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P2.T7. Operational & Integrated Risk

Management

Basel III: Global Regulatory Framework for More

Resilient Banks and Banking Systems

Bionic Turtle FRM Study Notes

By David Harper, CFA FRM CIPM

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Basel III: Global Regulatory Framework for More Resilient Banks and Banking
Systems

DESCRIBE REASONS FOR THE CHANGES IMPLEMENTED IN BASEL III FRAMEWORK. .................. 3
DESCRIBE CHANGES TO THE REGULATORY CAPITAL FRAMEWORK, INCLUDING CHANGES TO: THE
MEASUREMENT, TREATMENT, AND CALCULATION OF TIER 1 ................................................... 4
DESCRIBE CHANGES TO THE REGULATORY CAPITAL FRAMEWORK, INCLUDING CHANGES TO:
TIER 2, AND TIER 3 CAPITAL................................................................................................. 7
DESCRIBE CHANGES TO THE REGULATORY CAPITAL FRAMEWORK, INCLUDING CHANGES TO:
RISK COVERAGE, THE USE OF STRESS TESTS AND THE TREATMENT OF COUNTER-PARTY RISK
WITH CREDIT VALUATION ADJUSTMENTS. .............................................................................. 8
DESCRIBE CHANGES TO THE REGULATORY CAPITAL FRAMEWORK, INCLUDING CHANGES TO: THE
USE OF EXTERNAL RATINGS ............................................................................................... 10
DESCRIBE CHANGES TO THE REGULATORY CAPITAL FRAMEWORK, INCLUDING CHANGES TO: THE
USE OF LEVERAGE RATIOS ................................................................................................. 10
EXPLAIN CHANGES DESIGNED TO DAMPEN THE PROCYCLICAL AMPLIFICATION OF FINANCIAL
SHOCKS AND TO PROMOTE COUNTER-CYCLICAL BUFFERS. ................................................... 11
DESCRIBE CHANGES INTENDED TO IMPROVE THE HANDLING OF SYSTEMIC RISK..................... 11

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Basel III: Global Regulatory Framework for More Resilient

Banks and Banking Systems
Describe reasons for the changes implemented through the Basel III framework.

Describe changes to the regulatory capital framework, including changes to:

 The measurement, treatment, and calculation of Tier 1, Tier 2, and Tier 3 capital

 Risk coverage, the use of stress tests, the treatment of counter-party risk with
credit valuation adjustments, the use of external ratings, and the use of leverage
ratios

Explain changes designed to dampen the procyclical amplification of financial shocks

and to promote countercyclical buffers.

Describe changes intended to improve the handling of systemic risk.

Describe changes intended to improve the management of liquidity risk including

liquidity coverage ratios, net stable funding ratios, and the use of monitoring metrics.

Describe reasons for the changes implemented in Basel III

framework.
During the economic and financial crisis (that began in 2007), weaknesses in the
banking sector rapidly transmitted to the rest of the financial system
 Banks in many countries had built-up excessive on- and off-balance sheet leverage
 Gradual erosion of level and quality of capital base
 Many banks were holding insufficient liquidity buffers
 Banking system was not able to absorb systemic trading and credit losses
 Banking system could not cope with “reintermediation of large off-balance sheet
exposures that had built up in the shadow banking system.”
 Crisis amplified by procyclical deleveraging process and by interconnectedness
of systemic institutions through an array of complex transactions.
 During the most severe episode of the crisis, the market lost confidence in the
solvency and liquidity of many banking institutions.

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Describe changes to the regulatory capital framework, including

changes to: The measurement, treatment, and calculation of Tier 1
Total regulatory capital is the sum of:
 Tier 1 capital (going-concern capital), plus
o Common Equity Tier 1
o Additional Tier 1
 Tier 2 Capital (gone-concern capital)

Common
Capital requirements Equity Tier 1 Total
and buffers Tier 1 Capital Capital

Minimum 4.5% 6.0% 8.0%

Conservation buffer 2.5%

Minimum plus Conservation 7.0% 8.5% 10.5%

buffer

Countercyclical buffer range 0 to 2.5%

Tier 1: the predominant form of Tier 1 capital must be common shares and retained
earnings
 Common Equity Tier 1 includes:
o Common shares issued by the bank that meet the criteria for classification as
common shares for regulatory purposes;
o Stock surplus (share premium) resulting from the issue of instruments
included Common Equity Tier 1;
o Retained earnings;
o Accumulated other comprehensive income and other disclosed reserves;
o Minority interest
o Regulatory adjustments applied in the calculation of Common Equity Tier 1

