Topic 9. Bank regulation and Basel 9.1 Capital 9.2 Reasons for regulating bank capital 9.3 History of bank regulation 9.4 Pre-1988 9.5 BIS Accord (Basel I) 9.6 1996 Amendment 9.7 Basel II 9.8 Basel III

9.1 Capital

9.1 Capital Capital can be interpreted as the amount of money that the bank should keep in order to protect it from an extremely unfavorable loss. The expected losses are often taken into account in pricing the financial products by FI. The capital a FI requires should cover the difference between expected losses over some time horizon and “worst-case losses” (e.g. 99% VaR) over the same time horizon. Source of capital: Stockholder’s equity, issuing debt, …etc. 3

9.2 Reasons for regulating bank capital Banks collect deposits from ordinary savers, and they play a key role in the payment and credit system. In U.S. and also in H.K., the government provides deposit insurance scheme to protect the saving of the ordinary savers. So, the government has a direct interest in ensuring that banks remain capable of meeting their obligations. FDIC To avoid a systemic “domino effect”, whereby the failure of an individual bank, or a run on a bank caused by the fear of such a failure, propagates to the rest of the financial system. 4

9.3 History of bank regulation Pre-1988 1988: Bank of International Settlement (BIS) Accord (Basel I) 1996: Amendment of BIS Accord 1999: Basel II first proposed Ongoing: Basel III 5

9.4 Pre-1988 Banks were regulated using the ratio of capital over total assets. The lower this ratio is, the more highly leveraged the bank is. So, the bank has to maintain this ratio above certain specified minimum level. The ratio is only consider the on-balance-sheet items. The off-balance-sheet positions are ignored in this ratio. The definitions of capital and the required ratios varied from country to country. And enforcement of regulations also varied from country to country. That made banks compete with each other on uneven playground. 6

9.5 BIS Accord (Basel I) The growing exposure of banks to off-balance-sheet claims together with the problems of developing countries (e.g. Mexico, Argentina) debt created the needs to reconsider the regulation and led supervisory authorities of 12 major industrial countries Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States to form the Basel Committee on Banking Supervision. 7

9.5 BIS Accord (Basel I) Basel is the centre of north-western Switzerland, on the border with Germany and France, and located at the very core of central Europe. 8

9.5 BIS Accord (Basel I) The committee worked out a document entitled “International Convergence of Capital Measure and Capital Standards”. (The 1988 BIS Accord, or Basel I). The 1988 BIS Accord was intended to raise capital ratio and to harmonize minimum capital ratios for banks in all major jurisdictions across the world. Its main focus was on credit risk. Two minimum standards defined: Assets-to-capital multiple Cooke ratio 9

9.5 BIS Accord (Basel I) Assets-to-capital multiple Total assets include specified off-balance-sheet items. e.g. letter of credit and guarantees, and sale and repurchases agreements. Off vs on The maximum allowed value of the assets-to-capital multiple is 20. 10

9.5 BIS Accord (Basel I) Cooke ratio The minimum requirement of Cooke ratio is 8%. That’s mean the total regulatory capital is at least 8% of the risk-weighted assets. Risk-weighted assets = Risk-weighted on-balance-sheet assets + Risk-weighted off-balance-sheet assets 11

9.5 BIS Accord (Basel I) A risk weight is applied to each on-balance-sheet asset according to its risk. Table 9.1 Risk weights for on-balance-sheet items Risk weight (%) Asset category Cash, OECD governments bonds or insured residential mortgages. 20 Claims on OECD banks and OECD public sector entities. 50 Uninsured residential mortgage loans. 100 All other claims, such as corporate bonds and less-developed country debt, claims on non-OECD banks. OECD: Organisation for Economic Co-operation and Development 12

9.5 BIS Accord (Basel I) The total risk-weighted assets for N on-balance-sheet items equals where Li is the principal amount of the ith item and wi is its risk weight. Example 9.1 The assets of a bank consists of $100 million of corporate loans, $10 million OECD government bonds and $50 million of uninsured residential mortgage. The risk-weighted assets is 1.0100 + 0.010 + 0.5 50 = $125 million 13

9.5 BIS Accord (Basel I) For each off-balance-sheet item, we first calculate a credit equivalent amount and then apply the corresponding risk weight. The credit equivalent amount for nonderivative instruments is calculated by applying a conversion factor to the principal amount of the instrument. 14

9.5 BIS Accord (Basel I) Conversion factor (%) Category 100 Table 9.2 Credit conversion factors for nonderivative off-balance-sheet items Conversion factor (%) Category 100 Direct credit substitutes, bankers’ acceptances, standby letters of credit, sale and repurchase agreements, forward purchase of assets. 50 Transaction-related contingencies such as performance bonds. 20 Short-term self-liquidating trade-related contingencies such as letters of credit. Commitments with an original maturity of one year or less. 15

9.5 BIS Accord (Basel I) Risk weight (%) Type of counterparty Table 9.3 Risk weight for off-balance-sheet items from different counter party Risk weight (%) Type of counterparty OECD governments 20 OECD banks and public-sector entities 50 Corporations and other counterparties 16

