Annexure A

Basel Committee on Banking Supervision

The Basel Committee’s response to the financial crisis: report to the G20

October 2010

BANK FOR INTERNATIONAL SETTLEMENTS

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Contents

Executive summary ................................................................................................................... 1
Section I – Micro prudential, firm-specific reform measures ................................................... 4

1. Capital ............................................................................................................................... 4
   Quality and level of the capital base ................................................................................ 4
   Risk coverage ................................................................................................................... 4
   Raising the level of capital ............................................................................................... 5
   Containing leverage .......................................................................................................... 5
2. Liquidity ........................................................................................................................... 6
   Global liquidity standards and supervisory monitoring ..................................................... 6
3. Risk management and supervision ................................................................................... 6
4. Market discipline .............................................................................................................. 8
   Section II – Macro prudential measures ................................................................................ 8
5. Addressing procyclicality ................................................................................................ 8
   Capital buffers .................................................................................................................. 9
   Provisioning ..................................................................................................................... 9
6. Systemic risk and interconnectedness ........................................................................... 10
   Contingent capital ........................................................................................................... 10
   Cross-border bank resolution ......................................................................................... 10
   Section III – Implementation of reform measures ............................................................... 11
7. Impact assessment ......................................................................................................... 11
   Comprehensive quantitative impact study ...................................................................... 11
   Macroeconomic impact assessment ............................................................................... 11
8. Transition to the new standards ..................................................................................... 12
   Section IV – Future work ................................................................................................... 13
   Fundamental review of the trading book ......................................................................... 13
   Ratings and securitisations ............................................................................................ 13
   Systemically important banks ......................................................................................... 13
   Contingent capital ........................................................................................................... 14
   Large exposures .............................................................................................................. 14
   Cross-border bank resolution ......................................................................................... 14
   Review of Core Principles for Effective Banking Supervision ......................................... 14
   Standards implementation .............................................................................................. 14
   Annex 1: Phase-in arrangements ........................................................................................ 16

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The Basel Committee’s response to the financial crisis: Report to the G20

Executive summary

The Basel Committee on Banking Supervision and its oversight body, the Group of Governors and Heads of Supervision¹, have developed a reform programme to address the lessons of the crisis, which delivers on the mandates for banking sector reforms established by the G20 at their 2009 Pittsburgh summit. This report, which the Committee is submitting to the G20, details the key elements of the reform programme and future work to strengthen the resilience of banks and the global banking system.

The depth and severity of the crisis were amplified by weaknesses in the banking sector such as excessive leverage, inadequate and low-quality capital, and insufficient liquidity buffers. The crisis was exacerbated by a procyclical deleveraging process and the interconnectedness of systemically important financial institutions. In response, the Committee’s reforms seek to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spill over from the financial sector to the real economy.

The reforms strengthen bank-level, or micro prudential, regulation, which will help raise the resilience of individual banking institutions in periods of stress. The reforms also have a macro prudential focus, addressing system wide risks, which can build up across the banking sector, as well as the procyclical amplification of these risks over time. Clearly, these micro and macro prudential approaches to supervision are interrelated, as greater resilience at the individual bank level reduces the risk of system wide shocks.

Collectively, the new global standards to address both firm-specific and broader, systemic risks have been referred to as “Basel III”. Basel III is comprised of the following building blocks, which have been agreed and issued by the Committee and the Governors and Heads of Supervision between July 2009 and September 2010:

• Raising the quality of capital to ensure banks are better able to absorb losses on both a going concern and a gone concern basis;
• Increasing the risk coverage of the capital framework, in particular for trading activities, securitisations, exposures to off-balance sheet vehicles and counterparty credit exposures arising from derivatives;

¹ The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. It seeks to promote and strengthen supervisory and risk management practices globally. The Committee is comprised of central bank and supervisory authority representatives from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The Committee’s Secretariat is based at the Bank for International Settlements in Basel, Switzerland.

The Basel Committee’s governing body is the Group of Central Bank Governors and Heads of Supervision, which is comprised of central bank governors and (non-central bank) heads of supervision from member countries.

