7. Bank regulation Basel I-III

• The Basel Committee on Banking Supervision (BCBS) was formed in 1974 to address globalization challenges in financial and banking markets

• Basel Accords: Develops guidelines and standards for banks (Basel I, II, III).

• first global regulatory framework for banks

• main focus: credit risk

• Minimum capital requirement: It established a minimum capital adequacy ratio of 8%.

• introduced the concept of risk-weighted assets to assess the level of risk associated with different types of assets

Basel I does not consider market risk

—> amendment introduced capital charge for market risk associated with all items in trading book except

• debt and equity traded securities

• positions in commodities and foreign exchange

• RWA for trading book items computed using VaR

Pillar 1 —>Minimum Capital Requirements

Pillar 2 —>Supervision

Pillar 3 —>Market discipline

Minimum capital Requirements

—>for credit and operational risk

Operational risk: basic indicator, standardized, AMA

Three approaches for credit risk:

Formula for translating PD, LGD, EAD, M (effective maturity) into a risk weight

1. Standardized Approach

   • Banks and corporations treated similarly

2. Foundation Internal Rating-based

   • Bank estimates PD, Basel II guidelines determine other variables

3. Advanced Internal Rating-based

   • Banks estimate all variables

Supervision

1.          Banks should have process for assessing capital adequacy related to risk profile + strategy for maintaining capital level

2.          Supervisor should evaluate point 1 & banks’ ability to monitor & ensure compliance w/ regulatory capital ratios —> take action if not satisfied

3.          Supervisors should expect & have ability to require banks to hold capital > min. requirement

4.          Supervisors should intervene before capital falls below min. requirement —> remedial action if capital is not maintained or restored

Market discipline

Banks should disclose:

-               Entities in banking group

-               Terms & conditions of capital instruments

-               Tier 1 capital instruments & amount of capital for them

-               Tier 2 capital amount

-               Capital requirements for credit, market and operational risk

Changes in Computation of market risk

Introduction of:

• Stressed VaR for market risk

  • Capital requirements now VaR + sVaR

  • sVaR from 250 day period of stressed market conditions

• Incremental risk charge (ICR)

  • Ensure that products like bonds & credit derivatives in the trading book have the same capital requirement as if they were in the banking book

• Comprehensive risk measure

  • Ensure that enough capital is kept for instruments depending on default correlations in the trading book

• Capital Conservation Buffer: Banks are required to maintain an additional capital buffer to absorb losses during periods of stress (additional 2.5%)

• Countercyclical Capital Buffer: Provides an additional buffer that can be activated during periods of excessive credit growth to address systemic risks (up to 2.5%)

• Leverage Ratio: Introduces a non-risk-based leverage ratio to limit excessive leverage in the banking sector

  • Ratio of tier 1 capital to total exposure must be > 3%

Liquidity must be ensured short- and long-term by keeping:

• Liquidity Coverage ratio:

  High quality assets > cash outflows over 30 days (short-term)

• Net Stable Funding Ratio:

  Stable funding > required amount of stable funding (long-term)

Credit Valuation Adjustment:

• Adjustment to value of transactions with a counterparty to allow for possibility of a counterparty default

—> Basel III requires market risk capital for CVA risk arising from changing credit spreads

• aims to address shortcomings in the previous trading book framework (specifically under Basel 2.5) and improve the accuracy of capital requirements for market risk

• introduction of stressed ES

  • Expected shortfall (CVaR) (97.5%; 250d) replaces VaR (99%)

  • 2 approach

• Introduction of stress-based risk measures

• Process for non-modellable risk factors

1. Internal Models approach:

   • Calculate ES based on overlapping 10-day periods

1. Standardized Approach (Trading desk level)

• Instruments with similar risk characteristics are grouped into buckets

• capital charge for each desk = sum of

  1. risk charge

1. default risk charge (to consider jump to default)

2. residual risk add-on

Calculation of ES based on stress periods (like in Basel II.5)

• Can take a subset of market variables accounting for 75% of current ES

• Es is then scaled up

• introduction of two capital buffers

• Non-risk measure leverage ratio

• Liquidity ratios

• market risk capital for CVA

• Systemic risk