## wpiea2019127 — References and Key Extracts

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### Glossary and scope
- AE: Advanced Economies
- BCP: Basel Core Principles for Effective Banking Supervision
- BCBS: Basel Committee on Banking Supervision
- CAMELS: Capital adequacy, Asset quality, Management, Earnings, and Liquidity
- CCF: Credit Conversion Factor
- D-SIB: Domestic Systemically Important Bank
- DEs: Developing Economies
- FSAP: Financial Sector Assessment Program
- FSB: Financial Stability Board
- GFC: Global Financial Crisis
- G-SIB: Global Systemically Important Bank
- HQLA: High-Quality Liquid Asset
- ICAAP: Internal Capital Adequacy Assessment Process
- IMF: International Monetary Fund
- IRB: Internal Ratings-Based Approach
- IRRBB: Interest Rate Risk in the Banking Book
- LCR: Liquidity Coverage Ratio
- LR: Leverage Ratio
- NSFR: Net Stable Funding Ratio
- QIS: Quantitative Impact Study
- RBS: Risk-Based Supervision
- RWA: Risk-Weighted Assets
- SIB: Systemically Important Bank
- SME: Small- and medium-sized enterprises
- SRP: Supervisory Review Process

### I. Introduction — context and guiding principles
- Key context:
  - The Global Financial Crisis (GFC) revealed regulatory, oversight, incentive, risk measurement/pricing, and corporate governance flaws.
  - Reforms mainly targeted large internationally active banks; full international standards may not fit smaller, less complex systems.
  - New international standards provide a "good basis" to strengthen financial systems in Developing Economies (DEs).
- Lessons for DEs emphasized:
  - liquidity buffers to avoid destabilizing fire sales and enable early intervention;
  - system-wide or macroprudential regulation and supervision;
  - resolvability of systemically important institutions to mitigate moral hazard and costly bailouts;
  - sound corporate governance and risk management;
  - legal/operational frameworks for early corrective supervisory action before minimum thresholds are breached.
- Characteristics of many DEs: financial systems still deepening, smaller/simpler institutions, less developed market infrastructure and institutional frameworks.
- Guiding principles for adapting standards in DEs:
  - Rigor, Context, Scope, Evolution, Effectiveness.
- Implementation context:
  - IMF technical assistance to more than 70 countries every year.
  - FSAP: some 280 detailed assessments in over 160 jurisdictions since 1999.
- Focus: banking regulatory and supervisory issues in DEs.
- Structure: use of BCP (Section II); enhanced capital and liquidity requirements (Sections III–IV); priorities moving from Basel I to Basel III (Section V).

### II. Establishing priorities: Basel Core Principles (BCP)
- High-level messages:
  - Resilience requires oversight beyond Basel capital standards; supervision must be comprehensive and intrusive.
  - BCP are minimum standards, universally applicable, with proportionality for context, risk profile, and systemic importance.
  - IMF and World Bank routinely assess BCP compliance; BCP enhanced in 2012 to incorporate GFC lessons.
- Common supervisory weaknesses identified:
  - Inappropriate institutional setting (mandates lacking weight, insufficient independence/legal protection);
  - Lack of skilled resources for forward-looking supervisory judgment;
  - Insufficient forward-looking analysis and early action;
  - Lax credit risk standards (underwriting, loan classification, collateral valuation, provisioning);
  - Inadequate liquidity risk standards and monitoring;
  - Weak corporate governance (CRO seniority, Board accountability);
  - Weak enforcement and follow-through.
- Priority recommendation:
  - Addressing BCP implementation weaknesses is the best approach for DEs.
  - BCP assessments create road maps; capital requirements BCP has among highest compliance rates — other principles should receive priority attention.
  - Strengthen resolution frameworks aligned with FSB’s Key Attributes; many DEs show fragilities (unclear mandates, ineffective coordination, insufficient independence, limited resolution powers, few recovery and resolution plans).

### Box 1 — Bird’s Eye View of Post-GFC Reforms
- Four reform building blocks:
  - Building resilient financial institutions: new capital and liquidity requirements and compensation guidelines.
  - Ending too-big-to-fail: higher loss absorbency for systemically important institutions, new resolution frameworks, more intensive supervision.
  - Making derivatives markets safer: reporting of OTC contracts to trade repositories and clearing standardized contracts through central counterparties.
  - Transforming shadow banking into resilient market-based finance: strengthened oversight/regulation.
- Complementary policy changes: central counterparty resolution guidance; enhanced disclosure; revised capital treatment of securitizations; guidelines for prudential treatment of problem assets; corporate governance principles; risk data aggregation and reporting guidelines.
- Outcome: improved quantity/quality of regulatory capital, new liquidity requirements, higher standards for systemically important institutions, progress in crisis management, shadow banking, financial market infrastructure, and derivatives.

### A. Practical guidance for DEs implementing international standards
- Implementation considerations:
  - Implement standards alongside development of supervisory capacity; sound supervisory judgment is core.
  - Take a conservative approach when adjusting capital/liquidity standards to reflect local risks.
  - Draw closely on international standards in spirit to ensure resilience and comparability.
  - Departures from standards must be justified.
  - Facilitate industry engagement for consistent understanding and realistic plans.
  - Undertake QIS early and repeatedly to inform calibration and build familiarity.
  - Implement transitional arrangements consistent with operational challenges; consider phased increases over several years if impact is meaningful.
  - Consider regulatory tiers to tailor framework to bank size and complexity.

### Box 2 — Importance of International Standards
- Role and rationale:
  - International standards set minimum prudential requirements promoting global stability and efficiency.
  - Non-compliance risks a race to the bottom, fragmentation of capital/liquidity pools, and higher national risks.
- Compliance and peer pressure:
  - Standard-setters (BCBS, FSB) lack legal enforcement; rely on member commitment and peer pressure (examples: RCAP).
  - Full, timely, consistent implementation supports international recognition.
- Flexibility and proportionality:
  - Standards allow adaptations and national discretions; Basel III contains such provisions.
  - International standards are minimums; national regulators can establish additional measures.
  - Transitional arrangements are national discretions; non-member jurisdictions may consider later implementation.

### III. Capital requirements — overview and context for DEs
- Observations:
  - Low capital quality/quantity in AEs pre-GFC was less pronounced in most DEs.
  - Many DEs tightened regulation after 1990s crises; DE banks rely more on common equity and limited use of complex internal models.
  - Many DEs still operate under Basel I or partial Basel II and can improve capital quality, risk coverage, risk sensitivity, and macroprudential dimensions.

A. Definition of Capital — reforms and implications
- Reforms increased loss-absorbing capacity by:
  - (i) greater focus on common equity,
  - (ii) more comprehensive regulatory adjustments and deductions,
  - (iii) stronger requirements for hybrid and debt instruments for Tier 1 and Tier 2 eligibility (BCBS, 2011a).
- Implementation implications for DEs:
  - Basel III capital definition could improve capital quality without material costs for many DEs.
  - Exceptions where impacts may be meaningful: substantial deferred tax assets; investments in insurance entities; lack of deductions for goodwill/intangibles.
- Recommendation:
  - Implement Basel III definition of capital as a priority.
  - If implementation has meaningful impact, it signals low capital quality.
  - DEs can implement in a simpler robust way by fully deducting items that typically do not apply to DEs (e.g., mortgage servicing rights; deferred tax assets from time differences; significant investments in unconsolidated financial institutions).
- Hybrid and debt instruments:
  - Authorities should consider instrument volume, maturity, and redemption options in transition design.
  - Support could include encouraging regulatory event clauses; grandfathering should be restricted to instruments issued before announcement (not implementation) of new regulation to avoid front-loading.

