Basel Regulation Changes Post 2008 Financial Crisis

21 March 2019 Financial AnalyticsPage 1
Changes to Basel Regulation
post 2008 crisis

Excessive Risk Taking
Sub-
Prime
Lending
Securitization
Housing prices
decline resulting in
sub-prime defaults
Sub-prime defaults,
Securitized assets
& derivatives
trading resulted in
huge
losses
Excessive leverage &
poor capital could not
absorb losses fully,
demanding fresh
equity infusion
Huge losses resulted
in a crisis of
confidence causing
liquidity to evaporate
Short term borrowing
demanded fresh
borrowing which
failed in liquidity crisis
Firms on the verge of
insolvency;
threatening system
failure
Governments step in
to inject capital to
prevent systemic
failure
In stressed market situations,
Credit Rating downgrades of
Financial
Institutions & securitized products
further lowered valuations &
increased losses

Objectives of Basel Committee
• The cornerstone of the Basel Committee’s reforms is stronger
capital and liquidity regulation.
• But at the same time, it is critical that these reforms are
accompanied by
• Improvements in supervision
• Risk management
• Governance
• Greater transparency
• Disclosure.

History of Basel Committee
• Basel I: the Basel Capital Accord, introduced in 1988 and focuses on
- Capital adequacy of financial institutions.
• Basel II: the New Capital Framework, issued in 2004, focuses on following three main
pillars
- Minimum capital Standard [Minimum CAR or CRAR]
- Supervisory review [Review by central Bank RBI, from time to time]
- Market discipline [Review by market, stake holders, customer, share holder, govt. etc.]
• Basel III: Basel III released in December, 2010, (implementation till March 31, 2020)"Basel
III" is a comprehensive set of reform measures in,
– Regulation,
– Supervision &
– Risk Management Of The Banking Sector.

Basel Regulation
Three pillars of BASEL-II still standing in BASEL-III
►Capital Adequacy
►Risk Coverage
►Leverage Ratio
►Liquidity Requirements
Capital Requirements
► Pillar 3 is designed to increase
the transparency in banking
system
► Increased in minimum public
disclosure of banks risk
information
► Improve disclosure of capital
structure
► Improve disclosure of risk
measurement and
management practices
► Improve disclosure of capital
adequacy
Market Discipline
►Whether Bank is
maintaining proper
capital or not, that
aspect will be reviewed
time to time by central
bank (RBI) in India
Supervisory Review

Basel III
Basel III
Capital
Proposals
Basel III
Liquidity
Proposals

Increased Capital
Requirementson Certain counterparty Credit Risks
Introduction of a Leverage Ratio
Addressing Procyclicality
Improving Quality & Consistency of
Regulatory Capital
Components of Basel III Capital

Basel III
Capital Requirements
Capital
Ratios
Capital
Buffer
s
Definitio
n Of
Capital

Total minimum capital
requirement remains at
8%, subject to new
capital Buffers.
Combined with
buffers, Total Risk-
based capital
Basel III
Risk-
based
Capital Ratios
Core Tier
1
Total Tier
1
Total
Capital
Basel 3 requires banks to
hold 4.5% of common
equity, up from 2%.
6% of capital must be Tier
1. Tier 2 no more than
2%.
Total Tier 1
increased from 4%
to 6%.
Other types of Tier 1
can account for 1.5%.
Combined with
buffers, Total Tier 1 =

Leverage Ratio
• Ratio of Tier 1 capital to total exposure (not risk weighted) must be
greater than 3% (Higher in U.S. and UK)
• Exposure includes all items on balance sheet, derivatives
exposures (calculated as in Basel I), securities financing
exposures, and some off-balance sheet items
• To be introduced on January 1, 2018 after a transition period

Basel III
Capital Buffers
Conservation Buffer
To be used by
banks in times of
stress
(2.5% of core Tier
1; to be met with
Common equity only)
Countercyclical Buffer
A range of up to
2.5% of common
equity.
Left to the
discretion of
national
regulator

