Basel II to Basel III: Changes and Requirements
Hesham Hamdy Chief Risk Officer, Arab International Bank Nairobi, 7-8 March 2012

Basel; what is it?
• A New Standard for the Measurement of Risks in Banks, and for the Allocation of Capital to cover those risks, published by the Basel Committee of G10 Central Banks.
• What Does Basel Committee Do? - Acts as Think-Tank for banking regulators - Issues guidance on best practice for banks - Standards accepted worldwide - Generally incorporated in national banking regulations

Basel I
• Basel I was the round of deliberations by central banks from around the world, and in 1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set of minimum capital requirements for banks. This was known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992 . • Basel I primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most corporate debt).

Basel I (continued)
• Banks with international presence were required to hold capital equal to 8 % of the risk-weighted assets. • Basel I was then widely viewed as outmoded because the world has changed as financial corporations, financial innovation and risk management have developed. Therefore, a more comprehensive set of guidelines, known as Basel II were introduced.

Basel II
• Basel II, initially published in June 2004, was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face.

• One focus was to maintain sufficient consistency of regulations so that this does not become a source of competitive inequality amongst internationally active banks.

Basel II (continued)
• Advocates of Basel II believed that such an international standard could help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. • In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank has adequate capital for the risk the bank exposes itself to, through its lending and investment practices.

Basel II (continued)
The final Basel II version aimed at: • Ensuring that capital allocation is more risk sensitive; • Enhance disclosure requirements which will allow market participants to assess the capital adequacy of an institution; • Ensuring that credit risk, operational risk and market risk are quantified based on data and formal techniques; • Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

Basel II (continued)
• Basel II used a "three pillars" concept : (1) minimum capital requirements (addressing risk), (2) supervisory review and, (3) market discipline. • The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.

The first pillar
• The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and, market risk. • The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach". • For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or STA, and the internal measurement approach (AMA). • For market risk the preferred approach is VaR.

The second pillar
• The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It provides a framework for dealing with all other risks a bank may face, such as, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. • Internal Capital Adequacy Assessment Process (ICAAP) is the result of Pillar II of Basel II accords

• This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to measure the capital adequacy of an institution. • Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies which leads to good corporate governance. • Aim of pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the institution.

The third pillar

The Need for Basel III
• Since the beginning of the international financial crisis in 2008, central banks all over the world worked on figuring out its reasons and the points of weakness in Basel II accord that was supposed to prevent the occurrence of such a crisis. • Hence the Basel committee on banking supervision at the bank for international settlements (BIS) issued a new accord known as the Basel III Accord concerning the minimum requirements for capital adequacy to face the last financial crisis that has been exploded in 2008.

• BASEL III is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010-11.
• This third of the Basel Accords was developed in response to the deficiencies in financial regulation revealed by the late financial crisis. • Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage.

Basel III

Basel III
• In Basel III a more formal scenario analysis is applied (three official scenarios from regulators, with ratings agencies and firms urged to apply more extreme ones).

• Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). • • Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth.

Basel III
• In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios.

• The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

Summary of B III proposed changes
• First, the quality, consistency, and transparency of the capital base will be raised. • Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings
• Tier 2 capital instruments will be harmonized

• Tier 3 capital will be eliminated.

Summary of B III proposed changes
• Second, the risk coverage of the capital framework will be strengthened. • Promote more integrated management of market and counterparty credit risk • Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit rating • Strengthen the capital requirements for counterparty credit exposures arising from banks’ derivatives, repo and securities financing transactions • Raise the capital cushions backing these exposures

Summary of B III proposed changes
• Reduce procyclicality
• Provide additional incentives to move OTC derivative contracts to central counterparties (probably clearing houses) • Provide incentives to strengthen the risk management of counterparty credit exposures

• Raise counterparty credit risk management standards by including wrong-way risk

Summary of B III proposed changes
• Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework. • The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives: - Put a floor under the build-up of leverage in the banking sector - Introduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simpler measure that is based on gross exposures.

Summary of B III proposed changes
• Fourth, the Committee is introducing a series of measures to promote the build up of capital buffers in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting countercyclical buffers"). • The Committee is introducing a series of measures to address procyclicality: - Dampen any excess cyclicality of the minimum capital requirement; - Promote more forward looking provisions; - Conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and

Summary of B III proposed changes
• Achieve the broader macro prudential goal of protecting the banking sector from periods of excess credit growth. • Requirement to use long term data horizons to estimate probabilities of default, • downturn loss-given-default estimates, recommended in Basel II, to become mandatory • Improved calibration of the risk functions, which convert loss estimates into regulatory capital requirements. • Banks must conduct stress tests that include widening credit spreads in recessionary scenarios.

