Module 2: basel and BCBS (Basel Committee on Banking Supervision)

 With the introduction of the basel 3 accords after the 2007-2009 crisis some new concepts such as Leverage Ratio, Liquidity Coverage Ration or LCR, Net Stable Funding Ration NSFR, SIB or Systematically Important banks, and the capital buffers emerged. 

BCBS Origin and Role

Basel is a city in Switzerland. Where the representatives of G10 countries got together in 1974 to form BCBS- Basel Comittee on Banking Supervision. The trigger for setting up BCBS was the failure of Herstatt bank in Germany. 

There were two main objectives for setting up BCBS:-

1. To enhance financial stability by improving the quality of banking supervision by central banks. 

2. To monitor and ensure capital adequacy of the banks.

To achieve these objectives BCBS releases accords which are known as Bassel accords. Today BCBS comprises of 45 members from 28 jurisdictions. 

Basel Accords

The primary risk that the banks face is the non-repayment or default on loan by a borrower and is called credit risk. Basel 1 record released in 1988 was primarily focussed on credit risk. In 1996 market risk was added as an amendment to the Basel Accord. Market risk can be defined as the risk of change in market value of trading securities such as Bonds, equities and foreign exchange. 

Basel 2 was release in 2004 and operational risk was added. One of the triggers for addition of operational risk in Basel 2 was the failure of 200 year old British Bank Barings Bank. Barings Bank collapsed in 1995 and the reason was a person named Nick Leeson. Nick was a derivates trader in the Bank based in Singapore. His strategy was to arbitrage on Nikkei 225 Future contracts between two exchanges in Osaka and Singapore. That is he would buy at lower price in exchange where the price is low and sell it on an exchange where the price is high for a tiny gain. This arbitrage trading conducted throughout the day resulted in significant profit to the bank at the end of the day with miniscule risk. But Leeson got greedy and held the contracts for longer duration betting on the direction of the Japanes Market and incurred losses. He falsified trading records in the banking system and used the money meant for margin payments for more trading. Due to this he was able to hide his losses and seemed to be making significant profits. He was regarded as a star and was given huge incentives. Then came the Kobe earthquake which resulted in the crash of the Japanese Markets. By this times Leeson had already incurred huge loses but he made a last bet in quick recovery of the Japanes markets which did not happen. As a result he had more loses. His total loses were 1.3 billion $ which was two times of the allocated capital of the bank. It was later found that Nick was able to hide his actions as most of the internal controls were missing. He was able to do that as he was incharge of both trading and settlement means the front office and the back office. Bank management was not even aware of what Leeson was doing. 

The Three Pillars

Another major milestone in Basel 2 was introduction of the three pillars. These three mutually re-inforcing pillars aim to strengthen the resilience and stability of the banks. The pillars were introduced in Basel 2 but have continued in Base 3.

Pillar 1: Minimum Capital Requirement

The three risks we have discussed up until now are credit risk, market risk and operational risk. Pillar 1 caters to these three primary risks. It is called minimum capital requirement as only for these three primary risks minimum capital requirement is prescribed. Methodologies have been specified for computing risk weighted assets and capital charge for these three primary risks.What is the capital requirement for pillar 1 risks- it is the CRAR- Capital to risk weighted assets ratio. Risk weighted assets for three primary risks- Capital, Market and operational. Basel has recommended 8% but regulators may even recommend higher. For example in India the Central Bank, the Reserve Bank of India has prescribed a CRAR of 9% .

Pillar2: Supervisory Review Process

The other risks banks face are Liquidity Risk, Reputation Risk, Cyber Risk. These risks are categorised as other risks under Basel Pillar 2. For pillar 2 no mimimum capital requirement has been prescribed. Banks do their own internal assesment using ICAAP- Internal Capital Adequacy Assesment Process. ICAAP is an annual exercise undertaken by the risk management department of the bank. Besides assesment of Pillar 2 risks ICAAP encompases Future capital planning, Setting of Risk Apetite and stress testing. For each risk in Pillar 2 assessment is done both for the risk as well as controls put in place to mitigate the risk. banks take a call whether sufficient controls are in place or additional capital is required over and above the CRAR requirement is needed for the risk. Banks submit the ICAAP document to the supervisor. 

