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BUSINESS AND TECHNOLOGICAL CHALLENGES
SEPTEMBER 17, 2010
By Rustom Barua, Fabio Battaglia, Ravindran Jagannathan, Jivantha Mendis and Mario Onorato
Basel III: What’s New? Business and Technological Challenges
September 17, 2010
Table of Contents
1. 2. 2.1. 2.2. 2.3. 2.3.1. 2.3.2. 2.3.3. 2.3.4. 2.3.5. 2.3.6. 2.3.7. 2.3.8. 2.4. 2.4.1. 2.4.2. 2.4.3. 3. 3.1. 3.2. 3.2.1. 3.2.2. 3.2.3. 3.2.4. 3.2.5. 3.2.6. 3.2.7. 3.2.8. 3.2.9. 3.2.10. 3.2.11. 3.2.12. 3.3. 3.4. 3.5. 4. 5. 5.1. 5.2. 6. 7. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Liquidity Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 The Regulatory Effort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 The New Liquidity Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 The New Liquidity Ratios: Tasks and Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Insufficiency of Standardized Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Building Differentiated Incentives to Traditional Banking vs. Speculative Trading . . . . . . . . . . . . . .10 Accounting for Bank’s Size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 Need to Raise New Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 Securitization Disruption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 Raising New Medium/Long-Term Finance (NSFR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 Distorting Bond Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14 Reshaping Interbank Deposit Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14 Survival Horizon Models: Optimizing the Liquidity Buffer in a Comprehensive Risk Management Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15 The Relationship between the Basel Ratios and Bank-Specific Survival Horizon Models . . . . . . . .15 Calculating the Amount of the Liquidity Buffer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16 Optimising the Liquid Asset Buffer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 Proposals Regarding Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18 Capital Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18 Risk Coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19 Addressing General Wrong-way Risk – Stressed EEPE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19 Capturing CVA Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 Specific Wrong-way Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 Higher Risk Weights for Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 Increase Margin Period of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22 Preclude Downgrade Triggers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22 Collateral Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Central Counterparties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Stressed PDs for Highly Leveraged Counterparties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Stress Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 Back Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 Reduce Reliance on External Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 Leverage Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25 Counter-Cyclical Capital Buffers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27 Systemic Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31 Implementation Timelines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .32 Business impact and challenges: exploring the interplay between Liquidity and Capital . . . . . . .32 Exploring Interconnections and Trade-Offs between Capital and Liquidity . . . . . . . . . . . . . . . . . . . .34 Misunderstanding How Liquidity Risk and Capital are Connected . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35 Technology Direction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36 Conclusion: Moving Towards a Holistic System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40
Basel III: What’s New? Business and Technological Challenges
September 17, 2010
An extensive effort is underway to strengthen the financial sector and make banks and other institutions more resilient in the face of unexpected stress.The hope is that any future crisis will not lead to governments again being forced to spend billions of dollars of taxpayer’s money saving the banking system. In terms of regulatory requirements, this effort has been concentrated in proposals envisaging three areas where constraints are being substantially overhauled: regulatory capital, liquidity and leverage. These proposals were summarized in two Consultation Papers issued by the Basel Committee on Banking Supervision (BCBS) In December 2009: • Strengthening the Resilience of the Banking Sector, dealing with regulatory capital and leverage. • International Framework for Liquidity Risk Measurement, Standards and Monitoring, addressing liquidity requirements. The urgency of the tasks was expressed by Mario Draghi, the Chairman of the Financial Stability Board, in his Letter to the gathering of G20 world leaders in Toronto. Published on June 27th, 2010, it read:“It will be important that Leaders support calibration of the new capital, liquidity and leverage standards to a level and quality that enable banks to withstand stresses of the magnitude experienced in this crisis, without public support. The quality and amount of capital in the banking system must be significantly higher to improve loss absorbency and resiliency.We should provide transition arrangements that enable movement to robust new standards without putting the recovery at risk, rather than allow concerns over the transition to weaken the standards” . On July 26, 2010 the Bank for International Settlements (BIS) announced that the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee, had reached a broad agreement on a capital and liquidity reform package. This resulted not only in a significant easing of the rules compared to the first draft, but more importantly in a substantial delay in their effective implementation. For the leverage ratio and the net stable funding ratio, which had been concerning banks most, transition periods were established such that the new rules will not come into force until 2018. Jean-Claude Trichet, President of the European Central Bank and Chairman of the of Governors and Heads of Supervision, made clear that this delay is aimed at avoiding the possibility of the new constraints hitting the global economy while a difficult recovery is in course:“ We will put in place transition arrangements that ensure the banking sector is able to support the economic recovery”1. The BIS communiqué stated that the Governors and Heads of Supervision had taken account of the results of the quantitative impact study undertaken by the Basel Committee to assess the potential impact on bank profitability and the broader economy of the new rules.The results of this study will be published by the Committee later this year. At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision fully endorsed the agreements reached on 26 July 2010. These capital reforms, together with the introduction of a global liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the G20 Leaders summit taking place in Seoul in November.
Bank for International Settlements,The Group of Governors and Heads of Supervision reach broad agreement on Basel Committee capital and liquidity reform package, Press Release, 26 July 2010.
Basel III: What’s New? Business and Technological Challenges
September 17, 2010
The agreement was widely seen by the market as good news for banks, and bank shares worldwide spiked. Banks will still be allowed to recapitalize through retained earnings rather than fresh capital and will push back into the future the downwards pressure on profits that would result from the obligation to hold greater amounts of capital, liquid assets and medium/long-term debt. However, concern was expressed by commentators as to the effectiveness of such a long transition in view of system protection.We could also question whether European supervisors have fully taken advantage of lessons from the crisis. The above “win”on July 26 for banks came just days after the European Central Bank released the results of the stress tests conducted on a significant sample of European banks.The tests showed that most of these would be capable of withstanding a significant and protracted stress. However, the tests focused on capital levels only and did not test banks for liquidity risk.This persistence of a “silo”approach to risk management is, in our view, to be seen as a weakness. There is significant evidence from the crisis that interdependence among risks cannot be dismissed and that unexpected fallouts in terms of liquidity can put financial institutions at extreme risk.We will outline in the last part of this document that the “silo”approach should be completely overcome in favour of an integrated view of different risk types that duly considers interdependencies among risks. This paper will focus on the current version of the new Basel requirements on capital, liquidity and leverage as amended after the 26 July communiqué and ratified on September 12, 2010. It will analyse implications, issues and interconnections between them and discuss some of new trends in best practice of banks’ risk management and capital optimization that are likely to emerge as a result. The enhanced set of rules has been widely referenced in the industry as “Basel III” When the Basel II Accord . was finalized in 2004 the assumption was that the overall quality and quantity of capital was sufficient, but the BCBS wanted to make the regulatory capital measure more risk sensitive. Current discussions on Basel III intend to achieve better quality capital as well as increasing the amount of capital. In this document we will first describe the liquidity risk rules and potential shortcomings in Basel III. In section 3 we describe changes to capital requirements, with special emphasis on risk coverage, leverage ratio and countercyclical capital buffers. In section 4 we summarize the implementation timelines as specified in the September 12,2010 press release.Section 5 describes the potential business impact for global banks and explores the interplay between capital and liquidity. Section 6 is our view of how enterprise risk technology will evolve over the next few years.We conclude with section 7 on how business processes and systems are moving towards a holistic, integrated risk management framework.
They are instead disciplined under Pillar 2.liquidity risk has suddenly taken centre stage thanks to the financial crisis. Typically. 2. Its business is borrowing money from excess sectors and lending it to sectors in need. 5 . As a result.This entails two consequences: 1. However. a high leverage boosts the impact of any liquidity problem. the current Basel II framework does not in effect address liquidity risk. regulators cannot aim to remove mismatch liquidity risk from the system. The banking industry is a leveraged one. it has been generally accepted that capital is not a suitable mitigant for liquidity risk. As such. whereby banks are required to undertake the ICAAP (Internal Capital Adequacy Assessment). that a bank would always be creditworthy as long as asset quality was preserved.e. As a result a continuous flow of new best practice guidance and supervisory requirement documents have emerged over the last couple of years. At the root of this construction stood a very fundamental assumption. One individual bank could theoretically fund itself such that all maturity mismatches are hedged. while not matching outflows in terms of maturities. a calculation of the amount of capital (called internal capital) they deem sufficient to support all their risks. for virtually any amounts. the term on which liquid operators are ready to invest their liquidity is shorter than that on which illiquid operators are willing to borrow. Obviously. provided the quality of assets was good enough then a bank would always find finance at fair prices. but this is impossible at the system level. it is fundamentally inherent to the banking business. Banks inherently work on others’ money. Risks arising from the liability side (including liquidity risk alongside other risks. While reallocating financial resources from one sector to the other. such as interest rate risk of the banking book). As a result. Liquidity Risk After being neglected for decades. Pillar 2 requires that the ICAAP include liquidity risk. both on an individual and a system basis. This assumption proved completely wrong when the crisis erupted and entire liquidity channels suddenly dried up. the banking system bears such mismatch of maturities in the form of liquidity risk. Liquidity risk originates from the mismatch between the timings of cash inflows and outflows. for instance. In both Basel I and Basel II. one of the key functions of the banking industry in a modern economic system is to allow the reallocation of financial resources from the liquid sectors (those which have excess financial resources to invest) to the illiquid ones. In fact. The banking industry is necessarily exposed to a maturity mismatch. This phenomenon grew to systemic proportions since many in the industry had been massively leveraging maturity mismatches between assets and liabilities as a key component of an extremely profitable business model. such that even institutions with high ratings and excellent asset quality found themselves trouble as a result of liquidity mismatches. 2010 2.Basel III: What’s New? Business and Technological Challenges September 17. this provision has resulted in an inconsistency: after years of sterile debate on the possible methodologies for calculating internal capital for liquidity risk. The entire Basel framework only looked at the asset side of the balance sheet. are not subject to any regulatory capital requirement. Regulators are therefore trying to cope with the problem the other way around: forcing banks to build liquid reserves such that. In other words. i. they ensure that if a stress occurs then banks can withstand cash imbalances until the situation returns to normality. liquidity risk received only limited attention. Such a stringent approach to liquidity risk supervision is indeed rather new in the regulatory framework.
Move to reassure banks on tough rules. Basel Committee representatives mentioned that estimates such as those quoted above could be excessively pessimistic. Investors are likely to require a lower return on capital as a result of the perception of a lower risk. with the United States somewhere in the middle” as per the following table: Cumulative Effects Results in Summary difference between regulatory change and base scenario Difference in average rates: Real GDP growth difference United States Euro Area Japan G3 (GDP-weighted) 2011-15 -.06 2011-20 -.01 -.McKinsey expects that the return on equity (ROE) of the banking sector in Europe could decline by 5% compared to its long-term average of 15% At the end of the G20 meeting in Toronto. Letter to the G20 Meeting in Toronto.03 • According to a McKinsey survey on European banks4. 2010 2. We will quote two authoritative ones: • The Institute for International Finance3 has estimated that “the current calibration of regulatory reform would subtract an annual average of about 0.The recent announcement by Unicredit. July 2010 Institute for International Finance. 3. without public support2. Interim Report on the Cumulative Impact on the Global Economy of Proposed Changes in the Banking Regulatory Framework. of a new hybrid product designed to match the new capital eligibility requirements is an example in this direction.3 percentage points from the growth path over the full ten year period. The Euro Area would be hit the hardest. • NSFR: increase in long-term funding (>1 year) in the range of Eur.05 -. General Manager of the Bank for International Settlements. tried to reassure banks that the new rules “will not undermine economic growth” and will . 2 3 See Mario Draghi. June 2010 4 Basel III: What the draft proposals might mean for European banking. the third largest European bank by market value.5 to 5.04 -. Also.0 trillion (this compares to current outstanding long-term unsecured debt of Eur. 2011-2020.03 -.Several studies have tried to measure the cost for banks and the broader economy of the new rules as proposed by the Basel Committee in the December 2009 formulation. McKinsey on Corporate & Investment Banking. 10 trillion). • As to banks’profitability.1. Chairman of the Financial Stability Board.09 -.05 -. and to smoothen the impact of new regulation on costs. 5 July 2010 6 . Japan the least. Summer 2010 5 The Financial Times.6 percentage points from the path of real GDP growth over the five year period 2011-15. The Regulatory Effort In the regulator’s view the new requirements will have to be stringent: capital and liquidity resources will be such that the financial system must have the strength to withstand a crisis of the size and persistency of the recent one. 2 trillion. 5 only have a “small and temporary” effect on demand . the impact of the liquidity ratios in their current versions is estimated as follows: • LCR: increase in liquid asset holdings in the region of Eur.Basel III: What’s New? Business and Technological Challenges September 17. banks are likely to build new products designed to match the more stringent regulatory requirements in terms of both capital and medium/long term funding. Security will come at a cost. Jaime Caruana.McKinsey provides an estimate that covers both the liquidity ratios and the proposed tougher requirements on capital. and an average of about 0. particularly on the basis that they do not sufficiently account for the dynamics of the financial system and the behavior of its operators.