9.5 BIS Accord (Basel I) Example 9.2 A bank has $200 million of GM performance bonds , $20 million OECD bank 3-month letter of credit and $50 million forward purchase of coal from OECD public sector entity. The risk-weighted off-balance-sheet assets is 0.50.5200 + 0.20.220 + 0.21.0 50 = $60.8 million Risk weight Conversion factor 17

9.5 BIS Accord (Basel I) Example 9.3 By combining the risk-weighted assets in Examples 9.1 and 9.2, the total risk-weighted assets is $185.8 million. On-the-balance sheet items, risk weight Off-the-balance sheet items, risk weight + conversion The regulatory capital is at least $14.86 million (=8%185.8). 18

9.5 BIS Accord (Basel I) The bank could raise up the regulatory capital through two sources: Tier 1 (Core) capital: Most reliable form of capital. At least 50% of the Tier 1 capital should come from the common equity. Tier 2 (Supplementary) capital: The second reliable form of financial capital such as revaluation reserve, cumulative preferred stocks, subordinated debt with an original life of more than 5 years. 19

9.5 BIS Accord (Basel I) Under the regulation, the Tier 1 capital ratio should be at least 4%. (i.e. at least 50% of Cooke ratio.) Example 9.4 From Example 9.3, at least $7.43 million (=0.514.86) must come from Tier 1 capital. In practice, banks tend to exceed the minimum requirement on regulatory capital. The reasons include: To create a buffer that prevent them from accidentally against the regulatory rules. To maintain credit ratings allowing them to access wholesale markets cheaply. 20

9.6 1996 Amendment In 1995, the Basel Committee issued a consultative proposal to amend the 1988 Accord. This is known as the “1996 Amendment”. It was implemented in 1998 (BIS 98). In addition to the 1988 BIS Accord credit risk capital, BIS 98 outlined a standardized approach for measuring the capital charge for market risk. 21

9.6 1996 Amendment The regulatory capital required by BIS 98 = Credit risk capital charge + Market risk capital charge = 8%(Credit risk RWA + Market risk RWA) (7.4) where RWA stands for risk-weighted assets. From (7.4), Market risk RWA = Market risk capital charge  8%. 22

9.6 1996 Amendment The BIS 98 also allowed sophisticated banks with well-established risk management functions to use their own VaR model, known as the “internal models approach”, for setting market risk capital. The examples include RiskMetrics, historical simulation and Monte Carlo. It gave banks freedom to set up more suitable risk management practice for their own interests and to lead to lower capital requirement. 23

9.6 1996 Amendment Further than Tier 1 and Tier 2 capital, a bank can also use Tier 3 capital as a part of capital requirement for market risk. Tier 3 capital: short term subordinated debt with an original maturity of at least 2 years. 24

9.7 Basel II Basel I has significant weakness: All corporation loans, irrespective to the corporation’s credit rating, have the same risk weight of 100%. No model of default correlation. To overcome such weakness, the Basel Committee proposed new rules in June 1999 and finally implemented them from 2007 after several revisions (Basel II). Details may refer to: http://www.bis.org/publ/bcbsca.htm 25

9.7 Basel II Three pillars: Pillar 1: Capital charges for market risk, credit risk and operational risk Pillar 2: Supervisory review Pillar 3: Market discipline 26

9.7 Basel II Pillar 1: Calculation of capital charges Under Basel II, the minimum capital adequacy (total capital) ratio and Tier 1 capital ratio are still 8% and 4% respectively. However, the total capital charge is made up of 3 components. Capital charge = Market risk capital charge + Credit risk capital charge + Operational risk capital charge = 8%×(Market risk RWA + Credit risk RWA + Operational risk RWA) (7.5) 27

9.7 Basel II The calculation of the market risk capital charge remains unchanged from the 1996 Amendment. The calculation of the capital charges for credit risk and operational risk are modified and newly introduced respectively. 28

9.7 Basel II Credit risk Banks have two choices in calculating the credit risk capital charge: Standardized approach Internal rating based (IRB) approach The standardized approach is conceptually the same as Basel I (1988 BIS Accord) but it has been designed to be more risk sensitive. 29

9.7 Basel II Table 9.4 Risk weights for calculation credit risk RWA under Basel II’s standardized approach. Rating AAA to AA- A+ to A- BBB+ to BBB- BB+ to BB- B+ to B- Below B- Unrated Country 0% 20% 50% 100% 150% Banks Corporates Risk weights of other categories: Retail lending - 100%; Claims are secured by a residential mortgage - 35%. 30

9.7 Basel II By comparing Table 9.4 with Table 9.1, we see that the OECD status of a bank or a country is no longer important under Basel II. Under Basel II, the risk weights depend much more on the credit rating. Example 9.5 Suppose that the assets of a bank consist of $100 million of loans to corporation rated A, $10 million of government bonds rated AAA, and $50 million of residential mortgages. The risk weighted assets under standardized approach is 0.5100 + 0.0 10 + 0.35 50 = 67.5 million (< 125 million in Example 9.1) 31

