Basel II to Basel III The Way forward

White Paper Basel II to Basel III The Way forward - Rohit VM, Sudarsan Kumar, Jitendra Kumar Abstract Basel III guidelines are the response of BCBS (Basel Committee on Banking Supervision) to the 2008 Crisis. It is aimed at strengthening Individual Financial Institutions as well as the overall Financial System by eliminating the weaknesses which were present in BASEL II that were revealed during the crisis. BASEL III has a multi-dimensional impact on financial Institutions and will require associated changes to the IT systems. This paper covers various BASEL III guidelines, and describes the Why and How different areas of IT infrastructure and systems will be impacted. www.infosys.com

Introduction Some very fundamental assumptions by financial institutions and regulators were proven wrong during the 2008 Crisis. The business of subprime lending was based on the assumption that housing prices would keep going up. This assumption proved wrong and it triggered a chain reaction that engulfed the global financial system. This crisis cycle is illustrated in the diagram below. There were some incentives present in the financial system that encouraged risk taking. Transferring of risk through securitization; relying on credit ratings provided by credit rating agencies, which were paid for by the issuers; compensation of top management based on absolute growth, revenue and profit rather than risk adjusted profitability; were just some of the reasons that encouraged excessive risk taking by banks. When subprime loan defaults started impacting the balance sheets of financial institutions, it became a systemic problem. Quarterly losses to the tune of billions of dollars by major Financial Institutions resulted in a crisis of confidence that sucked out liquidity from the financial system. At this time, the weaknesses of the BASEL II guidelines became very evident. Exposure to risky assets in the form of subprime loans, securitization and derivatives resulted in excessive losses. The low quality and quantity of capital could not absorb these losses when systemic risk materialized. The bank s loss absorbing capacity was affected because of their excessive leverage and their short term sources of funding made financial institutions gasping for capital when it was most difficult to raise capital. Sub-Prime Lending Securitization Housing prices decline resulting in sub-prime defaults Sub-prime defaults, Securitized assets & derivatives trading resulted in huge losses Excessive leverage & poor capital could not absorb losses fully, demanding fresh equity infusion Excessive Risk Taking In stressed market situations, Credit Rating downgrades of Financial Institutions & securitized products further lowered valuations & increased losses Governments step in to inject capital to prevent systemic failure Firms on the verge of insolvency; threatening system failure Short term borrowing demanded fresh borrowing which failed in liquidity crisis Huge losses resulted in a crisis of confidence causing liquidity to evaporate BASEL III attempts to plug the loopholes present in BASEL II by recommending steps to further strengthen the overall financial system. BASEL III requires higher risk weights for risky assets bringing more assets/exposure into the umbrella of Risk Weighted Asset (RWA) calculations, prescribes a higher regulatory capital requirement and demands a very high quality of capital. It also introduces requirements to manage liquidity risk better. Finally, it introduces an additional requirement of absolute leverage ratio to take into consideration the model error which might be present in RWA calculations. 2 Infosys White Paper

The diagram below highlights where and how BASEL III changes will address the deficiencies in the crisis cycle. Capital Conservation / Counter-cyclical buffers Less reliance on external ratings agencies CVA Capital Charge Stressed Testing Higher quantity & quality of capital Leverage Ratio introduced 100% weight for trade finance Sub-Prime Lending Securitization Housing prices decline resulting in sub-prime defaults Sub-prime defaults, Securitized assets & derivatives trading resulted in huge losses Excessive leverage & poor capital could not absorb losses fully, demanding fresh equity infusion Excessive Risk Taking Correlation to financial institutions will carry more risk weights to prevent systemic risks and an overall collapse In stressed market situations, Credit Rating downgrades of Financial Institutions & securitized products further lowered valuations & increased losses Governments step in to inject capital to prevent systemic failure Firms on the verge of insolvency; threatening system failure Short term borrowing demanded fresh borrowing which failed in liquidity crisis Huge losses resulted in a crisis of confidence causing liquidity to evaporate Enhanced Supervisory Review and Disclosure Two new liquidity ratios In summary, the BASEL III rules will strengthen the capital reserves and introduce stringent reporting requirements that cover key risk, liquidity and leverage parameters. The BASEL III guidelines also attempt to bolster the weak links in the financial system with the introduction of Central Clearing Houses and lessen the dependency on Rating Agencies. The chart below captures the key aspects of the BASEL III guidelines that have been introduced. CAPITAL Increase in common equity requirement from 2% to 4.5% Increase in Tier 1 Capital (Going Concern) from 4% to 6% Overall capital will remain the same at 8%. (Which means Tier 2 capital, or gone concern capital to reduce to 2% of total capital) Tier 1 Capital can no longer include hybrid capital instruments with an incentive to redeem through features such as step-up clauses. These will be phased out Tier 3 Capital will be eliminated (previously used for market risk) CAPITAL - BUFFERS Introduction of Capital Conservation Buffer - 2.5% of Common Equity Tier 1 Introduction of Counter Cyclical Buffer - 0 to 2.5% of Risk Weighted Assets (RWA) RISK MANAGEMENT Credit Valuation Adjustment (CVA) Capital Charge must be calculated to cover Mark-to-Market losses on counterparty risk to Over The Counter (OTC) Derivatives. Stressed parametes must be used to calculate Counterparty Credit Risk Effective Expected Positive Exposure (EPE) with stressed parameters to be used to address general Wrong-Way Risk (WWR) and Counterparty Credit Risk Banks must ensure complete trade capture and exposure aggregation across all forms of counterparty credit risk (not just OTC derivatives) at the counterparty-specific level in a sufficient time frame to conduct regular stress testing. A multiplier of 1.25 is applied to the corelation parameter of all exposures to financial institutions (meeting certain criteria) (Asset Value Correlation - AVC) Additional margining required for illiquid derivative exposures 100% risk weight for Trade finance Infosys White Paper 3