The regulators are moving across unknown ground and it is difficult to assess the potential outcome of the new constraints. The ratios are as follows: • Liquidity Coverage Ratio:focuses on the shorter end of the time horizon and is aimed at ensuring that each bank owns liquid resources to such an amount that short-term cash obligations are fulfilled even under a severe stress. 2. 2010 Nevertheless. while at the same time creating the space to assess their potential impact on all the phases of the cycle. • Net Stable Funding Ratio: looks at a medium-term horizon and focuses on the structural balance between maturities of a bank’s assets and liabilities. subsequently amended in the communiqué of 26 July. supervisors want to avoid them hitting economies while a difficult recovery is taking its course. Net cash outflows are calculated by aggregating the bank’s assets and liabilities under standardized categories and applying to each of them standardized coefficients reflecting predefined stress assumptions.The NSFR will be finalized and introduced as a regulatory standard on 1 January 2018. The Committee proposes to introduce two new ratios (Liquidity Coverage Ratio and Net Stable Funding Ratio) that banks must maintain as a minimum at all times to ensure they maintain sufficient liquidity to withstand cash obligations even under stress. It is aimed at preventing banks from exposing themselves to extreme maturity transformation risks by funding medium and long-term assets with very short-term liabilities. It was this practice that generated a massive risk in 2007. 7 .The decisions stated in the BIS 26 July statement. which turned into a systemic liquidity shortage when major short-term liquidity channels (especially those linked to securitized products) suddenly dried up. Standards and Monitoring. The New Liquidity Requirements BCBS’s proposals for enhanced liquidity requirements were presented in the consultative document: International Framework for Liquidity Risk Measurement. are a clear sign of this. which defined very long transition periods for the newest and most challenging subset of the new planned requirements (the Leverage Ratio and the Net Stable Funding Ratio). published in December 2009. For the NSFR. the regulatory effort is extremely delicate.For example.Basel III: What’s New? Business and Technological Challenges September 17.2. The ratio requires banks hold enough liquid assets to offset the sum of all cash outflows expected over the next 30 days: Stock of High-Quality Liquid Assets > = 100% Net Cash Outflows over a 30-day Period Liquid assets are considered in terms of market value. By delaying the new regulations until after a full economic cycle has taken place. the 26 July statement set forth an “observation phase to address any unintended consequences across business models or funding structures” . 2010 and finally formalized on 12 September.to which standardized haircuts are applied depending on type of asset and grade of liquidity.a 75% factor applied to unsecured wholesale funding in the denominator of the ratio entails an assumption that 75% of the currently outstanding amount will run off within the next 30 days.
for instance. the NSFR is calculated by aggregating a bank’s assets and liabilities (including contingent liabilities) into standardized categories and applying a set of coefficients reflecting standard scenario assumptions regarding.or because they can be considered “sticky”even if their contractual maturity falls within that year (as is the case.Securitizable assets. the Committee has listed a set of monitoring metrics that should be considered as the minimum types of information supervisors should use in their monitoring activity. for instance. .Assets from securitizations (unless for covered bonds). As well the LCR. 2010 The NSFR requires banks to have enough funding to last at least one year to compensate for all cash needs expected to occur beyond the same deadline: Available Amount of Stable Funding >= 100% Required Amount of Stable Funding Available Amount of Stable Funding is made up by cash. either because they have a longer contractual maturity. equity prices. .Any security with rating lower than A-.These include: .Market-related monitoring tools: asset prices and liquidity. . for which banks must therefore have 100% Stable Funding: .Contractual maturity mismatch. • Monitoring tools: in addition to the ratios. CDS spreads.Basel III: What’s New? Business and Technological Challenges September 17. equity and liabilities which are expected to remain with the bank for at least one year. 8 . for a share of retail deposits). etc. . Required Amount of Stable Funding is the amount of assets that are not expected to be reimbursed for at least one year (and therefore need to be funded for at least this period) and cash outflows expected to occur beyond one year as a result of contingent liabilities. No favourable treatment is envisaged for the following instruments.Securities issued by banks or other financial institutions. .Available unencumbered assets. . the “stickiness” of the bank’s deposit base.Concentration of funding.
1. independently of the regulatory requirements. For instance. compliance with the ratios should be seen as a minimum requirement and should not be taken in itself as a sufficient indicator of soundness or stability. if a bank is heavily involved in correspondent banking. a standardized assumption on the runoff of deposits in case of stress can be too loose in one situation and unnecessarily strict in another. etc.The observation periods are standardized irrespective of individual banks’ business models. for instance on month two. 2010 2. and be perfectly compliant with the LCR. In other words. where 30 days would be considered a short-term observation period. Each bank should then define the required amount of the liquid asset buffer on this basis. .The ratios only look at liquidity gaps in defined time horizons. In fact.The significance of standardized aggregations and stress assumptions can differ substantially across banks with different sizes and business models. A bank could have very substantial liquidity exposures.6 and should by no means override these. The New Liquidity Ratios: Tasks and Issues 2. 6 Basel Committee for Banking Supervision. Insufficiency of Standardized Figures The Basel proposals entail all banks maintaining the liquid asset buffer such that the Liquidity Coverage Ratio is above 100% at all times. i.3.The ratios are calculated with pre-defined standard aggregations and stress assumptions (a one-size-fits-all approach). those operating in different countries. No information is provided about liquidity exposures in other periods (from 30 days to one year and from one year onwards). Principles for sound liquidity risk management and supervision. then 30 days could be a very long-term horizon. the Basel Committee has made clear that the ratio requirements must be seen in conjunction with the principles for liquidity risk management best practice set forth in the 2008 document. In this context the Basel ratio should be seen as an external minimum constraint.Basel III: What’s New? Business and Technological Challenges September 17. each bank defines its own risk appetite and runs internal stress tests for liquidity exposures that reflect its individual business model and vulnerabilities. However.3. It is imperative that on top of complying with the regulatory ratios.e. September 2008 9 . as opposed to a bank heavily focused on the retail deposit base.exclusively looking at the two ratios could leave critical weaknesses and exposures completely hidden: . We will get back to this topic later in this document. For instance.but the possibility that the optimal buffer is higher than that required by the regulatory ratios should not be ruled out. . clearing and settlement activities.
banks with a large deposit base performed better than others. Speculative Trading It is critical that the final calibration of requirements generates a grid of balanced incentives for different kinds of banking activities. 80% of banks that had a ‘solid funding ratio’before the crisis that was above 0. Oliver Wyman 2009 10 . long-term debt and equity capital over liabilities) have performed significantly better on average compared to banks relying on shorter-term funding options. In this sample of selected global banks in developed markets.00 Industry average Average Solid Funding Ratio Before-Crisis (Jan ‘04-July ‘07) Source: Bloomberg.25 0.This is also consistent with the outcome of an Oliver Wyman survey:“Banks which had a solid funding base (defined as the ratio between customer deposits. 2. Retail and corporate deposit taking and lending should be granted a favourable treatment as opposed to more speculative activities. A fundamental rationale for this is that a favourable treatment should be reserved for those parts of banking that respond to a public interest at the broader economy level. 2010 2. During the crisis.3.Basel III: What’s New? Business and Technological Challenges September 17.65 0.75 1. Building Differentiated Incentives to Traditional Banking vs. From a more technical perspective. where as all banks below 0. customer deposits deserve a favourable treatment as they are the most stable funding source for a bank.65 underperformed significantly”7 as also shown by the following chart: Solid funding ratio Before-Crisis contributes to shareholder value creation After-Crisis Selected global banks in developed markets After-Crisis SPI (Aug ‘07-Dec ‘08) 400 200 0 -200 -400 -600 -800 -1000 -1200 0. Datastream and Olive Wyman analysis 7 State of the Financial Services Industry Report. Liquidity mismatch risk should be more politically and socially acceptable to the extent that it responds to the crucial role of the banking industry of efficiently reallocating financial resources across lending and borrowing sectors of the economy.65 outperformed the industry average after the crisis.50 0.
capital is directly and fully eligible as a “stable” funding source in support of medium/long term liquidity needs. more speculative instruments such as derivatives (especially if traded over-the-counter) are subject to much higher capital requirements. and 50% if granted to non-financial corporations. Need to Raise New Capital One of the main issues with the new regulatory requirements is that banks may prove unable to raise capital or medium/long-term funding in the amounts required. this penalizing assumption could be smoothed. as it is assumed that banks will be forced to roll over beyond the one-year horizon 85% of such loans if granted to retail clients. When we come to the liquidity ratios. Indeed. the implication of this is that investors would be asked for new capital under the certainty that it will be invested into low-yield instruments. we believe the incentive to “traditional”lending could be further enhanced.the Basel ratios are uniform irrespective of the size of the banks to which they apply. loans with maturity below one year severely impact the required amount of medium/long-term funding. capital is only indirectly considered as an eligible source of liquidity for the calculation of the ratio: it is taken into account only to the extent it is invested into eligible liquid assets. 2010 The task of providing differentiated incentives for “traditional” banking as opposed to more speculative financial activity is apparent in how the Committee has addressed the new requirements for capital and leverage. conditions could be defined under which a more favourable treatment in the NSFR is allowed for medium/long-term maturity assets that are bound to be securitized in the short run. Accounting for Bank’s Size In their current formulation. Nevertheless. In fact: • In the NSFR. 11 .3. 2. Even if two banks show equal ratios.3. however. Investors might be ready to accept a lower return on their capital in view of lower risk. such differentiation of incentives is less clear.4. while not providing the desired degree of protection against systemic effects for larger banks. Here. but this will need to be tested. We will address securitizations in a dedicated section later in this document. In our view.3. the BIS has shown it will to move in this direction in the 26 July document by defining a more favourable treatment of deposits from retail and small to medium-size enterprises both in the LCR and the NSFR. and then invest it to build the liquid asset buffer.the potential systemic impact of a liquidity issue can be totally different depending on the absolute amounts of their exposures. It should be noted that there is a clear interdependence between capital and liquidity requirements. Also. and netting of derivatives is in principle forbidden. Indeed. For instance. in the current formulation of the leverage ratio a variety of derivatives are fully considered as assets to be accounted for against capital. the Committee’s idea is clearly for banks first to raise the amounts of new capital as required. a uniform measure can prove unnecessarily strict for smaller banks. 2. We would therefore find it suitable that the individual bank’s size be taken into account in the definition of the standard requirement. • In the LCR. and of mortgages in the NSFR.Basel III: What’s New? Business and Technological Challenges September 17. However. In this view. Also.
