Basel III Standardized ApproachNew Capital Requirements for Mid-Tier Banks
tarting January 1, 2015, US banks will be subject to new regulationsunder the Basel III capital accord designed to mitigate systemic risk to the global economy posed by financial institutions. Basel IIIrepresents a significant change to existing US financial regulations.
The new regulatory framework will apply to all US banks with more thanUS$500 million in assets and the exact manner in which the new rules are applied will vary significantly depending on a multitude of factors.
On Tuesday, September 16, GARP hosted “Basel III Standardized Approach—New Capital
Requirements for Mid-Tier Banks,” a SAS-sponsored webcast led by Henry Fields, Partner
at Morrison & Foerster, and Tom Kimner, Head of the Americas Risk Practice at SAS. The
discussion focused on what mid-tier financial institutions can do to prepare themselves for
the coming regulatory changes.
Many banks are still unprepared for either the costs involved or the complexity inherent
in adhering to such a wide-ranging set of rules. “While Basel III may seem straight forward
on the surface, there’s an enormous amount of complexity underneath when you start look-
ing at the rules, the conditions of different asset classes, and the complexity around the
application of the rules,” Kimner said during his opening remarks.
“This is a rational scheme, but it’s highly complicated,” Fields said. “It basically reflects
what the standardized approach under Basel II was. US banks did not adopt the standard-
ized approach for Basel II as a general rule. So it’s going to require a significant amount of
internal work to determine how to comply.”
The major changes going into effect under Basel III include new capital rules and capital
floors (as outlined in Section 171 of the Dodd-Frank Act); higher capital ratios; changes in
the components of capital ratios; the introduction of an entirely new capital ratio (known as
Common Equity Tier 1); a capital conservation buffer; new thresholds for prompt corrective
action; and substantial changes to credit risk weightings.
New Capital Ratios
Perhaps the most significant regulatory change being promulgated as part of Basel III is
the introduction of new rules for capital ratios. Banks covered by Basel III are required to
maintain a minimum Tier I capital ratio of 6%, compared to a previous minimum of 4%. The
minimum total capital ratio will remain at 8%. The minimum ratio of Tier I capital to average
consolidated assets, which had been 3% for CAMELS 1-rated banks will now climb to 4%.
Although these additional requirements may not be applicable to mid-tier banks, Fields
said it is still in their interests to pay attention to the ramifications. “Consider the high lever-
age ratios these banks will have and what businesses may not be as attractive to them, and
where there might be opportunities for smaller banks.”
Basel III introduces an entirely new concept, known as Common Equity Tier I. This capital
category includes common stock, retained earnings, and accumulated other comprehensive
income (AOCI). Mid-tier banks will also have a one-time opportunity to elect to not include
most AOCI components in Tier I capital. “Banks should be sitting down and looking hard at
how they’re going to treat this election,” Fields said. Other significant changes to capital
ratios include the exclusion of cumulative preferred stock, which will no longer qualify as
Tier I capital of any kind. Prompt corrective action ratios are also higher than before.
S
analytics. Risk weighting for overdue
loans will also increase, which will
need to be taken into account in
capital planning.
However, several new categories
of credit risk mitigants can lower a
bank’s risk weight. But in order to take
advantage of such mitigating factors,
banks will again need to have the
proper analytics in place to demon-
strate that the credit risk mitigation is
being used properly.
The Tech Objective
The level of complexity reflected in
the Basel III framework is likely to be
the biggest issue for mid-tier banks,
according to Fields. Developing appro-
priate compliance procedures for the
new rules will be both technically chal-
lenging and expensive to implement.
“While Basel III may
seem straight forward on
the surface, there’s an
enormous amount of
complexity underneath
when you start looking at
the rules, the conditions of
different asset classes, and
the complexity around
the application of the rules”
—Tom Kimner
Banks will need to implement
appropriate technology, tracking
systems and procedures to comply
with the new rules. “For many smaller
banks, Basel III is really a large leap,”
Kimner said. “Many institutions are
new to the process.”
Even if a mid-tier bank’s capital
level is technically adequate, it will
have to build much more systematic
compliance programs to meet Basel III
requirements for sourcing and audit-
ing data.
Certain areas of the Basel III
framework, such as deductions to the
Common Equity Tier I category, will
represent a particular challenge to
mid-tier banks. “There are a lot of
elements that are deducted. All the
categories have to be looked at and
treated,” Fields said. “You need to
have the software and the capability
of looking at your financial state-
ments and making the appropriate
deductions.”
Among the key issues required to
comply with Basel III is the ability to
structure and validate data appropri-
ately. Regulators will require banks
to go into detailed explanations of
where their data comes from, how
reliable it is, and how it was gener-
ated, manipulated and transformed
throughout the reporting process.
“There’s an entire body of work that
goes around sourcing the appropriate
information,” Kimner explained.
