BANKING REGULATION AND BASEL III

REGULATION HISTORY

The breakdown of the Bretton Woods system of managed exchange rates in 1973 led to incidents within
international banking which required greater cooperation amongst central banks within the principal world
economies. Central bank governors of the G10 countries decided to establish a global standard-setter for the
prudential regulation of banks, a body which came to be known as the Basel Committee on Banking
Supervision (BCBS). It is headquartered at the Bank for International Settlements in Switzerland. The BCBS was
designed as a forum for regular cooperation between its member countries on banking supervisory matters. Its
aim is to enhance financial stability by enhancing the quality of banking supervision worldwide. The BCBS
published its first Accord in 1988 and it established the first international standards for capital adequacy. Pre-
1988 regulatory definitions and capital adequacy ratios varied globally, and enforcement of regulations varied
from country to country. There was a substantial increase in bank leverage starting in the 1980’s and off-
balance sheet derivatives trading increased sharply.

The objective of the BCBS is to improve the quality of banking supervision worldwide. Banks had to hold capital
equivalent to 8% of their risk-weighted assets. The key concept of risk weighted assets (RWA’s) was
introduced. Each type of asset on a bank’s balance sheet has a risk weighting that reflects its riskiness. For a
bank that is holding a highly rated sovereign bond, that asset should have a much lower risk weight than a
corporate bond from a less creditworthy issuer. In fact, for the highest rated sovereign issues the risk
weighting would be 0% - meaning, in practice, that the bank does not have to hold loss absorbing capital to
cover it since it is deemed to be “risk-free”, while the corporate bond might attract a risk weighting of 100%
(or even higher under Basel III). Under Basel 1 the risk weightings ranged from 0% for cash and claims on OECD
governments, 50% for residential mortgages and 100% for corporate bonds, equities and real estate.

The second Basel Accords, known as Basel II, were introduced starting in 2004 and led to a much more
sophisticated framework than that seen under Basel 1. There was a major expansion of the rules governing
the determination of credit risk. The BCBS introduced two broad approaches. Risk weights could either be
based on external credit ratings (standardized approach) or a bank’s own internal credit ratings (IRB approach).
A more systematic approach for market risk was introduced which hinged on the application of Value at Risk
(VaR) techniques. A capital charge for operational risk was introduced, and three methods for determining a
bank’s exposure to losses from operations were outlined – a Basic Indicator Approach (BIA), Standardized and
Advanced Measurement Approach (AMA). The entire framework was organized around three pillars. Pillar
One related to the calculation of RWA’s and the classification of regulatory capital. Pillar Two related to the
supervisory review process and internal capital adequacy assessment (ICAAP). Pillar Three, which became
known as the market discipline pillar, required the detailed publication of the findings from the supervisory
process and the disclosure of the relevant calculation methods and amounts required under Pillar One.

The current framework, Basel III, which is in the process of being fully implemented by 2022, contains new
principles and regulations designed to reduce systemic risk and to create a more resilient banking sector. The
following are highlights which come from the Overview to the Basel III framework: The objective of the
reforms is to improve the banking sector’s ability to absorb shocks arising from financial and economic
stress…reducing the risk of spill-over from the financial sector to the real economy. One of the main reasons
the crisis, which began in 2007, 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. Many banks were holding insufficient liquidity buffers. The banking system,
therefore, was not able to absorb the resulting systemic trading and credit losses.

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CAPITAL RATIOS UNDER BASEL III
Under Basel III newly defined common equity Tier 1 (CET1) and Tier 2 instruments must be more loss-
absorbing and the instruments issued by banks to provide capital should not contain incentives to redeem
prior to their stated maturity. With regard to some of the capital raised there must be disclosures to those
investing in this capital that instruments can be written off or converted to equity at the determination by the
relevant supervisor either that the bank would not be viable without the write-off or that a public sector
capital injection is to be made. Changes introduced under Basel III rendered ineligible a wide range of
outstanding upper Tier 1 and Tier 2 instruments that were permitted under Basel II.

Core Tier 1 Capital or CET1 is confined to common equity plus retained earnings i.e. the balance sheet reserve
of previous profits. Banks must determine their available CET 1 capital after deductions. They must exclude
goodwill, other intangibles, deferred tax assets and defined benefit pension plan deficits. CET 1 must be at
least 4.5% of the bank’s risk weighted assets. Additional Tier 1, AT1, instruments sit above CET1 on the capital
stack and must be at least 1.5% of the bank’s risk weighted assets. AT1 capital is raised through the issuance of
hybrid instruments, often in the form of Contingent Convertible securities (CoCo’s). Initially CoCo’s are issued
as bonds (and therefore as a liability to the bank) but they need to convert into CET1 well before capital ratios
fall to levels at which there is a loss of confidence in the ability of a bank to continue to operate as a going
concern. AT1 is designed to create CET1 at point when most needed. Tier 2 capital, which must be at least 2%
of the bank’s risk weighted assets, is designed to provide loss absorbency on a gone concern basis. Tier 2
capital is essentially a form of capital which can be bailed in. Bail-in refers to the ability of a resolution
authority (typically a central bank) to take control of Tier 2 capital as part of the resources available before
public funds are used as part of a bail out. Only dated subordinated debt remains eligible as Tier 2 capital

