Basel Iii: What'S New? Business and Technological Challenges

BASEL III: WHAT’S NEW?
BUSINESS AND TECHNOLOGICAL CHALLENGES

SEPTEMBER 17, 2010
By Rustom Barua, Fabio Battaglia, Ravindran Jagannathan,

Jivantha Mendis and Mario Onorato
Basel III: What’s New?
Business and Technological Challenges
September 17, 2010
Table of Contents
1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2. Liquidity Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.1. The Regulatory Effort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2. The New Liquidity Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.3. The New Liquidity Ratios: Tasks and Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.3.1. Insufficiency of Standardized Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.3.2. Building Differentiated Incentives to Traditional Banking vs. Speculative Trading . . . . . . . . . . . . . .10
2.3.3. Accounting for Bank’s Size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11
2.3.4. Need to Raise New Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11
2.3.5. Securitization Disruption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12
2.3.6. Raising New Medium/Long-Term Finance (NSFR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13
2.3.7. Distorting Bond Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14
2.3.8. Reshaping Interbank Deposit Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14
2.4. Survival Horizon Models: Optimizing the Liquidity Buffer in a Comprehensive
Risk Management Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15
2.4.1. The Relationship between the Basel Ratios and Bank-Specific Survival Horizon Models . . . . . . . .15
2.4.2. Calculating the Amount of the Liquidity Buffer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16
2.4.3. Optimising the Liquid Asset Buffer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17
3. Proposals Regarding Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18
3.1. Capital Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18
3.2. Risk Coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19
3.2.1. Addressing General Wrong-way Risk – Stressed EEPE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19
3.2.2. Capturing CVA Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20
3.2.3. Specific Wrong-way Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21
3.2.4. Higher Risk Weights for Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21
3.2.5. Increase Margin Period of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22
3.2.6. Preclude Downgrade Triggers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22
3.2.7. Collateral Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
3.2.8. Central Counterparties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
3.2.9. Stressed PDs for Highly Leveraged Counterparties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
3.2.10. Stress Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24
3.2.11. Back Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24
3.2.12. Reduce Reliance on External Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24
3.3. Leverage Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25
3.4. Counter-Cyclical Capital Buffers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27
3.5. Systemic Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31
4. Implementation Timelines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .32
5. Business impact and challenges: exploring the interplay between Liquidity and Capital . . . . . . .32
5.1. Exploring Interconnections and Trade-Offs between Capital and Liquidity . . . . . . . . . . . . . . . . . . . .34
5.2. Misunderstanding How Liquidity Risk and Capital are Connected . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35
6. Technology Direction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36
7. Conclusion: Moving Towards a Holistic System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39
REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40
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September 17, 2010
1. Introduction
An extensive effort is underway to strengthen the financial sector and make banks and other institutions
more resilient in the face of unexpected stress.The hope is that any future crisis will not lead to governments
again being forced to spend billions of dollars of taxpayer’s money saving the banking system.
In terms of regulatory requirements, this effort has been concentrated in proposals envisaging three
areas where constraints are being substantially overhauled: regulatory capital, liquidity and leverage.
These proposals were summarized in two Consultation Papers issued by the Basel Committee on Banking
Supervision (BCBS) In December 2009:
• Strengthening the Resilience of the Banking Sector, dealing with regulatory capital and leverage.
• International Framework for Liquidity Risk Measurement, Standards and Monitoring, addressing
liquidity requirements.
The urgency of the tasks was expressed by Mario Draghi, the Chairman of the Financial Stability Board, in
his Letter to the gathering of G20 world leaders in Toronto. Published on June 27th, 2010, it read:“It will
be important that Leaders support calibration of the new capital, liquidity and leverage standards to
a level and quality that enable banks to withstand stresses of the magnitude experienced in this crisis,
without public support. The quality and amount of capital in the banking system must be significantly
higher to improve loss absorbency and resiliency.We should provide transition arrangements that enable
movement to robust new standards without putting the recovery at risk, rather than allow concerns over
the transition to weaken the standards”.
On July 26, 2010 the Bank for International Settlements (BIS) announced that the Group of Governors
and Heads of Supervision, the oversight body of the Basel Committee, had reached a broad agreement
on a capital and liquidity reform package. This resulted not only in a significant easing of the rules
compared to the first draft, but more importantly in a substantial delay in their effective implementation.
For the leverage ratio and the net stable funding ratio, which had been concerning banks most, transition
periods were established such that the new rules will not come into force until 2018. Jean-Claude Trichet,
President of the European Central Bank and Chairman of the of Governors and Heads of Supervision, made
clear that this delay is aimed at avoiding the possibility of the new constraints hitting the global economy
while a difficult recovery is in course:“ We will put in place transition arrangements that ensure the banking
sector is able to support the economic recovery”1.
The BIS communiqué stated that the Governors and Heads of Supervision had taken account of the results
of the quantitative impact study undertaken by the Basel Committee to assess the potential impact on
bank profitability and the broader economy of the new rules.The results of this study will be published by
the Committee later this year.
At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision fully endorsed the
agreements reached on 26 July 2010. These capital reforms, together with the introduction of a global
liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the
G20 Leaders summit taking place in Seoul in November.
1
Bank for International Settlements,The Group of Governors and Heads of Supervision reach broad agreement on Basel Committee capital and liquidity reform
package, Press Release, 26 July 2010.
3
September 17, 2010
The agreement was widely seen by the market as good news for banks, and bank shares worldwide spiked.
Banks will still be allowed to recapitalize through retained earnings rather than fresh capital and will push
back into the future the downwards pressure on profits that would result from the obligation to hold
greater amounts of capital, liquid assets and medium/long-term debt. However, concern was expressed by
commentators as to the effectiveness of such a long transition in view of system protection.We could also
question whether European supervisors have fully taken advantage of lessons from the crisis. The above
“win”on July 26 for banks came just days after the European Central Bank released the results of the stress
tests conducted on a significant sample of European banks.The tests showed that most of these would be
capable of withstanding a significant and protracted stress. However, the tests focused on capital levels
only and did not test banks for liquidity risk.This persistence of a “silo”approach to risk management is, in
our view, to be seen as a weakness. There is significant evidence from the crisis that interdependence
among risks cannot be dismissed and that unexpected fallouts in terms of liquidity can put financial
institutions at extreme risk.We will outline in the last part of this document that the “silo”approach should
be completely overcome in favour of an integrated view of different risk types that duly considers
interdependencies among risks.
This paper will focus on the current version of the new Basel requirements on capital, liquidity and leverage
as amended after the 26 July communiqué and ratified on September 12, 2010. It will analyse implications,
issues and interconnections between them and discuss some of new trends in best practice of banks’ risk
management and capital optimization that are likely to emerge as a result.
The enhanced set of rules has been widely referenced in the industry as “Basel III”. When the Basel II Accord
was finalized in 2004 the assumption was that the overall quality and quantity of capital was sufficient,
but the BCBS wanted to make the regulatory capital measure more risk sensitive. Current discussions on
Basel III intend to achieve better quality capital as well as increasing the amount of capital.
In this document we will first describe the liquidity risk rules and potential shortcomings in Basel III.
In section 3 we describe changes to capital requirements, with special emphasis on risk coverage, leverage
ratio and countercyclical capital buffers. In section 4 we summarize the implementation timelines as
specified in the September 12,2010 press release.Section 5 describes the potential business impact for global
banks and explores the interplay between capital and liquidity. Section 6 is our view of how enterprise
risk technology will evolve over the next few years.We conclude with section 7 on how business processes
and systems are moving towards a holistic, integrated risk management framework.
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September 17, 2010
2. Liquidity Risk
After being neglected for decades,liquidity risk has suddenly taken centre stage thanks to the financial crisis.
As a result a continuous flow of new best practice guidance and supervisory requirement documents have
emerged over the last couple of years.
Such a stringent approach to liquidity risk supervision is indeed rather new in the regulatory framework.
In both Basel I and Basel II, liquidity risk received only limited attention. The entire Basel framework only
looked at the asset side of the balance sheet. Risks arising from the liability side (including liquidity risk
alongside other risks, such as interest rate risk of the banking book), for instance, are not subject to any
regulatory capital requirement.They are instead disciplined under Pillar 2, whereby banks are required to
undertake the ICAAP (Internal Capital Adequacy Assessment), i.e. a calculation of the amount of capital
(called internal capital) they deem sufficient to support all their risks. Pillar 2 requires that the ICAAP
include liquidity risk. However, this provision has resulted in an inconsistency: after years of sterile debate
on the possible methodologies for calculating internal capital for liquidity risk, it has been generally
accepted that capital is not a suitable mitigant for liquidity risk. As a result, the current Basel II framework
does not in effect address liquidity risk.
At the root of this construction stood a very fundamental assumption, that a bank would always be
creditworthy as long as asset quality was preserved. In other words, provided the quality of assets was
good enough then a bank would always find finance at fair prices, for virtually any amounts.
This assumption proved completely wrong when the crisis erupted and entire liquidity channels suddenly
dried up, such that even institutions with high ratings and excellent asset quality found themselves trouble
as a result of liquidity mismatches. This phenomenon grew to systemic proportions since many in the
industry had been massively leveraging maturity mismatches between assets and liabilities as a key
component of an extremely profitable business model.
Liquidity risk originates from the mismatch between the timings of cash inflows and outflows. As such, it
is fundamentally inherent to the banking business. In fact, one of the key functions of the banking industry
in a modern economic system is to allow the reallocation of financial resources from the liquid sectors
(those which have excess financial resources to invest) to the illiquid ones.This entails two consequences:
1. The banking industry is necessarily exposed to a maturity mismatch. Typically, the term on
which liquid operators are ready to invest their liquidity is shorter than that on which illiquid
operators are willing to borrow. While reallocating financial resources from one sector to the
other, the banking system bears such mismatch of maturities in the form of liquidity risk.
2. The banking industry is a leveraged one. Its business is borrowing money from excess sectors
and lending it to sectors in need. Banks inherently work on others’ money. Obviously, a high
leverage boosts the impact of any liquidity problem, both on an individual and a system basis.
As a result, regulators cannot aim to remove mismatch liquidity risk from the system. One individual bank
could theoretically fund itself such that all maturity mismatches are hedged, but this is impossible at the
system level. Regulators are therefore trying to cope with the problem the other way around: forcing banks
to build liquid reserves such that, while not matching outflows in terms of maturities, they ensure that if
a stress occurs then banks can withstand cash imbalances until the situation returns to normality.
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September 17, 2010
2.1. The Regulatory Effort

In the regulator’s view the new requirements will have to be stringent: capital and liquidity resources will
be such that the financial system must have the strength to withstand a crisis of the size and persistency
of the recent one, without public support2.
Security will come at a cost.Several studies have tried to measure the cost for banks and the broader economy
of the new rules as proposed by the Basel Committee in the December 2009 formulation. We will quote
two authoritative ones:
• The Institute for International Finance3 has estimated that “the current calibration of regula-
tory reform would subtract an annual average of about 0.6 percentage points from the path
of real GDP growth over the five year period 2011-15, and an average of about 0.3 percentage
points from the growth path over the full ten year period, 2011-2020. The Euro Area would be
hit the hardest; Japan the least, with the United States somewhere in the middle” as per the
following table:
Cumulative Effects Results in Summary

difference between regulatory change and base scenario
Difference in average rates: 2011-15 2011-20

Real GDP growth difference
United States -.05 -.03
Euro Area -.09 -.05
Japan -.04 -.01
G3 (GDP-weighted) -.06 -.03
• According to a McKinsey survey on European banks4, the impact of the liquidity ratios in their
current versions is estimated as follows:
• LCR: increase in liquid asset holdings in the region of Eur. 2 trillion.
• NSFR: increase in long-term funding (>1 year) in the range of Eur. 3.5 to 5.0 trillion (this compares
to current outstanding long-term unsecured debt of Eur. 10 trillion).
• As to banks’profitability,McKinsey provides an estimate that covers both the liquidity ratios and the
proposed tougher requirements on capital.McKinsey expects that the return on equity (ROE) of the
banking sector in Europe could decline by 5% compared to its long-term average of 15%
At the end of the G20 meeting in Toronto, Jaime Caruana, General Manager of the Bank for International
Settlements, tried to reassure banks that the new rules “will not undermine economic growth”, and will
only have a “small and temporary” effect on demand5. Basel Committee representatives mentioned that
estimates such as those quoted above could be excessively pessimistic, particularly on the basis that they
do not sufficiently account for the dynamics of the financial system and the behavior of its operators.
Investors are likely to require a lower return on capital as a result of the perception of a lower risk. Also,
banks are likely to build new products designed to match the more stringent regulatory requirements in
terms of both capital and medium/long term funding, and to smoothen the impact of new regulation on
costs.The recent announcement by Unicredit, the third largest European bank by market value, of a new
hybrid product designed to match the new capital eligibility requirements is an example in this direction.
2
See Mario Draghi, Chairman of the Financial Stability Board, Letter to the G20 Meeting in Toronto, July 2010
3
Institute for International Finance, Interim Report on the Cumulative Impact on the Global Economy of Proposed Changes in the Banking Regulatory
Framework, June 2010
4
Basel III: What the draft proposals might mean for European banking, McKinsey on Corporate & Investment Banking, Summer 2010
5
The Financial Times, Move to reassure banks on tough rules, 5 July 2010
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September 17, 2010
Nevertheless, the regulatory effort is extremely delicate. The regulators are moving across unknown
ground and it is difficult to assess the potential outcome of the new constraints.The decisions stated in the
BIS 26 July statement, which defined very long transition periods for the newest and most challenging
subset of the new planned requirements (the Leverage Ratio and the Net Stable Funding Ratio), are a clear
sign of this. By delaying the new regulations until after a full economic cycle has taken place, supervisors
want to avoid them hitting economies while a difficult recovery is taking its course, while at the same time
creating the space to assess their potential impact on all the phases of the cycle.
2.2. The New Liquidity Requirements

