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Overview of Basel II- Why, What, How and When -
SAARCFINANCE Seminar on Basel II Implementation in South Asia
Islamabad, Pakistan26 June 2008
Jason GeorgeFinancial Staiblilty Institute / Bank for International Settlements
Representative Office for Asia and the PacificHong Kong SAR
2
Agenda
Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil
“Basel II introduces a far more comprehensive framework for regulatory capital and risk management than we have ever known”
Former Basel Committee Chairman Jaime Caruana11 May 2004
3
Capital Adequacy
Supervisors must set prudent and appropriate minimum capital adequacy requirements for banks that reflect the risks that the bank undertakes, and must define the components of capital, bearing in mind its ability to absorb losses. At least for internationally active banks, these requirements must not be less than those established in the applicable Basel requirement.
Core Principle 6, Core Principles for Effective Banking Supervision, October 2006
4
The Case for a Capital Framework
Financial instability is costly to the economy, such as…– Disruption in the distribution of funds – Breakdown in the payment systems– Possibility of international contagion
Therefore, the need for supervision and capital regulation– But the objective should not be to assure that banks
will never fail Capital regulation can have competitive implications
– The need to have internationally harmonised rules for internationally active banks competing with each other
– International versus domestic banks
5
Benefits of Basel I … and Some Issues
Created an internationally recognised standard
– Adopted world-wide
Contributed to financial stability
– Reversed a downward trend in international banks’ capital levels
– Promoted level playing field among internationally-active banks
Relatively simple
Capital requirements not always reflective of economic risk
Does not address innovation in risk measurement and management practices
– Arbitrage opportunities (eg through securitisation)
• Little recognition of credit risk mitigants
“OECD Club-Rule”
6
Objectives of Basel II
Greater use of the roles played by bank management (pillars 1 and 2) and the market (pillar 3)
Better align regulatory capital to underlying risk (economic capital)
Encourage banks to improve risk management capabilities
Comprehensive coverage of risks– Pillar 1: credit, market and operational risk– Pillar 2: all other risks, aspects of pillar 1 risks not
captured in pillar 1, and external factors Applicability to a wider range of banks and systems
(menu of options)
7
Basel II: The Three Pillars
Perfect rules are not feasible- no perfect measurement system- difficult balance between accuracy and simplicity
8
Basel II: The Three Pillars Plus…
Standard isedApproach
Interna lR atings-based
Approach
C redit risk
BasicInd icatorApproach
S tandard isedApproach
AdvancedM easurem entApproaches
O perationalrisk
S tandard isedApproach
M odelsApproach
M arketrisks
R isk w eightedassets
C oreC apita l
Supplem entaryC apita l
D efin ition ofcapita l
M in im um capita lrequirem ents
Supervisory revie wprocess
M arketd iscip line
ThreeBasic P illars
9
Relationship of the Three Pillars
Pillar 1: A quantitative approach to minimum capital requirements
Pillar 2: Banks should have a process for assessing their overall capital adequacy; supervisors will review this process and require additional capital if necessary
Pillar 3: Market participants should have better access to information regarding the credit standing of banks (ie enhanced disclosure)
All three pillars are mutually reinforcing
10
Potential Implications of Basel II
Major improvement in capital regulation– Intended to enhance safety and soundness of the banking
system– Implementation poses significant challenges
Capital requirements more aligned to underlying risks– Less incentives for regulatory arbitrage– Transactions likely to be motivated more by funding and
credit risk management needs– Better risk management and pricing by institutions– More efficient allocation of capital
11
Agenda
Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil
12
Main elements of Basel II
Based on three pillars Revised capital requirements for credit risk, new ones for
operational risk, and hardly changed ones for market risks (1996 amendment)
Menu of approaches for the measurement of risks More recognition of drivers of credit risk
13
Basel II: The three pillars
• Credit risk
• Operational risk
• Market risk
• Bank ICAAP
• Supervisory review
• Enhanced disclosure
14
Capital requirements for credit risk
Several approaches to choose from
– Standardised approach (SA)
– Foundation internal ratings-based approach (FIRB)
– Advanced internal ratings-based approach (AIRB)
15
Credit risk: Standardised approach
Main characteristics
– Closest to 1988 Capital Accord
– OECD/non-OECD distinction for claims on sovereigns replaced
– Riskiness determined by external credit assessments
– Lower risk weights for claims on retail and residential mortgages
– Significantly more recognition of credit risk mitigation techniques
16
1 Risk weighting based on risk weights of sovereign in which the bank is incorporated, but one category less favourable.
2 Risk weighting based on the assessment of the individual bank.3 Claims on banks of an original maturity of less than three months generally receive a weighting
that is one category more favourable than the usual risk weight on the bank’s claim.
