Regulatory Capital and Liquidity Risk Compliance


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» The Basel III Reform
» The New Liquidity Risk Requirements
» The Challenges for Financial Institutions
» Regulatory Solutions Demo – RiskAuthority

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  • Basel III is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010-11. The third installment of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. First, the quality of capital will be improvedand quantity of the capital base will be increased.Second, the risk coverage of the capital framework will be strengthened in order to:Promote more integrated management of market and counterparty credit riskAdd the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit ratingStrengthen the capital requirements for counterparty credit exposures arising from banks’ derivatives, repo and securities financing transactionsRaise counterparty credit risk management standards by including wrong-way risk explicit Pillar I capital chargeThird, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework. The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives: Put a floor under the build-up of leverage in the banking sectorIntroduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simpler measure that is based on gross exposures.Fourth, the Committee is introducing a series of measures to promote the build up of capital buffers in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting countercyclical buffers"). The Committee is introducing a series of measures to address procyclicality: Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio called the Net Stable Funding Ratio. The Committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions.
  • Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital,[1] which consists primarily of common stock and disclosed reserves (or retained earnings),[2] but may also include non-redeemable non-cumulative preferred stock. The Basel Committee also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital. The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets (RWA).Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base [1]. These constituents include Undisclosed Reserves, Revaluation Reserves, General Provisions, Hybrid Instruments, Subordinated Term Debt. Tier 2 capital is limited to 100% of Tier 1 capital.Tier 3 capital will be eliminated.
  • The phase in of Basel III rules will substantially increase bank capital as can be seen on the graph. It is unclear what the impact will be on risk adjusted returns.
  • MA can help navigate capital eligibility requirements and deductions as well as implement the new RWA requirements.
  • The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives: Put a floor under the build-up of leverage in the banking sectorIntroduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simpler measure that is based on gross exposures.The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.
  • The US Federal Reserve announced in December 2011 that it would implement substantially all of the Basel III rules.[9] It summarized them as follows, and made clear they would apply not only to banks but to all institutions with more than US$500 million in assets:
  • "Risk-based capital and leverage requirements" including first annual capital plans, conduct stress tests, and capital adequacy "including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions”Market liquidity, first based on the US's own "interagency liquidity risk-management guidance issued in March 2010" that require liquidity stress tests and set internal quantitative limits, later moving to a full Basel III regime - see below.The Federal Reserve Board itself would conduct tests annually "using three economic and financial market scenarios." Institutions would be encouraged to use at least five scenarios reflecting improbable events, and especially those considered impossible by management, but no standards apply yet to extreme scenarios. Only a summary of the three official Fed scenarios "including company-specific information, would be made public" but one or more internal company-run stress tests must be run each year with summaries published.
  • Description of which banks are responsible for what.
  • The Basel Committee is monitoring the status of Blll for the rest of the world if you want to review