BCBS’s proposals for enhanced liquidity requirements were presented in the consultative document:
International Framework for Liquidity Risk Measurement, Standards and Monitoring, published in December
2009, subsequently amended in the communiqué of 26 July, 2010 and finally formalized on 12 September.
The Committee proposes to introduce two new ratios (Liquidity Coverage Ratio and Net Stable Funding
Ratio) that banks must maintain as a minimum at all times to ensure they maintain sufficient liquidity to
withstand cash obligations even under stress. For the NSFR, the 26 July statement set forth an “observation
phase to address any unintended consequences across business models or funding structures”.The NSFR
will be finalized and introduced as a regulatory standard on 1 January 2018.
The ratios are as follows:
• Liquidity Coverage Ratio:focuses on the shorter end of the time horizon and is aimed at ensuring
that each bank owns liquid resources to such an amount that short-term cash obligations are
fulfilled even under a severe stress.
The ratio requires banks hold enough liquid assets to offset the sum of all cash outflows
expected over the next 30 days:
Stock of High-Quality Liquid Assets > = 100%
Net Cash Outflows over a 30-day Period
Liquid assets are considered in terms of market value,to which standardized haircuts are applied depending
on type of asset and grade of liquidity. Net cash outflows are calculated by aggregating the bank’s assets
and liabilities under standardized categories and applying to each of them standardized coefficients
reflecting predefined stress assumptions.For example,a 75% factor applied to unsecured wholesale funding
in the denominator of the ratio entails an assumption that 75% of the currently outstanding amount will
run off within the next 30 days.
• Net Stable Funding Ratio: looks at a medium-term horizon and focuses on the structural
balance between maturities of a bank’s assets and liabilities. It is aimed at preventing banks
from exposing themselves to extreme maturity transformation risks by funding medium and
long-term assets with very short-term liabilities. It was this practice that generated a massive
risk in 2007, which turned into a systemic liquidity shortage when major short-term liquidity
channels (especially those linked to securitized products) suddenly dried up.
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September 17, 2010
The NSFR requires banks to have enough funding to last at least one year to compensate for
all cash needs expected to occur beyond the same deadline:
Available Amount of Stable Funding >= 100%
Required Amount of Stable Funding
Available Amount of Stable Funding is made up by cash, equity and liabilities which are
expected to remain with the bank for at least one year, either because they have a longer
contractual maturity,or because they can be considered “sticky”even if their contractual maturity
falls within that year (as is the case, for instance, for a share of retail deposits). Required Amount
of Stable Funding is the amount of assets that are not expected to be reimbursed for at least
one year (and therefore need to be funded for at least this period) and cash outflows expected
to occur beyond one year as a result of contingent liabilities.
As well the LCR, the NSFR is calculated by aggregating a bank’s assets and liabilities (including contingent
liabilities) into standardized categories and applying a set of coefficients reflecting standard scenario
assumptions regarding, for instance, the “stickiness” of the bank’s deposit base.
No favourable treatment is envisaged for the following instruments, for which banks must therefore have
100% Stable Funding:
- Securitizable assets.
- Assets from securitizations (unless for covered bonds).
- Securities issued by banks or other financial institutions.
- Any security with rating lower than A-.
• Monitoring tools: in addition to the ratios, the Committee has listed a set of monitoring metrics
that should be considered as the minimum types of information supervisors should use in their
monitoring activity.These include:
- Contractual maturity mismatch.
- Concentration of funding.
- Available unencumbered assets.
- Market-related monitoring tools: asset prices and liquidity, CDS spreads, equity prices, etc.
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September 17, 2010
2.3. The New Liquidity Ratios: Tasks and Issues

2.3. 1. Insufficiency of Standardized Figures
The Basel proposals entail all banks maintaining the liquid asset buffer such that the Liquidity Coverage
Ratio is above 100% at all times. However, the Basel Committee has made clear that the ratio requirements
must be seen in conjunction with the principles for liquidity risk management best practice set forth in the
2008 document,6 and should by no means override these.
In other words, compliance with the ratios should be seen as a minimum requirement and should not be
taken in itself as a sufficient indicator of soundness or stability.
In fact,exclusively looking at the two ratios could leave critical weaknesses and exposures completely hidden:
- The ratios only look at liquidity gaps in defined time horizons. No information is provided about
liquidity exposures in other periods (from 30 days to one year and from one year onwards).
A bank could have very substantial liquidity exposures, for instance on month two, and be
perfectly compliant with the LCR.
- The ratios are calculated with pre-defined standard aggregations and stress assumptions
(a one-size-fits-all approach).The significance of standardized aggregations and stress assump-
tions can differ substantially across banks with different sizes and business models, those
operating in different countries, etc. For instance, a standardized assumption on the runoff of
deposits in case of stress can be too loose in one situation and unnecessarily strict in another.
- The observation periods are standardized irrespective of individual banks’ business models.
For instance, if a bank is heavily involved in correspondent banking, clearing and settlement
activities, then 30 days could be a very long-term horizon, as opposed to a bank heavily focused
on the retail deposit base, where 30 days would be considered a short-term observation period.
It is imperative that on top of complying with the regulatory ratios, each bank defines its own risk appetite
and runs internal stress tests for liquidity exposures that reflect its individual business model and vulner-
abilities. Each bank should then define the required amount of the liquid asset buffer on this basis, i.e.
independently of the regulatory requirements. In this context the Basel ratio should be seen as an external
minimum constraint,but the possibility that the optimal buffer is higher than that required by the regulatory
ratios should not be ruled out. We will get back to this topic later in this document.
6
Basel Committee for Banking Supervision, Principles for sound liquidity risk management and supervision, September 2008
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September 17, 2010
2.3. 2. Building Differentiated Incentives to Traditional Banking

vs. Speculative Trading
It is critical that the final calibration of requirements generates a grid of balanced incentives for different
kinds of banking activities. Retail and corporate deposit taking and lending should be granted a favourable
treatment as opposed to more speculative activities. A fundamental rationale for this is that a favourable
treatment should be reserved for those parts of banking that respond to a public interest at the broader
economy level. Liquidity mismatch risk should be more politically and socially acceptable to the extent
that it responds to the crucial role of the banking industry of efficiently reallocating financial resources
across lending and borrowing sectors of the economy.
From a more technical perspective, customer deposits deserve a favourable treatment as they are the
most stable funding source for a bank. During the crisis, banks with a large deposit base performed better
than others.This is also consistent with the outcome of an Oliver Wyman survey:“Banks which had a solid
funding base (defined as the ratio between customer deposits, long-term debt and equity capital over
liabilities) have performed significantly better on average compared to banks relying on shorter-term
funding options. In this sample of selected global banks in developed markets, 80% of banks that had a
‘solid funding ratio’before the crisis that was above 0.65 outperformed the industry average after the crisis,
where as all banks below 0.65 underperformed significantly”7 as also shown by the following chart:
Solid funding ratio Before-Crisis contributes to shareholder value

creation After-Crisis Selected global banks in developed markets
After-Crisis SPI (Aug ‘07-Dec ‘08)
400
200 Industry average

0
-200
-400
-600
-800
-1000
0.65
-1200
0.25 0.50 0.75 1.00
Average Solid Funding Ratio Before-Crisis (Jan ‘04-July ‘07)
Source: Bloomberg, Datastream and Olive Wyman analysis
7
State of the Financial Services Industry Report, Oliver Wyman 2009
10
September 17, 2010
The task of providing differentiated incentives for “traditional” banking as opposed to more speculative
financial activity is apparent in how the Committee has addressed the new requirements for capital and
leverage. Here, more speculative instruments such as derivatives (especially if traded over-the-counter)
are subject to much higher capital requirements. Also, in the current formulation of the leverage ratio a
variety of derivatives are fully considered as assets to be accounted for against capital, and netting of
derivatives is in principle forbidden.
When we come to the liquidity ratios, however, such differentiation of incentives is less clear. Indeed,
the BIS has shown it will to move in this direction in the 26 July document by defining a more favourable
treatment of deposits from retail and small to medium-size enterprises both in the LCR and the NSFR, and
of mortgages in the NSFR. Nevertheless, we believe the incentive to “traditional”lending could be further
enhanced. For instance, loans with maturity below one year severely impact the required amount of
medium/long-term funding, as it is assumed that banks will be forced to roll over beyond the one-year
horizon 85% of such loans if granted to retail clients, and 50% if granted to non-financial corporations.
In our view, this penalizing assumption could be smoothed.
Also, conditions could be defined under which a more favourable treatment in the NSFR is allowed
for medium/long-term maturity assets that are bound to be securitized in the short run. We will address
securitizations in a dedicated section later in this document.
2.3.3. Accounting for Bank’s Size

In their current formulation,the Basel ratios are uniform irrespective of the size of the banks to which they apply.
Even if two banks show equal ratios,the potential systemic impact of a liquidity issue can be totally different
depending on the absolute amounts of their exposures. In this view, a uniform measure can prove unnec-
essarily strict for smaller banks, while not providing the desired degree of protection against systemic
effects for larger banks.
We would therefore find it suitable that the individual bank’s size be taken into account in the definition
of the standard requirement.
2.3.4. Need to Raise New Capital

One of the main issues with the new regulatory requirements is that banks may prove unable to raise capital
or medium/long-term funding in the amounts required.
It should be noted that there is a clear interdependence between capital and liquidity requirements. In fact:
• In the NSFR, capital is directly and fully eligible as a “stable” funding source in support of
medium/long term liquidity needs.
• In the LCR, capital is only indirectly considered as an eligible source of liquidity for the calculation
of the ratio: it is taken into account only to the extent it is invested into eligible liquid assets.
Indeed, the Committee’s idea is clearly for banks first to raise the amounts of new capital as required, and
then invest it to build the liquid asset buffer.
However, the implication of this is that investors would be asked for new capital under the certainty that
it will be invested into low-yield instruments. Investors might be ready to accept a lower return on their
capital in view of lower risk, but this will need to be tested.
11
September 17, 2010
If banks are not able to raise new capital in the amounts required then the only alternative would be to
reduce assets.This could hit the broader economy by capping the amount of credit available to it.
This undesired impact would be exacerbated in the context of a constrained leverage ratio, whereby liquid
assets are fully considered in the calculation of total assets to be put against capital as per the current
proposal from the Basel Committee. Indeed, this provision does not appear to be fully justified in theory
and could in our view be lifted.This would allow banks using borrowed resources to fund the liquid asset
buffer, and would therefore grant them a greater degree of freedom in making strategic decisions about
the amount of credit available for clients.
2.3.5. Securitization Disruption

In its current formulation, the NSFR has the potential to disrupt the market for asset securitizations. Indeed,
the core attractiveness of securitization is its capacity to transform assets that are illiquid in nature into
liquid instruments that can be managed and traded on a short-term basis. In addition, securitizations can
effectively provide reserve liquidity to the extent that asset-backed securities (ABS) are eligible as collateral
for repos with the relevant central bank (as is currently the case under certain conditions with the
European Central Bank).This characteristic is denied by the NSFR from two perspectives:
- Perspective of a bank willing to invest in asset-backed securities: ABS are not eligible as
liquid assets to any extent. All holdings of ABS with a maturity exceeding one year are 100%
accounted for in the determination of required stable funding and must be matched with
medium/long-term funding.
- Perspective of a bank willing to grant medium/long-term credit to its customers in the form of
mortgages,credit card loans,personal loans etc: the NSFR states that loans with maturity exceeding
one year must be funded with medium/long-term finance up to percentages that depend on
the loan credit quality and are completely independent of the possibility of being securitized.
As a result, lending banks cannot draw any benefits in terms of treasury from securitizations.
The misuse of ABS was indeed a main instigating factor for the crisis in 2007. However, the case for
securitization is still valid, and it is important to avoid throwing out the baby with the bathwater.The NSFR
approach appears unnecessarily strict. ABS misuse should be addressed by specific regulation.The NSFR
should instead recognize the case for securitization and allow banks to manage liquidity exposures
accordingly. Examples of possible approaches are as follows:
- Investor’s perspective: grant a more favorable treatment to ABS by applying coefficients that
do not imply full medium/long-term funding.
- Lender’s perspective: allow banks with an established and demonstrable record of asset
securitization to segregate certain loans that have been issued in view of being securitized
over a specified time horizon and fund them over that specified time horizon; allow ABS that are
eligible for central bank repo to be accounted for as liquid assets.
12
September 17, 2010
2.3.6. Raising New Medium/Long-Term Finance (NSFR)

