This document summarizes key aspects of the Basel III banking regulations and discusses their potential implications. The main points are:
1) Basel III aims to strengthen bank capital requirements, introduce new liquidity standards, and address systemic risks. It requires higher quality capital reserves and establishes capital buffers.
2) To comply, banks will need to raise more capital through equity issuances, reducing dividends, and shrinking loan books. This could put downward pressure on equity markets and loan growth.
3) Banks will favor more stable funding like deposits and long-term debt to meet liquidity standards, increasing competition in bond markets and potentially raising yields. OTC derivatives pricing and transactions will also be impacted by higher capital charges.
Basel III - Implications of ImplementationDavid Kyson
This report has been commissioned to give an investigative insight into the implementation of Basel III; the implications of implementing, previous accords and also the impact this has on various systems and activities. It will explore the previous shortcomings of the accords, aswel as the new requirements. There will be a brief description on each topic as well as a sound, but critical analysis of the impact upon each of these, caused by Basel III. Topics include: Basel III, previous accords, Global Bank Lending and the Bank System.
It incorporates a variety of information sources to gain a broader understanding of viewpoints and effects, but will focus largely on Bank Behaviour in Response to Basel III: A Cross-Country Analysis by Thomas F. Cosimano and Dalia S. Hakura (2011).
Tracking money and fund flows from one financial entity to another will lead to a long chain or network of entities spread all over the world. Along with the funds financial risks also flow across the network. They can have a devastating cascading effect when one entity collapses. The financial melt down of global markets in 2007-08 was precipitated by failure in such networks. We present the dimensions and complexity in modelling fund flows in these networks.
Mercer Capital's Atlantic Coast Bank Watch | August 2013Mercer Capital
The August 2013 issue of Bank Watch is available now at www.mercercapital.com, and features articles by Jeff Davis, Madeleine Davis, and the announcement of an upcoming webinar on the recently finalized capital rules.
MTBiz is for you if you are looking for contemporary information on business, economy and especially on banking industry of Bangladesh. You would also find periodical information on Global Economy and Commodity Markets.
Signature content of MTBiz is its Article of the Month (AoM), as depicted on Cover Page of each issue, with featured focus on different issues that fall into the wide definition of Market, Business, Organization and Leadership. The AoM also covers areas on Innovation, Central Banking, Monetary Policy, National Budget, Economic Depression or Growth and Capital Market. Scale of coverage of the AoM both, global and local subject to each issue.
MTBiz is a monthly Market Review produced and distributed by Group R&D, MTB since 2009.
Basel III - Implications of ImplementationDavid Kyson
This report has been commissioned to give an investigative insight into the implementation of Basel III; the implications of implementing, previous accords and also the impact this has on various systems and activities. It will explore the previous shortcomings of the accords, aswel as the new requirements. There will be a brief description on each topic as well as a sound, but critical analysis of the impact upon each of these, caused by Basel III. Topics include: Basel III, previous accords, Global Bank Lending and the Bank System.
It incorporates a variety of information sources to gain a broader understanding of viewpoints and effects, but will focus largely on Bank Behaviour in Response to Basel III: A Cross-Country Analysis by Thomas F. Cosimano and Dalia S. Hakura (2011).
Tracking money and fund flows from one financial entity to another will lead to a long chain or network of entities spread all over the world. Along with the funds financial risks also flow across the network. They can have a devastating cascading effect when one entity collapses. The financial melt down of global markets in 2007-08 was precipitated by failure in such networks. We present the dimensions and complexity in modelling fund flows in these networks.
Mercer Capital's Atlantic Coast Bank Watch | August 2013Mercer Capital
The August 2013 issue of Bank Watch is available now at www.mercercapital.com, and features articles by Jeff Davis, Madeleine Davis, and the announcement of an upcoming webinar on the recently finalized capital rules.
MTBiz is for you if you are looking for contemporary information on business, economy and especially on banking industry of Bangladesh. You would also find periodical information on Global Economy and Commodity Markets.
Signature content of MTBiz is its Article of the Month (AoM), as depicted on Cover Page of each issue, with featured focus on different issues that fall into the wide definition of Market, Business, Organization and Leadership. The AoM also covers areas on Innovation, Central Banking, Monetary Policy, National Budget, Economic Depression or Growth and Capital Market. Scale of coverage of the AoM both, global and local subject to each issue.
MTBiz is a monthly Market Review produced and distributed by Group R&D, MTB since 2009.
