View Point. What are the implications for your business? Abstract

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1 View Point Basel III Is Here Introduced to strengthen the banking system, Basel III regulations require greater cooperation and transparency from financial institutions What are the implications for your business? Amit Patni, CFA, FRM Abstract This article focuses on the key requirements of the Basel III proposals. It highlights key issues uncovered during the financial crisis, delineates measures introduced to prevent the repeat of the issues, and outlines the impact on the financial industry and larger economy on the whole. The paper then takes a deep-dive into the impact of the new regulations on data and technology systems and the challenges firms face in re-engineering their data and IT systems. Finally, it offers a solution to these challenges. Infosys View Point 1

2 Basel III Is Here An extensive effort is underway to strengthen the financial sector and make banks and other institutions more resilient in the face of unexpected stress. The hope is that any future crisis will not lead to governments again being forced to spend billions of dollars of taxpayer s money to save the banking system. Regulatory requirements included in the Basel III proposals have been introduced to help facilitate this overhaul. Nonetheless, much is still being debated in the industry. Regulators are moving across unknown ground as the industry comes to grips with the difficulties of assessing the potential outcomes of the new regulations. Basel III Impact Overview Basel III is a paradigm shift that is rapidly changing risk management practices, the regulatory landscape, and capital adequacy principles for the financial industry. Broadly speaking, Basel III will have a significant impact on three key areas: Business Practices Capital Management Liquidity Management Financial Disclosure Leverage Ratios New Data Requirements Data Integration Data Accessibility Data Analysis Technology & Systems Advanced Analytics Reconciliation Systems Risk Management Communications 2 Infosys View Point

3 Basel III Goals The new regulations aim to strengthen the global financial system by implementing initiatives designed to: Strengthen bank-level, or micro-prudential regulations, which will help raise the resilience of individual banking institutions during periods of stress. Strengthen system-wide, or macro-prudential regulations, addressing risks that can build up across the banking sector and broader economies because of the cyclical nature and interconnectedness of the global financial industry. Strengthen global quality and quantity capital rules with the goal of promoting a more resilient banking sector. Strengthen short- and long-term liquidity coverage and balance sheet funding for the global banking system. Constrain excess leverage in the banking system by introducing a leverage ratio requirement as a backstop measure to risk-based capital rules. Reduce interconnectedness and cyclical gyrations to prevent the risk of spillover from the financial sector to the wider economy while addressing the lessons learned from the financial crisis. This includes introducing counter-cyclical capital, contingent convertible capital, and systemically important financial institutions akin to toobig-to-fail provisions. Improve risk coverage and expand disclosure requirements for the banking system. This includes introducing better counterparty credit risk measures with stressed conditions, better risk weights for central counterparty use, and enhanced counterparty valuation adjustment requirements. Implications for Management of Data, Technology and Operations Financial industry players will likely incur higher regulatory compliance costs as they try to decipher and implement a multitude of Basel III rules issued by regulatory bodies. Basel III impacts all areas of the firm and requires a holistic-approach to data, technology and operations management. Some of the major focus areas of Basel III include: Consistent data sourcing and reconciliation: Systems need to be based on common reference data to drive market, credit, and liquidity risk including risk-weighed-assets and regulatory and economic capital. Liquidity management: Systems need to monitor intra-day liquidity and require granular data to capture and forecast short-term liquidity coverage ratios and long-term net stable funding ratios. Consistent stress testing: Create a system with common risk factors across market, credit, and liquidity risk to cover the various supervisory stress-testing scenarios including margin requirements, cash-flow generation and back-testing needs. Enhanced collateral systems: Basel III proposes forward looking (ex-ante) provisions to answer issues related to counterparty valuation adjustment (CVA) and wrong-way risks. Systems need to develop capabilities to capture pro-forma data into models and develop methodologies to incorporate risk weights and mitigate the effect of central clearinghouse counterparties such as national stock exchanges. Consistent risk-weighted-asset and capital calculation: IT systems should share common models and provide consistent measures across risk types including cash flow, asset-liability management, liquidity management, and counterparty credit risk management. Integrated reporting: IT systems should provide a consistent view across the enterprise to show the impact of different types of risks and associated functional-, portfolio-, and enterprise-level reporting. System flexibility, automation and scalability: Systems should be able to handle large volumes of data and automate enterprisewide runs while allowing for interactive what-if analysis at the portfolio level. As firms assess the impact of new regulations and change their business strategy, it is imperative that systems be flexible. Operational improvements: Although much focus is on Pillar 1 Capital, liquidity and leverage management, Basel III presents a unique opportunity to streamline business and operational processes including training of key staff and senior management. Infosys View Point 3