C l a i m As s e s s m e n t
A A A - A A-
A+ - A- B B B + -
B B B - B B + - B - B e l o w B - U n r a t ed
S o v e r e i g n s ( E x p o r t c re d i t a g en c i e s )
0 % ( 0 - 1 )
2 0 % ( 2 )
5 0 % ( 3 )
1 0 0 % ( 4 - 6 )
1 5 0 % ( 7 )
1 0 0 %
O p t i o n 1 1 2 0 % 5 0 % 1 0 0 % 1 0 0 % 1 5 0 % 1 0 0 %
B a n k s
O p t i o n 2 2 2 0 %
( 2 0 % ) 3 5 0 %
( 2 0 % ) 3 5 0 %
( 2 0 % ) 3 1 0 0 % ( 5 0 % ) 3
1 5 0 % ( 1 5 0% ) 3
5 0 % ( 2 0 % ) 3
C o rp o r a t e s 2 0 % 5 0 % 1 0 0 % B B + - B B -
1 0 0 % B e l o w B B -
1 5 0 % 1 0 0 %
M o r t g ag e s 3 5 % R e t a i l
O t h e r r e t a i l
7 5 %
Credit risk: Standardised approach
Area of national
discretion
17
Credit risk: IRB approach
Basic principles Relies on a bank‘s internal ratings system Based on three main elements
– Risk components (e.g. PD, LGD, EAD)– Risk weight functions– Minimum requirements
Separate approaches for each portfolio of assets Subject to supervisory validation and approval
18
Credit risk: IRB approach risk weights
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
200%
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
Probability of defailt
Ris
k w
eig
ht
Corporates SME 5mn Retail
19
Operational risk: Definition
Risk of loss resulting from:
Inadequate or failed
– Internal processes– People– Systems
Or from external events
Includes legal risk
Excludes strategic and reputational risk
Includes, but not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements
20
Operational risk: It is not new …. however,
New complex financial products and strategies
Growing reliance on automated technology
Cost reduction strategies
Mergers
Migration to outsourcing
Banks are increasing their operational risk exposure
21
Operational risk: Pillar 1 approaches
Choice of three approaches…– Basic indicator (15% of average gross income over 3
years)– Standardised approach (based on separate scaling
factors for gross income from defined business lines between 12% and 18% gross income)
– Range of advanced methods based on loss experience, subject to additional risk control criteria
22
Pillar 2 – Supervisory review process
• The three pillars together are intended to achieve a level of capital commensurate with a bank‘s overall risk profile
• Pillar 2 is based on four key principles:– Banks‘ own assessment of capital adequacy– Supervisors‘ review of banks‘ capital adequacy
assessment– Capital above regulatory minimums– Supervisory intervention
Foundation = existing supervisory guidance, especially Core Principles for Effective Banking Supervision
23
Rationale for Pillar 2
Encourage banks to utilise better risk management techniques
Ensure banks have adequate capital to support all risks
Focus on internal, not regulatory, capital
Accommodate differences between banks
24
Capital above regulatory minimums
Pillar 1 requirements include a buffer for uncertainties that affect the banking population as a whole
All banks are expected to operate ABOVE the minimum requirement (i.e. not just at 8%!)
Supervisors will need to consider whether the particular features of their banks/markets are adequately covered
25
Pillar 3 – Market Discipline
Disclosure requirements allow market participants to assess key information relating to:
– Scope of application
– Capital
– Risk exposures
– Risk assessment process
Both quantitative and qualitative disclosures
Some disclosures are required in order to use the more advanced Pillar 1 approaches
26
Pillar 3 – Market Discipline
Particularly relevant because internal methodologies allow banks discretion in assessing capital requirements
Disclosures should be consistent with how management and the board assess and manage risks
Pillar 3 disclosures based upon Basel II framework inform the market about a bank’s exposure to risk in a consistent and understandable manner (ie enhanced comparability)
27
Pillar 3 - Achieving Appropriate Disclosures
Supervisors have different powers available to achieve disclosure requirements– Disclosure on safety and soundness grounds– Disclosure of regulatory reports
Mechanisms to enforce requirements– Moral suasion (to change behavior)– Enforcement actions– Financial penalties
Nature of exact measures will depend upon legal powers of the supervisor and nature of any deficiency
Refer to Basel Committee Disclosure Surveys
28
Agenda
Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil
“The implementation of the Basel II framework provides an opportunity for banks and supervisors to strengthen the resilience of the banking system…”
Basel Committee Chairman Nout Wellink4 March 2008
29
Building the Road to the Implementation of Basel II
30
Necessary Steps for Building a Road
1) Assessing the current environment
2) Making a plan:
a) Where should the road lead to?
b) What kind of road are we building?
