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Introduction to Basel III

Copyright 2011 Tata Consultancy Services


Limited

Agenda
Background
Liquidity Risk Management
Capital & Leverage
Counterparty Credit Risk
Market risk

Objective
The objective of WBT (web based training) on Introduction to Basel III
is to provide high level overview of Basel III

Prior knowledge / experience in Basel II is mandatory for this WBT

Basel III Highlights

Stress calibration of CCR measures


New risk measure CVA for MTM losses
CVA Capital Charge Adv & Std
Pillar 1 RWA for Specific Wrong Way Risk
AVC multiplier for exposures to FI
Increased margin period & collateral haircuts
Incentives to move to CCP

Increase in quality and quantity of capital


New Capital deductions from CET1 (DTA)
Increase in minimum capital ratios
Capital buffers, Leverage Ratio , Capital
Surcharge (SIFI)

Capital

Counterparty
Credit Risk

Increased MR Specific Risk Charge for


equities, credit derivatives
Enhanced VaR modeling, MR stress
testing guidelines
New risk measures - Incremental Risk
Charge, Stressed VaR

Market Risk

Basel III
Pillar 2 &
Pillar 3**
Enhanced Pillar 2 guidelines for
Securitisation, illiquid positions, wrong way
risk, Model Validation, Back Testing, Credit
Rating Agencies
Enhanced disclosures for Securitisation
exposures in Trading Book, Market Risk,
Counterparty Credit Risk (incl. Wrong Way
Risk)

Securitisation
Liquidity
Risk

Liquidity Coverage Ratio (LCR) High


quality liquid assets to sustain a significant
30-day stress scenario
Net Stable Funding Ratio (NSFR) - stable
sources of funding ( 1 year horizon)
Monitoring metrics - Contractual maturity
mismatch, Concentration of funding,
Available unencumbered Assets, Marketrelated monitoring tools

Higher risk weights for resecuritisations


Banks not permitted to use Ratings
resulting from self-guarantees
Increased CCF for Liquidity facilities
Specific Risk Charge alignment across
Banking Book & Trading Book
New measure CRM for Correlation
Trading Portfolio

** Not in scope
for this WBT

Key Timelines Basel III

5
Source : BCBS Basel III Timelines

Liquidity Risk Management


LRM Introduction

Fundamental Principles of LRM as per BCBS


LRM Basel III Key Changes
LRM Functional View
LRM Data Sources
LRM Liquidity Risk Measures
LRM Capital & Liquidity Gap under Basel III An
example
LRM Monitoring
LRM Stress Test
LRM Governance - Principles & Supervision
LRM Public Disclosures
LRM Summary
6

Liquidity Risk Management (LRM) - Genesis


In 2008 & 2009, BCBS published Principles for Sound Liquidity Risk Management & Supervision & a
consultative document, proposing new measures to strengthen liquidity regulations in the banking sector.
The BIS guidelines for LRM published under BCBS144*, 165* & 188* require all banks to significantly enhance
their liquidity risk infrastructure & functionality in providing granular liquidity-related data, in-depth analysis &
reporting
The two key metrics introduced under Basel III- LRM are
Liquidity Coverage Ratio (LCR)
Net Stable Funding Ratio (NSFR)
There are other monitoring tools which includes Contractual Maturity Mismatch, Concentration of Funding,
Instruments & Currencies & tracking of Available Unencumbered Assets.
A strong Governance Model should be put in place to develop , review & approve strategies, policies &
practices related to management of liquidity effectively

BCBS *LRM
Papers

Assessment
Impact Analysis

Implementation

Observation

Liquidity Reporting

2008 - 2010

2010 - 2011

2011 2012

2013 2015

2015 - 2018

*BCBS - 165 International Framework for Liquidity Risk Measurement, Standards & Monitoring
*BCBS - 144 Principles for Sound Liquidity Risk Management & Supervision
*BCBS 188 - International framework for liquidity risk measurement, standards & monitoring

Liquidity Risk Introduction (1/4)


One of the main reasons the economic and financial crisis became so severe was that
the banking sectors of many countries had built up excessive on- and off-balance sheet
leverage.
This was accompanied by a gradual erosion of the level and quality of the capital base.
At the same time, many banks were holding insufficient liquidity buffers.
The banking system therefore was not able to absorb the resulting systemic trading and
credit losses nor could it cope with the re-intermediation of large off-balance sheet
exposures that had built up in the shadow banking system.
The crisis was further amplified by a procyclical deleveraging process and by the
interconnectedness of systemic institutions through an array of complex transactions
Basel Committee, Strengthening the resilience of the banking sector consultative document

Liquidity Risk Introduction

(2/4)

Asset and liability mismatch generates not only interest rate


risk liquidity risk
Different meaning of liquidity:
Security ease with which it can be cashed back or traded, even
in large amounts, on a secondary market

Market liquidity of the securities traded in the market


different proxies of liquidity (e.g. bid-ask spread, volume)
Affected by many factors: n. market participants, size & frequency of trades, degree of
informational asymmetry, time needed to carry out a trade
Function of tightness (markets ability to match supply and demand at low cost) and depth
(ability to absorb large trades without significant price impact)

Financial institution ability to fund increases in assets and


meet obligations as they come due, without incurring high losses
Generally proxied by the difference between the average liquidity of assets and that of
liabilities

Liquidity Risk Introduction..(3/4)


Selling assets
at a price below
their market
value

Inability to
payback
liabilities

Unforeseen
Usage of
Credit lines

Events
leading to
Liquidity Risk

transformation
of
short-term
deposits into
long-term loans

Prepayment of
loans

10

LRM Introduction..(4/4)
8

Difficulty providing sufficient


and timely assets for
transactions increases

Party A fails to fulfill


liquidity to execute
transaction

2
Accrued difficulty to fund
ongoing bank activity on
the interbank market

Long-term
funding risk

Transactional
Liquidity
Risk

Other counterparties
Subsequently lack liquidity,
creating trust issues
in the market

6
Banks compete for
increasingly smaller pool
of liquidity

Tradability
risk

Part of banks existing


liquidity buffer de facto
becomes illiquid

Market
liquidity risk

Market refrains
from providing
liquidity

Uncertain, lower-quality
assets are no longer
accepted for trade or
collateral against liquidity

Liquidity Risk Vicious Cycle

11

Fundamental Principles of LRM as per BCBS


Fundamental principle
1.A bank needs to establish a robust liquidity risk management framework
Governance of liquidity risk management
2.A bank should clearly articulate a LR tolerance appropriate for its business strategy and role
3.Senior management needs to be actively involved in LRM
4.Liquidity costs need to be factored into internal transfer pricing, so that LR is considered adequately
Measurement & management of liquidity risk
5.A bank should have sound a process for identifying, measuring, monitoring and controlling LR
6.A bank should actively monitor and control LR exposures throughout the group and take into account legal, regulatory and
operational limitations to the transferability of liquidity
7.A bank should establish a funding strategy for effective diversification of sources / tenor of funding
8.A bank should actively manage its intraday liquidity positions and risks
9.A bank should actively manage its collateral positions
10.A bank should conduct stress tests regularly and use the results to adapt strategy / positions
11.A bank should have a formal contingency funding plan
12.A bank should maintain a cushion of high quality liquid assets as insurance against a range of liquidity stress
scenarios (see International framework for LRM)
Public Disclosure
13.A bank should issue regular public disclosure on LRM and positions
Role of supervisors
14.Comprehensive assessment of liquidity risk management framework
15.Monitoring of internal reports, prudential reports & market information
16.Effective and timely intervention (New)
17.Communication with other supervisors and public authorities
12

LRM Basel III - Key Changes

# Basel III - LRM 2010 BCBS Guidelines


* ALM Guidelines
^ LCR Liquidity Coverage Ratio
% NSFR Net Stable Funding Ratio

13

LRM Functional View


Banks Assets and Liabilities
ALM Data

Cash Flow Data

Quantitative Analysis
Risk Models

Simulations

Transaction
Data

Position Data

LRM Components
LCR

NSFR

Reconciliation

Public Disclosures
Daily Cash Flow Reports
Enhanced Mismatch Reports
Local Regulators(OSFI,APRA ..)
Disclosures

