I. Introduction
3.1 This chapter discusses prudential standards relating to capital and liquidity developed by the Basel Committee on Banking Supervision (BCBS)— the international standard setter for banks—which are relevant to compiling FSIs.1 An overview of the concepts and key terminology is provided, but much of the technical detail, which will not in the normal course be required by compilers, has been omitted. Compilers requiring additional detail are referred to the publications of the BCBS.2
3.2 International standards are not themselves binding or enforceable, but rather are implemented, on a voluntary basis, by national authorities. Compilers will rely on national definitions and standards for capital, liquidity, leverage and large exposures related series, drawing on supervisory data rather than themselves calculating the various elements of Basel Committee-prescribed methodology.
3.3 Despite the expected reliance on supervisory data, it is important for compilers to have a broad understanding of the Basel concepts and principles related to capital and liquidity. Compilers need to be able to document in the metadata which version of the Basel Capital Accord provides the foundation for the national capital adequacy regime. They also need to identify whether their jurisdiction has exercised any of the many elements of national discretion, and if there are any national variations from the relevant Basel regime (other than the elements of express national discretion).
II. Evolution of the Basel Capital Accord
3.4 There were three novel elements to the original Basel Capital Accord. Prior to 1988, there were no agreed international standards with respect to deposit takers, and national approaches to capital adequacy were not linked to the riskiness of individual institutions. The Accord (i) introduced commonly accepted definitions of the elements of regulatory capital; (ii) linked capital requirements to risk through the introduction of risk weights—factors approximating risk applied to the assets of the bank to determine required capital; and (iii) established a minimum capital requirement of 8 percent of risk-weighted assets for internationally active banks, which soon became a de facto standard for almost all banks through its widespread adoption by national authorities.
3.5 The Basel I capital requirement was to be met by Tier 1 capital—the most permanent and loss absorbing instruments; and Tier 2 capital—instruments with some shortcomings with respect to the key features of capital—to a limit of 50 percent of total capital.
3.6 The 1996 Amendment to Incorporate Market Risks partially addressed one of the early criticisms of the original Accord—banks are exposed to many risks, but Basel I originally considered only credit risk. To maintain consistency with the original approach, the calculation of market risk exposure was expressed in the form of a risk-weighted asset equivalent. A new element of capital, Tier 3, was introduced at national discretion, with use limited solely to supporting market risks.3
3.7 Basel II, while retaining the original definitions of capital and 8 percent minimum, more thoroughly addressed the criticism that Basel I focused on only one (two after 1996) of the many risks faced by banks. It also responded to criticisms that the risk weightings were insufficiently granular, not distinguishing, for example, between the risk of an AAA-rated corporate exposure and a CCC-rated (one notch above default) exposure—each was weighted at 100 percent.
3.8 Basel II also reflected feedback from large and complex banks, which indicated that the risk weights and capital required by Basel I bore little resemblance to how risks were internally assessed, and capital allocated in managing risk in the bank. In response, Basel II introduced the advanced measurement approaches, permitting the use of banks’ internal models, subject to supervisory approval, in the determination of capital requirements for credit and operational risks.4 Allowing the use of models aligned capital more closely with complex banks’ actual risk management practices, while the Basel II Standardized Approach introduced additional granularity for smaller or less complex banks by using external credit ratings to further differentiate the risk of credit exposures.
3.9 Basel II required banks to hold capital against three “Pillar 1” risks—credit, market and operational risks, and introduced requirements for banks to identify other risk exposures and capital requirements in “Pillar 2 .” The Pillar 2 concept requires banks, whether using the standardized or advanced approaches, to undertake an internal capital adequacy assessment process (ICAAP). This requires the identification of all material risks faced by the bank, and the allocation of capital against those risks.
3.10 In the immediate aftermath of the global financial crisis, Enhancements to the Basel II Framework (2009), often called Basel II.5, addressed some issues that had proven particularly problematic. Requirements for retention of a portion of the credit risk for securitized assets or application of penal risk weights ensured that banks originating asset-backed securities retained an interest in the credit risk of the underlying assets. More stringent requirements were introduced to ensure that assets securitized or sold truly had a “clean break” from the bank before the assets were removed from the banks risk-weighted assets for regulatory purposes. Additional capital charges were introduced for some elements of market risk, and the advanced method of calculation of market risk capital charges was revised to require consideration of stress scenarios.
3.11 Basel III (2010) was a more far-reaching response to the lessons of the crisis, requiring banks to hold more, higher quality capital (Figure 3.1), introducing a leverage ratio and two new liquidity ratios. While the original 8 percent capital adequacy limit from Basel I and II was retained, effectively the minimum capital requirement became 10.5 percent of risk-weighted assets through the introduction of the capital conservation buffer (Table 3.1). In addition, other capital buffers can result in higher minimum requirements for the system overall, and for individual banks. The countercyclical capital buffer is a Basel III macroprudential tool, which can be used by authorities to require banks to hold additional capital in a period of increasing risks. Higher minimum capital requirements for large and complex banks result from the application of buffers for globally and domestically systemically important banks.
