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Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III
Publication date: 09-Jun-2011 10:35:09 EST
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Banks around the globe are preparing for Basel III's higher capital requirements. The minimum common equity regulatory capital ratio will gradually increase to 7% in 2019 (including a 2.5% "capital conservation buffer") from its current 2%. Banks will also be subject to a variable countercyclical buffer set by national authorities of up to 250 basis points (bps). Institutions deemed systemically important will need to hold an additional but still unspecified capital buffer. Standard & Poor's Ratings Services believes this buffer could be up to 300 bps in several mature markets. We introduced our risk-adjusted capital framework (RACF) in April 2009 to address comparability issues with the regulatory ratios that we believe will persist under Basel III. The RACF also includes our opinion about potential unexpected losses, which may differ from bank models or regulatory approaches. (Watch the related CreditMatters TV segment titled, "Standard & Poor's Risk-Adjusted Capital Framework: How It Compares With Basel III Recommendations," dated June 9, 2011.) Although it is built independently from regulatory ratios, our RAC ratio provides insight into Basel III levels in a globally consistent manner. In particular, our RAC ratio already addresses several areas of Basel III, including multiplying market-risk capital charges by a factor of 3, deducting tax losses carried forward from capital, deducting the change in the fair value of debt from capital, and imposing a 1,250% risk weight (i.e., one for one) to securitization equity tranches. For example, on trading book market risk, our risk-weighted assets (RWA) average only 3% higher than Basel II.5 estimates (increased trading-book capital requirements to be implemented in 2011) for a sample of banks with large investment-banking businesses. Although Basel III ratios are subject to numerous assumptions, some banks started to estimate them (see chart 1).
For this sample of banks, the average RAC ratio after diversification is comparable to the common equity tier 1 (CET1) ratio estimated under Basel III. There is, however, significant volatility around this average. For example, the RAC ratio is 3% to 5% lower than Basel III estimates for U.S. trust banks. Our framework translates into higher operational-risk capital charges on assets under custody and assets under management, which are major businesses for trust banks (see U.S. Trust Banks' Off-Balance-Sheet Exposures Are Addressed In The Risk-Adjusted Capital Framework, published March 4, 2011, on RatingsDirect on the Global Credit Portal). We believe that asset managers' operational risk has increased significantly during the past decade. In particular, we apply a heavier capital charge for cash and money-market funds to reflect the financial support many independent asset managers (or parent banking companies) might provide to their funds.
http://www.standardandpoors.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245306237078[5/31/2012 6:12:30 PM]
g. we highlighted the need for higher capital requirements related to the trading book (see Trading Losses At Financial Institutions Underscore Need For Greater Market Risk Capital. regulators are still conducting the fundamental review of trading-book rules. or loans (i. the inclusion of the stressed VaR alone already at least doubles the capital requirements. This new charge will capture risk at a http://www. The stressed VaR is computed using market parameters calibrated to a period of stress (e. leveraged loans and commercial real estate loans). scheduled to be completed by year-end 2011. published Apr. whereas they had only one previously. Even after regulators implement the new trading-book regime in 2011. We believe that the stressed VaR will reduce procyclicality of regulatory capital charges. we highlighted that our approach is to scale up the regulatory capital by a factor of three. capital charges for securitization positions in the trading book will be aligned to charges for securitization positions in the banking book.5" by the market. The Swiss banks have already implemented Basel II. This includes banks with an approved VaR model. Banks in most mature markets. we expect the improved disclosure to help market participants' analysis of trading-book market risks. our RAC ratio has integrated a capital charge for trading-book market risk that is three to four times higher than current regulatory charges derived from VaR models. 15. we expect the capital charge in our RAC ratio to remain higher than the charge under Basel II. 2008).. consist of higher charges for securitization exposures and the introduction of a "stressed" value at risk (VaR) and an "incremental risk charge" (IRC). this risk is poorly captured by specific-risk VaR models (which often merely capture spread risk at unchanged level of ratings). We believe reported Basel II.5 ratios will begin to converge to our RAC ratio.e.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245306237078[5/31/2012 6:12:30 PM] . and excludes "correlation trading" positions for which a "comprehensive risk measure" can be developed with supervisory approval.5. including the U.5 In April 2008..S&P | Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III | Americas RAC Ratio Already Addresses Some Enhancements Of Basel III Trading-book market-risk capital requirement will triple under Basel II. Finally..S.5. Under Basel II. Assuming that the current conditions are less stressful than the period used for the stressed VaR. In our opinion. we believe that the average capital requirements for market risk in the trading book will triple with the implementation of Basel II. 2008). However.5 for Swiss Financial Market Supervisory Authority (FINMA) regulatory purposes since the beginning of the year.5 (see chart 2). As the stress VaR and the IRC metrics become publicly available. the introduction of the IRC aims to capture credit risk (default risk and migration risk) for securities in the trading book such as bonds. In particular. credit derivatives. dubbed "Basel II. Chart 2 Since its introduction in April 2009.5 reduces capital arbitrage opportunities between banking and trading book. These increased capital requirements. We believe that Basel II. Overall. will have to increase their regulatory capital requirements with regard to the trading book at year-end 2011. These regulators have up to four market-risk internal models to validate. banks have to compute a stressed VaR in addition to the current VaR-based capital requirements. In particular.standardandpoors.
