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Presented by:
Anna PinedoPartner, Morrison & Foerster
Peter Went
VP, Bank Risk Program Manager, GARP
February 7, 2012
GARP Webcast
How Basel III Will Change RiskManagement in the U.S.
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Peter Went is a Senior Researcher for GARP's Research Center, where he
conducts research in financial risk management. Peter has co-authored fivebooks on risk management and numerous articles on foreign exchange,global equity market and commodity risk as well as on the impact emergingfinancial regulation has on financial and capital markets.
Previously, Peter worked for a boutique investment firm and taught financeand risk management at University of Nebraska and the University ofConnecticut.
Peter has earned a degree in Economics from the Stockholm School ofEconomics and was awarded a PhD in finance from the University ofNebraska. He is a Chartered Financial Analyst (CFA). He is a member of theboard of Woodlands Financial Services Corporation.
Peter Went, GARP
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The Basel III Framework:An Overview
Peter Went, GARP
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A long and winding road of proposals and consultative documents
Since December 2010, the Basel Committee on Banking Supervision has issued aseries of updates and clarifications on the Basel III proposals
o Technical changes
o Designating global systemically important institutions
The Basel III Process
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June 1, 2011 A global regulatory framework for more resilient banks and
banking systems
o Capital treatment of counterparty credit risk in bilateral trades
o Standardized and advanced approaches
o Minor impact on the CVA calculations reflecting the results of its impact study
o Gap in computing capital requirements for CCC-rated counterparties Reduce the weight from 18% to 10%
o Net effect: double the capital requirements for counterparty credit risk Incorporate both default risk (Basel II) and credit quality deterioration
(Basel III/CVA)
Basel III Technical Changes
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October 25, 2011 Basel capital framework's treatment of trade finance
o Impact on trade with low-income countries that penalize some trade financetransactions
o Average tenure of trade transactions less than one year Waive the one-year maturity floor for certain trade finance instruments under
the advanced internal ratings-based (AIRB) approach for credit risk
o Low-income country banks may not have public credit ratings, which the capitalrequirements for letters of credit demand imply either 20% or 50% risk weight yetare subject to the sovereign public risk rating, which is often 100%
Waive the so-called sovereign floor for certain trade-finance-related claims onbanks using the standardized approach for credit risk
Basel III Technical Changes
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December 19, 2011 Definition of capital disclosure requirements
(consultative document)
o Disclose composition of regulatory capital, improving the transparency andcomparability of capital bases
o Increase consistency in reporting across jurisdictions
Basel III Technical Changes
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The Basel Committee, together with the Financial Stability Board, has outlined an
assessment methodology for identifying systemically important institutions
Systemically Important Institutions
Cross-jurisdictionalactivity
The global footprint
Cross-jurisdictionalclaims
Cross-jurisdictionalliabilities
Size
Activities comprise alarge share of globalactivity
Noticeable impact incase of failure
Interconnectedness
Likelihood of contagion Intra-financial systemassets
Intra-financial systemliabilities
Wholesale fundingratio
Substitutability
Alternatives to a major
business line or service Assets under custody
Payments cleared andsettled throughpayment systems
Value of underwrittentransactions in debtand equity markets
Complexity
Systemic impact of
distress or failure Notional value of OTCderivatives
Level 3 assets
Size of trading bookand available for saleexposures
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The additional loss absorbency requirement will be phased-in with the capital
conservation and countercyclical buffers from 2016 to 2019
Global systemically important banks (G-SIBs) are subject to a Common Equity Tier 1(CET1) surcharge between 1% and 3.5%o Basel III 7% CET1 minimumo A maximum of 2.5% surcharge when fully implemented in 2019o The extra 1% surcharge is designed as a disincentive to become more systemic
Higher Capital Charge
Bucket
Additional
Capital
5 3.5%
4 2.5%
32.0%
2 1.5%
1 1.0%
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Of the 29 institutions that are considered G-SIBs (according to year-end
2009 data), 17 are European
29 G-SIBs
10 European Banks Within the Eurozone
France Banque Populaire CdE, BNP Paribas,Dexia (Belgium), Group Crdit Agricole,Socit GnraleGermany Commerzbank, Deutsche Bank
