Impacts of Basel III from an IT Systems Perspective

The recent crisis has revealed significant market failures in the banking system. In response to that the Basel Committee is introducing a number of fundamental reforms to the international regulatory framework unofficially called “Basel III”. These regulations are designed to create a more risk sensitive framework for banks. This framework captures the risks a bank is exposed to more comprehensively, and also strengthens the risk management, governance, and transparency.

In this article the current developments around the finalization of the Basel III requirements are presented. Furthermore the article tries to anticipate the impacts of the expected regulatory changes to the IT environments of financial institutions.

Changes in the Regulatory Capital Framework – the Roadmap to Basel III

The international capital framework is subject to a constant change. In July 2009 a set of enhancements were adopted to amend the existing Basel II regulations. These enhancements affected in particular the treatment of the trading book and must be implemented by December 2010.

At the end of 2009 the initial work on Basel III started with the publications of the consultative documents Strengthening the Resilience of the Banking Sector (BCBS 164) and International Framework for Liquidity Risk Measurement, Standards and Monitoring (BCBS 165). According to the initial time schedule the consultative phase ended in April 2010. Finalization of the regulations was planned for December 2010 to be followed by an implementation phase of two years.

As a reaction to the Basel committee’s papers the banking industry warned that economic growth in the Euro-zone, the US and Japan will be cut significantly in the next years, if current proposals to force banks to hold more capital and liquid assets go forward unchanged.

During the recent G20 summit in Toronto a draft of the latest thinking of the committee was presented where Basel committee was suggesting that its proposals will be thinned down. The revised version of the Basel Committee’s proposals will be presented on the mid-Novembers G20 summit in Seoul. After the Toronto summit, the general public opinion could be summarized as “Banks win battle for limits to Basel III”.

In July the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision confirmed that steady progress is being made towards the end-year publication of fully fleshed-out Basel III standards. However, it is already clear that extensive transition periods (up to 2018 on some cases) will be allowed for implementation of several of the new elements, and final decisions have yet to be taken on calibration. At the same time the Group of Governors expresses that they remain committed to all elements of Basel III including the Net Stable Funding Ratio (LSFR) as a longer term structural complement to the Liquidity Coverage Ratio (LCR) (see figure 1).

Strengthening the Resilience of the Banking Sector (BCBS 164) –
Key Elements of the Paper

The suggestions for the Basel III framework are divided in two documents as mentioned in the first section of this article. The first publication Strengthening the Resilience of the Banking Sector (BCBS 164) defines changes for the recognition of regulatory capital, which is the numerator of the current regulatory capital ratio. Furthermore the valuation for the elements of the denominator, i.e. market risk, credit risk, and operational risk are adapted.

The main objectives of the paper are summarized in remainder of this section.

Raising the quality, consistency and transparency of the capital base

In the current framework the treatment of regulatory capital shows various weak points. In the first place regulatory capital is disconnected from common equity. Furthermore there is currently no harmonization across countries – e.g. IFRS adopting countries vs. non IFRS adopting countries – this contradicts the idea of an internationally level playing field for the banking industry. As a final point regulatory capital lacks transparency since the disclosure provided by banks about their regulatory capital bases is frequently deficient.

To advance on the treatment of regulatory capital the Basel Committee makes the following suggestions. The quality of Tier 1 capital will be enhanced. Tier 1 capital must help a bank to remain a “going concern”. Tier 2 capital will be simplified. A 5 years “amortization rule” will be introduced for borrowed funds. Tier 3 capital will be completely abolished. Of course new limits have to be defined between the remaining capital components. Finally the Basel Committee proposes a projection of the regulatory capital to a future point in time for a more comprehensive view on the future risk exposure and regulatory capital consumption of banks.

Impacts to the IT architecture

New harmonized rules make it necessary to introduce a new standardized calculation routine for regulatory capital. The introduction of an “amortization rule” requires a more detailed view on the regulatory capital elements, a calculation on a “single deal” level will be necessary. Finally the suggested projection of regulatory capital into the future raises needs for a new view on the regulatory reporting architecture of the bank.

Enhancing risk coverage for counterparty credit risk (CCR)

During the recent crisis, needs for improvement of risk coverage in the current regulatory framework became obvious. Wrong-way risk was not covered adequately; it could be found that counterparty exposures still went up, when creditworthiness went down. Credit valuation adjustments (CVA) were not directly capitalized. Another problem occurred because the interconnectedness between large counterparties was not properly reflected in the systems. Finally time horizons for the close-out were longer than expected and initial margins were too low.

The new regulatory framework proposes several changes to overcome those shortfalls. A first building block is the calculation of the effective expected positive exposure (EPE), taking into account stress scenarios (3 years of time). The valuation of this risk figure should be consistent to the market risk framework. Furthermore to capture losses from credit value adjustments (CVA) the Basel Committee suggests generating a bond-equivalent of the counterparty exposure. For this synthetic deal, which will represent the EAD to the counterparty, the calculation of (99%-)worst-case P/L as per the market risk framework must be performed. To cover wrong-way risk the banks should design stress testing and scenario analyses to identify risk factors that are positively correlated with counterparty creditworthiness. Last but not least various minor changes are proposed, e.g. the implementation of higher asset correlation factor to Basel II formula, a change to external rating framework, and an adaption of the netting framework.

