baseli2baselii2baseliii (1)

8/13/2019 BaselI2BaselII2BaselIII (1)

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Basel I to Basel III: A Journey in

Risk Management in Banks

Presented by

Prof. Debajyoti Ghosh Roy

MSc. (Physics), CAIIB, DBM, CAIB (U.K.)

Adjunct Professor,

Symbiosis School of Banking Management, Pune.

1/4/2014 1Basel I to Basel III: A Journey in RiskManagement in Banks


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Outreach to other countries

Committee started as a closed shop

Over time, has developed close ties with non-members

Committee tries to address issues relevant for alljurisdictions worldwide

Core Principles Liaison Group (16 non-Committeejurisdictionsincluding Indiaplus IMF, WorldBank)

Working Group on Capital

Regional groups

International Conference of Banking Supervisors(ICBS)

Participation in work of the Secretariat

Trainin , s eeches, consultation 31/4/2014Basel I to Basel III: A Journey in RiskManagement in Banks


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The three Cs

Concordat (and subsequent papersdealing with cross-border supervision)

Core Principles for Effective BankingSupervision

Capital Adequacy Framework

Many other topics: risk management,corporate governance, accounting,money laundering, etc, on theCommittees website (www.bis.org/bcbs)



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Basel I Accord: International Convergenceof Capital Measurements and Capital

Standards Purpose and content of Basel I standards Events and circumstances in the 1970s and

1980s (increased volatility on financial markets,deregulation, globalization, innovative

instruments, debt crises) which resulted in theerosion of the capital base of large banksaround the world, motivated the BCBS to createand publish in 1988 the first international

agreement on capital requirements for thebanks (Basel Capital Accord), known as Basel I.The purpose of Basel I standards was tointroduce a uniform way of calculating capital

adequacy in order to strengthen financialstabilit . 1/4/2014Basel I to Basel III: A Journey in RiskManagement in Banks 5


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CapitalRisk weighted assets

8 %

Minimum ratio:

Basel I Accord

1988 Capital Accord established minimum capitalrequirements for banks

In 1998, Committee started revising the 1988 Accord:

More risk sensitive

More consistent with current best practice in banksrisk management

Numerator (definition of capital) remains unchanged1/4/2014 7Basel I to Basel III: A Journey in RiskManagement in Banks


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Basel I Accord: 3 Pillars

Pillar I: The Constituents of Capital (Tier I and Tier 2Capital)

Pillar 2: Risk Weighting, creates a comprehensive

system to risk weight a banks assets, or in other words,

its loan book. Five risk categories encompass all assetson a banks balance sheet.

Pillar 3: A Target Standard Ratio, unites the first and

second pillars of the Basel I Accord. It sets a universal

standard whereby 8% of a banks risk-weighted assetsmust be covered by Tier 1 and Tier 2 capital reserves.

Transitional and Implementing Agreements, sets the

stage for the implementation of the Basel Accords.

1/4/2014Basel I to Basel III: A Journey in RiskManagement in Banks 8


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Basel I Accord

Advantages and positive effects ofimplementation of Basel I standards:

Substantial increases in capital adequacy ratios ofinternationally active banks;

Relatively simple structure;

Worldwide adoption;

Increased competitive equality among

internationally active banks; Greater discipline in managing capital;

A benchmark for assessment by marketparticipants.



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Basel I Accord

Weaknesses of Basel I standards

In spite of advantages and positive effects,

weaknesses of Basel I standards eventually became

evident:

Capital adequacy depends on credit risk, while otherrisks (e.g. market and operational) are excluded from

the analysis;

In credit risk assessment there is no difference

between debtors of different credit quality and rating; Emphasis is on book values and not market values;

Inadequate assessment of risks and effects of the

use of new financial instruments, as well as risk

mitigation techniques. 1/4/2014 Basel I to Basel III: A Journey in RiskManagement in Banks 10


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Basel I Accord

The most important amendments to Basel I

standards

Some of the weaknesses of Basel I, especiallythose related to market risk, were over bridged bythe amendment to recommendations from 1993

and 1996, by means of introducing capitalrequirements for market risk and a new instrumentfor the assessment of banks market risk VaR(Value at Risk).

Capital

8 %

Risk weigh ted exposu res (credi t and market

r isks)



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Basel II Accord

In 1998, Committee started revising the 1988 Accord:International Convergence of Capital Measurementand Capital Standards:

More risk sensitive

More consistent with current best practice in banksrisk management

Numerator (definition of capital) remainsunchanged.

Basel II provides Banks incentives to Banks investand increase sophistication of their internal riskmanagement capabilities to gain reduction incapital.

Greater Disclosure by Banks.

Follow certain standards of market discipline.1/4/2014 Basel I to Basel III: A Journey in RiskManagement in Banks 12


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What are the basic aims of BaselII?

To deliver a prudent amoun t of capi talin relationto risk

To provide the right incentives for sound r iskmanagement

To maintain a reasonable level p laying f ield

Basel II is notintended to be neutral between

different banks/different exposuresHowever, there is a desire not to change theoveral lamount of capital in the system



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Three pillars of the Basel II framework

Credit risk

Operational risk

Market risk

Evaluate Risk Assessment.

Banks own capital strategy.

Supervisors review.

Ensure soundness and integrity of banksinternal processes to assess the adequacy ofcapital.

Ensure maintenance of minimum capital

Prescribe differential capital where internalcontrols are slack.

Enhanced disclosureCore disclosures andsupplementary disclosures.

Minimum CapitalRequirements

SupervisoryReview Process

Market Discipline



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The Three Pillars

All three pillars togetherare intended to achieve a level of

capital commensurate with a banks overall risk profile.

Tier I capital and Tier II capital.

Core and supplementary capital.

Limits on components of capital.


