Basel-III

Introduction to Basel - III and Key Enhancements

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Shortcomings in Basel-II and the need for Basel-III

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Shortcomings of Basel-II
Importance of diversification in Pillar 1
Credit risk capital rises linearly regardless
of exposure size
Unclear and inconsistent definition
of capital
Non- application of regulatory
adjustments across jurisdictions

One global risk factor

1. Portfolio
Invariance
6. Unclear &
inconsistent
definitions

2. Single
Global Risk
Factor

Non recognition of
interdependence across exposure &
geographies

Shortcomings

Prices for Over the Counter

products
Manipulation of inputs for reducing
capital requirements

3. Securiti
zation

5. Subjective
Risk Inputs

Warehousing of securitization
exposures on and off-balance sheet

4. Pro-cyclicality

Underestimates risk in good times &

overestimate in bad times
PD, LGD & EAD tend to be point in time

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Shortcomings in existing capital definition

Regulatory adjustments generally not applied to common equity
Adjustments currently applied to total Tier 1 capital or to a combination of Tier 1 and Tier 2 capital
Generally not applied to the common equity component of Tier 1
Allows banks to report high Tier 1 ratios despite low levels of common equity, net of regulatory adjustments

No harmonized list of regulatory adjustments

Significant differences in the manner of application of adjustments across various jurisdictions
Undermines the consistency of the regulatory capital base
Hampers the ability of market participants & supervisors to compare capital adequacies of banks across
jurisdictions

Weak transparency
Inadequate disclosure provided by banks about their regulatory capital bases
Insufficient details on the components of capital
Difficulties in assessing capital quality and performing comparisons with other banks

Reconciliation of regulatory capital components with the published financial accounts frequently absent

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Shortcomings in banks risk management of CCR

Back testing
Use of models with poor back testing results

Under estimation of actual losses due to

Stress testing
Non comprehensiveness in stress testing of counter party

credit risk

Improper statistical interpretation of back testing results

Infrequent stress testing of CCR (sometimes on an

ad-hoc basis)

Non consideration of problems identified in back testing

Inadequate coverage of counterparties or associated risks

inappropriate models

Wrong way risk

Own estimates of alpha

High correlation with the credit quality of the counter

parties with the exposure amount

Alpha is a multiplier applied to Effective EPE to determine

exposure at default

Inadequate assessment of wrong way risk

Significant variations while estimating alpha internally

Mis-specification of the models for estimating alpha,
especially for exposures with non-linear risk profiles

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Shortcomings Capital arbitrage & Promise shifting

Transactions
Bank A
Sells Bond

Buys CDS on bond

Passing the promise
to redeem

Underwrites Risk

Bank B
20% Risk Weighted

Passing the promise

to redeem

Lends $1000

Re-insurance
Company
Outside the scope of Banking
system, thus non application of
BIS capital rules

BBB rated Company

100% Risk Weighted
Capital Requirement

Reducing the capital

requirement in the
Banking system form $80
to $ 18.6 - 70.6% fall
Increasing the leverage

from 12.5 to 53.8 in the

banking system

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Promise
Transformations

Bank A

Bank A
Bond Face Value

100% Cap Weight

8% Required K

1,000

80

Bank A

Bank B

20% Cap Weight

8% Required K

Regulatory Adjustment
50% Off B/sheet Wt.
1.5% Surcharge Coef. & 8% Required K

Reducing capital requirement

Face value BBB bond

Buy CDS on BBB bond
from Bank B

16

Bank B
Underwrites to Reinsurqnce $50 perm,

2.6

Total Banking Capital

80

16

2.6

Re-insurer

Impact of shifting promises & leverage

Promise shifting leading to excess leverage due to capital arbitrage i.e. economising on capital while expanding balance sheet

Basel risk weighting led to perverse outcome i.e. greater the Tier-1 adequacy of the bank greater the cumulative losses
Low capital Vs. the un-weighted balance sheet is symptomatic of a banking risk culture a culture of privatizing gains and
socializing losses

Capital Adequacy Ratio (Tier 1) vs.

Writedowns & Losses / Total Assets

2.5

Switzerland

2.0

Writedowns & Losses /

Total Assets (%)

Writedowns & Losses /

Total Assets (%)

2.5

Common Equity / Total Assets (Lev. Ratio) vs.

