Basel II to Basel III – The Way Forward
 

Basel II to Basel III – The Way Forward

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This white paper covers various Basel III guidelines, and describes why and how these will impact different areas of IT infrastructure and systems.

This white paper covers various Basel III guidelines, and describes why and how these will impact different areas of IT infrastructure and systems.

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Basel II to Basel III – The Way Forward Basel II to Basel III – The Way Forward Document Transcript

  • White Paper Basel II to Basel III – The Way forward - Rohit VM, Sudarsan Kumar, Jitendra Kumar Abstract Basel III guidelines are the response of BCBS (Basel Committee on Banking Supervision) to the 2008 Crisis. It is aimed at strengthening Individual Financial Institutions as well as the overall Financial System by eliminating the weaknesses which were present in BASEL II that were revealed during the crisis. BASEL III has a multi-dimensional impact on financial Institutions and will require associated changes to the IT systems. This paper covers various BASEL III guidelines, and describes the “Why” and “How” different areas of IT infrastructure and systems will be impacted. www.infosys.com
  • IntroductionSome very fundamental assumptions by financial institutions and regulators were proven wrong during the 2008 Crisis. The businessof subprime lending was based on the assumption that housing prices would keep going up. This assumption proved wrong and ittriggered a chain reaction that engulfed the global financial system. This ‘crisis cycle’ is illustrated in the diagram below.There were some incentives present in the financial system that encouraged risk taking. Transferring of risk through securitization; relying oncredit ratings provided by credit rating agencies, which were paid for by the issuers; compensation of top management based on absolutegrowth, revenue and profit rather than risk adjusted profitability; were just some of the reasons that encouraged excessive risk taking by banks.When subprime loan defaults started impacting the balance sheets of financial institutions, it became a systemic problem. Quarterlylosses to the tune of billions of dollars by major Financial Institutions resulted in a crisis of confidence that sucked out liquidity from thefinancial system. At this time, the weaknesses of the BASEL II guidelines became very evident.Exposure to risky assets in the form of subprime loans, securitization and derivatives resulted in excessive losses. The low quality andquantity of capital could not absorb these losses when systemic risk materialized. The bank’s loss absorbing capacity was affectedbecause of their excessive leverage and their short term sources of funding made financial institutions gasping for capital when it wasmost difficult to raise capital. Sub-Prime Sub-prime defaults, Excessive leverage & Lending Housing prices Securitized assets & poor capital could not decline resulting in derivatives trading absorb losses fully, sub-prime defaults resulted in huge demanding fresh Securitization losses equity infusion Excessive Risk Taking In stressed market situations, Credit Rating downgrades of Financial Institutions & securitized products further lowered valuations & increased losses Governments step in Firms on the verge of Short term borrowing Huge losses resulted to inject capital to insolvency; demanded fresh in a crisis of prevent systemic threatening system borrowing which confidence causing failure failure failed in liquidity crisis liquidity to evaporateBASEL III attempts to plug the loopholes present in BASEL II by recommending steps to further strengthen the overall financial system. BASELIII requires higher risk weights for risky assets bringing more assets/exposure into the umbrella of Risk Weighted Asset (RWA) calculations,prescribes a higher regulatory capital requirement and demands a very high quality of capital. It also introduces requirements to manageliquidity risk better. Finally, it introduces an additional requirement of absolute leverage ratio to take into consideration the model errorwhich might be present in RWA calculations.2 | Infosys – White Paper