4 Already Basel II Compliant? Take Note of these Basel III Updates In many cases, Basel II compliant firms can use their existing infrastructure and processes to comply with Basel III proposals with minimal additional expenses. There are exceptions, however, and Basel III requires additional compliance measures in the following notable areas: Regulation Subject Development of liquidity ratios Development of leverage ratios Forecast of counterparty credit risk Use of central clearinghouse counterparties (CCC) Use of external ratings Compliance Measures Develop methodology to capture key business, data, and technical requirements to create, validate, and back-test short-term liquidity coverage and long-term net stable funding ratios. Formulate leverage ratios which are risk-invariant and act as a backstop measure. Create capabilities to capture forward-looking pro-forma data into models. Basel III proposes forward looking (ex-ante) provisions to help clarify issues related to CCR, CVA, and wrong-way risks. Build methodologies to incorporate risk weights and the mitigating effects of CCC. Firms need to revisit their standardized and A-IRB approaches to measure credit and market risk that rely on external ratings and improve their internal rating methodologies and RWA and capital calculations. Infosys Recommendations for the Current Regulatory Outlook Infosys has a series of recommendations for companies looking to comply with these regulatory changes, and more importantly, improve their businesses. These recommendations are intended to improve key focus areas like data reconciliation, liquidity and leverage management, risk coverage, risk modeling, and operational and process improvements. Data Reconciliation Consistent data sourcing and reconciliation are critical. Systems need to be based on common reference data to drive market, credit, operational and liquidity risk for both regulatory and economic capital. Systems should have the ability to reconcile data across different risk categories. Position and counterparty, obligor and facility data should be driven from a single source that is the truth version for the firm. A single data load with all the attributes required for market, counterparty credit risk (CCR), risk-weighted assets (RWA), economic capital and liquidity risk should be extracted from source systems and reconciled in the central data-warehouse systems. Diagram A outlines a sample Basel II and III end-to-end system architecture. 4 Infosys View Point

5 Liquidity and Leverage Management Firms need to develop methodology to capture key business, data and technical requirements to develop, validate and back-test the new liquidity ratios. Systems need to monitor 30-day liquidity and require granular data to capture and forecast short-term liquidity coverage ratios (LCR) and long-term net stable funding ratios (NSFR). Cash flow generation for liquidity risk should also leverage the cash flow generation routines that should be common to the risk and finance system including the impact to asset liability management systems. Systems need to understand the implications of leverage ratio requirements on capital and the asset relationship loop and be able to adjust the capital and asset base to satisfy leverage requirements as set by firm strategy. Systems should be able to load key risk systems with common risk factors to enable consistent stress testing across markets, credit and liquidity risks and look at the impact on its capital, asset and leverage. Risk Coverage Counterparty Credit Risk, Stress Testing and Collateral Management Systems Basel III proposes forward looking (ex-ante) provisions to answer issues related to CCR, CVA and wrong-way risks in stressed conditions. Firms need to develop capabilities to capture forward looking pro-forma data into the models. Firms need to develop methodologies to incorporate risk weights and the mitigating effect of central clearinghouse counterparties. Firms need to develop the specification of the new requirements for trading book positions and within the counterparty credit risk framework (e.g. credit valuation adjustments). The system must be driven with common risk factors across market, credit and liquidity risk to cover the various supervisory stress-testing scenarios including margin requirements, cash flow and back testing needs. Risk Modeling, Capital Calculations and Reporting For modeling, systems should share common models and provide consistent measures across risk types including cash flow, asset-liability management, liquidity management, and counterparty credit risk management. For capital calculations, using consistent data and models allow the business line user to break down the differences between regulatory and economic capital into sources of risk, such as name concentration, sector concentration and migration risk. An economic capital model allows the user to configure economic capital calculations under multiple assumptions. IT systems should provide a clear view of the impact of different types of risks and associated functional-level, portfolio-level and enterprise-level reporting. Solutions should produce reports required internally (Pillar 2) and externally (Pillar 3, disclosure reports and regulatory reports). Operational and Process Improvements Although much focus is on Pillar 1 capital and liquidity/ leverage management, Basel III presents a unique opportunity to streamline firms business processes and improve their operational efficiency and effectiveness. Program governance is a key to a successful implementation. Firms should take a coordinated approach among the different functional, technical and operating units and departments such as risk, finance, IT and the affected LOBs. Firms should automate enterprise-wide runs for modeling and reporting purposed while allowing for interactive what-if analysis at the portfolio level. As firms assess the impact of new regulations and change their business strategy, the need for systems to be flexible is an imperative so the firm can quickly adapt with new regulatory paradigm. Systems need to capture new regulatory requirements (e.g. stress testing, limit system and risk quantification). Infosys View Point 5

6 Infosys Has the Experience to Help Clients Prepare For and Capitalize On Basel III Opportunities Infosys has the experience and domain expertise to navigate through the changes and help clients achieve goals beyond just regulatory compliance. Infosys brings a unique combination of qualifications and experiences to regulatory compliance and Basel II and Basel III initiatives. Our team has direct experience with large financial institutions operating environments, data and technology systems, and risk and capital. We also have deep experience implementing the Basel framework and have regulatory experts who understand the implications of regulatory rules on firms. Infosys provides end-to-end solutions that help firms achieve their Basel III goals through project management, business requirements, functional and technical architecture, model development and validation, and capital calculation and reporting. Infosys has undertaken major projects for financial services firms, helping them in areas including: As-is / to-be assessment and regulatory impact analysis Model development and validation Basel II initiatives in areas of credit, market and operational risk ICAAP and liquidity planning Program management people, process, technology and control frameworks Stress-testing and back-testing Project management office (PMO) Data, systems, technology architecture and management 6 Infosys View Point

7 About the Author Amit Patni, CFA, FRM Amit Patni is a Principal in the Risk and Compliance practice at Infosys with 12 years of experience in implementing large scale projects in risk management/basel initiatives for various banking and capital markets participants. Infosys View Point 7

8 For more information, contact About Infosys Many of the world's most successful organizations rely on Infosys to deliver measurable business value. Infosys provides business consulting, technology, engineering and outsourcing services to help clients in over 30 countries build tomorrow's enterprise. For more information about Infosys (NASDAQ:INFY), visit 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. 8 Infosys View Point