Handbook of Basel III Capital E-Book

Juan Ramirez

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch
• Veröffentlichungsjahr: 2016

Seitenzahl: 1093

Beschreibung

A deeper examination of Basel III for more effective capital enhancement The Handbook of Basel III Capital - Enhancing Bank Capital in Practice delves deep into the principles underpinning the capital dimension of Basel III to provide a more advanced understanding of real-world implementation. Going beyond the simple overview or model, this book merges theory with practice to help practitioners work more effectively within the regulatory framework, and utilise the complex rules to more effectively allocate and enhance capital. A European perspective covers the CRD IV directive and associated guidance, but practitioners across all jurisdictions will find value in the strategic approach to decisions surrounding business lines and assets; an emphasis on analysis urges banks to shed unattractive positions and channel capital toward opportunities that actually fit their risk and return profile. Real-world cases demonstrate successful capital initiatives as models for implementation, and in-depth guidance on Basel III rules equips practitioners to more effectively utilise this complex regulatory treatment. The specifics of Basel III implementation vary, but the underlying principles are effective around the world. This book expands upon existing guidance to provide a deeper working knowledge of Basel III utility, and the insight to use it effectively. * Improve asset quality and risk and return profiles * Adopt a strategic approach to capital allocation * Compare Basel III implementation varies across jurisdictions * Examine successful capital enhancement initiatives from around the world There is a popular misconception about Basel III being extremely conservative and a deterrent to investors seeking attractive returns. In reality, Basel III presents both the opportunity and a framework for banks to improve their assets and enhance overall capital - the key factor is a true, comprehensive understanding of the regulatory mechanisms. The Handbook of Basel III Capital - Enhancing Bank Capital in Practice provides advanced guidance for advanced practitioners, and real-world implementation insight.

Leseprobe

Table of Contents

Cover

Title Page

Copyright

Dedication

Preface

About the Author

Chapter 1: Overview of Basel III

1.1 Introduction to Basel III

1.2 Expected and Unexpected Credit Losses and Bank Capital

1.3 The Three-Pillar Approach to Bank Capital

1.4 Risk-Weighted Assets (RWAs)

Chapter 2: Minimum Capital Requirements

2.1 Components and Minimum Requirements of Bank Capital

2.2 Components and Minimum Requirements of Capital Buffers

2.3 Capital Conservation Buffer

2.4 Countercyclical Buffer

2.5 Systemic Risk Buffers

2.6 Going Concern vs. Gone Concern Capital

2.7 Case Study: UBS vs. JP Morgan Chase G-SIB Strategies

2.8 Transitional Provisions

Chapter 3: Common Equity 1 (CET1) Capital

3.1 CET1 Minimum Requirements

3.2 Eligibility Requirements of CET1 Instruments

3.3 Case Study: UBS Dividend Policy and its Impact on CET1

3.4 Case Study: Santander Dividend Policy and its Impact in CET1

3.5 Accumulated Other Comprehensive Income

3.6 Case Study: Banco BPI’s Partial Disposal of Portfolio of Portuguese and Italian Government Bonds

3.7 Other Items Eligible for CET1 Capital

3.8 CET1 Prudential Filters

3.9 Additional Valuation Adjustments

3.10 Intangible Assets (Including Goodwill)

3.11 Case Study: Danske Bank’s Goodwill Impairment

3.12 Case Study: Barclays Badwill Resulting from its Acquisition of Lehman Brothers N.A.

3.13 Deferred Tax Assets

3.14 Fair Value Reserves Related to Gains or Losses on Cash Flow Hedges

3.15 Negative Amounts Resulting from the Calculation of Expected Loss Amounts

3.16 Equity Increases Resulting from Securitised Assets

3.17 Gains or Losses on Liabilities Valued at Fair Value Resulting from Changes in Own Credit Standing

3.18 Defined-Benefit Pension Plans

3.19 Case Study: Lloyds’ De-Risking of its Defined Benefit Pension Plans

3.20 Holdings by a Bank of Own CET1 Instruments

3.21 Case Study: Danske Bank’s Share Buyback Programme

3.22 Case Study: Deutsche Bank’s Treasury Shares Strategy

3.23 Holdings of the CET1 Instruments of Financial Sector Entities

3.24 Deduction Election of 1,250% RW Assets

3.25 Amount Exceeding the 17.65% Threshold

3.26 Foreseeable Tax Charges Relating to CET1 Items

3.27 Excess of Qualifying AT1 Deductions

3.28 Temporary Filter on Unrealised Gains and Losses on Available-for-Sale Instruments

Chapter 4: Additional Tier 1 (AT1) Capital

4.1 AT1 Minimum Capital Requirements

4.2 Criteria Governing Instruments Inclusion in AT1 Capital

4.3 Deductions from AT1 Capital

4.4 Holdings of AT1 Instruments of Other Financial Institutions

4.5 Case Study: Lloyds Banking Group Exchange Offer of Tier 2 for AT1 Securities

Chapter 5: Tier 2 Capital

5.1 Tier 2 Capital Calculation and Requirements for Inclusion

5.2 Negative Amounts Resulting from the Calculation of Expected Loss Amounts

5.3 Deductions from Tier 2 Capital

5.4 Holdings of Tier 2 Instruments of Other Financial Institutions

5.5 Case Study: Deutsche Bank’s Tier 2 Issue

Chapter 6: Contingent Convertibles (CoCos)

6.1 Types of CoCos

6.2 Trigger Levels

6.3 CoCos’ Statutory Conversion or Write-Down — Point of Non-Viability

6.4 CoCo’s Coupon Suspension — Maximum Distributable Amount

6.5 Adding Pillar 2 Capital Requirements to the MDA Calculation

6.6 Case Study: Barclays’ Equity Convertible CoCo

6.7 Case Study: Deutsche Bank’s Write-Down CoCo

6.8 CoCos from an Investor’s Perspective

Chapter 7: Additional Valuation Adjustments (AVAs)

