BANKREG" Basel III: Implementation Challenges

Dr.R.Vasanthagopal University of Kerala 1
BASEL III:
IMPLEMENTATION CHALLENGES
Dr. R.VASANTHAGOPAL
University of Kerala

Bank Failures in Mature
Economies
Germany Herstatt bank 1974-80
Japan* 180 Deposit banks were closed (NPA was Y102
trillion (20% of GDP)
1992 -2001
Norway Three large banks (DnB, CBK and Fokus) lost
their capital; had market share of 24%
1988-90
Spain Banesto, the fourth largest Spanish bank by
volume of deposits failed
1978-83
Sweden Some banks faced credit risk and capital
shortage. Govt. pumped 4% of GDP to solve the
crisis.
1986-90
UK* Bank of Credit and Commerce International and
number of small UK banks failed due to credit
losses
1985-91
USA 1,650 federally insured banks closed their
activities
1980-90
Credit risk, real estate crisis, financial liberalisation, operational risk(inc. fraud) were the
reasons.
* Slow recovery.

Bank for International
Settlement
 Basel is a city in Switzerland which is also the
headquarters of Bank for International Settlement
(BIS).
 Established on 17th May 1930.
 BIS fosters co-operation among central banks with a
common goal of financial stability and common
standards of banking regulations.

Basel Committee on Banking
Supervision
 Herstatt debacle, the G-10 countries, Spain and
Luxembourg formed a standing committee in 1974 under
the auspices of the Bank for International Settlements
(BIS), called the Basel Committee on Banking
Supervision.
 Since BIS is headquartered in Basel, this committee got
its name from there.
 The committee comprises representatives from central
banks and regulatory authorities.
 At present 28 member nations in the BIS, called Basel
Committee on Banking Supervision (BCBS).

The Basel Committee
 It is the primary global standard-setter for the prudential
regulation of banks and provides a forum for cooperation
on banking supervisory matters.
 Its mandate is to strengthen the regulation, supervision
and practices of banks worldwide with the purpose of
enhancing financial stability.
 Stefan Ingves, Governor of Sveriges Riks Bank (The
National bank of Sweden is the chairman of the Basel
Committee).
 The Committee's Secretariat is located at BIS in Basel,
Switzerland.
Dr.R.Vasanthagopal University of Kerala )5

Capital Adequacy Ratio*
 Capital adequacy ratio(CAR) is a measure of the amount
of a bank's core capital expressed as a percentage of its
risk-weighted asset.
 CAR=Tier 1 capital+ Tier 2 capital
Risk weighted assets
 Tier 1 capital= (paid up capital + statutory reserves + disclosed
free reserves) - (equity investments in subsidiary + intangible
assets + current & b/f losses)
 Tier 2 capital= Undisclosed Reserves + General Loss reserves +
hybrid debt capital instruments and subordinated debts
*Also called “Cooke Ratio” named after Peter Cooke (Bank of
England), the chairman of the first Basel committee.

Capital Adequacy Ratio-
Illustration
Liabilities Amount Assets Amount
Equity 100 Cash 500
Retained earnings 50 Govt. bonds 500
Provisions 50 Mortgage loans 500
Convertible debentures 50 Unsecured loans 1500
Deposits 4750 Other loans 2000
5000 5000
T1=150; T2= 100; Total core capital= 250

Capital Adequacy Ratio-
Illustration
CAR= Tier 1 capital+ Tier 2 capital 250 x100
Risk weighted assets 2850 =8.77%
Assets Amount Risk(%) Risk weighted assets
Cash 500 0 0
Govt. bonds 500 0 0
Mortgage loans 500 20 100
unsecured loans 1500 50 750
Other assets 2000 100 2000
Total 2850

Risks of Banks
 Credit Risk( Default Risk)
The potential for loss due to failure of a borrower to meet
its contractual obligation to clear a debt in accordance
with the established terms in contract
 Operational Risk
The risk of direct or indirect loss resulting from
inadequate or failed internal process, people and
systems or from external events including legal risks
 Market Rate Risk
Include interest rate risk and equity risk in the trading
portfolios and currency risk and commodity risk for the
whole bank Dr.R.Vasanthagopal University of Kerala 9