Reference
Data

Pricing /
Valuation

Historical Data

Cash Flow Engine


Cash Outflow
Cash Inflow

Monitoring Tools

Scenario Analysis

Maturity Mismatch

Stress Testing

Funding Concentration

Extreme Stressed Scenario

Market Monitoring

Stressed Cash Flow

Unencumbered Assets

Limits Management

LCR by Currency

Behaviour Analysis

Governance & Liquidity Policies

Regulatory Requirements

14

LRM Data Sources


Source System Data

Cash Flows
Transaction Data
Position Data
Reference Data
Market Data
Security Data
Historical Data
Internal Limits

Categorize Data

LRM Ready Data

ON Balance Sheet / OFF Balance Sheet


Banking Book / Trading Book
Data Hierarchy / Liquidity Category
Legal Entity / Business Units
Reporting Lines
Asset / Liability

Analytics Data
Stressed Data
Ratio Calculation Data
Forecasting Data
Limits Data
Reporting Data
Exception Data

Data Mapping / Business Rules / Reconciliation

Transformation
Source Target Data Check
Data Validation / Integrity Check
Data Reconciliation
Defaulting / Enrichment / Aggregation / Limit

15

LRM Liquidity Risk Measures

(1/9)

Basel Committee has developed two standards to be used in


supervision of liquidity risk.
1.The Liquidity Coverage Ratio, addresses the sufficiency of a stock of
high quality liquid assets to meet short-term liquidity needs under a
specified acute stress scenario.
2.The Net Stable Funding Ratio, addresses longer term structural
liquidity mismatches.

Source: http://www.liquidity-coverage-ratio.com
16

LRM Liquidity Risk Measures..(2/9)


The liquidity coverage ratio identifies how much of unencumbered, high
quality liquid assets an institution needs to hold, which can be used to
offset the net cash outflows under an acute short-term stress scenario
specified by supervisors.
The scenario entails:
a significant downgrade of the institutions public credit rating;
a partial loss of deposits;
a loss of unsecured wholesale funding;
a significant increase in secured funding haircuts; and
increases in derivative collateral calls and substantial calls on
contractual and non contractual off-balance sheet exposures, including
committed credit and liquidity facilities.

Source: http://www.liquidity-coverage-ratio.com
17

LRM Liquidity Risk Measures..(3/9)


Liquidity Coverage Ratio (LCR)
Aims to ensure adequate level of unencumbered high quality liquid assets which can be liquidated
during stress scenarios to endorse net cash outflow for the next 30 calendar days.

LCR =

Stock of High quality liquid assets (HQLA)


-------------------------------------------------- 100%
Net cash outflows over a 30-day time period

Liquidity Coverage Ratio


Defines level of liquidity buffer to be held to cover short-term funding gaps under
severe liquidity stress
Has a Cash flow perspective
Predefined stress scenario
Time horizon: 30 days

18

LRM Liquidity Risk Measures..(4/9)

High Quality Liquid Assets


There are two categories of assets that can be included in the stock
namely Level 1 & Level 2.
Level 1 assets can be included without limit while Level 2 assets
can only comprise 40% of the stock.
These Level 1 & Level 2 assets are considered to be high-quality
liquid assets (HQLA) if they can be easily and immediately converted
into cash at little or no loss of value.
The liquidity of an asset depends on the underlying stress scenario,
the volume to be monetised and the timeframe considered.

19

LRM Liquidity Risk Measures..(5/9)


Level 1 Assets
Assets can comprise an unlimited share of pool, are held at market value and are not subject to haircut under LCR
Cash
Central Bank Reserve
To the extent that can be drawn during stress times
Marketable Securities
Representing claims guaranteed by sovereigns, central banks, PSEs, BIS ,
IMF 0% risk weight according to Basel II Standardized Approach
Non 0%risk-weighted sovereigns
Sovereign or central bank debt securities issued in domestic currencies by the sovereign or central bank in the
country
Domestic sovereign or central bank debt securities issued in foreign currencies,

Level II Assets
Subject to the requirement that they comprise no more than 40% of overall stock after haircuts have been applied
Level I assets generated by secured funding transactions maturing within 30 days
Corporate Bonds and Covered Bonds
Not issued by any financial institutions or bank itself or respective affiliated entities
Rated AA- or higher by ECAI
Marketable securities
Representing claims guaranteed by sovereigns, central banks, PSEs, BIS , IMF
Maximum of 20% risk weight according Basel II Standardized Approach

20

LRM Liquidity Risk Measures..(6/9)


The asset price calculation formula of highquality assets should be simple and not
depend on strong assumptions.
Portfolios should have least
correlation

Ease and
Certainty of
Valuation
Low
Correlation
With Risky
Assets

Listed on
Recognized
Stock
Exchange
Being listed increases assets
transparency.

These assets tend to have higher


liquidity. Low credit and market risk
lowers duration, volatility, inflation
risk and foreign exchange risk
enhancing asset's liquidity.
Low Credit
And Market
Risk

Fundamental
Characteristic
of HQLA
Unencumbered
Asset

Eligible for
Intraday
Liquidity Needs

Unencumbered Asset shouldn't be


pledged as a collateral except for
some exceptions

Eligible by central bank for intraday liquidity


needs.
21

LRM Liquidity Risk Measures..(7/9)

Asset should have active outright


sale or repurchase agreement
markets at all times

Historically, the market has shown


tendencies to move into these
types of assets in a systemic crisis
Active and
Sizeable
Market

Presence
of Committed
Market
Makers
Quotes will most likely be available
for buying and/or selling a highquality liquid asset.

Flight to
Quality

HQLA Market
Characteristic
Low Market
Concentration
Diverse group of buyers and sellers
in an assets market increases the
reliability of its liquidity

22

LRM Liquidity Risk Measures..(8/9)


Available Stable Funding (ASF)
Net stable Funding Ratio

= --------------------------------------------Required Stable Funding (RSF)

RSF Factor

100%

ASF Factor

Liabilities
Assets

Long
Term
Funding

Short Term Funding

0 % - 50 %

Unencumbered
Assets

0 % - 50 %

Non Core Deposit

70 %

Consumer loans

85 % - 100 %

Core Deposit

85 % - 100 %

Long Term Funding

100 %

Equity

100 %

Corporate Loans

50 % - 100 %

Inter Bank Loans

50 % - 100 %

Long
Term
Funding

23

LRM Liquidity Risk Measures..(9/9)


NSFR promotes medium to long-term funding thus reducing incentives for
short-term wholesale funding and supplements the LCR (by counterbalancing
cliff-effects)
The stress scenario is defined differently from the one underlying the LCR
idiosyncratic stress over 1 yr
Stable funding is defined as those types of equity and liabilities expected to
be reliable sources of funds under an extended stress scenario of one year
For determination of the required funding amount accounting and regulatory
treatment is irrelevant required funding amount depends solely on the
respective instruments liquidity characteristics

24

ABC Banks Capital & Liquidity Gap under Basel III..(1/2)


ABC bank faces material shortfalls of both tier 1 and tier 2 capital under Basel III
The planned business growth leads to a potential material breach of the upcoming maximum leverage ratios
Under the upcoming mandatory liquidity ratios, the bank would be obliged to hold at least 200m additional
liquid funds in order to sustain the LCR Funding test
As a consequence, the banks plans need to be materially adapted in order to reflect the additional capital
and liquidity needs of Basel III

Basel III Impact

2011

2012

2013

2014

2015

RWA banking book

1600

1899

2282

2726

3270

RWA trading
book(x12.5)

938

1078

1240

1426

1640

Total RWA

2538

2977

3522

4152

4910

Required Tier I
capital under Basel
III

114

149

194

270

344

Required total
capital under Basel
III

228

268

370

436

516

RWA under Basel


III

25

ABC Banks Capital & Liquidity Gap under Basel III..(2/2)


Basel III Impact

2011

2012

2013

2014

2015

Tier I Capital
shortfall

42

50

13

-42

-88

Total Capital
shortfall

10

23

-76

-103

-137

Leverage ratio
under Basel III

31X

29X

34X

37X

40X

Maximum leverage
3%

33X

33X

33X

33X

33X

Adjustment need

2X

4X

-1X

-4X

-7X

Basel III LCR


funding gap

-200

Basel III LTFR


(observation)

141%

137%

130%

126%

123%

Capital shortfall
under Basel III

Leverage ratio
limitations

Liquidity ratios

26

LRM Cash Flow (1/3)


