Solvency, Liquidity and Other Regulation After the Global Financial Crisis

After completing this reading, you should be able to:

• Describe and calculate the stressed VaR introduced in Basel 2.5, and calculate the market risk capital charge.
• Explain the process of calculating the incremental risk capital charge for positions held in a bank’s trading book.
• Describe the comprehensive risk (CR) capital charge for portfolios of positions that are sensitive to correlations between default risks.
• Define in the context of Basel III and calculate where appropriate:
  • Tier 1 capital and its components.
  • Tier 2 capital and its components.
  • Required Tier 1 equity capital, total Tier 1 capital, and total capital.
• Describe the motivations for and calculate the capital conservation buffer and the countercyclical buffer, including special rules for globally systemically important banks (G-SIBs).
• Describe and calculate ratios intended to improve liquidity risk management, including the required leverage, liquidity coverage, and net stable funding ratios.
• Describe the mechanics of contingent convertible bonds (CoCos) and explain the motivations for banks to issue them.
• Explain motivations for the “gold plating” of regulations and provide examples of legislative and regulatory reforms that were introduced after the 2007–2009 financial crisis.

The 2007-2009 financial crisis exposed flaws and informed the establishment of solvency and liquidity regulations. Moreover, it exposed the market practice and product structures that were not able to withstand stressful periods. As a response to these flaws, global regulators came up with more strict regulations and supervision.

The Financial Stability Forum was a body that frequently conducted research. Later, it transformed into the Financial Stability Board (FSB). FSB consisted of representatives from different sectors, such as central banks, prudential regulators, and finance ministries. FSB became the body that approves international standards. However, after the crisis, FSB concentrated on other issues. Note that other institutions, such as the Basel Committee, retained their independence and authority.

The Basel 2.5

The Global Financial Crisis of 2007-2008 proved that the minimum capital charges under the market risk amendment were not sufficient to address trading-book risks. This was evident in that, during the crisis, the market prices of financial assets fell sharply, hedging strategies failed, and there was doubt about securitizations.

Consequently, the Basel Committee reacted by introducing three main changes by the end of 2011:

1. The committee incorporated incremental risk capital to reflect the jump-to-default risk roughly.
2. The committee improved Var computations to include the stressed Var components.
3. The committee incorporated comprehensive risk capital requirements for securitizations and related instruments.

The Stressed VaR

Numerous banks calculated capital based on the market risk amendment using historical simulation. Remember that the market risk amendment involved the calculation of 1-day VaR by drawing the daily changes from the recent history and then scaling the same by \(\sqrt { 10 } \). However, VaR slowly decreases during the low volatility periods because the historical observations were small in value. Moreover, during high volatility periods (such as in 2007 for the majority of assets), historical VaR was slow to reflect since analysts took historical observations from low volatility periods.

Consequently, the Basel Committee recommended the stressed VaR. Instead of drawing daily observations from the recent historical time, a bank was advised to pick a one-year (250-day period) period from the last seven years that shows stress to its current portfolio. The VaR for this period would be intuitively high and unchanged unless the period of low volatility remains for seven years.

The stressed VaR expanded the traditional VaR measure to get:

$$ \text {M}{ \text {R}}_{ 2.5 }=\text {max} \left( \text {Va}{ \text {R} }_{ \text {t}-1 },{ \text {m} } \times \text{Va}{\text {R} }_{ \text {avg} } \right) +\text {max}\left( \text {SVa}{ \text{R} }_{ \text{t}-1 },{ \text{m} }_{ \text{s} }\times \text{S}{ \text{VaR} }_{ \text{avg} } \right) $$

Where:

\(\text {Va}{ \text {R} }_{ \text {t}-1 }\) and \(\text{Va}{\text {R} }_{ \text {avg} }\) are traditional 10-day, 99% VaR computed from the previous day and average from the 60 most recent days respectively.

\(\text {SVa}{ \text {R} }_{ \text {t}-1 }\) and \(\text {SVa}{ \text {R} }_{ \text {avg} }\) are computed for equivalent times as above but from the most stressful period in the past seven years.

\({ \text{m} }\) and \({ \text{m} }_{ \text{s} }\) are the multipliers, which according to the 1996 amendment, should, at least, be equal to 3.

