An Insider’s Perspective on the
Basel Capital and Liquidity Reforms
Marc Saidenberg
Federal Reserve Bank of New York
The views expressed here are my own and do not necessarily represent the views
of the Federal Reserve Bank of New York or the Federal Reserve System
Background and Objectives
• During the financial crisis, market participants began to question the
capacity of systemically important financial institutions to withstand
shocks
• Questions about the financial condition of key institutions were linked to
shortcomings in the regulatory framework
o Measures
of capital and capital requirements were not commensurate with
risks taken by banks, particularly those realized in a stressed environment
o Regulation and supervisory assessments of liquidity risk and liquidity risk
management were inconsistent
• Basel Committee on Banking Supervision responded with capital and
liquidity reforms designed to improve the banking sector’s ability to
absorb shocks arising from financial and economic stress
o Stated
objective is to reduce the risk of spillover from the financial sector to
the real economy
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Basel Capital and Liquidity Reforms
• In December 2010, the Basel Committee agreed on a package of
reforms (“Basel 3”) designed to:
o Increase
the capacity of banks to absorb losses relative to risk
o Constrain leverage through a credible, non-risk-based backstop
o Increase the capacity of banks to absorb shocks to funding and constrain
structural funding mismatches
o Incorporate macroprudential perspectives into regulatory framework
o Provide greater transparency to market participants
• The capital and liquidity standards are subject to phase-in and
transitional arrangements
o Liquidity
and leverage standards subject to observation periods reflecting
need to assess unintended consequences
• Work continues on enhanced prudential standards for SIFIs and
recovery and resolution planning
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Measuring Capital Adequacy
• Reforms introduce an explicit common equity standard and revisions to
composition of regulatory capital to increase capacity to absorb loses on
a ‘going concern’ basis
o More
stringent criteria for instruments to qualify as regulatory capital
o Limited recognition of intangible assets and significant investments in the
common shares of FIs
• Revisions to measures of risk (RWA) designed to ensure capital
requirements are commensurate with risks taken by banks and the risks
they pose to the financial system
o Revisions
to Market Risk rules to capitalize appropriately credit-sensitive and
structured trading positions
o Changes to capital requirements for counterparty credit risk, including charge
for mark-to-market losses
o Increased capital requirements for credit exposures to large FIs.
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Calibrating Capital Requirements
• Amount of capital banks must hold relative to RWAs increased through
imposition of higher minimum capital requirements and new ‘capital
conservation’ buffer requirements
o Introduction
of explicit tangible common equity standard (tier 1 common
equity)
o Non-discretionary restrictions on capital distributions for banks that fail to
maintain a buffer of capital above the minimum
• Under Base 1 and Basel 2, Tier 1 and Total Capital minimum
requirements of 4% and 8% -- no explicit common equity standards
• Under Basel 3:
o Tier
1 common equity minimum of 4.5% of RWA
o Plus “capital conservation buffer” of 2.5% of RWA
o Plus countercyclical buffer – maximum of 2.5% of RWA
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Calibrating Capital Requirements (cont.)
• Basel Committee developed conceptual definitions to guide calibration
efforts
o Minimum
requirement: the amount of capital needed to be regarded as a
viable, going-concern in the market
o Capital Conservation Buffer: an amount of capital sufficient to withstand a
systemically stressful period and remain above minimum regulatory capital
requirements
• Conceptual definitions are informative, but they cannot be directly
observed (particularly the minimum)
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Empirical Strategy: Regulatory Minimum
• Examined historical distribution of earnings relative to RWA for large
banks
o Key
assumption is that a high percentile loss realization is good proxy for
market viability test in an ex ante, unconditional way
• Return on Risk-weighted Assets (RORWA)
o Data
from seven countries
o Estimated negative tail of the distributions (99th to 99.9th percentile) over
different horizons
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Summary of International Results: RORWA
Figure 1
Return on Risk-Weighted Assets
99th Percentile Results
2.00
0.00
1
2
3
4
5
6
7
8
9
10
11
-2.00
-4.00
-6.00
Bars are the 99th percentile of the distribution of net income to risk-weighted assets
based on data submitted by seven member countries. Some countries submitted more
than one sample, using different definitions of net income (pre -tax and after-tax) or
different definitions of risk-weighted assets.