Risks of Banks
 Liquidity Risk
The risk that a bank may be unable to meet short term
financial demands.
This usually occurs due to the inability to convert a
security or hard asset or cash without a loss of capital
and/or income in the process.
This inability is due to an inefficient market or illiquid
market where it is difficult to bring buyers and sellers
together

Basel I, II &III
Basel I Basel II Basel III
Year of Introduction 1988 1996 2011
Emphasis Capital Capital Liquidity
Risk focus Credit risk Credit risk,
operational risk and
market rate risk
Credit risk, operational
risk, market rate risk,
liquidity risk
Capital Adequacy
Ratio
8% 8% 8+2.5%=10.5%
credit risk weights:
AAA to AA
A+ to A-
BBB+ to BBB-
BB+ to B+
Un rated
0%,10%
20%,50%
up to
100%
0% ,20%,
50%,100%,150%,
100%
0% ,20%,
50%,100%,150%,
100%

...And what went wrong in 2007
and 2008?
 Banks suffered heavy losses due to sharp decrease in
assets value .The results were:
 ƒCapital problems:
 Basel II risk weights did not reflect the real risks in the trading
books and banks did not have adequate capital to cover the
losses.
 ƒLiquidity problems :
 There was heavy reliance on short term wholesale funding which
disappeared by night (Financial Institutions stops lending one to
another)
 Banks wanted to liquidate their own assets, but there were no
markets

Background for Basel III
 Liquidity was central to the banking crisis of 2008, as
many solvent banks were denied access to short term
interbank lending that many had built their business
models on. Unable to secure adequate liquidity, some
banks were forced to seek additional funding from
outside investors or from governments. Others went into
liquidation(Lehman Brothers, USA)
 The consequences of the crisis spurred the BIS to
enhance the Basel II framework, incorporating many
developments including liquidity compliance, to create
Basel III.

Basel III: Preamble
 Basel III guidelines are norms to strengthen the
regulation, supervision and risk management of the
banking sector.
 India started implementing Basel III w.e.f. April 1,
2013 and will fully migrate to the revised standards in
1 January 2019.
 The most significant differences for banks are the
introduction of liquidity and leverage ratios, and
enhanced minimum capital requirements.

Basel I, II & III: Capital
Requirements
Requirements Basel1
(%)
Basel 2
(%)
Basel 3
(%)
Minimum Ratio of Total Capital to RWAs 8.0 8.0 10.5
Minimum Ratio of Common Equity to RWAs None 2.0 4.5 - 7.0
Tier I capital to RWAs None 4.0 6.0
Core Tier I capital to RWAs None 2.0 5
Capital Conservation Buffers to RWAs
(to absorb losses during financial and economic stress)
None None 2.5
Buffers to RWAs None None 0-2.50
Minimum Liquidity Coverage Ratio None None 60 (2015)
Minimum Net Stable Funding Ratio None None 100(2019)

Basel III: An Enhancement of
Basel II
Pillars Basel II Basel III
Pillar I Minimum Capital
Requirements
Enhanced Minimum Capital &
Liquidity Requirements
Pillar II Supervisory
Review
Process
Enhanced Supervisory
Review Process for Firm-wide
Risk Management and
Capital Planning
Pillar III Disclosure&
Market
Discipline
Enhanced Risk Disclosure &
Market Discipline

Liquidity and Basel III
Basel III introduces two key liquidity standards that need
to be calculated and reported to supervisors.
 Liquidity Coverage Ratio (LCR)
LCR = Stock of High Quality Liquid Assets ≥ 100%
Net Cash Outflow Over 30 Days
 This means that the bank must ensure that the excess of outflows
over inflows over a rolling 30 day calendar period does not exceed
the amount of high quality liquid assets available to the bank. These
liquid assets cover cash, specified types of sovereign debt, as well
as other high quality public and corporate debt.
 The observation period for LCR begins in 2011 and will become a
compliance requirement in 2018.