It is worth noting that if the multipliers are equal for both the traditional VaR and stressed VaR, then \(\text {M}{ \text {R}}_{ 2.5 }\) must, at least, be twice MR under the 1996 amendment.

Incremental Risk Charge

Incremental Risk Charge (IRC) was first introduced in 2005 as a result of regulation on arbitrage opportunities between the banking and trading book. Besides, regulators introduced IRC as a result of the Global Financial crisis.

Specific risk charges were meant to cover the default risk and some idiosyncratic risks. However, by the early 2000s, banks realized that even in the presence of specific risk charges, the majority of banking-book exposure needed lesser capital requirements in the trading book than in the banking book. Consequently, banks categorized illiquid assets with predisposing default risk in the trading book.

As a response to this drawback, the Basel Committee proposed an addition of incremental default risk charge (IDRC), which had two methods of calculation:

1. An internal model of default risk structured to the 99.9^th percentile at a one-year horizon similar to the IRB approach.
2. In the absence of an internal model, a standardized current exposure approach similar to that of Basel I capital charges for a specific risk.

Towards the end of the crisis, the committee realized that portfolio losses were mainly associated with credit resulting from changes in ratings, credit spreads, or liquidity, not defaults. Therefore, the IRC was an amendment to include the changes in ratings in that the \({99.9}^{\text{th}}\) percentile was maintained, but the banks were required to approximate losses due to rating downgrades. The credit quality of a portfolio was approximately held constant by virtue that a position replaces the downgraded position of defaulting one with the same pre-downgraded rating. The replacement period differs across the positions based on the liquidity level but not less than three months.

The Comprehensive Risk (CR) Measure

Gordy’s (2003) model in Basel II assumes that the correlation parameter is constant across the obligors (but not across assets) over time. This assumption is only relevant to the debt instruments portfolio so that the banking-book capital can be determined effectively. However, the assumption does not apply to correlation book securitizations and derivatives written on securitizations.

The correlation book puts a portfolio in a special purpose vehicle and generates tranche liabilities that differ in seniority and, therefore, in their credit losses. Conventionally, correlations change over time and, as such, in this context, change the value of the trances. For instance, the AAA-rated tranches had a low default rate in the pre-crisis period, but the PD changed in times of crisis, and thus their prices fell.

To address this issue, the Basel Committee substituted the incremental risk charge (IRC) and the specific risk charge with the comprehensive risk (CR) charge for the correlation book. Under this new dimension, banks may use a standardized approach that only depends on the ratings of the instruments. The ratings were as shown below:

$$ \begin{array}{l|c|c|c|c|c} {} & \textbf{AAA,AA} & \textbf{A} & \textbf{BBB} & \textbf{BB} & \textbf{Less than BB, unrated} \\ \hline \text{Securitizations} & {1.6\%} & {4\%} & {8\%} & {28\%} & {100\%} \\ \hline \text{Re-Securitizations} & {3.2\%} & {8\%} & {18\%} & {52\%} & {100\%} \\ \end{array} $$

Note that the percentages are not the risk weights but rather the capital as a fraction of exposure. Moreover, since re-securitizations are more valuable to correlation changes and hence higher capital requirements, the tranches that fall into rating BB and below attract more capital charges because they are prone to losses.

The Basel Committee proposed that banks could also use the internal model to compute the CR charge only after approval from the supervisors. The model-based charge may not be less than the fraction under the standardized approach, and it is more complicated than the standardized approach.

The Basel III Accord

Apart from the weaknesses of the Basel II stated earlier, the global financial crisis unraveled more flaws in the Basel II accord:

1. During the crisis, market participants were mainly concerned with the tangible Tier 1 common equity capital, which was the capital that could cover losses and maintain banks as a going concern. However, the Basel definition of the said capital was limited to the purpose of maintaining banks as a going concern.
2. The official sector of the market believed that distress in some banks greatly affected society more than in other banks and that those significantly affected should have the ability to manage the distress. In other words, systematically important financial firms were created and subjected to numerous regulatory and supervisory practices.
3. The risk-based capital ratios were presumed to be vulnerable to gaming. For instance, the leverage-ratio capital requirement was required as a block since market participants concentrated on tangible common equity capital, which was tailored based on leverage ratios.
4. Banks were unable to be solvent up to the level of maximum losses. In other words, banks were operating as a going concern, so they required huge capital after covering losses. One of the unpopular sources of capital was the government. Therefore, banks’ capital buffers above the minimum requirements and means of recapitalizations failed them.
5. The entities that regulators thought to be sufficiently solvent experienced runs and sometimes failed. This happened because the entities’ solvent reserves were too inadequate to cope with the withdrawals. Wholesale funding was, therefore, not stable and, as such, needed liquidity requirements.
6. The capital to cover the credit risk was needed, especially after Lehman’s failure.

To address the above flaws, BCBS published proposals in December 2010 as “Basel III: International framework for liquidity risk measurement standards and monitoring” and in June 2011 as “Basel III: A global regulatory framework for more resilient banks and banking systems.” The components of Basel III are discussed below.

Basel III Capital Definition

The Basel III removed Tier 3 Capital and divided Tier 1 capital into:

• Tier 1 Equity Capital, also called Core Tier 1 capital.
• Additional Tier 1 Capital (this meant that the Core Tier 1 capital has more quality than Additional Tier 1).

Moreover, the minimum capital requirements were also amended as follows:

• Core Tier 1 capital must be at least 4.5% of the risk-weighted (RWA).
• The total Tier 1 capital (Core Tier 1 plus Additional Tier 1 capital) must be at least 6% of RWA.
• The total capital (Tier 1 plus Tier 2) was unchanged by at least 8% of the RWA.

Moreover, the constituents of each capital category were changed:

1. The Tier Equity Capital consisted of the following:
   • Common equity.
   • Retained earnings.
   • A limited amount of minority interest and unrealized gains and losses.

   Goodwill and other intangibles, deferred tax assets, and any other shortfall reserves based on IRB expected losses are subtracted from the Tier 1 Equity Capital.

2. Additional Tier 1 Capital includes:
   • Unguaranteed, unsecured, non-cumulative perpetual preferred equity instruments subordinated to depositors and subordinated debt callable after five or more years.
   • Debt with suitable factors leads to conversion to equity or write-downs.
   • Approved minority interest excluded in Core Tier 1 capital.
3. Tier 2 capital was structured to cover losses after failure, thus protecting the depositors and other creditors. Tier 2 consisted of:
   • Subordinated debt included unsecured, unguaranteed debt instruments subordinated to depositors and subordinated debt with five or more years of maturity and callable only after five or more years.
   • General loan loss reserves. These were not allocated to absorb losses on specific positions. They included capital limited at 1.25% of standardized approach RWAs or 0.6% of IRB RWAs.

There were the required subtractions such as:

• Certain cross-holdings within a group.
• Defined-benefit pension plan deficits.
• Mortgage servicing rights greater than 10 percent of common equity.

The general feature of the Basel III accord is that compared to Basel II, its capital requirements were higher. This was because the minimum ratios were increased and allowable capital restricted.

Leverage Ratio Capital Requirements

Before the Basel III accord, the minimum capital ratios were expressed by the Basel Committee as the percentage of RWA. However, in the post-crisis period, many observers noted that this had underestimated the risks faced by banks and hence overleveraged. Although flaws in the calculation of RWA were addressed, its future errors were imminent. Moreover, market participants concentrated on simple ratios of equity to unweighted assets as they determined the soundness of banking organizations, making the risk-weighted ratio value subject of discussions.

Reacting to the above flaws, the Basel Committee proposed a “simple” leverage ratio capital requirement as a supplement to the risk-based requirements. This simple leverage capital ratio requires banking organizations to maintain a ratio of Core Tier 1 Capital to Leverage Exposure of at least 3%.

Note that the leverage exposure incorporated both the on-balance-sheet and off-balance-sheet assets. The handling of off-balance-sheet assets by the committee was somewhat different from IFRS and GAAP accounting principles. Even then, it was much more detailed to allow comparison across different countries.

The Systematically Important Financial Institutions

The Financial Stability Board (FSB), in cooperation with the International Association of Insurance Supervisors (IAIS), publishes the list of the globally systematically important banks (G-SIBs) and globally systematically significant insurers (G-SII). In some cases, some nations assign some banks to be G-SIBs.

