Overview of Basel Accord

• Bank for International Settlement (BIS) was established on 17 May 1930 and is the world’s oldest international financial organisation. BIS serves as the Banker to Central Banks and Monetary Authorities in their pursuit of monetary and financial stability, to foster international cooperation and economic, monetary, financial and legal research in those areas and to act as a prime counterparty for central banks in their financial transactions. The BIS currently has 60 members as Central Banks or Monetary Authorities. BASEL Committee on Banking Supervision was established by Central Banks of G-10 countries in 1974.Today BCBS consists of Central Banks and supervisory regulators from 27 countries. BASEL Accords are created by BCBS.
• Agreements must be implemented within each country via local legislation and enforced by local supervision.
• The first Basel Accord, known as Basel I, was issued in Jan1988 and dealt only with Credit Risk. Focused on the capital adequacy of financial institutions. The capital adequacy risk categorized the assets of financial institution into five risk categories (0%, 10%, 20%, 50%, 100%). Banks that operate internationally were required to have a risk weight of 8% or less.
• The second Basel Accord, known as Basel II, was introduced in Nov 2005 and is to be fully implemented by 2015. It focused on three main areas: minimum capital requirements, supervisory review and market discipline which are known as the three pillars. The focus of Basel II was to strengthen international banking requirements as well as to supervise and enforce these requirements. Operational risk was introduced in Basel II.
• The third Basel Accord, known as Basel III was introduced in Dec 2010 and is to be fully implemented by 1 Jan 2019.The global financial crisis of 2007-2008 made risk management a very complex and challenging job that needs constant monitoring and supervision from both, banks and their regulators. This led to creation of BASEL III which is a comprehensive set of reform measures, developed by the BCBS to strengthen the regulation, supervision and risk management of the banking sector& its ability to absorb shocks arising from financial and economic stress.

Evolution of Basel Reform

Banking Book and Trading Book

Three Pillars of Regulation

Summary of Key Basel III Capital Requirements

Capital Type	Minimum Requirement (% of RWAs)
CET1 Capital	4.5%
Tier 1 Capital (CET1 + Additional Tier 1)	6%
Total Capital (Tier 1 + Tier 2)	8%
CCB	2.5%
CET1 + CCB	7% (4.5% + 2.5%)
CET1 + CCB + CCyB	9.5% (7% +2.5%)
Total Capital (Tier 1 + Tier 2) + CCB	10.5% (8% +2.5%)

High Level Summary of Basel III Reforms

Quality and level of capital

Greater focus on common equity. The minimum is raised to 4.5% of RWA after deductions.

Capital loss absorption at the point of non-viability

Contractual terms of capital instruments will include a clause that allows – at the discretion of the relevant authority – write-off or conversion to common shares if the bank is judged to be non-viable. This principle increases the contribution of the private sector to resolving future banking crises and thereby reduces moral hazard.

Capital Conservation Buffer

2.5% of risk-weighted assets, to me met entirely from common equity Tier 1 capital, bringing the total common equity standard to 7%. Constraint on a bank’s discretionary distributions will be imposed when banks fall into the buffer range.

Countercyclical buffer

Imposed within a range of 0-2.5% comprising common equity, when authorities judge credit growth is resulting in an unacceptable build-up of systematic risk.

Securitisations

Strengthens the capital treatment for certain complex securitisations. Requires banks to conduct more rigorous credit analysis of externally rated securitisation exposures.

Trading book

Significantly higher capital for trading and derivatives activities, as well as complex securitisations held in the trading book. Introduction of a stressed value-at-risk framework to help mitigate procyclicality. A capital charge for incremental risk that estimates the default and migration risks of unsecuritised credit products and takes liquidity into account.

Counterparty credit risk

Substantial strengthening of the counterparty credit risk framework. Includes: more stringent requirements for measuring exposure; capital incentives for banks to use central counterparties for derivatives; and higher capital for inter-financial sector exposures.

Bank exposures to central counterparties (CCPs). The Committee has proposed that trade exposures to a qualifying CCP will receive a 2% risk weight and default fund exposures to a qualifying CCP will be capitalised according to a risk-based method that consistently and simply estimates risk arising from such default fund.

Leverage ratio

A non-risk-based leverage ratio that includes off-balance sheet exposures will serve as a backstop to the risk-based capital requirement. Also helps contain system wide build-up of leverage

Supplemental Pillar 2 requirements.