2010 If banks are not able to raise new capital in the amounts required then the only alternative would be to reduce assets.personal loans etc: the NSFR states that loans with maturity exceeding one year must be funded with medium/long-term finance up to percentages that depend on the loan credit quality and are completely independent of the possibility of being securitized. the case for securitization is still valid.5. Securitization Disruption In its current formulation.Investor’s perspective: grant a more favorable treatment to ABS by applying coefficients that do not imply full medium/long-term funding. whereby liquid assets are fully considered in the calculation of total assets to be put against capital as per the current proposal from the Basel Committee. securitizations can effectively provide reserve liquidity to the extent that asset-backed securities (ABS) are eligible as collateral for repos with the relevant central bank (as is currently the case under certain conditions with the European Central Bank). .Basel III: What’s New? Business and Technological Challenges September 17. the NSFR has the potential to disrupt the market for asset securitizations. As a result. Examples of possible approaches are as follows: . Indeed. lending banks cannot draw any benefits in terms of treasury from securitizations. and it is important to avoid throwing out the baby with the bathwater.3. allow ABS that are eligible for central bank repo to be accounted for as liquid assets. This undesired impact would be exacerbated in the context of a constrained leverage ratio. The misuse of ABS was indeed a main instigating factor for the crisis in 2007. and would therefore grant them a greater degree of freedom in making strategic decisions about the amount of credit available for clients. In addition. 12 .Perspective of a bank willing to grant medium/long-term credit to its customers in the form of mortgages.This could hit the broader economy by capping the amount of credit available to it. the core attractiveness of securitization is its capacity to transform assets that are illiquid in nature into liquid instruments that can be managed and traded on a short-term basis.The NSFR approach appears unnecessarily strict. 2. Indeed. ABS misuse should be addressed by specific regulation.This would allow banks using borrowed resources to fund the liquid asset buffer.The NSFR should instead recognize the case for securitization and allow banks to manage liquidity exposures accordingly.This characteristic is denied by the NSFR from two perspectives: . this provision does not appear to be fully justified in theory and could in our view be lifted.Lender’s perspective: allow banks with an established and demonstrable record of asset securitization to segregate certain loans that have been issued in view of being securitized over a specified time horizon and fund them over that specified time horizon.Perspective of a bank willing to invest in asset-backed securities: ABS are not eligible as liquid assets to any extent. However.credit card loans. All holdings of ABS with a maturity exceeding one year are 100% accounted for in the determination of required stable funding and must be matched with medium/long-term funding. .
it would generate a strong incentive to increase the average maturity of interbank deposits. At the same time.Basel III: What’s New? Business and Technological Challenges September 17. cannot be considered as liquid assets and cannot count 100% as required stable funding. It should be noted that the NSFR provides a clear counter-incentive for banks to invest in securities issued by other banks as these. as they could still fund 30-year loans with 12-monthplus-one-day funding. such that not enough time would be left to find viable solutions in case of generalized and persistent stress. 9 This type of requirement is not new in liquidity risk supervision. a looser approach to ABS and securitizations as suggested in Paragraph 3.5 above would help in this respect. Indeed. 13 . what is at stake here is the impact on the broader economy. Also. To the extent that sufficient debt is not available.6. start of the crisis. the only option for banks would be to reduce the amount of medium/long-term credit available. Again. While substantially reducing the impact on borrowing costs for banks.The Bank of Italy required for some years local banks to comply with the so-called “Maturity Transformation Rule” that implied a limitation on the possibility to get exposed to maturity mismatches. Raising New Medium/Long-Term Finance (NSFR) Even after considering new liquid resources incoming from capital increases. At the same time.Therefore. It might not be obvious that non-financial investors are ready to provide medium/long-term finance in the amounts required. at what prices. And even if they were then the question could be asked. which is currently unnaturally and undesirably stuck to the shortest end of the maturity ladder.This rule was lifted some years ago. we would favor smoothing the calculation of the ratio in a number of ways. 2010 2. they would probably try to pass additional funding costs on to customers such that the cost of credit would increase. What the NSFR is addressing is the building of massive maturity mismatches over the short run.such a time horizon would probably still provide a sufficient timeframe for finding solutions in case of systemic and persistent stress.3. well before the . which is important from a systemic perspective9. no matter how actively traded. For instance. We believe the NSFR addresses a real need in the banking industry because it sets a limit on the ability to create maturity mismatches in the short run. the observation period could be shortened to 6 months.To the extent that banks succeed in raising debt in the required amount. banks should seek new debt from non-financial sectors. It should also be noted that the NSFR does not prevent banks from assuming maturity mismatches. concerns about the possible impacts of NSFR on banks and the economy are the core reason for delaying the introduction of the NSFR as a requirement until 2018. banks would probably still need to raise new medium/long-term funding in quite substantial amounts to comply with the NSFR.2.
3. they cannot be treated as liquid assets and are fully considered in determining the minimum required amount for medium/long term funding. 2010 2. if a bank holds securities issued by banks or other financial institutions. The BIS 26 July statement has broadened the acceptable criteria for security that are eligible as liquid assets. This would apply to both instruments eligible and non-eligible as liquid assets.such as six months and above. This would act as a de facto constraint for banks that finance government deficits. although not in any way removed. this might be a desirable effect that would help preserve financial stability at the global level. for the reasons explained above. neither in the LCR nor in the NSFR is interbank funding granted any favorable treatment as an eligible source of liquidity in relation to potential cash obligations. As a result.3. interbank financing is only apparent and does not provide any safety if there is a systemic funding liquidity issue. Both ratios are calculated upon the stress assumption that no maturing interbank liabilities will be rolled over and no new interbank funding will be available. It will be important that distortions are closely monitored and assessed. • Market prices would no longer be indicative of the market’s risk appetite and required risk/reward profiles. in NSFR these have a 100% weighting in the calculation of Required Stable Funding.compared to the current one month and below. 14 . Reshaping Interbank Deposit Markets A clear task of the Basel Committee is to reduce individual bank’s dependence on interbank funding. As a result. while the market for instruments not eligible for the buffer would be negatively impacted. The ratios have been built on the assumption that from a system point of view. • The above would negatively impact the ability of non-banking industries to raise funds through bond markets. 2. In addition. higher yields and lower prices. Therefore. Given the current imbalanced situation of public finances worldwide. with reduced liquidity. While in agreement with this approach.8. we nevertheless believe that the requirement might be smoothed in view of encouraging a reshaping of the interbank deposit market towards a more desirable concentration of trades on longer maturities. such that further calibration can be done to minimize such effects.Basel III: What’s New? Business and Technological Challenges September 17. no matter how liquid.7. G8 liquid government bonds. But at the same time this would have undesirable consequences: • Bond markets would be distorted: liquidity and prices of liquid assets would be artificially increased and their yield depressed. Distorting Bond Markets The LCR is likely to generate a huge shift in demand towards assets eligible for inclusion in the liquid asset buffer – in essence. banks will be allowed to rely on outstanding interbank funding only to the extent they have a contractually formalized right to avoid repayment for more than 30 days (LCR) or for more than one year (NSFR).The potential for the above impacts is therefore reduced.
The survival horizon is the period over which the existing liquid or liquefiable resources are sufficient to support all expected cash outflows under the defined stress assumptions. . after integrating the potential impact of different kinds of liquidity risk (e. Discussion Paper. i. after proper impact assessment. 10 APRA’s prudential approach to ADI liquidity risk. The LCR is in fact based on a survival horizon model with a 30-day observation period and standardized stress assumptions. while not expressly imposing SH-modeled reporting. Individual requirements for liquid asset holdings must be defined after the results of individual stress tests. typically low-yield instruments.Basel III: What’s New? Business and Technological Challenges September 17. The need to hold substantially greater amounts of liquid assets will oblige banks to switch part of their investments from more profitable assets to high-quality. the sum of expected cash flows over a defined period. did disclose during public hearings that it will use banks’reported figures to feed SH models in order to assess their resilience against stress. Basel Committee documents make it clear that the regulatory ratios should not be seen as absolute.g. models not being expressly included by the Basel Committee in its list of mandatory metrics banks are required to use in liquidity risk assessment. 11 September 2009 15 . excluding certain categories of liquid assets from the calculation of the leverage ratio.1. APRA. Survival Horizon Models: Optimizing the Liquidity Buffer in a Comprehensive Risk Management Framework Despite ‘survival horizon’. and the regulatory ratios should rather be seen as a regulatory minimum. Survival horizon models are effective in delivering a synthetic indicator of a bank’s resistance to stress.e. However.4. including an obligation for banks to provide survival horizon analysis10. The UK’s regulator. Survival horizon models are based on a comparison of ‘forward liquidity exposure’.The Net Stable Funding Ratio will determine the minimum amount of medium/long term funding given capital. or ‘survival period’.The Liquidity Coverage Ratio will determine the minimum amount of liquid assets given expected cash flows over the short run (unless the results of bank-specific stress tests mandate holding greater amounts of liquid assets). 2. liquid asset holdings are fully taken into account in the calculation of the leverage ratio – although the Basel Committee has stated it might consider. 2010 2. This trade-off might be further emphasized by the envisaged leverage ratio: in the current proposal. the FSA. market and funding liquidity risk) and a variety of scenario assumptions. they are gaining space among supervisors for their ability to provide a synthetic indicator of a bank’s resilience against liquidity stresses. Australia’s regulator.Both terms of the comparison are made subject to stress assumptions of defined severity. they lend themselves to providing a single measure that can be used as a reference for the definition of the bank’s risk tolerance. to the amount of cash that the bank can expect to raise by selling or pledging its liquefiable assets over the same period. medium/long lending business and contingent liabilities.4. in 2009 released a consultation paper where it envisaged a new regulatory regime for liquidity risk. As such. The Relationship between the Basel Ratios and Bank – Specific Survival Horizon Models The new liquidity ratios will have a key role in defining banks’ strategies: .
stress tests should tend to stress business strategies and business models rather than external risk factors.Basel III: What’s New? Business and Technological Challenges September 17.e. The required liquid asset buffer should be defined as the minimum amount that ensures the bank’s ability to fulfil expected cash obligations. 16 . idiosyncratic. the following key elements: • A synthetic indicator of the bank’s risk appetite. reporting and decision-making. the main steps of the process can be schematized as follows: i) The bank’s board formally defines the bank’s liquidity risk tolerance. iii) The bank calculates its survival horizon under the defined stress assumptions. its calculation should be performed within the framework of a process that has its core in the bank’s Risk Tolerance Policy and includes procedures for monitoring. In our view. iv) The bank compares the minimum liquid asset buffer resulting from the above process to the regulatory amount based on the Basel ratio. business model and vulnerabilities. the required amount of liquid assets should be defined as the maximum of the results of the regulatory ratios and the amount resulting from individual stress testing.e. As an example. and • The level of severity of the stress assumptions. that the bank will continuously monitor and control.combined) to be used in monitoring the bank’s compliance with the defined risk threshold. controlled and reported. As a result. The required amount of liquid assets is the one that ensures matching the minimum survival period as defined in the risk tolerance policy.market-wide. such a process would be most effectively supported by a stress-based survival horizon model. Bank-specific stress tests should be based on assumptions designed to match the bank’s specific context.2. i. the liquidity risk appetite could be synthetically expressed as the capability to survive for two weeks under a high-severity stress scenario and for three months under a mild-severity stress scenario. ii) Based upon indicators from the risk tolerance policy. It therefore has critical implications in terms of allocation of resources and risk-taking strategy. The greatest of the two is the required liquid asset buffer.We would mention reverse stress testing as a particularly suitable technique for this task. among other things. In our view. Calculating the Amount of the Liquidity Buffer The Basel Committee has outlined that banks’ stress tests must not be seen as an isolated exercise but rather be seamlessly inserted into their organizational processes and provide inputs for decision-making and action. At a high level. the maximum amount of risk it is willing to bear in its activity. This maximum risk should be defined under a stress scenario and expressed in terms of indicators that can be continuously monitored. 2010 Therefore. 2. A ‘risk tolerance policy’ document should include. as well as the type(s) of scenario (i.As such.4. a survival horizon model is a particularly suitable framework for defining the synthetic indicator of liquidity risk appetite. the bank defines in detail the stress scenario assumptions that it will periodically test for its survivability capacity.