B. Minimum Requirements and Capital Buffers — structure and guidance for DEs
- Basel III structure: three independent minimum capital ratios plus buffers drawable in stress.
  - Banks required to meet different ratios of common equity, Tier 1, and total capital at all times.
  - Buffers encourage capital buildup via earnings retention and can be drawn down when losses arise.
- Capital Conservation Buffer:
  - Formed by three elements: capital conservation buffer, countercyclical buffer, and systemically important banks buffer — in practice they form a single capital buffer.
  - Suits DEs: simple uniform rule, limits distributions when drawn down.
  - Separation of minimums and buffers and gradual restrictions useful where limiting distributions and early remedial action is challenging.
- Caution on recalibration:
  - DEs should not automatically recalibrate Basel III thresholds downward; many DEs have higher minimums than Basel II and additional capital served well during GFC.
  - Authorities should consider appropriate target capital including buffers.
- Countercyclical Capital Buffer:
  - Designed to protect system from excessive credit growth (BCBS, 2010).
  - Requires national authorities to monitor systemic risk build-up and apply judgement on buffer level.
- Key numeric references depicted in Figure 2:
  - CET11 > 4.5% RWA
  - Tier 1 > 6% RWA
  - Total Capital > 8% RWA
  - Tier 1 > 4% RWA
  - Total Capital > 8% RWA
  - >2.5% RWA (Conservation Buffer highlighted)

### Box 3 — Proportionality in regulation of small banks
- Rationale:
  - Compliance costs can be substantial for small banks; post-crisis complexity increased.
  - Simplification must not be less conservative.
  - Eligibility should consider risk profile and business model, not size alone.
  - Small banks’ failure can have reputational/systems effects; strong governance remains essential.
- Alternatives/design principles:
  - Use existing financial statements to compute capital requirements and RWAs through simpler risk weights tied to existing reporting.
  - Some new reports may still be necessary for liquidity and concentration oversight.
  - Strong resolution frameworks and safety nets are important when applying proportionality.
- Countercyclical buffer constraints in DEs:
  - Data gaps and institutional weaknesses constrain operation; biases toward inaction and political pressure can arise.
  - In weak institutional contexts, stronger role for rules rather than judgement may be advisable.
  - Invest in better data collection.
- D-SIBs (Domestic Systemically Important Banks):
  - Identification: parsimonious indicators (size, interconnectedness, lack of substitutes, complexity) often sufficient.
  - Calibration: use supervisory judgment, historical losses, stress tests, equal expected impact approach; consider resolution framework soundness.
  - Communication: avoid perceptions of too-big-to-fail; stress objective is to reduce failure impact.
  - Supervisory/resolution expectations: stronger supervision, recovery and resolution plans required and challenged.

C. Risk-Weighted Assets — Standardized Approach for Credit Risk
- Revised standardized approach reduces reliance on external ratings, enhances granularity and risk sensitivity (BCBS, 2017b).
- Relevance for DEs:
  - Standardized approach often most relevant; IRB not viable due to complexity/data.
  - Standardized approach will be base for output floor for IRB banks.
- Implementation priorities:
  - Incorporate new standards focusing on most relevant credit portfolios.
  - Consider updated housing mortgage treatment where material.
  - Retail loan revisions more granular; applicability varies by DE.
- Going beyond Basel:
  - Where external ratings are scarce, DEs may use objective borrower/collateral drivers ensuring weighted average risk-weight not lower than Basel prescriptions.
- Portfolio parameter adjustments:
  - SME definition threshold “€50 million” may be too high for many DEs; consider lowering.
- Investment grade classification caution:
  - Supervisors should carefully assess subjective "investment grade" classifications where supervisory capacity is limited.
- Off-balance sheet and unhedged exposures:
  - New risk-weight multiplier addresses currency-mismatch exposures in foreign currency.
  - Recalibration of credit conversion factors (e.g., change to zero percent CCF for unconditionally cancellable commitments) has implications where cancellation ability is limited.
- Investments in asset management products:
  - Revised prudential treatment (BCBS, 2013e) uses look-through to underlying asset risks and funds’ leverage.

Market Risk
- New market risk framework aims at better tail risk capture and preventing trading-banking arbitrage (BCBS, 2019).
- Three approaches: internal models, standardized, simplified standardized.
  - Simplified standardized approach suitable for small/non-complex trading portfolios (relies on Basel II structure).
  - Flat surcharge option can be used where even simplified approach is unsuitable: fixed RWAs or assets kept at fair value.
- FX risk:
  - FX risk often needs more sensitive treatment across trading and banking books.
- Trading/banking boundary and valuation:
  - Adopt revised boundary to reduce arbitrage and enforce sound valuation for fair value instruments.

Operational Risk
- Basel II advanced measurement removed; single standardized approach introduced (BCBS, 2017b).
- Limitations for DEs/small banks:
  - Requires 10 years of high-quality loss data often unavailable.
  - Calibration targets large banks; should not meaningfully impact small/medium banks.
- Supervisory priorities:
  - Implement Principles for Sound Operational Risk Management (BCBS, 2011b).
  - Require operational loss databases regardless of framework adoption; enforce minimum loss data standards proportionally.
- Business Indicator:
  - Proxy based on variables such as interest income/expenses, fees, profits; may require tweaks based on accounting availability.

D. Leverage Ratio (LR)
- LR introduced to supplement risk-based capital (BCBS, 2014a); aimed to constrain leverage build-up.
- LR buffer for G-SIBs introduced (BCBS, 2017).
- DE relevance:
  - LR typically not binding in DEs given limited internal models and derivatives use.
  - LR useful to limit excessive exposures to sovereigns/low RWA assets.
  - Complexity: derivatives exposure calculation burdensome; DEs may simplify using credit-risk exposure amounts.
  - Calibration considerations:
    - Proposed 3 percent calibration might be too low for DEs that have higher risk-based capital requirements.
    - 35 percent conversion ratio between Tier 1 risk-based and LR in Basel standards is a reference.
    - Example: assuming 8 percent minimum Tier 1 and a 2.5 percent capital conservation buffer, the LR could be set at 3.5 percent. Surcharges for D-SIBs could follow Basel (leverage buffer equals 50 percent of risk-based surcharge).

Pillars 2 and 3: supervisory review and disclosure
- Role:
  - Pillar 2 (supervisory review) and Pillar 3 (disclosure) are critical components.
  - Pillar 2 ensures risks outside Pillar 1 are captured; fosters bank board responsibility.
  - Pillar 3 ensures market discipline complementary to Pillars 1 and 2.
- Implementation for DEs:
  - Prioritize Pillar 2; requires supervisory capacity and bank practices improvement.
  - Supervisors need powers to require capital/liquidity, limit dividends, strengthen provisions, impose exposure limits, improve internal controls.
  - Address frequent failures on BCP 11 (corrective and sanctioning powers).
  - Pillar 2 tools: risk-based supervision, CAMELS ratings, supervisory stress testing, ICAAP.
  - ICAAP: focus initial implementation on large banks; smaller banks may be exempt from formal ICAAP submissions in first three years or complex requirements.
  - Pillar 3 templates: consider simplifying templates and reducing granularity for smaller banks while maintaining Basel definitions where possible.

Interest Rate Risk in the Banking Book (IRRBB)
- Definition: risk to capital and earnings from adverse interest rate movements.
- BCBS strengthened IRRBB framework (BCBS, 2016); no Pillar 1 charge agreed.
- DE considerations:
  - IRRBB often more important than trading-book risks.
  - Consider imposing IRRBB capital charge even if Pillar 2 is developing.
  - Pillar 2 provides flexibility; Pillar 1 standardized charge preferable when exposures are not substantial or capacities limited.

Liquidity requirements and LCR
- Basel III liquidity framework: LCR (short-term resilience) and NSFR (long-term stable funding).
- LCR: HQLA divided by total net cash outflows over 30 calendar days; target no less than 100 percent.
- Benefits: forward-looking, risk-sensitive, discourages short-term funding reliance.
- DE implementation challenges:
  - Limited HQLA availability (often only government bonds and cash); shallow secondary markets.
  - LCR presumes private market liquidity and central bank as backstop not primary source.
- Alternatives/adaptations:
  - Option 1: use of central bank liquidity facility;
  - Option 2: use foreign currency assets for domestic needs;
  - Option 3: additional use of Level 2 assets with higher haircut.
- Sequencing and simplifications:
  - Start with robust liquidity risk management standards and monitoring.
  - Gain experience with LCR before imposing minimum requirement; many DEs with structural surplus liquidity may meet 100 percent but need other adjustments.

