11 April 2017

Prudential regulation in the form of the Basel accords on capital adequacy has been evolving for almost 30 years. Etay Katz and Kirsty Taylor explain this quest for safety and soundness as “Basel IV” awaits agreement.

Since the first Basel accord of 1988, the standards on bank regulatory capital requirements have been refined and reformed by the Basel Committee on Banking Supervision (BCBS) based on lessons learned and perceived shortfalls of the then existing standards. This process continues today with a package of proposed reforms to Basel III sometimes referred to in the market as “Basel IV”. This article looks at how regulatory capital requirements have evolved, what is required today and what looks set to come.

Who is the BCBS?

The Basel Committee, initially named the Committee of Banking Regulations and Supervisory Practices, was established by the central bank governors of the Group of Ten countries at the end of 1974. It has since expanded its membership to 45 institutions from 28 jurisdictions and has established a series of international standards for bank regulation, most notably the accords on capital adequacy.

Although these standards are in and of themselves non-binding, they are issued when agreed by the BCBS and as such, its members are committed to transposing them into their own legislation in one form or another. In the EU, Basel III has been implemented by the Capital Requirements Directive IV (CRDIV) and the Capital Requirements Regulation (CRR).

Basel I and II

The onset of the Latin American debt crisis in the early 1980s heightened the concern of the BCBS that the capital ratios of the main international banks were deteriorating at a time of growing international risks. The BCBS resolved to halt the erosion of capital standards in the banking system and to work towards greater convergence in the measurement of capital adequacy. The result was the publication of the 1988 Basel Capital Accord which called for a minimum ratio of capital to risk-weighted assets of 8% to be implemented by the end of 1992.

The accord was always intended to evolve over time. It was amended in 1991 to more precisely define the general provisions or general loan loss reserves that could be included in the capital adequacy calculation. In 1995 it was further amended to recognise the effects of bilateral netting of bank’s credit exposures in derivatives products and to expand the matrix of add-on factors and in 1996, the BCBS issued a further paper explaining how members intended to recognise the effects of multilateral netting.
 
The BCBS also refined the framework to address risks other than credit risk, which had been the focus of the 1988 Accord and an amendment to incorporate market risks was published in 1996. It also allowed banks to use internal models (value-at-risk, or VaR models) as a basis for measuring their market risk capital requirements, subject to quantitative and qualitative standards.

The 1988 Accord was replaced in 2004 with the release of Basel II following almost six years of preparation. Basel II comprised three pillars (see Figure 1).

figure
Basel II was designed to improve the way regulatory capital requirements reflect underlying economic risks and to better reflect financial innovation during the intervening years but it focused primarily on the banking book. In 2005, Basel II was supplemented by a consensus document governing the treatment of bank’s trading books which was integrated into Basel II in 2006.

Basel III

Basel III was initiated following the financial crisis of 2007/2008 and was endorsed and published in late 2010. It revised and strengthened the three pillars established by Basel II and resulted in an increase in the quantity and quality of capital required with the addition of various capital buffers. A non-risk based leverage ratio was introduced as well as two liquidity ratios (liquidity being one of the primary causes of some bank failures). The requirements are expected to be introduced in some instances in a phased manner by the end of 2018.

Put simply, banks and investment firms must today maintain at all times financial resources equal to or greater than a percentage of its risk weighted assets.

Financial resources

Financial resources constitute (in broad terms) equity or equity-like instruments which provide a cushion against losses. These contribute to investor protection and financial stability by mitigating the risk of insolvency, and thereby the risk of depositors or other creditors suffering losses. Financial resources are split into two categories – Tier 1 and Tier 2 (Tier 3 capital, a feature of Basel II, has been abolished) – depending on their characteristics and quality as capital.

As part of the calculation of financial resources, certain assets or exposures are required to be deducted from the capital items that constitute financial resources.