Capital calculation updates, risk
reporting and auditability will also be
key aspects of Basel III. “It’s increas-
ingly important to make sure these
rules are applied correctly and that
the data used is managed appropri-
ately,” Kimner said. In particular,
Even institutions that meet the
higher standard for well-capitalized
ratios will not necessarily receive
automatic permission for acquisition
activity from regulators, Fields warned.
Banks will still be required to stress
test their portfolios to determine what
levels of capital are appropriate for
the kind of risk in its portfolio. “Meet-
ing the minimum rules is not neces-
sarily going to cut it,” Fields added.
The Conservation Buffer
Banks will also need to maintain an
additional capital conservation buffer
of 2.5% over the minimum capital
ratios. Compliance with this ratio will
impact the ability of mid-tier financial
institutions to pay bonuses and make
capital distributions without restric-
tions. Banks that fail to maintain the
2.5% buffer will not be able to make
discretionary bonuses, with a sliding
scale being applied to those banks
that fall somewhere in between.
“In capital planning, you’re going to
need to take this into account,” Fields
said. “Not being able to meet the mini-
mum buffer is going to be a significant
impediment on your ability to make
distributions and probably will have
an adverse effect on your stock price.”
Risk weighting is another area
affected by Basel III. Of particular
concern to mid-tier and community
banks will be the creation of 11 new
asset categories, each with different
rules for risk weighting. Some changes
to risk weighting will make certain
loans more expensive to hold. The
categorization scheme includes a new
category for unsettled transactions.
Rules for securitization exposure,
meanwhile, have become more com-
plex and will require a different set of continued on back page
Risk Reporting• Dashboards• Management Reports• Regulatory Reports
Risk Aggregation• On demand aggregation• Ad hoc analytics• Cross risk aggregation
Data Management• Data quality metrics• Linking report data
to source• Business and IT
collaboration
s
Ás s
s s
regulators will be looking to ensure
that calculations banks do for their
reporting is easily repeatable.
In terms of risk reporting, it is
important to make sure not only that
compliance requirements are being
met but also that the reporting offers
a comprehensive look at risk exposure
and weights. Identifying and sourcing
data will be a major challenge for
many mid-tier banks, Kimner said.
“Information mapping is an area that
takes a considerable amount of time
when trying to undertake something
like a Basel III compliance program.”
Due to the sheer number of rules
and their underlying complexity,
information will be difficult to track
with general tools such as an Excel
spreadsheet. “A lot of institutions are
looking for technology solutions that
let them track what rules and weights
are applied to what asset classes,”
Kimner explained.
Complicating matters further,
some rules can be expected to evolve
over time. Compliance targets such as
capital ratios may see changes in the
future, providing mid-tier banks with
a moving target. The evolving nature
of these regulations will create a
dynamic effect that will impact how
the data is not only sourced, but also
how it is applied to different asset
classes, according to Kimner.
“One thing that helps is having a
robust data governance program,”
he said. “As regulations change, you
want to be able understand what is
happening to the data in the overall
system.”
Deploying and maintaining an
integrated data platform will be criti-
cal to complying with the new rules
in Basel III. This type of platform not
only allows a bank to source informa-
tion into a larger repository for com-
pliance purposes but also helps
facilitate business decisions.
“Having an integrated platform to
capture all the information and model
it in a structured way may be a neces-
sary building block for organizations
to meet the demands of Basel III com-
pliance,” Kimner said.
Basel III was designed in an interna-
tional context to help assess and mini-
mize potential systemic risk. In the US,
mid-tier and community banks face
some unique challenges in complying
with this complex regulatory frame-
work, which was initially designed for
much larger financial institutions.
Creating a culture of risk awareness®
Global Association of Risk Professionals111 Town Square Place, 14th Floor • Jersey City, New Jersey 07310, U.S.A. • + 1 201.719.72102nd Floor • Bengal Wing • 9A Devonshire Square • London, EC2M 4YN, U.K. • + 44 (0) 20 7397 9630www.garp.org
© 2
014
Glo
bal
Ass
oci
atio
n o
f R
isk
Pro
fess
ion
als.
All
rig
hts
res
erve
d. 1
1-14
www.sas.com/en_us/software/risk-management.html
Having an integrated platform to capture all the information and model it in a structured way maybe a necessary building block for organizations to meet the demands of Basel III compliance...
DECISIONMGMT
DATA ACCESS
UNIFIEDPLATFORM
MASTERDATA
DATA QUALITY
ANALYTICMGMT
DATA STANDARDS
An Integrated Data Platform is Critical
SAS and all other SAS Institute Inc. product or service names are registered trademarks or trademarks of SAS Institute Inc. in the USA and other countries. ® indicates USA registration. Other brand and product names are trademarks of their respective companies. 107462_S129723.1114