consolidation – 100% deduction of reciprocal
cross-holding of capital; deduction of holdings
exceeding 10% of bank‟s common equity:
“corresponding deduction approach”
Deduction: Following items can be either be Deduction: Items eligible to be deducted 50%
deducted 50% from Tier 1 and 50% from Tier 2 or from Tier 1 and 50% from Tier 2 or be risk
be risk weighted: weighted, now have a risk weight of 1250%.
• Certain securitization exposures
• Certain equity exposures under the PG/LGD
approach
• Non-payment/ delivery on non-DvP and non-PvP
transactions
• Significant investments in commercial entities


Basel II vs. Basel III – Additional Tier 1 Capital Components

Basel II Basel III
-- Instruments issued by the bank meeting the
criteria for inclusion in AT 1
-- Stock surplus (share premium) resulting from
instruments included in AT 1
-- Instruments issued by consolidated subsidiaries
of the bank & held by third parties (i.e minority
interest) that meet criteria for AT 1
-- Regulatory Adjustments

Additional Tier 1 Capital was not available under Basel II



Basel II Basel III
( Limited to a max of 100% of Tier 1 ) ( No max limit on Tier 2 capital )

Undisclosed reserves Instruments issued by the bank meeting the
criteria for inclusion in Tier 2
Asset revaluation reserves (latent gains on Stock surplus (share premium) resulting from the
unrealized securities are subject to a discount of issue of instruments
50%)
General provisions / loan-loss reserves (limited General provisions / loan-loss reserves held
to max of 1.25% of RWA) against future, presently unidentified losses
(limited to a max 1.25% of credit RWA calculated
under standardized approach)
Hybrid capital instruments (unsecured, Total eligible provisions minus total expected
subordinated, fully paid-up, not redeemable) loss amount (limited to max 0.6% of credit RWA
calculated under IRB approach)
Subordinated debt (limited to a max of 50% of Instruments issued by consolidated subsidiaries
Tier 1 capital) of the bank & held by third parties (i.e minority
interests) that meet the criteria for Tier 2
Deduction: 50% of investments in other financial Regulatory adjustments
institutions; 50% of securitization exposure

Hybrid capital instruments have been removed from Tier 2 Capital definition under Basel III



Basel II Basel III
( Limited to a max of 250% of Tier 1 ) --

Short-term subordinated debt (at the discretion --
of the national authority for the sole purpose of
meeting capital requirements for market risks)

Tier 3 Capital has been removed from the regulatory capital under Basel III


Criteria for Inclusion – Key Aspects

Common Equity Tier 1 Additional Tier 1 Tier 2
ISSUER
1. General • Bank • Bank • Bank
• Fully-consolidated subsidiary • Consolidated subsidiary of bank • Consolidated subsidiary of
of bank meeting conditions meeting conditions below bank meeting conditions below
below • Special purpose vehicle (SPV) • Special purpose vehicle (SPV)
meeting conditions below meeting conditions below
2. Subsidiary • Held by third parties • Held by third parties • Held by third parties
Issuers • Common equity, if issued by • Instrument, if issued by bank, • Instrument, if issued by bank,
bank, would qualify as Tier 1 would qualify as Tier 1 capital in would qualify as Tier 1 or Tier 2
Common Equity in all respects all respects capital in all respects
• Subsidiary is itself a bank • Amount recognized limited to • Amount recognized limited to
• Amount recognized limited to total amount of Tier 1 capital of total amount of total capital of
total amount of common equity subsidiary minus surplus subsidiary minus surplus
of subsidiary minus surplus attributable to third party investors attributable to third party
attributable to minority (if any) (surplus calculated as investors (if any) (surplus
shareholders (if any) (surplus lower of (i) minimum Tier 1 calculated as lower of (i)
calculated as lower of (i) requirement of subsidiary plus minimum total capital
minimum Tier 1 Common capital buffer (i.e., 8.5% of risk requirement of subsidiary plus
Equity requirement of weighted assets) and (ii) portion capital buffer (i.e., 10.5% of risk
subsidiary plus capital buffer of consolidated minimum Tier 1 weighted assets) and (ii) portion
(i.e., 7.0% of risk weighted requirement plus capital buffer of consolidated minimum Tier 1
assets) and (ii) portion of relating to subsidiary) requirement plus capital buffer
consolidated minimum Tier 1 • Excludes any instrument relating to subsidiary)
requirement plus capital buffer recognized as Tier 1 CE • Excludes any instruments
relating to subsidiary) recognized as Tier 1 CE or Tier
1 Additional Capital