B k T i ll f Th Ki d f M j


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Market

Credit

Operational

Banks Typically face Three Kinds of MajorRisks

Risk of loss due tounexpected re-pricing ofassets owned by the bank,caused by either

Exchange rate fluctuation

Interest rate fluctuations

Market price ofinvestment fluctuations

Risk of loss due tounexpected borrowerdefault

Risk of loss due to asudden reduction inoperational margins,caused by either internal orexternal factors

Daily pricechange (%)

Unexpectedprice volatility

Time

Time

Defaultrate (%)

UnexpecteddefaultAvg. default

Time

Monthly change

of revenue to cost(%)

Unexpectedlow costutilization

Example

Stocks

Loans with credit rating 3

Business unit A

Type of Risk



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Risk

StandardizedApproach

Foundation Internal

Ratings

Based Approach

Advanced

Internal

Ratings BasedApproach

Risk weights are based onassessment by external creditassessment inst i tu t ions

Banks use internal estimations of

prob abil i ty of d efault (PD) to calcu late riskweights fo r exposu re classes. Other riskcom pon ents are standardized.

Banks u se internal est imat ions ofPD, loss giv en default (LGD) andexposure at default (EAD) tocalculate r isk w eights for exposu reclasses

Pillar 1 Credit Risk stipulates three levels of increasing sophistication. The

more sophisticated approaches allow a bank to use its internal models tocalculate its regulatory capital. Banks who move up the ladder are rewarded by

a reduced capital charge .

Reduce Capital requirements



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Pillar IOperational Risk

Basic Indicator

Approach

Standardized

approach

AdvancedMeasurement

Approach.

.




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Risk

Standardized

Duration

Method.

Internal Models

Method

(VaR based

approaches)




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Advantages of Capital

Provides safety and soundness

Depositor protection

Limits leveraging Cushion against unexpected losses

Brings in discipline in risk taking



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Framework



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RBI Time-Frame

Serial No. Approach The earliest date

of makingapplication by

banks to the RBI

Likely date of

approval by theRBI

a. Internal Models Approach(IMA)For Market Risk

April 1, 2010 March 31, 2011

b. The Standardised Approach(TSA) for Operational Risk

April 1, 2010 September 30,2010

c. Advanced MeasurementApproach

(AMA) for Operational Risk

April 1, 2012 March 31, 2014

d. Internal Ratings-Based (IRB)Approaches for Credit Risk(Foundation- as well asAdvanced IRB)

April 1, 2012 March 31, 2014



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Capital Funds of Banks Banks are required to maintain a minimum Capital to Risk-weighted

Assets Ratio (CRAR) of 9 percent on an ongoing basis. Banks are encouraged to maintain, at both solo and consolidated

level, a Tier I CRAR of at least 6 per cent. Banks which are below this

level must achieve this ratio on or before March 31, 2010.

A bank should compute its Tier I CRAR and Total CRAR in thefollowing manner:

Tier I CRAR = [Eligible Tier I capital funds]/ .

[Credit Risk RWA* + Market Risk RWA + Operational Risk RWA]

* RWA = Risk weighted Assets

Total CRAR = [Eligible total capital funds]/

[Credit Risk RWA + Market Risk RWA + Operational Risk RWA]



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Elements of Tier I Capital

For Indian banks, Tier I capital would include the following

elements: i) Paid-up equity capital, statutory reserves, and other disclosed

free reserves, if any;

ii) Capital reserves representing surplus arising out of sale

proceeds of assets;

iii) Innovative perpetual debt instruments eligible for inclusion in

Tier I capital, which comply with the regulatory requirements as

specified in ;

iv) Perpetual Non-Cumulative Preference Shares (PNCPS), which

comply with the regulatory requirements, and

v) Any other type of instrument generally notified by the Reserve

Bank from time to time for inclusion in Tier I capital.



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Elements of Tier II Capital 1. Revaluation Reserves: These reserves often serve as a cushion against

unexpected losses, but they are less permanent in nature and cannot be consideredas Core Capital.

2. General Provisions and Loss Reserves: Such reserves, if they are not attributable

to the actual diminution in value or identifiable potential loss in any specific asset and

are available to meet unexpected losses, can be included in Tier II capital.

3. Hybrid Debt Capital Instruments: In this category, fall a number of debt capital

instruments, which combine certain characteristics of equity and certain characteristics

of debt.

4. Subordinated Debt: To be eligible for inclusion in Tier II capital, the instrument

should be fully paid-up, unsecured, subordinated to the claims of other creditors, free

of restrictive clauses, and should not be redeemable at the initiative of the holder or

without the consent of the Reserve Bank of India.

5. Innovative Perpetual Debt Instruments (IPDI) and Perpetual Non-Cumulative1/4/2014Basel I to Basel III: A Journey in RiskManagement in Banks 25

C i b t B l I B l II


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Comparison between Basel I n Basel II

1/4/2014 26

S

No

Basel I Basel II

1. Capital Adequacy based on RWA Capital Adequacy based on RWA

2. Not risk sensitive. Prescriptive. Risk sensitive.

3. All credit exposures carried RW of100%-except for some sovereign

exposures n mortgages.

Credit exposures carry RW based oncredit quality

4. Risk capital = Creditexposure*RW*8%

Risk capital similar to Basel II butefficient banks can have less capital

Implications were:Every bank had to maintain same 8%capital. Thus banks with good quality

assets had no incentives. As a resultcredit quality had to be lowered toincrease returns.Low rated exposures were subsidizedby high rated exposures.No provision for economic pricing by

banks.

Implications are:Banks with good quality assets requirelesser capital.

Better quality assets require lessercapital.Risk pricing can be done by banksbased on credit risk perception.Provision exists for economic pricing bybanks.

Basel I to Basel III: A Journey in RiskManagement in Banks


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Basel III Norms: RBIGuidelinesfor Capital Requirement


S mmar of Basel III Capital


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Improving the Quality, Consistency and Transparency of the Capital

Base:

Presently, a banks capital comprises Tier 1 and Tier 2 capital with a

restriction that Tier 2 capital cannot be more than 100% of Tier 1

capital.

Within Tier 1 capital, innovative instruments are limited to 15% of Tier 1capital.

Further, Perpetual Non-Cumulative Preference Shares along with

Innovative Tier 1 instruments should not exceed 40% of total Tier 1

capital at any point of time.

Within Tier 2 capital, subordinated debt is limited to a maximum of 50%of Tier 1 capital.

