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The solvency

regime of the
banking sector
BASEL III / CRD IV
[PART 1]

Solvency Models | May 2016 | Hugo Borginho

Instituto Superior de Estatstica e Gesto de Informao


Universidade Nova de Lisboa
Agenda

1. Introduction
2. Pillar I quantitative requirements
a) Own funds
b) Capital requirements
c) Capital buffers
d) Liquidity
e) Leverage

3. Pillar II supervisory review and evaluation process


4. Pillar III market discipline

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Historical background

The Basel Committee on Banking Supervision


is a supervisory forum of the Bank for
International Settlements (BIS), created in
1974 following an initiative of the G10
Exchange of information and experience on
supervisory activities, namely on cross-border
operations

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Basel I

In 1988, the Basel Capital Accord was issued


by the Basel Committee
Strengthen the resilience and stability of the
international banking system, with the
establishment of minimum solvency levels
Reduce the competitive distortions between banks
and national banking systems
Establish the minimum capital requirement of 8% of
the risk weighted assets
Initially, its scope covered only credit risk

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Basel I

The Basel I Accord was transposed to the


European legislation in 1989
In the early 90s, banks suffered significant losses
due to the materialization of market risks
(derivatives)
This event triggered the revision of the Accord in 1996 to
contemplate market risk
Separation between the asset classes of the banking
book and the trading book
Recognition of the use of internal models for market risk

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Basel II

In 2004, a deep review of the Accord was


finalized, giving rise to the Basel II Capital
Accord
Increase of the sensitivity of the capital
requirements to the risks
Scope is broadened to include operational risk
Focus on the actions of supervisors and on market
discipline, besides capital requirements creation
of the 3 pillars system
Reward the good practices on the management of
risks

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Basel II

The Basel II Accord was calibrated such that


the global level of capitalization of the
internationally active banks was broadly kept
unchanged
It establishes common minimum rules to be
applied at international level by the Member
countries, i.e. non-binding good practices
It quickly became the standard for almost all
remaining countries with internationally active
banks

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Basel II | CRD

The Basel II Accord was implemented in the


European Union through the Directives
2006/48/EC and 2006/49/EC (Capital
Requirements Directive (CRD))
Entry into force at 1st January 2007
The advanced methods were made available one
year after

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Basel II | CRD

In the wake of the 2007 financial crisis, several


vulnerabilities were identified:
Lack of quality of certain capital instruments
Perverse incentives to excessive risk-taking and inadequate
risk assessment
Excessive growth of banks level of credit and leverage
Dependence of market-based sources of funding
Low focus of regulation and supervision on the
Macroprudential area
Systemic relevance of institutions too big to fail

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Basel III

The crisis generated a number of initiatives to


strengthen the banking regulatory framework:
At global level, the Basel Committee developed
reforms to incorporate the lessons of the crisis,
leading to the Basel III package
Endorsement by the G20 in November 2010
At European level: CRD II, CRD III and CRD IV
packages

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CRD II

Quick answer to the crisis


Directives 2009/111/EC, 2009/27/EC and
2009/83/EC
Improvements on the areas of management
of large exposures, quality of banks capital,
liquidity risk management, securitisations
and establishment of colleges of
supervisors
Application since 31st December 2010

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CRD III

Quick answer to the crisis


Directive 2010/76/EC
Improvements on the areas of capital
requirements for the trading book, re-
securitisations and supervisory review of
remuneration policies
Gradual implementation:
1st January 2011: remuneration policies
31st December 2011: remaining provisions

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CRD IV

Implementation of the Basel III rules at European level


Reduces the options for national discretion, improving
the harmonization
Package comprises:
Directive 2013/36/EU (CRD IV), covering the access to
deposit-taking activities and other areas requiring
transposition by Member States to adapt to national
specificities
Regulation 575/2013 (CRR), including detailed prudential
requirements for credit institutions and investment firms (direct
application) single rule book
Application since 1st January 2014, but some new
provisions are phased-in between 2014 and 2019

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Basel III vs. Basel II

Basel III: main changes relative to


Basel II:
Strengthening the quality, consistency
and transparency of own funds
Capital buffers
Leverage ratio
Liquidity ratios

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Basel III vs. CRD IV

On top of Basel III, the European


implementation (CRD IV) includes changes in
the following areas:
Remuneration policies
Enhanced governance
Diversity in board composition
Enhanced transparency
Systemic risk buffer, Global systemic institution
buffer and Other systemic institution buffer
Reduction of reliance on external credit ratings

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Scope

The Basel rules apply to all internationally


active banks, on a consolidated basis
Banking and relevant financial activities
(regulated and non-regulated) are captured
through the consolidation of operations
In the EU, the CRD IV is mandatory to all
banks and investment firms, regardless of size

