Restricted 11 Challenges to implementing global regulatory reform in Asia Presentation at IADI-DICGC Conference on Role of Deposit Insurance in Bank Resolution Framework – Lessons from the Financial Crisis Jodhpur, India, 15 November 2011 Ilhyock Shim Senior Economist Bank for International Settlements * The views expressed here are those of the presenter, and do not necessarily represent those of the Bank for International Settlements.

Restricted 2 Overview I. Global regulatory reform and its impact on Asia –Revised micro-prudential capital regulation –Macro-prudential capital regulation –New micro-prudential liquidity regulation –Impact of global regulatory reform on Asian banks II. Macroprudential policy framework and deposit insurance –Macroprudential policy framework and the G20 –Macroprudential policy framework and financial safety net –Macroprudential policy framework and deposit insurance

Restricted 3 I. Global regulatory reform and its impact on Asia

Restricted 4 The reform of bank capital regulation Overview Capital ratio = Capital Risk-weighted assets Enhancing risk coverage ●Securitisation products ●Trading book ●Counterparty credit risk New capital ratio ● Common equity ● Tier 1 ● Total Capital ● Capital conservation buffer Raising the quality of capital ● Focus on common equity ● Stricter criteria for Tier 1 ● Harmonised deductions from capital Macroprudential overlay Mitigating procyclicality ● Countercyclical buffer Leverage ratio Mitigating systemic risk ● Capital surcharges ● Contingent capital ● Bail-in debt ● OTC derivatives 4

Restricted 5 Capital ratio: the new requirements Increases under Basel III are even greater when one considers the stricter definition of capital and enhanced risk weighting In percentage of risk-weighted assets Capital requirements Common equityTier 1 capitalTotal capital Minimum Conservation buffer RequiredMinimumRequiredMinimumRequired Basel II248 Memo: Equivalent to around 1% for an average international bank under the new definition Equivalent to around 2% for an average international bank under the new definition Basel III New definition and calibration

Restricted 6 Leverage ratio Objectives –Supplement the risk-based framework with a simple measure of total assets and off-balance sheet exposures –Contain the build-up of leverage during boom periods –Introduce safeguards against model risk, measurement error and attempts to “game” risk-based requirements Implementation –Supervisory monitoring from –Parallel run – % Tier 1 leverage ratio –View to migrate the requirement to Pillar 1 on after appropriate review and calibration –Need to monitor closely the relationship between risk weighted assets and total assets which varies across countries

Restricted 7 Countercyclical capital buffer Objective –Create a buffer of capital to protect the banking sector from periods of excess aggregate credit growth –Ensure that adequate capital is on hand to maintain flow of credit during stress Buffer decisions and reciprocity –Each jurisdiction responsible for determining the buffer size ( %) –Buffer size is based upon the location of the exposure Buffer calibration –Buffer size is determined through use of a credit/GDP guide and judgement The BCBS also issued on 16 December 2010 “Guidance for national authorities operating the countercyclical capital buffer” as a supplement to the requirements set out in the Basel III rules text.

Restricted 8 Systemically important banks On 29 September 2011, the BCBS agreed to finalise the assessment methodology for G-SIBs and to retain the proposed calibration for the additional loss absorbency requirement, which will range from 1% to 2.5% Common Equity Tier 1 (CET1) depending on a bank's systemic importance, with an empty bucket of 3.5% CET1 as a means to discourage banks from becoming even more systemically important. These requirements will be introduced in parallel with the Basel III capital conservation and countercyclical buffers, ie between 1 January 2016 and year-end 2018, becoming fully effective on 1 January There has been strong resistance from financial industry on capital surcharges. Domestic or regional SIBs are the next issue to consider.

Restricted 9 Liquidity requirements Objectives –Improve liquidity risk management of banks and reduce reliance of banks on short-term wholesale funding LCR : stock of high-quality assets > total net cash outflow over 30-day period –Promote short-term resilience by requiring sufficient high-quality liquid assets to survive acute stress lasting for 30 calendar days –Revision by mid 2013, fully applied on 1 Jan The revision is expected to have small changes on the definition of highly liquid assets. NSFR: available amount of stable funding > required amount of stable funding –Promote resilience over longer-term through incentives for banks to fund activities with more stable sources of funding –Revision by mid 2016, fully applied on 1 Jan Central banks are concerned about consistency between liquid assets and central bank liquidity operations.

Restricted 10 Impact of global regulatory reform on Asian banks Capital and liquidity requirements –Changes in the numerator, denominator and capital ratios as well as the introduction of the leverage ratio are expected to have a relatively moderate effect on the banks in the region, except for a few large banks. –Impact of global liquidity standards is somewhat uncertain at the moment. Many banks rely on deposits, so are in a comfortable position to meet the liquidity standards. Some countries don’t have enough first-tier eligible liquid assets. In many jurisdictions, second-tier eligible liquid assets also in short supply.

