Basel III - Training Deck v1.11

7/23/2019 Basel III - Training Deck v1.11

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Copyright © 2011 Tata Consultancy ServicesLimited

Introduction to Basel III



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Agenda

Background

Liquidity Risk Management

Capital & Leverage

Counterparty Credit Risk

Market risk



3

• 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

Objective



4

Basel III – Highlights

Basel III

Capital

Market Risk

Pillar 2 &

Pillar 3**Securitisation

Liquidity

Risk

Counterparty

Credit Risk

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

Increased MR Specific Risk Charge for

equities, credit derivatives

Enhanced VaR modeling, MR stress

testing guidelines

New risk measures - Incremental Risk

Charge, Stressed VaR

Enhanced Pillar 2 guidelines for

Securitisation, illiquid positions, wrong wayrisk, Model Validation, Back Testing, Credit

Rating Agencies

Enhanced disclosures for Securitisation

exposures in Trading Book, Market Risk,

Counterparty Credit Risk (incl. Wrong Way

Risk)

Higher risk weights for resecuritisations

Banks not permitted to use “Ratingsresulting from self-guarantees”

Increased CCF for Liquidity facilities

Specific Risk Charge alignment across

Banking Book & Trading Book

New measure “CRM” for Correlation

Trading Portfolio

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)

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, Market-

related monitoring tools** Not in scope

for this WBT



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Key Timelines – Basel III

Source : BCBS Basel III Timelines



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Liquidity Risk Management

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 Introduction

LRM Monitoring

LRM Stress Test

LRM Governance - Principles & Supervision

LRM Public Disclosures

LRM Summary



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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 AnalysisImplementation Observation Liquidity Reporting

2008 - 2010 2010 - 20112011 -

2012

2013 -

20152015 - 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



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Liquidity Risk – Introduction (1/4)

“One of the main reasons the economic and financial crisis became so severe was thatthe banking sectors of many countries had built up excessive on- and off-balance sheetleverage.

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 andcredit losses nor could it cope with the re-intermediation of large off-balance sheetexposures 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 Comm it tee, Strengthening the resi l ience of the banking sector -

cons ul tat ive document



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Liquidity Risk – Introduction (2/4)

Asset and liability mismatch generates not only interest rate

risk liquidity risk

Different meaning of “liquidity”:

Secur i ty ease with which it can be cashed back or traded, evenin 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 ofinformational asymmetry, time needed to carry out a trade

Function of tightness (market’s ability to match supply and demand at low cost) and depth(ability to absorb large trades without significant price impact)

Financ ial inst i tut ion ability to fund increases in assets andmeet obligations as they come due, without incurring high losses

Generally proxied by the difference between the average liquidity of assets and that ofliabilities



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Liquidity Risk – Introduction……..(3/4)

Selling assets

at a price belowtheir market

value

transformationof

short-termdeposits into

long-term loans

Prepayment of loans

UnforeseenUsage of

Credit lines

Inability to

paybackliabilities

Eventsleading to

Liquidity Risk



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LRM Introduction…………..(4/4)

TransactionalLiquidity

Risk

Market

liquidity risk

Tradability

risk

Long-termfunding risk

Party A fails to fulfill

liquidity to execute

transaction

Other counterparties

Subsequently lack liquidity,

creating trust issues

in the market

Uncertain, lower-quality

assets are no longer

accepted for trade or

collateral against liquidity

Market refrains

from providing

liquidity

Part of banks’ existing

liquidity buffer – de facto –

becomes illiquid

Banks compete for

increasingly smaller pool

of liquidity

Accrued difficulty to fund

ongoing bank activity on

the interbank market

Difficulty providing sufficient

and timely assets for

transactions increases

1

2

3

45

6

7

8

Liquidity Risk – Vicious Cycle



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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 liquidity7.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



