The January 2010 edition of the Basel ii
Compliance Professionals Association (BCPA)
newsletterDear Members,
I wanted to take a
moment to extend my best wishes for a safe, prosperous
and blessed year to all.
I do
hope that you will transform the difficulties around
into opportunities.
Breaking News:
The Basel Committee has announced consultative
proposals to strengthen the resilience of the banking
sector
The Basel Committee on Banking Supervision has
approved for consultation
a package of proposals to
strengthen global capital and liquidity regulations
with the goal of promoting a more resilient banking
sector.
Along with the
measures taken by the Committee in July 2009 to
strengthen the Basel II Framework, the proposals
announced are part of the
Committee's comprehensive response to address the
lessons of the crisis related to the regulation,
supervision and risk management of global banks.
These reforms carry forward the 7 September 2009
mandate of the Governors and Heads of Supervision, the
oversight body of the Basel Committee.
The reform
programme has also been
endorsed by the Financial Stability Board and by the
G20 leaders at their
Pittsburgh Summit.
The Committee's consultative documents cover the
following key areas:
Raising the quality, consistency
and transparency of the capital base.
This will ensure
that the banking system is in a better position to
absorb losses on both a going concern and a gone
concern basis.
In addition to
raising the quality of the Tier
1 capital base, the Committee is also
harmonising the other elements of the capital
structure.
Strengthening the risk coverage
of the capital framework.
In addition to the
trading book and securitisation reforms announced in
July 2009, the Committee is proposing to strengthen
the capital requirements for counterparty credit risk
exposures arising from derivatives, repos and
securities financing activities.
The strengthened
counterparty capital requirements will also increase
incentives to move OTC derivative exposures to central
counterparties and exchanges.
The Committee will
also promote further convergence in the measurement,
management and supervision of operational risk.
Introducing a leverage ratio as
a supplementary measure to the Basel II risk-based
framework with a view to migrating to a Pillar 1
treatment based on appropriate review and calibration.
The leverage ratio
will help contain the build-up of excessive leverage
in the banking system, and introduce additional
safeguards against model risk and measurement error.
To ensure
comparability, the details of the leverage ratio will
be harmonised internationally, fully adjusting for any
remaining differences in accounting.
Introducing a series of measures
to promote the build-up of capital buffers in good
times that can be drawn upon in periods of stress.
A
countercyclical capital
framework will contribute to a more stable banking
system, which will help dampen, instead of amplify,
economic and financial shocks.
In addition, the
Committee is promoting more forward-looking
provisioning based on expected losses, which captures
actual losses more transparently and is also
less procyclical than the current "incurred loss"
provisioning model.
Introducing a global minimum
liquidity standard for internationally active banks
that includes a 30-day liquidity coverage ratio
requirement underpinned by a longer-term structural
liquidity ratio.
The framework also
includes a common set of monitoring metrics to assist
supervisors in identifying and analysing liquidity
risk trends at both the bank and system wide level.
These standards
and monitoring metrics complement the Committee's
Principles for sound liquidity risk management and
supervision issued in September 2008.
The Committee is also reviewing the need for
additional capital, liquidity or other supervisory
measures to reduce the externalities created by
systemically important institutions.
The Committee is mindful of the need to
introduce these measures in a
manner that raises the resilience of the banking
sector over the longer term, while avoiding
negative effects on bank lending activity that could
impair the economic recovery.
To this end, the
Committee is
initiating a comprehensive impact assessment of the capital
and liquidity standards proposed in the consultative
documents.
In a number of
proposals, the Committee is still considering
different options, which will be included in the
impact assessment.
The impact assessment will be carried out in the first
half of 2010.
On the basis of
this assessment, the Committee will then review the
regulatory minimum level of capital and the reforms
proposed in this document to arrive at an
appropriately calibrated total level and quality of
capital.
The calibration
will consider all the elements of the Committee's
reform package and will not be conducted on a
piecemeal basis.
The fully calibrated set of standards will be
developed by the end of 2010 to be phased in as
financial conditions improve and the economic recovery
is assured, with the aim of implementation by end-2012
The Committee will
put in place appropriate phase-in measures and
grandfathering arrangements for a sufficiently long
period to ensure a smooth transition to the new
standards.
We will discuss
some important parts of the
proposals to strengthen global capital and liquidity
regulations with the goal of promoting a more
resilient banking sector.
Stress
testing
Stress testing is an important risk management tool
and this is especially true for
counterparty credit
risk management.