7.1 Fair Valuation Accounting Framework (IFRS 13)

7.2 Case Study: Goldman Sachs Investment in Industrial and Commercial Bank of China

7.3 Prudent Valuation vs. Fair Valuation

7.4 Additional Valuation Adjustments (AVAs) Under the Core Approach

7.5 Market Price Uncertainty AVA

7.6 Close-Out Costs AVA

7.7 Model Risk AVA

7.8 Unearned Credit Spreads AVA

7.9 Investing and Funding Costs AVA

7.10 Concentrated Positions AVA

7.11 Future Administrative Costs AVA

7.12 Early Terminations Costs AVA

7.13 Operational Risk AVA

Chapter 8: Accounting vs. Regulatory Consolidation

8.1 Accounting Recognition of Investments in Non-Structured Entities

8.2 Accounting for Full Consolidation

8.3 Working Example on Consolidation

8.4 Loss of Control

8.5 The Equity Method — Associates

8.6 Case Study: Deutsche Bank’s Acquisition of Postbank

8.7 IFRS Consolidation vs. Regulatory Consolidation

Chapter 9: Treatment of Minority Interests in Consolidated Regulatory Capital

9.1 Minority Interests Included in Consolidated CET1

9.2 Minority Interests Included in Consolidated AT1, Tier 1, Tier 2 and Qualifying Total Capital

9.3 Illustrative Example 1: Calculation of the Impact of Minority Interests on Consolidated Capital

9.4 Illustrative Example 2: Calculation of the Impact of Minority Interests on Consolidated Capital

9.5 Case Study: Artificial Creation of Minority Interests

9.6 Case Study: Banco Santander Repurchase of Minority Interests in Santander Brasil

Chapter 10: Investments in Capital Instruments of Financial Institutions

10.1 Basel III Treatment of Investments in Capital Instruments of Financial Institutions

10.2 Worked Examples of Investments in Capital Instruments of Unconsolidated Financial Institutions

10.3 Case Study: BBVA’s Acquisition of Garanti

Chapter 11: Investments in Capital Instruments of Insurance Entities

11.1 The Concept of Double Leverage

11.2 Case Study: ING’s Double Leverage

11.3 Regulatory Peculiarities of Investments in Insurance Entities

11.4 Case Study: Lloyds Banking Group’s Capital Enhancement Initiatives Related to its Insurance Subsidiaries

Chapter 12: Equity Investments in Non‐financial Entities

12.1 Basel III and Equity Exposures to Non-Financial Entities in the Banking Book

12.2 Equity Exposures Under the Standardised Approach

12.3 Equity Exposures Under the IRB Approach

12.4 Expected Losses from Equity Exposures Under the IRB Approach

12.5 Qualified Holdings Outside the Financial Sector Exceeding the 15% Threshold

12.6 Temporary Exemption from the IRB Treatment of Certain Equity Exposures

12.7 Case Study: CaixaBank’s Mandatory Exchangeable on Repsol

12.8 Case Study: Mitsubishi UFJ Financial Group’s Corporate Stakes

Chapter 13: Deferred Tax Assets (DTAs)

13.1 Taxes from an Accounting Perspective

13.2 Accounting for Deferred Taxes Arising from Temporary Differences — Application to Equity Investments at Either FVTPL or FVTOCI

13.3 Worked Example: Temporary Differences Stemming from Debt Instruments Recognised at Fair Value

13.4 Case Study: UBS’s Deferred Tax Assets

13.5 Deferred Tax Assets from a Regulatory Capital Perspective

13.6 Case Study: Spanish Banks Conversion of DTAs Into Tax Credits, Improving Their CET1 Positions

13.7 Case Study: Lloyds Banking Group’s Expected Utilisation of Deferred Tax Assets

13.8 Initiatives to Reduce Impacts of Deferred Tax Assets on Bank Capital

Chapter 14: Asset Protection Schemes and Bad Banks

14.1 ING’s Illiquid Asset Back-Up Facility with the Dutch State

14.2 Royal Bank of Scotland’s Asset Protection Scheme

14.3 Case Study: SAREB, The Spanish Bad Bank

14.4 Case Study: NAMA, The Irish Bad Bank

14.5 Asset Protection Schemes versus Bad Banks

Chapter 15: Approaching Capital Enhancement Initiatives

15.1 Initial Thoughts

15.2 Overview of Main CET1 Capital Ratio Enhancement Initiatives

15.3 Case Study: Deutsche Bank’s Rights Issue

15.4 Case Study: Structuring the Disposal of a Portfolio of NPLs

15.5 Case Study: Banco Popular Joint Venture with Verde Partners and Kennedy Wilson

15.6 Case Study: Co-Operative Bank’s Liability Management Exercise

Glossary

Bibliography

Index

End User License Agreement

List of Tables

Chapter 2: Minimum Capital Requirements

Table 2.1 UBS's G‐SIB Indicators and their Amounts

Table 2.2 UBS's Score of G‐SIB Indicators

Table 2.3 UBS's Calculation of Final G‐SIB Score

Table 2.4 Implications of a separation between JP Morgan's retail activities and its corporate and investment bank

Table 2.5 Phase‐in Eligibility AT1 and Tier 2 Instruments

Table 2.6 Transitional Provisions Regarding Capital Conservation and G‐SIB Buffers

Chapter 3: Common Equity 1 (CET1) Capital

Table 3.1 HSBC's Fully‐loaded CET1 Capital as of 31 December 2015

Table 3.2 Santander's Outstanding Number of Ordinary Shares under the Previous and New Dividend Policies (in millions)

Table 3.3 Translation of Subco's Assets, Liabilities and Shareholders' Equity on Acquisition Date

Table 3.4 Translation of Subco's Shareholders' Equity on Acquisition Date

Table 3.5 ParentCo's, SubCo's and the Group's Balance Sheets as of 1 January 20X0

Table 3.6 SubCo's Stand‐alone Balance Sheet as of 31 December 20X0

Table 3.7 Translation of SubCo's Statement of Financial Position on 31 December 20X0

Table 3.8 Exchange Differences Stemming from the Translation of SubCo's Balance Sheet

Table 3.9 Fixed‐rate Bond Main Terms

Table 3.10 Calculation of Interest Income and Amortised Cost Amounts

Table 3.11 Period Change in Bond's Clean Fair Value

Table 3.12 Amounts recognised in the FVOCI Reserve

Table 3.13 BPI's Bond Portfolio and Related Hedges Unrealised Losses as of 31 December 2013

Table 3.14 BPI's Bond Portfolio and related Hedges Unrealised Losses as of 31 March 2014

Table 3.15 Main Terms of Bank ABC's Floating‐rate Bond

Table 3.16 Main Terms of Bank ABC's Interest Rate Swap

Table 3.17 Bond Interest and Swap Settlement Amounts

Table 3.18 Swap Effective and Ineffective Amounts

Table 3.19 Initiatives taken by Lloyds to reduce its OCI Volatility due to its DBPPs

Table 3.20 Main Terms of Deutsche Bank's Forward on its own Shares

Table 3.21 Calculation of Interest Expense and Carrying Amount of the Liability

Table 3.22 Main Terms of Deutsche Bank's Put Option on Own Shares

Table 3.23 Calculation of Interest Expense and the Liability Carrying Amount

Table 3.24 Main Terms of Deutsche Bank's Call Option on Own Shares

Chapter 4: Additional Tier 1 (AT1) Capital

Table 4.1 Main Terms of Lloyds' USD ECN Bond

Table 4.2 Main Terms of Lloyds' GBP AT1 Instruments

Chapter 5: Tier 2 Capital

Table 5.1 Template of Tier 2 Instruments' Main Terms

Table 5.2 Main Terms of Deutsche Bank's USD Tier 2 Issue

Table 5.3 Calculation of Interest Expense and Amortised Cost Amounts

Chapter 6: Contingent Convertibles (CoCos)