9.7 Basel II In IRB approach, we have the following input and output. The one-year probability of default of each loan. The outstanding amount of each loan at default (exposure at default). The proportion of the exposure that is lost at default. The credit correlation among the loans in the portfolio. Output: 99.9% 1-year Credit VaR. (The details of IRB approach are omitted.) Credit risk capital charge = 99.9% 1-year Credit VaR – Expected portfolio credit loss. 32

9.7 Basel II In Basel II, the capital requirement (Standardized and IRB approach) for credit risk could be reduced for a bank if it adopts some strategies to mitigate its credit risk like collaterals, guarantees and credit derivatives. 33

9.7 Basel II Operational risk Basel II requires banks to keep capital for operational risks: An increasingly complex business environment Regulators want banks to pay more attention to their internal systems. 34

9.7 Basel II 3 choices are available for calculating capital requirement of the operational risk: Basic indicator approach: Capital = Multiplicative factor (=15%)  Gross income Gross income = interest income + noninterest income Standardized approach: Different multiplicative factor for gross income arising from each business line. Internal measurement approach: Assess 99.9% worst case operational risk loss over one year. 35

9.7 Basel II Business line Multiplicative factor (%) Corporate finance Table 9.5 Multiplicative factor for the standardized approach Business line Multiplicative factor (%) Corporate finance 18 Trading & Sales Retail banking 12 Commercial banking 15 Payment &Settlement Agency services Asset management Retail brokerage 36

9.7 Basel II Pillar 2: Supervisory review The supervisory review is intended to ensure that a bank’s capital position and strategy are consistent with its overall risk portfolio. Early supervisory intervention will be encouraged if the capital amount is thought not to provide a sufficient buffer against risk. Regulators need to define a sound conceptual framework for the determination of bank capital adequacy. 37

9.7 Basel II Pillar 3: Market discipline The Basel Committee intends to foster market transparency so that market participants can better assess bank capital adequacy. Banks will be required to disclose Scope and application of Basel framework Nature and components of capital (composition in each tier of capital and % allocation to each tier of capital) Capital requirements for credit, market and operational risk 38

9.8 Basel III Aims: Microprudential - To increase the resilience of individual banking institutions in periods of stress. Macroprudential - To address system wide risks which will build up across the banking sector. Basel III will be phased-in between 1 January 2013 and 1 January 2019. The details of Basel III may refer to http://www.bis.org/bcbs/basel3.htm http://www.hkma.gov.hk/eng/key-functions/banking-stability/basel-3.shtml 39

9.8 Basel III Microprudential In the microprudential (firm-specific) approach, it mainly focuses on the three elements of the capital adequacy ratio: capital, risk-weighted assets and the ratio itself. Capital: As learned from the crisis, credit losses and writedowns come directly out of common equity. So, Common equity (or just call “equity” if there is no confusion) is considered as the most reliable form of loss absorbing capital. The component of common equity in Tier 1 capital is increased from 2% of RWA (in Basel II) to 4.5% of RWA in Basel III. 40

9.8 Basel III Risk-weighted asset: Apparently low-risk assets under normal time may suddenly become very risky during a systemic crisis. For example, highly rated sovereigns and AAA-rated CDO tranches. The risk weights for calculating credit risk RWA are refined especially higher risk weights are assigned for resecuritisation exposures such as CDOs of ABS. Increasing regulatory capital for the trading book, around three to four times the original capital requirements. 41

9.8 Basel III Capital ratio: The Tier 1 capital ratio will increase from 4% to 6% but the capital adequacy ratio is unchanged (= 8%). Besides the capital adequacy ratio, a capital conservation buffer comprising common equity of 2.5% of RWA is established. Together with the new requirement in Tier 1 capital, it brings the total common equity level to 7% of RWA. The buffer requires the bank to maintain higher percentage of equity which can absorb losses more effectively during the period of economic stress. 42

9.8 Basel III Macroprudential The macroprudential approach is an entirely new way of thinking about capital in Basel III. It involves FIVE new elements. Leverage ratio: A non-risk-based leverage is established to supplement the risk-based capital ratio to safeguard the bank who tries to build up high levels of on and off balance sheet leverage. The leverage ratio will be a measure of a bank’s Tier 1 capital as a percentage of its assets plus off balance sheet exposures and derivatives. 43

9.8 Basel III Countercyclical capital buffer: A countercyclical capital buffer which is made up of common equity or other fully loss absorbing capital is established. According to the national credit growth condition in the banking system, each jurisdiction can set the countercyclical capital buffer within the range of 0% to 2.5% of RWA. The countercyclical capital buffer not only protects the banking sector from losses resulting from periods of excess credit growth followed by periods of stress, but it helps to ensure that credit remains available during this period. 44

9.8 Basel III The other three elements are in progress Systemic capital surcharge for systemically important financial institutions in order to reduce the moral hazard posed by them. The higher capital requirements for bilateral over the counter (OTC) derivatives in order to increase incentive to use central counterparty clearing houses and exchanges as the derivative counterparty. To encourage the banks to enhance their stress testing programmes in the VaR calculation model in order to capture the tail events more effectively. 45

9.8 Basel III 46