Basel III - Part 2 - What's on the menu

With each financial crisis there will inevitably be a response from the Bank for International Settlements (BIS) but then that is their main charter of work.   In our first article on Basel III, which can be found by clicking here, we discussed what brought us to this place.  I suppose that leads us unerringly to the riposte which is the purpose of this article; where to from here.
 
Continue on reading to see what's on the menu for Basel III.

Firstly before leaping into the semantics of what BIS are proposing with Basel III, I have to say in summary the new accord is an encouraging and well thought through response to the credit crisis.  I am personally in favor of Basel III although, I fair it needs some fine tuning before being brought into operation.

Basel III takes each “feature” of the credit crisis and puts in place a specific ruling that appears on the surface to be well adjusted and carefully connected in the overall context of the Basel framework.   It is a bit of pity that some of the national regulators didn’t have the patience and diligence to wait or work more closely with BIS before releasing their knee jerk reactions and one is left feeling that the Volcker Rule might just end up dejecting the American banking sector completely, the British government is probably going to throw the baby out with the bath water if it pulls FSA apart yet, exciting as this is, all of this though is for a different debate.

So what’s on the menu for Basel III.

  

What isn't changing

Let's start off with what is not changing. 

The good news is that Basel III should be seen as an extension of Basel II, so all the work that has been completed in Basel II by banks is valid to date.  The IRB approach and even the foundation approach for credit all stand in Basel III.  In respects to specific risk disciplines, the emphasis on operational risk and market risk is not heavy at all in this new mandate. There is a small overlap with market risk and pricing CVA into capital charges or to be specific; "banks can use the market risk internal models approach for CVA models" - section 98, BIS.  None the less much of the agendas for market risk in Basel III lie away from the style in which this core discipline has been presented in the past.
  
The key to understanding the emphasis BIS is looking for from this initiative, as with any of their programs, is to glance at the noise they make with various publications when they communicate a formal announcement.  The list of documents below were all published days apart when Basel III was released in December 2010.

FIG 1: Basel III - Recent Publications : Linked Here

The documents prefixed Basel III are just that. The core principles for effective deposit insurance has me wondering whether BIS are trying to align themselves with the US regulatory program.  However, the academic literature for risk on trading books and the sound practices for backtesting counterparty risk are key messages for Basel III with little doubt. 

 

I am not sure what the intentions are for re-releasing "Supervision of Operational Risk" but perhaps some banks were too focussed on modelling operational risk losses during Basel II than managing them. Even so, there isn't too much operational risk work laying on the path ahead for the Basel III team.

What does Basel III come down to?

Basel III is heavily focussed on these specific aspects of the capital, liquidity and stress testing.  

There are eleven key themes which should be considered and I have taken to list these below: 

 

[ 1 ] New Capital Structure

The first is a complete revamp of the capital structure for banks, starting with axing tier 3 capital altogether. The effort is to "build-up adequate buffers" to absorb losses.  "At the onset of the financial crisis, a number of banks continued to make large distributions in the form of dividends" ... "Stronger tools are going to be used to promote capital conservatism" - BIS

[ 2 ] Introducing a new global liquidity standard

BIS is including "liquidity surcharges, tighter large exposure restrictions and enhanced supervision", more information will be released in 2011. "The introduction of liquidity requirements that penalise excessive reliance on short term, interbank funding to support longer dated assets"  There will be the development of a liquidity coverage ratio to maintain adequate level of unencumbered high quality liquid assets.

[ 3 ] The introduction of a leverage ratio
BIS will "add a requirement indicating the PD estimates for highly leveraged counterparties" ... "A new leverage ratio which would serve as the basis for testing during a parallel run period" ... "A capital measure for the leverage ratio" - BIS

[ 4 ] Development of countercyclical buffer

A make hay while the sun shines concept has been included or as BIS puts it "Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer".  The buffer will vary between jurisdictions but it is likely to range between 0 and 2.5% of Risk Weighted Assets when finished.

[ 5 ] Changes to credit risk assessment and ratings

A number of measures will be introduced to mitigate the reliance on external ratings for the Basel II framework.   "Banks will have to perform their own internal assessments ... to address reliance on external credit ratings and minimising cliff effects" - BIS

[ 6 ] The introduction of wrong way risk as formal measure

"While procyclicality amplified shocks over the time dimension, excessive interconnectedness among systemically important banks transmitted shocks" ... "Banks should measure general wrong way risk by product, region, industry and other categories" - BIS. More information on wrong way risk can be found by clicking here.