Despite
the importance of this tool, the development of stress
testing for counterparty credit lags the development
of stress testing for market risk or for traditional
credit risk.
Stress
testing of counterparty credit risk faces several
difficulties that have hindered its development.
The
multiplicity of counterparties makes it
difficult to
develop easily understood stress tests.
Furthermore, exposure measures are
still developing.
For example, the use of CVA
[Credit Valuation Adjustments]
which allows banks to
encapsulate credit rating and exposure into a single
measure of counterparty credit risk is a recent
development.
Fundamentally,
counterparty credit stress testing must be done at the
individual counterparty level.
Lists of
counterparty exposures under stress scenarios are the
key element of all successful stress testing programs.
However,
stresses of CVA now allow aggregation to a firm-wide
level, as well as joint stresses of counterparty
creditworthiness
and exposure.
The Committee is proposing to
revise the Basel II text by replacing the existing
paragraph 56, Annex 4, of the Basel II text with the
following:
Banks must have a comprehensive
stress testing program for
counterparty credit risk.
The
stress testing program must include the following
elements:
• Banks must ensure complete trade capture and
exposure aggregation across all forms of counterparty
credit risk (not just OTC derivatives) at the
counterparty-specific level in a sufficient time frame
to conduct regular stress testing.
• For all counterparties, banks should produce,
at
least monthly, exposure stress testing of principal
market risk factors (eg, interest rates, FX, equities,
credit spreads, and commodity prices) in order to
proactively identify, and when necessary, reduce
outsized concentrations to specific directional
sensitivities.
• Banks should apply
multifactor stress testing
scenarios and assess material non-directional risks (ie
yield curve exposure, basis risks, etc) at least
quarterly.
Multiple-factor stress tests should,
at a minimum, aim
to address scenarios in which
a)
severe economic or market events have occurred;
b) broad
market liquidity has decreased significantly; and
c) the
market impact of liquidating positions of a large
financial intermediary.
These
stress tests may be part of firm wide stress testing.
• Stressed market movements have an impact not only on
counterparty exposures, but also on the
credit quality
of counterparties.
At least quarterly,
banks should conduct stress testing applying stressed
conditions to the joint movement of exposures and
counterparty creditworthiness.
• Exposure stress testing
—including single factor,
multifactor and material non-directional risks— and
joint stressing of exposure and creditworthiness
should be performed at the
counterparty-specific,
counterparty group (eg industry and region), and
aggregate firm-wide CCR levels.
• Stress tests results should be integrated into
regular reporting to senior management.
The
analysis should capture the largest counterparty-level
impacts across the portfolio, material concentrations
within segments of the portfolio (within the same
industry or region), and relevant portfolio and
counterparty specific trends.
• The severity of factor shocks should be consistent
with the purpose of the stress test.
When
evaluating solvency under stress,
factor shocks should be severe
enough to capture historical extreme market
environments and/or extreme but plausible stressed
market conditions.
The
impact of such shocks on capital resources should be
evaluated, as well as the impact on capital
requirements and earnings.
For the
purpose of day-to-day portfolio monitoring, hedging,
and management of concentrations, banks should also
consider
scenarios of
lesser severity and higher probability.
• Banks should consider reverse stress tests
to
identify extreme, but plausible, scenarios that could
result in significant adverse outcomes.
• Senior Management must take a lead role in the
integration of stress testing into the risk management
framework and risk culture of the firm and ensure that
the results are meaningful and proactively used to
manage counterparty credit risk.
At a
minimum, the results of stress testing for significant
exposures should be compared to guidelines that
express the bank’s risk appetite and elevated for
discussion and action when excessive or concentrated
risks are present.
Back-testing
Back-testing is the comparison of forecasts to
realised outcomes.
VaR
back-testing is a particular example of testing forecast distributions against
realised outcomes whereby a single aspect of the
distribution, the 99th
percentile, is tested.
Strengthening the global capital framework
Raising the quality, consistency and transparency
of the capital base
Introduction
One of the highest priority issues on the Basel
Committee’s regulatory reform agenda for the banking
sector is the need to strengthen the quality,
consistency and transparency of the regulatory capital
base.
This
objective has been endorsed by the FSB and the G20
Leaders.
While it
is critical that the regulatory capital framework
captures the key risks to which a bank and the banking
sector are exposed, it is equally important that
these
risks are backed by a high quality buffer of capital
which is capable of absorbing losses
when the risks identified materialise.
