White Paper
Basel II to Basel III The Way forward
- Rohit VM, Sudarsan Kumar, Jitendra Kumar
Abstract
Basel III guidelines are the response of BCBS (Basel Committee on Banking Supervision) to the 2008 Crisis. It is aimed at
strengthening Individual Financial Institutions as well as the overall Financial System by eliminating the weaknesses which
were present in BASEL II that were revealed during the crisis.
BASEL III has a multi-dimensional impact on financial Institutions and will require associated changes to the IT systems.
This paper covers various BASEL III guidelines, and describes the Why and How different areas of IT infrastructure and
systems will be impacted.
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Introduction
Some very fundamental assumptions by financial institutions and regulators were proven wrong during the 2008 Crisis. The business
of subprime lending was based on the assumption that housing prices would keep going up. This assumption proved wrong and it
triggered a chain reaction that engulfed the global financial system. This crisis cycle is illustrated in the diagram below.
There were some incentives present in the financial system that encouraged risk taking. Transferring of risk through securitization; relying on
credit ratings provided by credit rating agencies, which were paid for by the issuers; compensation of top management based on absolute
growth, revenue and profit rather than risk adjusted profitability; were just some of the reasons that encouraged excessive risk taking by banks.
When subprime loan defaults started impacting the balance sheets of financial institutions, it became a systemic problem. Quarterly
losses to the tune of billions of dollars by major Financial Institutions resulted in a crisis of confidence that sucked out liquidity from the
financial system. At this time, the weaknesses of the BASEL II guidelines became very evident.
Exposure to risky assets in the form of subprime loans, securitization and derivatives resulted in excessive losses. The low quality and
quantity of capital could not absorb these losses when systemic risk materialized. The banks loss absorbing capacity was affected
because of their excessive leverage and their short term sources of funding made financial institutions gasping for capital when it was
most difficult to raise capital.
Sub-Prime
Lending
Securitization
Excessive Risk Taking
Governments step in
to inject capital to
prevent systemic
failure
Housing prices
decline resulting in
sub-prime defaults
Sub-prime defaults,
Securitized assets &
derivatives trading
resulted in huge
losses
Excessive leverage &
poor capital could not
absorb losses fully,
demanding fresh
equity infusion
In stressed market situations, Credit
Rating downgrades of Financial
Institutions & securitized products
further lowered valuations &
increased losses
Firms on the verge of
insolvency;
threatening system
failure
Short term borrowing
demanded fresh
borrowing which
failed in liquidity crisis
Huge losses resulted
in a crisis of
confidence causing
liquidity to evaporate
BASEL III attempts to plug the loopholes present in BASEL II by recommending steps to further strengthen the overall financial system. BASEL
III requires higher risk weights for risky assets bringing more assets/exposure into the umbrella of Risk Weighted Asset (RWA) calculations,
prescribes a higher regulatory capital requirement and demands a very high quality of capital. It also introduces requirements to manage
liquidity risk better. Finally, it introduces an additional requirement of absolute leverage ratio to take into consideration the model error
which might be present in RWA calculations.
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The diagram below highlights where and how BASEL III changes will address the deficiencies in the crisis cycle.
Capital Conservation /
Counter-cyclical buffers
Sub-Prime
Lending
Securitization
Excessive Risk Taking
Governments step in
to inject capital to
prevent systemic
failure
Higher quantity & quality of
capital
Leverage Ratio introduced
100% weight for trade finance
Less reliance on external
ratings agencies
CVA Capital Charge
Stressed Testing
Housing prices
decline resulting in
sub-prime defaults
Sub-prime defaults,
Securitized assets &
derivatives trading
resulted in huge
losses
Correlation to financial institutions
will carry more risk weights to
prevent systemic risks and an
overall collapse
Firms on the verge of
insolvency;
threatening system
failure
Enhanced Supervisory
Review and Disclosure
Excessive leverage &
poor capital could not
absorb losses fully,
demanding fresh
equity infusion
In stressed market situations,
Credit Rating downgrades of
Financial Institutions &
securitized products further
lowered valuations &
increased losses
Short term borrowing
demanded fresh
borrowing which
failed in liquidity crisis
Huge losses resulted
in a crisis of
confidence causing
liquidity to evaporate
Two new liquidity
ratios
In summary, the BASEL III rules will strengthen the capital reserves and introduce stringent reporting requirements that cover key risk, liquidity and
leverage parameters. The BASEL III guidelines also attempt to bolster the weak links in the financial system with the introduction of Central Clearing
Houses and lessen the dependency on Rating Agencies. The chart below captures the key aspects of the BASEL III guidelines that have been introduced.