Basel III Capital Ratios (percent of risk-weighted assets)
Source: BCBS (2011).Note: CET1 = Common Equity Tier 1.Basel III Capital Ratios (percent of risk-weighted assets)
| CET1 | Tier 1 Capital | Total Capital | |
|---|---|---|---|
| Minimum | 4.5 | 6 | 8 |
| Capital conservation buffer | 2.5 | 2.5 | 2.5 |
| Minimum plus capital conservation buffer | 7 | 8.5 | 10.5 |
Basel III Capital Ratios (percent of risk-weighted assets)
| CET1 | Tier 1 Capital | Total Capital | |
|---|---|---|---|
| Minimum | 4.5 | 6 | 8 |
| Capital conservation buffer | 2.5 | 2.5 | 2.5 |
| Minimum plus capital conservation buffer | 7 | 8.5 | 10.5 |
3.12 Basel III introduced a Common Equity Tier 1 (CET1) capital requirement of 4.5 percent of risk-weighted assets, which is effectively 7 percent since the 2.5 percent capital conservation buffer must be met with CET1. This, plus the requirement for Tier 1 capital of at least 6 percent of risk-weighted assets, increased the minimum capital available to absorb losses on a going-concern basis. To ensure going concern loss absorption, instruments qualifying as Additional Tier 1 (AT1) capital must be subject to write-down or conversion to common equity. This meant that some hybrid instruments previously qualifying at Tier 1 capital were no longer eligible, requiring banks to raise more high-quality capital.
3.13 Basel III introduced for the first time agreed international standards for liquidity. Reflecting that banks and their supervisors had paid insufficient attention to liquidity risk during the long period of benign market conditions preceding the crisis, the stress-scenario- based liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) require banks not only to hold higher levels of high quality liquid assets (HQLA), but also require increased focus on liquidity risk management. At minimum, calculation of the LCR and NSFR requires banks to apply liquidity stress scenarios to their balances sheets and requires supervisory review of banks’ application of these stress-tests. These liquidity ratios are discussed in more detail in paragraphs 3.49–3.55.
3.14 Basel III: Finalisation of Post Crisis Reforms (2017) is in some ways even more far-reaching than the original 2010 Basel III reforms. Key elements are (i) a far more granular approach to credit risk weights in the standardized approach; (ii) a new Standardized Credit Risk Assessment providing an alternative to the use of external credit ratings in risk weightings; (iii) constraints on the use of internal models intended to reduce variability in risk-weighted asset calculations across banks; (iv) an output foor for internal model calculation of capital for credit risk of 72.5 percent of the requirement determined using the standardized approach; and (v) a single new method for calculating operational risk capital charges that replaces all previous options.
3.15 Annex 3.1 summarizes key aspects of Basel I, II, and III.
III. Concepts and Terminology Regulatory Capital
3.16 Capital is similar to, but not the same as, the accounting concept of equity. Capital represents a buffer between the value of banks’ liabilities and assets, similar to the accounting definition of equity as the difference between the value of assets and liabilities. From a supervisory perspective, the purpose of capital is to absorb unexpected losses so that the providers of banks’ liabilities—commonly depositors—will be repaid in full even if the providers of capital—owners and subordinated debt holders—incur losses.
3.17 Regulatory capital differs from accounting equity because of the supervisory focus on absorbing losses. Certain accounting liabilities may be loss absorbing, for example, debt which is subordinated to the claims of other creditors (including depositors), so liabilities meeting specific criteria are included in regulatory capital.
3.18 The distinguishing elements of regulatory capital are its permanence, its freedom from fixed charges against income, and its ability to absorb losses. The highest quality capital, common equity, exists for the life of the bank unless repurchased at the discretion of the bank, receives dividends only on a discretionary basis, and ranks last in the priority of claims and thus has the highest loss absorption capacity.
3.19 Other capital instruments generally are deficient with respect to one or more of these key qualities. For example, subordinated debt must have a minimum term to maturity of five years to qualify as capital. It is not permanent, and as a debt instrument has a contractually agreed interest rate and thus has a fixed charge against income. It ranks behind other creditors, and, while not subject to loss while the bank continues in normal operation, will absorb losses on a gone concern basis.
3.20 The value of some assets is deducted from regulatory capital. This is because intangible assets such as goodwill, and deferred tax assets, which only have value to a profit-making bank, are normally written-of—they are completely worthless—when a bank is liquidated. The value of these assets is deducted from capital so that the amount of capital recognized for regulatory purposes has already been reduced by the losses expected in liquidation from the write-off of intangible and other specified types of asset.
3.21 While there are many specific and technical requirements, in general, regulatory capital (i) includes all elements of accounting equity; (ii) includes liability instruments meeting prescribed criteria to ensure their ability to absorb losses either on a going concern basis or in liquidation (gone concern basis); and (iii) is reduced by the value of assets likely to be worthless in liquidation.
3.22 To prevent the double counting of capital, capital requirements should be applied on a consolidated basis. Intra-group positions are eliminated in an accounting consolidation, so capital in subsidiaries created through the parent bank’s ownership of its equity (and possibly qualifying debt instruments) is eliminated. The amount of any investment in a subsidiary which is not consolidated with the accounts of the parent should be deducted from the parent bank’s capital.5
3.23 The original Basel Accord defined two tiers of capital; Tier 1, comprising the highest quality capital; and Tier 2, comprising instruments with some, but not all, of the characteristics of capital discussed earlier. The elements of Tier 1 and Tier 2 capital remained unchanged in Basel II. Despite modifications in Basel III, the two tier approach remains central to the Basel standard.
3.24 Under Basel I and II, total regulatory capital can be expressed as:
(Tier 1 capital – goodwill) + Tier 2 capital – adjustments.
Regulatory adjustments are deductions from capital, which except for goodwill, are deducted from total capital in Basel I, and 50 percent from Tier 1 and 50 percent from Tier 2 capital in Basel II.
