Chapter 2: Banking Regulations Flashcards
3 Risks Covered from Basel II
- Credit Risk
- Market Risk
- Operational Risk
Credit Risk Definition
Risk of loss that banks face in the event that borrowers fail to meet their obligations to the bank, either partially or in full.
Market Risk Definition
Risk that the bank experiences loss (both on and off balance sheet) due to fluctuations in the value of its assets and liabilities as a result of adverse movements in market prices.
Factors influencing market risk
1. Economic conditions:
* Interest Rates
* Inflation
* Currency exchange rates
2. Change in fundamental factor
* New Management
* New Product
* New Strategy
3. Systemic risk
* Disaster
* Sovereign risk
* Large third party ruined
Operational Risk Definition
Risk of loss as a result of:
* Systems
* People
* Processes
…failing or being inadequate, or from…
* External events.
3 Pillars Introduced with Basel II
1. Minimum Capital Requirements:
* Requirement for banks to hold a certain amount of capital for each type of risk.
2. Supervisory Review:
* Requirement for regulatory review of capital adequacy, and early intervention. Includes risk management framework requirements, ICAAP, ILAAP, and Supervisory Review and Evaluation Process (SREP)
* Pillar 2a = quantitative aspects like additional capital requirements
* Pillar 2b = qualitative aspects like risk management and governance
3. Market Discipline:
* Requirements for public disclosure
Two Approaches for
Credit Risk Capital
STANDARDISED APPROACH
* Simplest approach.
* Uses external credit ratings to quantify the required capital for credit risk.
* Assigns predetermined risk weights to categories, not capturing specific risk characteristics of individual borrowers.
INTERNAL RATINGS-BASED APPROACHED
* More sophisticated approach.
* Tailored approach allowing banks to use their own models, providing a more granular assessment of credit risk.
* Requires regulatory approval.
* Two forms:
a. Foundational (own estimate of PD can be used).
b. Advanced (own estimates of PD, LGD, and EAD can be used - more rigorous supervision and very strong risk management systems required).
Two Approaches for
Market Risk Capital under Basel II
1. STANDARDISED APPROACH
A. Sensitivities-Based Requirements (Delta, Vega, Curvature)
B. Default Risk Capital Requirement (Capture jump-to-default risk not captured by above credit-risk spread)
C. Residual Risk Add-On (RRAO)
2. INTERNAL MODEL APPROACH
(must meet requirements around risk management system, capacity to execute, trading desk risk management, recurring stress tests)
Three Approaches for
Operational Risk Capital Under Basel II
BASIC INDICATOR APPROACH (BIA)
* Simplest approach.
* Based on the average of the previous 3 years’ positive annual income.
STANDARDISED APPROACH
* More complicated.
* Process: Similar to the above, except factors vary by 8 business lines, each with their own corresponding beta factor.
* Note: There is also an “ASA” (alternative standardised approach), which uses loan exposure instead of income exposure.
ADVANCED MEASUREMENT APPROACH (AMA)
* Most sophisticated method.
* Banks are allowed to use their own internal measurement systems to calculate capital requirements.
* The system must meet certain quantitative and qualitative criteria of the regulator.
* Hedging (e.g. with insurance) can be allowed, to a maximum of 20% of the total VaR
* No prescribed methodology, but the bank must demonstrate that the tail events are captured. VaR must capture aggregate losses (expected and unexpected) over 1 year with 99.9% confidence
* BASEL III SWITCH OFF!
Total Capital Requirements
- 8% of Bank’s RWA
- Made up of (CET1 + AT1 + T2) regulatory capital
- Measured with CAR (Capital Adequacy Ratio)
= (Regulatory Capital) / RWA - G-SIBs have an additional requirement to have meet TLAC requirements
Benefits of Basel II
(~shortfalls of Basel I)
More risk-sensitive approach to capital requirements.
* Different risk weights to different types of loans (Basel I only had a single risk weight for all loans).
* Entails riskier assets require more capital.
Banks now allowed to use internal models for capital requirements.
* If banks meet certain criteria, they can use their own model instead of a standardised one.
* Entails greater flexibility for banks in managing capital.
Supervisory review process.
* Risk management framework is required and needs to be reviewed by regulators.
* Entails better/more effective management of risks.
Public disclosure of capital and risk exposures.
* Information is intended to better help market participants to make informed decisions based on their assessment of the banks’ riskiness.
