Discussion on Regulating Capital in Banks : Where are We? From Basel I to Basel III

1. Discussion onRegulating Capital in Banks : Where are We?From Basel I to Basel III DirghaRawal Bank Supervision Department Nepal Rastra Bank

2. Outline • Background • Evolution of Capital Regulation • Basel III : Way Ahead • Recent Developments in BSD : Where are we? • Conclusion

3. Background • The Basel I – 1988 • capital charge for credit risk only; a simple “broad-brush” approach/ one size fits all • Amendment to Basel I – 1996 • to incorporate capital charge for market risk • Market risk capital framework • The Basel II – 2004 • Enhanced risk coverage • Credit • Market and • Operational risks • A menu of approaches – standardized to model based with increasing complexity • Three pillar approach • Minimum Capital Requirements • Supervisory Review Process • Disclosure Nepal : Implementation of New Capital Adequacy Framework 2007(Updated 2008)

4. Evolution of Capital Regulations

5. Global Scenario • Rapid market development and technological Innovation • New product developments; MBS, ABS, CDO, CDS and other complex types of financial instruments. • Increasing Off balance sheet exposures, Subprime Mortgage Products, Securitization of Assets and increasing banks trading portfolio. • The capital charge framework for market risk did not keep pace with new market developments and practices • Capital charge for market risk in trading book calibrated much lower compared to banking book positions on the assumption that markets are liquid and positions can be wound up or hedged quickly

6. Global Financial Crisis • The global financial crisis mostly happened in the areas of trading book /off balance sheet derivatives / market risk and inadequate liquidity risk management • Banks suffered heavy losses in their trading book • Banks did not have adequate capital to cover the losses • Heavy reliance on short term wholesale funding • Unsustainable maturity mismatch • Insufficient liquid assets to raise finance during stressed period

7. Basel 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

8. Enhancement to Basel II • Post- crisis, global initiatives to strengthen the financial regulatory system • July 2009 Enhancement to Basel II – mostly in trading book • Pillar 1 – Standardized approach • Higher risk weights for securitization and other re-securitization exposures – almost doubled

9. Enhancement to Basel II • Pillar 2 guidance • firm wide governance and risk management; • capturing risk of off balance sheet exposures and securitization activities; • managing risk concentrations; • managing reputation risk and liquidity risk; • improving valuation practices; and • implementing sound stress testing practices

10. Enhancement to Basel II • Pillar 3 • appropriate additional disclosures completing enhancements in Pillars 1 and 2 • Securitization exposures in trading book • Sponsorship of off balance sheet vehicles • Re-securitization exposures; and • Pipeline and warehousing risks with regard to securitization exposures

11. Basel III : Way forward • December 17, 2009 Basel Committee issued two consultative documents: • Strengthening the resilience of the banking sector • International framework for liquidity risk measurement, standards and monitoring • The proposals were finalized and published on December 16, 2010: • Basel III: A global regulatory framework for more resilient banks and banking systems • Basel III: International framework for liquidity risk measurement, standards and monitoring

12. Basel III…. • Objectives • Improving banking sector’s ability to absorb shocks • Reducing risk spillover to the real economy • Fundamental reforms proposed in the areas of • Micro prudential regulation – at individual bank level • A new definition of capital (the numerator) • Enhanced risk coverage (the denominator) • Calibration and impact • Other measures • Macro prudential regulation – at system wide basis • Leverage ratio • Capital conservation and countercyclical capital buffers • Systemically important financial institutions

13. Basel II and Basel III Capital Requirements (% of RWA) Basel II Basel III* • Minimum common equity capital ratio 2.0% 4.5% • Capital conservation buffer - 2.5% Common equity + capital conservation 2.0% 7.0% • Minimum Tier 1 capital ratio 4.0% 6.0% • Minimum total capital ratio 8.0% 8.0% Total capital + capital conservation 8.0% 10.5% • Leverage ratio (non-risk-based) - 3.0% • Countercyclical capital buffer (nat. discretion) - 0 -2.5% • SIFI capital buffer - Under Discussion

14. Source: “The Basel III-An Enhanced Capital Framework”, Training Hands out FSI-EMEAP Regional Seminar Stress Testing, Jason George

15. Basel III : Main Features • Raising quality (Tier 1 – 6%, of which TCE - 4.5%), level (8+2.5% CCB), consistency (deductions mostly from TCE) and transparency of capital base • Improving/enhancing risk coverage on account of counterparty credit risk • Supplementing risk based capital requirement with leverage ratio • Addressing systemic risk and interconnectedness ( Capital and liquidity surcharge on SIFIs, Activity restriction/exposure on SIFIs, Intensive supervision SIFIs) • Reducing pro-cyclicality and introducing countercyclical capital buffers (0-2.5%) • Minimum liquidity standards

16. Leverage ratio • Ratio – 3% • Objectives – to supplement capital ratio in capturing risk • Numerator – Tier 1 capital • Denominator – on and off balance sheet exposure • As a Pillar 2 measure to start with but will be integrated with Pillar 1 • Leverage ratio will be monitored from January 1, 2011 to see the result of the above definition and parallel run from January 1, 2013 to 2017 and final adjustment in 2017 – Disclosure from January 2015 • As Pillar 1 ratio from January 1, 2018

17. Liquidity risk measurement • Key characteristic of the financial crisis was inaccurate and ineffective management of liquidity risk • Two standards/ratios proposed • Liquidity Coverage Ratio (LCR) for short term (30 days) liquidity risk management under stress scenario • Net Stable Funding Ratio (NSFR) for longer term structural liquidity mismatches

18. Liquidity Coverage Ratio (LCR) • Ensuring enough liquid assets to survive an acute stress scenario lasting for 30 days • Defined as stock of high quality liquid assets / Net cash outflow over 30 days > 100% • Stock of high quality liquid assets – cash + central bank reserves + high quality sovereign paper (also in foreign currency supporting bank’s operation) + state govt., & PSE assets and high rated corporate/covered bonds at a discount of 15%

19. Net Stable Funding Ratio (NSFR) • To promote medium to long term structural funding of assets and activities • Defined as Available amount of stable funding / Required amount of stable funding > 100%

20. Other monitoring tools for liquidity risk management • Contractual maturity mismatch • Concentration of funding • Available unencumbered assets • Liquidity Coverage Ratio by significant currency • Market-related monitoring tools

21. Nepalese Banking : Self Assessment • Capital Ratios are already more than Basel requirements (10% and 6%). Capital Conservation Buffers may be necessary. • Trading Portfolio of the banks is smaller yet. Low exposure in securitized assets and off balance sheet exposures. • Banks mostly follow a retail business model and do not depend on wholesale funds • We have already introduced Liquidity Monitoring Framework which is similar to Liquidity Coverage Ratio of Basel III(not implemented yet in global context) • Initiations of Forward looking Approaches : Stress Testing

22. Nepalese Banking : Self Assessment • Nepalese banks are generally not as highly leveraged as other global counterparts. The leverage ratio of Nepalese banks would be comfortable. • Banks having a huge trading book and off balance sheet derivative exposures may be impacted due to increased risk coverage (capital) on account of counterparty credit risk- Low exposure of Nepalese banks in such areas. • Special provision for SIFIs is the issue remained yet to be discussed.

23. Thank You