Increase in common equity requirement from 2% to 4.5%
CAPITAL
Increase in Tier 1 Capital (Going Concern) from 4% to 6%
Overall capital will remain the same at 8%. (Which means Tier 2 capital, or gone concern capital to reduce to 2% of
total capital)
Tier 1 Capital can no longer include hybrid capital instruments with an incentive to redeem through features such as
step-up clauses. These will be phased out
Tier 3 Capital will be eliminated (previously used for market risk)
CAPITAL BUFFERS
Introduction of Capital Conservation Buffer - 2.5% of Common Equity Tier 1
Introduction of Counter Cyclical Buffer - 0 to 2.5% of Risk Weighted Assets (RWA)
Credit Valuation Adjustment (CVA) Capital Charge must be calculated to cover Mark-to-Market losses on counterparty
risk to Over The Counter (OTC) Derivatives.
RISK
MANAGEMENT
Stressed parametes must be used to calculate Counterparty Credit Risk
Effective Expected Positive Exposure (EPE) with stressed parameters to be used to address general Wrong-Way Risk
(WWR) and Counterparty Credit Risk
Banks must ensure complete trade capture and exposure aggregation across all forms of counterparty credit risk (not
just OTC derivatives) at the counterparty-specific level in a sufficient time frame to conduct regular stress testing.
A multiplier of 1.25 is applied to the corelation parameter of all exposures to financial institutions (meeting certain
criteria) (Asset Value Correlation - AVC)
Additional margining required for illiquid derivative exposures
100% risk weight for Trade finance
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LIQUIDITY
Liquidity Coverage Ratio (LCR) >= 100%
Net Stable Funding Ratio (NSFR) > 100%
LEVERAGE
REPORTING
Leverage Ratio >= 3%
Contractual maturity mismatch
Concentration of funding
Available unencumbered assets
Market-related monitoring tools: asset prices and liquidity, Credit Default Swap (CDS) spreads and equity prices
LCR by currency
Results of stress tests should be integrated into regular reporting to senior management
RATING
AGENCIES
Lower reliance on External Rating Agencies
Basel III New Requirements
IT Impact Summary of Change
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Data Sources
ETL
Staging
Origination
System
Basel II Risk Environment
G/L Reconciliation
Collateral
Mgmt.
System
Factor Model Environment
Reference
Data
External
Sources
Staging/ODS
Servicing
System
Loss &
Recovery
System
RWA Calculation will change
because of the new data
fields and new risk weights
RWA Calculation and Reporting
Risk
Datamarts
Source System Extracts
In general, a BASEL III implementation
will require additional source
systems to be included, changes
to the data elements of existing
source systems to be made, changes
to the risk data models to be done,
RWA calculations and reporting
modules to comply with regulatory
reporting guidelines. These changes
are highlighted in the pictorial
representation in the diagram.
Updated Models will incorporate
new sources of capital (new data
fields) and stressed parameters
New Sources of Data
(Cash Flows) required to
calculate LCR/NSFR.
Data Quality/CDC
The architecture below represents
a typical BASEL II set-up. Exposure
and reference data information
is extracted from multiple source
systems through Extract, Transform
& Load (ETL) processes and the
modelling parameters Probability
of Default (PD), Exposure at Default
(EAD) and Loss Given Default (LGD)
are calculated. This data is stored
in a Risk Data-Warehouse and then
the RWA calculations are performed
on the risk data to calculate the
regulatory capital requirements.
