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Account for why the Basel III framework needed revising, and for what the December 2017 reforms aimed to do and the effects they had.

FRM® Part II · Operational Risk and Resilience · High-level summary of Basel III reforms · FRM2.ORR.23.a

The idea

The 2010 Basel III package raised the quality and quantity of capital and added buffers, a leverage ratio and liquidity standards. It left most of the rules for measuring risk-weighted assets (RWA) as they were. The crisis and later Committee studies showed that RWA computed with internal models varied too much across banks for similar portfolios, so risk-based capital ratios were hard to compare and to trust. The December 2017 reforms completed the post-crisis work. They aimed to cut excessive RWA variability, restore credibility to RWA and improve comparability of capital ratios. They did so by making standardised approaches more risk sensitive, constraining internal models, adding a revised output floor and refining the leverage ratio. The effect falls mostly on the denominator. Capital stays the same, RWA rises for many banks, and their ratios fall. For the exam, remember that the reform targets the RWA framework, not the definition of capital.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which description of the December 2017 package, often called the finalisation of Basel III, is most accurate?

  1. A return to Basel I flat risk weights for all asset classes, replacing every risk-sensitive approach with a single weight per exposure class.Why not: Confuses the output floor and tighter standardised approaches with a return to Basel I; the 2017 standardised weights are more granular, not flatter.
  2. A new set of liquidity standards that adds the liquidity coverage ratio and net stable funding ratio to the existing capital framework.Why not: Names the earlier Basel III liquidity reforms; the 2017 package concerns the RWA framework.
  3. A revision of the definition of capital that raises the minimum common equity Tier 1 ratio above 4.5 percent of RWA.Why not: Mixes up the 2017 changes with the 2010 capital definition and minimum; the 2017 package leaves the capital definition largely unchanged.
  4. A completion of the post-crisis reforms that revises how RWA is measured, with an output floor and a refined leverage ratio. - correct

The 2017 reforms complete Basel III by revising the credit, CVA and operational risk frameworks and the leverage ratio, constraining internal models and adding a revised output floor. They do not redefine capital or add liquidity rules.

A harder one

Committee exercises in which many banks computed RWA for the same hypothetical portfolios found large differences in results. Which pair of measures in the 2017 package most directly targets this source of variability?

  1. Input floors on PD, LGD and EAD together with removal of the advanced IRB approach for certain exposure classes. - correct
  2. A higher countercyclical capital buffer together with a larger G-SIB surcharge.Why not: Buffers raise required capital but do not change how RWA is measured, so they leave modelling variability untouched.
  3. Extending the advanced measurement approach to all banks and lowering the operational risk multiplier.Why not: The advanced measurement approach is abolished in the 2017 package, not extended.
  4. A higher minimum leverage ratio and enhanced disclosure of the leverage ratio exposure measure.Why not: The leverage ratio is a non-risk-based backstop; it does not reduce variability in modelled RWA.

Variability comes from internal modelling choices. The reforms constrain those choices through input floors, removal of advanced IRB for large corporates, banks and other financial institutions and for equities, and the aggregate output floor.

The hardest tier

A bank has CET1 capital of EUR 54 billion and RWA of EUR 450 billion, a CET1 ratio of 12.0 percent. Under the 2017 reforms its RWA rises by 18 percent while capital is unchanged. The new CET1 ratio is closest to:

  1. 9.8 percentWhy not: Subtracts 18 percent proportionally from the ratio: 12.0 x (1 - 0.18). The ratio falls by dividing by 1.18, not multiplying by 0.82.
  2. 11.5 percentWhy not: Adds EUR 18 billion instead of 18 percent to RWA: 54 / 468.
  3. 12.0 percentWhy not: Assumes capital is unchanged so the ratio is unchanged, ignoring that the denominator has risen.
  4. 10.2 percent - correct

New RWA = 450 x 1.18 = 531. Ratio = 54 / 531 = 10.17 percent, about 10.2 percent. The ratio falls by a factor of 1/1.18, which is about 1.8 percentage points. Reforms to RWA change the ratio even when capital does not move.

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