Basel III: The Road to Compliance

Financial institutions need to adopt best practices to meet new regulatory requirements for liquidity management, capital allocation and stress testing.

Tuesday, October 04, 2011 , By S. Ramakrishnan

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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 forward.

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