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Handbook of Basel III Capital

Handbook of Basel III Capital

Enhancing Bank Capital in Practice

JUAN RAMIREZ

This edition first published 2017© 2017 Juan Ramirez

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Library of Congress Cataloging-in-Publication Data is available

ISBN 9781119330820 (hardcover) ISBN 9781119330806 (ePDF)ISBN 9781119330899 (ePub)

Cover Design: WileyCover Image: © Vasiliy Yakobchuk/iStockphoto

Set in 9/11pt and Sabon LT Std by SPi Global, Chennai, IndiaPrinted in Great Britain by TJ International Ltd, Padstow, Cornwall, UK

10 9 8 7 6 5 4 3 2 1

To my wife Marta and our children Borja, Martuca and David

Preface xiii

About the Author xv

CHAPTER 1Overview of Basel III 1

1.1 Introduction to Basel III 11.2 Expected and Unexpected Credit Losses and Bank Capital 31.3 The Three‐Pillar Approach to Bank Capital 41.4 Risk‐Weighted Assets (RWAs) 8

CHAPTER 2Minimum Capital Requirements 11

2.1 Components and Minimum Requirements of Bank Capital 112.2 Components and Minimum Requirements of Capital Buffers 122.3 Capital Conservation Buffer 132.4 Countercyclical Buffer 142.5 Systemic Risk Buffers 192.6 Going Concern vs. Gone Concern Capital 232.7 Case Study: UBS vs. JP Morgan Chase G-SIB Strategies 252.8 Transitional Provisions 36

CHAPTER 3Common Equity 1 (CET1) Capital 39

3.1 CET1 Minimum Requirements 393.2 Eligibility Requirements of CET1 Instruments 393.3 Case Study: UBS Dividend Policy and its Impact on CET1 483.4 Case Study: Santander Dividend Policy and its Impact in CET1 543.5 Accumulated Other Comprehensive Income 583.6 Case Study: Banco BPI’s Partial Disposal of Portfolio of Portuguese

and Italian Government Bonds 693.7 Other Items Eligible for CET1 Capital 743.8 CET1 Prudential Filters 753.9 Additional Valuation Adjustments 763.10 Intangible Assets (Including Goodwill) 763.11 Case Study: Danske Bank’s Goodwill Impairment 84

Contents

vii

viii CONTENTS

3.12 Case Study: Barclays Badwill Resulting from its Acquisition of Lehman Brothers N.A. 85

3.13 Deferred Tax Assets 873.14 Fair Value Reserves Related to Gains or Losses on Cash Flow Hedges 873.15 Negative Amounts Resulting from the Calculation of Expected

Loss Amounts 973.16 Equity Increases Resulting from Securitised Assets 983.17 Gains or Losses on Liabilities Valued at Fair Value Resulting

from Changes in Own Credit Standing 993.18 Defined‐Benefit Pension Plans 1103.19 Case Study: Lloyds’ De‐Risking of its Defined Benefit Pension Plans 1193.20 Holdings by a Bank of Own CET1 Instruments 1213.21 Case Study: Danske Bank’s Share Buyback Programme 1243.22 Case Study: Deutsche Bank’s Treasury Shares Strategy 1253.23 Holdings of the CET1 Instruments of Financial Sector Entities 1403.24 Deduction Election of 1,250% RW Assets 1403.25 Amount Exceeding the 17.65% Threshold 1413.26 Foreseeable Tax Charges Relating to CET1 Items 1423.27 Excess of Qualifying AT1 Deductions 1423.28 Temporary Filter on Unrealised Gains and Losses

on Available‐for‐Sale Instruments 142

CHAPTER 4Additional Tier 1 (AT1) Capital 144

4.1 AT1 Minimum Capital Requirements 1444.2 Criteria Governing Instruments Inclusion in AT1 Capital 1444.3 Deductions from AT1 Capital 1514.4 Holdings of AT1 Instruments of Other Financial Institutions 1544.5 Case Study: Lloyds Banking Group Exchange Offer

of Tier 2 for AT1 Securities 158

CHAPTER 5T ier 2 Capital 172

5.1 Tier 2 Capital Calculation and Requirements for Inclusion 1725.2 Negative Amounts Resulting from the Calculation

of Expected Loss Amounts 1775.3 Deductions from Tier 2 Capital 1785.4 Holdings of Tier 2 Instruments of Other Financial Institutions 1795.5 Case Study: Deutsche Bank’s Tier 2 Issue 183

CHAPTER 6Contingent Convertibles (CoCos) 187

6.1 Types of CoCos 1876.2 Trigger Levels 1896.3 CoCos’ Statutory Conversion or Write‐Down – Point of Non‐Viability 190

CONTENTS ix

6.4 CoCo’s Coupon Suspension – Maximum Distributable Amount 1956.5 Adding Pillar 2 Capital Requirements to the MDA Calculation 2006.6 Case Study: Barclays’ Equity Convertible CoCo 2006.7 Case Study: Deutsche Bank’s Write‐Down CoCo 2106.8 CoCos from an Investor’s Perspective 226