Source: Regulatory Capital Reform under Basel III – Latham & Watkins (2011) 21

Criteria for Inclusion – Key Aspects (Cont‟d)

ISSUER
3. SPV Issuers • Proceeds of instrument issued • Proceeds of instrument issued
by SPV must be immediately by SPV must be immediately
available without limitation to available without limitation to
operating entity or holding operating entity or holding
company in form meeting or company in form meeting or
exceeding all other criteria for exceeding all other criteria for
inclusion in Tier 1 Additional inclusion in Tier 2 Capital
Capital
4. Source of • Neither bank nor related party • Neither bank nor related party
funds over which bank exercises control over which bank exercises
or significant influence can have control or significant influence
purchased instrument, nor can can have purchased instrument,
bank directly or indirectly have nor can bank directly or
funded purchase of instrument indirectly have funded purchase
of instrument



TERM
1. In general Perpetual • Perpetual • Minimum original maturity of
• No step-ups or other at least 5 years
incentives to redeem • Recognition in regulatory
capital in remaining 5 years
before maturity amortized on
straight-line basis
• No step-ups or other
incentives to redeem (an option
to call after 5 years but prior to start
of amortization period, without
creating expectation of call, is not
incentive to redeem)
2. Redemption • Principal perpetual & never • Repayment of principal (e.g. • Investor must have no rights
/ Repayment repaid outside of liquidation through repurchase or to accelerate repayment of
• Discretionary repurchases & redemption) only with prior future scheduled payments
other discretionary means of supervisory approval (coupon or principal), except in
effectively reducing capital • Instrument cannot have bankruptcy and liquidation
permitted if allowable under features hindering
national law recapitalization, such as
provisions requiring issuer to
compensate investors if new
instrument issued at lower price
during specified time frame



TERM
3. Call • Callable at initiative of issuer • Callable at initiative of issuer
only after minimum of five years: only after minimum of five years:
a. To exercise call option bank a. To exercise call option bank
must receive prior supervisory must receive prior supervisory
approval; and approval; and
b. Bank must not do anything b. Bank must not do anything
creating expectation that call will creating expectation that call will
be exercised; and be exercised; and
c. Bank must not exercise call c. Bank must not exercise call
unless: unless:
i. bank replaces called i. bank replaces called
instrument with capital of same or instrument with capital of same or
better quality and replacement better quality and replacement
done at conditions sustainable for done at conditions sustainable for
income capacity of bank income capacity of bank
(replacement must be concurrent (replacement must be concurrent
with call, not after); or with call, not after); or
ii. bank demonstrates that ii. bank demonstrates that
capital position well above capital position well above
minimum capital requirement after minimum capital requirement after
call exercised (“minimum” call exercised (“minimum”
requirement refers to national law requirement refers to national law
not Basel III rules) not Basel III rules)



TERM
4. No • Bank does nothing to create • Bank should not assume or • Bank must not do anything
Expectation expectation at issuance that create market expectation that creating expectation that call will
instrument will be bought back, supervisory approval for be exercised
redeemed or cancelled nor do repayment of principal will be
statutory or contractual terms given
provide any feature which might
give rise to such expectation

DISTRIBUTIONS / COUPONS

1. Source • Distributions paid out of • Dividends/ coupons paid out
distributable items of distributable items
• Level of distributions not in any
way tied or linked to amount
paid in at issuance and not
subject to cap (except to extent
bank unable to pay distributions
exceeding level of distributable
items)



2. No Obligation • No circumstances under • Dividends/ coupons discretion: • Investor must have no rights
which distributions obligatory a) Bank must have full to accelerate repayment of
• Non-payment not event of discretion at all times future scheduled payments
default to cancel distributions/ (coupon or principal), except in
payments bankruptcy and liquidation
b) Cancellation of
discretionary
payments must not be
event of default
c) Banks must have full
access to cancelled
payments to meet
obligations as they fall
due
d) Cancellation of
distributions/
payments must not
impose restrictions on
bank except in
relation to
distributions to
common stockholders