Address firm-wide governance and risk management; capturing the risk of off-balance sheet exposures and securitisation activities; managing risk concentrations; providing incentives for banks to better manage risk and returns over the long term; sound compensation practices; valuation practices; stress testing; accounting standards for financial instruments; corporate governance; and supervisory colleges.

Liquidity coverage ratio

LCR requires banks to have sufficient high-quality liquid assets to withstand a 30-day stressed funding scenario that is specified by supervisors.

Net stable funding ratio

NSFR is a longer-term structural ratio designed to address liquidity mismatches. It covers the entire balance sheet and provides incentives for banks to use stable sources of funding.

Principles for Sound Liquidity Risk Management and Supervision

The Committee’s 2008 guidance Principles for Sound Liquidity Risk Management and Supervision takes account of lessons learned during the crisis and is based on a fundamental review of sound practices for managing liquidity risk in banking organisations.

Supervisory monitoring

The liquidity framework includes a common set of monitoring metrics to assist supervisors in identifying and analysing liquidity risk trends at both the bank and system-wide level.

G SIFI Capital Charge

Global systemically important financial institutions (SIFIs) must have higher loss absorbency capacity to reflect the greater risks that they pose to the financial system. The Committee has developed a methodology that includes both quantitative indicators and qualitative elements to identify global systemically important banks (SIBs). The additional loss absorbency requirements are to be met with Common Equity Tier 1 (CET1) capital requirement ranging from 1% to 3.5%, depending on a bank’s systemic importance.

Market Discipline- Revised Pillar 3 disclosures requirements

The requirements introduced relate to securitisation exposures and sponsorship of off-balance sheet vehicles. Enhanced disclosures on the detail of the components of regulatory capital and their reconciliation to the reported accounts will be required, including a comprehensive explanation of how a bank calculates its regulatory capital ratios.

Market risk: disclosures for banks using the Standardised Method approach Qualitative disclosures: The general qualitative disclosure including the portfolios covered by the standardised approach for market risk needs to be disclosed.

Quantitative disclosures: The capital requirements for: interest rate risk; equity position risk; foreign exchange risk and commodity risk.

Market Risk: disclosures for banks using the IMA approach for trading portfolio.

Qualitative disclosures for IMA

(a)The general qualitative disclosure including the portfolios covered by the IMA. Banks needs to disclose the extent of & methodologies for compliance with the “Prudent valuation guidance” for positions held in the trading book.

(b) Banks need to disclose the soundness standards on which the bank’s internal capital adequacy assessment is based. It should also include a description of the methodologies used to achieve a capital adequacy assessment that is consistent with the soundness standards.

(c)For each portfolio covered by the IMA: the characteristics of the models used; the description of stress testing applied to the portfolio & a description of the approach used for backtesting/validating the accuracy and consistency of the internal models

and modelling processes and the scope of acceptance by the supervisor.

(d)For the IRC charge and the comprehensive risk capital charge, the methodologies used and the risks measured through the use of internal models. Qualitative description should include: the approach & the methodologies used by the bank to determine liquidity horizons & achieve the required capital assessment and the approaches used in the validation of the models.

Quantitative disclosures for IMA

For trading portfolios under the IMA: The high, mean and low VaR , SVaR, incremental and comprehensive risk capital charges values over the reporting period and period-end are to be computed and disclosed. Also a comparison of VaR estimates with actual gains/losses

experienced by the bank, with analysis of important “factors” in backtesting results needs to be disclosed.

Counter Party Credit Risk Capital Charge

CCR is a complex risk to assess. It is a hybrid between credit and market risk and depends on both changes in the creditworthiness of the counterparty and movements in underlying market risk factors. The CVA capital requirement is the capital charge for the risk of loss due to the deterioration in the creditworthiness of the counterparty to a derivatives transaction or a SFT. This potential mark to market loss is known as CVA risk. It captures changes in counterparty credit spreads and other market risk factors such as Delta and Vega risk for IRR, FX risk, reference credit spread risk, equity risk and commodity risk. SFTs only apply for CVA risk if the transactions are fair valued for accounting purposes. Moreover, the capital calculation for CVA risk also exempts direct transactions with a qualified CCP. There

The CVA risk capital requirement is calculated for a bank’s total CVA portfolio on a standalone basis. This calculation takes into account risk-reducing effects, such as netting, collateral arrangements and certain offsetting hedges.