Table 6.1 Comparative Main Terms of AT1 CoCos and Tier 2 Instruments

Table 6.2 Main terms of Barclays Bank's GBP AT1

Table 6.3 Main terms of Deutsche Bank's EUR tranche contingent convertible

Chapter 7: Additional Valuation Adjustments (AVAs)

Table 7.1 Calculation of unreduced valuation exposure

Table 7.2 Calculation of reduced valuation exposure

Chapter 8: Accounting vs. Regulatory Consolidation

Table 8.1 Aggregation of Megabank's and Trustbank's financial statement items

Table 8.2 Elimination entries performed to the combined financial statements

Table 8.3 Non‐controlling interest adjustment

Table 8.4 Consequent consolidation worksheet

Table 8.5 Consolidated profit or loss statement

Table 8.6 Fair valuation of Postbank's identifiable assets and liabilities

Chapter 9: Treatment of Minority Interests in Consolidated Regulatory Capital

Table 9.1 Capital position of Bank S

Table 9.2 Calculation of the qualifying consolidated capital attributable to minority interests

Table 9.3 Calculation of consolidated regulatory capital

Chapter 10: Investments in Capital Instruments of Financial Institutions

Table 10.1 Fair valuation of Garanti's identifiable assets and liabilities

Chapter 12: Equity Investments in Non‐financial Entities

Table 12.1 Main terms of CaixaBank's mandatory exchangeable into Repsol

Chapter 13: Deferred Tax Assets (DTAs)

Table 13.1 Carrying amount for assets and liabilities

Table 13.2 Main terms of the debt instrument acquired by Megabank

Table 13.3 Calculation of each period interest income and amortised cost amounts

Table 13.4 Calculation of the period change in the debt's fair value

Table 13.5 Calculation of amounts in OCI related to the debt investment

Table 13.6 Calculation of the debt's tax base related to its amortised cost balances

Table 13.7 Calculation of the debt's tax base related to its interest income

Table 13.8 Temporary differences arising from the debt investment where taxation is based on its amortised cost

Table 13.9 Temporary differences arising from the debt investment where taxation is based on its original cost

Table 13.10 Calculation of reversing temporary differences requiring further assessment of utilisation

Table 13.11 Calculation of the adjusted taxable profit (or loss) for utilisation assessment

Table 13.12 Expiries of UBS's unrecognised tax loss carry forwards

Table 13.13 Main sources of Lloyds' gross deferred tax assets

Table 13.14 Main sources of Lloyds' gross deferred tax liabilities

Table 13.15 Sale and leaseback transactions undertaken by Santander

Table 13.16 Main terms of Santander's sale and leaseback transaction on its headquarters building complex

Chapter 14: Asset Protection Schemes and Bad Banks

Table 14.1 Asset types covered by RBS's asset protection scheme

Table 14.2 Scenarios of potential conversion of RBS's B shares

Table 14.3 Actions on RBS's share capital in 2008 and 2009

Table 14.4 Geographical split of NAMA's collateral

Chapter 15: Approaching Capital Enhancement Initiatives

Table 15.1 Quorum and voting requirements to obtain approval by the holders of the exchanged instruments

List of Illustrations

Chapter 1: Overview of Basel III

Figure 1.1 Bank regulatory capital accords

Figure 1.2 Expected and unexpected credit losses

Figure 1.3 The three pillars around Basel III

Figure 1.4 Pillar 1 of Basel III

Figure 1.5 Liquidity coverage

Figure 1.6 Main components of RWAs

Chapter 2: Minimum Capital Requirements

Figure 2.1 Components of a bank's regulatory total capital

Figure 2.2 Minimum CET1 requirements including capital buffers

Figure 2.3 Interaction of the countercyclical buffer with the capital conservation buffer

Figure 2.4 Interaction of the countercyclical buffer with the credit‐to‐GDP gap

Figure 2.5 Countercyclical buffer situation

Figure 2.6 Systemic risk buffers

Figure 2.7 Group/subsidiary – G‐SII/O–SII/SRB combinations

Figure 2.8 Going concern vs. gone concern regulatory capital

Figure 2.9 G‐SIIs – Individual indicators of designation criteria

Figure 2.10 RWAs divisional breakdown, as at the end of 2014

Figure 2.11 EUR/USD spot rate (Jan‐13 to Apr‐15)

Figure 2.12 Three‐dimensional assessment of G‐SIB enhancement initiatives

Figure 2.13 G‐SIB surcharge share of each Corporate and Investment Banking division business (2014)

Figure 2.14 G‐SIB indicator distribution within the Corporate and Investment Banking division (2014)

Chapter 3: Common Equity 1 (CET1) Capital

Figure 3.1 Components in the calculation of CET1

Figure 3.2 Main elements of (accounting) shareholders' equity

Figure 3.3 Balance sheet effects of the scrip dividend

Figure 3.4 Balance sheet effects of the cash dividend

Figure 3.5 EBA's hierarchy in the calculation of a dividend payout ratio

Figure 3.6 UBS dividends and buybacks 2000–2014

Figure 3.7 UBS's 2011–2014 CET1 capital ratio

Figure 3.8 Accounting impact of UBS's stock dividend paid using treasury shares

Figure 3.9 Impact on CET1 of UBS's stock dividend paid using treasury shares

Figure 3.10 Accounting impact of UBS's stock dividend paid with newly issued shares

Figure 3.11 Impact on CET1 of UBS's stock dividend paid with newly issued shares

Figure 3.12 Impact on UBS's balance sheet and CET1 capital of a CHF 2,961 mn cash dividend

Figure 3.13 Santander scrip dividend – alternatives to shareholders

Figure 3.14 Santander scrip dividend: cash vs. shares election by shareholders

Figure 3.15 Santander's outstanding number of ordinary shares

Figure 3.16 Accounting shareholders' equity section

Figure 3.17 Net assets of a foreign operation

Figure 3.18 Elements of the net assets of a foreign subsidiary

Figure 3.19 Group's structure post‐acquisition

Figure 3.20 Process to calculate exchange differences

Figure 3.21 IFRS 9 financial assets classification categories – summary flowchart

Figure 3.22 Second‐year impact on the bank's balance sheet of the debt investment at FVTOCI

Figure 3.23 BPI's asset swap of Italian and Portuguese bond portfolio

Figure 3.24 Balance sheet recognition of BPI's asset swap of Italian and Portuguese bond portfolio

Figure 3.25 Balance sheet recognition of BPI's asset swap of Italian and Portuguese bond portfolio

Figure 3.26 Impact of BPI's bond investment strategy on CET1 ratio as of 31 December 2013

