Post on 20-Oct-2015
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Abstract
Basel III guidelines are the response of BCBS (Basel Committee on Banking Supervision) to the 2008 Crisis. It is aimed at strengthening Individual Financial Institutions as well as the overall Financial System by eliminating the weaknesses which were present in BASEL II that were revealed during the crisis.
BASEL III has a multi-dimensional impact on financial Institutions and will require associated changes to the IT systems.
This paper covers various BASEL III guidelines, and describes the Why and How different areas of IT infrastructure and systems will be impacted.
Whi
te P
aper
Basel II to Basel III The Way forward
- Rohit VM, Sudarsan Kumar, Jitendra Kumar
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BASEL III attempts to plug the loopholes present in BASEL II by recommending steps to further strengthen the overall financial system. BASEL III requires higher risk weights for risky assets bringing more assets/exposure into the umbrella of Risk Weighted Asset (RWA) calculations, prescribes a higher regulatory capital requirement and demands a very high quality of capital. It also introduces requirements to manage liquidity risk better. Finally, it introduces an additional requirement of absolute leverage ratio to take into consideration the model error which might be present in RWA calculations.
Some very fundamental assumptions by financial institutions and regulators were proven wrong during the 2008 Crisis. The business of subprime lending was based on the assumption that housing prices would keep going up. This assumption proved wrong and it triggered a chain reaction that engulfed the global financial system. This crisis cycle is illustrated in the diagram below.
There were some incentives present in the financial system that encouraged risk taking. Transferring of risk through securitization; relying on credit ratings provided by credit rating agencies, which were paid for by the issuers; compensation of top management based on absolute growth, revenue and profit rather than risk adjusted profitability; were just some of the reasons that encouraged excessive risk taking by banks.
When subprime loan defaults started impacting the balance sheets of financial institutions, it became a systemic problem. Quarterly losses to the tune of billions of dollars by major Financial Institutions resulted in a crisis of confidence that sucked out liquidity from the financial system. At this time, the weaknesses of the BASEL II guidelines became very evident.
Exposure to risky assets in the form of subprime loans, securitization and derivatives resulted in excessive losses. The low quality and quantity of capital could not absorb these losses when systemic risk materialized. The banks loss absorbing capacity was affected because of their excessive leverage and their short term sources of funding made financial institutions gasping for capital when it was most difficult to raise capital.
Introduction
Excessive Risk Taking
Sub-Prime Lending
Securitization
Housing prices decline resulting in sub-prime defaults
Sub-prime defaults, Securitized assets & derivatives trading resulted in huge losses
Excessive leverage & poor capital could not absorb losses fully, demanding fresh equity infusion
Huge losses resulted in a crisis of condence causing liquidity to evaporate
Short term borrowing demanded fresh borrowing which failed in liquidity crisis
Firms on the verge of insolvency; threatening system failure
Governments step in to inject capital to prevent systemic failure
In stressed market situations, Credit Rating downgrades of Financial Institutions & securitized products further lowered valuations & increased losses
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The diagram below highlights where and how BASEL III changes will address the deficiencies in the crisis cycle.
In summary, the BASEL III rules will strengthen the capital reserves and introduce stringent reporting requirements that cover key risk, liquidity and leverage parameters. The BASEL III guidelines also attempt to bolster the weak links in the financial system with the introduction of Central Clearing Houses and lessen the dependency on Rating Agencies. The chart below captures the key aspects of the BASEL III guidelines that have been introduced.
CAPITAL
Increaseincommonequityrequirementfrom2%to4.5%
IncreaseinTier1Capital(GoingConcern)from4%to6%
Overallcapitalwillremainthesameat8%.(WhichmeansTier2capital,orgoneconcerncapitaltoreduceto2%oftotal capital)
Tier1Capitalcannolongerincludehybridcapitalinstrumentswithanincentivetoredeemthroughfeaturessuchasstep-up clauses. These will be phased out
Tier3Capitalwillbeeliminated(previouslyusedformarketrisk)
RISK MANAGEMENT
CreditValuationAdjustment(CVA)CapitalChargemustbecalculatedtocoverMark-to-MarketlossesoncounterpartyrisktoOverTheCounter(OTC)Derivatives.