Financial Market Failure and Regulation of the Financial Systemtutor2u
This is a study presentation on different causes of financial market failure and also policies introduced designed better to regulate the activities of the financial sector.
Discusses briefly shadow banks, their role in the subprime crisis, their activities in China, and the regulations and measures taken to control or reduce the negative effects of those financial institutions on the world economy.
31 August 2011--US Banking Sector Report 2011EconReport
The US dollar is falling in value as its debts increase, expenditures increase, and the
Federal Reserve so-called Quantitative Easing (QE) experiments only prove to further punish the
survivors of the so-called World Financial Crisis/Credit Crunch with the inability to preserve and
grow hard-won capital. The main cause of the dollars decline is the “blatant disrespect” of the
natural inverse relationship between the value and the interest-rate of bonds—which is a debt
issue—as all fiat bills are. Inflation began on 25 March 2009 when the US central bank decided
to “buy” at least US $100B worth of Treasury bonds.
Financial instruments statistics important for central banks, and especially for the National Bank of Poland because if the statistical system imposes a responsibility on the central bank it must meet all the requirements of statistical excellence. This is a very important argument, but only a formal one for our interest in this subject. There is a second stream of motives for addressing this problem in central banks. Experience gained over the last decade shows clearly that financial instruments, especially those issued by enterprises, are becoming increasingly important for monetary transmission mechanisms and for financial stability. Among other things, there is empirical evidence that corporate bond spreads lead real economic activity. The situation in the financial instruments market is also meaningful for the general condition of the credit market, as bonds are close substitutes for banking credit. Development of the financial instruments market also contributes to the so-called financial market deepening effect, with multiple consequences for transmission mechanisms.7 It should be noted that, owing to the wide variety of channels through which financial instruments can interfere with monetary policy operations, the central banks are interested in collecting detailed information on these instruments. In practice it results in a complexity of standards for financial instruments security statistics that central banks are expected to meet.
My Master's Thesis with the title "The Elephant in the Regulator's Room: Estimating the Size of the Global Shadow Banking System" compares different approaches to measuring the true size of shadow banking, for which crucial data is still missing. In addition to official statistics, I propose two further methods of empirically estimating assets in this amorphous system following a recent paper. The findings suggest that the system is larger than assumed and accumulated $96 trillion in 2015.
Mandatory Centralised Clearing - Creating a liquidity crisis?John Wilson
Co-presentation with Nicole Grootveld [Cardano] on the liquidity issues presented by the introduction of mandatory clearing for OTC derivatives. Includes commentary on the buy-side and some potential solutions to the issues created.
Financial Market Failure and Regulation of the Financial Systemtutor2u
This is a study presentation on different causes of financial market failure and also policies introduced designed better to regulate the activities of the financial sector.
Discusses briefly shadow banks, their role in the subprime crisis, their activities in China, and the regulations and measures taken to control or reduce the negative effects of those financial institutions on the world economy.
31 August 2011--US Banking Sector Report 2011EconReport
The US dollar is falling in value as its debts increase, expenditures increase, and the
Federal Reserve so-called Quantitative Easing (QE) experiments only prove to further punish the
survivors of the so-called World Financial Crisis/Credit Crunch with the inability to preserve and
grow hard-won capital. The main cause of the dollars decline is the “blatant disrespect” of the
natural inverse relationship between the value and the interest-rate of bonds—which is a debt
issue—as all fiat bills are. Inflation began on 25 March 2009 when the US central bank decided
to “buy” at least US $100B worth of Treasury bonds.
Financial instruments statistics important for central banks, and especially for the National Bank of Poland because if the statistical system imposes a responsibility on the central bank it must meet all the requirements of statistical excellence. This is a very important argument, but only a formal one for our interest in this subject. There is a second stream of motives for addressing this problem in central banks. Experience gained over the last decade shows clearly that financial instruments, especially those issued by enterprises, are becoming increasingly important for monetary transmission mechanisms and for financial stability. Among other things, there is empirical evidence that corporate bond spreads lead real economic activity. The situation in the financial instruments market is also meaningful for the general condition of the credit market, as bonds are close substitutes for banking credit. Development of the financial instruments market also contributes to the so-called financial market deepening effect, with multiple consequences for transmission mechanisms.7 It should be noted that, owing to the wide variety of channels through which financial instruments can interfere with monetary policy operations, the central banks are interested in collecting detailed information on these instruments. In practice it results in a complexity of standards for financial instruments security statistics that central banks are expected to meet.
