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Terms in this set (17)
The first Basel Accord, was issued in 1988 and focuses on the capital adequacy of financial institutions. The capital adequacy risk (the risk that a financial institution will be hurt by an unexpected loss), categorizes the assets of financial institutions into five risk categories (0%, 10%, 20%, 50% and 100%). Under Basel I, banks that operate internationally are required to have a risk weight of 8% or less.
-Set minimum rules so that the capital base is no longer exposed. Over 100% of the capital base was exposed to Latin America.
-To force all "internationally-active" G10 incorporated banks to comply with minimum capital adequacy rules of 8%. Incorporated Jan 1st 1993. To ensure the minimum (RAR) was always met. RAR = totally adjusted capital / total risk weighted assets.
Type of capital is the most absorbable, acts as a buffer and is always available to absorb unexpected losses. No questions asked.
-Ordinary paid up share of common stock - don't have to repay or re-service
-Disclosed reserves - all reserves have to be transparent
-Non cumulative perpetual preferred stock - preferences shares, so in a wind up or liquidation you get paid out 1st but you still at risk.
No debt in tier 1 because it's an obligation that has to be repaid.
- Undisclosed reserves
- Asset revaluation reserves
- General provisions
- Hybrid (debt/equity)
- Subordinated term debt maturity of at least 5 years. bonds
RAR Numerator: Total adjusted capital
Tier 1 and Tier 2 added together = total capital. Adjustments are made after to then make adjusted capital.
RAR Denominator: Total weighted assets
Every asset/ instrument has risk bucket attached to it which gives percentage of likelihood of default. Basel committee determines risk attached.
Calculating the denominator:
Calculating everything that's on balance sheet first (step 1)
1. Loans + Investment x risk weight attached to it (all ON BALANCE SHEET)
2. Non-derivatives - off balance sheet which is called notional principal amount at risk. First convert to a credit risk equivalent (CRE) using Exhibit 1C conversion factors then x risk buckets as in step 1.
3. Derivatives - mark to market (best estimate of how much a derivative is worth). Now due to future risk exposures (because derivative price fluctuates) we use conversion factors in exhibit 1D to understand value. Then x by original risk buckets in exhibit 1B (step 1).
4. Finally total all of step 1, 2 and 3 = total risk weighted assets
What is wrong with Basel 1
-Assumed risks were additive but they were not.
-Diversification was not rewarded or penalised therefore as a measure of risk this was not suitable. All in accordance with portfolio theory. 8% figure is arbitrary and Banks have to hold this number which can be too much or too little. Too much non-financial sector suffers, too little = high risk.
- Banks products were sold at wrong price therefore so were I/R. Due to 8% being arbitrary and as such resources were misallocated. Induced distortions = thinking process changed due to minimum requirements. Changes your strategy.
- Banks made the most of anomalies (within Basel 1) due to regulatory arbitrage and exploited on and off-balance sheet products.
- "Cherry picking" by banks. Chose to target 100% risk weight bucket such as pay day lenders because they earn more and know they won't default. Perverse from societies perspective.
- High pre-securitisation of assets.
What is wrong with Basel 1: Market Risk
Another thing that was wrong with Basel 1 came with the introduction of market risk under 1988 redacted regime.
- Numerator of RAR looks at Tier 3 cap too (subordinated debt with a maturity of 2 years)
- Denominator is split into banking and trading book (to do with market risk). Banking book calculated the same. Trading book = 12.5 x market risk capital charge. MRCC is sum of all 5 trading instruments.
Subject to supervisory approval banks could use VaR to calculate MRCC. Must satisfy 6 safeguards to do this.
VaR did not take into account tail risk. Showed 99% certainty but the 1% was low probability, high risk impact. VaR could suggest 10-20% losses but in reality, it was far more than that.
-VaR = yesterdays VaR (everyday bank calculate this) and average VaR of proceeding 60 days VaR (prior 60 days) x SMT (supervisory multiplier reflecting how good you were at risk management. Between 3 and 5). Better risk management, lower number was. Lower risk weight would allow use for capital in other areas. However, VaR does not capture tail risk therefore all market risk calculations were wrong and banks would have been perceived to be safer than they actually were. Therefore, lower SMT used as well as specific risk indicator used to calculate total VaR.
An attempt to catch up with market developments (such as securitisation) and deal with the acknowledged deficiencies of Basel 1. Aims to:
- Improve capital requirements
- Incorporates operational risk
- 3 pillars introduced.
o P1 all we had in Basel 1 in terms of regulatory capital requirements.
o P2 embrace supervisors more fully
o P3 embrace market discipline More transparent and material info is released
Pillar I links capital requirement for large, internationally active banks more closely to actual risk of three types: market risk, credit risk, and operational risk. It does so by specifying many more categories of assets with different risk weights in its standardized approach. (Sulimierska, 2016)
Essentially what we had in Basel 1 with amendments.