Impacts to the IT architecture

The necessity for the valuation of the expected positive exposure (EPE) requires new software components calculating the EPE according to internal or shortcut methods and to do significant stress testing on the EPE. Likewise credit value adjustments (CVA) have to be valuated and stress tested. In the existing Basel II calculation kernels, minor changes have to be done to be able to comply with the expected new framework.

Introducing a leverage ratio

The introduction of a leverage ratio is meant to more adequately measure the off-balance-sheet exposure of the banks. One of the major problems in the crisis was that the excessive on-balance/off-balance leverage was not reflected in the regulatory figures. Many banks showed strong risk-based capital ratios despite excessive leverage.

The Basel Committee proposes the introduction of a leverage ratio to integrate off-balance sheet exposure properly in the pillar 1 treatment. The leverage is defined as the ratio between capital and exposure, where capital is the Tier 1 capital and the exposure is the total exposure (on-balance and off-balance) of the bank.

Impacts to the IT architecture

The leverage ratio is a new risk figure, currently not available in the systems. If the result set of the existing Basel II solution is based on single deal data the calculation of this value can be easily implemented on these data. Clearly the existing reporting framework has to be adapted.

Avoiding systemic risk and interconnectedness of risk

The current regulatory framework does not reflect systemic risk and the interconnectedness of different risk types. Furthermore cyclicality is not yet properly introduced in Basel.

To overcome these shortfalls the following changes are proposed. Cyclicality shall be introduced in the current framework. For this purpose calculation of downturn PD and downturn LGD are foreseen in the Basel Committee’s paper. Furthermore a forward looking provisioning shall be introduced, ensuring consistency of EL calculation between IFRS accounting and minimum capital standards. To be prepared for times of crisis the Committee plans to enforce banks to build up adequate capital buffers based on expected credit growth.

Impacts to the IT architecture

The requirements of the new regulatory framework, concerning systemic risk and interconnectedness of risk make high demands on the software architecture. The PD and LGD modelling framework has to provide stress testing capabilities, taking into account the effects of macro-economic parameters like GDP growth, unemployment rate. Furthermore the calculations have to be consistent to IFRS to do a forward looking provisioning. To be able to fulfil the extensive requirements to build up adequate capital buffers banks need a completely integrated risk environment, including behavioural analysis and a dynamic B/S & P/L view to project required capital.

International Framework for Liquidity Risk Measurement, Standards and Monitoring (BCBS 165) – Key Elements of the Paper

The second publication International framework for liquidity risk measurement, standards and monitoring (BCBS 165) defines changes for liquidity risk measurement in banks. For regulatory reporting purposes new standardized measures of liquidity risk exposure are defined. Furthermore it is stipulated that banks and supervisors use common liquidity risk monitoring tools. Finally all tools and processes shall be applied in the banks daily routine.

The main objectives of the paper are summarized in remainder of this section.

New standardized measures of liquidity risk exposure

A key characteristic of this of the global financial crisis which began in mid-2007 was the inaccurate and ineffective management of liquidity risk. In the current regulatory (Pillar 1) framework liquidity risk is not even covered. One of the key elements of the Basel Committee’s international framework on liquidity risk is the introduction of new standardized liquidity risk measures.

The Liquidity Coverage Ratio (LCR) is a short term measure for the banks’ liquidity exposure. It combines Basel II specific information (e.g. the asset class) and cash flow based information. Besides the pure calculation of the LCR the Basel Committee requires the presentation of the effects of different scenarios on the measure. To cover longer term effects in liquidity risk measurement the Net Stable Funding Ratio (NSFR) has to be calculated as the ratio between Available Stable Funding (ASF) and Required Stable Funding (RSF). The calculations have to be done on a single deal basis. Both values, ASF and RSF, require a specific selection and individual weighting of financial instruments.

Impacts to the IT architecture

The calculation of new standardized measures for the liquidity risk exposure is a new requirement in the banks IT architecture. Calculations have to be done on a single deal basis and the calculation engine has to select data from multiple sources, e.g. the existing Basel II result data or from ALM/cash flow data marts. Furthermore banks have to think about the integration of the new required templates (see figure 2).

Implementation of monitoring tools

Besides the calculation of the standardized liquidity risk measures described in the section above the Basel Committee encourages national supervisors to implement additional risk figures. Banks will have to provide raw data to the supervisor to enable him to calculate at least the following metrics:

• Contractual maturity mismatch
• Concentration of funding
• Available unencumbered assets

Impacts to the IT architecture

The calculation of additional values requires a comprehensive and centralized cash flow generation. Furthermore banks will have to re-calculate the measures inside the existing ALM and Liquidity solution. If there was no centralized cash flow generation component this would result in additional efforts for the reconciliation between internal and external reporting.

Conclusion

The consultative papers presented in this article will finally lead to a Basel III guideline. Currently the time for implementation and potential transition phases for the different building blocks of Basel III are not yet clear. Clarification on the final contents of the framework and the implementation schedule will be disclosed on the next G20 meeting in Korea mid-November.

From an IT-systems perspective, compared to Basel II, there will NOT BE A SINGULAR “Basel-III-system”, but the requirements will affect multiple systems and raise the need for punctual solutions. Examples for these topics are calculation modules for counterparty credit risk, the leverage ratio, the liquidity ratios as well as a stress testing module, a module for regulatory capital recognition and projection, and the new reporting framework for liquidity risk.

A potential system architecture for a Basel III-compliant IT architecture can be seen in the figure 3.

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