the risk weight on DTAs will be 250%.K. Instead. we expect differences in regulatory risk weights to remain as much driven by differences in banks' risk profiles as by variation in the methodology and models they use to assess the risk weights. adding rules from local regulators) when translating the recommendations from the BCBS into local regulation. For example.K.60 Tier-one capital 9. the most conservative bank estimated a probability of default for corporate obligors rated 'A' 10 times higher than the estimate of the most aggressive one.30 0.) A significant part of Basel III is devoted to raising the quality. ¶Based on APRA 20% loss given default (LGD) floor compared to the FSA's 10% and the group's downturn LGD loss experience. Comparability issues will persist under Basel III On Dec. (See Bank Capital Methodology And Assumptions. the Commonwealth Bank of Australia's Tier 1 capital ratio as of December 2010 would be 13.7% under the Australian rules (see table 1). there is no single implementation of the Basel recommendations.80 0.60 0.10 *Represents fundamental Tier 1 capital net of Tier 1 deductions. based on APRA risk weights under APS 112 compared to the FSA's standard. 16. 2010.5% under FSA rules instead of 9.standardandpoors.20 10. The liquidity horizon appears more suited to these products than the classic 10-day VaR. each country exercises its own national discretions and potentially engages in "goldplating" (i. Even within the same jurisdiction.50 Total capital 11.10 0.60 0. We expect this to neutralize some. jointly with mortgage servicing rights and significant minority financial institutions holdings).60 0. Financial Services Authority (FSA) on 13 banks revealed very different estimates of probabilities of default for the same underlying risk.80 13.50 1. Minority interests will be fully deducted from CET1 under Basel III.9% confidence interval will limit regulatory arbitrage with positions in the banking book. http://www.30 0. the Basel Committee on Banking Supervision (BCBS) released its final recommendations for "Basel III: A global regulatory framework for more resilient banks and banking systems.00 3. Source: Commonwealth Bank of Australia Basel II 2010 Pillar 3 report. On the one hand. Table 1 Regulatory Capital Frameworks Comparison For Commonwealth Bank Of Australia (%) Reported risk-weighted capital ratios RWA treatment-mortgages¶ and margin loans IRRBB risk weighted assets Future dividends (net of dividend reinvestment plan) Tax impact in EL v EP calculation Equity investments Value of in force (VIF) deductions§ Total adjustments Normalised FSA equivalent Common equity capital* 7.9% (versus 99% for VaR models).e. For example. published Dec. including the U. 2010. For example. §VIF at acquisition is treated as goodwill and intangibles and therefore is deducted at Tier 1 by APRA.S&P | Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III | Americas one-year horizon (versus 10 business days for VaR models) with liquidity horizons of at least three months and a confidence interval of 99.. Basel III rules require banks to deduct minority interests and deferred tax assets (DTAs) due to timing differences in some instances (particularly if they exceed 15% of the bank's CET1.50 3.60 15. Table 2 Calculation Of Total Adjusted Capital Common shareholders' equity Add minority interests: equity Deduct dividends not yet distributed Deduct revaluation reserves Deduct goodwill and nonservicing intangibles Deduct interest-only strips Deduct deferred tax loss carry forwards Add or deduct postretirement benefit adjustments Add or deduct cumulative effect of credit-spread-related revaluation of liabilities Add or deduct other equity adjustments = Adjusted common equity Add preferred stock and hybrid capital instruments (subject to limits) = Total adjusted capital National regulators implementing the Basel III recommendation may be more conservative than our definition on some factors and less on others. a study conducted by the U.10 0. Even if they are not deducted from capital under Basel III rules. 6.60 0. we use our own globally consistent definition of capital and risk-weighted assets (see table 2). This difference alone drives about 40% of the impact on the proforma CBA Tier 1 capital ratio.50 3.70 0.40 0.80 0.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245306237078[5/31/2012 6:12:30 PM] . for a detailed definition of each adjustment performed. the oneyear horizon and the 99. By contrast. of the national discretions affecting the numerators of the capital ratios. consistency.40 1. which is usually a higher risk weight than what we apply. For standardized portfolio." However.30 0.70 1. FSA allows VIF to be included in Tier 1 capital but deducted from total capital. but not all.20 0.20 0. and transparency of the capital base. The Australian rules impose a minimum 20% loss given default compared with 10% in most other countries.