3.25 Under Basel III, total regulatory capital is still the sum of Tier 1 plus Tier 2 capital, less adjustments; however, all regulatory adjustments are deducted from their respective components. Basel III regulatory capital can be expressed as:
(CET 1 capital – adjustments) + (AT 1 – adjustments) + (Tier 2 capital – adjustments)
3.26 Tier 1 capital (Basel I definition continued in Basel II) consists of equity capital and disclosed reserves that are considered freely available to meet claims against the bank. It comprises paid-up shares and common stock-issued and fully paid ordinary shares/common stock and perpetual noncumulative preference shares—and disclosed reserves created or increased by appropriations of retained earnings or other surplus. The latter include, among others, share premiums, retained profit, general reserves, and legal reserves, and are considered to be freely and immediately available to meet claims against the bank.6 Tier 1 capital excludes revaluation reserves and cumulative preference shares.
3.27 CET1 capital (Basel III definition) consists of the sum of common shares, retained earnings, accumulated other comprehensive income and other disclosed reserves, and common shares issued by subsidiaries of the bank that are consolidated with the bank and held by third parties that meet the criteria for inclusion in CET1, less regulatory adjustments.
3.28 AT1 capital (Basel III definition) consists of subordinated instruments with no maturity and neither secured nor covered by a guarantee of the issuer. To be eligible for inclusion in additional Tier 1, financial instruments must, among other criteria, be: (1) issued and paid in; (2) subordinated to depositors and general creditors of the bank; (3) neither secured nor covered by a guarantee of the issuer or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis bank creditors; and (4) perpetual, that is, there is no maturity and there are no incentives to redeem.
3.29 Tier 2 capital (Basel I definition continued in Basel II) consists of financial instruments and reserves that are available to absorb losses, but which might not be permanent, have uncertain values, might entail costs if sold, or which otherwise lack the full loss-absorption capacity of Tier 1 capital items. These include (1) undisclosed reserves, that is, that part of accumulated retained earnings that banks in some countries may be permitted to maintain as an undisclosed reserve; (2) asset revaluation reserves with regard to fixed assets, and with regard to long-term holdings of equities valued in the balance sheet at historic cost but for which there are “latent” revaluation gains; (3) general provisions/general loan loss reserves (up to 1.25 percent of risk-weighted assets);7 (4) hybrid instruments that combine the characteristics of debt and equity and are available to meet losses;8 and (5) unsecured subordinated debt with a minimum original fixed term of maturity of more than five years and limited-life redeemable preference shares. Tier 2 capital and subordinated debt cannot exceed 100 percent and 50 percent, respectively, of Tier 1 capital.
3.30 Tier 2 capital (Basel III definition) consists of the sum of: (1) unsecured subordinated debt with a minimum original maturity of at least five years and limited-life redeemable preference shares; (2) stock surplus resulting from the issuance of instruments included in Tier 2 capital; (3) instruments issued by subsidiaries that are consolidated with the bank and held by third parties that meet the criteria for inclusion in Tier 2 capital; (4) general provisions or loan-loss reserves held against future unidentified losses, not ascribed to particular assets or known liabilities;9 and (5) regulatory adjustments applied in the calculation of Tier 2 capital.
3.31 The adjustments to regulatory capital in Basel I and II include deducting the value of goodwill from Tier 1 capital, and deduction from total capital (50 percent from Tier 1 and 50 percent from Tier 2 in Basel II) of the value of investments in unconsolidated banking and financial subsidiaries to prevent the multiple use of the same capital resources within the same banking group.10 National authorities have the discretion to add to these supervisory deductions investment in the capital of other banks and financial institutions, and other intangible assets. Basel III introduced a wider set of deductions to buttress the quality of the capital in times of stress. These deductions include: (1) goodwill; (2) deferred tax assets; (3) defined benefit pension plan deficits; (4) excess minority interest in subsidiaries; (5) profit revaluation of own debt; and (6) threshold deductions (other deferred taxes arising from timing differences, mortgage servicing rights, and investments in unconsolidated subsidiaries) taken as the excess over 10 percent of CET1 individually and the excess of 15 percent of CET1 when considered in aggregate.
Risk-Weighted Assets
Credit Risk
3.32 Basel I introduced the concept of adjusting assets through the application of a weighting factor to approximate risk. Banks are required to hold the specified minimum capital relative to their risk-weighted (or risk-adjusted) assets, rather than their total assets. Basel I initially considered only credit risk, with the 1996 Amendment incorporating market risk by expressing the measure of market risk as a risk-weighted asset equivalent. Basel II introduced an expression of the measure of operational risk as a risk-weighted asset equivalent. Applying the Basel minimum 8 percent capital adequacy standard, a bank would require $8 in capital for each $100 in 100 percent risk-weighted commercial loans ($100 * 1.00 * 0.08), $2 in capital for each $100 in 20 percent risk-weighted debt of another bank ($100 * 0.20 * 0.08), and no capital for $100 in 0 risk-weighted government bonds ($100*0.0*0.08). Total capital requirements can be calculated as follows:
Total Risk-Weighted Assets * 0.08 = Minimum Capital Requirement
3.33 There are four Basel I groupings of assets with corresponding credit-risk weights (Table 3.2). Basel II and Basel III have introduced more granular versions of the original Basel I approach to credit-risk weighting, breaking the original four groupings of assets into an increasing number of categories in efforts to make the standardized approaches more nuanced. An illustration of the increasing granularity is provided in Annex 3.2. Basel II also introduced a treatment of risk-mitigants, whereby risk weights can be adjusted to reflect the value of collateral and guarantees. Compilers requiring additional detail on the standardized approaches to risk weights and the treatment of risk-mitigants should refer to national supervisory standards and the relevant version of the Capital Accord.