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LRM Basel III - Key Changes

# Basel III - LRM 2010 BCBS Guidelines

* ALM Guidelines

^ LCR – Liquidity Coverage Ratio

% NSFR – Net Stable Funding Ratio



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LRM Functional View

Cash Flow DataTransaction

DataHistorical DataPosition Data

Reference

DataALM Data

Pricing /

Valuation

Bank’s Assets and Liabilities

Governance & Liquidity Policies Regulatory Requirements

LRM Components Cash Flow Engine

Cash Inflow

Cash Outflow

Monitoring Tools

Maturity Mismatch

Funding Concentration

Market Monitoring

Unencumbered Assets

LCR by Currency

Public Disclosures

Daily Cash Flow Reports

Enhanced Mismatch Reports

Local Regulators(OSFI,APRA ..)

Disclosures

Quantitative Analysis

Risk Models Simulations

Reconciliation

Scenario Analysis

Stress Testing

Extreme Stressed Scenario

Stressed Cash Flow

Limits Management

Behaviour Analysis

LCR NSFR



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LRM Data Sources

Source System Data

• Cash Flows

• Transaction Data

• Position Data

• Reference Data

• Market Data

• Security Data

• Historical Data• Internal Limits

Data Mapping / Business Rules / ReconciliationCategorize Data

• ON Balance Sheet / OFF Balance Sheet

• Banking Book / Trading Book

• Data Hierarchy / Liquidity Category

• Legal Entity / Business Units

• Reporting Lines

• Asset / Liability

• Transformation

• Source Target Data Check

• Data Validation / Integrity Check

• Data Reconciliation

• Defaulting / Enrichment / Aggregation / Limit

LRM Ready Data

• Analytics Data

• Stressed Data

• Ratio Calculation Data

• Forecasting Data

• Limits Data

• Reporting Data

• Exception Data



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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



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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 institution’s 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, includingcommitted credit and liquidity facilities.

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



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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.

Stock of High quality liquid assets (HQLA)

LCR = --------------------------------------------------- ≥ 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



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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.



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Level 1 Assets

Level II 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 thecountry

– Domestic sovereign or central bank debt securities issued in foreign currencies,

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



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Portfolio’s should have least

correlation

Being listed increases assets

transparency.

Unencumbered Asset shouldn't be

pledged as a collateral except for

some exceptions

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.

Fundamental

Characteristic

of HQLA

Ease and

Certainty of

Valuation

Eligible for

Intraday

Liquidity Needs

Low

CorrelationWith Risky

Assets

Low Credit

And MarketRisk

Listed on

Recognized

Stock

Exchange

Unencumbered

Asset

Eligible by central bank for intraday liquidity

needs.

The asset price calculation formula of high-

quality assets should be simple and not

depend on strong assumptions.




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Asset should have active outright

sale or repurchase agreement

markets at all times

Quotes will most likely be available

for buying and/or selling a high-

quality liquid asset.

Diverse group of buyers and sellers

in an asset’s market increases the

reliability of its liquidity

Historically, the market has shown

tendencies to move into these

types of assets in a systemic crisis


HQLA Market

Characteristic

Active and

SizeableMarket

Flight toQuality

Presence

of Committed

Market

Makers

Low Market

Concentration



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Net stable Funding Ratio

Available Stable Funding (ASF)

= --------------------------------------------- ≥ 100%Required Stable Funding (RSF)

RSF Factor ASF Factor

Assets

Unencumbered

Assets

Consumer loans

Corporate Loans

Inter Bank Loans

0 % - 50 %

85 % - 100 %

50 % - 100 %

50 % - 100 %

LongTerm

Funding

Liabilities

Non Core Deposit

Core Deposit

Long Term Funding

Equity

70 %

85 % - 100 %

100 %

100 %

LongTerm

Funding

Short Term Funding 0 % - 50 %



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NSFR promotes medium to long-term funding thus reducing incentives forshort-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 instrument’s liquidity characteristics



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ABC Bank’s 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 bank’s 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 under Basel

III

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 BaselIII

228 268 370 436 516



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Basel III Impact 2011 2012 2013 2014 2015