419) Concentration Matters The RACF embeds explicit adjustments for concentration and diversification of credit.6 10. Each of the adjustments except the single-name can be positive (i. net of taxes Net change in foreign currency translation adjustment.5) (2.0) (4.972) (1. net of taxes Pension liability adjustment.7 8.647) Net change in Accumulated other comprehensive income (loss) Balance. net of taxes Net change in cash flow hedges.6 12.684) (20. Table 4 Concentration And Diversification Adjustments In The RACF Single name as % of corporate portfolio RWA Asia-Pacific average EEMEA average Latin America average North America average Western Europe average Global unweighted average Global median Global weighted 14. geographic concentration or diversification of the credit risk and equity riskweighted assets. and the weighted averages..8) 9.7 (3. net of taxes Adjustments to initially apply SFAS 158. 2008.5 2. Through this one-for-one risk weight.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245306237078[5/31/2012 6:12:30 PM] .8 Sector as % of corporate portfolio RWA 3. end of year Total common stockholders' equity and common shares outstanding Total stockholders' equity Comprehensive income (loss) Net income (loss) Net change in Accumulated other comprehensive income (loss) Comprehensive income (loss) Data for year ended Dec.5 2. which can lead to significant volatility in the capital ratio through the cycle.e. net of taxes – – (1. Table 3 Citigroup Consolidated Statement Of Changes In Stockholders' Equity (Mil. industry-sector concentration or diversification of the corporate portfolio.standardandpoors.3) (3.0 7. $) Accumulated other comprehensive income (loss) Balance. Source: 2008 annual report.9) Total adjustments as % of total RWA 6. As indicated by the significant differences among the simple averages.219) (20.250% under the RACF.6 9.118) (2. Another difference relates to accumulated other comprehensive income (AOCI).7 9.535) (25. the change in AOCI for Citigroup in 2008 represented 17% of its Tier 1 capital (see table 3). and concentration or diversification of business lines and risk types. The adjustment aims to capture four different components: single-name concentrations in the corporate portfolio..0 1. banks will likely include AOCI in CET1 capital.. Under the RACF.8 5.4 2.0 8.195) 70.1 10.9 8. and insurance risks.7 2.3) (16. a benefit) depending on the bank (see table 4).660) (10. the medians. Under Basel III.6 18.1 2. For example. On the other hand.3 8.2 26.2 32.630 (4.026) (6.2) 7.0 12.8 2. as long as the total of these holdings does not exceed 10% of the entity's issued common share capital.966 141. the range of concentration and diversification adjustments are extremely varied and significantly affect the RAC ratio for most banks. Those investments are risk weighted at 1. we neutralize double leverage in our capital metric.7 40.1) (4.7 2.e. significant minority financial institutions holdings (i.535) (48. beginning of year Net change in unrealized gains and losses on investment securities. holdings for which the bank has a stake more than 10% but less than 50%) will continue to be risk weighted like other exposures under Basel III.4 4. 31. (27. market.1 (12.e.S&P | Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III | Americas whereas we only deduct them on a case-by-case basis.9 Geographic as % of credit risk & equity RWA 7. operational. increase the risk-weighted assets) or negative (i.3 (4.9) http://www. we only consider unrealized gains or losses on equities in the denominator of the RAC ratio.1 Business and risk type as % of total RWA (5.
2011). reproduced or distributed in any form by any means. The Content shall not be used for any unlawful or unauthorized purposes. geographic and business line/risk type concentration and diversification Limits arbitrage between banking book and trading book Allows to finely differentiate risk weights based on each counterparty Different implementations and "goldplating" rules in different jurisdictions Globally consistent definition of capital In IRB No No In IRB Yes No Basel III In IRB No Yes In IRB ? Maybe¶ RACF No Yes Yes No* No Yes IRB-Internal ratings based. The Content is provided on an "as is" basis. In no event shall S&P Parties be liable to any party for any direct. New York (1) 212-438-3090. 2011 Basel's Global Quantitative Impact Study Exposes Large Banks' Regulatory Capital Shortfall. Trust Banks' Off-Balance-Sheet Exposures Are Addressed In The Risk-Adjusted Capital Framework. Banks Are Gearing Up For Capital Distributions. SOFTWARE ERRORS OR DEFECTS. Capital Is Still A Weakness For Large Global Banks. without the prior written permission of S&P. http://www. reverse engineered. *The RAC ratio uses a top-down approach calibrated at industry level." Related Criteria and Research U. Table 5 Highlights Of Differences Between Basel And Standard & Poor's RAC Ratios Basel II Allows banks to use their own models to compute risk weights Explicitely adjusts for single-name. Jan. incidental.S. Moreover. But this assessment is not explicitly included in Pillar I risk-weighted assets. its affiliates. employees or agents (collectively S&P Parties) do not guarantee the accuracy. punitive. software or other application or output therefrom) or any part thereof (Content) may be modified. Also. On the contrary. 2011 U.S. banks are required to conduct an internal capital-adequacy assessment that regulators will review. Basel III embeds transition arrangements to increase capital requirements gradually and phase out ineligible capital instruments during a 10-year period starting in 2013. model. regardless of the cause. THAT THE CONTENT'S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. for the results obtained from the use of the Content. or for the security or maintenance of any data input by the user. However. 