Motivations And Goals For Basel III

• The Basel III framework is a central element of the Basel Committee’s response to the global   financial crisis. It addresses a number of shortcomings in the pre-crisis regulatory framework   and provides a foundation for a resilient banking system that will help avoid the build-up of   systemic vulnerabilities. The framework will allow the banking system to support the real   economy through the economic cycle.

• The initial phase of Basel III reforms focused on strengthening the following components –

1. improving the quality of bank regulatory capital by placing a greater focus on going-concern loss-absorbing capital in the form of Common Equity Tier 1 (CET1) capital;

2. increasing the level of capital requirements to ensure that banks are sufficiently resilient

3. enhancing risk capture by revising the risk-weighted capital framework, including the global standards for market risk, counterparty credit risk and securitization;

4. adding macroprudential elements to the regulatory framework, by:

i. introducing capital buffers that are built up in good times and can be drawn down in times of stress to limit procyclicality,

ii. establishing a large exposures regime that mitigates systemic risks arising from interlinkages across financial institutions and concentrated exposures, and putting in place a capital buffer to address the externalities created by systemically important banks

5. specifying a minimum leverage ratio requirement to constrain excess leverage in the banking system and complement the risk-weighted capital requirements; and

6. introducing an international framework for mitigating excessive liquidity risk and maturity transformation, through the Liquidity Coverage Ratio and Net Stable Funding Ratio.

• The Committee’s now finalized Basel III reforms complement these improvements to the   global regulatory framework. The revisions seek to restore credibility in the calculation of risk-   weighted assets (RWAs) and improve the comparability of banks’ capital ratios by:

1. enhancing the robustness and risk sensitivity of the standardised approaches for credit risk, credit valuation adjustment (CVA) risk and operational risk;

2. constraining the use of the internal model approaches for credit risk and by removing the use of the internal model approaches for CVA risk and for operational risk

3. introducing  a  leverage  ratio  buffer  to  further  limit  the  leverage  of  global  systemically important banks (G-SIBs); and

4. replacing the existing Basel II output floor with a more robust risk-sensitive floor.

Standardized Approach For Credit Risk

• Credit risk accounts for the bulk of most banks’ risk-taking activities and hence their regulatory   capital requirements. The standardised approach is used by the majority of banks around the   world, including in non-Basel Committee jurisdictions.

• The Committee’s revisions to the standardised approach for credit risk enhance the regulatory   framework by:

1. improving its granularity and risk sensitivity. For example, the Basel II standardised approach assigns a flat risk weight to all residential mortgages. In the revised standardised approach mortgage risk weights depend on the loan-to-value (LTV) ratio of the mortgage;

2. reducing mechanistic reliance on credit ratings, by requiring banks to conduct sufficient due diligence,  and  by  developing  a  sufficiently  granular  non-ratings-based  approach  for jurisdictions that cannot or do not wish to rely on external credit ratings; and

3. as a result, providing the foundation for a revised output floor to internally modelled capital requirements (to replace the existing Basel I floor) and related disclosure to enhance comparability across banks and restore a level playing field.

• Following is the summary of key revisions to the standardised approach for credit risk, relative to the existing standardised approach –
• A  more  granular  approach  has  been  developed  for  unrated  exposures  to  banks  and corporates, and for rated exposures in jurisdictions where the use of  credit ratings is permitted.
• For  exposures  to  banks,  some  of  the  risk  weights  for  rated  exposures  have  been recalibrated. In addition, the risk weighted treatment for unrated exposures is more granular than the existing flat risk weight. A standalone treatment for covered bonds has also been introduced.
• For exposures to corporates, a more granular look-up table has been developed. A specific risk weight applies to exposures to small and medium-sized enterprises (SMEs). In addition, the revised standardised approach includes a standalone treatment for exposures to project finance, object finance and commodities finance.
• For residential real estate exposures, more risk-sensitive approaches have been developed, whereby risk weights vary based on the LTV ratio of the mortgage (instead of the existing single risk weight) and in ways that better reflect differences in market structures.
• For retail exposures, a more granular treatment applies, which different types of retail exposures. For example, the regulatory retail portfolio distinguishes between revolving facilities (where credit is typically drawn upon) and transactors (where the facility is used to facilitate transactions rather than a source of credit).
• For commercial real estate exposures, approaches have been developed that are more risk- sensitive than the flat risk weight which generally applies.
• For subordinated debt and equity exposures, a more granular risk weight treatment applies (relative to the current flat risk weight).
• For off-balance sheet items, the credit conversion factors (CCFs), which are used to determine the amount of  an exposure to be risk-weighted, have been made more risk sensitive, including the introduction of  positive CCFs for unconditionally cancellable commitments (UCCs).

Internal Rating-Based Approaches For Credit Risk

• The financial crisis highlighted a number of  shortcomings related to the use of  internally   modelled approaches for regulatory capital, including the IRB approaches to credit risk. These   shortcomings  include  the  excessive  complexity  of  the  IRB  approaches,  the  lack  of   comparability in banks’ internally modelled IRB capital requirements and the lack of robustness   in modelling certain asset classes.