Even after considering new liquid resources incoming from capital increases, banks would probably still
need to raise new medium/long-term funding in quite substantial amounts to comply with the NSFR.
It should be noted that the NSFR provides a clear counter-incentive for banks to invest in securities issued
by other banks as these, no matter how actively traded, cannot be considered as liquid assets and cannot
count 100% as required stable funding.Therefore, banks should seek new debt from non-financial sectors.
It might not be obvious that non-financial investors are ready to provide medium/long-term finance in
the amounts required. And even if they were then the question could be asked, at what prices. Again, what
is at stake here is the impact on the broader economy.To the extent that banks succeed in raising debt in
the required amount, they would probably try to pass additional funding costs on to customers such that
the cost of credit would increase. To the extent that sufficient debt is not available, the only option for
banks would be to reduce the amount of medium/long-term credit available.
Indeed, concerns about the possible impacts of NSFR on banks and the economy are the core reason for
delaying the introduction of the NSFR as a requirement until 2018. We believe the NSFR addresses a real
need in the banking industry because it sets a limit on the ability to create maturity mismatches in the
short run, which is important from a systemic perspective9. It should also be noted that the NSFR does not
prevent banks from assuming maturity mismatches, as they could still fund 30-year loans with 12-month-
plus-one-day funding. What the NSFR is addressing is the building of massive maturity mismatches over
the short run, such that not enough time would be left to find viable solutions in case of generalized and
persistent stress.
At the same time, we would favor smoothing the calculation of the ratio in a number of ways. For instance,
the observation period could be shortened to 6 months. While substantially reducing the impact on
borrowing costs for banks,such a time horizon would probably still provide a sufficient timeframe for finding
solutions in case of systemic and persistent stress. At the same time, it would generate a strong incentive
to increase the average maturity of interbank deposits, which is currently unnaturally and undesirably
stuck to the shortest end of the maturity ladder.
Also, a looser approach to ABS and securitizations as suggested in Paragraph 3.2.5 above would help in
this respect.
9
This type of requirement is not new in liquidity risk supervision.The Bank of Italy required for some years local banks to comply with the so-called “Maturity
Transformation Rule”, that implied a limitation on the possibility to get exposed to maturity mismatches.This rule was lifted some years ago, well before the
start of the crisis.
13
September 17, 2010
2.3.7. Distorting Bond Markets

The LCR is likely to generate a huge shift in demand towards assets eligible for inclusion in the liquid asset
buffer – in essence, G8 liquid government bonds. This would act as a de facto constraint for banks that
finance government deficits. Given the current imbalanced situation of public finances worldwide, this
might be a desirable effect that would help preserve financial stability at the global level. But at the same
time this would have undesirable consequences:
• Bond markets would be distorted: liquidity and prices of liquid assets would be artificially
increased and their yield depressed, while the market for instruments not eligible for the buffer
would be negatively impacted, with reduced liquidity, higher yields and lower prices.
• The above would negatively impact the ability of non-banking industries to raise funds through
bond markets.
• Market prices would no longer be indicative of the market’s risk appetite and required
risk/reward profiles. This would apply to both instruments eligible and non-eligible as liquid
assets, for the reasons explained above.
The BIS 26 July statement has broadened the acceptable criteria for security that are eligible as liquid
assets.The potential for the above impacts is therefore reduced, although not in any way removed. It will
be important that distortions are closely monitored and assessed, such that further calibration can be
done to minimize such effects.
2.3.8. Reshaping Interbank Deposit Markets

A clear task of the Basel Committee is to reduce individual bank’s dependence on interbank funding.
The ratios have been built on the assumption that from a system point of view, interbank financing is only
apparent and does not provide any safety if there is a systemic funding liquidity issue.
As a result, neither in the LCR nor in the NSFR is interbank funding granted any favorable treatment as an
eligible source of liquidity in relation to potential cash obligations. Both ratios are calculated upon the
stress assumption that no maturing interbank liabilities will be rolled over and no new interbank funding
will be available.
In addition, if a bank holds securities issued by banks or other financial institutions, no matter how liquid,
in NSFR these have a 100% weighting in the calculation of Required Stable Funding. As a result, they
cannot be treated as liquid assets and are fully considered in determining the minimum required amount
for medium/long term funding.
Therefore, banks will be allowed to rely on outstanding interbank funding only to the extent they have
a contractually formalized right to avoid repayment for more than 30 days (LCR) or for more than one
year (NSFR).
While in agreement with this approach, we nevertheless believe that the requirement might be smoothed
in view of encouraging a reshaping of the interbank deposit market towards a more desirable concentration
of trades on longer maturities,such as six months and above,compared to the current one month and below.
14
September 17, 2010
2.4. Survival Horizon Models: Optimizing the Liquidity Buffer in

a Comprehensive Risk Management Framework
Despite ‘survival horizon’, or ‘survival period’, models not being expressly included by the Basel Committee
in its list of mandatory metrics banks are required to use in liquidity risk assessment, they are gaining space
among supervisors for their ability to provide a synthetic indicator of a bank’s resilience against liquidity
stresses. The LCR is in fact based on a survival horizon model with a 30-day observation period and
standardized stress assumptions. Australia’s regulator, APRA, in 2009 released a consultation paper where it
envisaged a new regulatory regime for liquidity risk, including an obligation for banks to provide survival
horizon analysis10. The UK’s regulator, the FSA, while not expressly imposing SH-modeled reporting, did
disclose during public hearings that it will use banks’reported figures to feed SH models in order to assess
their resilience against stress.
Survival horizon models are based on a comparison of ‘forward liquidity exposure’, i.e. the sum of expected
cash flows over a defined period, to the amount of cash that the bank can expect to raise by selling or
pledging its liquefiable assets over the same period.Both terms of the comparison are made subject to stress
assumptions of defined severity.The survival horizon is the period over which the existing liquid or liquefiable
resources are sufficient to support all expected cash outflows under the defined stress assumptions.
Survival horizon models are effective in delivering a synthetic indicator of a bank’s resistance to stress,
after integrating the potential impact of different kinds of liquidity risk (e.g. market and funding liquidity
risk) and a variety of scenario assumptions. As such, they lend themselves to providing a single measure
that can be used as a reference for the definition of the bank’s risk tolerance.
2.4.1. The Relationship between the Basel Ratios and Bank –

Specific Survival Horizon Models
The new liquidity ratios will have a key role in defining banks’ strategies:
- The Liquidity Coverage Ratio will determine the minimum amount of liquid assets given
expected cash flows over the short run (unless the results of bank-specific stress tests mandate
holding greater amounts of liquid assets).
- The Net Stable Funding Ratio will determine the minimum amount of medium/long term funding
given capital, medium/long lending business and contingent liabilities.
The need to hold substantially greater amounts of liquid assets will oblige banks to switch part of their
investments from more profitable assets to high-quality, typically low-yield instruments. This trade-off
might be further emphasized by the envisaged leverage ratio: in the current proposal, liquid asset holdings
are fully taken into account in the calculation of the leverage ratio – although the Basel Committee has
stated it might consider, after proper impact assessment, excluding certain categories of liquid assets from
the calculation of the leverage ratio.
However, Basel Committee documents make it clear that the regulatory ratios should not be seen as
absolute. Individual requirements for liquid asset holdings must be defined after the results of individual
stress tests, and the regulatory ratios should rather be seen as a regulatory minimum.
10
APRA’s prudential approach to ADI liquidity risk, Discussion Paper, 11 September 2009
15
September 17, 2010
Therefore, the required amount of liquid assets should be defined as the maximum of the results of the
regulatory ratios and the amount resulting from individual stress testing.
Bank-specific stress tests should be based on assumptions designed to match the bank’s specific context,
business model and vulnerabilities.As such,stress tests should tend to stress business strategies and business
models rather than external risk factors.We would mention reverse stress testing as a particularly suitable
technique for this task.
2.4.2. Calculating the Amount of the Liquidity Buffer

The Basel Committee has outlined that banks’ stress tests must not be seen as an isolated exercise but
rather be seamlessly inserted into their organizational processes and provide inputs for decision-making
and action.
The required liquid asset buffer should be defined as the minimum amount that ensures the bank’s ability
to fulfil expected cash obligations. It therefore has critical implications in terms of allocation of resources
and risk-taking strategy. As a result, its calculation should be performed within the framework of a process
that has its core in the bank’s Risk Tolerance Policy and includes procedures for monitoring, reporting
and decision-making. In our view, such a process would be most effectively supported by a stress-based
survival horizon model.
At a high level, the main steps of the process can be schematized as follows:
i) The bank’s board formally defines the bank’s liquidity risk tolerance, i.e. the maximum amount
of risk it is willing to bear in its activity. This maximum risk should be defined under a stress
scenario and expressed in terms of indicators that can be continuously monitored, controlled
and reported. A ‘risk tolerance policy’ document should include, among other things, the
following key elements:
• A synthetic indicator of the bank’s risk appetite, that the bank will continuously
monitor and control; and
• The level of severity of the stress assumptions, as well as the type(s) of scenario (i.e.
idiosyncratic,market-wide,combined) to be used in monitoring the bank’s compliance
with the defined risk threshold.
In our view, a survival horizon model is a particularly suitable framework for defining the
synthetic indicator of liquidity risk appetite. As an example, the liquidity risk appetite could
be synthetically expressed as the capability to survive for two weeks under a high-severity
stress scenario and for three months under a mild-severity stress scenario.
ii) Based upon indicators from the risk tolerance policy, the bank defines in detail the stress
scenario assumptions that it will periodically test for its survivability capacity.
iii) The bank calculates its survival horizon under the defined stress assumptions. The required
amount of liquid assets is the one that ensures matching the minimum survival period as
defined in the risk tolerance policy.
iv) The bank compares the minimum liquid asset buffer resulting from the above process to
the regulatory amount based on the Basel ratio. The greatest of the two is the required
liquid asset buffer.
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September 17, 2010
The above schematic only refers to a fraction of the overall process.Indeed,both the Basel Committee and the
Committee of European Banking Supervisors (CEBS) guidance documents make clear that internal processes
need to ensure full consistency and integration of risk tolerance definition, stress testing, risk monitoring
and control, and decision making to prevent risk from climbing above the defined risk appetite thresholds.
The following summary figure provides a schematic:
Risk Tolerance Policy Stress Test
Liquid Asset Buffer Survival Horizon
Early Warnings Limits Contingency Funding Plans
2.4.3. Optimising the Liquid Asset Buffer

The liquid asset buffer is typically composed of high-quality, low-yield instruments. Banks will therefore
need to optimize the amount of liquid assets by actively managing the portfolio so that it is kept as close
to the minimum required amount as possible.
In this perspective, the following implications of optimizing the liquid asset buffer should be considered:
- The CEBS clarifies in its guidance document11 that the global amount of the liquid asset buffer
should be entirely driven by the longer end of the stress scenario horizon.However,results on the
shorter end should be relevant for defining the composition of the buffer, as only instruments
that can be very quickly liquefied should be held as a shield against short-term, unpredicted
severe scenarios.
- Actively managing the liquid asset portfolio implies that information relevant for measuring
the required minimum buffer is available as frequently as possible. In other words, the bank
should be able to obtain up-to-date reports by re-running cash flow projections and liquid
asset price simulations under the defined stress assumptions with a high frequency in order to
have the possibility of adjusting downwards the required amount of the buffer.
- Also, frequently updating projections and stressed simulations should be seen as a prerequisite
to keeping the portfolio at a level which is very close to the required minimum. High frequency
updates of current and simulated data would in fact ensure that the bank is prompt in catching
early-warning signals that would trigger an increase of the buffer amount. If simulated data are
to remain static for long intervals due to an inability to update the stressed simulations, the
buffer should be prudentially maintained above the minimum.
- The stress assumptions used to build the model underlying the required buffer amount should
also be reviewed on a regular basis.
- Cash flow projections should be available over the time periods and with the time bucket
granularity required by the model chosen for defining the risk tolerance. Only looking at
cumulative cash inflows and outflows over a defined time period will not ensure protection
against possible stress, as cash outflow needs to be fulfilled whenever it occurs, such that the
adequacy of the buffer must be assessed for each day in the observation period.
11
Committee of European Banking Supervisors, Guidelines on Liquidity Buffers & Survival Periods, 9 December 2009
17
September 17, 2010
Example: Assume a bank’s risk tolerance policy sets the survival horizon at one month.To assess
whether the liquid asset buffer is sufficient for this task, the bank compares the current buffer
to the net of cumulative cash inflows and outflows over 30 days under the internally defined
stress assumptions. Assume however that a big cash outflow is expected on day five, and an
equally big cash inflow is expected on day 29. In the cumulative 30-day cash flow projection
the two flows will offset each other so that the spike in cash needs on day five will remain hidden.
As a result, the buffer may prove insufficient to cover the cash requirement on days five to 29.
3. Proposals Regarding Capital