3 Components of Regulatory Capital
1. COMMON EQUITY TIER 1
* Most important regulatory capital.
* Most liquid form of capital.
* First form of capital to absorb losses.
* Can absorb losses while still a ‘going concern’.
* Comprises of banks’:
i) Common shares.
ii) Retained earnings.
iii) Other bank reserves.
* Example: Ordinary shares
2. ADDITIONAL TIER 1 CAPITAL
* Type of hybrid capital, combining the features of both equity and debt.
* Comprises of capital instruments that share characteristics of equity, such as the ability to absorb loss in the event of a default/stress.
* Can absorb losses while still a ‘going concern’.
* Not as liquid as CET1, but still considered a relatively high-quality form of capital.
* Example: Convertible Bonds
3. TIER 2 CAPITAL
* Comprises of debt capital instruments, that are subordinated to depositors and senior creditors.
* Less liquid form of capital than CET1 and AT1.
* Can absorb losses when a ‘gone concern’.
* Can include:
i) Subordinated debt.
ii) Hybrid capital instruments.
iii) General loan loss reserves.
iv) Covered bonds.
v) Bonds issued by governments.
* Example: Subordinated Debt Securities
Importance of Regulatory Capital
- Protects depositors.
- Stabilizes the financial system (by reducing risk of bank failure).
Key Changes in Basel III
1. NEW CAPITAL REQUIREMENTS
A. Change in capital composition
B. Additional capital buffers
C. Leverage ratio introduced
2. NEW LIQUIDITY REQUIREMENTS
A. Liquidity Risk never catered for before
B. New robust liquidity risk managment framework required
C. New measures for Liquidity (LCR, NSFR and Leverage Ratio)
3. NEW CONTROLS ON TRADING BOOK
A. Credit Valuation Adjustment
B. Counterparty Credit Risk
Basel III Changes in Capital Composition
TIER 1:
4% OF RWA (BII) → 6% OF RWA (BIII)
CET1:
2% OF RWA (BII) → 4.5% OF RWA (BIII)
REMAINING 1.5% CAN BE IN ANY OTHER T1
TIER 2:
4% OF RWA (BII) → 2% OF RWA (BIII)
Basel III New Capital Buffers
CAPITAL CONSERVATION BUFFER
* Mandatory buffer.
* Banks are required to hold an additional 2.5% in CET1 capital. (Brings CET1 to 7% under Basel III).
* Purpose: To absorb losses during future periods of economic stress – e.g. during COVID-19.
COUNTERCYCLICAL CAPITAL BUFFER
* Discretionary buffer.
* Ranges from 0% to 2.5% additional CET1. (Means a bank can have a CET1 of 9.5% with the buffer.)
* Held during periods of growth.
* Purpose: to assist banks to absorb losses during periods of cyclical economic contraction.
G-SIB BUFFER
* Part of Higher Loss Absorbency Requirements (HLA)
* Only applies to large banks that pose systemic risk.
* G-SIBs need to have loss absorbing capacity beyond foundational standards for banks.
* G-SIBs can hold up to an additional 1% to 3.5% of RWAs in CET1 (depending on systemic importance).
* Purpose: To ensure banks that are globally ‘too big to fail’ have sufficient loss absorbing capacity to withstand financial shocks wihout requiring a bailout
Liquidity Coverage Ratio (LCR)
= (HQLA ) / (NET CASH OUTFLOWS OVER 30 CALENDAR DAYS – USING STRESS SCENARIO)
…needs to be >=100%
OBJECTIVES:
* Ensure the bank holds sufficient HQLA to withstand acute stress scenarios over 1 month.
* Promote short-term resilience of the liquidity risk profile of banks.
Net Stable Funding Ratio (NSFR)
= (ASF) / (RSF)
…USING 1 YEAR STRESS SCENARIO
…MUST BE >= 100%
OBJECTIVES:
* Improve stability of a bank’s funding over the longer term (1 year).
ASF – Comprises of capital and liabilities weighted by ASF factors prescribed by regulator. Higher stability, means higher ASF factor
RSF – Comprises of assets weighted by RSF factors prescribed by regulator. RSF is measured based on broad characteristics of liquidity risk profile of an institutions assets and Off-Balance Sheet exposures. Stable assets have Lower RSF factors.