### Box 4 — Internal Model Approaches in DEs
- Objectives and outcomes:
  - Internal models intended to increase risk sensitivity and incentivize better risk management.
  - Observed variability in risk weights and parameter estimates across banks (BCBS, 2013b; BCBS, 2013d) causing concerns about arbitrage and inconsistent application.
- Governance and skills:
  - Internal models require specialized skills, strong governance across three lines of defense, and extensive supervisory resources for model approval/validation.
- Capital outcomes in DEs:
  - Expectations of capital savings may not hold in DEs due to higher volatility, default probabilities, and loss given default.
- Recommended steps:
  - DEs are not required to adopt internal models.
  - If adopted, develop multi-year road maps emphasizing capacity building and communication.
- LR relevance reiterated:
  - LR not usually binding; can address sovereign/low-RWA exposures.
  - Simplify exposure calculations where derivatives are limited.
  - Consider calibration (e.g., reference 3 percent; example LR 3.5 percent given 8 percent Tier 1 and 2.5 percent buffer).
- Pillars 2 and 3 reiterated:
  - Emphasize supervisory review, ICAAP rollout, and proportional Pillar 3 disclosures.

### Box 5 — Principles for Sound Liquidity Risk Management and Supervision
- Overview:
  - 17 principles in 5 categories: fundamental principle; governance; measurement and management; public disclosure; role of supervisors.
  - Bank responsibility: maintain sufficient liquidity including unencumbered HQLA cushion.
  - Supervisors: assess adequacy and intervene early.
- Governance (Principles 2–4):
  - Senior management and Board responsibilities for liquidity strategy, policies, and incentives.
- Measurement and management (Principles 5–12):
  - Identify/measure/monitor/control liquidity across legal entities, lines, and currencies.
  - Funding strategy diversification, intraday liquidity management, collateral management, stress testing, contingency planning, and liquidity cushion maintenance.
- Public disclosure (Principle 13): regular disclosures to support market judgement.
- Supervisory role (Principles 14–17):
  - Comprehensive assessments, supervisory monitoring, early intervention, cross-border cooperation.
- LCR/NSFR considerations for DEs:
  - Modifications may be required initially with rollback over time.
  - Sovereign bond concentration risk: restrict HQLA eligibility where no secondary market or collateral use with central bank absent.
  - Supervise liquidity by currency in dollarized systems.
- NSFR:
  - Enhances long-term funding resilience; sequencing after LCR embedding.
  - Calibration requires extensive quantitative analysis; remediation can require balance sheet and business model changes.

### Appendix I — Prudential Standards Implementation Steps (indicative roadmap)
- Sequenced steps:
  - a. Draft regulation and guidance.
  - b. Draft supervisory reporting templates.
  - c. Establish supervisory/industry working group.
  - d. Publish draft regulation for consultation.
  - e. Conduct QIS workshop with banks.
  - f. Establish reporting database.
  - g. Conduct a QIS with detailed guidance and reconciliation requirements.
  - h. Analyze QIS results and hold feedback meetings.
  - i. Refine drafts; repeat QIS if revisions are meaningful.
  - j. Design phase-in and transitional arrangements.
  - k. Publish final rules and amended regulations.
  - l. Align regulatory reporting to new methodologies.
  - m. Initiate parallel run period and work with banks to improve data quality.

### Appendix II — Guiding Principles for Modifying LCR
- Assets:
  - Pragmatic HQLA eligibility: market liquidity test strictness can render many sovereign securities ineligible in EMDEs.
  - Recommendation: relax market liquidity test for sovereign bonds; retain tests for Level 2 assets while pursuing market development to expand HQLA.
- Liabilities:
  - Challenge estimating stressed outflows where deposits treated homogeneously.
  - Practical solution: standardized run-off rates (example: 10 percent for retail and SME deposits), permitting differential treatment in exceptional demonstrable cases.
  - Use QIS to inform run-off calibrations; conservative floor classify deposits as “less stable.”
  - 3 percent run-off rate under LCR requires conditions (stable classification, funded deposit insurance, historical support); 3 percent should not be de facto minimum.
- Retail deposit stability indicators (seven examples):
  - (i) not covered by deposit insurance;
  - (ii) high-value deposits;
  - (iii) lack of established relationship;
  - (iv) internet-only savings accounts;
  - (v) high net worth;
  - (vi) withdrawn quickly;
  - (vi) foreign-exchange denominated deposits.
- Decision framework summarized in Figure A1 (Decision Tree for Classification of Retail Deposits).

*Source: wpiea2019127 — References (excerpt from source PDF).*

### References .............................................................................................................

### References

### Glossary
- AE: Advanced Economies
- BCP: Basel Core Principles for Effective Banking Supervision
- BCBS: Basel Committee on Banking Supervision
- CAMELS: Capital adequacy, Asset quality, Management, Earnings, and Liquidity
- CCF: Credit Conversion Factor
- D-SIB: Domestic Systemically Important Bank
- DEs: Developing Economies
- FSAP: Financial Sector Assessment Program
- FSB: Financial Stability Board
- GFC: Global Financial Crisis
- G-SIB: Global Systemically Important Bank
- HQLA: High-Quality Liquid Asset
- ICAAP: Internal Capital Adequacy Assessment Process
- IMF: International Monetary Fund
- IRB: Internal Ratings-Based Approach
- IRRBB: Interest Rate Risk in the Banking Book
- LCR: Liquidity Coverage Ratio
- LR: Leverage Ratio
- NSFR: Net Stable Funding Ratio
- QIS: Quantitative Impact Study
- RBS: Risk-Based Supervision
- RWA: Risk-Weighted Assets
- SIB: Systemically Important Bank
- SME: Small- and medium-sized enterprises
- SRP: Supervisory Review Process

### I. Introduction — context and guiding principles
- The Global Financial Crisis (GFC) prompted a major reform program addressing: regulatory and oversight system deficiencies; inappropriate incentives; flaws in risk measurement, pricing, and management techniques; and corporate governance weaknesses.
- Reforms mainly targeted large internationally active banks and complex markets; full international standards may not be directly applicable to smaller, less complex financial systems.
- The new international standards provide a "good basis" for strengthening financial systems in Developing Economies (DEs).
- Key lessons for DEs emphasized by the GFC include the importance of:
  - liquidity buffers to avoid destabilizing fire sales and enable early intervention;
  - a system-wide or macroprudential approach to regulation and supervision;
  - making systemically important institutions resolvable to mitigate moral hazard and costly bailouts;
  - sound corporate governance and risk management;
  - a legal and operational framework for early corrective supervisory action, even before minimum regulatory thresholds are breached.
- Characteristics of many DEs: financial systems still deepening, relatively smaller and simpler institutions, less developed market infrastructure, less mature institutional frameworks. Simple transposition of international standards may lead to inadequate buffers, excessive compliance costs, enforcement challenges, inappropriate incentives, and ineffective regulation.
- Guiding principles for adapting standards in DEs:
  - Rigor: Adaptations should not lead to less rigorous prudential frameworks or promote riskier behavior.
  - Context: Regulations must account for pronounced risk-environment features (market illiquidity, high volatility, enforcement challenges).
  - Scope: Authorities should not compromise on regulation scope and must address fundamental weaknesses identified during the crisis.
  - Evolution: As financial systems deepen, the regulatory framework should support convergence to international practices.
  - Effectiveness: Preconditions and expectations of the Basel Core Principles (BCP) should be met even if full standards are not applicable.

- Implementation context and evidence:
  - IMF technical assistance is provided every year to more than 70 countries.
  - The FSAP has undertaken some 280 detailed assessments of banking supervision in over 160 jurisdictions since 1999.
- The paper focuses on banking regulatory and supervisory issues given banks’ dominance in most DEs’ financial systems.
- Structure preview:
  - Section II: Use of BCP to set priorities.
  - Sections III and IV: Enhanced capital and liquidity prudential requirements post-GFC.
  - Section V: Priorities when moving from Basel I to Basel III.

