An Insider’s Perspective on the Basel Capital and Liquidity Reforms

Marc SaidenbergFederal Reserve Bank of New York

The views expressed here are my own and do not necessarily represent the views of the Federal Reserve Bank of New York or the Federal Reserve System

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Background and Objectives

• During the financial crisis, market participants began to question the capacity of systemically important financial institutions to withstand shocks

• Questions about the financial condition of key institutions were linked to shortcomings in the regulatory framework oMeasures of capital and capital requirements were not commensurate with

risks taken by banks, particularly those realized in a stressed environmentoRegulation and supervisory assessments of liquidity risk and liquidity risk

management were inconsistent

• Basel Committee on Banking Supervision responded with capital and liquidity reforms designed to improve the banking sector’s ability to absorb shocks arising from financial and economic stressoStated objective is to reduce the risk of spillover from the financial sector to

the real economy

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Basel Capital and Liquidity Reforms

• In December 2010, the Basel Committee agreed on a package of reforms (“Basel 3”) designed to: o Increase the capacity of banks to absorb losses relative to riskoConstrain leverage through a credible, non-risk-based backstop o Increase the capacity of banks to absorb shocks to funding and constrain

structural funding mismatches o Incorporate macroprudential perspectives into regulatory frameworkoProvide greater transparency to market participants

• The capital and liquidity standards are subject to phase-in and transitional arrangementso Liquidity and leverage standards subject to observation periods reflecting

need to assess unintended consequences

• Work continues on enhanced prudential standards for SIFIs and recovery and resolution planning

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Measuring Capital Adequacy

• Reforms introduce an explicit common equity standard and revisions to composition of regulatory capital to increase capacity to absorb loses on a ‘going concern’ basisoMore stringent criteria for instruments to qualify as regulatory capitalo Limited recognition of intangible assets and significant investments in the

common shares of FIs

• Revisions to measures of risk (RWA) designed to ensure capital requirements are commensurate with risks taken by banks and the risks they pose to the financial systemoRevisions to Market Risk rules to capitalize appropriately credit-sensitive and

structured trading positionsoChanges to capital requirements for counterparty credit risk, including charge

for mark-to-market losses o Increased capital requirements for credit exposures to large FIs.

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Calibrating Capital Requirements

• Amount of capital banks must hold relative to RWAs increased through imposition of higher minimum capital requirements and new ‘capital conservation’ buffer requirementso Introduction of explicit tangible common equity standard (tier 1 common

equity)oNon-discretionary restrictions on capital distributions for banks that fail to

maintain a buffer of capital above the minimum

• Under Base 1 and Basel 2, Tier 1 and Total Capital minimum requirements of 4% and 8% -- no explicit common equity standards

• Under Basel 3: oTier 1 common equity minimum of 4.5% of RWA oPlus “capital conservation buffer” of 2.5% of RWAoPlus countercyclical buffer – maximum of 2.5% of RWA

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Calibrating Capital Requirements (cont.)

• Basel Committee developed conceptual definitions to guide calibration effortsoMinimum requirement: the amount of capital needed to be regarded as a

viable, going-concern in the market oCapital Conservation Buffer: an amount of capital sufficient to withstand a

systemically stressful period and remain above minimum regulatory capital requirements

• Conceptual definitions are informative, but they cannot be directly observed (particularly the minimum)

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Empirical Strategy: Regulatory Minimum

• Examined historical distribution of earnings relative to RWA for large banksoKey assumption is that a high percentile loss realization is good proxy for

market viability test in an ex ante, unconditional way

• Return on Risk-weighted Assets (RORWA)oData from seven countriesoEstimated negative tail of the distributions (99th to 99.9th percentile) over

different horizons

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Summary of International Results: RORWA

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-4.00

-2.00

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Figure 1 Return on Risk-Weighted Assets

99th Percentile Results

Bars are the 99th percentile of the distribution of net income to risk-weighted assets based on data submitted by seven member countries. Some countries submitted more than one sample, using different definitions of net income (pre-tax and after-tax) or different definitions of risk-weighted assets.

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Empirical Strategy: Capital Conservation Buffer

• Look at historical episodes of systemic stress in the banking industry and see how much banks losto Losses (negative net income) in the recent crisis and in past historical crises,

U.S. and abroad

• Also examine 2009 stress tests results for eight countrieso Includes U.S. SCAP results

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Distribution of Net Income

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Summary of Capital Calibration Analysis

• Regulatory minimum results across percentiles, horizons, samples: 4% to 6% of RWA

• Capital conservation buffer results across approaches and samples: 3% to 7% of RWA -- results for some individual banks much bigger

• Empirical analysis based on Basel 1 and Basel 2 measures of RWA needs to be “translated” into Basel 3oMinimum: 4% - 6% Basel 1 4.5% Basel 3oBuffer: 3% - 7% Basel 1 2.5% (capital conservation) + max 2.5%

(countercyclical) Basel 3

• Calibration supported by Quantitative Impact Study (QIS) and analysis of long-run and transitional economic costs and benefits associated with higher capital standards

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Measuring Adequacy of Liquidity

• Basel Committee seeking to promote financial stability by addressing two complementary objectives:oEnhance resilience to short-term, acute shocks to funding oEffect longer-term structural changes in liquidity mismatches

• Two measures of liquidity risk developed to be implemented as minimum regulatory standardso Liquidity coverage ratio (LCR) -- risk sensitive, scenario-based measure to

size a minimum pool of high-quality liquid assets oNet stable funding ratio (NSFR) -- structural measure that compares estimate

of ‘reliable’ funding sources to estimate of required stable funding

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Designing and Calibrating Liquidity Standards

• LCR compares stock of high-quality unencumbered liquid assets to projected net cash outflows over a 30-day horizonoHigh-quality liquid assets should be unencumbered, liquid in markets during a

time of stress and central bank eligible

• Measure of stressed net cash outflows designed to capture potential risks associated with contractual and behavioral responses related to on- and off-balance sheet positionsoScenario reflects firm-specific shock during period of market stress

• Short-term stress net cash outflows scenario includes:oPartial loss of retail depositsoSignificant loss of unsecured and secured wholesale fundingoContractual outflows associated with a 3-notch rating downgradeoSubstantial draws on off-balance sheet exposures oHaircut on contractual inflows and aggregate cap

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Designing and Calibrating Liquidity Standards (cont.)

• Calibration of scenario runoff rates reflects a judgmental combination of historical experience during financial crisis, banks’ internal stress scenarios and existing regulatory and supervisory standard oCertain parameters reflect concerns about the potential drivers of systemic

risks including interconnectedness and the spillovers associated with the distressed fire sale of assets

• The Committee estimated impact of the liquidity standards -- assuming banks were to make no changes to their liquidity risk profile or funding structure, as of end-2009: oThe average LCR for Group 1 banks was 83%; the average for Group 2

banks was 98%oThe average NSFR for Group 1 banks was 93%; the average for Group 2

banks was 103%

• Committee observed material differences across institutions, business models and markets

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Going Forward

• Domestic rule making, phase in and observation period for capital and liquidity standards

• Basel Committee and Financial Stability Board continue to review regulatory and supervisory framework for global SIFIsoBasel Committee agreed on need for additional loss absorbency for G-SIFIsoPotential to link additional capital requirements to measures of systemic

importanceoDFA mandates that SIFIs in US have more stringent prudential requirements

• Expectations for recovery and resolution planning