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The 3 Pillars

Pillar I
Minimum capital requirements to cover credit, market
and operational risks

Pillar II
Supervisory review and evaluation process
Internal Capital Adequacy Assessment Process (ICAAP)
Risk management and internal control systems

Pillar III
Market discipline
Public disclosure requirements

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Banks balance sheet structure

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Banking book and trading book

Trading book: means all positions in financial instruments


and commodities held by an institution either with trading
intent, or in order to hedge positions held with trading intent.
Positions with trading intent include proprietary positions
and positions arising from client servicing and market
making; positions intended to be resold short term; and
positions intended to benefit from actual or expected short-
term differences between buying and selling prices or from
other price or interest rate variations.
Non-trading book (banking book): consists of positions
which do not belong to the trading book (e.g. assets from
traditional banking activities, assets held to maturity, etc.)

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Own funds

Own funds are given by the sum of (after


deductions):
Common Equity Tier 1
Additional Tier 1
Tier 2
Tier 1: Going concern capital, i.e. it allows a bank
to continue its activities and helps to prevent
insolvency
Tier 2: Gone concern capital, i.e. it helps ensuring
that depositors and senior creditors can be repaid
if the bank fails

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Tier 1

CET1 includes mainly:


Ordinary shares or equivalent
Retained earnings
AT1 includes capital instruments:
Rank below Tier 2 in the event of insolvency
Full discretion to cancel the distributions for an
unlimited period and on a non-cumulative basis
Perpetual
With no incentives to redeem
When capital ratio falls below 5,125%, principal is
written down or item is converted into CET1

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Tier 2

Tier 2 includes capital instruments and


subordinated loans:
Subordinated to claims of all non-subordinated
creditors
Original maturity of at least 5 years
With no incentives to redeem
In the final 5 years, recognition considers linear
depreciation of the value of the item

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Deductions to CET1, AT1 and T2

The calculated amounts of CET1, AT1 and T2


are subject to a number of deductions to
improve quality
The deductions are harmonized and they
apply, as a general rule, to the CET1
component
These deductions are phased-in until 2018

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Deductions to CET1

Goodwill and other intangible assets


Deferred tax assets that rely on future profitability
Negative difference between expected losses (EL)
calculated using the IRB method and the accounting
provisions
Assets covering defined benefit pension plans
Holdings of own CET1 instruments
Participations in financial sector entities (banking,
financial, insurance)
Others
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Own funds requirements

Minimum ratios (as % of risk weighted assets


(RWA)):
CET1 ratio of 4,5%
Tier 1 ratio of 6%
Total capital ratio of 8%

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Phasing-in (own funds)

2013 2014 2015 2016 2017 2018 2019

CET1 ratio 3,5% 4,0% 4,5% 4,5% 4,5% 4,5% 4,5%

Phasing-in of deductions to CET1 - 20% 40% 60% 80% 100% 100%

Tier 1 ratio 4,5% 5,5% 6,0% 6,0% 6,0% 6,0% 6,0%

Total solvency ratio 8,0% 8,0% 8,0% 8,0% 8,0% 8,0% 8,0%

Capital instruments no longer


Phasing-out during 8 years starting from 2014
accepted in Tier 1 and Tier 2

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General assumption

Expected losses:
To be recognised by provisions
Unexpected losses:
To be covered by eligible own funds
(establishment of minimum capital
requirements)

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Risks

Credit risk: risk of loss due to default or


deterioration of the credit quality of the
counterparty
Market risk: risk of loss due to adverse
movements on market prices, negatively
affecting the investment portfolio
Operational risk: current or potential risk of
natural catastrophes, failures of processes,
persons or systems

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RWA

Within the calculation of credit risk, the


concept of Risk Weighted Assets (RWA)
is used
The accounting value of each asset is
multiplied by a parameter reflecting its
level of risk (the higher the parameter,
the higher the risk)
The capital requirement is given by 8% of
the sum of the RWA

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Capital ratio

Eligible own funds


100%
Capital requiremen t

Capital Requiremen t CR credit CR market CR operational

Eligible own funds


Capital ratio 8%
Capital requiremen t 12,5

(note :12,5 1 8%)


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Capital requirements vs. RWA

Capital requiremen ts 8% RWA

RWA 12,5 Capital requiremen ts

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Methods to calculate the capital requirements

Operational
Credit risk Market risk
risk
Standardised
Standardised Basic indicator
measurement
approach approach (BIA)
method

Internal ratings-
Internal models Standardised
based approach
approach approach
(IRB)

Advanced
measurement
approaches (AMA)

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Methods to calculate the capital requirements

The existence of alternatives of calculation


accomodates the different levels of
sophistication on the measurement and
management of risks by institutions

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