Pillar3: Market Discipline

It basically relates to the disclosures in Banks Annual report. Besides the financial statements and reports there are various disclosures. There are disclosure pertaining to group entities, capital adequacy, credit risk, market risk, operational risk, composition of capital in terms of  Tier 1, Tier 2, disclosures pertaining to Leverage Ratio. Disclosures increase transparency as well as comparibility between the banks. Through disclosures additional information pertaining to a bank is coming in public domain into the market. Banks know they will have to disclose this information to the market. This acts as a check or restraint on Banks from doing something wrong and they adhere to the discipline of the market. 

Base; 2 was amended in 2006 and counterparty credit risk was added. Counterparty credit risk is the credit risk for derivatives. 

Basel 3 was introduced in December 2010

When a Bank gives a loan, only the borrower can default, so bank faces a possibility of loss due to default by a borrower and keeps capital for this risk of loss.

Counterparty Credit Risk is the credit risk for Derivatives. In Derivatives both the parties in the deal can have a positive value at different times (depending on the movement of the price of underlying asset). Hence both the parties face the risk of default by the other party(counterparty) before the final settlement. 

basel 3 trigger

The great finacial crisis -2007-2009 subprime mortgage crisis

MBS- mortgage Backed Securities

CDS- Credit default swaps

CDO- collateralized  Debt Obligations

Lehman Brothers which failed, Countrywide and Merill Lynch which were bought by Bank Of America

Bear Sterns and Washington Mutual which were bought by JP Morgan

Wachovia Bank which was bought by Wells Fargo

Both America and Europe went into recession

The Subprime were the borowers. Banks were giving mortgage loans to borrowers whom they themselves classified as Sub Prime or below prime. Later on Loans were given to Ninja customers- No assets, No Income, No Job.

There was an economic boom in America from 1997 to 2007. The world was investing in USA. The american banks were flush with funds. Excess credit was available. Housing prices were going up and interest rates were coming down. Banking institutions started giving ARM loans to undeserving customers as well who were classifies as sub prime borrowers. ARM stands for Adjustable Rate Mortgages are teaser loans where the rate is low for 1-2 years and then it starts going up. As the rate is low of 1st year the subprime borrower becomes eligible. So what happens after 2 years when the rate goes up and the installment goes beyond the capacity of the subprime borrower. Banks felt there was no risk. Housing prices were constantly going up and the interest rates were coming down. There were three scenarios:-

1. Borowers could re-finance the loan at lower rate as the interest rates were coming down

2. Borrowers could sell as the housing prices were going up and they could return the loan with the sale and earn some extra amount

3. If the borrower does not refinance or sell the bank could sell at higher rate and earn money

Two of the biggest housing loan companies of the USA - Fannie Mae and Freddie Mac

Housing loan companies securitized these loans and sold them to other banks as Mortgage Backed Securities or MBS. They got cash from which they could finance more mortgages. The MBS were further bundled together and sold as CDO Colateralized Debt Obligations. The American International Group or AIG started selling an insurance product for MBS known as CDS- Credit Default Swaps. It was more of a derivative than insurance. A person holding CDS would make money if the price of MBS goes down. Huge markets for trading of MBS, CDO, CDS were developed. The MBS and CDS were sold in tranches. Tranches were structured in a way that 90% of them got rated as AAA by rating agencies. A huge bubble was created which could sustain only if the underlying mortgage selling activity continued. So more and more homes were being built and sold. By 2007 huge inventory of houses were created but no more buyers could be found. As a result house prices start to go down and also interest rate went up. So now subprime borrowers were unable to refinance or sell. They started defaulting. This depressed the markets. Seeing this even the prime borrowers who had the capacity to pay started defaulting. The reason was the prime borrowers were not living in the houses they finances seeing the surge in housing market they had purchased to make money but as the prices were falling there was no sense in being in this market. Rating agencies started downgrading the instruments and started marking them junk. Therefore there was no market left for MBS and CDO. These securities were regarded as quasi sovereign and very liquid. As these securities were giving much better returns as compared to equivalent bonds Banks had parked their excess money in them. Suddenly there was no market left. Banks were left holding papers. 

