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Basel III challenges: Operational Data Store defines a solution

Thought Paper

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Basel III challenges: Operational Data Store defines a solution

What exactly is Basel III?

The financial gloom notwithstanding, the recession resulted in some positive developments in the realm of banking regulation. The Basel III Accords/Norms for the banking sector is prominent among them. Basel III is considered to be an intelligent addition to the Basel I & II accords hitherto adhered to by financial institutions.

Basel Accords are supervisory recommendations on banking regulations issued by the Basel Committee on Banking Supervision (BCBS). The

“A global regulatory framework for more resilient banks and banking systems” given by the Basel Committee on Banking Supervision (BCBS) issued in December 2010.

In the light of the recession, which had devastating consequences, Basel III aims to

committee takes its name after the Swiss city where it meets and maintains its secretariat with the Bank of International Settlements1 .

With Basel III, the committee has imposed more stringent regulations upon banks to proactively handle any liquidity crunch situation. Liquidity Coverage Ratio and Net Stable Funding Ratio, two new terms introduced by Basel III, ensure increased, high-quality liquid assets and resources in the bank2.

create more resilient individual financial institutions, which in turn can lead to a far more stable financial sector. By plugging loopholes present in the earlier versions, Basel III recommends better mechanisms for risk and liquidity management.

New and stricter definitions of capital.

Tier 3 capital instruments eliminated from regulatory capital definition.

Introduction of Credit Value Adjustments risk capital charge, for OTC Derivatives.

Requirements for raising capital.

Reduced reporting cycle duration for minimum requirements.

Introduction of Capital Conservation Buffer.

Introduction of Countercyclical Buffer.

Introduction of Liquidity Coverage Ratio (LCR).

Introduction of Net Stable Funding Ratio (NSFR).

Introduction of Leverage Ratio.

Rise in Counterparty Risk Management standards.

Major features

1 Bank of International Settlements is an international organization which serves as the bank of Central Banks.2 Noteworthy is the fact that the RBI has always been stricter than the Basel recommendations.

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Basel III – Implementation in India – RBI guidelines

Basel definitions

Following are the RBI guidelines to Indian banks3:

3 RWA - Risk Weighted Assets

MinimumCapital

Requirement

• Banks must have common equity Tier 1 capital as at least 5.5% of RiskWeightage assets

• Tier 1 capital in banks must be at least 7% of RWA. (#3)

• Total capital must be at least 9% of RWA.

• RWA-Risk Weighted Assets

• Banks must have 2.5% of RWA in the form of common equity CapitalConservation Buffer.

• The implementation of Minimum Capital requirement and deductions fromcommon equity capital as per the new definition is proposed to begin fromJanuary 1, 2013 and should end by March 31, 2017, in India, by the Apex Bank.

• As per RBI guidelines, Capital conservation buffer requirement should beimplemented between March 31, 2014 and March 31, 2017.

• Basel has changed the definition of the regulatory instruments such as capital.The instruments which do not qualify now as per the Basel definitions ofregulatory capital, should be phased out from the banks definitions also andbanks should accommodate the new definitions during the period beginningfrom January 1, 2013 to March 31, 2022.

CapitalConservation

Buffer

TransitionalAgreement

• For OTC derivatives, as per the previous norms banks had to calculate capitalcharge for counterparty default risk. Now Banks would be required tocompute credit value adjustments (CVA) risk capital charge in addition to theprevious norms.

EnhancingRisk

Coverage

• As per RBI guidelines banks are expected to maintain a minimumTier 1 leverage ratio of 5% during the period from January 1, 2013 toJanuary 1, 2017.

LeverageRatio

Tier 1 Capital (Common Equity)

• Common Equity Tier 1 capital consists of:

• Common Shares/Equity issued by Banks

• Stock surplus (Share premium) resulting from the issue ofinstruments included in common equity Tier 1

• Retained earnings and reserves

• Accumulated other comprehensive income and otherdisclosed reserves.

The Regulatory Capital is defined in the following elements by BASEL Committee.

C o m p o n e n ts o f C a p ita l

Tier 2 Capital

• Tier 2 capital is the addendum capital to the Tier 1 capital

• For any banking institution to consider some capital asTier 1 or Tier 2 capital, Basel Committee has issuedsome guidelines and limitations, which must be followedto qualify

• As per the Basel III Guidelines following are the limitsimposed on the capital

• Common equity Tier 1 capital must be at least 4.5% of RWAat all times.