The BCBS also introduced two new capital buffers. The Capital Conservation Buffer is a mandatory
requirement. The buffer must be funded with CET 1 and should be 2.5% of the bank’s risk weighted assets.
Should the buffer be depleted there is a mechanism designed to restrict a bank’s ability to pay out retained
earnings until the buffer is replenished. A Counter Cyclical Buffer is a discretionary buffer. A supervisor’s
discretion regarding this buffer is based on judgments regarding excessive credit creation. A supervisor could
require 2.5% of CET1 to be in this buffer.

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Under Basel III, the BCBS introduced a new supplementary measurement approach for capital adequacy.
Banks must calculate a Leverage Ratio which does not hinge on risk weights. The numerator of the ratio is Tier
1 capital and the denominator is equal to the gross value of all exposures both on and off-balance sheet. The
BCBS recommended that this ratio should be at least equal to 3% and the EU implementation of this ratio
accepted that figure. Banks must determine their capital requirements depending on which, of the RWA
approach and the Leverage Ratio, results in the higher amount of capital calculated.

The BCBS also introduced a Liquidity Coverage Ratio (LCR). The LCR is designed to ensure that a bank has
sufficient liquidity to cover a thirty-day period of stress e.g. complete loss of wholesale funding and
increased collateral calls from counterparties. The numerator for the LCR is High Quality Liquid
Assets (HQLA) and the denominator is the net outflows during a thirty-day period. The numerator
can be composed of Level 1 and Level 2 assets. There is no ceiling on the percentage of Level 1
assets but there is a ceiling of 40% for the Level 2 assets. Level 1 assets are those which can be most
readily converted into cash even when markets are critically stressed. Level 2A assets include highly
rated corporate bonds and Level 2B assets can equities. In the case of the denominator, total
expected cash outflows are calculated by multiplying outstanding liabilities and off-balance sheet
commitments by the rates at which the BCBS believes that they are expected to run off or be drawn
down.

One further element of the Basel Accords, introduced in Basel II but which is now taking on more importance
under Basel III, relates to a Pillar 2 objective regarding the Internal Capital Adequacy Assessment Process
(ICAAP). Pillar 2 of the Basel Accords addresses the role of national regulators and supervisors with respect to
compliance with the full intent of Pillar 1 metrics and the “spirit” of the Basel framework. As part of their
oversight of the commercial banks, the ICAAP is a key requirement and banks are required to publish annual
reports which include reference to their own assessments of their capital adequacy. Supervisors can challenge
the assumptions behind modelling methods, the robustness of stress testing and a variety of other
organizational procedures that banks have in place to ensure best practice in risk management. The following
are some of the key requirements of the ICAAP requirements. The ICAAP process is designed to provide all
relevant information for firm’s senior management and regulators enabling them to make informed decisions
on the appropriate capital level and risk management approach. Pillar Two also requires the involvement of
the board of directors in the on-going assessment of the firm’s risks, and the articulation of policies as to how
it intends to mitigate those risks. The ICAAP process should also identify how much current and future capital
is necessary. Pillar Two also focuses on the establishment of a risk governance framework and enhancement
of the risk culture of the enterprise. Pillar Two’s primary aim is to engender an understanding of risk
management within the context of major Basel Pillar One objectives. For example, credit concentration risk is
not addressed under the calculation methods for Credit Risk RWA’s under Pillar One but is an important
element of Pillar Two. Stress testing is also an integral part of Pillar Two and this is a vital tool in the
determination of Economic Capital which is distinct from regulatory capital. Economic capital can be thought
of as the amount of capital that the bank’s board considers necessary for it to survive in the implementation of
its business model.

Following the undertaking of the ICAAP process, also known as the Supervisory Review and Evaluation (SREP)
process, a bank’s supervisor can impose additional capital requirements on individual banks. Discretionary
Pillar Two buffers, if imposed, will add to the capital stack that a bank is required to hold. One of the main
techniques which banks have adopted to fulfil their requirements under ICAAP is a methodology for measuring
the Risk Adjusted Return on Capital or RAROC. In addition to providing the kinds of internal assessments by
banks of their own capital adequacy – rather than a formulaic adherence to the Pillar One guidelines – the
RAROC calculations can also enable banks to better assess the risk/return profiles of different units of their
business and product lines. A RAROC analysis will enable the bank to optimize the way that it allocates its
capital to different business units. Also, very usefully, a RAROC analysis of such business activities can act as a
benchmark for determining remuneration for employees that are engaged in the different business units of a
large diversified bank.