Capital shortfallunder Basel III

Tier I Capital

shortfall

42 50 13 -42 -88

Total Capital

shortfall

10 23 -76 -103 -137

Leverage ratio

limitations

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

Liquidity ratios

Basel III LCR

funding gap

0 0 0 0 -200

Basel III LTFR

(observation)

141% 137% 130% 126% 123%

ABC Bank’s Capital & Liquidity Gap under Basel III..(2/2)



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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)



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LRM Cash Flow (2/3) – Cash Outflow Categorization

Retail

DepositRun offs

Secured

WholesaleFunding Run-offs

Unsecured

WholesaleFunding Run-offs

AdditionalRequirements

Deposits from anindividual

natural person

Secured Fundingcollateralized

by level 1 assets (run-offrate = 0%)

Provided by smallbusiness customers(5%, 10%, 15% and

higher)

Derivatives Payable(run-off rate = 100%)

Retail depositsSubjectto LCR include demand

deposits and termdeposits

Secured Fundingcollateralized

by level 2 assets (run-offrate = 15%)

Funding with

operational relationships(run-off rate = 25%)

Valuation change onposted collateral

securing derivativetransaction of non-Level 1

Asset (run-off rate = 20%)

Stable deposits(run-off rate = 5% or

higher)

Secured Funding withdomestic sovereigns,

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

Treatment of deposits ininstitutional networks of

cooperative banks (run-offrate = 25%)

Liabilities related toderivative collateral callsrelated to a downgrade ofup 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 entitycustomers

(run-off rate = 100%)

Draw-downs on credit andliquidity facilities havedifferent run off rates

Other Contractual cashoutflows (outflow rate =

100%)



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LRM Cash Flow (3/3) – Cash Outflow categorization

Reverse Repo and

SecuritiesBorrowings

Other CashInflows Inflows byCounterparty OperationalDeposits

Level I assets if collateral not

used to covershort positions -0%

if collateral used

to cover shortpositions- 0%

DerivativesReceivable

(Inflow rate = 100%)

Retail and SmallBusiness

Inflow (inflow rate =50%)

Inflow rate is 0%since deposits heldat other institution

for operationalpurpose areassumed to

stay with institution

Credit or

Liquidity Facility

The draw-down rateis 0%

since Credit,liquidity, or any othercontingent fundingthat bank holds at

other institution forits own purpose areassumed to be

unable to be drawnin stress times.Level II assets

if collateral notused to covershort positions-15%

if collateral usedto cover short

positions – 0 %

For all the remainingcontractual

inflows,its inflowrate is

decided by thesupervisor

Other wholesaleInflow 100% inflows

from financialinstitutioncounterparties

50% inflow ratefor non- financial

wholesalecounter parties

Valuation changeson posted collateralsecuring derivative

transactions of non-Level 1 Assets (run-

off rate = 20%)

All other collateral if collateral not

used to covershort positions -100%

if collateral usedto cover shortpositions - 0%

Liabilities related toderivative collateral

calls related to adowngrade of up to3-notches.(run-off

rate = 100%)



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LRM Monitoring (1/4)

Contractual

Maturity

Mismatch

Funding

Concentration

Market

Monitoring

Unencumbered

Assets

Contractual maturity used as

behavior model Measures time to insolvency

No short-term funding is rolled

over

To monitor concentration of

Counterparty , Product andCurrency

Funding should be

diversified

Equity prices, debt markets,

Forex markets etc

Monitoring financial sector

Monitoring bank specific

(i) Eligible for collateral, or, (ii)

Eligible for central bank facilities

Amount , Currency denomination

Estimated market haircut

Location/Business unit



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LRM Monitoring (2/4) – Maturity Mismatch Report



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LRM Monitoring (3/4) - Funding Concentration Report



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LRM Monitoring (4/4) – Market Monitoring