There are three approaches available for calculating CVA risk:

(1) Banks with less engagement in derivatives activities in which they can choose to use their CCR capital requirements as a proxy for their CVA charge. Any bank below a materiality threshold of EUR 100 billion for the aggregate notional amount of non-centrally cleared derivatives may choose to set its CVA capital equal to 100% of the bank’s capital requirement for CCR.

(2) (A) Basic Approach (BA-CVA)- Reduced Version

It is the reduced version for banks that do not actively hedge CVA risk. All banks must calculate the capital requirement under the reduced version of the BA-CVA. This is based on the individual CVA capital requirements computed for each counterparty and a supervisory correlation parameter for credit spreads of any two counterparties. BA-CVA is the summation of both the systematic components and the idiosyncratic components of CVA Risk.

(2) (B) Basic Approach (BA-CVA)- Full Version

It is intended for banks that actively hedge CVA risk. Only single name CDS, single name contingent CDS and index CDS are eligible CVA hedges. Banks using full version of BA-CVA, must calculate the reduced version of BA-CVA.

Capital full version = 0.25 × capital reduced version + 0.75 × capital hedges

(3) Standardised Approach (SA-CVA)

This is the most complex one. It is an adaptation of the SA for market risk and requires regulatory approval. Reporting is Monthly. Banks using SA-CVA, must have a CVA Desk for risk management and hedging of CVA and banks must be able to model exposures and calculate CVA sensitivities to market risk factors. SA-CVA capital requirement is the sum of the capital requirements for delta and vega risks for interest rate risk, FX risks, counterparty credit spread risk, reference credit spread risk, equity risk and commodity risk.

Leverage Ratio

The leverage ratio introduced by Basel III acts as a non-risk-based backstop to the risk-based capital rules. This limits any excessive build-up in leverage. Under this requirement, the Tier 1 capital of the bank must be at least 3% of the bank’s on- and off-balance sheet exposures. The leverage ratio applies to all internationally active banks.

One of the underlying causes of the Great Financial Crisis was the build-up of excessive on- and off-balance sheet leverage in the banking system. The objective of introducing Leverage Ratio is to restrict the build-up of leverage in the banking sector to avoid destabilizing deleveraging processes that can damage the broader financial system and the economy. In simple terms, Leverage Ratio is designed to limit the amount of debt a bank can take relative to its capital and to ensure banks maintain a sufficient capital buffer to absorb potential losses and avoid excessive leverage.

Tier I Capital

Leverage Ratio = —————————————— ≥ 3%

Total exposure

Calculation: Simple arithmetic mean of the monthly leverage ratio over the quarter

Total Exposure = On-balance sheet exposures + Derivative exposures + SFT exposures + Off-balance sheet exposures + Repos

Scope of application: Solo, consolidated and sub-consolidated level

Disclosure: Disclosure of the key elements of the leverage ratio under Pillar 3

G-SIFIs Capital Charges- 1% to 3.5% : indicator-based approach

Global Systemically Important Banks (G-SIBs).

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Revised Pillar 3

disclosures requirements

The requirements introduced relate to securitisation exposures and sponsorship of off-balance sheet vehicles. Enhanced disclosures on the detail of the components of regulatory capital and their reconciliation to the reported accounts will be required, including a comprehensive explanation of how a bank calculates its regulatory capital ratios. During the Great Financial Crisis, the failure of a number of large, globally active Banks and Fis created enormous stress in the financial system and harmed the real economy. The BCBS published a G-SIB methodology in 2011, updating it in 2013 and then again in 2018.

The methodology relies on an indicator-based quantitative approach that aims to capture the systemic importance of a G-SIB. The selected indicators reflect the size of the banks, their interconnectedness, the lack of readily available substitutes or financial institution infrastructure for the services they provide, their global (cross-jurisdictional) activity and their complexity. The G-SIB score can fall into one of five buckets. The methodology, as updated in 2018, clarifies the disclosure requirements that national authorities would set for their G-SIBs, and especially for the 75 largest banks in the world.

G-SIBs are required to hold additional capital, depending on their score. The additional capital requirements start at 1.0% of risk-weighted assets for the lowest bucket, up to a capital requirement of 3.5% of risk-weighted assets for the highest bucket.