Basel I Risk Weights for On-balance-Sheet Assets
Source: BCBS (1988).Note: OECD = Organisation for Economic Co-operation and Development.Basel I Risk Weights for On-balance-Sheet Assets
| Risk Weight (Percent) | Asset Category |
|---|---|
| 0 | Cash, including, at national discretion, gold bullion held in own vaults or on an allocated basis to the extent backed by bullion liabilities Claims on central governments and central banks denominated in national currency and funded in that currency Other claims on OECD central governments and central banks Claims collateralized by cash of OECD central-government securities or guaranteed by OECD central governments |
| 0, 10, 20, or 50 (At National Discretion) | Claims on domestic public sector entities, excluding central governments, and loans guaranteed by such entities |
| 20 | Claims on multilateral development banks and claims guaranteed by or collateralized by securities issued by such banks Claims on banks incorporated in the OECD and loans guaranteed by OECD-incorporated banks Claims on banks incorporated in countries outside the OECD with a residual maturity of up to one year and loans with a residual maturity of up to one year, guaranteed by banks incorporated in countries outside the OECD; claims on non domestic OECD public sector entities, excluding central governments, and loans guaranteed by such entities Cash items in process of collection |
| 50 | Loans fully secured by mortgage on residential property that is or will be occupied by the borrower or that is rented |
| 100 | Claims on the private sector Claims on banks incorporated outside the OECD with a residual maturity of over one year Claims on central governments outside the OECD (unless denominated in national currency— and funded in that currency—see above) Claims on commercial companies owned by the public sector Premises, plant and equipment, and other fixed assets Real estate and other investments (including nonconsolidated investment participations in other companies) Capital instruments issued by other banks (unless deducted from capital) All other assets |
Basel I Risk Weights for On-balance-Sheet Assets
| Risk Weight (Percent) | Asset Category |
|---|---|
| 0 | Cash, including, at national discretion, gold bullion held in own vaults or on an allocated basis to the extent backed by bullion liabilities Claims on central governments and central banks denominated in national currency and funded in that currency Other claims on OECD central governments and central banks Claims collateralized by cash of OECD central-government securities or guaranteed by OECD central governments |
| 0, 10, 20, or 50 (At National Discretion) | Claims on domestic public sector entities, excluding central governments, and loans guaranteed by such entities |
| 20 | Claims on multilateral development banks and claims guaranteed by or collateralized by securities issued by such banks Claims on banks incorporated in the OECD and loans guaranteed by OECD-incorporated banks Claims on banks incorporated in countries outside the OECD with a residual maturity of up to one year and loans with a residual maturity of up to one year, guaranteed by banks incorporated in countries outside the OECD; claims on non domestic OECD public sector entities, excluding central governments, and loans guaranteed by such entities Cash items in process of collection |
| 50 | Loans fully secured by mortgage on residential property that is or will be occupied by the borrower or that is rented |
| 100 | Claims on the private sector Claims on banks incorporated outside the OECD with a residual maturity of over one year Claims on central governments outside the OECD (unless denominated in national currency— and funded in that currency—see above) Claims on commercial companies owned by the public sector Premises, plant and equipment, and other fixed assets Real estate and other investments (including nonconsolidated investment participations in other companies) Capital instruments issued by other banks (unless deducted from capital) All other assets |
3.34 All versions of Basel employ conversion factors to determine a credit equivalent amount for off-balance-sheet items (Table 3.3). This credit equivalent amount is then subject to risk weighting in accordance with the factor applicable to the counterparty.
Credit Conversion Factors for Off-Balance-Sheet Items
Source: Basel IIICredit Conversion Factors for Off-Balance-Sheet Items
| Instruments | Credit conversion factors (in percent) |
|---|---|
| Direct credit substitutes, eg general guarantees of indebtedness (including standby letters of credit serving as financial guarantees for loans and securities) and acceptances (including endorsements with the character of acceptances). | 100 |
| Sale and repurchase agreements and asset sales with recourse where the credit risk remains with the bank. | 100 |
| The lending of banks’ securities or the posting of securities as collateral by banks, including instances where these arise out of repo-style transactions. | 100 |
| Forward asset purchases, forward deposits and partly paid shares and securities, which represent commitments with certain drawdown. | 100 |
| Off-balance sheet items that are credit substitutes not explicitly included in any other category. | 100 |
| Note issuance facilities and revolving underwriting facilities regardless of the maturity of the underlying facility. | 50 |
| Transaction-related contingent items such as performance bonds, bid bonds, warranties and standby letters of credit related to particular transactions. | 50 |
| Commitments, regardless of the maturity of the underlying facility, unless they qualify for a lower CCF. | 40 |
| The issuing and confirming banks of short-term self-liquidating trade letters of credit arising from the movement of goods (e.g. documentary credits collateralized by the underlying shipment). | 20 |
| Commitments that are unconditionally cancellable at any time by the bank without prior notice, or that effectively provide for automatic cancellation due to deterioration in a borrower’s creditworthiness. | 10 |
Credit Conversion Factors for Off-Balance-Sheet Items
| Instruments | Credit conversion factors (in percent) |
|---|---|
| Direct credit substitutes, eg general guarantees of indebtedness (including standby letters of credit serving as financial guarantees for loans and securities) and acceptances (including endorsements with the character of acceptances). | 100 |
| Sale and repurchase agreements and asset sales with recourse where the credit risk remains with the bank. | 100 |
| The lending of banks’ securities or the posting of securities as collateral by banks, including instances where these arise out of repo-style transactions. | 100 |
| Forward asset purchases, forward deposits and partly paid shares and securities, which represent commitments with certain drawdown. | 100 |
| Off-balance sheet items that are credit substitutes not explicitly included in any other category. | 100 |
| Note issuance facilities and revolving underwriting facilities regardless of the maturity of the underlying facility. | 50 |
| Transaction-related contingent items such as performance bonds, bid bonds, warranties and standby letters of credit related to particular transactions. | 50 |
| Commitments, regardless of the maturity of the underlying facility, unless they qualify for a lower CCF. | 40 |
| The issuing and confirming banks of short-term self-liquidating trade letters of credit arising from the movement of goods (e.g. documentary credits collateralized by the underlying shipment). | 20 |
| Commitments that are unconditionally cancellable at any time by the bank without prior notice, or that effectively provide for automatic cancellation due to deterioration in a borrower’s creditworthiness. | 10 |
3.35 In addition to a more granular standardized approach, Basel II introduced internal ratings–based approaches (IRB) for credit risk, which use models to determine risk weightings. Subject to supervisory approval, banks may use data from their own internal ratings–based models as inputs into the function determining the capital requirement for credit risk exposures. In the advanced IRB approach, the bank provides the key risk inputs of probability of default (PD), loss given default (LGD), exposure at default (ED), and effective maturity (M). In the foundation IRB approach, the bank provides only the estimates of PD, with the supervisory authority prescribing the other risk inputs.