  • “Shadow Banking System”Conduits & SIVs, MMMF’s, hedge fundsBanks –overreliance on “liquid” marketsShort funding of securitization pipelinesShort funding of dealer inventories and “trading” positionsSecurities Financing Transactions (SFTs)ReposSecurities lending & collateral pool reinvestment strategiesPrime BrokerageOverreliance on customer’s excess cash balancesRe-hypothecated collateralInstitutional InvestorsYield chasingInsufficient appreciation of risks
  • Regulatory Capital and Liquidity Risk Compliance

    1. 1. Regulatory Capitaland Liquidity Risk CompliancePierre-Etienne Chabanel – Senior Director, Regulatory SolutionsRobert J. Wyle, CFA - Senior Director, Asset and Liability Management SolutionsPresented at Moody’s Analytics Risk Practitioner Conference; Chicago | October 15-18, 2012
    2. 2. 2Agenda» The Basel III Reform» The New Liquidity Risk Requirements» The Challenges for Financial Institutions» Regulatory Solutions Demo – RiskAuthority – RiskConfidence February 1, 2013
    3. 3. Basel III: Major Changes Compared to Basel II February 1, 2013
    4. 4. Basel II vs. Basel III Capital RatiosAdditional capital ratio buffer (up to 2.5% CET1) for specified G-SIB (SIFIs) February 1, 2013
    5. 5. Basel III Squeezes Capital! » More stringent rules on eligible capital » I.e., Tier 3 not eligible, increased deductions » RWA will increase for some asset classes » I.e., OTC derivatives via CVA » Increased capital ratios » I.e., Core Tier 1, Tier 1, Buffers February 1, 2013
    6. 6. Basel III Capital Ratios – Own Funds and Deductions» Basel III capital eligibility and deductions rules are sophisticated» RWA is only one side of the equation (ratio denominator). Common Equity Tier 1 Tier 1 Tier 1 + Tier 2 Calculated Deductions Requirement Requirement Requirement and Adjustments RWA Ratio BII - Deductions 13.0 % Provision Shortfall Counter B3 Goodwill Cyclical Additional Ratio: Buffer (13%) 11.0 % 11.4% 10.5 % Counter Cyclical Buffer Basel 2 Conservation Tier 2 Tier 1 9.5 % Additions Buffer (10.5%) Basel 3 Provision Excess Counter Cyclical Buffer Eligible Core Tier 1 8.5 % BIII-Deductions Basel II & III Buffer Basel III Conserv. (8%) 7.0 % Remaining Significant Buffer Conserv. 6.0 % Investment 6% BIII - Deductions Adjustment 4.5 % Sum of all For Negative consolidated Additional Tier 1 holdings Basel III 4.5% 4% Basel II Negative Tier 2 Including Interests Minority Significant Investments Basel II 2% 0% February 1, 2013
    7. 7. The New Basel III Leverage and Liquidity RatiosA leverage ratio as a non-risk-based metric to avoid excessive leverage Roll out: Tested 2013 to 2017 Binding 2018Liquidity risk ratios: a short term ratio (LCR) with a 30 day time horizon anda more long term measure (NSFR) with a 1 year time horizon relying on rules basedstress test scenario factors. Roll out: Tested 2011 to 2014 Binding 2015 Roll out: Tested 2012 to 2017 Binding 2018 February 1, 2013
    8. 8. Basel III Compliance – Starts This Year» Capital – 2013 – Counterparty Credit Risk & CVA – 2015 – Minimum core tier 1 ratio – 2018 – Capital deductions – 2019 – New capital ratio buffers» Leverage – 2018 – Leverage ratio» Liquidity – 2015 – Liquidity coverage ratio (LCR) – 2018 – Net stable funding ratio (NSFR) February 1, 2013
    9. 9. Which Countries are Implementing Basel II vs. Basel III?G20 country members are committed to implement Basel III from 2013 February 1, 2013
    10. 10. What Does Basel III Look Like In the U.S.?» Basel III is one of the many requirements of Dodd Frank (DFA)» Detailed Basel III NPR on regulatory capital published on June 7th, 2012 (comments expected by Nov 2012, new standardized approach RWA rules by 2015)» Final Basel II.5 market risk update published June 7th, 2012 as well (application date: 1st of January 2013, one year late)» New rules for Basel III liquidity ratios and G-SIBs additional capital buffers will be addressed in future proposals» BIII figures to be reported and forecasted in CCAR (FRY-14)» Common data requirement between BIII and FRY-14 reports» FRY-15 reports for G-SIBs» Single Counterparty Limits requirements February 1, 2013
    11. 11. U.S. Basel III Breakdown February 1, 2013
    12. 12. ROW – Basel Committee and FSI Progress Reports • • • February 1, 2013
    13. 13. 13Agenda» The Basel III Reform» The New Liquidity Risk Requirements» The Challenges for Financial Institutions» Regulatory Solutions Demo – RiskAuthority – RiskConfidence February 1, 2013
    14. 14. 14The Context: Systemic Liquidity Mismatches February 1, 2013