Basel II regulations that were finalized in 2004 were based on two key assumptions: the overall level of
capital in the system is sufficient, but there is a need to increase the risk sensitivity within the framework
to promote better risk management and to reduce regulatory arbitrage. Therefore the focus of Basel II,
Pillar 1 was in the definition of risk-weighted assets. Regulators did recognize the need to refine the
definition of the capital components, but agreed to revisit the issue after ratification of Basel II.The financial
crisis expedited the need for re-definition of capital since items that were considered Tier 1 capital could
not absorb losses as a going concern.The predominant form of Tier 1 capital must now be common shares
and retained earnings, and the remaining part must be comprised of instruments that are subordinated,
have fully discretionary non-cumulative dividends or coupons, and have neither a maturity nor an incentive
to redeem. Also, the risk sensitivity assumptions underlying various transaction types, especially
securitizations and derivatives, was found to be insufficient during the financial crisis. With the
December 2009 paper on Strengthening the Resilience of the Banking System, the Basel Committee
showed that it intends to increase the quality, quantity and international consistency of the capital base,
while also increasing capital requirements for certain types of transactions and obligors. In addition,
regulators are also introducing a non-risk based leverage ratio to reduce build up of leverage in the overall
system.BCBS is also introducing rules to reduce pro-cyclicality inherent in the Basel II framework.This section
summarizes the salient features in the December 2009 proposals as well as subsequent communiqués
related to capital base, risk coverage, leverage ratio, countercyclical buffers and systemic risk, and highlights
some of the potential inconsistencies and perverse incentives inherent in the rules as currently proposed.
3.1. Capital Base

The proposal addresses the shortcomings in the current capital framework in terms of the quality of the
capital, application of regulatory adjustments and the lack of international harmonisation in the way the
regulatory adjustments are calculated.The main drawback in the current framework is that the regulatory
adjustments are applied either to a combination of Tier 1 and Tier 2 capital or only to Tier 1 capital, as
opposed to the common equity component, which provides the real loss absorbing capacity as a going
concern. Under the current proposals, Tier 1 capital is defined as items that can absorb losses under a
going concern assumption,and Tier 2 is defined as capital that can be used to offset losses as a gone concern.
Tier 3 capital, which was allowed to offset market risk under Basel II, will be completely eliminated.
The qualifying criteria for the classification of the capital instruments into common equity,Tier 1 and Tier 2
capital have all been made more stringent. When the draft proposal was introduced in December 2009,
the Basel Committee had introduced stringent measures on eligibility of minority interest for inclusion in
the common equity component of Tier 1 and deduction of deferred tax assets from Tier 1. In the July 2010
communiqué, which outlines the broad agreement reached between the Board of Governors of the Basel
Committee, some of the earlier proposals have been softened. For example, the prudent recognition of
minority interest for a banking subsidiary is now allowed.
18
September 17, 2010
With a view to improving the transparency of the capital base, financial institutions would be required to
disclose all components of the capital along with the regulatory adjustments. In addition, banks are
required to provide a reconciliation of the regulatory capital elements back to the audited financial statements.
A stricter definition of capital will make it more expensive as well as be a binding constraint in business
decision making.
3.2. Risk Coverage

In addition to tightening the definition of capital, the new rules also propose to increase capital require-
ments for certain types of transactions and obligors.There are multiple areas in which the regulators want
to increase capital requirements. A major thrust of the proposed Basel III rules focus on counterparty
credit risk (CCR) arising from bank’s derivative, repo and securities financing transactions (SFT) operations.
The limitations of the current practices were highlighted during the financial crisis, especially by the
Lehman collapse. BCBS has focused heavily on this section, with detailed guidance on addressing general
and specific wrong-way risks,accounting for CVA losses with capital,requiring higher risk weights for financial
counterparties, providing incentives for banks to move trades to central counterparties, strengthening
the collateral management function, increasing margin periods of risk, as well as stress testing and back
testing requirements.
3.2.1. Addressing General Wrong-way Risk – Stressed EEPE

General wrong-way risk occurs when the creditworthiness of the counterparties are positively correlated
with general market risk factors. During the financial crisis it was observed that the exposures to counter-
parties increased precisely when their creditworthiness deteriorated.
To address this issue, BCBS requires banks calculate CCR using stressed parameters. Effective expected
positive exposures (EEPE) is calculated by first calculating exposures under multiple (Monte Carlo)
scenarios and time paths, and then calculating the average exposure taking into account roll-off effects.
Under the current proposals, EEPE needs to be calculated using a three-year period that includes a one-year
stress period. Stressed EEPE needs to be used in regulatory capital calculations in case it exceeds the EEPE
calculated using current period market data.This requires the bank calculate two EEPEs and compare the
results on a periodic basis. Flexibility and performance of existing risk systems is critical to achieving this
requirement without major system re-engineering.
The alpha add-on factor under Basel II already captures the general wrong-way risk. Therefore, using
stressed EEPE will double-count general wrong-way risk, which can have a substantial effect in a trading
book that’s already encumbered with additional market risk and incremental risk charge (IRC) capital
requirements. BCBS studies have shown that own estimates of alpha (ratio of bank internal estimate of
economic capital based on stochastic exposures to economic capital based on EPE) are subject to
significant variations across banks due to mis-specifications of the models, particularly for exposures with
non-linear risk profiles.The committee intends to strengthen the requirements for own estimates of alpha
to address this issue.There is industry demand to allow alpha based on counterparty, industry or product
characteristics and not a single alpha across all counterparties.For banks that can implement such a system,
alpha will provide a more useful measure of general wrong-way risk than the proposed stressed EPE.
After the quantitative impact study, if it appears that more capital is required to support counterparty
trading activity then it is more desirable to apply a transparent scalar to increase capital to the desired
level, instead of double counting through alpha and stressed EPE.
19
September 17, 2010
3.2.2. Capturing CVA Losses

During the financial crisis capital charge for mark-to-market losses was greater than the losses due to
defaults. Since global banks have diverging practices for CVA calculations, BCBS is introducing a simplified
“bond equivalent of the counterparty exposure” approach to calculating CVA risk. This entails modelling
all of the counterparty’s exposures as a zero coupon bond with a notional amount equal to EEPE and
a maturity equal to effective maturity (M) of the exposure profile. CVA risk is defined as the regulatory
market risk charge for this stylized position calculated using a 1-year horizon instead of the 10-day market
risk horizon, excluding the incremental risk charge.
There is a double counting issue here as well.The existing maturity adjustment in the risk-weighted assets
(RWA) formulas already account for migration risk with an analytical approximation.This maturity adjustment
should be removed if the CVA charge is included in capital to avoid double counting.
The bond equivalent approach is introduced to achieve methodological consistency across banks as well
as to provide a simple, intuitive approach the Committee assumes will reduce the system and method-
ological burden for banks. However, banks that already calculate EPE have the full distribution of potential
future exposure (PFE) profiles at their disposal since EPE is essentially a function of the PFE distribution.
Therefore, it is an extra burden for banks that already calculate EPE using a simulation approach.
Furthermore, the “simple” bond equivalent approach can in fact end up causing perverse incentives.
Depending on the shape of the PFE profile using only EPE and M to represent the full profile can result
in over- or under-estimation of the sensitivities and the required hedges. For example, in the case of a
downward sloping exposure profile, EPE will be close to the time zero exposure (which is the maximum
exposure when the exposure is decreasing over time). In a downward sloping profile, the bank will need
larger short-term hedges and smaller longer term hedges to effectively hedge counterparty risk that is
decreasing over time. However, the bond equivalent approach, which assumes a single maturity date (set
to effective maturity) and a constant exposure, will require a hedge that is equal to EEPE for duration equal
to effective maturity.This will result in an inconsistency between the hedges required for the actual exposure
versus the hedge required to minimize regulatory capital. Therefore, the bond equivalent approach is a
poor approximation to CVA risk and does not properly capture hedge effectiveness. From a sensitivity
and stress testing perspective, using the bond equivalent approach to model CVA risk will result in larger
sensitivities for maturities less than M, and no sensitivity for maturities longer than M. Given that full PFE
profile and hedge information is already available as inputs to the EPE calculation, it would be much more
productive to allow banks to use internal models for capturing CVA leveraging full PFE profile.
Furthermore, if the bond equivalent approach is ratified, banks will have to calculate CVA twice – once for
internal purposes and then for regulatory purposes.This will overly burden banks to maintain two systems
in addition to being contrary to the spirit of “use tests”.
The bond equivalent method, however, does provide an opportunity for banks that do not have a CVA
system to calculate CVA in a simplified manner. It is desirable to provide incentives for banks to develop
fully-fledged CVA systems and use it for regulatory capital purposes.This will be consistent with the current
Basel principles of mandating a simplified approach while providing banks with the incentive to move to
internal models subject to supervisory review.
20
September 17, 2010
BCBS has realized some of the shortcomings of the bond equivalent approach and is addressing some of
the issues.The July 2010 communiqué was encouraging as it will allow the bond equivalent approach to
address hedging, risk capture, effective maturity and double counting, although it is lacking in detail.
It is encouraging that BCBS has mentioned addressing double counting, as we encounter that in many
places in the document and this needs to be revised to ensure the rules are internally consistent. BCBS
has indicated that it will undertake a more fundamental review of the trading book and look at more
advanced alternatives to the bond equivalent approach.We hope this will lead to full approval of internal
CVA methodology and systems.
3.2.3. Specific Wrong-way Risks

Counterparty risk management standards are being raised where there is specific wrong way risk i.e. where
counterparty exposures increase when the credit quality of the counterparty deteriorates. Banks are now
required to perform stress testing and scenario analyses to identify risk factors that are positively correlated
with counterparty credit worthiness, and these scenarios should address the possibility of severe shocks
occurring when relationships between risk factors change.
Banks should manage wrong-way risk by product, region and industry or by other relevant categories.
Transactions where specific wrong way risk (future exposure to a specific counterparty is highly correlated
with the counterparty’s creditworthiness) has been identified will require significantly higher exposure
measures, which in turn results in higher capital charges:
• For single name credit default swaps (CDS) with specific wrong way risk (where the single name
and issuer have a legal connection) exposure at default (EAD) = Notional Amount.
• For equity derivatives referencing a single company (with specific wrong-way risk): EAD = value
of the derivative under assumption of default of the underlying.
This is in contrast to the Basel II treatment of calculating EAD under the ‘current exposure method’ for
credit derivatives and equity derivatives as mark-to-market plus an add-on. Add-on factors for credit deriv-
atives are 5% for a qualifying reference obligation and 10% for non-qualifying. The new treatment can
increase EAD and capital easily by 10 times or more for derivatives where specific wrong-way risk exists
under the current exposure method.The impact under the internal model method (IMM) can be possibly
higher. This provides a strong disincentive to trade such contracts outside of central counterparties.
3.2.4. Higher Risk Weights for Financial Institutions

Empirical studies by the Basel Committee have indicated that asset value correlations for financial firms
are, in relative terms, 25% or higher than those of non-financial firms. A multiplicative factor of 1.25 (to be
calibrated after a quantitative impact study) is to be applied on the formula used to compute the corre-
lation for exposures to financial intermediaries that are regulated banks, broker/dealers and insurance
companies with assets of over $100 billion as well as other (unregulated) financial intermediaries, such as
hedge funds/financial guarantors.
This clause can increase capital to low probability of default (PD), high asset value correlation (AVC) financial
institutions (typical profile being large inter-connected financial institution) by approximately 35% due
to the non-linear relationship between capital and AVC.
21
September 17, 2010
In the Basel II internal ratings-based (IRB) formulas,AVC is used to capture the default risk part of capital, and
the ‘maturity adjustment’ captures the migration risk. The justification given by BCBS is that “...financial
institutions credit quality deteriorated in a highly correlated manner...”. If the intention is to capture
migration risk, it is best captured either by a modified maturity adjustment or through the CVA.To increase
the correlation value increases the default losses and not the migration losses.This is another instance of
potential inconsistency in the proposals.
3.2.5. Increase Margin Period of Risk

The financial crisis has shown that the mandated margin periods of risk for regulatory capital calculations
under-estimated the realized risk during the financial crisis. For transactions subject to daily re-margining
and mark-to-market valuation, the supervisory floor is set at five business days for netting sets consisting
only of repo-style transactions, and 10 business days for all other netting sets for calculating EAD with
margin agreements. A higher supervisory floor applies to all netting sets where the number of trades
exceeds 5,000, and for netting sets that contain one or more trades involving collateral that is illiquid, or
an OTC derivative that cannot easily be replaced. If a netting set has experienced more than two margin
call disputes over the previous two quarters then the margin period should be twice the supervisory floor
for that netting set. Proposed rules will substantially reduce the effect of netting and collateral on exposure
and capital for repo,SFT and OTC derivatives,further providing incentives to move to central counterparties.
While all these rules are in the right direction and provide for a conservative approach, some of the
thresholds are arbitrary. For example, the 5000 limit for netting sets is better considered guidance,
and adjusted based on the capabilities of the collateral management system and the liquidity of the
instruments in the netting set.
3.2.6. Preclude Downgrade Triggers