Bucketing Approach

Liquidity Coverage Ratio (LCR)

The financial crisis of 2007 highlighted significant lapses in liquidity management among banks, despite adequate capital levels. This led to the development of the LCR as a response to ensure better liquidity risk management. 

• Many banks faced liquidity issues during the financial crisis of 2007 due to poor management practices. 
• The crisis underscored the importance of liquidity in maintaining the stability of financial markets. 
• The Basel Committee published the “Sound Principles” in 2008 to guide banks in liquidity risk management. 

The Liquidity Coverage Ratio (LCR) is a key reform by the Basel Committee aimed at enhancing the short-term resilience of banks’ liquidity risk profiles. It ensures that banks maintain an adequate stock of high-quality liquid assets (HQLA) to meet liquidity needs during a 30-day stress scenario. By then, it is assumed that appropriate corrective action can be taken by management and supervisors, or that the bank can be resolved in an orderly way.

• The LCR requires banks to hold sufficient HQLA to cover total net cash outflows for 30 days. 
• The minimum LCR requirement is set at 100%, meaning HQLA must equal or exceed net cash outflows.
• The LCR aims to reduce the risk of financial spillover to the real economy during stress events. ​

LCR is defined as stock of unencumbered high-quality liquid assets (HQLA) that can be easily and immediately converted into cash in private markets with little or no loss of value to meet their liquidity needs for a 30calendar days under liquidity stress scenario, arising from financial & economic stress.

Stock of Unencumbered High Quality Liquid Assets (HQLA)

LCR = —————————————————————————————- ≥ 100%

Net Cash Outflow Over 30 Calendar Days

The formula for the calculation of the stock of HQLA is as follows:

Stock of HQLA = Level 1 + Level 2A + Level 2B – Adjustment for 15% cap – Adjustment for 40% cap

Where:

Adjustment for 15% cap = Max (Adjusted Level 2B – 15/85*(Adjusted Level 1 + Adjusted Level 2A), Adjusted Level 2B – 15/60*Adjusted Level 1, 0)

Adjustment for 40% cap = Max ((Adjusted Level 2A + Adjusted Level 2B – Adjustment for 15% cap) – 2/3*Adjusted Level 1 assets, 0)

Alternatively, the formula can be expressed as:

Stock of HQLA = Level 1 + Level 2A + Level 2B – Max ((Adjusted Level 2A+Adjusted Level 2B) – 2/3*Adjusted Level 1, Adjusted Level 2B – 15/85*(Adjusted Level 1 + Adjusted Level 2A), 0)

Total net cash outflows over the next 30 calendar days = Total expected cash outflows – Min{total expected cash inflows; 75% of total expected cash outflows}

LCR must be reported at least Monthly, with potential for more frequent reporting in stress situations like Weekly or Daily. The LCR must be monitored in significant currencies to capture potential mismatches. Significant currencies are those with liabilities amounting to 5% or more of total liabilities. The LCR is required to be met in one single currency, but monitoring in significant currencies is essential.

Banks must ensure that the excess of outflows over inflows over a rolling 30day calendar period does not exceed the amount of high-quality liquid assets available to the bank. These liquid assets cover cash, qualifying marketable securities from sovereigns, central banks, PSEs, multilateral development banks as well as other high-quality public and corporate debt and common equity shares. In the absence of any financial stress, LCR has to be 100%. However, during a period of financial & liquidity stress, Banks are allowed to have a lower LCR, thereby falling below 100% and banks can use their stock of HQLA which is intended to serve as a defense against the potential onset of liquidity stress.

The LCR was introduced gradually from 1 January 2015 but the minimum requirement was set at 60% and rose by 10% every year to reach 100% on 1 January 2019. This graduated approach was adopted to ensure no material disruption to the orderly strengthening of banking systems or the ongoing financing of economic activity.

Unencumbered Assets: Unencumbered Assets are those assets which are free of legal, regulatory, contractual or other restrictions on the ability of the bank to liquidate, sell, transfer, or assign the asset.

HQLA in a Nutshell

Net Stable Funding Ratio (NSFR)

The Net Stable Funding Ratio complements the LCR and focuses on the medium and long term source of funding for banks. NSFR is defined as:

Available amount of Stable Funding

Net Stable Funding Ratio = ———————————————– ≥ 100%

Required amount of Stable Funding

Introduction 1 January 2018

Scope of Application Individual Bank-specific

Reporting Quarterly

Disclosure Disclosure of NSFR under Pillar 3

The NSFR requirement means that illiquid loans to customers, with maturities of 12 months or more, need to be matched with funding from internal or external sources with a similar maturity rather than by short term inter-bank lending.