[ 7 ] The full back testing of counterparty risk systems

BIS is raising the counterparty credit management standards in a number of areas. "Additional guidance for the sound backtesting of counterparty credit exposures is to be released" - BIS

[ 8 ] On / Off Balance Sheet switching

"complex trading activities, resecuritisations and exposures to off-balance sheet vehicles are to be addressed" - BIS.  There will be higher capital requirements for trading derivative activities and increases in derivatives collateral calls on contractual and non contractual off balance sheet exposures.

[ 9 ] Asset Quality Measurement and Security Funding

A strict definition of level 1 and level 2 assets will need to be tied to the Liquidity Coverage Ratio and limits will be placed on specific level 2 assets "especially for funding maturing in 30 days"..."A 15% haircut is applied to the current market value of each level 2 asset held" - BIS

[ 10 ] Systemically Important Financial Institutions Charge

Addressing the too big to fail will be implemented by BIS developing ... "A well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt" - BIS

[ 11 ] Net Stable Funding Ratio
A minimum amount of stable sources of funding at a bank relative to liquidity profiles of assets will be required.  Changes to over reliance on short term wholesale funding will also need to be addressed and a set of monitoring tools will be installed to ensure the funding ratio is monitored.

A complete road map to the Basel III accord can be found here and shows the interrelationships of specific agendas for the program.

FIG 2: Basel III Road Map

If you are interested in seeing the Basel III road-map please contact the author Martin Davies for the URL link to the active map.  In earlier posts we made this road map publicly available but we have taken this schematic out of general circulation so that it can be substantially evolved.

Round Up Comments

The round up, this is where the fun begins.  

We have some challenges for banks, regulators and the economy.  Let's have a brief and quick response on all of this for readability sake.

 

[] Some of the challenges for Banks

The challenges for banks are obviously two fold, building the framework for Basel III and then running it.  Operating it is going to require some carefully planned policy changes in banks large and small.  If we take the market today, just for example, the ECB has just announced that banks are struggling to raise cash yet again in what looks like a strong temporary market recovery. This liquidity issue is a clear sign banks have a long way to travel before they are "harmonized" as Basel III puts it.

 

For large international tier 1 banks much of the risk framework to meet Basel III will already exist or so it should in theory however, the diversity of the nature in which these banks raise capital, hedge and the complex booking model for some of their hybrid and composite trading strategies will need to be planned and mapped carefully in the new framework. The framework itself actually needs to be constructed and sensitive to trading approaches and modes of instrument booking in the bank.  

Truly measuring wrong way risk in these tier 1 institutions is going to be a gigantic task and at present most banks general aptitude for this is thin on the ground to say the least.  I know of one international bank that monitors margin positions on a spreadsheet, another that has no loop back for its CVA pricing models, yet another global bank that is still measuring counterparty risk in silos and another which has no deal clearance pricing for anything more exotic than a forward rate agreement or a vanilla interest rate swap. Oh this last institution trades options but let's not talk about credit clearing them and thank goodness the "reg-reporting" team are on a different floor is much of the modus operandi of some of these beasts.

This is all incredible stuff but then the credit crisis was brought about by such aperture in monitoring risk on the trading book. These banks' institutional knowledge and management oversight are going to need to improve substantially otherwise Basel III might just end being another jungle of headaches with political finger pointing perplexities that the predecessor ruling had.

The smaller more nationally based institutions are going to have different grievances. Some of them have launched into derivatives in a solid but conservative way, especially in Asia.  These banks generally aren't running CVA pricing models in a formal manner and they have a bit of catching up to do. Hopefully they won't fall into the same traps that the tier 1 banks have over the years but who knows at the moment.

 

For the local regulators, well they have a bit of work to do as well and this is going to be uniquely tricky because they can't "cut and paste" what other regulators do around the world which is what many of them did for Basel II.
  
