Basel III challenges: Operational Data Store defines a solution

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1 Basel III challenges: Operational Data Store defines a solution Thought Paper Universal Banking Solution Systems Integration Consulting Business Process Outsourcing

2 Basel III challenges: Operational Data Store defines a solution The financial gloom notwithstanding, the recession resulted in some positive developments in the realm of banking regulation. The Basel III Accords/Norms for the banking sector is prominent among them. Basel III is considered to be an intelligent addition to the Basel I & II accords hitherto adhered to by financial institutions. Basel Accords are supervisory recommendations on banking regulations issued by the Basel Committee on Banking Supervision (BCBS). The committee takes its name after the Swiss city where it meets and maintains its secretariat with the Bank of International Settlements 1. With Basel III, the committee has imposed more stringent regulations upon banks to proactively handle any liquidity crunch situation. Liquidity Coverage Ratio and Net Stable Funding Ratio, two new terms introduced by Basel III, ensure increased, high-quality liquid assets and resources in the bank 2. What exactly is Basel III? A global regulatory framework for more resilient banks and banking systems given by the Basel Committee on Banking Supervision (BCBS) issued in December In the light of the recession, which had devastating consequences, Basel III aims to create more resilient individual financial institutions, which in turn can lead to a far more stable financial sector. By plugging loopholes present in the earlier versions, Basel III recommends better mechanisms for risk and liquidity management. Major features New and stricter definitions of capital. Tier 3 capital instruments eliminated from regulatory capital definition. Introduction of Credit Value Adjustments risk capital charge, for OTC Derivatives. Requirements for raising capital. Reduced reporting cycle duration for minimum requirements. Introduction of Capital Conservation Buffer. Introduction of Countercyclical Buffer. Introduction of Liquidity Coverage Ratio (LCR). Introduction of Net Stable Funding Ratio (NSFR). Introduction of Leverage Ratio. Rise in Counterparty Risk Management standards. 1 Bank of International Settlements is an international organization which serves as the bank of Central Banks. 2 Noteworthy is the fact that the RBI has always been stricter than the Basel recommendations. 02 Thought Paper

3 Basel III Implementation in India RBI guidelines Following are the RBI guidelines to Indian banks 3 : Minimum Capital Requirement Capital Conservation Buffer Transitional Agreement Banks must have common equity Tier 1 capital as at least 5.5% of Risk Weightage assets Tier 1 capital in banks must be at least 7% of RWA. (#3) Total capital must be at least 9% of RWA. RWA-Risk Weighted Assets Banks must have 2.5% of RWA in the form of common equity Capital Conservation Buffer. The implementation of Minimum Capital requirement and deductions from common equity capital as per the new definition is proposed to begin from January 1, 2013 and should end by March 31, 2017, in India, by the Apex Bank. As per RBI guidelines,capital conservation buffer requirement should be implemented between March 31, 2014 and March 31, Basel has changed the definition of the regulatory instruments such as capital. The instruments which do not qualify now as per the Basel definitions of regulatory capital, should be phased out from the banks definitions also and banks should accommodate the new definitions during the period beginning from January 1, 2013 to March 31, Enhancing Risk Coverage Leverage Ratio For OTC derivatives, as per the previous norms banks had to calculate capital charge for counterparty default risk. Now Banks would be required to compute credit value adjustments (CVA) risk capital charge in addition to the previous norms. As per RBI guidelines banks are expected to maintain a minimum Tier 1 leverage ratio of 5% during the period from January 1, 2013 to January 1, Basel definitions Components of Capital The Regulatory Capital is defined in the following elements by BASEL Committee. Tier 1 Capital (Common Equity) Common Equity Tier 1 capital consists of: Common Shares/Equity issued by Banks Stock surplus (Share premium) resulting from the issue of instruments included in common equity Tier 1 Retained earnings and reserves Accumulated other comprehensive income and other disclosed reserves. Tier 2 Capital Tier 2 capital is the addendum capital to the Tier 1 capital For any banking institution to consider some capital as Tier 1 or Tier 2 capital, Basel Committee has issued some guidelines and limitations, which must be followed to qualify As per the Basel III Guidelines following are the limits imposed on the capital Common equity Tier 1 capital must be at least 4.5% of RWA at all times. Overall Tier 1 capital must be at least 6.6% of RWA. Total Capital (Tier 1 plus Tier 2 capital) must be at least 8% of RWA at all times. India has stricter limits compared to these limits 3 RWA - Risk Weighted Assets Thought Paper 03

