Introduction to Basel III

1. Basel III
Shameel Ahmed Shakir | Risk Modeller
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2. Core Concept
• Introduction to Basel III
• Accounting vs. Regulatory Objective
• Expected and Unexpected Credit Losses and Bank Capital
• The Three-Pillar Approach to Bank Capital
• Minimum Capital Requirement
• Common Equity 1 Capital (CET1), Additional Tier 1 (AT1) Capital, Tier 2 Capital
• Regulatory Buffers
• Risk-Weighted Assets(RWAs)
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3. Introduction to Basel III
• Basel III’s main set of recommendations were issued by BCBS(Basel
Committee on Banking Supervision
• Issued in December 2010, Revised in June 2011
• The Unprecedented nature of the 2007-2008 financial crisis obliged the
BCBS to propose an amendment to Basel II, commonly called Basel III.
• Basel III introduced significant changes in the prudential regulatory regime
applicable to banks, including
– Increased minimum capital ratios
– Changes to the definition of Capital
– Calculation of RWA
– Introduction of new measures (LLF)– Leverage, Liquidity and Funding
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4. Accounting vs. Regulatory Objective
• Both objectives are not fully aligned
• Accounting financial statements is the provision of information about
• Financial position
• Cash flows
• Performance
• Changes in the financial position of an entity
It is useful for making economic decision to a users(investors, lenders, employee, the
general public)
• The main objective of Prudential regulation is to promote a resilient
banking sector (to improve the ability to absorb shocks arising from
financial and economic stress)
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5. Expected and Unexpected Credit Losses | Bank Capital
Assume that a bank provided a loan to a client, with worst case, the
client defaults and that as a consequence, the bank losses the entire
loaned amount. Due to this,
Requiring bank to hold capital for the entire loan
• With excessively conservative, the bank is likely to pass the cost of the capital
requirement to the client.
• making the loan too costly for the client
Requiring bank to hold no capital for the entire loan
• Compromise the bank’s viability if the client defaults.
Thus, bank regulator has to require banks to hold capital levels
• That assures their viability with a high probability
• Maintaining their appetite to extend loans to borrowers at reasonable levels.
Credit losses on debt instruments may be divided into expected and
unexpected losses within certain confidence interval.
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6. Expected Loss(EL)
• The expected losses on a debt instrument is
• The level of credit loss that the bank is reasonably expected to experience
• The Interest priced on the debt instrument at its inception incorporates the
expected loss during the life of the instrument.
• Banks are expected to cover their expected credit losses on an
ongoing basis
• By revenue, provisions and write-offs.
• It represent another cost component of the lending business.
• Regulators need to make sure that banks do indeed build enough
provision against expected losses.
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7. Unexpected Loss(UL)
• The unexpected losses on a debt instrument is
• The level of credit loss in excess of the EL that the bank may be exposed to with a
certain probability of occurrence.
• The size of the UL depends on the confidence interval chosen.
• UL relate to potentially large losses that occur rather seldomly.
• Banks cannot know it advance their timing and severity.
• Banks are required to hold regulatory capital to absorb unexpected
losses.
• The RWA relate to the Unexpected losses only.
• Regulatory capital is needed to cover the risks in such unexpected
losses and thus it has a loss absorbing function.
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8. The Three-Pillar Approach to Bank Capital
• The Capital Adequacy Framework consists of three pillars, each of
which focuses on a different aspect of Capital Adequacy.
• Pillar 1, called “Minimum Capital Requirement”.
• Minimum amount of capital that a bank should have against its credit, market and
operational risks.
• It provides guidelines for calculating the risk exposures in the assets of a bank’s
balance sheet and the capital components, and sets the minimum capital
requirements.
• Pillar 2, called “Supervisory Review and Evaluation Process”.
• Involves both banks and regulators, taking a view on whether a firm should hold
additional capital against risks not covered in Pillar 1.
• ICAAP, which is the bank’s self-assessment of risks not captured by Pillar 1.
• Pillar 3, called “Market Discipline”.
• Aims to encourage market discipline by requiring banks to disclosure specific and
prescribed details of their risks, capital and risk management.
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9. Pillar 1 – Minimum Capital Requirement
• Pillar 1, covers the calculation of capital, liquidity, leverage and funding
levels.
• Leverage Ratio, this ratio was designed to put a cap on the build-up of
leverage in the banking system as well as to introduce additional
safeguards against model risk and measurement errors.
• It is non-risk weighted measure.
• Calculated as an “Average over the quarter”
• Tier 1 Leverage ratio = Tier 1 Capital / Average total restated balance sheet assets
• Liquidity Coverage Ratio, Basel III requires banks to hold a pool of
highly liquid assets(quickly converted into cash at most no loss) which
is sufficient to maintain the forecasted net cash outflows over a 30-day
period under stress assumption. This requirement tries to improve a
bank’s resilience against potential short-term liquidity shortages.
• LCR = (Stock of high-quality liquid assets(HQLAs) / Net cash Outflows over a 30-day time period )>=100%
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10. Pillar 1 – Minimum Capital Requirement - CONT
• Net Stable Funding Ratio(NSFR) , Basel III requires a minimum amount
of funding that is expected to be stable over a 1 year time horizon
based on liquidity factors assigned to assets and off-balance sheet
exposure.
• Banks must hold at least an amount of long-term (i.e., more than 1
year) funding equal to its long-term(i.e., more than 1 year) assets.
• NSFR = (Available amount of stable funding / Required amount of stable funding) >=100%
The numerator is calculated by summing a bank’s liabilities, weighted by
their degree of permanence. The denominator is calculated by
summing a bank’s assets, weighted by their degree of permanence.
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11. Pillar 1 – Minimum Capital Requirement - CONT
• Bank’s regulatory capital is divided into several categories or tiers of
capital.
• Tier 1 capital, is the best quality capital. Tier 1 capital is to absorb
losses and help banks to remain “Going Concern” (remain solvent)
• There are two layers of Tier 1 Capital:
a. Common Equity Tier 1 Capital (“CET1”) – which includes permanent
shareholder’s equity.
b. Additional Tier 1 Capital (“AT1”) – which includes some instruments with ability
to absorb losses.
• Tier 2 capital, a supplementary capital with less loss absorption
capabilities, is aimed at providing loss absorption on a “gone Concern”
basis to protect depositors. It contains mainly of subordinated notes
less prudential deductions.
• Total capital, is a sum of Tier 1 and Tier 2 Capital
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12. Pillar 1 – Minimum Capital Requirement - CONT
Tier 2 Capital
Additional Tier 1 Capital
Common Equity Tier 1 Capital
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8.0%
Tier 14.5%
6.0%
Total Capital
Lowest absorption Capacity
Highest absorption Capacity
Loss absorption
Capacity

