Basel III - Training Deck v1.11

Introduction to Basel III
Copyright 2011 Tata Consultancy Services

Limited
Agenda
Background
Liquidity Risk Management
Capital & Leverage
Counterparty Credit Risk
Market risk
Objective
The objective of WBT (web based training) on Introduction to Basel III
is to provide high level overview of Basel III
Prior knowledge / experience in Basel II is mandatory for this WBT
Basel III Highlights
Stress calibration of CCR measures

New risk measure CVA for MTM losses
CVA Capital Charge Adv & Std
Pillar 1 RWA for Specific Wrong Way Risk
AVC multiplier for exposures to FI
Increased margin period & collateral haircuts
Incentives to move to CCP
Increase in quality and quantity of capital

New Capital deductions from CET1 (DTA)
Increase in minimum capital ratios
Capital buffers, Leverage Ratio , Capital
Surcharge (SIFI)
Capital
Counterparty
Credit Risk
Increased MR Specific Risk Charge for

equities, credit derivatives
Enhanced VaR modeling, MR stress
testing guidelines
New risk measures - Incremental Risk
Charge, Stressed VaR
Market Risk
Basel III
Pillar 2 &
Pillar 3**
Enhanced Pillar 2 guidelines for
Securitisation, illiquid positions, wrong way
risk, Model Validation, Back Testing, Credit
Rating Agencies
Enhanced disclosures for Securitisation
exposures in Trading Book, Market Risk,
Counterparty Credit Risk (incl. Wrong Way
Risk)
Securitisation
Liquidity
Risk
Liquidity Coverage Ratio (LCR) High

quality liquid assets to sustain a significant
30-day stress scenario
Net Stable Funding Ratio (NSFR) - stable
sources of funding ( 1 year horizon)
Monitoring metrics - Contractual maturity
mismatch, Concentration of funding,
Available unencumbered Assets, Marketrelated monitoring tools
Higher risk weights for resecuritisations

Banks not permitted to use Ratings
resulting from self-guarantees
Increased CCF for Liquidity facilities
Specific Risk Charge alignment across
Banking Book & Trading Book
New measure CRM for Correlation
Trading Portfolio
** Not in scope
for this WBT
Key Timelines Basel III
5
Source : BCBS Basel III Timelines
Liquidity Risk Management

LRM Introduction
Fundamental Principles of LRM as per BCBS

LRM Basel III Key Changes
LRM Functional View
LRM Data Sources
LRM Liquidity Risk Measures
LRM Capital & Liquidity Gap under Basel III An
example
LRM Monitoring
LRM Stress Test
LRM Governance - Principles & Supervision
LRM Public Disclosures
LRM Summary
6
Liquidity Risk Management (LRM) - Genesis

In 2008 & 2009, BCBS published Principles for Sound Liquidity Risk Management & Supervision & a
consultative document, proposing new measures to strengthen liquidity regulations in the banking sector.
The BIS guidelines for LRM published under BCBS144*, 165* & 188* require all banks to significantly enhance
their liquidity risk infrastructure & functionality in providing granular liquidity-related data, in-depth analysis &
reporting
The two key metrics introduced under Basel III- LRM are
Liquidity Coverage Ratio (LCR)
Net Stable Funding Ratio (NSFR)
There are other monitoring tools which includes Contractual Maturity Mismatch, Concentration of Funding,
Instruments & Currencies & tracking of Available Unencumbered Assets.
A strong Governance Model should be put in place to develop , review & approve strategies, policies &
practices related to management of liquidity effectively
BCBS *LRM
Papers
Assessment
Impact Analysis
Implementation
Observation
Liquidity Reporting
2008 - 2010
2010 - 2011
2011 2012
2013 2015
2015 - 2018
*BCBS - 165 International Framework for Liquidity Risk Measurement, Standards & Monitoring
*BCBS - 144 Principles for Sound Liquidity Risk Management & Supervision
*BCBS 188 - International framework for liquidity risk measurement, standards & monitoring
Liquidity Risk Introduction (1/4)

One of the main reasons the economic and financial crisis became so severe was that
the banking sectors of many countries had built up excessive on- and off-balance sheet
leverage.
This was accompanied by a gradual erosion of the level and quality of the capital base.
At the same time, many banks were holding insufficient liquidity buffers.
The banking system therefore was not able to absorb the resulting systemic trading and
credit losses nor could it cope with the re-intermediation of large off-balance sheet
exposures that had built up in the shadow banking system.
The crisis was further amplified by a procyclical deleveraging process and by the
interconnectedness of systemic institutions through an array of complex transactions
Basel Committee, Strengthening the resilience of the banking sector consultative document
Liquidity Risk Introduction
(2/4)
Asset and liability mismatch generates not only interest rate

risk liquidity risk
Different meaning of liquidity:
Security ease with which it can be cashed back or traded, even
in large amounts, on a secondary market
Market liquidity of the securities traded in the market

different proxies of liquidity (e.g. bid-ask spread, volume)
Affected by many factors: n. market participants, size & frequency of trades, degree of
informational asymmetry, time needed to carry out a trade
Function of tightness (markets ability to match supply and demand at low cost) and depth
(ability to absorb large trades without significant price impact)
Financial institution ability to fund increases in assets and

meet obligations as they come due, without incurring high losses
Generally proxied by the difference between the average liquidity of assets and that of
liabilities
Liquidity Risk Introduction..(3/4)

Selling assets
at a price below
their market
value
Inability to
payback
liabilities
Unforeseen
Usage of
Credit lines
Events
leading to
Liquidity Risk
transformation
of
short-term
deposits into
long-term loans
Prepayment of
loans
10
LRM Introduction..(4/4)
8
Difficulty providing sufficient

and timely assets for
transactions increases
Party A fails to fulfill

liquidity to execute
transaction
2
Accrued difficulty to fund
ongoing bank activity on
the interbank market
Long-term
funding risk
Transactional
Liquidity
Risk
Other counterparties
Subsequently lack liquidity,
creating trust issues
in the market
6
Banks compete for
increasingly smaller pool
of liquidity
Tradability
risk
Part of banks existing

liquidity buffer de facto
becomes illiquid
Market
liquidity risk
Market refrains
from providing
liquidity
Uncertain, lower-quality
assets are no longer
accepted for trade or
collateral against liquidity
Liquidity Risk Vicious Cycle
11
Fundamental Principles of LRM as per BCBS

Fundamental principle
1.A bank needs to establish a robust liquidity risk management framework
Governance of liquidity risk management
2.A bank should clearly articulate a LR tolerance appropriate for its business strategy and role
3.Senior management needs to be actively involved in LRM
4.Liquidity costs need to be factored into internal transfer pricing, so that LR is considered adequately
Measurement & management of liquidity risk
5.A bank should have sound a process for identifying, measuring, monitoring and controlling LR
6.A bank should actively monitor and control LR exposures throughout the group and take into account legal, regulatory and
operational limitations to the transferability of liquidity
7.A bank should establish a funding strategy for effective diversification of sources / tenor of funding
8.A bank should actively manage its intraday liquidity positions and risks
9.A bank should actively manage its collateral positions
10.A bank should conduct stress tests regularly and use the results to adapt strategy / positions
11.A bank should have a formal contingency funding plan
12.A bank should maintain a cushion of high quality liquid assets as insurance against a range of liquidity stress
scenarios (see International framework for LRM)
Public Disclosure
13.A bank should issue regular public disclosure on LRM and positions
Role of supervisors
14.Comprehensive assessment of liquidity risk management framework
15.Monitoring of internal reports, prudential reports & market information
16.Effective and timely intervention (New)
17.Communication with other supervisors and public authorities
12
LRM Basel III - Key Changes
# Basel III - LRM 2010 BCBS Guidelines

* ALM Guidelines
^ LCR Liquidity Coverage Ratio
% NSFR Net Stable Funding Ratio
13
LRM Functional View

Banks Assets and Liabilities
ALM Data
Cash Flow Data
Quantitative Analysis
Risk Models
Simulations
Transaction
Data
Position Data
LRM Components
LCR
NSFR
Reconciliation
Public Disclosures
Daily Cash Flow Reports
Enhanced Mismatch Reports
Local Regulators(OSFI,APRA ..)
Disclosures
Reference
Data
Pricing /
Valuation
Historical Data
Cash Flow Engine