However, under Basel III, with a view to improving the quality of capital,

the Tier 1 capital will predominantly consist of Common Equity.

The qualifying criteria for instruments to be included in Additional Tier 1ca ital outside the Common E uit element as well as Tier 2 ca ital28

Summary of Basel III CapitalRequirements

Basel I to Basel III: A Journey in Risk Management inBanks

um

mary o ase ap ta


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Enhancing Risk Coverage

At present, the counterparty credit risk in the trading bookcovers only the risk of default of the counterparty. The reformpackage includes an additional capital charge for CreditValue Adjustment (CVA) risk which captures risk of mark-to-

market losses due to deterioration in the credit worthiness ofa counterparty.

The risk of interconnectedness among larger financial firms(defined as having total assets greater than or equal to $100billion) will be better captured through a prescription of 25%

adjustment to the asset value correlation (AVC) under IRBapproaches to credit risk. In addition, the guidelines oncounterparty credit risk management with regard tocollateral, margin period of risk and central counterpartiesand counterparty credit risk management requirements havebeen strengthened.

29

ummary o ase ap taRequirements


ummary o ase ap ta


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Enhancing the Total Capital Requirement and Phase-inPeriod

The minimum Common Equity, Tier 1 and Total Capitalrequirements will be phased-in between January 1, 2013 andJanuary 1, 2015, as indicated below:

30

ummary o ase ap taRequirements

As a %age to Risk

Weighted Assets

(RWAs)

January 1,

2013

January 1,

2014

January 1,

2015

Minimum Common

EquityTier 1 capital

3.5% 4.0% 4.5%

Minimum Tier 1capital

4.5% 5.5% 6.0%

Minimum Totalcapital

8.0% 8.0% 8.0%


Summary of Basel III Capital


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Capital Conservation Buffer

The capital conservation buffer (CCB) is designed to ensurethat banks build up capital buffers during normal times (i.e.outside periods of stress) which can be drawn down as lossesare incurred during a stressed period.

The requirement is based on simple capital conservation rules

designed to avoid breaches of minimum capital requirements. Therefore, in addition to the minimum total of 8% as indicated

above, banks will be required to hold a capital conservationbuffer of 2.5% of RWAs in the form of Common Equity towithstand future periods of stress bringing the total Common

Equity requirement of 7% of RWAs and total capital to RWAsto 10.5%.

The capital conservation buffer in the form of Common Equitywill be phased-in over a period of four years in a uniformmanner of 0.625% per year, commencing from January 1,2016.

31



Summary of Basel III Capital


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Countercyclical Capital Buffer Further, a countercyclical capital buffer within a range of02.5% of Common Equity or other fully lossabsorbing capital will be implemented according tonational circumstances.

The purpose of countercyclical capital buffer is toachieve the broader macro-prudential goal of protectingthe banking sector from periods of excess aggregatecredit growth.

For any given country, this buffer will only be in effectwhen there is excess credit growth that results in asystem-wide build up of risk. The countercyclical capitalbuffer, when in effect, would be introduced as anextension of the capital conservation buffer range.

32




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Supplementing the Risk-based Capital Requirement with a

Leverage Ratio

One of the underlying features of the crisis was the build-up of excessive on and off-

balance sheet leverage in the banking system. In many cases, banks built up

excessive leverage while still showing strong risk based capital ratios.

Subsequently, the banking sector was forced to reduce its leverage in a manner that

amplified downward pressure on asset prices, resulting in decline in bank capital and

contraction in credit availability.

Therefore, under Basel III, a simple, transparent, non-risk based regulatory leverage

ratio has been introduced. Thus, the capital requirements will be supplemented by a

non-risk based leverage ratio which is proposed to be calibrated with a Tier 1 leverage

ratio of 3% (the Basel Committee will further explore to track a leverage ratio using

total capital and tangible common equity).

The ratio will be captured with all assets and off balance sheet (OBS) items at their

credit conversion factors and derivatives with Basel II netting rules and a simple

measure of potential future exposure (using Current Exposure Method under Basel II

framework) ensuring that all derivatives are converted in a consistent manner to a loan

equivalent amount. The ratio will be calculated as an average over the quarter.33

Requirements



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Banks are required to maintain a minimum Pillar 1 Capital to Risk

weighted Assets Ratio (CRAR) of 9 % on an on-going basis (other than

capital conservation buffer and countercyclical capital buffer).

With a view to improving the quality and quantity of regulatory capital, it

has been decided that the predominant form of Tier 1 capital must be

Common Equity; since it is critical that banks risk exposures are backed

by high quality capital base. Non-equity Tier 1 and Tier 2 capital would continue to form part of

regulatory capital subject to eligibility criteria as laid down in Basel III.

Accordingly, under revised guidelines (Basel III), total regulatory capital

will consist of the sum of the following categories:

(i) Tier 1 Capital (going-concern capital)

(a) Common Equity Tier 1

(b) Additional Tier 1

(ii) Tier 2 Capital (gone-concern capital)

34

Definition of Regulatory Capital



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Limits and Minima

If a bank has complied with the minimumCommon Equity Tier 1 and Tier 1 capital ratios,then the excess Additional Tier 1 capital can beadmitted for compliance with the minimum CRAR

of 9% of RWAs. In addition to the minimum Common Equity Tier 1capital of 5.5% of RWAs, banks are also requiredto maintain a capital conservation buffer (CCB) of

2.5% of RWAs in the form of Common Equity Tier1 capital.

Thus, with full implementation of capital ratios andCCB the capital requirements are summarised as

follows: (next slide)35




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Regulatory Capital As % to RWAs

(i) Minimum Common Equity Tier 1 ratio 5.5

(ii) Capital conservation buffer (comprised ofCommon Equity)

2.5

(iii) Minimum Common Equity Tier 1 ratio pluscapital conservation buffer [(i)+(ii)]

8.0

(iv) Additional Tier 1 Capital 1.5

(v) Minimum Tier 1 capital ratio [(i) +(iv)] 7.0

(vi) Tier 2 capital 2.0

(vii) Minimum Total Capital Ratio (MTC) [(v)+(vi)] 9.0

(viii) Minimum Total Capital Ratio plus capitalconservation buffer [(vii)+(ii)]

11.5

36



f f C


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For the purpose of reporting Tier 1 capital and CRAR, any excess

Additional Tier 1 capital and Tier 2 capital will be recognised in the

same proportion as that applicable towards minimum capital

requirements. This would mean that to admit any excess AT1 and T2

capital, the bank should have excess CET1 over and above 8%

(5.5%+2.5%).