LIQUIDITY Liquidity Coverage Ratio (LCR) >= 100% Net Stable Funding Ratio (NSFR) > 100% LEVERAGE Leverage Ratio >= 3% REPORTING Contractual maturity mismatch Concentration of funding Available unencumbered assets Market-related monitoring tools: asset prices and liquidity, Credit Default Swap (CDS) spreads and equity prices LCR by currency Results of stress tests should be integrated into regular reporting to senior management RATING AGENCIES Lower reliance on External Rating Agencies Basel III New Requirements IT Impact Summary of Change The architecture below represents a typical BASEL II set-up. Exposure and reference data information is extracted from multiple source systems through Extract, Transform & Load (ETL) processes and the modelling parameters Probability of Default (PD), Exposure at Default (EAD) and Loss Given Default (LGD) are calculated. This data is stored in a Risk Data-Warehouse and then the RWA calculations are performed on the risk data to calculate the regulatory capital requirements. In general, a BASEL III implementation will require additional source systems to be included, changes to the data elements of existing source systems to be made, changes to the risk data models to be done, RWA calculations and reporting modules to comply with regulatory reporting guidelines. These changes are highlighted in the pictorial representation in the diagram. New Sources of Data (Cash Flows) required to calculate LCR/NSFR. Data Sources Origination System Servicing System Collateral Mgmt. System Loss & Recovery System Reference Data External Sources General Ledger Data Quality/CDC ETL Possible new Data marts to hold data for the measurement of Liquidity and Leverage ratios Source System Extracts Staging Staging/ODS Updated Models will incorporate new sources of capital (new data fields) and stressed parameters Basel II Risk Environment Risk Datamarts G/L Reconciliation Factor Model Environment Segment Definition PD, LGD, EAD Op Risk Models Model Validation/ Feedback Model Execution and Output Data Governance Data Governance across the system New Reports 1. LSR, NSFR 2. Leverage 3. Contractual maturity mismatch 4. Concentration of funding 5. Available unencumbered assets RWA Calculation will change because of the new data fields and new risk weights RWA Calculation and Reporting RWA Calculator Reporting Tool FFIEC 101 Reports ICAAP Reports Management Reports 6. Market-related monitoring tools: asset prices and liquidity, CDS spreads, equity prices, institution specific information related to the ability of the institution to fund itself in various wholesale markets 7. LCR by currency 4 Infosys White Paper

BASEL III s IT impact can be further understood by looking at its impact on each of the areas separately. The table below lists the impact expected in different areas of implementation and also lists some of the challenges that will be encountered while implementing them. Risk Data Identification Infrastructure and Data Management Risk Modeling and Quantification RWA Calculation Regulatory Reporting IMPACT Some new sources of data that would need to interact with the Basel framework include: Asset Liability Management (ALM) systems Cash Flow Management systems Existing Liquidity Risk Management systems Data from Central Counterparties for data related to Over- The-Counter (OTC) derivatives. The new liquidity ratios that Basel III introduces (LCR and NSFR), will entail the creation of new Liquidity Risk Data Marts to hold relevant Data Use of Stressed parameters as well as calculating CVA for counterparty credit risks will need huge amounts of historical data, which may require the use of new data marts/ databases to store such information. The formulas used in the calculation of PD, LGD, EAD will change due to the need to incorporate stressed parameters and to also reflect a higher EAD value for counterparties where specific Wrong Way Risk (WWR) has been identified. Changes will be required at the risk engines to accommodate the new buffers (Counter Cyclical, Capital Conservation). It will also need to accommodate the new Risk Weights assigned to derivatives, trade finance products as well as account for exposures to financial institutions. The reporting systems will have to be enhanced to cater to the new reports mentioned in Basel III The existing reports will also be modified to reflect liquidity, leverage and CVA, besides the new capital structure Subsidiary reporting requirements will be augmented. CHALLENGES Identifying the right Data Elements. This would require a good knowledge of accounting systems as well as knowledge of the various reports required by Basel III. Identifying sources and data requirements for different legislations. A single data load with all the attributes required for market, CCR, RWA, economic capital and liquidity risk should be extracted from source systems. As a result, DQ checks will be rigorous. Consultants having experience in Stress Testing, Analytics, and general knowledge about the business of Banks will be required to identify and stress the required parameters. Model validation should be a focus area. The system should be configured to provide Group Data, Solo Data, Basel I, II and III data on demand. Understanding the new reporting requirements Bringing out synergies across stakeholders and consolidating the reporting platform. DATA GOVERNANCE Put in place a rigorous and scalable Data Governance framework (People + Process + Technology) Align source systems data quality capabilities to meet Fit For Purpose norms End-to-end audit capability from source system data to final output calculation may be a challenge in Basel III because of the many new source systems interacting with the reporting systems. Infosys White Paper 5

