Basel II.

5, Basel III, and

Other Post-Crisis Changes
Chapter 16

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 1
 Basel II.5 (Implemented Dec 31, 2011)
• Stressed VaR for market risk
– Calculated over one year period of stressed market
conditions
– Capital = max(VaRt-1,mc × VaRavg)
+max(sVaRt-1, ms × sVaRavg)
• Incremental Risk Charge
– Ensures that products such as bonds and credit
derivatives in the trading book have the same
capital requirement that they would if they were in
the banking book
Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 2
 Basel II.5 continued
 Comprehensive Risk Measure
 Designed to make sure sufficient capital is
kept for instruments in the trading book that
depend on on credit default correlations
 Standard approach:
Credit Rating AAA or A BBB BB Below BB
AA
Securitizations 1.6% 4% 8% 28% Deduction
Resecuritizations 3.2% 8% 18% 52% Deduction

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 3
 Basel III
 Capital Definition and Requirements
 Capital Conservation Buffer
 Countercyclical Buffer
 Leverage Ratio
 Liquidity Ratios
 Capital for CVA Risk

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 4
 Capital Definition and
Requirements
• Three types:
– Common equity Tier 1

– Additional Tier 1

– Tier 2

• Definitions tightened
• Limits
– Common equity > 4.5% of RWA

– Tier 1 > 6% of RWA

– Tier 1 plus Tier 2 > 8% of RWA

• Capital levels implemented

• Phased implementation of capital definition stretching to January
1, 2018
Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 5
 Capital Conservation Buffer
 Extra 2.5% of common equity required in
normal times to absorb losses in periods
of stress
 If total common equity is less than 7%
(=4.5%+2.5%) dividends are restricted
 Phased in between January 1, 2016 and
January 1, 2019

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 6
 Countercyclical Buffer
 Extra equity capital to allow for cyclicality
of bank earnings
 Left to the discretion of national regulators
 Can be as high as 2.5% of RWA
 Dividends restricted when capital is below
required level
 Phased in between January 1, 2016 and
January 1, 2019
Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 7
 Leverage Ratio
 Ratio of Tier 1 capital to total exposure (not risk
weighted) must be greater than 3% (Higher in
U.S. and UK)
 Exposure includes all items on balance sheet,
derivatives exposures (calculated as in Basel I),
securities financing exposures, and some off-
balance sheet items
 To be introduced on January 1, 2018 after a
transition period

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 8
 Liquidity Risk Ratios
High Quality Liquid Assets
Liquidity Coverage Ratio   100%
Net Cash Outflows for 30 day period
for an acute 30 - day stress period (3 notch downgrade, partial loss of deposits,
loss of unsecured wholesale funding, increased haircuts on secured funding,
increased collateral requiremen ts, drawdowns on lines of credit, etc)

Amount of Stable Funding

Net Stable Funding Ratio   100%
Required Amount of Stable Funding
for a period of longer term stress. Each category of funding (capital, deposits, etc)
is multiplied by an available stable funding (ASF) factor to form numerator.
Each category of required funding (assets, off - balance sheet exposures
is multiplied by a required stable funding factor (RSF) to form denominato r

The LCR and NSFR will be introduced on January 1, 2015 and January
1, 2018, respectively
Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 9
 ASF Factors (Table 16.4, page 362)
ASF Factor Category
100% Tier 1 and Tier 2 capital
Preferred stock and borrowing with a
remaining maturity greater than 1 year
90% Stable demand deposits and term deposits
80% Les stable demand deposits and term
deposits
50% Wholesale demand deposits
0% All other liability and equity categories

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 10
 RSF Factors (Table 16.5, page 362)

RSF Factor Category

0% Cash and short-term instruments (<1 yr)
5% Claims on sovereign governments with a
risk weight =0% (>1 yr)
20% Corporate bonds rating AA or higher (>1 yr)
Claims on sovereigns with risk weight =20%
50% Gold, equities, and bond rated A
65% Residential mortgages
85% Loans to retail and small business (<1 year)
100% All other assets

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 11
 Capital for CVA Risk
 CVA is the adjustment to the value of
transactions with a counterparty to allow
for the possibility of a counterparty default
 Basel III requires market risk capital for
CVA risk arising from changing credit
spreads

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 12
 G-SIBs
 G-SIBs are Global Systemically Important Banks
 These are required to hold extra Tier 1 equity capital
between 1% and 3.5% of risk-weighted assets
 For banks in the 2.5% category (JPMorgan and
HSBC in Nov 2014 list) Tier 1 equity capital is the
basic 4.5% plus the 2.5% capital conservation buffer
plus 2.5% for being G-SIBs. This totals 9.5% of
RWAs. The total capital requirement (including
additional Tier 1 and Tier 2 is 13%)
 There are also proposals from the FSB and Basel
Committee concerning the total loss absorbing
capacity (TLAC) of G-SIBs. This concerns
requirements for the total of equity, debt and eligible
liabilities
Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 13
 D-SIBs
 D-SIBs are domestic systemically
important banks.
 These banks may be subject to additional
capital, extra disclosure, and stress tests.
 In the United States, banks with assets
over $50 billion are classified as D-SIBs.
(There were 22 in 2014)

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 14
 Contingent Convertible Bonds
 Bonds which automatically get converted
into equity if certain conditions are
satisfied
 In Credit Suisse issue (See Business
Snapshot 16.1) there is conversion if
 Tier 1 equity falls below 7% of RWA, or
 Swiss regulator determines that the bank
needs public sector support

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 15
 Dodd-Frank includes…
 New bodies to monitor systemic risk (FSOC and OFR)
 Volcker rule
 Central clearing for OTC derivatives
 Living wills
 More capital for SIFIs
 No use of external ratings
 Oversight of rating agencies
 Originators of asset backed securities must keep “skin in the game”
 Separately capitalized affiliates for more risky business
 All trades reported to a central agency
 …

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 16
 Rules in Other Countries
 UK: Committee under Sir John Vickers led
to Financial Services (Banking Reform
Act) in 2013
 In European Union committee headed by
Erkki Liikanen proposed new regulations
in 2012.

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 17
 Key issues all regulators are
attempting to address
 Central clearing
 Use of electronic platforms to trade
 Restrict proprietary trading (or at least
insulate it from other activities)
 Living wills
 Compensation (less restrictions in U.S.)

Risk Management and Financial Institutions 4e, Chapter 16, Copyright © John C. Hull 2015 18