The global banking system entered the crisis with
capital which was of insufficient quality.
Banks
had to rebuild their capital bases in the midst of the
crisis at the point when it was most difficult to do
so.
The
result was the need for massive government support of
the banking sector in many countries and a deepening
of the economic downturn.
The existing definition of capital suffers from
certain fundamental flaws:
1. Regulatory adjustments generally are not applied to
common equity.
These adjustments are currently generally applied to
total Tier 1 capital or to a combination of Tier 1 and
Tier 2.
They are
not generally applied to the common equity component
of Tier 1.
This
allows banks to report high Tier 1 ratios, despite the
fact that they may have low levels of common equity
when considered net of regulatory adjustments.
It is
this common equity base which best absorbs losses on a
going concern basis.
2. There is
no harmonised list of regulatory
adjustments.
The way
these adjustments are applied across Basel Committee
countries varies substantially, undermining the
consistency of the regulatory capital base.
3. Weak transparency.
The
disclosure provided by banks
about their regulatory capital bases is frequently
deficient.
Often
there is insufficient detail on the components of
capital, making an accurate assessment of its quality
or a meaningful comparison with other banks difficult.
Furthermore, reconciliation to the reported accounts
is often absent.
These shortcomings resulted in the banking sector
entering the crisis with a definition of capital that
was neither harmonised nor transparent, and it allowed
a number of banks to
report high Tier 1 ratios but
with low levels of common equity net of regulatory
adjustments.
As the
crisis deepened, banks faced growing losses and write
downs which directly reduced the retained earnings
component of common equity, calling into question
fundamental solvency.
Many
market participants therefore lost confidence in the
Tier 1 measure of capital adequacy.
They
instead focused on measures such as tangible common
equity (which nets out elements like goodwill from
common equity, as these are not realisable in
insolvency).
The following sections set out proposals to
strengthen
the definition of capital, focusing on its overall
quality, consistency and transparency.
These
proposals will help ensure that banks move to a higher
capital standard that promotes long term stability and
sustainable growth.
Appropriate grandfathering and transitional
arrangements will be established which will ensure
that this process is completed without aggravating
near term stress.
Rationale and objective
There are certain overarching objectives which have
guided the development of the proposed new definition
of capital.
Tier 1 capital must help a bank to remain a going
concern
Common
equity is recognised as the highest quality component
of capital.
It is
subordinated to all other elements of funding, absorbs
losses as and when they occur, has full flexibility of
dividend payments and has no maturity date.
It is
the primary form of funding which helps ensure that
banks remain solvent.
The
framework must ensure that all instruments included in
capital as common stock truly meet the standards
intended by the
Committee.
There
can be no features which add additional leverage or
which could cause the condition of the bank to be
weakened as a going concern during periods of market
stress.
It is critical that for non-common equity elements to
be included in Tier 1 capital, they must also absorb
losses while the bank remains a going concern.
Qualifying instruments must contribute in a meaningful
way to ensuring the going concern status of the bank
and they must be capable of absorbing losses in
practice without exacerbating a bank’s condition in a
crisis.
Certain
innovative features which over time have been
introduced to Tier 1 to lower its cost, have done so
at the expense of its quality. These elements will
need to be phased out.
Furthermore, banks must not over-rely on non-common
equity elements of capital and so the extent to which
these can be included in Tier 1 capital must be
limited.
Finally
the regime should accommodate the specific needs of
non-joint stock companies, such as mutuals and
cooperatives, which are unable to issue common stock.
Regulatory adjustments must be applied to the
appropriate component of capital
Generally, regulatory adjustments must be applied at
the level of common equity.
There are two reasons for this:
1) If an
element of the balance sheet is of
insufficient
quality to be included in the calculation of Tier 1
capital, then it is also not adequate to be included
in the calculation of its highest quality component:
common equity; and
2)
Regulatory adjustments should be applied to that
component of capital which is affected by the
recognition of the relevant element on the balance
sheet, which is generally retained earnings.
Taken
together, these measures will help ensure that banks
cannot show strong Tier 1 capital ratios while having
low levels of tangible common equity.
Regulatory capital must be simple and harmonised
across jurisdictions
The number of tiers and sub-tiers of capital must be
limited. The definitions of Tier 1 and Tier 2 capital
should correspond to capital which absorbs losses on a
going concern basis and capital which absorbs losses
on a gone concern basis, respectively. In addition,
the minimum set of regulatory adjustments must be
harmonised internationally.
