In this chapter, we begin by discussing what Basel II.5 is all about. This is a collection of changes to the Market risk capital computation put in place by the Basel Committee due to the large losses banks experienced during the financial crisis.

We then consider Basel III, which happened to overhaul bank regulations in a massive way and was published by the Basel Committee. A series of rules on increasing the capital amounts to be kept by banks for credit risk, are included in Basel III. The liquidity requirements specification to be met by all banks is a crucial new feature of Basel III.

Furthermore, other regulations introduced since the 2008 financial meltdown to compel the Basel Committee’s work will be discussed in this chapter.

Basel II.5

The computation of market risk capital required some changes, as was recognized during the credit crisis. Basel II.5 is the term used to refer to these changes and they were implemented in December 2011. The changes were about:

1. A stressed VaR’s computation.
2. A new incremental risk charge.
3. A risk measure for instruments relying on credit correlation that is comprehensive.

Stressed VaR

Capital for banks was to be based on a 10-day 99% VaR measure as allowed by the 1996 Basel I Amendment. The computation of VaR by most banks applies historical simulation. Before the introduction of new rules in 1996, the computation of market risk capital was based on the assumption that the percentage change in market variables in the course of the day that follows would be randomly sampled from the daily percentage changes observed in the previous 1 to 4 years.

Most market variables during the 2003-2006 period had low volatilities and, hence, the computed market risk VaR for the purposes of regulating capital was low during this period. Due to the fact that most of the data applied in the VaR computation still originated from a period of low volatility, after the onset of the crisis, low VaRs were still persistent for some time.

A stressed VaR measure was therefore introduced by the Basel Committee. The movement of market variables during a 250-day period of stressed market conditions is the basis of stressed VaR computations. The assumption made by the historical simulation computations to get a stressed VaR is that market variables’ percentage changes in the day that follows are randomly sampled from their daily percentage changes in the course of the 250-day period of stressed market conditions.

According to Basel II.5, two VaRs should be computed where one is the usual VaR and the other is the stressed VaR. To compute the total capital charge, the two VaR measures are combined via the following formula:

$$ max\left( { VaR }_{ t-1 },m_{ c }\times { VaR }_{ avg } \right) +max\left( { sVaR }_{ t-1 },m_{ s }\times s{ VaR }_{ avg } \right) $$

The VaR and the stressed VaR computed on the previous day are given as \({ VaR }_{ t-1 }\) and \({ sVaR }_{ t-1 }\). Also, the average of the VaR and the average of the stressed VaR are given as \({ VaR }_{ avg }\) and \(s{ VaR }_{ avg }\), and are computed over the past 60 days. The multiplicative factors, equal to three, at least, and determined by bank supervisors, are depicted as parameters \(m_{ c }\) and \(m_{ s }\).

Before Basel II.5, the capital requirement was:

$$ max\left( { VaR }_{ t-1 },m_{ c }\times { VaR }_{ avg } \right) $$

Incremental Risk Charge

The concern of the Basel Committee in 2005 was that exposures in the trading book attracted less capital compared to similar ones in the banking book. To compute the capital of a bond held in the trading book, a multiplier should be used to the 99% VaR. If the same bond is held in the banking book, we apply a VaR with a one-year time horizon and 99% confidence level in the computation of its capital.

Compared to the banking book computation, a much lower capital charge is obtained from the trading book computation. For this reason, credit-dependent instruments were held whenever possible by banks in the trading books.

In 2005, an incremental default risk charge (IDRC) was proposed by regulators to be computed with a 99.9% confidence level and a time horizon of one year for sensitive instruments in the trading book.

Much of the loss during the 2007-2008 credit market turmoil was due to credit rating changes, credit spreads widening, and loss of liquidity, in addition to the usual default events. Therefore, to reflect this, the Basel Committee amended its previous proposals, with the IDRC becoming the incremental risk charge (IRC).

For losses from credit-sensitive products in the trading book, a one-year 99.9% VaR should be computed by banks while accounting for both credit rating changes and defaults. This was aimed at setting the capital to equal the maximum of that obtained via the application of trading book computations and that obtained using banking book calculations.

Furthermore, a bank should estimate a liquidity horizon, representing the necessary time for a position to be sold or all material risks to be hedged in a stressed market, for each instrument subject to the IRC.

If the liquidity horizon of a bond with a credit rating of A is supposedly 3 months, and at the end of the three months, the rating changes or the bond defaults, an A-rated bond similar to the one held at the start of the trading period replaces it. This, subsequently, happens again at the end of six months and 9 months. This situation is referred to as the constant level of risk assumption.

