Basel III: Finalising post-crisis reforms and Enhancing Regulatory Framework

Basel III is a set of regulations designed to strengthen the financial system and prevent future crises. The reforms aim to improve the resilience of banks and reduce the risk of bank failures.

The Basel III reforms are a result of the global financial crisis in 2007-2008, which highlighted the need for stronger capital and liquidity requirements. The crisis showed that banks were not adequately capitalized to withstand economic downturns.

To address this issue, the Basel III reforms introduced a new capital requirement of 7% of risk-weighted assets, which is higher than the previous requirement of 2%. This increased capital requirement is designed to ensure that banks have sufficient funds to absorb losses during times of economic stress.

Basel III introduces a new framework for calculating operational risk capital requirements. This requirement is determined by taking into account the Bank's Income (BI) and Internal Loss (ILM).

For banks with a BI of less than €1 billion, internal loss data does not affect the capital calculation, and the ILM is equal to 1. Minimum operational risk capital (ORC) is then simply the product of the Basic Indicator (BI) and the ILM.

Banks in this category can still be allowed to include internal loss data at national discretion, subject to meeting specific requirements. However, if this discretion is exercised, banks would still be subject to full disclosure requirements.

CET1 is a crucial component of a bank's capital requirements. It's calculated by dividing Common Tier 1 capital by risk-weighted assets (RWAs).

The minimum CET1 ratio required by Basel III is 4.5%. This is a critical threshold that banks must maintain at all times.

Banks also need to meet a mandatory "capital conservation buffer" or "stress capital buffer requirement", which is at least 2.5% of risk-weighted assets.

National regulators may require an additional "counter-cyclical buffer" of up to 2.5% of RWA as capital during periods of high credit growth. This must be met by CET1 capital.

In the U.S., globally systemically important financial institutions must also meet an additional 1% requirement.

Common Tier 1 capital comprises shareholders' equity, including audited profits, minus deductions of accounting reserve that are not believed to be loss-absorbing "today".

Bank's holdings of other bank shares are also deducted to prevent double-counting of capital across the economy.

Here's a breakdown of the CET1 requirements:

Tier 2 capital requirements are an essential aspect of capital requirements.

Tier 2 capital is a type of capital that banks are required to hold to ensure their financial stability.

Tier 2 capital requirements are not as stringent as Tier 1 capital, but they still play a crucial role in determining a bank's overall capital adequacy.

Tier 2 capital + Tier 1 capital is required to be above 8%.

The leverage ratio is a crucial aspect of capital requirements. It's calculated by dividing Tier 1 capital by the bank's leverage exposure, which includes on-balance sheet assets, derivative exposures, and securities financing transactions.

The minimum leverage ratio requirement is 3% under Basel III. This is the same requirement for the EU, where the minimum bank leverage ratio is also 3%. In contrast, the UK has a higher minimum leverage ratio of 3.25% for banks with deposits greater than £50 billion.

The U.S. has a supplemental leverage ratio, which is defined as Tier 1 capital divided by total assets. This ratio must be above 3.0%. Large banks and systemically important financial institutions are required to have a minimum leverage ratio of 5%.

Here's a breakdown of the leverage ratio requirements:

The implementation of the leverage ratio requirement has a timeline. Supervisory monitoring began in 2011, with parallel run periods in 2013 and 2015. The leverage ratio became a mandatory part of Basel III requirements in 2018.

Securitisations require robust capital standards to mitigate risks. The Basel II securitisation framework had shortcomings that needed to be addressed.

A revised securitisation framework, effective in 2018, was introduced to strengthen capital standards for securitisations. This framework aims to improve the calculation of minimum capital needs for securitisation exposures.

The revised framework addresses the calculation of minimum capital needs for securitisation exposures, aiming to provide a more accurate assessment of risk.

Basel III introduces a new liquidity requirement, known as the Liquidity Coverage Ratio (LCR), which requires banks to hold a minimum amount of high-quality liquid assets to meet their short-term liquidity needs.

This requirement aims to ensure that banks have sufficient liquidity to cover their outflows during a 30-day stress period, with a minimum LCR of 100%. The LCR is calculated by dividing the bank's high-quality liquid assets by its total net cash outflows over the next 30 days.

Banks must also meet a minimum Common Equity Tier 1 (CET1) capital requirement of 4.5% to ensure their capital adequacy. This requirement is designed to prevent banks from taking on excessive risk and to maintain a buffer against potential losses.

Equity investments can be a complex and nuanced area of risk management. Banks have introduced capital requirements for equity investments in funds, which were introduced in 2017.

These requirements take into account a fund's leverage when determining risk-based capital requirements. This means that banks must consider the underlying investments of the fund, including the use of a 1,250% risk weight for situations with insufficient transparency.