The components of regulatory capital must be clearly
disclosed
Finally, the components of regulatory capital must be
clearly disclosed and reconciled with the published
financial accounts. This will ensure that market
participants and supervisors will be in a position to
compare the capital adequacy of banks across
jurisdictions.
Key elements of proposal
Overview
The following key changes to the definition of
capital are proposed:
• The quality and consistency of the common equity
element of Tier 1 capital will be significantly
improved, with regulatory adjustments generally
applied to this element.
• The required features for instruments to be included
in Tier 1 capital outside of the common equity element
will be strengthened.
• Tier 2 will be simplified.
There will be one set of
entry criteria, removing subcategories of Tier 2
• Tier 3 will be abolished
to ensure that market risks
are met with the same quality of capital as credit and
operational risks.
• The transparency of capital will be improved, with
all elements of capital required to be disclosed along
with a detailed reconciliation to the reported
accounts.
• Without prejudging the outcome of the calibration
work in 2010, the system of limits applied to elements
of capital will be revised to ensure that common
equity forms a greater proportion of Tier 1 than is
permitted at present.
The
current limitation on Tier 2 capital (it cannot exceed
Tier 1) will be removed and replaced with explicit
minimum Tier 1 and total capital requirements.
Tier 1 - common equity less regulatory adjustments
For banks structured as joint stock companies the
predominant form of Tier 1 capital must be common
shares and retained earnings. Regulatory adjustments
will be harmonised internationally and generally
applied at the level of common equity.
To ensure their quality and consistency, common
shares will need to meet a set of entry criteria
before being permitted to be included in the
predominant form of Tier 1 capital.
These
entry criteria will also be used to
identify
instruments of equivalent quality which non joint
stock companies, such as mutuals and cooperatives, can
include in the predominant form of Tier 1 capital.
Tier 1 – other elements
To be included in Tier 1, instruments will need to be
sufficiently loss absorbent on a going-concern basis.
To be considered loss absorbent on a going concern
basis, all instruments included in Tier 1 will, among
other things, need to be subordinated, have fully
discretionary noncumulative dividends or coupons and
neither have a maturity date nor an incentive to
redeem.
In
addition, as part of the impact assessment, the
Committee will consider the appropriate treatment in
the non-predominant element of Tier 1 capital of
instruments which have tax deductible coupons.
“Innovative” features such as step-ups, which over
time have eroded the quality of Tier 1, will be phased
out.
The use
of call options on Tier 1 capital will be subject to
strict governance arrangements which ensure that the
issuing bank is not expected to exercise a call on a
capital instrument unless it is in its own economic
interest to do so.
Payments
on Tier 1 instruments will also be considered a
distribution of earnings under the capital
conservation buffer proposal (see Section II.4.c.).
This will improve their loss absorbency on a going
concern basis by increasing the likelihood that
dividends and coupons will be cancelled in times of
stress.
Tier 2
Tier 2 capital will be simplified. There will be one
set of entry criteria, removing subcategories of Tier
2.
Under
the proposal all Tier 2 capital will need to meet the
minimum standard of being subordinated to depositors
and general creditors and have an original maturity of
at least 5 years.
Recognition in regulatory capital will be “amortised”
on a straight line basis during the final 5 years to
maturity.
Tier 3
Tier 3 capital will be
abolished.
This
will ensure that capital used to meet market risk
requirements will be of the same quality of
composition as capital used to meet credit and
operational risk requirements.
Transparency
To improve transparency and market discipline,
banks
will be required to disclose the following:
• A full reconciliation of regulatory capital elements
back to the balance sheet in the audited financial
statements;
• Separate disclosure of all regulatory adjustments;
• A description of all limits and minima, identifying
the positive and negative elements of capital to which
the limits and minima apply;
• A description of the main features of capital
instruments issued; and
• Banks which disclose ratios involving components of
regulatory capital (eg “Equity Tier 1”, “Core Tier 1”
or “Tangible Common Equity” ratios) to accompany these
with a comprehensive explanation of how these ratios
are calculated.
In addition to the full transparency requirements, a
bank will need to make available the full terms and
conditions of all instruments included in regulatory
capital on its website.
The existing requirement for the main features of
capital instruments to be easily understood and
publically disclosed will be retained.