Summary of B III proposed changes
• Promoting stronger provisioning practices (forward looking provisioning):

• Advocating a change in the accounting standards towards an expected loss (EL) approach
(usually, EL amount := LGD*PD*EAD).

• Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement supported by a longer-term structural liquidity ratio called the Net Stable Funding Ratio.
• In January 2012, the oversight panel of the Basel Committee on Banking Supervision issued a statement saying that regulators will allow banks to dip below their required liquidity levels, the liquidity coverage ratio, during periods of stress.

Summary of B III proposed changes

• The Committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions.

Amendments to Basel 2
• These amendments were taken from the 3 July 2009 Basel 2 papers. • The changes listed in the coming slides were to be brought into effect by 31.12.2011 in the EU and G20 countries.
• Subsidiaries of international banks in these countries will be obliged to comply with these measures even if their head offices do not.

Amendments to Basel 2 - Trading Book
• New stressed VaR requirement (for one year period) for banks using VaR models in the trading book
• New incremental risk capital charge (default and migration risk) for IRB banks • Capital charges used in the banking book must be applied to securitized products in the trading book to avoid regulatory arbitrage (see page 6 of July doc)

• Removal of concessionary 4% RW treatment for “liquid and diversified” portfolios

Amendments to Basel 2Complex Securitization
• Resecuritizations obtain higher risk weights in the banking book * • No self-guarantees allowed to improve credit ratings of securities guaranteed by the bank itself when such securities are held on the bank’s own books • Operational criteria must be applied before banks may use above risk weights in the Basel 2 securitization framework. Otherwise all holdings of securitizations must be deducted from capital • Standard 50% CCF for liquidity facilities in the securitization framework (no more concessionary risk weights)

Amendments to Basel 2:
• • • • • • • • • • • • • • • • • • Complex Securitization Securitization Resecuritisations AAA 20% 40% A+ to A50% 100% BBB+ to BBB100% 225% BB+ to BB350% 650% B+ to unrated Deduction Deduction

Amendments to Basel 2:
• Enhanced Pillar Two requirements for ICAAPs and internal controls generally • This means the need for new Pillar 2 modules in the Rulebook (the CBB drafted a module called SR in 2008, but this was never released)

Amendments to Basel 2:
Enhanced Pillar Three requirements

• Enhanced disclosures for securitizations and credit risk mitigants

Basel 3 Changes: 1. Capital Ratio
• Tier One (6% of total RWAs) – paragraphs 50, 53

A. Minimum common equity ≥ 4.5% of total RWAs (by 1.1.2015) after all deductions below (including unaudited/audited losses or audited profits for current period plus all eligible reserves). Paragraph 52

There are tougher requirements for Common Equity:
• •
• • • • • •

Common shares only and must be recognized as equity by accounting standards Most subordinated claim, not fixed or capped
Perpetual and never repaid outside liquidation No features that encourage buy-backs, redemption or cancellation Distributions not contractually capped or linked to amount paid in No obligatory or preferential payment of dividend (which can create a technical event of default) Issued and paid up Unsecured, unguaranteed

• •

Only issued with explicit shareholders’ approval May include share premium, retained earnings and P&L

Deductions from common equity (full deduction by 1.1.2018)
• Intangibles (paragraph 67)

• Investments in own shares (paragraph 78)
• Any outstanding Tier 1 instruments that do not meet the definition of common equity (w.e.f. 1.1.2013) • Minority interests in financial subsidiaries (see section G)

• Deferred tax assets (paragraphs 69 & 70) • Mortgage servicing rights

Deductions from common equity (full deduction by 1.1.2018) cont’d.
• • Cash flow hedge reserves for items not fair valued (paragraphs 11, 71 & 72) Any shortfall of provisions to expected losses under IRB (paragraph 73)

• •
•

Gains on sales due to securitization transactions (paragraph 74) Unrealized gains arising from changes in the fair value of liabilities caused by changes in the bank’s own credit risk/rating (paragraph 75)
Defined pension fund assets and liabilities (paragraph 76)

•

Reciprocal cross shareholdings in the capital of financial and insurance entities (paragraph 79)

Deductions from common equity (full deduction by 1.1.2018) cont’d.
B. Net Common Equity

