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Abstract
Basel III guidelines are the response of BCBS (Basel Committee on Banking Supervision) to the 2008 Crisis. It is aimed at strengthening Individual Financial Institutions as well as the overall Financial System by eliminating the weaknesses which were present in BASEL II that were revealed during the crisis. BASEL III has a multi-dimensional impact on financial Institutions and will require associated changes to the IT systems. This paper covers various BASEL III guidelines, and describes the Why and How different areas of IT infrastructure and systems will be impacted.
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Introduction
Some very fundamental assumptions by financial institutions and regulators were proven wrong during the 2008 Crisis. The business of subprime lending was based on the assumption that housing prices would keep going up. This assumption proved wrong and it triggered a chain reaction that engulfed the global financial system. This crisis cycle is illustrated in the diagram below. There were some incentives present in the financial system that encouraged risk taking. Transferring of risk through securitization; relying on credit ratings provided by credit rating agencies, which were paid for by the issuers; compensation of top management based on absolute growth, revenue and profit rather than risk adjusted profitability; were just some of the reasons that encouraged excessive risk taking by banks. When subprime loan defaults started impacting the balance sheets of financial institutions, it became a systemic problem. Quarterly losses to the tune of billions of dollars by major Financial Institutions resulted in a crisis of confidence that sucked out liquidity from the financial system. At this time, the weaknesses of the BASEL II guidelines became very evident. Exposure to risky assets in the form of subprime loans, securitization and derivatives resulted in excessive losses. The low quality and quantity of capital could not absorb these losses when systemic risk materialized. The banks loss absorbing capacity was affected because of their excessive leverage and their short term sources of funding made financial institutions gasping for capital when it was most difficult to raise capital.
Sub-Prime Lending
Securitization
Sub-prime defaults, Securitized assets & derivatives trading resulted in huge losses
Excessive leverage & poor capital could not absorb losses fully, demanding fresh equity infusion
In stressed market situations, Credit Rating downgrades of Financial Institutions & securitized products further lowered valuations & increased losses
Short term borrowing demanded fresh borrowing which failed in liquidity crisis
BASEL III attempts to plug the loopholes present in BASEL II by recommending steps to further strengthen the overall financial system. BASEL III requires higher risk weights for risky assets bringing more assets/exposure into the umbrella of Risk Weighted Asset (RWA) calculations, prescribes a higher regulatory capital requirement and demands a very high quality of capital. It also introduces requirements to manage liquidity risk better. Finally, it introduces an additional requirement of absolute leverage ratio to take into consideration the model error which might be present in RWA calculations.
The diagram below highlights where and how BASEL III changes will address the deficiencies in the crisis cycle.
Capital Conservation / Counter-cyclical buffers Less reliance on external ratings agencies CVA Capital Charge Stressed Testing Higher quantity & quality of capital Leverage Ratio introduced 100% weight for trade finance
Sub-Prime Lending
Securitization
Sub-prime defaults, Securitized assets & derivatives trading resulted in huge losses
Excessive leverage & poor capital could not absorb losses fully, demanding fresh equity infusion
Correlation to financial institutions will carry more risk weights to prevent systemic risks and an overall collapse
In stressed market situations, Credit Rating downgrades of Financial Institutions & securitized products further lowered valuations & increased losses Huge losses resulted in a crisis of confidence causing liquidity to evaporate
Short term borrowing demanded fresh borrowing which failed in liquidity crisis
In summary, the BASEL III rules will strengthen the capital reserves and introduce stringent reporting requirements that cover key risk, liquidity and leverage parameters. The BASEL III guidelines also attempt to bolster the weak links in the financial system with the introduction of Central Clearing Houses and lessen the dependency on Rating Agencies. The chart below captures the key aspects of the BASEL III guidelines that have been introduced.
CAPITAL
Increase in Tier 1 Capital (Going Concern) from 4% to 6% Overall capital will remain the same at 8%. (Which means Tier 2 capital, or gone concern capital to reduce to 2% of total capital) Tier 1 Capital can no longer include hybrid capital instruments with an incentive to redeem through features such as step-up clauses. These will be phased out Tier 3 Capital will be eliminated (previously used for market risk)
CAPITAL BUFFERS
Introduction of Capital Conservation Buffer - 2.5% of Common Equity Tier 1 Introduction of Counter Cyclical Buffer - 0 to 2.5% of Risk Weighted Assets (RWA)
Credit Valuation Adjustment (CVA) Capital Charge must be calculated to cover Mark-to-Market losses on counterparty risk to Over The Counter (OTC) Derivatives.