Limits
The current system of limits is complex and makes the
maximum level of Tier 2 capital a function of how much
Tier 1 capital the bank has issued. To address this
situation the following system of limits and minima
will apply:
• Separate explicit minima will be established for the
common equity component of Tier 1 (after the
application of regulatory adjustments), total Tier 1
and total capital.
• The predominant form of Tier 1 must be its common
equity component (after the application of regulatory
adjustments).
Strengthening the resilience of the banking sector
• The restriction that Tier 2 cannot exceed Tier 1
will be removed.
The data collected in the impact assessment will be
used to calibrate the above minimum required levels
and ensure a consistent interpretation of the
predominance standard.
Grandfathering and transitional provisions
Given the significant changes proposed to the
definition of capital, the Committee recommends that
members consider the possibility of allowing the
grandfathering of instruments which have already been
issued by banks prior to the publication of this
consultative document.
The
impact assessment will be used to consider
recommendations for an appropriate grandfathering
period for instruments and an appropriate phase in
period for the new capital standards.
Detailed proposal
This section sets out the detailed proposed rules
which will govern the definition of capital.
To give
context to these proposals the following box
summarises the structure of regulatory capital under
the proposed rules.
Proposed harmonised structure of capital
Elements of capital
Total regulatory capital will consist of the sum of
the following elements:
1. Tier 1 Capital (going-concern capital)
a. Common Equity
b. Additional Going-Concern Capital
2. Tier 2 Capital (gone-concern capital)
For each of the three categories above (1a, 1b and 2)
there will be a single set of criteria which
instruments are required to meet before inclusion in
the relevant category.
Limits and minima
All elements above are net of regulatory adjustments
and are subject to the following restrictions:
• Common Equity, Tier 1 Capital and Total Capital must
always exceed explicit minima of x%, y% and z% of
risk-weighted assets, respectively, to be calibrated
following the impact assessment.
• The predominant form of Tier 1 Capital must be
Common Equity
The detailed proposals are set out in the
following sections:
• Criteria governing inclusion in the Common Equity
component of Tier 1 capital
• Criteria governing the inclusion in Tier 1
Additional Going Concern Capital
• Criteria governing the inclusion in Tier 2 Capital
• Regulatory adjustments applied to the elements of
capital and clarification of the treatment of stock
surplus and minority interest
• Limits and minima applied to the components of
capital
• Disclosure requirements
Criteria governing inclusion in the Common Equity
component of Tier 1
For an instrument to be included in the predominant
form of Tier 1 capital it must meet all of the
criteria which follow.
The vast
majority of internationally active banks are
structured as joint stock companies18 and for these
banks the criteria must be met solely with common
shares.
In the
rare cases where banks need to issue non-voting common
shares as part of the predominant form of Tier 1, they
must be identical to voting common shares of the
issuing bank in all respects except the absence of
voting rights.
Criteria for classification as common shares for
regulatory capital purposes
1. Represents the most subordinated claim in
liquidation of the bank.
2. Entitled to a claim of the residual assets that is
proportional with its share of issued capital, after
all senior claims have been repaid in liquidation (ie
has an unlimited and variable claim, not a fixed or
capped claim).
3. Principal is perpetual and never repaid outside of
liquidation (setting aside discretionary repurchases
or other means of effectively reducing capital in a
discretionary manner that is allowable under national
law).
4. The bank does nothing to create an expectation at
issuance that the instrument will be bought back,
redeemed or cancelled nor do the statutory or
contractual terms provide any feature which might give
rise to such an expectation.
5. Distributions are paid out of distributable items
(retained earnings included).
The
level of distributions are not in any way tied or
linked to the amount paid in at issuance and are not
subject to a cap (except to the extent that a bank is
unable to pay distributions that exceed the level of
distributable items).
6. There are no circumstances under which the
distributions are obligatory.
Non
payment is therefore not an event of default.
7. Distributions are paid only after all legal and
contractual obligation have been met and payments on
more senior capital instruments have been made.
This
means that there are no preferential distributions,
including in respect of other elements classified as
the highest quality issued capital.
8. It is the issued capital that takes the first and
proportionately greatest share of any losses as they
occur.
Within
the highest quality capital, each instrument absorbs
losses on a going concern basis proportionately and
pari passu with all the others.
9. The paid in amount is recognised as equity capital
(ie not recognised as a liability) for determining
balance sheet insolvency.
10. The
paid in amount is classified as equity under the
relevant accounting standards.