CHAPTER 7Additional Valuation Adjustments (AVAs) 228

7.1 Fair Valuation Accounting Framework (IFRS 13) 2297.2 Case Study: Goldman Sachs Investment in Industrial

and Commercial Bank of China 2417.3 Prudent Valuation vs. Fair Valuation 2437.4 Additional Valuation Adjustments (AVAs) Under the Core Approach 2487.5 Market Price Uncertainty AVA 2507.6 Close‐Out Costs AVA 2667.7 Model Risk AVA 2677.8 Unearned Credit Spreads AVA 2687.9 Investing and Funding Costs AVA 2697.10 Concentrated Positions AVA 2697.11 Future Administrative Costs AVA 2717.12 Early Terminations Costs AVA 2727.13 Operational Risk AVA 272

CHAPTER 8Accounting vs. Regulatory Consolidation 275

8.1 Accounting Recognition of Investments in Non‐Structured Entities 2758.2 Accounting for Full Consolidation 2768.3 Working Example on Consolidation 2838.4 Loss of Control 2948.5 The Equity Method – Associates 2958.6 Case Study: Deutsche Bank’s Acquisition of Postbank 2988.7 IFRS Consolidation vs. Regulatory Consolidation 309

CHAPTER 9Treatment of Minority Interests in Consolidated Regulatory Capital 312

9.1 Minority Interests Included in Consolidated CET1 3129.2 Minority Interests Included in Consolidated AT1,

Tier 1, Tier 2 and Qualifying Total Capital 3169.3 Illustrative Example 1: Calculation of the Impact of Minority

Interests on Consolidated Capital 3199.4 Illustrative Example 2: Calculation of the Impact of Minority

Interests on Consolidated Capital 3229.5 Case Study: Artificial Creation of Minority Interests 3259.6 Case Study: Banco Santander Repurchase of Minority

Interests in Santander Brasil 326

x CONTENTS

CHAPTER 10Investments in Capital Instruments of Financial Institutions 334

10.1 Basel III Treatment of Investments in Capital Instruments of Financial Institutions 335

10.2 Worked Examples of Investments in Capital Instruments of Unconsolidated Financial Institutions 347

10.3 Case Study: BBVA’s Acquisition of Garanti 354

CHAPTER 11Investments in Capital Instruments of Insurance Entities 370

11.1 The Concept of Double Leverage 37011.2 Case Study: ING’s Double Leverage 37111.3 Regulatory Peculiarities of Investments in Insurance Entities 37711.4 Case Study: Lloyds Banking Group’s Capital Enhancement

Initiatives Related to its Insurance Subsidiaries 379

CHAPTER 12Equity Investments in Non‐financial Entities 384

12.1 Basel III and Equity Exposures to Non‐Financial Entities in the Banking Book 384

12.2 Equity Exposures Under the Standardised Approach 38512.3 Equity Exposures Under the IRB Approach 38612.4 Expected Losses from Equity Exposures Under the IRB Approach 39212.5 Qualified Holdings Outside the Financial Sector Exceeding

the 15% Threshold 39312.6 Temporary Exemption from the IRB Treatment

of Certain Equity Exposures 39412.7 Case Study: CaixaBank’s Mandatory Exchangeable on Repsol 39512.8 Case Study: Mitsubishi UFJ Financial Group’s Corporate Stakes 405

CHAPTER 13Deferred Tax Assets (DTAs) 411

13.1 Taxes from an Accounting Perspective 41113.2 Accounting for Deferred Taxes Arising from Temporary Differences –

Application to Equity Investments at Either FVTPL or FVTOCI 41513.3 Worked Example: Temporary Differences Stemming

from Debt Instruments Recognised at Fair Value 42813.4 Case Study: UBS’s Deferred Tax Assets 43513.5 Deferred Tax Assets from a Regulatory Capital Perspective 44213.6 Case Study: Spanish Banks Conversion of DTAs Into Tax Credits,

Improving Their CET1 Positions 44913.7 Case Study: Lloyds Banking Group’s Expected Utilisation

of Deferred Tax Assets 45213.8 Initiatives to Reduce Impacts of Deferred Tax Assets

on Bank Capital 459

CONTENTS xi

CHAPTER 14Asset Protection Schemes and Bad Banks 469

14.1 ING’s Illiquid Asset Back‐Up Facility with the Dutch State 46914.2 Royal Bank of Scotland’s Asset Protection Scheme 47614.3 Case Study: SAREB, The Spanish Bad Bank 48614.4 Case Study: NAMA, The Irish Bad Bank 48914.5 Asset Protection Schemes versus Bad Banks 493

CHAPTER 15Approaching Capital Enhancement Initiatives 495

15.1 Initial Thoughts 49515.2 Overview of Main CET1 Capital Ratio Enhancement Initiatives 49715.3 Case Study: Deutsche Bank’s Rights Issue 50115.4 Case Study: Structuring the Disposal of a Portfolio of NPLs 50215.5 Case Study: Banco Popular Joint Venture with

Verde Partners and Kennedy Wilson 50815.6 Case Study: Co‐Operative Bank’s Liability Management Exercise 516

GLOSSARY 523

BIBLIOGRAPHY 531

INDEX 533

xiii

Preface

Often banks feel Basel III regulations are excessively conservative and act as a deterrent to investors looking for attractive returns. However, Basel III is an opportunity for banks to improve their asset

quality and risk‐return profiles. It encourages a strategic approach to decisions about businesses and assets, allocating precious capital toward opportunities that fit the bank’s actual risk and return pro-files, and exerting pressure to shed unattractive positions.

