Basel III/IV Framework

Capital requirements, liquidity ratios, leverage — comprehensive Basel regulatory framework for banking supervision.

When to Activate

• Capital adequacy calculations (CET1, Tier 1, Total Capital)
• Risk-weighted asset computation (credit, market, operational risk)
• Liquidity ratio analysis (LCR, NSFR)
• Leverage ratio assessment
• Capital buffer requirements
• FRTB (Fundamental Review of the Trading Book) implementation
• Basel IV output floor impact analysis
• Regulatory capital planning and stress testing

Core Concepts

Capital Structure

Common Equity Tier 1 (CET1) — highest quality:

• Common shares, retained earnings, accumulated OCI (with adjustments)
• Deductions: goodwill, intangible assets, deferred tax assets (threshold), investments in financial institutions
• Minimum requirement: 4.5% of RWA

Additional Tier 1 (AT1):

• Perpetual instruments with loss-absorption features (CoCos — contingent convertibles)
• Write-down or conversion trigger at CET1 ratio of 5.125% (or higher)
• AT1 + CET1 minimum: 6.0% of RWA

Tier 2 Capital:

• Subordinated debt (minimum 5-year original maturity, amortized in last 5 years)
• Eligible provisions (up to limit)
• Total Capital minimum: 8.0% of RWA

Capital Requirements Summary

                            Minimum    + Conservation    + Countercyclical    + G-SIB
CET1                         4.5%         7.0%             7.0-9.5%          8.0-10.5%
Tier 1                       6.0%         8.5%             8.5-11.0%         9.5-12.0%
Total Capital                8.0%        10.5%            10.5-13.0%        11.5-14.0%

Capital Buffers

Risk-Weighted Assets (RWA)

Credit Risk — Standardized Approach:

• Sovereign: 0% (AAA-AA), 20% (A), 50% (BBB), 100% (BB-B), 150% (below B), 100% (unrated)
• Banks: Based on External Credit Assessment or SCRA (Standardized Credit Risk Assessment)
• Corporate: 20-150% based on rating; SME support factor available
• Retail: 75% (regulatory retail), Residential mortgage: 20-70% (based on LTV)
• Commercial real estate: 60-150% (based on LTV and income-producing)

Credit Risk — IRB Approaches:

• Foundation IRB (F-IRB): Bank estimates PD; LGD, EAD, M prescribed by supervisor
• Advanced IRB (A-IRB): Bank estimates PD, LGD, EAD, M
• Key parameters: PD (Probability of Default), LGD (Loss Given Default), EAD (Exposure at Default), M (Maturity)
• RWA = K x 12.5 x EAD, where K is the capital requirement from the IRB formula

Market Risk — FRTB:

• Standardized Approach (SA): Sensitivities-based method (delta, vega, curvature) + Default Risk Charge + Residual Risk Add-on
• Internal Models Approach (IMA): Expected Shortfall (replaces VaR), with liquidity horizons, P&L attribution test, backtesting
• Boundary between banking book and trading book: stricter rules, reduced arbitrage

Operational Risk — Basel IV:

• New Standardized Approach replaces all previous approaches (BIA, TSA, AMA)
• Business Indicator Component (BIC) = Business Indicator x marginal coefficient (alpha)
• Internal Loss Multiplier (ILM) based on historical losses (optional, jurisdictional discretion)

Liquidity Ratios

Liquidity Coverage Ratio (LCR):

LCR = High Quality Liquid Assets (HQLA) / Total net cash outflows over 30 days >= 100%

• HQLA Level 1: Cash, central bank reserves, sovereign bonds (0% risk weight) — no haircut
• HQLA Level 2A: 20% RW sovereign/PSE bonds, covered bonds (AA-) — 15% haircut, max 40% of HQLA
• HQLA Level 2B: Corporate bonds (A+ to BBB-), RMBS (AA), equities — 25-50% haircut, max 15% of HQLA
• Cash outflows: Retail deposits (3-10%), unsecured wholesale (5-100%), secured funding, derivative obligations
• Cash inflows: Contractual inflows capped at 75% of outflows

Net Stable Funding Ratio (NSFR):

NSFR = Available Stable Funding (ASF) / Required Stable Funding (RSF) >= 100%

• ASF: Weighted liabilities and equity (weight 0-100% based on stability)
• RSF: Weighted assets and off-balance sheet exposures (weight 0-100% based on liquidity)
• Ensures stable funding for assets over 1-year horizon

