Basel 3 is refers to the new update of the Basel accords that is under development. “Basel 3″A is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to: improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source improve risk management and governance Strengthen banks’ transparency and disclosures. The reforms target: Bank-level, or micro prudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress. Macro prudential,A system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time. These two approaches to supervision are complementary as greater resilience at the individual bank level reduces the risk of system wide shocks. The Basel Committee’s oversight body – the Group of Central Bank Governors and Heads of Supervision (GHOS) – agreed on the broad framework of Basel 2I in September 2009and the Committee set out concrete proposals in December 2009.
These consultative documents formed the basis of the Committee’s response to the financial crisis and are part of the global initiatives to strengthen the financial regulatory system that have been endorsed by the G20 Leaders. The GHOS subsequently agreed on key design elements of the reform package at its July 2010 meeting and on the calibration and transition to implement the measures at its September 2010 meeting. Basel 3 is part of the Committee’s continuous effort to enhance the banking regulatory framework.A It buildsA on the International Convergence of Capital Measurement and Capital Standards document (Basel 2). 1.2. DEVELOPMENT OF BASEL 3 ACCORD: 1.2.1. Summary of proposed changes in Basel 3: The consistency, transparency and the consistency of the capital is raised. The risk coverage of the framework is strengthened. The committee introduced the leverage ratio as a supplementary measure to the Basel 2 framework. The committee introduced a series of measures to promote to the buildup of the capital buffers. The committee is introducing the series of measures to the address procyclicality. Achieve the macro prudential goal of protecting the bank from the excess of the credit growth. Providing the stronger provisions. The committee is introducing a global liquidity standard for internationally active banks.
Basel 3 and Recent Efforts to Address Pro Cyclical Effects of Basel 2 In response to the recent Financial Crisis and to the realization that capital levels (which banks operated with) during the period of the Crisis were insufficient and also lacking in quality, the Basel Committee responded by raising the quality of capital – as well as its level. Further consequences of the recent Basel reforms also include: A tightening of the definition of common equity Limitation of what qualifies as Tier 1 capital An introduction of a harmonized set of prudential filters The enhancement of transparency and market discipline through new disclosure requirements. The introduction of Basel 2 resulted in changes being made to the 1988 Basel Capital Accord to provide for a choice of three broad approaches to credit risk. This was introduced into Basel 2 in view of the realization that “the optimal balance may differ significantly across banks.”The increased focus on risk (and particularly credit risk), resulted from growing realization of the importance of risk within the financial sector. The range of approaches to credit risk – as introduced under Basel 2, and which also exists for market risk, consists of the standardized approach (which is the simplest of the three broad approaches), the Internal Ratings based (IRB) foundation approach and the IRB advanced approach.
Under the standardized approach, regulatory capital requirements are more closely aligned and in harmony with the principal elements of banking risk – owing to the introduction of wider differentiated risk weights and a broader recognition of techniques which are applied in the risks.A The proposals defining the contents of the Basel 3 framework evolved during the crisis that started in 2007, and reflect the prudential regulatory lessons learned throughout the crisis. Based on these experiences, including the success of various regulatory policies and tools used in mitigating and resolving the effects of the crisis on the banking system and the global financial system, the Basel Committee on Banking Supervision outlined these new regulations. 1.3. BASEL COMMITTEE: The Basel Committee on Banking Supervision, which sets rules that national banking regulators implement, announced a comprehensive reform package in September that raises capital requirements and, for the first time, sets global standards for overall borrowing, known as leverage, and liquidity.
The “Basel 3” rules are designed to make banks more resilient and prevent a repeat of the financial crisis, but several provisions combine to make trade finance, already a low-margin business, much less profitable. Portions of the leverage rule, new risk-weighting requirements and the rules for liquidity raise the costs of trade finance for banks. The combination could drive many smaller banks out of the market and prompt large banks to cut back their lending, bankers and policymakers say. Banking groups and policymakers are lobbying for changes to the proposals, as is Lars Thunell, head of the IFC, the World Bank’s private sector arm. They point out that outsourcing by companies in the developed world is a critical source of jobs and investment and trade finance is an essential part of the process. Mike Rees, chief executive of wholesale banking at Standard Chartered, the world’s second-biggest provider of trade finance after HSBC, says: “If they want to promote economic growth, the Basel Committee should encourage trade finance, one of the few things that create jobs in a global economy.”