Cash Outflow
Cash Inflow
Monitoring Tools
Scenario Analysis
Maturity Mismatch
Stress Testing
Funding Concentration
Extreme Stressed Scenario
Market Monitoring
Stressed Cash Flow
Unencumbered Assets
Limits Management
LCR by Currency
Behaviour Analysis
Governance & Liquidity Policies
Regulatory Requirements
14
LRM Data Sources

Source System Data
Cash Flows
Transaction Data
Position Data
Reference Data
Market Data
Security Data
Historical Data
Internal Limits
Categorize Data
LRM Ready Data
ON Balance Sheet / OFF Balance Sheet

Banking Book / Trading Book
Data Hierarchy / Liquidity Category
Legal Entity / Business Units
Reporting Lines
Asset / Liability
Analytics Data
Stressed Data
Ratio Calculation Data
Forecasting Data
Limits Data
Reporting Data
Exception Data
Data Mapping / Business Rules / Reconciliation
Transformation
Source Target Data Check
Data Validation / Integrity Check
Data Reconciliation
Defaulting / Enrichment / Aggregation / Limit
15
LRM Liquidity Risk Measures
(1/9)
Basel Committee has developed two standards to be used in

supervision of liquidity risk.
1.The Liquidity Coverage Ratio, addresses the sufficiency of a stock of
high quality liquid assets to meet short-term liquidity needs under a
specified acute stress scenario.
2.The Net Stable Funding Ratio, addresses longer term structural
liquidity mismatches.
Source: http://www.liquidity-coverage-ratio.com
16
LRM Liquidity Risk Measures..(2/9)

The liquidity coverage ratio identifies how much of unencumbered, high
quality liquid assets an institution needs to hold, which can be used to
offset the net cash outflows under an acute short-term stress scenario
specified by supervisors.
The scenario entails:
a significant downgrade of the institutions public credit rating;
a partial loss of deposits;
a loss of unsecured wholesale funding;
a significant increase in secured funding haircuts; and
increases in derivative collateral calls and substantial calls on
contractual and non contractual off-balance sheet exposures, including
committed credit and liquidity facilities.
Source: http://www.liquidity-coverage-ratio.com
17

Liquidity Coverage Ratio (LCR)
Aims to ensure adequate level of unencumbered high quality liquid assets which can be liquidated
during stress scenarios to endorse net cash outflow for the next 30 calendar days.
LCR =
Stock of High quality liquid assets (HQLA)

-------------------------------------------------- 100%
Net cash outflows over a 30-day time period
Liquidity Coverage Ratio

Defines level of liquidity buffer to be held to cover short-term funding gaps under
severe liquidity stress
Has a Cash flow perspective
Predefined stress scenario
Time horizon: 30 days
18
High Quality Liquid Assets

There are two categories of assets that can be included in the stock
namely Level 1 & Level 2.
Level 1 assets can be included without limit while Level 2 assets
can only comprise 40% of the stock.
These Level 1 & Level 2 assets are considered to be high-quality
liquid assets (HQLA) if they can be easily and immediately converted
into cash at little or no loss of value.
The liquidity of an asset depends on the underlying stress scenario,
the volume to be monetised and the timeframe considered.
19

Level 1 Assets
Assets can comprise an unlimited share of pool, are held at market value and are not subject to haircut under LCR
Cash
Central Bank Reserve
To the extent that can be drawn during stress times
Marketable Securities
Representing claims guaranteed by sovereigns, central banks, PSEs, BIS ,
IMF 0% risk weight according to Basel II Standardized Approach
Non 0%risk-weighted sovereigns
Sovereign or central bank debt securities issued in domestic currencies by the sovereign or central bank in the
country
Domestic sovereign or central bank debt securities issued in foreign currencies,
Level II Assets
Subject to the requirement that they comprise no more than 40% of overall stock after haircuts have been applied
Level I assets generated by secured funding transactions maturing within 30 days
Corporate Bonds and Covered Bonds
Not issued by any financial institutions or bank itself or respective affiliated entities
Rated AA- or higher by ECAI
Marketable securities
Representing claims guaranteed by sovereigns, central banks, PSEs, BIS , IMF
Maximum of 20% risk weight according Basel II Standardized Approach
20

The asset price calculation formula of highquality assets should be simple and not
depend on strong assumptions.
Portfolios should have least
correlation
Ease and
Certainty of
Valuation
Low
Correlation
With Risky
Assets
Listed on
Recognized
Stock
Exchange
Being listed increases assets
transparency.
These assets tend to have higher

liquidity. Low credit and market risk
lowers duration, volatility, inflation
risk and foreign exchange risk
enhancing asset's liquidity.
Low Credit
And Market
Risk
Fundamental
Characteristic
of HQLA
Unencumbered
Asset
Eligible for
Intraday
Liquidity Needs
Unencumbered Asset shouldn't be

pledged as a collateral except for
some exceptions
Eligible by central bank for intraday liquidity

needs.
21
Asset should have active outright

sale or repurchase agreement
markets at all times
Historically, the market has shown

tendencies to move into these
types of assets in a systemic crisis
Active and
Sizeable
Market
Presence
of Committed
Market
Makers
Quotes will most likely be available
for buying and/or selling a highquality liquid asset.
Flight to
Quality
HQLA Market
Characteristic
Low Market
Concentration
Diverse group of buyers and sellers
in an assets market increases the
reliability of its liquidity
22

Available Stable Funding (ASF)
Net stable Funding Ratio
= --------------------------------------------Required Stable Funding (RSF)
RSF Factor
100%
ASF Factor
Liabilities
Assets
Long
Term
Funding
Short Term Funding
0 % - 50 %
Unencumbered
Assets
0 % - 50 %
Non Core Deposit
70 %
Consumer loans
85 % - 100 %
Core Deposit
85 % - 100 %
Long Term Funding
100 %
Equity
100 %
Corporate Loans
50 % - 100 %
Inter Bank Loans
50 % - 100 %
Long
Term
Funding
23

NSFR promotes medium to long-term funding thus reducing incentives for
short-term wholesale funding and supplements the LCR (by counterbalancing
cliff-effects)
The stress scenario is defined differently from the one underlying the LCR
idiosyncratic stress over 1 yr
Stable funding is defined as those types of equity and liabilities expected to
be reliable sources of funds under an extended stress scenario of one year
For determination of the required funding amount accounting and regulatory
treatment is irrelevant required funding amount depends solely on the
respective instruments liquidity characteristics
24
ABC Banks Capital & Liquidity Gap under Basel III..(1/2)

ABC bank faces material shortfalls of both tier 1 and tier 2 capital under Basel III
The planned business growth leads to a potential material breach of the upcoming maximum leverage ratios
Under the upcoming mandatory liquidity ratios, the bank would be obliged to hold at least 200m additional
liquid funds in order to sustain the LCR Funding test
As a consequence, the banks plans need to be materially adapted in order to reflect the additional capital
and liquidity needs of Basel III
Basel III Impact
2011
2012
2013
2014
2015
RWA banking book
1600
1899
2282
2726
3270
RWA trading
book(x12.5)
938
1078
1240
1426
1640
Total RWA
2538
2977
3522
4152
4910
Required Tier I
capital under Basel
III
114
149
194
270
344
Required total
capital under Basel
III
228
268
370
436
516
RWA under Basel

III
25
ABC Banks Capital & Liquidity Gap under Basel III..(2/2)

Basel III Impact
2011
2012
2013
2014
2015
Tier I Capital
shortfall
42
50
13
-42
-88
Total Capital
shortfall
10
23
-76
-103
-137
Leverage ratio
under Basel III
31X
29X
34X
37X
40X
Maximum leverage
3%
33X
33X
33X
33X
33X
Adjustment need
2X
4X
-1X
-4X
-7X
Basel III LCR

funding gap
-200
Basel III LTFR

(observation)
141%
137%
130%
126%
123%
Capital shortfall
under Basel III
Leverage ratio
limitations
Liquidity ratios
26
LRM Cash Flow (1/3)

