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Basel 3: A new perspective on

portfolio risk management

Tamar JOULIA-PARIS October 2011

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Content

1. Basel 3 A complex regulatory framework

With possible unintended consequences

2. Consequences on Main banking products and business models

Risk management

Portfolio and balance sheet management

3. Conditions for success of an active balance-sheet optimization

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1. Basel 3: A challenging objective

The 2008 financial crisis proved that Basel II was insufficient:

1. Amount and quality of Capital were inadequate to absorb extreme losses, forcing for some banks bail-out

2. Some risks were not adequately recognised : counterparty risk, rating agencies, securitizations, excessive growth, procyclicality, etc

3. Interconnectedness between obligors and toxic asset classes, and systemic risks, were underestimated.

4. Banks did not have enough liquidity buffers.

Negative impact on depositors (Bankruptcies), banking systems and global economy required state aids in US and Europe.

New rules are being implemented at country level as of Jan 2013: Basel III → CRD IV (EU) → Country laws.

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Systemic risk management: a complex supervisory framework

(For illustration : EU framework)

European Systemic Risk Board (ESRB) = new independent body, for all financial sectors & guarantee schemes, responsible for macro-prudential oversight at the level of the EU.

European System of Financial Supervision (ESFS) = network of actors who ensure the micro-prudential supervision of EU financial system:

the European Banking Authority (EBA); the European Insurance and Occupational Pensions Authority (EIOPA); the European Securities and Markets Authority (ESMA) ; the Joint Committee of the European Supervisory Authorities (ESA); the competent or supervisory authorities in the Member States; the European Systemic Risk Board. Rem: Basel III (banks) and Solvency II (Insurers) have similar objectives but different approaches, with possible unintended consequences.

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Basle 3 : Minimum financial resources

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Solvency ratios

Risk based (Tier I) : Eligible Capital / RWA > 8%, 3 capital buffers, 2 tiers

Purpose : Increase risk coverage (2013-2018) and quality of capital

Non risk based (Leverage) : Capital > 3% of total on/off balance-sheet

Purpose : Constrain leverage build-up

Liquidity ratios

Liquidity Coverage ratio (LCR): 30 days net outflow / Liquid assets < 100%

Purpose : Ensure high quality liquid assets can fund 30 days stressed outflows

Net Stable Funding Ratio (NSFR): Available stable (LT) funding / Required stable (LT) funding > 100%

Purpose : Ensure illiquid assets can be funded during one year with a minimum amount of stable financial resources

Basel III: a long but challenging phase–in 2011 to 2018

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2011 2012 2013 2014 2015 2016 2017 2018 Jan 2019

Common equity ratio 3.5% 4% 4.5%

Conservation buffer 0.625% 1.25% 1.875% 2.5%

Common equity+conservation 3.5% 4% 4.5% 5.125% 5.75% 6.375% 7%

Tier 1 capital ratio 4.5% 5.5% 6%

Total capital ratio (unchanged) 8%

Total capital + conservation 8% 8.625% 9.125% 9.875% 10.5%

Countercyclical buffer 0 to 2.5 %

Uneligible capital instruments Phased out over 10 yrs starting 2013

LCR ratio Observation Introduction

NSFR ratio Observation Introduction

Leverage ratio Monitoring Parallel run + disclosure (2015) Pillar I

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2. Basel 3 – Summary of consequences

On Products :

Some banking products will become more expensive and reduce banks ROE

On Business models :

Basel 3 favors traditional retail & commercial banking vs complex trading activities, but challenge the bank’s transformation role

On Risk Management

New risk paradigm, with partnership between Risk and Finance

On Portfolio and Balance-Sheet management:

The combined management of capital, leverage & liquidity ratios will require a new framework for balance-sheet optimization

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Basel 3 : Impact on main banking products

More favorable

Less favorable

Tier 1 ratio

Low risk assets (mortgages, govt debt)

Trading activities

Financials, securitization, wrong-way risk

High risk assets, re-

securitization

Leverage ratio

High risk assets Central clearing of derivatives

Low risk assets, undrawn

commitments

LCR (short term

liquidity)

Cash, central bank reserves,

govt bonds

Low risk corporate and covered bonds

Unsecured bank bonds

NSFR

(long term funding)

Term deposits > 1 yr

Stable savings Wholesale savings

Funding from Financials

LT debt, high quality bonds

Low LTV mortgages

High LTV mortgages

Liquidity facilities

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Increased amount & cost of capital, combined with additional cost of liquid assets & long term funding, will make some

banking products more expensive and reduce banks ROE

Basel III – Impact on business models

a) The business context: Limited growth perspectives

Customer behavior transformation

Continued exposure to systemic risks

Cost cutting programs

Large technology programs

Uncertainties in interest rate, tax and regulations

Mismatch between shareholders expectations & regulatory requirements

etc

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The business context is not so exciting for Financial Institutions in developed markets….