Downgrade triggers are a popular credit mitigation technique banks use to cut off further lending to
counterparties when their ratings fall below a threshold unless they post extra collateral. During the
financial crisis, however, some fallen angels downgraded so fast that the banks were not able to impose
downgrade triggers, and these clauses did not provide the expected credit mitigation. Therefore, the
new proposals require that banks using internal models do not take into account clauses in the collateral
agreement that require receipt of collateral when credit quality deteriorates.This is a conservative practice
in line with the spirit of the new proposals, since the likelihood of counterparties posting collateral
decreases when their rating goes down, especially during a crisis when the downgrade happens rapidly.
However, banks are required to take into account downgrade triggers imposed on them by their lenders.
Going by the same logic, the bank will not be able to post collateral in a timely manner if its credit quality
deteriorates rapidly. In order to make the rules symmetrical and internally consistent, it would make sense
not to model own bank downgrade triggers as well.
22
September 17, 2010
3.2.7. Collateral Management

BCBS intends to strengthen the standards for collateral management and initial margining under Pillar 2.
BCBS supports the creation of a collateral management unit responsible for calculating and making
margin calls and managing margin call disputes. On a daily basis, the collateral management unit would
accurately report levels of independent amounts, initial margins and variation margins. It would track the
extent of reuse of collateral and the concentration to individual collateral asset classes. Reliable data on
collateral will enable the bank to use this data in PFE and EPE calculations.
In the Basel II framework, the standardized haircuts currently treat corporate debt and securitizations in the
same manner. During the crisis, the securitizations exhibited much higher price volatility than similarly
rated corporate debt. Therefore, collateral haircuts for securitization exposures are doubled relative to
similar rated corporate debt. Further, BCBS has made re-securitizations ineligible as collateral going
forward, and stipulated strict controls around re-use of collateral.
There should be built-in regulatory incentives for banks to improve risk management systems.For example,
for a bank that shows the regulator it has a comprehensive collateral management system and can easily
handle large netting sets, the increase in margin risk period should not be applied when the netting set
exceeds 5000.
Bank risk systems should be flexible enough to calculate exposure and capital under multiple assumptions
such as different margin periods of risk, different initial and variation margins, so the sensitivity of these
specific rules on the level of capital can be compared.
3.2.8. Central Counterparties

At the height of the financial crisis in 2008, major financial institutions could not tally exposures against
counterparties across various transactions. Therefore, regulators and economic policy makers could not
make the right decisions in a timely manner. For example, when the US Treasury allowed Lehman Brothers
to default it did not have a detailed picture of all the counterparties exposed to a Lehman default. If this
information was readily available the final outcome could have been different.
Exposures to the central counterparty will receive a near-zero risk weight (1-3%), providing banks with a
strong incentive to move trades to the central counterparty clearing house (CCP). Given their systemic
importance, CCPs should be strictly supervised through rigorous standards, as a failure of a central coun-
terparty could make the problem much worse. The upshot of these rules will be more standardized OTC
contracts clearing through CCPs.
3.2.9 Stressed PDs for Highly Leveraged Counterparties

New rules stipulate that PD for a highly levered counterparty should be estimated based on a period of
stressed volatilities.This again smacks of double counting. Leverage should be one of the factors already
considered, especially in rating financial counterparties. Furthermore, through-the-cycle (TTC) models
capture stress periods in the rating estimate for all counterparties.
A better approach is for the committee to require banks to explicitly use leverage as a factor in determining
PDs for all counterparties.This would result in a more consistent treatment across all counterparties.
23
September 17, 2010
3.2.10. Stress Testing

Banks are required to have a comprehensive stress testing program for counterparty credit risk. This
includes ensuring complete trade capture and exposure aggregation across all forms of counterparty
credit risk in a timely manner so as to conduct regular stress tests. For all counterparties, banks should
stress test principal market risk factors (e.g., interest rates, FX, equities, credit spreads and commodity
prices) in order to identify outsized concentrations to specific directional sensitivities. Banks should also
apply multi-factor stress tests which should analyze the impact of the portfolio under scenarios that reflect
severe economic and market events that occurred during the financial crisis, where broad market liquidity
decreased significantly and liquidating positions of a large financial intermediary created a large market impact.
Banks should also conduct reverse stress test to identify extreme but plausible scenarios that could result
in significant adverse outcomes on exposures and capital. This requires an integrated data and analytic
platform across all significant risk types.
The proposals stipulate periodicity of stress tests, and this seems overly prescriptive. Stress testing should
be an integral part of the bank risk management policy. However, stipulating periodicity and nature of
stress tests with a one-size fits all approach is not ideal. Larger, interconnected firms should have a more
robust and automated system for stress testing wrong-way risks and generating reverse stress tests.
Bank systems should be able to adapt to have more frequent stress tests and the ability to perform ad-hoc
stress tests, especially during a crisis period.This type of requirement will be overly burdensome for smaller
institutions with limited resources, and may also not be required since these institutions are typically not
systemically important.
3.2.11. Back Testing

Banks are required to conduct a regular back testing program, which would compare risk measures
generated by the model against realized outcomes. These requirements call for manipulation of large
datasets. A comprehensive back testing program calls for a system that can handle large batch systems as
well as provide the ability to set up ad-hoc queries.
3.2.12. Reduce Reliance on External Ratings

A major consequence under Basel II was to rely excessively on external ratings for regulatory capital
requirements.This resulted in the neglect of bank’s own independent internal assessment of risks to a certain
degree. Ratings agencies have an incentive to produce “good ratings” since issuers, originators and
investors all prefer “good ratings”. Given the Basel II rules, banks have an incentive to seek ratings just above
the “cliff”. For example, the ‘standardized’ approach prescribes a higher risk weight to corporate exposures
that are rated below BB- (150%) than for unrated exposures (100%).This provides banks with an incentive
not to get ratings for companies that are likely to be rated below BB-.
With the new proposals low quality ratings would apply to unrated exposures that are pari passu or
subordinated to the low quality rating. Banks should internally assess if the risk weights applied (under
the standardized approach) are appropriate for their inherent risk. If it turns out that the inherent risk is
higher,then the bank should consider the higher degree of credit risk.BCBS also proposes the elimination of
the A- minimum requirement for guarantors in the standardized approach and the foundation IRB approach.
24
September 17, 2010
3.3. Leverage Ratio

Another major cause for the financial crisis was the uncontrolled build up of leverage in the banking system.
In order to constrain the build-up of leverage, the proposals reinforce the risk-based requirements with a
simple non-risk-based “backstop”measure based on gross exposure.The July 2010 communiqué clarified
that the leverage ratio will be calculated after applying Basel II netting for all derivatives (including credit
derivatives). In addition, a simple measure of potential future exposure based on the standardized factors
of the current exposure method (CEM) is to be applied to arrive at a “loan equivalent”amount for derivative
products.The leverage ratio would be calculated as an average over the quarter.
The 26 July document, confirmed by the 12 September press release, stated that the phases of the
transition to the adoption of the ratio are as such:
- Supervisory monitoring period from 2011 to 2012, focusing on developing templates to track
in a consistent manner the underlying components of the ratio.
- Parallel run period from 1 January 2013 to 1 January 2017, during which the leverage ratio and
its components will be tracked. Bank disclosure of the leverage ratio and its components will
start on 1 January 2015.
- Migration to a Pillar 1 treatment from 1 January 2018 after proper calibration based on the
results of the parallel run.
The Committee proposes to test a minimum Tier 1 leverage ratio of 3% during the parallel run period. For
the purposes of calibration, it is suggested that the new definition of Tier 1 capital as well as the ‘total capital’
and ‘tangible common equity’ be used. The additional leverage ratio will act as a binding constraint for
some banks when deciding on whether to pursue new business. Therefore, banks will have to examine
the impact of a new transaction on both the capital ratio and leverage ratio. This will result in additional
business and system impact.
There are substantial differences in accounting treatments among jurisdictions. As a result, the leverage
ratio will need to be calibrated thoroughly in order to avoid level playing field issues that could easily occur.
Accounting regimes lead to the largest variations. In particular, the use of International Financial Reporting
Standards (IFRS) results in significantly higher total asset amounts, and therefore lower leverage ratios for
similar exposures, than does the use of U.S. Generally Accepted Accounting Principles (GAAP).
The Committee agreed on the following design and calibration for the leverage ratio, which would serve
as the basis for testing during the parallel run period:
a) For off-balance-sheet (OBS) items use uniform credit conversion factors (CCFs) with a 10% CCF
for unconditionally cancellable OBS commitments (subject to further review to ensure that
the 10% CCF is appropriately conservative based on historical experience).
b) For all derivatives (including credit derivatives), apply Basel II netting plus a simple measure of
potential future exposure based on the standardized factors of the current exposure method. This
ensures that all derivatives are converted in a consistent manner to a “loan equivalent”amount12.
12
Taken together, this approach would result in a strong treatment for OBS items. It would also strengthen the treatment of derivatives relative to the purely
accounting based measure (and provide a simple way of addressing differences between IFRS and GAAP).
25
September 17, 2010
c) Since the leverage ratio proposed by the Basel Committee is non risk sensitive, it discriminates
against safer assets and liabilities. In fact less risky assets – which usually also have lower
returns – will become less attractive, some of the most important examples being mortgages
and credit provision to small and medium-sized enterprises.
Banks that are facing the limits of the leverage ratio will have an incentive to take on riskier assets that
provide higher returns, effectively increasing the risk appetite of the institution as a result of balance sheet
constraints that need to be taken into account alongside the risk management considerations.In particular,
a differentiated adoption of Basel constraints across jurisdictions could prevent a competitive level
playing field in terms of competition. Asset portfolios of banks that have fully adopted the Basel II frame-
work (and therefore are using a risk sensitive approach for capital requirements purposes) are generally
less risky compared to the non Basel II compliant banks. Consequently, often the Basel II compliant banks
have a higher leverage ratio to compensate for the lower revenue that is a consequence of having safer
assets on the balance sheet.These banks, in their attempt to optimize their balance sheet in terms of risk,
will decrease the leverage ratio. But at the same time, in order to maintain the same expected returns, they
will have an incentive to invest in riskier assets. This is certainly an unwelcome outcome that the Basel
Committee should monitor carefully.
d) Moreover, the fact that no specific elements of different business models are taken into
account by developing only a single indicator is a major weakness in the concept.The leverage
ratio will impact the business model of the bank on an integral basis. As the other proposals
of the Basel Committee pertain to an array of different areas, the overlaps with the leverage
ratio will be numerous.In our opinion,the only way to properly assess the impact of the leverage
ratio is to see it in an integrated way with all the other proposals, including those regarding
the framework for liquidity risk. It is now clear that this compartmentalized approach, with
add-ons to meet minimum regulatory requirements, is seriously flawed.With the emergence
of Basel III we have an opportunity to reverse the trend towards splitting risk into different
silos. However, we are concerned that the new rules could again fail to produce a framework
that refutes the compartmentalized way of thinking. This is seen in the way the Basel
Committee is addressing liquidity risk, and specifically in the lack of recognition of the
connections between leverage ratio, capital requirements and liquidity buffer.
e) Last, but not least there is a possibility that lending would shift from regulated banking to less
regulated financial institutions.The unwelcome result will likely be that in periods of financial
distress most of the risk that apparently will sit in these financial institutions will turn back
to the banking organizations that were indirectly subsidizing the less regulated financial
institution. What we have learnt during the recent crisis is that – and this is also important
from a reputational perspective – what ultimately matters is from where risk has originated,
which of course will lead to the same answer: in the banking system.
26
September 17, 2010
3.4. Counter-Cyclical Capital Buffers