G-SIBS, G-SIIs, and other firms are classified as systematically important financial institutions (SIFIs). For a firm to qualify as SIFI, FSB determines the size, complexity, interconnectedness, and other factors of the firm. A firm is regarded as SIFI if its failure or distress is amplified to the whole financial system or the real economy. For instance, the whole financial market and its counterparties felt the failure of Lehman Brothers.

SIFIs are often regarded as “too big to fail.” Still, the main objective of this is to lower the probability of it failing and make it not disrupt the real economy of the financial system in case it fails. Moreover, in the event of failure, the shareholders will be eliminated, and creditors will experience losses. However, a SIFI should continue operating and should recapitalize without government assistance. Lastly, SIFIs are subject to a wide range of supervision and regulation.

Buffers

By early 2019, Basel had specified the requirements for capital above the minimum fractions of RWA. These include:

1. A 2.5% capital conservation buffer (CCB) requirement.
2. A countercyclical capital buffer (CCyB) that varies at the discretion of the national supervisors and should be between 0% and 2.5%.
3. An additional G-SIB requirement is dependent on the organization’s score based on the Committee’s method of identification of G-SIBs. The additions were 1%, 1.5%., 2%, 2.5%, and 3.5%. The rationale for this buffer is similar to that of a capital conservation buffer (CCB), only that it recognizes the impact of the distress at G-SIB on society.

Motivations for Capital Conservation Buffers

The rationale in the case of countercyclical capital buffer (CCyB) is similar to the US regulation Prompt Corrective Action (PCA) of 1991. This regulation stipulates that a bank with ratios nearing the minimums should be subjected to more stringent supervision in a bid to return it to a well-capitalized status. The restrictions induced by the committee were restrictions on dividend and bonus payments and planned to restore the ratios.

The rationales in the case of CCyB were to give an instrument for macroprudential control of overheating and address the cost of capital. Overheating, in this case, implies that a higher capital requirement limits the credit supply by the banks and thus causing overheating in the credit market, lowering the maximum point of the credit cycle, and thus reducing the frequency and severity of the financial crisis. The demerit of this rationale is that the calculation of CCyB for a bank with international activities is sophisticated because CCyB differs across the nations. In addition, a bank with international operations might be required to give a combined average of CCyB as a weighted average of the requirements in each nation.

In the case of cost of capital, the rationale supposes that the cost of a bank’s increase in its capital ratio is less in good times than in bad times. For this reason, financial stability can be increased by achieving a lower cost by increasing CCyB during good times and lowering it during bad times.

For the case of G-SIB, the rationale is similar to that of CCB, only that it recognizes the impact of the distress at G-SIB on society. Therefore, higher buffers are stated to lower the likelihood of further failure.

Basel III Post-crisis Reforms

The BCBS finalized the reforms in December, including the revisions of the previous accord. These revisions include:

1. The standardized approach to credit.
2. The operational risk.
3. The leverage ratio.
4. The CVA framework for counterparty credit.
5. The Internal ratings-based approach.

Additionally, the output floor was introduced. This made sure that the capital calculations under the ratings-based and other models are capped at not less than 72.5% of the standardized approach.

Revisions on Standardized Approach

1. Risk weights have been adjusted so that one set of weights is based on external rating agencies and the other credit risk assessment (grades A, B, or C). Credit assessment risk weights are used when a country does not allow external ratings to be used for capital measures. The weights were 20% of RWA for AAA and over 150% of RWA for B- and below.
2. The covered bonds that meet specific criteria carry a risk weight of between 10% and 100%.
3. Corporate bonds carry a weight of 20%, 50%, 75%, 100%, and 150%, depending on the ratings. In nations where ratings are not allowed, a weight of 65% applies to the investment grade and 100% to the non-investment grade. Moreover, favorable treatment is accorded to loans to small and medium enterprises (SMEs).
4. Specialized lending is composed of several buckets, such as project finance or object finance, with elaborate definitions and specific risk weights.
5. The risk weight of the equities is 400% risk weight, and the sub-debt or other instruments have a risk weight of 150%.
6. New risk weights were embedded in real estate tied to the value and type of loan.
7. New credit conversion factors were created for the range of off-balance sheet exposures.
8. Default was defined-payments past due 90 days, non-accrual assets, write-offs in anticipation of default, sale of asset loss, distressed restructuring, bankruptcy, and failure to pay without recourse to collateral.
9. The treatment of hedges and collateral was detailed extensively.