Accordingly, excess Additional Tier 1 capital above the 1.5% of RWAscan be reckoned by the bank further to the extent of 27.27% (1.5/5.5)

of Common Equity Tier 1 capital in excess of 8% RWAs. Similarly,

excess Tier 2 capital above 2% of RWAs can be reckoned by the bank

further to the extent of 36.36% (2/5.5) of Common Equity Tier 1 capital

in excess of 8% RWAs. In cases where the a bank does not have minimum Common Equity

Tier 1 + capital conservation buffer of 2.5% of RWAs as required but,

has excess Additional Tier 1 and / or Tier 2 capital, no such excess

capital can be reckoned towards computation and reporting of Tier 1

capital and Total Capital.37



a cu a on o m ss e xcess ona er


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Capital Ratios in the year 2018

Common Equity Tier 1 7.5% of RWAs

CCB 2.5% of RWAs

Total CET1 10% of RWAs

PNCPS / PDI 3.0% of RWAs

PNCPS / PDI eligible for Tier 1capital

2.05 % of RWAs {(1.5/5.5)*7.5% of CET1}

PNCPS / PDI ineligible for Tier 1capital

0.95% of RWAs (3-2.05)

Eligible Total Tier 1 capital 9.55% of RWAs

Tier 2 issued by the bank 2.5% of RWAs

Tier 2 capital eligible for CRAR 2.73% of RWAs {(2/5.5)*7.5% of CET1}

PNCPS / PDI eligible for Tier 2capital

0.23% of RWAs (2.73-2.5)

PNCPS / PDI not eligible Tier 2capital 0.72% of RWAs (0.95-.23)Basel I to Basel III: A Journey in Risk Management in

a cu a on o m ss e xcess ona er(AT1) n Tier 2 Capital for the Purpose of Reporting n

Disclosing Minimum Total Capital Ratios

Elements of

Common Equity Tier 1 Capital


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Elements of Common Equity Tier 1 capital will remain the same under Basel III.

Accordingly, the Common Equity component of Tier 1 capital will comprise thefollowing:

(i) Common shares (paid-up equity capital) issued by the bank which meet the

criteria for classification as common shares for regulatory purposes;

(ii) Stock surplus (share premium) resulting from the issue of common shares;

(iii) Statutory reserves;

(iv) Capital reserves representing surplus arising out of sale proceeds of assets;

(v) Other disclosed free reserves, if any;

(vi) Balance in Profit & Loss Account at the end of the previous financial year;

(vii) While calculating capital adequacy at the consolidated level, common shares

issued by consolidated subsidiaries of the bank and held by third parties (i.e.

minority interest) which meet the criteria for inclusion in Common Equity Tier 1

capital ; and

(viii) Less: Regulatory adjustments / deductions applied in the calculation of39

Elements of Common Equity Tier 1 CapitalIndian Banks

Basel I to Basel III: A Journey in Risk Management in Banks

Elements of Add

itional Tier 1 Capital Indian


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Elements of Additional Tier 1 capital will remain the same. Additional Tier 1

capital consists of the sum of the following elements:

(i) Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with

the regulatory requirements;

(ii) Stock surplus (share premium) resulting from the issue of instruments

included in Additional Tier 1 capital; (iii) Debt capital instruments eligible for inclusion in Additional Tier 1 capital,

which comply with the regulatory requirements;

(iv) Any other type of instrument generally notified by the Reserve Bank from

time to time for inclusion in Additional Tier 1 capital;

(v) While calculating capital adequacy at the consolidated level, Additional Tier

1 instruments issued by consolidated subsidiaries of the bank and held by

third parties which meet the criteria for inclusion in Additional Tier 1 capital;

and

(vi) Less: Regulatory adjustments / deductions applied in the calculation of40

Elements of Additional Tier 1 CapitalIndianBanks


Elements of Tier 2 Capital Indian Banks


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(i) General Provisions and Loss Reserves

a. Provisions or loan-loss reserves held against future, presently unidentified

losses, which are freely available to meet losses which subsequently materialize,will qualify for inclusion within Tier 2 capital. Accordingly, General Provisions on

Standard Assets, Floating Provisions, Provisions held for Country Exposures,

Investment Reserve Account, excess provisions which arise on account of sale of

NPAs and countercyclical provisioning buffer will qualify for inclusion in Tier 2

capital. However, these items together will be admitted as Tier 2 capital up to a

maximum of 1.25 % of the total credit risk-weighted assets under the standardized

approach. Under Internal Ratings Based (IRB) approach, where the total expected

loss amount is less than total eligible provisions, banks may recognise the

difference as Tier 2 capital up to a maximum of 0.6 % of credit-risk weighted assets

calculated under the IRB approach.

b. Provisions ascribed to identified deterioration of particular assets or loan

liabilities, whether individual or grouped should be excluded. Accordingly, for

instance, specific provisions on NPAs, both at individual account or at portfolio

level, provisions in lieu of diminution in the fair value of assets in the case ofrestructured advances, rovisions a ainst de reciation in the value of investments41

Elements of Tier 2 Capital - Indian Banks


ements o er ap ta - n an


42/73

(ii) Debt Capital Instruments issued by the banks;

(iii) Preference Share Capital Instruments [Perpetual Cumulative

Preference Shares (PCPS) / Redeemable Non-Cumulative Preference

Shares (RNCPS) / Redeemable Cumulative Preference Shares

(RCPS)] issued by the banks;

(iv) Stock surplus (share premium) resulting from the issue of

instruments included in Tier 2 capital; (v) While calculating capital adequacy at the consolidated level, Tier 2

capital instruments issued by consolidated subsidiaries of the bank and

held by third parties which meet the criteria for inclusion in Tier 2 capital

;

(vi) Revaluation reserves at a discount of 55%;