RWA Calculator
Reporting Tool
Segment
Definition
PD, LGD,
EAD
Op Risk
Models
ICAAP
Reports
Model Validation/ Feedback
Model Execution and Output
General
Ledger
FFIEC 101
Reports
Management
Reports
Data Governance
Data Governance across the system
Possible new Data marts to hold
data for the measurement of
Liquidity and Leverage ratios
New Reports
1. LSR, NSFR
2. Leverage
3. Contractual maturity mismatch
4. Concentration of funding
5. Available unencumbered assets
6. Market-related monitoring tools: asset
prices and liquidity, CDS spreads, equity
prices, institution specific information
related to the ability of the institution to
fund itself in various wholesale markets
7. LCR by currency
BASEL IIIs IT impact can be further understood by looking at its impact on each of the areas separately. The table below lists the impact
expected in different areas of implementation and also lists some of the challenges that will be encountered while implementing them.
Risk Data
Identification
Some new sources
of data that would
need to interact with
the Basel framework
include:
IMPACT
Asset Liability
Management (ALM)
systems
Cash Flow
Management
systems
Existing Liquidity
Risk Management
systems
DATA GOVERNANCE
CHALLENGES
Data from Central
Counterparties for
data related to OverThe-Counter (OTC)
derivatives.
Infrastructure
and Data
Management
The new liquidity
ratios that Basel III
introduces (LCR and
NSFR), will entail
the creation of
new Liquidity Risk
Data Marts to hold
relevant Data
Use of Stressed
parameters as well
as calculating CVA
for counterparty
credit risks will need
huge amounts of
historical data, which
may require the use
of new data marts/
databases to store
such information.
Identifying the right
Data Elements. This
would require a
good knowledge of
accounting systems
as well as knowledge
of the various
reports required by
Basel III.
A single data
load with all the
attributes required
for market, CCR,
RWA, economic
capital and liquidity
risk should be
extracted from
source systems.
Identifying
sources and data
requirements for
different legislations.
As a result, DQ
checks will be
rigorous.
Risk
Modeling and
Quantification
The formulas used
in the calculation
of PD, LGD, EAD will
change due to the
need to incorporate
stressed parameters
and to also reflect
a higher EAD value
for counterparties
where specific
Wrong Way Risk
(WWR) has been
identified.
Consultants having
experience in
Stress Testing,
Analytics, and
general knowledge
about the business
of Banks will be
required to identify
and stress the
required parameters.
RWA
Calculation
Changes will be
required at the
risk engines to
accommodate the
new buffers (Counter
Cyclical, Capital
Conservation).
It will also need
to accommodate
the new Risk
Weights assigned
to derivatives, trade
finance products
as well as account
for exposures to
financial institutions.
The system should
be configured to
provide Group Data,
Solo Data, Basel I,
II and III data on
demand.
Regulatory
Reporting
The reporting
systems will have
to be enhanced to
cater to the new
reports mentioned
in Basel III
The existing reports
will also be modified
to reflect liquidity,
leverage and CVA,
besides the new
capital structure
Subsidiary reporting
requirements will be
augmented.
Understanding
the new reporting
requirements
Bringing out
synergies across
stakeholders and
consolidating the
reporting platform.
Model validation
should be a focus
area.
Put in place a rigorous and scalable Data Governance framework (People + Process + Technology)
Align source systems data quality capabilities to meet Fit For Purpose norms
End-to-end audit capability from source system data to final output calculation may be a challenge in Basel III because of the many
new source systems interacting with the reporting systems.
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BASEL III Implementation Approach
A BASEL III Implementation will require a core team to co-ordinate with multiple track owners who would be responsible for making changes
to the applications and systems that they manage. Ideally, a BASEL III Project Management Office (PMO) will be responsible for initial impact
assessment, identifying multiple tracks within the overall program, co-ordinating and monitoring the overall execution and reporting to
the senior management.
