Basel 3: A new perspective on portfolio risk management Tamar JOULIA-PARIS October 2011 1
Content Basel 3 1. A complex regulatory framework With possible unintended consequences Consequences on 2. Main banking products and business models Risk management Portfolio and balance sheet management Conditions for success of an active balance- 3. sheet optimization 2
1. Basel 3: A challenging objective The 2008 financial crisis proved that Basel II was insufficient: Amount and quality of Capital were inadequate to absorb extreme 1. losses, forcing for some banks bail-out Some risks were not adequately recognised : counterparty risk, 2. rating agencies, securitizations, excessive growth, procyclicality, etc 3. Interconnectedness between obligors and toxic asset classes, and systemic risks , were underestimated. Banks did not have enough liquidity buffers. 4. Negative impact on depositors (Bankruptcies), banking systems and global economy required state aids in US and Europe . New rules are being implemented at country level as of Jan 2013: Basel III → CRD IV (EU) → Country laws. 3 3
Systemic risk management: a complex supervisory framework (For illustration : EU framework) European Systemic Risk Board ( ESRB ) = new independent body, for all financial sectors & guarantee schemes, responsible for macro -prudential oversight at the level of the EU. European System of Financial Supervision ( ESFS ) = network of actors who ensure the micro -prudential supervision of EU financial system: the European Banking Authority ( EBA ); the European Insurance and Occupational Pensions Authority ( EIOPA ); the European Securities and Markets Authority ( ESMA ) ; the Joint Committee of the European Supervisory Authorities ( ESA ); the competent or supervisory authorities in the Member States; the European Systemic Risk Board. Rem: Basel III (banks) and Solvency II (Insurers) have similar objectives but different approaches, with possible unintended consequences. 4
Basle 3 : Minimum financial resources Solvency ratios Risk based (Tier I) : Eligible Capital / RWA > 8%, 3 capital buffers, 2 tiers Purpose : Increase risk coverage (2013-2018) and quality of capital Non risk based (Leverage) : Capital > 3% of total on/off balance-sheet Purpose : Constrain leverage build-up Liquidity ratios Liquidity Coverage ratio (LCR): 30 days net outflow / Liquid assets < 100% Purpose : Ensure high quality liquid assets can fund 30 days stressed outflows Net Stable Funding Ratio (NSFR): Available stable (LT) funding / Required stable (LT) funding > 100% Purpose : Ensure illiquid assets can be funded during one year with a minimum amount of stable financial resources 5
Basel III: a long but challenging phase – in 2011 to 2018 Jan 2011 2012 2013 2014 2015 2016 2017 2018 2019 Common equity ratio 3.5% 4% 4.5% Conservation buffer 0.625% 1.25% 1.875% 2.5% Common equity+conservation 3.5% 4% 4.5% 5.125% 5.75% 6.375% 7% Tier 1 capital ratio 4.5% 5.5% 6% Total capital ratio (unchanged) 8% Total capital + conservation 8% 8.625% 9.125% 9.875% 10.5% Countercyclical buffer 0 to 2.5 % Uneligible capital instruments Phased out over 10 yrs starting 2013 LCR ratio Observation Introduction NSFR ratio Observation Introduction Leverage ratio Monitoring Parallel run + disclosure (2015) Pillar I 6
2. Basel 3 – Summary of consequences On Products : Some banking products will become more expensive and reduce banks ROE On Business models : Basel 3 favors traditional retail & commercial banking vs complex trading activities, but challenge the bank’s transformation role On Risk Management New risk paradigm, with partnership between Risk and Finance On Portfolio and Balance-Sheet management: The combined management of capital, leverage & liquidity ratios will require a new framework for balance-sheet optimization 7 7
Basel 3 : Impact on main banking products Increased amount & cost of capital, combined with additional cost of liquid assets & long term funding, will make some banking products more expensive and reduce banks ROE More Less favorable favorable Low risk assets Financials, High risk Tier 1 Trading (mortgages, securitization, assets, re- ratio activities govt debt) wrong-way risk securitization Low risk assets, Leverage High risk assets Central clearing undrawn ratio of derivatives commitments LCR Cash, central Low risk Unsecured bank bank reserves, corporate and (short term bonds govt bonds covered bonds liquidity) Term deposits Wholesale Funding from Stable savings > 1 yr savings Financials NSFR (long term LT debt, high Low LTV High LTV Liquidity funding) quality bonds mortgages mortgages facilities 8