3. Priority • Distributions paid only after
all legal and contractual
obligations met and payments
on more senior capital
instruments made
• No preferential distributions,
including in respect of other
elements classified as highest
quality issued capital
4. Margin • Instrument may not have a • Instrument may not have a
adjustment credit sensitive dividend feature, credit sensitive dividend feature,
i.e., dividend/ coupon reset i.e., dividend/ coupon reset
periodically based in whole or periodically based in whole or
part on bank‟s current credit part on bank‟s current credit
standing standing
SUBORDINATION
1. Priority • Most subordinated claim in • Subordinated to depositors , • Subordinated to depositors ,
liquidation of bank general creditors and general creditors of bank
• Entitled to claim of residual subordinated debt of bank
assets proportional with share
of issued capital after all senior
claims repaid in liquidation



SUBORDINATION
2. Loss • Takes first and proportionately • Instruments classified as liabilities
Absorbency greatest share of any losses as must have principal loss absorption
occur through either
• Within highest quality capital; a) conversion to common shares at
absorbs losses on going-concern objective pre-specified trigger point
basis proportionately and pari or
passu with all others b) Write-down mechanism allocating
losses to instrument at pre-
specified trigger point

Write-down will have the following
effects
a) reduce claim of instrument in
liquidation,
b) Reduce amount re-paid when call
is exercised, and
c) Partially or fully reduce coupon/
dividend payments on instrument
3. Equity-like • Paid-in amount recognized as • Instrument can‟t contribute to
nature equity capital for determining liabilities exceeding assets if
balance sheet insolvency balance sheet test forms part of
• Paid-in amount classified as national insolvency law
equity under relevant accounting
standards



SUBORDINATION
4. Security • Neither secured nor covered by • Neither secured nor covered by • Neither secured nor
guarantee of issuer or related guarantee of issuer or related covered by guarantee of
entity or subject to other entity or other arrangement legally issuer or related entity or
arrangement legally or or economically enhancing other arrangement legally
economically enhancing seniority seniority of claim vis-à-vis bank or economically
of claim creditors enhancing seniority of
claim vis-à-vis depositors
and general bank creditors


D. Capital Conservation Buffer & Countercyclical Buffer

Buffers Comparison

Capital Conservation Buffer Countercyclical Capital Buffer
2.5% of RWA 0% - 2.5% of RWA

Fixed Variable

Objective is to build capital buffers outside periods Objective is to dampen excessive credit growth in
of stress which can be drawn down as losses are the economy to ensure capital levels in the
incurred banking sector
Non-discretionary – disclosed buffer Discretionary – buffer requirement is decided by
requirements national authorities
Pre-determined set of consequences for banks Pre-determined set of consequences for banks
that do not meet the buffer requirements that do not meet the buffer requirements similar to
that of Capital Conservation Buffer
Implemented as it is and sits on top of the Implemented as an extension to the Capital
Common Equity Tier 1 capital requirements Conservation Buffer
-- National authorities pre-announce the decision to
raise the buffer requirements by up to 12 months

31

Capital Conservation Buffer – Objective

 The Capital Conservation Buffer is intended to „promote the conservation of capital and the build-up
of adequate buffers above the minimum that can be drawn down in periods of stress.‟

 Outside of period of stress, banks should hold buffers of capital above the regulatory minimum.

 When buffers have been drawn down, banks should rebuild them through:
 Reducing discretionary distribution of earnings (reducing dividend payouts, share-backs, staff nous payments)

 Raising ne w capital from the private sector

 In the absence of raising capital in the private sector, the share of earnings retained by banks for the
purpose of rebuilding their capital buffers should increase the nearer their capital levels are to the
minimum capital requirement.

 The framework reduces the discretion of banks which have depleted their capital buffers to engage in
„unacceptable‟ practices like:
 Using future predictions of recovery as justification for maintaining generous distribution to shareholders, other
capital providers and employees

 Using the distribution of capital as a way to signal their financial strength

32

Capital Conservation Buffer – The Framework

 A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the
regulatory minimum capital requirement. Capital distribution constraints will be imposed on a bank
when capital levels fall within this range.