My Master's Thesis with the title "The Elephant in the Regulator's Room: Estimating the Size of the Global Shadow Banking System" compares different approaches to measuring the true size of shadow banking, for which crucial data is still missing. In addition to official statistics, I propose two further methods of empirically estimating assets in this amorphous system following a recent paper. The findings suggest that the system is larger than assumed and accumulated $96 trillion in 2015.
Mandatory Centralised Clearing - Creating a liquidity crisis?John Wilson
Co-presentation with Nicole Grootveld [Cardano] on the liquidity issues presented by the introduction of mandatory clearing for OTC derivatives. Includes commentary on the buy-side and some potential solutions to the issues created.
The impact of Basel III, also known as The Third Basel Accord, will vary by geography -- from potentially slowing down economies in emerging nations, to protecting the European Union from financial collapse, to increasing capital adequacy and improving risk management. Given the framework and timeline for implementing Basel III, the burden falls on national regulators to translate the international guidelines into national policies that suit and stabilize their economic environment and support economic growth.
“Basel III is more about improving the risk management systems in the Banks than just Improved Quality and enhanced Quantity of capital”. Please discuss the challenges to the Indian Banks by March,2017
Quantifi whitepaper basel lll and systemic riskQuantifi
One of the key shortcomings of the first two Basel Accords is that they approached the solvency of each institution independently. The recent crisis highlighted the additional ‘systemic’ risk that the failure of one large institution could cause the failure of one or more of its counterparties, which could trigger a chain reaction.
Basel III addresses this issue in two ways:
1) by significantly increasing capital buffers for risks related to the interconnectedness of the major dealers and
2) incentivising institutions to reduce counterparty risk through clearing and active management (hedging). Since Basel III may not explicitly state how some of the new provisions address systemic risk, some analysis is necessary.
A set of international banking regulations put forth by the Basel Committee on Bank Supervision, which set out the minimum capital requirements of financial institutions with the goal of minimizing credit risk. Banks that operate internationally are required to maintain a minimum amount (8%) of capital based on a percent of risk-weighted assets.
Classmate 1When a bank is unable to fulfill its obligations to .docxrichardnorman90310
Classmate 1:
When a bank is unable to fulfill its obligations to its depositors and creditors, it is considered to be insolvent. Additionally, it can occur when the belongings' market value decreases significantly in comparison to the accountability's market value. If the collapsed bank is unable to arrange funds from the solvent bank, the depositors of the collapsed bank will become incensed and attempt to withdraw their funds as soon as possible. Additionally, the collapsed bank will sell their belongings at a significantly lower price than their market value in order to obtain liquid funds for the urgently deposited individuals. (McLeay, Michael; 2016) As a result, the bank won't be able to meet the requirements of depositors.
-- One way to assign the fund in a way that reduces its exposure to particular assets or risks is through bank diversification. Diversifying by investing in a variety of assets to reduce risk is the most common strategy. And if the cost of the belongings hasn't changed perfectly, a larger portfolio will often have lower volatility than its least volatile component and a lower difference than the calculated average difference of its belongings. Furthermore, diversification is unquestionably one strategy for mitigating investment risk.
-- Everyone is trying to save more money and has stopped buying cash from their homes and cars. The bank has faced a significant challenge as a result, as they have lost a significant portion of their loan profits. In addition, the bank has experienced a severe economic downturn over the past seven years as a result of a large number of customers who are not appropriately repaying either the loan amount or the loan interest, resulting in substantial losses for the bank.
-- Additionally, during the recession, the bank will make a favorable offer to reduce their current interest rate by a small amount, attracting a greater number of borrowers ready to take out new loans. Because the government is attempting to encourage economic growth through policy divergence, taxes and government payouts will also differ significantly.
Classmate 2:
Diversification, on the other hand, ensures that a bank's risk is not concentrated in any one industry, so that the negative impact of downturns in a sector is reduced on the bank, thereby lowering the likelihood of the bank collapsing into bankruptcy. Diversification, therefore, is about the risk-financing of risk-taking activities to boost the return of the institution. An important issue in credit risk management is deciding whether the risks are related to the activity or the organization. Banks tend to be concentrated in a few large industries. They invest heavily in short-term borrowing and in emerging market bonds and equity securities. To diversify their risk, they have developed sophisticated analytical models to model financial risk (Manthoulis et al., 2020).
For the period from 1900 to 2000, the bank assets of the U.S. economy.