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 Criteria for classification as Common Shares for regulatory capital purposes:

1. Represents the most subordinated claim in liquidation of the bank.
2. Entitled to a claim on the residual assets proportional with its share of issued
capital, after all senior claims have been repaid in liquidation (i.e., has an
unlimited and variable claim, not a fixed or capped claim).
3. Principal is perpetual and never repaid outside of liquidation
4. The bank does nothing to create an expectation at issuance that the instrument
will be bought back, redeemed or cancelled nor do the statutory or contractual
terms provide any feature which might give rise to such an expectation.
5. Distributions are paid out of distributable items (retained earnings included).
6. There are no circumstances under which the distributions are obligatory.
Nonpayment is therefore not an event of default.
7. Distributions are paid only after all legal and contractual obligations have been
met and payments on more senior capital instruments have been made. This
means that there are no preferential distributions, including in respect of other
elements classified as the highest quality issued capital.
8. It is the issued capital that takes the first and proportionately greatest share of
any losses as they occur. Within the highest quality capital, each instrument
absorbs losses on a going concern basis proportionately and pari passu with all
the others.
9. The paid in amount is recognized as equity capital (i.e., not recognized as a
liability) for determining balance sheet insolvency.
10. The paid in amount is classified as equity under the relevant accounting
standards.
11. It is directly issued and paid-in and the bank cannot directly or indirectly have
funded the purchase of the instrument.

 Additional Tier 1 capital:

o Remainder of the Tier 1 capital base must be comprised of instruments that
are subordinated, have fully discretionary non-cumulative dividends or
coupons and have neither a maturity date nor an incentive to redeem.
o Innovative hybrid capital instruments … will be phased out
 Criteria for inclusion in Additional Tier 1 capital:
1. Issued and paid-in
2. Subordinated to depositors, general creditors and subordinated debt of the bank
3. Is neither secured nor covered by a guarantee of the issuer or related entity or
other arrangement that legally or economically enhances the seniority of the
claim vis-à-vis bank creditors
4. Is perpetual, ie there is no maturity date and there are no step-ups or other
incentives to redeem A related entity can include a parent company, a sister
company, a subsidiary or any other affiliate. A holding company is a related entity
irrespective of whether it forms part of the consolidated banking group.

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5. May be callable at the initiative of the issuer only after a minimum of five years:
o To exercise a call option a bank must receive prior supervisory approval;
and
o A bank must not do anything which creates an expectation that the call will
be exercised; and
o Banks must not exercise a call unless:
i. They replace the called instrument with capital of the same or better
quality and the replacement of this capital is done at conditions which are
sustainable for the income capacity of the bank; or
ii. The bank demonstrates that its capital position is well above the minimum
capital requirements after the call option is exercised.
6. Any repayment of principal (e.g. through repurchase or redemption) must be with
prior supervisory approval and banks should not assume or create market
expectations that supervisory approval will be given
7. Dividend/coupon discretion:
o the bank must have full discretion at all times to cancel
distributions/payments
o cancellation of discretionary payments must not be an event of default
o banks must have full access to cancelled payments to meet obligations as
they fall due
o cancellation of distributions/payments must not impose restrictions on the
bank except in relation to distributions to common stockholders.
8. Dividends/coupons must be paid out of distributable items
9. The instrument cannot have a credit sensitive dividend feature, that is a
dividend/coupon that is reset periodically based in whole or in part on the banking
organization’s credit standing.
10. The instrument cannot contribute to liabilities exceeding assets if such a balance
sheet test forms part of national insolvency law
11. Instruments classified as liabilities for accounting purposes must have principal
loss absorption through either (i) conversion to common shares at an objective
pre-specified trigger point or (ii) a write-down mechanism which allocates losses
to the instrument at a pre-specified trigger point. The write-down will have the
following effects:
o Reduce the claim of the instrument in liquidation;
o Reduce the amount re-paid when a call is exercised; and
o Partially or fully reduce coupon/dividend payments on the instrument.
12. Neither the bank nor a related party over which the bank exercises control or
significant influence can have purchased the instrument, nor can the bank directly
or indirectly have funded the purchase of the instrument

