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Capital Adequacy beyond Basel
Add to Wishlist. Ships in 10 to 15 business days. Link Either by signing into your account or linking your membership details before your order is placed. Description Table of Contents Product Details Click on the cover image above to read some pages of this book! Industry Reviews "This book, by lawyers, economists, and experienced financial specialists, evaluates various aspects of risk management and the associated needs of banks, securities firms, and insurance companies for capital Flannerty: No Pain, No Gain?
Kuritzkes and Hal S. More Books in Finance See All. Sovereign Exposures The Final Rules retain the current risk-weighting rules for exposures to debt directly and unconditionally guaranteed by the US Government and its agencies. The CRC methodology, established in , assigns one of eight risk categories to each country, with countries assigned to the 0 category having the lowest possible risk assessment and countries assigned to the 7 category having the highest possible risk assessment.
The distribution of CRCs for European countries and territories is as follows:. For these purposes, "sovereign default" means noncompliance by a sovereign with its external debt service obligations or the inability or unwillingness of the sovereign to service an existing loan according to its original terms, as evidenced by failure to pay principal and interest, arrearages or voluntary or involuntary restructuring. Bank for International Settlements. The Final Rules define a GSE as an entity established or chartered by the US Government to serve public purposes but whose debt obligations are not "explicitly guaranteed" by the full faith and credit of the US Government.
The Final Rules continue this treatment as to US banks and credit unions. As to foreign banks, the risk-weighting for exposures would correlate to the CRC rating or lack thereof of the sovereign, in accordance with a chart. Corporate Exposures The Final Rules treat corporate exposures in a manner consistent with the current risk-based capital rules. Corporate exposure would be defined as exposures to a company that is not otherwise provided for in the rules. Given the size of exposures of US and foreign banks to securities firms, this unilateral decision by the Banking Agencies could place US banks at a material competitive disadvantage to their foreign counterparts, particularly in counterparty-based activities.
Residential Mortgage Exposures The treatment of residential mortgages under the Final Rules represents one of the most significant positive changes from the Proposed Rules. In response to substantial industry comments about the complexity and burden imposed by the multi-dimensional matrix in the Proposed Rules, the Final Rules rejected that approach and generally returned to the treatment under the current capital rules.
Is secured by property that is owner-occupied or rented. Is made in accordance with "prudent underwriting standards" undefined in the Final Rules, but defined generally in a footnote to the current rules. Is not 90 days or more past due or in nonaccrual status. Is not restructured or modified loans modified or restructured solely pursuant to the US Home Affordable Modification Program are not considered modified or restructured for these purposes. Multifamily mortgage loans not meeting the criteria in the Final Rules are treated as corporate exposures.
Generally, HVCREs are defined as a credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development or construction of real property. In response to industry concerns about the scope of the Proposed Rules, however, the Final Rules exempt in addition to one-to-four family residential properties and commercial real estate projects meeting certain LTV and other requirements, as in the Proposed Rules additional exposures, including those relating to investments in community development and the purchase or development of agricultural land.
Over-the-Counter Derivative Transactions Under the Final Rules, a banking organization is required to hold risk-based capital for counterparty credit risk for OTC derivative contracts. To determine the risk-weighted asset amount for an OTC derivative contract, a banking organization must first determine its exposure amount for the contract and then apply to that amount a risk-weight based on the counterparty, eligible guarantor, or recognized collateral. The Final Rules define "OTC derivatives contract" broadly to capture all common types of derivatives and include transactions with a contractual settlement or delivery lag that is longer than the lesser of the market standard for the particular underlying instrument or five business days.
Cleared derivatives transactions are not treated as OTC derivatives contracts. However, an OTC derivatives contract includes exposure of a banking organization that is a clearing member banking organization to its clearing member client if either:. The clearing member banking organization is acting as a financial intermediary and enters into an offsetting transaction with a clearing house. The clearing member banking organization provides a guarantee to the clearing house on the performance of the client. For a single OTC derivative contract that is not subject to a qualifying master netting agreement, the rule requires the exposure amount to be the sum of:.