National Economic Survey - Volume I - Chapter 8 Financial Fragility In The NB...DVSResearchFoundatio
OBJECTIVE
National Economic Survey (NES) is the flagship annual document of the Ministry of Finance of the Government of India. It reviews the developments in the Indian economy over the past financial year, summarizes the performance on major development programs, and highlights initiatives of the government and the prospects of the economy in the short to medium term.
This is a free e-book from the London School of Economics. It includes several stand alone chapters. Each one of them is written by a different expert or professor. The main underlying topics include how to manage and prevent future financial crisis. And, what would be the best financial regulatory framework to do just that.
Week-9 Bank RegulationMoney and Banking Econ 311Tuesdays 7 .docxalanfhall8953
Week-9 Bank Regulation
Money and Banking Econ 311
Tuesdays 7 - 9:45
Instructor: Thomas L. Thomas
Capital Adequacy Management
Bank capital helps prevent bank failure
The amount of capital affects return for the owners (equity holders) of the bank
Regulatory requirement – Regulatory Capital – Tier 1 and Tier 2 Basle Rules
Economic Capital - What is this
2
Capital Adequacy Management:
Returns to Equity Holders
3
Traditional Economic Capital Value-At-Risk (VaR) View
Frequency of Occurrence / Probability
Mean/Average Expected Losses (m)
Unexpected Losses @ 99.9% confidence Level (s)
Economic Capital
Reserves
Value-at-Risk
VAR
Before we can develop adequate credit stress testing we need to understand the differences between traditional credit loss measures and what stress tests incorporate.
Aside form standard concentration and coverage analysis, a standard portfolio credit risk analysis typically employs a Value-at-Risk view.
Credit risk in this view generally follows a positive skewed distribution (by definition one cannot have negative defaults and thus a normal distribution is not applicable).
Reserves ALLL generally cover average expected losses over a horizon. In reality these are usually allocated to general reserves since most ALLL have two components: general reserves and specific reserves for known credits that are detraining.
Economic capital functions as a cushion against unexpected loss up to some confidence level. In this case 99.9% or a single “A” rating is the regulatory standard (once every 10,000 years)
In addition to a loss cushion economic capital represents the amount of the firm’s equity that is at risk which requires a return sufficient to cover the associated risk.
The shape of the curve or tail will then reflect the underlying credit risk of the portfolio or product.
However this view has some assumptions that can miss important risk elements.
The distribution is generally based on one variable PD in this case and does necessarily fully account for other correlated factors that when combined either change the tail or increase the likelihood of default.
Second, while the event may be rare, this methodology does not tell how severe or the magnitude of the event when it occurs beyond the confidence level prescribed for economic capital.
4
Old Measure: New Ones
RAROC - Risk Adjusted Return on Capital
EVA - Economic Value Added.
Hurdle Rate – What is it. How is it measured?
5
Time Line of the Early History of Commercial Banking in the United States
6
Historical Development of the Banking System
Bank of North America chartered in 1782
Controversy over the chartering of banks.
National Bank Act of 1863 creates a new banking system of federally chartered banks
Office of the Comptroller of the Currency
Dual banking system
Federal Reserve System is created in 1913.
7
Asymmetric Information and Financial.
Similar to Impact_of_Basel_III_published_2012Feb (20)
Week-9 Bank RegulationMoney and Banking Econ 311Tuesdays 7 .docx
Impact_of_Basel_III_published_2012Feb
1. C F A M A G A Z I N E / M A R C H – A P R I L 2 0 1 2 11
BY JOEY CHAN, CFA, AND STEPHEN HORAN, CFA, CIPM
evere economic crises are usually associated with
banking sector distress. Because banks are highly
leveraged, bank capital can be wiped out quickly
when asset quality and value deteriorate during a
crisis. A devastated banking sector jeopardizes the payment
system (which is crucial to the smooth operation of the
economy), the provision of liquidity, and the extension of
credit, all of which can lead to a broader economic reces-
sion. Risks from the banking system can spread to sover-
eigns as governments increase their debts to rescue the
economy and the systemically important banks. Therefore,
it is imperative for policymakers to improve resilience of
the banking sector against shocks.
In response to the global financial crisis, the G20
nations and the Basel Committee on Banking Supervision
(BCBS) released Basel III, a package of reforms to the exist-
ing Basel II regime for banking regulation. Basel III has
three principal aims: (1) to boost the banking sector’s abili-
ty to absorb shocks arising from financial and economic
stress, (2) to improve risk management and governance,
and (3) to strengthen banks’ transparency and disclosure.