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• Raising the level of the minimum capital requirements, including an increase in the minimum common equity requirement from 2% to 4.5% and a capital conservation buffer of 2.5%, bringing the total common equity requirement to 7%;
• Introducing an internationally harmonised leverage ratio to serve as a backstop to the risk-based capital measure and to contain the build-up of excessive leverage in the system;
• Raising standards for the supervisory review process (Pillar 2) and public disclosures (Pillar 3), together with additional guidance in the areas of sound valuation practices, stress testing, liquidity risk management, corporate governance and compensation;
• Introducing minimum global liquidity standards consisting of both a short term liquidity coverage ratio and a longer term, structural net stable funding ratio; and
• Promoting the build up of capital buffers in good times that can be drawn down in periods of stress, including both a capital conservation buffer and a countercyclical buffer to protect the banking sector from periods of excess credit growth.

The Committee is also working with the Financial Stability Board to address the risks of systemic banks. On 12 September 2010, the Governors and Heads of Supervision agreed that systemically important banks should have loss absorbing capacity beyond the minimum standards of the Basel III framework.

The Committee’s reforms will transform the global regulatory framework and promote a more resilient banking sector. Accordingly, the Committee has undertaken a comprehensive assessment of Basel III’s potential effects, both on the banking sector and on the broader economy. This work concludes that the transition to stronger capital and liquidity standards is expected to have a modest impact on economic growth. Moreover, the long-run economic benefits substantially outweigh the costs associated with the higher standards.

Going forward, the Committee will concentrate its efforts on the implementation of the Basel III framework and related supervisory sound practice standards. It is also conducting work in the following areas:

• A fundamental review of the trading book;
• The use and impact of external ratings in the securitisation capital framework;
• Policy response to systemically important banks;
• The treatment of large exposures;
• Enhanced cross-border bank resolution;
• A review of the Core Principles for Effective Banking Supervision to reflect the lessons of the crisis; and
• Standards implementation and stronger collaboration among bank supervisors through supervisory colleges.

In 2009 the membership of the Basel Committee doubled in size to 27 jurisdictions. It is now represented by senior officials from 44 central banks and supervisory authorities. The greater diversity of supervisory views and practices shared among members has enriched the Committee’s discussions. The broader representation has also served to enhance the Committee’s legitimacy as a global standard setter.

In the course of its standard-setting process, the Committee regularly solicits public comments on its proposals. For example, its December 2009 proposals on capital and

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liquidity generated close to 300 comments from bankers, academics, governments, other standard setters and prudential supervisors, and various other market participants and interested parties. Such comments are carefully reviewed by the Committee and its working groups and proposed standards are modified as appropriate. Together, the transparent public consultations and comprehensive impact assessments help ensure that the Committee is developing standards on a well informed and inclusive basis.

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Section I – Micro prudential, firm-specific reform measures

The cornerstone of the Basel Committee’s reforms is stronger capital and liquidity regulation. But at the same time, it is critical that these reforms are accompanied by improvements in supervision, risk management and governance, as well as greater transparency and disclosure.

1. Capital

The global banking system entered the crisis with an insufficient level of high quality capital. Banks were forced to rebuild their common equity capital bases in the midst of the crisis at the point when it was most difficult to do so. The crisis also revealed the inconsistency in the definition of capital across jurisdictions and the lack of disclosure that would have enabled the market to fully assess and compare the quality of capital across institutions.

Quality and level of the capital base

The Basel Committee reached agreement on a new definition of capital in July 2010. Higher quality capital means more loss-absorbing capacity. This in turn means that banks will be stronger, allowing them to better withstand periods of stress.

A key element of the new definition is the greater focus on common equity, the highest quality component of a bank’s capital. Credit losses and write downs come directly out of retained earnings, which is part of a bank’s common equity base. The Committee therefore has adopted a stricter definition of common equity, requiring regulatory capital deductions to be taken from common equity rather than from Tier 1 or Tier 2 capital as is currently the case. As a result, it will no longer be possible for banks to display strong Tier 1 capital ratios with limited common equity net of regulatory deductions. As part of its reforms, the Committee also recognised the unique circumstances of non-joint stock companies, which are not in a position to issue common shares to the public.