Total Cash Outflows
Total expected cash outflows = Outstanding balances of various categories or types of liabilities and
off-balance sheet commitments * rates at which they are expected to run off or be drawn down.
Total expected cash inflows = Outstanding balances of various categories of contractual receivables *
rates at which they are expected to flow in under the scenario up to an aggregate cap of 75% of total
expected cash outflows

Total Net Cash outflows over the next 30 calendar days = outflows - Min (Inflows; 75% of
outflows)

27

LRM Cash Flow (2/3) Cash Outflow Categorization


Retail
Deposit
Run offs

Secured
Wholesale
Funding Run-offs

Unsecured
Wholesale
Funding Run-offs

Additional
Requirements

Deposits from an
individual
natural person

Secured Funding
collateralized
by level 1 assets (run-off
rate = 0%)

Provided by small
business customers
(5%, 10%, 15% and
higher)

Derivatives Payable
(run-off rate = 100%)

Retail depositsSubject
to LCR include demand
deposits and term
deposits

Secured Funding
collateralized
by level 2 assets (run-off
rate = 15%)

Funding with
operational relationships
(run-off rate = 25%)

Valuation change on
posted collateral
securing derivative
transaction of non-Level 1
Asset (run-off rate = 20%)

Stable deposits
(run-off rate = 5% or
higher)

Secured Funding with


domestic sovereigns,
central banks, or PSEs
(run-off rate = 25%)

Treatment of deposits in
institutional networks of
cooperative banks (run-off
rate = 25%)

Liabilities related to
derivative collateral calls
related to a downgrade of
up to 3-notches.(run-off
rate = 100%)

Less stable deposits


(run-off rate = 10% or
higher)

All other Secured


funding (run-off rate =
100%)

Provided by Non-financial
corporate, sovereigns,
central bank and PSEs
(run-off rate = 75%)

Liabilities maturing within


30 calendar days
(outflow rate = 100%)

Other Legal entity


customers
(run-off rate = 100%)

Draw-downs on credit and


liquidity facilities have
different run off rates
Other Contractual cash
outflows (outflow rate =
100%)
28

LRM Cash Flow (3/3) Cash Outflow categorization


Reverse Repo and
Securities
Borrowings
Level I assets
if collateral not
used to cover
short positions 0%
if collateral used
to cover short
positions- 0%
Level II assets
if collateral not
used to cover
short positions15%
if collateral used
to cover short
positions 0 %
All other collateral
if collateral not
used to cover
short positions 100%
if collateral used
to cover short
positions - 0%

Inflows by
Counterparty

Operational
Deposits

Credit or
Liquidity Facility

Derivatives
Receivable
(Inflow rate = 100%)

Retail and Small


Business
Inflow (inflow rate =
50%)

Inflow rate is 0%
since deposits held
at other institution
for operational
purpose are
assumed to
stay with institution

For all the remaining


contractual
inflows,its inflow
rate is
decided by the
supervisor

Other wholesale
Inflow
100% inflows
from financial
institution
counterparties
50% inflow rate
for non- financial
wholesale
counter parties

The draw-down rate


is 0%
since Credit,
liquidity, or any other
contingent funding
that bank holds at
other institution for
its own purpose are
assumed to be
unable to be drawn
in stress times.

Other Cash
Inflows

Valuation changes
on posted collateral
securing derivative
transactions of nonLevel 1 Assets (runoff rate = 20%)

Liabilities related to
derivative collateral
calls related to a
downgrade of up to
3-notches.(run-off
rate = 100%)
29

LRM Monitoring (1/4)


Contractual maturity used as
behavior model
Measures time to insolvency
No short-term funding is rolled
over

Equity prices, debt markets,


Forex markets etc
Monitoring financial sector
Monitoring bank specific

To monitor concentration of
Counterparty , Product and
Currency
Funding should be
diversified

Contractual
Maturity
Mismatch

Funding
Concentration

Market
Monitoring

Unencumbered
Assets
(i) Eligible for collateral, or, (ii)
Eligible for central bank facilities
Amount , Currency denomination
Estimated market haircut
Location/Business unit
30

LRM Monitoring (2/4) Maturity Mismatch Report

31

LRM Monitoring (3/4) - Funding Concentration Report

32

LRM Monitoring (4/4) Market Monitoring


Asset Type wise

Geography wise
$7,471,425
$58,744,523

$65,656,875

North America
Latin America
Africa

$69,852,365

EMEA

$58,874,125

Asia
APAC

$5,869,854
$25,852,541

BRIC
AUSTRALIA

$9,854,758

$6,502,521
Bonds

Options*

$5,878,962

$258,524

$6,985,425

Forwards*
Equities
Money Market

$7,035,319

Portfolio wise
$1,325,822

Banking & Finance


Aviation

5.0000%
5.0000%

4.2000%

$14,568,752

$25,658,415

1.2000%
4.2000%

3.0000%

Emerging Markets

Oil and Gas

Blue Chips

Construction

Infrastructure

Telecommunication

1.0000%

1.2000%

$25,874,152

Futures*

Information Technology

4.2000%

3.0000%

$85,241

Swaps*

Returns Quarterly
1.0000%

$685,214

Forex *

Energy & Utilities

Food and Drinks

$6,515,852

Mining

Transport

Technology

$5,236,517

33

LRM Stress Test (1/2) - Guidelines


A bank should conduct stress tests on a regular basis for a variety of short-term and protracted
institution-specific and market-wide stress scenarios (individually and in combination) to identify sources
of potential liquidity strain and to ensure that current exposures remain in accordance with a banks
established liquidity risk tolerance.
A bank should use stress test outcomes to adjust its liquidity risk management strategies, policies, and
positions and to develop effective contingency plans.

This stress test should be viewed as a minimum supervisory requirement for banks.
Banks are expected to conduct their own stress tests to assess the level of liquidity they should hold
beyond this minimum, and construct their own scenarios that could cause difficulties for their specific
business activities.
Such internal stress tests should incorporate longer time horizons than the one mandated by this
standard. Banks are expected to share the results of these additional stress tests with supervisors.
Refer Basel III: International framework for liquidity risk measurement , standards & monitoring Para 19

34

LRM Stress Test (2/2) - Methodology

Identify Liquidity
Risk Drivers

Erosion in value of
liquid assets
Additional collateral
requirements
Evaporation of
funding
Withdrawal of
deposits etc

Design Stress
Scenarios (and
Probabilities)
External scenarios
Emerging markets
crisis,systemic shock
in maincentres of
business,market risk
Internal scenarios
Operational risk,
ratings Downgrade
Ad-hoc scenarios
e.g. Country/industry
specific

Model Stress
Tests
Step 1
Quantify liquidity
outflows in all scenarios
for each risk driver
Step 2
Identify cash inflows to
mitigate liquidity
shortfalls identified

Step 3
Determine net liquidity
position under each
scenario

35

LRM Governance Principles & Supervision


Key Highlights of Committees Proposal
Key elements
Of robust
framework for
liquidity risk
management

Governance of
liquidity
Risk Management

Measurement
and
Management of
Liquidity risk

Public Disclosure

The Role of
supervisors

Board and senior


management oversight

Clearly articulate
liquidity risk tolerance
for
business strategy

Identifying, measuring,
monitoring and
controlling liquidity risk

Disclose information
On regular basis

regularly perform a
comprehensive
assessment

Establishment of
policies and risk
tolerance

Strategy policies
and practices in tandem
with risk tolerance

Projecting cash flows


from assets, liabilities
and off- B/S items

Market participants to
make an informed
judgment

Monitoring combination
of internal , prudential
reports and mkt info

Comprehensive cash
flow
forecasting

Incorporate
liquidity costs

Actively manage Intraday liquidity positions

Incorporate benefits and


risks in
internal pricing

Actively manage
collateral positions

performance measure
& new product
approval process

Conduct stress tests


on a regular basis

Limits and liquidity


scenario stress testing
Robuust and
multifaceted
contingency
funding plans
Maintenance of
sufficient
cushion of HQLA