Figure 3.27 Goodwill amounts using the partial and full goodwill methods

Figure 3.28 Badwill resulting from Barclays' acquisition of Lehman Brothers NA

Figure 3.29 Recognition of the change in fair value of a hedging instrument

Figure 3.30 Accounting for a cash flow hedge

Figure 3.31 Overall annual interest expense

Figure 3.32 Effects in profit or loss in absence of hedge accounting application

Figure 3.33 Hedge accounting terminology: hedged item and hedging instrument

Figure 3.34 Effects of the hedge on Bank ABC's financial statements on 31‐Dec‐20X1

Figure 3.35 Treatment of the shortfall in provisions from expected losses calculated under the IRB approach

Figure 3.36 Treatment of the excess in provisions from expected losses calculated under the IRB approach

Figure 3.37 IFRS 9 financial liabilities classification categories

Figure 3.38 CVA/DVA calculation steps

Figure 3.39 CVA/DVA calculation first step

Figure 3.40 CVA/DVA calculation second step

Figure 3.41 CVA/DVA calculation third step – first task

Figure 3.42 CVA/DVA calculation third step – second task

Figure 3.43 CVA/DVA calculation third step – third task

Figure 3.44 CVA/DVA calculation third step – final task

Figure 3.45 My own pecking order regarding PD calculation sources

Figure 3.46 Example of CVA/DVA allocation using a relative fair value approach

Figure 3.47 Defined benefit pension plans balance sheet recognition

Figure 3.48 Changes in the assets of a defined benefit pension plan

Figure 3.49 Items of a defined benefit pension plan recognised in profit or loss, or OCI

Figure 3.50 Initiatives taken by Lloyds on its defined benefit pension plans

Figure 3.51 Impact of its buyback programme on Danske Bank's statement of financial position

Figure 3.52 Initial recognition of Deutsche Bank's forward on own shares

Figure 3.53 Recognition of Deutsche Bank's forward on own shares during the first year

Figure 3.54 Impact on CET1 of Deutsche Bank's forward on own shares, following its settlement

Figure 3.55 Scenarios at maturity of Deutsche Bank's sale of put option on own shares

Figure 3.56 Initial recognition of Deutsche Bank's sale of put on own shares

Figure 3.57 Recognition of Deutsche Bank's sale of put on own shares on 31 December 20X0

Figure 3.58 Overall impact of Deutsche Bank's sale of put on own shares – option exercised

Figure 3.59 Overall impact of Deutsche Bank's sale of put on own shares – option

not

exercised

Figure 3.60 Scenarios at maturity of Deutsche Bank's purchase of call option on own shares

Figure 3.61 Initial recognition of Deutsche Bank's purchase of call on own shares

Figure 3.62 Overall impact of Deutsche Bank's purchase of call on own shares – option exercised

Figure 3.63 Overall impact of Deutsche Bank's purchase of call on own shares – option

not

exercised

Figure 3.64 Deutsche Bank's share price during 2014

Figure 3.65 Amounts exceeding the 17.65% threshold

Figure 3.66 Excess of qualifying AT1 deductions

Chapter 4: Additional Tier 1 (AT1) Capital

Figure 4.1 Tier 1 minimum capital requirements

Figure 4.2 Calculation of a bank's AT1 capital

Figure 4.3 Excess of qualifying Tier 2 deductions

Figure 4.4 Treatment of investments in AT1 instruments of other financial institutions

Figure 4.5 Main terms of Lloyds' B shares

Figure 4.6 Basel II regulatory capital categories

Figure 4.7 APS regulatory capital effects

Figure 4.8 APS strengths and weaknesses

Figure 4.9 Share of losses in Lloyds' APS

Figure 4.10 APS – Benefits vs. cost profile excluding the 7% dividend

Figure 4.11 Accounting impact of exchange offer

Figure 4.12 Lloyds' Core Tier 1 and CET1 capital as of 31 December 2013

Figure 4.13 Impact of exchange in Lloyds' regulatory capital

Figure 4.14 Accounting impact of Lloyds' exchange offer

Chapter 5: Tier 2 Capital

Figure 5.1 Tier 2 capital in a bank's regulatory total capital

Figure 5.2 Components of a bank's Tier 2 capital

Figure 5.3 Treatment of the excess in provisions from expected losses calculated under the IRB approach

Figure 5.4 Treatment of investments in Tier 2 instruments of other financial institutions

Figure 5.5 Effects of the Tier 2 instrument on Deutsche Bank's financials at the end of the first year

Chapter 6: Contingent Convertibles (CoCos)

Figure 6.1 CoCos classification according to their loss absorption mechanism

Figure 6.2 Stages in a bank financial situation

Figure 6.3 BRRD – Priority of instruments subject to (and excluded from) bail‐in

Figure 6.4 Composition of the combined buffer requirement

Figure 6.5 Bounds of each MDA quartile as a function of excess CET1

Figure 6.6 MDA factor

Figure 6.7 MDA factor including Pillar 1 and Pillar 2 capital requirements

Figure 6.8 Barclays' capital levels prior and following the CoCo issuance

Figure 6.9 Barclays' 7.875% CoCo – Headroom to contractual trigger at issuance

Figure 6.10 Barclays' 7.875% CoCo – Headroom to coupon payment restrictions

Figure 6.11 Convertible CoCo – Suggested split to assess accounting recognition

Figure 6.12 Initial recognition of Barclays' convertible CoCo

Figure 6.13 Barclays' convertible CoCo – Balance sheet impact of a coupon payment

Figure 6.14 Recognition of Barclays' convertible CoCo upon conversion

Figure 6.15 EUR‐denominated CoCo – Call rights and coupon reset dates

Figure 6.16 AT1 issuance effects on Deutsche Bank's Tier 1 capital

Figure 6.17 Deutsche Bank AT1 – Headroom to trigger

Figure 6.18 Deutsche Bank – CET1 plus combined buffer requirement

Figure 6.19 Ranking of Deutsche Bank's CoCo

Figure 6.20 Write‐down CoCo – Suggested split to assess accounting recognition

Figure 6.21 Deutsche Bank's write‐down CoCo – Initial recognition

Figure 6.22 Deutsche Bank's write‐down CoCo – Initial impact on balance sheet

Figure 6.23 Deutsche Bank's write‐down CoCo – Recognition of a coupon payment

Figure 6.24 Deutsche Bank's write‐down CoCo – Recognition of a write‐down

Figure 6.25 Deutsche Bank's write‐down CoCo – Recognition of a write‐up

Figure 6.26 Deutsche Bank's write‐down CoCo – Bifurcation on initial recognition

Figure 6.27 Deutsche Bank's write‐down CoCo – Initial impact on balance sheet

Figure 6.28 Deutsche Bank's write‐down CoCo – Subsequent recognition

Figure 6.29 Deutsche Bank's write‐down CoCo – Balance sheet impact of the write‐down

Figure 6.30 Deutsche Bank's write‐down CoCo – Balance sheet impact of the write‐up