-8.00
-10.00
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Empirical Strategy: Capital Conservation Buffer
• Look at historical episodes of systemic stress in the banking industry
and see how much banks lost
o Losses
(negative net income) in the recent crisis and in past historical crises,
U.S. and abroad
• Also examine 2009 stress tests results for eight countries
o Includes
U.S. SCAP results
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Distribution of Net Income
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Summary of Capital Calibration Analysis
• Regulatory minimum results across percentiles, horizons, samples:

4% to 6% of RWA
• Capital conservation buffer results across approaches and samples:

3% to 7% of RWA -- results for some individual banks much bigger
• Empirical analysis based on Basel 1 and Basel 2 measures of RWA
needs to be “translated” into Basel 3
4% - 6% Basel 1  4.5% Basel 3
o Buffer: 3% - 7% Basel 1  2.5% (capital conservation) + max 2.5%
(countercyclical) Basel 3
o Minimum:
• Calibration supported by Quantitative Impact Study (QIS) and analysis
of long-run and transitional economic costs and benefits associated with
higher capital standards
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Measuring Adequacy of Liquidity
• Basel Committee seeking to promote financial stability by addressing
two complementary objectives:
o Enhance
resilience to short-term, acute shocks to funding
o Effect longer-term structural changes in liquidity mismatches
• Two measures of liquidity risk developed to be implemented as
minimum regulatory standards
o Liquidity
coverage ratio (LCR) -- risk sensitive, scenario-based measure to
size a minimum pool of high-quality liquid assets
o Net stable funding ratio (NSFR) -- structural measure that compares estimate
of ‘reliable’ funding sources to estimate of required stable funding
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Designing and Calibrating Liquidity Standards
• LCR compares stock of high-quality unencumbered liquid assets to
projected net cash outflows over a 30-day horizon
o High-quality
liquid assets should be unencumbered, liquid in markets during a
time of stress and central bank eligible
• Measure of stressed net cash outflows designed to capture potential
risks associated with contractual and behavioral responses related to
on- and off-balance sheet positions
o Scenario
reflects firm-specific shock during period of market stress
• Short-term stress net cash outflows scenario includes:
o Partial
loss of retail deposits
o Significant loss of unsecured and secured wholesale funding
o Contractual outflows associated with a 3-notch rating downgrade
o Substantial draws on off-balance sheet exposures
o Haircut on contractual inflows and aggregate cap
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Designing and Calibrating Liquidity Standards (cont.)
• Calibration of scenario runoff rates reflects a judgmental combination of
historical experience during financial crisis, banks’ internal stress
scenarios and existing regulatory and supervisory standard
o Certain
parameters reflect concerns about the potential drivers of systemic
risks including interconnectedness and the spillovers associated with the
distressed fire sale of assets
• The Committee estimated impact of the liquidity standards -- assuming
banks were to make no changes to their liquidity risk profile or funding
structure, as of end-2009:
o The
average LCR for Group 1 banks was 83%; the average for Group 2
banks was 98%
o The average NSFR for Group 1 banks was 93%; the average for Group 2
banks was 103%
• Committee observed material differences across institutions, business
models and markets
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Going Forward
• Domestic rule making, phase in and observation period for capital and
liquidity standards
• Basel Committee and Financial Stability Board continue to review
regulatory and supervisory framework for global SIFIs
o Basel
Committee agreed on need for additional loss absorbency for G-SIFIs
o Potential to link additional capital requirements to measures of systemic
importance
o DFA mandates that SIFIs in US have more stringent prudential requirements
• Expectations for recovery and resolution planning
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