Communicate with other


supervisors and
public authorities

Contingency funding
plan that addressing
liquidity shortfalls

36

LRM Public Disclosures


A bank needs to disclose sufficient information regarding its liquidity risk management to enable
relevant stakeholders to make an informed judgment about the power of the bank to meet its
liquidity needs
These include quantitative & qualitative disclosures such as
Organizational structure and framework for the management of liquidity risk
The degree to which the treasury function and liquidity risk management is centralized or
decentralized
The aspects of liquidity risk to which the bank is exposed and that it monitors
Diversification of the bank's funding sources
Explanation of how stress testing is used
Description of the stress testing scenarios modeled
Regulatory restrictions on the transfer of liquidity among group entities.
The frequency and type of internal liquidity reporting
Regulatory reports like LCR, NSFR & Maturity mismatch
Drilldown reports Portfolio wise, Fund concentration, Cash flows and Aggregate Reports

37

LRM Summary
Background
The recent credit crisis compounded quickly into a major liquidity crunch leading to insolvency of major
financial institutions
Inadequate liquidity management in almost all banks
No dedicated liquidity buffer or liquidity portfolio in banks

BCBS Response

17 Principles for Sound Liquidity Risk Management and Supervision ( BCBS 144).
Importance of managing liquidity contingency buffer similarly as capital
Maintaining High Quality liquidity portfolio that can hedge out liquidity outflows under stress scenarios
Improved Risk Policies, Procedures & Governance to be reviewed & implemented

Action on Banks
The Basel III Liquidity regulation imposes significant challenges to banks for enhancing existing liquidity
measurement and management methods
Improved Governance Policies for Liquidity Risk ( Review, Modify)
Sophisticated scenario based approach ( Stressed Scenarios) for LRM
Completely Revamp their Liquidity Risk System to include Calculation of LCR, NSFR and Monitoring
Tools as per BCBS papers
Periodically inform Regulator about their LRM approach and get necessary guidance & approval
38

Basel III - Capital Requirements


What changes in Basel III

Composition of Capital
Capital Adjustment
Former deduction from capital
Capital Conservation Buffer
Counter Cyclical Buffer
Leverage Ratio
Summary

39

Why Basel II has changes

Basel II key
weakness

Many regulatory adjustments


are not applied to common
equity, allowing to report high
Tier 1 ratios
No harmonized list of regulatory
adjustments

Hybrid capital proved to be less


valuable in times of stress than
anticipated

Basel II
key changes

Raising the quality,


consistency and transparency
of the capital base

Reducing procyclicality and


promoting countercyclical
buffers

Supplementing the riskbased capital requirement


with a leverage ratio

40

Composition of Common Equity Tier 1 Capital


Common shares issued by the
bank that meet the criteria for
classification as common
shares for regulatory purposes
(or the equivalent for non-joint
stock companies);
Stock surplus (share
premium) resulting from the
issue of instruments included
Common Equity Tier 1;

Regulatory adjustments
applied in the calculation of
Common Equity Tier 1

Common
Equity Tier 1
Common shares issued by
consolidated subsidiaries of
the bank and held by third
parties (ie minority interest)
that meet the criteria for
inclusion in Common Equity
Tier 1 capital.

Retained earnings;

Accumulated other
comprehensive income and
other disclosed reserves;

41

Composition of Additional Tier 1 Capital

Instruments issued by the bank that


meet the criteria for inclusion in
Additional Tier 1 capital (and are not
included in Common Equity Tier 1);

Regulatory
adjustments
applied in the
calculation of
Additional Tier 1
Capital

Additional
Tier 1 Capital

Stock surplus
(share premium)
resulting from the
issue of
instruments
included in
Additional Tier 1
capital;1;

Instruments issued by consolidated


subsidiaries of the bank and held by
third parties that meet the criteria for
inclusion in Additional Tier 1 capital
and are not included in Common
Equity Tier 1.

42

Composition of Common Equity Tier 1 Capital


Instruments issued by the
bank that meet the criteria
for inclusion in Tier 2 capital
(and are not included in Tier
1 capital)

Stock surplus (share


premium) resulting from
the issue of instruments
included in Tier 2 capital

Regulatory adjustments
applied in the calculation
of Tier 2 Capital

Common
Equity Tier 1

Certain loan loss


provisions

Instruments issued by
consolidated subsidiaries
of the bank and held by
third parties that meet the
criteria for inclusion in
Tier 2 capital and are not
included in Tier 1 capital

43

Capital adjustments
Capital
Adjustment

Goodwill and other


intangibles (except
mortgage servicing
rights)

Shortfall of the stock of


provisions to expected
losses

Deferred tax assets

Gain on sale related to


securitisation transactions

Cash flow hedge reserve

Defined benefit pension


fund assets and liabilities

Investments in own
shares (treasury stock)

Reciprocal cross holdings


in the capital of banking,
financial and insurance
entities
%)

44

Former deductions from capital


Treatment

The following items, which under Basel II were deducted 50% from Tier 1 and 50% from Tier 2 (or had
the option of being deducted or risk weighted), will receive a 1250% risk weight:
Certain securitisation exposures;

Certain equity exposures under the PD/LGD approach;

Non-payment/delivery on non-DvP and non-PvP transactions;

Significant investments in commercial entities

45

Capital Conservation Buffers


Background

The capital conservation buffer, which is designed to ensure that banks build up capital buffers outside
periods of stress which can be drawn down as losses are incurred.

Requirement

A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the
regulatory minimum capital requirement

Restriction

Mentioned below are the minimum capital conservation ratios a bank must maintain for various levels
of the Common Equity Tier 1 (CET1) capital ratios
Common Equity Tier 1 Ratio is 4.5% - 5.125% then the MCCR (Minimum Capital Conservation
Ratios) to be maintained is 100%
Common Equity Tier 1 Ratio is >5.125% - 5.75% then the MCCR to be maintained is 80%
Common Equity Tier 1 Ratio is >5.75% - 6.375% then the MCCR to be maintained is 60%
Common Equity Tier 1 Ratio is >6.375% - 7.0% then the MCCR to be maintained is 40%
Common Equity Tier 1 Ratio is > 7.0% then the MCCR to be maintained is 0%

46

Counter Cyclical Buffers


Background

The countercyclical buffer regime consists of the following elements:


National authorities will monitor credit growth and other indicators that may signal a build up of
system-wide risk and make assessments of whether credit growth is excessive and is leading to
the build up of system-wide risk
Internationally active banks will look at the geographic location of their private sector credit
exposures and calculate their bank specific countercyclical capital buffer

Disclosure

Public disclosure of how the bank is calculating the countercyclical buffers .

Restrictions

Each Basel Committee member 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 risk weighted assets, depending on their judgment as to the
extent of the build up of system-wide risk
If a bank's capital level falls into the extended buffer range, they would be given 12 months to get
their capital level within the acceptable range before restrictions on the distributions of their earnings
come into effect. Any decision to decrease Countercyclical Buffer will take effect immediately. The
Buffer decisions along with the actual Buffers will be announced on the BIS website

47

Leverage Ratio

What is leverage ratio

constrain the build-up of leverage in the banking sector, helping


avoid destabilising deleveraging processes which can damage
the broader financial system and the economy; and

reinforce the risk based requirements with a simple, non-risk


based backstop measure.

48

Calculation of Leverage Ratio


Total Capital
Leverage Ratio

Capital measure
The capital measure for the leverage
ratio will be based on the new
definition of Tier 1 capital
Items that are deducted completely
from capital do not contribute to
Leverage and will be deducted from
the measure of exposure

= --------------------------------------------Total On and Off Balance Sheet Exposure

Exposure measure
General measurement principles
On-balance sheet items
(a) Treatment of Repurchase agreements
and securities finance
(b) Treatment of Derivatives
Off-balance sheet items

49

Summary
Composition of Tier 1 capital and Tier 2 Capital.
Phasing out of Tier 3
Requirement of Capital Conservation Buffers
Restriction related to Capital Conservation Buffer
Requirement of Counter Cyclical Buffers
Restriction related to Counter Cyclical Buffer
Composition of Leverage Ratio
Parallel run for Leverage ratio

50

Agenda
Counterparty Credit Risk (CCR) - Introduction
Changes in Basel III on CCR
Other Changes
Wrong Way Risk
Credit Valuation Adjustment (CVA)

Types of CVA Capital Charges


Types of Aggregation of CCR Capital Charges

Qualitative Criteria
Other measures
Summary

51

Counterparty Credit Risk (CCR) - Introduction


What is CCR ?
The counterparty credit risk (CCR) is defined as the risk that the counterparty to a
transaction could default before the final settlement of the transactions cash flows.
In 2007,the financial crisis spread to financial market causing systematic risk, preparing
the context to analyze impact on derivatives and financial risk management on
counterparty credit risk (CCR).
CCR covers loans and repo transactions, and most importantly, the enormous volume of
over-the-counter (OTC) derivatives.
Unlike a firms exposure to credit risk through a loan, where the exposure to credit risk is
unilateral and only the lending bank faces the risk of loss, the counterparty credit risk
creates a bilateral risk of loss - the market value of the transaction can be positive or
negative to either counterparty to the transaction

52

Changes in Basel III on CCR

Other Measures

Qualitative Criteria

Specific Wrong Way Risk

General Wrong Way Risk

Aggregation of CCR Capital

CVA Capital Charge

Wrong Way Risk

Credit Valuation Adjustment

CCR Focus Areas

Changes in Basel III on Counterparty Credit Risk (CCR)?