StressedparametesmustbeusedtocalculateCounterpartyCreditRisk
EffectiveExpectedPositiveExposure(EPE)withstressedparameterstobeusedtoaddressgeneralWrong-WayRisk(WWR) and Counterparty Credit Risk
Banksmustensurecompletetradecaptureandexposureaggregationacrossallformsofcounterpartycreditrisk(notjustOTCderivatives)atthecounterparty-specificlevelinasufficienttimeframetoconductregularstresstesting.
Amultiplierof1.25isappliedtothecorelationparameterofallexposurestofinancialinstitutions(meetingcertaincriteria) (Asset Value Correlation - AVC)
Additionalmarginingrequiredforilliquidderivativeexposures
100%riskweightforTradefinance
CAPITAL - BUFFERS
IntroductionofCapitalConservationBuffer-2.5%ofCommonEquityTier1
IntroductionofCounterCyclicalBuffer-0to2.5%ofRiskWeightedAssets(RWA)
Excessive Risk Taking
Sub-Prime Lending
Securitization
Housing prices decline resulting in sub-prime defaults
Sub-prime defaults, Securitized assets & derivatives trading resulted in huge losses
Excessive leverage & poor capital could not absorb losses fully, demanding fresh equity infusion
Huge losses resulted in a crisis of condence causing liquidity to evaporate
Short term borrowing demanded fresh borrowing which failed in liquidity crisis
Firms on the verge of insolvency; threatening system failure
Governments step in to inject capital to prevent systemic failure
In stressed market situations, Credit Rating downgrades of Financial Institutions & securitized products further lowered valuations & increased losses
Capital Conservation / Counter-cyclical buers
Less reliance on external ratings agencies
CVA Capital Charge Stressed Testing
Higher quantity & quality of capital
Leverage Ratio introduced 100% weight for trade nance
Correlation to nancial institutions will carry more risk weights to prevent systemic risks and an overall collapse
Enhanced Supervisory Review and Disclosure
Two new liquidity ratios
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LIQUIDITY LiquidityCoverageRatio(LCR)>=100%
NetStableFundingRatio(NSFR)>100%
LEVERAGE LeverageRatio>=3%
RATINGAGENCIES LowerrelianceonExternalRatingAgencies
REPORTING Contractualmaturitymismatch
Concentrationoffunding
Availableunencumberedassets
Market-relatedmonitoringtools:assetpricesandliquidity,CreditDefaultSwap(CDS)spreadsandequityprices
LCRbycurrency
Resultsofstresstestsshouldbeintegratedintoregularreportingtoseniormanagement
Basel III New Requirements
IT Impact Summary of ChangeThe architecture below represents a typical BASEL II set-up. Exposure and reference data information is extracted from multiple source systems through Extract, Transform & Load (ETL) processes and the modelling parameters Probability ofDefault(PD),ExposureatDefault(EAD)andLossGivenDefault(LGD)are calculated. This data is stored inaRiskData-Warehouseandthenthe RWA calculations are performed on the risk data to calculate the regulatory capital requirements.
In general, a BASEL III implementation wil l require additional source systems to be included, changes to the data elements of existing source systems to be made, changes to the risk data models to be done, RWA calculations and reporting modules to comply with regulatory reporting guidelines. These changes are highlighted in the pictorial representation in the diagram.
General Ledger
Origination System
Servicing System
Collateral Mgmt.
System
Loss & Recovery System
Reference Data
External Sources
Sour
ce S
yste
m E
xtra
cts
Dat
a Q
ualit
y/CD
C
RiskDatamarts
Segment Denition
PD, LGD, EAD
Op Risk Models
Model Validation/ Feedback
Factor Model Environment
Model Execution and Output
G/L Reconciliation RWA Calculator
Reporting Tool
ICAAP Reports
Management Reports
FFIEC 101 ReportsSt
agin
g/O
DS
Data Sources Basel II Risk EnvironmentETL Staging
Data Governance
Possible new Data marts to hold data for the measurement of Liquidity and Leverage ratios
New Sources of Data (Cash Flows) required to calculate LCR/NSFR.