Basel 3 enhancements: 

Too Big to fail or Systematically Important Banks this concept was introduced in Basel 3: These were the banks which should not fail because if they fail they may take with them down the entire economy or the Financial Sector. How are these banks selected? SIB's are selected from a sample for Global Banks based on Size, Complexity, Interconnectedness, Global activity and lack of substitutes. These are classified as G-SIB's or Globally Systematically important banks. Similarly we have D-SIB's which are Domestic Systematically Important Banks which are important for the health of Domestic economy. What do these banks have to do to ensure that they do not fail? They must have higher loss absorbing capacity. That is they should be maintaning a higher Capital to Risk Weighted Assets Ration (CRAR) or the Leverage ratio. In addition they must fulfill higher supervisory expectations in terms of risk management, risk governance and controls. 

Leverage Ratio

It was found that during the crisis banks were highly leverages that is they had high debt and low capital. So Basel 3 introduced leverage ratio. This ratio requires banks to hold a minimum value of Tier 1 capital relative to banks total assets that is both on and off balance sheet assets. 

Banks should not base their capital adequacy just on the ratings given by rating agencies hence Leverage Ration based on actual exposure was introduced. Leverage ratio is mean as non-risk back stop to risk-based capital measures such as the Capital to risk weighted assets ration or the CRAR. 

Liquidity Ratios

During the financial crisis even the biggest banks such as the Citi Bank and Bank of America faced liquidity crunch and had to seek liquidity from Federal Reserve. Hence new liquidity measures were introduced in Basel 3. Liquidity Coverage Ration (LCR) requires banks to hold sufficient liquid assets to sustain them for a period of 30 days in times of stress. LCR ensures that banks have sufficient amount of unencumbered high quality liquid assets or HQLA to meet its liquidity needs for a 30 day stress period. HQLA are assets such as cash or assets that can be quickly converted into cash at little or no loss value. 

The second liquidity measure is Net Stable Funding Ratio (NSFR). NSFR aids banks to better match their assets that is loans and investments to their liabilities that is deposits. NSFR is a long term ratio which addresses the maturity mismatches during the entire year. NSFR looks at liquidity from the funding side and aims to reduce dependence on the short term wholesale funding, which is less stable. NSFR aims to ensure that long term assets are funded from long term stable liabilities. 

Both LCR and NSFR have to be maintained at 100% or more.

capital Buffers

Another enhancement in Basel 3 was the introduction of capital buffers. The buffers aim to limit procyclicality. It means during periods of economic growth banks should aim to build up capital buffers by retaining earning. This concept is that the banks should save for a rainy day in times of sunshine. Two buffers were introduced Capital Conservation Buffer (CCB) and Countercyclical capital buffer (CCyB). Capital Conservation buffer is to act as an additional layer of common equity. If the additional requirement limit is reached bank has to take measures such as stop the dividend payout and incentives and thus conserve capital. Countercyclical Capital Buffers requires banks to withhold themselves from lending all out during a period of credit boom and instead create buffers. This would help the bank in reducing its loss in periods of subsequent credit bust. 

Basel 3 also aims to increase the standards of Basel Pillars 2 and 3. That is the Supervisory Review Process and Market discipline through additional public disclosures. 

Basel 4

In January 2016 Basel Comitee on Banking Supervision (BCBS) issued new approach for computation of Market Risk Capital Charge making changes to both the Standardised approach and internal models based approach. 

In 2017 BCBS came up with the final set of reforms to Basel 3:-

1. Revision in the approach for computation of Credit Risk Capital Charge (Both Standardized and internal rating Basel approach )

2. Revision in Operation Risk capital charge approach

3. Computation of Credit Value Adjustments (CVA) risk for derivatives. 

4. Changes to the leverage ration framework for GSIB Globally Systematic Important Banks

5. Finalization of output floor, wherein the minimum value of Risk Weighted Assets calculated used internal model approaches had to be in terms of certain percentage of the RWA calculated through the standardised approaches. 

These set of reforms in 2016 and 2017 have been dubbed by financial industry as Basel 4

Summary of Basel IV Reforms

Level 2 headings may be created by course providers in the future.

The fixing of Output Floor aims to improve the credibility of risk weight calculations using the internal rating-based approaches.