### II. Establishing priorities: the Basel Core Principles (BCP) for Effective Banking Supervision
- High-level messages:
  - Increasing financial resilience requires oversight beyond implementing Basel capital standards; supervision must be more comprehensive and intrusive.
  - The BCP are a framework of minimum standards, universally applicable, with a proportionality approach for context, risk profile, and systemic importance.
  - The IMF and World Bank routinely assess BCP compliance, and the BCP were enhanced in 2012 to incorporate GFC lessons.

- Common supervisory weaknesses identified in assessments:
  - Inappropriate institutional setting: mandates without sufficient weight to financial stability, lack of operational independence and legal protection for supervisors.
  - Lack of skilled resources: need for strong technical skills and experience to enable sound supervisory judgment and rigorous challenge of industry practices.
  - Insufficient forward-looking analysis: many supervisors struggle to make risk-based forward-looking assessments and take early action before regulatory breaches.
  - Lax credit risk standards: weak credit risk management standards; need for enhanced scrutiny of credit underwriting, proactive supervisory role in loan classification and collateral valuation, conservative guidance on provisioning.
  - Inadequate liquidity risk standards and monitoring: insufficient supervisory information and enforcement of sound liquidity risk management; banks often do not plan for market-wide strain or severe liquidity disruptions.
  - Weak corporate governance: Chief Risk Officers often not senior enough; Boards need active roles and accountability for risk management effectiveness and independence.
  - Weak enforcement: supervision must be conclusive with persistent follow-through; implementation and enforcement are key to credibility.

- Priority recommendation:
  - Addressing weaknesses in BCP implementation is the best approach for DEs to improve supervisory standards.
  - BCP assessments create road maps; capital requirements BCP has among highest compliance rates, implying other principles should receive priority attention.
  - Supervisors should identify and strengthen resolution frameworks aligned with the FSB’s Key Attributes for Effective Resolution Regimes; many DEs show fragilities (unclear mandates, ineffective coordination, insufficient independence, limited resolution powers, few recovery and resolution plans).

### Box 1 — A Bird’s Eye View of the Regulatory Reforms
- Four main reform building blocks post-GFC:
  - Building resilient financial institutions: new capital and liquidity requirements and compensation guidelines.
  - Ending too-big-to-fail: higher loss absorbency for systemically important institutions, new resolution frameworks, and more intensive supervision.
  - Making derivatives markets safer: reporting of OTC contracts to trade repositories and clearing standardized contracts through central counterparties.
  - Transforming shadow banking into resilient market-based finance: strengthened oversight and regulation of shadow banking.
- Complementary policy changes: guidance on central counterparty resolution; enhanced disclosure requirements; revised capital treatment of securitizations; guidelines for prudential treatment of problem assets; principles for corporate governance; guidelines for risk data aggregation and reporting.
- Outcome: post-crisis reforms substantially strengthened the system—improved quantity and quality of regulatory capital and new liquidity requirements; higher standards for systemically important institutions; progress in crisis management, shadow banking, financial markets infrastructure, and derivatives.

### A. Effective implementation of international standards in DEs — practical guidance
- A BCP assessment can reveal capital and liquidity framework weaknesses; the BCP do not require full Basel III compliance for all countries due to proportionality.
- Key practical considerations for DEs implementing international standards:
  - Implement standards alongside development of supervisory capacity; core element is sound supervisory judgment to enforce regulation and challenge banks.
  - Take a conservative approach when adjusting international capital and liquidity standards to reflect differences with advanced economies; adjustments should reflect international minimum thresholds and actual local risks.
  - Draw closely on international standards when framing national regulations—follow them in spirit to ensure resilience, international comparability, and minimize later revisions.
  - Departures from international standards should be justified by clear reasons and benefits.
  - Facilitate industry engagement to ensure consistent understanding and realistic implementation plans.
  - Undertake Quantitative Impact Studies (QIS) early and repeatedly to inform calibration and policy; QIS enable familiarity with new regulations.
  - Implement transitional arrangements consistent with operational challenges and banks’ abilities to meet prudential ratios without major disruptions; consider phased increases over several years if impact is meaningful.
  - Consider different regulatory tiers to tailor the framework to bank size and complexity.

_Italic: Content derived from wpiea2019127 - References (source PDF content provided). _

### Box 2. The Importance of International Standards

### Box 2. The Importance of International Standards

### Role and rationale of international standards
- International standards establish minimum prudential requirements that promote stability and efficiency of global financial markets.
- Disregard to international standards may start a race to the bottom: jurisdictions may underbid each other by lowering prudential requirements to attract foreign financial firms.
- Fragmented global regulatory frameworks can hinder trust in the global financial system, fragment pools of capital and liquidity, impact cross-border flows, and produce inefficient financing and higher risks to national economies.
- This rationale underpins the multilateral approach to financial regulation and the creation of international standard-setting bodies such as the BCBS and the FSB.

### Compliance, enforcement, and peer pressure
- Significant deviations from international standards by member jurisdictions would undermine the global standard-setting process.
- Standard-setter bodies such as the BCBS and FSB develop and agree upon standards but have no legal enforcement power.
- These bodies rely on member commitment and on peer pressure mechanisms to encourage jurisdictions to comply within an established time period.
- Example: the BCBS implementation program called the Regulatory Consistency Assessment Program (RCAP), which is based on peer reviews and disclosure.
- Full, timely, and consistent implementation by member countries is key to support the international recognition of the standards; standard-setters’ member jurisdictions should lead by example.

### Flexibility, proportionality, and national discretions
- International standards allow room for adaptations and tailoring to establish a proportional regulatory regime.
- Many standards, such as the BCP, are expressed as principles or high-level elements allowing jurisdictions to define implementation details according to specific characteristics.
- More prescriptive standards can contain national discretions to address meaningful differences across jurisdictions.
- Basel III contains provisions allowing jurisdictions to accommodate different practices in relation to external credit rating agencies and different options to treat exposures to public sector entities, banks, and commercial real estate.
- International standards are minimum requirements; national regulators can establish additional or complementary measures beyond the agreed minimum.
- Standards such as Basel III are designed for large internationally active banks; regulators can establish different regimes for other banks when appropriate.
- Transitional arrangements are national discretions: member jurisdictions can implement standards when they wish but not later than the agreed deadlines. Non-member jurisdictions may consider implementing standards later than these deadlines.

### III. CAPITAL REQUIREMENTS — overview and context for DEs
- The low quality and low quantity of capital observed in advanced economies (AE) prior to the GFC was not so pronounced in most DEs.
- Based on lessons from emerging markets financial crises in the late “1990s”, several DEs had tightened regulation beyond pre-GFC international standards.
- Factors contributing to relatively more robust capital in DE banks include limited access to innovative hybrid instruments (leading to heavier reliance on common equity) and limited use of complex internal models approaches.
- Most DEs have room to improve their capital framework: many operate under Basel I or a partial version of Basel II and can gain from improving the quality of capital, risk coverage, risk sensitivity, and the system-wide or macroprudential dimension of the regulatory framework.

### A. Definition of Capital — reforms and implications
- Reforms increased banks’ capacity to absorb losses by increasing the quality of regulatory capital via:
  - (i) greater focus on common equity,
  - (ii) more comprehensive set of regulatory adjustments and deductions from capital,
  - (iii) stronger requirements for hybrid and debt instruments to be eligible for Tier 1 and Tier 2 capital (BCBS, 2011a).
- Implementation of the new definition of capital could improve capital quality in DEs without imposing material costs in most cases because DEs rely more heavily on common equity and regulatory deductions are usually not meaningful.
- Exceptions: some DE banks hold substantial deferred tax assets or investments in insurance entities; some DE capital frameworks do not deduct goodwill and intangibles, potentially overstating banks’ capital ratios relative to the new Basel III definition.
- Recommendation: Implementing the Basel III definition of capital should be a priority in all countries as a strong definition of capital is the cornerstone of an effective prudential framework.
  - If implementation has a meaningful impact, it signals low quality of capital and that capital may be unable to absorb losses as expected.
- DEs can implement the Basel III definition in a simpler but robust way by fully deducting items that typically do not apply to DEs under complex international rule waivers, for example:
  - (i) mortgage servicing rights;
  - (ii) deferred tax assets from time differences;
  - (iii) significant investments in unconsolidated financial institutions.
- On hybrid and debt instruments becoming ineligible under Basel III:
  - Previously issued instruments with long maturities and higher cost than senior debt may be rendered ineligible.
  - Authorities should consider instrument volume, maturity, and redemption options when designing transitions.
  - Supporting the transition could include encouraging or requesting the industry to include a regulatory event clause before conclusion of regulatory changes.
  - To avoid incentives for front-loading issuance of soon-to-be ineligible instruments, grandfathering could be restricted to instruments issued before the announcement (not before the implementation) of the new regulation.