To promote more medium & long-
term funding of the assets &
activities of the bank over a 1-year
horizon
Basel III
Global Liquidity
Standards
Liquidity
Coverage
Ratio
Net Stable
Funding
Ratio
Short-term liquidity
metric
Structural funding
metric
It requires banks to maintain high-
quality, unencumbered assets in
excess of their stressed cash outflows
over 30-day time.
201
5
201
8

Objectives of Basel III Liquidity Standards
• Basel III set out 2 liquidity ratios;
(A)short-term ratio
(B)A longer-term funding ratio by reference to the amount of
“longer-term-stable sources of funding” relative to the “liquidity
profiles” of the assets funded and the off-balance sheet exposures.
• The aim is to ensure banks maintain 30 days’ liquidity coverage
for extreme stress conditions

Macro prudential measures
• Stronger individual banks will lead to a stronger banking
system. Broader measures required to address the
procyclicality and resilience of the industry.
• Measure to address risks arising out of interconnectedness
among banks and moral hazards of the perception of too
big to fail.
• The following needs to be looked upon:
• Increased sensitivity to financial innovation
• Consistent and timely implementation of regulations
• Rigorous supervision to avoid risks.

Addressing procyclicality
• Contain the build up of excessive leverage by introducing
leverage ratios specially during period of credit expansion.
• Review different approaches to address any excess
cyclicality.
Capital Conservation Buffers
The CCB is the capital buffer that banks have to accumulate in
normal times to be used for offsetting losses during periods of stress
and adverse economic conditions. The banks will be required to hold
a minimum of 2.5% which is currently at 1.875% of the core capital.
• Indian banks to implement CCB by March 31st, 2020.

Contd..
• The Committee’s oversight body agreed on a
countercyclical buffer within a range of 0 to 2.5%.
• Countercyclical capital buffer requirement requires banks
to add capital at times when credit is growing rapidly so
that the buffer can be reduced when the financial cycle
turns.
• Thus, protecting the banking sector in periods of excess
aggregate credit growth

Provisioning
• The Committee published principles to assist in
addressing issues related to provisioning and fair value
measurement.
• Principles called for valuation adjustments to avoid
misstatement of both initial and subsequent profit and loss
recognition when there was significant valuation
uncertainty.
• Loan loss provisions should be robust and based on
sound methodologies that reflect expected credit losses in
the banks’ existing loan portfolio over the life of the
portfolio

Systemic risk and interconnectedness
• Excessive interconnectedness among systemically
important banks also transmitted shocks across the
financial system and economy.
• The Basel committee is developing a well integrated
approach which could include combinations of capital
surcharges, contingent capital and bail-in debt.
• Proposal on a provisional methodology comprising both
quantitative and qualitative indicators to assess the
systemic importance of financial institutions at a global level
is also being developed.

Contingent capital
• In case of “Gone concern”, the contractual terms of capital instruments
would require to include a clause that will allow them – at the discretion
of the relevant authority – to be written off or converted to equity if the
bank is judged to be non-viable by the relevant authority for e.g. Jet
Airways by SBI and PNB (Not a bank though).
• Review of “Going concern” is also underway.
The objective here is to decrease the probability of banks reaching the
point of non-viability and, if they do reach that point, to help ensure that
there are additional resources that would be available to manage the
resolution or restructuring of banking institutions.

Counterparty Credit Risk
• Credit value adjustment (CVA) is the amount by which a dealer must reduce
the value of transactions because of counterparty default risk
• For each of its derivatives counterparties, a bank calculates a quantity known
as the credit value adjustment (CVA). This is the expected loss because of the
possibility of a default by the counterparty.