Total Cash Outflows
Total expected cash outflows = Outstanding balances of various categories or types of liabilities and
off-balance sheet commitments * rates at which they are expected to run off or be drawn down.
Total expected cash inflows = Outstanding balances of various categories of contractual receivables *
rates at which they are expected to flow in under the scenario up to an aggregate cap of 75% of total
expected cash outflows
Total Net Cash outflows over the next 30 calendar days = outflows - Min (Inflows; 75% of
outflows)
27
LRM Cash Flow (2/3) Cash Outflow Categorization

Retail
Deposit
Run offs
Secured
Wholesale
Funding Run-offs
Unsecured
Wholesale
Funding Run-offs
Additional
Requirements
Deposits from an
individual
natural person
Secured Funding
collateralized
by level 1 assets (run-off
rate = 0%)
Provided by small
business customers
(5%, 10%, 15% and
higher)
Derivatives Payable
(run-off rate = 100%)
Retail depositsSubject
to LCR include demand
deposits and term
deposits
Secured Funding
collateralized
by level 2 assets (run-off
rate = 15%)
Funding with
operational relationships
Valuation change on
posted collateral
securing derivative
transaction of non-Level 1
Asset (run-off rate = 20%)
Stable deposits
(run-off rate = 5% or
higher)
Secured Funding with

domestic sovereigns,
central banks, or PSEs
Treatment of deposits in
institutional networks of
cooperative banks (run-off
rate = 25%)
Liabilities related to
derivative collateral calls
related to a downgrade of
up to 3-notches.(run-off
rate = 100%)
Less stable deposits

(run-off rate = 10% or
higher)
All other Secured

funding (run-off rate =
100%)
Provided by Non-financial
corporate, sovereigns,
central bank and PSEs
Liabilities maturing within

30 calendar days
(outflow rate = 100%)
Other Legal entity

customers
Draw-downs on credit and

liquidity facilities have
different run off rates
Other Contractual cash
outflows (outflow rate =
100%)
28
LRM Cash Flow (3/3) Cash Outflow categorization

Reverse Repo and
Securities
Borrowings
Level I assets
if collateral not
used to cover
short positions 0%
if collateral used
to cover short
positions- 0%
Level II assets
if collateral not
used to cover
short positions15%
if collateral used
to cover short
positions 0 %
All other collateral
if collateral not
used to cover
short positions 100%
if collateral used
to cover short
positions - 0%
Inflows by
Counterparty
Operational
Deposits
Credit or
Liquidity Facility
Derivatives
Receivable
(Inflow rate = 100%)
Retail and Small

Business
Inflow (inflow rate =
50%)
Inflow rate is 0%
since deposits held
at other institution
for operational
purpose are
assumed to
stay with institution
For all the remaining

contractual
inflows,its inflow
rate is
decided by the
supervisor
Other wholesale
Inflow
100% inflows
from financial
institution
counterparties
50% inflow rate
for non- financial
wholesale
counter parties
The draw-down rate

is 0%
since Credit,
liquidity, or any other
contingent funding
that bank holds at
other institution for
its own purpose are
assumed to be
unable to be drawn
in stress times.
Other Cash
Inflows
Valuation changes
on posted collateral
securing derivative
transactions of nonLevel 1 Assets (runoff rate = 20%)
Liabilities related to
derivative collateral
calls related to a
downgrade of up to
3-notches.(run-off
rate = 100%)
29
LRM Monitoring (1/4)

Contractual maturity used as
behavior model
Measures time to insolvency
No short-term funding is rolled
over
Equity prices, debt markets,

Forex markets etc
Monitoring financial sector
Monitoring bank specific
To monitor concentration of
Counterparty , Product and
Currency
Funding should be
diversified
Contractual
Maturity
Mismatch
Funding
Concentration
Market
Monitoring
Unencumbered
Assets
(i) Eligible for collateral, or, (ii)
Eligible for central bank facilities
Amount , Currency denomination
Estimated market haircut
Location/Business unit
30
LRM Monitoring (2/4) Maturity Mismatch Report
31
LRM Monitoring (3/4) - Funding Concentration Report
32
LRM Monitoring (4/4) Market Monitoring

Asset Type wise
Geography wise
$7,471,425
$58,744,523
$65,656,875
North America
Latin America
Africa
$69,852,365
EMEA
$58,874,125
Asia
APAC
$5,869,854
$25,852,541
BRIC
AUSTRALIA
$9,854,758
$6,502,521
Bonds
Options*
$5,878,962
$258,524
$6,985,425
Forwards*
Equities
Money Market
$7,035,319
Portfolio wise
$1,325,822
Banking & Finance

Aviation
5.0000%
5.0000%
4.2000%
$14,568,752
$25,658,415
1.2000%
4.2000%
3.0000%
Emerging Markets
Oil and Gas
Blue Chips
Construction
Infrastructure
Telecommunication
1.0000%
1.2000%
$25,874,152
Futures*
Information Technology
4.2000%
3.0000%
$85,241
Swaps*
Returns Quarterly
1.0000%
$685,214
Forex *
Energy & Utilities
Food and Drinks
$6,515,852
Mining
Transport
Technology
$5,236,517
33
LRM Stress Test (1/2) - Guidelines

A bank should conduct stress tests on a regular basis for a variety of short-term and protracted
institution-specific and market-wide stress scenarios (individually and in combination) to identify sources
of potential liquidity strain and to ensure that current exposures remain in accordance with a banks
established liquidity risk tolerance.
A bank should use stress test outcomes to adjust its liquidity risk management strategies, policies, and
positions and to develop effective contingency plans.
This stress test should be viewed as a minimum supervisory requirement for banks.
Banks are expected to conduct their own stress tests to assess the level of liquidity they should hold
beyond this minimum, and construct their own scenarios that could cause difficulties for their specific
business activities.
Such internal stress tests should incorporate longer time horizons than the one mandated by this
standard. Banks are expected to share the results of these additional stress tests with supervisors.
Refer Basel III: International framework for liquidity risk measurement , standards & monitoring Para 19
34
LRM Stress Test (2/2) - Methodology
Identify Liquidity
Risk Drivers
Erosion in value of
liquid assets
Additional collateral
requirements
Evaporation of
funding
Withdrawal of
deposits etc
Design Stress
Scenarios (and
Probabilities)
External scenarios
Emerging markets
crisis,systemic shock
in maincentres of
business,market risk
Internal scenarios
Operational risk,
ratings Downgrade
Ad-hoc scenarios
e.g. Country/industry
specific
Model Stress
Tests
Step 1
Quantify liquidity
outflows in all scenarios
for each risk driver
Step 2
Identify cash inflows to
mitigate liquidity
shortfalls identified
Step 3
Determine net liquidity
position under each
scenario
35
LRM Governance Principles & Supervision

Key Highlights of Committees Proposal
Key elements
Of robust
framework for
liquidity risk
management
Governance of
liquidity
Risk Management
Measurement
and
Management of
Liquidity risk
Public Disclosure
The Role of
supervisors
Board and senior

management oversight
Clearly articulate
liquidity risk tolerance
for
business strategy
Identifying, measuring,
monitoring and
controlling liquidity risk
Disclose information
On regular basis
regularly perform a
comprehensive
assessment
Establishment of
policies and risk
tolerance
Strategy policies
and practices in tandem
with risk tolerance
Projecting cash flows

from assets, liabilities
and off- B/S items
Market participants to
make an informed
judgment
Monitoring combination
of internal , prudential
reports and mkt info
Comprehensive cash
flow
forecasting
Incorporate
liquidity costs
Actively manage Intraday liquidity positions
Incorporate benefits and

risks in
internal pricing
Actively manage
collateral positions
performance measure
& new product
approval process
Conduct stress tests

on a regular basis
Limits and liquidity

scenario stress testing
Robuust and
multifaceted
contingency
funding plans
Maintenance of
sufficient
cushion of HQLA
Communicate with other

supervisors and
public authorities
Contingency funding
plan that addressing
liquidity shortfalls
36
LRM Public Disclosures