• Amount A after all deductions above

C. Additional “Going Concern” Capital – paragraph 54 and 13 January 2011 Annex
There are enhanced criteria for classification as additional “Going Concern” Capital: • • • • • • • Issued & paid up Subordinated to depositors, general creditors and subordinated debt Not secured or guaranteed Perpetual and no step-ups or other incentives to redeem Callable only at initiative of issuer after minimum 5 years, subject to prior supervisory approval Documentation should not create the expectation of a call by the issuer Call cannot be made without bank concurrently replacing capital without issuance of capital of same or better quality, and capital must be well above minimum required capital level

C. Additional “Going Concern” Capital
• Coupon payments must be discretionary • Cancellation of payments must not constitute an event of default • Cancellation of payments must not put restrictions on the bank
• Dividend only payable out of distributable items • No credit sensitive dividend payment features • Must be convertible at the option of the supervisory authority to common equity or to be written down in value

D. Total Tier One Capital
• Item B plus item C

E. Tier Two Capital (“gone concern” capital) There are simplified and tougher requirements for Tier 2:

E. Tier Two Capital (“gone concern” capital)
• Issued and paid in
• Subordinated to depositors and general creditors • Unsecured and not guaranteed

• Minimum maturity of 5 years with straight line amortisation over last five years to maturity
• No redemption incentives

• Callable only at the initiative of issuer after minimum of five years
• Early calls subject to prior supervisory approval

E. Tier Two Capital (“gone concern” capital)
• No expectation of early calls to be created by the documentation • Calls may not be exercised unless capital of the same or better quality is issued concurrently and the issuer demonstrates its capital is well above minimum required

• Investors may not accelerate the repayment of payments (except in bankruptcy or liquidation)
• No credit sensitive dividend feature • The issuer and its related parties may not have purchased or funded the purchase of the instrument

• Proceeds must be immediately available without limitation (where raised by an SPV that is part of the consolidated group)

Capital Ratio
• Tier Three (Abolished).

• F. Total Capital (w.e.f. 1.1.2015) This is the sum of D and E above. Banks must have a Minimum ratio of 8%, of which 6% must be Tier One. Remaining 2% can be met by Tier 2

G. Minority Interests (paragraph 62)
Minority interests in the common equity Tier One of a fully consolidated subsidiary may receive recognition in Common Equity Tier One if: • The instruments meet all the criteria for common equity • The subsidiary is a bank (i.e. not an SPV) • The subsidiary has a surplus above its minimum Tier One capital requirements • The surplus is added after deducting: a) the lower of the required minimum common equity Tier One plus its capital conservation buffer

H. Countercyclical Buffers (0-2.5% of RWAs)
The size of the Buffer is set by the regulator and must take account of macroeconomic environment in which the bank(s) operate.

So, it will be applied according to national circumstances of countries' banks and related financial institutions and will be determined to be between 0% and 2.5% and to be met by common equity or other loss absorbing capital instruments.
The purpose of this buffer is for the protection of the whole banking system from periods of excessive credit growth activities as it will work on preventing banks from following more than needed Expansionary credit policies during economic booms that would increase the severity of inflation or more than needed contractionary ones during deflation that would deepen the economic downturn.

Basel 3 Changes: 2. Leverage Ratio
• Based on Tier One Capital only
• Off-balance sheet items subject to uniform 10% CCF

• Derivatives will be subject to Basel 2 netting plus PFE
• Minimum 3% ratio (w.e.f. 1.1.2018)

• Disclosure of the leverage ratio will start w.e.f. 1.1.2015
• Calculation will be on an “average” basis over the reporting quarter

Basel 3 Changes: 3. Counterparty credit risk
• Stressed inputs to be used

• Elements of counterparty risk charges are related to MTM losses as a result of the fall in the credit – worthiness of a counterparty
• Collateral and margining requirements strengthened

• Increase in risk weights on financial institutions • An additional capital charge (the CVA)

Basel 3 Changes: 4. Liquidity
• Liquidity Coverage Ratio – 30 day stressed funding scenario set by supervisor dictates level of high quality liquid assets to be held at all times (w.e.f. 1.1.2015) • Net Stable Funding Ratio (w.e.f. 1.1.2018)

Basel 3 Changes: 4. Liquidity (cont’d.)
Liquidity became a major matter of concern specially after the latest financial crisis; it has been agreed upon that 2 liquidity ratios will be suggested to measure banks liquidity. = The first ratio targets the short term and is called (Liquidity Coverage Ratio-LCR) that is measured by calculating the ratio between existing high liquidity assets inside the bank and the volume of 30 days of cash flows. The aim of this ratio is to enhance banks' ability to face liquidity needs at times of stress. = The other ratio aims at measuring liquidity ratios on medium and long terms for providing banks with net stable funding sources.