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13. The instrument cannot have any features that hinder recapitalization, such as
provisions that require the issuer to compensate investors if a new instrument is
issued at a lower price during a specified time frame
14. If the instrument is not issued out of an operating entity or the holding company in
the consolidated group (eg a special purpose vehicle – “SPV”), proceeds must be
immediately available without limitation to an operating entity or the holding
company in the consolidated group in a form which meets or exceeds all of the
other criteria for inclusion in Additional Tier 1 capital

Describe changes to the regulatory capital framework, including

changes to: Tier 2, and Tier 3 capital
 Tier 2 Capital (going-concern capital) instruments “will be harmonized.” Criteria
for inclusion in Tier 2:
o Issued and paid-in
o Subordinated to depositors and general creditors of the bank
o Is neither secured nor covered by a guarantee of the issuer or related entity
or other arrangement that legally or economically enhances the seniority of
the claim vis-à-vis depositors and general bank creditors
o Maturity: original maturity of at least five years
o Maybe be callable (by issuer) but only after a minimum of five years
 Tier 3 capital instruments are eliminated
 Limits and minima
o Common Equity Tier 1 must be at least 4.5% of risk-weighted assets at all
times
o Tier 1 Capital must be at least 6.0% of risk-weighted assets at all times
o Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 8.0% of risk-
weighted assets at all times

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Describe changes to the regulatory capital framework, including

changes to: Risk coverage, the use of stress tests and the
treatment of counter-party risk with credit valuation adjustments.
Counterparty credit risk

 Revised metric to better address counterparty credit risk, credit valuation adjustments
and wrong-way risk (Effective EPE with stressed parameters to address general
wrong-way risk)

“Going forward, banks must determine their capital requirement for counterparty
credit risk using stressed inputs. This will address concerns about capital charges
becoming too low during periods of compressed market volatility and help address
procyclicality. The approach, which is similar to what has been introduced for market
risk, will also promote more integrated management of market and counterparty
credit risk.

Banks will be subject to a capital charge for potential mark-to-market losses (ie credit
valuation adjustment – CVA – risk) associated with a deterioration in the credit
worthiness of a counterparty. While the Basel II standard covers the risk of a
counterparty default, it does not address such CVA risk, which during the financial
crisis was a greater source of losses than those arising from outright defaults.”
 Asset value correlation multiplier for large financial institutions
 Collateralized counterparties and margin period of risk
 Central counterparties
Enhanced counterparty credit risk management requirements include:

5a) Stress testing: Banks must have a comprehensive stress testing program for
counterparty credit risk. The stress testing program must include the following elements:
 Banks must ensure complete trade capture and exposure aggregation across all
forms of counterparty credit risk (not just OTC derivatives) at the counterparty-
specific level in a sufficient time frame to conduct regular stress testing.
 For all counterparties, banks should produce, at least monthly, exposure stress
testing of principal market risk factors (eg interest rates, FX, equities, credit spreads,
and commodity prices) in order to proactively identify, and when necessary, reduce
outsized concentrations to specific directional sensitivities
 Banks should apply multifactor stress testing scenarios and assess material
non-directional risks (i.e. yield curve exposure, basis risks, etc) at least quarterly.
Multiple-factor stress tests should, at a minimum, aim to address scenarios in which
a) severe economic or market events have occurred; b) broad market liquidity has
decreased significantly; and c) the market impact of liquidating positions of a large
financial intermediary. These stress tests may be part of bank-wide stress testing.
 Stressed market movements have an impact not only on counterparty exposures, but
also on the credit quality of counterparties. At least quarterly, banks should conduct
stress testing applying stressed conditions to the joint movement of exposures and
counterparty creditworthiness.

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 Exposure stress testing (including single factor, multifactor and material non-
directional risks) and joint stressing of exposure and creditworthiness should be
performed at the counterparty-specific, counterparty group (eg industry and region),
and aggregate bank-wide CCR levels.
 Stress tests results should be integrated into regular reporting to senior
management.
 The severity of factor shocks should be consistent with the purpose of the stress test.
When evaluating solvency under stress, factor shocks should be severe enough to
capture historical extreme market environments and/or extreme but plausible
stressed market conditions.
 Banks should consider reverse stress tests to identify extreme, but plausible,
scenarios that could result in significant adverse outcomes.
 Senior management must take a lead role in the integration of stress testing into the
risk management framework and risk culture of the bank and ensure that the results
are meaningful and proactively used to manage counterparty credit risk.