4 Capital Conservation Buffer Banks are required to hold some of the capital apart from the minimum capital required by the regulators, which can be utilized in case of losses.this buffer is called Capital Conservation Buffer.It is an addition on top of the minimum capital requirement. As per the Basel III framework, banks must hold a capital conservation buffer at 2.5% above the minimum capital required Counter Cyclical Buffer In the previous downturns, it has been seen that the banks suffers losses when the downturn is caused by the excessive credit growth i.e.,when banks lend excessively, seeing the good economic indicators. With introduction of Countercyclical Buffer, the Basel Committee mandates that the banks hold some addition capital buffer as a safeguard against losses.the Economic risk and Excessive credit growth conditions are monitored by the regulators and national authorities, and the Countercyclical Buffer is decided based on that. Liquidity Coverage Ratio To keep banks liquid during recession, economic downturn, high losses, losses in investments and shortage of funds, liquidity coverage ratio is introduced in Basel III. As per these guidelines, banks are required to maintain a liquidity coverage ratio at all times to ensure that they have high quality liquid assets to fulfill the cash demands during recessionary times and protect themselves from the bankruptcy. Net Stable Funding Ratio With the introduction of NSFR Basel Committee expects that banks should have high quality and stable source of funding to sustain liquidity during stress times and to meet the contingent liquidity requirements that can arise any time. Banks are required to assess the liquidity risk at all times on all on- and off- balance sheet items and should maintain the Net Stable Funding Ration. Impact of Basel III accords on financial institutions Upon full implementation of Basel III by 2019, banks will be required to maintain overall minimum capital of 10% to 12.5% of RWA (inclusive of all the requirements) with additional buffer; which means Indian banks will have to provision a higher amount owing to stricter norms. This simply means that the banks will have less leverage to lend money and maintain profitability, forcing them to increase lending rates which in turn will hit the scale of their business, more so in retail banking. Additionally, the higher capital requirements and tighter liquidity limitation will affect small and mid-sized banks more severely given their smaller customer base with fewer deposits. Higher capital reserves would further decrease funds for lending and investing. Introduction of LCR and NSFR will force banks to change their liquidity position and increase investments in high-quality assets, resulting in long-term gains. Stringent regulations mandate frequent regulatory reports adhering to the RBIprescribed format, the cost of which will have to be borne by the banks. 04 Thought Paper

5 Increased capital, liquidity cost and RWA will adversely affect banks profit margins across all lines of business. With the introduction of NSFR, banks will have to invest in high-quality assets and retire low to medium-quality, high-return investments from their portfolio, leading to reduced net interest margin (NIM), necessitating greater focus on Asset Liability Management strategies to recover the NIM degradation and maintain profitability. However, with these regulations, banks will be relatively immune to adverse economic conditions given limited exposure to system wide risks and will have greater liquidity at all times. Lower exposure to risky assets and higher exposure to high-quality liquid assets will leave banks unfazed by recessions/downturns, lowering their likelihood of filing bankruptcy in troubled times. Introduction of Countercyclical Buffer will create capital conservation in case of excessive credit growth thus averting another recession. These norms will have a positive impact from a macro-economic perspective but banks will grapple with reduced profitability, low margin and higher costs. How Data Warehouses (DWH) can help financial institutions in facing the challenges posed by Basel III framework implementation Basel III implementation presents banks with many challenges, the foremost being sustaining profitability in the face of increased costs and reduced margins. Increasing the IT intensity of all departments is one way for banks to save cost and improve efficiency and this in turn would necessitate data warehousing solutions. Today, banks are stuck with enormous amounts of data scattered haphazardly. There is a pressing need for a system that can not only consolidate this data but also streamline it into patterns that are easy to analyze and ready to use. The ideal Data Warehouse that supports the successful implementation of Basel III will have to possess the following qualities: Such a robust system will offer banks competitive advantage in the form of Intelligent Data Repositories. Holistic Data Approach Data Availability/ Provisioning Great Data Consistency and Quality High Quality and Standard Data Model Data Completeness Exclusive Data Marts System Flexibility, Extensibility and Adaptability Adherence to International Industry Standards Thought Paper 05