### B. Minimum Requirements and Capital Buffers — structure and guidance for DEs
- Basel III changed the capital framework structure by creating three independent minimum capital ratios and supplementing them with buffers drawable in periods of stress.
  - Banks are required to meet different ratios of common equity, Tier 1, and total capital.
  - The three established minimum ratios should be observed at all times.
  - Capital buffers encourage buildup of capital through earnings retention and can be drawn down when losses arise.
- Implementation of the new capital structure is important for DEs; it is not complex and supports greater emphasis on common equity.
- Having the three independent ratios established in regulation is important for disclosure and market discipline, as common equity and Tier 1 capital ratios are common benchmarks to assess capitalization.

- Capital Conservation Buffer
  - The capital buffer established by Basel III is formed by three elements: the capital conservation buffer, the countercyclical capital buffer, and the systemically important banks buffer; in practice they form a single capital buffer.
  - The capital conservation buffer suits DEs: it is based on a simple capital conservation rule uniformly applicable to all banks and is not expected to change over time.
  - When buffers are drawn down, the rule limits dividend distributions, share-backs and staff bonus payments and facilitates preservation of capital.
  - The separation of minimum requirements and capital buffers and the framework’s gradual automatic restrictions are useful for countries challenged in limiting distributions and taking remedial action before breaches of minimum thresholds.

- Caution on recalibration
  - DEs should exercise caution not to automatically recalibrate thresholds prescribed by Basel III because many DEs have already established minimum capital requirements substantially higher than those prescribed by Basel II.
  - The additional capital served DEs well during the GFC and is often necessary due to higher economic and financial volatility and weaker institutional settings.
  - Authorities should carefully consider the appropriate target level of capital, including all capital buffers, to ensure appropriate capitalization without hindering the banking system’s proper functioning.

- Countercyclical Capital Buffer
  - The countercyclical capital buffer is designed to protect the financial system from periods of excessive credit growth associated with build-up of systemic risks (BCBS, 2010).
  - The aim is to ensure the banking sector, in aggregate, has enough capital to maintain the flow of credit after a systemic shock and to help lean against the build-up phase of the cycle.
  - The tool requires national authorities to monitor systemic risk build-up and apply judgement to determine the appropriate buffer level.

### Key numeric references depicted in Figure 2 (as presented)
- CET11 > 4.5% RWA
- Tier 1 > 6% RWA
- Total Capital > 8% RWA
- Tier 1 > 4% RWA
- Total Capital > 8% RWA
- >2.5% RWA (Conservation Buffer highlighted in diagram context)

*Source: Box 2. The Importance of International Standards, wpiea2019127*

### Box 3. Proportionality in the Regulation of S mall Banks

### Box 3. Proportionality in the Regulation of Small Banks

### Rationale for proportional regulation
- Compliance costs associated with prudential regulation can be substantial for small banks.
- Post-crisis regulatory reform closed gaps identified after the GFC but increased complexity, particularly in risk areas where many small banks have little or no business.
- Small banks may lack the necessary scale or business model that warrants full implementation of new standards.
- Any simplification should not be less conservative; the prudential framework should not jeopardize financial stability.
- Size is not the only eligibility criterion: risk profile and business model are important. Small banks engaged in sophisticated products and complex business models should be subject to frameworks that capture their risks.
- Small institutions’ failure can have significant reputational impact for supervisors, can be prone to contagion, and their collective failure may have financial stability implications.

### Alternatives and design principles for simpler requirements
- Use existing financial statements and reports to impose capital requirements to maintain risk sensitivity while avoiding additional supervisory reports and processes.
  - Calculate risk-weighted assets by using risk weights that apply to exposures already calculated and segregated for other purposes (e.g., accounting or other existing supervisory reports).
  - This approach: can be easily implemented, does not require costly new information systems, and is more risk sensitive than simple LRs.
- Where reporting burden can be partially alleviated, some new reports may still be needed to ensure timely supervisory assessment, because liquidity and concentration risks tend to be higher in small banks.
- Strong corporate governance is essential regardless of size; many small bank failures are driven by corporate governance issues. Supervisors should enforce standards consistent with international best practices.
- Strong resolution frameworks and effective financial safety nets are important when considering proportional regulation for smaller banks to ensure orderly resolution without endangering financial stability.

### Countercyclical capital buffer constraints in DEs
- Lack of data and underdeveloped institutional settings can constrain the operation of the countercyclical capital buffer in DEs.
- The buffer is subject to biases towards inaction, often exacerbated by political pressures and lobbying focused on short-term costs.
- In environments lacking independent institutions and strong accountability frameworks, a stronger role for rules (rather than judgement) to activate the buffer may be advisable.
- DEs should invest in improving the quality of data collection to ensure appropriate policy making.

### Domestic Systemically Important Banks (D-SIBs)
- The distress or failure of systemically important banks motivated higher loss absorbency requirements.
- The D-SIBs framework is flexible and applicable to DEs; the challenge is operationalizing high-level recommendations.
- Identification:
  - D-SIBs are often easier to identify in a national context; supervisors and market participants usually know which institutions are D-SIBs.
  - Mathematical scoring formulas can help avoid perceptions of arbitrariness, but precision can be misleading. A parsimonious set of indicators (e.g., size, interconnectedness, lack of substitutes, complexity) is often sufficient in DEs.
- Calibration:
  - Supervisory judgment is needed to calibrate higher loss absorbency requirements.
  - Quantitative analyses used include historical losses, stress test results, and the equal expected impact approach (calculates buffer to bring down probability of default of a D-SIB to reduce its economic cost of failure to that of a reference non-D-SIB).
  - Analyses have limitations; final decisions should consider degree of systemic importance and soundness of the resolution framework.
- Communication and moral hazard:
  - The D-SIB exercise risks creating perceptions of too-big-to-fail; moral hazard and competitive distortions may follow.
  - Communication should stress the goal is to reduce impact and negative externalities of failures, and that institutions are not considered too-big-to-fail.
- Supervisory and resolution expectations:
  - D-SIBs should face stronger supervision (more frequent inspections and interactions with senior management) and higher expectations on corporate governance, risk management, and data reporting.
  - Supervisors should require D-SIBs to prepare recovery and resolution plans that are thoroughly analyzed and challenged for effectiveness and implementability.

### C. Risk-Weighted Assets — Standardized Approach for Credit Risk
- The standardized approach was revised to reduce reliance on external credit ratings, enhance granularity and risk sensitivity, update calibrations, and improve clarity (BCBS, 2017b).
- In DEs the standardized approach is often the most relevant or only driver of capital charge because:
  - Banks tend to have limited trading-book operations.
  - The IRB approach is not viable in most DEs due to complexity and data requirements.
  - The standardized approach will be used as the base of the output floor for IRB banks.
- Implementation priorities for DEs:
  - Incorporate the new standard focusing on most relevant credit portfolios rather than revamping the whole framework at once.
  - Housing mortgage portfolio treatment improved; consider adopting where significant.
  - Revisions for retail loans provide more granular treatment (e.g., revolving facilities vs trans-actors) though less relevant to many DEs.
- Going beyond Basel revisions:
  - The new standardized approach still uses external ratings; applicability is limited in DEs with low shares of rated borrowers.
  - DEs may increase risk sensitivity using objective drivers (borrower characteristics like leverage, profitability, size; collateral characteristics) at the country level, ensuring any further differentiation does not result in a weighted average risk-weight lower than Basel prescriptions.
- Portfolio parameter adjustments for DEs:
  - Example: SME definition in Basel framework uses “€50 million” reported sales; this threshold may be too high in many DEs and could be lowered to ensure granularity and appropriate risk classification.
  - Similar issues arise for the regulatory retail portfolio definition.
- Caution on “investment grade” corporate classification:
  - The new standardized approach allows a lower risk-weight for corporates banks classify as “investment grade.”
  - Criteria may be subjective and hard to enforce; supervisors should carefully assess risks of inadequate implementation where supervisory systems cannot ensure consistent classification across banks.
- Off-balance sheet and unhedged exposures:
  - New risk-weight multiplier for exposures with currency mismatch addresses credit risk from unhedged retail and residential real estate exposures in foreign currency.
  - Recalibration of credit conversion factors: zero percent credit conversion factor for unconditionally cancellable commitments was increased — relevant where legal/risk management constraints limit banks’ ability to cancel such commitments.
- Investments in asset management products:
  - Revised prudential treatment of banks’ investments in the equity of investment funds (BCBS, 2013e) uses a look-through approach to identify underlying asset risks, better accounts for funds’ leverage, and reflects fund underlying investment risk more appropriately.