    15. 15. 15The Post-Mortem… “Measuring and managing bank liquidity risk is as important as capital/solvency risk management, but in the years running up to the crisis did not receive adequate attention, either in the UK or internationally, where debates about bank regulation were dominated by the design of the Basel II capital adequacy standard. It is essential now to restore liquidity regulation and supervision to a position of central importance.” The Turner Review: A regulatory response to the global banking crisis; March 2009 February 1, 2013
    16. 16. 16 What Is the Liquidity Coverage Ratio (LCR)?» LCR Definition» Objective – To ensure that banks maintain an adequate level of unencumbered, high-quality liquid assets; – For a 30 calendar day time horizon; – Under a significantly severe liquidity stress scenario specified by supervisors.» Numerator - Stock of high quality liquid assets: – Level 1- Cash, central bank reserves and sovereign paper (from same country and in same currency) – Level 2- Sovereigns @ 20% RWA, qualifying corporate and covered bonds AA- or higher » haircuts 20%-40% and no more than 40% of total stock of high quality assets» Net cash outflow over 30 days: – Net cash outflow under a severe stress scenario (30 day) = outflows – min {inflows, 75% of outflows} – Stress scenario: significant rating downgrade, partial loss of deposits, loss of unsecured wholesale funding, increase in a) secured funding haircuts, b) collateral calls, c) calls from OBS exposures – Under this stress scenario, outflows and inflows are calculated according to rules based regulatory factors (i.e. minimum run-off factor of 7.5% for stable deposits) February 1, 2013
    17. 17. 17What Is the Net Stable Funding Ration (NSFR)?» Definition: – NSFR = Available amount of stable funding / Required amount of stable funding (shall be ≥ 100%)» Objective – To promote more medium and long-term funding of assets» Available amount of stable funding (ASF) – Sum of: a) Capital, b) preferred shares c) liabilities with effective maturity > 1yr d) stable deposits and wholesale funding provided by non financial corporate (using appropriate weighting factors)» Required amount of stable funding (RSF) – Sum of assets and OBS exposures weighted by required stable funding factors (i.e. 0% for cash and 85% for loans to retail) February 1, 2013
    18. 18. 18Why Do We Need the New Ratios? Traditional CashCapital Calculations Were Wrong Volatile Liability Dependency Cash Capital Required Stable Funding February 1, 2013
    19. 19. 19The Liquidity Ratios – It’s Just the Beginning» Liquidity Gap» Concentration of Funding» Available Unencumbered Assets» LCR by Significant Currency February 1, 2013
    20. 20. 20Intra-Day Liquidity Management» “A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems”» Proposed intraday liquidity indicators: February 1, 2013
    21. 21. 21U.S. Specific Issues Related to Basel III Liquidity» Sources of Liquidity are Limited – Fannie Mae and Freddie Mac MBS and Debentures: o Regarded as Level 2 (L2) assets even though they may have better credit characteristics and were demonstrably more liquid than L1 assets during the credit crisis o Unduly limited because they are capped at 40% of L1 assets – Federal Home Loan Bank Advances not regarded as source of liquidity in US banks » Increased lending by 50% or $300 billion from 2Q 2007 through 3Q 2008» Calibration of Basel III Assumptions Are Inconsistent with the U.S. Experience – Decay factors for deposits experienced a maximum outflow of 38% versus an LCR outflow of 100% – Assumed draw rates on credit and liquidity facilities were at most 10% during the credit crisis versus a fully drawn LCR assumption (i.e. 100% LCR factor) February 1, 2013
    22. 22. 22US Policy and Market Consequences» The price and structure of common banking products are likely to change due to discrepancy between bank’s internal liquidity models, empirical evidence, and LCR’s implied outflow rate. – Commercial Paper Back-Stops: Maximum 10% outflow versus 100% LCR coverage – Financial Institution Liquidity Lines: Maximum 9% outflow versus 100% LCR coverage – Variable Rate Demand Notes: Maximum 10% outflow versus 100% LCR coverage – Non Operational Deposits: Maximum 38% outflow versus 100% LCR coverage» The Basel III liquidity rules have a clear bias toward increased Holdings of Sovereign Debt. This trend will likely increase concentration risk, exert downward pressure on risk free rates, and cause dislocation in market pricing.» The LCR will force US banks to replace substantial portions of their agency MBS portfolios with US Treasuries. This will adversely impact the US Mortgage Market. February 1, 2013