A bank needs to disclose sufficient information regarding its liquidity risk management to enable
relevant stakeholders to make an informed judgment about the power of the bank to meet its
liquidity needs
These include quantitative & qualitative disclosures such as
Organizational structure and framework for the management of liquidity risk
The degree to which the treasury function and liquidity risk management is centralized or
decentralized
The aspects of liquidity risk to which the bank is exposed and that it monitors
Diversification of the bank's funding sources
Explanation of how stress testing is used
Description of the stress testing scenarios modeled
Regulatory restrictions on the transfer of liquidity among group entities.
The frequency and type of internal liquidity reporting
Regulatory reports like LCR, NSFR & Maturity mismatch
Drilldown reports Portfolio wise, Fund concentration, Cash flows and Aggregate Reports
37
LRM Summary
Background
The recent credit crisis compounded quickly into a major liquidity crunch leading to insolvency of major
financial institutions
Inadequate liquidity management in almost all banks
No dedicated liquidity buffer or liquidity portfolio in banks
BCBS Response
17 Principles for Sound Liquidity Risk Management and Supervision ( BCBS 144).
Importance of managing liquidity contingency buffer similarly as capital
Maintaining High Quality liquidity portfolio that can hedge out liquidity outflows under stress scenarios
Improved Risk Policies, Procedures & Governance to be reviewed & implemented
Action on Banks
The Basel III Liquidity regulation imposes significant challenges to banks for enhancing existing liquidity
measurement and management methods
Improved Governance Policies for Liquidity Risk ( Review, Modify)
Sophisticated scenario based approach ( Stressed Scenarios) for LRM
Completely Revamp their Liquidity Risk System to include Calculation of LCR, NSFR and Monitoring
Tools as per BCBS papers
Periodically inform Regulator about their LRM approach and get necessary guidance & approval
38
Basel III - Capital Requirements

What changes in Basel III
Composition of Capital
Capital Adjustment
Former deduction from capital
Capital Conservation Buffer
Counter Cyclical Buffer
Leverage Ratio
Summary
39
Why Basel II has changes
Basel II key
weakness
Many regulatory adjustments

are not applied to common
equity, allowing to report high
Tier 1 ratios
No harmonized list of regulatory
adjustments
Hybrid capital proved to be less

valuable in times of stress than
anticipated
Basel II
key changes
Raising the quality,

consistency and transparency
of the capital base
Reducing procyclicality and

promoting countercyclical
buffers
Supplementing the riskbased capital requirement

with a leverage ratio
40
Composition of Common Equity Tier 1 Capital

Common shares issued by the
bank that meet the criteria for
classification as common
shares for regulatory purposes
(or the equivalent for non-joint
stock companies);
Stock surplus (share
premium) resulting from the
issue of instruments included
Common Equity Tier 1;
Regulatory adjustments
applied in the calculation of
Common Equity Tier 1
Common
Equity Tier 1
Common shares issued by
consolidated subsidiaries of
the bank and held by third
parties (ie minority interest)
that meet the criteria for
inclusion in Common Equity
Tier 1 capital.
Retained earnings;
Accumulated other
comprehensive income and
other disclosed reserves;
41
Composition of Additional Tier 1 Capital
Instruments issued by the bank that

meet the criteria for inclusion in
Additional Tier 1 capital (and are not
included in Common Equity Tier 1);
Regulatory
adjustments
applied in the
calculation of
Additional Tier 1
Capital
Additional
Tier 1 Capital
Stock surplus
(share premium)
resulting from the
issue of
instruments
included in
Additional Tier 1
capital;1;
Instruments issued by consolidated

subsidiaries of the bank and held by
third parties that meet the criteria for
inclusion in Additional Tier 1 capital
and are not included in Common
Equity Tier 1.
42
Composition of Common Equity Tier 1 Capital

Instruments issued by the
bank that meet the criteria
for inclusion in Tier 2 capital
(and are not included in Tier
1 capital)
Stock surplus (share

premium) resulting from
the issue of instruments
included in Tier 2 capital
Regulatory adjustments
applied in the calculation
of Tier 2 Capital
Common
Equity Tier 1
Certain loan loss

provisions
Instruments issued by
consolidated subsidiaries
of the bank and held by
third parties that meet the
criteria for inclusion in
Tier 2 capital and are not
included in Tier 1 capital
43
Capital adjustments
Capital
Adjustment
Goodwill and other

intangibles (except
mortgage servicing
rights)
Shortfall of the stock of

provisions to expected
losses
Deferred tax assets
Gain on sale related to

securitisation transactions
Cash flow hedge reserve
Defined benefit pension

fund assets and liabilities
Investments in own
shares (treasury stock)
Reciprocal cross holdings

in the capital of banking,
financial and insurance
entities
%)
44
Former deductions from capital

Treatment
The following items, which under Basel II were deducted 50% from Tier 1 and 50% from Tier 2 (or had
the option of being deducted or risk weighted), will receive a 1250% risk weight:
Certain securitisation exposures;
Certain equity exposures under the PD/LGD approach;
Non-payment/delivery on non-DvP and non-PvP transactions;
Significant investments in commercial entities
45
Capital Conservation Buffers

Background
The capital conservation buffer, which is designed to ensure that banks build up capital buffers outside
periods of stress which can be drawn down as losses are incurred.
Requirement
A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the
regulatory minimum capital requirement
Restriction
Mentioned below are the minimum capital conservation ratios a bank must maintain for various levels
of the Common Equity Tier 1 (CET1) capital ratios
Common Equity Tier 1 Ratio is 4.5% - 5.125% then the MCCR (Minimum Capital Conservation
Ratios) to be maintained is 100%
Common Equity Tier 1 Ratio is >5.125% - 5.75% then the MCCR to be maintained is 80%
Common Equity Tier 1 Ratio is > 7.0% then the MCCR to be maintained is 0%
46
Counter Cyclical Buffers

Background
The countercyclical buffer regime consists of the following elements:

National authorities will monitor credit growth and other indicators that may signal a build up of
system-wide risk and make assessments of whether credit growth is excessive and is leading to
the build up of system-wide risk
Internationally active banks will look at the geographic location of their private sector credit
exposures and calculate their bank specific countercyclical capital buffer
Disclosure
Public disclosure of how the bank is calculating the countercyclical buffers .
Restrictions
Each Basel Committee member will identify an authority with the responsibility to make decisions on
the size of the countercyclical capital buffer
This will vary between zero and 2.5% of risk weighted assets, depending on their judgment as to the
extent of the build up of system-wide risk
If a bank's capital level falls into the extended buffer range, they would be given 12 months to get
their capital level within the acceptable range before restrictions on the distributions of their earnings
come into effect. Any decision to decrease Countercyclical Buffer will take effect immediately. The
Buffer decisions along with the actual Buffers will be announced on the BIS website
47
Leverage Ratio
What is leverage ratio
constrain the build-up of leverage in the banking sector, helping

avoid destabilising 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.
48
Calculation of Leverage Ratio

Total Capital
Leverage Ratio
Capital measure
The capital measure for the leverage
ratio will be based on the new
definition of Tier 1 capital
Items that are deducted completely
from capital do not contribute to
Leverage and will be deducted from
the measure of exposure
= --------------------------------------------Total On and Off Balance Sheet Exposure
Exposure measure
General measurement principles
On-balance sheet items
(a) Treatment of Repurchase agreements
and securities finance
(b) Treatment of Derivatives
Off-balance sheet items
49
Summary
Composition of Tier 1 capital and Tier 2 Capital.
Phasing out of Tier 3
Requirement of Capital Conservation Buffers
Restriction related to Capital Conservation Buffer
Requirement of Counter Cyclical Buffers
Restriction related to Counter Cyclical Buffer
Composition of Leverage Ratio
Parallel run for Leverage ratio
50
Agenda
Counterparty Credit Risk (CCR) - Introduction
Changes in Basel III on CCR
Other Changes
Wrong Way Risk
Credit Valuation Adjustment (CVA)
Types of CVA Capital Charges

Types of Aggregation of CCR Capital Charges
Qualitative Criteria
Other measures
Summary
51
Counterparty Credit Risk (CCR) - Introduction

What is CCR ?
The counterparty credit risk (CCR) is defined as the risk that the counterparty to a
transaction could default before the final settlement of the transactions cash flows.
In 2007,the financial crisis spread to financial market causing systematic risk, preparing
the context to analyze impact on derivatives and financial risk management on
counterparty credit risk (CCR).
CCR covers loans and repo transactions, and most importantly, the enormous volume of
over-the-counter (OTC) derivatives.
Unlike a firms exposure to credit risk through a loan, where the exposure to credit risk is
unilateral and only the lending bank faces the risk of loss, the counterparty credit risk
creates a bilateral risk of loss - the market value of the transaction can be positive or
negative to either counterparty to the transaction
52
Changes in Basel III on CCR
Other Measures
Specific Wrong Way Risk
General Wrong Way Risk
Aggregation of CCR Capital
CVA Capital Charge
Wrong Way Risk
Credit Valuation Adjustment
CCR Focus Areas
Changes in Basel III on Counterparty Credit Risk (CCR)?