Available amount of Stable Funding (ASF) refers to the reliability of the sources of funding over a one-year horizon.

Required amount of Stable Funding (RSF) refers to the value of assets that require funding. The precise calculations for both ASF and RSF are weighted to reflect the degree of stability of existing liabilities (under ASF) and the level of support a supervisor believes an asset requires (under RSF).

Furthermore, these calculations are subject to a stressed scenario: A significant decline in profitability or solvency arising from heightened credit risk, market risk or operational risk and/ or other risk exposures and/or A potential downgrade in a debt, counterparty credit or deposit rating by any nationally recognized credit rating organization and/or A material event that calls into question the reputation or credit quality of the institution.

ASF = 0% x MAX ((NSFR derivative liabilities – NSFR derivative assets), 0).

NSFR identifies OBS exposure categories based broadly on whether the commitment is a credit or liquidity facility or some other contingent funding obligation.

The risk-based capital charges for CCR in Basel III cover two important characteristics of CCR: the risk of counterparty default and a credit valuation adjustment (CVA). The risk of counterparty default was already covered in Basel I and Basel II. The Basel III reforms introduced a new capital charge for the risk of loss due to the deterioration in the creditworthiness of the counterparty to a derivatives transaction or an SFT. This potential mark-to-market loss is known as CVA risk. It captures changes in counterparty credit spreads and other market risk factors. CVA risk was a major source of unexpected losses for banks during the Great Financial Crisis.

Capital Conservation Buffer Ratio (CCB)

The objective is to protect the banking system against potential future losses. It ensures that banks build up capital buffers in normal times to absorb losses during periods of stress which can be drawn down as losses are incurred. It is 2.5% of Total RWA. Comprises of Common Equity Tier 1 (CET 1) and is established above the regulatory minimum capital requirement. Capital distribution constrains are imposed on a bank when capital levels fall within this range. Banks will be able to conduct business as normal when their capital levels fall into the conservation range as they experience losses. The constraints imposed only relate to distributions, not the operation of the bank.

Thus, CCB is a permanent buffer for general resilience. Applies at all times and not discretionary. Whenever the CCB falls below 2.5%, the Bank automatically faces restrictions on dividends, bonuses, and share buybacks.

Individual bank minimum capital conservation standards

Common Equity Tier 1 Ratio Minimum Capital Conservation Ratios Required (%)

4.5% – 5.125% 100.00%

>5.125% – 5.75% 80.00%

>5.75% – 6.375% 60.00%

>6.375% – 7.0% 40.00%

> 7.0% 0.00%

Countercyclical Buffer Ratio (CCyB)

Banks are subject to a countercyclical buffer that varies between 0 and 2.5% of Total RWA. The countercyclical buffer aims to ensure that banking sector capital requirements take account of the macro-economic and financial environment in which banks operate. It will be deployed by national jurisdictions when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure the banking system has a buffer of capital to protect it against future potential losses. Each Basel Committee member jurisdiction will identify an authority with the responsibility to make decisions on the size of the countercyclical capital buffer. This will vary between zero and 2.5% of total risk weighted assets (RWA).

Thus, CCyB is activated by regulators when excessive credit growth signals systemic risk. It is designed to cool down lending booms and release capital in downturns. Varies by country and economic conditions (discretionary). It is an adjustable tool to counter credit cycles.

Output Floors

The 2017 reforms replace the existing capital floor with a more robust, risk sensitive output floor based on the revised standardised approaches. Jurisdictions have not implemented the existing floor consistently, partly because of differing interpretations of the requirement and also because it is based on Basel I standards, which many banks and jurisdictions no longer apply.

The revised output floor limits the amount of capital benefit a bank can obtain from its use of internal models, relative to using the standardised approaches. • Banks’ calculations of RWAs generated by internal models cannot, in aggregate, fall below 72.5% of the risk-weighted assets computed by the standardised approaches. This limits the benefit a bank can gain from using internal models to 27.5%.

*In addition, at national discretion, supervisors may cap the increase in a bank’s total RWAs that results from the application of the output floor during its phase-in period. The transitional cap on the increase in RWAs will be set at 25% of a bank’s RWAs before the application of the floor. The cap will be removed on 1 January 2027.