Netherlands ING BankSpain SantanderItaly Unicredit Group
7 European Banks Outside the Eurozone
U.K. Barclays, HSBC, Lloyds Banking Group,Royal Bank of ScotlandSwitzerland Credit Suisse, UBS
Sweden Nordea
4 Asian Banks
China Bank of ChinaJapan Mitsubishi UFJ FG, Mizuho FG,Sumitomo Mitsui FG
8 U.S. Banks
Bank of America, Bank of New York Mellon,Citigroup, Goldman Sachs, JP Morgan Chase,Morgan Stanley, State Street, Wells Fargo
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Implications for Capital
Anna Pinedo, Morrison & Foerster
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Under the Dodd-Frank Acts Collins Amendment, trust-preferred securities and other
hybrids will be excluded from the numerator of Tier 1, subject to limited exceptions
o The exclusion applies to all hybrid securities issued on or after May 19, 2010
o For mutual holding companies and thrift and bank holding companies with less than$15 billion in total consolidated assets, hybrids issued before May 19, 2010 areincluded in Tier 1 until they mature
o For bank holding companies with assets of $50 billion or more and systemicallyimportant nonbank financial companies, hybrids issued before May 19, 2010 will bephased out of Tier 1 from January 2013 to January 2016
o Intermediate U.S. holding companies of foreign banks have a five-year transitionperiod to phase-out pre-May 19, 2010 hybrid securities from Tier 1 capital
Capital Components: Hybrids
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Definition of Tier 1 capital moves toward the definition of tangible common equity
Explicit minimum ratio of common equity to risk-weighted assets
Specific eligibility criteria for common equity, including full subordination andabsence of any repurchase or redemption obligation
Capital Components: Common Equity
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Basel III introduces a series of new deductions from Tier 1 capital
o Minority interests in consolidated subsidiaries of banks
o Banks own non-controlling, minority investments in financial institutions
o Deferred tax assets up to a limit
o Shortfall in reserves
o Mortgage serving rights
o Goodwill and other intangibles
o Gains on sale in securitization transactions
o Gains and losses due to changes in banks own credit risk
o Defined benefit pension fund assets and liabilities
Capital Components: Deductions
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Basel III simplifies Tier 2 capital by establishing a single set of eligibility criteria and
eliminating Upper and Lower Tier 2
In order to qualify as Tier 2 capital, any instrument must:o Be subordinated to depositors and general creditorso Not be securedo Not be guaranteedo Have an original maturity of at least five years
o Be callable by the issuer only after a minimum of five years
Tier 3 (market risk) will be eliminated completely
Capital Components: Tier 2 and Tier 3
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The Collins Amendment (Sec. 171) is an overlay on the Basel III requirements
o Requires the establishment of new minimum leverage and risk-based capitalrequirements for bank and thrift holding companies
o The floor for the new standards is the current set of rules applicable to banks and thrifts
Limits discretion in establishing Basel III requirements: U.S. can adopt more onerous
standards, but cannot adopt laxer standards
Dodd-Frank Act
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On June 14, an interagency final rule (pursuant to Sec 171) was approved that
establishes a permanent floor equal to the capital requirements calculated under anagencys general capital rules
This replaces the transitional floors in the banking agencies Basel II internal ratingsbased approach for risk-based capital (originally adopted in 2007)
Risk-Based Capital Floor
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Minimum common equity
o Current Basel requirement is 2%o New requirement of 3.5% will take effect Jan. 1, 2013, rising to 4.5% by Jan. 1, 2015
Minimum Tier 1 capitalo Current requirement is 4%o Requirement of 4.5% will take effect Jan. 1, 2013, rising to 6% by Jan. 1, 2015
Minimum total capital requirement remains at 8%
New ratios are based on more stringent definition of capital
Increased Risk-Based Ratios
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Capital conservation buffer Banks must build up capital outside periods of stress,
which can be drawn down as losses are incurredo Ratio of Tier 1 common equity to risk-weighted assetso Buffer is phased-in in equal increments over three-year period, beginning with 0.625%
on Jan. 1, 2016o On January 1, 2019 permanent buffer of 2.5% takes effect
Countercyclical buffer to be employed when excess credit growth is judged to be
associated with a build-up of system-wide risko An extension of the capital conservation buffero Set on a national basis; buffers will not be internationally uniformo Requirement should be announced 12 months in advance of effective dateo Phase-in along the same time frame and in the same amounts as conservation buffero Ceiling will be 2.5% as of Jan. 1, 2019