(vii) Any other type of instrument generally notified by the Reserve Bank

from time to time for inclusion in Tier 2 capital; and

(viii) Less: Regulatory adjustments / deductions applied in the

calculation of Tier 2 capital [i.e. to be deducted from the sum of items (i)42

ements o er ap ta - n anBanks


rans t ona

rrangements o


43/73

Minimum capital ratios Jan 1,

2013

Mar 31,

2014

Mar 31,

2015

Mar 31,

2016

Mar 31,

2017

Minimum Common EquityTier 1 (CET1)

4.5 5 5.5 5.5 5.5

Capital conservationbuffer (CCB)

0.625 1.25 1.875 2.5

Minimum CET1+ CCB 4.5 5.625 6.75 7.375 8

Minimum Tier 1 capital 6 6.5 7 7 7

Minimum Total Capital* 9 9 9 9 9

Minimum Total Capital+CCB

9 9.625 10.25 10.825 11.5

Phase-in of all deductionsfrom CET1 (in %)

40 60 80 100 100

43

rans t ona rrangements oRWAs)

*The difference between the minimum total capital requirement of 9% and theTier 1

requirement can be met with Tier 2 and higher forms of capital.Basel I to Basel III: A Journey in Risk Management inBanks

C it l C ti B ff


44/73

The capital conservation buffer (CCB) is designed to ensure that

banks build up capital buffers during normal times (i.e. outside periods

of stress) which can be drawn down as losses are incurred during astressed period. The requirement is based on simple capital

conservation rules designed to avoid breaches of minimum capital

requirements.

Outside the period of stress, banks should hold buffers of capital

above the regulatory minimum. When buffers have been drawn down,

one way banks should look to rebuild them is through reducing

discretionary distributions of earnings. This could include reducing

dividend payments, share buybacks and staff bonus payments.

Banks may also choose to raise new capital from the market as analternative to conserving internally generated capital. However, if a

bank decides to make payments in excess of the constraints imposed

as explained above, the bank, with the prior approval of RBI, would

have to use the option of raising capital from the market equal to the

amount above the constraint which it wishes to distribute.44



C it l C ti B ff


45/73

Banks are required to maintain a capital conservation buffer of2.5%, comprised of Common Equity Tier 1 capital, above theregulatory minimum capital requirement of 9%. Banks shouldnot distribute capital (i.e. pay dividends or bonuses in any form)in case capital level falls within this range.

However, they will be able to conduct business as normal when

their capital levels fall into the conservation range as theyexperience losses. Therefore, the constraints imposed arerelated to the distributions only and are not related to theoperations of banks. The distribution constraints imposed onbanks when their capital levels fall into the range increase as

the banks capital levels approach the minimum requirements.The Table (next slide) shows the minimum capital conservationratios a bank must meet at various levels of the Common EquityTier 1 capital ratios.

Basel I to Basel III: A Journey in Risk Management in


C it l C ti B ff


46/73

Minimum capital conservation standards for individual bank

Common Equity Tier 1 Ratio Minimum Capital ConservationRatios

(expressed as a %age of earnings)

5.5% - 6.125% 100%

>6.125% - 6.75% 80%>6.75% - 7.375% 60%

>7.375% - 8.0% 40%

>8.0% 0%

46


For example, a bank with a Common Equity Tier 1 capital ratio in therange of6.125% to 6.75% is required to conserve 80% of its earnings in thesubsequent financial year (i.e. payout no more than 20% in terms ofdividends, share buybacks and discretionary bonus payments is

allowed). Basel I to Basel III: A Journey in Risk Management inBanks

C it l C ti B ff


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The Common Equity Tier 1 ratio includes amountsused to meet the minimum Common Equity Tier 1capital requirement of 5.5%, but excludes anyadditional Common Equity Tier 1 needed to meetthe 7% Tier 1 and 9% Total Capital requirements.

For example, a bank maintains Common EquityTier 1 capital of 9% and has no Additional Tier 1 orTier 2 capital. Therefore, the bank would meet allminimum capital requirements, but would have azero conservation buffer and therefore, the bank

would be subjected to 100% constraint ondistributions of capital by way of dividends, share-buybacks and discretionary bonuses.



L R ti


48/73

One of the underlying features of the crisis was the build-up of excessive on and

off-balance sheet leverage in the banking system. In many cases, banks built up

excessive leverage while still showing strong risk based capital ratios. During the

most severe part of the crisis, the banking sector was forced by the market to

reduce its leverage in a manner that amplified downward pressure on asset prices,

further exacerbating the positive feedback loop between losses, declines in bank

capital, and contraction in credit availability.

Therefore, under Basel III, a simple, transparent, non-risk based leverage ratio has

been introduced. The leverage ratio is calibrated to act as a credible

supplementary measure to the risk based capital requirements. The leverage ratio

is intended to achieve the following objectives:

(a) constrain the build-up of leverage in the banking sector, helping avoiddestabilising deleveraging processes which can damage the broader financial

system and the economy; and

(b) reinforce the risk based requirements with a simple, non-risk based backstop

measure.

48

Leverage Ratio


Definition n Calc lation of Le erage Ratio


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The provisions relating to leverage ratio contained in the Basel III

document are intended to serve as the basis for testing the leverage ratio

during the parallel run period. The Basel Committee will test a minimum

Tier 1 leverage ratio of 3% during the parallel run period from 1 January

2013 to 1 January 2017.

During the period of parallel run, banks should strive to maintain their

existing level of leverage ratio but, in no case the leverage ratio should fallbelow 4.5%. A bank whose leverage ratio is below 4.5% may endeavor to

bring it above 4.5% as early as possible. Final leverage ratio requirement

would be prescribed by RBI after the parallel run taking into account the

prescriptions given by the Basel Committee.

The leverage ratio shall be maintained on a quarterly basis. The basis ofcalculation at the end of each quarter is the average of the month-end

leverage ratio over the quarter based on the definitions of capital (the

capi ta l measure) and total exposure (the expo sure measure) specified

in the following paragraphs.

