FINANCIAL REGULATORY
REGIMES IN SMALL STATES
Miguel Borg
The Three Pillars of Basel II
STABILITY SOUNDNESS SAFETY
Pillar 1:
Minimum
Capital
Requirements
Pillar 2:
Supervisory
Review
Process
Pillar 3:
Market
Discipline
Basel II – Capital Charge
Unchanged
Tier 1 + Tier 2 +Tier 3
Risk
Weighted +
Assets
>
12.5 x capital charge for
Market Risk & Operational Risk
Unchanged
Credit Risk
New
element
Unchanged
Major change
8%
Basel II: Details of Pillars
Operational
Risk
Market
Risk
Credit
Risk
Standardized Approach
Internal
Ratings
Based
Approach
Foundation Approach
Advanced Approach
Standardized Approach
Internal Measurement Approach
Basic Indicator Approach
Standardized Approach
Internal Measurement Approach
Supervisory
Review
Market
Discipline
Pillar 1 – Credit Risk: Standardised Approach
Credit Quality
Fitch
S&P
Moody's
1
2
3
4
5
6
AAA to AAA+ to ABBB+ to BBBBB+ to BBB+ to BCCC+ >
Unrated
AAA to AAA+ to ABBB+ to BBBBB+ to BBB+ to BCCC+ >
Aaa to Aa3
A1 to A3
Baa1 to Baa3
Ba1 to Ba3
B1 to B3
Caa1 >
Sovereign Corporate
0%
20%
50%
100%
100%
150%
100%
20%
50%
100%
100%
150%
150%
100%
Institution
< 3 months > 3 months
20%
20%
20%
50%
20%
50%
50%
100%
50%
100%
150%
150%
20%
50%
Pillar 1 – Credit Risk: Internal Rating Based
Approach
Expected
Loss
Unexpected
Loss
Stress
Loss
Pillar 1 – Credit Risk: Internal Rating Based
Approach
Customer
Related
Expected
Loss
EL
=
=
Loan Related
Probability
of
Default
x
Loss
Given
Default
PD
x
LGD
x
x
Exposure
at
Default
EAD
Pillar 1 – Credit Risk: Internal Rating Based
Approach
VAR
Expected
Loss
Unexpected
Loss
Stress
Loss
Covered by Capital
Covered by
‘Insurance’
Included in
Pricing
Covered by
Provisions
Pillar 1 – Credit Risk: Internal Rating Based
Approach
99.95%
VAR
confidence
level VaR
Total Loss
incurred at
99.95%
confidence level
= EUR 6000
Expected
Loss
EUR 1000
Expected Loss,
Provisions/Pricing
Unexpected
Loss
Economic Capital
EUR 5000
Stress
Loss
Losses
remote = no
capital cover
Pillar 1: Market Risk
Market risk is defined as “the risk of losses in on and off-balance-sheet positions
arising from movements in market prices.”
Market Risk Amendment 1996
Interest Rate Risk
Equity Position Risk
Foreign Exchange Risk
Commodities Risk
Options
VaR is a single number (currency amount) which estimates the maximum
expected loss of a portfolio over a given time horizon and at a given confidence
level.
Pillar 1: Operational Risk
“Operational risk is defined as the risk of loss resulting from
inadequate or failed internal processes, people and systems or
from external events.
The definition includes legal risk* but excludes strategic and
reputational risk.”
Basel II § 644
* legal risk includes, but is not limited to, exposure to fines,
penalties, or punitive damages resulting from supervisory
actions, as well as private settlements.
Pillar 1: Operational Risk
Source: BIS
Part B: Pillar 2
“Banks should have a process for assessing overall capital
adequacy in relation to risk profile and a strategy for
maintaining capital levels”
ICAAP
Assess all material risks
and identify any weaknesses
in the internal governance
Identify amount and quality of
internal capital in relation to risk
profile, strategies and business plan
Produce ICAAP number and
assessment
ICAAP - Risk Coverage
1.
Pillar 1 risks
2.
Risks not fully captured under pillar 1 (e.g. residual risk of credit risk
deriving from risk mitigation techniques, securitisation risk, model risk)
3.
Risks to be covered under pillar 2 (interest rate risk in the banking book,
concentration risk, etc.)
4.
External factors (risks deriving from the economic and regulatory
environment, risks resulting from the business performance of the
institution)
5.