Capital Conservation and Countercyclical Buffers
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A leverage ratio will be used as a supplementary measure to the risk-based capital
framework
Ratio requires a minimum level of capital relative to total assets
o 3% minimum ratio of Tier 1 capital to total assets will be monitored in 2011 and 2012
o Ratio will be used on a parallel run through 2016. Ratio must be disclosed beginning in
2015o Adjustments may be made in 2017, and the presumptive rate of 3% takes effect on
Jan. 1, 2018
Capital Measure: numeratorof the leverage ratio (capital) would consist of onlyhigh-quality capital that is generally consistent with revised definition of Tier 1 capital
Total Exposure Measure: generally, the proposal indicates that the denominator of theleverage ratio (the total exposures) would be determined in accordance withapplicable accounting rules
Leverage Ratio
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High-quality liquid assets include cash and cash-like instruments in the measure of
exposure
Securitization exposures would be counted in a manner generally consistent withaccounting treatment
Derivatives exposures would either follow the applicable accounting treatment or usethe current exposure method
Other off-balance-sheet items include commitments, unconditionally cancellablecommitments, direct credit substitutes
Dodd-Frank addresses leverage in other ways:
o Possible limits on short-term debt
o Specific debt-to-equity limit of 15% for bank holding companies with consolidatedassets of $50 billion or more and systemically important nonbank financial companies
Leverage Ratio
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Minimum common equity and Tier 1 requirements to be phased in between Jan. 1,
2013 and Jan. 1, 2015
o Common equity Tier 1 minimum raised to 3.5% in 2013, 4% in 2014 and 4.5% in 2015o Total Tier 1 capital to be raised to 4.5% in 2013, 5.5% in 2014 and 6% in 2015
Regulatory adjustments to be phased in beginning Jan. 1, 2014
o Initially 20% of deduction; increasing to 100% by 2018
Grandfathering of existing instruments
o Capital instruments that no longer qualify as Tier 1 or Tier 2 capital and were issuedbefore Sept. 12 2010 (or July 20, 2011, under CRD4) will be gradually de-recognizedfrom Jan. 1 2013 over 10 years
o Other capital instruments no longer qualifying as common equity will be excluded fromJan. 1, 2013
Basel III/CRD IV Phase-In of New Capital Requirements
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Basel III/CRD IV Minimum Capital Requirements
% of
RiskWeightedAssets
12
11
9
10
8
7
6
5
4
3
2
1
0
2010 2011 2012 2013 201620152014 2017 2018 2019 2020 2021 2022
10.5%
8.625%
9.25%
9.875%
Capital ConservationBuffer
Tier 2 Capital
Additional Tier 1Capital
Common Equity Tier 1 Capital
3.5%
4%
4.5%4.5%
5.5%
6%
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What is it?
o Principal write-downo Conversion to equity
Market experience with contingent capital productso RaboBank issuanceso Credit Suisse issuances
European Banking Authority recommendationso European banks should create a temporary capital buffer by June 30, 2012 by attaining
Core Tier 1 ratio of 9%o Core Tier 1 capital includes ordinary shares, plus contingent convertible instruments
that comply with EBA term sheet for buffer convertible capital securitieso No grandfather for existing convertible capital instrumentso Term sheet terms for buffer convertible capital securities
Contingent Capital
C i C i l
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EBA term sheet provides for two conversion events:
o A contingency event A bank giving notice that its Core Tier 1 ratio fell below 7%, or abank giving notice post-Jan 1, 2013 that its common equity Tier 1 has fallen below5.125%
o A viability event either:
A decision by the national supervisor that a conversion of the Basel Committee isnecessary to prevent a bank from becoming non-viable
A decision to make a public sector (or similar) capital injection without which thebank will become non-viable
Contingent Capital
S d F di
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Regulatory discussions of bail-in have caused investors to move away from senior,
unsecured debt securities of financial institutions, especially in Europe
European banks have historically relied on the issuance of covered bonds (securedand consequently not subject to bail-in)
o For diversification and other purposes, European banks considering other securedfunding alternatives
o Secured notes
o Quasi covered bonds (collateral not compliant with statute)
o Collateralized repo
Secured Funding
R i i C it l
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In the U.S., there has been no further guidance on interpretation of the Collins
Amendment
Fair to assume that common stock and non-cumulative perpetual preferred stock willbe eligible for Tier 1 capital
There have been a number of recent issuances of non-cumulative perpetual preferredstock
o PNC, USBancorp, First Republic, etc.
