basel 2 to basel 3 - proposed changes and required amendments

7/28/2019 Basel 2 to Basel 3 - Proposed Changes and Required Amendments

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Basel 2 to Basel 3

Proposed Changes and Required Amendments

Basel 2 to Basel 3 -

Proposed Changes and

Required Amendments

13th July 2011


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Amendments to Basel 2 Page 1

Amendments to Basel 2(taken from the 3 July 2009 Basel 2 papers)

The changes listed below are to be brought into effect by 31.12.2011 in the

EU and G20 countries. Subsidiaries of Bahraini banks in these countries willbe obliged to comply with these measures even if their head offices do not.

Trading Book

New stressed VaR requirement (for one year period) for banks usingVaR models in the trading book

New incremental risk capital charge (default & migration risk) for IRBbanks

Capital charges used in the banking book must be applied to securitisedproducts in the trading book to avoid regulatory arbitrage (see page 6 ofJuly doc)

Removal of concessionary 4% RW treatment for liquid anddiversified portfolios

Complex Securitisations

Resecuritisations obtain higher risk weights in the banking bookSecuritisation Resecuritisations

AAA 20% 40%

A+ to A- 50% 100%

BBB+ to BBB- 100% 225%

BB+ to BB- 350% 650%B+ to unrated Deduction Deduction

No self-guarantees allowed to improve credit ratings of securitiesguaranteed by the bank itself when such securities are held on the

banks own books


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Amendments to Basel 2 Page 2

Operational criteria must be applied before banks may use above riskweights in the Basel 2 securitisation framework. Otherwise all holdingsof securitisations must be deducted from capital

Standard 50% CCF for liquidity facilities in the securitisationframework (no more concessionary risk weights)

Enhanced Pillar Two requirements for ICAAPs and internal controls

generally

This means the need for new Pillar 2 modules in the Rulebook (theCBB drafted a module called SR in 2008, but this was never released)

Enhanced Pillar Three requirements

Enhanced disclosures for securitisations and credit risk mitigants


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Basel 3 changes Page 1

Basel 3 changes(Paragraph references from December 2010 Basel paper)

1. Capital Ratio

Tier One (6% of total RWAs)paragraphs 50, 53

A. Minimum common equity 4.5% of total RWAs (by 1.1.2015) after

all deductions below (including unaudited/audited losses or audited

profits for current period plus all eligible reserves). Paragraph 52

There are tougher requirements for Common Equity: Common shares only and must be recognised as equity by

accounting standards

Most subordinated claim, not fixed or capped Perpetual and never repaid outside liquidation No features that encourage buy-backs, redemption or

cancellation

Distributions not contractually capped or linked to amountpaid in

No obligatory or preferential payment of dividend (which cancreate a technical event of default)

Issued and paid up Unsecured, unguaranteed Only issued with explicit shareholders approval May include share premium, retained earnings and p&l

Deductions from common equity (full deduction by 1.1.2018)

Intangibles (paragraph 67) Investments in own shares (paragraph 78) Any outstanding Tier 1 instruments that do not meet the definition

of common equity (w.e.f. 1.1.2013)

Minority interests in financial subsidiaries (see section G) Deferred tax assets (paragraphs 69 & 70) Mortgage servicing rights


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Cash flow hedge reserves for items not fair valued (paragraphs 11,71 & 72)

Any shortfall of provisions to expected losses under IRB(paragraph 73)

Gains on sales due to securitisation transactions (paragraph 74) Unrealised gains arising from changes in the fair value of liabilities

caused by changes in the banks own credit risk/rating(paragraph 75)

Defined pension fund assets and liabilities (paragraph 76) Reciprocal cross shareholdings in the capital of financial and

insurance entities (paragraph 79)

Investments in the capital of other financial and insurance entitieswhere the bank owns < 10% of the issued common share capital ofthat entity (applies to both trading and banking book). If the

aggregate of all holdings listed above exceed 10% of the bankscommon equity (after applying all other deductions), then the

amount exceeding 10% of the concerned banks capital (of suchholdings) must be deducted applying a corresponding deduction

approach (i.e. common equity from common equity, tier two fromtier two). Amounts below the 10% threshold will continue to be

risk-weighted (paragraph 80 & 81)

Investments in the capital of other financial institutions andinsurance companies where the bank owns > 10% of the issuedcommon capital of the entity (applies to trading and banking book).

All such investments must be deducted (paragraphs 84 86) afterabove deductions where the aggregate of such investments exceeds

15% ofa bankscommon equity. There must be full disclosure ofthese deductions. Any (remaining) holdings below 15% of capital

will be weighted at 250% (paragraph 89).