Liquidity and Basel III
 Net Stable Funding Ratio (NSFR)
 NSFR complements the LCR and focuses on the
medium and long term source of funding for banks.
NSFR= Available Stable Funding(ASF) ≥ 100%
Required Stable Funding(RSF)
 The NSFR requirement means that illiquid loans to customers, with
maturities of 12 months or more, need to be matched with funding
from internal or external sources with a similar maturity rather than
by short term inter-bank lending.
 ASF refers to the reliability of the sources of funding over a one-year
horizon. RSF refers to the value of assets that require funding.

Basel III: Major Features
 Better Capital Quality (Better quality capital means the
higher loss-absorbing capacity)
 Capital Conservation Buffer (to absorb losses during
periods of financial and economic stress)
 Minimum Common Equity and Tier 1 Capital
Requirements
 Liquidity Ratios(LCR and NSFR)
 Supervision and regulations of Systemically Important
Financial Institutions (SIFI)*
*is a bank or financial institution whose failure might trigger a financial crisis.

Basel III: BIS- Phase in
Arrangements

Basel III: Monitoring Tools
Contractual Maturity
Mismatch
Identify and report gap between inflows and
outflows of liquidity
Concentration of Funding Identify and report the sources of wholesale
funding
Available Unencumbered
Assets
Identify and report information about a bank’s
available unencumbered assets that potentially
could be used as additional collateral to raise
additional secured funding
Market-related Monitoring
Tools
Identify and report real time or near real time
market, sector and bank specific data that can
provide additional insight to highlight potential
liquidity issues.

Implementation Monitoring of
Basel Standards
 Comprehensive Regulatory Consistency Assessment
Programme (RCAP) –Adopted by Basel Committee in
2012
 Consistency assessments carried out in two ways:
 Member Jurisdiction Assessment review the extent to
which domestic regulations are aligned with the minimum
Basel requirements and help identify material gaps in the
regulations.
 Thematic assessments examine bank implementation of
the Basel requirements and seek to ensure that prudential
ratios are calculated consistently by banks across
jurisdictions

Why Is Basel III Important?
 The recent financial crisis proved:
 Capital levels that large international banks operated
with were insufficient, and
 Capital lacked quality
 Basel III would result in:
 Tightened definition of common equity(from 2% to 4.5% - 7%)
 Limitation of what qualifies as Tier 1 capital (4%-6%)
 Market discipline through new disclosure requirements
 Systematic capital surcharge for systematically
important financial institutions

Basel Impacts
McKinsey *Estimates:
 ƒBanks would need to raise an additional 40% to 50% of
its current Tier 1 capital base
 Top 16 European banks will need to raise 700 Billion
Euros in capital and 1.8 trillion Euros in long-term
funding
 Industry ROE would reduce by about 5% from its current
level of 15 %
* Management consulting firm. HQ-New York

Basel Impacts
Institute for International Finance*
*Global association of financial institutions-HQ-Washington DC
2011-15 2011-20
Real GDP Growth
difference
US
Euro area
Japan
-.05
-.09
-.06
-.03
-.05
-.03

Impact of Basel III for Commercial
Banks?
Ideal or Blue Sky World
 Fewer bank failures - banks hold more and better
quality capital to withstand future shocks
 Stronger banking system in the long run
 Greater confidence in the stability of the financial
system once implementation commences
 Longer implementation period allows banks to adapt by
retaining earnings, issuing equity
 Profits rise as bad loans decline
 Bank share prices improve as they engage in
acquisitions

Banks?
Worse Case or Grey Sky World
 Regulatory authorities can underestimate the
riskiness of sovereign debt on banks balance sheet
 Reduction in credit
 Decreased availability and increased borrowing
cost
 Fewer borrowers have access to funding
 Significantly more onerous conditions
 Higher unemployment

Banks?
 Banks not meeting the ratio requirements cannot pay
out dividends, bonuses, share buybacks etc.
 Banks may have to come up sizeable amounts of:
 New equity
 Retained earnings, or
 Dispose of assets
 to meet the new capital ratios
 Restrict lending for exports in economies where
export credit is financed by banks but guaranteed by
governments

Basel III: Observation
BCBS
Basel III is a comprehensive set of reform measures, to
strengthen the regulation, supervision and risk management
of the banking sector
Researchers
 Basel III is only a continuation of the banking regulatory
framework under Basel I and Basel II.
 But it helps to improve the banking sector's ability to deal
with financial and economic stress, improve risk
management and strengthen the banks' transparency.
29

Basel III: Implementation
Challenges
“Implementation reforms not without challenges”

Data Capture and Consolidation
 It is imperative that all the data is easily accessible in
one place to deliver the accuracy and speed supervisors
demand (single unified data mart)

Data Quality and Reconciliation
Capture
 It is vital to ensure that all the data is of sufficient quality.
 The dataset needs to be validated to highlight errors and
omissions that must be corrected.