o Non-cum perpetual preferred with at least a five-year non call period
Raising Capital
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Liquidity Ratios
Anna Pinedo, Morrison & Foerster
Basel III Liquidity Ratios
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Two proposed liquidity ratios
Short-term liquidity cover ratio (LCR)
Longer-term net stable funding ratio (NSFR)
Liquidity cover ratio
High-quality liquid assts to cover net cash outflows over 30 day period
Builds on traditional internal methodologies used by banks to assess exposure tocontingent liability events
Defined as stock of high-quality liquid assets divided by total net cash outflows fornext 30 days
Basel III Liquidity Ratios
Basel III Liquidity Ratios
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Certain high-quality liquid assets (level 1 assets) to be included on asset side on an
unlimited, undiscounted basis
Level 2 assets must comprise no more than 40% of the overall stock and must have aminimum 15% haircut
Observation period for liquidity cover ratio commences in 2011; ratio is to beintroduced at start of 2015
Basel III Liquidity Ratios
Basel III Liquidity Ratios
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Net stable funding ratio
o Designed to promote resilience over a period of one yearo Available stable funding (ASF) must be at least equal to required stable funding (RSF)
NSFR should be reported at least quarterly
NSFR will be a minimum standard by Jan. 1, 2018
Basel III Liquidity Ratios
CRD IV Liquidity Ratios
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Liquidity cover ratio
o Binding ratio to be introduced in 2015o Detail less prescriptive than Basel III on liquidity weightings given to different assetso Obligation to hold sufficient liquid assets to cover net liquidity outflows for a short period
under stressed conditions
Net stable funding ratioo Observation period up to 2018, but currently no absolute obligation to maintain a
particular ratioo Commission committed to reaching minimum standard by 2018o EBA to report to Commission by end of 2015o Commission to report to European Parliament by end of 2016 on whether institutions
should be required to maintain a particular ratio
CRD IV Liquidity Ratios
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Credit Ratings and Basel III
Anna Pinedo, Morrison & FoersterPeter Went, GARP
Credit Ratings Conundrum
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Basel III framework continues to rely on credit ratings
Dodd-Frank (Section 939A) requires that the banking agencies amend their rulesin order to eliminate reliance on ratings
o Will new measures applicable to U.S. banks be more effective than ratings?
o Will requirement that U.S. banks use other standards for creditworthiness lead to
differences with foreign banks that continue to rely on Basel III ratings basedframework?
Credit Ratings Conundrum
Credit Ratings
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In December, the banking agencies proposed market risk capital rules to incorporate
new creditworthiness standards for risk-weighting debt and securitization positions
Affects internal modeling, calculations of risk-based capital and required disclosures
o Proposal offers alternative methodologies for calculating capital requirements forcalculating
o Sovereign debt positionso
Exposures to supranational entities/multilateralso Exposures to GSEso Exposures to other depository institutions and to foreign bankso Public sector entity debt positionso Corporate debt positionso Securitization positions
Credit Ratings
Credit Ratings: The European Story
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Existing regulation* focuses on registration, business practices, and defines a
supervisory agency (ESMA)o Does not regulate the use of ratings
Proposed draft directive and regulation IP/11/1355 (Nov. 15, 2011)o Reduce mechanical reliance on credit ratings
CRD IV reduces the scope of external ratings and requires increaseddue diligence
o The G20 approved FSB's principles on reducing reliance on external credit ratingsat the Nov. 2010 Seoul Summit
Same as current FTC standardo More transparent, more frequent sovereign debt ratings
EU members to be rated semi-annuallyo More diversity and stricter independence of credit rating agencies
Rotation of raters and multiple ratings for complex securitization transactionso More accountability for ratings
Credit Ratings: The European Story
* Regulation (EC) No 1060/2009 of the European Parliament and of the Council of Sept. 16, 2009 on credit rating agencies, OJ L302, 17.11.2009. Regulation (EC) No 1060/2009 is often referred to as CRA I Regulation.