With a constant level of risk assumption, there will be a reduced likelihood of a default event. Rating downgrades may lead to small losses in case of rebalancing. The one-year 99.9% VaR can be typically reduced by the assumption.

Hence, a default measure and a measure of credit migration risk are provided by the IRC for credit products at the 99.9% confidence level and over a one-year horizon. The individual positions’ (or set of positions’) liquidity horizons have to be taken into account.

The Comprehensive Risk Measure (CRM)

According to the design of this measure, risks are taken into account in the correlation book. A correlation book is a portfolio of instruments sensitive to the correlation between the default risks of different assets.

For instruments that rely on credit correlation, the CRM happens to be a single capital charge that replaces the incremental risk charge and the specific risk charge. Compared to securitizations, the capital charges for re-securitizations are higher. In a deduction, the principal amount is subtracted from the capital, which is equivalent to a capital charge of 100%.

For CRM computations, internal models for banks can be used with supervisory approval as allowed by Basel II.5. For the models to be approved by bank supervisors, there must be sophistication in the models developed internally by banks.

In January 2018, new rules on capital charges for exposures due to securitizations were effected, in which less reliance on the external rating was involved.

Basel III

There was a necessity for the Basel Committee to overhaul Basel II due to the 2007-2009 credit risk. The capital requirement for market risk was, as such, increased by Basel II.5. Credit risk capital requirements were to be increased by the Basel Committee as well. Further, the definition of the needed capital was to be tightened. It is worth noting that addressing liquidity risk needed regulations.

In December 2009, the Basel III proposals were first published. In December 2010, the final version of these regulations was published, after a quantitative impact study at various international summits. The following are the six parts of the regulations:

1. Capital Definition and Requirements.
2. Capital Conservation Buffer.
3. Countercyclical Buffer.
4. Leverage Ratio.
5. Liquidity Risk.
6. Counterparty Credit Risk.

Capital Definition and Requirements

Under Basel III, the components of a bank’s capital are as follows:

1. Tier 1 equity capital.
2. Additional Tier 1 capital.
3. Tier 2 capital.

The share capital and retained earnings are included in Tier 1 equity capital also known as core Tier 1 capital. Goodwill or deferred tax assets are not included. To mirror defined benefit pension plan deficits, Tier 1 capital must be adjusted downwards. For minority interests and capital issued by consolidated subsidiaries, some different rules are also applicable.

In the additional Tier 1 capital category, items previously considered to be Tier 1 that are not common equity, e.g., non-cumulative preferred stock, are included. In Tier 2 capital, debts subordinated to depositors with a five-year original maturity are included.

The Basel Committee referred to common equity as going-concern capital. Losses are absorbed by common equity when a bank is a going concern. On the other hand, Tier 2 capital is referred to as a gone concern (a business that is either already in a liquidation state or is likely to enter the liquidation state in the near future). Tier 2 capital absorbs losses whenever the bank ceases to be a going concern.

The following are the capital requirements:

1. Tier 1 equity capital should be a minimum of 45% of risk-weighted assets at all times.
2. Total Tier 1 capital must always be at 6% of the risk-weighted assets.
3. Total capital should always be at least 8% of the risk-weighted assets.

Under Basel I, Tier 1 equity capital had to be a minimum of 2% of the risk-weighted assets, and total Tier 1 capital had to be less than 4% of the risk-weighted assets.

Capital Conservation Buffer

A capital conservation buffer in normal times is required under Basel II. It should consist of a further amount of core Tier 1 equity capital equal to 2.5% of the risk-weighted assets. Under this provision, capital is built up by banks during normal times to be run down in the event that losses get incurred in times of financial turmoil.

Banks can constraint their dividends until capital is replenished, in cases where the capital conservation buffer has been used up either partially or wholly. Achieving the return on equity possessed by banks in the 1990-2006 period may be problematic due to increased equity capital requirements.

Countercyclical Buffer

A countercyclical buffer has been specified by Basel III in addition to the capital conservation buffer. The intention of the buffer is the protection from the cyclicality of bank earnings.

The buffer should be met with Tier 1 equity capital and set to be between 0% and 25% of total risk-weighted assets. The phasing out of the countercyclical buffer requirements takes place in between January 1, 2016, and January 1, 2019.

Leverage Ratio

The minimum leverage ratio specified by Basel III is 3%, as an addition to the capital requirements based on risk-weighted assets. The leverage ratio can be defined as the ratio of a capital measure to an exposure measure.

A summation of total Tier 1 capital gives the capital measure. For the exposure measure, we sum up:

1. On-balance-sheet exposures.
2. Off-balance-sheet items.
3. Derivatives exposures.
4. Securities financing transaction exposures.