$65,656,875

$7,471,425

$9,854,758

$5,869,854

$58,874,125

$25,852,541

$69,852,365

$58,744,523

Geography wise

North America

Latin America

Africa

EMEA

Asia

APAC

BRIC

AUSTRALIA

1.0000%

5.0000%

4.2000%

1.2000%

3.0000%4.2000%

1.2000%

3.0000%

1.0000%

5.0000%

4.2000%

Returns Quarterly

Information Technology

Banking & Finance

Aviation

Oil and Gas

Construction

Telecommunication

Food and Drinks

Mining

Transport

$6,502,521

$685,214

$85,241

$5,878,962$258,524

$6,985,425

$7,035,319

$25,874,152

Asset Type wise

Bonds

Forex *

Swaps*

Options*

Futures*

Forwards*

EquitiesMoney Market

$1,325,822

$14,568,752

$6,515,852

$5,236,517

$25,658,415

Portfolio wise

Emerging Markets

Blue Chips

Infrastructure

Energy & Utilities

Technology



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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 bank’s

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

LRM Stress Test (1/2) - Guidelines



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LRM Stress Test (2/2) - Methodology

Erosion in value of

liquid assets

Additional collateral

requirements

Evaporation of

funding

Withdrawal of

deposits etc

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

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

Identify Liquidity

Risk Drivers

Design StressScenarios (and

Probabilities)

Model Stress

Tests



36

LRM Governance Principles & Supervision

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

Establishment of

policies and risk

tolerance

Comprehensive cash

flow

forecasting

Limits and liquidity

scenario stress testing

Robuust and

multifaceted

contingency

funding plans

Maintenance of

sufficient

cushion of HQLA

Clearly articulate

liquidity risk tolerance

for

business strategy

Strategy policies

and practices in tandem

with risk tolerance

Incorporate

liquidity costs

Incorporate benefits and

risks ininternal pricing

performance measure

& new product

approval process

Identifying, measuring,

monitoring and

controlling liquidity risk

Projecting cash flows

from assets, liabilities

and off- B/S items

Actively manage Intra-

day liquidity positions

Actively manage

collateral positions

Conduct stress tests

on a regular basis

Contingency funding

plan that addressing

liquidity shortfalls

Disclose information

On regular basis

Market participants to

make an informed

judgment

regularly perform a

comprehensive

assessment

Monitoring combination

of internal , prudential

reports and mkt info

Communicate with other

supervisors and

public authorities

Key Highlights of Committee’s Proposal



37

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 itsliquidity 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



38

LRM Summary

Background

The recent credit crisis compounded quickly into a major liquidity crunch leading to insolvency of majorfinancial 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



39

Basel III - Capital Requirements

Composition of Capital

Capital Adjustment

Former deduction from capital

Capital Conservation Buffer

Counter Cyclical Buffer

Leverage Ratio

Summary

What changes in Basel III



40

Why Basel II has changes

Raising the quality,

consistency and transparency

of the capital base

Reducing procyclicality and

promoting countercyclical

buffers

Supplementing the risk-

based capital requirement

with a leverage ratio

Basel II – key

weaknessBasel II –

key changes

Many regulatory adjustments

are not applied to common

equity, allowing to report highTier 1 ratios

No harmonized list of regulatory

adjustments

Hybrid capital proved to be lessvaluable in times of stress than

anticipated



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Composition of Common Equity Tier 1 Capital

Common shares issued by thebank that meet the criteria for

classification as common

shares for regulatory purposes(or the equivalent for non-joint

stock companies);

Stock surplus (sharepremium) resulting from the

issue of instruments includedCommon Equity Tier 1;

Retained earnings;

Accumulated othercomprehensive income andother disclosed reserves;

Common shares issued byconsolidated subsidiaries ofthe bank and held by third

parties (ie minority interest)that meet the criteria for

inclusion in Common Equity

Tier 1 capital.