49

Definition n Calculation of Leverage Ratio


Definition n Calculation of Leverage


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Capital Measure:

(a) The capital measure for the leverage ratio should be based on the new definitionof Tier 1 capital as set out in this presentation.

(b) Items that are deducted completely from capital do not contribute to leverage,

and should therefore also be deducted from the measure of exposure. That is, the

capital and exposure should be measured consistently and should avoid double

counting. This means that deductions from Tier 1 capital should also be made fromthe exposure measure.

Exposure Measure

The exposure measure for the leverage ratio should generally follow the accountingmeasure of exposure. In order to measure the exposure consistently with financial

accounts, the following should be applied by banks:

(a) on-balance sheet, non-derivative exposures will be net of specific provisions and

valuation adjustments (e.g. prudent valuation adjustments for AFS and HFT

positions, credit valuation adjustments);

(b) physical or financial collateral, guarantees or credit risk mitigation purchased is

not allowed to reduce on-balance sheet exposures; and

(c) netting of loans and deposits is not allowed.


Definition n Calculation of LeverageRatio


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Liquidity Coverage Ratio (LCR)


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The stress scenario specified by the BCBS for LCR incorporates many of theshocks experienced during the crisis that started in 2007 into one significant

stress scenario for which a bank would need sufficient liquidity on hand tosurvive for up to 30 calendar days. The scenario, thus, entails a combinedidiosyncratic and market-wide shock that would result in:

a) the run-off of a proportion of retail deposits;

b) a partial loss of unsecured wholesale funding capacity;

c) a partial loss of secured, short-term financing with certain collateral andcounterparties;

d) additional contractual outflows that would arise from a downgrade in thebanks public credit rating by up to three notches, including collateral postingrequirements;

e) increases in market volatilities that impact the quality of collateral or

potential future exposure of derivative positions and thus require largercollateral haircuts or additional collateral, or lead to other liquidity needs;

f) unscheduled draws on committed but unused credit and liquidity facilitiesthat the bank has provided to its clients; and

g) the potential need for the bank to buy back debt or honour non-contractualobligations in the interest of mitigating reputational risk.





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Characteristics of High Quality Liquid Assets:

Liquid assets comprise of high quality assets that can be readilysold or used as collateral to obtain funds in a range of stressscenarios. They should be unencumbered i.e. without legal,regulatory or operational impediments. Assets are considered to

be high quality liquid assets if they can be easily andimmediately converted into cash at little or no loss of value.

While the fundamental characteristics of these assets includelow credit and market risk; ease and certainty of valuation; lowcorrelation with risky assets and listed on a developed and

recognized exchange market, the market related characteristicsinclude active and sizeable market; presence of committedmarket makers, low market concentration and flight to quality(tendencies to move into these types of assets in a systemiccrisis).





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Definition of High Quality Liquid Assets

There are two categories of assets that can be included in the stock of high quality

liquid assets viz. Level 1 and Level 2 assets. Assets to be included in eachcategory are those that the bank is holding on the first day of the stress period.

Level 1 Assets

Level 1 assets of banks would comprise of the following and these assets can beincluded in the stock of liquid assets without any limit as also without applying anyhaircut:

Cash including cash reserves in excess of required CRR.

Government securities in excess of the SLR requirement.

SLR securities within the mandatory requirement to the extent allowed by RBI.

Marketable securities issued or guaranteed by foreign sovereigns satisfying allthe following conditions:

assigned a 0% risk weight under the Basel II standardized approach;

traded in large, deep and active repo or cash markets characterized by a low level of

concentration;

proven record as a reliable source of liquidity in the markets (repo or sale) even during

stressed market conditions; and

not issued by a bank/financial institution/NBFC or any of its affiliated entities.Basel I to Basel III: A Journey in Risk Management in




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Definition of High Quality Liquid Assets

Level 2 Assets Level 2 assets can be included in the stock of liquid assets, subject to the

requirement that they comprise no more than 40% of the overall stock after

haircuts have been applied. The portfolio of Level 2 assets held by the bank

should be well diversified in terms of type of assets, type of issuer and specific

counterparty or issuer. A minimum 15% haircut should be applied to thecurrent market value of each Level 2 asset held in the stock. Level 2 assets

are limited to the following:

i. Marketable securities representing claims on or claims guaranteed by

sovereigns, Public Sector Entities (PSEs) or multilateral development banks

that are assigned a 20% risk weight under the Basel II Standardised Approach

for credit risk and provided that they are not issued by a bank/financial

institution/NBFC or any of its affiliated entities.

ii. Corporate bonds (not issued by a bank/financial institution/NBFC or any of

its affiliated entities) which have been rated AA- or above by an Eligible CreditBasel I to Basel III: A Journey in Risk Management in


Net Stable Funding Ratio

(NSFR)


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The NSFR is designed to ensure that long term assets are funded with at least aminimum amount of stable liabilities in relation to their liquidity risk profiles. TheNSFR aims to limit over-reliance on short-term wholesale funding during times of

buoyant market liquidity and encourage better assessment of liquidity risk across allon- and off-balance sheet items. In addition, the NSFR approach offsets incentivesfor banks to fund their stock of liquid assets with short-term funds that mature justoutside the 30-day horizon for meeting LCR. .

The ratio can be calculated as: NSFR = [Available Stable Funding (ASF) / Required

amount of Stable Funding (RSF)] * 100 > 100%

Stable funding is defined as the portion of those types and amounts of equity and

liability financing expected to be reliable sources of funds over a one-year timehorizon under conditions of extended stress.

ASF is defined as the total amount of an institutions: ( i) capital; (ii) preferred stock with

maturity of equal to or greater than one year; (iii) liabilities with effective maturities of oneyear or greater; and (iv) that portion of stable non-maturity deposits and/or term

deposits with maturities of less than one year that would be expected to stay with the

institution for an extended period in an idiosyncratic stress event.