3) Setting up a project:
a) What is the time schedule for building the road?
b) What is required to build the road to Basel II?
4) Testing (and, if need be, improving) the foundation
5) Constructing the road
31
Where Should the Road Lead To?
Adequately capitalised banks A sounder and safer banking (and financial) system as a
precondition for a stable economy and economic growth
32
Readiness on the Regulators’ Side
Preconditions– Sound macro-economic policies– Legal, accounting, auditing and payment systems– Systemic protection
Institutional setting of the supervisor– Independence, governance, accountability, transparency– Resources, legal power
Control over bank’s structure– Licensing– Ownership– Activities,
acquisitions
Risk management and capital– Provisioning– Large
exposure– Related party
exposure– Liquidity
Banks’ internal control and governance
Account-ing and disclosure
On-site, off- site monitoring
Remedial actions
Consolidated supervision
Home-host cooperation
Basel II framework
33
What Kind of Road are we Building?
34
What Kind of Road are we Building?
35
What Kind of Road are we Building?
The superhighway appears attractive, but traveling at high speeds brings great risks!!
36
What Kind of Road are we Building?
Approaches for credit risk– Simplified standardised approach– Standardised approach– Foundation internal ratings-based approach– Advanced internal ratings-based approach
Approach for operational risk– Basic Indicator approach– Standardised approach– Alternative standardised approach– Advanced measurement approaches
There is not one way to implement Basel II
37
Big banks urge emerging markets to move quickly…
IIF Steering Committee on Regulatory Capital (Nov 2005)
…member banks believe that, as soon as reasonably possible, they and their local jurisdictions should aim to take advantage of … the Internal Ratings Based (IRB) Approaches.
…but the IMF board cautions against moving too quickly…
IMF Executive Board (Nov 2005)
(The Directors) urged staff to be completely candid when asked to assess countries’ readiness to move to Basel II and to indicate clearly the risks of moving too quickly and too ambitiously.
38
Basel II Implementation…(when do we build the road?)
When should Basel II be implemented?– Only national authorities can answer this question– Basel II may be a lesser priority compared to other efforts
Depending on a bank‘s business, the 1988 Accord may remain an alternative
– But principles of Basel II are valuable for supervisors and banks in all markets
In their assessments of a country’s compliance with Core Principle 6 the IMF and the World Bank will not assess compliance based on whether or not a country has implemented Basel II. (IMF staff note, 23 April 2004)
39
What is Required to Build the Basel II Road?
Implementing Basel II is a major challenge for banks and supervisors
Assessing resource and training needs– Human resources– Financial resources– Information systems
Ongoing communication between supervisors and between supervisors and banks
40
Solid Foundation
A solid foundation is essential for building a road Basel II requires an appropriate infrastructure
– Otherwise there could be a false sense of financial stability
Preconditions for Core Principles are fundamental Compliance with Core Principles is crucial
– System of effective supervision must exist in a country– Sound accounting and provisioning standards
41
The Construction Process – Practical Steps for Implementation Transform the framework into enforceable rules Implementation
– Minimum capital ratio – is 8% enough (the speed limit)– Deciding on the use of national discretion– Accord Implementation Group– Determining the scope of application of Basel II
Paper on “practical considerations” published in July 2004– Intended as a “roadmap” for implementation
42
Areas of National Discretion
Recognises countries‘ different realities Essential part to ensure that the implementation is to be a
success Supervisors should develop policy decisions on the whole
range of issues (Annex of “practical considerations paper“)– Draw upon domestic market practice and experience– Be consistent with the Basel II principles
Share information with other supervisors
43
Think About the Intersections
44
Think About the Intersections
Cross-border implementation as a major issue Relationship between home and host supervisor Examples
– HSBC has offices over 80 countries and jurisdictions – Citigroup has offices in approximately 90 countries and
jurisdictions– Barclays has offices in over 60 countries
45
Agenda
Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil
“This document is being circulated to supervisory authorities worldwide with a view to encouraging them to consider adopting this revised Framework at such time as they believe is consistent with their broader supervisory priorities.”
Basel II Framework, para 3June 2006
46
Basel II Implementation in Asia
Implementation status
Credit Risk Operational Risk
Australia SA: 01.01.2008
FIRB: 01.01.2008
AIRB: 01.01.2008
BIA: 01.01.2008
SA: 01.01.2008
AMA: 01.01.2008
China SA: Not permitted
FIRB: 31.12.2010/2013*
AIRB: 31.12.2010/2013*
BIA: Undecided
SA: Undecided
AMA: Undecided
Hong Kong SA: 01.01.2007
FIRB: 01.01.2007
AIRB: 01.01.2008
BIA: 01.01.2007
SA: 01.01.2007
AMA: Not permitted
* Only for internationally active banks; banks can implement IRB as early as 31.12.2010 but must have implemented it by 31.12.2013.