Credit Ratings: The European Story
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Similarities with the U.S.
o Address conflicts of interests due to the "issuer-pays" model
o Transparency of structured finance instruments
g p y
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Risk Management Considerations
Peter Went, GARP
U.S. Implementation of Basel Accords
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Basel IIo
Final rule issued Dec. 7, 2007
Basel 2.5o Fed issued notice of proposed rulemaking (NPR) on Risk-Based Capital Guidelines:
Market Risk on Jan. 11, 2011; comments due April 11, 2011o NPR on Risk-Based Capital Guidelines: Market Risk; Alternatives to Credit Ratings for
Debt and Securitization Position issued Dec. 21, 2011; comments due Feb. 3, 2012o CRD III came into effect Dec. 31, 2011
Basel III / Dodd-Frank mandated enhanced standardso Proposed rule Enhanced Prudential Standards and Early Remediation Requirements
for Covered Companies released Jan. 5, 2012; comments due March 31, 2012o Final implementation is not yet known
Capital rules should be implemented starting in 2013 U.S. is largely compliant
p
Increased Regulatory Risk
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Differences in regulatory implementationo
Volcker ruleo Swaps tradingo Credit ratingso Systemic regulation
Problems with time lineso Dodd-Frank implementation is laggingo Collateral effects on Basel III
Basel 2.5 market risk proposals
Basel III proposals
Fundamental Structural Differences
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The swaps push-out ruleo
Requires dealers to shift OTC equity, most commodity, un-cleared CDS into entities notcovered under FDIC with no access to FRB supporto International imbalance implies higher capital requirements
Volcker ruleo Limitation on trading activities of U.S. bankso Impacts the provision of liquidity for sovereign bonds
Removing credit ratings from prudential useo Basel 2.5 proposals use OECDs Country Risk Classifications
A measure of currency convertibility risk Sovereign debt rating impact U.S. and Greek sovereign debt is rated the same
Dodd-Frank Differs on Systemic Banks
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Institution Name Total Assets 09/30/2011
JPMorgan Chase $2,289.2Bank of America $2,221.4
Citigroup Inc. $1,936.0
Wells Fargo $1,304.9
Goldman Sachs $949.3
Morgan Stanley $794.9
MetLife $785.2
Taunus (Deutsche Bank) $380.6
HSBC North America (HSBC) $346.0
U.S. Bancorp $330.1
Bank of New York Mellon $323.0
PNC Financial Services $269.6
State Street $207.2
Capital One $200.1Td Bank Us (TDBank) $199.6
Ally Financial $182.0
Suntrust Banks $172.6
BBT $167.7
American Express $147.6
Citizens Financial (RBS) $130.7
Regions Financial $129.8
BMO Financial (BMO) $117.9
Fifth Third Bancorp $114.9
Northern Trust $96.1
RBC USA (RBC) $95.8
Keycorp $89.4
Unionbancal (Mitsubishi UFJ) $84.0
MT Bank $77.9Bancwest $77.1
Discover Financial $68.1
BBVA USA (BBVA) $64.5
Comerica $61.0
Huntington Bancshares $55.0
Zions Bancorporation $51.5
Under Dodd-Franks US$50 Billion Cut-Off, 34 Banks Are Considered Systemic
Convergence or Divergence?
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Qualitative and quantitative differences between the U.S. regulatory approach and theG-20, Financial Stability Board and Basel Committee
Contingent convertibleso Basel Committee supports the use of contingent capital to meet national loss
absorbency requirements Contingent convertible debt: securities that automatically convert into equity on the
occurrence of specified events If the equity capital ratio falls below 8 percent, it triggers conversion of the debt
into equityo Issuances of contingent convertibles in the U.S.
Unfavorable tax treatment Viewed as equity rather than debt in the U.S. Interest payments would not be tax deductible
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