3.36 Compilers should ensure that the metadata indicates whether the national supervisory standards make the advanced approaches are available to banks. Compilers should not normally require details of the internal ratings–based approach to credit risk, but if required, should refer to national supervisory standards and the BCBS publications International Convergence of Capital Measurement and Capital Standards: A Revised Framework (Basel II, 2004), and Basel III: Finalizing Post-Crisis Reforms (2017).
Market Risk
3.37 Market risk is the risk of losses in on- and off-balance-sheet positions arising from movements in market prices. The 1996 Amendment to the Capital Accord to Incorporate Market Risks introduced capital charges for interest rate–related instruments and equities in the trading book (instruments not held primarily for the collection of cash flows), and to total (trading book plus banking book) currency and commodities positions. Banks can measure their market risk exposure and calculate the required capital using the standardized approach or, subject to supervisory approval, internal models. The market risk requirements remained unchanged in Basel II. A revised approach to market risk, including a new standardized approach and revisions to the requirements for internal models was introduced in 2016.11
3.38 Under Basel I and II, in the standardized framework, the capital charge is calculated using fixed risk factors. The capital charge for foreign currency exposure, for example, is calculated as 8 percent of the overall net currency positions.12 For interest rate and equity risk (including derivatives), a specific risk (issuer risk) charge is added to the general market risk charge.
3.39 Under Basel I and II, banks with well-established risk management practices are allowed, subject to supervisory approvals, to calculate market risk regulatory capital requirement using their own value at risk (VaR) estimates.13 Supervisory approval is subject to certain conditions, including daily VaR back-tests, that is, to test the validity of the VaR measure by comparing VaR figures to actual or hypothetical outcomes.
3.40 Reflecting experience in the global financial crisis with models significantly underestimating actual volatility and the probabilities of extreme tail events, the 2009 revisions to Basel II, often called Basel II.5, introduced a number of changes to the calculation of capital requirements for market risk. These included (1) the calculation of VaR under stressed market conditions; (2) a new incremental risk charge to capture default and credit mitigation risk; (3) for securitized products, the application of the same capital charge applied for exposures in the banking book; and (4) an incremental charge for credit risk in the trading book to minimize capital arbitrage by eliminating the difference in capital requirements for identical instruments held in the trading book and banking book.
3.41 The new capital standards for market risk introduced in 2016 revised the required methodology for internal models, and also introduced a much more detailed standardized approach. Reflecting experience in the global financial crisis, the approach shifed from VaR to expected shortfall (ES) to better capture tail risk. In addition, both the internal model and standardized approach introduced varying liquidity horizons to incorporate the risk of market illiquid-ity, and, following on from Basel II.5, made technical revisions to more clearly identify the boundary between the trading book and banking book.
3.42 In January 2019, the BCBS published a revised standard for minimum capital requirements for market risk. The main changes were the introduction of a new standardized approach and simplified standardized approach to enhance market risk sensitivity, clearer delineation of the boundary between the trading book and the banking book, and more detailed and stringent requirements for banks’ internal market risk models and the processes for supervisory review.
3.43 Compilers should be aware of whether capital charges for market risk have been incorporated into national supervisory standards and should disclose in the metadata whether the approach is based on the Basel I and II approach, the Basel II.5 revisions, or Basel III. Any national variations from the Basel regime should be noted. Compilers will generally not need the details of the standardized or internal model calculations of market risk capital requirements but if required should refer to the relevant Basel publications.
Operational Risk
3.44 Operational risk is defined as the risk of loss resulting from inadequate internal procedures or from external events. This definition includes legal risk but excludes strategic and reputational risks. Capital charges for operational risk were introduced in Basel II. Initially banks were to choose from three methods to calculate the capital required for operational risk: (1) the basic indicator approach; (2) the standardized approach, and (3) the advanced measurement approaches. The advanced measurement approaches were later withdrawn, reflecting that the state of the art of operational risk management was not as advanced as credit and market risk management. Basel III introduced in 2017 a new standardized approach, using business line revenues and assumed or observed operational loss experience as inputs, replacing the two other options for calculating operational risk.
3.45 Compliers should disclose in the metadata whether capital charges for operational risk have been adopted in national supervisory frameworks, and, if so, which calculation methods are available to banks. Further detail on operational risk capital charges should not normally be needed by compilers but, if required, can be obtained from national supervisory standards and BCBS BasellH: Finalising Post-Crisis Reforms (2017).