Basel 3 Changes: 5. New Disclosure Requirements
• Full reconciliation of all regulatory capital elements to the balance sheet
• Separate disclosure of all regulatory adjustments

• Disclosure of all capital limits and minima • Description of main features of capital instruments
• Disclosure of Equity Tier One ratio as well as other capital ratios (Tier One, Total)

• Any transitional provisions

Summary of Basel 3 1) Raise Quality of Capital Base
• Raise Quality of Common Equity (2013).

• Abolish “Innovative” Instruments from Tier One and only allow “Going Concern/Loss Participating” Tier One instruments (2013).

• Additional deductions from Tier One (2014 onward).
• Simplify and toughen Tier Two Capital (2013).

• Only limited inclusion of non-equity elements in Tier One

Summary of Basel 3 2) Enhanced capital charges for securitization and off-balance sheet exposures (December 2011)
• July 2009 securitisation and trading book requirements.
• New counterparty credit risk charges and requirements.

Summary of Basel 3 3) New 3% Leverage Ratio (2015)
• Based on Tier One Capital only. • Will include off-balance sheet exposures at 10% CCF.

Summary of Basel 3 4) New Liquidity Standards
• Liquidity Coverage Ratio (2015).

• Net Stable Funding Ratio (2018).

Summary of Basel 3 5) New Capital Buffers
• Capital conservation buffer (2.5% of RWAs – starting 2016 → 2019). • Countercyclical buffer (0-2.5% of RWAs – no set date). • Also forward looking provisioning may play a role (expected loss approach to be explored).

• It is worth mentioning that the application of Basel III requirements will urge banks to increase their capital levels, and even if Basel III requirements are considered as recommendations, but banks have to apply those guidelines because in case that some banks will not be able to fulfill those requirements, they will not be able to enlarge their credit levels.

Finally

• Those countries that will not apply Basel III requirements will be deprived from future advantages.

Key dates - Capital Requirements
Date Milestone: Capital Requirement
Minimum capital requirements: Start of the gradual phasing-in of the higher minimum capital requirements.

2013

2015

Minimum capital requirements: Higher minimum capital requirements are fully implemented.
Conservation buffer: Start of the gradual phasing-in of the conservation buffer.

2016

2019

Conservation buffer: The conservation buffer is fully implemented.

Key dates - Leverage Ratio
Date 2011 Milestone: Leverage Ratio

Supervisory monitoring: Developing templates to track the leverage ratio and the underlying components. Parallel run I: The leverage ratio and its components will be tracked by supervisors but not disclosed and not mandatory.
Parallel run II: The leverage ratio and its components will be tracked and disclosed but not mandatory. Final adjustments: Based on the results of the parallel run period, any final adjustments to the leverage ratio.

2013

2015

2017

2018

Mandatory requirement: The leverage ratio will become a mandatory part of Basel III requirements.

Key dates - Liquidity Requirements
Date Milestone: Liquidity Requirements

2011

Observation period: Developing templates and supervisory monitoring of the liquidity ratios.

2015

Introduction of the LCR: Introduction of the Liquidity Coverage Ratio (LCR).

2018

Introduction of the NSFR: Introduction of the Net Stable Funding Ratio (NSFR).

Abbreviations
• • • • • • • • • • • ABCP Asset-backed commercial paper ASF Available Stable Funding AVC Asset value correlation CCF Credit conversion factor CCPs Central counterparties CCR Counterparty credit risk CD Certificate of Deposit CDS Credit default swap CP Commercial Paper CRM Credit risk mitigation CUSIP Committee on Uniform Security Identification Procedures

Abbreviations
• • • • • • • • • • • CVA Credit valuation adjustment DTAs Deferred tax assets DTLs Deferred tax liabilities DVA Debit valuation adjustment DvP Delivery-versus-payment EAD Exposure at default ECAI External credit assessment institution EL Expected Loss EPE Expected positive exposure FIRB Foundation internal ratings-based approach IMM Internal model method

Abbreviations
• • • • • • • • • • IRB Internal ratings-based IRC Incremental risk charge ISIN International Securities Identification Number LCR Liquidity Coverage Ratio LGD Loss given default MtM Mark-to-market NSFR Net Stable Funding Ratio OBS Off-balance sheet PD Probability of default PSE Public sector entity

Abbreviations
• • • • • • • • • PvP Payment-versus-payment RBA Ratings-based approach RSF Required Stable Funding SFT Securities financing transaction SIV Structured investment vehicle SME Small and medium-sized Enterprise SPV Special purpose vehicle VaR Value-at-risk VRDN Variable Rate Demand Note