• To address these shortcomings, the Committee   has  made  the  following  revisions  to  the  IRB   approaches:

a)Removing  the  option  to  use  the  advanced   IRB  (A-IRB)  approach  for  certain  asset   classes – These include exposures to large and   mid-sized corporates, and exposures to banks   and  other  financial  institutions.  This  table   outlines  the  revised  scope  of  approaches   available  under  Basel  III  for  certain  asset   classes relative to the Basel II framework.

Portfolio/ Exposure	Basel II: Available Approaches	Basel III: Available Approaches
Large and mid-sized corporates (consolidated revenues > €500m)	A-IRB, F-IRB, SA	F-IRB, SA
Banks and other financial institutions	A-IRB, F-IRB, SA	F-IRB, SA
Equities	Various IRB approaches	SA
Specialised lending	A-IRB, F-IRB, slotting, SA	A-IRB, F-IRB, slotting, SA

b) Adoption of “input” floors (for metrics like PD and LGD) – This is done to ensure a minimum level of  conservativism in model parameters for asset classes where IRB approaches are available. This table summarizes the set of input floors in the revised IRB framework.

 

	Probability of Default (PD)	Loss-Given-Default (LGD)		Exposure at Default (EAD)
		Unsecured	Secured
Corporate	5 bp	25%	Varying by collateral type: 0% financial 10% receivables 10% commercial or residential real estate 15% other physical	EAD subject to a floor that is the sum of (i) the on-balance sheet exposures; and (ii) 50% of the off-balance sheet exposure using the applicable Credit Conversion Factor (CCF) in the standardised approach
Retail classes:
Mortgages	5 bp	N/A	5%
QRRE transactors	5 bp	50%	N/A
QRRE revolvers	10 bp	50%	N/A
Other retail	5 bp	30%	Varying by collateral type: 0% financial 10% receivables 10% commercial or residential real estate 15% other physical

 

c)Providing  greater  specification  of  parameter  estimation  practices  to  reduce  RWA variability – Adjustments were made to the supervisory specified parameters in the F-IRB approach, including:

i.for exposures secured by non-financial collateral, increasing the haircuts that apply to   the collateral and reducing the LGD parameters; and

ii.for  unsecured  exposures,  reducing  the  LGD  parameter  from  45%  to  40%  for   exposures to non-financial corporates.

Given the enhancements to the IRB framework and the introduction of  an aggregate output floor, the Committee agreed to remove the 1.06 scaling factor that is currently applied to RWAs determined by the IRB approach to credit risk..

CVA Risk Framework

• CVA risk was a major source of losses for banks during the global financial crisis. The Committee   has agreed to revise the CVA framework to:

a)Enhance its risk sensitivity – The revised CVA framework takes into account the exposure   component of CVA risk along with its associated hedges. This component is directly related to the price of the transactions that are within the scope of application of the CVA risk capital charge. As these prices are sensitive to variability in underlying market risk factors, the CVA also materially depends on those factors.

b)Strengthen its robustness – As CVA is a complex risk, the Committee is of the view that such a risk cannot be modelled by banks in a robust and prudent manner. The revised framework removes the use of  an internally modelled approach, and consists of: (i) a standardised approach; and (ii) a basic approach. Also, a bank with an aggregate notional amount of non- centrally cleared derivatives less than or equal to €100 billion may calculate their CVA capital charge as a simple multiplier of its counterparty credit risk charge.

c)Improve its consistency – CVA risk is a form of market risk. Hence, the standardised and basic approaches  of  the  revised  CVA  framework  have  been  designed  to  be  consistent with approaches used in the revised market risk framework. The standardised CVA approach, is based on fair value sensitivities to market risk factors and the basic approach is benchmarked to the standardised approach.

Operational Risk Framework

• The financial crisis highlighted two main shortcomings with the existing operational risk   framework.

1. First, capital requirements for operational risk proved insufficient to cover operational risk losses incurred by some banks.

2. Second, the nature of these losses – covering events such as misconduct, and inadequate systems and controls – highlighted the difficulty associated with using internal models

The Committee has streamlined the operational risk framework. The advanced measurement approaches (AMA) for calculating operational risk capital requirements (which are based on banks’ internal models) and the existing three standardised approaches are replaced with a single risk-sensitive standardised approach to be used by all banks.

• The new standardised approach for operational risk determines  a bank’s operational risk capital requirements based on two components:

a)a measure of a bank’s income assuming that operational risk increases at an increasing rate with a bank’s income and

b)a measure of a bank’s historical losses assuming that banks which have experienced greater operational risk losses historically will be more likely to experience them in the future.

•The operational risk capital requirement can be summarised as follows:

where

Business Indicator Component (𝐵𝐼𝐶) = ∑(𝛼_i × 𝐵𝐼_i)

𝐵𝐼  (Business  Indicator)  is  the  sum  of  three  components:  the  interest,  leases  and  dividends component; the services component and the financial component 𝛼 is a set of marginal coefficients that are multiplied by the 𝐵𝐼 based on three buckets (i = 1, 2, 3 denotes the bucket), as given in this table 𝐼𝐿𝑀 (the Internal Loss Multiplier) is a function of the 𝐵𝐼𝐶 and the Loss Component (𝐿𝐶), where the latter is equal to 15 times a bank’s average historical losses over the preceding 10 years. The 𝐼𝐿𝑀 increases as the ratio of (𝐿𝐶/𝐵𝐼𝐶) increases, although at a decreasing rate.

