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Enhan cements to the Regulatory Capital Framework (Basel III)

Enhan cements to the Regulatory Capital Framework (Basel III). SAARCFINANCE Regional Seminar on Basel II Enhancements and Policy Responses Islamabad, Pakistan 11 April 2011 Jason George Financial Stability Institute / Bank for International Settlements Hong Kong SAR. 1. Agenda.

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Enhan cements to the Regulatory Capital Framework (Basel III)

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  1. Enhancements to theRegulatory Capital Framework (Basel III) SAARCFINANCE Regional Seminar on Basel II Enhancements and Policy Responses Islamabad, Pakistan 11 April 2011 Jason George Financial Stability Institute / Bank for International Settlements Hong Kong SAR 1

  2. Agenda • Bank capital and the financial crisis • The reform of bank capital regulation • Macroprudential overlay • Systemically important financial institutions • Impact of the global reforms • Conclusions 2

  3. I. Bank capital and the financial crisisBasel II: Weaknesses identified by the crisis • Basel II attempted to keep the overall level of capital the same as that under Basel I • Basel II did not sufficiently capture the risk in complex structured products • Basel II capital requirements are procyclical; thereby amplifying business cycle fluctuations • Basel II did not consider the impact of stress in the broader economy 3

  4. I. Bank capital and the financial crisisBanks: Weaknesses identified by the crisis • Insufficient recognition of risks involved in re-securitization and trading activities (insufficient risk capture) • A build-up of excessive leverage • Inadequate and low-quality capital • Low loss absorbing capacity • Insufficient liquidity buffers • Procyclical deleveraging process • Interconnectedness of SIFIs 4

  5. I. Bank capital and the financial crisisReform measures: firm-specific and macroprudential • In July 2009 the BCBS issued measures to strengthen the… • Rules governing trading book capital • The treatment of certain securitisations in Pillar 1 • In September 2009 the Group of Central Bank Governors and Heads of Supervision reached agreement to… • Raise the quality, consistency and transparency of the capital base • Introduce a leverage ratio • Introduce a framework for countercyclical capital buffers • Issue recommendations to reduce systemic risk 5

  6. 12/1996 Market risk amendment issued 12/2009 Basel III consultative document issued 07/1988 Basel I issued 06/2004 Basel II issued 07/2009 Revised securitisation & trading book rules issued 01/2019 Full implementation of Basel III 12/2006 Basel II implemented 12/1992 Basel I fully implemented 12/1997 Market risk amendment implemented 12/2007 Basel II advanced approaches implemented 12/2011 Trading book rules implemented 01/2013 Basel III becomes effective 11/2010 G20 endorsement of Basel III Thirty years of bank capital regulation

  7. Capital Capital ratio = Risk-weighted assets II. The reform of bank capital regulationOverview Supplements to the capital ratio Three minimum standards ● Common equity ● Tier 1 ● Total capital Raising the quality of capital ● Stricter criteria for Tier 1 and Tier 2 ● Harmonised deductions from capital Leverage ratio Mitigating procyclicality ● Building buffers ● Restricting capital distributions Additional measures for SIFIs ● Capital surcharges ● Contingent capital ● Bail-in debt ● Other supervisory tools Enhancing risk coverage ● Securitisation products ● Trading book ● Counterparty credit risk 7

  8. II. The reform of bank capital regulationThe numerator: weaknesses in the current definition • Numerous elements of capital with complicated maximums and minimums for each category • Common equity can be as low as 2% of risk-weighted assets • Lack of harmonised deductions and filters • Banking system in 2007 was: • Insufficiently capitalised given the level of risk in the system • Existing capital was not of sufficient quality • Highly leveraged 8

  9. II. The reform of bank capital regulationThe numerator: a new, simpler definition • Loss absorbtion matters…focus is on common equity capital (high quality) • Banks can no longer report strong Tier 1 capital levels with limited tangible common equity • Common equity capital will be the predominant form of Tier 1 capital • Clarification of roles different tiers of capital • Tier 1 going concern capital • Tier 2 gone concern capital • Strict eligibility requirements for all elements of capital • Treatment of deductions strengthened and harmonised • More items deducted from common equity…improves consistency and comparability of retained earnings 9