http://www.marketobservation.com/blogs/media/blogs/b/CartoonMoralFailure.jpg

Basel 3 – Impact on business models

b) The Business consequences of Basel III: Increased cost of holding a balance-sheet

Downsizing of activities severely impacted by Basel III

Increased competition for customer deposits (LCR) and granular high yield assets (SME loans)

Challenge of banks maturity transformation role (NSFR)

Development of new products combining loans and deposits

Less incentive for talented people to work for banks

Balance between short term and long term management

etc

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…. and Basel 3 favors traditional banking versus complex trading activities, while also challenging the bank’s transformation role

Basel 3 – Impact on risk management

Growing importance of stress tests

Sensitivity analyses (unconditional stress tests),

“Probable” scenarios for business, finance and risk planning,

“Stressed” scenarios for capital, liquidity and appetite for risk management.

Focus on governance and risk appetite:

Tolerance defined at the top, and aligned with group strategy,

Cascading down via KRI’s per business line (value) and risk type (concentrations)

KRI’s connected to KPI’s (Capital, Liquidity, Earnings, Growth).

Internal emphasis on regulatory requirements

Break-up of silo risk management at portfolio level

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The famous “new” risk paradigm, managing risk together with return on a pro-active basis….

Basel 3 – Impact on CPM

a) The business context of CPM activities

Reduced activity in support of tier I ratio (RWA release)

Lower incentive to originate or retain investment grade loans

Limited liquidity in credit markets, CDS and mainly securitizations,

Challenge of the value of straightforward « diversification »

Priority on funding and management of liquidity ratios

High recognition as experts in combining business, market, risk, finance and regulatory knowledge.

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The competences of CPM teams (clients, products, models, markets, accounting, regulations, etc)

are leveraged for complementary purposes ….

Basel 3 – From CPM to balance sheet management

b) The change in credit portfolio functions

Front end CPM integrated with funding for new loans

Back end CPM integrated with balance-sheet management

Migration towards a more holistic internal transfer pricing

Priority on liquidity, more than credit or capital management

Management of client/business value at balance-sheet level

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The combined management of capital, leverage & liquidity ratios will require a new infrastructure for balance-sheet optimization

(Capital management, Treasury, ALM, CPM)

B/S

Capital

Risk

Models

Scenarios

Treasury

Liquidity

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Basel 3 – FROM CPM to B/S management Summary

Financial institutions should prepare for an active balance-sheet management, by …

1) Understanding the combined effect of all financial risks on pricing and on financial performance

Technology : Collecting & stressing Risk & Finance cash flow information;

Risk management : Combining top-down management of financial risks (Credit, ALM, and liquidity);

Risk and finance Planning : Combining scenarios/stress tests on P/L, balance sheet and cash flows;

Benchmarking KPI’s and KRI’s with performance targets and appetite for risk;

Combined contingency plans on funding and capital;

Single internal performance benchmark : new fund transfer price.

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Basel 3 – From CPM to B/S management Conditions for success

2) Developing solutions to transfer granular long term loans to investors with a more adequate liability profile, i.e.

Revive a different loan securitization market, complementary to covered bonds, allowing for eligibility as HQLA and lower RWA %,

Set up independent but regulated Utilities, acting as providers of fiduciary services to facilitate risk transfers, mainly between regulated institutions,

Allow long term investors to invest in a regulatory accepted form, reducing their exposure to inflation risk while supporting the economy.

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Basel 3 – From B/S management to ... Asset management ?A vision on organization

Due to

the increased and continuous systemic risks,

the necessity to actively manage the retained balance-sheet,

the technology & knowledge required to manage B/S risks,

Basel 3 might gradually encourage for new organization, with

An independent B/S Management function, ultimately reporting to the CEO,

A separation between commercial and balance sheet activities, the latter acting like an internal (or external ?) asset manager.

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Basel 3 - Conclusion

Will new regulations

prevent systemic risks ?

No, Systemic risks seem to be part of our day-to-day life…..

Sovereign debt crisis in Europe and USA,

Asset bubble in Asia : inflation risk, commodities prices,

Potential new shadow system if financial institutions are too squeezed without capacity to off-load balance sheet risks,

etc.

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Basel 3 - Conclusion

Will regulations mitigate

the impact of systemic risks ?

Yes :

Banks will become more resilient, if they can actively manage their balance-sheet,

Long term investors will access alternative investments, less sensitive to inflation and sovereign risks,

Supervision will be significantly more intense, mainly for large systemic institutions.

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