 Banks will be able to conduct business as normal when their capital levels fall in to the conservation
range as they experience losses. The constraints imposed only relate to distributions, not the
operation of the bank.

 The distribution constraints imposed on banks when their capital levels fall into the range increases
as the banks‟ capital levels approach the minimum requirements.

 The Basel Committee does not wish to impose the constraints for entering the range that would be so
restrictive as to result in the range being viewed as establishing a new capital requirement.

33

Capital Conservation Buffer – Mechanics

For example, a bank with a CET 1 capital ratio in the range of 5.125% to 5.75% is required
to conserve 80% of its earnings in the subsequent financial year (i.e payout no more than
20% in terms of dividends, share buybacks and discretionary bonus payments).

Individual bank minimum capital conservation standards
Common Equity Tier 1 Ratio Minimum Capital Conservation Ratios
(expressed as a percentage of earnings)
Within 1st quartile of buffer (4.5% - 5.125%) 100%
Within 2nd quartile of buffer (> 5.125% - 5.75%) 80%
Within 3rd quartile of buffer (> 5.75% - 6.375%) 60%
Within 4th quartile of buffer (> 6.375% - 7%) 40%
Above top of buffer (> 7%) 0%

Source: bcbs189 – BIS (2011) 34

Capital Conservation Buffer – Other Key Aspects & Timeline

 Items considered to be distributions include dividends and share buybacks, discretionary payments
on other Tier 1 capital instruments and discretionary bonus payments to staff.

 Earnings are defined as distributable profits calculated prior to the deduction of elements subject to
the restriction on distributions. Earnings are calculated after the tax which would have been reported
had none of the distributable items been paid.

 The Capital Conservation Buffer framework should be applied at the consolidated level, i.e
restrictions would be imposed on distributions out of the consolidated group. National supervisors
would have the option of applying the regime at the solo level to conserve resources in specific parts
of the group.

 Banks should not choose in normal times to compete with other banks and win market share. To
ensure that this does not happen, supervisors have the additional discretion to impose time limits on
banks operating within the buffer range on a case-by-case basis.

 The Capital Conservation Buffer will be phased in between 01 Jan 2016 and year end 2018
becoming fully effective on 01 Jan 2019. It will begin at 0.625% of RWAs on 01 Jan 2016 and
increase each subsequent year by an additional 0.625 percentage points, to reach its final level of
2.5% of RWAs on 01 Jan 2019.
2016 2017 2018 2019

Capital Conservation Buffer 0.625% 1.25% 1.875% 2.5%

35

Capital Conservation Buffer – Impact on Regulatory Capital

Regulatory Capital
12%

10%

8%

Tier 2
6%
Other Tier 1
4% CET1 + CCB

2%

0%
Basel II Basel III

36

Countercyclical Buffer – Objective

 The countercyclical buffer aims to „ensure that the banking sector in aggregate has the capital on
hand to help maintain the flow of credit in the economy without its solvency being questioned’.

 „It will be deployed by national jurisdictions when excess aggregate credit growth is judged to be
associated with a build-up of system-wide risk to ensure the banking system has a buffer of capital to
protect it against future potential losses.‟ The objective behind countercyclical buffer is to dampen
excessive credit growth when national regulatory authorities judge the credit-to-GDP ratio is deviating
from the trend.

 The buffer for internationally active banks will be a weighted average of the buffers deployed across
all national jurisdictions to which they have credit exposures.

 Banks would be subject to restrictions on distributions if they do not meet the buffer requirements as
mandated by the regulatory authority.

 The buffer will vary between zero and 2.5% of risk weighted assets, depending on the judgment of
the relevant national authority.

37

Countercyclical Buffer – Mechanics

 Since the Countercyclical Buffer is implemented as an extension of the Capital Conservation Buffer
(2.5%), a hypothetical Countercyclical Buffer requirement of 2% implies that the bank would need to
maintain a capital ratio of 9% failing which restriction on distribution of earnings would be applicable.