  10. II. The reform of bank capital regulationThe denominator: securitisations • Strengthened risk coverage/higher risk weights for securitisation products • Higher credit conversion factors for short-term liquidity facilities to off-balance sheet conduits • More rigorous own credit analyses of externally rated securitisation exposures • Implementation of higher capital charge for securitsation and market risk by end-2011 10

  11. II. The reform of bank capital regulationThe denominator: trading book • Lessons from the crisis • Capital requirements for trading book exposures are low, even relative to banks’ economic capital estimates • Valuation practices and the inputs to them were unreliable, particularly in times of stress • Revised framework • Introduction of 12-month stressed VaR capital charge • Incremental risk capital charge applied to the measurement of specific risk in credit sensitive positions when using VaR • Similar treatment for TB and BB securitisations 11

  12. II. The reform of bank capital regulationThe denominator 12

  13. II. The reform of bank capital regulationCalibration 13 * Fully phased-in requirements

  14. II. The reform of bank capital regulationCalibration 14

  15. II. The reform of bank capital regulationOther measures • Enhanced Pillar 2 guidance to address… • Firm-wide governance and risk management • The risk of off-balance sheet exposures and securitisation activities • Managing risk concentrations • Sound compensation practices • Enhanced Pillar 3 disclosures covering… • Securitisation exposures • Components of capital • Remuneration practices 15

  16. II. The reform of bank capital regulationOther measures • Additional supervisory guidance… • Liquidity risk management principles (09/2008) • The assessment of valuation practices (04/2009) • Stress testing principles (05/2009) • Compensation principles and standards assessment methodology (01/2010) • Principles for enhancing corporate governance (10/2010) • Good practice principles on supervisory colleges (10/2010) 16

  17. III. Macroprudential overlayOverview • Leverage ratio • Procyclicality building blocks • Dampen cyclicality in the minimum capital requirement • Promote forward looking provisions • Conserve capital to build buffers to be used during stress (capital conservation buffer) • Protect the banking sector from periods of excess growth (countercyclical capital buffer) • Additional measures for systemically important financial institutions 17

  18. III. Macroprudential overlayLeverage ratio • Objectives • Supplement the risk-based framework with a simple measure of total assets and off-balance sheet exposures • Contain the build-up of leverage during boom periods • Introduce safeguards against model risk, measurement error and attempts to “game” risk-based requirements • Implementation • Supervisory monitoring from 01.01.2011 • Parallel run 01.01.2013 – 01.01.2017 3.0% • View to migrate the requirement to Pillar 1 on 01.01.2018 after appropriate review and calibration 18

  19. III. Macroprudential overlayLeverage ratio • Average leverage ratio for banks with TEC1 > € billion is 2.8%; for all other banks 3.8% 19

  20. III. Macroprudential overlayLeverage ratio: Definitions • Capital • Tier 1 • BCBS will collect data during the transition period to track the impact of using total reg. capital and CET1 • Exposures • Repos: Apply accounting measure of the exposure netting rules based upon Basel II framework • Derivatives: Future potential exposure under current exposure method and netting rules based upon Basel II framework • Other OBS: 100%CCF unless unconditionally cancelable at any time by the bank, then 10% 20

  21. III. Macroprudential overlayCapital conservation buffer • Lesson from the crisis • Banks made discretionary payments as their condition was deteriorating • Best practices • Banks should build capital buffers outside of periods of stress that can be drawn upon as losses are incurred • The buffer should be sufficient to maintain capital levels above the minimum during a sector-wide downturn • Buffers should be rebuilt through a reduction in discretionary distributions of earnings 21

  22. III. Macroprudential overlayCapital conservation buffer • Framework • Buffer range above the minimum capital requirements is established (2.5%) • Capital distribution constraints are imposed when capital levels fall within this range • Capital type: Buffer capital must be capable of absorbing losses on a going concern basis Tier 1 capital • Elements subject to restriction: Dividends, share buybacks, discretionary bonuses 22

  23. III. Macroprudential overlayCountercyclical capital buffer • Objective • Create a buffer of capital to protect the banking sector from periods of excess aggregate credit growth • Ensure adequate capital in banking sector to maintain the flow of credit in the economy during periods of stress • Likely to be deployed infrequently • Buffer decisions and reciprocity • Each jurisdiction is responsible for determining the buffer size (0-2.5%) • Buffer size is based upon the location of the exposure 23