Basel III introduces measures to strengthen the capital requirements for Counterparty for
counterparty credit exposures arising from banks derivatives, repo and securities financing
activities. The building blocks as described in the diagram above are explained in later
slides.

- 53 -

53

Other changes - CCR Reform Objectives


Why CCR reform ?
The Reform Objectives for Counterparty Credit Risks as in Basel III are as follows
Determine capital requirement for counterparty credit risk using stressed inputs
Introduce a capital charge for potential mark-to-market losses (ie credit valuation
adjustment - CVA - risk) associated with a deterioration in the credit worthiness of a
counterparty
Apply longer margining periods as a basis for determining the regulatory capital
requirement
Address the systemic risk arising from the interconnectedness of banks and other
financial institutions through the derivatives markets
Address the treatment of so-called wrong-way risk, ie cases where the exposure
increases when the credit quality of the counterparty deteriorates

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

54

Other Changes - Counterparty Credit Risk (CCR)


Key Terms
What is Exposure?
A few Key Terms are Introduced below
Counterparty exposure is the larger of zero and the market value of the portfolio of
derivative positions with a counterparty that would be lost if the counterparty were to
default and there were zero recovery. Counterparty exposures created by OTC
derivatives are usually only a small fraction of the total notional amount of trades with a
counterparty
Expected positive exposure (EPE) is the average Expected Exposure EE(t) for t in a
certain interval (for example, for t during a given year).
Potential future exposure (PFE) is the maximum amount of exposure expected to
occur on a future date with a high degree of statistical confidence.

55

Wrong Way Risk


Wrong-way risk is an unfavourable correlation between exposure and counterparty credit quality (i.e.
the exposure is high when the counterparty is more likely to default and vice versa).
Wrong-way risk is often difficult to define. For example, general empirical evidence supports a
clustering of U.S. corporate defaults during periods of falling interest rates.
If users of derivatives are hedging then they should generate right-way risk.

?
56

Types of Wrong Way Risk


The following are the Types of Wrong Way Risk
General Wrong-Way Risk arises when the probability of default of counterparties is positively
correlated with general market risk factors.
Specific Wrong-Way Risk arises when the exposure to a particular counterpart is positively correlated
With the probability of default of the counterparty due to the nature of the transactions with the
counterparty.

?
57

Specific Wrong Way Risk


A bank is exposed to specific wrong-way risk if future exposure to a specific counterparty is highly
correlated with the counterpartys probability of default.
For example, a company writing put options on its own stock creates wrong way exposures for the
buyer that is specific to the counterparty.
A bank must have procedures in place to identify, monitor and control cases of specific wrong way risk,
beginning at the inception of a trade and continuing through the life of the trade.
For single-name credit default swaps , EAD equals the full expected loss in the remaining fair value of
the underlying instruments with the assumption that the underlying issue is in liquidation

?
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

58

General Wrong Way Risk


General Wrong-Way Risk arises when the probability of default of counterparties is positively
correlated with general market risk factors.
Stress testing and scenario analyses must be designed to identify risk factors that are positively
correlated with counterparty credit worthiness.
Banks should monitor general wrong way risk by product, by region, by industry, or by other categories
that are related to the business.

?
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

59

Credit Valuation Adjustment (CVA)


Credit value adjustment (CVA) is the difference between the risk-free portfolio value
and the true portfolio value that takes into account the possibility of a counterpartys default..
This adjustment can be either positive or negative, depending on which of the two counterparties
bears the larger burden to the other of exposure and of counterparty default likelihood
Example

For example, assume Party X is the Euro receiver in a Euro-US dollar currency swap, where the midmarket valuation is 100. Assume this valuation already includes an effective market value of 2 for the
default risk to Party X, but the swap carries a net market value of default risk (to Party X) of 6. Then
the CVA is a downward adjustment of 4, leaving a fair market value of (to Party A) of 96

60

Types of Credit Valuation Adjustment (CVA) Capital Charge

Types of
CVA Capital Charge

Banks with IMM approval


and Specific Interest Rate
Risk VaR model approval
for bonds Advanced CVA risk capital
charge

All other banks standardised CVA risk


capital charge

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

61

Aggregation of CCR Capital Charge


Types of Aggregation
of
CCR Capital Charge

Banks with IMM approval


and market-risk internalmodels approval for the
specific interest-rate risk
of bonds

All other banks


Banks with IMM approval
and without Specific Risk
VaR approval for bonds

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

62

Banks with IMM approval and Market-risk Internal


Models approval for the Specific Interest-rate Risk of Bonds

Further details : The total CCR capital charge for such a bank is determined as the sum of the following
components
The higher of (a) the IMM capital charge based on current parameter calibrations for
EAD and (b) the IMM capital charge based on stressed parameter calibrations for EAD.
The advanced CVA risk capital charge

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

63

Banks with IMM approval and without Specific Risk VaR


approval for Bonds
Further details : The total CCR capital charge for such a bank is determined as the sum of the following
components
The higher of (a) the IMM capital charge based on current parameter calibrations for
EAD and (b) the IMM capital charge based on stressed parameter calibrations for EAD.
The standardised CVA risk capital charge

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

64

All Other Banks


Further details : The total CCR capital charge for such a bank is determined as the sum of the following
components
The sum over all counterparties of the CEM or SM based capital charge (depending on
the banks CCR approach) with EAD
The standardised CVA risk capital charge

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

65

Qualitative requirements
Basel has prescribed certain qualitative measures to cover the inadequacies in banks margining
practices, backtesting and stress testing program
The banks using the Internal Model Methods (IMM) are required to follow these qualitative
requirements .

?
66

Other measures Enhanced Collateral Management Requirement


Qualitative Criteria
The Bank must have a collateral management unit that is responsible for calculating and
making margin calls, managing margin call disputes and reporting levels of independent
amounts, initial margins and variation margins accurately on a daily basis.
The unit is required to track the extant of reuse of collateral and the concentration to
individual asset classes accepted by the bank.
The enhanced collateral management process is to enable the bank more reliable data
which can be used in PFE and EPE calculations.

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

67

Other measures - Enhanced requirements regarding re-use of


collateral
Qualitative Criteria
The nature of collateral is consistent with the Banks liquidity strategy and enable the
banks ability to post or return collateral in time.

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

68

Other measures - Treatment of highly leveraged counterparties


Qualitative Criteria
The Basel Committee prescribes qualitative requirement indicating that the PD estimates
for highly leveraged counterparties should reflect the performance of their assets based on a
stressed period.
PD estimates for borrowers that are highly leveraged or for borrowers whose assets are
mostly traded assets must reflect the performance of the underlying assets based on
periods of stressed volatilities.

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

69

Other measures - Requirements for stress testing of CCR


models 1/3
Qualitative Criteria
Banks are required to have have a comprehensive stress testing program for counterparty
credit risk.
The stress testing is required to include main the key elements:
Banks must ensure complete trade capture and exposure aggregation across all forms
of counterparty credit risk
For all counterparties, banks should produce, at least monthly, exposure stress testing
of principal market risk factors to proactively identify, and when necessary, reduce
outsized concentrations to specific directional sensitivities.
Banks should apply multifactor stress testing scenarios and assess material nondirectional risks (ie yield curve exposure, basis risks, etc) at least quarterly.
Multiple-factor stress tests should, at a minimum, aim to address scenarios in which
a) severe economic or market events have occurred;
b) broad market liquidity has decreased significantly; and
c) the market impact of liquidating positions of a large financial intermediary.