Leverage Ratio
= (Tier 1 Capital) / (Total on- and off-balance sheet asset exposure)
>= 3% to ensure banks efficiently manage leverage (4% in SA)
Non-risk-based ratio (values represent their full balance sheet/nominal value)
OBJECTIVE:
* To measure a bank’s overall resilience to balance sheet stress events
* To prevent banks from engaging in regulatory arbitrage by shifting risk from their balance sheets to off-balance sheets vehicles
Advantages and Disadvantages of the Leverage Ratio
ADVANTAGES (SABER)
* Simplicity:
It is a Simple and transparent measure that is easy to understand and calculate.
* Complementary to Risk-Weighted Measures:
Acts as a backstop to risk-weighted capital measures, be ensuring banks can’t reduce their capital requirements by too much using lower risk weights.
* Limits Excessive Leverage:
Can be used as a Brake to aggressive balance sheet growth in an economic upturn.
It constrains banks from taking on Excessive debt relative to their equity, promoting financial stability.
* helps mitigate Regulatory arbitrage from low risk weighting abuse.
DISADVANTAGES (LIARS)
* Limited scope:
It only focuses on capital in relation to total assets and doesn’t consider other important factors like the quality of the bank’s assets, its risk management practices, or its earnings capacity.
* Impact is uncertain.
* it treats All exposures equally, regardless of their risk, counting against banks with larger volumes of low-risk assets.
* potential for Regulatory arbitrage: Banks may try to manipulate their leverage ratio by adjusting the composition of their assets or liabilities. (not sure on this one)
HQLA Characteristics
CERL
- low Correlation with risky assets.
- Easy to value with certainty.
- low Risk, with low or no subordination.
- must be Listed on a developed and recognized exchange.
_
2.5 levels: - Level 1: Highest quality with no haircut or limit (e.g. cash, cash reserves, marketable securities from SARB or PSEs)
- Level 2A: Haircut of 15% with max of 40% of HQLA (e.g. corp and SOE debt with AA- or higher)
- Level 2B: Haircut of 50% with max of 15% of the 40% Level 2 cap of HQLA (e.g. corp and SOE debt with BBB- or higher)
Basel IV Changes
(aka Basel III reforms or Basel 3.1)
REVISED APPROACH FOR CREDIT RISK (SA + IRBA)
* Increased risk-sensitivity, granularity and robustness. (weights recalibrated and a more differentiated approach was introduced for unrated exposures)
* Internal model limits on inputs: Input floors for PD, LGD and EAD introduced, and the use of the A-IRBA is limited for certain asset classes.
REVISED APPROACH FOR MARKET RISK
* Fundamental Review of the Trading Book:
Revised boundary between banking and trading books (to discourage banks from attempting arbitrage between the books)
REVISED SA:
* Sensitivities-based.
* Default Risk Capital (DRC).
* Residual Risk Add-On (RRAO).
REVISED IMA:
* Global expected shortfall (modellable).
* Default Risk Capital (modellable).
* Stressed capital add-on (non-modellable).
- Shift from VaR to ES of risk under stress.
- Means of incorporating risk of market illiquidity.
REVISED APPROACH FOR OPERATIONAL RISK CAPITAL
* New Standardised Approach (NSA) introduced
* Increased risk-sensitivity, consistency, and robustness.
* Internal model (AMA) no longer allowed.
REVISED CREDIT VALUATION ADJUSTMENT (CVA)
* Increased risk-sensitivity, consistency, and robustness.
* Internal Model Approach no longer allowed.
* Calibrated in line with revised market risk framework since CVA is a form of market risk.
REVISED LEVERAGE FRAMEWORK:
* Leverage ratio buffer introduced to further limit the leverage of G-SIBs and enhance their resilience.
CAPITAL OUTPUT FLOORS
* Limiting the extent that banks can reduce their capital requirements using internal models.
Objectives of Basel IV
R-CLIP
- Reliability - restore credibility in RWA calculation. Different approaches under Basel III have very different results.
- Comparability - improve comparability in banks’ capital ratios.
- Leveling the playing field - reducing the level of national discretion
- Internal models - balance the complexity of modeled outputs with overall risk sensitivity.
- Prudence - improve robustness and risk sensitivity in banks’ capital ratios.