The Basel 3 reforms hit at trade finance in several ways. The rules sharply increase the risk-weighting of lending between financial firms – an essential element of trade finance because it involves the importer’s bank lending money to the exporter’s bank, often through a letter of credit. The Basel 3 rules risk making it uneconomic to provide transaction banking services, warns Brian Stevenson, head of transaction banking at RBS: “Tougher operational risk capital and liquidity requirements could make the business of providing services to financial institutions inefficient if they went too far.” Much of trade finance is also supported by export credit guarantees, which are essentially government credits and therefore in theory low-risk. But the new rules also tighten the definition of what counts as a government guarantee; some export credit agencies may not qualify. Simon Gleeson, partner at Clifford Chance, the law firm, says: “An enormous number of letters of credit are guaranteed by a form of government support, which should mean they carry a zero per cent risk rating.
But Basel 3 is much tighter about what can count as a government-backed credit and many export credit agencies have been privatized.” Basel 3’s new leverage ratio will also bring trouble for trade finance, when it takes effect in the latter part of this decade. The rule seeks to prevent banks from gaming the risk-weighting rules, by requiring banks to hold top quality core tier one capital equal to 3 per cent of their total assets, including those traditionally held off-balance sheet. The part of the liquidity proposals that would require banks to match long-term obligations with long-term funding and vice versa, could also penalize trade finance. Bankers say they understand why regulators are trying to crack down on dependence on short-term funding but they also say that it is unfair to lump trade finance – which is well collateralized and not self-renewing – with other short-term funding, such as working capital and liquidity guarantees. A transaction banking subgroup within the UK Bankers Association for Finance and Trade is lobbying the Basel Committee in an effort to persuade regulators to soften the rules. 1.4. Research objectives and questions: The research objectives of the study are: To focus on the liquidity risk from the wide range of risks available in Basel 3.
To focus on the impacts of the Basel 3 proposals for Liquidity Risk. A Questions: A A A A A A The purpose of the study was to discover the following:A Does the liquidity risk break down the risk silos? Is the liquidity risk in the Basel 3 on the right track? Will the new rules in the liquidity risk will be helpful to improve the committee’s approach? Will the liquidity risk makes bank strong? Does the Basel committee understand the linkage between the liquidity risk and capital? Does the committee fail to understand the nature of liquidity risk? Is the Basel 3’s approach to the liquidity risk missed the opportunity to break down the risk silos?A 1.5. BASEL 3 IMPACT: The Basel Committee on Banking Supervision (“Basel Committee”) has undertaken a program of substantial revisions of its capital guidelines. In particular, the changes envisaged in the so called “Basel 2.5” guidelines will result in increased capital requirements for market risk; in addition, the so-called “Basel 3” guidelines set new minimum capital ratios, revise the definition of Tier 1 Capital, introduce Tier 1 common equity as a regulatory metric, and make substantial revisions to the computation of risk-weighted assets for credit exposures. Implementation of the new requirements under Basel 2.5 and Basel 3 is expected to take place over an extended transition period, starting at the end of 2012.
