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The Evolving Basel III Requirements

How the requirements strengthen the regulation of international banks

Andy Pettit

 

Protecting investors has been an increasing global regulatory trend in recent years and was at the heart of the wide-ranging MiFID II rules that took effect across Europe this year.

Other recent regulatory themes include more disclosure of information, such as the controversial new PRIIPs Key Information Document in Europe, and higher standards of advice, such as proposed best-interest rules in the U.S., first from the Department of Labor and now the SEC.

At a corporate level, equally major rule changes have, and continue, to occupy financial institutions as they seek to comply with frameworks designed to strengthen and stabilise their balance sheets and position themselves to withstand the aftershocks of future crises.

For example, European insurers (and the European operations of non-EU insurers) are subject to Solvency II requirements. These enforce the monitoring and reporting of risk management processes, capital allocation, and publication of their solvency capital requirement, a measure designed to ensure that each insurer can meet its obligations over the next 12 months with a probability of 99.5%.

Banks meanwhile are subject to capital and liquidity requirements and leverage limits in the form of the Basel III requirements, developed by the Basel Committee on Banking Supervision. The principles have been implemented by the Federal Reserve Board in the U.S. and the Capital Requirements Directive and Regulation in Europe.

The practicalities of Solvency II requirements for insurers

In addition to assessing the liability risks, insurers must also hold capital against the market risk of their investments falling in value; the credit risk of non-repayment of debt by third parties; and the operational risk of such things as system failures or bad practice.

Here’s the three-pillar structure that provides the framework for these assessments:

  1. Calculations, models and capital requirements. These may be done using a standard model from the regulator or an internal model, and they can be tailored to a firm’s business and subject to much scrutiny from its regulator. In addition to the solvency capital requirement, a minimum capital requirement of the minimum amount of capital the insurer needs to cover its risks must be calculated. If an insurer´s risk capital falls below this, then they will be prohibited from writing any further business.
  2. Own risk and solvency assessment. Insurers must explain how they are governed, demonstrate an understanding of their full range of risks, and how they manage and mitigate those risks.
  3. Reporting. Insurers must report privately to regulators and provide a solvency and financial condition report that’s publicly available.

Basel III requirements for international banking organisations

Basel III has a similar three-pillar framework. Here are the components:

  1. Calculation of capital requirements. This pillar encompasses: a) the setting of capital requirements in relation to risk to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices; b) the liquidity standards, including the liquidity coverage ratio, designed to ensure enough high-quality liquid resources are available to survive one month in a stress scenario and c) adherence to a maximum leverage ratio.
  2. Risk management, supervision and corporate governance. This part of the requirements sets out how an institution assesses their risks and the processes for actioning issues that arise from the assessments.
  3. Disclosure. The third pillar objective is to promote market discipline and comparability across sectors. It does so by defining what has to be published about capital condition, risk exposures, risk management processes and capital adequacy.

What Basel III and Solvency II requirements mean in practice

Both sets of rules mean that the greater the risk to which a firm is exposed, the greater the amount of capital it needs to hold. Overall risk is assessed using a bottom-up approach, with each type of security assigned a risk weight, incentivising firms to look through each asset to the most granular level and assess each component security.

Banks and insurers that invest the time and effort to employ this look-through approach can minimise their capital requirements. Their alternative is to apply the highest risk weight to each unidentified or unassigned asset, increasing their capital requirement and leaving correspondingly less capital available to be put to work in growing the business. It’s another example of the value of financial data disclosure generally and of portfolio holdings data in particular, a practice well established in many markets and growing in others.

Basel III requirements aim to strengthen the regulation, supervision and risk management of banks. Morningstar Data enables banks to calculate their capital requirements using the most granular look-through approach to their collective investment scheme holdings.

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