ASSIGNMENT 2

Archa E S

M180017MS

1. Discuss the relationship between the capital base of the banks and (2007-2010)
financial crisis and the great recession.
Capital base is important because it provides a benchmark when measuring returns.
Without it, investors and companies would be unaware of how their investments
have performed because they would have no starting point to use in their
measurements. A bank will keep an eye on its capital base, or bank capital, since it is
a regulatory requirement to maintain certain levels of funding. When a bank starts to
become inadequately funded, it can raise capital by selling bonds or taking other
steps to reduce its liabilities or increase its assets.

The 2007-2009 financial crisis resulted in the largest realization of bank risk since the
Great Depression. The decimation of the market value of banking shares during this
period was unprecedented: more than 3 trillion euros were erased from the market
capitalisation of banks in Europe and the United States. This corresponds to a
decrease of 82% in the stock market value of these banks between May 2007 and
March 2009. The impact on the real economy triggered by the problems in the
banking sector was extremely severe, producing record levels of unemployment and
giving way to what is now referred to as the “Great Recession”. Structural
developments in the banking industry before the crisis probably helped distort
banks’ incentives towards more risk-taking and a closer dependence on financial
markets. Yet, the majority of indicators of bank risk in the years preceding the crisis
showed a fairly benign picture. Indeed, even the forward looking measures of bank
risk regularly used by financial institutions, investors, central banks, and regulators to
monitor the health of the financial system remained at very low levels. There was
also a convergence or “flattening” in the differences between banks before the crisis
broke. The crisis, however, revealed huge variability across individual banks, as
evidenced by the cross-sectional dispersion of risk indicators, which widened
significantly during this period.
2. Evaluate the need for counter cyclical capital buffer and discuss how this might be
structured.
Counter Cyclical Capital buffer is the capital to be kept by a bank to meet business
cycle related risks. It is aimed to protect the banking sector against losses from
changes in economic conditions. Banks may face difficulties in phases like recession
when the loan amount doesn’t return. To meet such situations, banks should have
own additional capital. This is an important theme of the Basel III norms.
 According to the RBI regulations, universal banks in India have to maintain a counter
cyclical capital conservation buffer of 1 2.5% by 2019.
Countercyclical capital regulation can reduce the procyclicality of the banking system
and dampen aggregate economic fluctuations. If over time regulators want to
increase the degree of countercyclicality of capital regulation, they might consider
adopting a rule-based countercyclical buffer, that is, a buffer that is automatically
lowered during recessions according to a rule. To achieve the broader
macroprudential goal of protecting the banking sector in periods of excess aggregate
credit growth. In particular, regulators could consider a buffer that varies over the
business cycle automatically according to a rule. Compared to a discretion-based
approach, a rule-based approach could help regulators achieve the desired degree of
countercyclicality in capital regulation. With discretion, regulators may be tempted
to avoid raising the buffer during expansions, perhaps to avoid adverse
consequences on banks’ lending. As a result, the buffer may be set too low too often,
and may not generate the desired degree of countercyclicality. A rule-based
approach could help regulators commit to raising the buffer during expansions and
achieve a greater degree of countercyclicality. As Arjani 2009 points out, a rule-
based approach “serves as an effective recommitment device, in that supervisors will
not be put in the difficult and unpopular position of requesting on an ad hoc basis
that banks raise their capital in the middle of an economic boom
3. Discuss the need to include leverage ratio and off balance sheet in Basel 3
A leverage ratio is any one of several financial measurements that look at how much
capital comes in the form of debt (loans) or assesses the ability of a company to
meet its financial obligations. The leverage ratio category is important because
companies rely on a mixture of equity and debt to finance their operations, and
knowing the amount of debt held by a company is useful in evaluating whether it can
pay its debts off as they come due. 
The Basel Committee on Banking Supervision (BCBS) introduced a leverage ratio in
the 2010 Basel III package of reforms. Basel III leverage ratio framework and
disclosure requirements followed in January 2014 with detailed specification of the
leverage ratio framework. This Executive Summary provides an overview of the
framework and its main components.
An underlying cause of the Great Financial Crisis was the build-up of excessive on-
and off-balance sheet leverage in the banking system. In many cases, banks built up
excessive leverage while maintaining seemingly strong risk-based capital ratios. The
ensuing deleveraging process at the height of the crisis created a vicious circle of
losses and reduced availability of credit in the real economy. The BCBS introduced a
leverage ratio in Basel III to reduce the risk of such periods of deleveraging in the
future and the damage they inflict on the broader financial system and economy.
The leverage ratio is also intended to reinforce the risk-based capital requirements
with a simple, non-risk-based "backstop". The framework is designed to capture
 leverage associated with both on- and off-balance sheet exposures. It also aims to
make use of accounting measures to the greatest extent possible, while at the same
time addressing concerns that (i) different accounting frameworks across
jurisdictions raise level playing field issues and (ii) a framework based exclusively on
accounting measures may not capture all risks.
The leverage ratio is defined as the capital measure divided by the exposure
measure, expressed as a percentage:

The minimum requirement is set at 3%, where it will remain until the BCBS finalises
the calibration and makes any necessary adjustments to the definition of the
exposure measure, with a view to migrating to Pillar 1 treatment on 1 January 2018.
The related public disclosure requirements have been in effect since 1 January 2015.
4. What measures should limit counter party credit risk
Counterparty credit risk is the risk arising from the possibility that the counterparty
may default on amounts owned on a derivative transaction. Counterparty credit risk
is 2-way when both counterparties exchange a series of payments periodically such
as in interest rate swap transactions as explained in my Derivatives blog. In short,
counterparty credit risk for each party in a transaction is that the counterparty might
fail to meet its financial obligations.
Risk coverage
The risk-based capital charges for CCR in Basel III cover two important characteristics
of CCR: the risk of counterparty default and a credit valuation adjustment (CVA). The
risk of counterparty default was already covered in Basel I and Basel II. The Basel III
reforms introduced a new capital charge for the risk of loss due to the deterioration
in the creditworthiness of the counterparty to a derivatives transaction or an SFT.
This potential mark-to-market loss is known as CVA risk. It captures changes in
counterparty credit spreads and other market risk factors. CVA risk was a major
source of unexpected losses for banks during the Great Financial Crisis.
Capital charges for CVA risk
The CVA risk capital requirement is calculated for a bank's total CVA portfolio on a
standalone basis. This calculation takes into account risk-reducing effects, such as
netting, collateral arrangements and certain offsetting hedges. The BCBS incentivises
active risk management as hedging by recognising external and bank internal
hedges. There are three approaches available for calculating CVA risk: (1) the
standardised approach (SA-CVA), which is an adaptation of the SA for market risk
and requires supervisory approval; (2) the simpler basic approach (BA-CVA); and (3)
an approach for banks with less engagement in derivatives activities in which they
can choose to use their CCR capital requirements as a proxy for their CVA charge.
5. Discuss the use of liquidity ratios as a value focus for international regulations.
Liquidity ratios are an important class of financial metrics used to determine a
debtor's ability to pay off current debt obligations without raising external capital.
Liquidity ratios measure a company's ability to pay debt obligations and its margin of
safety through the calculation of metrics including the current ratio, quick ratio,
and operating cash flow ratio.
Liquidity ratio affects the credibility of the company as well as the credit rating of the
company. If there are continuous defaults in repayment of a short-term liability then
this will lead to bankruptcy. Hence this ratio plays important role in the financial
stability of any company and credit ratings. The LCR will ensure that banks maintain
a defined level of high-quality assets that can withstand problems in short-term
funding. Banks can convert the assets into cash in the case of liquidity problems. The
LCR also works to counteract the interconnectedness of the financial system because
the definition of high-quality assets used to calculate the LCR excludes both bank
debt and insurance firm debt. Liquidity problems at other financial institutions will
therefore have less influence on bank’s ability to remain liquid.
The availability of low-cost funding as well as poor risk evaluation supported the
build-up of leverage prior to the financial crisis. Leverage was often predominantly
composed of short-term whole funding.
The liquidity framework sets an international minimum standard and requires more
detailed analysis of each bank.
6. Discuss the need for various domestic regulation to supplement Basel 3 with special
reference to India
The Basel III framework, whose main thrust has been enhancing the banking sector's
safety and stability, emphasises the need to improve the quality and quantity of
capital components, leverage ratio, liquidity standards, and enhanced disclosures.
This article first lays the context of Basel III and then incorporates the views of senior
executives of Indian banks and risk management experts on addressing the
challenges of implementing the Basel III framework, especially in areas such as
augmentation of capital resources, growth versus financial stability, challenges for
enhanced profitability, deposit pricing, cost of credit, maintenance of liquidity
standards, and strengthening of risk architecture.
There are countries and Unions that have their own regulatory systems: For Eg:-
USA: Dodd-Frank Wall Street Reform and Consumer Protection Act: It is the most
significant national regulation enacted in response to the financial crisis. The bill
created the Consumer Protection Agency to prevent deceptive financial products
and practices. The “Volcker Rule” would ban proprietary trading by commercial
banks, and would prohibit a commercial bank from owning or investing in a hedge
fund or private equity fund. 2. Canada: Principle-Based Approach: This uses general
frameworks to guide banks’ compliance without establishing specific rules. 3. EU: A
New International Regulatory Framework: EU members have debated the terms and
conditions for providing EU assistance to individual banks when they encounter
severe difficulties. There are proposals to broaden the responsibilities to all banks.
In case of India, the Reserve Bank of India (RBI) implemented Basel I norms from
1992 onwards. The post 1990 scenario world over saw banks increasing their trading
activity by investing in securities which exposed banks to price risks and responding
to this, in 1996, the Basel Committee suggested that banks maintain capital funds
against market risk by following either the standardized measurement approach
(SMA) or internal measurement approach (IMA) to meet the unforeseen losses
arising out of market risks. RBI applies regulations in our Banks. It relaxes the
leverage ratio (LR) for banks in a bid to help them expand their lending activities.
Keeping in mind financial instability and with a view to moving further towards
harmonization with Basel III standards, it has been decided that minimum LR should
be 4% for Domestic Systemically Important Banks (DSIBs) and 3,5% for other banks.