Chapter 7: Additional Valuation Adjustments (AVAs)

Figure 7.1 Additional valuation adjustments: fair value vs. prudent value

Figure 7.2 Commonly fair valued financial items in a bank's balance sheet

Figure 7.3 IFRS 13's framework

Figure 7.4 IFRS 13's fair value definition

Figure 7.5 Market for fair value pricing

Figure 7.6 Three‐Level Fair Value Hierarchy

Figure 7.7 Decision tree for the Level classification of financial instruments (part one)

Figure 7.8 Decision tree for the Level classification of financial instruments (part two)

Figure 7.9 Fair valuation on the basis of net position: decision tree

Figure 7.10 Derivative hedge process

Figure 7.11 Derivative initial profit recognition

Figure 7.12 Accounting vs. regulatory valuations

Figure 7.13 Prudent valuation framework

Figure 7.14 Confidence interval and AVAs

Figure 7.15 EBA's prudent valuation approaches

Figure 7.16 Fair value hedge accounting

Figure 7.17 AVA categories under the EBA's core approach

Figure 7.18 IPV function – Interaction with other valuation areas in a bank

Figure 7.19 Reliability hierarchy of market data sources

Figure 7.20 Steps in the calculation of the market price uncertainty AVA

Figure 7.21 Megabank portfolios subject to prudent valuation

Figure 7.22 Megabank – Vector of parameters used to risk manage the EUR interest rate swap book

Figure 7.23 Megabank – Vector of parameters identified as lacking or having market price uncertainty

Figure 7.24 Megabank – EUR swap book exposures (amounts in EUR thousands)

Figure 7.25 Megabank – EUR swap book exposures reduced to seven parameters

Figure 7.26 Steps in the calculation of the prudent mid‐price

Figure 7.27 Upper and lower boundaries with a 90% confidence interval in a normal distribution – Small sample size

Figure 7.28 Upper and lower boundaries with a 90% confidence interval in a normal distribution – Large sample size

Figure 7.29 Allocation to other AVAs of unearned credit spreads AVA

Figure 7.30 Allocation to other AVAs of investing and funding costs AVA

Figure 7.31 Calculation of concentrated positions AVAs – Flowchart

Figure 7.32 Basel III approaches to operational risk

Figure 7.33 Approaches to operational risk AVA

Chapter 8: Accounting vs. Regulatory Consolidation

Figure 8.1 Accounting recognition of equity investments

Figure 8.2 Representation of a non‐controlling interest in a group's financial statements

Figure 8.3 Simplified calculation of a non‐controlling interest

Figure 8.4 Main intercompany items in banking

Figure 8.5 Structure of the Megabank group

Figure 8.6 Book vs. fair values of Trustbank's net assets

Figure 8.7 Megabank's balance sheet after acquisition

Figure 8.8 Megabank's consolidated balance sheet

Figure 8.9 Megabank's balance sheet after loss of control over Banktrust

Figure 8.10 Ownership structure of Postbank were the initial acquisition to materialise (it did not happen)

Figure 8.11 Main clauses of the initial agreement between Deutsche Bank (DB) and Deutsche Post (DP)

Figure 8.12 Ownership structure of Postbank after its capital increase

Figure 8.13 Main elements of the restructured agreement between Deutsche Bank and Deutsche Post

Figure 8.14 Ownership structure of Postbank assuming full implementation of the restructured agreement

Figure 8.15 Impact on Deutsche Bank's balance sheet of its initial investment in Postbank

Figure 8.16 Impact on Deutsche Bank's balance sheet related to the Postbank transaction

Figure 8.17 Regulatory treatment of Deutsche Bank's initial equity investment in Postbank

Figure 8.18 Impact on CET1 of Deutsche Bank's initial equity investment in Postbank

Chapter 9: Treatment of Minority Interests in Consolidated Regulatory Capital

Figure 9.1 Structure of the Bank P group

Figure 9.2 Bank P and Bank S, stand‐alone and consolidated balance sheets

Figure 9.3 Bank S's Tier 1 capital and its contribution to consolidated Tier 1 capital

Figure 9.4 Trustbank's minimum capital requirements

Figure 9.5 Creating non‐deductible minority interests

Figure 9.6 SmallBank's consolidated balance sheet, ignoring the derivative fair valuing

Figure 9.7 Banco Santander (Brasil) – Shareholding prior and after the IPO

Figure 9.8 Initial recognition of the mandatorily convertible bond into Banco Santander (Brasil) shares

Figure 9.9 Impact on CET1 capital of the transfer of the Banco Santander (Brasil) shares by Banco Santander S.A

Figure 9.10 Planned timetable of Santander Brasil minority buyout at the time of its announcement

Figure 9.11 Effect on the group's CET1 capital of Santander Brasil minority buyout

Chapter 10: Investments in Capital Instruments of Financial Institutions

Figure 10.1 Main regulatory approaches on investments in capital instruments of financial institutions

Figure 10.2 General framework of the regulatory treatment of investments in capital instruments of banks

Figure 10.3 General framework of the regulatory treatment of investments in capital instruments of insurance companies

Figure 10.4 Basel III's treatment of non‐significant investments in the capital instruments of unconsolidated financial institutions

Figure 10.5 Basel III treatment of risk‐weighted capital investments in the banking book

Figure 10.6 Relevant CET1 for 10% threshold

Figure 10.7 Basel III's treatment of significant investments in capital instruments of unconsolidated financial entities

Figure 10.8 Relevant CET1 capital for 10% threshold calculations

Figure 10.9 Garanti's ownership structure following BBVA's initial investment

Figure 10.10 Regulatory capital effects of BBVA's equity investment in Garanti

Figure 10.11 Fictional regulatory treatment of BBVA's equity investment in Garanti

Figure 10.12 Capital impact of fictional regulatory treatment of BBVA's equity investment in Garanti

Figure 10.13 Accounting and regulatory impact of BBVA's stake increase in Garanti

Figure 10.14 Two‐step acquisition

Figure 10.15 Effect on BBVA's CET1 of its investment in Garanti after assuming control

Chapter 11: Investments in Capital Instruments of Insurance Entities

Figure 11.1 Individual and consolidated balance sheets – double leverage

Figure 11.2 Customer financial life cycle

Figure 11.3 ING's strategic priorities following its agreement with the EU

Figure 11.4 Steps in the separation of ING's banking and insurance/asset management businesses

Figure 11.5 ING Group's new structure

Figure 11.6 ING's deadlines for the divestments of its insurance businesses

Figure 11.7 Alternatives to dispose of ING's insurance businesses

Figure 11.8 ING Group's capital position as of 31 December 2011

Figure 11.9 Regulatory treatment of investments in capital instruments of insurance entities

Figure 11.10 Main subsidiaries of Lloyds Banking Group

Figure 11.11 Basel III's treatment of significant investments in unconsolidated financial entities

