Unlike the Basel II framework, where a clear distinction was introduced between advanced and standardised banks and their capital adequacy calculations, Basel III has both a greater commonality of requirements (e.g. the new liquidity ratios) but also greater national discretions (e.g. the calculation of counter-party credit risk by way of internal models).
Basel III changes include:
- formalising requirements for development and ongoing review of risk appetite statements, and for capital planning to form part of business strategy decisions
- introducing short-term liquidity and longer balance sheet maturity transformation ratios, together with a regulatory focus on funds transfer pricing
- revising the calculation of market risk, counterparty credit risk and identifying re-securitisation risk. Further review of the treatment of the trading book is expected to be announced in 2013
- revising minimum capital adequacy ratios inclusive of capital buffers and introducing a leverage ratio
- introducing the requirement that Boards formally address and establish explicit recovery planning frameworks as part of business and risk governance frameworks.
- introducing the recognition of qualifying central counterparties and consequent capital requirements for trade and clearing member exposures
- regulators identifying systemically important financial institutions (at both a global and national level) with resultant additional regulatory capital adequacy requirements
- several key regulatory requirements to be 'stressed' rather than business-as-usual measures including: the capital conservation buffer, the revised general market risk Value at Risk (VaR) calculation, the liquidity coverage ratio and recovery/resolution planning.
While most banks have progressed their compliance approach to Basel III, there is a consequent uncertainty as to whether these many 'input' changes will result in greater transparency and usefulness of information disclosures.
In particular, the introduction of so many new ratio requirements creates numerous points of information. How are they appropriately combined to develop an aggregated and comparable picture of each bank’s overall risk profile? Further the timing of the ratio changes between risks (and across countries) is not aligned so that the disclosure of fully revised Basel III risk profiles is some time off.
National regulators are separately considering new requirements to: separate retail/commercial banking from investment banking activities, limit the permissible extent of proprietary trading and introduce mandatory centralised clearing for derivative transactions.
The consequence is emergent regulatory frameworks may involve differing requirements as to organisational and legal structures, minimum levels of regulatory capital and permissible risk calculations for regulatory purposes.
These differences could reflect the significance of the financial markets in which banks operate as well as assessments of the economic importance of individual banks.
For Australian banks there are significant additional regulatory uncertainties as they await the release of:
- APRA’s Conglomerates Policy including additional regulatory requirements with respect to contagion risk and those institutions considered to be of 'domestic systemic importance'
- potential changes to prudential arrangements for recognition and capital treatment of securitisation
- details regarding access to the Reserve Bank of Australia’s committed liquidity facility.
At the same time APRA continues to appear unwilling to recognise/require levels of sophistication in risk measurement techniques for Australian banks that are permissible under the Basel II and III frameworks.
The minimum 20 percent LGD floor for mortgage lending and the restrictions on equity exposure risk calculations are longstanding, whilst it has recently announced its unwillingness to recognise the internal model method of counterparty credit risk measurement until at least 2014.
Banks should respond to this changing and uncertain regulatory landscape by continuing to review their economic capital models and what their outcomes mean for the expected profitability of current and proposed business strategies. They should continue to refine their business practices to minimise regulatory RWA calculations.
Banks must plan for possible 'cliff effects' from differences in their permissible access to sophisticated regulatory risk calculations. These differences can also reflect data collection costs needed to support these calculations. Risk appetites should also continue to be reviewed.