    23. 23. 23Agenda» The Basel III Reform» The New Liquidity Risk Requirements» The Challenges for Financial Institutions» Regulatory Solutions Demo – RiskAuthority – RiskConfidence February 1, 2013
    24. 24. It’s A Burden. And An Uncertain One.» Basel III roll out (from draft to production) much quicker than previous Basel reforms» Many other parallel regulatory initiatives are overwhelming financial institutions compliance and IT teams – Regulation around OTC derivatives and Clearing Houses (e.g. EMIR in EU) – Trading platform regulation (e.g. MIFID in EU) – Voluminous Dodd Frank Financial reforms in the US (e.g. Volcker rules) – Other regulatory reporting requirements popping up on many different topics (e.g. FSB initiatives, new trade level reports on derivative and asset back securities in EU and in US, new trade level monthly or quarterly reporting required for retail and wholesale business in the US as part of CCAR FRY 14 …)» Regulatory uncertainty – New guidelines for B3 CCP rules published by BCBS in July – EU final BIII rules delayed from August to October; deadline is still Jan 1st, 2013? – A lot of uncertainty concerning possible changes on Basel3 liquidity risk and leverage ratio rules … February 1, 2013
    25. 25. Regulatory burden and uncertainties» Cross border institutions will have to simultaneously comply with several Basel regimes and cope with various regulatory “flavors” for each jurisdiction E.g.: – Basel II (or even Basel I) in some countries and Basel III in others – IRB for some regulators & Standardized for others that did not rule out IRB yet – Major US banks will have to compute in parallel IRB and standardized RWA (and the standardized capital requirement will be the new floor replacing Basel I) – Even if inside the EU there is an effort to standardize rules and reporting requirements; internationally some significant local discrepancies and national discretions will remain (e.g. US prohibiting the use of rating agencies ratings in regulation) All these uncertainties are a big challenge for banking organizations and IT projects Some answers: - Banks need to design (or buy) risk management infrastructure and software flexible enough to adapt to a rapidly changing regulatory landscape. - Start by investing in a centralized risk and finance DataMart (as rich as possible) - Avoid data short cuts for maximum flexibility to be able to adapt to new requirements later on - Maintain “agile” program management and governance policies February 1, 2013
    26. 26. Convergence between risk and finance» Liquidity ratios require not only asset/liability cash flows, but also counterparty details E.g. – Securities issuers asset classes, ratings information and standardized risk weight for LCR buffer – For NSFR, need to identify fully secured mortgage positions – eligible for 35% risk weight» For leverage ratio, netting is allowed for OTC derivatives and REPO transactions but will follow the Basel “Current Exposure Approach” used for credit risk RWA => leverage ratio requires information from risk system» Accurate collateral and guarantee information is a must to optimize regulatory capital and new information is required for Basel III (e.g. inception ratings when hedging securitization)» Regulators are starting to implement consistency checks between risk and finance regulatory reports (FRY 9C vs FRY 14)» A holistic view is now required when performing stress testing or when assessing regulatory costs for new trades at origination February 1, 2013
    27. 27. Convergence between risk and finance» Consolidating at a financial group level requires information about concentration risk (including direct and indirect risks coming from collateral issuers, guarantors, or funds underlying the assets). This is a big challenge for many institutions.» New regulatory requirements are challenging for many financial institutions that are still organized into silos, e.g.: – Liquidity risk was traditionally managed by finance/treasury teams in charge of ALM. Risk and compliance teams now need to be involved. – Holistic stress testing is very challenging for many institutions. In addition, stress test results are more routinely challenged by regulators. Some answers: -Create “Basel III” transverse program management organization and governance -Invest in centralized risk and finance DataMart. Focus on data and data quality! -Invest in centralized Enterprise Risk Management system that meets most of the Basel III and Balance Sheet management analytics and reporting requirements -Needs to interface with origination systems and perform holistic stress tests February 1, 2013
