Calibrating regulatory minimum capital requirements group members ... Calibrating regulatory minimum capital requirements ... to conduct a “top-down” assessment of the overall level of capital requirements

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<ul><li><p> Basel Committee on Banking Supervision </p><p> Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach </p><p>October 2010 </p></li><li><p> Copies of publications are available from: </p><p>Bank for International Settlements Communications CH-4002 Basel, Switzerland </p><p>E-mail: publications@bis.org </p><p>Fax: +41 61 280 9100 and +41 61 280 8100 </p><p>This publication is available on the BIS website (www.bis.org). </p><p> Bank for International Settlements 2010. All rights reserved. Brief excerpts may be reproduced or translated provided the source is cited. </p><p>ISBN 92-9131-852-3 (print) </p><p>ISBN 92-9197-852-3 (online) </p></li><li><p>Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach </p><p>Contents </p><p>I. Overview and executive summary ..................................................................................1 I.A. Conceptual framework ...........................................................................................1 I.B. Regulatory minimum requirements ........................................................................2 I.C. Capital buffers ........................................................................................................3 I.D. Leverage ratio ........................................................................................................4 I.E. Risk-weighted assets .............................................................................................4 I.F. Caveats ..................................................................................................................4 I.G. Summary of calibration findings .............................................................................5 </p><p>II. Detailed discussion of the findings ..................................................................................6 II.A. Regulatory minimum requirements ........................................................................6 II.B. Buffers....................................................................................................................9 II.C. Leverage ratio ......................................................................................................16 </p><p>Working group members ........................................................................................................19 </p></li><li><p>Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach 1 </p><p>Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach </p><p>I. Overview and executive summary </p><p>As part of its work to strengthen global capital requirements, the Basel Committee on Banking Supervision established a working group to conduct a top-down assessment of the overall level of capital requirements that should be held within the banking system. The working group was tasked with undertaking empirical analysis to inform the calibration of the common equity and Tier 1 risk-based ratios and the Tier 1 leverage ratio, as well as the regulatory buffers above the common equity and Tier 1 risk-based ratios. This analysis represented one of the inputs to the Committees calibration of the new capital framework, and complements the cost-benefit analysis conducted by the Long-Term Economic Impact (LEI) group and the detailed bottom up Quantitative Impact Study (QIS) of the effects of the proposed regulatory reforms on individual banks. </p><p>This note summarises the findings of the top-down calibration work. In particular, it provides a conceptual framework for the calibration work, describes the various empirical exercises that were performed, and summarises the results. </p><p>It is important to highlight that there is not a single correct approach to determine the calibration, nor is there a single model that can be used to provide the right answer. The approach adopted in this paper, therefore, is to generate information from a range of sources and from a variety of perspectives. In the face of uncertainty, the combination of many estimates will produce better outcomes than reliance on a single estimate or approach. Also, as explained in the paper, a number of caveats need to be carefully kept in mind when interpreting the results, primarily relating to the use of historical data generated under a regulatory regime different from that which will prevail in the future. </p><p>I.A. Conceptual framework An appropriate starting point for calibration is to first establish a conceptual framework outlining the role of minimum capital and buffer requirements, along with strategies and methods for putting these concepts into practice. The following high-level concepts are adopted in this paper: the regulatory minimum requirement is the amount of capital needed for a bank to be regarded as a viable going concern by creditors and counterparties, while a buffer can be seen as an amount sufficient for the bank to withstand a significant downturn period and still remain above minimum regulatory levels.1 An overview of the strategies and empirical work undertaken to inform the high-level concepts is provided in the remainder of this section. Further details are contained in the third section of the paper, which also presents the results. </p><p> 1 The definition of the buffer draws directly from the December 2009 Consultative Document, which stated that </p><p>the capital conservation buffer ...should be capable of being drawn down through losses and large enough to enable banks to maintain capital levels above the minimum requirement throughout a significant sector-wide downturn. (Basel Committee on Banking Supervision, Strengthening the Resilience of the Banking Sector, December 2009) </p></li><li><p>2 Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach </p><p>I.B. Regulatory minimum requirements It is not possible to directly observe the minimum amount of capital needed for a bank to be viewed as viable and solvent by investors and creditors, including short-term funding providers. Presumably, market participants make some assessment of the likelihood and size of shocks that they expect a bank to be able to withstand, and transact only with those banks that they believe have a high probability of remaining solvent in the future, consistent with their risk tolerance. Unfortunately, we cannot observe these market assessments directly. Further, the assessments will vary across institutions and over time given differences in business models and as macroeconomic and banking industry environments change. An additional complication is that the level of capital demanded by market participants may be influenced by historical regulatory requirements and the perceived costs of falling below those ratios. This introduces a certain circularity into the relationship between historical ratios, regulatory ratios and assessments of potential losses. </p><p>In the face of these factors, one operational approach is to examine the distribution of historical earnings in the banking industry under the assumption that a high percentile net loss realisation for a typical bank is a good approximation of the markets ex ante, unconditional view of going-concern capital sufficiency. This seems an appropriate benchmark for a risk-based regulatory capital standard that applies across all banks for all points in time. In this regard, it is important to note