What is new in Basel 3:

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1 Camera dei Deputati 17 Indagine conoscitiva 4 ALLEGATO What is new in Basel 3: How it will influence market participants Krishnan Ramadurai Managing Director

2 Camera dei Deputati 18 Indagine conoscitiva 4 Agenda 1. Why Basel 3 2. What is new in Basel 3 3. How will it impact banks and their response 4. What is Fitch doing

3 Camera dei Deputati 19 Indagine conoscitiva 4 Agenda 1. Why Basel 3 2. What is new in Basel 3 3. How will it impact banks and their response 4. What is Fitch doing

4 Why Basel 3? We identify three root causes of failures Network externalities Spill over effects transmitted from the banking system to the economy Propensity to underestimate risk Risk models were precisely wrong rather than being roughly right Misaligned incentives Pay, bonus and moral hazard 4 Camera dei Deputati 20 Indagine conoscitiva 4

5 Camera dei Deputati 21 Indagine conoscitiva 4 Agenda 1. Why Basel 3 2. What is new in Basel 3 3. How will it impact banks and their response 4. What is Fitch doing

6 Camera dei Deputati 22 Indagine conoscitiva 4 What is new in Basel 3: Macro Prudential Framework 6

7 Why Macro Prudential Regulation Spill over effects from the failure of multiple financial institutions to other sectors imposes a monetary cost which is unacceptable to society Failure requires banks to repair their balance sheets. Two options raise capital or shrink balance sheets. Raising capital is difficult when a bank has problems Balance sheet shrinkage is often the chosen option. Shrinkage by multiple banks results in significant costs Two primary costs: credit crunch makes new credit more expensive and fire sale of assets results in asset prices falling sharply Exacerbated by the fact that equity is expensive and short-term debt is cheaper 7 Camera dei Deputati 23 Indagine conoscitiva 4

8 How is it being addressed: Policy Tools Source: IMF Effective resolution regimes Resolution plans CoCos / Bail in Strengthened market infrastructure Levies, fees or taxes Capital / Liquidity Surcharges Intensive supervision CoCos/ Bail-in Disclosure Recovery plans Compensation Measures to reduce cost of failure Measures to reduce likelihood of failure Identifying systemically important institutions Measures to directly reduce systemic importance Size Interconnectedness Complexity Lack of substitutability Global activity Limitation on size and organizational structure Restrictions on scope of activities Central clearing-houses 8 Camera dei Deputati 24 Indagine conoscitiva 4

9 What is new in Basel 3: Micro Prudential Risks 2/3 of Losses due to Mark to Market losses of trading book exposures, only 1/3 due to actual defaults Increased risk coverage: A focus on problem areas of trading book exposures, counterparty credit risk and treatment of securitisation exposures Build up of excessive On and Off balance sheet leverage Introduction of a leverage ratio: As a backstop to the risk-based framework. Important as complete markets in credit under mine the current risk weighting system. Gradual erosion of the level and quality capital. The nearest to having your cake and eating it Capital: Increased quantity, improved quality, more consistent and transparent Market Risk Capital Basel 3 Leverage Liquidity 9 Camera dei Deputati 25 Indagine conoscitiva 4

10 What is new in Basel 3: Micro Prudential Risks (cont.) Liquidity here today gone tomorrow. Insufficient liquidity barriers Introduction of global liquidity standards: To address short-term and long-term liquidity mismatches The Forgotten Pillars, probably the most important one Enhancements to Pillar II and III: Stress testing, regulatory intervention, increased transparency and disclosures 10 Camera dei Deputati 26 Indagine conoscitiva 4

11 Camera dei Deputati 27 Indagine conoscitiva 4 Agenda 1. Why Basel 3 2. What is new in Basel 3 3. How will it impact banks and their response 4. What is Fitch doing

12 How will it impact banks Retail Banking Higher capital & Liquidity requirements will raise cost of products This is an across the board impact for all banks However, banks which can pass on some of these costs, attract deposits, or access cheaper funding will be winners Business models will change Corporate Banking Similar to retail banking higher capital & liquidity requirements will raise the cost of these products Long-term loans, unsecured loans will be costly. Conversely secured and short term loans will be more profitable Cost increases may not be easy to pass on as corporates are more interest rate sensitive Uncommitted lines will be costly Trade finance will be impacted by leverage ratios, liquidity and higher capital ratios for interbank lending 12 Camera dei Deputati 28 Indagine conoscitiva 4

13 How will it impact banks Investment Banking Changes to the market risk framework, new liquidity rules and the retention rules for securitisation will result in higher costs Central clearing for derivatives business will bring down profits Ability to pass on these costs is limited Business models will need to change 13 Camera dei Deputati 29 Indagine conoscitiva 4

14 How will it Impact Trade Finance Example A Borrower PD & LGD Basel I (100% RW) Standardized (if rated) IRB (with CCF of 100%) IRB (with CCF of 20% & 50%) CCF- Credit Conversion Factor Higher Quality Borrower 0.50% PD and 45% LGD 8% 8% 12.8% 5.6% % Change vs 1988 Accord n.a. 0% 60% -30% Lower Quality Borrower - 7% PD and 45% LGD 8% 8% 31.1% 13.5% % Change vs 1988 Accord n.a. 0% 288% 69% 14 Camera dei Deputati 30 Indagine conoscitiva 4

15 How will it Impact Trade Finance Example B PD And LGD Of Borrower Standardised (if rated) IRB Foundation Approach (with maturity of 2.5 year) IRB Foundation Approach (with maturity of 0.5 years) Higher Quality Borrower 0.50% PD and 35% LGD 4.7% 3.9% 2.6% % Change vs STD Approach -17% -44% Lower Quality Borrower - 7% PD and 35% LGD 4.7% 9.4% 8.1% % Change vs STD Approach 100% 72% 15 Camera dei Deputati 31 Indagine conoscitiva 4

16 How will banks respond Balance Sheet Restructuring Capital quality & deductions. Liability management Ongoing balance sheet management. Deleverage and reduce RWAs Reduce dependence on short-term funding. Raise deposits Business Model Changes Redesign products Customer mix Focus on capital light products Risk Transfer Fee based products Legal Structure On-Going Changes Improved Risk Models Centralised liquidity management Centralised clearing Enhanced funding plans 16 Camera dei Deputati 32 Indagine conoscitiva 4

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