risk monitoring and control.3. unpredicted severe scenarios. . such that the adequacy of the buffer must be assessed for each day in the observation period. the buffer should be prudentially maintained above the minimum. and decision making to prevent risk from climbing above the defined risk appetite thresholds. Banks will therefore need to optimize the amount of liquid assets by actively managing the portfolio so that it is kept as close to the minimum required amount as possible. as only instruments that can be very quickly liquefied should be held as a shield against short-term. In this perspective. Guidelines on Liquidity Buffers & Survival Periods.4. . If simulated data are to remain static for long intervals due to an inability to update the stressed simulations. . In other words. 9 December 2009 17 .Basel III: What’s New? Business and Technological Challenges September 17. as cash outflow needs to be fulfilled whenever it occurs. 11 Committee of European Banking Supervisors. 2010 The above schematic only refers to a fraction of the overall process. the following implications of optimizing the liquid asset buffer should be considered: .both the Basel Committee and the Committee of European Banking Supervisors (CEBS) guidance documents make clear that internal processes need to ensure full consistency and integration of risk tolerance definition. the bank should be able to obtain up-to-date reports by re-running cash flow projections and liquid asset price simulations under the defined stress assumptions with a high frequency in order to have the possibility of adjusting downwards the required amount of the buffer.The CEBS clarifies in its guidance document11 that the global amount of the liquid asset buffer should be entirely driven by the longer end of the stress scenario horizon.Indeed. High frequency updates of current and simulated data would in fact ensure that the bank is prompt in catching early-warning signals that would trigger an increase of the buffer amount.The stress assumptions used to build the model underlying the required buffer amount should also be reviewed on a regular basis.Cash flow projections should be available over the time periods and with the time bucket granularity required by the model chosen for defining the risk tolerance. frequently updating projections and stressed simulations should be seen as a prerequisite to keeping the portfolio at a level which is very close to the required minimum.Actively managing the liquid asset portfolio implies that information relevant for measuring the required minimum buffer is available as frequently as possible. low-yield instruments. The following summary figure provides a schematic: Risk Tolerance Policy Stress Test Liquid Asset Buffer Survival Horizon Early Warnings Limits Contingency Funding Plans 2. Only looking at cumulative cash inflows and outflows over a defined time period will not ensure protection against possible stress. stress testing. Optimising the Liquid Asset Buffer The liquid asset buffer is typically composed of high-quality.Also.However. .results on the shorter end should be relevant for defining the composition of the buffer.
and have neither a maturity nor an incentive to redeem. especially securitizations and derivatives. will be completely eliminated. and the remaining part must be comprised of instruments that are subordinated. 3. Pillar 1 was in the definition of risk-weighted assets.The main drawback in the current framework is that the regulatory adjustments are applied either to a combination of Tier 1 and Tier 2 capital or only to Tier 1 capital. Assume however that a big cash outflow is expected on day five.To assess whether the liquid asset buffer is sufficient for this task. but there is a need to increase the risk sensitivity within the framework to promote better risk management and to reduce regulatory arbitrage. The qualifying criteria for the classification of the capital instruments into common equity. which was allowed to offset market risk under Basel II. In the cumulative 30-day cash flow projection the two flows will offset each other so that the spike in cash needs on day five will remain hidden. quantity and international consistency of the capital base. Tier 1 capital is defined as items that can absorb losses under a going concern assumption.Basel III: What’s New? Business and Technological Challenges September 17.This section summarizes the salient features in the December 2009 proposals as well as subsequent communiqués related to capital base. application of regulatory adjustments and the lack of international harmonisation in the way the regulatory adjustments are calculated. the prudent recognition of minority interest for a banking subsidiary is now allowed. As a result. the risk sensitivity assumptions underlying various transaction types. 18 . and an equally big cash inflow is expected on day 29.and Tier 2 is defined as capital that can be used to offset losses as a gone concern. risk coverage. which provides the real loss absorbing capacity as a going concern. some of the earlier proposals have been softened.Tier 1 and Tier 2 capital have all been made more stringent. the Basel Committee showed that it intends to increase the quality. Also. countercyclical buffers and systemic risk. Under the current proposals. have fully discretionary non-cumulative dividends or coupons.The predominant form of Tier 1 capital must now be common shares and retained earnings. regulators are also introducing a non-risk based leverage ratio to reduce build up of leverage in the overall system. as opposed to the common equity component.1. was found to be insufficient during the financial crisis. Proposals Regarding Capital Basel II regulations that were finalized in 2004 were based on two key assumptions: the overall level of capital in the system is sufficient. Capital Base The proposal addresses the shortcomings in the current capital framework in terms of the quality of the capital. In the July 2010 communiqué. When the draft proposal was introduced in December 2009. 2010 Example: Assume a bank’s risk tolerance policy sets the survival horizon at one month. and highlights some of the potential inconsistencies and perverse incentives inherent in the rules as currently proposed. the buffer may prove insufficient to cover the cash requirement on days five to 29. Tier 3 capital. Therefore the focus of Basel II. which outlines the broad agreement reached between the Board of Governors of the Basel Committee. For example. but agreed to revisit the issue after ratification of Basel II. leverage ratio. With the December 2009 paper on Strengthening the Resilience of the Banking System.The financial crisis expedited the need for re-definition of capital since items that were considered Tier 1 capital could not absorb losses as a going concern. In addition.BCBS is also introducing rules to reduce pro-cyclicality inherent in the Basel II framework. while also increasing capital requirements for certain types of transactions and obligors. the bank compares the current buffer to the net of cumulative cash inflows and outflows over 30 days under the internally defined stress assumptions. 3. the Basel Committee had introduced stringent measures on eligibility of minority interest for inclusion in the common equity component of Tier 1 and deduction of deferred tax assets from Tier 1. Regulators did recognize the need to refine the definition of the capital components.
Flexibility and performance of existing risk systems is critical to achieving this requirement without major system re-engineering. Effective expected positive exposures (EEPE) is calculated by first calculating exposures under multiple (Monte Carlo) scenarios and time paths. if it appears that more capital is required to support counterparty trading activity then it is more desirable to apply a transparent scalar to increase capital to the desired level. After the quantitative impact study. Under the current proposals. and then calculating the average exposure taking into account roll-off effects. particularly for exposures with non-linear risk profiles. BCBS has focused heavily on this section. increasing margin periods of risk.requiring higher risk weights for financial counterparties. A major thrust of the proposed Basel III rules focus on counterparty credit risk (CCR) arising from bank’s derivative. as well as stress testing and back testing requirements.There are multiple areas in which the regulators want to increase capital requirements. In addition. Therefore. The alpha add-on factor under Basel II already captures the general wrong-way risk. The limitations of the current practices were highlighted during the financial crisis. strengthening the collateral management function. using stressed EEPE will double-count general wrong-way risk. industry or product characteristics and not a single alpha across all counterparties. During the financial crisis it was observed that the exposures to counterparties increased precisely when their creditworthiness deteriorated. 3. To address this issue. alpha will provide a more useful measure of general wrong-way risk than the proposed stressed EPE. BCBS studies have shown that own estimates of alpha (ratio of bank internal estimate of economic capital based on stochastic exposures to economic capital based on EPE) are subject to significant variations across banks due to mis-specifications of the models.2. which can have a substantial effect in a trading book that’s already encumbered with additional market risk and incremental risk charge (IRC) capital requirements.1.accounting for CVA losses with capital. the new rules also propose to increase capital requirements for certain types of transactions and obligors. financial institutions would be required to disclose all components of the capital along with the regulatory adjustments. 19 . Stressed EEPE needs to be used in regulatory capital calculations in case it exceeds the EEPE calculated using current period market data. BCBS requires banks calculate CCR using stressed parameters. especially by the Lehman collapse.The committee intends to strengthen the requirements for own estimates of alpha to address this issue. 2010 With a view to improving the transparency of the capital base.Basel III: What’s New? Business and Technological Challenges September 17. providing incentives for banks to move trades to central counterparties. instead of double counting through alpha and stressed EPE.2.For banks that can implement such a system. with detailed guidance on addressing general and specific wrong-way risks.There is industry demand to allow alpha based on counterparty.This requires the bank calculate two EEPEs and compare the results on a periodic basis. 3. EEPE needs to be calculated using a three-year period that includes a one-year stress period. A stricter definition of capital will make it more expensive as well as be a binding constraint in business decision making. banks are required to provide a reconciliation of the regulatory capital elements back to the audited financial statements. Risk Coverage In addition to tightening the definition of capital. Addressing General Wrong-way Risk – Stressed EEPE General wrong-way risk occurs when the creditworthiness of the counterparties are positively correlated with general market risk factors. repo and securities financing transactions (SFT) operations.
will require a hedge that is equal to EEPE for duration equal to effective maturity.2. 2010 3. the “simple” bond equivalent approach can in fact end up causing perverse incentives.Basel III: What’s New? Business and Technological Challenges September 17. There is a double counting issue here as well. in the case of a downward sloping exposure profile. This entails modelling all of the counterparty’s exposures as a zero coupon bond with a notional amount equal to EEPE and a maturity equal to effective maturity (M) of the exposure profile. Given that full PFE profile and hedge information is already available as inputs to the EPE calculation. intuitive approach the Committee assumes will reduce the system and methodological burden for banks. For example.or under-estimation of the sensitivities and the required hedges. excluding the incremental risk charge. which assumes a single maturity date (set to effective maturity) and a constant exposure. BCBS is introducing a simplified “bond equivalent of the counterparty exposure” approach to calculating CVA risk. The bond equivalent approach is introduced to achieve methodological consistency across banks as well as to provide a simple. EPE will be close to the time zero exposure (which is the maximum exposure when the exposure is decreasing over time). it would be much more productive to allow banks to use internal models for capturing CVA leveraging full PFE profile. Depending on the shape of the PFE profile using only EPE and M to represent the full profile can result in over. 20 .This will overly burden banks to maintain two systems in addition to being contrary to the spirit of “use tests” . the bond equivalent approach is a poor approximation to CVA risk and does not properly capture hedge effectiveness.This will be consistent with the current Basel principles of mandating a simplified approach while providing banks with the incentive to move to internal models subject to supervisory review. the bank will need larger short-term hedges and smaller longer term hedges to effectively hedge counterparty risk that is decreasing over time. Therefore. it is an extra burden for banks that already calculate EPE using a simulation approach. Furthermore. Since global banks have diverging practices for CVA calculations. However.The existing maturity adjustment in the risk-weighted assets (RWA) formulas already account for migration risk with an analytical approximation. however. Furthermore.This will result in an inconsistency between the hedges required for the actual exposure versus the hedge required to minimize regulatory capital. In a downward sloping profile. Capturing CVA Losses During the financial crisis capital charge for mark-to-market losses was greater than the losses due to defaults. banks that already calculate EPE have the full distribution of potential future exposure (PFE) profiles at their disposal since EPE is essentially a function of the PFE distribution. the bond equivalent approach. banks will have to calculate CVA twice – once for internal purposes and then for regulatory purposes. From a sensitivity and stress testing perspective. However. CVA risk is defined as the regulatory market risk charge for this stylized position calculated using a 1-year horizon instead of the 10-day market risk horizon. Therefore.2.This maturity adjustment should be removed if the CVA charge is included in capital to avoid double counting. It is desirable to provide incentives for banks to develop fully-fledged CVA systems and use it for regulatory capital purposes. does provide an opportunity for banks that do not have a CVA system to calculate CVA in a simplified manner. if the bond equivalent approach is ratified. using the bond equivalent approach to model CVA risk will result in larger sensitivities for maturities less than M. and no sensitivity for maturities longer than M. The bond equivalent method.