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B. Net Common Equity

Amount A after all deductions above


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C. Additional Going Concern Capital paragraph 54 and 13J anuary 2011 Annex

There are enhanced criteria for classification as additionalGoingConcern Capital

Issued & paid up Subordinated to depositors, general creditors and subordinated

debt

Not secured or guaranteed Perpetual and no step-ups or other incentives to redeem Callable only at initiative of issuer after minimum 5 years,

subject to prior supervisory approval

Documentation should not create the expectation of a call by theissuer

Call cannot be made without bank concurrently replacing capitalwithout issuance of capital of same or better quality, and capitalmust be well above minimum required capital level

Coupon payments must be discretionary Cancellation of payments must not constitute an event of default Cancellation of payments must not put restrictions on the bank Dividend only payable out of distributable items No credit sensitive dividend payment features Must be convertible at the option of the supervisory authority to

common equity or to be written down in value (e.g. by reducing

the amount repaid at call point), or contain a write-down feature

which allocates losses to the instrument before tax payers are

exposed to loss* (see bullet point below)

Issuer and connected counterparties may not have purchased theinstrument, nor can the bank have funded the purchase of the

instrument

No compensation features if other similar instruments aresubsequently issued at a lower price

Proceeds must be immediately available without limitation(e.g. from an SPV that is part of the consolidated group)

May include share premium


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The convertibility feature above must be supported by a law (not adirective) that the instrument must be written off/down or fullyabsorb losses before tax payers (i.e. the Government) are exposed

to loss. Furthermore, there must be a peer group review to confirm

that such laws are in place and both the bank and the regulator (inissuing documents) disclose that these instruments are loss-bearing.

Only common stock may be issued to instrument holders (i.e. nopayment of cash or other compensation may be given) if a

trigger event (see bullet point below) occurs.

The bank must have all approvals to issue common equity to theamount required should a trigger event occur.

A trigger event is the earlier of: (1) a decision that a write-off(without which the bank would be unviable) is necessary, as

determined by the supervisor; or (2) the decision to make apublic sector injection of capital (or equivalent support) withoutwhich the bank would have become unviable (as determined by

the supervisor).

Deduct investment in own shares. Deduct holdings of such instruments issued by other financial and

insurance entities which do not exceed 10% of the investees

capital, but which in aggregate exceed 10% of the concerned bankscapital (paragraph 80).

All instruments issued after 1 January 2013 must meet the abovecriteria to be included in regulatory capital. Instruments issuedprior to 1 January 2013 that do not meet the criteria above will be

phased out from 1 January 2013 (90% cap in 2013, reducing by10% per annum). Instruments with early calls or step-ups will not

generally be recognised as regulatory capital.


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D. Total Tier One Capital

Item B plus item C


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E. Tier Two Capital (i.e. gone concern capital)

paragraphs 57 & 58 and 13 January Annex

There are simplified and tougher requirements for Tier 2:

Issued and paid in Subordinated to depositors and general creditors Unsecured and not guaranteed Minimum maturity of 5 years with straight line amortisation over last

five years to maturity

No redemption incentives Callable only at the initiative of issuer after minimum of five years Early calls subject to prior supervisory approval No expectation of early calls to be created by the documentation Calls may not be exercised unless capital of the same or better quality is

issued concurrently and the issuer demonstrates its capital is well above

minimum required

Investors may not accelerate the repayment of payments (except inbankruptcy or liquidation)

No credit sensitive dividend feature The issuer and its related parties may not have purchased or funded the

purchase of the instrument

Proceeds must be immediately available without limitation(where raised by an SPV that is part of the consolidated group)


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Interim unaudited profits for the current period will still be allowed Expected loss approach to provisioning still under review, but general

provisions up to 1.25% of credit risk weighted assets (i.e. not including

operational risk or market risk charges)paragraphs 60

61

Includes stock surplus (i.e. premium) Deduct holdings of own Tier 2 capital Must be convertible at the option of the supervisory authority to

common equity or to be written down in value (e.g. by reducing theamount repaid at call point), or contain a write-down feature which

allocates losses to the instrument before tax payers are exposed to loss*

(see bullet point below)

The convertibility feature above must be supported by a law (not adirective) that the instrument must be written off/down or fully absorblosses before tax payers (i.e. the Government) are exposed to loss.