6 This agile data system can empower banks with a reliable and technologically secure IT infrastructure, to help them derive maximum value from data to meet the expectations and challenges of the business. Also, this system can amply fulfill the regulatory requirements arising out of Basel III implementation and also comply with the exacting standards of data fidelity. The above attributes make this system a cost effective solution that can help banks meet the analytical, reporting and regulatory requirements of Basel III, resulting in better customer management and retention. Overall, this would bring forth a greater Value Proposition, which is the game changer in any industry. ODS - One Stop DWH Holistic Data Approach Data Availability/ Provisioning Great Data Consistency and Quality High Quality and Standard Data Model Data Completeness Exclusive Data Marts System Flexibility, Extensibility and Adaptability Adherence to International Industry Standards Review of Current position, strategies and Architecture Regulatory Reporting New Methodologies and Calculations Risk Management Methodologies and Forecasting Asset Liability Management Exclusive Data Marts How a complete data warehousing solution will help banks face major issues imposed by Basel III: Review of current position, strategies and architecture During the initial phase of implementation, institutions will be required to review their current position, strategy and architecture relative to the target position required by Basel. Institutions will require historical data that can report their past and current positions in the form of ratios and also bring forth the limitations of their past performance. This will enable them to identify the action and resources required to meet the requirements and devise new strategies accordingly. Only a DWH flexible enough to accommodate, collate and consolidate data from all other integrated and non-integrated systems in the bank and then produce the historical data in the required format can successfully accomplish this task. Regulatory reporting With increased cost of regulatory reporting, a DWH with complete data provisioning and highly consistent data becomes necessary. Using a combination of reporting tools, this DWH should also be able to cost effectively support various downstream systems with holistic data provisioning. New methodologies and calculations Introduction of various new ratios and calculations such as LCR, NSFR, and the new definition of capital will require banks to align their existing systems and create new methodologies for calculating and maintaining the new ratios and limitations. High-quality consistent data will help them achieve this. Risk management and forecasting Banks will be required to devise various risk management methodologies to comply with the framework laid down by Basel III. To maintain risk compliance they will be required to monitor, at all times, both internal system performance and prevailing market conditions, and also accurately simulate and forecast the same. Forecasting and predictive analytics require tools like SAS, R etc. to run. 06 Thought Paper

7 To this end, a DWH system that provides consistent and complete data to these tools is indispensable. Asset liability management With the implementation of NSFR, banks Net Interest Margin will reduce considerably. To remain profitable, they will have to create new asset liability management strategies. Data availability within departments will enable better corporate governance and decision-making. Exclusive data marts In addition to DWH, an exclusive data mart for Basel III compliance will help banks monitor their position with respect to the framework at any given point. Banks will be able to change their current strategies to comply with the regulatory guidelines, while also maintaining margins and profitability. Conclusion The implementation of the Basel III framework will impose many challenges on banks. With capital, risk, asset and liability restrictions, along with increased cost and shorter reporting cycles, banks will have their jobs cut out to maintain margins and profitability. A DATA WAREHOUSE (or more specifically an Operational Data Store) as a complete data provision solution can help banks and financial institutions implement this new framework and comply with the guidelines. Being a highquality holistic data provisioning tool, it can retain the banks competitiveness while making them resilient, which is the whole purpose of the Basel framework. Considering all the points outlined in this paper, it stands to reason that an early mover advantage would certainly propel any bank forward and also enable it to customize and mold the DWH to its own needs and business requirements. Its implementation, while inevitable and beneficial, does require considerable investment, both monetary and non-monetary. Needless to say, only its early adoption and integration into the institution s ecosystem would yield rich dividends. Vaibhav Sahu Associate Consultant, Finacle, Infosys Anupriya Sharma Senior Associate Consultant, Finacle, Infosys Thought Paper 07

8 About Finacle Finacle from Infosys partners with banks to transform process, product and customer experience, arming them with accelerated innovation that is key to building tomorrow s bank. For more information, contact Infosys Limited, Bangalore, India, Infosys believes the information in this publication is accurate as of its publication date; such information is subject to change without notice. Infosys acknowledges the proprietary rights of the trademarks and product names of other companies mentioned in this document.

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