June 18, 2015
Basel norms are a set of standards and practices that were put in place by the Basel Committee of Banking Supervision (BCBS) with the aim of ensuring that banks maintain adequate capital to withstand periods of economic stress and improve risk management and disclosures in the banking sector.
Basel I norms were introduced in 1988 followed by release of Basel II norms in 2004 as an improvement over Basel I norms. With the global financial crisis of 2008, it was widely felt that Basel II norms were inadequate in capturing systemic risk – subprime loan defaults started impacting financial institutions and it became a systemic problem. Exposure to risky assets in the form of subprime loans and securitisation products resulted in significant losses and the low quality and quantity of banks ‘capital could not absorb these losses .Basel III was BCBS’s response to the global financial crisis aimed at strengthening the banking system by eliminating weaknesses in Basel II – Basel III norms prescribe higher risk weights for risky assets, higher regulatory capital requirements and high quality of capital thereby strengthening the global capital and liquidity rules. The norms also aim at strengthening some weak points in the financial system by introducing Central Clearing Counterparties (CCPs) and reducing dependency on external rating agencies.
In this post we will go through the key aspects and focus points of Basel III guidelines and understand how each aspect focuses on strengthening the banking sector:
• Capital Structure: Basel 3 guidelines have left the capital requirement unchanged at 8% of Risk Weighted Assets (RWA) but have increased Tier 1 Capital from 4% to 6%, thereby reducing Tier 2 Capital to 2% (Tier 3 Capital has been eliminated). Common equity requirements have been increased from 2% to 4.5%. The main aim of these changes is to improve the quality and consistency of the capital base.
• Capital Buffers: Two new capital buffers have been introduced – Countercyclical buffer which should be 0% to 2.5% of Risk Weighted Assets (RWA) and Capital Conservation buffer which should be 2.5% of Common Equity Tier 1. Main objective of these buffers is to reduce cyclicality of minimum capital requirement and conserve capital to build buffers in banks which can be used in periods of stress.
• Liquidity: Liquidity Coverage Ratio should be >=100% and Net Stable Funding Ratio should be > 100%.
Liquidity Ratio (Ratio of High Quality Liquid Assets to Total Net Liquidity Outflows over a 30 day period) has been introduced with the objective of ensuring that a bank has sufficient high quality liquid assets to face a stressed scenario over a 30 day period
Net Stable Funding Ratio (Ratio of Available Stable Funding to Required Stable Funding) has been introduced to ensure that banks have a sound funding structure over a stressed period of one year
• Leverage : Leverage Ratio (Ratio of Tier 1 Capital to Total Exposure) should be >=3% – This ratio has been introduced to constrain the build up of leverage and avoid a destabilising deleveraging processes
• Counterparty Credit Risk – The term Counterparty Credit Risk is used in the context of derivatives and refers to the risk arising from the possibility that a counterparty may default on a derivative position. From a better risk management perspective following changes have been prescribed by the Basel III guidelines with reference to Counterparty Credit Risk :
• Credit Value Adjustment (CVA) Capital Charge is to be calculated to cover risk of mark to market losses on credit exposure from OTC derivatives
• Wrong Way Risk: Basel III has introduced a Pillar 1 capital charge for Specific Wrong Way Risk. Banks are exposed to Specific Wrong Way Risk if future exposure to counterparty is highly correlated with counterparty’s probability of default. Stressed parameters should be used to estimate counterparty credit risk
• Effective Expected Positive Exposure (EPE) with stressed parameters should be used to address General Wrong Way Risk and Counterparty Credit Risk
• For regular stress testing, banks must ensure that all trade data is captured and exposure aggregation completed at counterparty level for all forms of counterparty credit risk and not just OTC derivatives
• Asset Value Correlation – The new guidelines have increased risk weights on exposure to financial institutions relative to exposure to non financial institutions. In this effect, a multiplier of 1.25 is to be applied to the asset value correlation parameter of all exposures to financial institutions
• Incentives in the form of lower own capital requirements are being promoted for trades cleared through Central Counterparties (CCPs) as compared to OTC derivatives. Moreover, CVA capital charge is not applicable on exposure to eligible CCPs.
• Corporate Governance Framework : The new guidelines aim at strengthening the corporate governance framework by improving the monitoring and control by risk governance and increasing the effectiveness of risk management and risk oversight functions
Complying with the guidelines laid down by Basel III is imperative to lay the foundations of a strong risk management system and making the banking sector safer. Banks are working towards becoming Basel III compliant by 2019 in accordance with the schedule shown below.