The potential future exposure PFE , which is calculated by multiplying the notional principal amount of the OTC derivative contract by the appropriate conversion factor set forth in the Final Rules. Conversion factors range from 0 to 0. For multiple OTC derivatives contracts subject to a qualifying master netting agreement, a banking organization must calculate the exposure amount by adding:.
The net current credit exposure, which is the greater of zero and the net sum of all positive and negative mark-to-fair values of the individual OTC derivatives contracts subject to such netting agreement. A qualifying master netting agreement is defined as any written, legally enforceable netting agreement that creates a single legal obligation for all individual transactions covered by it upon an event of default. To recognize the benefit of a master netting agreement, a banking organization may rely on legal review of an in-house counsel instead of an external or internal legal opinion on the enforceability of the netting agreement.
When an OTC derivatives contract is collateralized by financial collateral, the banking organization must first determine the exposure amount as described above, then either:. Use the simple approach for collateralized transactions. Adjust the exposure amount using the collateral haircut approach if the collateral is marked-to-market on a daily basis and subject to daily margin maintenance requirement. Under the Final Rules, if a banking organization purchases a credit derivatives contract that is recognized as a credit risk mitigant for an exposure that is not a covered position under the market risk rules, it is not required to calculate a separate counterparty credit risk capital requirement for that credit derivatives contract as long as it does so consistently for all applicable credit derivatives contracts.
When a banking organization sells protection via a credit derivatives contract that is not a covered position under the market risk rules, it must treat such contract as an exposure to the underlying reference asset and calculate a risk-weighted asset amount in accordance with the Final Rules, but is not required to calculate a counterparty credit risk capital requirement as long as it does so consistently for all applicable credit derivatives contracts. However, when a banking organization sells protection via a credit derivatives contract that is a covered position under the market risk rules, it must compute a supplemental counterparty credit risk capital requirement.
In either case, the PFE of the protection selling banking organization is capped at the net present value of the amount of unpaid premiums of the credit derivatives contracts. A banking organization must treat an equity derivatives contract as an equity exposure and calculate the related risk-weighted asset amount in accordance with the simple risk-weight approach SRWA described below, unless such contract is a covered position under the market risk rules. If a banking organization uses the SRWA, it may elect not to hold risk-based capital against the counterparty risk of the equity derivatives contract as long as it does so consistently with all applicable equity contracts.
Cleared Transactions The Final Rules establish a framework for the regulatory capital treatment of cleared transactions exposures associated with derivatives or repo-style transactions entered into with a central counterparty CCP. Risk Weighting for Cleared Transactions Consistent with the Proposed Rules, the Final Rules require a banking organization to calculate risk-weighted assets for cleared transactions when acting as a clearing member or clearing member client, and to determine the risk-weighted asset amount for a cleared transaction by multiplying the trade exposure amount of the transaction by the appropriate risk weight.
Banking organizations must calculate the risk-weighted asset amount for Default Fund Contributions at least quarterly, or more frequently, if there is a material change in the financial condition of the QCCP. The two alternatives for calculating Default Fund Contributions are:.
Alternative 1. Under the first alternative for calculating Default Fund Contributions to a QCCP, a banking organization must apply a three-step process:. If the QCCP has already disclosed this amount, the banking organization must rely on the disclosed amount unless it determines a higher amount is appropriate;. The banking organization may be required to allocate additional capital depending on the results of these calculations; and. Alternative 2. Guarantees and Credit Derivatives The Final Rules permit banking organizations to recognize the risk-mitigation effects of guarantees and credit derivatives, and provide for a "substation approach" to the recognition of the credit risk mitigation effects of eligible guarantees, pursuant to which a banking organization must substitute the risk weight of the guarantor for the risk weight of the guaranteed exposure.