Basel III – Impact on business models The business context is not so exciting for Financial Institutions in developed markets…. a) The business context: Limited growth perspectives Customer behavior transformation Continued exposure to systemic risks Cost cutting programs Large technology programs Uncertainties in interest rate, tax and regulations Mismatch between shareholders expectations & regulatory requirements etc 9
Basel 3 – Impact on business models …. and Basel 3 favors traditional banking versus complex trading activities, while also challenging the bank’s transformation role b) The Business consequences of Basel III: Increased cost of holding a balance-sheet Downsizing of activities severely impacted by Basel III Increased competition for customer deposits (LCR) and granular high yield assets (SME loans) Challenge of banks maturity transformation role (NSFR) Development of new products combining loans and deposits Less incentive for talented people to work for banks Balance between short term and long term management etc 10
Basel 3 – Impact on risk management The famous “new” risk paradigm, managing risk together with return on a pro- active basis…. Growing importance of stress tests Sensitivity analyses (unconditional stress tests), “Probable” scenarios for business , finance and risk planning, “Stressed” scenarios for capital , liquidity and appetite for risk management. Focus on governance and risk appetite: Tolerance defined at the top, and aligned with group strategy, Cascading down via KRI’s per business line (value) and risk type (concentrations) KRI’s connected to KPI’s (Capital, Liquidity, Earnings, Growth). Internal emphasis on regulatory requirements Break-up of silo risk management at portfolio level 11
Basel 3 – Impact on CPM The competences of CPM teams (clients, products, models, markets, accounting, regulations, etc) are leveraged for complementary purposes …. a) The business context of CPM activities Reduced activity in support of tier I ratio (RWA release) Lower incentive to originate or retain investment grade loans Limited liquidity in credit markets, CDS and mainly securitizations, Challenge of the value of straightforward « diversification » Priority on funding and management of liquidity ratios High recognition as experts in combining business, market, risk, finance and regulatory knowledge. 12
Basel 3 – From CPM to balance sheet management The combined management of capital, leverage & liquidity ratios will require a new infrastructure for balance-sheet optimization (Capital management, Treasury, ALM, CPM) Capital Liquidity Risk B/S b) The change in credit portfolio functions Models Treasury Scenarios Front end CPM integrated with funding for new loans Back end CPM integrated with balance-sheet management Migration towards a more holistic internal transfer pricing Priority on liquidity, more than credit or capital management Management of client/business value at balance-sheet level 13
Basel 3 – FROM CPM to B/S management Summary Financial institutions should prepare for an active balance-sheet management, by … 1) Understanding the combined effect of all financial risks on pricing and on financial performance Technology : Collecting & stressing Risk & Finance cash flow information; Risk management : Combining top-down management of financial risks (Credit, ALM, and liquidity); Risk and finance Planning : Combining scenarios/stress tests on P/L, balance sheet and cash flows; Benchmarking KPI’s and KRI’s with performance targets and appetite for risk; Combined contingency plans on funding and capital; Single internal performance benchmark : new fund transfer price. 14 14
Basel 3 – From CPM to B/S management Conditions for success 2) Developing solutions to transfer granular long term loans to investors with a more adequate liability profile, i.e. Revive a different loan securitization market, complementary to covered bonds, allowing for eligibility as HQLA and lower RWA %, Set up independent but regulated Utilities, acting as providers of fiduciary services to facilitate risk transfers, mainly between regulated institutions, Allow long term investors to invest in a regulatory accepted form, reducing their exposure to inflation risk while supporting the economy. 15 15
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