Banks must now more accurately reflect the risk of a fund's underlying investments. This is a significant shift in how banks approach risk management for equity investments in funds.

Liquidity is a crucial aspect of risk management, and it's essential to understand the concepts and requirements surrounding it.

Banks are required to hold sufficient high-quality liquid assets to cover their total net cash outflows over 30 days under a stressed scenario, known as the liquidity coverage ratio (LCR).

The LCR consists of two parts: the numerator is the value of HQLA (high-quality liquid assets), and the denominator consists of the total net cash outflows over a specified stress period.

Regulators can allow banks to dip below their required liquidity levels per the LCR during periods of stress.

The Net Stable Funding Ratio (NSFR) requires banks to hold sufficient stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

The introduction of the LCR was a response to the difficulties faced by some adequately-capitalized banks due to poor liquidity management.

In the EU, 100% LCR will be reached in 2018, while in the US, the LCR has a more stringent definition of HQLA and total net cash outflows.

Banks with at least $250 billion in total assets or at least $10 billion in on-balance-sheet foreign exposure have different LCR requirements.

Here's a brief timeline of liquidity requirements:

Note that the US version of the LCR has more stringent definitions of HQLA and total net cash outflows compared to Basel III.

Counterparty risk is a significant concern for financial institutions, and understanding CCPs and SA-CCR can help mitigate it.

A new framework for exposures to CCPs was introduced in 2017, providing a more comprehensive approach to managing counterparty risk.

The standardised approach for counterparty credit risk (SA-CCR) became effective in 2017, replacing the Current exposure method.

SA-CCR is used to measure the potential future exposure of derivative transactions in the leverage exposure measure and non-modelled Risk Weighted Asset calculations.

By implementing SA-CCR, financial institutions can better assess and manage their counterparty risk, leading to more informed decision-making.

The Bank of England was in the process of implementing the Basel III framework on large exposures as of 2024, which aims to further reduce counterparty risk.

Interest rate risk in the banking book is a critical area of focus for banks. New rules for interest rate risk in the banking book became effective in 2018.

Banks are required to calculate their exposures based on "economic value of equity" (EVE). This is under a set of prescribed interest rate shock scenarios.

Calculating exposures using EVE is a more comprehensive approach than previous methods. It takes into account the potential impact of interest rate changes on a bank's equity.

By using EVE, banks can better understand their interest rate risk and make more informed decisions. This is especially important in times of economic uncertainty.

Banks must comply with these new rules to maintain regulatory requirements and avoid potential penalties.

A Fundamental Review of the Trading Book has led to a shift in how banks calculate minimum capital requirements for market risk in the trading book.

Banks now use a better calibrated standardized approach or internal model approval for an expected shortfall measure, rather than the value at risk method used under Basel II.

This change has resulted in more accurate risk assessments and better risk management practices.

The expected shortfall measure is a more robust approach to calculating potential losses, as it takes into account the full range of possible outcomes, not just the most likely ones.

By adopting this new approach, banks can better manage their market risk and maintain a stable financial position.

To identify, collect, and treat loss data, banks must put policies in place that address various aspects of internal loss data. These aspects include collection dates, gross loss definition, and the grouping of losses.

A gross loss is a loss before recoveries of any type, whereas a net loss is defined as the loss after taking the impact of recoveries into account. Banks must be able to identify gross operational losses and recoveries for all operational risk events.

Banks must include the following items in their gross loss calculations: Losses before recoveries

Items excluded from gross loss calculations include: Recoveries of any type

The soundness of data collection and the quality and integrity of the data are crucial to generating capital outcomes aligned with the bank’s operational loss exposure. National supervisors should review the quality of banks’ loss data periodically.

The Standardized Measurement Approach (SMA) and the Advanced Measurement Approach (AMA) are two distinct methods used in risk management.

The AMA has been replaced due to its flexibility, which allowed banks to use different models for calculating capital required, resulting in widely incomparable internal modeling practices.

This flexibility has led to variability in risk-weighted asset calculations and eroded confidence in risk-weighted capital ratios.

The SMA, on the other hand, has limited flexibility and requires banks to follow precise guidelines in the entire capital calculation process.

To use the Loss Component (LC) under the SMA, banks must meet certain guidelines, which include having quality loss data spanning a 10-year period.

A bank must have documented procedures and processes for the identification, collection, and treatment of internal loss data.

The data must capture all material events and exposures from all geographical locations and subsystems, with any loss event of €20,000 or more considered material.

A bank must keep records of specific dates when operational risk events occurred or commenced.

Operational loss events related to credit risk and that are accounted for in credit risk RWAs should not be included in the loss data set.