There continues to be considerable uncertainty regarding the impact of the Basel Committee’s new guidelines. Although certain important aspects of Basel 3 have now been finalized, other matters remain under discussion; in addition, the federal banking regulatory agencies in the United States have not yet issued draft regulations by which they will implement either Basel 2.5 or Basel 3 for banks and bank holding companies. Accordingly, the final regulations to which Goldman Sachs will be subject may be substantially different from our current expectations. In order to assess the firm’s position under the Basel Committee’s new guidelines, we have adjusted our computation of Tier 1 common equity and risk-weighted assets as of June 2010 to reflect our good faith estimate of the impact of the methodologies set out in Basel 2.5 and Basel 3. In addition, we have adjusted the June 2010 computation to reflect assumed changes in shareholders’ equity and risk-weighted assets at year-end 2012. In particular, shareholders’ equity has been increased from June 2010 levels by an amount equal to analysts’ consensus earnings expectations for 2010 less actual June YTD earnings, plus earnings for 2011 and 2012, which are assumed to be equal to consensus earnings for 2010. Risk-weighted assets have been adjusted to reflect the contractual and expected run-off of positions in our mortgage derivative and credit correlation businesses, both of which will be significantly impacted by the introduction of Basel 2.5. No other items have been adjusted, and this calculation should not be taken as a projection of what our capital ratios, risk-weighted assets, earnings or other results will actually be at year-end 2012.
The Basel Committee on Banking Supervision expects risks such as the credit risk, liquidity risk, operational risk etc to be recognized, addressed and managed by banking institutions in a prudent manner according to the fundamental characteristics and challenges of e-banking services. These characteristics include the unprecedented speed of change related to technological and customer service innovation, the ubiquitous and global nature of open electronic networks, the integration of e-banking applications with legacy computer systems and the increasing dependence of banks on third parties that provide the necessary information technology. While not creating inherently new risks, the Committee noted that these characteristics increased and modified Some of the traditional risks associated with banking activities, in particular strategic, operational, legal and reputational risks, thereby influencing the overall risk profile of banking. In the following sections the liquidity risk is focused on risk management. LIQUIDTY RISK MANAGEMENT: The recent financial crisis involved a sharp decrease in market liquidity and growing distrust among market participants, resulting in serious (liquidity and solvency) problems for many banks.
This led in turnA to reliance upon financial support from governments, oftenA under restrictive conditions or even nationalization. This lack of liquidity, the vast sums the central banks injected into markets and sovereigns provided for the support of tarnished institutes to alleviate the problems – as well as the subsequent substantial impact on the real economy – has broughtA liquidity risk to the forefront of regulatory authorities’ priorities, and to the attention of the public in general.A Dimensions of liquidity (risk) The term liquidity is used in the financial world in different contexts: liquidity as a measure of the salability of securities such as bonds or sharesA liquidity as a description of the financial solvency of individual institutionsA liquidity as a level of market activityA liquidity as unhindered cash flows within an economy The primary objective of liquidity risk management remains the same: to ensureA an institution’s ability to meet financial obligations as they fall due at all times – for example, achievable by an adequate liquidity buffer consisting of unencumbered, high quality liquid assets. By its digital character (either a firm is able to meet financial obligations or it is out of business) liquidity risk takes on a unique position within the risk management; unlike other types of risk (market risk, credit risk, operational risk etc.) it cannot be covered entirely by regulatory capital requirements, but it has a significant emphasis on short term activities, requiring immediate but adequate reaction in stressed situations.
To successfully manage liquidity risk, one should consider all relevant factors: from the business structure which determines liquidity needs, the analysis of markets (market price, market liquidity and market depth), and finally the necessary level of funding diversification. This makes liquidity risk management a very complex and comprehensive topic.A New regulatory requirements One consequence of the recent crisis is closer supervision and a tighter regulatory regime to be imposed upon the banks and financial markets by Government-sponsored regulatory authorities. Recent updates of the MaRisk (regulatory requirements in Germany, 08/2009) reveal the lessons learned through the financial crisis. The following innovations can be found:A Specification of three types of stress scenarios (idiosyncratic, market-wide and combination of both) that have to be considered in the treatment of liquidity risk Updated requirements for the provision of liquidity reservesA Separate analysis of liquidity per currencyA In general, the updated MaRisk requirements (regarding the coverage and the degree of specification) are significantly less stringent than those released by the UK’s FSA, as described in the following section. In October 2009 the FSA (the UK regulatory authority) specified new regulatory requirements concerning liquidity risk management in the policy statement PS09/16 (Strengthening liquidity standards), therebyA finalizing a series of consultation papers (CP08/22, CP09/13 and CP09/14).
