Basel Presentation

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an elaborate quantitative analysis of the impact that an upgrade from Basel 2 to Basel 3 has on the stability and profitability of banks. It is a project work in a master course in International Economics, Banking and Finance. Upload with the consent of all the member in the group. The presentation was given to and graded by Professor Kent Matthews.






ZHU LIZI+Our TopicWhat are the main features of the Basel I and Basel II?How has Basel II attempted to address the problems associated with Basel I?What are the implications for international banking of adopting the proposed Basel III regulations?MEI KEFENG+2What is The Basel Accord? Refers to the recommendations on banking regulations Issued by the Basel Committee on Banking Supervision The Basel Committee is established by the central bank governors of the G10 countries in 1974 The first Basel Accord was released in 1988MEI KEFENG+BASEL I

Capital Accord(or the 1988 Accord)MEI KEFENG+Features of Basel I To determine minimum capital adequacy of a bank The Committee adopted the capital ratio as the measurement of capital adequacy

MEI KEFENG+Risk-Based Capital Ratio

MEI KEFENG+Types of Capital Tier 1 (Core capital)Banks are required to hold at least 4%Highest quality, lowest priority of repayment Tier 2 (supplementary capital)Limited to 100% of Tier 1 capitalAll other capital

MEI KEFENG+Credit Risk WeightsTypes of Assets Included in the Risk CategoryMEI KEFENGRisk WeightsAssets Category0%Cash, gold, bonds10%Short-term treasury bills20%Loans to OECD banks50%Residential mortgages100%All other loans+Market RiskDefined as a risk of loss from movements in market prices Tier 3 capital introduced to support market riskConsists of short-term subordinated debt with condition for at least two years maturity subject to lock-in provisionUnsecured debt, non-repayable before agreed repayment date and non-paid interest or principal Standardised Approach Internal Model (Value at Risk)

MEI KEFENG+Implications of Basel I Created global standard for banking regulations Same markets under the same regulatory capital requirements Fair and consistent systemDecrease competitive inequalityMEI KEFENG+Limitations of Basel I Overly broad Neglect other type of riskLack of risk diversification Created regulatory arbitrage A gap between the differences in risk profiles of the assets Pushed to the new framework of Basel IIMEI KEFENG+BASEL II

The International Convergence of Capital Measurement and Capital Standards:A revised Framework

SARANRAT ANUWATSIRIKUL+Minimum Capital Requirement

Market DisciplineBasel IIPillar 1Pillar 3Supervisory Review

Pillar 2 Some key elements from Basel I remain unchangedSARANRAT ANUWATSIRIKUL+Pillar 1: Minimum Capital RequirementRegulatory capital requirements against each risk type: Credit risk Market risk Operational riskSARANRAT ANUWATSIRIKUL+Credit RiskStandardised Approach (External Ratings)

Internal Ratings Based ApproachFoundation IRBAdvanced IRBSecuritisation ExposuresSeparate framework for exposures from securitisationCredit RatingAAA to AA-A+ to A-BBB+ to BB-Below BB-UnratedRisk Weight20%50%100%150%100%SARANRAT ANUWATSIRIKUL+Market RiskBasel I methods are still validStandardised ApproachBased on external ratings agencyInternal Value at RiskThe preferred waySARANRAT ANUWATSIRIKUL+Operational RiskDefined as risk of loss from internal processes, people, systems or external eventsBasic Indicator Approach15% of indicator (e.g. gross income)Standardised ApproachEach business segment uses own indicatorAdvanced Measurement ApproachBank uses own risk measurement systemSARANRAT ANUWATSIRIKUL+Pillar 2:Supervisory Review Review and evaluate banks internal models Intervene to correct potential imbalances Ensure all criteria are satisfiedSARANRAT ANUWATSIRIKUL+Pillar 3:Market Discipline Provide further insight into banks risk exposures Reinforce transparency to public Banks are to publish the information periodicallySARANRAT ANUWATSIRIKUL+How has Basel II addressed the problems of Basel I? Increase risk sensitivity Risk weights are assigned differently More accurate level of capital requiredNew approach to determine risk Minimise regulatory arbitrageMonitor more closely with banks real risk