### Market Risk
- The new market risk framework increases consistency, coherence, and risk capture; expected to better capture tail risks and prevent arbitrage across banking and trading books, while raising the bar for internal models (BCBS, 2019).
- Framework comprises three approaches: internal models, standardized, and simplified standardized.
  - Internal models and standardized approaches are complex and rely more on pricing models, complicating implementation in smaller institutions and DEs.
  - BCBS created a simplified standardized approach for banks with small or non-complex trading portfolios.
- For many DE banks the simplified standardized approach is most suitable: it relies on Basel II market risk structure, lowering implementation costs while recalibrated to address GFC lessons and reduce trading-banking book arbitrage.
- Where even the simplified approach is unsuitable, a flat surcharge to cover market risks could be an option:
  - In low and relatively uniform market-risk jurisdictions, a credible flat surcharge could increase capital requirements by a fixed amount in terms of RWAs or total assets kept at fair value.
  - As trading books grow and become more complex, capital treatment should evolve toward the international standard.
- Foreign exchange risk:
  - FX risk often needs more risk-sensitive treatment across trading and banking books even where trading books are small.
  - Given Basel’s modularity, jurisdictions can adopt a more risk-sensitive approach for FX and complement it with simpler options for other risks.
- Trading/banking book boundary and valuation:
  - Adopt the revised boundary between trading and banking books even if the rest of the framework is not fully implemented to reduce capital arbitrage.
  - Enforce sound valuation practices for instruments at fair value; capital requirements are no substitute for strong valuation practices (prudent valuation guidance is particularly relevant for illiquid positions).

### Operational Risk
- The Basel II operational risk framework was overhauled; the advanced measurement approach was removed in favor of a single standardized approach (BCBS, 2017b).
- The new standard increases consistency and reduces complexity in RWAs calculations while better capturing operational risk, mainly via use of banks’ internal operational loss data.
- Limitations for DEs and small banks:
  - Improvement requires 10 years of high-quality annual loss data that may be unavailable in some DEs.
  - Calibration targets undercapitalization at large banks and should not meaningfully impact small- and medium-sized banks.
- Supervisory priorities:
  - Prioritize implementation of operational risk management standards (Principles for Sound Operational Risk Management, BCBS, 2011b) to complement transition to the new indicator.
  - Require banks to develop operational loss databases regardless of adopting the new framework; loss databases are the first step to sound operational risk management.
  - Enforce minimum standards for loss data proportionally to the size and operational complexity of each bank, even if not used to calculate the operational risk capital charge.
- Calibration and data availability:
  - The new proxy for operational risk, the Business Indicator, is based on variables such as interest income and expenses, fees and profits.
  - Depending on accounting standards, exact variables may not be readily available; it may be preferable to tweak the indicator using available accounting information rather than require new reports, provided changes do not bias the indicator downward.

### D. Leverage Ratio (LR)
- The regulatory reforms introduced an LR to supplement risk-based capital requirements (BCBS, 2014a).
- The LR is designed to constrain leverage build-up by reinforcing the capital framework with a non-risk-based measure.
- The new requirement is expected to mitigate destabilizing deleveraging processes and introduce additional safeguards against model risk.
- Finalized Basel III reforms introduced an LR buffer to further limit leverage of G-SIBs (BCBS, 2017).

*Source: Box 3. Proportionality in the Regulation of Small Banks (wpiea2019127).*

### Box 4. Internal Model Approaches in DEs

### Box 4. Internal Model Approaches in DEs

### Internal model approaches: objectives and practical outcomes
- Expected benefits:
  - Designed to be more risk sensitive, generating a capital charge that better fits the actual risks incurred by banks.
  - Higher skin-in-the-game when banks take more risk should, in principle, provide regulatory incentives against excessive risk taking.
  - Capital incentives embedded in the framework were expected to promote adoption of stronger risk management practices by the banking industry.
- Observed limitations:
  - Risk weights for credit and market risk vary significantly across banks (BCBS, 2013b; BCBS, 2013d).
  - Hypothetical portfolio exercises revealed notable dispersion in estimates of risk parameters; meaningful part of variability driven by banks’ and supervisory practices.
  - Variability generated concerns about regulatory arbitrage and inconsistent application, challenging effective enforcement of internal model approaches.

### Governance, skills, and supervisory capacity
- Requirements and challenges for banks:
  - Internal model approaches are complex and require specialized skill sets within banks to apply appropriate modeling techniques used in the estimation of risk parameters.
  - Risk governance is crucial across the three lines of defense to ensure oversight at each phase of model development, deployment, and ongoing validation.
- Supervisory resource implications:
  - Accepting internal models for regulatory purposes is resource intensive; supervisors need strong knowledge of econometric and statistical techniques, capital regulation, corporate governance, and risk management.
  - Supervisors may need to authorize many quantitative models, sometimes hundreds, requiring maintenance and monitoring over time.
  - Resource intensity might divert capable supervisors from broader supervisory assessments and actions more important for financial stability.

### Capital outcomes in DEs and advice on implementation
- Capital savings expectation:
  - One driver for banks implementing internal models is expectation of a lower capital charge; however, in DEs this is often not the case.
  - Higher market volatility, probability of defaults, and legal challenges reflecting in higher loss given default may result in capital requirements above those prescribed in standardized approaches.
- Recommended preparatory steps for DEs:
  - No country needs to implement internal models approaches to follow the Basel framework; DEs are not expected to do so.
  - If DEs decide to allow banks to use internal models for regulatory capital purposes, develop a road map to build necessary capacity for supervisors and the banking industry.
  - Road maps should be sufficiently long (several years) and emphasize communication between supervisors and the industry throughout the process.

### Leverage Ratio (LR): relevance and implementation in DEs
- General observations:
  - Typically, the LR is not a relevant binding constraint in DEs.
  - GFC lessons: banks could build up excessive on- and off-balance sheet leverage while still showing relatively strong risk-based capital ratios, in part due to internal model approaches and off-balance sheet exposures not appropriately captured.
  - As banks in DEs do not use internal models extensively and usually have limited derivatives exposures, LR implementation tends to have relatively limited practical impact when calibrated as recommended by Basel.
- Potential uses:
  - LR may help limit excessive exposures of banks to sovereigns and other low RWAs where standardized risk weights may underestimate actual risk and correlations.
  - LR implementation does not preclude other supervisory/regulatory measures that could be more effective.
- Implementation complexity and calibration:
  - LR is meant to be simple and transparent but requires a global measure not biased by accounting differences; calculation of derivatives exposures can be burdensome.
  - DEs without meaningful derivatives exposures should consider simplifying total exposures calculation (e.g., using amounts of derivative exposures already calculated for credit risk purposes).
  - The proposed 3 percent calibration might be too low for the LR to work as an effective backstop in DEs that have implemented risk-based capital requirements higher than international standards.
  - Calibration should be increased when necessary, but ensure LR remains a backstop and not the binding requirement for most banks during the non-boom phase of the financial cycle (Fender and Lewrick, 2015).
  - The 35 percent conversion ratio between the Tier 1 risk-based capital requirements and the LR embedded in the Basel standards is a good reference for appropriate calibration.
  - Example conversion: assuming an 8 percent minimum Tier 1 requirement and a 2.5 percent capital conservation buffer, the LR could be set at 3.5 percent. Eventual surcharges for D-SIBs could follow the Basel approach, creating a leverage buffer that equals 50 percent of the risk-based surcharge (BCBS, 2017).