Furthermore, there must be a peer group review to confirm that suchlaws are in place and both the bank and the regulator (in issuing

documents) disclose that these instruments are loss-bearing. Only

common stock may be issued to instrument holders (i.e. no payment of

cash or other compensation may be given) if a trigger event (seebullet point below) occurs. The bank must have all approvals to issue

common equity to the amount required should a trigger event occur.

A trigger event is the earlier of: (1) a decision that a write-off (withoutwhich the bank would be unviable) is necessary, as determined by the

supervisor; or (2) the decision to make a public sector injection ofcapital (or equivalent support) without which the bank would have

become unviable (as determined by the supervisor).

All instruments issued after 1 January 2013 must meet the above criteriato be included in regulatory capital. Instruments issued prior to 1

January 2013 that do not meet the criteria above will be phased outfrom 1 January 2013 (90% cap in 2013, reducing by 10% per annum).

Instruments with early calls or step-ups will not generally be recognisedas regulatory capital.


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Tier Three

(Abolished).


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F. Total Capital (w.e.f. 1.1.2015)

This is the sum of D and E above. Banks must have a Minimum ratioof 8%, of which 6% must be Tier One. Remaining 2% can be met by

Tier 2 (paragraph 50)


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G. Minority Interests (paragraph 62)

Minority interests in the common equity Tier One of a fullyconsolidated subsidiary may receive recognition in Common Equity

Tier One if:

The instruments meet all the criteria for common equity The subsidiary is a bank (i.e. not an SPV) The subsidiary has a surplus above its minimum Tier One capital

requirements

The surplus is added after deducting: a) the lower of the requiredminimum common equity Tier One plus its capital conservation

buffer; or the proportion of consolidated minimum common equityTier One plus the capital conservation buffer that relates to the

subsidiary; and b) the amount of surplus Common Equity Tier Oneattributable to the minority shareholders.

Minority interests attributable to other Tier One and Tier Two Capital

instruments will be allowed under similar conditions (see paragraphs63 and 64).

Capital issued by SPVs can be included in consolidated AdditionalTier One and Tier Two capital, but not in Common Equity

(paragraph 65).


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H. Countercyclical Buffers (0-2.5% of RWAs)

The size of the Buffer is set by the regulator and must take account ofmacroeconomic environment in which the bank(s) operate. This maymean that wholesale banks and retail banks will legitimately have

different buffers

Although each jurisdiction must decide for itself on the extent of thebuffer, there are references and principles to follow (FSD of the CBB

will have to be involved to apply individual buffers or the CBB maysimply impose an industry wide percentage)

The buffer is a function of the weighted average of capital buffer add-ons applied in each jurisdiction where the bank has exposure(this process could potentially be very complex for some banks)

The countercyclical buffer would increase the 2.5% capital conservationbuffer (see next page) by up to an additional 2.5% during periods ofexcessive credit growth

Buffer can be released when the released capital would absorb losses inthe system that pare a threat to financial stability

Banks will be forced to conserve earnings where the buffer is belowthat required by the supervisor(paragraph 147)


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J. Capital Conservation Buffer (2.5% of RWAs)

Capital in excess of minimum to be used in times of stress (2.5% - mustbe common equity)

Constraint on dividends, share buybacks and bonuses (subject to 100%conservation ratio (paragraph 131) if CET1 below 5.125% and sliding

conservation scale up to 7% CET1 ratio)

Phased in from 1.1.2016 to 1.1.2019


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K. New Risk Weightings

A 1,250% Risk Weight will apply for the following items:

Securitisation (and resecuritisations) exposures B+ or below Certain Equity exposures under the PD/LGD approach Non-payment/delivery on non Delivery versus payment transactions Significant investments in commercial entities (above 15% of capital

base)paragraph 90


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2. Leverage Ratio

Based on Tier One Capital only (but subject to review)

Off-balance sheet items subject to uniform 10% CCF All derivatives will be subject to Basel 2 netting plus PFE Minimum 3% ratio (w.e.f. 1.1.2018)i.e.

Tier One Capital .

Unweighted on-balance sheet + 10% off-balance sheet assets

Disclosure of the leverage ratio will start w.e.f. 1.1.2015 Calculation will be on an average basis over the reporting quarter


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3. Counterparty credit risk(paragraph 98 onward)

Stressed inputs to be used

Elements of counterparty risk charges are related to MTM losses as aresult of the fall in the creditworthiness of a counterparty

Collateral and margining requirements strengthened Increase in risk weights on financial institutions An additional capital charge (the CVA)

These changes only apply to banks using the internal model method.