To be effective, these regulations will require all coun-
tries to work together to implement the “minimum” stan-
dards. Otherwise, institutions are likely to engage in “regu-
latory arbitrage.” Under Basel III, similar to Basel I and II,
countries can still choose to implement tighter standards
tailored to their idiosyncratic national needs. Unlike Basel I
and II, however, Basel III attempts to be more comprehen-
sive and consists of reforms addressing risks at the individ-
ual financial institutions and risks at the systemic level.
Exhibit 1 presents the core of the Basel III framework
in broad strokes. Many of these requirements, especially
those related to capital and liquidity, are tailored to the na-
ture of the financial institutions’ assets and liabilities.
From the perspective of investors, the main concern
is how new requirements will affect equity markets, bond
markets, over-the-counter (OTC) derivatives, and trade fi-
nance. Unfortunately, implementation of the proposed
package is likely to come with many potential drawbacks.
Implications for Equity Markets
According to a McKinsey paper in September 2011, banks
in Europe and the U.S. will need an additional US$1.5
trillion in equity by 2015 when the requirement of 4.5
The Impact of Basel III on Financial Markets
Will a combination of structural flaws and illogical, mathematically inconsistent rules make matters worse?
S
Strengthened Capital Base
• Increasing minimum Tier 1 capital
to 6% of risk-weighted assets (RWA)
by 2015.
• Increasing minimum Common Equity
Tier 1 capital to 4.5% of RWA by 2015.
• Improving the quality of capital (e.g.,
tighter definition of Common Equity
Tier 1 capital to include only common
stocks, retained earnings, and other
comprehensive income).
• Creating capital conservation buffer for
use during a financial crisis and eco-
nomic distress. (Starting from 0.625%
of RWA in 2016 and increasing to 2.5%
of RWA by 2019.)
Liquidity Requirements
• Setting a minimum liquidity coverage
ratio (LCR) to ensure banks have suffi-
cient high-quality liquid assets for
expected net cash outflows over a
30-day period stress scenario.
• Setting a minimum net stable fund
ratio (NSFR) to ensure that assets at
greater risk of suffering a one-year
stress event are matched with longer-
term sources of financing.
Governance & Systemic Risk Mitigation
• Creating firm-wide governance and
risk management.
• Requiring sound compensation
practices.
• Widening coverage of risks (e.g.,
higher capital requirements for securi-
tization exposure, counterparty credit
risk, OTC activities, etc.).
• Creating countercyclical capital buffer
to mitigate systemic risk during a
financial crisis and economic distress.
• Setting maximum leverage ratios to
prevent excess leverage in good times
and reduce the deleveraging dynamic
in periods of stress.
• Identifying global systemically impor-
tant banks (G-SIBs) for special treat-
ment (e.g., greater loss absorbency,
more intense supervisory oversight,
stronger resolution, reducing their
systemic importance over time, etc.).
EXHIBIT 1
Basel III Framework: Highlighting Select Requirements
Viewpoint
2. C F A M A G A Z I N E / M A R C H – A P R I L 2 0 1 212
Banks are likely to adopt a two-pronged approach of
amassing liquid assets and at the same time scaling down
their business operations that are more susceptible to liq-
uidity risks. For example, they will have an incentive to
raise capital through retail deposits, repurchase agree-
ments, and stable credit corporate facilities because these
types of assets are assigned lower 30-day runoff rates in
the LCR calculation.
To the extent that banks hold less-liquid assets, they
will be required to secure more stable funding and increase
the proportion of longer-term debts in order to reduce
the maturity mismatch and maintain the minimum NSFR.
This accounts for the popularity of the European Central
Bank’s (ECB’s) recent program of offering three-year loans
to banks. Banks borrowed €500 billion, enough to refi-
nance almost two-thirds of the debt they have maturing
over the next year. The banks’ additional demand for
longer-term financing will compete with other borrowers
in the bond market, potentially driving up the yields on
bank bonds once the central bank’s cheap money is
removed from the market.
To curb funding costs, banks will try to raise more
retail deposits, especially because these are treated favor-
ably in the LCR calculation. But such deposits are in lim-
ited supply, particularly in jurisdictions where banks have
to compete for retail savings with insurance companies
and pension funds. Accordingly, banks are likely to secure
funding through covered bonds or unsecured bonds with
longer maturity.