Basel III introduces measures to strengthen the capital requirements for Counterparty for
counterparty credit exposures arising from banks derivatives, repo and securities financing
activities. The building blocks as described in the diagram above are explained in later
slides.
- 53 -
53
Other changes - CCR Reform Objectives

Why CCR reform ?
The Reform Objectives for Counterparty Credit Risks as in Basel III are as follows
Determine capital requirement for counterparty credit risk using stressed inputs
Introduce 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
Apply longer margining periods as a basis for determining the regulatory capital
requirement
Address the systemic risk arising from the interconnectedness of banks and other
financial institutions through the derivatives markets
Address the treatment of so-called wrong-way risk, ie cases where the exposure
increases when the credit quality of the counterparty deteriorates
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011
54
Other Changes - Counterparty Credit Risk (CCR)

Key Terms
What is Exposure?
A few Key Terms are Introduced below
Counterparty exposure is the larger of zero and the market value of the portfolio of
derivative positions with a counterparty that would be lost if the counterparty were to
default and there were zero recovery. Counterparty exposures created by OTC
derivatives are usually only a small fraction of the total notional amount of trades with a
counterparty
Expected positive exposure (EPE) is the average Expected Exposure EE(t) for t in a
certain interval (for example, for t during a given year).
Potential future exposure (PFE) is the maximum amount of exposure expected to
occur on a future date with a high degree of statistical confidence.
55
Wrong Way Risk

Wrong-way risk is an unfavourable correlation between exposure and counterparty credit quality (i.e.
the exposure is high when the counterparty is more likely to default and vice versa).
Wrong-way risk is often difficult to define. For example, general empirical evidence supports a
clustering of U.S. corporate defaults during periods of falling interest rates.
If users of derivatives are hedging then they should generate right-way risk.
?
56
Types of Wrong Way Risk

The following are the Types of Wrong Way Risk
General Wrong-Way Risk arises when the probability of default of counterparties is positively
correlated with general market risk factors.
Specific Wrong-Way Risk arises when the exposure to a particular counterpart is positively correlated
With the probability of default of the counterparty due to the nature of the transactions with the
counterparty.
?
57
Specific Wrong Way Risk

A bank is exposed to specific wrong-way risk if future exposure to a specific counterparty is highly
correlated with the counterpartys probability of default.
For example, a company writing put options on its own stock creates wrong way exposures for the
buyer that is specific to the counterparty.
A bank must have procedures in place to identify, monitor and control cases of specific wrong way risk,
beginning at the inception of a trade and continuing through the life of the trade.
For single-name credit default swaps , EAD equals the full expected loss in the remaining fair value of
the underlying instruments with the assumption that the underlying issue is in liquidation
?
58
General Wrong Way Risk

General Wrong-Way Risk arises when the probability of default of counterparties is positively
correlated with general market risk factors.
Stress testing and scenario analyses must be designed to identify risk factors that are positively
correlated with counterparty credit worthiness.
Banks should monitor general wrong way risk by product, by region, by industry, or by other categories
that are related to the business.
?
59
Credit Valuation Adjustment (CVA)

Credit value adjustment (CVA) is the difference between the risk-free portfolio value
and the true portfolio value that takes into account the possibility of a counterpartys default..
This adjustment can be either positive or negative, depending on which of the two counterparties
bears the larger burden to the other of exposure and of counterparty default likelihood
Example
For example, assume Party X is the Euro receiver in a Euro-US dollar currency swap, where the midmarket valuation is 100. Assume this valuation already includes an effective market value of 2 for the
default risk to Party X, but the swap carries a net market value of default risk (to Party X) of 6. Then
the CVA is a downward adjustment of 4, leaving a fair market value of (to Party A) of 96
60
Types of Credit Valuation Adjustment (CVA) Capital Charge
Types of
CVA Capital Charge
Banks with IMM approval

and Specific Interest Rate
Risk VaR model approval
for bonds Advanced CVA risk capital
charge
All other banks standardised CVA risk

capital charge
61
Aggregation of CCR Capital Charge

Types of Aggregation
of
CCR Capital Charge

and market-risk internalmodels approval for the
specific interest-rate risk
of bonds
All other banks

and without Specific Risk
VaR approval for bonds
62
Banks with IMM approval and Market-risk Internal

Models approval for the Specific Interest-rate Risk of Bonds
Further details : The total CCR capital charge for such a bank is determined as the sum of the following
components
The higher of (a) the IMM capital charge based on current parameter calibrations for
EAD and (b) the IMM capital charge based on stressed parameter calibrations for EAD.
The advanced CVA risk capital charge
63
Banks with IMM approval and without Specific Risk VaR

approval for Bonds
components
The higher of (a) the IMM capital charge based on current parameter calibrations for
EAD and (b) the IMM capital charge based on stressed parameter calibrations for EAD.
The standardised CVA risk capital charge
64
All Other Banks

components
The sum over all counterparties of the CEM or SM based capital charge (depending on
the banks CCR approach) with EAD
The standardised CVA risk capital charge
65
Qualitative requirements
Basel has prescribed certain qualitative measures to cover the inadequacies in banks margining
practices, backtesting and stress testing program
The banks using the Internal Model Methods (IMM) are required to follow these qualitative
requirements .
?
66
Other measures Enhanced Collateral Management Requirement

The Bank must have a collateral management unit that is responsible for calculating and
making margin calls, managing margin call disputes and reporting levels of independent
amounts, initial margins and variation margins accurately on a daily basis.
The unit is required to track the extant of reuse of collateral and the concentration to
individual asset classes accepted by the bank.
The enhanced collateral management process is to enable the bank more reliable data
which can be used in PFE and EPE calculations.
67
Other measures - Enhanced requirements regarding re-use of

collateral
The nature of collateral is consistent with the Banks liquidity strategy and enable the
banks ability to post or return collateral in time.
68
Other measures - Treatment of highly leveraged counterparties

The Basel Committee prescribes qualitative requirement indicating that the PD estimates
for highly leveraged counterparties should reflect the performance of their assets based on a
stressed period.
PD estimates for borrowers that are highly leveraged or for borrowers whose assets are
mostly traded assets must reflect the performance of the underlying assets based on
periods of stressed volatilities.
69
Other measures - Requirements for stress testing of CCR

models 1/3
Banks are required to have have a comprehensive stress testing program for counterparty
credit risk.
The stress testing is required to include main the key elements:
Banks must ensure complete trade capture and exposure aggregation across all forms
of counterparty credit risk
For all counterparties, banks should produce, at least monthly, exposure stress testing
of principal market risk factors to proactively identify, and when necessary, reduce
outsized concentrations to specific directional sensitivities.
Banks should apply multifactor stress testing scenarios and assess material nondirectional risks (ie 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.
70

models 2/3
Qualitative Requirements
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.
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 and aggregate bank-wide CCR levels.
Stress tests results should be integrated into regular reporting to senior management.
The analysis should capture the largest counterparty-level impacts across the portfolio,
material concentrations within segments of the portfolio (within the same industry or region),
and relevant portfolio and counterparty specific trends.
71

models 3/3
Qualitative Requirements
A 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.
The impact of such shocks on capital resources should be evaluated, as well as the impact
on capital requirements and earnings. For the purpose of day-to-day portfolio monitoring,
hedging, and management of concentrations, banks should also consider scenarios of lesser
severity and higher probability.
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.
At a minimum, the results of stress testing for significant exposures should be compared to
guidelines that express the banks risk appetite and elevated for discussion and action when
excessive or concentrated risks are present.
72
Other measures - Back testing and model validation guidelines for