Risk weighted assets (RWA)

Assets or exposures that are not components of, or deducted from, financial resources are risk weighted. For these purposes, assets may fall into the banking book (also known as the non-trading book) or the trading book. In broad terms the trading book includes assets held with short-term trading intent (or to hedge such assets). Other assets fall within the banking book.

Pillar One

The core requirement of Pillar One remains that an institution's capital must be not less than 8% of risk-weighted assets. The purpose of risk-weighting is to ensure that the regulatory capital required for any specific asset is in line with the actual risk profile of that asset.

Credit risk – the banking book

For credit risk, there is a range of three approaches on which non-trading book assets may be risk weighted:

  • standardised approach;
  • foundation Internal Ratings Based approach (IRB approach); or
  • advanced IRB approach.

Each institution is required to adopt one of these three approaches. The IRB approaches are complex and require considerable resource as well as robust systems and controls. In general, only the most significant institutions will have sufficient resource to use the IRB approaches. Most major banks are on advanced IRB.

Basel III enhances credit risk coverage by the addition of a credit valuation adjustment (CVA) charge to take account of the risk of mark-to-market losses relating to counterparty risk under over-the-counter (OTC) derivatives, introducing new requirements for risk-weighting exposures to central counterparties, and strengthening requirements on counterparty credit risk and collateral management.

Securitisation

Basel II introduced a new framework for the assessment of risk weighted assets arising in respect of securitisations and synthetic securitisations – both in the hands of originators and sponsors of such structures and in the hands of holders of securitised exposures. These seek to avoid securitisation being used as a means to arbitrage regulatory capital, and to recognise the concentration of credit risk through tranching. Following the financial crisis the EU has introduced additional prudential requirements for securitisation, including enhanced due diligence and retention (‘skin in the game’) requirements and additional capital charges for resecuritisations.

Market risk – the trading book

Market risk rules require capital against items in the trading book by reference to the risk of movements in market price. They establish capital requirements for position risk, counterparty risk and currency risk.

Operational risk

A further area of regulation under Pillar One is quantitative regulation of operational risk. Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events, including legal risk. Again, there are three approaches that may be taken to the measurement of operational risk capital:

  • Basic indicator approach;
  • Standardised approach; or
  • Advanced measurement approach (AM approach).


The basic indicator and standardised approaches use percentages of net income associated with the relevant business as a proxy for operational risk. The AM approach uses more sophisticated means of establishing the operational risk requirement, and again requires significant resource, and robust systems and controls, to implement and maintain.

Pillar Two

Pillar Two effectively comprises two elements. The first is the requirement for institutions to assess their own capital needs – the individual capital adequacy assessment process (ICAAP) – and for regulators to engage actively in the review of those requirements, systems and controls – the supervisory review evaluation process (SREP). The second is the discretion of regulators to impose additional capital requirements on firms following the SREP.

Pillar Three

Pillar Three constitutes a disclosure regime for institutions. The aim is to provide sufficient transparency for investors so as to ensure that the price which institutions pay to raise capital in the market reflects the level of risk undertaken by them.

The Pillar Three framework is intended to complement bank and investment accounts, and the proposals are intended to be supplementary to disclosure mandated by accounting standards.

Capital buffers

Basel III introduces capital buffers which apply in addition to the Pillar One requirements outlined above and must be met using core equity tier 1 (CET 1) capital.

The capital conservation buffer requires institutions to hold a buffer of CET 1 capital equal to 2.5% of RWAs. The buffer aims to limit the ability of institutions to make distributions during periods of stress. When an institution’s holding of CET 1 capital falls below the buffer threshold (7% of RWAs when aggregated with the Pillar One CET 1 requirements) its ability to make distributions will be limited by incrementally increasing percentages.

The countercyclical buffer will be set by the relevant national authority. The relevant national authority may require institutions that have credit exposures in the member state to hold a buffer of CET 1 capital between 0% and 2.5% of RWAs – its aim is to require firms to build up a buffer of capital during periods of growth which can be relied upon in downturns.
 