This book tries to fill a gap in the financial literature on regulatory bank capital. I found a sub-stantial number of excellent books often written by developers of quantitative models on the estima-tion of credit risk parameters (i.e., exposures, probabilities of default and so on). There also several good books providing a general overview of Basel III, which are useful to grasp an introductory knowl-edge of the regulation, but that might be too elementary for regulatory capital professionals.

This book has two objectives: (i) to provide readers with a deep understanding of the principles underpinning the capital dimension of Basel III (i.e., the numerator of the capital ratio calculation) and (ii) to be exposed to real‐life cases of initiatives to enhance capital. The first objective is a notably chal-lenging one due to the large number of complex rules and because it requires a thorough understanding of the accounting treatment of the items affecting regulatory capital. To meet the second objective, a large number of real case studies have been included.

This book is aimed primarily at capital practitioners at banks, bank equity analysts, institutional investors and banking supervisors. I believe that it is also a useful resource for structurers at investment banks developing capital‐efficient transactions and for professionals at auditing, consulting and law firms helping client banks to enhance their capital positions.

Whilst the Basel III rules are intended to provide a common framework for financial institutions, its implementation may vary across the globe, as national supervisors have discretion about the domes-tic implementation of the Basel III rules. This book is based on the European Union version of Basel III, which is referred to as CRD IV. Whilst some particular changes to the general Basel III framework are introduced by the CRD, most of its contents are likely to be common to the regulation of other jurisdictions.

The interpretations described in this book are those of the author alone and do not reflect the positions of the entities which the author is or has been related to.

xv

Juan Ramirez currently works for Deloitte in London, assessing the accounting treatment, risk man-agement and regulatory capital impact of complex transactions.Prior to joining Deloitte, Juan worked for 20 years in investment banking in sales and trading at

JP Morgan, Lehman Brothers, Barclays Capital, Santander and BNP Paribas. He has been involved with interest rate, equity, FX and credit derivatives. Juan holds an MBA from University of Chicago and a BSc in electrical engineering from ICAI.

Juan is the author of the books Accounting for Derivatives and Handbook of Corporate Equity Derivatives and Equity Capital Markets, both published by Wiley.

About the Author

1

CHAPTER1

Bank executives are in a difficult position. On the one hand their shareholders require an attractive return on their investment. On the other hand, banking supervisors require these entities to hold a

substantial amount of expensive capital. As a result, banks need capital‐efficient business models to prosper.

Banking regulators and supervisors are in a difficult position as well. Excessively conservative capital requirements may lessen banks’ appetite for lending, endangering economic growth. Excessively light capital requirements may weaken the resilience of the banking sector and cause deep eco-nomic crises.

1.1 INTRODUCTION TO BASEL III

Basel III’s main set of recommendations were issued by the Basel Committee on Banking Supervision (BCBS) in December 2010 (revised June 2011) and titled Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems.

It is important to note that the BCBS does not establish laws, regulations or rules for any financial institution directly. It merely acts in an advisory capacity. It is up to each country’s specific lawmakers and regulators to enact whatever portions of the recommendations they deem appropriate that would apply to financial institutions being supervised by the country’s regulator.

1.1.1 Basel III, CRR, CRD IVWith a view to implementing the agreements of Basel III and harmonising banking solvency regulations across the European Union as a whole, in June 2013 the European Parliament and the Council of the European Union adopted the following legislation:

◾◾ Capital Requirements Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 (hereinafter the “CRD IV”), on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC. CRD IV entered into force in the EU on 1 January 2014; and

◾◾ Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 (hereinafter the “CRR”).

Overview of Basel III

2 HANDBOOK OF BASEL III CAPITAL

National banking regulators then give effect to the CRD by including the requirements of the CRD in their own rulebooks. The national regulators of the bank supervises it on a consolidated basis and therefore receives information on the capital adequacy of, and sets capital requirements for, the bank as a whole. Individual banking subsidiaries are directly regulated by their local banking regula-tors, who set and monitor their capital adequacy requirements.

◾◾ In Germany, the banking regulator is the Bundesanstalt für Finanzdienstleistungsaufsicht (“BaFin”).

◾◾ In Switzerland, the banking regulator is the Swiss National Bank (“SNB”).◾◾ In the United Kingdom, the banking regulator is the Prudential Regulation Authority (“PRA”).◾◾ In the United States, bank holding companies are regulated by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board” or “FSB”).

