Basel 3

Monitoring Tools

Basel IIINihar RautAmitkumar MishraTable of ContentsCapital regulationsCET1Additional tier 1Tier 2Risk CoverageCVA Adjustment CalculationWrong way riskCapital conservational BufferCounter Cyclical BufferLiquidity Coverage RatioHQLANet Cash outflowsMonitoring toolsContractual Maturity Mismatch Concentration of Funding Available Unencumbered Assets LCR by significant currency Market related Monitoring Tools Net stable funding ratioASFRSF

Capital RegulationsAccording to BISTotal regulatory capital will consist of the sum of the following elements:1. Tier 1 Capital (going-concern capital)a. Common Equity Tier 1b. Additional Tier 12. Tier 2 Capital Limitations on CapitalCommon Equity Tier 1 must be at least 4.5% of risk-weighted assets at all times.Tier 1 Capital must be at least 6.0% of risk-weighted assets at all times.Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 8.0% of risk weighted assets at all times.CET1Common Equity Tier 1 capital consists of the sum of the following elements: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; Retained earnings Accumulated other comprehensive income and other disclosed reserves Common shares issued by consolidated subsidiaries of the bank and held by third parties (i.e. minority interest) that meet the criteria for inclusion in Common Equity Tier 1 capital.Additional Tier 1 capitalAdditional Tier 1 capital consists of the sum of the following elements: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);Stock surplus (share premium) resulting from the issue of instruments included in Additional Tier 1 capital;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 inCriteria for Addl. Tier 1Issued and paid-in Subordinated to depositors, general creditors and subordinated debt of the bankIs neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis--vis bank creditorsIs perpetual, i.e. there is no maturity date and there are no step-ups or other incentive to redeemMay be callable at the initiative of the issuer only after a minimum of five yearsAny repayment of principal (e.g. through repurchase or redemption) must be with prior supervisory approvalThe instrument cannot have a credit sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organisations credit standing.The instrument cannot contribute to liabilities exceeding assets if such a balance sheet test forms part of national insolvency law.Instruments classified as liabilities for accounting purposes must have principal loss Absorption

Tier 2 CapitalTier 2 capital consists of the sum of the following elements: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;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. Certain loan loss provisionsRisk CoverageThis section addresses the changes in computations for counter party credit risk where there were some weaknesses. Counterparty Credit Risk (CCR) relates to the risk that an organization will not pay the due amounts on a future date due to liquidity issues or non-availability of funds or for any other reason.

Procyclicality of EPE measurement One of the items not addressed under Basel II was the procyclicality of the EPE measure. In other words, the risk of counterparty default increases when the market conditions become worse. It has a direct linkage to market conditions. The guideline therefore specifies that the EPE computation must take the maximum of the following: RWA from EPE calculated with current historical covariance. RWA from EPE calculated with historical covariance aligned to the stressed period used to calibrate Stressed Value at Risk (VaR). This will ensure that the RWA takes into account stressed market conditions or current conditions, whichever is worse and thus make it a conservative estimate.Additional Credit Value Adjustment (CVA) ChargeWhile MTM was a factor in computing the total exposure for off-balance sheet future settlement instruments, the capital was insufficient to cover the profit and loss impact because of MTM variances. This charge is not required for transactions involving a central counterparty like an exchange and not required for SFT transactions unless the supervisor determines that the banks losses from SFT credit value adjustments are material. This additional CVA risk capital charge is the standalone market risk charge calculated on the set of CVAs for all OTC counterparties. The CVA charge computation varies on the option chosen by the bank for computing counterparty risks