Figure 11.12 Accounting and regulatory effects of dividend from Lloyds' insurance subsidiaries

Figure 11.13 Accounting and regulatory effects on Lloyds of the disposal of St James's Place

Chapter 12: Equity Investments in Non‐financial Entities

Figure 12.1 Risk weights of equity exposures held in the banking book under the standardised approach

Figure 12.2 Methods available under the IRB approach for equity exposures in the banking book

Figure 12.3 Thinking behind Basel III's credit risk approach

Figure 12.4 Number of shares to be received in the case of physical settlement

Figure 12.5 Value of the instrument at maturity, ignoring dividends, as a function of Repsol's share price

Figure 12.6 CaixaBank's stake in Repsol – equity method recognition

Figure 12.7 Initial recognition of the mandatory exchangeable

Figure 12.8 Impact of the mandatory exchangeable on CaixaBank's balance sheet

Figure 12.9 Impact on CET1 of CaixaBank's stake in Repsol

Figure 12.10 Nikkei 225 index spot price (1‐Jan‐13 to 31‐Mar‐15)

Figure 12.11 MFUG's price‐to‐book value (1‐Jan‐13 to 31‐Mar‐15)

Figure 12.12 MFUG's acquisition cost of its domestic equity holdings

Figure 12.13 Calculations of MUFG's CET1 capital of the potential disposal of its equity holdings

Figure 12.14 Impact on MUFG's CET1 capital of the potential disposal of its equity holdings

Chapter 13: Deferred Tax Assets (DTAs)

Figure 13.1 Recognition of taxes in the balance sheet and profit or loss statements

Figure 13.2 Income taxes overview

Figure 13.3 Current income tax recognition

Figure 13.4 Steps for accounting for deferred taxes

Figure 13.5 Deductible deferred assets: DTA vs. valuation allowance

Figure 13.6 Steps in the assessment of the utilisation of deductible temporary differences

Figure 13.7 Steps in the assessment of the utilisation of deductible temporary differences

Figure 13.8 Tax base determination – Debt instruments

Figure 13.9 Steps in the assessment of the utilisation of deductible temporary differences

Figure 13.10 Resulting utilisation of deductible temporary differences through the two‐step process

Figure 13.11 UBS's reported DTAs and DTLs, as of 31 December 2014

Figure 13.12 Items in UBS's deductible deferred taxes, as of 31 December 2014

Figure 13.13 Items in UBS's taxable deferred taxes, as of 31 December 2014

Figure 13.14 Location of UBS's tax loss carry forwards (pre‐tax amounts), as of 31 December 2014

Figure 13.15 Recognition of UBS's tax loss carry forwards, as of 31 December 2014

Figure 13.16 Deferred tax items recognised in UBS's shareholders' equity, as of 31 December 2014

Figure 13.17 Basel III (CRR) treatment of tax assets

Figure 13.18 Regulatory treatment of DTAs that rely on future profitability and arise from temporary differences

Figure 13.19 Relevant CET1 for DTAs' 10% threshold calculations

Figure 13.20 Relevant CET1 for 17.65% threshold calculations

Figure 13.21 Spanish banks' DTAs as a percentage of Basel II's core capital, end of 2013

Figure 13.22 Spanish Royal Decree and [CRR 39] requirements

Figure 13.23 Impact of the changes in DTA laws on Banco Santander, as of year‐end 2014

Figure 13.24 Disclosed DTAs and DTLs in Lloyds' consolidated balance sheet, as of year‐end 2014

Figure 13.25 Structure of Lloyds' deductible deferred tax assets, as of year‐end 2014

Figure 13.26 Structure of Lloyds' taxable deferred tax assets, as of year‐end 2014

Figure 13.27 Reconciliation of Lloyds' accounting vs. regulatory DTAs, as of year‐end 2014

Figure 13.28 Calculation of regulatory impact of Lloyds' DTAs, as of year‐end 2014 (part I of II)

Figure 13.29 Calculation of regulatory impact of Lloyds' DTAs, as of year‐end 2014 (part II of II)

Figure 13.30 Impact on CET1 capital ratio of Lloyds' DTAs, as of year‐end 2014 (part II of II)

Figure 13.31 Sources of utilisation of deductible temporary differences

Figure 13.32 Sources of utilisation of deductible tax loss and tax credit carryforwards

Figure 13.33 Types of initiative to enhance impact of deferred taxes on regulatory capital

Figure 13.34 Recovery of an asset: ordinary income/expense vs. capital gain/loss

Figure 13.35 HSBC USA funding vs. dividends distributions

Figure 13.36 Sale and leaseback of Santander's headquarters

Chapter 14: Asset Protection Schemes and Bad Banks

Figure 14.1 Transfer pricing of 80% of ING's Alt‐A portfolio

Figure 14.2 Recognition of 80% of ING's Alt‐A portfolio

Figure 14.3 Main flows of ING's IABF during its life

Figure 14.4 ING's balance sheet before and after the IABF

Figure 14.5 ING's IABF – summary of potential benefits (excluding capital securities and rights issues)

Figure 14.6 UK government's aid to RBS during the 2008–09 credit crisis

Figure 14.7 RBS's APS – Share of losses

Figure 14.8 RBS's APS – Share of losses split between expected and unexpected losses

Figure 14.9 RBS's APS – Summary of potential benefits

Figure 14.10 SAREB's balance sheet structure at inception

Figure 14.11 NAMA's balance sheet structure at 31 December 2010

Chapter 15: Approaching Capital Enhancement Initiatives

Figure 15.1 Common pattern of the business cycle in banking

Figure 15.2 Main initiatives to enhance CET1 capital ratios

Figure 15.3 Deutsche Bank's rights issue timeline of key events

Figure 15.4 Conflicting interests between the bank and the investor

Figure 15.5 General structure of a disposal of a portfolio of NPLs

Figure 15.6 Accounting roadmap for the assessment of control of an entity

Figure 15.7 Assets to be included in the derecognition assessment

Figure 15.8 Accounting roadmap of a financial asset derecognition assessment

Figure 15.9 End result of a financial asset derecognition assessment

Figure 15.10 Example of tax efficient group structure

Figure 15.11 Significant risk transfer

Figure 15.12 Aliseda SGI ownership structure

Figure 15.13 Aliseda initial transaction structure

Figure 15.14 Aliseda's balance sheet as of 31 December 2013

Figure 15.15 Impact on Banco Popular's balance sheet of its investment in Aliseda

Figure 15.16 Impact on Banco Popular's CET1 ratio of its investment in Aliseda

Figure 15.17 Impact on Banco Popular's capital of its equity exposure in Aliseda

Figure 15.18 Types of LME transactions

Figure 15.19 Co‐operative Bank's ownership structure

Figure 15.20 Main terms of Co‐operative Bank's liability management exercise

Figure 15.21 CET1 effects of Co‐operative Bank's liability management exercise and capital contribution

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Handbook of Basel III Capital

Enhancing Bank Capital in Practice

JUAN RAMIREZ

This edition first published 2017

© 2017 Juan Ramirez

Registered office

John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom

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Library of Congress Cataloging-in-Publication Data is available

ISBN 9781119330820 (hardcover) ISBN 9781119330806 (ePDF)

ISBN 9781119330899 (ePub)

Cover Design: Wiley

Cover Image: © Vasiliy Yakobchuk/iStockphoto

To my wife Marta and our children Borja, Martuca and David

Preface

Often banks feel Basel III regulations are excessively conservative and act as a deterrent to investors looking for attractive returns. However, Basel III is an opportunity for banks to improve their asset quality and risk‐return profiles. It encourages a strategic approach to decisions about businesses and assets, allocating precious capital toward opportunities that fit the bank's actual risk and return profiles, and exerting pressure to shed unattractive positions.