4.5% (CE Tier 1) + 4.5% (Conservation Buffer + Countercyclical Buffer) = 9%

Individual bank minimum capital conservation charges, when a bank is subject to a
2% Countercyclical Buffer requirement
Common Equity Tier 1 Minimum Capital Conservation Ratios
(expressed as a percentage of earnings)
Within 1st quartile of buffer (4.5% - 5.625%) 100%
Within 2nd quartile of buffer (>5.625% - 6.75%) 80%
Within 3rd quartile of buffer (>6.75% - 7.875%) 60%
Within 4th quartile of buffer (>7.875% – 9%) 40%
Above top of buffer (> 9%) 0%

Source: bcbs189 – BIS (2011) 38

Countercyclical Buffer – Timeline & Transitional Agreements

 The BIS document titled „Guidance for national authorities operating the countercyclical capital
buffer‟, delineates the principles that national regulatory authorities have agreed to follow in making
buffer decisions.

 To give banks time to adjust to a new buffer level, a period of up to 12 months would be given after
the announcement of the decision by the concerned regulatory authority. Decision to reduce the
buffer level would take effect immediately post-announcement.

 The countercyclical buffer regime will be phased-in in parallel with the capital conservation buffer
between 01 Jan 2016 and year end 2018 becoming fully effective on 01 Jan 2019.

 The maximum countercyclical buffer requirement will begin at 0.625% of RWAs on 01 Jan 2016 and
increase each subsequent year by an additional 0.625 percentage points, to reach its final maximum
of 2.5% of RWAs on 01 Jan 2019.
2016 2017 2018 2019

Countercyclical Buffer 0.625% 1.25% 1.875% 2.5%

 Countries that experience excessive credit growth should consider accelerating the build up of the
capital conservation buffer and the countercyclical buffer. National authorities have the discretion to
impose shorter transition periods and should do so where appropriate.

 In addition, jurisdictions may choose to implement larger countercyclical buffer requirements. In such
cases the reciprocity provisions of the regime will not apply to the additional amounts or earlier time-
frames.

39

Credit-to-GDP Guide to determine Countercyclical Buffer

Guidance for national authorities operating the Countercyclical Capital Buffer

 National authorities are urged to take countercyclical capital buffer decisions on a quarterly or more
frequent basis.

 Basel Committee believes that national authorities should implement a communication strategy that
provides regular updates on their assessment of macro financial situation and the prospects for
potential buffer actions. This would promote accountability and sound decision-making while allowing
banks and their stakeholders to prepare for buffer decisions.

 The capital surplus created when the countercyclical buffer is returned to zero should be unfettered.
i.e there are no restrictions on distributions when the buffer is turned off.

Credit-to-GDP Guide

 National authorities can determine the buffer add-on by the following 3 steps:
1. Calculate the aggregate private sector credit-to-GDP ratio

2. Calculate the credit-to-GDP gap (the gap between the ratio and its trend)

3. Transform the credit-to-GDP gap in to the guide buffer add-on

40

Credit-to-GDP Guide to determine Countercyclical Buffer (cont‟d)

1. Calculating the credit-to-GDP ratio

The credit-to-GDP ratio in period t for each country is calculated as:

RATIOt = CREDITt / GDPt Х 100%

GDPt is domestic GDP and CREDITt is a broad measure of credit to the private, non-financial sector
in period t. Both GDP and CREDIT are in nominal terms and on a quarterly frequency.

2. Calculating the credit-to-GDP gap

The credit-to-GDP ratio is compared to its long term trend. If the credit-to-GDP ratio is significantly
above its trend (i.e there is a large positive gap) then this is an indication that credit may have grown
to excessive levels relative to GDP.

The gap (GAP) in period t for each country is calculated as the actual credit-to-GDP ratio minus its
long-term trend (TREND):

GAPt = RATIOt – TRENDt

TREND is a simple way of approximating something that can be seen as a sustainable average of
ratio of credit-to-GDP based on the historical experience of the given economy. It is established using
the Hodrick-Prescott filter which tends to give higher weights to more recent observations.