Restricted 11 Impact of global regulatory reform on Asian banks Capital flows and FX liquidity risk –The recent crisis clearly showed that dependence on short-term, wholesale and cross-border lending corresponded to increased vulnerabilities. –Current liquidity regulation does not have specific provisions for FX funding liquidity risk or maturity mismatches for each currency. At a minimum, aggregated across transferable and convertible currencies. Currency composition of LCR buffer should broadly match the currency composition of net cash outflows.

Restricted 12 Impact of global regulatory reform on Asian banks Macroprudential perspective –Many authorities in the region have built up invaluable experience over the past two decades in using monetary, prudential and fiscal measures to address procyclicality. –However, risk management systems at the firm level are still relatively weak Micro and macro stress testing Data requirement Analytical capacity

Restricted 13 Impact of global regulatory reform on Asian banks Credit provision to support growth –In some countries, strong demand for bank loans exists to support strong growth and upgrade standards of living Infrastructure and real estate loans –Can Basel III support these loans effectively? In particular, given that it is relatively more difficult for banks to raise capital in the market in Asia, any expansion of bank balance sheets may not be easily supported by increases in bank equity unless banks have strong profits. Also, new liquidity regulation such as NSFR may hinder investment in long-term risky projects. –Overall, the long-term benefit of higher and stronger capital base will outweigh the potential short-term cost in Asia and the Pacific.

Restricted 14 Impact of global regulatory reform on Asian banks Treatment of trade finance under Basel capital framework –G20 leaders at the 2011 Seoul Summit decided to “evaluate the impact of regulatory regimes on trade finance”. –The BCBS established Trade Finance Group, had consultations with the World Bank, WTO and the International Chamber of Commerce. –100% Credit Conversion Factor in calculating the leverage ratio for contingent trade finance exposures: need exception for trade finance? CCF is determined by the likelihood of off-b/s position becoming an on-b/s item, and whether commitments are unconditionally cancellable. –20% Credit Conversion Factor for short-term self-liquidating trade letters of credit under the risk-based measure: need to lower it? CCF is determined by the likelihood of off-b/s position becoming an on-b/s item, not by the probability of default of a trade finance instrument –One-year maturity floor when calculating RWAs under the Advanced IRB: inappropriate for short-term self-liquidating letters of credit? The BCBS agree to waive the floor and use a maturity less than one year. –Sovereign floor of risk weighting for to short-term self-liquidating letters of credit The BCBS decided to waive it: for low-income countries, the risk-weighting decreases from 100% to 50% or even 20%.

Restricted 15 II. Macroprudential policy framework and deposit insurance

Restricted G20 SEOUL SUMMIT DOCUMENT, Paragraph 41, first bullet “Further work on macro-prudential policy frameworks: In order to deal with systemic risks in the financial sector in a comprehensive manner and on an ongoing basis, we called on the FSB, IMF and BIS to do further work on macro-prudential policy frameworks, including tools to mitigate the impact of excessive capital flows, and update our Finance Ministers and Central Bank Governors at their next meeting.” 2011 G20 Cannes SUMMIT DOCUMENT “ tbc ” Macroprudential policy in the G20 process

Restricted 17 Macroprudential policy and financial safety nets Three lines of defence to minimise the impact of a systemic distress (1) ex-ante regulation and supervision to provide the right incentive to discourage excessive risk-taking at an institutional level and in a system (2) buffers maintained by financial institutions or by the financial system against realized losses and liquidity shocks (3) financial safety nets provided by national authorities. Important to maintain consistency between the macroprudential policy framework and financial safety net arrangements. –If financial safety net is strong, the moral hazard problem is likely to occur. Thus, we need to introduce strict regulation to avoid risk- taking by financial institutions. –If financial safety net is weak, financial institutions need to maintain more buffers to reduce the probability and extent of relying on the safety net.

Restricted 18 Macroprudential policy and financial safety nets The financial safety net arrangements should be made to explicitly incorporate macroprudential approaches, such as central bank liquidity provision in episodes of systemic liquidity shortages, deposit insurer and fiscal capacity to deal with systemic bailout (to avoid too-big-to-bailout situations). –Moreover, fiscal policy and the capacity of financial safety net are closely related: the macroprudential authority need to have close dialogue with the fiscal authority so that fiscal buffers are maintained in good times so that it can be drawn down whenever necessary. Global banks vs global regulation and global financial safety nets

Restricted 19 Macroprudential policy and deposit insurance Do deposit insurers need to have a macroprudential perspective (systemic risk and procyclicality)? Did micro-prudential Prompt Corrective Action work during the recent international financial crisis? How about systemic risk exception? –If not, why? How to revise it? Since the crisis, a lot of progress has been made in designing regulation to mitigate both procyclicality and systemic risk. What are the roles deposit insurers play in the macro-prudential policy framework? –What specific roles deposit insurers should play in financial stability or macroprudential council? –What funding arrangements, deposit insurance premium, coverage, and cross-border coordination of deposit insurance?