Guarantees must be provided by "eligible guarantors," which include certain enumerated entities for example, BHCs and SLHCs as well as entities that are not special purpose entities and have issued and outstanding unsecured debt securities without credit enhancement that are investment grade and meet certain other requirements.
The Banking Agencies note that the use of credit risk mitigants may increase operational, liquidity, market and other risks, and indicate that banking organizations should have "robust procedures and processes" in place to control such risks.
Collateralized Transactions Eligible Collateral Banking organizations may reduce the risk-based capital requirements associated with collateralized transactions by recognizing the credit risk mitigation benefits of eligible financial collateral. Consistent with the Proposed Rules, the Final Rules recognize an expanded range of financial collateral as eligible credit risk mitigants.
Under the Final Rules, eligible financial collateral includes:. Cash on deposit with the banking organization or held for the banking organization by a third-party custodian or trustee. Short-term debt instruments that are not resecuritization exposures and are investment grade. Money market fund shares and other mutual fund shares, if a price for the shares is publicly quoted daily.
A banking organization must adhere to certain risk management standards in order to recognize the benefits of financial collateral. Simple Approach The Final Rules provide for a "simple approach" to collateralized transactions, which the Banking Agencies have adopted without substantive change from the Proposed Rules.
Under the simple approach, the collateralized portion of an exposure receives the risk weight applicable to the financial collateral. To qualify for the simple approach, financial collateral must be:. Subject to a collateral agreement for at least the life of the exposure;. Other than gold, be denominated in the same currency as the exposure. Collateral Haircut Approach Consistent with the Proposed Rules, the Final Rules permit a banking organization to use the "collateral haircut" approach to recognize the credit risk mitigation benefits of financial collateral securing derivatives, repo-style or eligible margin loan transactions.
Under the collateral haircut approach, the transaction exposure amount is equal to the sum of the:. Value of the exposure less the value of the collateral. Absolute value of the net position in a given instrument multiplied by the market price volatility appropriate to the instrument.
Absolute value of the net position of instruments and cash in a currency that is different from the settlement currency multiplied by a haircut appropriate to the currency mismatch. The collateral haircut approach requires a banking organization to apply standard supervisor haircuts or, with prior approval of the appropriate federal banking agency, its own estimates of haircuts for market price and foreign currency volatility when calculating the exposure amount.
In response to comments on the Proposed Rules, the Banking Agencies have reduced the standard supervisory haircut for financial collateral issued by non-sovereign issuers, but have retained the standard supervisory haircut for currency mismatches. The collateral haircut approach requires a banking organization to assume a holding period of 20 business days for collateral for certain transactions covered by netting sets, including netting sets where the number of trades exceeds 5, per quarter. In response to comments on the Proposed Rules, the Banking Agencies clarify in the preamble to the Final Rules that the 5, trade threshold applies on a counterparty-by-counterparty, rather than an aggregate basis.
The Banking Agencies also clarify that for indemnified securities lending transactions, a "trade" arises if there is an order by a securities borrower, and that a number of securities lenders providing shares to fulfill an order or a number of shares underlying such order does not constitute a "trade" for purposes of the threshold.
Simple Value-at-Risk and Internal Models Methodology Banking organizations subject to the general risk-based capital rules currently are permitted to use simple Value-at-Risk Simple VaR and internal models methodology IMM approaches to calculate risk-based capital requirements for certain types of repo-style transactions. See , for example, Board Letter to Gregory J. Lyons Nov. In the Proposed Rules, the Banking Agencies sought comment on whether to continue to permit the use of these models-based approaches.
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Unsettled Transactions Consistent with the Proposed Rules, the Final Rules require a banking organization to hold additional capital against the risks of unsettled transactions involving securities, foreign exchange instruments and commodities. Certain transactions would not be subject to these additional capital requirements, including:. Cleared transactions that are marked to market daily and subject to daily receipt and payment of variation margin.