13. Minimum CET1 requirement including Capital Buffers
Systemic Risk Buffers (min 1%)
Counter Cyclical Buffer (0 -2.5%)
Capital Conservation Buffer
(2.5%)
Common Equity Tier 1 (4.5%)
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Min 8.0%
7.0 %
7-9.5%
Buffers to be
met with CET1
eligible
instruments
4.5%

14. Pillar 1 – Regulatory Buffers
Capital Conservation Buffer (2.5%) – It provide banks with an extra cushion of capital to draw on during times of
stress (financial/economic stress) avoiding breaching minimum capital requirements. Banks are expected to build up the capital
conservation buffer in good times and uses those buffers in period of stress. It helps dampen excessive banking sector credit
extension and leverage.
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Counter Cyclical Buffer (0 -2.5%) – It is a pre-emptive measure designed to protect banks against future losses
stemming from assets originated during periods of unsustainable levels of leverage, debt or credit growth, and to support bank
lending in the economic downturn. It has three main objectives.
• To protect the banking sector from losses resulting from periods of excessive credit growth followed by period of stress
• To help ensure credit remains available during periods of stress.
• To lean against the build up excesses, when credit is being granted at a rapid pace, by reducing the attractiveness of bank
lending due to an increase in the cost of credit.
Systemic Risk Buffers (min 1%) - Banks need to comply with SRB requirements in order to compensate for the risk
that such banks represent for the financial system and the potential impact of their failure on taxpayers. It is to be deployed as
necessary by each country with a view to mitigating long term, non-cyclical systemic or macro prudential risk at a national level. It
is not set on an individual firm basis, but is to be applied to the whole financial sector or one or more subsets of it.

15. Risk-Weighted Asset(RWAs)
• When assessing how much capital a bank needs to hold, regulators
weigh a bank’s assets according to their risk.
• Safe assets(e.g., Cash) are disregarded.
• Other assets (e.g., loans to other institutions) are considered more risky and get a
higher weight.
• The more risky assets a bank holds, the higher the likelihood of a reduction to
earnings or capital, and as a result, the more capital it has to have.
• The RWAs are a bank’s assets and off-balance sheet items that carry
credit, market, operational and / or non-counterparty risk.
• The link between RWAs and Capital Charges
Capital Charge (Capital Requirement ) = 8 % * RWAs
RWAs = 12.5 * Capital Charge (Capital Requirement )
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16. Appendix
Prepared by – Shameel Ahmed Shakir
sashakir.exams@gmail.com
Reference – Handbook of BASEL III Capital (Juan Ramirez)
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Shameel Ahmed Shakir | Risk Modeller