The policy details new requirements such as the Individual Liquidity Adequacy Standards (ILAS) or the Liquidity Reporting. Crucial points are: enhanced system and control requirements for adequate liquidity risk managementA A definition of principles of adequate liquidity and self-sufficiencyA multidimensional breakdown of contracts (e.g. currency, asset type or time buckets) stress-test scenarios have to cover short-term and protracted stress scenarios (2 weeks / 3 months), institution-specific (idiosyncratic) and market-wide stress, as well as combinations of both – all evaluated across 10 prescribed key risk drivers coherent interpretation of results and individual liquidity guidance (ILG) by the FSA new definition of liquid assets and risk-based buffer as well as the demand for a regular realization of a significant portion of the liquidity buffer New reporting regime: granular, frequent (daily, weekly, monthly, quarterly) and partially automated – the “Enhanced Mismatch Report” has to be submitted weekly (with the ability to report daily) in an automated process. With regard to systemic risksA these standards do not only apply to UK firms only, but also to non-UK firms with branches in the UK.
In order to keep the regulatory requirements to a reasonableA level, modifications and simplification on an individual basis are provided. In particular, non-UK firms with branches in UK may apply for a “whole-firm modification” in the course of which the supervision is mainly left to the parent firm and only a significantly reduced amount of reports at low frequency (but for the whole firm) has to be submitted.A Based on their “Principles for Sound Liquidity Risk Management and Supervision” published in 09/2008 the Basel Committee on Banking Supervision (BCBS) issued a new consultation document “International framework for liquidity risk measurement, standards and monitoring” for comment in December 2009. Within this paper they propose – amongst other things – two new standards: Liquidity Coverage Ratio (LCR): ratio of the stock of unencumbered, high quality liquid assetsA to the net cash outflows over a 30-day time period under an acute liquidity stress scenario (prescribed combination of idiosyncratic and market-wide shock).A Net Stable Funding (NSF) ratio: ratio of the available amount of stable fundingA to the required amount of stable funding.
The LCR is intended as a measure for the short-term (30 days) view in a stressed situation (prescribed by the supervisors), whereas the NSF ratio has a longer perspective (1 year) on the funding needs with respect to illiquid assets and securities held (regardless of accounting treatment). Furthermore, the paper recommends consistent monitoring tools; including contractual maturity mismatch, concentration of funding, available unencumbered assets, and market-related tools to monitor the liquidity risk profiles of supervised entities.A Following the invitation of the BCBS to comment upon this document, the international discussion on sound liquidity risk management and corresponding supervision will continue, and further standards and requirements on national level will be developed. Liquidity risk management framework Prior to the crisis, the management of liquidity risks was not an issue because banks wereA accustomed to a functioning interbank money market which usually was a reliable source for short-term funding. Nowadays sound liquidity risk management has gained significant importance and is emphatically required by public and regulators. All firms active in the financialA markets should be equipped with an adequate framework to identify measure, manage and monitorA their liquidity risks.
The aims of a comprehensive liquidity risk management, based on a well-founded knowledge and understanding of the institution’s liquidity profile, are included in (but not limited to) the following aspects: Securing the institution’s ability to meet its financial obligations at all times, andA possessing a graduated and detailed plan for different stress situations at hand Creation of revenue possibilities by controlled maturity transformation and resulting in applicable steering recommendationsA Optimization of liquidity costs (e.g. the composition of the liquidity buffer) OnA an organizational level, the liquidity risk management framework should be separated into a management and a controlling side. At the top level, the Board of Directors defines the risk appetite and sets the liquidity risk strategy – which has to be approved, and will be continuously monitored, by the Supervisory Board. OnA an operational level the Treasury department is responsible for meeting the short-term financial obligations of the firm. The risk controlling department assures that all Treasury operations stay within the liquidity risk strategy. Moreover, the risk controlling department defines modeling for liquidity risk analyses (e.g. for non-deterministic cash flows) and performs stress tests. Results emanating fromA the risk controlling department’s actionsA on the liquidity situation of the bank may also serve as basis for regulatory reporting. We can see the liquidity risk in detail in the following chapters.
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