The recent financial crisis highlighted the pro-cyclical amplification of financial shocks. The measures
proposed in the consultative paper are designed to dampen excess cyclicality, promote forward looking
provisioning, conserve capital for use in periods of stress and protect the overall banking system from
excessive credit growth. The BCBS issued a consultative document regarding its proposal for a counter-
cyclical capital buffer (the “Proposal”)13.
In this consultative paper, the BCBS stated that the four key objectives of introducing countercyclical
buffers are:
• Dampening any excess cyclicality of the minimum capital requirement;
• Promoting more forward-looking provisions;
• Conserving capital to build buffers at individual banks and the banking sector to be used in
times of stress;
• Achieving the broader macro prudential goal of protecting the banking sector from periods of
excess credit growth.
In the annex (published in July 2010), BCBS states that the capital conservation buffer should be available
to absorb losses during a period of severe stress while the countercyclical buffer would extend the capital
conservation range during periods of excess credit growth (or other appropriate national indicators).
Through a quantitative impact study, BCBS is considering ways to mitigate cyclicality, by adjusting for the
compression of probability of default estimates in the IRB approach during benign credit conditions
through the use of downturn probability of default estimates.
The Proposal provides that a buffer would be “deployed when excess aggregate credit growth is judged
to be associated with a build-up of system-wide risk to ensure the banking system has a buffer of capital
to protect it against future potential losses.” Accordingly, such countercyclical capital buffers are expected
to be deployed in a given jurisdiction only on an infrequent basis,“perhaps as infrequently as once every
10 to 20 years.” In general, national bank regulators would inform banks 12 months in advance of their
judgment of any necessary “buffer add-on” in order to give banks time to build up the additional capital
requirements, while reductions in a buffer would take effect immediately to help reduce the risk that the
supply of credit would be constrained by regulatory capital requirements.
Under the Proposal, internationally active banks would look at the geographic location of their credit
exposures and calculate their buffer add-on for each exposure on the basis of the buffer in effect being in
the jurisdiction in which the exposure is located. (In other words, an internationally active bank’s buffer
would effectively be equal to a weighted average of the buffer add-ons applied in jurisdictions to which
it has exposures.) Accordingly, internationally active banks “will likely find themselves carrying a small
buffer on a more frequent basis, since credit cycles are not always highly correlated across the jurisdictions
to which they have credit exposures.” The Proposal also notes that the BCBS is continuing to consider the
home-host aspects of the Proposal.
13
The issue of procyclicality was specifically addressed by the BIS in the Working Paper:Countercyclical capital buffers:exploring options,published on July 22,2010.
27
September 17, 2010
To assist the relevant national banking regulators in each jurisdiction in making buffer decisions, the BCBS
developed a methodology to serve as a common starting reference point. The methodology “transforms
the aggregate private sector credit/GDP gap into a suggested buffer add-on,” with a zero guide add-on
when credit/GDP is near or below its long-term trend and a positive guide add-on when credit/GDP
exceeds its long-term trend by an amount which suggests there could be excess credit growth. The BCBS
noted, though, that national authorities are not expected to rely mechanistically on the credit/GDP guide,
but rather are expected to apply judgment in the setting of the buffer in their jurisdiction after using the
best information available to gauge the build-up of system-wide risk.
In the latest September press release the Basel Committee agreed that a countercyclical buffer within a
range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according
to national circumstances. The purpose of the countercyclical buffer is to achieve the broader macro-
prudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any
given country,this buffer will only be in effect when there is excess credit growth that results in a system-wide
build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the
conservative buffer range. Please see last section of this paper for an overview of the agreed detailed
implementation timeline.
There is a general consensus on the need for stronger counter-cyclical capital buffers to be part of the
Basel capital framework. This is clearly a powerful and necessary starting point. However, the challenge
lies in the calibration of the parameters when trying to implement in practice this generally agreed objective.
We have identified several design issues that we believe deserve further attention by the committee14:
1. Which approach to follow in determining the counter-cyclical capital buffer: discretionary,
rule based or mixed?
2. What are the most appropriate policy instruments to introduce counter-cyclicality?
3. Is there a need for a counter-cyclical liquidity measure?
4. What is the most appropriate accounting treatment of a counter-cyclical capital reserve?
5. How do you provide disincentives for the (mis)use of financial innovation and tighten
counter-cyclical rules for financial institutions that extensively use it?
6. How do you avoid regulatory arbitrage associated with the introduction of a countercyclical
regulatory capital measure?
7. Does size and correlation matter during systemic crisis?
8. Is there a need for a holistic balance sheet management approach?
After a detailed analysis of possible alternative methodologies that can be used in determining the
counter-cyclical capital buffer, three approaches seem to emerge so far:
i. The discretionary approach.
ii. The rule-based approach.
iii. A mixture of the two.
14
More details on this topic can be found in the Algorithmics response to the Basel Committee on the countercyclical capital buffer.
28
September 17, 2010
With a discretionary system, bank regulators would need to judge the appropriate level of required capital
ratios in light of analysis of the macroeconomic cycle and of macro-prudential concerns. It would depend
crucially on the quality and independence of the judgments made. Using a formula-driven system, the
required level of capital would vary according to some predetermined metric such as the growth of the
balance sheet.The Turner and other (e.g., Geneva) reports make the case that there is merit in making the
regime, at least to a significant extent, formula driven.This could be combined with regulatory discretion
to add additional requirements on top of the formula-driven element if macro-prudential analysis
suggested that this was appropriate. We believe this is the right approach to follow.
There are several options that have been analyzed in different consultative papers, research papers and
international reports (see references at the end of this document) regarding instruments that can be used as
a counter cyclical buffer.We believe that the right way forward is to consider a combination of instruments.
At a minimum we believe that any countercyclical buffer rules should consider an increase on capital
requirements, as currently outlined in the July consultative paper.The buffer must be able to absorb losses
on a “going concern” basis. Consequently, the buffer must comprise the highest quality capital, most
likely equity and retained earnings. Also, to avoid regulatory capital arbitrage, as we will describe in the
subsequent sections, we recommend that further countercyclical measures be added, in particular:
• A cap on leverage15 and
• A capital multiplier if significant currency or maturity mismatch is found
As solvency and liquidity are complementary, these rules should be implemented jointly, which would
imply requiring more capital in a counter-cyclical way for institutions with large maturity mismatches.
However, as capital will never be enough to deal with serious liquidity problems, there is a clear case for
having a counter-cyclical liquidity requirement as well. As the U.S.Treasury September 2009 Report argues,
excessive funding of longer term assets with short term debt by a bank can contribute as much or more
to its failure as insufficient capital. Furthermore, the report states that liquidity is always and everywhere
a highly pro-cyclical phenomenon. Indeed, because capital, even though high, may be insufficient to deal
with liquidity problems in a crisis, sufficient liquidity requirements are also very important, and need to be
determined simultaneously with the general capital requirements in an integrated/out-of-silos framework.
Banks with larger structural funding mismatches, or those that rely on volatile short-term funding sources
should be required to hold more capital.This would force the banks to internalize higher liquidity risks as
a cost, thus encouraging them to seek longer term funding. The Geneva Report and Warwick Report go
further by recommending that regulators increase the existing capital requirements by two multiples,
one linked to the growth of credit, and the other to maturity mismatches.
The accounting treatment of a counter-cyclical capital reserve is hugely important. As regards to accounting
disclosure rules, these should satisfy both the needs of investors and those of financial stability. An optimal
approach may be to rely on dual disclosure, where both current profits and losses are reported, and profits
after deducting a non-distributable counter cyclical buffer that sets aside profits in good years for likely
losses in the future.
15
For a detailed analysis of this topic please refer to the leverage ratio section 3.3
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September 17, 2010
Financial innovations increase during booms, when new and untested instruments that are difficult to
value are introduced.This exacerbates pro-cyclicality, as new, often opaque and complex instruments can
hide and under-price risk. Regulators should introduce appropriate model risk capital charges if such
instruments are traded, or at least tighten counter-cyclical rules for financial institutions that extensively
use them.When new and complex products are originated and then distributed it is non-trivial to understand
the interplay between risk classes, regulatory and accounting treatments and how, ultimately, this cocktail
will influence and drive the setting up of the overall business strategy.The evolution of the collateralized
debt obligation (CDO) market during the credit crunch is a good example of this. Only through a holistic
view of the balance sheet is it possible to disentangle and understand if the resulting “new”bank portfolio
is aligned with the overall risk appetite of the bank.
The standards proposed in the consultative document can be seen as an effort by the Basel Committee to
achieve a higher degree of harmonization among supervisory regimes for countercyclical capital buffer
requirements. We strongly endorse this effort. We believe that as much effort as possible should be put
into the convergence of local supervisory regimes of capital and liquidity risk supervision. To avoid
regulatory arbitrage, the comprehensiveness of counter-cyclical regulation is an important issue, both
nationally and internationally. The best approach utilizes equivalent comprehensive counter-cyclical
regulation for all institutions, instruments, and markets.This would include also all non-banking financial
institutions, such as hedge funds, private equity, insurance companies etc (the so-called shadow banking
system), as well as all instruments within banks – by consolidating all activities onto the balance sheet.
It should also include counter-cyclical margin and collateral requirements on all securities and derivatives
instruments. Having different capital buffers in different jurisdictions will contribute to differences in cost
of capital. This might encourage regulatory arbitrage where multi-national companies will borrow from
the cheapest jurisdiction that has a lower counter cyclical buffer to finance activity in other jurisdictions.
The emphasis that the U.S. Treasury report and other reports place on higher capital requirements for
systemically important institutions draws on research from the BIS and elsewhere showing that large
banks,and those more exposed to system-wide shocks,contribute more than proportionally to systemic risks.
Both the size of individual banks and the total banking system – or even financial system – are important,
because in crisis situations they may need to be bailed out. In addition to size, bank business models
should also be taken into account. For example, a bank largely financing exposures through deposits
should have a smaller countercyclical buffer relative to a bank that is completely dependent on
wholesale funding.
Supervision and business strategy is a multidimensional discipline: increasingly complex balance sheets,
opaque structured products embedding unclear leverage and optionalities all make it difficult to gain an
overall, timely, transparent and objective view of the interplay among risk types. It is therefore not always
clear what exact business strategy is being pursued at a legal entity or even at the holding group level.
30
September 17, 2010
The real problem has become that the resulting overall bank portfolio balance sheet at legal entity level
is now very difficult to understand. As a result, communicating the business strategy to the interested
internal and external stakeholders, and how this is aligned with the overall risk appetite of the financial
institutions, has been, and still looks to be, a challenge. This means that bankers need to use new “fit for
purpose” tools and methodologies that can identify the real risk drivers, their interplay, and the role they
play within different legal jurisdictions, accounting, and under differing regulatory treatments. The limi-
tations of the current regulatory, organizational and business silos mindset is probably the biggest and
toughest lesson learned from the crisis.We strongly suggest that regulators endorse and gradually intro-
duce, in the spirit and in the letter of the upcoming legislation, this holistic view of the balance sheet,
where the interplay of liquidity risk and economic capital is more precisely described. Consequently, we
recommend that the impact on the bank and the financial system as a whole be estimated once the stress
tests are simultaneously and coherently (same time horizon and severity) executed across all risk types. We
believe that the need to simultaneously look at the whole legal entity at balance sheet level (and at its
dynamic evolution under stress conditions) from a risk, economic, regulatory, and accounting perspective
is not a sophistication but a necessity.
3.5. Systemic Risk

One of the findings of the Committee is that while the interconnectedness of international banks has
supported economic growth, in time of distress this interconnectedness transmits negative shocks across
the financial system and the economy. The Committee is in the process of developing policy options
designed to reduce risks related to the failure of systemically relevant, cross–border institutions. These
options include empowering the regulatory authorities to write-off or convert certain capital instruments
into common shares when a bank becomes unviable, the introduction of a capital and/or liquidity
surcharge for cross-border institutions, or the introduction of contingent capital as an element of the
capital base. These proposals are expected to be issued for draft consultation in December 2010.
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September 17, 2010
4. Implementation Timelines
At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision fully endorsed the
agreements reached on 26 July 2010. The capital reforms, together with the introduction of a global
liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the
Seoul G20 Leaders summit in November. Annex 2 of the document, reproduced below, summarizes the
key requirements and the required implementation deadlines.
Phase-in arrangements (shading indicates transition periods)
(all dates are as of 1 January)
2011 2012 2013 2014 2015 2016 2017 2018 As of
1 January
2019
Leverage Ratio Supervisory monitoring Parallel run Migration to
1 Jan 2013 – 1 Jan 2017 Pillar 1
Disclosure starts 1 Jan 2015
Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50%
Minimum common equity plus capital 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
conservation buffer
Phase-in of deductions from CET1 20% 40% 60% 80% 100% 100%
(including amounts exceeding the limit
for DTAs, MSRs and financials)
Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Minimum Total Capital plus 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%
conservation buffer
Capital instruments that no longer qualify Phased out over 10 year horizon beginning 2013
as non-core Tier 1 capital or Tier 2 capital
Liquidity coverage ratio Observation Introduce