### Pillars 2 and 3: supervisory review and disclosure
- Role and importance:
  - Pillars 2 and 3 are key components of the Basel capital framework.
  - Robust Pillar 2 implementation, including banks’ assessment of capital adequacy and supervisors’ review, is critical to ensure risks not covered under Pillar 1 are taken into account.
  - Pillar 2 fosters improvements in risk management and requires bank Boards to take responsibility for capital policies.
  - Pillar 3 disclosures are essential to ensure market discipline as a complement to Pillars 1 and 2.
- Implementation priorities and practices for DEs:
  - Pillar 2 implementation is challenging and long-term but should be a priority for DEs; it requires enhancing supervisory capacity and industry practices.
  - Supervisors should have powers to require more capital or liquidity and limit dividend distributions; but corrective measures should also include strengthening provisions/reserves, imposing limits on specific exposures, and improving internal controls and risk management.
  - Failures to comply with Basel Core Principle 11 on corrective and sanctioning powers are frequently observed in IMF/World Bank FSAP assessments and should be addressed promptly.
  - Pillar 2 tools (risk-based supervision, supervisory ratings such as CAMELS, supervisory stress testing, ICAAP) should be integrated into the supervisory approach.
  - Initial ICAAP implementation could focus on large banks; early stages are a learning process requiring intense interaction between banks and supervisors. For instance, smaller banks could be exempted from formal ICAAP submissions in the first three years, or exempted from more complex requirements (e.g., stress testing).
- Pillar 3 disclosures:
  - Revised templates for quantitative disclosures enhance comparability but may be less relevant and costlier for smaller local banks in DEs.
  - Supervisors in DEs should consider simplifying templates, reducing granularity, and disregarding templates covering standards not implemented domestically while maintaining Basel definitions where possible.

### Interest Rate Risk in the Banking Book (IRRBB)
- Definition and significance:
  - IRRBB refers to current or prospective risk to the bank’s capital and earnings from adverse movements in interest rates affecting banking book positions.
  - Changes in interest rates can affect net interest income, profitability, and shareholder value; excessive IRRBB can threaten current capital base and/or future earnings.
- Basel Committee action:
  - BCBS issued standards strengthening IRRBB framework (BCBS, 2016); no agreed Pillar 1 charge due to heterogeneity of the risk, but supervisory expectations and disclosure requirements were enhanced.
  - Updated standardized framework is a useful option for DEs to consider when establishing capital charge.
- DE-specific considerations:
  - IRRBB is often more important to DEs than trading-book risks because trading books may be small.
  - Countries should consider imposing an interest rate risk capital charge even if Pillar 2 is still being developed.
  - Supervisors can apply either a Pillar 1 or Pillar 2 approach:
    - Pillar 2 is more flexible and better accommodates complex business models and heterogeneity across banks but is difficult to implement and enforce.
    - Pillar 1 standardized charge can be preferable when exposures from complex financial products are not substantial or supervisory/bank risk management capacity is still developing.

### Liquidity requirements and the Liquidity Coverage Ratio (LCR)
- Basel III liquidity framework:
  - Introduced prudential ratios and risk management standards: Liquidity Coverage Ratio (LCR) for short-term resilience and Net Stable Funding Ratio (NSFR) for long-term stable funding.
- LCR overview:
  - LCR calculates HQLA divided by total net cash outflows for the scenario for 30 calendar days into the future; absent stress, ratio should be no less than 100 percent.
  - LCR benefits over traditional metrics: calibrated against stressed assumptions, rigorous HQLA eligibility criteria, encourages stronger liability management with differentiated stressed outflow rates.
- Benefits for DEs:
  - More accurate, forward-looking, risk-sensitive measure of liquidity and funding risk using stressed assumptions.
  - Strengthens resilience to short-term liquidity shocks, discourages reliance on short-term funding, and encourages improved liability management.
- Implementation challenges in DEs:
  - Main challenges: availability of HQLA and calibration of stressed outflows.
  - In many DEs, only assets meeting HQLA definitions are government bonds and cash; interbank markets often limited and secondary market liquidity lacking.
  - LCR presumes ability to liquidate HQLA in private markets; reliance on central bank liquidity as primary source is inconsistent with LCR design.
- LCR alternatives and adaptations:
  - Alternative Liquidity Arrangements: Option 1 (use of a central bank liquidity facility), Option 2 (use foreign currency assets for domestic currency needs), Option 3 (additional use of Level 2 assets with higher haircut).
  - These options may help DEs facing HQLA scarcity.
- Implementation sequencing and simplifications:
  - Priority should be robust liquidity risk management standards (BCBS, 2008 principles).
  - DEs should begin with information gathering and liquidity monitoring; design data templates using LCR information but consider simplifying templates by reducing granularity when specific items are not relevant.
  - DEs are encouraged to gain experience with the LCR before imposing it as a minimum requirement, given differences from AEs (e.g., reliance on customer deposits, shallow debt markets, less widespread deposit insurance).
  - Target convergence with the LCR over a time horizon that considers local conditions; many DEs with structural surplus liquidity may meet the 100 percent threshold but may need other adjustments (development of debt/capital markets, investment in deposit product systems to estimate stressed outflows).

*Source: Box 4. Internal Model Approaches in DEs (excerpt).*

### Box 5. Principles for Sound Liquidity Risk Management and Supervision

### Box 5. Principles for Sound Liquidity Risk Management and Supervision

### Overview
- The Sound Principles constitute a comprehensive framework for bank liquidity risk management containing "17 principles" broken into "5 categories": (i) fundamental principle; (ii) governance; (iii) measurement and management; (iv) public disclosure; and (v) the role of supervisors.
- A bank is responsible for the sound management of liquidity risk (Principle 1) and should maintain sufficient liquidity, including a cushion of unencumbered, HQLA, to withstand a range of stress events.
- Supervisors should assess the adequacy of a bank’s liquidity position and risk management framework and take actions early.

### Governance of liquidity risk management (Principles 2–4)
- A bank should clearly articulate a liquidity risk tolerance appropriate for the business strategy.
- Senior management responsibilities:
  - develop strategies, policies and practices to manage liquidity risk within tolerance;
  - continually review strategies, policies and practices.
- Board responsibilities:
  - ultimately responsible for liquidity risks assumed by the bank;
  - should review and approve the liquidity strategy, policies and practices.
- Liquidity costs and benefits should be incorporated into internal pricing and performance management and aligned with incentives.

### Measurement and management of liquidity risk (Principles 5–12)
- A bank should have a sound process for identifying, measuring, monitoring, and controlling liquidity risk within and across legal entities, business lines and currencies, taking into account legal, regulatory, and operational limitations to the transferability of liquidity.
- Funding strategy:
  - establish a funding strategy that provides effective diversification in the sources and tenor of funding.
- Intraday liquidity:
  - actively manage intraday liquidity positions.
- Collateral management:
  - actively manage collateral positions, differentiating between encumbered and unencumbered assets.
- Stress testing:
  - conduct stress tests on a regular basis for a variety of short-term and protracted institution-specific and market-wide stress scenarios (individually and in combination);
  - use stress test outcomes to adjust liquidity risk management strategies, policies, and positions and to develop effective contingency plans.
- Contingency planning:
  - maintain a formal contingency funding plan.
- Liquidity cushion:
  - maintain a cushion of unencumbered, HQLA to be held as insurance against a range of liquidity stress scenarios.

### Public disclosure (Principle 13)
- A bank should publicly disclose information on a regular basis to help market participants make an informed judgement about the soundness of its liquidity risk management framework and liquidity position.