CCR 1/3
Qualitative criteria
The Basel committee identified significant shortcomings in the banks ability to conduct back
testing and model validation and made recommendations. Only those banks in full
compliance with the qualitative criteria will be eligible for application of the minimum
multiplication factor. The qualitative criteria include:
The bank must conduct a regular program of back testing, i.e. an ex-post comparison of the
risk measures45 generated by the model against realised risk measures, as well as
comparing hypothetical changes based on static positions with realised 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. In this regard, the
daily reports prepared by the independent risk control unit must be reviewed by a level of
management with sufficient seniority and authority to enforce both reductions of positions
taken by individual traders and reductions in the banks overall risk exposure.
banks
exposure.
Source:overall
Basel III: A risk
global regulatory
framework for more resilient banks and banking systems, rev June 2011
73

CCR 2/3
The banks internal risk measurement exposure model must be closely integrated into the
day-to-day risk management process of the bank. Its output should accordingly be an
integral part of the process of planning, monitoring and controlling the banks counterparty
credit risk profile
The risk measurement system should be used in conjunction with internal trading and
exposure limits. In this regard, exposure limits should be related to the banks risk
measurement model in a manner that is consistent over time and that is well understood by
traders, the credit function and senior management.
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. The banks risk measurement system must be well documented, for example,
through a risk management manual that describes the basic principles of the risk
management system and that provides an explanation of the empirical techniques used to
measure counterparty credit risk.
74

CCR 3/3
A review of the overall risk management process should take place at regular intervals
(ideally no less than once a year) and should specifically address, at a minimum:
The adequacy of the documentation of the risk management system and process;
The organisation of the risk control unit;
The integration of counterparty credit risk measures into daily risk management;
The approval process for counterparty credit risk models used in the calculation of
counterparty credit risk used by front office and back office personnel;
The validation of any significant change in the risk measurement process;
The scope of counterparty credit risks captured by the risk measurement model;
The integrity of the management information system;
The accuracy and completeness of position data;
The verification of the consistency, timeliness and reliability of data sources used to
run internal models, including the independence of such data sources;
The accuracy and appropriateness of volatility and correlation
assumptions;
The accuracy of valuation and risk transformation calculations; and
The verification of the models accuracy as described
75
Other measures - Increase margin period of risk for collateralised trades

1/2
Other measures
Basel committee introduces indicators of when to compel the banks to extend the margin
period of risk is extended to 20 business days for netting sets where
(a) the number of trades exceeds 5,000 or
(b) the set contains illiquid collateral or OTC derivatives that can not be replaced in
the market place
Banks with a history of margin call disputes on a netting set which exceeds the margin
period of risk will be required to double the applicable margin period of risk for the affected
netting set.
76
Other measures - Increase margin period of risk for collateralised trades

2/2
Other measures
Product Minimum holding period
Transaction Type
Minimum holding
period
Condition
Repo-style
transaction
5 business days
Daily re-margining
Other capital market

transactions
5 business days
Daily re-margining
Secured lending
20 business days
Daily revaluation
77
Other measures - Capital charges for exposures to CCP
Other measures
In order to prudently manage the systematic risks, the Basel Committee introduces
incentives to the banks to move the trades to central counterparty clearing house (CCP)
with exposure to CCPs assigned low risk weights.
The favorable treatment of exposures to CCPs applies only where the qualifying CCPs
complies with the standards set by
the Committee on Payment and Settlement System (CPSS) and
the International Organization of Securities commissions (IOSCO).
78
Other measures - Standard haircut for securitization collateral

Other measures
Basel committee has introduced a new recalibrated supervisory haircuts (assuming markto-market, daily re-margining and 10-buiness day holding period) expressed as a
percentage. Supervisory haircuts for collateral are as follows:
79
Other measures - Expected positive exposure(EPE)

calculated based on stressed input
Other measures
Effective expected positive exposure (EEPE) is required to be calculated using a threeyear period of stress
IMM banks are required to calculate EAD using current market data and compare this
with the EAD using current parameters
Wherever stressed EEPE exceeds the EEPE calculated using current market data, the
former will be used for the portfolio-level capital charge.
80
Other measures - Changes in External Ratings

Other measures
Banks are required to choose ECAI and use their rating consistently in order to eliminate
Cherry picking of assessments. In parallel, the use of unsolicited ratings is allowed subject
to certain conditions and supervisory control
The measures eliminates undesirable benefits where unrated exposures could have
received lower risk-weights than those of non-investment grade ratings
The requirement for eligible guarantors to be rated A- or better has been removed except
in the case of securitization exposures for Cliff effect.
81
Summary
The financial crisis necessitated reforms in Basel accord and Basel III came into being.
One of the key emphasis in the Basel III accord is the risk coverage of Counterparty
Credit Risk (CCR).
Credit Valuation adjustment(CVA) is introduced into a capital charge.
CVA capital charge differs based of approval status of the Bank and are of three types.
Aggregation of CCR and CVA charge is dependant on types of approval status of the
banks and are of two types.
Management of Wrong way risk is addressed in the Basel III.
Wrong way risk are of two types - Specific and general wrong way risk.
There are qualitative criteria and other measures for management of CCR risk
82
Agenda
Basel II vs. Basel II.5
Summary of Market Risk updates
Correlation Trading Portfolios
Specific Risk Charges
Resecuritization
Stressed VaR (sVaR)
Incremental Risk Charges
Comprehensive Risk Measures (CRM)
Summary
83
Basel II vs. Basel 2.5

In July 2009 the Basel Committee on Banking Supervision published the revisions to the Basel II market risk framework
(also known as Basel 2.5) and Enhancements to the Basel II framework. Summary of the proposed revisions are stated
below
Basel II.5
Basel II
Underestimation of losses under

normal market conditions
Uncertainty about re-securitization

exposures
Underestimation of exposure in
banks trading books to credit-risk
related products whose risk is not
reflected in VaR
20% CCF to short term eligible

liquidity facilities within the
securitization framework
4% RW treatment for liquid and

diversified portfolios for specific
risk capital charge for equities
Stressed VaR for banks using VaR

models in the trading book
New Incremental Risk Capital

Charge for IRB banks
Higher risk weights for resecuritizations in the banking book
The CCF for short-term eligible

liquidity facilities within the
securitization framework is changed
from 20% to 50%
Removal of concessionary 4% RW
treatment for liquid and diversified
portfolios
84
Summary of Market Risk updates

Market Risk updates
Standardized Approach
Specific risk charge for correlation
portfolios
Internal Measurement Approach

trading
Specification of Market risk factors
Specific risk charge for securitization
Amendment of qualitative standards
Specific risk charge for credit derivatives
Stressed VaR
Specific risk charge for equities
Specific risk charge for Interest rate sensitive

positions
Risk weights for resecuritization
Incremental Risk Charge (IRC)
CCF for securitization liquidity facilities
85
Correlation Trading Portfolios

In the past, banks did not hold sufficient capital for specific risk and thats where large losses arose
from trading credit derivatives and securitization positions. So, in Basel II.5 major changes have
been introduced in relation to the calculation of specific risk
The correlation trading portfolio is for specific risk and is treated separately
Correlation Trading Portfolio

Correlation trading portfolio is defined by Basel Committee to incorporate securitization
exposures and n-th-to-default credit derivatives that meet the following criteria
An n-th-to-default credit derivatives contract is the one where the derivative is triggered in the
event of a specified number (n) of defaults out of a pool of underlying assets
Correlation Trading Portfolio Criterion

The positions should not be re-securitization positions, nor derivatives of securitization
exposures that do not provide a pro-rate share in the proceeds of a securitization tranche
All reference entities are single-name products, including credit derivatives, for which a liquid
two-way market exists. It also includes traded indices based on these reference entities
Hedges for these instruments are also included, provided they also meet the criteria
mentioned above
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009
86
Specific Risk Charge - for Correlation Portfolios