One-way cash payments on OTC derivatives contracts. Transactions with a contractual settlement period longer than normal settlement periods. Securitization Exposures The Final Rules implement substantial revisions to the regulatory capital treatment of securitization exposures. The revised framework differs from the ratings-based approach to the treatment of securitizations under the Basel framework because of the prohibition against the use of credit ratings under Section A of the Dodd-Frank Act. The Final Rules define a "securitization exposure" as an on- or off-balance sheet credit exposure including credit-enhancing representations and warranties that arise from a traditional or synthetic securitization including a resecuritization , or an exposure that directly or indirectly references a securitization exposure.
Banking organizations subject to the market risk rule may apply the simplified supervisory formula approach SSFA to assign risk weights to securitization exposures. The SSFA formula is composed of:. A baseline derived from the capital requirements that apply to the exposures underlying the securitization. Risk weights based on the subordination level of the exposure. The Banking Agencies acknowledge that the SSFA may lead to differences in capital requirements for securitization exposures as compared to the Basel framework, and state that they will monitor implementation of the SSFA and consider modifications as necessary in the future.
Banking organizations not subject to the market risk rule may apply a gross-up approach similar to the existing approach under the general risk-based capital rules that assigns risk-weighted asset amounts for securitization exposures based on the full amount of the credit-enhanced assets for which the banking organization directly or indirectly assumes credit risk.
A banking organization applying the gross-up approach is generally required to do so for all of its securitization exposures, subject to certain specific exceptions. Specifically, the Final Rules generally require a banking organization to apply the SRWA to equity exposures that are not exposures to investment funds, and certain "look-through" approaches to equity exposures to investment funds.
Under the SRWA, a banking organization must determine the risk-weighted asset amount for the equity exposure by multiplying the adjusted carrying value of the exposure by the applicable risk weight, which depends on the underlying equity exposure. Full Look-Through Approach. A banking organization may use the Full Look-Through Approach only if it can calculate the risk-weighted asset amount for each of the underlying exposures held by the investment fund. Under the Full Look-Through Approach, a banking organization calculates the risk-weighted asset amount of its proportionate ownership share of each of the exposures held by the fund, as if each underlying exposure were held directly by the banking organization.
EconPapers: Capital Adequacy beyond Basel: Banking, Securities, and Insurance
Simple Modified Look-Through Approach. Alternative Modified Look-Through Approach. With respect to BHCs and SLHCs that conduct insurance activities but are not Excluded Insurance SLHCs, the Final Rules, similar to the Proposed Rules, continue to include special provisions relating to the determination of risk-weighted assets for nonbanking exposures unique to insurance activities, including:.
Policy Loans. Separate Accounts. The Proposed Rules defined a "non-guaranteed separate account" as a separate account for which, inter alia, an insurance company is not required to hold reserves for separate account assets pursuant to its contractual obligations on the associated insurance policies. Commenters argued that this prong of the proposed definition was overly broad because state laws generally require insurance companies to hold reserves for all contractual commitments, meaning that many separate accounts held by insurance companies would fail to meet the definition of non-guaranteed separate account.
Commenters also argued that insurance company separate accounts should not be included in the denominator of the leverage ratio, noting that separate account assets generally are not available to satisfy claims of general creditors and do not affect the actual leverage position of an insurance company. While the Final Rules continue to include separate account assets in the denominator of the leverage ratio, the Board states in the preamble that it is "continu[ing] to consider this issue together with other issues raised by commenters regarding the regulatory capital treatment of insurance companies.
Deduction for Investments in Insurance Underwriting Subsidiaries. Commenters argued that it was inappropriate to apply the deduction approach in the existing advanced approaches rule, which was implemented with traditional banking organizations in mind, to holding companies that are predominantly engaged in insurance activities where insurance underwriting companies constitute the predominant amount of regulatory capital and assets.