In addition, member states have the possibility of introducing a systemic risk buffer of additional CET 1 capital for a financial sector, subset of a sector, or systemically important institutions. A further risk buffer will be mandatory for global systemically important institutions (G-SIIs) but at the relevant member state’s discretion for other systemically important institutions (O-SIIs).

Liquidity requirements: the Liquidity Coverage Ratio and Net Stable Funding Ratio

Basel III also contains a liquidity coverage ratio (LCR) to address short term liquidity. The LCR requires institutions to hold a buffer of unencumbered (i.e. not pledged in any way to secure, collateralise or credit enhance any transaction) high quality liquid assets (HQLA) to meet net liquidity outflows under a stress scenario lasting 30 days. The objective of the LCR is to ensure that, during a period of idiosyncratic or market wide stress, institutions will be able to use the buffer to cover outflows. The LCR measures the available HQLAs against net cash outflows arising in the 30-day stress scenario period and institutions are ultimately expected to maintain a LCR of at least 100%.

A net stable funding ratio (NSFR) addresses long term liquidity mismatches and is aimed at incentivising institutions to use stable sources of funding in the long term. The NSFR will measure the amount of stable funding available to a firm against the required amount of stable funding over a period of a year under conditions of extended stress. The required amount of stable funding will be measured on the basis of the broad characteristics of the liquidity risk profiles of an institution’s assets, off-balance sheet exposures and other selected activities.

Leverage ratio

The leverage ratio aims to restrict the level of leverage that an institution can take on to ensure that an institution’s assets are in line with its capital. It will also act as a safeguard for the existing risk-based capital requirements. The leverage ratio is a non-risk based measure and is defined as an institution’s Tier 1 capital divided by its average total consolidated assets (i.e. non-weighted assets and off-balance exposures) and expressed as a percentage which must be at least 3%.

“Basel IV”??

In 2012, the BCBS established the Regulatory Consistency Assessment Programme (RCAP) to monitor progress and assess the implementation of Basel III and its outcomes.

The RCAP focused on the consistent calculation of risk-weighted assets under the Basel III framework. The BCBS separately analysed the banking book, the trading book and operational risk.

The review is considered by many in the industry to be comprehensive and the proposals to pose a substantial impact on banks’ capital requirements, especially when viewed alongside other reforms at global level such as the requirements for Total Loss Absorbing Capacity. It is for this reason that some in the industry are referring to the package as “Basel IV” albeit that it remains a collection of refinements, additional and further specifications to the Basel III framework.

The “Basel IV” proposals

The current open proposals fall into three main categories:

  • constraints on the use of internal models;
  • parameter floors; and
  • leverage ratio.

In March 2016, the BCBS published a consultation document “Reducing variation in credit-risk weighted assets – constraints on the use of internal model approaches”. 
In addition to the issues flagged above, the proposed changes to Basel III include a number of complementary measures that aim to:

  • 1. reduce the complexity of the regulatory framework and improve comparability; and
  • 2. address excessive variability in the capital requirements for credit risk.

Constraints on the use of internal models

The consultation proposes, amongst other things, to remove the option to use the IRB approaches for certain exposures, where it is judged that the model parameters cannot be estimated sufficiently reliably for regulatory capital purposes.

For counterparties that produce low default exposures (e.g., banks, large corporations, and other financial institutions), probability of default (PD) is hard to estimate and is considered to lead to inconsistent results.

Additionally, the BCBS's review of banks' operational risk modelling practices and capital outcomes revealed that the AM approach's inherent complexity, and the lack of comparability arising from a wide range of internal modelling practices, have exacerbated variability in risk-weighted asset calculations and eroded confidence in risk-weighted capital ratios. The BCBS therefore proposes to remove the AM approach from the regulatory framework.

The revised operational risk capital framework will be based on a single non-model-based method for the estimation of operational risk capital, which is termed the Standardised Measurement Approach (SMA). The SMA relies on a business indicator (based on the three main sources of income) and the past performance of the financial institution.