Updated Models will incorporate new sources of capital (new data elds) and stressed parameters
RWA Calculation will change because of the new data elds and new risk weights
Data Governance across the system
New Reports1. LSR, NSFR2. Leverage3. Contractual maturity mismatch4. Concentration of funding5. Available unencumbered assets
6. Market-related monitoring tools: asset prices and liquidity, CDS spreads, equity prices, institution specic information related to the ability of the institution to fund itself in various wholesale markets
7. LCR by currency
RWA Calculation and Reporting
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BASEL IIIs IT impact can be further understood by looking at its impact on each of the areas separately. The table below lists the impact expected in different areas of implementation and also lists some of the challenges that will be encountered while implementing them.
Some new sources of data that would need to interact with the Basel framework include:
AssetLiabilityManagement (ALM) systems
CashFlowManagement systems
ExistingLiquidityRisk Management systems
DatafromCentralCounterparties for datarelatedtoOver-The-Counter(OTC)derivatives.
Thenewliquidityratios that Basel III introduces (LCR and NSFR), will entail the creation of new Liquidity Risk DataMartstoholdrelevantData
UseofStressedparameters as well as calculating CVA for counterparty credit risks will need huge amounts of historical data, which may require the use of new data marts/databases to store such information.
Theformulasusedin the calculation ofPD,LGD,EADwillchange due to the need to incorporate stressed parameters and to also reflect ahigherEADvaluefor counterparties where specific Wrong Way Risk (WWR) has been identified.
Changeswillberequired at the risk engines to accommodate the new buffers (Counter Cyclical, Capital Conservation).
Itwillalsoneedto accommodate the new Risk Weights assigned to derivatives, trade finance products as well as account for exposures to financial institutions.
Thereportingsystems will have to be enhanced to cater to the new reports mentioned in Basel III
Theexistingreportswill also be modified to reflect liquidity, leverage and CVA, besides the new capital structure
Subsidiaryreportingrequirements will be augmented.
IMPA
CT
IdentifyingtherightDataElements.Thiswould require a good knowledge of accounting systems as well as knowledge of the various reports required by Basel III.
Identifyingsources and data requirements for different legislations.
Asingledataload with all the attributes required for market, CCR, RWA, economic capital and liquidity risk should be extracted from source systems.
Asaresult,DQchecks will be rigorous.
Consultantshavingexperience in Stress Testing, Analytics, and general knowledge about the business of Banks will be required to identify and stress the required parameters.
Modelvalidationshould be a focus area.
Thesystemshouldbe configured to provideGroupData,SoloData,BaselI,II and III data on demand.
Understandingthe new reporting requirements
Bringingoutsynergies across stakeholders and consolidating the reporting platform.
CH
ALL
ENG
ES
PutinplacearigorousandscalableDataGovernanceframework(People+Process+Technology)
AlignsourcesystemsdataqualitycapabilitiestomeetFitForPurposenorms
End-to-endauditcapabilityfromsourcesystemdatatofinaloutputcalculationmaybeachallengeinBaselIIIbecauseofthemanynew source systems interacting with the reporting systems.
DAT
A G
OV
ERN
AN
CE
Risk Data Identification
RWA Calculation
Regulatory Reporting
Infrastructure and Data Management
Risk Modeling and Quantification
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BASEL III Implementation Approach A BASEL III Implementation will require a core team to co-ordinate with multiple track owners who would be responsible for making changes totheapplicationsandsystemsthattheymanage.Ideally,aBASELIIIProjectManagementOffice(PMO)willberesponsibleforinitialimpactassessment, identifying multiple tracks within the overall program, co-ordinating and monitoring the overall execution and reporting to the senior management.
