Finalized Guidance Document Concerning the Implementation of Basel III

Basel III Framework – Enhanced Risk Coverage Basel III also introduced measures to strengthen the capital requirements through Enhanced Risk Coverage as given below, which included counterparty credit exposures arising from banks’ derivatives, repo and Securities Financing Activities (SFA). These reforms also included the raising of capital buffers backing these additional exposures, in order to reduce procyclicality and provide additional incentives to move to OTC derivative contracts to central counterparties, thus helping reduce systemic risk across the financial system. Further, Basel III also provides incentives to strengthen the risk management of counterparty credit exposures. The enhancement to counterparty credit exposures as given below was the main change amongst others to Enhanced Risk Coverage in the Basel III framework : A. Counterparty Credit Risk 1. Revised metric to better address counterparty credit risk, credit valuation adjustments and wrong-way risks 2. Introduction of Asset Value correlation (AVC) for Financial Institutions 3. Collateralized counterparties and increased margin period of risk 4. Central Counterparties (CCPs) 5. Enhanced counterparty credit risk management requirements B. Addressing Reliance on external credit ratings and minimizing cliff effects 1. Standardized Inferred rating treatment for long-term exposure 2. Incentive to avoid getting exposures rated 3. Incorporation of IOSCO’s Code of Conduct Fundamentals for Credit Rating Agencies 4. ‘‘Cliff effects’’ arising from guarantees and credit derivatives- ‘‘CRM’’ 5. Unsolicited ratings and recognition of ECAI’s The more specific, Basel III enhancements include the following: 1. Banks will be subject to an additional capital charge for potential mark-to-market losses (i.e. credit valuation adjustment – CVA – risk) associated with a deterioration in the credit worthiness of a counterparty. This charge is applicable both i) under Standardized Approach and ii) IRB Approaches. While the Basel II standard covers the risk of a counterparty default, it does not address such CVA risk, which during the financial crisis was a greater source of losses than those arising from outright defaults. Consequently, an additional Counterparty Credit risk. 2. Under IRB, banks must determine their capital requirement for counterparty credit risk using stressed inputs. This will address concerns about capital charges becoming too low during periods of compressed market volatility and help address procyclicality. The approach, which is similar to what has been introduced for market risk, will also promote more integrated management of market and counterparty credit risk. 3. Basel III Framework has strengthened standards for collateral management and initial margining. Banks with large and illiquid derivative exposures to a counterparty will have to apply longer margining periods as a basis for determining the regulatory capital requirement. Additional standards have been adopted to strengthen collateral risk management practices. 4. Basel III Framework also includes the additional systemic risk arising from the interconnectedness of banks and other financial institutions through the derivatives markets. In this regard, the Basel III Framework supports the efforts of the Committee on Payments and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) to establish strong standards for financial market infrastructures, including central counterparties. These standards have now been finalized through the BCBS Finalized Document entitled "Capital Requirements for Banks Exposures to Central Counterparties" of July 2012 .The capitalization of bank exposures to central counterparties (CCPs) is based in part on the compliance of the CCP with such standards. A bank’s collateral and mark-to-market exposures to CCPs meeting these enhanced principles will be subject to a low risk weight, proposed at 2%; and default fund exposures to CCPs will be subject to risk-sensitive capital requirements. These criteria, together with strengthened capital requirements for bilateral OTC derivative exposures, will create strong incentives for banks to move exposures to such CCPs. Moreover, to address systemic risk within the financial sector, the Committee also is raising the risk weights through IRB Approaches only on exposures to financial institutions relative to the non-financial corporate sector, as financial exposures are more highly correlated than non-financial ones. 5. The Committee is raising counterparty credit risk management standards in a number of areas, including for the treatment of wrong-way risk, i.e. cases where the exposure increases when the credit quality of the counterparty deteriorates. It also issued final additional guidance for the sound backtesting of counterparty credit exposures. Finally, the Committee assessed a number of measures to mitigate the reliance on external ratings of the Basel II framework. The measures include requirements for banks to perform their own internal assessments of externally rated securitization exposures, the elimination of certain “cliff effects” associated with credit risk mitigation practices, and the incorporation of key elements of the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies into the Committee’s eligibility criteria for the use of external ratings in the capital framework. The Committee also is conducting a more fundamental review of the securitization framework, including its reliance on external ratings. A. Regulatory Capital Under Basel III 2. Definition of Regulatory Capital for Basel III