The Basel Committee is of the view that all regulatory capital instruments must be capable of absorbing a loss at least in gone concern situations. The Committee has consulted on a proposal to ensure that all non-common Tier 1 and Tier 2 capital instruments are able to absorb losses in the event that the issuing bank reaches the point of non-viability.

By itself, the new definition of capital constitutes a significant improvement in the global capital regime, which will be enhanced further by better risk coverage, the introduction of buffers and higher minimum capital requirements.

Risk coverage

In addition to raising the quality and level of the capital base, there is a need to ensure that all material risks are captured in the capital framework. During the crisis, many risks were not appropriately covered in the risk-based regime. For example, some banks held significant volumes of complex, illiquid credit products in their trading books without a commensurate amount of capital to support the risk. Moreover, failure to capture major on- and off-balance sheet risks, as well as derivative related exposures, was a key factor that amplified the crisis.

In response, in July 2009 the Committee introduced a set of enhancements to the capital framework that, among other things, considerably strengthen the minimum capital requirements for complex securitisations. This includes higher risk weights for resecuritisation exposures (eg CDOs of ABS) to better reflect the risk inherent in these products, as well as raising the capital requirements for certain exposures to off-balance

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sheet vehicles. The Committee also required that banks conduct more rigorous credit analyses of externally rated securitisation exposures.

Increasing regulatory capital for the trading book has been another crucial element of the Committee’s reform programme. In July 2009 the Committee substantially strengthened the rules that govern capital requirements for trading book exposures. This included a stressed value-at-risk requirement, an incremental risk charge for migration and default risk, as well as higher requirements for structured credit products held in the trading book. The revised trading book framework, on average, requires banks to hold additional capital of around three to four times the old capital requirements, thus better aligning regulatory capital requirements with the risks in banks’ trading portfolios. These higher capital requirements for trading, derivative and securitisation activities reinforce the stronger definition of capital and will be introduced at the end of 2011.

Deterioration in the credit quality of counterparties also was a significant source of credit-related loss. In response, the Committee has focused on increasing regulatory capital requirements and improving risk management for counterparty credit risk. This includes the use of stressed inputs to determine the capital requirement for counterparty credit default risk, as well as new capital requirements to protect banks against the risk of a decline in the credit quality of a counterparty, for example, as occurred in the case of the monoline insurers.

Raising the level of capital

Basel III also introduces higher levels of capital. The minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments. In addition, factoring in the capital conservation buffer brings the total common equity requirements to 7%. The higher level of capital is in addition to the stricter definition of common equity and the increase in capital requirements for trading activities, counterparty credit risk and other capital markets related activities. Taken together, these measures represent a substantial increase in the minimum capital requirement to help ensure that banks are able to withstand the type of stress experienced in the previous crisis. Moreover, as discussed below, supervisors can require additional capital buffers during periods of excess credit growth and, in the case of systemically important banks, they can demand additional loss absorbency capacity.

The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments whose inclusion is based on stricter criteria, will increase from 4% to 6% (before factoring in the conservation buffer).

Containing leverage

Another key element of the Basel III regulatory capital framework is the introduction of a non-risk-based leverage ratio that will serve as a backstop to the risk-based capital requirement. In the lead up to the crisis, many banks reported strong Tier 1 risk-based ratios while still being able to build high levels of on- and off-balance sheet leverage. The use of a supplementary leverage ratio will help contain the build-up of excessive leverage in the system. It will also serve as an additional safeguard against attempts to “game” the risk-based requirements and will help address model risk.

The Committee’s governing body in July 2010 agreed on the design and calibration of the leverage ratio, which will serve as the basis for testing during a parallel run period. It is proposing to test a minimum Tier 1 leverage ratio of 3% over this period that begins in 2013. The leverage ratio will capture both on- and off-balance sheet exposures and derivatives. The treatment of derivatives will be harmonised across accounting regimes using the