- Credit assessments used. Rating agencies defined the credit worthiness of instruments.
- New risk bucket (150%). Assets are so risky they needed a new risk bucket.
- New risk weighting scheme to address asset-securitisation.
Pillar II focuses on strengthening the supervisory process, particularly in assessing the quality of risk management in banking institutions and evaluating whether these institutions have adequate procedures to determine how much capital they need. (Sulimierska, 2016)
-PCA (prompt corrective action) implemented by congress. Regulators must intervene in the event certain thresholds are hit (in a bad way). To stabilise banking system.
- Supervisors set bank specific capital charges based on the risk assessment of each bank. On top of 8% RAR. More capitalised- safer they are.
Pillar III focuses on improving market discipline through increased disclosure of details about a bank's credit exposures, its amount of reserves and capital, the official who control the bank, and the effectiveness of its internal rating system. (Sulimierska, 2016)
- Employment of QIS (quantitative impact assessments) To ask industry to inform committee about impact will be, should latest consultation paper be implemented.
- To calculate Internal Ratings Based used: Probability of Default, Loss Given Default, Exposure at Default and effect at maturity.
- Normal IRB used probability of default (PD) and exposures but advanced IRB used all parameters. As risk management improved you moved up from standardised approach to advanced IRB. This all meant lower capital charges for banks, so they had more money but they were safe.
What was wrong with Basel 2
- Retention of flawed standardised approach risk assessments ignoring risk correlation. Same basic problem still existed.
- Property loans and residential mortgages marked lower in risk therefore lower impact in VaR models. Marked safer than they actually were so when calculating risk, less exposure so charging lower I/r so not protecting self. So, capital you hold won't be enough.
- Failure to address pro-cyclical impact. Makes booms and busts worse. Embraced real time credit ratings therefore accentuates a boom an upward spiral - lending becomes cheaper and boom continues. Worked viciously in a crash due to rates in lending increasing as credit ratings dropped or they cut lending completely.
Response to Sub Prime Crisis
- needed to deal with failed VaR models as still doesn't capture tail risks.
- lack of capital adequacy held
-failure to capture on and off balance sheet risk. The way it should have.
-failure to prevent excessive credit growth and high leverage. Lehman Brothers was leveraged at 60:1. Every £60 of debt £1 of equity. 1.6% of entire debt defaulted.
- did not take into account systemic risk (interconnected risk between entire economy- if something happens to one how does it affect you) Need another buffer essentially.
-unavailability of certain hybrid instruments to capture losses.
-weak risk management and liquidity
-failure to address pro-cyclicity.
What Basel committee looked to do afterwards:
-it boosted capital cushions by adding new requirements
-create robust liquidity buffers
-strengthen pillar 2 risk management and supervision
- enhanced market discipline with more transparent data.
- Increase in quality and transparency of capital.
- introduce leverage ratio.
- more capital buffers on complex instruments.
A continuation of the three pillars, along with additional requirements and safeguards, including requiring banks to have minimum amount of common equity and a minimum liquidity ratio.
Also includes additional requirements for what the Accord calls "systemically important banks," or those financial institutions that are colloquially called "too big to fail."
Basel 3: Capital Requirements
- Minimum common equity capital ratio requirement to be increased from the current 2% level to 4.5%.
- Minimum Tier 1 capital ratio requirement, which includes common equity and other qualifying capital instruments based on stricter criteria, to be increased from the current level of 4% to 6%.
-A new "conservation buffer", to be built up outside periods of stress and designed to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress- rather than to be used to pay discretionary bonuses and dividends or buy back shares.
-A new "countercyclical buffer", within a range of 0% to 2.5% of risk-weighted assets, may also be introduced, at national discretion.
- The overall minimum total ratio requirement will remain at its current level of 8% until the end of 2015, after which it will gradually increase to reach 10.5% by 1 January 2019 as a result of the phasing in of the capital conservation buffer.
- A new non-risk-based leverage ratio, serving as a backstop to the risk-based measures will also be introduced in Pillar one. Its calibration will depend on the review of the application of a minimum Tier 1 leverage ratio of 3%. Meaning if the minimum tier 1 ratio is 3% this implies a multiplier of 33 and a third. So for every £1 the balance sheet cannot be more than 33.33 times that amount.
Basel 3: Liquidity Requirements
-A new "liquidity coverage ratio" requirement will be introduced on 1 January 2015 (full compliance was later delayed until 2019). This is a short term ratio and banks are concerned because it reduces profitability. If introduced too quickly banks may threaten to slow the growth of real economy by slowing grow of lending.
-A new "net stable funding ratio" requirement will be introduced on 1 January 2018. Long term ratio designed to ensure banks of long term liquidity i.e. excess of 1 year.
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