The bank computes
(i) Total specific risk capital charges that would apply just to the net long positions from the net
long correlation trading exposures combined, and
(ii) Total specific risk capital charges that would apply just to the net short positions from the
net short correlation trading exposures combined.
The larger of these total amounts is then the specific risk capital charge for the correlation
trading portfolio. The risk weights are the same as for non-correlation securitization.
Internal Model Approach

Under Internal Model Approach, the correlation trading portfolio is a limited exception that
applies to securitized products where banks may be allowed to apply a Comprehensive Risk
Measure (CRM). In broad terms, this will allow the bank to combine the measurement of
specific risk and Incremental Risk Charge for these portfolios.
87
Specific Risk Charge - for Securitization (1/2)

Due to demand for yield by investors and desire of banks to move assets off their balance sheets to
free up the capital resulted in rapid growth in the credit derivatives. Banks share of the market for
credit securities exceed their share of any other market.
In order to eliminate the trading book/ banking book arbitrage the Basel Committee introduced
changes to specific risk charges for securitization in trading book
Under this approach the bank computes the specific risk of the securitization positions in the
trading book using the same method, used for such positions in banking book.
Table below gives the Securitization Risk Weights for Standardized Approach
Resecuritization exposures are subject to specific risk capital charges depending on whether
or not the exposure is senior
88
Specific Risk Charge - for Securitization (2/2)

Internal Rating Based Approach
If the bank have an approval to use Internal Rating Based (IRB) Approach, in the banking book
a more granular table of risk weights will be used for the securitization positions in the trading
book.
Table below shows the securitization risk weights for IRB Approach
89
Specific Risk Charge - for Credit Derivatives

First to default credit derivative
Specific risk charge is set as lesser of the
Sum of the specific risk charges for all of individual reference credit instruments in the basket,
and
Maximum possible credit event payment under the contract.
Some offset is allowed if the reference entities hedge parts of the banks exposure
N-th-to-default credit derivative

Specific risk charge is set as lesser of the
Sum of the specific risk capital charge for the individual reference credit instrument but
disregarding (n-1) obligations with the lowest specific risk charges, and
Maximum possible credit event payment under the contract.
No offset is allowed for these derivatives if it hedges a reference entity in trading book
90
Specific Risk Charge for Equities

Basel II
The capital charge for specific risk will be 8%, unless the portfolio is both liquid and
well-diversified, in which case the charge will be 4%. National authorities will have discretion to
determine the criteria for liquid and diversified portfolios.
The general market risk charge will be 8%.
Basel II.5
The capital charge for specific risk and for general market risk will each be 8%
91
Resecuritization under Standardized Approach

What is Resecuritization ?
A resecuritization exposure is a securitization exposure in which the risk associated with an underlying pool of
exposures is tranched and at least one of the underlying exposures is a securitization exposure.
Definition of resecuritization captures collateralized debt obligations (CDOs) of asset-backed securities (ABS)
including, for example, a CDO backed by residential mortgage-backed securities (RMBS).

Risk weights applicable for resecuritization exposures are added for Standardized approach
as well as IRB Approach, to reflect that they are riskier
Source: Enhancements to the Basel II framework: BIS: July 2009
92
Resecuritization under IRB Approach

Banks using the internal ratings-based (IRB) approach to securitization will be required to apply higher risk
weights to resecuritization exposures
The ratings-based approach risk weight tables were modified to add two additional columns for resecuritization
exposures as shown below.
93
CCF for Securitization liquidity facilities SA

Basel II
The Standardized Approach of the Basel II framework applies a
20% CCF to commitments with a maturity under one year, and
50% CCF to commitments over one year
Eligible liquidity facilities under one year in the Standardized Approach securitization framework
receive a 20% CCF, while those over one year receive a 50% CCF
Basel II.5
The CCF for short-term eligible liquidity facilities within the securitization framework is changed
from 20% to 50% to be consistent with the CCF applied to long-term eligible liquidity facilities
94
Specification of Market Risk Factors

An important part of a banks internal market risk measurement system is the specification of an
appropriate set of market risk factors, i.e. the market rates and prices that affect the value of the
banks trading positions.
Apart from the existing guidelines specified under Basel II, following addition guidelines are
prescribed.
Although banks will have some discretion in specifying the risk factors for their internal models, the
following guidelines should be fulfilled.
Additional Guidelines
Factors deemed relevant for the pricing of instruments should be incorporated as risk
factors in VaR model.
The amendment re-emphasizes that the models must capture non-liner risk of options and
other relevant products (e.g. mortgage backed securities, tranched exposures or n-th-todefault credit derivatives)
VaR models should also capture the correlation risk and basis risk of products (e.g.
between credit default swaps and bonds)
Where proxies are used, a good track record for estimating the risk of the actual position
should exist
95
Amendment of Quantitative Standards

Apart from existing quantitative standards specified under Basel II for the calculation of capital
charge using VaR models, following additional quantitative standards have been incorporated
Additional Quantitative Standards

The regulatory capital requirement is based on estimating a 10-day 99% VaR figure. In
most implementations of VaR models this is achieved by following equation:
(1 day VaR)* Square root (10) = 10 Day VaR
Using the square root of time makes a number of implicit assumptions. In the new
regulations the bank has to prove that there is no underestimation of the risk when using
this method
Market data update period have been shorten to one month from three months, to ensure
that models adjust more quickly to market volatility
The bank must also make provision to be able to update the data sets more frequently if
required
96
Stressed VaR (sVaR): Introduction

Why Stressed VaR ?
Losses in most banks trading books during the financial crisis were significantly higher than the minimum
capital requirements under the Basel II Pillar 1 market risk rules.
The Basel Committee therefore requires banks to calculate a stressed value-at-risk taking into account a oneyear observation period relating to significant losses
What is Stressed VaR ?
It is VaR based on a one-year observation period relating to significant losses (additional to the VaR based on
the most recent one-year observation period)
In terms of capital requirements, the capital estimate for sVaR is added to capital requirement for VaR
sVaR estimate must be calculated at least on a weekly basis
Purpose of Stressed VaR ?
To reduce the pro-cyclicality of the minimum capital requirements for market risk and to increase the overall
level of capital
It is intended to replicate VaR for the banks current portfolio if the relevant market factors were experiencing a
period of stress
97
Stressed VaR: Guidelines

Key Guidelines
No particular model is prescribed for the calculation of sVaR, so long as each model used captures all the
material risks run by the bank
On a daily basis, a bank must meet the capital requirement (c) given by the expression:
Maximum of its
Previous days value-at-risk number
(VaRt-1); and
Average of the daily value-at-risk
measures on each of the preceding
sixty business days (VaRavg), multiplied
by a multiplication factor (mc)
Maximum of its
Latest available stressed-value-at-risk
number (sVaRt-1); and
Average of the stressed value-at-risk
numbers over the preceding sixty business
days (sVaRavg), multiplied by a multiplication
factor (ms)
The multiplication factors mc and ms will be set by individual supervisory authorities on the basis of their
assessment of the quality of the banks risk management system, subject to an absolute minimum of 3 for m c
and an absolute minimum of 3 for ms
Data sets update every month and reassess whenever a material change in market prices takes place
98
Treatment of Specific Risk: Interest Rate Positions

Key Guidelines
Banks are allowed to include specific risk for equity and interest rate risk positions in their VaR
model.
For interest rate risk positions, the bank will not be required to subject these positions to the
standardized capital charge for specific risk, if following conditions are met
The bank has a value-at-risk measure that incorporates specific risk and the supervisor has
determined that the bank meets all the qualitative and quantitative requirements for general
market risk models
The supervisor is satisfied that the banks internally developed approach adequately captures
incremental default and migration risks for positions subject to specific interest rate risk
The specific risk VaR model must include all the material components of price risk and be
sensitive to changes in market conditions and portfolio composition. The model should
explain the historical price variation in the portfolio
capture concentrations (magnitude and changes in composition)
be robust to an adverse environment
capture name-related basis risk
capture event risk
be validated through back-testing
99
Incremental Risk Charge (IRC): Introduction