Since the data collected by the Basel Committee is on the application of the leverage ratio from banks, both capital and exposure may have changing definitions. There may also be a change in the 3% minimum ratio level.

For the Basel Committee to introduce the leverage ratio, the regulators had thought that there was a lot of discretion in banks concerning the computation of risk weighted-assets. For the computation of total exposure, the discretion is far less.

Banks are required by regulators to satisfy:

1. Capital to risk-weighted assets ratio.
2. Capital to non-risk-weighted exposure leverage requirement ratio.

Liquidity Risk

Ensuring that banks had sufficient capital for the risk they handled was the focus of the Basel regulations before the crisis. However, a shortage of capital was not the cause of problems faced by financial institutions during the crisis, but rather the liquidity risks taken by the banks.

The tendency of banks to finance long-term needs with short-term funding leads to liquidity risk. This may not be an issue if the market perceives the bank to be financially healthy.

For banks to survive liquidity pressure, the following two liquidity ratios, whose requirements have been introduced by Basel III, should be applied:

1. Liquidity Coverage Ratio (LCR).
2. Net Stable Funding Ratio (NSFR).

The focus of the LCR is the ability of banks to survive a 30-day period of liquidity disruption.

$$ LCR=\frac { High-Quality\quad Liquid\quad Assets }{ Net\quad Cash\quad Out\quad flows\quad in\quad a\quad 30-Day\quad period } $$

The focus of the NSFR is the management of liquidity over a one-year period.

$$ NSFR=\frac { Amount\quad of\quad Stable\quad Funding }{ Required\quad Amount\quad of\quad Stable\quad Funding } $$

To determine the amount of stable funding, we compute the product of each category of funding and an available stable funding (ASF) factor to reflect each component’s stability. For the required amount of stable funding to be calculated, the items that require funding must be taken into account. To reflect the permanence of the required funding, each category of the items requiring funding must be multiplied by the required stable funding (RSF).

G-SIBs, SIFIs, and D-SIBs

Another concern of the regulators is whether sufficient capital is kept by large, systemically important financial institutions to avoid a repeat of government bailouts witnessed during the 2007-2009 credit crisis.

G-SIB stands for Global Systemically Important Bank. SIFI, on the other hand, stands for Systematically Important Financial Institution and is used to describe both banks and nonbanks considered as systemically important.

The impact of a failure by systemic important banks on the global financial system is critical to the systemic importance of a bank or other financial institution. To determine the banks that are G-SIBs, a scoring methodology is applied by the Basel Committee.

The categorization of the G-SIBs is in accordance with whether the extra capital is 1%, 1.5%, 2%, 2.5%, or 3.5% of the risk-weighted assets.

Some banks are designated by national regulators as Domestic Systemically Important Banks (D-SIBs). Therefore, they may be subjected to higher capital requirements than the minimum, extra disclosure requirements, or stress tests that are stringent.

Describe Regulations for Global Systemically Important Banks (G-SIBs), Including Incremental Capital Requirements and Total Loss-absorbing Capacity (TLAC)

In late 2014, a list of G-SIBs was published, categorized according to whether the extra equity capital is 1%, 1.5%, 2%, 2.5%, or 3.5% of risk-weighted assets. The list had 30 banks:

$$ \begin{array}{ll} Extra\quad equity\quad capital & Number\quad of\quad banks \\ 1\% & 18 \\ 1.5\% & 6 \\ 2\% & 4 \\ 2.5\% & 2 \\ 3.5\% & 0 \\ \end{array} $$

For example, HSBC and JPMorgan Chase are two banks in the 2.5% category.

On top of the extra equity capital as outlined in the table above, G-SIBs must:

• Keep a baseline amount of Tier 1 equity capital equal to 4.5% of risk-weighted assets.
• Keep a further 2.5% for the capital conservation buffer.

In the case of the 18 banks in the 1% category, the total equity capital, therefore, amounts to \(4.5 + 2.5 + 1\% = 8\% \) of risk-weighted assets. In the case of HSBC and JPMorgan Chase, the total equity capital amounts to \(4.5 + 2.5 + 2.5\% = 9.5\%\) of risk-weighted assets. It is important to point out that these calculations exclude extra capital requirements that may be imposed on banks by national supervisors, such as the countercyclical buffer.

The Total Loss Absorbing Capacity (TLAC) requirement put forth by the Financial Stability Board, working in liaison with the Basel Committee, dictates that total capital (including equity, debt, and other eligible liabilities, but excluding capital buffers) be between 16% and 20% of risk-weighted assets and at least twice the Basel III Tier 1 leverage ratio requirements. The requirement is aimed at providing G-SIBs with sufficient loss-absorbing capacity.