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

70

Other measures - Requirements for stress testing of CCR


models 2/3
Qualitative Requirements
Stressed market movements have an impact not only on counterparty exposures, but also
on the credit quality of counterparties.
At least quarterly, banks should conduct stress testing applying stressed conditions to the
joint movement of exposures and counterparty creditworthiness.
Exposure stress testing (including single factor, multifactor and material non-directional
risks) and joint stressing of exposure and creditworthiness should be performed at the
counterparty-specific, counterparty group and aggregate bank-wide CCR levels.
Stress tests results should be integrated into regular reporting to senior management.
The analysis should capture the largest counterparty-level impacts across the portfolio,
material concentrations within segments of the portfolio (within the same industry or region),
and relevant portfolio and counterparty specific trends.

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

71

Other measures - Requirements for stress testing of CCR


models 3/3
Qualitative Requirements
A The severity of factor shocks should be consistent with the purpose of the stress test.
When evaluating solvency under stress, factor shocks should be severe enough to capture
historical extreme market environments and/or extreme but plausible stressed market
conditions.
The impact of such shocks on capital resources should be evaluated, as well as the impact
on capital requirements and earnings. For the purpose of day-to-day portfolio monitoring,
hedging, and management of concentrations, banks should also consider scenarios of lesser
severity and higher probability.
Banks should consider reverse stress tests to identify extreme, but plausible, scenarios that
could result in significant adverse outcomes.
Senior management must take a lead role in the integration of stress testing into the risk
management framework and risk culture of the bank and ensure that the results are
meaningful and proactively used to manage counterparty credit risk.
At a minimum, the results of stress testing for significant exposures should be compared to
guidelines that express the banks risk appetite and elevated for discussion and action when
excessive or concentrated risks are present.
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

72

Other measures - Back testing and model validation guidelines for


CCR 1/3
Qualitative criteria
The Basel committee identified significant shortcomings in the banks ability to conduct back
testing and model validation and made recommendations. Only those banks in full
compliance with the qualitative criteria will be eligible for application of the minimum
multiplication factor. The qualitative criteria include:
The bank must conduct a regular program of back testing, i.e. an ex-post comparison of the
risk measures45 generated by the model against realised risk measures, as well as
comparing hypothetical changes based on static positions with realised measures.
The bank must carry out an initial validation and an on-going periodic review of its IMM
model and the risk measures generated by it. The validation and review must be
independent of the model developers.
The board of directors and senior management should be actively involved in the risk
control process and must regard credit and counterparty credit risk control as an essential
aspect of the business to which significant resources need to be devoted. In this regard, the
daily reports prepared by the independent risk control unit must be reviewed by a level of
management with sufficient seniority and authority to enforce both reductions of positions
taken by individual traders and reductions in the banks overall risk exposure.
banks
exposure.
Source:overall
Basel III: A risk
global regulatory
framework for more resilient banks and banking systems, rev June 2011
73

Other measures - Back testing and model validation guidelines for


CCR 2/3
Qualitative criteria
The banks internal risk measurement exposure model must be closely integrated into the
day-to-day risk management process of the bank. Its output should accordingly be an
integral part of the process of planning, monitoring and controlling the banks counterparty
credit risk profile
The risk measurement system should be used in conjunction with internal trading and
exposure limits. In this regard, exposure limits should be related to the banks risk
measurement model in a manner that is consistent over time and that is well understood by
traders, the credit function and senior management.

Banks should have a routine in place for ensuring compliance with a documented set of
internal policies, controls and procedures concerning the operation of the risk measurement
system. The banks risk measurement system must be well documented, for example,
through a risk management manual that describes the basic principles of the risk
management system and that provides an explanation of the empirical techniques used to
measure counterparty credit risk.
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

74

Other measures - Back testing and model validation guidelines for


CCR 3/3
Qualitative criteria
A review of the overall risk management process should take place at regular intervals
(ideally no less than once a year) and should specifically address, at a minimum:
The adequacy of the documentation of the risk management system and process;
The organisation of the risk control unit;
The integration of counterparty credit risk measures into daily risk management;
The approval process for counterparty credit risk models used in the calculation of
counterparty credit risk used by front office and back office personnel;
The validation of any significant change in the risk measurement process;
The scope of counterparty credit risks captured by the risk measurement model;
The integrity of the management information system;
The accuracy and completeness of position data;
The verification of the consistency, timeliness and reliability of data sources used to
run internal models, including the independence of such data sources;
The accuracy and appropriateness of volatility and correlation
assumptions;
The accuracy of valuation and risk transformation calculations; and
The verification of the models accuracy as described
Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

75

Other measures - Increase margin period of risk for collateralised trades


1/2
Other measures
Basel committee introduces indicators of when to compel the banks to extend the margin
period of risk is extended to 20 business days for netting sets where
(a) the number of trades exceeds 5,000 or
(b) the set contains illiquid collateral or OTC derivatives that can not be replaced in
the market place
Banks with a history of margin call disputes on a netting set which exceeds the margin
period of risk will be required to double the applicable margin period of risk for the affected
netting set.

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

76

Other measures - Increase margin period of risk for collateralised trades


2/2
Other measures
Product Minimum holding period

Transaction Type

Minimum holding
period

Condition

Repo-style
transaction

5 business days

Daily re-margining

Other capital market


transactions

5 business days

Daily re-margining

Secured lending

20 business days

Daily revaluation

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

77

Other measures - Capital charges for exposures to CCP

Other measures
In order to prudently manage the systematic risks, the Basel Committee introduces
incentives to the banks to move the trades to central counterparty clearing house (CCP)
with exposure to CCPs assigned low risk weights.
The favorable treatment of exposures to CCPs applies only where the qualifying CCPs
complies with the standards set by
the Committee on Payment and Settlement System (CPSS) and
the International Organization of Securities commissions (IOSCO).

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

78

Other measures - Standard haircut for securitization collateral


Other measures
Basel committee has introduced a new recalibrated supervisory haircuts (assuming markto-market, daily re-margining and 10-buiness day holding period) expressed as a
percentage. Supervisory haircuts for collateral are as follows:

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

79

Other measures - Expected positive exposure(EPE)


calculated based on stressed input
Other measures
Effective expected positive exposure (EEPE) is required to be calculated using a threeyear period of stress
IMM banks are required to calculate EAD using current market data and compare this
with the EAD using current parameters
Wherever stressed EEPE exceeds the EEPE calculated using current market data, the
former will be used for the portfolio-level capital charge.

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

80

Other measures - Changes in External Ratings


Other measures
Banks are required to choose ECAI and use their rating consistently in order to eliminate
Cherry picking of assessments. In parallel, the use of unsolicited ratings is allowed subject
to certain conditions and supervisory control
The measures eliminates undesirable benefits where unrated exposures could have
received lower risk-weights than those of non-investment grade ratings
The requirement for eligible guarantors to be rated A- or better has been removed except
in the case of securitization exposures for Cliff effect.

Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011

81

Summary
The financial crisis necessitated reforms in Basel accord and Basel III came into being.
One of the key emphasis in the Basel III accord is the risk coverage of Counterparty
Credit Risk (CCR).
Credit Valuation adjustment(CVA) is introduced into a capital charge.
CVA capital charge differs based of approval status of the Bank and are of three types.
Aggregation of CCR and CVA charge is dependant on types of approval status of the
banks and are of two types.
Management of Wrong way risk is addressed in the Basel III.
Wrong way risk are of two types - Specific and general wrong way risk.
There are qualitative criteria and other measures for management of CCR risk

82

Agenda
Basel II vs. Basel II.5
Summary of Market Risk updates
Correlation Trading Portfolios
Specific Risk Charges
Resecuritization
Stressed VaR (sVaR)
Incremental Risk Charges
Comprehensive Risk Measures (CRM)
Summary
83

Basel II vs. Basel 2.5


In July 2009 the Basel Committee on Banking Supervision published the revisions to the Basel II market risk framework
(also known as Basel 2.5) and Enhancements to the Basel II framework. Summary of the proposed revisions are stated
below

Basel II.5

Basel II

Underestimation of losses under


normal market conditions

Uncertainty about re-securitization


exposures

Underestimation of exposure in
banks trading books to credit-risk
related products whose risk is not
reflected in VaR