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The remaining pillar of the Basel III framework, Pillar Three, aims to increase market transparency by requiring
banks to comprehensively make full disclosures as to its financial condition. It requires enhanced disclosures
on the detail of the components of regulatory capital and their reconciliation to the reported accounts. Focus
is on providing information on the scope of application, regulatory capital, risk positions, risk measurement
approaches equity, risk positions, articulation of the IRB-Approach, any off-balance sheet vehicles and
economic capital requirements. Banks in the EU are required to publish Pillar Three disclosures on a quarterly
basis, and these enable various stakeholders – customers, employees and investors – to assess the health of
the bank. Investors, for example, are provided a very detailed disclosure of the bank’s financial position and
can thereby judge whether they want to either invest in shares or sell their existing shares in the bank.

COUNTERPARTY CREDIT RISK

Following the 2008 crisis, the BCBS was faced with a critical challenge of addressing counterparty credit risk.
For example, Lehman Brothers had approximately 1.5 million derivatives transactions with about 8000
counterparties at the time it failed. Given the highly inter-connected nature of linkages across the banking
system the default of Lehman Brothers led to a systemically threatening bout of financial contagion. Two
thirds of the losses inherent to counterparty risk during the period 2007-2010 were caused by valuation
discrepancies resulting from counterparty credit rating downgrades. One third of losses were due to real
defaults by counterparties. Pre-crisis most derivatives were in the form of bilateral, over the counter (OTC)
transactions. These were governed by contracts and collateral provisions from the International Swaps and
Derivatives Association (ISDA), and very often these arrangements proved to be wholly inadequate. Large
financial institutions, including AIG, had posted very little collateral, and when market conditions became
critically stressed in 2008, they faced massive margin calls.

Basel III strengthens the requirements for the management and capitalization of counterparty credit risk (CCR).
Basel III includes an additional capital charge for possible losses with deterioration in creditworthiness of
counterparties. The BCBS introduced valuation adjustments to reflect the two-way risk of loss for the
counterparty and the bank itself. These adjustments are referred to either a Credit valuation adjustment
(CVA) – i.e. those reflecting the counterparty’s credit risk and Debit valuation adjustment (DVA) – i.e. those
reflecting a bank’s own credit risk. When marking derivative positions to the market, in addition to the purely
commercial marks, the bank must also evaluate the creditworthiness of its counterparties and also its own
credit risk. CVA is effectively a recognition by the bank that the counterparty may not be able to honour its
obligations from a positive exposure. The need to make such an adjustment also enhanced the incentives for
clearing over the counter (OTC) instruments through central counterparties (CCP’s).

IMPACT ON BUSINESS MODEL OF BANKING

The Basel III framework, as adopted in the EU by legislation and regulations from the European parliament, has
been largely implemented in 2019. Further changes will be required by 2022. The rules have had a profound
impact on the business model of banking. Capital adequacy requirements have led to a substantial increase in
the capitalization of banks. LCR requires banks to hold significantly more liquid, low-yielding assets. Increased
capital requirements, particularly in the common equity element of Tier 1 capital and capital buffers and the
minimum liquidity requirements under LCR have reduced the return on equity (ROE) for banks.
As discussed the focus on CVA, as well as legislation such as the Dodd-Frank Act (2010) in the US and the
European Market Infrastructure Regime (EMIR) has led to a major migration from OTC to CCP clearing of
derivatives trading which has meant that the degree of high margin OTC activities has declined considerably.
The BCBS has substantially revamped its approach to market risk with the introduction of the Fundamental
Review of the Trading Book (FRTB). Although the new FRTB rules have not yet been fully finalized and the
deadline for implementation is January 2022, there will be significant data and systems challenges for many
banks in implementing FRTB. FRTB requires extensive use of market data and analytics and a more granular
approach to the approval of the Internal Model Approach (IMA) will increase the administrative burden of the
risk control department. Loss of supervisory approval to use IMA could lead a bank to switch to the use of the
Standardized Model under FRTB which requires a much greater amount of loss absorbing capital. A major
challenge to the banking business model has been the implications for collateral management as a result of
the switch to CCP clearing. The collateral requirements for centralized clearing, as well as for those derivatives

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that remain as OTC has increased funding costs for banks and can also lead to increased likelihood of
operational errors. An alleged unintended consequence of LCR is the claim that banks are hoarding the
highest quality assets and this has led to market liquidity concerns in sections of the global bond markets.