Regulatory adjustmentsapplied in the calculation of

Common Equity Tier 1

CommonEquity Tier 1



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Composition of Additional Tier 1 Capital

Instruments issued by the bank thatmeet the criteria for inclusion inAdditional Tier 1 capital (and are notincluded in Common Equity Tier 1);

Stock surplus

(share premium)resulting from theissue of

instrumentsincluded in

Additional Tier 1capital;1;

Instruments issued by consolidatedsubsidiaries of the bank and held bythird parties that meet the criteria forinclusion in Additional Tier 1 capital

and are not included in CommonEquity Tier 1.

Regulatoryadjustmentsapplied in thecalculation of

Additional Tier 1Capital

AdditionalTier 1 Capital



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Composition of Common Equity Tier 1 Capital

Instruments issued by the

bank that meet the criteriafor inclusion in Tier 2 capital(and are not included in Tier1 capital)

Stock surplus (sharepremium) resulting fromthe issue of instrumentsincluded in Tier 2 capital

Instruments issued byconsolidated subsidiaries

of the bank and held bythird parties that meet the

criteria for inclusion inTier 2 capital and are notincluded in Tier 1 capital

Certain loan lossprovisions

Regulatory adjustments

applied in the calculationof Tier 2 Capital

Common

Equity Tier 1



44

Capital adjustments

Goodwill and other

intangibles (except

mortgage servicing

rights)

Shortfall of the stock ofprovisions to expected

losses

Investments in own

shares (treasury stock)

Deferred tax assetsGain on sale related to

securitisation transactions

Reciprocal cross holdings

in the capital of banking,

financial and insurance

entities%)

Cash flow hedge reserve Defined benefit pensionfund assets and liabilities

Capital

Adjustment



45

Former deductions from capital

Treatment

• The following items, which under Basel II were deducted 50% from Tier 1 and 50% from Tier 2 (or hadthe 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



46

Capital Conservation Buffers

Background

• The capital conservation buffer, which is designed to ensure that banks build up capital buffers outsideperiods 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 theregulatory 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 > 7.0% then the MCCR to be maintained is 0%



47

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



48

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-riskbased “backstop” measure.



49

Calculation of Leverage Ratio

Leverage RatioTotal Capital

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

Capital measure

The capital measure for the leverage

ratio will be based on the new

definition of Tier 1 capital

Exposu re measure

On-balance sheet items

(a) Treatment of Repurchase agreements

and securities finance

(b) Treatment of Derivatives

General measurement principles

Items that are deducted completely

from capital do not contribute to

Leverage and will be deducted fromthe measure of exposure Off-balanc e sheet items



50

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



51

Agenda

Counterparty Credit Risk (CCR) - Introduction

Changes in Basel III on CCR

Wrong Way Risk

Credit Valuation Adjustment (CVA)

Types of CVA Capital Charges

Types of Aggregation of CCR Capital Charges

Qualitative Criteria

Other measures

Summary

Other Changes



52

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 transaction’s 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 firm’s 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




53


- 5 3 -

CCR Focus Areas

C r e d i t V a l u a t i o n A d j u s t m e n t

W r o n g W a y R i s k

C V A C a p i t a l C h a r g e

G

e n e r a l W r o n g W a y R i s k

S p

e c i f i c W r o n g W a y R i s k

O t h e r M e a s u r e s

A g g

r e g a t i o n o f C C R C a p i t a l

Q u a l i t a t i v e C r i t e r i a

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 financingactivities. The building blocks as described in the diagram above are explained in later

slides.



54

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

Other Changes - Counterparty Credit Risk (CCR) –



55

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.

W W Ri k



56

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.

?

T f W W Ri k



57

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.

?