Wrong way riskWrong way risk occurs when exposure by a bank to counterparty is adversely correlated with the credit quality of that counter-party. In other words, exposure is high to a counterparty whose creditworthiness is decreasing General Wrong Way Risks (GWWR) relate to risks in the macro economic conditions and not specific to a counterparty. Like the current economic scenario of high interest rates and higher probability of default is general in the market. There are no specific capital charges for general wrong way risk. Specific Wrong Way Risks (SWWR) arises on specific transaction e.g. they arise through poorly structured transactions, for example those collateralized by own or related party shares. For transactions with specific wrong way risk, Basel guidelines recommend the following treatment Assign maximum remaining loss to EAD for credit default swaps with SWWR. Assign EAD for equity derivatives with SWWR commensurate with an assumption that the counterparty is in default. Apply 100% LGD. Collateralized Counterparties and margin period of risk Requirement: Increase margin period of risk where: There is a history of large, prolonged disputes with counterparty. There is one or more complex or illiquid products in the portfolio. There are more than 5,000 trades in the portfolio. For portfolios with > 5,000 trades, the supervisory floor for the period of risk is 20-days. Where one or more complex/illiquid products exist in the portfolio, a supervisory floor for the period or risk is 20-days. Where firms have had more than two large margin call disputes (to be calibrated) in the last two quarters that have lasted more than the applicable base period of risk, then banks must double the supervisory floor for that netting-set for the next two quarters. Capital Conservation BufferOutside of periods of stress, banks should hold buffers of capital above the regulatory minimum.When buffers have been drawn down, one way banks should look to rebuild them is through reducing discretionary distributions of earnings. This could include reducing dividend payments, share-backs and staff bonus payments. Banks may also choose to raise new capital from the private sector as an alternative to conserving internally generated capital.

FrameworkA capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement.The distribution constraints imposed on banks when their capital levels fall into the range increase as the banks capital levels approach the minimum requirements

Counter Cyclical BufferThe countercyclical buffer aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. It will be deployed by national jurisdictions when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure the banking system has a buffer of capital to protect it against future potential losses.Bank specific countercyclical bufferBanks will be subject to a countercyclical buffer that varies between zero and 2.5% to total risk weighted assets.The buffer that will apply to each bank will reflect the geographic composition of its portfolio of credit exposures. Banks must meet this buffer with Common Equity Tier 1 or other fully loss absorbing capital.

Liquidity Coverage Ratio(LCR)Objective: To ensure bank maintains HQLA that can be converted in cash to meet its funding need over next 30 days under highly stressed scenarios.LCR = Stock of HQLA/ Total net cash outflows over next 30 calendar days .In absence of financial stress ratio should be >=100%What are HQLA? What are net cash outflows?

Stock of HQLAAssets are considered to be HQLA if they can be easily and immediately converted into cash at little or no loss of value.Characteristics of HQLA:Low Risk: Low duration, legal , inflation, foreign exchange risk.Ease and certainty on valuation (Formula, inputs, standardised)Low correlation with risky assetsListed on a developed and recognised exchange.Active market size(active sale or repo, low spread, high trading volume, robust market place, diverse market participants)Low volatility.Flight to quality (Market moves to these assets in stressed conditions)HQLAs are generally eligible at central banks intraday liquidity needs.

Operational Requirement of HQLABank should periodically monetize representative proportion of HQLA to demonstrate and test its characteristics.Assets should be unencumbered.Several other requirements w.r.t. control, mobilizing the asset, rehypothecation.

Diversification of HQLALevel 1: Unlimited share of the pool and are not subject to a haircut. Coins and Bank notes, central bank reserves(which can be drawn down in times of stress), marketable securities representing claims on or guaranteed by sovereigns, central banks, BIS, IMF, ECB or multilateral dev bank.Level 2 : Comprise no more than 40% of the overall stock after haircuts(15%) have been applied. Level 2A:Marketable securities representing claims on or guaranteed by sovereigns(proven record of haircut not exceeding 10%)Corporate debt securities and Covered bonds(AA- or higher)or higher)(proven record of haircut not more than 10% )Level 2BResidential mortgage backed securities(RMBS)(proven record of maximum haircut of 20%)(25% haircut applied)Corporate debt(50% haircut)(Rating of A+ to BBB-)(Not issued by financial institution)Equities (Not issued by financial institution, major stock exchange, proven record of maximum decline not more than 40% and haircut not more than 40%)Net cash outflowsTotal Net cash outflows over the next 30 calendar days = Outflows Min (Inflows; 75 percent of outflows) i.e. 25% of outflows must always be covered by HQLA.Inflows:Inflows considered must be cash based and accruals and other non-cash based income should be excluded.Interest on placementsDividends and interest on securities/bonds/equityFees from Fee based productsAny other inflows like rents and other incomeOutflows:Run down on liabilities(Stable deposit =3%, Less stable deposit =10%, unsecured wholesale funding callable in 30 days varies from 5% to 100%)Secured Funding (Level 1, 2A, 2B with run down rate varying from 0% to 100%)Operational Expenses for the next 30 daysAdditional interests on borrowings because of stressed conditions.Application issues for LCRFrequency of calculation and reporting.Atleast monthly and with operational potential to report weekly or daily.Scope of applicationShould be applied across all international active banks and its subsets and should be applied consistently.There might be differences in home/host liquidity requirment and treatment of liquidity transfer restrictions.CurrenciesBanks and supervisors cannot assume that currencies will remain transferable and convertible in a stress period, even for currencies that in normal times are freely transferable and highly convertible.