• At national discretion, supervisors can elect to set 𝐼𝐿𝑀 = 1 for all banks in their jurisdiction. This means that capital requirements in such cases would be determined solely by the BIC. Hence, capital requirements would not be related to a bank’s historical operational risk losses. However, for comparability, all banks would be required to disclose their historical operational risk losses.

Leverage Ratio Framework

The Basel III reforms revise the leverage ratio framework in the following ways –

a) Buffer for Global Systemically Important Banks –

The finalized Basel III reforms introduce a leverage ratio buffer for G-SIBs. Such an approach is consistent with the risk-weighted G-SIB buffer, which seeks to mitigate the externalities created by G-SIBs. The leverage ratio G-SIB buffer must be met with Tier 1 capital and is set at 50% of a G-SIB’s risk- weighted higher-loss absorbency requirements. For example, a G-SIB subject to a 2% risk-weighted higher-loss absorbency requirement would be subject to a 1% leverage ratio buffer requirement.

Capital distribution constraints will be imposed on a G-SIB that does not meet its leverage ratio buffer requirement.  The distribution constraints imposed on a G-SIB will depend on its CET1 risk-weighted ratio and Tier 1 leverage ratio. A G-SIB that meets: (i) its CET1 risk- weighted requirements (defined as a 4.5% minimum requirement, a 2.5% capital conservation buffer  and the G-SIB higher loss-absorbency requirement) and; (ii) its Tier 1 leverage ratio requirement (defined as a 3% leverage ratio minimum requirement and the G-SIB leverage ratio buffer) will not be subject to distribution constraints. A G-SIB that does not meet one of these requirements will be subject to the associated minimum capital conservation requirement (expressed as a percentage of  earnings). A G-SIB that does not meet both requirements will be subject to the higher of the two associated conservation requirements.

b) Refinements to the Leverage Ratio Exposure Measure –

In addition to the introduction of  the G-SIB buffer, the Committee has agreed to make various  refinements  to  the  definition  of  the  leverage  ratio  exposure  measure.  These refinements include modifying the way in which derivatives are reflected in the exposure measure and updating the treatment of off-balance sheet exposures to ensure consistency with their measurement in the standardised approach to credit risk.

Jurisdictions may exercise national discretion in periods of  exceptional macroeconomic circumstances to exempt central bank reserves from the leverage ratio exposure measure on a temporary basis. Such jurisdictions would be required to recalibrate the minimum leverage ratio requirement commensurately to offset the impact of excluding central bank reserves, and require their banks to disclose the impact of this exemption on their leverage ratios.

The Committee will review the impact of the leverage ratio on banks’ provision of clearing services and any consequent impact on the resilience of central counterparty clearing.

Output Floor

• An output floor limits the benefits banks can derive from using internal models to calculate   minimum capital requirements. The Basel III reforms replace the existing Basel II floor with a   floor based on the revised standardised approaches. In effect, the output floor provides a risk-   based backstop that limits the extent to which banks can lower their capital requirements relative   to the standardised approaches. This helps to maintain a level playing field between banks using   internal models and those on the standardised approaches. It also supports the credibility of   banks’ risk weighted calculations, and improves comparability via related disclosures.

• Under the revised output floor, banks’ risk-weighted assets must be calculated as the higher of:

(i) total risk-weighted assets calculated using the approaches that the bank has supervisory approval to use in accordance with the Basel capital framework (including both standardised and internal model-based approaches); and (ii) 72.5% of the total risk-weighted assets calculated using only the standardised approaches.

• The standardised approaches to be used when calculating the output floor are as follows:

1. Credit risk – The standardised approach tor credit risk has already been discussed earlier.

2. Counterpartv credit risk – To calculate the exposure for derivatives, banks must use the standardised approach for measuring counterparty credit risk (SA-CCR). The exposure amounts must then be multiplied by the relevant borrower risk weight using the standardised approach for credit risk to calculate RWA under the standardised approach for credit risk.

3. CVA risk – Standardised approach for CVA (SA-CVA), Basic Approach (BA-CVA) or 100% of a bank’s counterparty credit risk capital requirement, as discussed earlier (depending on which approach the bank is eligible for and uses for CVA risk).

4. Securitization framework – External ratings-based approach (SEC-ERBA), the standardised approach (SEC-SA) or a 1250% risk weight

5. Market risk – Standardised (or simplified standardised) approach of the revised market risk framework. The SEC ERBA, the SEC-SA or a 1250% risk weight must also be used when determining the default risk charge component for securitizations held in the trading book.

6. Operational risk – Standardised approach for operational risk. Banks will also be required to disclose their risk-weighted assets based on the revised standardised approaches. Details about these disclosure requirements will be set forth in a forthcoming consultation paper.

• The transitional cap on the increase in RWAs to be set at 25% of a bank’s RWAs before the application of the floor.