What is IRC ?
Incremental Risk Charge (IRC) is an additional charge to the trading book meant to capture Default risk and
Credit Migration Risk. It measures losses due to default and migration for unsecuritized credit products, at the
99.9% percent confidence interval over a capital horizon of one year
Default Risk is the potential for direct loss due to obligors default, as well as the potential for indirect loss that
may arise from a default event
Credit Migration Risk is the potential for direct loss due to internal/ external rating downgrade or upgrade as
well as the as the potential for indirect loss that may arise from a credit migration event
Why IRC was introduced ?
During the financial crisis a number of major banking organizations experienced large losses, most of which
were sustained in banks trading books.
Most of these looses were not captured in the 99%, 10-day VaR since the losses had not arisen from actual
defaults but rather from credit migrations combined with widening of credit spreads and the loss of liquidity
Purpose of IRC ?
To address the shortcoming of regulatory capital model
To produce an estimate of default and credit migration risks of unsecuritized credit products over a year capital
horizon at 99.9 % confidence level
Source: Guidelines for computing capital for incremental risk in the trading book : BIS: July 2009
100
IRC: Estimation & Coverage

Estimation of IRC
IRC only applies to banks adopting the internal model approach and that seek to model specific risk in the
trading book
Capital charge for IRC will be estimated as, C= max (IRCt-1, mc *IRCavg)
Maximum of its
Previous days Incremental Risk measure (IRCt-1); and
Average of the Incremental Risk Charge measures over 12 weeks
(IRCavg), multiplied by a multiplication factor (mc)
IRC will be measured at least on a weekly basis
Positions covered under IRC
IRC will be calculated on all positions that are subjected to a capital charge for specific interest rate risk according to
Internal Models Approach to specific market risk, but that are not subject to treatment outlined for unrated securities
under Basel II framework
With supervisory approval, the bank may choose to include all listed equity and derivative positions, based on the listed
equity of a company, in its incremental risk model when the inclusion is consistent with how the bank internally measures
and manages this risk at the trading desk level
Securitization positions are excluded from IRC, even when they are viewed as hedging underlying credit instruments
held in the trading account
101
IRC: Supervisory Requirements

Key Supervisory parameters for IRC
Soundness standard: IRC must adhere to a soundness standard comparable to IRB approaches in the banking book
Constant level of risk over one-year capital horizon: This measure must take into account the liquidity horizons
applicable to individual trading positions. Trading positions are rebalanced at the end of their liquidity horizons to achieve
a constant level of risk
Liquidity horizon: The liquidity horizon must be measured under conservative assumptions and should be sufficiently
long that the act of selling or hedging, in itself, does not materially affect market prices. The liquidity horizon for a position
or set of positions has a floor of three months
Correlation: IRC should include correlations between defaults and migrations, which are caused by economic and
financial dependence among obligors. The correlations between default and migration risks and other market factors in
the VaR model are excluded and no diversification is allowed when capital is calculated
Concentration: IRC should reflect issuer and market concentrations. Considering , other things being equal, a
concentrated portfolio should attract a higher capital charge than a more granular portfolio
Risk mitigation and diversification effects: Netting of exposures is only allowed if the instruments are exactly the
same. IRC model should take significant basis risk into account. IRC must include the impact of potential risks that could
occur during the interval between the maturity of the instrument and the liquidity horizon
Optionality: IRC model must reflect the impact of optionality. This should include the nonlinear impact of options and
other positions with material nonlinear behavior with respect to price changes. The bank should have an understanding
of the model risk associated with estimation of price risks
102
IRC: Modelling
Modelling the IRC
Modelling the IRC is a complex task, two models have been implemented by the banks to do
this
Jump diffusion model
Merton model
Jump Diffusion Model: In this model, in addition to a Brownian Motion term, the price process
of the underlying is allowed to have jumps. The risk of these jumps is assumed to not be
priced. This model is not very popular due to issues such as problems with calibration of the
jumps to actual migration or default probabilities
Merton Model: It is a simulation based model used by majority of the banks for assessing the
default risk.
In deriving data to use in the IRC model one should use market estimates for estimating
probabilities of default and hence implied migration probabilities
The market data from products such as CDS strips can be used to determine forward default
probabilities
The effect of seniority or other instrument specific characteristics must be incorporated within
the estimates for loss given default
103

What is CRM ?
Under Internal Model Approach, for correlation trading portfolio the banks may be allowed to
apply a Comprehensive Risk Measure (CRM). This will allow the bank to combine the
measurement of specific risk and Incremental Risk Charge for correlation trading portfolios
Estimation of CRM
CRM applies to banks adopting the internal model approach and that seek to model specific
risk and IRC for correlation trading portfolio
Capital charge for CRM will be estimated as, C= max (CRMt-1, mc *CRMavg)
Maximum of its
Previous days Comprehensive risk measures (CRMt-1); and
Average of the Comprehensive risk measures over 12 weeks (CRMavg),
multiplied by a multiplication factor (mc)
Capital charges for CRM and IRC are calculated separately and added. There is no
adjustment for double counting between the CRM and any other risk measure
CRM estimates will be calculated at least on a weekly basis
104
CRM: Modelling
Modelling CRM
Modelling CRM must ensure that following are captured in the model
Cumulative risk arising from multiple defaults, including defaults in tranched products;
Credit spread risk, including gamma and cross-gamma effects;
Volatility of correlations, including the cross effect between spreads and correlation;
Basis risk between indices and constituents or bespoke portfolios;
Recovery rate volatility; and
Hedging slippage and cost of rebalancing
On an overall basis CRM must comply with all requirements for the IRC
In addition, the banks will be required to design stress testing scenarios for correlation trading
portfolios and examine the effect of these scenarios on default rates, recovery rates, credit
spreads and correlations
These tests must be applied weekly and the results submitted to the regulator
The regulator may apply a supplementary capital charge if deemed necessary
A floor on this measure was introduced , being 8 % of the measurement under the
standardized measurement method ( published in the press release of 18th June 2010)
105
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Introduction to Basel III

Copyright 2011 Tata Consultancy Services

Prior knowledge / experience in Basel II is mandatory for this WBT

Basel III Highlights

Stress calibration of CCR measures

Increase in quality and quantity of capital

Increased MR Specific Risk Charge for

Liquidity Coverage Ratio (LCR) High

Higher risk weights for resecuritisations

Key Timelines Basel III

Liquidity Risk Management

Fundamental Principles of LRM as per BCBS

Liquidity Risk Management (LRM) - Genesis

Liquidity Risk Introduction (1/4)

Liquidity Risk Introduction

Asset and liability mismatch generates not only interest rate

Market liquidity of the securities traded in the market

Financial institution ability to fund increases in assets and

Liquidity Risk Introduction..(3/4)

Difficulty providing sufficient

Party A fails to fulfill

Part of banks existing

Liquidity Risk Vicious Cycle

Fundamental Principles of LRM as per BCBS

LRM Basel III - Key Changes

# Basel III - LRM 2010 BCBS Guidelines

LRM Functional View

Cash Flow Data

Cash Flow Engine

Extreme Stressed Scenario

Stressed Cash Flow

Governance & Liquidity Policies

LRM Data Sources

LRM Ready Data

ON Balance Sheet / OFF Balance Sheet

Data Mapping / Business Rules / Reconciliation

LRM Liquidity Risk Measures

Basel Committee has developed two standards to be used in

LRM Liquidity Risk Measures..(2/9)

LRM Liquidity Risk Measures..(3/9)

Stock of High quality liquid assets (HQLA)

Liquidity Coverage Ratio

LRM Liquidity Risk Measures..(4/9)

High Quality Liquid Assets

LRM Liquidity Risk Measures..(5/9)

LRM Liquidity Risk Measures..(6/9)

These assets tend to have higher

Unencumbered Asset shouldn't be

Eligible by central bank for intraday liquidity

LRM Liquidity Risk Measures..(7/9)

Asset should have active outright

Historically, the market has shown

LRM Liquidity Risk Measures..(8/9)

= --------------------------------------------Required Stable Funding (RSF)

Short Term Funding

Non Core Deposit

Long Term Funding

Inter Bank Loans

LRM Liquidity Risk Measures..(9/9)

ABC Banks Capital & Liquidity Gap under Basel III..(1/2)

Basel III Impact

RWA banking book

RWA under Basel

ABC Banks Capital & Liquidity Gap under Basel III..(2/2)