Period Minimum
begins Standard
Net stable funding ratio Observation Introduce

Period Minimum
begins Standard
Implementation timeline reported in the 12th September press release
5. Business impact and challenges: exploring the interplay

between Liquidity and Capital
The Basel II Accord,which was ratified in 2004,had as its main objective increasing the risk sensitivity of capital
requirements while maintaining the capital amount at a systemic level. Basel II focused on calculating
minimum capital requirements and postponed the discussion on capital quality and definitions. It accounted
for liquidity risk through Pillar 2, while discussion of liquidity risk had not matured by the time the financial
crisis hit.It was liquidity risk that led to the failure of financial institutions like Northern Rock and Bear Sterns.
Also, the Basel II accord did not consider leverage in determining the capital requirements of a bank. Some
major banks, while being well capitalized from a Basel II perspective, had leverage ratios of 70:1 without
taking into account netting (30:1 when netting is taken into account). There was a lot of faith in the risk
sensitivity rules under Basel II. However, some of this was misguided.The capital requirements and the risk
measurement mechanisms, especially in the trading book, led to regulatory arbitrage. For example,
securitization transactions got much more lenient treatment in the trading book versus the banking book,
and these shortcomings in the Basel II framework in a way contributed to the capital arbitrage between
the banking and trading books and provided incentives for banks to assume high-risk trading strategies.
Some of the new rules address these issues. For example, the July 2009 Enhancements to Basel Framework
addressed the inadequate capital requirements for securitization transactions,and eliminated the possibility
of capital arbitrage from the banking book to the trading book by aligning the capital requirements across
the banking and the trading books.
32
September 17, 2010
It is widely believed that the proposed capital and liquidity rules would significantly increase the banking
sector’s capitalization and funding levels. One study by McKinsey titled “Basel III:What the draft proposals
might mean for European banking”estimates that the industry would need to raise an additional 40% to 50%
of its current Tier 1 capital base.Top 16 European banks will need to raise 700 Billion Euros in capital and
1.8 trillion Euros in long-term funding. It is also estimated the Industry ROE would reduce by about 5%
from its current level of 15 %.
While the efforts by the Basel Committee are believed to result in lower systemic risk and lower risk for
the individual banks over the longer term, the need for the huge infusions of capital in the short to
medium term places a huge strain on the capital markets. As investors perceive that current risk in the
banking system is high, the required rate of return for any investment in the banking sector will be high.
This, viewed along with the lower ROE from the banking industry, and the proposed restrictions on earnings
distributions is likely to create a strain in the capital markets till such time the perception of reduced risk
in the banking sector sinks in the investors’ minds.
Above estimates assume current bank structures remain the same, but given the scope of the Basel III
rules large scale restructuring of bank balance sheets and corporate structures are on the cards.For example,
banks might reduce deferred tax assets (assuming profitability over the next few years), sell minority-
owned subsidiaries and move away from unsecured interbank funding with larger banking groups.
Trading books will almost certainly reduce given estimates that capital might increase about three fold;
estimates are high as 20-fold for some banks.
Large multinational banks might look more keenly on regulatory arbitrage as capital becomes dearer, by
taking into account the differences in regulatory requirements across geographies while deciding the
booking location for transactions.As long as regulators allow them,banks will also raise deposits in countries
where it is cheapest to fund business in other jurisdictions.
The proposed buffers – capital conservation buffer and the countercyclical capital buffer – are likely to
smooth the capital requirement crests and troughs.
Under the Basel II regime international banks were fairly well capitalized and regulatory capital was rarely
binding. However, with Basel III regulatory capital, and for some large banks leverage ratios and liquidity
ratios, will become binding constraints when making business decisions. Currently most banks look at
regulatory and economic capital when making business decisions. With Basel III this process becomes
more complex. Banks will need to examine the incremental impact of deals on regulatory capital, economic
capital, leverage ratios and liquidity ratios, and also how it impacts capital and liquidity buffers.
This will lead to fine tuning of RWA in the bank’s effort for capital conservation. Banks will focus on data
quality with a special focus on credit mitigation. Some banks currently do not centrally collect collateral,
guarantee and netting data for smaller obligors. Although these counterparties might be smaller, in total
this effort will tend to reduce RWA significantly. Also, banks will use credit mitigant optimization routines,
where mitigants are eligible across lending facilities to apply the mitigants to minimize total RWA across
the lending facility. Similarly, CCF models will also be refined to achieve capital optimization. Although
Basel III precludes using rating triggers to reduce EADs in the current period,instituting a rigorous procedure
can reduce CCF estimates in future periods as well as reduce losses in the current period.
33
September 17, 2010
As regulatory capital becomes binding, banks will move away from capital heavy sectors to capital light
sectors and adjust the business model accordingly. In terms of the product analysis, the capital costs for
OTC derivatives, liquidity facilities and short term/long term corporate loans are expected to increase,
while the funding costs for OTC Derivatives,fixed income bond investments,covered bonds,liquidity facilities
and short term retail loans are expected to increase.Therefore,there will be a move away from these products.
For example, retail mortgages get better capital treatment than commercial mortgages. It is noted with
interest that although the BCBS has increased capital on the capital markets side of the business, there is
no language to require banks to strengthen underwriting procedures for retail mortgages and other retail
loans. Regardless, in most countries banks have strengthened underwriting procedures, and strict rules
regarding securitizations will reduce the incentive for banks to be lax on this front. This will cut off the
vicious cycle of originate to securitize.
Basel III is highlighting the integral nature of credit, market and liquidity risk. Before the crisis, most banks
appeared to be well capitalized, although they were pushed to the brink due to liquidity risk.The following
is a quote from the BCBS,“Findings on the interaction of market and credit risk,Working Paper No. 16, 2009:
Studies suggest that banks’exposures to market risk and credit risk vary with liquidity conditions
in the market, and liquidity conditions in turn are also determined by perceptions of market
and credit risk. This suggests that banks and regulators need to think about a framework that
better integrates all three types of risk.”
We expect BCBS to smooth out the internal inconsistencies and the double counting in the current
proposals before finalizing the rules. The longer implementation framework gives banks and regulators
time to optimize the rules as well as not adversely affect the current tentative growth prospects for the
economy. In particular, a move towards an integrated framework will let banks examine the impact of
different hedging strategies. Some strategies might reduce credit risk but increase liquidity risk, for example.
It is imperative that banks gain a holistic view of risk.
5.1. Exploring Interconnections and Trade-Offs between Capital and Liquidity

The new rules could repeat the mistakes of the past by compounding the ‘silo’-based approach to risk
management.
It is of course right that governments and regulators take stringent steps to ensure we never again find
ourselves in a situation where billions of dollars of taxpayer’s money is used to save the banking system.
But to the question: Are we on the right track with Basel III? The answer at the moment is that it goes only
part way to addressing the weaknesses of the established ‘silo’-based approach to risk management.
Granted there has been a regulatory and business push to break down risk silos in recent years, with
market and credit risk coming together over the last three to four years.This has been driven by changes
such as the introduction under Basel of the Incremental Risk Charge for market risk and the need to have
a centralized credit valuation adjustment (CVA) desk with profit and loss responsibility.The recent emphasis
on CVA risk is a first step towards some banks managing complex counterparty relationships and the
interaction of market and credit risk in an effective way. Operational risk meanwhile has moved under the
market risk group, mainly because of the analytical nature of measuring and managing operational risk.
However, the systems still tend to be separate.
34
September 17, 2010
But these are minor advances in addressing a pervasive,deeply ingrained problem.As the banking business
has become more complex over the last 30 years, banks in general have tended to take a bottom-up,
piecemeal approach to developing risk management functions.When it comes to risk measurement and
management, the default option has been for banks to have separate units managing different types of
risk. At the same time, as trading and structured finance has become more spread out and complex, the
corporate structure of banks has also become more complex, such that different parts of the business run
their own profit and loss books. This has made it harder, in general, for managers at the top to have an
all-encompassing view of the risks on the group’s balance sheet.
As risk management has come into its own as a primary discipline within banks, reporting tools and risk
management functions such as stress testing have not been integrated across different departments.
Systems have been maintained mostly by decentralized IT functions supporting finance, treasury,
business lines and risk management. There has been less thought given to reconciling data across
systems, which has led to benchmark risk management practices, and ultimately a culture of risk manage-
ment that has failed to view risk in a necessarily holistic way. A truly effective risk management system
would take a top-down approach to risk measurement and reporting, viewing and managing the intercon-
nections between risk factors at a high level, such that their potential impact on the balance sheet can be
properly accounted for.
It is now clear that this compartmentalized approach, with add-ons to meet minimum regulatory require-
ments, was seriously flawed.With the emergence of Basel III we have an opportunity to reverse the trend
towards splitting risk into different silos. However, as things stand at the moment it seems the new rules
will again fail to produce a framework that refutes the compartmentalized way of thinking.
This is seen in the way the Basel Committee is addressing liquidity risk, and specifically in the lack of recog-
nition of the connections between leverage, capital and liquidity.The current stress test recommendations,
for example, call for the stress testing of liquidity and capital separately. Witness this summer’s widely
publicized European bank stress test exercise. Although the exercise showed that most banks will be able
to withstand a significant and protracted period of stress, the tests focused on capital levels only.
They completely failed to touch on liquidity risk.
If we are to have a robust and truly risk-based framework then the interdependence of capital and liquidity
risk must be addressed.One can see the attractiveness of trying to get to grips with liquidity risk by viewing
it largely on a stand-alone basis. But this is a mistake. If we are to have a real sense of the nature of liquidity
risk, and from there be in a position to put in place systems to effectively manage it, then we must be
prepared to engage in the more difficult intellectual challenge of viewing and managing risk holistically.
5.2. Misunderstanding How Liquidity Risk and Capital are Connected

By viewing capital as a primary mitigant of liquidity risk we fail to understand the nature of that risk.
Capital mitigates unexpected losses, but not cash flow imbalances – i.e. funding liquidity risk. Liquidity
risk is crystallized when a bank has to undertake a last minute fire sale of assets to meet its obligations.
In short, if an institution has a liquidity problem then it needs cash, not capital. Indeed, should a liquidity
situation arise and the bank begins using reserves set aside to guard against liquidity risk in order to
absorb losses and meet obligations, then the value of the company and therefore also the value of the
capital is likely to go down, since the bank will start to be perceived as “riskier”. Liquidity risk and capital are
therefore inextricably linked.
35
September 17, 2010
The Basel Committee’s primary response to liquidity risk, the liquidity coverage ratio and the net stable
funding ratio, do not recognize this link. As with previous compartmentalized approaches to risk manage-
ment, these ratios view liquidity risk more or less as a stand-alone risk silo. As such, the implementation
of the current approach does not effectively address the flawed silo-based approach.
The prescriptive nature of these ratios is not helpful, as it does not allow the tailoring of a liquidity risk
buffer to the needs of the specific institution. Under a top-down, holistic risk management model, the senior
management of the bank would decide on the size of the liquidity buffer and what survival horizon is
appropriate for it, based on a careful assessment of the bank’s overall risk appetite.This is important from
a best practice governance perspective, because if an institution is holding more than the needed amount
of liquid assets then the part of the liquidity buffer that is not needed has an opportunity cost associated
with it – that money could be deployed elsewhere to make a higher return for shareholders. And if the
institution holds less than necessary to maintain stability then the bank risks bankruptcy.
6. Technology Direction
Over the last two decades, banks approached risk management from a silo approach across market, credit
and operational risk. Basel I was addressed mainly through finance systems. Banks developed market risk
systems after the 1996 Amendment. Liquidity risk became a risk discipline only over the past few years.
As risk systems grew organically over the years with own data requirements, reporting tools and stress
test set ups, they addressed requirements of different departments within the banks. Risk management
itself has come into its own as a primary discipline within the banking industry only over the past 15 years
or so. Systems were maintained mostly by decentralized IT functions supporting finance, treasury, business
lines, risk management etc.There was no thought given to reconciling data across these systems.
Spurred by Basel II, larger banks embarked on enterprise data warehouse projects to collect data across
trading books, corporate, retail and securitization exposures. However, these systems originally focused
on driving credit risk-weighted asset calculations, local regulatory reporting and Basel pillar 3 reporting.
Over the last three to four years banks also invested in expanding these data warehouses to cover credit
economic capital. Market risk and operational risk were calculated separately and typically brought
together at the reporting layer, with manual interventions for regulatory and management reporting
purposes under Basel II.
With the advent of ICAAP stress test requirements banks needed to examine the impact of a market stress
event across risk silos. Banks realized the shortcomings of current systems, but manual aggregation was
a practical solution given these stresses needed to be run typically only at a semi-annual frequency.
However, the systems are prone to manual errors and find it difficult to cope with ad-hoc stress testing
requirements that regulators are now pushing for.
36
September 17, 2010
To address Basel III, banks will need to re-think data and IT strategy.The main drivers will be:
• The ability to reconcile data across different risk categories.This will lead to a system based on
common data inputs to drive market, credit and liquidity risk. Position and counterparty/obligor
data should be driven from a single source of truth. A single data load with all the attributes
required for market, CCR, RWA, economic capital and liquidity risk should be extracted from
source systems. Since this data will be shared across risk types, data reconciliation requirements
will be automatically met.
• Drive the system with common risk factors to enable consistent stress testing across market,
credit and liquidity risks. In addition to stress testing, this will also let the bank look at the impact
on its capital and liquidity position of changes in assumptions. For example, it would let the
bank examine the impact of an increase in the margin period of risk when there are over 5000
transactions in the netting set.
• Consistent calculation engines that share common models and provide consistent measures
across risk types. For example, the pricing models used for market risk valuation purposes
should be used for counterparty credit risk simulations. Cash flow generation for liquidity risk
should also leverage the cash flow generation routines that should be common to market risk
and CCR. On the capital front, using consistent data and models will allow the user to break
down the differences between regulatory and economic capital into sources of risk, such as
name concentration, sector concentration, migration risk etc. An economic capital model that
allows the user to configure economic capital calculations under multiple assumptions (e.g.
full granularity, default/no default mode etc) will enable such a breakdown of sources of risk.
• Integrated reporting across risk types, which is the ultimate aim of the system.This would allow
senior managers and investors to get a consistent view across the enterprise of the impact of
different types of risk. There will be demand for systems than can perform “what-if” analysis
based on incremental transactions or scenarios. This will enable business users to get a
comprehensive view of the risk of incremental trades or hedging strategies. For example, a
particular hedge might reduce credit risk but increase liquidity risk.
• Systems should allow both large volumes, enterprise-wide batch runs while allowing for
interactive what-if analysis.This will let the bank examine the impact across market, credit and
liquidity risk of incremental deals. It will also let the bank check the impact of new regulations
or assumptions such as the margin period of risk.
It will make sense for banks to leverage existing investment in Basel II systems to achieve this. Banks that
have been successful in building enterprise data warehouses will want to expand them to address Basel
III.We see a trend where banks extend the current market risk system for CCR mainly to ensure consistent
pricing models. As computation has become cheaper it is feasible to use the same market risk pricing
models for counterparty credit risk simulations.
At most banks RWA and economic capital systems are now driven by the same data. Liquidity risk covers
the enterprise and uses market risk factors for cash flow generation and stress testing.
The following table summarizes the current silos of risk types,their scope,risk factors,functionality,measures,
confidence intervals and primary functionality.
37
September 17, 2010
Market CCR RWA Credit Risk Liquidity

