Basel III Overview and Update - June 2010

Firstly, some Basel II History (Basel III Overview is below)

Basel II was implemented by many European and Worldwide banks in

2006.
The existing guidelines were found to be unsuitable to ensure adequate
bank liquidity during the Credit Crunch conditions. Basel II rules are now
being reviewed in conjunction with the industry.
There are a number of criticisms of Basel II, including that the rules are
influenced by the industry, and they are very dependent on rating
agencies.
There were a number of weaknesses exacerbated by the credit crunch
including,
excessive leverage in the banking and financial system and not
enough high quality capital to absorb losses;
excessive credit growth based on weak underwriting standards and
under pricing of liquidity and credit risk;
insufficient liquidity buffers and overly aggressive maturity
transformation, both direct and indirect (for example, through the
shadow banking system);
inadequate risk governance and poor incentives to manage risks
towards prudent long term outcomes, including through poorly
designed compensation systems;
inadequate cushions in banks to mitigate the inherent procyclicality
of financial markets and its participants;
too much systemic risk, and connected financial players with
common exposures to similar shocks, and inadequate oversight that
should have served to mitigate the too-big-to fail problem.

Basel III Key Facts

Basel III is an update to the existing Basel II guidelines
The updated rules will affect the Capital Requirements Directive that banks use to
determine the minimum capital they should hold to adequately fund them through
periods of financial stress
Basel III is currently in the consultation phase and here are numerous changes to the
framework that are being considered.
There are two new rations that will be used in Basel III, see below.

New Proposed Ratios to measure and monitor Liquidity Risk

Liquidity Coverage Ratio
Introduction of a Liquidity Coverage Ratio - to promote the short-term resiliency of the
liquidity risk profile of institutions by ensuring that they have sufficient high quality liquid
resources to survive an acute stress scenario lasting for one month.
Net Stable Funding Ratio

To promote resiliency over longer-term time horizons by creating additional incentives for
banks to fund their activities with more stable sources of funding on an ongoing structural
basis. The Net Stable Funding Ratio has been developed to capture structural issues related to
funding choices.

Basel III can be described as

A key characteristic of the financial crisis was the inaccurate and ineffective management of
liquidity risk. In recognition of the need for banks to improve their liquidity risk management
and control their liquidity risk exposures new proposals are being produced, commonly
referred to Basel III or Basel 3.
Basel III are proposed changes to Basel II regulations put forward by the BCBS (Basel
Committee of Banking Standards) to deliver a banking and financial system that acts as a
stabilizing force for the real economy in highly stress tested conditions. These conditions can
include systemic risk, withdrawals by depositors or concentration of risk etc.

Changes to Basel III regulation proposals are produced by who

Basel Committee on Banking Supervision

Who is in the committee tasked with producing the new Basel III
proposals ?
Below are some details of the committee named the 'Basel Committee on
Banking Supervision.'
The Committee provides a forum for regular cooperation on banking supervisory
matters. Over recent years, it has developed increasingly into a standard-setting
body on all aspects of banking supervision.
Membership of the Committee
Senior officials responsible for banking supervision or financial stability issues in
central banks and authorities with formal responsibility for the prudential
supervision of banking business where this is not the central bank.
Basel Committee Member Countries
Argentina, Korea
Australia, Luxembourg
Belgium, Mexico
Brazil, Netherlands
Canada, Russia
China, Saudi Arabia
France, Singapore
Germany, South Africa
Hong Kong SAR, Spain
India, Sweden
Indonesia, Switzerland
Italy, Turkey

Japan, United Kingdom

United States

What new ratio is included in Basel III?

The Committee developed the Liquidity Coverage Ratio.
The objective is to promote the short-term resiliency of the liquidity risk profile of
institutions by ensuring that they have sufficient high quality liquid resources to survive an
acute stress scenario lasting for one month.

What is the 2nd new ratio included in Basel III?

The Net Stable Funding Ratio is to promote resiliency over longer-term time horizons by
creating additional incentives for banks to fund their activities with more stable sources of
funding on an ongoing structural basis.
The Net Stable Funding Ratio has been developed to capture structural issues related to
funding choices.
The net stable funding (NSF) ratio measures the amount of longer-term, stable sources of
funding employed by an institution relative to the liquidity profiles of the assets funded and
the potential for contingent calls on funding liquidity arising from off-balance sheet
commitments and obligations.
The standard requires a minimum amount of funding that is expected to be stable over a one
year time horizon based on liquidity risk factors assigned to assets and off-balance sheet
liquidity exposures.
The NSF ratio is intended to promote longer-term structural funding of banks' balance sheets,
off-balance sheet exposures and capital markets activities.

EU Financial Regulations > Solvency II

The insurance industry are to implement Solvency II and this will attempt to link the
regulatory capital required, sometimes known as the reserving requirements, to the risk the
firm faces. These initiative are a result of work by the EU who have issued the rules of the
process.
The current EU Solvency system has so far has been able to achieve a reasonable level of
reserve capital is held, but there are critics who argues that the system didn't identify the real
risks and that insurance firms may be different depending on their profile, so they should not
be treated the same. This is where Solvency II will alter the landscape and the project was
launched at the end of the year 2000. In August 2002 a paper was released by the Committee
Europeen Des Assurances summarizing how Solvency 2 should develop. Parts of the
development included a 3 pillar approach much like Basel II for Banks.
Solvency II implementation was meant to be in 2007 but now looks as if it will be in 2012.

Firms will have to work on interpreting the requirements of Solvency II and implement a
more sophisticated approach to risk management. Internal models will have to be enhanced
and all the assumptions will have to be reported to the relevant regulators. Actuarial models
in systems such as MoSeS or Prophet will have to be altered and tested in time for the
Solvency II introduction.
For firms in the UK, Solvency II will be included in the soon to be released Integrated
Prudential Sourcebook which will set out the requirements for Insurers including the 'twin
peak' approach to reserving requirements. The FSA in the UK has released its most current
document which is the 'near final' rules of the sourcebook. In this text it specifies that
Solvency II is a part of the LTICR Long Term Insurance Capital Requirements component.