A multiplicative factor of 1. 2010 BCBS has realized some of the shortcomings of the bond equivalent approach and is addressing some of the issues. broker/dealers and insurance companies with assets of over $100 billion as well as other (unregulated) financial intermediaries. 25% or higher than those of non-financial firms.2.The impact under the internal model method (IMM) can be possibly higher. The new treatment can increase EAD and capital easily by 10 times or more for derivatives where specific wrong-way risk exists under the current exposure method. It is encouraging that BCBS has mentioned addressing double counting. risk capture. region and industry or by other relevant categories.3. in relative terms. Transactions where specific wrong way risk (future exposure to a specific counterparty is highly correlated with the counterparty’s creditworthiness) has been identified will require significantly higher exposure measures.e.Basel III: What’s New? Business and Technological Challenges September 17. which in turn results in higher capital charges: • For single name credit default swaps (CDS) with specific wrong way risk (where the single name and issuer have a legal connection) exposure at default (EAD) = Notional Amount. although it is lacking in detail. high asset value correlation (AVC) financial institutions (typical profile being large inter-connected financial institution) by approximately 35% due to the non-linear relationship between capital and AVC. where counterparty exposures increase when the credit quality of the counterparty deteriorates.The July 2010 communiqué was encouraging as it will allow the bond equivalent approach to address hedging.25 (to be calibrated after a quantitative impact study) is to be applied on the formula used to compute the correlation for exposures to financial intermediaries that are regulated banks. This is in contrast to the Basel II treatment of calculating EAD under the ‘current exposure method’ for credit derivatives and equity derivatives as mark-to-market plus an add-on.We hope this will lead to full approval of internal CVA methodology and systems.2. This clause can increase capital to low probability of default (PD). and these scenarios should address the possibility of severe shocks occurring when relationships between risk factors change. BCBS has indicated that it will undertake a more fundamental review of the trading book and look at more advanced alternatives to the bond equivalent approach. • For equity derivatives referencing a single company (with specific wrong-way risk): EAD = value of the derivative under assumption of default of the underlying. Add-on factors for credit derivatives are 5% for a qualifying reference obligation and 10% for non-qualifying. Higher Risk Weights for Financial Institutions Empirical studies by the Basel Committee have indicated that asset value correlations for financial firms are. Banks should manage wrong-way risk by product. as we encounter that in many places in the document and this needs to be revised to ensure the rules are internally consistent.4. 21 . Banks are now required to perform stress testing and scenario analyses to identify risk factors that are positively correlated with counterparty credit worthiness. 3. such as hedge funds/financial guarantors. This provides a strong disincentive to trade such contracts outside of central counterparties. 3. Specific Wrong-way Risks Counterparty risk management standards are being raised where there is specific wrong way risk i. effective maturity and double counting.
since the likelihood of counterparties posting collateral decreases when their rating goes down. the 5000 limit for netting sets is better considered guidance. While all these rules are in the right direction and provide for a conservative approach. and for netting sets that contain one or more trades involving collateral that is illiquid.This is a conservative practice in line with the spirit of the new proposals.2. Going by the same logic. In order to make the rules symmetrical and internally consistent. the supervisory floor is set at five business days for netting sets consisting only of repo-style transactions.Basel III: What’s New? Business and Technological Challenges September 17. Increase Margin Period of Risk The financial crisis has shown that the mandated margin periods of risk for regulatory capital calculations under-estimated the realized risk during the financial crisis. If a netting set has experienced more than two margin call disputes over the previous two quarters then the margin period should be twice the supervisory floor for that netting set. some fallen angels downgraded so fast that the banks were not able to impose downgrade triggers.6. the bank will not be able to post collateral in a timely manner if its credit quality deteriorates rapidly.. the new proposals require that banks using internal models do not take into account clauses in the collateral agreement that require receipt of collateral when credit quality deteriorates. it is best captured either by a modified maturity adjustment or through the CVA. However. A higher supervisory floor applies to all netting sets where the number of trades exceeds 5. 3. and the ‘maturity adjustment’ captures the migration risk.2. or an OTC derivative that cannot easily be replaced. it would make sense not to model own bank downgrade triggers as well. some of the thresholds are arbitrary. Proposed rules will substantially reduce the effect of netting and collateral on exposure and capital for repo.SFT and OTC derivatives. Therefore. For transactions subject to daily re-margining and mark-to-market valuation. Preclude Downgrade Triggers Downgrade triggers are a popular credit mitigation technique banks use to cut off further lending to counterparties when their ratings fall below a threshold unless they post extra collateral. If the intention is to capture migration risk.000. The justification given by BCBS is that “ ..”. banks are required to take into account downgrade triggers imposed on them by their lenders. 2010 In the Basel II internal ratings-based (IRB) formulas.5. however. 3. For example. especially during a crisis when the downgrade happens rapidly. and 10 business days for all other netting sets for calculating EAD with margin agreements. 22 .. and these clauses did not provide the expected credit mitigation.. During the financial crisis.This is another instance of potential inconsistency in the proposals.AVC is used to capture the default risk part of capital.To increase the correlation value increases the default losses and not the migration losses. and adjusted based on the capabilities of the collateral management system and the liquidity of the instruments in the netting set.financial institutions credit quality deteriorated in a highly correlated manner.further providing incentives to move to central counterparties.
9 Stressed PDs for Highly Leveraged Counterparties New rules stipulate that PD for a highly levered counterparty should be estimated based on a period of stressed volatilities. the securitizations exhibited much higher price volatility than similarly rated corporate debt. as a failure of a central counterparty could make the problem much worse.7. The upshot of these rules will be more standardized OTC contracts clearing through CCPs.8. and stipulated strict controls around re-use of collateral. A better approach is for the committee to require banks to explicitly use leverage as a factor in determining PDs for all counterparties. major financial institutions could not tally exposures against counterparties across various transactions. Exposures to the central counterparty will receive a near-zero risk weight (1-3%).For example. Therefore. Central Counterparties At the height of the financial crisis in 2008. Collateral Management BCBS intends to strengthen the standards for collateral management and initial margining under Pillar 2. Bank risk systems should be flexible enough to calculate exposure and capital under multiple assumptions such as different margin periods of risk.Basel III: What’s New? Business and Technological Challenges September 17. BCBS supports the creation of a collateral management unit responsible for calculating and making margin calls and managing margin call disputes. Reliable data on collateral will enable the bank to use this data in PFE and EPE calculations. It would track the extent of reuse of collateral and the concentration to individual collateral asset classes. so the sensitivity of these specific rules on the level of capital can be compared. If this information was readily available the final outcome could have been different. regulators and economic policy makers could not make the right decisions in a timely manner. the standardized haircuts currently treat corporate debt and securitizations in the same manner. collateral haircuts for securitization exposures are doubled relative to similar rated corporate debt. for a bank that shows the regulator it has a comprehensive collateral management system and can easily handle large netting sets. Therefore. Furthermore. On a daily basis. Further. 23 .This would result in a more consistent treatment across all counterparties.2. 3. Given their systemic importance. the collateral management unit would accurately report levels of independent amounts.2.This again smacks of double counting. 3. providing banks with a strong incentive to move trades to the central counterparty clearing house (CCP). initial margins and variation margins. For example. CCPs should be strictly supervised through rigorous standards. In the Basel II framework. the increase in margin risk period should not be applied when the netting set exceeds 5000. During the crisis. There should be built-in regulatory incentives for banks to improve risk management systems. 2010 3. Leverage should be one of the factors already considered. BCBS has made re-securitizations ineligible as collateral going forward. different initial and variation margins. especially in rating financial counterparties.2. through-the-cycle (TTC) models capture stress periods in the rating estimate for all counterparties. when the US Treasury allowed Lehman Brothers to default it did not have a detailed picture of all the counterparties exposed to a Lehman default.
This type of requirement will be overly burdensome for smaller institutions with limited resources. interconnected firms should have a more robust and automated system for stress testing wrong-way risks and generating reverse stress tests. Banks should also conduct reverse stress test to identify extreme but plausible scenarios that could result in significant adverse outcomes on exposures and capital. Stress Testing Banks are required to have a comprehensive stress testing program for counterparty credit risk.then the bank should consider the higher degree of credit risk. equities. which would compare risk measures generated by the model against realized outcomes. Bank systems should be able to adapt to have more frequent stress tests and the ability to perform ad-hoc stress tests. the ‘standardized’ approach prescribes a higher risk weight to corporate exposures . Stress testing should be an integral part of the bank risk management policy.This resulted in the neglect of bank’s own independent internal assessment of risks to a certain degree. A comprehensive back testing program calls for a system that can handle large batch systems as well as provide the ability to set up ad-hoc queries. Ratings agencies have an incentive to produce “good ratings” since issuers. 24 . Back Testing Banks are required to conduct a regular back testing program.2. FX. Larger. With the new proposals low quality ratings would apply to unrated exposures that are pari passu or subordinated to the low quality rating.. For all counterparties.BCBS also proposes the elimination of the A.Basel III: What’s New? Business and Technological Challenges September 17.10. These requirements call for manipulation of large datasets. originators and investors all prefer “good ratings” Given the Basel II rules.12. This requires an integrated data and analytic platform across all significant risk types.11. the “cliff” For example.This provides banks with an incentive not to get ratings for companies that are likely to be rated below BB-. especially during a crisis period.2. that are rated below BB. banks should stress test principal market risk factors (e. and may also not be required since these institutions are typically not systemically important. 3. This includes ensuring complete trade capture and exposure aggregation across all forms of counterparty credit risk in a timely manner so as to conduct regular stress tests.g. 3. and this seems overly prescriptive. The proposals stipulate periodicity of stress tests. interest rates. However. stipulating periodicity and nature of stress tests with a one-size fits all approach is not ideal. Reduce Reliance on External Ratings A major consequence under Basel II was to rely excessively on external ratings for regulatory capital requirements.2. 2010 3. banks have an incentive to seek ratings just above . credit spreads and commodity prices) in order to identify outsized concentrations to specific directional sensitivities.(150%) than for unrated exposures (100%).minimum requirement for guarantors in the standardized approach and the foundation IRB approach. where broad market liquidity decreased significantly and liquidating positions of a large financial intermediary created a large market impact. Banks should internally assess if the risk weights applied (under the standardized approach) are appropriate for their inherent risk. Banks should also apply multi-factor stress tests which should analyze the impact of the portfolio under scenarios that reflect severe economic and market events that occurred during the financial crisis. If it turns out that the inherent risk is higher.
it is suggested that the new definition of Tier 1 capital as well as the ‘total capital’ and ‘tangible common equity’ be used. The Committee proposes to test a minimum Tier 1 leverage ratio of 3% during the parallel run period.S. and therefore lower leverage ratios for similar exposures. 12 Taken together. focusing on developing templates to track in a consistent manner the underlying components of the ratio. In particular. a simple measure of potential future exposure based on the standardized factors of the current exposure method (CEM) is to be applied to arrive at a “loan equivalent”amount for derivative products. . The 26 July document. which would serve as the basis for testing during the parallel run period: a) For off-balance-sheet (OBS) items use uniform credit conversion factors (CCFs) with a 10% CCF for unconditionally cancellable OBS commitments (subject to further review to ensure that the 10% CCF is appropriately conservative based on historical experience).3. b) For all derivatives (including credit derivatives).Migration to a Pillar 1 treatment from 1 January 2018 after proper calibration based on the results of the parallel run. stated that the phases of the transition to the adoption of the ratio are as such: . 25 . It would also strengthen the treatment of derivatives relative to the purely accounting based measure (and provide a simple way of addressing differences between IFRS and GAAP). 2010 3.Basel III: What’s New? Business and Technological Challenges September 17. This will result in additional business and system impact. In addition. this approach would result in a strong treatment for OBS items.Supervisory monitoring period from 2011 to 2012. . the proposals reinforce the risk-based requirements with a simple non-risk-based “backstop”measure based on gross exposure. The Committee agreed on the following design and calibration for the leverage ratio. the leverage ratio will need to be calibrated thoroughly in order to avoid level playing field issues that could easily occur. As a result. The additional leverage ratio will act as a binding constraint for some banks when deciding on whether to pursue new business. than does the use of U. apply Basel II netting plus a simple measure of potential future exposure based on the standardized factors of the current exposure method. Leverage Ratio Another major cause for the financial crisis was the uncontrolled build up of leverage in the banking system.Parallel run period from 1 January 2013 to 1 January 2017. Bank disclosure of the leverage ratio and its components will start on 1 January 2015. the use of International Financial Reporting Standards (IFRS) results in significantly higher total asset amounts. This ensures that all derivatives are converted in a consistent manner to a “loan equivalent”amount12. There are substantial differences in accounting treatments among jurisdictions.The leverage ratio would be calculated as an average over the quarter. Therefore. Generally Accepted Accounting Principles (GAAP). banks will have to examine the impact of a new transaction on both the capital ratio and leverage ratio. during which the leverage ratio and its components will be tracked.The July 2010 communiqué clarified that the leverage ratio will be calculated after applying Basel II netting for all derivatives (including credit derivatives). In order to constrain the build-up of leverage. Accounting regimes lead to the largest variations. For the purposes of calibration. confirmed by the 12 September press release.
it discriminates against safer assets and liabilities. they will have an incentive to invest in riskier assets. in order to maintain the same expected returns. is seriously flawed.With the emergence of Basel III we have an opportunity to reverse the trend towards splitting risk into different silos.These banks. the fact that no specific elements of different business models are taken into account by developing only a single indicator is a major weakness in the concept. Consequently. It is now clear that this compartmentalized approach. some of the most important examples being mortgages and credit provision to small and medium-sized enterprises. will decrease the leverage ratio. with add-ons to meet minimum regulatory requirements. However. As the other proposals of the Basel Committee pertain to an array of different areas. which of course will lead to the same answer: in the banking system.In our opinion.The unwelcome result will likely be that in periods of financial distress most of the risk that apparently will sit in these financial institutions will turn back to the banking organizations that were indirectly subsidizing the less regulated financial institution. 2010 c) Since the leverage ratio proposed by the Basel Committee is non risk sensitive.The leverage ratio will impact the business model of the bank on an integral basis. in their attempt to optimize their balance sheet in terms of risk. but not least there is a possibility that lending would shift from regulated banking to less regulated financial institutions. a differentiated adoption of Basel constraints across jurisdictions could prevent a competitive level playing field in terms of competition. d) Moreover. Banks that are facing the limits of the leverage ratio will have an incentive to take on riskier assets that provide higher returns.the only way to properly assess the impact of the leverage ratio is to see it in an integrated way with all the other proposals. But at the same time. In fact less risky assets – which usually also have lower returns – will become less attractive.Basel III: What’s New? Business and Technological Challenges September 17. 26 . This is certainly an unwelcome outcome that the Basel Committee should monitor carefully. This is seen in the way the Basel Committee is addressing liquidity risk. What we have learnt during the recent crisis is that – and this is also important from a reputational perspective – what ultimately matters is from where risk has originated. the overlaps with the leverage ratio will be numerous. Asset portfolios of banks that have fully adopted the Basel II framework (and therefore are using a risk sensitive approach for capital requirements purposes) are generally less risky compared to the non Basel II compliant banks. and specifically in the lack of recognition of the connections between leverage ratio. effectively increasing the risk appetite of the institution as a result of balance sheet constraints that need to be taken into account alongside the risk management considerations. capital requirements and liquidity buffer. we are concerned that the new rules could again fail to produce a framework that refutes the compartmentalized way of thinking. often the Basel II compliant banks have a higher leverage ratio to compensate for the lower revenue that is a consequence of having safer assets on the balance sheet. including those regarding the framework for liquidity risk. e) Last.In particular.