Bond markets will expand as a result of increased
supply and the higher yields when the ECB finally steps
back from its role as a primary lender. The improved
market liquidity of long-term bonds may make short-term
investors more willing to consider longer-term invest-
ments. To whet investor appetite, banks may have to issue
more collateralized bonds with simpler structures and
higher transparency. Furthermore, unlike mortgage-backed
securities (MBS), covered bonds are acceptable for LCR,
which makes them attractive to banks. For MBS to increase
the chance of gaining LCR recognition, there should be a
highly liquid market coupled with improved transparency.
New regulations giving authorities more latitude to
handle failing institutions might also affect bond yields.
Investors may be concerned that they will be required to
share the burden in the event of a failure. Bank bond hold-
ers may not be willing to accept the increased political
risks without an adequate rise in bond yields.
Higher capital adequacy is likely to increase financial
system stability and encourage a more stable macro-envi-
ronment for bonds. Therefore, more stringent banking
regulations are likely to reduce risks for bond investors.
Implications for OTC Derivatives
Derivatives markets have started to factor the impact of
Basel III in transactions and pricing.
Basel III capital requirements are focused on controlling
percent of Common Equity Tier 1 capital kicks in. There-
fore, banks are expected to raise more capital through equity
market issuance. However, since 2005, the average annual
equity issuance for eurozone banks has been in the range
of €20 billion to €50 billion. The corresponding world-
wide equity issuance amount is in the range of US$50 bil-
lion to US$150 billion. Markets would have a hard time
absorbing the new issuance before 2015, even though the
banks can reduce external capital requirements by increas-
ing retained earnings, which would reduce dividends.
How stock prices of banks will be affected by Basel III
is more contentious. Although many market observers
believe that the capital and liquidity requirements are likely
to substantially reduce profitability of banks, some experts
argue that all things being equal, bank stocks may benefit
from higher capital ratios if the market places a greater
value on financial stability. The net impact depends on
how the possible profits loss from a small capital base
compares with the marginal reduction in expected costs of
financial distress. It is not easy to determine ex ante.
For the broader equity markets, higher capital reserves
increase costs of capital and reduce available funds for
lending. In effect, setting leverage ratios caps the bank’s scale
of business. Limiting leverage and increasing risk weights
(see below) discourages prime lending and long-term lend-
ing. It may also increase interest rates, making equity financ-
ing look relatively more attractive than debt financing for
firms in the product markets. Deleveraged capital structures
in the product markets will reduce the risk and return on
equity, and lower earnings per share for both the banking
sector and the broader stock market—assuming that aggre-
gate earnings potential remains at about the same level.
Banks may alternatively choose to shrink their loan
base rather than increasing equity, but that will have the
same effect. Either way, Basel III is likely to exert downward
pressure on the broader equity markets in the coming years.
Implications for Bond Markets
Global bonds markets will likely be severely impacted by
the introduction of the new liquidity requirements—the
liquidity coverage ratio (LCR), which measures the suffi-
ciency of liquid assets to satisfy short-term liquidity needs
under a stress-test, and net stable fund ratio (NSFR),
which measures the sufficiency of long-term stable financ-
ing sources to fund long-term illiquid assets.
Banks will favor holding assets that satisfy LCR’s
liquid-asset criteria and be discouraged from using fund-
ing sources with potentially high run-off rates, such as
structured investment vehicles (SIV) and special-purpose
vehicles (SPV). Because the LCR has a bias towards banks
holding government bonds, covered bonds, and high-qual-
ity corporate bonds, demand will decrease for less-liquid
assets, such as securitized assets and lower-quality corpo-
rate bonds. Banks’ preference for holding assets that are
considered liquid under LCR will shift investors’ return on
particular market segments and affect credit spreads.
3. C F A M A G A Z I N E / M A R C H – A P R I L 2 0 1 2 13
counterparty risk and thus depend on whether banks
trade through a derivatives dealer or a central clearing
counterparty (CCP).
When a bank enters into under-collateralized deriva-
tives trades with dealers, it assumes counterparty risk.
Basel III creates a liability for such trades and mandates
a high capital charge. If a bank trades through a CCP, the
capital charge will be a mere 2 percent, which would be
extremely attractive to the banks.
In addition to counterparty risk, Basel III capital
requirements attempt to distinguish between hedging and
speculative positions. Risk weightings for CCP positions
are applied only to a bank’s “loan equivalent amount” of
derivatives exposure to a counterparty, which is ascer-
tained after netting out the derivatives exposures. Allow-
ances for netting will encourage central clearing for more
bilateral OTC derivatives.
Nevertheless, the “loan equivalent amount” of an
exposure after netting must be included in total exposures.