  24. III. Macroprudential overlayCountercyclical capital buffer: National buffer decisions • Relevant authority must monitor credit growth and determine if it is excessive and leading to build-up of system-wide risk • Use of judgment to determine if buffer should increase or decrease over time • Subject to an upper bound of 2.5% during periods of excess credit growth that increase system-wide risk • Can be higher, but reciprocity provisions do not apply • Buffer add-on of zero at other times • Buffer add-on decision announced 12 months in advance of its effective date (buffer release effective immediately) 24

  25. III. Macroprudential overlayCountercyclical capital buffer: Buffer size • Treated as an extension to the capital conservation buffer with distribution restrictions applied to the combined buffer • Buffer size is determined through judgment and the use of a private sector credit/GDP guide that serves as a starting point • Credit/GDP guide • Would have been a useful indicator of build-up of systemic risk in the past, but • Does not work well in all jurisdictions at all times 25

  26. III. Macroprudential overlayCountercyclical capital buffer: Buffer size • Judgment must be anchored to clear principles: • Buffer decisions must be guided by the objectives to be achieved by the bufer • Credit/GDP guide is a starting point and does not need to play a dominant role • Risk of misleading signals (decline in GDP); is credit/GDP signal consistent with other indicators (eg credit condition surveys, funding & CDS spreads, real GDP growth, various asset prices) • Prompt release of the buffer in times of stress can reduce risk of the supply of credit being constrained • Buffer is one tool in a suite of macroprudential tools • Communication of the rationale behind buffer decisions is critical 26

  27. IV. Systemically important financial institutionsGlobal mandate Today, the Seoul Summit delivers… …core elements of a new financial regulatory framework, including…measures to better regulate and effectively resolve systemically important financial institutions, complemented by more effective oversight and supervision The G20 Seoul Summit Leaders’ Declaration 11-12 November 2010 No firm should be too big to fail or too complicated to fail; taxpayers should not bear the cost of resolution 27

  28. IV. Systemically important financial institutionsPolicy framework Global and national SIFIs • Effective and efficient resolution framework • More intense supervisory oversight • SIFIs should have a higher loss absorbency capacity • Robust core financial market infrastructure • Other supplementary measures Global SIFIs • Mandatory international recovery and resolution planning • Rigorous assessment through supervisory colleges • Implement cross-border resolution recommendations 28

  29. IV. Systemically important financial institutionsDefining boundaries • The risk of disruption to financial services that: • Is caused by an impairment of all or parts of the financial system and • has the potential to have serious negative consequences for the real economy • Criteria: • Size • Suitability • Interconnectedness • Assessments will involve judgment and will be time varying 29

  30. IV. Systemically important financial institutionsEffective and efficient resolution framework Objectives • Prevent systemic damage caused by a disorderly collapse • Taxpayers should not be exposed to the risk of loss • Ensure continued performance of essential functions • Uninterrupted access to depositor funds • Transfer and sale of portions of the firm Current challenges • Differences in national resolution regimes • Absence of mutual recognition (home – host) • Lack of planning for handling stress and resolution 30

  31. IV. Systemically important financial institutionsSupervisory intensity and oversight • Clear supervisory mandates, independence and resources • A full suite of powers • Especially in the area of early intervention • Improved standards for supervisors • Reflecting greater complexity of the financial system • Better integration of micro and macro risk detection • A stricter assessment regime • Earlier detection of potential weaknesses in the oversight process Policy changes are not enough: supervisors must have the will and ability to act 31

  32. IV. Systemically important financial institutionsHigher loss absorbency capacity • How much additional loss absorbency is necessary? • Potential combination of: • Capital surcharges • Contingent capital • Bail-in debt • Capital and liquidity reforms affecting SIFIs • Incentives to use CCPs for OTC derivatives • Higher requirements for trading and derivatives activities • Higher requirements for inter-financial sector exposures • Liquidity requirements penalising excessive reliance on short-term interbank funding to support long dated assets 32

  33. IV. Systemically important financial institutionsHigher loss absorbency capacity U.S. Bank Capital Ratios by Bank Size, 1976-2009 33 Source: Hanson, Kashyap, and Stein (July 2010)