IRB capital floors

Under the current framework, capital requirements cannot be lower than a floor calculated on the basis of the Basel I framework. However, this is now considered to be obsolete as, for example, some banks have never been subject to it. In addition, the leverage ratio also acts as a floor on the calculation of capital requirements, albeit it to address other issues.

The proposed replacement floor would be based on revised standardised approaches for credit, market and operational risk.

The floor is meant to mitigate model risk and measurement error stemming from internally-modelled approaches. It is intended to enhance the comparability of capital outcomes across banks, and also ensure that the level of capital across the banking system does not fall below a certain level.

The BCBS indicated that given the impact of output floors on the level of capital requirements, the final design and calibration would be done at a later stage on the basis of a comprehensive quantitative impact study. Therefore the overall issue of interactions between input floors, output floors and the leverage ratio has yet to be assessed.

Leverage ratio

An April 2016 consultative document “Revisions to the Basel III leverage ratio framework” among other things suggested amendments to the:

  • measurement of derivative exposures;
  • treatment of regular-way purchases and sales of financial assets;
  • treatment of provisions;
  • credit conversion factors for off-balance sheet items; and
  • additional requirements for global systemically important banks.

The final design and calibration of the proposals has yet to be published

Other areas of reform

The work programme of the BCBS also covers a review of the disclosure requirements under Pillar 3 with proposals aimed at improving the quality and granularity of requirements; a revision of the supervisory framework for measuring and controlling large exposures; and the treatment of sovereign exposures as part of the second consultative document on Revisions to the Standardised Approach for credit risk published in December 2015.

The BCBS standards on minimum capital requirements for market risk, were finalised in January 2016 and will come into effect on January 1, 2019. The framework for credit valuation adjustment risk remains open with further proposals introduced in the March 2016 consultation.Final standards on interest rate risk in the banking book were published in April 2016 and are to be implemented by 2018.

In July 2016, revisions were made to the 2014 capital standards for securitisations to incorporate the Simple, Transparent and Comparable securitisation criteria as defined by the BCBS and the International Organisation of Securities Commissions.

The process is stalled

In January 2017, the BCBS announced that it needed more time to consider the reforms package and the meeting scheduled for January 8 and intended for the Global Heads of Supervision (GHOS) to sign off the reforms, was postponed.

The proposals under consideration are undoubtedly the most ambitious attempt to tackle bank capitalisation needs and which perhaps explains the stalling of the process. The capital floors topic in particular is highly emotive as it is capable of applying asymmetrically to different banking business models across the globe. The primary concern is, however, that the Basel process loses credibility and that many smaller economies relying on just a fraction of the complex rules would lose out as a result of not having a crystallised standard to abide by.

Since the BCBS works by consensus and has no formal enforcement powers, a refrain throughout its history has been that “nothing is agreed until everything is agreed”.

Note: Standards produced by the Basel Committee are legally non-binding and need to be transposed into local law. The final implementation deadline therefore depends on this local transposition

Deutsche Bank Market Advocacy perspective

Angus Fletcher, Global Head of Market Advocacy GTB Product Management says that Basel measures (and regional implementation of the standards under CRR and CRD and US Basel) are key for GTB businesses – in particular trade finance.

“We continue to track leverage ratio, liquidity requirements, and operational risk measures to determine the impacts, highlighting to regulators the importance of differentiating trade finance risks and exposures (both on and off balance sheet) from other types of risks and exposures due to the real economy benefits that such activities provide, and their relative low risk nature.”

He continues, “Although we recognise that there is a pause in the original Basel timeline (largely due to the change of administration in the US that is driving a review of global measures), we still expect that ‘Basel IV’ approaches will be agreed within the next 12 months or so. We also continue to engage on the European proposals to CRR/CRDIV, which remain under consideration.”

Etay Katz

Partner at Allen & Overy

Etay Katz

Kirsty Taylor

Senior Professional Support Lawyer at Allen & Overy

Kirsty Taylor

Angus Fletcher

Global Head of Market Advocacy GTB Product Management

Fletcher_Angus_310x167(1).jpg

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