S ifi W W Ri k



58

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 counterparty’s 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


G l W W Ri k



59

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

C dit V l ti Adj t t (CVA)



60

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 counterparty’s 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 mid-

market 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

T f C dit V l ti Adj t t (CVA) C it l Ch



61

Types of Credit Valuation Adjustment (CVA) Capital Charge

Types ofCVA Capital Charge

Banks with IMM approvaland Specific Interest Rate

Risk VaR model approval

for bonds -

Advanced CVA risk capital

charge

All other banks -standardised CVA risk

capital charge


A ti f CCR C it l Ch



62

Aggregation of CCR Capital Charge

Types of Aggregationof

CCR Capital Charge

Banks with IMM approval

and market-risk internal-

models approval for the

specific interest-rate risk

of bonds

Banks with IMM approval

and without Specific Risk

VaR approval for bonds

All other banks


Banks with IMM approval and Market-risk Internal



63

Banks with IMM approval and Market-risk Internal

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 forEAD and (b) the IMM capital charge based on stressed parameter calibrations for EAD.

– The advanced CVA risk capital charge


Models approval for the Specific Interest-rate Risk of Bonds

Banks with IMM approval and without Specific Risk VaR



64

approval for Bonds

Further details :-


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


All Other Banks



65

All Other Banks

Further details :-


components

– The sum over all counterparties of the CEM or SM based capital charge (depending on

the bank’s CCR approach) with EAD

– The standardised CVA risk capital charge


Qualitative requirements



66

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 .

?

Other measures Enhanced Collateral Management Requirement



67

Other measures Enhanced Collateral Management Requirement


• 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.


Other measures - Enhanced requirements regarding re-use ofcollateral



68

collateral


• The nature of collateral is consistent with the Bank’s liquidity strategy and enable the

bank’s ability to post or return collateral in time.


Other measures Treatment of highly leveraged counterparties



69

Other measures - Treatment of highly leveraged counterparties


• 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.


Other measures - Requirements for stress testing of CCRmodels 1/3



70

models 1/3


• 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 testingof 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 non-

directional 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.





71

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.


models 2/3




72

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 lesserseverity 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 bank’s risk appetite and elevated for discussion and action when

excessive or concentrated risks are present.


models 3/3

Other measures - Back testing and model validation guidelines for



73

CCR 1/3

Qualitative criteria

The Basel committee identified significant shortcomings in the bank’s 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 ascomparing 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 essentialaspect 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 bank’s overall risk exposure.

bank’s overall risk exposure.Source: Basel III: A global regulatory framework for more resilient banks and banking systems, rev June 2011




74

CCR 2/3


•The bank’s 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 bank’s 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 bank’s riskmeasurement 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 bank’s 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.





75

CCR 3/3


• 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 model’s accuracy as described


Other measures - Increase margin period of risk for collateralised trades



76

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 affectednetting set.


Other measures - Increase margin period of risk for collateralised trades

2/2



77

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


2/2

Other measures - Capital charges for exposures to CCP



78

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).


Other measures - Standard haircut for securitization collateral



79

Other measures Standard haircut for securitization collateral

Other measures

Basel committee has introduced a new recalibrated supervisory haircuts (assuming mark-

to-market, daily re-margining and 10-buiness day holding period) expressed as a

percentage. Supervisory haircuts for collateral are as follows:


Other measures - Expected positive exposure(EPE)

l l d b d d i



80

calculated based on stressed input

Other measures

Effective expected positive exposure (EEPE) is required to be calculated using a three-

year 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.


Other measures - Changes in External Ratings



81

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.


Summary



82

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 CounterpartyCredit 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

Agenda



83

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

Basel II vs. Basel 2.5



84

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

• 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 thesecuritization 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 re-

securitizations 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

Basel II Basel II.5

Summary of Market Risk updates



85

Market Risk updates

Standardized Approach Internal Measurement Approach

Specif ic risk charge for correlation trading

portfolios

Specific risk charge for securitization

Specific risk charge for credit derivatives

Specific risk charge for equities

Risk weights for resecuritization

CCF for securitization liquidity facilities

Specification of Market risk factors

Amendment of qualitative standards

Stressed VaR

Specific risk charge for Interest rate sensitive

positions

Incremental Risk Charge (IRC)


y p

Correlation Trading Portfolios



86

g

8

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

• 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 theevent of a specified number (n) of defaults out of a pool of underlying assets

• 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 criteriamentioned above

Correlation Trading Portfolio

Correlation Trading Portfolio Criterion

In the past, banks did not hold sufficient capital for specific risk and that’s 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

Specific Risk Charge - for Correlation Portfolios



87

Spec c s C a ge o Co e at o o t o os


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.