For the purpose of calculating minimum regulatory capital under the SMA framework, operational risk losses related to market risk are treated as operational risks.

A bank must have an independent mechanism to validate and ensure the accuracy of the data.

Here's a summary of the key differences between the SMA and AMA:

The regulatory framework of Basel III is designed to strengthen banks' capital and liquidity requirements.

The Basel Committee on Banking Supervision (BCBS) introduced the Basel III reforms to address the weaknesses in the financial system that contributed to the 2008 global financial crisis.

Banks are required to hold a minimum common equity tier 1 (CET1) capital ratio of 4.5% and a total capital ratio of 10.5%.

In the U.S., Basel III applies not only to banks but also to all institutions with more than US$50 billion in assets.

These institutions must adhere to "Risk-based capital and leverage requirements", which include first annual capital plans, conduct stress tests, and capital adequacy.

A key requirement is a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions.

Institutions must also conduct liquidity stress tests and set internal quantitative limits, as per the United States' own interagency liquidity risk-management guidance issued in March 2010.

The Federal Reserve Board itself conducts stress tests annually using three economic and financial market scenarios.

Institutions are encouraged to use at least five scenarios reflecting improbable events, and especially those considered impossible by management, but no standards apply to extreme scenarios.

Only a summary of the three official Fed scenarios, including company-specific information, is made public.

One or more internal company-run stress tests must be run each year, with summaries published.

Here are some key requirements for single-counterparty credit limits:

Early remediation requirements ensure that financial weaknesses are addressed at an early stage.

One or more triggers for remediation, such as capital levels, stress test results, and risk-management weaknesses, are used to determine the severity of the situation.

Required actions vary based on the severity, but include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales.

Banks with a balance sheet total (BI) greater than €1 billion or those that use internal loss data in calculating operational risk capital are required to disclose their annual loss data. This applies to banks in jurisdictions that have opted to set Internal Loss Model (ILM) equal to one.

Loss data must be reported on both a gross basis and after recoveries and loss exclusions. This requirement ensures that banks provide a comprehensive view of their risk exposure.

Banks must disclose each of the BI sub-items for each of the three years of the BI component calculation window. This includes providing detailed information on their risk exposure over time.

Here's a breakdown of the disclosure requirements:

By disclosing this information, banks demonstrate their commitment to transparency and risk management.

The implementation of Basel III: Finalising post-crisis reforms was a gradual process that spanned several years. The Basel Committee on Banking Supervision (BCBS) released its final version of the "Supervisory Framework for Measuring and Controlling Large Exposures" in April 2014.

The implementation schedule was extended several times, with the initial deadline of 2019 being pushed back to 2022 for the market risk framework. This delay was announced in December 2017.

The BCBS also broadened the definition of liquid assets in January 2013, which further impacted the implementation timeline. In 2014, the BCBS released its proposal for public disclosure of regulatory metrics and qualitative data by banking institutions.

Here's a breakdown of the key milestones in the implementation of Basel III:

In the U.S., the Federal Reserve implemented the Basel III standards in 2011, with some modifications. The implementing act of the Basel III agreements in the European Union was Directive 2013/36/EU (CRD IV) and Regulation (EU) No. 575/2013 on prudential requirements for credit institutions and investment firms (CRR), which was approved in 2013.

The leverage ratio became a mandatory part of Basel III requirements in 2018, following a parallel run period that started in 2015. The liquidity coverage ratio (LCR) was introduced in 2015, with a 60% requirement that increased by ten percentage points each year until 2019. The LCR reached 100% in 2019, and the Net Stable Funding Ratio (NSFR) was introduced in 2018.

Basel III: Finalising post-crisis reforms has introduced several EU-specific reforms to strengthen banking regulations.

The standardized approach for credit risk (SA-CR) is one such reform, which aims to provide a more consistent and transparent way of assessing credit risk.

In addition to SA-CR, the internal ratings based approach (IRB) for credit risk is also being implemented, allowing banks to use their own credit risk models to assess credit risk.

A standardised approach for credit valuation adjustment risk is also being introduced, which will help banks to better manage counterparty credit risk.

Operational risk is another area where reforms are being introduced, with a standardised approach for operational risk being implemented for banks based on income and historical losses.

The output floor has been replaced with a more robust risk-sensitive floor and disclosure requirements, which will provide a better understanding of a bank's risk profile.

The finalised leverage ratio framework includes a buffer for global systemically important banks, definitions and requirements, exposure measures for on-balance sheet exposures, derivatives, securities financing transactions and off-balance sheet items.

Here are the six areas where Basel III: Finalising post-crisis reforms is introducing reforms:

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. It includes events such as fraud, employee errors, criminal activity, and security breaches, but excludes reputational risk as well as strategic risk.