Leverage Ratio
3.46 Basel III introduced a non-risk-based leverage ratio to serve as a supplementary measure to the risk-based capital requirements. Banks were initially required only to disclose their leverage ratio as defined in the original 2010 Basel III text. The capital measure (numerator) is Tier 1 capital (Basel III definition), and the exposure measure (denominator) comprises all balance sheet assets, derivatives exposures, securities financing transaction exposures, and off-balance-sheet items. Exposure as defined in Basel III provides a more comprehensive measure of risk than on- and off-balance-sheet items by requiring the use of the accounting measure of exposure plus regulatory requirements with respect to derivatives, repurchase agreements and securities finance, committed credit facilities, direct credit substitutes, and other specified items. The exposure measure was revised in December 2017.
3.47 By 2018, banks were required to hold Tier 1 capital equal to at least 3 percent of the exposure measure as originally defined and have until 2022 to meet the 3 percent requirement using the revised exposure definition. In addition, the December 2017 revisions introduced a requirement for a leverage buffer for global systemically important banks (G-SIB). The leverage buffer add-on is equal to half of the G-SIB buffer the bank is required to hold. For example, a G-SIB with a capital buffer of 1 percent would be required to meet a leverage limit of 3.5 percent—the broadly applicable 3 percent leverage limit, plus a leverage buffer equivalent to half of the applicable G-SIB buffer. Implementation will be phased in through 2022. There is the option, at national discretion, of early adoption of the revised exposure measure.
3.48 Compilers will rely on supervisory sources for leverage data but should note in the metadata whether the national definition is aligned with either the original or revised Basel definition.
Liquidity Standards
3.49 Basel III introduced two internationally harmonized global liquidity standards: the LCR and NSFR. These two ratios are calculated using prescribed stress-scenarios and agreed international definitions of HQLA. National implementation may vary, and compilers should rely on national supervisory standards. Some jurisdictions may apply the LCR and NSFR requirements only to a sub-set of banks, for example, only large internationally active banks. As described in Chapter 7, the LCR and NSFR FSIs should be compiled based on aggregation of those banks to which the standards apply.
Liquidity coverage ratio
3.50 The LCR is intended to promote resilience to potential liquidity disruptions over a 30 day horizon. The LCR standard is defined by dividing the stock of HQLA by net cash outflows over a 30-day time period under stressed conditions. Unlike other liquidity FSIs (except the net stable funding ratio discussed further), the LCR is not a ratio of balance sheet items, but rather the result of a supervisor-prescribed stress scenario. Compilers will rely on supervisory data sources.
3.51 Phased implementation ends in 2019, meaning that HQLA must equal or exceed a stressed one-month cash outflow using run-off rates prescribed by the supervisory authority.
3.52 HQLA are those assets that can be easily and immediately converted into cash at little or no loss of value. Basel III sets out fundamental and market-related characteristics and operational requirements that HQLA should possess or satisfy. These assets should be unencumbered, liquid in markets during a time of stress and, ideally, eligible as collateral for the central bank standing liquidity facilities.
3.53 Implementing the LCR will be challenging in many countries because of a lack of assets that would meet the Basel definition of HQLA.14 Compilers should provide in the metadata definitions of HQLA if these differ from the Basel standard. Full details of the Basel definition are available in the 2010 Basel III text.
Net stable funding ratio
3.54 The NSFR is defined as the ratio of the available amount of stable funding relative to the amount of required stable funding over a one-year time horizon. Like the LCR, but in contrast to other liquidity FSIs, the NSFR is not a ratio of balance sheet items, but the outcome of a supervisor-prescribed stress scenario applied to individual banks. It is intended to limit overreliance on short-term wholesale funding, encourage assessment of funding risks across all on- and off- balance sheet items, and promote funding stability. The NSFR should be greater than 100 percent and complements the short-term horizon of the LCR.
3.55 Available stable funding (ASF) is defined as the portion of a banks’ capital and liabilities that are expected to remain with the bank in a stress scenario over a one-year horizon. Calibration of the presumed degree of stability considers the funding tenor, the funding type, and counterparty. Required stable funding is institution-specific, reflecting the liquidity characteristics and residual maturities of its assets and its off-balance-sheet exposures. Compilers will rely on supervisory data and will not generally need to be familiar with the highly detailed specification of available stable funding and required stable funding (RSF). Additional detail, if required, can be obtained from national supervisory standards and BCBS Basel III: The Net Stable Funding Ratio (2014).
IV. Aggregation of Capital Components under Different Basel Accords
3.56 In some countries, there may be different prudential standards for different types or classes of bank. If differing capital definitions are in force, for example, Basel III for larger banks and an earlier definition for savings or mutual banks, this will create a problem for aggregating internal data based on different regulatory frameworks. Table 3.4 summarizes the recommended approach for aggregating on different regulatory frameworks.