RISK MANAGEMENT
Stressed parametes must be used to calculate Counterparty Credit Risk Effective Expected Positive Exposure (EPE) with stressed parameters to be used to address general Wrong-Way Risk (WWR) and Counterparty Credit Risk 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. A multiplier of 1.25 is applied to the corelation parameter of all exposures to financial institutions (meeting certain criteria) (Asset Value Correlation - AVC) Additional margining required for illiquid derivative exposures 100% risk weight for Trade finance
LIQUIDITY
Liquidity Coverage Ratio (LCR) >= 100% Net Stable Funding Ratio (NSFR) > 100%
LEVERAGE
REPORTING
Contractual maturity mismatch Concentration of funding Available unencumbered assets Market-related monitoring tools: asset prices and liquidity, Credit Default Swap (CDS) spreads and equity prices LCR by currency Results of stress tests should be integrated into regular reporting to senior management
RATING AGENCIES
Data Sources
Origination System
ETL
Staging
Risk Datamarts
G/L Reconciliation RWA Calculator
Servicing System
Data Quality/CDC
Staging/ODS
ICAAP Reports
External Sources
Data Governance
Possible new Data marts to hold data for the measurement of Liquidity and Leverage ratios
BASEL IIIs IT impact can be further understood by looking at its impact on each of the areas separately. The table below lists the impact expected in different areas of implementation and also lists some of the challenges that will be encountered while implementing them. Infrastructure and Data Management Risk Modeling and Quantification
RWA Calculation
Regulatory Reporting
Some new sources of data that would need to interact with the Basel framework include: Asset Liability Management (ALM) systems
The new liquidity ratios that Basel III introduces (LCR and NSFR), will entail the creation of new Liquidity Risk Data Marts to hold relevant Data Use of Stressed parameters as well as calculating CVA for counterparty credit risks will need huge amounts of historical data, which may require the use of new data marts/ databases to store such information.
IMPACT
Cash Flow Management systems Existing Liquidity Risk Management systems Data from Central Counterparties for data related to OverThe-Counter (OTC) derivatives.
The formulas used in the calculation of PD, LGD, EAD will change due to the need to incorporate stressed parameters and to also reflect a higher EAD value for counterparties where specific Wrong Way Risk (WWR) has been identified.
Changes will be required at the risk engines to accommodate the new buffers (Counter Cyclical, Capital Conservation). It will also need to accommodate the new Risk Weights assigned to derivatives, trade finance products as well as account for exposures to financial institutions.
The reporting systems will have to be enhanced to cater to the new reports mentioned in Basel III The existing reports will also be modified to reflect liquidity, leverage and CVA, besides the new capital structure Subsidiary reporting requirements will be augmented.
CHALLENGES
Identifying the right Data Elements. This would require a good knowledge of accounting systems as well as knowledge of the various reports required by Basel III. Identifying sources and data requirements for different legislations.
A single data load with all the attributes required for market, CCR, RWA, economic capital and liquidity risk should be extracted from source systems. As a result, DQ checks will be rigorous.
Consultants having experience in Stress Testing, Analytics, and general knowledge about the business of Banks will be required to identify and stress the required parameters. Model validation should be a focus area.
The system should be configured to provide Group Data, Solo Data, Basel I, II and III data on demand.
Understanding the new reporting requirements Bringing out synergies across stakeholders and consolidating the reporting platform.
DATA GOVERNANCE
Put in place a rigorous and scalable Data Governance framework (People + Process + Technology) Align source systems data quality capabilities to meet Fit For Purpose norms End-to-end audit capability from source system data to final output calculation may be a challenge in Basel III because of the many new source systems interacting with the reporting systems.
Solution Definition
Implementation
Program roadmap definition High level plan Establish current state of compliance PMO process definitions for change management, communication management and reporting Identify key stakeholders Kick-off meeting with all stakeholders
Product evaluation (if required) Architecture design Data analysis & modeling Technical design Data feed design Data sourcing and ETL Data sufficiency analysis Platform Development
Application customization and build Data quality testing Functional testing Regression testing Non-functional testing Defect management and reporting
Supervisory Monitoring
Parallel run 1 Jan 2013 - 1 Jan 2017 Disclosure starts 1 Jan 2015 3.5% 4.0% 4.5% 4.5% 0.625% 5.125% 60% 6.0% 8.0% 8.625%
Phased out over 10 year horizon beginning 2013 Introduce Minimum Standard Introduce Minimum Standard
Source - The website for the Bank for International Settlements - http://www.bis.org/bcbs/basel3.htm 6 | Infosys White Paper
Conclusion
BASEL III guidelines attempt to plug the gaps identified in BASEL II. However, the world economy and financial markets are dynamic and evolving ecosystems with many forces in play. Consequently, financial regulations will keep on evolving. The intensity of regulatory interventions is expected to increase in the future and the importance of risk management is expected to further move up in the priority of board members and top management. It is therefore imperative that a BASEL III implementation is planned and designed with a high degree of scalability to support future changes in regulation. A BASEL III implementation should be taken as an opportunity to remove a silo based approach to risk management and move towards a reliable and scalable enterprise wide risk management system. For such intent to be successful, an early start and preparation are essential so that enough due diligence goes into laying down the foundations of a strong risk management system.
Sudarsan Kumar is a Senior Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys.
He has over 4 years of risk and compliance experience with data warehousing in Basel II. He can be reached at Sudarsan_Kumar@infosys.com
Rohit VM is a Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. His current
focus is on Basel III. Rohit earned his Post Graduate Diploma in General Management (PGDGM) from XLRI, Jamshedpur. He can be reached at Rohit_V02@infosys.com
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