Question

Complete an internet search of the new requirements for Basel II and Basel III, namely the Strengthening of Capital, Global Liquidity Standards, Leverage ratio, and Risk Coverage. Identify a financial institution of the group choice or one that the group is familiar with. Using the latest available financials statements of the bank the group is familiar with you are required to do an analysis showing how the new Basel requirements will impact the bank/ financial institution and what plans the group will recommend to ensure compliance with the new requirements/ regulations. Work in your group to prepare your paper covering the following

: • A clear understanding of the new requirements under Basel II and Basel III, namely the new requirements for the Strengthening of Capital, Global Liquidity Standards, Leverage ratio, and Risk Coverage

. • Identify no less than five areas under Basel II and III/ or from the above four areas that the bank will need to improve to meet the new requirements. Present cogent arguments in support of each area you identify.

• Identify and explain no less than five risks to the bank as a result of the failure to meet the requirements based on the areas identified. • Present sound plans/ recommendations to mitigate each risk identified above based on the requirements of Basel II and III above.

Answer 1

The main Objective of Basel regulation is to align Regulatory/Internal Capital with the underlying risk and encourages bank to improve their risk Management System. Basel I proposals forced the banks to look at credit risk and regulatory capital more closely.

The three most requirements of Basel 2 has been classified in Pillar 1, Pillar 2 and Pillar 3.

These three pillars are :

1. Minimum Capital Requirements
2. Supervisory Review Process
3. Market Discipline.

1. Under Pillar 1 Banks are required to calculate Capital Under Credit Risk, Market Risk and Operational Risk.

For Credit Risk – Standardized approach, Foundation Internal Rating Based Approach and advanced internal rating based approach is used.

For Market Risk – Standardized Measurement Method, Internal Model Approach is used

For Operational Risk – Basic Indicator approach , Standardized approach and Advanced Measurement approaches is used

1. Pillar 2 requirement are overall assessment of risk that includes: quantitative and qulitativ factors

• Assessment of capital management and planning (ICAAP)
• Risks not taken into account such as IRRBB Risk, Business and Strategic Risk.

1. Pillar 3 Requirement are : - Minimum disclosure requirement

• Capital Transparency
• Capital adequacy
• Risk Measurement and Management

Five areas under Basel-III that the Bank will need to improve to meet the new requirements.

• Higher Minimum Tier 1 Capital Requirement under Basel -3 :- Tier 1 Capital Ratio: increases from 4% to 6%
• Higher Minimum Tier 1 Common Equity Requirement : Tier 1 Common Equity Requirement: increase from 2% to 4.5%
• Liquidity Standard : 100 % Liquidity Coverage Ratio (LCR): to ensure that sufficient high quality liquid resources are available for one month survival in case of a stress scenario
• 100% Net Stable Funding Ratio (NSFR): 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.
• Leverage Ratio
• Leverage Ratio : A supplemental 3% non-risk based leverage ratio.
• Capital for CVA : Capital requirements to cover Credit Value Adjustment risk and higher capital requirements for securitization products. Derivatives and Repos cleared through Central Clearing Parties (CCPs) are no longer risk-free and have a 2% risk weight and clearing members shares in CCPs default funds shall be capitalized

Five risks to the bank as a result of the failure to meet the requirements based on the areas identified.

• 1. Credit Risk
• Counterparty Risk – Failure to meet Obligation
• Credit Rating Risk
• Counterparty Default
• 2. Market Risk
• Interest Rate Risk
• Foreign Exchange Risk
• Equity Price Risk

• 3. Operational Risk
• Internal Operational Risk
• External Operational Risk

• 4. Business/ Strategic Risk
• 5. Liquidity Risk

• Lower Tier 1 Capital ratio bank would be more prone to the failure. For a bank to be robust strong capital adequacy is required
• The LCR measure ensure Liquidity in the Bank for the next 30 days. Failure to meet LCR requirement means bank has no liquidity to cover the payment.

Sound plans/ recommendations to mitigate each risk identified above based on the requirements of Basel II and III above.

1. Credit Risk Mitigation: Use of various techniques which reduce their exposure to individual customers and transactions. For example : The taking of guarantees and security to support the obligations of the primary borrower. The desire to avoid loss is simply a feature of prudent banking and is by no means intimately associated with the lender's capital position.
2. Funded Credit Protection: An arrangement under which the bank has recourse to cash or some other asset in order to recover the moneys owing to it.
3. On balance sheet netting. On balance sheet netting of mutual claims/reciprocal cash balances between the bank and the counterparty create effective security and accordingly recognized as an acceptable form of credit risk mitigation.
4. Hedging of Market Risk : Banks doing Forex/ Derivative Transaction can hedge their risk in market to mitigate the market risk.
5. Hedging of Non Parallel Interest Rate Risk : Non-parallel gap risk: refers to the risk associated with a change in the relative interest rates of instruments at different tenors, which invalidate hedge ratios between instruments repricing at different maturities.
6. Operational Risk is mitigated by buying various Insurance policies.