    28. 28. Regulations Just Got More Expensive» Basel III will have a significant impact on the financial services industry and the global macro economy. Specifically, stronger capital and liquidity standards will hurt profitability, raise lending rates, decrease lending volume, force banks to exit unprofitable businesses, and ultimately, reduce economic output.» The bulk of the earnings and economic impact will be caused by changes in the quantity and quality of regulatory capital. Source BCBS QIS results: February 1, 2013
    29. 29. Increased regulatory costs» RWA for large banks (Group 1) increased by more than 19%» Plus a 7% increase in RWA for the new CVA capital charge» And, additional charges for trades via CCP (and CCP default funds) are pending February 1, 2013
    30. 30. 30 Additional funding requirement» Changes in liquidity risk regulation will have a noticeable impact as well: – Anticipated short term liquidity shortfall » Europe: €1.3 Trillion1 » US: €.6 Trillion1 – Anticipated long term liquidity shortfall » Europe: € 2.3 Trillion1 » US: € 2.2 Trillion1 1Source: Basel III and European banking: Its impact, How Banks might respond, and the challenges of implementation; McKinsey and Company; November 2010» Balance sheet management will play a crucial role in terms of mitigating the impact of increased capital and liquidity buffers.» Institutions will need to determine how much of the new requirements can be met internally by raising capital and funding or externally from capital markets.» To the extent that these resources remain constrained, the focus of balance sheet management will inevitably result in exiting less attractive businesses as measured by RAROC, even if the bank is meeting its internal hurdle rate.» Efficient allocation of capital and better LRM practices will, in many cases, require investment in more sophisticated risk management systems. February 1, 2013
    31. 31. 31What’s the Impact on Return on Equity?» U.S. – Total US banking sector ROE decrease estimated at 3%. – With regard to liquidity, the most significant factors include funding sources (inability to collateralize mortgage related assets and recognize FHLB advances), the 40% limit in the LCR for debt issued by public-sector entities, the assumed draw-downs for corporate and financial credit and liquidity lines, and assumed runoff rates for wholesale deposits.» Europe – Pretax ROE for European banks to all Basel II requirements are estimated to decrease between 3.7% and 4.3 % from the pre-crisis level of 15%. – Effect to be felt only gradually over a period of years i.e. .3% by 2013 and 2.1% by 2016 – Liquidity impact estimated at .2% ROE for short term funding and .6% ROE for long term funding February 1, 2013
    32. 32. 32Agenda» The Basel III Reform» The New Liquidity Risk Requirements» The Challenges for Financial Institutions» Regulatory Solutions Demo – RiskAuthority – RiskConfidence February 1, 2013
    33. 33. RiskAuthority Delivers End-to-End Basel I/II/III Compliance February 1, 2013
    34. 34. RiskAuthorityData Modeling, Capital Requirements, Regulatory Ratios & Regulatory Reporting February 1, 2013
    35. 35. RiskConfidence February 1, 2013
    36. 36. 36Why RiskAuthority? Preserve Existing InvestmentsUse provided configuration files per supervisorAndPlug any existing Cash-Flows Provider to Compute Regulatory Ratios External cash- RiskAuthority™ Liquidity Compliance flows providers Regulatory rules & reporting Scenario Analyzer™ Buffer Content Stress Testing February 1, 2013
    37. 37. 37Why RiskAuthority? It’s An Enterprise Liquidity RiskSolution RiskAuthority™ Liquidity Compliance Regulatory rules & reportingCompute Regulatory Ratios Basedon Banks’ Own Stress Assumptionsand Liquidity Models (What If?) RiskConfidence™ Scenario Analyzer™ And/Or Liquidity Monitoring Holistic Stress testingCompute Liquidity Standards Basedon Liquidity Cash-flows provided byour Liquidity Monitoring product Internal liquidity models February 1, 2013
    38. 38. 38Moody’s Analytics can help you to meet the challenges February 1, 2013