41

Credit-to-GDP Guide to determine Countercyclical Buffer (cont‟d)

3. Transforming the credit-to-GDP gap into the guide buffer add-on

The size of the buffer add-on (VBt) (in percent of risk-weighted assets) is zero when GAPt is below a
certain threshold (L). It then increases with the GAPt until the buffer reaches its maximum level
(VBmax) when the GAP exceeds an upper threshold H.

Basel Committee on Banking Supervision‟s analysis has found that an adjustment factor based on
L=2 and H=10 provides a reasonable and robust specification based on historical banking crises.

For example, when the credit-to-GDP ratio is 2 percentage points or less above its long term
trend, the buffer add-on (VBt) will be 0%. Similarly, when the credit-to-GDP ratio exceeds its long
term trend by 10 percentage points or more, the buffer add-on will be 2.5% of risk weighted assets.

42

Leverage Ratio

 Prior to the financial crisis of 2007, many financial institutions and banks had built up excessive on-
and off-balance sheet leverage which were not accurately accounted for in the risk-based capital
ratios.

 LR is a secondary measure that is to be used alongside Basel II risk-based capital ratios.

 LR would „…constrain the build-up of leverage in the banking sector, helping to avoid destabilizing
deleveraging processes which can damage the broader financial system and the economy‟

Calculation Simple arithmetic mean of the monthly leverage ratio over the quarter

Scope of application Solo, consolidated and sub-consolidated level

Disclosure Disclosure of the key elements of the leverage ratio under Pillar 3

Introduction Planned for 01 Jan 2018

Transition period • 01 Jan 2011: Start supervisory monitoring period (development of
templates)
• 01 Jan 2013-2017: Parallel run (leverage ratio & its components will be
tracked, including its behavior relative to the risk based requirement)
• 01 Jan 2015: Disclosure of the leverage ratio by banks
• First half of 2017: Final adjustments
• 01 Jan 2018: Migration to Pillar 1 treatment

44

Leverage Ratio

 LR is not intended to be a binding instrument at this stage but as an “additional feature that can be
applied on individual banks at the discretion of supervisory authorities with a view to migrating to a
binding (Pillar 1) measure in 2018, based on appropriate review and calibration.”

Tier 1 Capital
Leverage Ratio = ≥ 3%
Total Exposure

Sum of the exposure values of all assets and off-balance sheet items not deducted from
the calculation of Tier 1 capital. Exposure measure generally follows accounting measure.
For off-balance sheet items, a specific credit risk adjustment of 10% generally applies for
undrawn credit facilities (this may be cancelled unconditionally at any time without notice),
and 100% for all other off-balance sheet items.

 Within the disclosure requirements, the following information should be reported:

 Leverage Ratio

 A breakdown of the total exposure method

 A description of the processes used to manage the risk of excessive leverage

 A description of the factors that had an impact on the leverage ratio during the period to which
the disclosed leverage ratio refers

45

Liquidity Standards – A Comparison

Liquidity Coverage Ratio Net Stable Funding Ratio
Introduction 01 Jan 2015; observation period starting 01 Jan 2018; under observation until then
01 Jan 2013
Goal To promote short-term resilience of a To promote long-term resilience of banks
bank‟s liquidity profile such that it survives by requiring a sustainable maturity
a “significant stress scenario” lasting for structure for assets and liabilities by
30 days creating incentives to use more stable
funding sources
Horizon 30 days 1 year

Scope of Level of individual institution (with legal Level of individual institution (with legal
Application personality) personality)
Reporting Monthly with the operational capacity to Quarterly
increase the frequency to weekly or even
daily in stressed situations
Disclosure Disclosure of LCR under Pillar 3 Disclosure of NSFR under Pillar 3

Source: Basel III Handbook – Accenture 47

Liquidity Coverage Ratio

 LCR is aimed at ensuring that banks have adequate, high-quality liquid assets to survive a short-term
stress scenario and is defined as:

Stock of high-quality liquid assets
≥ 100%
Total net cash outflows over the next 30 calendar days

 LCR has two components:
 Value of the stock of high-quality liquid assets in stressed conditions; and

 Total net cash outflows over the next 30 calendar days = Outflows - Min [Inflows; 75% of Outflows]