Repo and off-balance-sheet commitments must also be
counted towards this total and are assigned a 100 percent
credit conversion factor. Off-balance-sheet commitments
that are unconditionally cancellable carry only a 10 per-
cent credit conversion factor. Whether the end-client is a
financial institution, trading OTC derivatives with a CCP
will be relatively attractive because the capital charge is
much lower.
Under Basel III, either collateral will have to be
posted by end-clients to the CCP or bank fees will have
to increase to compensate for banks locking up their capi-
tal to supply liquidity for the non-cleared OTC deriva-
tives transactions.
Posting non-cash collateral on a CCP is likely to be
less costly. The dilemma is that most clients, such as air-
lines, energy companies and insurance firms, do not have
sufficient non-cash collaterals for the CCP. These clients
will have to acquire permitted collateral, such as govern-
ment bonds, or enter into a collateral-conversion/collat-
eral-upgrade trade (which is less cash demanding, though
not without its own cost).
Certain assets (such as equities, corporate bonds,
warrants, and other tradable products that are not accept-
able as collateral by a CCP but otherwise have value in
the market), may be used in a collateral-conversion trade.
The asset owner can enter into a securities lending or
repo transaction and receive treasury securities that can
be pledged to the CCP.
The market for collateral conversions has been prolif-
erating, mainly with banks as service providers. A CCP
can also provide the same service to reduce complexity
and give a one-stop solution to clients who are only
making fewer trades. But companies holding large and
ongoing OTC derivatives positions, such as insurance or
energy companies, may prefer a competitive market that
offers better pricing. In any event, banks facilitating col-
lateral conversion are well positioned to benefit from the
proliferation of collateral-conversion transactions.
Similarly, to economize the regulatory costs, banks
try to warehouse their illiquid securities by posting them
as collateral assets to the OTC swap transactions with
exchange-traded funds (ETFs). This practice explains the
growing popularity of swap-based synthetic ETFs.
No matter how institutions post collateral, the cost of
trading OTC derivatives will rise. The cost is likely to be
higher for dealer trades as opposed to CCP trades. In the
long run, CCPs will evolve to be credit neutral and the
least expensive means for market participants’ hedging
and investing needs. Changes likely will be reflected soon
in OTC derivatives agreements.
Implications for Trade Finance
One of the culprits of the recent financial crisis was secu-
ritization, a process by which banks move their assets off
balance sheet in order to economize the regulatory capital
charge. To address this problem, Basel III has increased
the risk weighting (i.e., credit conversion factor) assigned
to off-balance-sheet items by fivefold—from 20 percent
to 100 percent.
In the original proposal, Basel III would treat (among
others) standby letters of credit (LCs) and trade letters
of credit similar to off-balance-sheet items. The liquidity
and leverage requirements do not consider the risk profile
of a loan but simply treat LCs in the same manner as a
complex derivatives transaction. As a result, banks would
be required to hold 100 percent capital against a lending
commitment to finance a trade transaction (a fivefold
increase over the current 20 percent). Unless the banks
can pass on their increased costs, trade financing will be
far less attractive, and they may focus on other businesses
and limit their trade credit exposures.
With increased costs of LCs, the trade-financing
market is likely to deteriorate as exporters find other less
efficient alternatives, such as open account terms, forfeit-
ing, or other forms of unsecured financing. Already, banks
are pulling back their services in this area. Because LCs
are usually used for trading with emerging markets, these
economies may be hurt the most if financing means other
than LCs are used. In addition, companies doing business
with the developing economies will have to scrutinize
more closely the sovereign, geopolitical, and counterparty
risks. Similarly, small and medium exporters are likely to
be hurt more than large exporters who can diversify many
of these risks.
These rules have been severely criticized by trade-
financing professionals because LCs, unlike other off-bal-
ance-sheet items, are traditionally low-risk products for
banks. The rules may actually encourage rather than dis-
courage risk taking by treating low-risk trade credit in the
same way as higher-risk transactions that have much higher
profit potential. According to the International Chamber
of Commerce, LCs represent approximately 20 percent of
world trade and are vital to the world economy. LCs are
4. Viewpoint
C F A M A G A Z I N E / M A R C H – A P R I L 2 0 1 214
an effective means to support the underlying economic
transactions and should be recognized and encouraged
accordingly. Otherwise, nonbank financial companies that
do not fall under the purview of Basel III are likely to fill
the void and expose the financial system to systemic risk.