### The role of Supervisors (Principles 14–7)
- Supervisors should regularly perform a comprehensive assessment of a bank’s overall liquidity risk management framework and liquidity position to determine whether they deliver an adequate level of resilience to liquidity stress given the bank’s role in the financial system.
- Supervisory monitoring:
  - supplement regular assessments by monitoring a combination of internal reports, prudential reports and market information.
- Early intervention:
  - intervene early to require effective and timely remedial action to address deficiencies in liquidity risk management processes or liquidity position.
- Cross-border cooperation:
  - communicate with other supervisors and public authorities, such as central banks, both within and across national borders, to facilitate effective cooperation regarding supervision and oversight of liquidity risk management.

### LCR, NSFR and considerations for DEs
- Modifications to the LCR framework may be required with a view to reducing variances over time (Appendix II).
- Implementation challenges in DEs:
  - wide diversity of financial systems in DEs makes standardized approach challenging; modifications may smooth transition;
  - while modifications may be necessary initially, over time modifications can be rolled back so that the LCR and Net Stable Funding Ratio (NSFR) become the minimum standard globally.
- Sovereign bond concentration and HQLA availability:
  - DEs should be mindful of the risk of encouraging excessive concentration of exposures on local sovereign bonds where shallow financial markets limit availability of assets that can be considered HQLAs;
  - the ease with which government bonds can be converted into cash needs to be considered when defining eligibility as HQLA;
  - "In principle, the LCR considers that all sovereign bonds are HQLAs. However, in some cases there is no secondary market for some government bonds, which would imply that the clear majority of them would be held to maturity. (21) In the absence of a secondary market, the question of convertibility to cash hinges on whether banks would be able to post the securities as collateral with the central bank. If some variety of government bonds are not accepted as collateral for central bank operations and there is no meaningful secondary market for them, it might be prudent to restrict their eligibility as HQLAs. (22)"
- Supervisors should monitor and enforce appropriate liquidity standards by currency:
  - where financial systems of some DEs can be highly dollarized, banks should maintain liquid assets consistent with the distribution of their liquidity needs by currency because currencies may not remain transferable during stress.

### Net Stable Funding Ratio (NSFR)
- Purpose:
  - designed to enhance long-term resilience of bank funding models, reducing funding mismatches by requiring banks to fund activities with sufficiently stable sources of funding.
  - focuses on the structural funding profile to mitigate future funding stress.
- Risks of low NSFR:
  - if the NSFR is too low, the average maturity of liabilities might be too short or banks may hold illiquid assets or assets not adequate as collateral for secured borrowings.
- Implementation sequencing and calibration:
  - implementation of the NSFR may be undertaken after the LCR has been fully embedded;
  - many NSFR definitions of assets and liabilities are taken from the LCR;
  - ensure consistent use of definitions before moving to NSFR;
  - calibration of factors for available stable funding and required stable funding needs extensive quantitative analysis of impact on bank liquidity and management of assets and liabilities.
- Remediation of NSFR shortfalls:
  - remediation may require far-reaching changes to a bank’s balance sheet (examples: lengthening maturity profile of liabilities, purchasing assets with low required stable funding factor);
  - adjusting funding structure and asset profile may require changes to business models and strategy;
  - DEs are encouraged to gain experience with the NSFR and fully understand its impact on banks’ behavior before imposing it as a minimum requirement.

*Box 5. Principles for Sound Liquidity Risk Management and Supervision.*

### Appendix I . Prudential S tandards I mplementation S teps

### Appendix I . Prudential S tandards I mplementation S teps

### Indicative roadmap for implementation (sequenced approach)
- a. Draft regulation establishing (or reviewing) the prudential standard and guidance on any changes that are being proposed to other regulations or protocols.
- b. Draft supervisory reporting te mplates associated with new (revised) standard.
- c. Establish a supervisory/industry working group.
- d. Publish draft regulation for consultation.
- e. Conduct a QIS workshop with banks to provide instruction on the new standard and seek views where clarification might be required.
- f. Establish a reporting database.
- g. Conduct a QIS. Detailed guidance should accompany the QIS with a single point of contact for queries. The QIS submission should be accompanied with a reconciliation back to prudential returns and the balance sheet.
- h. Analyze and interpret QIS results, including feedback meetings with banks.
- i. Refine draft framework (regulation, guidance, and reporting templates publication and consultation); if revisions to the draft are meaningful, a new QIS may necessary.
- j. Design phase-in and other transitional arrangements.
- k. Publish final rules and any other amended regulations.
- l. Align relevant regulatory reporting to new standard methodology.
- m. Initiate parallel run period and work with banks to improve data quality.

*See Gambacorta and Marques-Ibanez (2011) for a discussion about credit provision during stress periods and Michelangeli and Sette (2016) for evidence on the supply of mortgages.*

### Appendix II. Guiding Principles for Modifying LCR and Main Issues — Assets
- Chief among the modifications to the LCR framework is the need to adopt a pragmatic approach to HQLA eligibility.
- The strict application of the LCR framework requires supervisors to apply the market liquidity test to assets eligible as HQLA.
- Objective: ensure banks hold assets that can be monetized in private markets in the first instance, but ultimately if private markets fail, the assets can be repo’ed with the central bank.
- The framework does not permit central bank repo eligibility by itself to be counted as HQLA, which is a significant change from many existing coverage ratio regimes across DEs.
- In EMDE markets, the thinness of markets will likely mean private markets are unavailable for most assets in a stress scenario; strict application of the market and fundamental characteristics will render ineligible sovereign and other securities in DEs.
- Practical recommendation: relax the market liquidity test for sovereign bonds to ease implementation given scarcity of liquid assets that meet the LCR definition of HQLA.
- Retain the market and fundamental tests for Level 2 assets while pursuing financial market development as a long-term solution to expand HQLA availability.
- Policy priority: broad-based financial sector development to deepen markets, diversify liquid assets, reduce reliance on the central bank, and help break the sovereign–bank loop so private markets absorb liquidity shocks before central bank intervention.

### Appendix II. Guiding Principles for Modifying LCR and Main Issues — Liabilities
- Challenge: accurately estimating stressed outflow assumptions for liabilities in EMDEs where liabilities are often treated as a homogenous pool and many customer deposits are at call.
- Practical solution: apply a standardized approach — assign a standardized run-off rate to customer deposits (i.e., retail and SME deposits, such as 10 percent), permitting differential treatment in exceptional cases where the bank can demonstrate alignment with the LCR definitions.
- Need to more frequently revise and update run-off assumptions owing to rapidly changing financial markets in DEs; historical run-off rates and assumptions about customer behavior may not be a close proxy for actual or expected stressed outflows.
- Starting point: classify depositors defaulting to the “less stable” outflow rate as a conservative floor; supervisors should classify customer deposits as “less stable” as a floor.
- Questionable applicability: minimum run-off rates prescribed by the LCR may not be applicable for DEs; a generally conservative calibration of weighted liabilities is suggested.
- Note on LCR “stable” retail run-off: run-off rates for “stable” retail deposits in the LCR framework attract a very low run-off rate of 5 percent (and lower if deposit guaranteed), which may not be appropriate given the nature of the deposit market, absent deposit insurance, and other factors.
- Seven characteristics (minimum examples) to determine “stable” vs “less stable” for retail deposits (BCBS, 2013a):
  - (i) not covered by deposit insurance;
  - (ii) high-value deposits;
  - (iii) lack of established relationship;
  - (iv) internet-only savings accounts;
  - (v) high net worth;
  - (vi) withdrawn quickly;
  - (vi) foreign-exchange denominated deposits.
- Calibration guidance: run-off rate calibration should be informed by results from a QIS exercise; the QIS will be a key step given differences between LCR minimum run-off assumptions and DE experience.
- Clarification on the 3 percent run-off: application of the 3 percent run off rate under the LCR needs to satisfy several conditions, such as: classified as stable, a fully funded deposit insurance scheme is in place, and historical run-off rates support the estimate (BCBS, 2013a). The 3 percent run off rate for retail deposits should not be seen as the de facto minimum.

- The decision framework for classification of retail deposits is summarized in Figure A1 (Decision Tree for Classification of Retail Deposits).

*Source: IMF staff.*

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_Source: https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019127.pdf_