In this consultative paper. while reductions in a buffer would take effect immediately to help reduce the risk that the supply of credit would be constrained by regulatory capital requirements. since credit cycles are not always highly correlated across the jurisdictions to which they have credit exposures. 2010 3.“perhaps as infrequently as once every 10 to 20 years. • Promoting more forward-looking provisions.” In general.Basel III: What’s New? Business and Technological Challenges September 17. promote forward looking provisioning. In the annex (published in July 2010). Counter-Cyclical Capital Buffers The recent financial crisis highlighted the pro-cyclical amplification of financial shocks. The BCBS issued a consultative document regarding its proposal for a countercyclical capital buffer (the “Proposal”)13.published on July 22. such countercyclical capital buffers are expected to be deployed in a given jurisdiction only on an infrequent basis.2010.” The Proposal also notes that the BCBS is continuing to consider the home-host aspects of the Proposal. • Conserving capital to build buffers at individual banks and the banking sector to be used in times of stress.4. conserve capital for use in periods of stress and protect the overall banking system from excessive credit growth. The Proposal provides that a buffer would be “deployed 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. Under the Proposal. BCBS states that the capital conservation buffer should be available to absorb losses during a period of severe stress while the countercyclical buffer would extend the capital conservation range during periods of excess credit growth (or other appropriate national indicators). The measures proposed in the consultative paper are designed to dampen excess cyclicality. BCBS is considering ways to mitigate cyclicality.” Accordingly. national bank regulators would inform banks 12 months in advance of their judgment of any necessary “buffer add-on” in order to give banks time to build up the additional capital requirements. the BCBS stated that the four key objectives of introducing countercyclical buffers are: • Dampening any excess cyclicality of the minimum capital requirement. by adjusting for the compression of probability of default estimates in the IRB approach during benign credit conditions through the use of downturn probability of default estimates. (In other words. internationally active banks “will likely find themselves carrying a small buffer on a more frequent basis. • Achieving the broader macro prudential goal of protecting the banking sector from periods of excess credit growth. an internationally active bank’s buffer would effectively be equal to a weighted average of the buffer add-ons applied in jurisdictions to which it has exposures. 27 . internationally active banks would look at the geographic location of their credit exposures and calculate their buffer add-on for each exposure on the basis of the buffer in effect being in the jurisdiction in which the exposure is located. Through a quantitative impact study.) Accordingly. 13 The issue of procyclicality was specifically addressed by the BIS in the Working Paper:Countercyclical capital buffers:exploring options.
We have identified several design issues that we believe deserve further attention by the committee14: 1.Basel III: What’s New? Business and Technological Challenges September 17. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. Please see last section of this paper for an overview of the agreed detailed implementation timeline. The countercyclical buffer. but rather are expected to apply judgment in the setting of the buffer in their jurisdiction after using the best information available to gauge the build-up of system-wide risk. The rule-based approach. There is a general consensus on the need for stronger counter-cyclical capital buffers to be part of the Basel capital framework. 2010 To assist the relevant national banking regulators in each jurisdiction in making buffer decisions. A mixture of the two. would be introduced as an extension of the conservative buffer range. 14 More details on this topic can be found in the Algorithmics response to the Basel Committee on the countercyclical capital buffer. How do you avoid regulatory arbitrage associated with the introduction of a countercyclical regulatory capital measure? 7. iii. that national authorities are not expected to rely mechanistically on the credit/GDP guide. The BCBS noted. rule based or mixed? 2.this buffer will only be in effect when there is excess credit growth that results in a system-wide build up of risk. For any given country. The discretionary approach. Is there a need for a holistic balance sheet management approach? After a detailed analysis of possible alternative methodologies that can be used in determining the counter-cyclical capital buffer. 28 .5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. the BCBS developed a methodology to serve as a common starting reference point. What are the most appropriate policy instruments to introduce counter-cyclicality? 3. Which approach to follow in determining the counter-cyclical capital buffer: discretionary. The methodology “transforms the aggregate private sector credit/GDP gap into a suggested buffer add-on. when in effect. Does size and correlation matter during systemic crisis? 8. ii. though. This is clearly a powerful and necessary starting point.” with a zero guide add-on when credit/GDP is near or below its long-term trend and a positive guide add-on when credit/GDP exceeds its long-term trend by an amount which suggests there could be excess credit growth. How do you provide disincentives for the (mis)use of financial innovation and tighten counter-cyclical rules for financial institutions that extensively use it? 6. What is the most appropriate accounting treatment of a counter-cyclical capital reserve? 5. the challenge lies in the calibration of the parameters when trying to implement in practice this generally agreed objective. However. Is there a need for a counter-cyclical liquidity measure? 4. three approaches seem to emerge so far: i. In the latest September press release the Basel Committee agreed that a countercyclical buffer within a range of 0% – 2.
there is a clear case for having a counter-cyclical liquidity requirement as well. these rules should be implemented jointly. as currently outlined in the July consultative paper. excessive funding of longer term assets with short term debt by a bank can contribute as much or more to its failure as insufficient capital.The Turner and other (e.Treasury September 2009 Report argues. we recommend that further countercyclical measures be added..This could be combined with regulatory discretion to add additional requirements on top of the formula-driven element if macro-prudential analysis suggested that this was appropriate. because capital. 15 For a detailed analysis of this topic please refer to the leverage ratio section 3. as capital will never be enough to deal with serious liquidity problems. We believe this is the right approach to follow. where both current profits and losses are reported. Furthermore. these should satisfy both the needs of investors and those of financial stability. 2010 With a discretionary system. Using a formula-driven system. may be insufficient to deal with liquidity problems in a crisis. At a minimum we believe that any countercyclical buffer rules should consider an increase on capital requirements. bank regulators would need to judge the appropriate level of required capital ratios in light of analysis of the macroeconomic cycle and of macro-prudential concerns.S. one linked to the growth of credit. which would imply requiring more capital in a counter-cyclical way for institutions with large maturity mismatches. sufficient liquidity requirements are also very important. Geneva) reports make the case that there is merit in making the regime. As the U. However.This would force the banks to internalize higher liquidity risks as a cost. Consequently.The buffer must be able to absorb losses on a “going concern” basis. at least to a significant extent. As regards to accounting disclosure rules. the buffer must comprise the highest quality capital.Basel III: What’s New? Business and Technological Challenges September 17. An optimal approach may be to rely on dual disclosure. Banks with larger structural funding mismatches. the required level of capital would vary according to some predetermined metric such as the growth of the balance sheet. The Geneva Report and Warwick Report go further by recommending that regulators increase the existing capital requirements by two multiples. There are several options that have been analyzed in different consultative papers. It would depend crucially on the quality and independence of the judgments made. or those that rely on volatile short-term funding sources should be required to hold more capital. in particular: • A cap on leverage15 and • A capital multiplier if significant currency or maturity mismatch is found As solvency and liquidity are complementary. thus encouraging them to seek longer term funding. formula driven. to avoid regulatory capital arbitrage.g. Also. and need to be determined simultaneously with the general capital requirements in an integrated/out-of-silos framework. The accounting treatment of a counter-cyclical capital reserve is hugely important. as we will describe in the subsequent sections. and profits after deducting a non-distributable counter cyclical buffer that sets aside profits in good years for likely losses in the future. and the other to maturity mismatches. the report states that liquidity is always and everywhere a highly pro-cyclical phenomenon. Indeed. most likely equity and retained earnings.We believe that the right way forward is to consider a combination of instruments. research papers and international reports (see references at the end of this document) regarding instruments that can be used as a counter cyclical buffer. even though high.3 29 .
or at least tighten counter-cyclical rules for financial institutions that extensively use them.This exacerbates pro-cyclicality. It should also include counter-cyclical margin and collateral requirements on all securities and derivatives instruments. In addition to size. We strongly endorse this effort. transparent and objective view of the interplay among risk types. Regulators should introduce appropriate model risk capital charges if such instruments are traded.When new and complex products are originated and then distributed it is non-trivial to understand the interplay between risk classes. because in crisis situations they may need to be bailed out.Basel III: What’s New? Business and Technological Challenges September 17.The evolution of the collateralized debt obligation (CDO) market during the credit crunch is a good example of this. ultimately. instruments. opaque structured products embedding unclear leverage and optionalities all make it difficult to gain an overall. this cocktail will influence and drive the setting up of the overall business strategy.This would include also all non-banking financial institutions. The best approach utilizes equivalent comprehensive counter-cyclical regulation for all institutions.and those more exposed to system-wide shocks. The standards proposed in the consultative document can be seen as an effort by the Basel Committee to achieve a higher degree of harmonization among supervisory regimes for countercyclical capital buffer requirements. the comprehensiveness of counter-cyclical regulation is an important issue. a bank largely financing exposures through deposits should have a smaller countercyclical buffer relative to a bank that is completely dependent on wholesale funding. Having different capital buffers in different jurisdictions will contribute to differences in cost of capital. often opaque and complex instruments can hide and under-price risk. This might encourage regulatory arbitrage where multi-national companies will borrow from the cheapest jurisdiction that has a lower counter cyclical buffer to finance activity in other jurisdictions. It is therefore not always clear what exact business strategy is being pursued at a legal entity or even at the holding group level. when new and untested instruments that are difficult to value are introduced.S. The emphasis that the U. as well as all instruments within banks – by consolidating all activities onto the balance sheet. bank business models should also be taken into account. 30 . both nationally and internationally. Only through a holistic view of the balance sheet is it possible to disentangle and understand if the resulting “new”bank portfolio is aligned with the overall risk appetite of the bank. Both the size of individual banks and the total banking system – or even financial system – are important. We believe that as much effort as possible should be put into the convergence of local supervisory regimes of capital and liquidity risk supervision. To avoid regulatory arbitrage. Treasury report and other reports place on higher capital requirements for systemically important institutions draws on research from the BIS and elsewhere showing that large banks. insurance companies etc (the so-called shadow banking system). such as hedge funds. as new. Supervision and business strategy is a multidimensional discipline: increasingly complex balance sheets. 2010 Financial innovations increase during booms. timely. private equity.contribute more than proportionally to systemic risks. For example. and markets. regulatory and accounting treatments and how.
and under differing regulatory treatments. The Committee is in the process of developing policy options designed to reduce risks related to the failure of systemically relevant. communicating the business strategy to the interested internal and external stakeholders. where the interplay of liquidity risk and economic capital is more precisely described. the introduction of a capital and/or liquidity surcharge for cross-border institutions. These options include empowering the regulatory authorities to write-off or convert certain capital instruments into common shares when a bank becomes unviable. cross–border institutions. and accounting perspective is not a sophistication but a necessity. Systemic Risk One of the findings of the Committee is that while the interconnectedness of international banks has supported economic growth. 2010 The real problem has become that the resulting overall bank portfolio balance sheet at legal entity level is now very difficult to understand. and still looks to be. has been.Basel III: What’s New? Business and Technological Challenges September 17. This means that bankers need to use new “fit for purpose” tools and methodologies that can identify the real risk drivers.We strongly suggest that regulators endorse and gradually introduce. a challenge. in time of distress this interconnectedness transmits negative shocks across the financial system and the economy. and how this is aligned with the overall risk appetite of the financial institutions. The limitations of the current regulatory. their interplay.5. As a result. These proposals are expected to be issued for draft consultation in December 2010. organizational and business silos mindset is probably the biggest and toughest lesson learned from the crisis. regulatory. Consequently. We believe that the need to simultaneously look at the whole legal entity at balance sheet level (and at its dynamic evolution under stress conditions) from a risk. economic. accounting. or the introduction of contingent capital as an element of the capital base. in the spirit and in the letter of the upcoming legislation. 3. we recommend that the impact on the bank and the financial system as a whole be estimated once the stress tests are simultaneously and coherently (same time horizon and severity) executed across all risk types. this holistic view of the balance sheet. and the role they play within different legal jurisdictions. 31 .