Wriedowns & Losses / Assets

Germany
UK

1.5

Belgium
Ireland
Australia

Canada

1.0
Spain
Italy
0.5

France

Norway
Japan

0.0

Switzerland
Germany

2.0

Belgium

1.5

UK
Canada
Australia

1.0

France

Ireland

Spain
Norway

0.5

Japan

Italy

0.0

10

11

Tier 1 ratio
Better Tier 1 capital ratio, greater the loss

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10

11

12

Common Equity / Total Assets (%)

Negative relationship of leverage ratio with losses

Capital adequacy vs. the simple leverage ratio

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The need for Basel-III

The BASEL-II Accord

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Shortcomings of Basel-II

Components of Basel-III

Unclear & inconsistent

capital definition

Enhanced transparency,
consistency & quality
of capital base

Exposures to some risks

not addressed (e.g. resecuritizations etc.)

Risk coverage includes

securitizations, off BS
items & CCR

Inadequate treatment of
Liquidity Risk

Enhanced liquidity
standards including
LCR & NSRF

Excessive BS growth
despite relatively small
levels of capital

Leverage ratio introduced

as a risk-invariant
measure of BS growth

Causes pro-cyclical
amplification of shocks
in financial sector

Adoption of measures to
counteract pro-cyclicality

The Proposed
BASEL-III Accord

Recap of the global financial crisis

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Overview of the global financial crisis

Root causes for the crisis
1

Risk management
post the crisis

Impact of the crisis

1

Macro economic imbalance

Significant

market-to-market losses
2
2

3
3

Capital Management

Liquidity dry-up / Bank runs

Underestimation of risk in
complex financial products

Risk Governance & Strategy

Massive credit losses

Self-reinforcing

Failure of huge Banks and

irrational exuberance

Investment Companies

Liquidity Risk Management

Credit Risk Management
Pro-cyclicality in Basel-II
Regulations

5
4

Significant loss of confidence

Deregulation of the

and downward spiraling of

Transparency and

Financial Services Industry

macro-economic indicators

Information Disclosure

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Chronological summary of the global financial crisis (1/3)

1

Copious inflow of foreign funds from countries with current account surpluses
The turn of this century witnessed China, oil exporting nations and Japan investing huge amounts of surplus
national savings in treasury bonds and related securities issued by the USA, UK and parts of EU.

Availability of surplus funds plummets interest rates and spurs aggressive lending
Fed interest rates were around 5.5% p.a. prior to year 2002. Inflow of foreign funds plummeted rates to 1.6%
between 2002 to 2005.

Combination of low interest rates and aggressive lending & investment practices leads to
innovation of new financial products
Innovation of structured credit products, modeled (and rated) as low risk - high yield instruments.

All the above factors, backed by huge house-hold and corporate demand, spurred lending, significantly
increased leveraged positions of Banks and changed maturity transformations

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Chronological summary of the global financial crisis (2/3)

5

Substantial growth in the financial sector lead by the structured credit model
The lending model using structured credit instruments caused banks to view that all risks involved in the
transactions were transferred to the buyers of such instruments, which was later on proved to be false.

Growth in the financial sector coupled with huge profits caused a vicious loop of
self reinforcing irrational exuberance
Model Risk prevalent in complex structured credit products were significantly undermined and ignored.

Deregulation of the financial services industry, in the USA, fuelled systemic risks
Emergence of shadow banking, Lack of capital requirements for non banking investment companies etc.

During 2006, Fed increased interest rates. Rates were substantially increased in year 2007 also
Average rates increased from 1.6% p.a. between 2002 to 2005 to 4.9% p.a. between 2006 to 2007.

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Chronological summary of the global financial crisis (3/3)

9

Increase in interest rates, initial incidence of sub-prime defaults and over-supply of real estate properties cause
real estate prices to fall & initiates a wave of negative market sentiment

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Negative sentiments freeze interbank markets and short term placements

Banks with heavy dependence on short-term funding faced liquidity dry-up. Deposit runs by retail and corporate
customers further added to the liquidity concerns (i.e. Bear-Stearns, Northern Rock).

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Banks incur massive credit losses from real estate financing. Investment Companies incur huge marked-tomarket losses on real estate investments

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Failure of huge Banks and Investment Companies (initially considered as "too big to fail"). It leads to significant
loss of confidence and downward spiraling of macro-economic indicators
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