Recommended Aggregation of Capital Components under Basel III and Basel II (or Basel I) for Deriving Sectoral Data
Source: IMF staff.Note: AT1 = Additional Tier 1; CET1 = Common Equity Tier 1.* Net of supervisory adjustments.Recommended Aggregation of Capital Components under Basel III and Basel II (or Basel I) for Deriving Sectoral Data
| Basel I | Basel II | Basel III | Sectoral data calculated by aggregation of capital data under different Basel standards |
|---|---|---|---|
| Tier I | Tier I | CET1* | Sectoral CET1 = Common Equity Under Basel I and II + Basel III CET1* |
| Tier 1 (CET1*+ AT1*) | Sectoral Tier 1 = Basel I Tier 1 + Basel II Tier 1 + Basel III Tier 1 | ||
| Tier 2 | Tier 2 | Tier 2* | Sectoral Tier 2 = Basel I Tier 2 + Basel II Tier 2 + Basel III Tier 2* |
| Tier 3 | Tier 3 | Tier 3 is eliminated | Sectoral Tier 3 (if applicable) = Basel I Tier 3 + Basel II Tier 3 |
| Supervisory adjustments (except for goodwill) are deducted from total regulatory capital | Supervisory adjustments (except for goodwill) are deducted 50 percent Tier 1 and 50 percent Tier 2 | Supervisory adjustments are deducted from each component of regulatory capital | Sectoral supervisory adjustments = Basel I supervisory adjustments + Basel II supervisory adjustments (as applicable) |
| Basel I total regulatory capital = Tier 1 + Tier 2 + Tier 3 (if applicable) – supervisory adjustments | Basel II total regulatory capital=Tier 1 + Tier 2 + Tier 3 (if applicable) – supervisory adjustments | Basel III total regulatory capital = Tier 1 (CET1* + AT1*) + Tier 2* | Sectoral Total Regulatory Capital = Sectoral Tier 1 + Sectoral Tier 2 + Sectoral Tier 3 (if applicable) – Sectoral supervisory adjustments (as applicable) |
Recommended Aggregation of Capital Components under Basel III and Basel II (or Basel I) for Deriving Sectoral Data
| Basel I | Basel II | Basel III | Sectoral data calculated by aggregation of capital data under different Basel standards |
|---|---|---|---|
| Tier I | Tier I | CET1* | Sectoral CET1 = Common Equity Under Basel I and II + Basel III CET1* |
| Tier 1 (CET1*+ AT1*) | Sectoral Tier 1 = Basel I Tier 1 + Basel II Tier 1 + Basel III Tier 1 | ||
| Tier 2 | Tier 2 | Tier 2* | Sectoral Tier 2 = Basel I Tier 2 + Basel II Tier 2 + Basel III Tier 2* |
| Tier 3 | Tier 3 | Tier 3 is eliminated | Sectoral Tier 3 (if applicable) = Basel I Tier 3 + Basel II Tier 3 |
| Supervisory adjustments (except for goodwill) are deducted from total regulatory capital | Supervisory adjustments (except for goodwill) are deducted 50 percent Tier 1 and 50 percent Tier 2 | Supervisory adjustments are deducted from each component of regulatory capital | Sectoral supervisory adjustments = Basel I supervisory adjustments + Basel II supervisory adjustments (as applicable) |
| Basel I total regulatory capital = Tier 1 + Tier 2 + Tier 3 (if applicable) – supervisory adjustments | Basel II total regulatory capital=Tier 1 + Tier 2 + Tier 3 (if applicable) – supervisory adjustments | Basel III total regulatory capital = Tier 1 (CET1* + AT1*) + Tier 2* | Sectoral Total Regulatory Capital = Sectoral Tier 1 + Sectoral Tier 2 + Sectoral Tier 3 (if applicable) – Sectoral supervisory adjustments (as applicable) |
Annex 3.1 The Basel Regulatory Frameworks
| Basel I | Basel II | Basel III |
|---|---|---|
| Capital adequacy framework | Capital adequacy framework | Capital adequacy framework |
Definition of capital
| Capital adequacy framework Definition of capital
| Capital adequacy framework Definition of capital
|
Credit risk
| Credit risk
| Credit risk
|
Market risk
| Market risk
| Market risk
|
Operational risk
| Operational risk
| |
Leverage ratio
| ||
New liquidity framework
| ||
Supervisory review process
| Supervisory review process
| |
Disclosure requirements
| Disclosure requirements
|
| Basel I | Basel II | Basel III |
|---|---|---|
| Capital adequacy framework | Capital adequacy framework | Capital adequacy framework |
Definition of capital
| Capital adequacy framework Definition of capital
| Capital adequacy framework Definition of capital
|
Credit risk
| Credit risk
| Credit risk
|
Market risk
| Market risk
| Market risk
|
Operational risk
| Operational risk
| |
Leverage ratio
| ||
New liquidity framework
| ||
Supervisory review process
| Supervisory review process
| |
Disclosure requirements
| Disclosure requirements
|
Annex 3.2 Illustration of Increasing Granularity in Standardized Approaches to Credit Risk
| Basel I | Basel II Standardized | Basel III Standardized | ||||
|---|---|---|---|---|---|---|
| Category | Risk weight | Category | Risk weight | Category | Risk weight | |
| Residential mortgages | Loans fully secured by mortgage on residential property | 50 percent | Loans fully secured by mortgages on residential property | 35 percent | LTV ≤ 50 | 20 percent* |
| 30 percent# | ||||||
| 50 < LTV ≤ 60 | 25 percent* | |||||
| 35 percent# | ||||||
| 60 < LTV ≤ 80 | 30 percent* | |||||
| 45 percent# | ||||||
| 80 < LTV ≤ 90 | 40 percent* | |||||
| 60 percent# | ||||||
| 90 < LTV ≤ 100 | 50 percent* | |||||
| 75 percent# | ||||||
| LTV >100 | 70 percent* | |||||
| 105 percent# | ||||||
| Commercial loans | All loans | 100 percent | AAA to AA– | 20 percent | AAA to AA– | 20 percent |
| A+ to A– | 50 percent | A+ to A– | 50 percent | |||
| BBB+ to BB– | 100 percent | BBB+ to BBB– | 75 percent | |||
| BB+ to BB– | 100 percent | |||||
| Below BB– | 150 percent | Below BB– | 150 percent | |||
| Unrated | 100 percent | Unrated | 100 percent | |||
| SME | 85 percent | |||||
| Project finance | 80 – 130 percent | |||||
| Object finance | 100 percent | |||||
| Commodities finance | 100 percent | |||||
| Basel I | Basel II Standardized | Basel III Standardized | ||||
|---|---|---|---|---|---|---|