5% 1. Some of the new rules address these issues.125% 60% 4.5% 1.375% 100% 4. It accounted for liquidity risk through Pillar 2.5% 3.It was liquidity risk that led to the failure of financial institutions like Northern Rock and Bear Sterns.5% 40% 4.0% 4. summarizes the key requirements and the required implementation deadlines. together with the introduction of a global liquidity standard. 2010 4.25% 6.0% 8. Basel II focused on calculating minimum capital requirements and postponed the discussion on capital quality and definitions. Some major banks. especially in the trading book. 32 .875% 6.had as its main objective increasing the risk sensitivity of capital requirements while maintaining the capital amount at a systemic level. while being well capitalized from a Basel II perspective.0% 8.0% 5. and these shortcomings in the Basel II framework in a way contributed to the capital arbitrage between the banking and trading books and provided incentives for banks to assume high-risk trading strategies.0% 8. some of this was misguided. The capital reforms.625% 6. Business impact and challenges: exploring the interplay between Liquidity and Capital The Basel II Accord.0% 8. the July 2009 Enhancements to Basel Framework addressed the inadequate capital requirements for securitization transactions. However.75% 80% 4.5% Phased out over 10 year horizon beginning 2013 Introduce Minimum Standard Introduce Minimum Standard Implementation timeline reported in the 12th September press release 5. Also.875% 6.0% 8.0% 8. There was a lot of faith in the risk sensitivity rules under Basel II.50% 7.5% 2.which was ratified in 2004. Annex 2 of the document. MSRs and financials) Minimum Tier 1 Capital Minimum Total Capital Minimum Total Capital plus conservation buffer Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital Liquidity coverage ratio Net stable funding ratio Observation Period begins Observation Period begins 2012 2013 2014 2015 2016 2017 2018 As of 1 January 2019 Supervisory monitoring Parallel run 1 Jan 2013 – 1 Jan 2017 Disclosure starts 1 Jan 2015 Migration to Pillar 1 3. securitization transactions got much more lenient treatment in the trading book versus the banking book.0% 8.25% 5.5% 4. Implementation Timelines At its 12 September 2010 meeting.5% 8.0% 100% 4. the Basel II accord did not consider leverage in determining the capital requirements of a bank.0% 8. had leverage ratios of 70:1 without taking into account netting (30:1 when netting is taken into account).5% 8. reproduced below.0% 6.0% 9. Phase-in arrangements (shading indicates transition periods) (all dates are as of 1 January) 2011 Leverage Ratio Minimum Common Equity Capital Ratio Capital Conservation Buffer Minimum common equity plus capital conservation buffer Phase-in of deductions from CET1 (including amounts exceeding the limit for DTAs.The capital requirements and the risk measurement mechanisms.0% 6. while discussion of liquidity risk had not matured by the time the financial crisis hit. led to regulatory arbitrage.5% 4.0% 10.Basel III: What’s New? Business and Technological Challenges September 17. the Group of Governors and Heads of Supervision fully endorsed the agreements reached on 26 July 2010.0% 9. deliver on the core of the global financial reform agenda and will be presented to the Seoul G20 Leaders summit in November.0% 20% 4. For example. For example.0% 8.625% 5.5% 0.and eliminated the possibility of capital arbitrage from the banking book to the trading book by aligning the capital requirements across the banking and the trading books.
Although these counterparties might be smaller. With Basel III this process becomes more complex. Some banks currently do not centrally collect collateral. estimates are high as 20-fold for some banks. the required rate of return for any investment in the banking sector will be high. Under the Basel II regime international banks were fairly well capitalized and regulatory capital was rarely binding.instituting a rigorous procedure can reduce CCF estimates in future periods as well as reduce losses in the current period. banks might reduce deferred tax assets (assuming profitability over the next few years). economic capital. This will lead to fine tuning of RWA in the bank’s effort for capital conservation.For example.Top 16 European banks will need to raise 700 Billion Euros in capital and 1. will become binding constraints when making business decisions. 33 . where mitigants are eligible across lending facilities to apply the mitigants to minimize total RWA across the lending facility. and for some large banks leverage ratios and liquidity ratios. Large multinational banks might look more keenly on regulatory arbitrage as capital becomes dearer. Currently most banks look at regulatory and economic capital when making business decisions. Trading books will almost certainly reduce given estimates that capital might increase about three fold. The proposed buffers – capital conservation buffer and the countercyclical capital buffer – are likely to smooth the capital requirement crests and troughs. Similarly. in total this effort will tend to reduce RWA significantly. but given the scope of the Basel III rules large scale restructuring of bank balance sheets and corporate structures are on the cards. However. by taking into account the differences in regulatory requirements across geographies while deciding the booking location for transactions. CCF models will also be refined to achieve capital optimization. leverage ratios and liquidity ratios. the need for the huge infusions of capital in the short to medium term places a huge strain on the capital markets. While the efforts by the Basel Committee are believed to result in lower systemic risk and lower risk for the individual banks over the longer term. As investors perceive that current risk in the banking system is high.banks will also raise deposits in countries where it is cheapest to fund business in other jurisdictions. banks will use credit mitigant optimization routines. and also how it impacts capital and liquidity buffers.8 trillion Euros in long-term funding. Banks will focus on data quality with a special focus on credit mitigation.As long as regulators allow them. and the proposed restrictions on earnings distributions is likely to create a strain in the capital markets till such time the perception of reduced risk in the banking sector sinks in the investors’ minds. guarantee and netting data for smaller obligors. Banks will need to examine the incremental impact of deals on regulatory capital. This. sell minorityowned subsidiaries and move away from unsecured interbank funding with larger banking groups. It is also estimated the Industry ROE would reduce by about 5% from its current level of 15 %. 2010 It is widely believed that the proposed capital and liquidity rules would significantly increase the banking sector’s capitalization and funding levels. viewed along with the lower ROE from the banking industry. One study by McKinsey titled “Basel III:What the draft proposals might mean for European banking”estimates that the industry would need to raise an additional 40% to 50% of its current Tier 1 capital base.Basel III: What’s New? Business and Technological Challenges September 17. Also. Although Basel III precludes using rating triggers to reduce EADs in the current period. with Basel III regulatory capital. Above estimates assume current bank structures remain the same.
34 . retail mortgages get better capital treatment than commercial mortgages. banks will move away from capital heavy sectors to capital light sectors and adjust the business model accordingly. Before the crisis.Working Paper No. Basel III is highlighting the integral nature of credit. Exploring Interconnections and Trade-Offs between Capital and Liquidity The new rules could repeat the mistakes of the past by compounding the ‘silo’-based approach to risk management. The longer implementation framework gives banks and regulators time to optimize the rules as well as not adversely affect the current tentative growth prospects for the economy. the systems still tend to be separate. there is no language to require banks to strengthen underwriting procedures for retail mortgages and other retail loans. although they were pushed to the brink due to liquidity risk. It is noted with interest that although the BCBS has increased capital on the capital markets side of the business. It is of course right that governments and regulators take stringent steps to ensure we never again find ourselves in a situation where billions of dollars of taxpayer’s money is used to save the banking system. This will cut off the vicious cycle of originate to securitize. Granted there has been a regulatory and business push to break down risk silos in recent years. In terms of the product analysis. Some strategies might reduce credit risk but increase liquidity risk. Regardless.” We expect BCBS to smooth out the internal inconsistencies and the double counting in the current proposals before finalizing the rules. It is imperative that banks gain a holistic view of risk. most banks appeared to be well capitalized.1. 5. for example.This has been driven by changes such as the introduction under Basel of the Incremental Risk Charge for market risk and the need to have a centralized credit valuation adjustment (CVA) desk with profit and loss responsibility. This suggests that banks and regulators need to think about a framework that better integrates all three types of risk. while the funding costs for OTC Derivatives. and strict rules regarding securitizations will reduce the incentive for banks to be lax on this front. However. the capital costs for OTC derivatives.Therefore. Operational risk meanwhile has moved under the market risk group.liquidity facilities and short term retail loans are expected to increase. liquidity facilities and short term/long term corporate loans are expected to increase. 2010 As regulatory capital becomes binding.covered bonds. market and liquidity risk. 16. For example.The recent emphasis on CVA risk is a first step towards some banks managing complex counterparty relationships and the interaction of market and credit risk in an effective way. In particular. with market and credit risk coming together over the last three to four years. 2009: Studies suggest that banks’exposures to market risk and credit risk vary with liquidity conditions in the market. mainly because of the analytical nature of measuring and managing operational risk. in most countries banks have strengthened underwriting procedures.Basel III: What’s New? Business and Technological Challenges September 17.“Findings on the interaction of market and credit risk. a move towards an integrated framework will let banks examine the impact of different hedging strategies. and liquidity conditions in turn are also determined by perceptions of market and credit risk.The following is a quote from the BCBS.fixed income bond investments.there will be a move away from these products. But to the question: Are we on the right track with Basel III? The answer at the moment is that it goes only part way to addressing the weaknesses of the established ‘silo’-based approach to risk management.
if an institution has a liquidity problem then it needs cash. 5. It is now clear that this compartmentalized approach.deeply ingrained problem. as things stand at the moment it seems the new rules will again fail to produce a framework that refutes the compartmentalized way of thinking. business lines and risk management. 2010 But these are minor advances in addressing a pervasive. Although the exercise showed that most banks will be able to withstand a significant and protracted period of stress. Indeed. Systems have been maintained mostly by decentralized IT functions supporting finance. funding liquidity risk. This has made it harder. then we must be prepared to engage in the more difficult intellectual challenge of viewing and managing risk holistically. Capital mitigates unexpected losses. and from there be in a position to put in place systems to effectively manage it. call for the stress testing of liquidity and capital separately. since the bank will start to be perceived as “riskier” Liquidity risk and capital are .The current stress test recommendations. then the value of the company and therefore also the value of the capital is likely to go down. for managers at the top to have an all-encompassing view of the risks on the group’s balance sheet. in general. the corporate structure of banks has also become more complex. There has been less thought given to reconciling data across systems. treasury. the tests focused on capital levels only. But this is a mistake. but not cash flow imbalances – i. not capital. Witness this summer’s widely publicized European bank stress test exercise.Basel III: What’s New? Business and Technological Challenges September 17. Misunderstanding How Liquidity Risk and Capital are Connected By viewing capital as a primary mitigant of liquidity risk we fail to understand the nature of that risk. This is seen in the way the Basel Committee is addressing liquidity risk. and ultimately a culture of risk management that has failed to view risk in a necessarily holistic way. piecemeal approach to developing risk management functions. If we are to have a real sense of the nature of liquidity risk. 35 . Liquidity risk is crystallized when a bank has to undertake a last minute fire sale of assets to meet its obligations. If we are to have a robust and truly risk-based framework then the interdependence of capital and liquidity risk must be addressed. which has led to benchmark risk management practices. such that their potential impact on the balance sheet can be properly accounted for. banks in general have tended to take a bottom-up.With the emergence of Basel III we have an opportunity to reverse the trend towards splitting risk into different silos. At the same time.When it comes to risk measurement and management. as trading and structured finance has become more spread out and complex.e. capital and liquidity. They completely failed to touch on liquidity risk.As the banking business has become more complex over the last 30 years. A truly effective risk management system would take a top-down approach to risk measurement and reporting. with add-ons to meet minimum regulatory requirements. As risk management has come into its own as a primary discipline within banks. viewing and managing the interconnections between risk factors at a high level. such that different parts of the business run their own profit and loss books.2. In short. reporting tools and risk management functions such as stress testing have not been integrated across different departments.One can see the attractiveness of trying to get to grips with liquidity risk by viewing it largely on a stand-alone basis. for example. the default option has been for banks to have separate units managing different types of risk. therefore inextricably linked. should a liquidity situation arise and the bank begins using reserves set aside to guard against liquidity risk in order to absorb losses and meet obligations. However. was seriously flawed. and specifically in the lack of recognition of the connections between leverage.
