How Basel III Will Change Risk Management

8/2/2019 How Basel III Will Change Risk Management

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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



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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



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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




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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




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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


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


* 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.



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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

Upcoming GARP Webcasts


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Opportunities and RisksTuesday, Feb. 14, 201211 AM EST/ 4 PM GMT/ 12 AM (Feb. 15) HKT

Current Risks in Energy Finance and EconomicsTuesday, Mar. 15, 2012

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To learn more and register, visit www.garp.org/webcasts

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About GARP The Global Association of Risk Professionals (GARP) is a not-for-profit organization dedicated to the risk management profession through education,training and the promotion of best practices globally. With a membership of over 150,000 individuals, GARP is the only worldwide organization offering comprehensiverisk management certification, training and educational programs from board-level to entry-level. To learn more about GARP, please visit www.garp.org.

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