Revisions on IRB Approach

1. Banks should use IRB for all assets in a given asset category and cannot cherry-pick some exposure to be covered under SA alone and IRB for others.
2. Input floors for LGD computations are provided for corporates, with a 25% minimum LGD on unsecured exposures and a range of 0% to 15% minimum on secured exposures. The retail exposures have a minimum LGD risk weight of 50% on credit cards, 30% on other unsecured exposures, and a similar 0% to 15% on secured loans.
3. Minimum unexpected loss (UL) risk weights apply to specialized lending, and collateral haircuts apply to secured landing.
4. IRB is not to be used for large corporates or banks where modeling is challenging, as shown by historical defaults and insufficient exposures in the data used.
5. The classes include corporate, sovereign, bank, retail, and equity. Retail is further divided into three subtypes, and specialty lending is classified into project finance, object finance, commodities, income-producing real estate, and high-volatility real estate.

Revisions on Calculating CVA Risk

The Basel III accord proposed two methods of calculating CVA risk:

1. The standardized approach (SA-CVA).
2. The basic approach (BA-CVA).

Key Changes in Operational Risk

A standardized approach replaces the Basel II approach to calculating operational risk. The main characteristics include the business indicator (BI) and the business indicator component (BIC). BIC is equal to BI multiplied by the internal loss multiplier (ILM). ILM is the scaling factor based on historical losses. The business indicator is given by:

$$ \text{BI}=\text{ILDC+SC+FC} $$

Where:

\( \begin{align*} \text{ILDC} & = \text{min}[\text{Abs}\left(\text{Interest Income–Interest Expense}\right), \ 2.25\% \\ & \times \text{Income Earnung Assets+Divident Income]} \end{align*} \)

\( \begin{align*} \text{SC } & = \text{max}⁡[\text{Other Operating Income, Other Operating Expense} \\ & + \text{max}⁡(\text{Fee Income, Fee Expense)]} \end{align*} \)

\(\text{FC} = \text{Abs}\left(\text{Net P&L Trading Book} \right) +\text{Abs}\left(\text{Net P&L Banking Book}\right) \)

The internal loss multiplier (ILM) is defined as:

$$ \text{ILM}=\text{ln } \left[ \text{exp}\left( 1 \right) -1+{ \left( \cfrac { \text{LC} }{ \text{BIC} } \right) }^{ 0.8 } \right] $$

The BIC is defined as follows:

• Bucket 1: Under €1 billion = 12%
• Bucket 2: €1 to €30 billion = 15%
• Bucket 3: over €30 billion = 18%

The Liquidity Requirements

Financial institutions that seem to be solvent can be exposed to running due to withdrawal by the depositors and counterparties. The withdrawals, in such instances, exceed what assets can cover. Regardless of the cause of the run, authorities desire to find a solution without involving the government.

Basel III addressed the liquidity risk by providing two requirements:

1. The liquidity coverage ratio (LCR).
2. The net stable funding ratio (NSFR).

Liquidity Coverage Ratio (LCR)

The LCR is structured to give the banks and authorities a month to address the crisis by selling liquid assets. The concept behind LCR is that if a bank has liquid assets (assets that can be sold quickly and are reasonably priced) whose sum value exceeds what it needs to cover liquidity requirements, it can sell its assets in an attempt to redeem itself.

The LCR requirement is defined as:

$$ \text{LCR}=\cfrac {\text{ High quality liquid assets}\left( \text{HQLA} \right) }{ \text{Net cash outflows in a 30 day period} } >1 $$

The HQLA is determined by classifying assets and applying haircuts based on the likely availability of buyers at prices near normal-times values. For instance, HQLA with no haircuts refers to the deposits at the central banks, government-issued securities (with 0 risk weight), and equity, which has 50% haircuts. Individual mortgage loans are excluded from the HQLA category.