  34. IV. Systemically important financial institutionsTimelines and process: Loss absorbency / capital surcharge 34

  35. IV. Systemically important financial institutionsLoss absorbency: Modified Scorecard Approach • Based upon… • a “benchmark guide approach” using: (1) quantitative indicator-based approach, (2) supervisory discretion and (3) a peer review process • A quantitative scorecard that uses a ranking methodology based upon standard deviation • Modified Scorecard Approach • Indicator-based approach • Equal weighting to five categories of systemic importance 35

  36. IV. Systemically important financial institutionsLoss absorbency: Modified Scorecard Approach 36

  37. IV. Systemically important financial institutionsLoss absorbency: Potential capital surcharge • Flat surcharge for all SIBs • Simple, easy to implement • Does not consider differences between systemic importance of SIBs • Two to five buckets • Empty bucket at the top • Continuous approach • Provides strongest incentive to reduce systemic importance • Avoids cliff effects • Modified Scorecard may not be accurate enough for this approach (data issues) 37

  38. IV. Systemically important financial institutionsConsistent implementation • Establishment of a Peer Review Council to review whether: • the national G-SIFI policy measures adopted constitute reasonable choices from amongst the available set of policy options and potential trade-offs • the G-SIFI Recovery and Resolution plans and institution-specific cooperation agreements are robust and likely to be effective; • the national G-SIFI policy measures are globally consistent and mutually supportive • additional loss absorbency measures have been implemented 38

  39. IV. Systemically important financial institutionsIssues for discussion • What are the challenges and issues associated with identifying SIFIs? • Most jurisdictions do not have a SIFI definition • Time and situation dependent • Should the list of SIFIs be made public? • Is some degree of moral hazard inevitable? • Banks are fundamental to the financial system • Consequences of a major bank liquiditation • Is some degree of systemic risk is unavoidable? • Potential over-reliance on capital • How effective is legislation in the context of SIFIs? 39

  40. V. Impact of the Global ReformsBasel III: Quantitative Impact Study (QIS) QIS sample • 263 banks from 23 Basel Committee countries • 94 Group 1 banks (Tier 1 capital > €3 billion); very high coverage of the banking sector • 169 Group 2 banks (Tier1 capital < €3 billion) • Data as of 31.12.2009 on consolidated basis • No assumptions about future profitibaility or behavioral responses (ie change in portfolio or business strategy) 40

  41. V. Impact of the Global ReformsBasel III: Quantitative Impact Study (QIS) • Decline in CET1 is largely attributable to… • New definition of capital deductions and filters not previously applied at CET1 level • Increase in risk weighted assets • Group 1 banks will need €165 billion to meet 4.5% CET1 requirement and €577 billion to meet CET1 target of 7% 41

  42. V. Impact of the Global ReformsBasel III: Quantitative Impact Study (QIS) 42

  43. V. Impact of the Global ReformsMacroeconomic impact • Macroeconomic assessment group (transition) • Stronger capital and liquidity standards will have only a modest impact on economic growth • If higher standards are implemented over 4 years • 0.19% decline in GDP for each 1.0% increase in capital once the new rules are in place • 0.04% decline in the annual growth rate • Long-term economic impact • Clear economic benefits from an increase in capital requirements (reduced probability of financial crises) • 1% reduction in probability => 0.2 – 0.6% output 43

  44. VI. ConclusionsFuture work • Fundamental review of the trading book: should a banking book - trading book distinction be maintained? • Ratings and securitisations: efforts to reduce the reliance on external ratings (an issue in the SA of Basel II) • Large exposures: strengthened guidance (particularly important for SIFIs) • Cross-border bank resolution • Core Principles: review to incorporate lessons from the crisis • Standards implementation • SIG • Thematic peer reviews; pilot to take place in 2011 44

  45. VI. Conclusions • Basel III successfully addresses both firm-specific (microprudential) and systemic (macroprudential) risks • Increase in the quality of capital • Increase in the level of capital • Introduction of a leverage ratio • Enhanced coverage and capture of risks • Reduction of procyclicality through capital buffers • Basel III represents a return to fundamentals and encourages banks to focus on core banking activities • Basel III alone is not enough: enhanced supervision and regulation in a number of other areas is also critical 45

  46. Enhancements to theRegulatory Capital Framework (Basel III) SAARCFINANCE Regional Seminar on Basel II Enhancements and Policy Responses Islamabad, Pakistan 11 April 2011 Jason George Financial Stability Institute / Bank for International Settlements Hong Kong SAR 46

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