This book tries to fill a gap in the financial literature on regulatory bank capital. I found a substantial number of excellent books often written by developers of quantitative models on the estimation of credit risk parameters (i.e., exposures, probabilities of default and so on). There also several good books providing a general overview of Basel III, which are useful to grasp an introductory knowledge of the regulation, but that might be too elementary for regulatory capital professionals.

This book has two objectives: (i) to provide readers with a deep understanding of the principles underpinning the capital dimension of Basel III (i.e., the numerator of the capital ratio calculation) and (ii) to be exposed to real‐life cases of initiatives to enhance capital. The first objective is a notably challenging one due to the large number of complex rules and because it requires a thorough understanding of the accounting treatment of the items affecting regulatory capital. To meet the second objective, a large number of real case studies have been included.

This book is aimed primarily at capital practitioners at banks, bank equity analysts, institutional investors and banking supervisors. I believe that it is also a useful resource for structurers at investment banks developing capital‐efficient transactions and for professionals at auditing, consulting and law firms helping client banks to enhance their capital positions.

Whilst the Basel III rules are intended to provide a common framework for financial institutions, its implementation may vary across the globe, as national supervisors have discretion about the domestic implementation of the Basel III rules. This book is based on the European Union version of Basel III, which is referred to as CRD IV. Whilst some particular changes to the general Basel III framework are introduced by the CRD, most of its contents are likely to be common to the regulation of other jurisdictions.

The interpretations described in this book are those of the author alone and do not reflect the positions of the entities which the author is or has been related to.

About the Author

Juan Ramirez currently works for Deloitte in London, assessing the accounting treatment, risk management and regulatory capital impact of complex transactions.

Prior to joining Deloitte, Juan worked for 20 years in investment banking in sales and trading at JP Morgan, Lehman Brothers, Barclays Capital, Santander and BNP Paribas. He has been involved with interest rate, equity, FX and credit derivatives. Juan holds an MBA from University of Chicago and a BSc in electrical engineering from ICAI.

Juan is the author of the books Accounting for Derivatives and Handbook of Corporate Equity Derivatives and Equity Capital Markets, both published by Wiley.

Chapter 1Overview of Basel III

Bank executives are in a difficult position. On the one hand their shareholders require an attractive return on their investment. On the other hand, banking supervisors require these entities to hold a substantial amount of expensive capital. As a result, banks need capital‐efficient business models to prosper.

Banking regulators and supervisors are in a difficult position as well. Excessively conservative capital requirements may lessen banks' appetite for lending, endangering economic growth. Excessively light capital requirements may weaken the resilience of the banking sector and cause deep economic crises.

1.1 INTRODUCTION TO BASEL III

Basel III's main set of recommendations were issued by the Basel Committee on Banking Supervision (BCBS) in December 2010 (revised June 2011) and titled Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems.

It is important to note that the BCBS does not establish laws, regulations or rules for any financial institution directly. It merely acts in an advisory capacity. It is up to each country's specific lawmakers and regulators to enact whatever portions of the recommendations they deem appropriate that would apply to financial institutions being supervised by the country's regulator.

1.1.1 Basel III, CRR, CRD IV

With a view to implementing the agreements of Basel III and harmonising banking solvency regulations across the European Union as a whole, in June 2013 the European Parliament and the Council of the European Union adopted the following legislation:

Capital Requirements Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 (hereinafter the “

CRD IV

”), on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC. CRD IV entered into force in the EU on 1 January 2014; and

Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 (hereinafter the “

CRR

”).

National banking regulators then give effect to the CRD by including the requirements of the CRD in their own rulebooks. The national regulators of the bank supervises it on a consolidated basis and therefore receives information on the capital adequacy of, and sets capital requirements for, the bank as a whole. Individual banking subsidiaries are directly regulated by their local banking regulators, who set and monitor their capital adequacy requirements.

In Germany, the banking regulator is the Bundesanstalt für Finanzdienstleistungsaufsicht (“BaFin”).

In Switzerland, the banking regulator is the Swiss National Bank (“SNB”).

In the United Kingdom, the banking regulator is the Prudential Regulation Authority (“PRA”).

In the United States, bank holding companies are regulated by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board” or “FSB”).

1.1.2 A Brief History of the Basel Accords

Global standards for bank capital are a relatively recent innovation, with an evolution along three phases (see Figure 1.1).

FIGURE 1.1 Bank regulatory capital accords

During the financial crises of the 1970s and 1980s the large banks depleted their capital levels. In 1988 the Basel Supervisors Committee intended, through the Basel Accord, to establish capital requirements aimed at protecting depositors from undue bank and systemic risk. The Accord, Basel I, provided uniform definitions for capital as well as minimum capital adequacy levels based on the riskiness of assets (a minimum of 4% for Tier 1 capital, which was mainly equity less goodwill, and 8% for the sum of Tier 1 capital and Tier 2 capital). Basel I was relatively simple; risk measurements related almost entirely to credit risk, perceived to be the main risk incurred by banks. Capital regulations under Basel I came into effect in December 1992, after development and consultations since 1988. Basel I was amended in 1996 to introduce capital requirements to addressing market risk in banks' trading books.

In 2004, banking regulators worked on a new version of the Basel accord, as Basel I was not sufficiently sensitive in measuring risk exposures. In July 2006, the Basel Committee on Banking Supervision published International Convergence of Capital Measurement and Capital Standards, known as Basel II, which replaced Basel I. The supervisory objectives for Basel II were to (i) promote safety and soundness in the financial system and maintain a certain overall level of capital in the system, (ii) enhance competitive equality, (iii) constitute a more comprehensive approach to measuring risk exposures and (iv) focus on internationally active banks.

The unprecedented nature of the 2007–08 financial crisis obliged the Basel Committee on Banking Supervision (BCBS) to propose an amendment to Basel II, commonly called Basel III. Basel III introduced significant changes in the prudential regulatory regime applicable to banks, including increased minimum capital ratios, changes to the definition of capital and the calculation of risk‐weighted assets, and the introduction of new measures relating to leverage, liquidity and funding.