SARANRAT ANUWATSIRIKUL+Limitations of Basel II Too much emphasis on external ratings agencyConcerns over reliability, biasness Create pro-cyclicalityBanks are forced to cut lending during crisis Further revise of Basel II Introduced Basel IIISARANRAT ANUWATSIRIKUL+BASEL IIIHUANG WENHAO+HUANG WENHAOPoor quality of capitalInconsistent regulation for leverage ratioProcyclicalityLack of considerations on systemic riskBasel IIIFinancial crisis+StructureHUANG WENHAO+ComponentsHUANG WENHAOPaid in capital, common equity

Share premium

Retained earnings

Surplus reserves

Minority interestsInnovative capital instruments

Basel IITier 1Basel IIICommon EquityOthersNot included> 50%> 50%+ComponentsHUANG WENHAOTier 3Tier 2Simplifying Tier 2 capital, only one set of eligibility criteria for Tier 2 capital, the other sub-categories will be canceledRevaluation reserves, undisclosed reserve

Hybrid Instruments

Subordinated Debt+Capital Requirement (Quantity)HUANG WENHAO

+Transition Period

Minimum Capital RequirementHUANG WENHAO

Capital Conservation BufferAs a supplement, capital conversation buffer with 0.625% annual rate of increase will be gradually introduced in 2016, and it will reach the final 2.5% requirement in 2019

+Counter-cyclical BufferTo combat procyclical behavior, Basel III requires banks to maintain a counter-cyclical bufferIt ranges from 0%-2.5% of risk-weighted assetsThe exact amount of the counter-cyclical buffer will be decided by national regulatory authorities and determined by the amount of credit in an economy, with more credit leading to a higher buffer Purpose: To ensure that banks are sufficiently capitalized during periods of excess credit growth, which usually occur when the perceived risk in assets is lowHUANG WENHAO+Counter-cyclical BufferHUANG WENHAO

+Leverage RatioBasel III also implements a leverage ratio, which requires banks to maintain an amount of capital at least 3% of the banks total assetsDefinition:Numerator: Measure of capital is Tier 1Denominator: Exposure is based on accounting balance sheetPurpose:Protect against model risk and measurement errorServe as a capital floor to ensure that banks have at least some amount of capital to protect it against unforeseen losses HUANG WENHAO+LiquidityTwo Indicators:HUANG WENHAO

>100%>100%+Implications of Basel IIIZHU LIZI+Implications of Basel IIIRECAP Requires higher level of capital ratio and higher quality of capital Introduces liquidity coverage ratio and leverage ratio ZHU LIZI+Implications of Capital Ratio Requirement Weakens banks ability to lend Leads to a likely slow recovery from crisis Reduces profitabilityZHU LIZI+Implications of LCR and NSFR Banks are forced to hold high quality liquid assets, and lower yielding assets, hurts profitability

In particular, those relying largely on short-term wholesale funding Banks will use more stable source of fundingZHU LIZI+Implications of Leverage Requirements Limits the size of the balance sheet of a bank Reduces the size of activity a bank can takeZHU LIZI+What banks do To lower cost Hire less people More IT - related segment Restructure business lines Reallocate resources ZHU LIZI+Timeline: The Bright Side of It The lengthy timeline mitigates the stress Banks will have time to adjustZHU LIZI+Issues Left Unaddressed The system of calculating RWAs carried over from Basel IIExternal rating system is hard to justifyInternal rating system is hard to harmonizeZHU LIZI+Outlook of Regulations Need to address a lot of issues with the way of calculating RWAs A step of a few to comeZHU LIZI+Thank You

Please feel free to ask questionsTHANK YOU+