11. It is directly issued and paid-up.
12. The paid in amount is neither secured nor covered
by a guarantee of the issuer or related entity or
subject to any other arrangement that legally or
economically enhances the seniority of the claim.
13. It is only issued with the approval of the owners
of the issuing bank, either given directly by the
owners or, if permitted by applicable law, given by
the Board of Directors or by other persons duly
authorised by the owners.
14. It is clearly and separately disclosed on the
bank’s balance sheet.
Criteria for inclusion in Tier 1 Additional Going
Concern Capital
This element of capital allows instruments other than
common shares to be included in Tier 1 capital.
Their
inclusion will be limited by the requirement that the
predominant form of Tier 1 Capital must be Common
Equity.
To
maintain the integrity of Tier 1 capital any
instrument included must at least:
1. Help the bank avoid payment default through
payments being discretionary;
2. Help the bank avoid balance sheet insolvency by the
instrument not contributing to liabilities exceeding
assets if such a balance sheet test forms part of
applicable national insolvency law; and
3. Be able to bear losses while the firm remains a
going concern.
Based on this high level view, the following box sets
out the proposed minimum set of criteria for an
instrument to meet or exceed in order for it to be
included in Tier 1 Additional
Criteria for inclusion in Tier 1 Additional Going
Concern Capital
1. Issued and paid-in
2. Subordinated to depositors, general creditors and
subordinated debt of the bank
3. Is neither secured nor covered by a guarantee of
the issuer or related entity or other
arrangement that legally or economically enhances the
seniority of the claim vis-àvis
bank creditors
4. Is perpetual, ie there is no maturity date and
there are no incentives to redeem
5. May be callable at the initiative of the issuer
only after a minimum of five years:
a. To exercise a call option a bank must receive prior
supervisory approval; and
b. A bank must not do anything which creates an
expectation that the call will be
exercised; and
c. Banks must not exercise a call unless:
i. They replace the called instrument with capital of
the same or better
quality and the replacement of this capital is done at
conditions which are
sustainable for the income capacity of the bank; or
ii. The bank demonstrates that its capital position is
well above the minimum
capital requirements after the call option is
exercised.
6. Any repayment of principal (eg through repurchase
or redemption) must be with
prior supervisory approval and banks should not assume
or create market
expectations that supervisory approval will be given
7. Dividend/coupon discretion:
a. the bank must have full discretion at all times to
cancel distributions/payments
b. cancellation of discretionary payments must not be
an event of default
c. banks must have full access to cancelled payments
to meet obligations as
they fall due
d. cancellation of distributions/payments must not
impose restrictions on the
bank except in relation to distributions to common
stockholders.
8. Dividends/coupons must be paid out of distributable
items
9. The instrument cannot have a credit sensitive
dividend feature, that is a
dividend/coupon that is reset periodically based in
whole or in part on the banking
organisation’s current credit standing
10. The instrument cannot contribute to liabilities
exceeding assets if such a balance
sheet test forms part of national insolvency law.
11. Instruments classified as liabilities must have
principal loss absorption through either
(i) conversion to common shares at an objective
pre-specified trigger point or
(ii) a
write-down mechanism which allocates losses to the
instrument at a pre-specified
trigger point.
The write-down will have the following
effects:
a. Reduce the claim of the instrument in liquidation;
Strengthening the resilience of the banking sector
b. Reduce the amount re-paid when a call is exercised;
and
c. Partially or fully reduce coupon/dividend payments
on the instrument.
12. Neither the bank nor a related party over which
the bank exercises control or
significant influence can have purchased the
instrument, nor can the bank directly or
indirectly have funded the purchase of the instrument
13. The instrument cannot have any features that
hinder recapitalisation, such as
provisions that require the issuer to compensate
investors if a new instrument is
issued at a lower price during a specified time frame
14. If the instrument is not issued out of an
operating entity or the holding company in
the consolidated group (eg a special purpose vehicle –
“SPV”), proceeds must be
immediately available without limitation to an
operating entity or the holding
company in the consolidated group in a form which
meets or exceeds all of the other
criteria for inclusion in Tier 1 Additional Going
Concern Capital
Additional requirements
• The criteria above will also apply to instruments
which appear in the consolidated
accounts as minority interest.
• This element of capital will be net of the
appropriate corresponding deductions
related to holding of non-common equity capital
instruments in other financial
institutions.
Criteria for inclusion in Tier 2 (gone concern
capital)
The objective of Tier 2 is to provide loss
absorption on a gone-concern basis.
