Learning objectives: Describe the motivations for and calculate the capital conservation buffer and the countercyclical buffer, including special rules for globally systemically important banks (G-SIBs). Describe and calculate ratios intended to improve the management of liquidity risk, including the required leverage ratio, the liquidity coverage ratio and the net stable funding ratio. Describe the mechanics of contingent convertible bonds (CoCos) and explain the motivations for banks to issue them. Explain motivations for “gold plating” of regulations and provide examples of legislative and regulatory reforms that were introduced after the 2007-2009 financial crisis.
Questions:
20.10.1. The central feature of Basel III's first pillar is the regulatory capital (i.e., CET1, Tier 1, and total capital) requirements which require minimum fractions of risk-weighted assets (RWA). In addition to these minimums, as of early 2019 (when the buffers were fully phased in), Basel specifies three buffers: the capital conservation buffer (CCB), the G-SIB buffer, and the countercyclical buffer (CCyB). This is all very confusing so you ask your colleague Mary to summarize these additional buffers and their motivations. She makes the following five points:
I. For all three, the additional buffer must be CET1
II. For all three, breach of the buffer requirements implies the bank's ability to pay dividends will be restricted
III. The CCB requires an additional 2.5% of CET1 capital and is meant to ensure that banks have an additional layer of usable capital that can be drawn down when losses are incurred.
IV. The additional G-SIB requirement includes five buckets {1.0%, 1.5%, 2.0%, 2.5%, or 3.5%} https://www.bis.org/fsi/fsisummaries/g-sib_framework.htm and is meant to reduce the likelihood and severity of the failure of a global systemically important financial institution
V. The CCyB requirement varies between zero and 2.5% and is meant to protect the banking sector from periods of excess aggregate credit growth that have often been associated with the build-up of system-wide risks
Is Mary correct in her summary?
a. No, unfortunately, none of her statements is correct
b. I. and II. are correct, but the others (III., IV., and V.) are wrong
c. III., IV., and V. are correct, but the others (I. and II.) are wrong
d. Yes, all five statements are correct
20.10.2. Below is a summary balance sheet of Acme Bank, but in addition to the typical accounts (assets, liabilities, and equities), there are four additional columns to assist in ascertaining whether the bank satisfies Basel III's liquidity risk requirements:
For purposes of estimating the bank's liquidity coverage rate (LCR), the following columns are included: HQLA factors, HQLA, Runoff rate, and Net cash outflows. For purposes of estimating the net stable funding ratio (NSFR), the following columns are included: RSF factor, required stable funding, ASF factor, and available stable funding. Does Acme Bank meet the LCR and NSFR requirements?
a. Neither LCR nor NSFR is met
b. LCR is met, but NSFR fails to meet the minimum
c. NSFR is met, but LCR fails to meet the minimum
d. Both LCR and NSFR are met
20.10.3. The Basel regulations (via their various implementations by national authorities) was hardly the only high-level effort by regulators (not to mention legislators) in response to the global financial crisis (GFC) of 2007-08. For example, as Mark Carey explains "Banks will fail in the future in spite of Basel I, II, III and later reforms. To limit the disruptions caused by such failures, the FSB [Financial Stability Board, https://www.fsb.org/] agreed in 2014 that national resolution regimes for G-SIBs would have 12 key attributes and that each G-SIB should have sufficient total loss absorbing capacity (TLAC) to enable it to recapitalize itself. Recapitalization might be accomplished by causing convertible bonds to become equity or by bail-in, in which certain whole-sale debt liabilities are either written down or converted to equity." (Source: 2020 FRM Part II: Operational Risk and Resiliency, 10th Edition. Pearson Learning Solutions, 10/2019)
In regard to this and other reforms, which of the following statements is TRUE?