Commenters also noted that any proposed deduction should not cover capital related to asset-specific risks to avoid in effect double counting of regulatory capital. These commenters suggested that the proposed deduction be eliminated or modified to include only insurance regulatory capital for non-asset risks, such as insurance risk and business risk for life insurers and underwriting risk for property and casualty insurers. In response to these comments, the Board has modified the deduction in the Final Rules to require, for companies using the life risk-based capital formula, a deduction of the regulatory capital requirement related to insurance risk and business risk and, for companies using the property and casualty risk-based formula, a deduction of the regulatory capital requirement related to underwriting risk — reserves and underwriting risk — net written premiums.
Because insurance companies often hold more significant amounts of AFS securities on their balance sheets than traditional banking organizations, the option for retaining the AOCI filter is a particularly welcome development for BHCs and SLHCs engaged in insurance activities. The required disclosures must be made publicly available for each of the last three years, or such shorter time period beginning when the banking organization becomes subject to the disclosure requirement. The Banking Agencies state their belief in the preamble to the Final Rules that covered banking agencies should be able to provide the required disclosures "without revealing proprietary and confidential information.
Counterparty Credit Risk Recognition of Financial Collateral The Final Rules modify the definition of "financial collateral" for purposes of calculating Exposure at Default EAD under the advanced approaches to exclude re-securitizations, conforming residential mortgages and non-investment grade debt securities.
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The Final Rules also revise the supervisory haircuts for specific types of financial collateral for purposes of EAD calculations, including securitizations and certain investment grade corporate debt securities. Holding Periods and Margin Period of Risk The Banking Agencies state in the preamble to the Final Rules that during the recent financial crisis, many financial institutions experienced significant delays in settling or closing out collateralized derivatives and repo-style transactions. To address this issue, and consistent with Basel III and the Proposed Rules, the Final Rules incorporate adjustments to the assumed holding periods for collateral in the collateral haircut and Simple VaR approaches and the margin period of risk in the IMM approach, but do not adjust the assumed holding period or margin period of risk for exposures to CCPs.
In addition, and consistent with Basel III and the Proposed Rules, the Final Rules require an Advanced Approaches Bank using the IMM approach to establish risk management procedures to identify, monitor and control wrong-way risk throughout the life of an exposure. The Final Rules implement these increases, but have been modified in several respects in response to comments on the Proposed Rules.
First, the multiples for wholesale exposures to both regulated and unregulated financial institutions have been changed from. Second, the definition of "unregulated financial institution" has been modified to incorporate changes to the definition of "financial institution" for purposes of deductions of investments in the capital of unconsolidated financial institutions, as discussed in Adjustments to and Deductions from Capital. Credit Valuation Adjustments The Banking Agencies state in the preamble to the Final Rules that the Basel Committee reviewed the treatment of counterparty credit risk and found that roughly two-thirds of counterparty credit risk losses arose from Credit Valuation Adjustments CVA , i.
Stress Period for Internal Estimates Consistent with Basel III and the Proposed Rules, the Final Rules require Advanced Approaches Banks to base internal estimate of haircuts on a historical observation period that reflected a continuous month period of significant financial stress appropriate to the security or category of securities. The Banking Agencies retain the discretion to require an Advanced Approaches Bank to use a different period of significant financial stress in the calculation of internal estimates. For example, the Final Rules replace the use of credit ratings in certain provisions of the current advanced approaches rule with an "investment grade" standard that does not rely on credit ratings.
An entity or reference entity is deemed to have "adequate capacity to meet financial commitments" if the risk of its default is low and the full and timely repayment of principal and interest is expected. Eligible Guarantor The current advanced approaches rules recognize credit risk mitigation benefits provided by "eligible securitization guarantors," which must have, inter alia , issued and outstanding an unsecured long-term debt security without credit enhancement in one of the three highest investment grade rating categories. Pursuant to Section A of the Dodd-Frank Act, the Final Rules replace the term "eligible securitization guarantor" with "eligible guarantor," which includes entities that have issued and outstanding "investment grade" debt securities, as defined above.
Technical Amendments to the Advanced Approaches The Final Rules make certain technical amendments to the advanced approaches. Eligible Guarantees and Contingent US Government Guarantees Advanced Approaches Banks currently may recognize the credit risk mitigation benefits of "eligible guarantees," which must be, inter alia , "unconditional. Although this new framework is considered to be part of Basel III, given the number of substantial changes proposed and the timeframe for implementation January ,  it is more appropriate to conceptualize it as a complementary element of the Basel IV credit risk revisions described above.
Beyond the microprudential proposals outlined thus far, the Basel IV package could incorporate a number of new macroprudential instruments, which would complete the countercyclical regulatory dimension introduced with Basel III. As part of such an effort, not only can exposure-based capital surcharges for G-SIIs and other credit institutions be implemented, but real estate tools, such as loan-to-value and debt-to-income caps, could also be developed in the near future by the BCBS.
In addition, the Basel IV framework could incorporate a macroprudential stress testing framework for liquidity and solvency risks.
Finally, in order to reflect the number of regulatory changes proposed under the Basel IV package, it is likely that the Basel III disclosure framework will be amended accordingly. The foundations of this enhanced disclosure regime can be found in the consultative document on Pillar 3 disclosure requirements published by the Basel Committee in March If all these proposals were implemented, what would remain of the Basel III framework? Not much. The adoption of these proposals as supplementary prudential standards would override the core components of Basel III, setting the stage for a radical reformulation of banking law throughout the world.
If this holds true, market participants need to ponder the implications of these regulatory reforms on the banking industry as a whole. Compliance with Basel III imposed substantial costs on credit institutions. The array of regulatory changes introduced by the BCBS in required banks to adjust not only their capital and liquidity structure, but also their business models, governance structure, and investment strategies.
In this evolving scenario, the implications of a future Basel IV package might be overwhelming. One the one hand, the likely simplification of risk-weighting and parameter calculations could provide some compliance cost savings to banks. On the other hand, limitations on the use of internal risk models for the purpose of capital requirements, along with the general increase of prudential buffers, could further undercut the viability of banking activities.
For now, whether the future macroeconomic benefits of the Basel IV package for society as a whole are likely to outweigh the microeconomic costs for individual institutions is a matter of speculation. Barr, Howell E. Tahyar, Financial Regulation: Law and Policy , — May , at 1— For a wider discussion on macroprudential approach to banking regulation, see Samuel G. Hanson, Anil K. Perspectives 3, 3—28 Monetary Fund, Working Paper No. However, to what extent this level playing field has been actually achieved is debatable.
For a critical analysis of the desirability of a level playing fields in international financial regulation, see Alan D. For example, Goldman Sachs decided to cut its business ties to hedge funds and moved to less profitable clients in order to adjust its balance sheet structure to the new prudential framework. For the same reasons, since Deutsche Bank has taken steps to reduce the size of its balance sheet.
See, e. Analysis ; Ahmed Al-Darwish et al. Central Bank, Working Paper No. It is interesting to note that the criticisms of the Basel III disclosure framework do not seem to be addressed by the last reform of disclosure standards proposed by the BCBS in and briefly discussed in the next few sections. Officers from different national and international authorities tend to downsize the prudential implications of these proposals, arguing that the idea of a Basel IV regulatory framework is just speculative. However, in view of the number of proposals published by the BCBS, it seems rather difficult to support these claims.
Times Mar. As the cases of Deutsche Bank and other major banks over the last few years demonstrate, this risk can be substantial and can erode the resilience of regulatory capital. However, the need to improve the understanding of climate risk and its related management is today a cornerstone of risk management practice developments. For this reason, a number of studies have been published at the international level on how to deal with this operational risk problem and how to measure it for the purpose of capital requirements.
The BCBS will decide what proposal is to be incorporated in the Basel prudential requirements at a later stage. Stability Rev. Times Oct. Bank for Intl. For similar results, see also Luis I. For detailed reports, see Eur. Specific concerns have been raised also by the Federal Reserve due to the current run-up of commercial real estate prices in US. For details, see Eric S. S ee also Dimitri G. Analysis 73 Banking Auth.