Based
on this objective, the following sets out the
proposed minimum set of criteria for an
instrument to meet or exceed in order for it to be
included in Tier 2 capital.
Criteria for inclusion in Tier 2 Capital
1. Issued and paid-in
2. Subordinated to depositors and general creditors of
the bank
3. Is neither secured nor covered by a guarantee of
the issuer or related entity or other
arrangement that legally or economically enhances the
seniority of the claim vis-àvis
depositors and general bank creditors
4. Maturity:
a. minimum original maturity of at least 5 years
b. recognition in regulatory capital in the remaining
5 years before maturity will
be amortised on a straight line basis
c. there are no incentives to redeem
5. May be callable at the initiative of the issuer
only after a minimum of five years:
a. To exercise a call option a bank must receive prior
supervisory approval; and
b. A bank must not do anything which creates an
expectation that the call will be
exercised; and
c. Banks must not exercise a call unless:
i. They replace the called instrument with capital of
the same or better
quality and the replacement of this capital is done at
conditions which are
sustainable for the income capacity of the bank; or
ii. The bank demonstrates that its capital position is
well above the minimum
capital requirements after the call option is
exercised.
6. The investor must have no rights to accelerate the
repayment of future scheduled
payments (coupon or principal), except in bankruptcy
and liquidation
7. The instrument may not have a credit sensitive
dividend feature, that is a dividend
that is reset periodically based in whole or in part
on the banking organisation’s
current credit standing
8. The bank or a related party cannot have knowingly
purchased, or directly or
indirectly have funded the purchase of, the instrument
9. If the instrument is not issued out of an operating
entity or the holding company in
the consolidated group (eg an SPV), proceeds must be
immediately available
without limitation to an operating entity or the
holding company in the consolidated
group in a form which meets or exceeds all of the
other criteria for inclusion in Tier 2
Capital
Additional requirements
• These criteria will also apply to instruments which
appear in the consolidated
accounts as minority interest.
• This element of capital will be net of the
appropriate corresponding deductions
related to holding of non-common equity capital
instruments in other financial
institutions.
In addition to the Tier 1 and Tier 2 criteria set
out in the sections above, the
Committee continues to review the role that contingent
capital, convertible capital
instruments and instruments with write-down features
should play in a regulatory capital
framework, both in the context of the entry criteria
for regulatory capital and their use as buffers over
the minimum requirement.
The Committee will discuss concrete proposals in this
area at its July 2010 meeting
The Committee would welcome feedback on whether
the safeguards introduced on
the use of call options will avoid the problem evident
in the crisis that in some jurisdictions
banks felt compelled to exercise call options, due to
the potential negative market reaction
that would have resulted if the call was not
exercised.
The Committee would also welcome
views on whether additional safeguards such as a
lock-in mechanism is necessary to ensure
that Tier 2 capital does not need to be repaid during
a period of stress.
Counterparty
Credit Risk (CCR)
[Counterparty credit risk is the risk that the
counterparty to a transaction could default before the
final settlement of the transaction's cash flows.
An
economic loss would occur if the transactions or
portfolio of transactions with the counterparty has a
positive economic value at the time of default.
Unlike
a firm’s exposure to credit risk through a loan, where
the exposure to credit risk is unilateral and only the
lending bank faces the risk of loss, CCR creates a
bilateral risk of loss: the market value of the
transaction can be positive or negative to either
counterparty to the transaction.
The market value is uncertain and can vary over time
with the movement of underlying market factors]
(a) Introduction
In its review of the treatment of counterparty
credit risk (CCR), the Committee
engaged in a wide-ranging effort to ascertain areas
where capital requirements for CCR
need to be strengthened.
In conducting this review,
the Committee carefully considered:
• areas where the current treatment did not adequately
capitalise for the risks during
the crisis;
• the provision of incentives to move bi-lateral OTC
derivative contracts to multilateral
clearing through central counterparties;
• the provision of incentives to reduce operational
risk arising from inadequate
margining practices, back-testing and stress testing;
and
• whether the changes would contribute to
reducing procyclicality.
(b) Key problems identified
The Committee identified several areas where
capital for CCR proved to be
inadequate.
Some of the concerns about the capital
treatment of CCR have broader
consequences and the resulting recommendations may, in
some cases, affect areas outside
of counterparty credit risk.
In these cases,
counterparty credit risk was where the problems
were most apparent.