1.1.2 A Brief History of the Basel AccordsGlobal standards for bank capital are a relatively recent innovation, with an evolution along three phases (see Figure 1.1).

During the financial crises of the 1970s and 1980s the large banks depleted their capital levels. In 1988 the Basel Supervisors Committee intended, through the Basel Accord, to establish capital require-ments aimed at protecting depositors from undue bank and systemic risk. The Accord, Basel I, provided uniform definitions for capital as well as minimum capital adequacy levels based on the riskiness of assets (a minimum of 4% for Tier 1 capital, which was mainly equity less goodwill, and 8% for the sum of Tier 1 capital and Tier 2 capital). Basel I was relatively simple; risk measurements related almost entirely to credit risk, perceived to be the main risk incurred by banks. Capital regulations under Basel I came into effect in December 1992, after development and consultations since 1988. Basel I was amended in 1996 to introduce capital requirements to addressing market risk in banks’ trading books.

In 2004, banking regulators worked on a new version of the Basel accord, as Basel I was not sufficiently sensitive in measuring risk exposures. In July 2006, the Basel Committee on Banking Supervision published International Convergence of Capital Measurement and Capital Standards, known as Basel II, which replaced Basel I. The supervisory objectives for Basel II were to (i) promote safety and soundness in the financial system and maintain a certain overall level of capital in the system, (ii) enhance competitive equality, (iii) constitute a more comprehensive approach to measuring risk exposures and (iv) focus on internationally active banks.

The unprecedented nature of the 2007–08 financial crisis obliged the Basel Committee on Banking Supervision (BCBS) to propose an amendment to Basel II, commonly called Basel III. Basel III

2019

Basel I

Implementationof Basel I

1988

Firstversionof Basel I

1992

Implementationof Basel II

2008

Market riskaddition to

Basel I

2010

Basel IIfirst draft

2013

Start ofphase-in of

Basel III

1996 2006

Full implementation

of Basel III

Basel IIIBasel II

Basel IIIfirst draft

FIGURE 1.1 Bank regulatory capital accords

Overview of Basel III 3

introduced significant changes in the prudential regulatory regime applicable to banks, including increased minimum capital ratios, changes to the definition of capital and the calculation of risk‐weighted assets, and the introduction of new measures relating to leverage, liquidity and funding.

1.1.3 Accounting vs. Regulatory ObjectivesIt is important to make clear that the accounting and regulatory objectives are not fully aligned. The aim of accounting financial statements is the provision of information about the financial position, performance, cash flow and changes in the financial position of an entity that is useful for making economic decisions to a range of users, including existing and potential investors, lenders, employees and the general public.

The main objective of prudential regulation is to promote a resilient banking sector or, in other words, to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.

1.2 EXPECTED AND UNEXPECTED CREDIT LOSSES AND BANK CAPITAL

Let us assume that a bank provided a loan to a client. The worst case one could imagine would be that the client defaults and that, as a consequence, the bank losses the entire loaned amount. This event is rather unlikely and requiring the bank to hold capital for the entire loan would be excessively con-servative and the bank is likely to pass the cost of the capital requirement to the client, making the loan too costly for the client. Requiring the bank to hold no capital for the loan would compromise the bank’s viability if the borrower defaults. Thus, the bank regulator has to require banks to hold capital levels that assure their viability with a high probability, while maintaining their appetite to extend loans to borrowers at reasonable levels.

Credit losses, within a certain confidence interval, on debt instruments may be divided into expected and unexpected losses.

1.2.1 Expected LossesThe expected loss on a debt instrument is the level of credit loss that the bank is reasonably expected to experience on that instrument. The interest priced on the debt instrument at its inception incorpo-rates the expected loss during the life of the instrument.

Banks are expected in general to cover their expected credit losses on an ongoing basis (e.g. by revenues, provisions and write‐offs), as shown in Figure 1.2, because they represent another cost com-ponent of the lending business. Bank supervisors need to make sure that banks do indeed build enough provisions against expected losses.

1.2.2 Unexpected LossesThe unexpected loss on a debt instrument is the level of credit loss in excess of the expected loss that the bank may be exposed to with a certain probability of occurrence. Thus, the size of the unexpected loss depends on the confidence interval chosen. Unexpected losses relate to potentially large losses that occur rather seldomly. In other words, the bank cannot know in advance their timing and severity.

Banks are required to hold regulatory capital to absorb unexpected losses, as shown in Figure 1.2. Thus, risk‐weighted assets relate to the unexpected losses only. Bank regulatory capital is needed to cover the risks in such unexpected losses and, thus, it has a loss absorbing function.


1.3 THE THREE‐PILLAR APPROACH TO BANK CAPITAL

The capital adequacy framework consists of three pillars (see Figure 1.3), each of which focuses on a different aspect of capital adequacy:

◾◾ Pillar 1, called “Minimum Capital Requirements”, establishes the minimum amount of capital that a bank should have against its credit, market and operational risks. It provides the guidelines for calculating the risk exposures in the assets of a bank’s balance sheet (the “risk‐weighted assets”) and the capital components, and sets the minimum capital requirements.