Contingent Convertible Bonds (CoCos)

The holder of convertible bonds can decide whether or not to convert them into equities at an exchange ratio that has been predetermined. Conversion can happen when a company is performing well and the price of the stock is high. Since they can be automatically converted into equity after satisfying certain conditions, CoCos are different from other bonds. For these conditions to be satisfied, the company must be experiencing financial difficulties.

The attraction of CoCos to banks is based on the fact that, under normal circumstances, bonds are debts through which an institution can make a relatively high return on equity. The bonds can be converted into equity to enable a bank to maintain an equity cushion and avoid insolvency in the event of financial turmoil.

With CoCos, there is no need for a bailout, and they are therefore attractive to regulators. The conversion of Cocos is also known as bail-in.

The specification of the trigger that forces conversion and the setting of the exchange ratio is a crucial issue in the design of CoCos. The ratio of Tier 1 equity capital to risk-weighted assets is a popular trigger in the bonds so far issued.

If the trigger is set at 5.125% or higher, the CoCos will qualify as additional Tier 1 capital. Otherwise, the CoCos qualify as Tier 2 capital.

Legislation in Other Countries

When there are worldwide variations in the regulations governing large banks, they are truly global and are liable to move partially or all of their operations from one jurisdiction to another for a more favorable treatment to be obtained.

Issues addressed by legislation in other countries are more or less similar. An independent committee in the U.K. considers issues facing the banking sector and new legislation. There are also similarities in rules and recommendations in the U.S. and E.U.

Apparently, similar rules in different countries may also differ in some aspects. Regulators in most countries consider living wills critical for SIFIs. Regulators, therefore, are applying pressure on SIFIs to develop them.

Sophisticated organizational structures for tax purposes are developed by SIFIs. This may be simplified for different activities of a SIFI to be in separately capitalized legal entities, due to the living will requirement. Therefore, in the event of a SIFI failure, there would be no need for it to be bailed out.

Another crucial issue is compensation. For many traders and employees, compensation was dominated mainly by the annual bonus, leading them to have a relatively short-term horizon in their decision-making.

Restriction compensation is enforced in some other countries and is sometimes temporary. A good example is the one-time super-tax for bonuses in excess of 25,000 Sterling Pounds introduced in the United Kingdom in 2009.

Practice Questions

1) One of the reasons that a change in the CVA for a counterparty can be attributed to is market variables underlying the value of the derivatives entered into with the counterparty change. Which of the following is the other best reason for a change in the CVA?

1. A change in the marketable securities with a residual maturity greater than one year.
2. Loans to retail and small business clients with a less than one-year remaining maturity.
3. The credit spreads applicable to the counterparty’s borrowing change.
4. Short-term instruments, securities, and loans to a financial entity with a residual maturity of less than one year.

The correct answer is C.

The credit spreads are applicable to the counterparty’s borrowing change. According to Basel III requirements, the CVA risk arising from changing credit spreads should be a component of market risk capital.

2) PhillyBank’s balance sheet (in million USD) contains the following items. The ASF and RSF factors for each category of funding capital are also provided:

$$ \begin{array}{|c|c|c|} \hline {} & {} & ASF \quad factor \\ \hline Retail \quad Deposits & 28 & 90\% \\ \hline Wholesale \quad Deposits & 32 & 50\% \\ \hline Tier \quad 2 \quad Capital & 3 & 100\% \\ \hline Tier \quad 1 \quad Capital & 11 & 100\% \\ \hline {} & {} & {} \\ \hline \end{array} $$

$$ \begin{array}{|c|c|c|} \hline {} & {} & RSF \quad Factor \\ \hline Cash & 5 & 0\% \\ \hline Residential \quad Mortgages & 33 & 65\% \\ \hline T-Bonds & 10 & 5\% \\ \hline Small \quad Business \quad Loans & 36 & 85\% \\ \hline Fixed \quad Assets & 72 & 100\% \\ \hline \end{array} $$

Which of the following is closest to the Net Stable Funding Ratio?

1. 2.11.
2. 0.48.
3. 0.44.
4. 2.26.

The correct answer is C.

Remember that:

$$ NSFR=\frac { Amount\quad of\quad Stable\quad Funding }{ Required\quad Amount\quad of\quad Stable\quad Funding } $$

$$ Amount\quad of\quad Stable\quad Funding=28\times 0.9+32\times 0.5+3\times 1+11\times 1=55.2 $$

And:

$$ RSF=5\times 0+33\times 0.65+10\times 0.05+36\times 0.85+72\times 1=124.55 $$

Therefore:

$$ NSFR=\frac { 55.2 }{ 124.55 } $$

$$ = 44.32\% $$