CMB- Assignment- Basel III

Name: Pranati Aggarwal Roll No. 12HR-019 Section: A

1) Discuss the relationship between the capital base of banks and financial crisis. Capital Base is essentially the money contributed by the shareholders who first purchased shares in the company plus retained earnings. Capital base is important because it provides a benchmark when measuring returns. Without it, investors and companies would be unaware of how they are doing relative to their investments. Financial institutions were effected to a great depth during the recent financial crisis. This dilemma could have been avoided or it wouldnt have had such an impact on these banks if Basel III tier 1 capital was in effect. The committee had to regulate and make adjustments to tier 1 capital which enforces banks to have more capital on common equity and retained earnings. Banks struggled to raise the capital requirement as the economy was rapidly going down. It was accomplished with the help of the government since many investors were not confident with the measures of tier 1 capital reserves for the reason that it was difficult to examine which banks had the adequate common stocks to resist the crisis. These new regulations support banks to sustain in difficult times. However, following implications may arise as a result: Banks will face a significant additional capital requirement, and the bulk of this shortfall will need to be raised as common equity or otherwise by retaining dividends. In principle, banks will be able to draw on the capital conservation buffer during periods of stress, but it seems unlikely that they would choose to do so, given the associated constraints on their earnings distributions. Consequently, banks are likely to target a higher common equity ratio and the market expectation for common equity Tier 1 appears to be moving to approximately 9 percent Thereislikelytobefurtheradd-onsforPillar2risks,systemically important firms, and the counter-cyclical capital buffer, so banks may target a total capital ratio of 1315 percent. Overall, results suggest that the importance of bank capital is elevated during crises, and particularly banking crises. Increasing the common equity held by banks will improve efficiency of banks to sustain losses during crisis. This also will help gain trust amidst the investors.

2) Is it important to include leverage ratio and off-balance sheet activities in Basel III? Leverage Ratio: Bank leverage is the use of funding borrowed from depositors to finance interest bearing assets like loans at higher interest rates to cover capital and operating costs. Leverage ratio is banks leverage to its capital level. High-quality capital/on-balance sheet and off-balance sheet assets. Off-Balance Sheet activities: Items which the company does not have legal claim or responsibility for. For eg. Securitized loans and operating lease. They are of interest to the investors because they help in determining the financial health of the company. They are hard to track and can become hidden liabilities. It is important to include leverage ratio as it helps in monitoring the off-balance sheet leverage and thus increases transparency. It also provides a non-risk based measure by not distinguishing between high and low risks. The ratio can also help identify banks that are operating on a different league. However, The leverage ratio acts as a non-risk sensitive backstop measure to reduce the risk of a build-up of excessive leverage in the institution and in the financial system as a whole.The leverage ratio remains controversial, and there remains ambiguity about certain aspects of the exact mechanics. Implications: The introduction of the leverage ratio could lead to reduced lending and is a clear incentive to banks to strengthen their capital position, although it remains to be seen whether the ratio will bite for individual firms. The non-risk-adjusted measure could incentivize banks to focus on higherrisk/higher-return lending. Pressure arises on banks to sell low margin assets (e.g., mortgages), which could drive down prices on these assets. Banks may be required by the market and the rating agencies to maintain a higher leverage ratio than required by the regulator.

3) What measures should limit the counterparty credit risk? The risk involved in a contract where the counterparty will not stick to his side of the contract. Its also called as default risk. Since Basel II did not require banks to hold enough capital to limit counter party credit risk Basel III imposed a more conservative measure. Basel III requires banks to include a period of economic and market stress when making model assumptions to calculate capital for counter party risks. This way banks will have to hold more capital in order to honour the agreement. Also it has been proposed that banks increase the correlation assumptions between financial firms assets, this will increase the risk adjusted weighting for banks funding from other financial institutions and this will decrease the inter dependency. Description of the key changes Calibration of counterparty credit risk modelling approaches such as Internal Model Methods (IMM) to stressed periods Increased correlation for certain financial institutions in the IRB formula to reflect experience of the recent crisis, new capital charges for Credit Valuation Adjustments, and wrong-way risk Carrot and stick approach to encouraging use of central counterparties (CCPs) for standardized derivatives Improved counterparty risk management standards in the areas of collateral management and stress-testing Implications Still a degree of uncertainty over the final capital impact as Credit Valuation Adjustments charge is being revised to reflect significant industry criticism. Controls and quality of the CCPs risk management is critical as risk is focused on central bodies. Reduce level of intra-financial sector business arising from increased capital charges intra-sector. Costs of dealing with financial counterparties need to be priced into the business, leading to a review of the business model.

4) Highlight the use of liquidity ratios as a focus for the regulatory bodies. The liquidity framework aims to improve banks resilience to liquidity problems in the market. Two liquidity ratios were recommended to monitor short term and long term scenarios. Liquidity Coverage Ratio: ratio of high-quality assets to net cash outflow over 30 day period. It is greater than equal to 100 %.Banks should maintain acceptable liquidity level. Net stable funding ratio: ratio of available stable funding to amount of stable funding required to cover all illiquid assets and securities held. Banks suffered from poor liquidity risk management in financial crisis. The LCR will ensure banks maintain a defined level of high quality assets it also helps to counteract interconnections of financial systems. Implications: The Risk of impact from a bank run should be reduced, which would improve the overall stability of the financial sector. The introduction of the LCR will require banks to hold significantly more liquid, lowyielding assets to meet the LCR, which will have a negative impact on profitability. Banks will change their funding profile, which will lead to more demand for longerterm funding. This funding may not be available from institutional investors that generally seek to reduce their holdings in the financial sector. Interpretation of right run-off rates by national regulators may cause level-playing field discussions.