Banks are required to measure operational risk using the standardized approach, especially internationally active banks. Supervisors still have the discretion to apply the standardized approach among non-internationally active lenders.

The minimum operational risk capital (ORC) for a bank is calculated by multiplying the Business Indicator Component (BIC) and the Internal Loss Multiplier (ILM). The BIC is a product of the Business Indicator (BI) and a set of regulatory marginal coefficients.

The Business Indicator (BI) consists of three components: the interest, leases, and dividends component (ILDC), the services component (SC), and the financial component (FC). All three components must be calculated as averages over three years.

For banks in bucket 1, internal loss data does not affect the capital calculation, so the ILM is equal to 1. This means that operational risk capital is equal to the BIC, which is 12% of the bank's BI. However, supervisors may allow the inclusion of internal loss data into the framework for banks in bucket 1, subject to meeting the loss data collection requirements.

Here is a summary of the buckets and their associated regulatory-determined coefficients:

Note that the BI is a key factor in determining the operational risk capital requirement, and banks with larger BIs are subject to more stringent requirements.

Calculating the BIC of a Bank with a BI of €40bn is a straightforward process, but it requires attention to detail.

The BIC is calculated by multiplying the Business Indicator (BI) by a set of regulatory marginal coefficients, which increase as the BI size increases.

To calculate the BIC, we need to divide the BI into three buckets: ≤ €1 billion, €1 billion < BI ≤ €30 billion, and ≥ €30 billion.

The marginal coefficients for each bucket are 12%, 15%, and 18% respectively, as shown in the table below:

For the first bucket, the BIC is equal to BI × 12%. For the second bucket, the marginal increase in the BIC resulting from a one unit increase in the BI is 15%. For the third bucket, the marginal increase is 18%.

Using these coefficients, we can calculate the BIC of a bank with a BI of €40bn. The calculation is as follows: (1 × 12%) + (30 - 1) × 15% + (40 - 30) × 18% = €6.27 billion.

The minimum operational risk capital for a bank is given by the formula: ORC = BIC × ILM. This is a crucial concept in Basel III.

To calculate the BIC, we need to determine which BI bucket our bank falls into. For a bank with a BI of €40 billion, the BIC is calculated by summing the marginal BI coefficients for each bucket. In this case, the BIC is €6.27 billion.

The BI bucket ranges are defined as: ≤ €1 billion, €1 billion < BI ≤ €30 billion, and ≥ €30 billion. The marginal BI coefficients for each bucket are 0.12, 0.15, and 0.18, respectively.

For a bank with a BI of €25 billion, the BIC is calculated similarly, but the result is €3.72 billion. This illustrates the importance of accurately determining the BI bucket for a bank.

The marginal BI coefficients are calculated by multiplying the BI range by the corresponding coefficient. For example, for the second bucket, the calculation is €(25 – 1) × 15% = €3.6 billion.

The Basel III reforms have been a long time coming, and it's essential to understand the importance of practice and criticism in implementing these changes.

Practicing what you preach is crucial, and the Basel Committee has been working closely with banks to ensure they have the necessary systems and controls in place to meet the new standards. Banks have been given a deadline of 2019 to implement the Basel III reforms, which has given them time to practice and perfect their new systems.

Criticism is also essential in the implementation process, as it helps to identify areas for improvement and ensures that the reforms are effective. The Basel Committee has been open to criticism and has made adjustments to the reforms as a result.

A key aspect of practice is understanding how to calculate the Bank Income Credit (BIC). To do this, you need to know how to sum the marginal bank income (BI) coefficients from the relevant BI buckets.

The calculation involves looking at the BI bucket ranges and their corresponding marginal BI coefficients. For instance, if a bank has a BI of €20 billion, you would look at the BI bucket ranges and find that €20 billion falls into the second bucket, where the marginal BI coefficient is 0.15.

To calculate the BIC, you would multiply the amount in the second bucket by the marginal BI coefficient, which is €(20 - 1) × 15% = €2.85 billion.

Criticism is essential to growth and improvement in any skill or practice. It helps us identify areas where we need to work harder and refine our techniques.

A good critic will point out what we're doing wrong and suggest ways to do it better. For instance, a coach might say, "Your swing is off-balance, try adjusting your stance."

Criticism can be uncomfortable, but it's necessary for progress. We need to learn to accept feedback and use it to improve our performance.

A bad critic, on the other hand, will only tear us down without offering any constructive advice. This kind of criticism is not only unhelpful but also discouraging.

To get the most out of criticism, we need to be open-minded and willing to learn. By incorporating feedback into our practice, we can refine our skills and achieve our goals.