48

Liquidity Coverage Ratio

High-quality liquid assets

“Level 1” assets
Cash; transferrable assets of extremely high liquidity & credit quality (Min. of 60% of liquid assets)
“Level 2” assets
Transferrable assets that are of high liquidity & credit quality (Max. 40% of liquid assets; market
value; haircut of min. 15%)

≥ 100%
Liquidity outflows Liquidity inflows
• Retail deposits (5-10%) • Monies due from non-financial customer
• Other liabilities coming due (5-10%)
during next 30 days (0-100%) • Secured lending & capital market driven
• Collateral other than “level 1 transactions (0-100%)
assets” (15-20%) • Undrawn credit & liquidity facilities (0%)
• Credit & liquidity facilities • Specified payables & receivables
(5-100%) expected over the 30 day horizon (100%)
• Liquid assets (0%)
Liquidity outflows are calculated • New issuance of obligations (0%)
by multiplying the assets with the
specified “run-off” factors Liquidity inflows are calculated by multiplying
the assets with the specified inflow factor

Total net cash outflows over the next 30 calendar days


What is a liquid asset?

Liquid Asset #

Cash and deposits held with central banks
Level 1 assets can comprise an which can be withdrawn in times of stress
unlimited share of the pool, are
Level 1 Transferrable assets that are of extremely
held at market value and are not
Asset high liquidity and credit quality
subject to a haircut under the LCR.
≥ 60% of the liquid assets. Transferrable assets representing claims on
or guaranteed by the central govt. of a
Member State or a third country if the
institution incurs a liquidity risk in that Member
State or third country that covers by holding
those liquid assets
Level 2 assets are subject to a
cap of 40% of all liquid assets and Level 2 Transferrable assets that are of high liquidity
subject to 15% haircut. Asset and credit quality

Fundamental Characteristic Market Characteristic
Low credit and market risk Active and sizable market

Ease and certainty of valuation Presence of committed market matters

Low correlation with risky assets Low market concentration

Listed on developed and recognized exchange market Investors show tendency to move into asset during
systemic crisis

# Source: Basel III Handbook – Accenture 50

High quality liquid assets

High Quality Liquid Asset Not High Quality Liquid Asset
Not issued by the institution itself or its parent or Assets issued by a credit institution unless they
subsidiary institutions or another subsidiary of its fulfill one of the following conditions:
parent financial holding company a) They are bonds eligible for treatment as
covered bonds
Eligible collateral in normal times for intraday b) The credit institution has been set up and is
liquidity needs & overnight liquidity facilities of a sponsored by a Member State central or
central bank in a Member State or if, the liquid regional govt. and the asset is guaranteed by
assets are held to meet liquidity outflows in the that govt. and used to fund promotional loans
granted on a non-competitive, not-for-profit
currency of a third country, or of the central bank
basis in order to promote its public policy
of that third country objectives
The price can be determined by a formula that is Assets issued by any of the following:
easy to calculate based on publicly available a) An investment firm
inputs and doesn‟t depend on strong assumptions b) An insurance undertaking
c) A financial holding company
as is typically the case for structured or exotic
d) A mixed-activity holding company
products e) Any other entity that performs one or more of
Listed on a recognized exchange the activities listed in Annex I of the Directive
as its main business (eg. financial leasing;
Tradable on active outright sale or repurchase acceptance of deposits and other mutual
agreement with a large and diverse number of recognition)
market participants, a high trading volume and
market depth and breadth


High quality liquid assets – operational requirements

To be considered as high quality liquid assets items have to fulfill several operational requirements:

 They are appropriately diversified

 “Level 1 assets” should not be less than 60% of the liquid assets

 They are legally and practically readily available at any time during the next 30 days to be
liquidated via outright sale or repurchase agreements in order to meet obligations coming due

 The liquid assets are controlled by a liquidity management function

 A portion of the liquid assets is periodically and at least annually liquidated via outright sale or
repurchase agreements for the following purposes:
o To test the access to the market for these assets

o To test the effectiveness of its processes for the liquidation of assets

o To test the usability of the assets

o To minimize the risk of negative signaling during a period of stress

 Price risks associated with the assets may be hedged but the liquid assets are subject to
appropriate internal arrangements that ensure that they will not be used in other ongoing
operations, including hedging or other trading strategies; providing credit enhancements in
structured transactions; to cover the operational costs