Basel III
Capital Standards
125% increase of Tier 1 Capital
from 2% to 4.5% of RWAs.
50% increase in Total Tier 1
Capital from 4% to 6% of RWAs.
Redefining Common Equity and
its Structure & Content
Simplifying Tier 2 & Abolishing
Tier 3 Capital Ratios
Capital Buffers
2.5%
Conservatio
n Buffer
0%-2.5%
Countercyclic
al
Buffer
New 3% Leverage Ratio of
Tier 1 Capital; as part of
Pillar 2.
Total Tier 1
Capital
+
Capital Buffer
= 7% of
RWAs up
from 2%
Increase of 250%

Standardized Approach
• Generic Approach
• For banks with less quantitative expertise
• Capital charge calculated on individual debt issues
• Risk factors
• Exposure at default (EAD)
• Capital charge ratio = Function of (LGD) for retail
= Function of (PD) for institutions
• Capital Charge = EAD X Capital Charge ratio

Use of Expected Shortfall
• VaR with a 99% confidence level is being replaced by ES with a
97.5% confidence level
• The two measures are almost exactly the same when applied to
normal distributions but the second measure is higher for
distributions with heavier tails than the normal distribution

Stressed Expected Shortfall
• ES is to be estimated using data from what would have been a
stressed 250-day period for the bank’s current portfolio

The Shocks to Market Variables
• The 10-day time horizon used for VaR in Basel I and Basel II.5 is
being replaced by a calculation where the time horizon used for a
market variable in ES calculations depends on its liquidity
• Time horizons of 10, 20, 60,120, and 250 days are proposed

Trading Book vs. Banking Book
• FRTB attempts to make the distinction between the trading book
and the banking book clearer
• It has rules covering the (very rare) situations when instruments
can be moved from one book to another

Credit Trades
• The incremental risk charge is modified to recognize the distinction
between
• Credit spread risk
• Jump to default risk
• Credit spread risk is handled as a market risk.
• Jump to default risk is handled separately similarly to other credit risks
(with a 1-year 99.9% VaR calculation)
• Internal models not allowed for securitization products

Future Work
• The Committee continues to work on a range of initiatives important to bank
resilience.
• The efforts taken are:
• Fundamental review of the trading book
• Ratings and securitisations
• Systemically important banks
• Contingent capital
• Large exposures
• Cross-border bank resolution
• Review of Core Principles for Effective Banking Supervision
• Standards implementation

Fundamental review of the trading book
o The underlying principle is to ensure a stronger boundary between the banking and
trading books as well as to make transfers between the books much harder to justify.
(Such transfers, to reduce capital, were seen as a major contributor to the global financial crisis)
o the FRTB introduces a risk factor sensitivity-based approach (SBA) to make the
standardised approach closer in its behaviour to the IMA
o If the data volume and quality for these models are not satisfied, the FRTB introduces
capital charges for non-modellable risk factors.
o Move from value at risk (VaR) approach to expected shortfall (ES), the average of the tail
of the distribution thus representing a measure of the impact of the more extreme events.
o The FRTB also introduces liquidity considerations to account for the different times to
liquidate positions during stressed conditions.

Ratings and securitisations
• The crisis highlighted several weaknesses in the Basel II securitisation framework, including
o mechanistic reliance on external ratings
o lack of risk sensitivity
o cliff effects and insufficient capital for certain exposures.
The most significant revisions with respect to the Basel II securitisation framework relate
to changes in
(i) the hierarchy of approaches
(ii) the risk drivers used in each approach
(iii) the amount of regulatory capital banks must hold for exposures to securitisations

Systemically important banks
The Committee agreed to the following enhancements to the G-SIB framework:
• Amending the definition of cross-jurisdictional indicators consistent with the definition of BIS
consolidated statistics
• Introducing a trading volume indicator and modifying the weights in the substitutability
category
• Extending the scope of consolidation to insurance subsidiaries
• Revising the disclosure requirements
• Providing further guidance on bucket migration and associated higher loss absorbency (HLA)
surcharge when a G-SIB moves to a lower bucket
• Adopting a transitional schedule for the implementation of these enhancements to the G-SIB
framework.