Deposit Insurance Regulation Considerations
P-FRAT
- Premiums (risk based or flat rate – paid by banks)
- Funding (by premiums and investment income; possibly government support)
- bank Resolution (reimbursal process)
- coverage limit Amounts (max amount insured per depositor)
- coverage Types (scope of types of deposits covered)
Total Loss Absorbing Capital (TLAC)
- Introduced by the FSB, at a similar time to Basel III
- Purpose: To ensure that G-SIBs have enough overall loss-absorbing and recapitalisaition capacity to prevent the need for bailouts
- Part of publication titled “Principles on Loss-absorbing and Recapitalisation Capacity of G-SIBs in Resolution”
- Requirement is expressed as percentage of bank’s RWA and the leverage ratio denominator (total exposure)
- 18% of RWA or 6.75% of leverage ratio denominator (whichever is higher)
New Standardised Approach (NSA)
for Operational Risk Capital (Basel III)
Key Features
Business Indicator (BI):
* Replaces gross income as the risk proxy.
* Financial statement-based measure that better captures a bank’s operational risk exposure by considering interest, services, and financial components.
* BI = ILDC + SC + FC
* 3 BI Components…
1.
ILDC = Interest, Leases and Dividend Component
ILDC = MIN[ABS(Interest Income - Interest Expense), 2.25%xInterest Earning Assets] + Dividend Income
2.
SC = Services component
SC = Max[Other Operating Income,Other Operating Expenses] +Max[Fee Income,Fee Expenses]
3.
FC = Financial Component
FC = ABS(Net P&L in trading book) + ABS(Net P&L in BB)
Business Indicator Component (BIC):
* Calculated by multiplying the BI by a set of marginal coefficients determined by regulators.
* These coefficients increase with the size of the BI, reflecting the idea that operational risk grows non-linearly with income.
Internal Loss Multiplier (ILM):
* A scaling factor based on a bank’s average internal operational risk losses over the past 10 years.
* It adjusts the BIC to reflect the bank’s specific loss experience.
* ILM = LN(e - 1 + (LC/BIC)^0.8 )
* LC = 15x (average internal annual ops losses over last 10 years)
Capital Requirement:
* Calculated as BIC x ILM.
* This ensures that banks with higher historical losses or riskier business activities hold more capital.
Goals
* To address over-reliance on gross income as a risk indicator
* To address the lack of comparability between banks using internal models
ICAAP Process
- = Internal Capital Adequacy Assessment Process (ICAAP)
- Pillar 2 regulatory requirement introduced in Basel II
- Requires banks to assess their capital adequacy in relation to their specific risk profile and business strategy.
- Comprises all of a bank’s procedures and measures designed to ensure that there exists (LIM):
* The appropriate Identification and measurement of all balance sheet risks
* An appropriate Level of internal capital in relation to the bank’s risk profile
* The application and further development of suitable risk Management systems -
Two types of capital assessment:
* Point-in-time capital assessment: Evaluating the bank’s capital adequacy at a specific date, considering both Pillar 1 (regulatory minimum capital requirements) and Pillar 2A (additional capital for risks not fully captured in Pillar 1).
* Forward-looking capital assessment: Using stress tests to project the bank’s capital position under various adverse scenarios and determining if additional capital buffers are needed to remain solvent during stressed periods.
ILAAP
The Internal Liquidity Adequacy Assessment Process (ILAAP) is a comprehensive assessment of a bank’s liquidity position.
It is a regulatory requirement under Basel III and is designed to ensure that banks have enough liquidity to meet their obligations even in times of stress.
The ILAAP process involves: (MR-SIPS)
- Identifying and measuring all liquidity risks: This includes both on-balance sheet risks (e.g., deposit withdrawals, loan drawdowns) and off-balance sheet risks (e.g., contingent funding obligations).
- assessing the bank’s liquidity Position: This involves calculating various liquidity metrics, such as the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), and comparing them to regulatory requirements and internal limits.
- developing a liquidity risk management Strategy: This strategy should outline how the bank will manage its liquidity risks under both normal and stressed conditions. It should include contingency funding plans and procedures for dealing with liquidity crises.
- Stress testing: The bank should conduct stress tests to assess the impact of various adverse scenarios on its liquidity position. This can help identify vulnerabilities and inform the development of contingency plans.
- Monitoring and Reporting: The results of the ILAAP should be reported to senior management and the board of directors on a regular basis. This allows them to monitor the bank’s liquidity risk profile and ensure that appropriate risk management measures are in place.