• Overall Tier 1 capital must be at least 6.6% of RWA.

• Total Capital (Tier 1 plus Tier 2 capital) must be at least 8%of RWA at all times.

• India has stricter limits compared to these limits

Impact of Basel III accords on financial institutionsUpon full implementation of Basel III by 2019, banks will be required to maintain overall minimum capital of 10% to 12.5% of RWA (inclusive of all the requirements) with additional buffer; which means Indian banks will have to provision a higher amount owing to stricter norms. This simply means that the banks will have less leverage to lend money and maintain profitability, forcing them to increase lending rates which in turn will hit the scale of their business, more so in retail banking.

Additionally, the higher capital requirements and tighter liquidity limitation will affect small

and mid-sized banks more severely given their smaller customer base with fewer deposits. Higher capital reserves would further decrease funds for lending and investing.

Introduction of LCR and NSFR will force banks to change their liquidity position and increase investments in high-quality assets, resulting in long-term gains.

Stringent regulations mandate frequent regulatory reports adhering to the RBI- prescribed format, the cost of which will have to be borne by the banks.

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Capital Conservation Buffer

• Banks are required to hold some of the capital apart from the minimum capital required by theregulators, which can be utilized in case of losses.This buffer is called Capital Conservation Buffer. It isan addition on top of the minimum capital requirement.

• As per the Basel III framework, banks must hold a capital conservation buffer at 2.5% above theminimum capital required

Counter Cyclical Buffer

• In the previous downturns, it has been seen that the banks suffers losses when the downturn is causedby the excessive credit growth i.e.,when banks lend excessively, seeing the good economic indicators.

• With introduction of Countercyclical Buffer, the Basel Committee mandates that the banks hold someaddition capital buffer as a safeguard against losses.The Economic risk and Excessive credit growthconditions are monitored by the regulators and national authorities, and the Countercyclical Buffer isdecided based on that.

Liquidity Coverage Ratio

• To keep banks liquid during recession, economic downturn, high losses, losses in investments andshortage of funds, liquidity coverage ratio is introduced in Basel III.

• As per these guidelines, banks are required to maintain a liquidity coverage ratio at all times to ensurethat they have high quality liquid assets to fulfill the cash demands during recessionary times andprotect themselves from the bankruptcy.

Net Stable Funding Ratio

• With the introduction of NSFR Basel Committee expects that banks should have high quality and stablesource of funding to sustain liquidity during stress times and to meet the contingent liquidityrequirements that can arise any time.

• Banks are required to assess the liquidity risk at all times on all on- and off- balance sheet items andshould maintain the Net Stable Funding Ration.

How Data Warehouses (DWH) can help financial institutions in facing the challenges posed by Basel III framework implementationBasel III implementation presents banks with many challenges, the foremost being sustaining profitability in the face of increased costs and reduced margins. Increasing the IT intensity of all departments is one way for banks to save cost and improve efficiency and this in turn would necessitate data warehousing solutions.

Today, banks are stuck with enormous amounts of data scattered haphazardly. There is a pressing need for a system that can not only consolidate this data but also streamline it into patterns that are easy to analyze and ready to use.

The ideal Data Warehouse that supports the successful implementation of Basel III will have to possess the following qualities:

Such a robust system will offer banks competitive advantage in the form of “Intelligent Data Repositories.”

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Increased capital, liquidity cost and RWA will adversely affect banks’ profit margins across all lines of business.

With the introduction of NSFR, banks will have to invest in high-quality assets and retire low to medium-quality, high-return investments from their portfolio, leading to reduced net interest margin (NIM), necessitating greater focus on Asset Liability Management strategies to recover the NIM degradation and maintain profitability.

However, with these regulations, banks will be relatively immune to adverse economic conditions given limited exposure to system

wide risks and will have greater liquidity at all times. Lower exposure to risky assets and higher exposure to high-quality liquid assets will leave banks unfazed by recessions/downturns, lowering their likelihood of filing bankruptcy in troubled times.

Introduction of Countercyclical Buffer will create capital conservation in case of excessive credit growth thus averting another recession.

These norms will have a positive impact from a macro-economic perspective but banks will grapple with reduced profitability, low margin and higher costs.