The Net Stable Funding Ratio (NSFR)

The NSFR utilizes a one-year time horizon and focuses on what remains after the stressful period rather than what can be sold. The NSFR requirement is defined as:

$$ \text{NSFR}=\cfrac { \text{Available amount of stable funding} }{ \text{Required amount of stable funding} } >1 $$

The available amount of stable funding is equivalent to the product of the amount in several categories and the available stable funding (ASF) factors (which can be thought of as haircuts). Note, however, that the categories are different from that of LCR. The required amount of stable funding is calculated by multiplying the amounts in each category of assets by the required stable funding (RSF) factor. The RSF for liquid assets is higher than that of illiquid assets.

Example: Calculating NSFR

The Bank of Afrika has liabilities of USD 800 million of stable retail deposits with not more than six months remaining to maturity. The bank has a 4-month certificate of deposit of USD 400 million, with each quarter maturing each month. The bank has USD 300 of 8-year senior bonds with none maturing in the next year and USD 200 common equity. The several ASF factors for these liabilities are 90%, 0%, and 100%.

On the assets side of the bank, it has USD 200 of valued cash, USD 200 debt of its sovereign, USD 200 of corporate debt securities rated BBB in the trading account, and USD 800 of loans to business with eight months remaining maturity. The respective RSF factors are 0%, 10%, 50%, and 80%.

What is the value of the net stable funding ratio (NSFR)?

Solution

The NSFR is defined as:

$$ \begin{align*} \text{NSFR} & =\cfrac { \text{Available amount of stable funding} }{ \text{Required amount of stable funding} } >1 \\ & =\cfrac {0.90 \times 800+0\% \times 400+100\% \times \left( 300+200 \right) }{ 0\% \times 200+10\% \times 200+50\% \times 200+80\% \times 800 } > 1 \\ & =\cfrac { 720+0+500 }{ 0+20+100+640 } =1.645 \end{align*} $$

So the bank will comply with the NFSR.

Derivative Counterparty Credit Risk

Banks are required to compute the credit adjustment (CVA) for each derivative counterparty. The CVA is defined as the difference between the value of the risk-free portfolio (of that particular counterparty) and the value of the actual portfolio. Intuitively, CVA rises with the counterparty’s credit spread. Also, CVA is affected by the portfolio market value variation, which in turn affects the profit.

Resolution Planning and Preparation

Banks are still prone to failure even after all the Basel Accords and other reforms. To reduce the effects of such failures, FSB agreed in 2014 that the national resolution regimes for G-SIBs would possess 12 attributes. In addition, FSB resolved that each G-SIB should have the sufficient total loss-absorbing capacity (TLAC) to give it the ability to recapitalize itself.

Recapitalization might be achieved by causing convertible bonds to become equity. Alternatively, recapitalization can be achieved by bail-in. That is, a specific wholesale debt liability is written down or converted to equity where the terms of conversion are spelled out into the indentured convertible bonds, which need conversion when the banks seem to be solvent. The bail-ins are overseen by national law, and the authority determines its structure after taking control of the bank.

CoCos

Contingent convertibles (CoCos) are debt instruments that can convert a bond into equity or stock once a specific strike price is breached. Convertible bonds are issued by a firm that desires to avoid dilution of issuing equity prior to the improvement of its performance. At the holder’s option, convertible bonds can be converted into equity when a firm’s share price rises above the limit written in the indenture.

Contingent convertible bonds (CosCos) cause a bank’s equity to rise when distress occurs, as shown by triggers written into the indenture and not the option of the option. With CosCos, equity increases due to conversion to equity or when its value is written down.

Some of the varied triggers include when the ratio of Core Tier 1 Capital to RWA falls below the limit or when a bank’s main regulator declares the nonviability of the CosCos. CosCos can be incorporated in Additional Tier 1 if the limit set is more than or equal to 5.125% or other included in Tier 2.

Cocos are debt instruments when issued, but the holders receive less or no returns as compared to equity holders when a bank performs well. On the other hand, holders bear losses that are almost similar to the equity holders when a bank fails and, therefore, seem expensive to the banks when they issue.