◾◾ Pillar 2, called “Supervisory Review and Evaluation Process”, involves both banks and regulators taking a view on whether a firm should hold additional capital against risks not covered in Pillar 1. Part of the Pillar 2 process is the “Internal Capital Adequacy Assessment Process” (“ICAAP”), which is a bank’s self‐assessment of risks not captured by Pillar 1.

◾◾ Pillar 3, called “Market Discipline”, aims to encourage market discipline by requiring banks to disclosure specific, prescribed details of their risks, capital and risk management.

This book focuses on Pillar 1.

1.3.1 Pillar 1 – Minimum Capital RequirementsPillar 1 covers the calculation of capital, liquidity and leverage levels (see Figure 1.4). Pillar 1 covers as well the calculation of risk‐weighted assets for credit risk, market risk and operational risk. Distinct regulatory capital approaches are followed for each of these risks.

Leverage Ratio One of the causes of the 2007–08 financial crisis was the build‐up of excessive bal-ance sheet leverage in the banking system, despite meeting their capital requirements. It was only when the banks were forced by market conditions to reduce their leverage that the financial system increased the downward pressure in asset prices. This exacerbated the decline in bank capital. To prevent the excessive deleveraging from happening again, Basel III introduced a leverage ratio. This ratio was designed to put a cap on the build‐up of leverage in the banking system as well as to introduce

Pro

bab

ility

of

loss

Loss Distribution

MeanConfidence interval

Unexpected lossExpected loss

Covered bycapital

Covered byprovisions and

write-offs

FIGURE 1.2 Expected and unexpected credit losses


additional safeguards against model risk and measurement errors. The leverage ratio is a simple, trans-parent, non‐risk‐weighted measure, calculated as an average over the quarter:

Tier leverage ratioTier capital

Average total restated bal1

1aance sheet assets

Pillar 2 Pillar 3Pillar 1

Market Discipline

• Enhanced risk disclosures

Supervisory Review and EvaluationProcess

• Economic capital• Stress testing and simulations• Portfolio and limits management• Concentration risk

Minimum Capital Requirements

• Risk-weighted assets (RWAs)• Minimum capital ratios• Liquidity ratios (LCR, NSFR)• Leverage ratio

FIGURE 1.3 The three pillars around Basel III

Pillar 1Basel III

• Risk-weighted assets (RWAs) • Minimum capital ratios• Capital buffers

• Leverage ratio • Liquidity coverage ratio (LCR)• Net stable funding ratio (NSFR)

Capital Requirements

Leverage Requirements Liquidity Requirements

FIGURE 1.4 Pillar 1 of Basel III


Liquidity Coverage Ratio Banks experienced severe liquidity problems during the 2007–08 financial crisis, despite meeting their capital requirements. Basel III requires banks to hold a pool of highly liquid assets which is sufficient to maintain the forecasted net cash outflows over a 30‐day period, under stress assumptions (see Figure 1.5). This requirement tries to improve a bank’s resilience against poten-tial short‐term liquidity shortages. The ratio is calculated as follows:

Liquidity Coverage Ratio LCRStock of high-quality liquid assets HQLAs

Net cash outflows over a -day time period301000%

Assets are considered “highly liquid” if they can be quickly converted into cash at almost no loss.All assets in the liquidity pool must be managed as part of that pool and are subject to operational

requirements. The assets must be available for the treasurer of the bank, unencumbered and freely available to group entities.

Net Stable Funding Ratio Basel III requires a minimum amount of funding that is expected to be stable over a one‐year time horizon based on liquidity risk factors assigned to assets and off‐balance sheet exposures. This requirement provides incentives for banks to use stable sources to fund banks’ balance sheets, off‐balance sheet exposures and capital markets activities, therefore reducing the refinancing risks of a bank. The Net Stable Funding Ratio (NSFR) establishes the minimum amount of stable fund-ing based on the liquidity characteristics of a bank’s assets and activities over a more than one‐year horizon. In other words, a bank must hold at least an amount of long‐term (i.e., more than one year) funding equal to its long‐term (i.e., more than one year) assets. The ratio is calculated as follows:

Net Stable Funding Ratio NSFRAvailable amount of stable fuundingRequired amount of stable funding

100%

The numerator is calculated by summing a bank’s liabilities, weighted by their degree of permanence. The denominator is calculated by summing a bank’s assets, weighted by their degree of permanence.

1.3.2 Pillar 2 – Supervisory Review and Evaluation ProcessPillar 2 is an additional discipline to evaluate the adequacy of the regulatory capital requirement under Pillar 1 and other non‐Pillar 1 risks. Pillar 2 refers to the possibility for national supervisors to impose a wide range of measures – including additional capital requirements – on individual institutions or groups of institutions in order to address higher‐than‐normal risk.