BASEL III Implementation Approach A BASEL III Implementation will require a core team to co-ordinate with multiple track owners who would be responsible for making changes to the applications and systems that they manage. Ideally, a BASEL III Project Management Office (PMO) will be responsible for initial impact assessment, identifying multiple tracks within the overall program, co-ordinating and monitoring the overall execution and reporting to the senior management. Strategy & Roadmap Impact Analysis & Track Segregation Solution Definition Implementation Maintenance & Support Program roadmap definition High level plan Establish current state of compliance PMO process definitions for change management, communication management and reporting Identify key stakeholders Kick-off meeting with all stakeholders Define individual tracks within the program Impact analysis and requirement documentation Identify dependencies, risks and assumptions Detail level planning for individual tracks Identify the critical path Product evaluation (if required) Architecture design Data analysis & modeling Technical design Data feed design Data sourcing and ETL Data sufficiency analysis Platform Development Application customization and build Data quality testing Functional testing Regression testing Non-functional testing Defect management and reporting Ongoing enhancements Maintenance and user support Platform migration Basel III Implementation Timeline Since the BASEL III requirements bring in critical buffers and significant capital outlays, the key aspects of the BASEL III guidelines will be implemented in phases from January 2013 through 2018. This should give banks enough time to review their financial preparedness and also enhance their operational and reporting capabilities. Legerage Ratio PHASE IN ARRANGEMENTS (Shading indicated transition periods - all dates are as of 1 January) 2011 2012 2013 2014 2015 2016 2017 2018 Supervisory Monitoring Parallel run 1 Jan 2013-1 Jan 2017 Disclosure starts 1 Jan 2015 Migration to Pillar 1 As of 1 Janurary 2019 Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50% Minimum Common Equity Plus Capital Conservation Buffer Phase-in of deductions from CET1 (including amounts exceeding the limit for DTAs, MSRs and Financials) 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0% 20% 40% 60% 80% 100% 100% Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Minimum Total Capital plus Conservation Buffer 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5% Capital Instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital Phased out over 10 year horizon beginning 2013 Liquidity Coverage Ratio Observation Period Begins Introduce Minimum Standard Net Stable Funding Ratio Observation Period Begins Introduce Minimum Standard Source - The website for the Bank for International Settlements - http://www.bis.org/bcbs/basel3.htm 6 Infosys White Paper

Conclusion BASEL III guidelines attempt to plug the gaps identified in BASEL II. However, the world economy and financial markets are dynamic and evolving ecosystems with many forces in play. Consequently, financial regulations will keep on evolving. The intensity of regulatory interventions is expected to increase in the future and the importance of risk management is expected to further move up in the priority of board members and top management. It is therefore imperative that a BASEL III implementation is planned and designed with a high degree of scalability to support future changes in regulation. A BASEL III implementation should be taken as an opportunity to remove a silo based approach to risk management and move towards a reliable and scalable enterprise wide risk management system. For such intent to be successful, an early start and preparation are essential so that enough due diligence goes into laying down the foundations of a strong risk management system. About the Authors Jitendra Kumar is a Principal Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. He has over 15 years of experience and has completed CFA level I & II from the CFA institute, USA. He can be reached at Jitendrakumar@infosys.com Sudarsan Kumar is a Senior Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. He has over 4 years of risk and compliance experience with data warehousing in Basel II. He can be reached at Sudarsan_Kumar@infosys.com Rohit VM is a Consultant with the Risk and Compliance Practice in the Financial Services and Insurance (FSI) Vertical at Infosys. His current focus is on Basel III. Rohit earned his Post Graduate Diploma in General Management (PGDGM) from XLRI, Jamshedpur. He can be reached at Rohit_V02@infosys.com Infosys White Paper 7

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