 The denomination of the liquid assets is consistent with the distribution by currency of liquidity
outflows after the deduction of capped inflows
52

Liquidity Coverage Ratio – Stress Conditions Scenarios

The stress scenarios envisaged for LCR incorporates many of the shocks experienced during the 2008
financial crisis at a systemic level as well as the idiosyncratic level (institution specific level):

 The run off of a proportion of retail deposits

 A partial loss of unsecured wholesale funding capacity

 A partial loss of secured, short-term financing with certain collateral and counterparties

 Contractual outflows that would arise from a downgrade in the bank‟s public credit rating by up to and
including 3 notches, including collateral posting requirements

 Increase in market volatilities that impact the quality of collateral or potential future exposure of
derivative positions

 Unscheduled draws on committed but unused credit and liquidity facilities

 The potential need to buy back debt or honor non-contractual obligations in the interest of mitigating
reputational risk

53

Net Stable Funding Ratio

 The objective of NSFR is to promote more medium and long-term funding of the assets and activities
of banking organizations.

 Institutions are required to maintain a sound funding structure over one year in an extended firm-
specific stress scenario.

 Assets currently funded and any contingent obligations to fund must be matched to a certain extent
by sources of stable funding.

 NSFR is designed to act as a minimum enforcement mechanism to complement the LCR and
reinforce other supervisory efforts by promoting structural changes in the liquidity risk profiles of
institutions away from short-term funding mismatches and toward more stable, longer-term funding of
assets and business activities.

 It aims to limit over-reliance 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.


54


ASF Factor Items
100% • Tier 1 & 2 capital
• Preferred stock not included in Tier 2 capital with maturity ≥ 1 year
• Secured & unsecured borrowings & liabilities with effective remaining maturities ≥ 1 year
90% • “Stable” non-maturity (demand) deposits and/or term deposits with residual maturity < 1
year
80% • “Less stable” non-maturity (demand) deposits and/or term deposits with residual maturity
< 1 year
50% * Unsecured wholesale funding, non-maturity deposits and/or term deposits with a residual
maturity < 1 year, provided by non-financial corporates, sovereigns, central banks, MDBs
and PSEs
0% • All other liabilities and equity categories not included in the above categories





RSF Factor Items
0% • Cash
• Unencumbered short-term unsecured instruments & transactions with outstanding maturities < 1 yr
• Unencumbered securities with stated remaining maturities < 1 year with no embedded options
• Unencumbered securities held where the institution has an offsetting reverse repurchase
transaction
• Unencumbered loans to financial entities with effective remaining maturities < 1 year that are not
renewable and for which the lender has an irrevocable right to call
5% • Unencumbered marketable securities with residual maturities of one year or greater representing
claims on or claims guaranteed by sovereigns, central banks, BIS, IMF, EC, non-central government
PSEs or multilateral development banks that are assigned a 0% risk-weight under the Basel II
standardized approach, provided that active repo or sale-markets exist for these securities
20% • Unencumbered corporate bonds or covered bonds rated AA- or higher with residual maturities 1 yr
satisfying all of the conditions for Level 2 assets in the LCR
• Unencumbered marketable securities with residual maturities 1 year representing claims on or
claims guaranteed by sovereigns, central banks, non-central government PSEs that are assigned a
20% risk-weight under the Basel II standardized approach, provided that they meet all of the
conditions for Level 2 assets in the LCR


Required stable funding (cont‟d)


RSF Factor Items
50% • Gold
• Unencumbered equity securities, not issued by financial institutions or their affiliates, listed on a
recognized exchange and included in a large cap market index
• Unencumbered corporate bonds and covered bonds that are central bank eligible and are not
issued by financial institutions
65% • Unencumbered residential mortgages of any maturity that would qualify for the 35% or lower risk-
weight under Basel II Standardized Approach
• Other unencumbered loans, excluding loans to financial institutions, with a remaining maturity ≥ 1
yr, that would qualify for the 35% or lower risk-weight under Basel II Standardized Approach for
credit risk
85% • Unencumbered loans to retail customers and SME (as defined in the LCR) having a remaining
maturity < 1 year
100% • All other assets not included in the above categories


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