Balance Sheet

Shareholders’equity

Highly liquidassets

Other assets

Other liabilities

Net 30-dayoutflows

FIGURE 1.5 Liquidity coverage


Pillar 2 has two aspects. The first requires banks to regularly assess their overall risk profile and to calculate any further capital that should be held against this additional risk. This assessment is called ICAAP. Pillar 1 captures exposures to credit risk, market risk and operational risk. Exposures to risks not captured by Pillar 1 are assessed in Pillar 2. These include credit concentration risk, liquidity risk, reputation and model risk. Consequently, Pillar 2 could add requirements to the amount of capital held by banks (and offset the lower credit‐risk capital requirement).

The second aspect of Pillar 2 is its inclusion of a “supervisory review process”. In the case of the European Union, the supervisory authorities assess how banking institutions are complying with EU banking law, the risks they face and the risks they pose to the stability of the financial system. This allows supervisors to evaluate each bank’s overall risk profile and, if needed, to mandate a higher pru-dential capital ratio where this is judged to be prudent.

ICAAP – Internal Capital Adequacy Assessment Process Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels. This assessment is called ICAAP – Internal Capital Adequacy Assessment Process. ICAAP assesses the amounts, types and distribution of capital that it considers adequate to cover the level and nature of the risks to which it is or might be exposed. This assessment should cover the major sources of risks to the firm’s ability to meet its liabilities as they fall due and incorporate stress testing and scenario analysis.

ICAAP is documented and updated annually by the firm or more frequently if changes in the busi-ness, strategy, nature or scale of its activities or operational environment suggest that the current level of financial resources is no longer adequate.

1.3.3 Pillar 3 – Market DisciplinePillar 3 requires disclosure of information regarding all material risks and the calculation of bank capi-tal positions. Pillar 3 also requires the disclosure of exposures and associated risk‐weighted assets for each risk type and approach to calculating capital requirements for Pillar 1.

Its objective is to help investors and other stakeholders to assess the scope of application by a bank of the Basel framework and the rules in their jurisdiction, their capital condition, risk exposures and risk assessment processes, and hence their capital adequacy.

This dimension of Basel III is designed to complement Pillars 1 and 2 by providing additional discipline on bank risk‐taking behaviour. The idea is that banks which the market judges to have increased their risk profiles without adequate capital may witness their securities sold down in debt and equity markets. The additional costs that this will impose on financing bank operations will pro-vide an incentive for management to modify either the bank’s risk profile or its capital base.

1.3.4 Significant Subsidiaries Disclosure Requirements[CRR 13(1)] (“Application of disclosure requirements on a consolidated basis”) requires that signifi-cant subsidiaries of EU parent institutions, and those subsidiaries which are of material significance for their local market, disclose information specified in the following articles on an individual or sub‐ consolidated basis:

◾◾ Own funds [CRR 437];◾◾ Capital requirements [CRR 438];◾◾ Capital buffers [CRR 440];◾◾ Credit risk adjustments [CRR 442];◾◾ Remuneration Policy [CRR 450];◾◾ Leverage [CRR 451]; and◾◾ Credit risk mitigation techniques [CRR 453].


[CRR 13(1)] does not provide explicit criteria for the determination of significant subsidiaries or those subsidiaries which are of material significance for their local market. Commonly, a banking group defines certain quantitative and qualitative criteria to determine which subsidiaries are subject to the requirements set forth in [CRR 13(1)]. These criteria take into account the subsidiary’s signifi-cance to the group as well as the subsidiary’s importance to its local market using quantitative meas-ures such as total assets and RWAs in relationship of the group’s consolidated assets and RWAs, as well as certain qualitative aspects of the subsidiary’s standalone systemic importance to their local markets using designations and measures as defined by local regulators.

1.4 RISK‐WEIGHTED ASSETS (RWAs)

When assessing how much capital a bank needs to hold, regulators weigh a bank’s assets according to their risk. Safe assets (e.g., cash) are disregarded; other assets (e.g., loans to other institutions) are con-sidered more risky and get a higher weight. The more risky assets a bank holds, the higher the likeli-hood of a reduction to earnings or capital, and as a result, the more capital it has to have. In addition to risk weighting on-balance sheet assets, banks must also risk weight off-balance sheet exposures such as loan and credit card commitments.

The risk‐weighted assets (“RWAs”) are a bank’s assets and off‐balance sheet items that carry credit, market, operational and/or non‐counterparty risk (see Figure 1.6):

◾◾ Credit risk: RWAs reflect the likelihood of a loss being incurred as the result of a borrower or counterparty failing to meet its financial obligations or as a result of deterioration in the credit quality of the borrower or counterparty.

◾◾ Market risk: RWAs reflect the risk due to volatility of in the fair values of financial instruments held in the trading book in response to market movements – including foreign exchange, commod-ity prices, interest rates, credit spread and equity prices – inherent in both the balance sheet and the off‐balance sheet items.