Contingent capital
• Under the Basel III contingent capital requirement, the home country supervisor of an
internationally active bank would have the authority to trigger a write-off or a conversion of
non-common Tier 1 and Tier 2 instruments issued by the bank.
• A trigger event may be declared as deemed necessary to help prevent the issuer from
becoming insolvent.
• For purposes of Basel III, non-common Tier 1 capital instruments generally consist of
perpetual preferred stock and perpetual debt instruments where the issuer has complete
discretion to cancel distributions/payments on the instrument. Tier 2 capital mainly consists of
subordinated debt with a minimum original maturity of at least five years.

Large Exposures
• Credit risk concentrations have consistently been the source of a number of major bank
failures over the years.
• Many jurisdictions have in place regulations that limit large exposures.
• This necessity is more crucial for systemically important banks given the potential impact that
their weakened solvency could have on other financial institutions and therefore the stability of
the financial system.
• The Committee has reviewed large exposure rules in place across different jurisdictions to
strengthen guidance in this area.

Cross-border bank resolution
• The regulatory and monetary policy changes have been important drivers of adjustments in
cross-border bank lending since the crisis. While expansionary monetary policy measures
have mitigated credit market fragmentation, regulatory policy changes have had mixed
effects, depending on the measure and region considered.
• National regulators aim at a lower degree of banking globalisation to facilitate the resolution of
large, internationally active banks, and hence to better protect taxpayers from potential losses.
• As part of this effort, the Committee has conducted an evaluation of different legal and policy
changes to assist authorities in their efforts to better prepare to address future needs for crisis
management and resolution of financial institutions.

Review of Core Principles for Effective Banking
Supervision
• The Committee’s Core Principles have been used by countries as a benchmark for assessing
the quality of their supervisory systems and for identifying the work done to achieve a
baseline level of sound supervisory practices.
• These principles also form the basis for IMF and World Bank assessments of banking
supervision in different jurisdictions.
• Many of the supervisory lessons learned during the crisis and articulated in the Committee’s
documents are incorporated in a revised set of Core Principles.
• The FSB has identified different areas of the Core Principles to be expanded to address
topics related to the supervision of systemically important financial institutions.

Standards Implementation
• Committee’s focus is mainly on monitoring and assessing the implementation of its standards and
guidance, particularly for topics identified as deficient during the crisis.
• A key objective of the Basel Committee is to promote common understanding of supervisory issues and
improve the quality of banking supervision worldwide.
• The Committee’s Standards Implementation Group (SIG), which was established in January 2009, has
developed a Standards Surveillance Framework, applicable to all Basel Committee standards, with the
aim of promoting consistency and comprehensiveness of the standards. This helps to ensure that the
standards keep up to date with market practices and financial innovation.
• The Committee has undertaken a review of implementation issues. It has also undertaken thematic peer
reviews related to the implementation of selected Basel Committee standards. It will monitor follow up
action plans to help promote the implementation of standards.

Excessive Risk Taking
Sub-Prime
Lending
Securitization
Housing prices
decline resulting in
sub-prime defaults
Sub-prime defaults,
Ssecuritized assets &
derivatives trading
resulted in huge losses
Excessive leverage & poor
capital could not absorb
losses fully, demanding fresh
equity infusion
Huge losses resulted in a
crisis of confidence
causing liquidity to
evaporate
Short term borrowing
demanded fresh
borrowing which
failed in liquidity crisis
Firms on the verge of
insolvency;
threatening system
failure
Governments step in
to inject capital to
prevent systemic
failure
In stressed market situations,
Credit Rating downgrades of
Financial Institutions &
securitized products further
lowered valuations &
increased losses
Capital Conservation /
Counter-cyclical buuers
Less reliance on external ratings
agencies
CVA Capital Charge
Stressed Testing
Higher quantity & quality of
capital
Leverage Ratio introduced
100% weight for trade finance
Correlation to financial institutions
will carry more risk weights – to
prevent systemic risks and an
overall collapse
Enhanced Supervisory Review
and Disclosure
Two new liquidity ratios

Thank you

Basel Regulation Changes Post 2008 Financial Crisis

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