20% CCF to short term eligible


liquidity facilities within the
securitization framework

4% RW treatment for liquid and


diversified portfolios for specific
risk capital charge for equities

Stressed VaR for banks using VaR


models in the trading book

New Incremental Risk Capital


Charge for IRB banks

Higher risk weights for resecuritizations in the banking book

The CCF for short-term eligible


liquidity facilities within the
securitization framework is changed
from 20% to 50%

Removal of concessionary 4% RW
treatment for liquid and diversified
portfolios

84

Summary of Market Risk updates


Market Risk updates
Standardized Approach
Specific risk charge for correlation
portfolios

Internal Measurement Approach


trading

Specification of Market risk factors

Specific risk charge for securitization

Amendment of qualitative standards

Specific risk charge for credit derivatives

Stressed VaR

Specific risk charge for equities

Specific risk charge for Interest rate sensitive


positions

Risk weights for resecuritization

Incremental Risk Charge (IRC)

CCF for securitization liquidity facilities

Comprehensive Risk Measures (CRM)

85

Correlation Trading Portfolios


In the past, banks did not hold sufficient capital for specific risk and thats where large losses arose
from trading credit derivatives and securitization positions. So, in Basel II.5 major changes have
been introduced in relation to the calculation of specific risk
The correlation trading portfolio is for specific risk and is treated separately

Correlation Trading Portfolio


Correlation trading portfolio is defined by Basel Committee to incorporate securitization
exposures and n-th-to-default credit derivatives that meet the following criteria
An n-th-to-default credit derivatives contract is the one where the derivative is triggered in the
event of a specified number (n) of defaults out of a pool of underlying assets

Correlation Trading Portfolio Criterion


The positions should not be re-securitization positions, nor derivatives of securitization
exposures that do not provide a pro-rate share in the proceeds of a securitization tranche
All reference entities are single-name products, including credit derivatives, for which a liquid
two-way market exists. It also includes traded indices based on these reference entities
Hedges for these instruments are also included, provided they also meet the criteria
mentioned above
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

86

Specific Risk Charge - for Correlation Portfolios


Standardized Approach
The bank computes
(i) Total specific risk capital charges that would apply just to the net long positions from the net
long correlation trading exposures combined, and
(ii) Total specific risk capital charges that would apply just to the net short positions from the
net short correlation trading exposures combined.
The larger of these total amounts is then the specific risk capital charge for the correlation
trading portfolio. The risk weights are the same as for non-correlation securitization.

Internal Model Approach


Under Internal Model Approach, the correlation trading portfolio is a limited exception that
applies to securitized products where banks may be allowed to apply a Comprehensive Risk
Measure (CRM). In broad terms, this will allow the bank to combine the measurement of
specific risk and Incremental Risk Charge for these portfolios.

Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

87

Specific Risk Charge - for Securitization (1/2)


Due to demand for yield by investors and desire of banks to move assets off their balance sheets to
free up the capital resulted in rapid growth in the credit derivatives. Banks share of the market for
credit securities exceed their share of any other market.

In order to eliminate the trading book/ banking book arbitrage the Basel Committee introduced
changes to specific risk charges for securitization in trading book

Standardized Approach
Under this approach the bank computes the specific risk of the securitization positions in the
trading book using the same method, used for such positions in banking book.

Table below gives the Securitization Risk Weights for Standardized Approach

Resecuritization exposures are subject to specific risk capital charges depending on whether
or not the exposure is senior
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

88

Specific Risk Charge - for Securitization (2/2)


Internal Rating Based Approach
If the bank have an approval to use Internal Rating Based (IRB) Approach, in the banking book
a more granular table of risk weights will be used for the securitization positions in the trading
book.
Table below shows the securitization risk weights for IRB Approach

Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

89

Specific Risk Charge - for Credit Derivatives


First to default credit derivative
Specific risk charge is set as lesser of the
Sum of the specific risk charges for all of individual reference credit instruments in the basket,
and
Maximum possible credit event payment under the contract.
Some offset is allowed if the reference entities hedge parts of the banks exposure

N-th-to-default credit derivative


Specific risk charge is set as lesser of the
Sum of the specific risk capital charge for the individual reference credit instrument but
disregarding (n-1) obligations with the lowest specific risk charges, and
Maximum possible credit event payment under the contract.

No offset is allowed for these derivatives if it hedges a reference entity in trading book

Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

90

Specific Risk Charge for Equities


Basel II
The capital charge for specific risk will be 8%, unless the portfolio is both liquid and
well-diversified, in which case the charge will be 4%. National authorities will have discretion to
determine the criteria for liquid and diversified portfolios.
The general market risk charge will be 8%.

Basel II.5
The capital charge for specific risk and for general market risk will each be 8%

Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

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Resecuritization under Standardized Approach


What is Resecuritization ?
A resecuritization exposure is a securitization exposure in which the risk associated with an underlying pool of
exposures is tranched and at least one of the underlying exposures is a securitization exposure.
Definition of resecuritization captures collateralized debt obligations (CDOs) of asset-backed securities (ABS)
including, for example, a CDO backed by residential mortgage-backed securities (RMBS).

Risk weights for resecuritization


Risk weights applicable for resecuritization exposures are added for Standardized approach
as well as IRB Approach, to reflect that they are riskier

Source: Enhancements to the Basel II framework: BIS: July 2009

92

Resecuritization under IRB Approach


Risk weights for resecuritization
Banks using the internal ratings-based (IRB) approach to securitization will be required to apply higher risk
weights to resecuritization exposures
The ratings-based approach risk weight tables were modified to add two additional columns for resecuritization
exposures as shown below.

Source: Enhancements to the Basel II framework: BIS: July 2009

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CCF for Securitization liquidity facilities SA


Basel II
The Standardized Approach of the Basel II framework applies a
20% CCF to commitments with a maturity under one year, and
50% CCF to commitments over one year
Eligible liquidity facilities under one year in the Standardized Approach securitization framework
receive a 20% CCF, while those over one year receive a 50% CCF

Basel II.5
The CCF for short-term eligible liquidity facilities within the securitization framework is changed
from 20% to 50% to be consistent with the CCF applied to long-term eligible liquidity facilities

Source: Enhancements to the Basel II framework: BIS: July 2009

94

Specification of Market Risk Factors


An important part of a banks internal market risk measurement system is the specification of an
appropriate set of market risk factors, i.e. the market rates and prices that affect the value of the
banks trading positions.

Apart from the existing guidelines specified under Basel II, following addition guidelines are
prescribed.
Although banks will have some discretion in specifying the risk factors for their internal models, the
following guidelines should be fulfilled.

Additional Guidelines
Factors deemed relevant for the pricing of instruments should be incorporated as risk
factors in VaR model.
The amendment re-emphasizes that the models must capture non-liner risk of options and
other relevant products (e.g. mortgage backed securities, tranched exposures or n-th-todefault credit derivatives)
VaR models should also capture the correlation risk and basis risk of products (e.g.
between credit default swaps and bonds)
Where proxies are used, a good track record for estimating the risk of the actual position
should exist
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

95

Amendment of Quantitative Standards


Apart from existing quantitative standards specified under Basel II for the calculation of capital
charge using VaR models, following additional quantitative standards have been incorporated

Additional Quantitative Standards


The regulatory capital requirement is based on estimating a 10-day 99% VaR figure. In
most implementations of VaR models this is achieved by following equation:
(1 day VaR)* Square root (10) = 10 Day VaR
Using the square root of time makes a number of implicit assumptions. In the new
regulations the bank has to prove that there is no underestimation of the risk when using
this method
Market data update period have been shorten to one month from three months, to ensure
that models adjust more quickly to market volatility
The bank must also make provision to be able to update the data sets more frequently if
required

Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

96

Stressed VaR (sVaR): Introduction


Why Stressed VaR ?

Losses in most banks trading books during the financial crisis were significantly higher than the minimum
capital requirements under the Basel II Pillar 1 market risk rules.

The Basel Committee therefore requires banks to calculate a stressed value-at-risk taking into account a oneyear observation period relating to significant losses

What is Stressed VaR ?

It is VaR based on a one-year observation period relating to significant losses (additional to the VaR based on
the most recent one-year observation period)

In terms of capital requirements, the capital estimate for sVaR is added to capital requirement for VaR

sVaR estimate must be calculated at least on a weekly basis

Purpose of Stressed VaR ?