◾◾ Operational risk: RWAs reflect the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

◾◾ Other risks: RWAs primarily reflect the capital requirements for equity positions outside the trading book, settlement risk, and premises and equipment.

Risk-WeightedAssets

Other RisksMarket RiskCredit Risk

CreditCounterpartyRisk (CCR)

Securitisationsin the Banking

Book

Advanced IRB(IRB-A)

FoundationalIRB (IRB-F)

StandardApproach

OperationalRisk

Other (Premises,Equipment,…)

Equity PositionsOutside Trading

Book

Settlement Risk

FIGURE 1.6 Main components of RWAs


1.4.1 Calculation of Credit Risk RWAsBasel III applies two approaches of increasing sophistication to the calculation credit risk RWAs:

◾◾ The standardised approach is the most basic approach to credit risk. It requires banks to use external credit ratings to determine the RWAs applied to rated counterparties, based on a detailed classification of asset and counterparty types. Other counterparties are grouped into broad cate-gories and standardised risk weightings are applied to these categories using standard industry‐wide risk weightings.

◾◾ The internal ratings‐based approach (IRB). The credit RWAs calculation under this approach is based on an estimate of the exposure at default (EAD), probabilities of default (PD) and loss given default (LGD) concepts, using bank‐specific data and internal models that are approved by the regulator. The IRB approach is further sub‐divided into two applications:

◾◾ Advanced IRB (AIRB): where internal calculations of PD, LGD and credit conversion factors are used to model risk exposures;

◾◾ Foundation IRB (FIRB): where internal calculations of probability of default (PD), but stand-ardised parameters for LGD and credit conversion factors are used.

1.4.2 Calculation of Counterparty Credit Risk (CCR) RWAsCounterparty credit risk (CCR) arises where a counterparty default may lead to losses of an uncertain nature as they are market‐driven. This uncertainty is factored into the valuation of a bank’s credit exposure to such transactions. The bank uses two methods under the regulatory framework to calcu-late CCR credit exposure:

◾◾ The mark to market method (MTM, also known as current exposure method), which is the sum of the current market value of the instrument plus an add‐on (potential future exposure or PFE) that accounts for the potential change in the value of the contract until a hypothetical default of the counterparty.

◾◾ The internal model method (IMM), subject to regulatory approval, allows the use of internal models to calculate an effective expected positive exposure (EPE), multiplied by a factor stipulated by the regulator.

1.4.3 Calculation of Market Risk RWAsRWA calculations for market risk assess the losses from extreme movements in the prices of financial assets. Under the regulatory framework there are two methods to calculate market risk:

◾◾ Standardised approach: A calculation is prescribed that depends on the type of contract, the net position at portfolio level and other inputs that are relevant to the position. For instance, for equity positions a specific market risk component is calculated that depends on features of the specific security (for instance, country of issuance) and a general market risk component captures changes in the market.

◾◾ Model‐based approach: With their regulator’s permission, firms can use proprietary Value-at-Risk (VaR) models to calculate capital requirements. Under Basel III, Stressed VaR, Incremental Risk Charge and All Price Risk models must also be used to ensure that sufficient levels of capital are applied.

1.4.4 Calculation of Securitisation Exposures RWAsSecuritisation exposures that fulfil certain criteria are treated under a separate framework to other market or credit risk exposures. For trading book securitisations, specific risk of securitisation transac-tions is calculated following standardised market risk rules; general market risk of securitisations is


captured in market risk models. For securitisations associated with non‐traded banking books, the following approaches are available to calculate risk‐weighted assets:

◾◾ Standardised approach: Where external ratings are available for a transaction, look‐up tables provide a risk weight to apply to the exposure amount. For unrated securitisations, depending on the type of exposure and characteristics, standard weights of up to 1250% are applied.

◾◾ Advanced approaches include:

◾◾ The ratings‐based approach, where external ratings are available, allows for a more granular assessment than the equivalent standardised approach.

◾◾ For unrated transactions, the “look through” approach can be used, which considers the risk of the underlying assets.

◾◾ The internal assessment approach can be used on unrated asset‐backed commercial paper pro-grammes; it makes use of internal models that follow similar methodologies to rating agency models.

1.4.5 Calculation of Operational Risk RWAsCapital set aside for operational risk is deemed to cover the losses or costs resulting from human fac-tors, inadequate or failed internal processes and systems or external events. To assess capital require-ments for operational risk, the following methods apply:

◾◾ Basic indicator approach (BIA): Sets the capital requirement as 15% of the net interest and non‐interest income, averaged over the last three years. If the income in any year is negative or zero, that year is not considered in the average.

◾◾ Standardised approach: Under this approach net interest and non‐interest income is classified into eight business lines as defined by the regulation. The capital requirement is calculated as a percent-age of the income, ranging between 12% and 18% depending on the business line, averaged over the last three years. If the capital requirement in respect of any year of income is negative, it is set to zero in the average calculation.

◾◾ Advanced management approach (AMA): Under the AMA the firm calculates the capital require-ment using its own models, after review and approval of the model and wider risk management framework by the regulator.