Leverage Ratio

Leverage Ratio = Tier 1 Capital / Total Exposure Measure >= 3%

• Exposure measure: On-balance sheet items + derivative exposures (SA-CCR) + SFT exposures + off-balance sheet items
• Non-risk-based backstop to risk-weighted capital requirements
• G-SIB leverage ratio buffer: 50% of G-SIB surcharge

Basel IV — Output Floor

• IRB banks: RWA cannot be less than 72.5% of standardized approach RWA
• Phase-in: 50% (2023) rising to 72.5% (2028) — timelines vary by jurisdiction
• Significant impact for banks with low-risk portfolios (e.g., residential mortgages)

Methodology

Capital Adequacy Assessment

1. Classify capital instruments: CET1, AT1, Tier 2 — apply deductions and adjustments
2. Calculate credit risk RWA: Standardized or IRB approach for each exposure class
3. Calculate market risk RWA: SA or IMA under FRTB rules
4. Calculate operational risk RWA: New Standardized Approach (BIC x coefficient)
5. Apply output floor: Max(IRB RWA, 72.5% x SA RWA)
6. Compute capital ratios: CET1%, Tier 1%, Total Capital%
7. Assess buffer requirements: Conservation + countercyclical + systemic
8. Identify shortfall or surplus: Actual ratios vs. requirements including buffers

LCR Calculation Steps

1. Inventory HQLA: Classify Level 1, 2A, 2B; apply haircuts and caps
2. Calculate cash outflows: Apply run-off factors to each liability/commitment category
3. Calculate cash inflows: Apply inflow rates to maturing assets (cap at 75% of outflows)
4. Net cash outflows: Outflows - min(inflows, 75% x outflows)
5. LCR: HQLA / net cash outflows

Stress Testing Integration

• Capital ratios under adverse scenarios (GDP decline, interest rate shock, credit losses)
• Supervisory stress tests (EBA, Fed CCAR/DFAST)
• Internal stress tests informing capital planning
• Reverse stress testing: What scenarios would breach minimum requirements?

Templates

Capital Ratio Computation

                                            Amount (EUR m)
CET1 Capital
  Common shares                               __________
  Retained earnings                           __________
  AOCI adjustments                            __________
  (-) Goodwill and intangibles                __________
  (-) Other regulatory deductions             __________
  = CET1 Capital                              __________

AT1 Capital                                   __________
Tier 1 Capital (CET1 + AT1)                   __________
Tier 2 Capital                                __________
Total Capital                                 __________

RWA — Credit Risk                             __________
RWA — Market Risk                             __________
RWA — Operational Risk                        __________
RWA — Output Floor Adjustment                 __________
Total RWA                                     __________

CET1 Ratio:       ____%    (min 4.5% + buffers)
Tier 1 Ratio:     ____%    (min 6.0% + buffers)
Total Cap Ratio:  ____%    (min 8.0% + buffers)

LCR Summary

                                    Amount    Weight    Weighted
HQLA Level 1                        _____    100%      _____
HQLA Level 2A                       _____     85%      _____
HQLA Level 2B                       _____    50-75%    _____
Total HQLA                                             _____

Cash Outflows
  Retail deposits (stable)           _____     3-5%     _____
  Retail deposits (less stable)      _____     10%      _____
  Unsecured wholesale                _____    5-100%    _____
  Secured funding                    _____    varies    _____
Total Outflows                                          _____

Cash Inflows (capped at 75%)                            _____
Net Cash Outflows                                       _____

LCR = HQLA / Net Outflows =                            ____%

Quality Gate

• Capital instruments correctly classified (CET1/AT1/T2) with all deductions applied
• Credit risk RWA uses correct approach (SA or IRB) per exposure class
• Market risk captured under FRTB framework (SA or IMA)
• Operational risk uses new standardized approach with correct BIC calculation
• Output floor applied (72.5% of SA RWA, or phase-in percentage)
• All applicable buffers identified (conservation, countercyclical, systemic)
• LCR HQLA composition respects caps (Level 2A: 40%, Level 2B: 15%)
• NSFR available and required stable funding weighted correctly
• Leverage ratio includes all exposure categories (derivatives via SA-CCR)
• Capital planning incorporates stress test results