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 ofspecific risk and Incremental Risk Charge for these portfolios.

Standardized Approach

Internal Model Approach

Specific Risk Charge - for Securitization (1/2)



88

p g ( )


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

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

Standardized Approach

Resecuritization exposures are subject to specific risk capital charges depending on whether

or not the exposure is senior

Specific Risk Charge - for Securitization (2/2)



89

p g ( )


If the bank have an approval to use Internal Rating Based (IRB) Approach, in the banking booka 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

Internal Rating Based Approach

Specific Risk Charge - for Credit Derivatives



90

p g


First to default credit derivative

N-th-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 bank’s exposure

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

Specific Risk Charge for Equities



91

g


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%.

The capital charge for specific risk and for general market risk will each be 8%

Basel II

Basel II.5

Resecuritization under Standardized Approach



92

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

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 applicable for resecuritization exposures are added for Standardized approach

as well as IRB Approach, to reflect that they are riskier

Resecuritization under IRB Approach



93

pp


• 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.


CCF for Securitization liquidity facilities – SA



94


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

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

Basel II

Basel II.5

Specification of Market Risk Factors



95


An important part of a bank’s 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

bank’s 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.

• 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-to-

default 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

Additional Guidelines

Amendment of Quantitative Standards



96


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

• 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 newregulations 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

Additional Quantitative Standards

Stressed VaR (sVaR): Introduction



97


What is Stressed VaR ?

• It is VaR based on a one-year observation period relating to significant losses (additional to the VaR based onthe 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 bank’s current portfolio if the relevant market factors were experiencing aperiod of stress

Why Stressed VaR ?

• Losses in most banks’ trading books during the financial crisis were significantly higher than the minimumcapital 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 one-

year observation period relating to significant losses

Stressed VaR: Guidelines



98


Key Guidelines

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

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

• The multiplication factors mc and ms will be set by individual supervisory authorities on the basis of their

assessment of the quality of the bank’s risk management system, subject to an absolute minimum of 3 for mc

and an absolute minimum of 3 for ms

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

Maximum of its

• Previous day’s 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-risknumbers over the preceding sixty business

days (sVaRavg), multiplied by a multiplication

factor (ms)

Treatment of Specific Risk: Interest Rate Positions



99


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 bank’s 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

Incremental Risk Charge (IRC): Introduction



100

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

Why IRC was introduced ?

• During the financial crisis a number of major banking organizations experienced large losses, most of whichwere 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 actualdefaults 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 capitalhorizon at 99.9 % confidence level

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 the99.9% percent confidence interval over a capital horizon of one year

• Default Risk is the potential for direct loss due to obligor’s 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

IRC: Estimation & Coverage



101


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)

• IRC will be measured at least on a weekly basis

Maximum of its

• Previous day’s Incremental Risk measure (IRCt-1); and

• Average of the Incremental Risk Charge measures over 12 weeks

(IRCavg), multiplied by a multiplication factor (mc)

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

IRC: Supervisory Requirements



102


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

IRC: Modelling



103

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 defaultprobabilities

• The effect of seniority or other instrument specific characteristics must be incorporated within

the estimates for loss given default





104

What is CRM ?

• Under Internal Model Approach, for correlation trading portfolio the banks may be allowed toapply 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)

• 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

Maximum of its

• Previous day’s Comprehensive risk measures (CRMt-1); and

• Average of the Comprehensive risk measures over 12 weeks (CRMavg),

multiplied by a multiplication factor (mc)


CRM: Modelling



105

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)




Thank You

Basel III - Training Deck v1.11

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