An Insider’s Perspective on the Basel Capital and Liquidity Reforms Marc Saidenberg Federal Reserve Bank of New York The views expressed here are my own and do not necessarily represent the views of the Federal Reserve Bank of New York or the Federal Reserve System

2 Background and Objectives During the financial crisis, market participants began to question the capacity of systemically important financial institutions to withstand shocks Questions about the financial condition of key institutions were linked to shortcomings in the regulatory framework o Measures of capital and capital requirements were not commensurate with risks taken by banks, particularly those realized in a stressed environment o Regulation and supervisory assessments of liquidity risk and liquidity risk management were inconsistent Basel Committee on Banking Supervision responded with capital and liquidity reforms designed to improve the banking sector’s ability to absorb shocks arising from financial and economic stress o Stated objective is to reduce the risk of spillover from the financial sector to the real economy

3 Basel Capital and Liquidity Reforms In December 2010, the Basel Committee agreed on a package of reforms (“Basel 3”) designed to: o Increase the capacity of banks to absorb losses relative to risk o Constrain leverage through a credible, non-risk-based backstop o Increase the capacity of banks to absorb shocks to funding and constrain structural funding mismatches o Incorporate macroprudential perspectives into regulatory framework o Provide greater transparency to market participants The capital and liquidity standards are subject to phase-in and transitional arrangements o Liquidity and leverage standards subject to observation periods reflecting need to assess unintended consequences Work continues on enhanced prudential standards for SIFIs and recovery and resolution planning

4 Measuring Capital Adequacy Reforms introduce an explicit common equity standard and revisions to composition of regulatory capital to increase capacity to absorb loses on a ‘going concern’ basis o More stringent criteria for instruments to qualify as regulatory capital o Limited recognition of intangible assets and significant investments in the common shares of FIs Revisions to measures of risk (RWA) designed to ensure capital requirements are commensurate with risks taken by banks and the risks they pose to the financial system o Revisions to Market Risk rules to capitalize appropriately credit-sensitive and structured trading positions o Changes to capital requirements for counterparty credit risk, including charge for mark-to-market losses o Increased capital requirements for credit exposures to large FIs.

5 Calibrating Capital Requirements Amount of capital banks must hold relative to RWAs increased through imposition of higher minimum capital requirements and new ‘capital conservation’ buffer requirements o Introduction of explicit tangible common equity standard (tier 1 common equity) o Non-discretionary restrictions on capital distributions for banks that fail to maintain a buffer of capital above the minimum Under Base 1 and Basel 2, Tier 1 and Total Capital minimum requirements of 4% and 8% -- no explicit common equity standards Under Basel 3: o Tier 1 common equity minimum of 4.5% of RWA o Plus “capital conservation buffer” of 2.5% of RWA o Plus countercyclical buffer – maximum of 2.5% of RWA

6 Calibrating Capital Requirements (cont.) Basel Committee developed conceptual definitions to guide calibration efforts o Minimum requirement: the amount of capital needed to be regarded as a viable, going-concern in the market o Capital Conservation Buffer: an amount of capital sufficient to withstand a systemically stressful period and remain above minimum regulatory capital requirements Conceptual definitions are informative, but they cannot be directly observed (particularly the minimum)

7 Empirical Strategy: Regulatory Minimum Examined historical distribution of earnings relative to RWA for large banks o Key assumption is that a high percentile loss realization is good proxy for market viability test in an ex ante, unconditional way Return on Risk-weighted Assets (RORWA) o Data from seven countries o Estimated negative tail of the distributions (99th to 99.9th percentile) over different horizons

8 Summary of International Results: RORWA

9 Empirical Strategy: Capital Conservation Buffer Look at historical episodes of systemic stress in the banking industry and see how much banks lost o Losses (negative net income) in the recent crisis and in past historical crises, U.S. and abroad Also examine 2009 stress tests results for eight countries o Includes U.S. SCAP results

10 Distribution of Net Income

11 Summary of Capital Calibration Analysis Regulatory minimum results across percentiles, horizons, samples:  4% to 6% of RWA Capital conservation buffer results across approaches and samples:  3% to 7% of RWA -- results for some individual banks much bigger Empirical analysis based on Basel 1 and Basel 2 measures of RWA needs to be “translated” into Basel 3 o Minimum: 4% - 6% Basel 1  4.5% Basel 3 o Buffer: 3% - 7% Basel 1  2.5% (capital conservation) + max 2.5% (countercyclical) Basel 3 Calibration supported by Quantitative Impact Study (QIS) and analysis of long-run and transitional economic costs and benefits associated with higher capital standards

12 Measuring Adequacy of Liquidity Basel Committee seeking to promote financial stability by addressing two complementary objectives: o Enhance resilience to short-term, acute shocks to funding o Effect longer-term structural changes in liquidity mismatches Two measures of liquidity risk developed to be implemented as minimum regulatory standards o Liquidity coverage ratio (LCR) -- risk sensitive, scenario-based measure to size a minimum pool of high-quality liquid assets o Net stable funding ratio (NSFR) -- structural measure that compares estimate of ‘reliable’ funding sources to estimate of required stable funding

13 Designing and Calibrating Liquidity Standards LCR compares stock of high-quality unencumbered liquid assets to projected net cash outflows over a 30-day horizon o High-quality liquid assets should be unencumbered, liquid in markets during a time of stress and central bank eligible Measure of stressed net cash outflows designed to capture potential risks associated with contractual and behavioral responses related to on- and off-balance sheet positions o Scenario reflects firm-specific shock during period of market stress Short-term stress net cash outflows scenario includes: o Partial loss of retail deposits o Significant loss of unsecured and secured wholesale funding o Contractual outflows associated with a 3-notch rating downgrade o Substantial draws on off-balance sheet exposures o Haircut on contractual inflows and aggregate cap

14 Designing and Calibrating Liquidity Standards (cont.) Calibration of scenario runoff rates reflects a judgmental combination of historical experience during financial crisis, banks’ internal stress scenarios and existing regulatory and supervisory standard o Certain parameters reflect concerns about the potential drivers of systemic risks including interconnectedness and the spillovers associated with the distressed fire sale of assets The Committee estimated impact of the liquidity standards -- assuming banks were to make no changes to their liquidity risk profile or funding structure, as of end-2009: o The average LCR for Group 1 banks was 83%; the average for Group 2 banks was 98% o The average NSFR for Group 1 banks was 93%; the average for Group 2 banks was 103% Committee observed material differences across institutions, business models and markets

15 Going Forward Domestic rule making, phase in and observation period for capital and liquidity standards Basel Committee and Financial Stability Board continue to review regulatory and supervisory framework for global SIFIs o Basel Committee agreed on need for additional loss absorbency for G-SIFIs o Potential to link additional capital requirements to measures of systemic importance o DFA mandates that SIFIs in US have more stringent prudential requirements Expectations for recovery and resolution planning