5b) Model validation and backtesting:

“It is important that supervisory authorities are able to assure themselves that banks using
models have counterparty credit risk management systems that are conceptually sound and
implemented with integrity. Accordingly, the supervisory authority will specify a number of
qualitative criteria that banks would have to meet before they are permitted to use a models-
based approach …. The qualitative criteria include:”
 The bank must conduct a regular program of backtesting; i.e., an ex-post
comparison of the risk measures generated by the model against realized risk
measures, as well as comparing hypothetical changes based on static positions with
realized measures.
 The bank must carry out an initial validation and an on-going periodic review of its
IMM model and the risk measures generated by it. The validation and review must be
independent of the model developers.
 The board of directors and senior management should be actively involved in the risk
control process and must regard credit and counterparty credit risk control as an
essential aspect of the business to which significant resources need to be devoted.
 The bank’s internal risk measurement exposure model must be closely integrated
into the day-to-day risk management process of the bank.
 The risk measurement system should be used in conjunction with internal trading and
exposure limits.
 Banks should have a routine in place for ensuring compliance with a documented
set of internal policies, controls and procedures concerning the operation of the risk
measurement system.
 An independent review of the risk measurement system should be carried out
regularly in the bank’s own internal auditing process.

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Describe changes to the regulatory capital framework, including

changes to: the use of external ratings
Changes to use of external ratings include:
 Disclosure: an ECAI should disclose the following information: its code of conduct;
the general nature of its compensation arrangements with assessed entities; its
assessment methodologies, including the definition of default, the time horizon, and
the meaning of each rating; the actual default rates experienced in each assessment
category; and the transitions of the assessments, e.g. the likelihood of AA ratings
becoming A over time
 Operational requirements: a rating must be published in an accessible form and
included in the ECAI’s transition matrix. Also, loss and cash-flow analysis as well as
sensibility of ratings to changes in the underlying ratings assumptions should be
publicly available. Consequently, ratings that are made available only to the parties to
a transaction do not satisfy this requirement.

Describe changes to the regulatory capital framework, including

changes to: The use of leverage ratios
The Committee agreed to introduce a simple, transparent, non-risk based leverage ratio
that 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:
 Constrain the build-up of leverage in the banking sector, helping avoid destabilizing
deleveraging processes which can damage the broader financial system and the
economy; and
 Reinforce the risk based requirements with a simple, non-risk based “backstop”
measure.

Leverage ratio = Capital / Total Exposure

 Capital is Tier 1 capital
 Exposure “should generally follow the accounting measure of exposure”
 On-balance sheet items, including repo, securities finance and derivatives
 Off-balance sheet (OBS) times: “OBS items are a source of potentially
significant leverage. Therefore, banks should calculate the above OBS items
for the purposes of the leverage ratio by applying a uniform 100% credit
conversion factor (CCF).”
The Committee will test a minimum Tier 1 leverage ratio of 3% during the parallel run
period from 1 January 2013 to 1 January 2017. Additional transitional arrangements
are set out in paragraphs 165 to 167.

“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.”

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Explain changes designed to dampen the procyclical amplification

of financial shocks and to promote counter-cyclical buffers.
 Banks will be subject to a countercyclical buffer that varies between zero and
2.5% to total risk weighted assets.
 The buffer that will apply to each bank will reflect the geographic composition of its
portfolio of credit exposures. Banks must meet this buffer with Common Equity Tier 1
or other fully loss absorbing capital or be subject to the restrictions on distributions

Describe changes intended to improve the handling of systemic

risk.
Changes to address systemic risk:
 Capital incentives for banks to use central counterparties for over-the-counter
derivatives;
 Higher capital requirements for trading and derivative activities, as well as complex
securitizations and off-balance sheet exposures (eg structured investment vehicles);
 Higher capital requirements for inter-financial sector exposures; and
 The introduction of liquidity requirements that penalize excessive reliance on short
term, interbank funding to support longer dated assets.

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