Monitoring ToolsTo measure the liquidity health of the banks.They are as good as standards as regulators will demand the data on periodic basis.Contractual Maturity Mismatch Concentration of Funding Available Unencumbered Assets LCR by significant currency Market related Monitoring Tools

Contractual Maturity Mismatch:Objective: Helps identify gaps in funds flow based on mismatch of contract expiry dates within a specified period(overnight to 5 years).Should include all on and off balance sheet items.Non-Maturing A&L should be reported separately.Assumptions:No rollover. Seperately report the customer collateral received. Reporting also in rehypothecation.Concentration of fundingObjective: To identify those sources of wholesale funding that are of such significance that withdrawal of this funding could trigger liquidity problems.Encourages diversification of funding sources.3 metric computations:A. Funding liabilities sourced from each significant counterparty as a % of total liabilities Threshold 1% B. Funding liabilities sourced from each significant product/instrument as a % of total liabilities Threshold 1%C. List of asset and liability amounts by significant currency Threshold 5%Available Unencumbered Assets( An asset or property that is free and clear of any encumbrances such as creditor claims or liens.)Objective: Provide supervisors with data on the quantity and key characteristics of unencumbered assets which can be used as collateral to raise additional HQLA or secured funding in secondary market and available unencumbered assets that are eligible for central banks standing facilities.Bank should report amount, type and location of AUA. In addition, it should report the estimated haircut that secondary market or relevant central bank would require on the asset.LCR by significant currencyObjective: LCR by currency will give an indication of the banks preparedness to meet obligations in each currency. Foreign Currency LCR = Stock of High Quality Liquid Assets in each significant currency / Total net cash outflows over a 30 day time period in each significant currency.Outflows must be net of any foreign exchange hedges. A currency is significant if aggregate liabilities in that currency > 5%.No global defined minimum required threshold. The ratio should be high for currency in which bank raises most of its funds in foreign currency market.Market Related Monitoring ToolsObjective: High frequency market data with little or no time lag can be used as early warning indicators in monitoring potential liquidity difficulties at banks.Market wide information : Information related to but not limited to equity prices(Overall market, sub-indices) in related exchanges, debt market(monet market, medium term notes, Long term debt, govt bond markets, Credit default spread indices etc) Foreign exchange markets, commodities markets and indices related to specific products.Information on financial sectorBank specific informationNet Stable Funding RatioThe NSFR is defined as the amount of available stable funding relative to the amount of required stable funding.NSFR => Available amount of stable funding/Required amount of stable funding.Should be >= 100% on ongoing basis.It complements the LCR and ensures that banks balance their liquidity profiles over short term without ignoring medium to long term requirements Should be reported atleast quaterly.What classifies as Available stable funding and Required stable funding?

Available Stable Funding(ASF)

ASF =

ASF Factor x Components of ASF categories Required Stable Funding(RSF)

RSF =

RSF Factor x Components of RSF categories

Application issues of NSFR:Frequency of calculation and reporting Should be reported quaterly with minimal time lags.Scope of application To all internationally active bank and also on their subsets to ensure greater consistency and level playing field between domestic and cross border bank.

Implementation timeline

ReferencesBasel III : A global regulatory framework for more resilient banks and banking systems Bank for International Settlement Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools - Bank for International Settlement(BIS).Basel III: The net stable funding ratio : Bank for International Settlement(BIS).White paper on Basel III : An easy to understand summary iCreate Software