More specifically, the Committee has determined
that
the regulatory capital
treatment for counterparty credit risk was
insufficient in the following areas:
• During the recent market crisis, a key observation
was that defaults and
deteriorations in the creditworthiness of trading
counterparties occured precisely at
the time when market volatilities, and therefore
counterparty exposures, were higher
than usual.
Thus, observed generalised wrong-way risk
was not adequately incorporated into the framework.
• Mark-to-market losses due to credit valuation
adjustments (CVA) were not directly
capitalised.
Roughly two-thirds of CCR losses were due
to CVA losses and only
about one-third were due to actual defaults.
The
current framework addresses CCR
as a default and credit migration risk, but does not
fully account for market value
losses short of default.
• Large financial institutions were more
interconnected than currently reflected in the
capital framework.
As a result, when markets entered
the downturn, banks’
counterparty exposure to other financial firms also
increased.
The evidence
suggests that the asset values of financial firms are,
on a relative basis, more
correlated than those of non-financial firms.
As such,
this higher degree of
correlation with the market needs to be reflected in
the asset value correlations.
The
Committee, based on its empirical work, found evidence
that asset value
correlations were at least 25% higher for financial
firms than for non-financial firms.
• The close-out period for replacing trades with a
counterparty with large netting sets
or netting sets consisting of complex trades or
illiquid collateral extended beyond the
horizon required for the capital calculations.
• Initial margining typically was very low at the
start of the crisis and increased rapidly
during the turmoil.
This had a destabilising effect on
many market participants and
sometimes caused or precipitated defaults.
Capital
based on Effective expected
positive exposure (EPE) did not provide sufficient
incentive for adequate initial
margins to be required at all points of the cycle.
• Central Counterparties (CCPs) were not widely used
to clear trades.
• Securitisations were treated as if they had the same
risk exposure as a similarly
rated corporate debt instrument.
In the aftermath of
the crisis, securitisations have
continued to exhibit much higher price volatility than
similarly rated corporate debt.
Under the Basel framework, the standardised haircuts
currently treat corporate debt
and securitisations in the same manner.
The crisis also revealed a number of shortcomings
in banks’ risk management of
counterparty credit exposures, including in particular
the areas of back-testing, stress testing
and monitoring of wrong way risk.
• Back-testing: The difficulties in statistical
interpretation of back-testing results for
counterparty credit risk suggest that many firms did
not appropriately consider
problems that were identified by back-testing.
The use
of models with poor backtesting
results contributed to an underestimation of actual
losses.
• Stress testing: Stress testing of counterparty
credit risk was not comprehensive;
was
run infrequently, sometimes on an ad hoc basis; and,
in many banks, provided
inadequate coverage of counterparties or the
associated risks.
• Wrong way risk: Transactions with counterparties,
such as the financial guarantors,
whose credit quality is highly correlated with the
exposure amount, contributed to
the losses during the crisis.
• Use of
own estimates of Alpha:
Where Alpha is set
using an own estimate of
economic capital (numerator) to economic capital based
on EPE (denominator),
there can be significant variation in such estimates
arising from the mis-specification
of the models used for the numerator, especially for
exposures with non-linear risk
profiles.
Wrong-way risk
Wrong-way risk is typically defined as an
exposure to a counterparty that is
adversely correlated with the credit quality of that
counterparty.
Wrong way
risk arises when there is a positive expected
correlation between EAD and PD to a given
counterparty.
There are
two types of wrong-way risk,
specific wrong-way risk and general
wrong-way risk.
•
Specific wrong-way risk
typically arises from poorly constructed transactions.
For
example, consider a counterparty that
provides its own
shares as collateral.
A long
put option position on that counterparty’s shares
would put the bank at risk.
A sharp
drop in counterparty share price would increase the
exposure to that counterparty at
the same time the ability of the counterparty to meet
its obligation decreases.
•
General wrong-way risk is a term used to describe
all other possible sources of
positive correlation between an exposure and the
probability of default.
During the recent crisis, there was significant
evidence of banks’ being exposed to
substantial wrong-way risk, particularly arising from
the purchase of credit protection via
credit default swaps from monoline insurers.
In periods of stress, as correlations increase,
general wrong-way risk will present a
problem for risk models.
Regulations must ensure that
banks’ risk models properly
accounting for the possibility of increased general
wrong-way risk that may accompany a
period of stress.
Dear members,
I wish you every success for 2010.
Success defined by what you achieve in the workplace,
measured in financial terms, and of course success in
your family life.