However, the accounting advantage of the CosCos lies in the fact that they are not put in the equity account until they are converted, and, therefore, a bank can report high profits on equity.

Living Wills

Some countries required G-SIBS to prepare a detailed resolution framework that expounds on how to capitalize themselves when in distress, how they would fund themselves, and how they would continue operating as a going concern even when subsidiaries fail, among other critical issues.

Applications of Basel

The Basel Accord (I, II, III) achieved a significant level of uniformity across countries, but there are some key differences. For instance, there exist differences in accounting standards, bankruptcy laws, and regulations. Notably, even with an existing agreement in Basel, some jurisdictions apply more stringent regulations than others.

Even though the participating countries are not required to impose lenient domestic laws and regulations on globally active banks, they may impose requirements that are relatively different but higher than the Basel Accord. This is beneficial for the Basel negotiations because it grants freedom to those countries that want stringent standards that are applied domestically.

Basel expects that on top of its minimum standards, each country has the mandate to oversee banks and take appropriate actions to ensure that they have sufficient capital and liquidity and efficient risk management and governance. For instance, in the US, supervised stress tests based on supervisory models and scenarios are conducted in a bid to make sure that banks have a capital and liquidity planning process, risk management, and sufficient buffers to allow compliance with minimum capital and liquidity standards, even when they (banks) are undergoing a stressful period.

Legislative and Regulatory Reforms That were Introduced After the 2007–2009 Financial Crisis

The reforms include:

1. The FSB promulgated the guidelines for better compensation practices after it was realized that the pre-crisis compensations at giant banks were independent of risk-taking, resulting in careless risk-taking. Consequently, numerous nations responded by increasing supervision and regulation. For instance, some countries concentrated on supervising risk-sensitive features in compensation frameworks.
2. The capacity to execute macroprudential policy was added through institutional reforms in some nations (where legal authority was unavailable). For example, in the UK, the Financial Policy Committee was formed at the Bank of England with significant authority to take macroprudential policy actions and recommend others to parliament.
3. The US’s Volcker Rule (which was part of the Dodd-Frank Act) restricts individual trading and investment in head funds and private equity at deposit-taking firms. The main reason for this is that banks should not be allowed to speculate when insured depositors fund them. The Volcker rule is hard to implement because it is difficult to identify the reasons for trading and differentiate between hedging and speculative activities.
4. In the US, the Securities and Exchange Commission formed the Office of the Credit Ratings was formed to give limited oversight of rating agencies since the pre-crisis rating agencies were blamed for the underestimation of credit risk in securitization.
5. The Consumer Financial Protection Bureau (CFPB) was formed in the US to improve information sharing between consumers of financial products and to control abuse by financial firms of all types.
6. In the US, huge banks were mandated to have a board of risk committees consisting of, at least, one member with extensive risk management experience in a large financial firm.
7. The issuers of the securitizations in the United States and the European Union were required to keep, at least, 5% of each tranche in order to, at least, align the incentives of the issuers and the investors.
8. The mortgage lenders in the US were mandated to assess whether borrowers can service the loans they acquire. Legal repercussions of faulty determination of mortgage borrowers have made some banks exit the mortgage industry.
9. In the US and EU, some OTC derivatives ought to be traded on swap execution facilities (SEFs). The SEFs are electronic platforms that promote price transparency. Moreover, the derivative done between the financial institutions must be overseen by the central counterparties (CCP).

Practice Question

Which of the following statements is correct about the stressed VaR in Basel 2.5?

A. Stressed VaR is calculated by multiplying 1-day VaR from the recent daily variation in values by \sqrt{10}.

B. Stressed VaR is drawn from one year from the most recent seven years that exhibited stress in its current portfolio.

C. Stressed VaR is drawn from one year from the most recent ten years that exhibited stress in its current portfolio.

D. None of the above.

The correct answer is: B).

A bank was required to identify a one-year (that is, 250 trading days) period from the latest seven years that was most stressful for its current portfolios.

Option A is incorrect: This was the method of calculating the market risk amendment using the historical simulation in the Basel I accord.

Option C is incorrect: Basel 2.5 required banks to identify one year from the latest seven years (not ten years) that was most stressful for its current portfolios.