In effect, regulators will need to assist in calibrating the leverage ratios and LGD estimates for local banks and that will be different for each region.  The regulators will also need to develop specific reporting requirements for local banks so that they can monitor these liquidity and leverage ratios. The problem with measuring liquidity is that it is going to be exclusive to each financial institution and low levels of cash for one bank may not be an issue for another when leverage is taken into consideration. Then, implicating a measure of liquidity for a 30 day window as described in the Basel III document is going to need to be evolved because that is unlikely to divulge the true risk over a trading horizon.  

Finally with liquidity and leverage measured back-to-back is a good move by BIS however one will find the sting is always concentrated in a near term forward position. Let's say a bank does actually report a poor liquidity coverage position, if the regulator transparently declares this knowledge to the market it will end up causing that institution to pay a larger hurdle for raising cash. This inevitably won't help resolve the liquidity issue the bank is suffering.

For software companies, there are some great opportunities in this new Basel agenda, especially for those firms that base their solutions around on / off balance sheet cash flow modelling or have ALM / liquidity solutions available. Unlike Basel II, software firms need to be able to sell unique offerings that address specific accord requirements rather than the whole kit. The reason for this is that many banks will already have systems in place which need to be evolved not replaced.

[] What is this going to cost us, has capital increased?
The big question that the market and the banks always ask is, what is the capital increase?  

One excellent summary study I have seen so far with respects to the differences in capital between Basel II and Basel III was pulled together by Kate Strachnyi as shown below.

FIG 3:Basel II to Basel III Capital Comparison

There have been arguments by many analysts that this is actually not enough and you have to ask yourself whether these analysts and the market in general are reading the fine print.  There are some key points to take into consideration here. 

Obviously if the capital increase is too large too quickly, the ruling will impact economic growth and in this respect an international group of economists have studied the implications of the capital standards on gross domestic product may result in a 0.29% dampening effect on the economy as a whole.  While this is spread out over nine years and a small 0.29% percentile may seem meek, I can guarantee the dollar value under that assessment is incredible and one kind of feels that the 0.29% will be concentrated on disadvantaging firms that need borrowing most.

In respects to enhanced risk coverage, as stated by BIS:

Banks will now hold capital for the trading book assets that, on average is about four times greater than what was required by the old capital requirements.

So capital requirements are going to increase on one hand and on the other we are moving from an open capital regime to a more closed capital regime over the nine years. What I mean by open and closed is that in addition to increasing capital, the new Basel III rulings seriously undermine a bank's ability to actually raise that capital. With all that in mind, let's ponder on our ECB liquidity warning only the other day in the context of what is written here.  

Under Basel II capital instruments themselves are a broad set yet, under Basel III the focus is on treasury stock, equity and retained earnings. The scrapping of tier 3 capital makes for limited options and a new minimum 15% haircut for level 2 asset classes will make banks pay dearly in coverage for using those funding options.

Trade offsetting / netting is also to be disallowed as part of this regulation and some banks may find capital requirements are much larger than four times as anticipated by BIS.  Finally if we place a Liquidity Coverage Ratio and a Net Stable Funding Ratio on top of all of this, just to be  conservative, I have to say this is all quite a meal ticket to stomach.

Are there broader Economic Issues?

There are numerous economic issues that Basel III could also induce and this topic alone is deserving of another blog article but some of the key areas of concern include:

 [] Who in the end pays for increases in capital and a reduction in leverage? The shareholders of bank stock or are some of these risk costs passed through to the customer to maintain profit margins?

 [] There have also been arguments by the industry at large that Basel III is too constrictive in specific facilities that banks are dependent on. This FT article Trade Finance May Become A Casualty clearly frames the conundrum in the context of trade finance.

 [] The Basel III liquidity coverage ratio may be well intentioned but it might also have unintended consequences.  Setting tight criterias for asset quality will drive banks to reduce their holdings of bonds that are below the highest rating.  A move to quality assets sounds like a great idea but for some banks that will translate to holding bonds such as US treasuries and in turn introduces an exposure to currency risk for banks that select the option 2 treatment for insufficient liquid assets. Then a fight for quality might also drive "liquidity stock" away from offshore assets to specific high AA-grade rating onshore assets and that can result in a price skew.   This last point needs to be evolved further and investigated to identify the extent of this potential flaw.

We will take a look at these agendas and many others in another blog article but that is about it for the wrap here.