Reporting the Results
 The reporting regime for all aspects of Basel III is
complex.
 The need to calculate-
 liquidity gaps,
 deliver trend analysis across multiple reporting dates
and data,
 concentration of funding and
 LCR and NSFR ratios
will be a challenge for the most well organized bank.

Managing Liquidity and Delivering
Compliance
 Basel III implementation should not be viewed as a ‘box–
ticking’ exercise to comply with regulations.

International Consistency
BCBS- Three Level Assessment Framework
 Level 1:Self-assessment by individual jurisdictions
to ensure timely adoption of Basel III
 Level 2: Assessment by Basel expert team on
consistency of local regulations with
Basel III
 Level 3:Efforts to ensure consistency of risk
weighted assets

Global Capital Shortfall
 EU estimated USD 639 bn in capital shortfall for 48 large
European banks
 Fed estimated USD 50 bn shortfall for 19 large US banks
 India estimated Rs.500000 L Cr for all the private and public
sector banks
 SBI alone requires Rs.100000 L Cr.
Implications:
Global competition for capital

Comparability of CAR
 Calculation of capital (numerator) well defined
 Calculation of RWA (denominator) subject to debate

38
Differences in RWA Calculations
RWA % of Total Asset
Risk Weight Range on the Same
Hypothetical Loan Portfolio

Liquidity
Liquidity: shortfall and lack of liquid assets
 BCBS estimated USD 2.2 tn in global liquidity shortfall
 India needs Rs.1.4 to 1.5 trillion for complying with the
guidelines
 Some jurisdictions lack liquid assets, esp. Asian
countries not relying on debt financing
Suggestion of BCBS to ensure liquidity:
 Liquidity facilities from central banks
 Use of foreign currency liquid assets
 Additional use of Level 2 assets with a higher haircut

Different Geographies, Different
Issues
 Different regions and countries face different
challenges in applying Basel III.
 The EU very consistent in its adoption of BIS
regulations plans to deliver a unified set of rules
across Europe, to discourage ‘gold plating’.
 Japan, Hong Kong, Singapore, and Australia are well
advanced, on a par with the EU.
 The picture in Russia and countries in Eastern Europe,
the Middle East, Africa, and Asia Pacific is less clear

Auditing the Data
 Once a regulatory report has been submitted, it is
highly likely that a regulator will follow up with the bank
to clarify critical issues about how the results were
calculated and how the rules were applied.
 This will require the bank to identify, check, approve
and submit the data, quickly and accurately.

Stress Testing
 Stress testing—the ability to understand the impact of
significant market events on the key ratios—receives
greater significance under Basel III.
 Stress testing will be required more often, performed
across more data, and delivered in more depth.

Basel III: A Flexible Management
Framework
Credit Risk
Market Risk
Liquidity Risk
Operational Risk
Expected Loss
Provisioning Data
Data
Repository
External
Data
Source
External
Data
Source
End
Users
Reporti
ng
Engine
Regulatory
Reporting
Basel I
Basel II
Basel III
Business
Reporting
Stress Testing
Calculations

Conclusion
 Basel III places more demands on banks (are really
challenging)
 Enhanced data management,
 Standardized requirements for liquidity compliance and
stress testing and complex reporting requirements
 It was criticized to harm the industry, increase systemic risk
and limit credit availability.
 However, Basel III gives plenty of potential for banks to
streamline their liquidity management processes and use
deeper business insight
 To conclude, imposing capital constraints on banking activities
involves social costs. Hence, there is a trade-off between
stability and efficiency.

BANKREG" Basel III: Implementation Challenges

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