47
Basel II Implementation in Asia
Implementation status
Credit Risk Operational Risk
India SA: 31.03.2008/2009*
FIRB: Undecided
AIRB: Undecided
BIA: 31.03.2008/2009*
SA: Undecided
AMA: Undecided
Japan SA: 01.04.2007
FIRB: 01.04.2007
AIRB: 01.04.2008
BIA: 01.04.2007
SA: 01.04.2007
AMA: 01.04.2008
Korea SA: 01.01.2008
FIRB: 01.01.2008
AIRB: 01.01.2009
BIA: 01.01.2008
SA: 01.01.2008
AMA: 01.01.2009
* 31.03.2008 for Indian banks having foreign presence and foreign banks operating in India; 31.03.2009 for all other domestic banks.
48
Basel II Implementation in Asia
Implementation status
Credit Risk Operational Risk
Malaysia SA: 01.01.2008
FIRB: 01.01.2010
AIRB: 01.01.2010
BIA: 01.01.2008/2010*
SA: 01.01.2008/2010*
AMA: Undecided
Singapore SA: 01.01.2008
FIRB: 01.01.2008
AIRB: 01.01.2008
BIA: 01.01.2008
SA: 01.01.2008
AMA: 01.01.2008
Thailand SA: 31.12.2008
FIRB: 31.12.2008
AIRB: 31.12.2009
BIA: 31.12.2008
SA: 31.12.2008
AMA: Not permitted
* 01.01.2008 for Malaysian banks that are adopting the SA for credit risk; 01.01.2010 for banks that are adopting an IRB approach for credit risk.
49
Basel II Implementation - Other Regions
Implementation status
Credit Risk Operational Risk
Basel Committee (ex US and Japan)
SA: 01.01.2007
FIRB: 01.01.2007
AIRB: 01.01.2008
BIA: 01.01.2007
SA: 01.01.2007
AMA: 01.01.2008
United States Currently only applies to the 10-15 largest banks (core banks)*
Only advanced approaches permitted Parallel run to begin 2009(?); minimum four
quarters of testing, followed by a … Three year transitional period (capital floors) 01.10.2008 implementation plan adoption
* US regulators will publish rules permitting the use of standardised approach for non-core banks
50
Basel II Implementation in Asia
Implementation challenges Supervisory infrastructure (laws, regulations, accounting
standards, supervisory guidance, Core Principles, etc) Pillar 2
– Banks: developing a robust ICAAP– Supervisors: understanding how to assess an ICAAP
and developing appropriate & proportionate responses Common reporting framework (eg Pillar 3) Data Resources and training
51
Agenda
Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil
“The new framework is designed to evolve over time and adapt to innovations in banking and financial markets…”
Federal Reserve Board Chairman Ben Bernanke2 November 2007
52
Basel II and the Current Market Turmoil
The build-up to, and unfolding of the financial turmoil took place in a Basel I environment– Lack of risk sensitivity– Inflexibility to rapid innovation– Perverse incentives to move exposures off the balance
sheet– Failure to fully capture important elements of a bank’s
risk exposures Basel II needs timely implementation
– The starting point for improving capital adequacy in banks is the timely implementation of Basel II
53
Basel II and the Current Market Turmoil
Pillar 1 (minimum capital requirements) The Basel Committee will revise Basel II to…
– Establish higher capital requirements for complex structured products• These have produced a majority of the losses
– Strengthen the capital treatment of liquidity facilities extended to support off-balance sheet vehicles (2008)
– Strengthen the capital requirements in the trading book• Trading assets, especially complex, less liquid
products, have increased significantly
54
Basel II and the Current Market Turmoil
Pillar 2 (risk management practices) The market turmoil has revealed significant risk
management weaknesses in financial institutions Pillar 2 provides supervisors with tools to assess risk
management and internal capital management processes The Basel Committee will issue Pillar 2 guidance to help
strengthen risk management and supervisory processes– Management of firm-wide risks– Stress testing practices and capital planning processes– Management of off-balance sheet exposures– Supervisory assessment of valuation practices
55
Basel II and the Current Market Turmoil
Pillar 3 (disclosure practices) Weaknesses in bank transparency for complex products
contributed to the build-up of concentrations in illiquid structured credit products
Enhanced disclosures relating to (2009)…– Complex securitisation exposures– ABCP conduits– Sponsorship of off-balance sheet vehicles (eg SIVs)
Other The Basel Committee will assess the level and cyclicality
of capital requirements over time (2008)
Overview of Basel II- Why, What, How and When -
Jason George
Financial Stability Institute
Bank for International Settlements
Representative Office for Asia and the Pacific
Hong Kong SAR
(852) 2878 7109