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of assets by providing insurance against credit loss. But the “wrapped” instrument quality is as good as the quality of the insurer. Downgrades of credit enhancers have a leverage effect as any instrument “wrapped” in a guarantee by credit enhancers is also downgraded.

      Because monolines extended so many guarantees to assets, they were highly exposed to the risk that erupted in a short period of time. It was not long before credit enhancers were downgraded. AIG, the biggest insurance company in the world, extended credit insurance by trading credit derivatives, and collapsed when lenders required the firm to post collateral against its numerous commitments.

      2.4 The Responses of Regulators to the Financial Crisis

      Following the 2008 financial crisis, the Basel regulators introduced a number of measures to make banks more resilient. A number of significant updates to the regulatory framework have been introduced, reshaping the regulations, after the Basel 2 Accord, into new Basel (2.5 or 3) rules. The main publications include: the global review of the regulatory framework was first published in December 2010, revised in June 2011, “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” [24], a “Revision to the Basel 2 Market Risk Framework” is dated February 2011 [25]; the Consultative Document “Fundamental Review of the Trading Book: A Revised Market Risk Framework” [27] was submitted to the industry in October 2013 and covers the regulations for both credit risk and market risk, as of this date.

Figure 2.1 maps the approaches under Basel 2 and the sequential sets of new regulations. The shaded boxes refer to the Basel extensions beyond Basel 2.

Figure 2.1 Overview of Basel regulations

      The Basel 2 blocks refer to the credit risk treatment for credit capital charges, with the risk-weighted assets according to banks' internal ratings. The current wave of regulations aims at reinforcing both the quality and the quantity of capital. The fraction of equity capital in total capital is reinforced and the capital ratio increases. The subsequent publications imposed new capital requirements, with a series of additions to the Basel 2 capital. The Basel 2 rules are expanded in Chapter 26 dedicated to credit regulations.

      The market risk approaches include the VaR-based capital plus the standardized approach of market risk for firms who do not comply with requirements of internal models. A stressed VaR was introduced as an additional capital charge in 2011. An alternate VaR measure is currently proposed for market risk. All market risk approaches are presented in Chapter 17 in the market risk section.

      The treatment of counterparty credit risk has been enhanced with the credit-value adjustment (CVA) that measures the impact of deteriorating credit standing on the value of derivative instruments. The CVA adjustment is introduced in Chapter 22 on counterparty credit risk.

      The blocks referring to liquidity and funding ratios cover three ratios gradually introduced by Basel 3. The Liquidity Coverage Ratio (LCR) imposes a minimum level of liquid assets for facing market disruptions to banks' funding. The Net Stable Funding Ratio imposes a minimum level of long-term funding, depending on banks' assets. The leverage ratio caps the size of the balance sheet and of certain off-balance sheet commitments as a function of the capital base. The three ratios are presented in Chapter 3 on balance sheet compliance, where the calculations and the consequences for the balance sheet of banks are detailed through a simplified example.

3

      BALANCE SHEET MANAGEMENT AND REGULATIONS

      The purpose of asset-liability management (ALM) is to manage assets and liabilities in conjunction with, rather than independently of, the bank so as to finance the bank and control the liquidity risk and the interest rate risk. In the aftermath of the 2008 crisis, regulators recognized that banks were not resilient enough to sustain periods of liquidity and funding stress, and imposed new rules. Under the new Basel regulations, new ratios constrain the balance sheet structure. Conventional ALM techniques apply once the bank complies with the rules. Many current issues relate to the implications of the new Basel 3 on the structure of the balance sheet and on profitability.

      This chapter introduces the new regulatory ratios. It shows how compliance with the set of the new regulatory ratios has a direct effect on how banks manage their balance sheet. These impacts are detailed using an example of a typical banking book.

      3.1 The New Regulatory Ratios

      The 2011 document “A global regulatory framework for more resilient banks and banking systems”, dated December 2010, revised June 2011 [24], requires that the capital adequacy ratio be enhanced and introduced two new ratios: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The reform is gradual, with full changes being enforced by 2018. A new leverage ratio is also introduced, aimed at preventing an excess buildup of credit in expansion phases.

3.1.1 Capital Adequacy

      Regulatory capital is divided into Tier 1 and Tier 2. Tier 1 capital includes equity and retained earnings. Tier 2 capital is made of subordinated debts. Tier 1 capital is available when the bank is solvent and operates as a going concern. If a bank's losses exceed its equity base, it should pay back all creditors. Tier 2 capital is relevant when the bank is no longer a going concern, under the “gone-concern” view.

      Under the new regulation mentioned above, Common Equity Tier 1 must be at least 4.5 % of risk-weighted assets at all times. Tier 1 capital must be at least 6.0 % of risk-weighted assets. Total capital (Tier 1 plus Tier 2) must be at least 8.0 % of risk-weighted assets at all times. An additional equity capital conservation buffer is required to ensure that banks build up capital buffers outside periods of stress, which can be drawn down when losses are incurred. A countercyclical buffer can be required for protecting the banking sector from excess aggregate credit growth by raising the cost of credit.

      The cumulative effect of these requirements is that the ratio of core capital to risk-weighted assets would reach 10 %, or more, by the time the new regulations would be fully enforced.

      The Basel 3 document also addresses the systemic risk implications of large banks, with additional capital buffers, and a greater supervisory discipline over banks designated as “systemic” because of their interconnectedness with the rest of the financial system.9

3.1.2 The Liquidity Coverage Ratio (LCR)

      The goal of the LCR is to improve the short-term resilience of a bank's liquidity risk profile by ensuring that it has sufficient high-quality liquid assets to survive an acute stress scenario lasting for one month.

      The LCR imposes that the liquidation value of eligible short-term assets be higher or equal to the “net stressed outflows” measured over a period of 30 days. The stress scenario might include: a significant downgrade of the institution's public credit rating; a partial loss of deposits; a loss of unsecured wholesale funding; a significant increase in secured funding haircuts; and increases in collateral calls on contractual and non-contractual off-balance sheet exposures, including committed credit and liquidity facilities.

      The net cash flows result from the runoffs of assets and liabilities under adverse conditions. They are measured from factors, or percentage runoffs, applied to assets and liabilities. On the asset side, the factors are fractions of assets expected as cash inflows. Term loans have low factors, while traded assets of good quality, which can be sold easily, have higher factors. The stressed outflows are calculated from runoff factors applied to liabilities, which measure the expected outlays of cash for various resources. Short-term wholesale debt has a runoff rate of 100 %. Other resources, such as deposits, are more stable but they are nevertheless expected to face withdrawals under stressed conditions. Long-term resources, such as capital and issued bonds, have no runoff over the short term.

3.1.3 The Net Stable Funding Ratio (NSFR)

      The objective of the NSFR is to promote the resilience over a longer time horizon than the LCR by creating additional incentives

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