do not recognize this link. Banks developed market risk systems after the 1996 Amendment. the systems are prone to manual errors and find it difficult to cope with ad-hoc stress testing requirements that regulators are now pushing for. these systems originally focused on driving credit risk-weighted asset calculations. with manual interventions for regulatory and management reporting purposes under Basel II. Liquidity risk became a risk discipline only over the past few years. treasury. Technology Direction Over the last two decades. banks approached risk management from a silo approach across market. but manual aggregation was a practical solution given these stresses needed to be run typically only at a semi-annual frequency. The prescriptive nature of these ratios is not helpful. corporate. the implementation of the current approach does not effectively address the flawed silo-based approach. as it does not allow the tailoring of a liquidity risk buffer to the needs of the specific institution. However. Banks realized the shortcomings of current systems. 2010 The Basel Committee’s primary response to liquidity risk. Over the last three to four years banks also invested in expanding these data warehouses to cover credit economic capital. 36 . larger banks embarked on enterprise data warehouse projects to collect data across trading books. 6. local regulatory reporting and Basel pillar 3 reporting. With the advent of ICAAP stress test requirements banks needed to examine the impact of a market stress event across risk silos.There was no thought given to reconciling data across these systems. As with previous compartmentalized approaches to risk management. they addressed requirements of different departments within the banks. Risk management itself has come into its own as a primary discipline within the banking industry only over the past 15 years or so. retail and securitization exposures. As risk systems grew organically over the years with own data requirements. credit and operational risk.Basel III: What’s New? Business and Technological Challenges September 17.This is important from a best practice governance perspective. the senior management of the bank would decide on the size of the liquidity buffer and what survival horizon is appropriate for it. As such. risk management etc. Basel I was addressed mainly through finance systems. And if the institution holds less than necessary to maintain stability then the bank risks bankruptcy. the liquidity coverage ratio and the net stable funding ratio. Systems were maintained mostly by decentralized IT functions supporting finance. Under a top-down. because if an institution is holding more than the needed amount of liquid assets then the part of the liquidity buffer that is not needed has an opportunity cost associated with it – that money could be deployed elsewhere to make a higher return for shareholders. Spurred by Basel II. business lines. these ratios view liquidity risk more or less as a stand-alone risk silo. holistic risk management model. Market risk and operational risk were calculated separately and typically brought together at the reporting layer. reporting tools and stress test set ups. based on a careful assessment of the bank’s overall risk appetite. However.
• Drive the system with common risk factors to enable consistent stress testing across market. On the capital front. the pricing models used for market risk valuation purposes should be used for counterparty credit risk simulations. confidence intervals and primary functionality. Since this data will be shared across risk types. Cash flow generation for liquidity risk should also leverage the cash flow generation routines that should be common to market risk and CCR.measures. 2010 To address Basel III.functionality.We see a trend where banks extend the current market risk system for CCR mainly to ensure consistent pricing models.This will let the bank examine the impact across market. As computation has become cheaper it is feasible to use the same market risk pricing models for counterparty credit risk simulations. migration risk etc. this will also let the bank look at the impact on its capital and liquidity position of changes in assumptions.risk factors. Banks that have been successful in building enterprise data warehouses will want to expand them to address Basel III. This will enable business users to get a comprehensive view of the risk of incremental trades or hedging strategies. default/no default mode etc) will enable such a breakdown of sources of risk. • Consistent calculation engines that share common models and provide consistent measures across risk types. full granularity. data reconciliation requirements will be automatically met. For example.This would allow senior managers and investors to get a consistent view across the enterprise of the impact of different types of risk. such as name concentration. economic capital and liquidity risk should be extracted from source systems. banks will need to re-think data and IT strategy.g. CCR. it would let the bank examine the impact of an increase in the margin period of risk when there are over 5000 transactions in the netting set. RWA. The following table summarizes the current silos of risk types.Basel III: What’s New? Business and Technological Challenges September 17. credit and liquidity risk of incremental deals.their scope. Position and counterparty/obligor data should be driven from a single source of truth. 37 . An economic capital model that allows the user to configure economic capital calculations under multiple assumptions (e. sector concentration. For example. • Systems should allow both large volumes. There will be demand for systems than can perform “what-if” analysis based on incremental transactions or scenarios. Liquidity risk covers the enterprise and uses market risk factors for cash flow generation and stress testing. A single data load with all the attributes required for market. At most banks RWA and economic capital systems are now driven by the same data.This will lead to a system based on common data inputs to drive market. enterprise-wide batch runs while allowing for interactive what-if analysis. which is the ultimate aim of the system. credit and liquidity risks. using consistent data and models will allow the user to break down the differences between regulatory and economic capital into sources of risk. It will also let the bank check the impact of new regulations or assumptions such as the margin period of risk.The main drivers will be: • The ability to reconcile data across different risk categories. In addition to stress testing. • Integrated reporting across risk types. It will make sense for banks to leverage existing investment in Basel II systems to achieve this. For example. a particular hedge might reduce credit risk but increase liquidity risk. credit and liquidity risk.
Volatility etc. With Basel III. creditworthiness for CVA PFE at any CI. EAD. 3 and 5 year typically for capital planning 99. NSFR. reconciling to GL. 2010 Market Scope Trading book assets IR. EL Time horizon 10-day 1-year for EPE.. retail pooling. EPE.9% for regulatory purposes. survival horizon Short Term: daily up to 30-90 days Long Term: yearly up to 15-20 years Non Stochastic Stress Test Risk Factors Measures VaR. Volatility etc. FX. the trend is towards integrated systems moving to enterprise risk groups that will look at risk holistically. CCR Trading book assets IR. based on risk appetite for internal Additive measures. Equity. LCR. Providing underlying data from a single source of truth will result in a consistent. EAD. FLE. Risk types might focus on part of the book or the enterprise. Commodity.. and might need incremental data to drive calculation engines. Multi-year for PFE 1-year 1-year for ICAAP. 38 . LVaR.Basel III: What’s New? Business and Technological Challenges September 17. FX. reconciled system while providing long term cost savings in terms of reduced manual intervention. Undrawn allocation. Volatility etc. Equity. 95 or 99% for PFE 99. EL. different types of risks should be driven by common data. CVA RWA Enterprise assets PD. Correlation Matrix UL. stress testing Survival Horizon & Liquidity Buffer As can be seen. Commodity.The original Basel systems for credit risk moved from finance to capital management or risk management due to Basel II. collateral etc. Reverse stress tests Confidence level 99% 50% for EPE.9% Main functionality Stress testing Simulation through time incorporating all credit mitigation including netting. IRC RWA. mitigant optimization. Transition Matrix. survival probability Liquidity Enterprise assets and liabilities IR. M Credit Risk Enterprise assets PD. Equity. Commodity. LGD. LGD. The thrust in the future will be towards an integrated risk management platform for regulatory purposes that will allow for ad-hoc stress tests. cash flow generation CBC. FX.
It is. there should be consistent calculation engines that share common models and provide coherent measures across risk types.This will mean that senior managers will once again. counterparty credit risk. systems should be designed that allow both for large volume.Basel III: What’s New? Business and Technological Challenges September 17. The implementation of such measures would allow the interplay between capital and liquidity to be fully tested. while taking account of regulations and accounting standards. in turn allowing them to take a harder line if they feel they have to. A single data load with all the attributes required for market. That starts with the senior management establishing a detailed. economic capital and liquidity risk should be extracted from source systems. senior management will be able to view a ‘dashboard’of risk indicators that give them a true picture of their group balance sheet and variances from the stated risk appetite. as well as at lower business or division levels. data reconciliation requirements would be automatically met. There should also be integrated reporting across risk types to give senior managers and investors a consistent view across the enterprise of the impact of different types of risk. RWA. With this breaking down of risk silos. Systems should be developed based on common data inputs to drive market. This ensures that shareholders. cash flow generation for liquidity risk should use the same cash flow generation routines common to market risk and counterparty credit risk. take ownership of the bank portfolio balance sheet at the legal entity level. therefore. like the days before the emergence of complex banking. clearly defined definition of the overall risk appetite of the bank. Since this data would be shared across risk types. 2010 7. a number of steps should be taken to ensure that the bank truly takes ownership of the risks it is running at the group level. 39 .This will also enable consistent stress testing across market. credit and liquidity risks. As Basel III progresses it is crucial that the interconnected nature of the risks on the balance sheet are properly assessed. From there. enterprise-wide batch runs and also interactive ‘what-if’ analysis. as they will all be driven by common risk factors. At the same time. deposit holders and other stakeholders have a clear understanding of the business strategy. credit and liquidity risk. time to break down those silos. For example. Conclusion: Moving Towards a Holistic System It is clear that we need to break down the silo-based approach to managing risk and that Basel III is the best opportunity we have of doing it. Meanwhile.
2010 http://www. 9 December 2009 18. Basel Committee of Banking Supervision. Press Release. F. April 2009. International Framework for Liquidity Risk Measurement. Group of Governors and Heads of Supervision announces higher global minimum capital standard. Strengthening the Resilience of the banking Sector. http://www.algorithmics. Financial Stability Forum Report. December 2007.algorithmics. July 2010 17. 15. 16. April 2010 http://www. 2009: 11. Battaglia and M. published on July 22.cfm?code=wp39 3.com/EN/media/pdfs/Algo-GC0409-LtrBaselCom. Principles for sound liquidity risk management and supervision. Good. European Banking Supervisors.com/EN/publications/whitepapers 6. 2010 REFERENCES 1. 2010. December 2007.algorithmics.pdf 4. 2010 16. Mario Draghi. Onorato and S. Algorithmics whitepaper: Towards active management of counterparty credit risk with CVA. July 26. M. F. APRA’s prudential approach to ADI liquidity risk. Liquidity Risk: Comparing Regulations Across Jurisdictions and The Role of Central Banks. Battaglia. Algorithmics whitepaper: Credit Value Adjustment and the changing environment for pricing and managing counterparty credit risk. standards and monitoring. 2010 14. Addressing Procyclicality in the Financial System.com/EN/media/pdfs/Algo-GC0410-LtrBaselCom2. http://www.algorithmics. 2010. Working Paper No. Guidelines on Liquidity Buffers & Survival Periods. Basel Committee of Banking Supervision. Basel Committee of Banking Supervision. http://www.Basel III: What’s New? Business and Technological Challenges September 17. Algorithmics’Response to the Basel Committee's request for comments on the consultative document: Proposed Enhancements to the Basel II Framework. 40 . Liquidity Risk Management – Assessing and Planning for Adverse Events.algorithmics. April 2009 http://www. June 2009 http://www. Algorithmics’Response to the Basel Committee’s request for comments on the consultative document: International framework for liquidity risk measurement. Letter to the G20 Meeting in Toronto. Basel Committee for Banking Supervision. Sept 12. Algorithmics' Response to the FSA's CP 09/13 – Strengthening Liquidity Standard 2: Liquidity Reporting.algorithmics. Basel Committee of Banking Supervision Working Paper: Countercyclical capital buffers: exploring options. Chairman of the Financial Stability Board. Basel Committee of Banking Supervision. Standards and Monitoring.com/EN/publications/whitepapers 8.com/EN/publications/whitepapers/registration. 11 September 2009 7. September 2008 10. Discussion Paper. Basel Committee of Banking Supervision. Annex. December 2009 12.com/EN/publications/whitepapers 5. December 2009 13.“Findings on the interaction of market and credit risk. Onorato.pdf 2. Strengthening the Resilience of the banking Sector.com/EN/publications/whitepapers 9.algorithmics.
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