Basel 3 - A Practical Look

Basel 3 - A Practical Look

Basel 3 A Practical Look Rules of the Game Three Distinct Areas of Regulation Changing Dynamics: Bank of the Future Association of Professional Bankers, 22nd November, 2017 Agenda 1. Why were the Basel 3 regulations needed? 2. What does Basel 3 mean for Banks? 3. What are the most common challenges in implementing Basel 3? 4. How does Basel 3 impact capital planning for Banks?

Page 2 21 November 2017 Why were the Basel 3 regulations needed? Page 3 Thursday, January 16, 2020 Presentation title Evolution of Regulatory Capital Guidance A look across the changes across time Page 4 21 November 2017 Increasing Coverage of the Basel Guidance Regulatory capital by risk factor Page 5

21 November 2017 Basel 3 Objectives Page 6 21 November 2017 Basel 3 Objectives Page 7 21 November 2017 What does Basel 3 mean for Banks? Page 8 Thursday, January 16, 2020 Presentation title

The Basel 3 Framework A look at the key components Page 9 21 November 2017 The Basel 2 Framework How the components stacked up Capital Adequacy Ratio Tier I Capital+ Tier II Capital RWA( Credit Risk + Market Risk+ Operational Risk) 10% Page 10 21 November 2017 Tier I 5%

+ Tier II 5% The Basel 3 Framework How the components now stack up Tier I 6% Capital Adequacy Ratio Tier I Capital (CET I+ AT I)+ Tier II Capital +CCB + DSIB CET I 4.5% Tier II 4% RWA( Credit Risk + Market Risk+ Operational Risk) 14% CCB

2.5% DSIB 1.5% Page 11 21 November 2017 AT I 1.5% The Basel 3 Framework The timelines for the staggered targets Minimum Ratios % Basel 2 Basel 3 Jul 17 Jan 18 Jan 19

Tier I Capital Requirement 5 6 6 6 Minimum Ratio of Total Capital 10 11.75 12.875 14.00 Capital Conservation Buffer N/A

1.25 1.875 2.50 Capital surcharge for DSIB N/A 0.50 1.000 1.50 Counter Cyclical Buffer N/A Page 12 21 November 2017

As and when required 0-2.5 The Basel 3 Framework The key revisions Under Basel II all claims on government of Sri Lanka were risk weighted at 0%, under Basel III CBSL has introduced 20% risk weightage for foreign claims on government of Sri Lanka from 01.01.2018. Further, CBSL has introduced the following risk weightages for gold backed lending based on the Loan To Value (LTV) ratio. Criteria Basel 2 Basel 3 Maximum Credit Exposure <200 Mn <250 Mn Annual turn over

<600 Mn <750 Mn LTV Ratio (%) Less than or equal 70 0 Over 70 and below 100 20 Over 100 100 Qualifying criteria for SME exposure Risk weight for SME Exposures Basel 2 - 75% for all SME exposure Basel 3 - 60% for SME exposure secured on immovable property. 75% for other SME exposure.

Page 13 21 November 2017 Risk Weight (%) What are the most common challenges in implementing Basel 3? Page 14 Thursday, January 16, 2020 Presentation title Key Challenges A look at the main issues across five dimensions Challenges Missing data and poor data quality

Small sample size or lack of bad cases Data Methodology Lack of standard methodologies for model development Common lack of trust in statistical methodology considering issues with quality data at many banks Lack of personnel with sufficient knowledge and experience in model development Human Resource

Page 15 Lack of formally established model development / validation teams which are staffed with these specific objectives 21 November 2017 Key Challenges A look at the main issues across five dimensions Challenges Senior management awareness and endorsement Board of Directors

Senior Management: Use Test Page 16 Model deployment is time-consuming, which adversely impacts planned time New models may detect high-risk customers, however, given that traditional criteria may be ignored, this may lead to challenges Credit Analyst

Incomplete appreciation of the benefits of risk quantification, and lacks orienting direction to the whole system. Not assigned specific responsibilities to personnel Additional responsibilities in model usage and maintenance Credit team are concerned about asking customers for additional documents Lack of continuous / on-going support, when there are issues faced in model usage 21 November 2017 How does Basel 3 impact capital planning for Banks? Page 17 Thursday, January 16, 2020 Presentation title

Basel Capital Planning Capital optimisation across risk types Risk type Opportunity Market Risk Limited opportunity VaR already perceived as low Operational Risk Limited opportunity AMA models complex and whilst capital may be exaggerated, the cost benefit is not attractive Credit risk Lots of opportunity many components of RW calculation, subjectivity in models, significant regulatory ambiguity, clear links with business processes, significant percentage of bank capital requirement...

Page 18 Basel Capital Planning The denominator: Where do RWA figures come from? Standardised Approach vs. Internal Ratings-Based Approach Counterparty Transaction Risk parameter estimates External ratings Risk Weight Internal Ratings Based Approach Standardised Approach Simple prescribed formulae Maturity (M)

Probability of default (PD) Loss given default (LGD) Exposure at default (EAD) Complex prescribed formulae Risk weighted assets (RWA) * 8% Capital requirement Page 19 F-IRB Ow n estimate PD A-IRB Ow n estimate PD, EAD, LGD Basel Capital Planning

Optimising RWA on standardised portfolios Missing ratings Matching limits to exposures CCFs allocation to categories Collateral eligibility for recognition Credit risk mitigation Maturity calculations

Exposure classes Retail / SME, central banks, government agencies Use of short term ratings Page 20 Basel Capital Planning Optimising Probability of Default (PD) in IRB Many choices / options in modelling PD Definition of default

Defining data sample use of external rating agency data Segmentation Calibration approach PiT / TTC considerations, scalar methodology Treatment of missing fields Use of rating grade mappings and master scales Obligor level or grade level feed into RWA calculator

Treatment of missing ratings Page 21 Basel Capital Planning Optimising Loss Given Default (LGD) in IRB Many choice / options in modelling LGD Typical components haircuts, LTV, possession / liquidation rollrates, time to liquidation, time to write-off, recovery rate... Segmentation

Types of averaging default weighted, exposure weighted, PD weighted etc. Downturn methodology Calibration of components or overall LGD compounding conservatism Severe outcome in benign period as a proxy for expected outcome in a downturn period bad proxy Page 22 Thank you

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