To reduce the pro-cyclicality of the minimum capital requirements for market risk and to increase the overall
level of capital

It is intended to replicate VaR for the banks current portfolio if the relevant market factors were experiencing a
period of stress

Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

97

Stressed VaR: Guidelines


Key Guidelines

No particular model is prescribed for the calculation of sVaR, so long as each model used captures all the
material risks run by the bank

On a daily basis, a bank must meet the capital requirement (c) given by the expression:

Maximum of its
Previous days value-at-risk number
(VaRt-1); and
Average of the daily value-at-risk
measures on each of the preceding
sixty business days (VaRavg), multiplied
by a multiplication factor (mc)

Maximum of its
Latest available stressed-value-at-risk
number (sVaRt-1); and
Average of the stressed value-at-risk
numbers over the preceding sixty business
days (sVaRavg), multiplied by a multiplication
factor (ms)

The multiplication factors mc and ms will be set by individual supervisory authorities on the basis of their
assessment of the quality of the banks risk management system, subject to an absolute minimum of 3 for m c
and an absolute minimum of 3 for ms

Data sets update every month and reassess whenever a material change in market prices takes place

Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

98

Treatment of Specific Risk: Interest Rate Positions


Key Guidelines
Banks are allowed to include specific risk for equity and interest rate risk positions in their VaR
model.
For interest rate risk positions, the bank will not be required to subject these positions to the
standardized capital charge for specific risk, if following conditions are met
The bank has a value-at-risk measure that incorporates specific risk and the supervisor has
determined that the bank meets all the qualitative and quantitative requirements for general
market risk models

The supervisor is satisfied that the banks internally developed approach adequately captures
incremental default and migration risks for positions subject to specific interest rate risk
The specific risk VaR model must include all the material components of price risk and be
sensitive to changes in market conditions and portfolio composition. The model should
explain the historical price variation in the portfolio
capture concentrations (magnitude and changes in composition)
be robust to an adverse environment
capture name-related basis risk
capture event risk
be validated through back-testing
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

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Incremental Risk Charge (IRC): Introduction


What is IRC ?

Incremental Risk Charge (IRC) is an additional charge to the trading book meant to capture Default risk and
Credit Migration Risk. It measures losses due to default and migration for unsecuritized credit products, at the
99.9% percent confidence interval over a capital horizon of one year

Default Risk is the potential for direct loss due to obligors default, as well as the potential for indirect loss that
may arise from a default event

Credit Migration Risk is the potential for direct loss due to internal/ external rating downgrade or upgrade as
well as the as the potential for indirect loss that may arise from a credit migration event

Why IRC was introduced ?

During the financial crisis a number of major banking organizations experienced large losses, most of which
were sustained in banks trading books.

Most of these looses were not captured in the 99%, 10-day VaR since the losses had not arisen from actual
defaults but rather from credit migrations combined with widening of credit spreads and the loss of liquidity

Purpose of IRC ?

To address the shortcoming of regulatory capital model

To produce an estimate of default and credit migration risks of unsecuritized credit products over a year capital
horizon at 99.9 % confidence level

Source: Guidelines for computing capital for incremental risk in the trading book : BIS: July 2009

100

IRC: Estimation & Coverage


Estimation of IRC

IRC only applies to banks adopting the internal model approach and that seek to model specific risk in the
trading book

Capital charge for IRC will be estimated as, C= max (IRCt-1, mc *IRCavg)
Maximum of its
Previous days Incremental Risk measure (IRCt-1); and
Average of the Incremental Risk Charge measures over 12 weeks
(IRCavg), multiplied by a multiplication factor (mc)

IRC will be measured at least on a weekly basis

Positions covered under IRC

IRC will be calculated on all positions that are subjected to a capital charge for specific interest rate risk according to
Internal Models Approach to specific market risk, but that are not subject to treatment outlined for unrated securities
under Basel II framework

With supervisory approval, the bank may choose to include all listed equity and derivative positions, based on the listed
equity of a company, in its incremental risk model when the inclusion is consistent with how the bank internally measures
and manages this risk at the trading desk level

Securitization positions are excluded from IRC, even when they are viewed as hedging underlying credit instruments
held in the trading account

Source: Guidelines for computing capital for incremental risk in the trading book : BIS: July 2009

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IRC: Supervisory Requirements


Key Supervisory parameters for IRC

Soundness standard: IRC must adhere to a soundness standard comparable to IRB approaches in the banking book

Constant level of risk over one-year capital horizon: This measure must take into account the liquidity horizons
applicable to individual trading positions. Trading positions are rebalanced at the end of their liquidity horizons to achieve
a constant level of risk

Liquidity horizon: The liquidity horizon must be measured under conservative assumptions and should be sufficiently
long that the act of selling or hedging, in itself, does not materially affect market prices. The liquidity horizon for a position
or set of positions has a floor of three months

Correlation: IRC should include correlations between defaults and migrations, which are caused by economic and
financial dependence among obligors. The correlations between default and migration risks and other market factors in
the VaR model are excluded and no diversification is allowed when capital is calculated

Concentration: IRC should reflect issuer and market concentrations. Considering , other things being equal, a
concentrated portfolio should attract a higher capital charge than a more granular portfolio

Risk mitigation and diversification effects: Netting of exposures is only allowed if the instruments are exactly the
same. IRC model should take significant basis risk into account. IRC must include the impact of potential risks that could
occur during the interval between the maturity of the instrument and the liquidity horizon

Optionality: IRC model must reflect the impact of optionality. This should include the nonlinear impact of options and
other positions with material nonlinear behavior with respect to price changes. The bank should have an understanding
of the model risk associated with estimation of price risks

Source: Guidelines for computing capital for incremental risk in the trading book : BIS: July 2009

102

IRC: Modelling
Modelling the IRC
Modelling the IRC is a complex task, two models have been implemented by the banks to do
this
Jump diffusion model
Merton model
Jump Diffusion Model: In this model, in addition to a Brownian Motion term, the price process
of the underlying is allowed to have jumps. The risk of these jumps is assumed to not be
priced. This model is not very popular due to issues such as problems with calibration of the
jumps to actual migration or default probabilities
Merton Model: It is a simulation based model used by majority of the banks for assessing the
default risk.
In deriving data to use in the IRC model one should use market estimates for estimating
probabilities of default and hence implied migration probabilities
The market data from products such as CDS strips can be used to determine forward default
probabilities
The effect of seniority or other instrument specific characteristics must be incorporated within
the estimates for loss given default
Source: Guidelines for computing capital for incremental risk in the trading book : BIS: July 2009

103

Comprehensive Risk Measures (CRM)


What is CRM ?
Under Internal Model Approach, for correlation trading portfolio the banks may be allowed to
apply a Comprehensive Risk Measure (CRM). This will allow the bank to combine the
measurement of specific risk and Incremental Risk Charge for correlation trading portfolios

Estimation of CRM
CRM applies to banks adopting the internal model approach and that seek to model specific
risk and IRC for correlation trading portfolio
Capital charge for CRM will be estimated as, C= max (CRMt-1, mc *CRMavg)
Maximum of its
Previous days Comprehensive risk measures (CRMt-1); and
Average of the Comprehensive risk measures over 12 weeks (CRMavg),
multiplied by a multiplication factor (mc)

Capital charges for CRM and IRC are calculated separately and added. There is no
adjustment for double counting between the CRM and any other risk measure
CRM estimates will be calculated at least on a weekly basis
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

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CRM: Modelling
Modelling CRM
Modelling CRM must ensure that following are captured in the model
Cumulative risk arising from multiple defaults, including defaults in tranched products;
Credit spread risk, including gamma and cross-gamma effects;
Volatility of correlations, including the cross effect between spreads and correlation;
Basis risk between indices and constituents or bespoke portfolios;
Recovery rate volatility; and
Hedging slippage and cost of rebalancing
On an overall basis CRM must comply with all requirements for the IRC
In addition, the banks will be required to design stress testing scenarios for correlation trading
portfolios and examine the effect of these scenarios on default rates, recovery rates, credit
spreads and correlations
These tests must be applied weekly and the results submitted to the regulator
The regulator may apply a supplementary capital charge if deemed necessary
A floor on this measure was introduced , being 8 % of the measurement under the
standardized measurement method ( published in the press release of 18th June 2010)
Source: Revisions to the Basel II Market Risk framework: BIS: July 2009

105

Thank You