Holistic Data Approach

Data Availability/ Provisioning

High Quality and Standard

Data Model

System Flexibility, Extensibility

and Adaptability

Adherence to International

Industry Standards

Great Data Consistency and Quality

Data Completeness

Exclusive Data Marts

ODS - One Stop DWH

• Holistic Data Approach

• Data Availability/

Provisioning

• Great Data Consistency

and Quality

• High Quality and

Standard Data Model

• Data Completeness

• Exclusive Data Marts

• System Flexibility,

Extensibility and

Adaptability

• Adherence to

International Industry

Standards

Review of Current position,

strategies and Architecture

Regulatory Reporting

New Methodologies and

Calculations

Risk Management

Methodologies and Forecasting

Asset Liability

Management

Exclusive Data Marts

This agile data system can empower banks with a reliable and technologically secure IT infrastructure, to help them derive maximum value from data to meet the expectations and challenges of the business.

Also, this system can amply fulfill the regulatory requirements arising out of Basel III implementation and also comply with the exacting standards of data fidelity.

The above attributes make this system a cost effective solution that can help banks meet the analytical, reporting and regulatory requirements of Basel III, resulting in better customer management and retention. Overall, this would bring forth a greater Value Proposition, which is the game changer in any industry.

How a complete data warehousing solution will help banks face major issues imposed by Basel III:• Review of current position, strategies

and architecture

During the initial phase of implementation, institutions will be required to review their current position, strategy and architecture relative to the target position required by Basel. Institutions will require historical data that can report their past and current positions in the form of ratios and also bring forth the limitations of their past performance. This will enable them to identify the action and resources required to meet the requirements and devise new strategies accordingly.

Only a DWH flexible enough to accommodate, collate and consolidate data from all other integrated and non-integrated systems in the bank and then produce the historical data in the required format can successfully accomplish this task.

• Regulatory reporting

With increased cost of regulatory reporting, a DWH with complete data provisioning and

highly consistent data becomes necessary. Using a combination of reporting tools, this DWH should also be able to cost effectively support various downstream systems with holistic data provisioning.

• New methodologies and calculations

Introduction of various new ratios and calculations such as LCR, NSFR, and the new definition of capital will require banks to align their existing systems and create new methodologies for calculating and maintaining the new ratios and limitations. High-quality consistent data will help them achieve this.

• Risk management and forecasting

Banks will be required to devise various risk management methodologies to comply with the framework laid down by Basel III. To maintain risk compliance they will be required to monitor, at all times, both internal system performance and prevailing market conditions, and also accurately simulate and forecast the same. Forecasting and predictive analytics require tools like SAS, R etc. to run.

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To this end, a DWH system that provides consistent and complete data to these tools is indispensable.

• Asset liability management

With the implementation of NSFR, banks’ Net Interest Margin will reduce considerably. To remain profitable, they will have to create new asset liability management strategies. Data availability within departments will enable better corporate governance and decision-making.

• Exclusive data marts

In addition to DWH, an exclusive data mart for Basel III compliance will help banks monitor their position with respect to the framework at any given point. Banks will be able to change their current strategies to comply with the regulatory guidelines, while also maintaining margins and profitability.

Vaibhav SahuAssociate Consultant, Finacle, Infosys

Anupriya SharmaSenior Associate Consultant, Finacle, Infosys

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The implementation of the Basel III framework will impose many challenges on banks. With capital, risk, asset and liability restrictions, along with increased cost and shorter reporting cycles, banks will have their jobs cut out to maintain margins and profitability.

A DATA WAREHOUSE (or more specifically an Operational Data Store) as a complete data provision solution can help banks and financial institutions implement this new framework and comply with the guidelines. Being a high-quality holistic data provisioning tool, it can retain the banks’ competitiveness while making

Conclusionthem resilient, which is the whole purpose of the Basel framework.

Considering all the points outlined in this paper, it stands to reason that an early mover advantage would certainly propel any bank forward and also enable it to customize and mold the DWH to its own needs and business requirements. Its implementation, while inevitable and beneficial, does require considerable investment, both monetary and non-monetary. Needless to say, only its early adoption and integration into the institution’s ecosystem would yield rich dividends.

Finacle from Infosys partners with banks to transform process, product and customer experience, arming them with ‘accelerated innovation’ that is key to building tomorrow’s bank.

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© 2012 Infosys Limited, Bangalore, India, Infosys believes the information in this publication is accurate as of its publication date; such information is subject to change without notice. Infosys acknowledges the proprietary rights of the trademarks and product names of other companies mentioned in this document.

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