Internal governance and oversight functions
Concentration
Risk
Diversification
Internal
IRRBB
Liquidity Risk
PILLAR 2
Risk
Exposures
Reputational
&
Strategic Risk
PILLAR 2
Governance
Internal
Governance
Risk
Mitigants
Controls &
Oversight
Residual Risk
External
Environment
Operational
Risk
Market
Risk
PILLAR 1
Credit
Risk
PILLAR 2
Regulatory
Capital
PILLAR 1
PILLAR 1
SREP – BR/12
Pillar 2: Capital Allocation
450,000
400,000
400,000
350,000
Surplus
350,000
300,000
Stress
Testing
300,000
Tier 2
250,000
250,000
IRRBB
200,000
200,000
150,000
Tier 1
Concentration
Risk
150,000
100,000
Operational
Risk
100,000
50,000
Credit Risk
50,000
0
-50,000
-
Illustrative Purpose Only
Basel III
Source:
Basel III: A global regulatory framework for more resilient banks and
banking systems.
Basel III: International framework for liquidity risk measurement,
standards and monitoring.
Objectives:
o Raising the quality, consistency and transparency of the capital base
o Enhancing risk coverage
o Supplementing the risk-based capital requirement with a leverage
ratio
o Reducing procyclicality and promoting countercyclical buffers
o Addressing systemic risk and interconnectedness
Basel III
There are nine key breakthroughs in Basel III as follows:
•
•
•
•
•
•
•
•
•
The numerator of the capital puts focus on tangible common equity, the
highest-quality component and the greatest loss-absorbing capacity.
Eradicate the trading book loophole, i.e. eliminate the possibility of
regulatory arbitrage between the banking and trading books.
A sevenfold increase in the common equity requirement for internationally
active banks.
Banks will no longer be able to pursue distribution policies that are
inconsistent with sound capital conservation principles.
Risk-based framework but includes a Tier 1 leverage that captures risks
arising from total assets.
The introduction of a countercyclical capital to mitigate the procyclicality.
SIFIs need a higher loss-absorbing capacity to reflect the greater risks that
they pose to financial system.
The attempt to address the “too connected to fail” problem.
Supervisors should avoid over-reliance on banks’ internal models, and their
supervision needs to be more intrusive to ensure that systemic risk and tail
events are adequately captured in banks’ risk modeling and stress testing.
Significant increase the required level of
capital
Basel III – Tier 1 Calculation
Tier 1 Capital Requirements =
14
2.5?
12
[Minimum Capital Ratio] +
10
[Capital Conservation Buffer] +
8
[Countercyclical Capital Buffer] +
6
[Capital for Systemically Important Banks] 4
2.5
2.5
6.0
2
0
1
Phase-in Arrangements
14.5
14.0
13.5
13.0
12.5
12.0
11.5
11.0
10.5
10.0
9.5
9.0
8.5
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
13.5%
11.63%
9.75%
7.88%
2.5%
0.63%
1.25%
1.88%
2017
2018
6.0%
5.5%
4.5%
2010
2011
Minimum Tier 1
2012
2013
2014
Capital Conservation Buffer
2015
2016
Countercyclical Buffer
2019
Systemically Important Banks
Basel III – New Requirements
Capital Conservation Buffer
The purpose of the conservation buffer is to ensure that banks
maintain a buffer of capital that can be used to absorb losses during
periods of financial and economic stress.
While banks are allowed to draw on the buffer during such periods
of stress, the closer their regulatory capital ratios approach the
minimum requirement, the greater the constraints on earnings
distributions (bonuses, dividend, buybacks).
Capital Conservation Buffer (Common Equity)
Countercyclical Capital Buffer
A countercyclical buffer within a range of 0% – 2.5% of common
equity or other fully loss absorbing capital will be triggered by
regulatory authorities from time to time during periods of excessive
aggregate credit growth in the economy which is indicative of
systemic risks building in the national and international banking
system.
Banks that have a capital ratio that is less than 2.5%, will face
restrictions on payouts of dividends, share buybacks and bonuses.
The BCBS expects such buffer to be imposed infrequently, perhaps
once every 10-20 years.
Countercyclical Capital Buffer
USA
Norway
Vertical shaded areas indicate the starting years of system wide banking crises.
1 The countercyclical buffer is 0 when the value of the credit/GDP gap is below 2 and 2.5 when it is above 10
per cent; for gaps between 2 and 10 percent the buffer is calculated as 2.5/8 times the value of the credit/GDP
gap exceeding 2 per cent.
SIFI Policy Framework
o a resolution framework and other measures to ensure that all financial
institutions can be resolved safely, quickly and without destabilising the
financial system and exposing the taxpayer to the risk of loss,
o a requirement that SIFIs and initially in particular global SIFIs (G-SIFIs) have
higher loss absorbency capacity to reflect the greater risks that these
institutions pose to the global financial system,
o more intensive supervisory oversight for financial institutions which may
pose systemic risk,
o robust core financial market infrastructures to reduce contagion risk from
the failure of individual institutions
o other supplementary prudential and other requirements as determined by
the national authorities.
Thanks
borgmiguel@gmail.com