  • The diagram below highlights where and how BASEL III changes will address the deficiencies in the ‘crisis cycle’. • Higher quantity & quality of Capital Conservation / • Less reliance on external capital Counter-cyclical buffers ratings agencies • Leverage Ratio introduced • CVA Capital Charge • 100% weight for trade finance • Stressed Testing Sub-Prime Sub-prime defaults, Excessive leverage & Lending Housing prices Securitized assets & poor capital could not decline resulting in derivatives trading absorb losses fully, sub-prime defaults resulted in huge demanding fresh Securitization losses equity infusion In stressed market situations, Excessive Risk Taking Credit Rating downgrades of Correlation to financial institutions Financial Institutions & will carry more risk weights – to prevent systemic risks and an securitized products further overall collapse lowered valuations & increased losses Governments step in Firms on the verge of Short term borrowing Huge losses resulted to inject capital to insolvency; demanded fresh in a crisis of prevent systemic threatening system borrowing which confidence causing failure failure failed in liquidity crisis liquidity to evaporate Enhanced Supervisory Two new liquidity Review and Disclosure ratiosIn summary, the BASEL III rules will strengthen the capital reserves and introduce stringent reporting requirements that cover key risk, liquidity andleverage parameters. The BASEL III guidelines also attempt to bolster the weak links in the financial system with the introduction of Central ClearingHouses and lessen the dependency on Rating Agencies. The chart below captures the key aspects of the BASEL III guidelines that have been introduced. • Increase in common equity requirement from 2% to 4.5% • Increase in Tier 1 Capital (Going Concern) from 4% to 6% CAPITAL • Overall capital will remain the same at 8%. (Which means Tier 2 capital, or gone concern capital to reduce to 2% of total capital) • Tier 1 Capital can no longer include hybrid capital instruments with an incentive to redeem through features such as step-up clauses. These will be phased out • Tier 3 Capital will be eliminated (previously used for market risk) CAPITAL - • Introduction of Capital Conservation Buffer - 2.5% of Common Equity Tier 1 BUFFERS • Introduction of Counter Cyclical Buffer - 0 to 2.5% of Risk Weighted Assets (RWA) • Credit Valuation Adjustment (CVA) Capital Charge must be calculated to cover Mark-to-Market losses on counterparty risk to Over The Counter (OTC) Derivatives. RISK • Stressed parametes must be used to calculate Counterparty Credit Risk MANAGEMENT • Effective Expected Positive Exposure (EPE) with stressed parameters to be used to address general Wrong-Way Risk (WWR) and Counterparty Credit Risk • Banks must ensure complete trade capture and exposure aggregation across all forms of counterparty credit risk (not just OTC derivatives) at the counterparty-specific level in a sufficient time frame to conduct regular stress testing. • A multiplier of 1.25 is applied to the corelation parameter of all exposures to financial institutions (meeting certain criteria) (Asset Value Correlation - AVC) • Additional margining required for illiquid derivative exposures • 100% risk weight for Trade finance Infosys – White Paper | 3
  • LIQUIDITY • Liquidity Coverage Ratio (LCR) >= 100% • Net Stable Funding Ratio (NSFR) > 100% LEVERAGE • Leverage Ratio >= 3% • Contractual maturity mismatch REPORTING • Concentration of funding • Available unencumbered assets • Market-related monitoring tools: asset prices and liquidity, Credit Default Swap (CDS) spreads and equity prices • LCR by currency • Results of stress tests should be integrated into regular reporting to senior management RATING AGENCIES • Lower reliance on External Rating Agencies Basel III –New RequirementsIT Impact – Summary of ChangeThe architecture below represents New Sources of Data Updated Models will incorporate RWA Calculation will changea typical BASEL II set-up. Exposure new sources of capital (new data because of the new data (Cash Flows) required toand reference data information calculate LCR/NSFR. fields) and stressed parameters fields and new risk weightsis extracted from multiple sourcesystems through Extract, Transform Data Sources ETL Staging Basel II Risk Environment RWA Calculation and Reporting& Load (ETL) processes and the Originationmodelling parameters – Probability System Riskof Default (PD), Exposure at Default Datamarts(EAD) and Loss Given Default (LGD) Servicing System G/L Reconciliation RWA Calculatorare calculated. This data is storedin a Risk Data-Warehouse and then Factor Model Environment Source System Extracts Collateral Mgmt . Data Quality/CDC Reporting Toolthe RWA calculations are performed System Staging/ODS Segment Definitionon the risk data to calculate the Loss & Recovery PD, LGD,regulatory capital requirements. System EAD FFIEC 101 ReportsIn general, a BASEL III implementation Reference Op Risk Models Data ICAAPwill require additional source Reportssystems to be included, changes External Model Validation/ Feedback Sourcesto the data elements of existing Management Reportssource systems to be made, changes Model Execution and Outputto the risk data models to be done, General LedgerRWA calculations and reporting Data Governancemodules to comply with regulatoryreporting guidelines. These changes Data Governance across the systemare highlighted in the pictorialrepresentation in the diagram. New Reports 6. Market-related monitoring tools: asset Possible new Data marts to hold 1. LSR, NSFR prices and liquidity, CDS spreads, equity data for the measurement of 2. Leverage prices, institution specific information Liquidity and Leverage ratios 3. Contractual maturity mismatch related to the ability of the institution to 4. Concentration of funding fund itself in various wholesale markets 5. Available unencumbered assets 7. LCR by currency4 | Infosys – White Paper
  • BASEL III’s IT impact can be further understood by looking at its impact on each of the areas separately. The table below lists the impactexpected in different areas of implementation and also lists some of the challenges that will be encountered while implementing them. Infrastructure Risk Risk Data RWA Regulatory and Data Modeling and Identification Calculation Reporting Management Quantification Some new sources • The new liquidity • The formulas used • Changes will be • The reporting of data that would ratios that Basel III in the calculation required at the systems will have need to interact with introduces (LCR and of PD, LGD, EAD will risk engines to to be enhanced to the Basel framework NSFR), will entail change due to the accommodate the cater to the new include: the creation of need to incorporate new buffers (Counter reports mentioned • Asset Liability new Liquidity Risk stressed parameters Cyclical, Capital in Basel III Management (ALM) Data Marts to hold and to also reflect Conservation). • The existing reports systems relevant Data a higher EAD value • It will also need will also be modified for counterparties • Cash Flow • Use of Stressed to accommodate to reflect liquidity, where specific IMPACT Management parameters as well the new Risk leverage and CVA, Wrong Way Risk systems as calculating CVA Weights assigned besides the new (WWR) has been • Existing Liquidity for counterparty to derivatives, trade capital structure identified. Risk Management credit risks will need finance products • Subsidiary reporting systems huge amounts of as well as account requirements will be historical data, which for exposures to • Data from Central augmented. may require the use financial institutions. Counterparties for of new data marts/ data related to Over- databases to store The-Counter (OTC) such information. derivatives. • Identifying the right • A single data • Consultants having • The system should • Understanding Data Elements. This load with all the experience in be configured to the new reporting would require a attributes required Stress Testing, provide Group Data, requirements good knowledge of for market, CCR, Analytics, and Solo Data, Basel I, • Bringing out accounting systems RWA, economic general knowledge II and III data on CHALLENGES synergies across as well as knowledge capital and liquidity about the business demand. stakeholders and of the various risk should be of Banks will be consolidating the reports required by extracted from required to identify reporting platform. Basel III. source systems. and stress the • Identifying required parameters. • As a result, DQ sources and data checks will be • Model validation requirements for rigorous. should be a focus different legislations. area. DATA GOVERNANCE • Put in place a rigorous and scalable Data Governance framework (People + Process + Technology) • Align source systems’ data quality capabilities to meet Fit For Purpose norms • End-to-end audit capability from source system data to final output calculation may be a challenge in Basel III because of the many new source systems interacting with the reporting systems. Infosys – White Paper | 5