| Category | Risk weight | Category | Risk weight | Category | Risk weight | |
| Residential mortgages | Loans fully secured by mortgage on residential property | 50 percent | Loans fully secured by mortgages on residential property | 35 percent | LTV ≤ 50 | 20 percent* |
| 30 percent# | ||||||
| 50 < LTV ≤ 60 | 25 percent* | |||||
| 35 percent# | ||||||
| 60 < LTV ≤ 80 | 30 percent* | |||||
| 45 percent# | ||||||
| 80 < LTV ≤ 90 | 40 percent* | |||||
| 60 percent# | ||||||
| 90 < LTV ≤ 100 | 50 percent* | |||||
| 75 percent# | ||||||
| LTV >100 | 70 percent* | |||||
| 105 percent# | ||||||
| Commercial loans | All loans | 100 percent | AAA to AA– | 20 percent | AAA to AA– | 20 percent |
| A+ to A– | 50 percent | A+ to A– | 50 percent | |||
| BBB+ to BB– | 100 percent | BBB+ to BBB– | 75 percent | |||
| BB+ to BB– | 100 percent | |||||
| Below BB– | 150 percent | Below BB– | 150 percent | |||
| Unrated | 100 percent | Unrated | 100 percent | |||
| SME | 85 percent | |||||
| Project finance | 80 – 130 percent | |||||
| Object finance | 100 percent | |||||
| Commodities finance | 100 percent | |||||
The Islamic Financial Services Board (IFSB) is the international standard setter for institutions offering Islamic financial services. ISFB 15, Revised Capital Adequacy for Institutions Ofering Islamic Financial Services, establishes capital adequacy standards, which, with differences required for Islamic finance, parallel the standards of the Basel Committee. IFSB Guidance Note 6 addresses the application of the Basel III liquidity ratios, LCR and NSFR, to institutions offering Islamic financial services.
Key publications include (i) International Convergence of Capital Measurement and Capital Standards (1988), and Amendment to the Capital Accord to Incorporate Market Risks (1996), collectively referred to as Basel I; (ii) International Convergence of Capital Measurement and Capital Standards: A Revised Framework (2004), commonly referred to as Basel II; (iii) Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems (2010); and (iv) Basel III: Finalising Post-Crisis Reforms (2017).
Tier 3 capital was eliminated in Basel III. Few countries adopted Tier 3 capital as part of their national frameworks, and the national discretion to allow Tier 3 capital no longer exists. Compilers generally should not require details of Tier 3 capital, so it is excluded from this discussion. Compilers requiring more information on Tier 3 capital should consult their national supervisory standards and BCBS Amendment to the Capital Accord to Incorporate Market Risks (1996).
Use of internal models for market risk had been introduced in Amendment to the Capital Accord to Incorporate Market Risks (1996).
While consolidation of the accounts of the parent and its subsidiaries is the usual accounting treatment, supervisors generally require that the accounts of banking and insurance entities not be consolidated. This is because the banking and insurance businesses are so different that neither banking nor insurance prudential standards and supervisory analysis can be meaningfully applied to accounts consolidating material amounts of the two types of business.
Tier 1 capital may also include general funds, such as funds for general banking risk, subject to four criteria: (1) allocations to the funds must be made out of post-tax retained earnings or out of pre-tax earnings adjusted for all potential tax liabilities; (2) the funds and movements into or out of them must be disclosed separately in the bank’s published accounts; (3) the funds must be available to a bank to meet losses for unrestricted and immediate use as soon as they occur; and (4) losses cannot be charged directly to the funds but must be taken through the profit and loss account.
Provisions held against specific assets are excluded from this definition of capital.
Eligible capital instruments should meet the following requirements: (1) they are unsecured, subordinated, and fully paid-up; (2) they are not redeemable at the initiative of the holder or without the prior consent of the supervisory authority; (3) they are available to participate in losses without the bank being obliged to cease trading (unlike conventional subordinated debt); (4) although the capital instrument may carry an obligation to pay interest that cannot permanently be reduced or waived (unlike dividends on ordinary shareholders’ equity), it should allow service obligations to be deferred (as with cumulative preference shares) where the profitability of the bank would not support payment.
Up to 1.25 percent of risk-weighted assets calculated under the standardized approach, and up to 0.6 percent of risk-weighted assets calculated under the IRB approach. At national discretion, lower limits may apply.
The assets representing the investment in subsidiary companies whose capital had been deducted from that of the parent would not be included in risk-weighted assets for the calculation of capital adequacy, or total assets when calculating the leverage ratio.
BCBS, Minimum Capital Requirements for Market Risk (2016).
The overall net open position is measured by aggregating (1) the sum of the net short positions or the sum of the net long positions, whichever is the greater; plus (2) the net position (short or long) in gold, regardless of sign.
VaR measures the maximum likely loss in a given period of time in the event of extreme market moves. It is calculated at a confidence level of 99 percent over a 10-day holding period, using at least 250 days of data.
This will be a significant problem in countries that do not have liquid domestic securities markets. Also, it is a problem for Islamic financial institutions that are constrained from holding interest-bearing instruments.