1.1.3 Accounting vs. Regulatory Objectives

It is important to make clear that the accounting and regulatory objectives are not fully aligned. The aim of accounting financial statements is the provision of information about the financial position, performance, cash flow and changes in the financial position of an entity that is useful for making economic decisions to a range of users, including existing and potential investors, lenders, employees and the general public.

The main objective of prudential regulation is to promote a resilient banking sector or, in other words, to improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.

1.2 EXPECTED AND UNEXPECTED CREDIT LOSSES AND BANK CAPITAL

Let us assume that a bank provided a loan to a client. The worst case one could imagine would be that the client defaults and that, as a consequence, the bank losses the entire loaned amount. This event is rather unlikely and requiring the bank to hold capital for the entire loan would be excessively conservative and the bank is likely to pass the cost of the capital requirement to the client, making the loan too costly for the client. Requiring the bank to hold no capital for the loan would compromise the bank's viability if the borrower defaults. Thus, the bank regulator has to require banks to hold capital levels that assure their viability with a high probability, while maintaining their appetite to extend loans to borrowers at reasonable levels.

Credit losses, within a certain confidence interval, on debt instruments may be divided into expected and unexpected losses.

1.2.1 Expected Losses

The expected loss on a debt instrument is the level of credit loss that the bank is reasonably expected to experience on that instrument. The interest priced on the debt instrument at its inception incorporates the expected loss during the life of the instrument.

Banks are expected in general to cover their expected credit losses on an ongoing basis (e.g. by revenues, provisions and write‐offs), as shown in Figure 1.2, because they represent another cost component of the lending business. Bank supervisors need to make sure that banks do indeed build enough provisions against expected losses.

FIGURE 1.2 Expected and unexpected credit losses

1.2.2 Unexpected Losses

The unexpected loss on a debt instrument is the level of credit loss in excess of the expected loss that the bank may be exposed to with a certain probability of occurrence. Thus, the size of the unexpected loss depends on the confidence interval chosen. Unexpected losses relate to potentially large losses that occur rather seldomly. In other words, the bank cannot know in advance their timing and severity.

Banks are required to hold regulatory capital to absorb unexpected losses, as shown in Figure 1.2. Thus, risk‐weighted assets relate to the unexpected losses only. Bank regulatory capital is needed to cover the risks in such unexpected losses and, thus, it has a loss absorbing function.

1.3 THE THREE‐PILLAR APPROACH TO BANK CAPITAL

The capital adequacy framework consists of three pillars (see Figure 1.3), each of which focuses on a different aspect of capital adequacy:

FIGURE 1.3 The three pillars around Basel III

Pillar 1

, called “

Minimum Capital Requirements

”, establishes the minimum amount of capital that a bank should have against its credit, market and operational risks. It provides the guidelines for calculating the risk exposures in the assets of a bank's balance sheet (the “risk‐weighted assets”) and the capital components, and sets the minimum capital requirements.

Pillar 2

, called “

Supervisory Review and Evaluation Process

”, involves both banks and regulators taking a view on whether a firm should hold additional capital against risks not covered in Pillar 1. Part of the Pillar 2 process is the “

Internal Capital Adequacy Assessment Process

” (“

ICAAP

”), which is a bank's self‐assessment of risks not captured by Pillar 1.

Pillar 3

, called “

Market Discipline

”, aims to encourage market discipline by requiring banks to disclosure specific, prescribed details of their risks, capital and risk management.

This book focuses on Pillar 1.

1.3.1 Pillar 1 – Minimum Capital Requirements

Pillar 1 covers the calculation of capital, liquidity and leverage levels (see Figure 1.4). Pillar 1 covers as well the calculation of risk‐weighted assets for credit risk, market risk and operational risk. Distinct regulatory capital approaches are followed for each of these risks.

FIGURE 1.4 Pillar 1 of Basel III

Leverage Ratio

One of the causes of the 2007–08 financial crisis was the build‐up of excessive balance sheet leverage in the banking system, despite meeting their capital requirements. It was only when the banks were forced by market conditions to reduce their leverage that the financial system increased the downward pressure in asset prices. This exacerbated the decline in bank capital. To prevent the excessive deleveraging from happening again, Basel III introduced a leverage ratio. This ratio was designed to put a cap on the build‐up of leverage in the banking system as well as to introduce additional safeguards against model risk and measurement errors. The leverage ratio is a simple, transparent, non‐risk‐weighted measure, calculated as an average over the quarter:

Liquidity Coverage Ratio

Banks experienced severe liquidity problems during the 2007–08 financial crisis, despite meeting their capital requirements. Basel III requires banks to hold a pool of highly liquid assets which is sufficient to maintain the forecasted net cash outflows over a 30‐day period, under stress assumptions (see Figure 1.5). This requirement tries to improve a bank's resilience against potential short‐term liquidity shortages. The ratio is calculated as follows:

FIGURE 1.5 Liquidity coverage

Assets are considered “highly liquid” if they can be quickly converted into cash at almost no loss.

All assets in the liquidity pool must be managed as part of that pool and are subject to operational requirements. The assets must be available for the treasurer of the bank, unencumbered and freely available to group entities.

Net Stable Funding Ratio

Basel III 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 exposures. This requirement provides incentives for banks to use stable sources to fund banks' balance sheets, off‐balance sheet exposures and capital markets activities, therefore reducing the refinancing risks of a bank. The Net Stable Funding Ratio (NSFR) establishes the minimum amount of stable funding based on the liquidity characteristics of a bank's assets and activities over a more than one‐year horizon. In other words, a bank must hold at least an amount of long‐term (i.e., more than one year) funding equal to its long‐term (i.e., more than one year) assets. The ratio is calculated as follows:

The numerator is calculated by summing a bank's liabilities, weighted by their degree of permanence. The denominator is calculated by summing a bank's assets, weighted by their degree of permanence.

1.3.2 Pillar 2 – Supervisory Review and Evaluation Process

Pillar 2 is an additional discipline to evaluate the adequacy of the regulatory capital requirement under Pillar 1 and other non‐Pillar 1 risks. Pillar 2 refers to the possibility for national supervisors to impose a wide range of measures – including additional capital requirements – on individual institutions or groups of institutions in order to address higher‐than‐normal risk.

Pillar 2 has two aspects. The first requires banks to regularly assess their overall risk profile and to calculate any further capital that should be held against this additional risk. This assessment is called ICAAP. Pillar 1 captures exposures to credit risk, market risk and operational risk. Exposures to risks not captured by Pillar 1 are assessed in Pillar 2. These include credit concentration risk, liquidity risk, reputation and model risk. Consequently, Pillar 2 could add requirements to the amount of capital held by banks (and offset the lower credit‐risk capital requirement).