  • BASEL III Implementation ApproachA BASEL III Implementation will require a core team to co-ordinate with multiple track owners who would be responsible for making changesto the applications and systems that they manage. Ideally, a BASEL III Project Management Office (PMO) will be responsible for initial impactassessment, identifying multiple tracks within the overall program, co-ordinating and monitoring the overall execution and reporting tothe senior management. Impact Analysis Strategy & Solution Maintenance & & Track Implementation Roadmap Definition Support Segregation • Program roadmap • Define individual • Product evaluation (if • Application • Ongoing definition tracks within the required) customization and enhancements • High level plan program • Architecture design build • Maintenance and user • Establish current state • Impact analysis • Data analysis & • Data quality testing support of compliance and requirement modeling • Functional testing • Platform migration documentation • PMO process • Technical design • Regression testing definitions for change • Identify • Data feed design • Non-functional management, dependencies, risks • Data sourcing and ETL testing communication and assumptions • Data sufficiency • Defect management management and • Detail level planning analysis and reporting reporting for individual tracks • Identify key • Identify the critical • Platform stakeholders path Development • Kick-off meeting with all stakeholdersBasel III Implementation TimelineSince the BASEL III requirements bring in critical buffers and significant capital outlays, the key aspects of the BASEL III guidelines will beimplemented in phases from January 2013 through 2018. This should give banks enough time to review their financial preparedness andalso enhance their operational and reporting capabilities. PHASE IN ARRANGEMENTS (Shading indicated transition periods - all dates are as of 1 January) As of 2011 2012 2013 2014 2015 2016 2017 2018 1 Janurary 2019 Supervisory Parallel run 1 Jan 2013 - 1 Jan 2017 Migration Legerage Ratio Monitoring Disclosure starts 1 Jan 2015 to Pillar 1 Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50% Minimum Common Equity Plus Capital 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0% Conservation Buffer Phase-in of deductions from CET1 (including amounts 20% 40% 60% 80% 100% 100% exceeding the limit for DTAs, MSRs and Financials) Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Minimum Total Capital plus Conservation Buffer 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5% Capital Instruments that no longer qualify as non-core Phased out over 10 year horizon beginning 2013 Tier 1 capital or Tier 2 capital Introduce Observation Liquidity Coverage Ratio Minimum Period Begins Standard Introduce Observation Net Stable Funding Ratio Minimum Period Begins StandardSource - The website for the Bank for International Settlements - http://www.bis.org/bcbs/basel3.htm6 | Infosys – White Paper
  • ConclusionBASEL III guidelines attempt to plug the gaps identified in BASELII. However, the world economy and financial markets are dynamicand evolving ecosystems with many forces in play. Consequently,financial regulations will keep on evolving. The intensity of regulatoryinterventions is expected to increase in the future and the importanceof risk management is expected to further move up in the priority ofboard members and top management.It is therefore imperative that a BASEL III implementation is planned anddesigned with a high degree of scalability to support future changes inregulation. A BASEL III implementation should be taken as an opportunityto remove a silo based approach to risk management and move towardsa reliable and scalable enterprise wide risk management system.For such intent to be successful, an early start and preparation areessential so that enough due diligence goes into laying down thefoundations of a strong risk management system. About the Authors Jitendra Kumar is a Principal Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. He has over 15 years of experience and has completed CFA level I & II from the CFA institute, USA. He can be reached at Jitendrakumar@infosys.com Sudarsan Kumar is a Senior Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. He has over 4 years of risk and compliance experience with data warehousing in Basel II. He can be reached at Sudarsan_Kumar@infosys.com Rohit VM is a Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. His current focus is on Basel III. Rohit earned his Post Graduate Diploma in General Management (PGDGM) from XLRI, Jamshedpur. He can be reached at Rohit_V02@infosys.com Infosys – White Paper | 7
  • About InfosysMany of the worlds most successful organizations rely on Infosys todeliver measurable business value. Infosys provides business consulting,technology, engineering and outsourcing services to help clients in over30 countries build tomorrows enterprise.For more information, contact askus@infosys.com www.infosys.com© 2012 Infosys Limited, Bangalore, India. Infosys believes the information in this publication is accurate as of its publication date; such information is subject to change without notice. Infosys acknowledgesthe proprietary rights of the trademarks and product names of other companies mentioned in this document.