Despite the rampant criticisms, not until late October
2011 did the BCBS adopt two technical changes on the
capital-adequacy framework to address issues with trade
finance. But still, in December 2011, banking association
BAFT–IFSA released a list of recommendations for BCBS
while a group of 23 banking and trade associations sent
a second letter to persuade BCBS to make further changes
to the capital requirements for trade finance.
Further Implications for the Banking Sector
Studies abound on Basel III’s implications for the banking
sector. This section summarizes some anticipated trends.
Banks are heavily regulated under Basel III and
respective national laws, such as the Dodd–Frank Act in
the U.S. They are under severe pressure to be more trans-
parent and have simpler balance sheets and capital struc-
tures. Thus, banks are likely to reduce certain lending
activities to effectively shrink their balance sheets, limit
capital market exposure, and eschew structured-product
transactions. They will prefer to have their OTC deriva-
tives transactions cleared by CCPs. The regulatory favor
bestowed on retail deposits will intensify competition for
retail deposits and discourage short-term wholesale fund-
ing. Similarly, banks will seek to issue covered bonds for
long-term funding because of their treatment in the NSFR
calculation. Standards for mortgage lending have already
become quite stringent and will remain so, and conven-
tional products and collateral requirements will be more
common. Pricing for credit lines, such as home equity
credit and credit cards, is likely to increase. Nonbank
institutions, outside the ambit of the regulations, will be
able to develop cost-effective products that may further
weaken the position of the banks and circumvent regula-
tors’ attempts to control systemic risk. The banking sector
will undergo a consolidation phase to improve efficiency.
Problems with Basel III
Establishing a minimum leverage ratio, requiring a capital
buffer, and combating pro-cyclicality through dynamic
provisioning based on expected losses are laudable ele-
ments of Basel III. The capital buffer, which is intended to
ensure that the leverage ratio is not compromised in crisis
situations, seems especially important and will require div-
idends, share-buyback policies, and executive bonuses to
be restrained in good times so banks can build buffers for
bad times. Despite the obvious benefits, Basel III raises
numerous concerns.
First, Basel III’s liquidity rules are primarily focusing
on risks at individual institutions and not risks at the sys-
temic level. The International Monetary Fund (IMF)
reports that the NSFR would not have signaled problems
in the banks that ultimately failed during the recent finan-
cial crisis—despite some of these banks failing from poor
liquidity management and overuse of short-term wholesale
funding. More needs to be done to develop effective meas-
ures to mitigate systemic liquidity risks.
Basel III has also been criticized for not resolving the
most fundamental problem—that banks can use deriva-
tives (such as CDS) to transform their risks and thus min-
imize capital costs, even shifting them beyond the bank
regulators’ jurisdiction—say, to a less-regulated sector,
such as insurance, or to a less regulated country.
The shadow banking system continues to compromise
the efforts of the regulators. As financial commitments and
exposures are shifted around and treated differently from
sector to sector and from jurisdiction to jurisdiction, one
must question the proper scope of regulatory oversight.
Considerations regarding structure of supervision and reg-
ulatory process and global coordination among regulators
from different jurisdictions can have far-reaching conse-
quences.
Moreover, the process for generating the framework
may be hampered by a structural problem. BCBS consists
mainly of heads of central banks of developed economies.
It has no representation from the broader community or
from developing countries that have growing economies
and younger populations. Their perception and assessment
of risk could be very different.
The group categorized risk and risk models into
strategic, market, operational, reputational, credit, and liq-
uidity risk. According to fundamental principles of diver-
sification, risk is not additive. Combining a 99 percent
confidence-level calculation for one type of risk with a
99.9 percent confidence level for another risk type is con-
fusing at best and misleading at worst. Risk aggregation
requires consideration of how the individual risks are
related to each other. The illogical and mathematically
inconsistent rules—coupled with different implementation
and modeling approaches at the banks—can be puzzling
for the boards of the banks. The new rules may be more
for regulators and compliance officers than guiding busi-
ness decisions in the board rooms.
Although some regulations are final, the Basel
Committee has not yet completed its work. Most of the
Basel III rules will be revised further as more people criti-
cize their suitability. The current timeline is for everything
to phase in by 2019, which provides ample opportunity
for things to change. For example, there were a number
of “final” versions before Basel II was refined to the final
June 2006 version. No one knows how much more Basel
III will change in the coming years. Conceivably, ineffi-
ciencies of the framework may lead to the drafting of Basel
IV before Basel III is finalized.
Joey Chan, CFA, is director of planning and programme
development and Stephen Horan, CFA, CIPM, is head of
university relations and private wealth at CFA Institute.