Basel III Implementation Timeline Since the BASEL III requirements bring in critical buffers and significant capital outlays, the key aspects of the BASEL III guidelines will be implementedinphasesfromJanuary2013through2018.Thisshouldgivebanksenoughtimetoreviewtheirfinancialpreparednessandalso enhance their operational and reporting capabilities.
Source - The website for the Bank for International Settlements - http://www.bis.org/bcbs/basel3.htm
Programroadmapdefinition
Highlevelplan
Establishcurrentstateof compliance
PMOprocessdefinitions for change management, communication management and reporting
Identifykeystakeholders
Kick-offmeetingwithall stakeholders
Defineindividualtracks within the program
Impactanalysisand requirement documentation
Identifydependencies, risks and assumptions
Detaillevelplanningfor individual tracks
Identifythecriticalpath
Productevaluation(ifrequired)
Architecturedesign
Dataanalysis&modeling
Technicaldesign
Datafeeddesign
DatasourcingandETL
Datasufficiencyanalysis
PlatformDevelopment
Applicationcustomization and build
Dataqualitytesting
Functionaltesting
Regressiontesting
Non-functionaltesting
Defectmanagementand reporting
Ongoingenhancements
Maintenanceandusersupport
Platformmigration
Strategy & Roadmap Implementation
Maintenance & Support
Impact Analysis & Track Segregation
Solution Definition
PHASEINARRANGEMENTS(Shadingindicatedtransitionperiods-alldatesareasof1January)
2011 2012 2013 2014 2015 2016 2017 2018As of
1Janurary2019
Legerage Ratio Supervisory MonitoringParallelrun1Jan2013-1Jan2017
Disclosurestarts1Jan2015Migration toPillar1
Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50%
Minimum Common Equity Plus Capital Conservation Buffer 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
Phase-inofdeductionsfromCET1(includingamountsexceedingthelimitforDTAs,MSRsandFinancials)
20% 40% 60% 80% 100% 100%
MinimumTier1Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Minimum Total Capital plus Conservation Buffer 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%
Capital Instruments that no longer qualify as non-core Tier1capitalorTier2capital
Phasedoutover10yearhorizonbeginning2013
Liquidity Coverage Ratio ObservationPeriod Begins
Introduce Minimum Standard
Net Stable Funding Ratio ObservationPeriod Begins
Introduce Minimum Standard
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About the AuthorsJitendra Kumar is a Principal Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. Hehasover15yearsofexperienceandhascompletedCFAlevelI&IIfromtheCFAinstitute,USA.
He can be reached at Jitendrakumar@infosys.com
Sudarsan Kumar is a Senior Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. Hehasover4yearsofriskandcomplianceexperiencewithdatawarehousinginBaselII.
He can be reached at Sudarsan_Kumar@infosys.com
Rohit VM is a Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. His current focusisonBaselIII.RohitearnedhisPostGraduateDiplomainGeneralManagement(PGDGM)fromXLRI,Jamshedpur.
He can be reached at Rohit_V02@infosys.com
ConclusionBASEL III guidelines attempt to plug the gaps identified in BASEL II. However, the world economy and financial markets are dynamic and evolving ecosystems with many forces in play. Consequently, financial regulations will keep on evolving. The intensity of regulatory interventions is expected to increase in the future and the importance of risk management is expected to further move up in the priority of board members and top management.
It is therefore imperative that a BASEL III implementation is planned and designed with a high degree of scalability to support future changes in regulation. A BASEL III implementation should be taken as an opportunity to remove a silo based approach to risk management and move towards a reliable and scalable enterprise wide risk management system.
For such intent to be successful, an early start and preparation are essential so that enough due diligence goes into laying down the foundations of a strong risk management system.
2012 Infosys Limited, Bangalore, India. Infosys believes the information in this publication is accurate as of its publication date; such information is subject to change without notice. Infosys acknowledges the proprietary rights of the trademarks and product names of other companies mentioned in this document.
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