1.4.6 Link between RWAs and Capital ChargesThe link between capital charges and RWAs is the following:

12.5 Capital charge(capital requirement)

Risk-weighted assets(RWAs)

8%= ×

×=

Risk-weighted assets(RWAs)

Capital charge(capital requirement)

11

CHAPTER2

Any financial institution subject to Basel III regulations is required to hold certain types and amounts of capital to help it meet its obligations as they fall due. This chapter addresses the minimum

capital requirements for banks. It is important to note that minimum capital requirements are not uniform across all banks: they depend on several factors including the jurisdiction where the bank operates and its presence in the domestic and global financial marketplace.

2.1 COMPONENTS AND MINIMUM REQUIREMENTS OF BANK CAPITAL

Both Pillar 1 and Pillar 2 result in capital requirements for the bank. Pillar 1 sets out the capital needed to absorb unexpected losses or asset impairments stemming from credit risk, counterparty credit risk, market risk and operational risk. Pillar 2 covers the consideration of whether additional capital is required over and above the Pillar 1 capital requirements.

2.1.1 Pillar 1 Capital RequirementsAccording to Basel III, a bank’s regulatory capital is divided into several categories or tiers of capital, which try to group constituents of capital depending on their degree of permanence and loss absor-bency, as shown in Figure 2.1.

Tier 1 capital is so called because it is the best-quality capital from the regulator’s perspective. The objective of Tier 1 capital is to absorb losses and help banks to remain “going concerns” (i.e., to remain solvent, or in other words, to prevent failures). There are two layers of Tier 1 capital:

◾◾ Common Equity Tier 1 capital (“CET1”), which includes permanent shareholders’ equity; and◾◾ Additional Tier 1 capital (“AT1”), which includes some instruments with ability to absorb losses.

Tier 2 capital, a supplementary capital with less loss absorption capabilities, is aimed at providing loss absorption on a “gone concern” basis (i.e., in case of insolvency of the bank) to protect depositors. It consists mainly of subordinated notes less prudential deductions.

The sum of Tier 1 and Tier 2 capital is called “total capital” or “own funds”. Both Tier 1 capital and Tier 2 capital items are subject to deductions that are specific to each type of capital.

2.1.2 Pillar 2 Capital RequirementsCompetent authorities are empowered to require banks to hold additional own funds requirements. These are called the “Pillar 2 capital requirements”.

Minimum Capital Requirements


In accordance with [CRD IV 104(1)(a)] competent authorities in Europe shall be empowered to require banks to hold additional regulatory capital requirements (“Pillar 2 capital requirements”). In addition to having this general power to impose Pillar 2 capital requirements, [CRD IV 104(2)] speci-fies a number of circumstances in which competent authorities must impose them:

◾◾ A bank does not meet the requirement set out in [CRR 73 and 74] or does not have the capacity to identify and manage large exposures as set out in [CRR 393];

◾◾ Risks or elements of risks are not covered by the Pillar 1 capital requirements (i.e., the 4.5% mini-mum CET1 capital, 6% minimum Tier 1 capital and the 8% total capital requirements) or by the CBR;

◾◾ The sole application of other administrative measures is unlikely to improve the arrangements, processes, mechanisms and strategies sufficiently within an appropriate timeframe;

◾◾ The review referred to in [CRD IV 98(4) or 101(4)] reveals that the non-compliance with the requirements for the application of the respective approach will likely lead to inadequate own funds requirements;

◾◾ The risks are likely to be underestimated despite compliance with the applicable requirements of CRD IV and of CRR; or

◾◾ A bank reports to the competent authority that the stress test results referred to in [CRR 377(5)] materially exceed its own funds requirement for the correlation trading portfolio.

According to the EBA in its document “Opinion of the European Banking Authority on the Inter-action of Pillar 1, Pillar 2 and Combined Buffer Requirements and Restrictions on Distributions” (EBA/Op/2015/24) of 16 December 2015, competent authorities should determine additional regula-tory capital requirements, covering:

◾◾ The risk of unexpected losses, and of expected losses insufficiently covered by provisions, over a 12-month period (except where otherwise specified in the CRR) (“unexpected losses”);

◾◾ The risk of underestimation of risk due to model deficiencies as assessed in the context of [CRD IV 101]; and

◾◾ The risk arising from deficiencies in internal governance, including internal control, arrangements and other deficiencies.

2.2 COMPONENTS AND MINIMUM REQUIREMENTS OF CAPITAL BUFFERS

In addition to the minimum capital requirements there are three further categories of capital, called regulatory buffers. The objective of these buffers is the introduction of instruments that will move in a countercyclical fashion to the capital levels of banks. In other words, buffers are intended to increase

Tier 2

8.0%

Common Equity Tier 1

Minimumrequirement (*)

Additional Tier 1

6.0%

4.5% Tier 1

(*) Excluding capital buffers

Lowest

Lossabsorption

capacity Totalcapital

Highest

FIGURE 2.1 Components of a bank’s regulatory total capital

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