2010 Trading Losses At Financial Institutions Underscore Need For Greater Market Risk Capital. 2010 U. Source: Standard & Poor's. S&P. Dec. elie_heriard_dubreuil@standardandpoors. 2011 Despite Significant Progress.S&P | Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III | Americas average RWA: Risk Weighted Assets. Banks' Risk-Adjusted Capital Has Improved. Despite a strong regulatory willingness to enhance the international consistency of Basel implementation--particularly regarding the definition of regulatory capital--we expect some material national discretions to remain.S.com Rodrigo Quintanilla. Jan. exemplary. compensatory. and any third-party providers. special or consequential damages. 18. 20. But Not Yet A Solution We believe that Basel III will reduce but not eliminate the considerable discrepancies in Basel Tier 1 capital ratio computations. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES. FREEDOM FROM BUGS.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245306237078[5/31/2012 6:12:30 PM] . Nov.com Bernard de Longevialle. As part of the second pillar of Basel. But Hurdles Remain. Dec. rodrigo_quintanilla@standardandpoors. thierry_grunspan@standardandpoors. ¶There is a scheduled 10-year transition period to Basel III with several grandfathering clauses. until April 17. April 15. officers. Paris (33) 1-4420-6739. as well as their directors. we believe that the multiple methodologies and approaches of the Basel framework and the reliance on internal models will continue to make comparisons of Basel III ratios an arduous exercise (see table 5). costs. 2010 Bank Capital Methodology And Assumptions. New York (1) 212-438-2949. shareholders. or stored in a database or retrieval system.com No content (including ratings. industry sector. 18. the Basel formula and hence Basel RWA assumes infinite granularity of the exposures and does not make any adjustment for institution-specific concentration or diversification. 6. March 4. S&P Parties are not responsible for any errors or omissions.standardandpoors. timeliness or availability of the Content.com Thierry Grunspan. Basel III is not yet implemented--not even translated into local jurisdictions (Basel II. This long road toward more comparability in regulatory capital ratios sheds new light on the statement made by the Basel Committee in 2005 that "Basel (II) is not a destination but a journey. completeness. But Remains Neutral To Negative For Ratings. bernard_delongevialle@standardandpoors. Paris (33) 1-4420-7334. 18. ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE. 2008 Primary Credit Analyst: Secondary Contacts: Elie Heriard Dubreuil. Source: Standard & Poor's. Basel III Is A Step In The Right Direction. INCLUDING. we seek to measure the quality of banks' risk-management practices in other parts of our rating process. credit-related analyses and data.5 was still in "request for comment" status in the U. indirect. BUT NOT LIMITED TO.S.
and www.com (subscription). Additional information about our ratings fees is available at www.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245306237078[5/31/2012 6:12:30 PM] . Credit-related analyses. judgment and experience of the user. S&P assumes no obligation to update the Content following publication in any form or format. (1) 212438-7280 or by e-mail to: research_request@standardandpoors.S&P | Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III | Americas expenses. S&P's public ratings and analyses are made available on its Web sites. 55 Water Street. S&P reserves the right to disseminate its opinions and analyses. and may be distributed through other means. No sharing of passwords/user IDs and no simultaneous access via the same password/user ID is permitted.com (free of charge). Any Passwords/user IDs issued by S&P to users are single user-dedicated and may ONLY be used by the individual to whom they have been assigned. legal fees. and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact or recommendations to purchase. certain business units of S&P may have information that is not available to other S&P business units. without limitation. While S&P has obtained information from sources it believes to be reliable. As a result. www. hold. including ratings.ratingsdirect. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. or sell any securities or to make any investment decisions.com and www. normally from issuers or underwriters of securities or from obligors. including via S&P publications and third-party redistributors. http://www.com/usratingsfees.com.standardandpoors. S&P does not act as a fiduciary or an investment advisor. S&P has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process. NY 10041.globalcreditportal. employees.standardandpoors. contact Client Services. S&P may receive compensation for its ratings and certain credit-related analyses. lost income or lost profits and opportunity costs) in connection with any use of the Content even if advised of the possibility of such damages.standardandpoors. translate. To reprint. New York. The Content should not be relied on and is not a substitute for the skill. S&P's opinions and analyses do not address the suitability of any security. S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. advisors and/or clients when making investment and other business decisions. or losses (including. its management. or use the data or information other than as provided herein.
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