RSF is calculated as the sum of the value of the assets held and funded by the

institution, multiplied by a specific required stable funding (RSF) factor assigned to eachparticular asset type, added to the amount of OBS (off balance sheet) activity (orBasel I to Basel III: A Journey in Risk Management in

Net Stable Funding Ratio (NSFR)

Transition

Phase for the Liquidity Standards


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Both the LCR and NSFR are currently subject to an observation period by the

BCBS, with a view to addressing any unintended consequences that thestandards may have for financial markets, credit extension and economic

growth. At the latest, any revisions would be made to the LCR by mid-2013 and

to the NSFR by mid-2016. Accordingly, the LCR, including any revisions, will be

introduced as on 1 January 2015 and the NSFR, including any revisions, will

move to a minimum standard by 1 January 2018. The LCR and NSFR will thusbecome binding for the banks from 1 January 2015 and 2018, respectively i.e.

banks will have to ensure that they maintain the required LCR and NSFR at all

times starting from January 2015 and January 2018, respectively. While the LCR

and NSFR standards would become binding only from January 2015 and 2018,

respectively, the supervisory reporting under the Basel III framework is expectedfrom 2012. Accordingly, banks are required to furnish statements on LCR and

NSFR and statements based on monitoring metrics/tools prescribed under Basel

III framework to Chief General Manager-in-Charge, Department of Banking

Operations and Development (DBOD), Central Office, Reserve Bank of India,

Mumbai on best efforts basis from the month ending /quarter ending June 2012.Basel I to Basel III: A Journey in Risk Management in

q yunder Basel III

Summary: Issues with Basel II


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1. Basel II is procyclical. In good times, whenbanks are doing well, and the market is willing toinvest capital in them, Basel II does not imposesignificant additional capital requirement onbanks. On the other hand, in stressed times, whenbanks require additional capital and markets arewary of supplying that capital, Basel II requiresbanks to bring in more of it.

2. The second issue with Basel II was that even

as it made capital regulation more risk sensitive, itdid not bring in corresponding changes in thedefinition and composition of regulatory capital toreflect the changing market dynamics.





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3. The third issue with Basel II concerns leverage. Basel II didnot have any explicit regulation governing leverage. It assumedthat its risk based capital requirement would automaticallymitigate the risk of excessive leverage. This assumption, as itturned out, was flawed as excessive leverage of banks was oneof the prime causes of the crisis. Similarly, Basel II did notexplicitly cover liquidity risk.

4. The fourth and final issue with Basel II was focusingexclusively on individual financial institutions, ignoring the

systemic risk arising from the interconnectedness acrossinstitutions which, as we now know with the benefit of hindsight,was the culprit for ferociously spreading the crisis acrossfinancial markets.



Basel II?


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The enhancements of Basel III over Basel II come primarily in four areas: (i)

augmentation in the level and quality of capital; (ii) introduction of liquidity

standards; (iii) modifications in provisioning norms; and (iv) better and morecomprehensive disclosures.

(i) Higher Capital Requirement

As can be seen from the comparative data in the Table , Basel III requires

higher and better quality capital. The minimum total capital remainsunchanged at 8 per cent of risk weighted assets (RWA). However, Basel III

introduces a capital conservation buffer of 2.5 per cent of RWA over and

above the minimum capital requirement, raising the total capital requirement

to 10.5 per cent against 8.0 per cent under Basel II. This buffer is intendedto ensure that banks are able to absorb losses without breaching the

minimum capital requirement, and are able to carry on business even in a

downturn without deleveraging. This buffer is not part of the regulatory

minimum; however, the level of the buffer will determine the dividend

distributed to shareholders and the bonus paid to staff.Basel I to Basel III: A Journey in Risk Management in

Basel II?

Table 1: Capital Requirements Under Basel II


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As a percentage of risk

weighted assets

Basel II Basel III (as onJanuary 1, 2019)

A = (B+D)B

C

D

E

F=C+E

G=A+E

Minimum Total CapitalMinimum Tier 1 Capital

of which:Minimum Common EquityTier 1 CapitalMaximum Tier 2 Capital(within Total Capital)Capital Conservation

Buffer(CCB)Minimum Common EquityTier 1 Capital + CCBMinimum Total Capital +CCB

8.04.0

2.0

4.0

----

2.0

8.0

8.06.0

4.5

2.0

2.5

7.0

10.5


p qand Basel III

ow s ase an mprovemen over ase :Higher Capital Requirement (Contd )


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In addition to the capital conservation buffer, Basel III introduces

another capital bufferthe countercyclical capital bufferin the range

of 02.5 per cent of RWA which could be imposed on banks duringperiods of excess credit growth. Also, there is a provision for a higher

capital surcharge on systemically important banks.

To mitigate the risk of banks building up excess leverage as happened

under Basel II, Basel III institutes a leverage ratio as a backstop to the

risk based capital requirement. The Basel Committee is contemplating

a minimum Tier 1 leverage ratio of 3 per cent (33.3 times) which will

eventually become a Pillar 1 requirement as of January 1, 2018.

To cover market risk, Basel III strengthens the counterparty credit risk

framework in market risk instruments. This includes the use ofstressed input parameters to determine the capital requirement for

counterparty credit default risk. Besides, there is a new capital

requirement known as CVA (credit valuation adjustment) risk capital

charge for OTC derivatives to protect banks against the risk of decline

in the credit quality of the counterparty.Basel I to Basel III: A Journey in Risk Management in

pHigher Capital Requirement (Contd.)

How is Basel III an improvement over Basel


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To mitigate liquidity risk, Basel III addresses both potential

short-term liquidity stress and longer-term structuralliquidity mismatches in banks balance sheets (Table: NextSlide).

To cover short-term liquidity stress, banks will be requiredto maintain sufficient high-quality unencumbered liquid

assets to withstand any stressed funding scenario over a30-day horizon as measured by the liquidity coverage ratio(LCR).