Impact Analysis
& Track
Segregation
Strategy &
Roadmap
Program roadmap
definition
High level plan
Establish current state
of compliance
PMO process
definitions for change
management,
communication
management and
reporting
Identify key
stakeholders
Define individual
tracks within the
program
Solution
Definition
Product evaluation (if
required)
Impact analysis
and requirement
documentation
Identify
dependencies, risks
and assumptions
Maintenance &
Support
Implementation
Architecture design
Application
customization and
build
Data analysis &
modeling
Data quality testing
Maintenance and user
support
Functional testing
Platform migration
Technical design
Regression testing
Data feed design
Non-functional
testing
Data sourcing and ETL
Detail level planning
for individual tracks
Data sufficiency
analysis
Identify the critical
path
Platform
Development
Ongoing
enhancements
Defect management
and reporting
Kick-off meeting with
all stakeholders
Basel III Implementation Timeline
Since the BASEL III requirements bring in critical buffers and significant capital outlays, the key aspects of the BASEL III guidelines will be
implemented in phases from January 2013 through 2018. This should give banks enough time to review their financial preparedness and
also enhance their operational and reporting capabilities.
PHASE IN ARRANGEMENTS
(Shading indicated transition periods - all dates are as of 1 January)
2011
Legerage Ratio
2012
Supervisory
Monitoring
Minimum Common Equity Capital Ratio
2013
2014
2015
2017
Parallel run 1 Jan 2013 - 1 Jan 2017
Disclosure starts 1 Jan 2015
3.5%
4.0%
4.5%
Capital Conservation Buffer
Minimum Common Equity Plus Capital
Conservation Buffer
2016
3.5%
Phase-in of deductions from CET1 (including amounts
exceeding the limit for DTAs, MSRs and Financials)
2018
As of
1 Janurary 2019
Migration
to Pillar 1
4.5%
4.5%
4.5%
4.5%
0.625%
1.25%
1.875%
2.50%
4.0%
4.5%
5.125%
5.75%
6.375%
7.0%
20%
40%
60%
80%
100%
100%
6.0%
Minimum Tier 1 Capital
4.5%
5.5%
6.0%
6.0%
6.0%
6.0%
Minimum Total Capital
8.0%
8.0%
8.0%
8.0%
8.0%
8.0%
8.0%
Minimum Total Capital plus Conservation Buffer
8.0%
8.0%
8.0%
8.625%
9.25%
9.875%
10.5%
Capital Instruments that no longer qualify as non-core
Tier 1 capital or Tier 2 capital
Phased out over 10 year horizon beginning 2013
Liquidity Coverage Ratio
Observation
Period Begins
Net Stable Funding Ratio
Observation
Period Begins
Introduce
Minimum
Standard
Source - The website for the Bank for International Settlements - http://www.bis.org/bcbs/basel3.htm
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Introduce
Minimum
Standard
Conclusion
BASEL III guidelines attempt to plug the gaps identified in BASEL
II. However, the world economy and financial markets are dynamic
and evolving ecosystems with many forces in play. Consequently,
financial regulations will keep on evolving. The intensity of regulatory
interventions is expected to increase in the future and the importance
of risk management is expected to further move up in the priority of
board members and top management.
It is therefore imperative that a BASEL III implementation is planned and
designed with a high degree of scalability to support future changes in
regulation. A BASEL III implementation should be taken as an opportunity
to remove a silo based approach to risk management and move towards
a reliable and scalable enterprise wide risk management system.
For such intent to be successful, an early start and preparation are
essential so that enough due diligence goes into laying down the
foundations of a strong risk management system.
About the Authors
Jitendra Kumar is a Principal Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys.
He has over 15 years of experience and has completed CFA level I & II from the CFA institute, USA.
He can be reached at
[email protected]Sudarsan Kumar is a Senior Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys.
He has over 4 years of risk and compliance experience with data warehousing in Basel II.
He can be reached at [email protected]
Rohit VM is a Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. His current
focus is on Basel III. Rohit earned his Post Graduate Diploma in General Management (PGDGM) from XLRI, Jamshedpur.
He can be reached at [email protected]
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