that risk-weighted assets are intended to capture differences in risk across institutions, so that the task in calibrating a minimum regulatory requirement is to find a minimum amount of capital relative to each firms risk that seems consistent with a bank being viewed as a viable going concern. </p><p>To put this approach into practice, analysis of the Return on Risk-Weighted Assets (RORWA) was undertaken, using data on net income for a large set of banking companies in seven member countries over relatively long time periods.2 Each country looked at the ratio of net income to risk-weighted assets (RWA) for each bank in every period that company was in the sample, and then examined the left-hand (negative net income) tail of the distribution. High percentiles of this distribution might be a reasonable proxy value for the degree of shock that market participants would expect banks to be able to withstand. </p><p>The RORWA analysis focused on the volatility of realised net income as a measure of potential loss and capital needs for a bank. Since negative net income feeds directly to common equity via declines in retained earnings, it has comparable effects on both Tier 1 and the common equity component of Tier 1 (holding other deductions constant). One question, therefore, is whether the analysis of net income is most directly applicable to calibration of the Tier 1 capital or common equity-risk based ratio. </p><p>There are reasonable arguments on both sides. One argument is that losses via negative net income feed directly into common equity, and thus the RORWA analysis is most relevant for calibration of the regulatory minimum level of the common equity risk-based ratio. An alternative view is that other Tier 1 capital components are also loss-absorbing and can protect creditors, and thus the RORWA work is best applied to the Tier 1 ratio. To some extent, the balance of the argument depends on the extent to which the non-common elements of Tier 1 capital are viewed as contributing to a banking companys viability. The experience of the recent crisis suggests that in many cases market participants viewed the </p><p> 2 This approach is derived from Andrew Kuritzkes and Til Schuermann, What We Know, Dont Know and Cant </p><p>Know about Bank Risk: A View from the Trenches. In The Known, the Unknown and the Unknowable in Financial Risk Management, ed. F.X. Diebold, N. Doherty, and R.J. Herring. Princeton University Press. (March 2008). </p></li><li><p>Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach 3 </p><p>non-common components of Tier 1 as less useful as a loss absorber or less relevant as a determinant of viability in periods of acute stress. This implies that a reasonable baseline for the RORWA analysis around potential stressed losses would be the amount of common equity needed for the minimum regulatory requirement, and this is the approach followed in this analysis.3 </p><p>I.C. Capital buffers To help determine the size of a buffer large enough for a bank to withstand a significant downturn period and remain above regulatory minimum capital levels, analysis of actual historical experience and the results of recent stress tests, both singly and in combination, was undertaken. Both realised loss experience during the current and past crises and projections of losses (negative net income or impact on Tier 1 capital or common equity) made during the recent crisis are relevant metrics for assessing the possible impact of severe stress and thus for sizing the capital buffer. </p><p> Current and Historical Crisis Losses this examines cumulative losses (negative net income, as a proxy for the impact on Tier 1 capital and the common equity component of Tier 1 capital) that banking companies sustained during the recent global financial crisis and peak losses during past financial crises in individual jurisdictions or regions. </p><p> Stress tests the projected decreases in capital from stress tests conducted by eight member countries during the recent financial crisis are examined. In addition, results for individual banking companies for one country are also examined, to provide a sense of the dispersion underlying aggregate or average countrywide numbers. An important challenge in interpreting the results of this work is to address the lack of comparability in the stress tests conducted by different countries. </p><p> The RORWA analysis was also used to help calibrate the supervisory buffer, as that analysis provides information about large, negative shocks to income and capital. </p><p>These exercises reveal considerable diversity across banks in the size of current and past crisis-related losses. In thinking about calibration, one important question is how to interpret this diversity of experience. Should the buffer be set relative to the average or typical experience across banks (that is, as the weighted average or median) or should the buffer be set as a higher percentile of the cross-sectional experience (for instance, the 75th percentile outcome, the 95th percentile outcome, or the maximum)? In general, all available information is considered, so that calibration of the buffers could be determined in light of the full range of experience across banks and countries, acknowledging that the analysis does not identify the sources of historical losses that may differentiate between business models and the source and incidence of the next banking crisis cannot be known. </p><p> 3 As an additional benchmark, a range of regulatory and other capital ratios from the period immediately before </p><p>and in the early phases of the financial crisis were examined. The idea was to see if there was a critical value of each ratio such that banks that eventually became severely stressed during the crisis tended to have capital ratios below this level, while less stressed banks tended to have ratios above it. The analysis, which is described in greater detail in the discussion of the leverage ratio, was used as a supplement to the analysis based on historical earnings, primarily as a means of benchmarking the results of the RORWA analysis against recent historical experience. This type of analysis, almost by definition, will imply critical values greater than the regulatory minimum stipulated in the pre-crisis regulation given that the minimum is typically the point of resolution and funding markets are likely too close to an institution before it reaches this point. In addition, the results are highly sensitive to the critical value limit used. This may reduce the reliability of using these critical values as a guide to the optimal level of the minimum capital requirement. </p></li><li><p>4 Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach </p><p>I.D. Leverage ratio The calibration of a backstop Tier 1 leverage ratio is not addressed in the same way as the risk-based ratios. The longer testing and transition period associated with the leverage ratio as compared to the new risk-based ratio standards is intended to provide a period to examine the performance and calibration of the leverage ratio in parallel run mode. That said, information was collected on historical trends in leverage in the banking systems of ten member countries. This data includes information on trends in traditional leverage capital relative to balance sheet assets as well as information on trends in different elements of Tier 1 capital, in risk-weighted to total assets and in the impact of off-balance sheet positions on overall le...</p></li></ul>

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