Scope Trading book Trading book Enterprise Enterprise Enterprise
assets assets assets assets assets and
liabilities
Risk Factors IR, FX, IR, FX, Equity, PD, LGD, PD, LGD, IR, FX,
Equity, Commodity, EAD, M EAD, Equity,
Commodity, Volatility etc., Transition Commodity,
Volatility etc. creditworthiness Matrix, Volatility etc.,
for CVA Correlation cash flow
Matrix generation
Measures VaR, IRC PFE at any CI, RWA, EL UL, EL, CBC, FLE,
EPE, CVA survival LVaR, LCR;
probability NSFR;
survival
horizon
Time horizon 10-day 1-year for EPE. 1-year 1-year for Short Term:
Multi-year for PFE ICAAP; daily up to
3 and 5 year 30-90 days
typically for Long Term:
capital yearly up to
planning 15-20 years
Confidence 99% 50% for EPE, 95 99.9% 99.9% for Non
level or 99% for PFE regulatory Stochastic
purposes; Stress Test
based on risk
appetite for
internal
Main Stress Simulation Undrawn Additive Survival
functionality testing through time allocation, measures, Horizon &
incorporating all mitigant Reverse Liquidity
credit mitigation optimization, stress tests Buffer
including netting, retail pooling,
collateral etc. reconciling to
GL, stress testing
As can be seen, different types of risks should be driven by common data. Risk types might focus on part
of the book or the enterprise, and might need incremental data to drive calculation engines. Providing
underlying data from a single source of truth will result in a consistent, reconciled system while providing
long term cost savings in terms of reduced manual intervention.
The thrust in the future will be towards an integrated risk management platform for regulatory purposes
that will allow for ad-hoc stress tests.The original Basel systems for credit risk moved from finance to capital
management or risk management due to Basel II. With Basel III, the trend is towards integrated systems
moving to enterprise risk groups that will look at risk holistically.
38
September 17, 2010
7. Conclusion: Moving Towards a Holistic System

It is clear that we need to break down the silo-based approach to managing risk and that Basel III is the
best opportunity we have of doing it. That starts with the senior management establishing a detailed,
clearly defined definition of the overall risk appetite of the bank. This ensures that shareholders, deposit
holders and other stakeholders have a clear understanding of the business strategy. From there, a number
of steps should be taken to ensure that the bank truly takes ownership of the risks it is running at the
group level, as well as at lower business or division levels.
Systems should be developed based on common data inputs to drive market, credit and liquidity risk.
A single data load with all the attributes required for market, counterparty credit risk, RWA, economic
capital and liquidity risk should be extracted from source systems. Since this data would be shared across
risk types, data reconciliation requirements would be automatically met. At the same time, there should be
consistent calculation engines that share common models and provide coherent measures across risk
types. For example, cash flow generation for liquidity risk should use the same cash flow generation
routines common to market risk and counterparty credit risk.
There should also be integrated reporting across risk types to give senior managers and investors a
consistent view across the enterprise of the impact of different types of risk. Meanwhile, systems should
be designed that allow both for large volume, enterprise-wide batch runs and also interactive ‘what-if’
analysis.This will also enable consistent stress testing across market, credit and liquidity risks, as they will
all be driven by common risk factors. The implementation of such measures would allow the interplay
between capital and liquidity to be fully tested.
With this breaking down of risk silos, senior management will be able to view a ‘dashboard’of risk indicators
that give them a true picture of their group balance sheet and variances from the stated risk appetite.This
will mean that senior managers will once again, like the days before the emergence of complex banking,
take ownership of the bank portfolio balance sheet at the legal entity level, in turn allowing them to take
a harder line if they feel they have to.
As Basel III progresses it is crucial that the interconnected nature of the risks on the balance sheet are
properly assessed, while taking account of regulations and accounting standards. It is, therefore, time to
break down those silos.
39
September 17, 2010
REFERENCES
1. Algorithmics’Response to the Basel Committee's request for comments on the consultative document:
Proposed Enhancements to the Basel II Framework, April 2009
http://www.algorithmics.com/EN/media/pdfs/Algo-GC0409-LtrBaselCom.pdf
2. Algorithmics' Response to the FSA's CP 09/13 – Strengthening Liquidity Standard 2: Liquidity
Reporting, June 2009
http://www.algorithmics.com/EN/publications/whitepapers/registration.cfm?code=wp39
3. Algorithmics’Response to the Basel Committee’s request for comments on the consultative document:
International framework for liquidity risk measurement, standards and monitoring, April 2010
http://www.algorithmics.com/EN/media/pdfs/Algo-GC0410-LtrBaselCom2.pdf
4. Algorithmics whitepaper: Towards active management of counterparty credit risk with CVA, 2010
http://www.algorithmics.com/EN/publications/whitepapers
5. Algorithmics whitepaper: Credit Value Adjustment and the changing environment for pricing and
managing counterparty credit risk, 2010.
6. APRA’s prudential approach to ADI liquidity risk, Discussion Paper, 11 September 2009
7. F. Battaglia and M. Onorato, Liquidity Risk: Comparing Regulations Across Jurisdictions and The Role
of Central Banks, December 2007;
8. F. Battaglia, M. Onorato and S. Good, Liquidity Risk Management – Assessing and Planning for
Adverse Events, December 2007;
9. Basel Committee for Banking Supervision, Principles for sound liquidity risk management and
supervision, September 2008
10. Basel Committee of Banking Supervision,“Findings on the interaction of market and credit risk,
Working Paper No. 16, 2009:
11. Basel Committee of Banking Supervision, Strengthening the Resilience of the banking Sector,
December 2009
12. Basel Committee of Banking Supervision, International Framework for Liquidity Risk Measurement,
Standards and Monitoring, December 2009
13. Basel Committee of Banking Supervision, Strengthening the Resilience of the banking Sector,
Annex, July 26, 2010
14. Basel Committee of Banking Supervision Working Paper: Countercyclical capital buffers: exploring
options, published on July 22, 2010.
15. Basel Committee of Banking Supervision, Group of Governors and Heads of Supervision announces
higher global minimum capital standard, Press Release, Sept 12, 2010
16. Mario Draghi, Chairman of the Financial Stability Board, Letter to the G20 Meeting in Toronto, July 2010
17. European Banking Supervisors, Guidelines on Liquidity Buffers & Survival Periods, 9 December 2009
18. Financial Stability Forum Report, Addressing Procyclicality in the Financial System. April 2009.
40
September 17, 2010
19. The Financial Times, Move to reassure banks on tough rules, 5 July 2010
20. Geneva Report on the world economy,The Fundamental Principles of Financial Regulation, May 2009
21. Institute for International Finance, Interim Report on the Cumulative Impact on the Global Economy
of Proposed Changes in the Banking Regulatory Framework, June 2010
22. McKinsey on Corporate & Investment Banking,Basel III: What the draft proposals might mean for
European banking, Summer 2010
23. M. Onorato, A Face-off On Funding: ERM and Liquidity Risk, 2008, TH!NK Magazine; www.algorith-
mics.com
24. M. Onorato, Liquidity Before and After: The Emergence Of Balance Sheet Risk Management; June
2009, TH!NK Magazine; -Web: www.algorithmics.com
25. M. Onorato, Grasping at shadows: Identifying an effective framework for liquidity risk management,
August 2009, GARP Professional;
http://www.garp.org/news-and-publications/2009/august.aspx
26. M. Onorato, A Comprehensive Framework For Defining Risk Appetite , forthcoming 2010; TH!NK
Magazine www.algorithmics.com
27. Goldman Sachs , Strengthening the Resilience of the banking Sector, Response to the Basel
Committee of Banking Supervision from Goldman Sachs, April 16, 2010
28. The Turner Review: A regulatory response to the global banking crisis, March2009, Financial
Services Authority.
29. U.K.Treasury Committee. (2009). Banking Crisis: regulation and supervision. July, House of
Commons, Treasury Committee, Fourteenth Report of Session 2008–09, London.
30. U.S.Treasury Department. Financial Regulatory Reform. A New Foundation: Rebuilding Financial
Supervision and Regulation. June 2009, U.S.Treasury Department, Washington, DC.
31. U.S.Treasury Department. Principles for Reforming the U.S. and International Regulatory Capital
Framework for Banking Firms. September 2009, U.S.Treasury Department, Washington, DC.
32. Warwick Commission on International Financial Reform: In Praise of Unlevel Playing Fields;
November 2009
33. Oliver Wyman, State of the Financial Services Industry Report, 2009
41
About Algorithmics
Algorithmics is the world’s leading provider of enterprise risk solutions.
Financial organizations from around the world use Algorithmics’ software,
analytics, and advisory services to help them make risk-aware business
decisions, maximize shareholder value, and meet regulatory requirements.
Supported by a global team of risk experts based in all major financial centers,
Algorithmics offers proven, award-winning solutions for market, credit, and
operational risk, as well as collateral and capital management. Algorithmics is
a member of the Fitch Group.
www.algorithmics.com
© 2010 Algorithmics Software LLC. All rights reserved.You may not reproduce or transmit any part of this
document in any form or by any means, electronic or mechanical, including photocopying and recording,
for any purpose without the express written permission of Algorithmics Software LLC or any other member
of the Algorithmics’ group of companies.
ALGORITHMICS, Ai Logo, ALGORITHMICS & Ai Logo, ALGO, MARK TO FUTURE, RISKWATCH, KNOW YOUR
RISK, ALGO RISK, ALGO MARKET, ALGO CREDIT, ALGO COLLATERAL, ALGO FIRST, ALGO ONE, ALGO
FOUNDATION, ALGO FINANCIAL MODELER, ALGO OPVAR and TH!NK Logo are trademarks of Algorithmics
Trademarks LLC.

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BASEL III: WHAT’S NEW?

BUSINESS AND TECHNOLOGICAL CHALLENGES

By Rustom Barua, Fabio Battaglia, Ravindran Jagannathan,

2.1. The Regulatory Effort

Cumulative Effects Results in Summary

Difference in average rates: 2011-15 2011-20

2.2. The New Liquidity Requirements

2.3. The New Liquidity Ratios: Tasks and Issues

2.3. 2. Building Differentiated Incentives to Traditional Banking

Solid funding ratio Before-Crisis contributes to shareholder value

200 Industry average

2.3.3. Accounting for Bank’s Size

2.3.4. Need to Raise New Capital

2.3.5. Securitization Disruption

2.3.6. Raising New Medium/Long-Term Finance (NSFR)

2.3.7. Distorting Bond Markets

2.3.8. Reshaping Interbank Deposit Markets

2.4. Survival Horizon Models: Optimizing the Liquidity Buffer in

2.4.1. The Relationship between the Basel Ratios and Bank –

2.4.2. Calculating the Amount of the Liquidity Buffer

Risk Tolerance Policy Stress Test

Liquid Asset Buffer Survival Horizon

Early Warnings Limits Contingency Funding Plans

2.4.3. Optimising the Liquid Asset Buffer

3. Proposals Regarding Capital

3.1. Capital Base

3.2. Risk Coverage

3.2.1. Addressing General Wrong-way Risk – Stressed EEPE

3.2.2. Capturing CVA Losses

3.2.3. Specific Wrong-way Risks

3.2.4. Higher Risk Weights for Financial Institutions

3.2.5. Increase Margin Period of Risk

3.2.6. Preclude Downgrade Triggers

3.2.7. Collateral Management

3.2.8. Central Counterparties

3.2.9 Stressed PDs for Highly Leveraged Counterparties

3.2.10. Stress Testing

3.2.11. Back Testing

3.2.12. Reduce Reliance on External Ratings

3.3. Leverage Ratio

3.4. Counter-Cyclical Capital Buffers

3.5. Systemic Risk

Liquidity coverage ratio Observation Introduce

Net stable funding ratio Observation Introduce

Implementation timeline reported in the 12th September press release

5. Business impact and challenges: exploring the interplay

5.1. Exploring Interconnections and Trade-Offs between Capital and Liquidity

5.2. Misunderstanding How Liquidity Risk and Capital are Connected

Market CCR RWA Credit Risk Liquidity

7. Conclusion: Moving Towards a Holistic System

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