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4. Liquidity

Liquidity Coverage Ratio 30 day stressed funding scenario set bysupervisor dictates level of high quality liquid assets to be held at all

times (w.e.f. 1.1.2015)

Net Stable Funding Ratio (w.e.f. 1.1.2018)


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5. New Disclosure Requirements (paragraph 9193)

Full reconciliation of all regulatory capital elements to the balance sheet

Separate disclosure of all regulatory adjustments Disclosure of all capital limits and minima Description of main features of capital instruments Disclosure of Equity Tier One ratio as well as other capital ratios

(Tier One, Total)

Any transitional provisions


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Summary of Basel 3 Page 1

Summary of Basel 3

1. Raise Quality of Capital Base

Raise Quality of Common Equity (2013). Abolish Innovative Instruments from Tier One and only allow

Going Concern/Loss Participating Tier One instruments (2013).

Additional deductions from Tier One (2014 onward). Simplify and toughen Tier Two Capital (2013). Only limited inclusion of non-equity elements in Tier One.

2. Enhanced capital charges for securitisation and off-balance sheet

exposures (December 2011)

July 2009 securitisation and trading book requirements. New counterparty credit risk charges and requirements.

3. New 3% Leverage Ratio (2015)

Based on Tier One Capital only. Will include off-balance sheet exposures at 10% CCF.

4. New Liquidity Standards

Liquidity Coverage Ratio (2015). Net Stable Funding Ratio (2018).

5. New Capital Buffers

Capital conservation buffer (2.5% of RWAs starting 2016 2019).

Countercyclical buffer (0-2.5% of RWAsno set date). Also forward looking provisioning may play a role (expected loss

approach to be explored).


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Revised Basel 3 Page 1

Revised Basel 3

Capital Components and Capital Adequacy Calculation

Step-by-step

The items below the revised components of eligible regulatory capital.

1. Common Equity plus disclosed reserves (using new criteria in17/12/2009 Basel Paper) including unaudited or audited losses and

including audited profits for the current periodunrealised gains to be

included at 45% as previously or at CBB discretion

2. Regulatory Deductions from Common Equity:a) Deduction of minority interests in subsidiaries (no longer

included in Common Equityassume worst case).

b) Deduction of goodwill and all other intangibles.c) Deduction of any deferred tax assets (should normally only apply

to foreign subsidiaries).

d) Deduction of any investments in own shares (treasury stock), anyown share purchases funded by the bank (e.g. employee stockincentive programs).

e) Deduction of investments in the capital of financial institutions (including banking and insurance and investment business

institutions). This deduction will include all holdings ofcommon equity in other financial institutions which are less

than 10% of the concerned financial institutions capital (above a10% threshold for the reporting bank). The full amount of such

holdings (above the 10% own funds threshold) must be deductedfrom the reporting banks common equity. Secondly, the holdings

of all common stock in all other financial institutions above 10% of

the investees capital must be aggregated (after performingthe above deduction). Where the aggregate of any such

holdings exceeds 15% of the reporting banks common equity,

then the amount over 15% of the reporting banks common equity


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R i d B l 3 P 2

must be deducted. Note that these deductions will apply

irrespective of the location of the exposure in the trading book or inthe banking book.

3. Common Equity after regulatory deductions (Item 1 less item 2)4. Additional Going Concern Capital (using new criteria for most

banks this should be a zero item, but certain preference shares or other

loss-bearing instruments may be included here subject to the new Basellimits)

5. Total Tier One Capital (Item 3 plus item 4 but subject to cap)6. Tier Two Capital (subject to 2% cap and using new conditions)7. Total Eligible Capital (Item 5 plus item 6)8. Risk-Weighted Assets

Calculate total risk weighted assets for the banking book, the tradingbook and operational risk as under existing PIR/Rulebook

requirements, but note that all significant investments in commercialentities above 15% of capital base must be risk-weighted at 1,250%.

Assume no grandfathering of concessions.

9. Calculation of Capital RatiosCalculate the following ratios:

a) Common Equity Capital Ratio (Item 3 divided by item 8)b) Tier One Capital Ratio (Item 5 divided by item 8)c) Total Capital Ratio (item 7 divided by item 8)

For the solo capital adequacy calculation, all shareholdings in subsidiariesmust be deducted from common equity in addition to the deductions made in

item 2e) above. Also all risk-weighted assets of subsidiaries for items 7 and

8 above must be deducted from the risk-weighted asset base of the reportingbank, prior to calculation of the solo capital ratios.

basel 2 to basel 3 - proposed changes and required amendments

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