While clarity has emerged around the basic rules of Basel III,
much uncertainty remains around how the accord's various provisions
will be interpreted and enforced by regulators in different
jurisdictions. Financial institutions (especially global
organizations), however, cannot delay their planning, as compliance
for many organizations will require the introduction of new, more
agile, processes and systems -- all of which take time to develop
and deploy with confidence.
How can financial institutions prepare for compliance, and what
should they do today to get ready for the journey ahead? Best
practices will point the way, beginning with assessment, as well as
defining and developing key processes, systems and organizational
structures that will be required to meet more rigorous liquidity
risk, stress testing and reporting requirements.
A New Capital Landscape
Basel III will have a significant impact on the manner in which
banking institutions calculate capital requirements, manage
liquidity and allocate existing capital. The new regulations will
increase the minimum capital requirements while simultaneously
reducing the available capital.
Under the new Basel III guidelines, Tier I capital will
predominantly consist of only common stock and retained earnings.
Tier III capital has been abolished, and capital adjustments --
such as reduction of goodwill - will be made in Tier I capital
only. The minimum Tier ratio that institutions need to maintain has
been increased from 2% to 4.5%, with a focus on using core capital
as a primary measure for assessing the solvency of an institution,
discouraging the use of innovative instruments.
In addition, financial institutions are required to maintain a
capital buffer consisting of 2.5% of Tier I capital, and are
required to evolve to a forward-looking expected loss approach for
loss forecasting and provisioning. The purpose here is to build
capital buffers that can be used during times of stress.
Basel III regulations also significantly enhance the Pillar 1
rules for calculation of minimum capital. The bulk of these
enhancements relate to the method of calculating capital for
counterparty credit risk on trading books. This includes higher
haircuts and higher margin periods for calculating minimum capital,
as well as a credit valuation adjustment (CVA) for overthe- counter
(OTC) derivatives in Tier I capital.
Further, stress testing requirements have been introduced for
counterparty credit risk. Banks are also required to identify and
address "Wrong Way" risk, which occurs when exposure value is
adversely correlated with the credit quality of an obligor, with
stress testing and scenario analysis used as the method for
managing "Wrong Way" risk.
Basel III introduces a new leverage ratio that banks are
required to calculate and report, in addition to a capital
threshold that needs to be maintained. This leverage ratio is based
on Tier I capital and is, therefore, conservative in nature. A 3%
leverage limit has been specified by the Basel Committee on Banking
Supervision (BCBS), and this ratio is determined on a gross basis.
Excessive leverage was one of the critical reasons for the collapse
of financial institutions during the crisis; consequently, the
purpose of this ratio is to prevent such a scenario moving
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