To mitigate liquidity mismatches in the longer term, banks

will be mandated to maintain a net stable funding ratio(NSFR). The NSFR mandates a minimum amount ofstable sources of funding relative to the liquidity profile ofthe assets, as well as the potential for contingent liquidityneeds arising from off-balance sheet commitments over a

one-year horizon. In essence, the NSFR is aimed atBasel I to Basel III: A Journey in Risk Management in

II?: Liquidity Standards

How is Basel III an improvement over Basel


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Ratio Basel II Basel III

Liquidity CoverageRatio (LCR) (to beintroduced as onJanuary 1, 2015)

--- Stock of high-qualityliquidassets 100 per centTotal net cash outflowsoverthe next 30 calendardays

Net Stable FundingRatio (NSFR) (to beintroduced as onJanuary 1, 2018)

--- Available amount ofstablefunding > 100 per centRequired amount of

stable Basel I to Basel III: A Journey in Risk Management in

II?:Liquidity Standards

II?:


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The Basel Committee is supporting the proposalfor adoption of an expected loss based measure

of provisioning which captures actual losses more

transparently and is also less procyclical than thecurrent incurred loss approach. The expected

loss approach for provisioning will make financial

reporting more useful for all stakeholders,

including regulators and supervisors.


II?:Provisioning Norms

II?:


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The disclosures made by banks are important for market

participants to make informed decisions. One of the

lessons of the crisis is that the disclosures made by banks

on their risky exposures and on regulatory capital were

neither appropriate nor sufficiently transparent to afford

any comparative analysis.

To remedy this, Basel III requires banks to disclose allrelevant details, including any regulatory adjustments, as

regards the composition of the regulatory capital of the

bank.


II?:Disclosure Requirement

Additional (On top of internal accruals)CommonEquity requirements of Indian Banks under Basel III:


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Public

Sector

Banks

Private

Sector

Banks

Total

A. Additional Equity Capital Requirementsunder Basel III

B. Additional Equity Capital Requirementsunder Basel II

C. Net Equity Capital Requirements underBasel III (A-B)D. Of Additional Equity Capital Requirementsunder Basel III for Public Sector Banks (A)

Government Share (if present shareholding pattern is maintained)

Government Share (if shareholdingis brought down to 51 per cent)

Market Share (if the Governmentsshareholding pattern is maintained at presentlevel)

1400-1500

650-700

750-800

880-910

660-690

520-590

200-250

20-25

180-225

---

---

---

1600-1750

670-725

930-1025

---

---

---


Equity requirements of Indian Banks under Basel III:Rs in billions (RBI Bulletin October 2012)

The Reserve Bank has made some estimates based on the following two conservative assumptionscovering the period to March 31, 2018: (i) risk weighted assets of individual banks will increase by 20

per cent per annum; and (ii) internal accruals will be of the order of 1 per cent of risk weighted assets.

Will Basel III hurt growth?


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The main concern is that the higher capital requirements under

Basel III will kick in at a time when credit demand in theeconomy will be on the rise.

Will this raise the cost of credit and hence militate against

growth?

At its core, this boils down to the tension between short-termcompulsions and long term growth prospects.

Comfortingly, empirical research by BIS economists shows thateven if Basel III may impose some costs in the short-term, it willsecure medium to long term growth prospects.


g

banks?


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Basel III requires higher and better quality capital. Admittedly, the cost of

equity capital is high. It is also likely that the loss absorbency

requirements on the non-equity regulatory capital will increase its cost.

The average Return on Equity (RoE) of the Indian banking system for the

last three years has been approximately 15 per cent. Implementation of

Basel III is expected to result in a decline in Indian banks RoE in the

short-term. However, the expected benefits arising out of a more stable

and stronger banking system will largely offset the negative impact of a

lower RoE in the medium to long term.

The relatively higher level of net interest margins (NIMs) of Indian banks,

of approximately 3 per cent, suggests that there is scope for banks to

improve their efficiency, bring down the cost of intermediation and ensurethat returns are not overly compromised even as the cost of capital may

increase.

The competitive dimensions of Indian banking sector should ensure that

banks are able to deliver efficient financial intermediation without

compromising the interests of depositors and borrowers.Basel I to Basel III: A Journey in Risk Management in

banks?

Minimum Regulatory Capital Prescriptions (ast f i k i ht d t )


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Basel

III (ason Jan

1,

2019)

RBI

Prescriptions

Current(BaselII)

Basel III(as onMarch31,

2018)A = B+D)BC

D

EF = C+E

G = A+EH

Minimum Total CapitalMinimum Tier 1 capitalof which:Minimum Common Equity Tier 1capital

Maximum Tier 2 capital (within TotalCapital)Capital Conservation Buffer (CCB)Minimum Common Equity Tier 1capital + CCBMinimum Total Capital + CCB

Leverage Ratio (ratio to total assets)

8.06.0

4.52.0

2.5

7.010.53.0

9.06.0

3.63.0

---

3.6------

9.07.0

5.52.0

2.5

8.011.54.5


percentage of risk weighted assets)

What are D-SIBs? Will any Indian bank bel ifi d D SIB?


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The moral hazard relating to too-big-to-fail institutions whichencourages risky behaviour by larger banks has been ahuge issue on the post-crisis reform agenda.

Basel III seeks to mitigate this externality by identifyingglobal systemically important banks (G-SIBs) and

mandating them to maintain a higher level of capitaldependent on their level of systemic importance. The list ofG-SIBs is to be reviewed annually. Currently, no Indian bankappears in the list of GSIBs.

Separately, the Basel Committee is working on establishing

a minimum set of principles for domestic systemicallyimportant banks (D-SIBs), and also on the norms forprescribing higher loss absorbency (HLA) capital standardsfor them. Besides, it is also necessary to evolve a soundresolution mechanism for D-SIBs.


classified as a D-SIB?

What sort of capacity building is required inth i l t ti f B l III?


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Banks in India are currently operating on the Standardised

Approaches of Basel II. The larger banks need to migrate to theAdvanced Approaches, especially as they expand theiroverseas presence. The adoption of advanced approaches torisk management will enable banks to manage their capitalmore efficiently and improve their profitability.

This graduation to Advanced Approaches requires three things.First and most importantly, a change in perception from lookingupon the capital framework as a compliance function to seeing itas a necessary pre-requisite for keeping the bank sound, stable,

and therefore profitable; second, deeper and more broad basedcapacity in risk management; and finally adequate and goodquality data.

[Slides No. 59-72 are based on a write up by Dr. Duvvuri Subbarao, Governor, Reserve Bank of

India, published in RBI Bulletin, October 2012] Basel I to Basel III: A Journey in Risk Management in

the implementation of Basel III?


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