a. Coco bonds contain an embedded put option that gives the buyer the right, but not the obligation, to purchase equity at a predetermined conversion (aka, exercise or strike) price
b. Coco bonds are attractive to banks because they do not decrease return on equity (ROE) prior to conversion, and they are also attractive to regulators because they absorb losses, when triggered, if distress occurs
c. Gold plating is when a national regulator (aka, supervisor) applies a less onerous (i.e., lower) regulatory capital ratio to their domestic banks, thus giving them a "gold plated" competitive advantage against international banks
d. The total loss-absorbing capacity (TLAC) minimums developed by Financial Stability Board (FSB) will be gradually phased-out and replaced by the leverage and liquidity ratios in Basel IV as they are phased-in
Answers here:
Questions:
20.10.1. The central feature of Basel III's first pillar is the regulatory capital (i.e., CET1, Tier 1, and total capital) requirements which require minimum fractions of risk-weighted assets (RWA). In addition to these minimums, as of early 2019 (when the buffers were fully phased in), Basel specifies three buffers: the capital conservation buffer (CCB), the G-SIB buffer, and the countercyclical buffer (CCyB). This is all very confusing so you ask your colleague Mary to summarize these additional buffers and their motivations. She makes the following five points:
I. For all three, the additional buffer must be CET1
II. For all three, breach of the buffer requirements implies the bank's ability to pay dividends will be restricted
III. The CCB requires an additional 2.5% of CET1 capital and is meant to ensure that banks have an additional layer of usable capital that can be drawn down when losses are incurred.
IV. The additional G-SIB requirement includes five buckets {1.0%, 1.5%, 2.0%, 2.5%, or 3.5%} https://www.bis.org/fsi/fsisummaries/g-sib_framework.htm and is meant to reduce the likelihood and severity of the failure of a global systemically important financial institution
V. The CCyB requirement varies between zero and 2.5% and is meant to protect the banking sector from periods of excess aggregate credit growth that have often been associated with the build-up of system-wide risks
Is Mary correct in her summary?
a. No, unfortunately, none of her statements is correct
b. I. and II. are correct, but the others (III., IV., and V.) are wrong
c. III., IV., and V. are correct, but the others (I. and II.) are wrong
d. Yes, all five statements are correct
20.10.2. Below is a summary balance sheet of Acme Bank, but in addition to the typical accounts (assets, liabilities, and equities), there are four additional columns to assist in ascertaining whether the bank satisfies Basel III's liquidity risk requirements:
For purposes of estimating the bank's liquidity coverage rate (LCR), the following columns are included: HQLA factors, HQLA, Runoff rate, and Net cash outflows. For purposes of estimating the net stable funding ratio (NSFR), the following columns are included: RSF factor, required stable funding, ASF factor, and available stable funding. Does Acme Bank meet the LCR and NSFR requirements?
a. Neither LCR nor NSFR is met
b. LCR is met, but NSFR fails to meet the minimum
c. NSFR is met, but LCR fails to meet the minimum
d. Both LCR and NSFR are met
20.10.3. The Basel regulations (via their various implementations by national authorities) was hardly the only high-level effort by regulators (not to mention legislators) in response to the global financial crisis (GFC) of 2007-08. For example, as Mark Carey explains "Banks will fail in the future in spite of Basel I, II, III and later reforms. To limit the disruptions caused by such failures, the FSB [Financial Stability Board, https://www.fsb.org/] agreed in 2014 that national resolution regimes for G-SIBs would have 12 key attributes and that each G-SIB should have sufficient total loss absorbing capacity (TLAC) to enable it to recapitalize itself. Recapitalization might be accomplished by causing convertible bonds to become equity or by bail-in, in which certain whole-sale debt liabilities are either written down or converted to equity." (Source: 2020 FRM Part II: Operational Risk and Resiliency, 10th Edition. Pearson Learning Solutions, 10/2019)
In regard to this and other reforms, which of the following statements is TRUE?
a. Coco bonds contain an embedded put option that gives the buyer the right, but not the obligation, to purchase equity at a predetermined conversion (aka, exercise or strike) price
b. Coco bonds are attractive to banks because they do not decrease return on equity (ROE) prior to conversion, and they are also attractive to regulators because they absorb losses, when triggered, if distress occurs
c. Gold plating is when a national regulator (aka, supervisor) applies a less onerous (i.e., lower) regulatory capital ratio to their domestic banks, thus giving them a "gold plated" competitive advantage against international banks
d. The total loss-absorbing capacity (TLAC) minimums developed by Financial Stability Board (FSB) will be gradually phased-out and replaced by the leverage and liquidity ratios in Basel IV as they are phased-in
Answers here:
