BASEL II

Basel II

Basel I

The first Basel agreement came in 1988, following events like the Third World debt crisis.

Basel I was intended to save the banks from the same fate by asking them to keep more capital (8% capital adequacy).

It focused mainly on Credit risk and set minimum levels of capital for banks.

Existing Capital Adequacy Framework: Basel I

The international standards in the field of banking supervision are set by the Basel Committee on Banking Supervision (BCBS).

Basel I has improved capital adequacy of banks globally and fostered competitive equality.

However, recent technological advancement, innovations in financial products and further globalization have underscored the limitations of the current framework:

Risk weightings are too broad-brush and insufficiently risk-sensitive It does not provide incentives for risk mitigation techniques

Shortcomings of Basel I Under the current Accord, capital requirements are only moderately

related to a bank’s risk taking.

The requirement on a credit exposure is the same whether the borrower’s credit rating is AAA or CCC.

During this period (1988-1998), markets for credit derivatives and securitizations grew rapidly, as banks were employing these to take advantage of shortcomings in the 1988 Accord's crude system of risk weights.

Banks are encouraged to structure transactions to minimize regulatory requirements or, in some cases, to undertake transactions whose main purpose is to reduce capital requirements with no commensurate reduction in actual risk taking.

Difference between Basel I and Basel II

Basel I1. Stress on Capital

Adequacy 2. Broad Brush Approach3. Lack of flexibility and

incentives for better Risk Management

4. Use of arbitrary risk categories and risk weightage

5. All assets within the same category assigned equal risk weightage

6. Capital Charge only for Credit Risk and Market Risk

Basel II1. Emphasis on Capital

Enhancement and Capital Optimization

2. Risk Sensitive3. Risk weightage to assets

assigned on the basis of ratings and strength of the assets

4. Incentives for better Risk Management techniques, especially for Credit Risk

5. Capital Charge for Operational Risk also

Risk management has emerged as a key area of focus for banks in recent times especially due to Basel II accord

Corporate Bank Sovereig

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Internal Process

People

External Factors

Interest Rate – in

banking and trading books

Foreign Exchange

Equity

Commodity

Systems Risk Security and Integrity Risk

Operational Risk

Credit Risk

Types of Risks Market Risk

Information Risk

Agenda

Understanding the global trends Evolution of Basel II Basel II – The Three Pillars Capital Adequacy Calculation Overview of the New Basel Capital Accord Credit Risk Measurement Approaches under Pillar I Operational Risk Measurement Approaches under Pillar I Strategic implications on Banking sector Challenges in Basel II implementation Phased approach to migration to Basel II implementation Basel II Survey Conclusions

Top 10 concerns of bankers *

1. Complex Financial Instruments2. Credit risk3. Macro economy4. Insurance5. Business continuation6. International regulation7. Equity markets8. Corporate governance9. Interest rates10.Political shocks

* Banana Skins 2003 – The CSFI’s annual survey of the risks facing banks

Regulatory developments – Basel II and IFRS

1. Complex Financial Instruments IFRS2. Credit risk Basel II3. Macro economy Basel II4. Insurance5. Business continuation6. International regulation IFRS Basel II7. Equity markets8. Corporate governance Basel II9. Interest rates Basel II10.Political shocks

Agenda


The Basel Accord is a constant WIP

July 1988 “Basel Accord”Nov 1991 Amendments for general provisionsJuly 1994 Amendment for re-structured country debtApril 1995 Netting amendments for derivativesJan 1996 Market risk amendmentsApril 1998 Securities firms added to “OECD banks” catJune 1999 CP 1Jan 2002 CP 2Apr 2003 CP 3Jun 2004 Final accord

Existing Basel Capital Accord – Why Changes ?

1988 Capital Accord served the industry well, but

– Severe limitations• Insufficiently sensitive to risk (broad categories)• Very limited account of risk mitigation

– Perverse incentives leading to regulatory arbitrage• To lend to poorer quality credits• To securitise better quality assets

– No incentive structure to improve risk measurement and risk management practice

Basel II : A Major Paradigm Shift

The Existing Accord The New Accord

•Focus on a single risk measure

•More emphasis on banks’ internal methodologies, supervisory review & market discipline

•One size fits all •Flexibility, menu of approaches, capital incentives for good risk management

•Broad brush structure •Increased risk sensitivity

Agenda


Basel II – The Three Pillars

Supervisory Review

Market Discipline

Providing a flexible, risk-sensitive capital management framework

Minimum Capital

Requirements

Basel IIThree Pillars

Advanced methods for capital allocation

Capital charge for operational risk

Focus on internal capabilities

Supervisors to review banks internal assessment and strategies

Focus on disclosure

The Basel Committee recommendations urge banks to adopt more risk sensitive approaches to Risk Management…

The new Basel Accord is based on Three Pillars

Minimum CapitalMinimum Capital Supervisory ReviewSupervisory Review Market DisciplineMarket Discipline

…and has proposed a challenging implementation deadline of 2006 for internationally active banks

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BASEL II Structure

Agenda


Risk Components to Capital Adequacy Calculation

Total CapitalCredit Risk + Market Risk + Operational Risk 8%8%

SignificantlyRefined

New

Unchanged

RelativelyUnchanged

Capital Adequacy under Basel II – Pillar I

Market risk – as per Basel Accord

Credit risk (a) Standardised approach – more granular version of Basel I (b) Foundation IRB – uses banks’ own credit ratings (c) Advanced IRB – other inputs also determined by bank

Operational risk (a) Basic indicator approach - % of revenue (b) Standard indicator approach - % of revenue/assets, by line

of business (c) Advanced Measurement Approach – internal models etc

The credit portfolio of ABC Bank has undergone a uniform downgrade as on 31-3- 2008 after an economic downturn. The position prior to the downgrade is given below:The minimum capital required after downgrade is …………..

Rating Scale Risk Weight (%) ExposureRs. In crores

Extent of downgrade

AAA 20 200 20 %

AA 50 200 20 %

A 50 100 20 %

BBB 100 200 20 %

BB& Below 150 100

800

Minimum capital under Basel II

Rs.48.60 crores

Working

Rating Scale

Risk Weight

Exposure RWABefore down grade

Exposure after Downgrade

RWAAFTER DOWNGRADE

AAA 20% 200 40 160 80

AA 50% 200 100 200 100

A 50% 100 50 120 60

BBB 100% 200 200 180 180

BB & below

150% 100 150 140 210

540 630

The Capital required will be

A]56.7 crores*B]58.6 croresC]60.6 croresD]62.6 crores

Agenda


Overview of the New Basel Capital Accord

Market riskUnchanged from existing Basel

AccordCredit risk Significant change from existing

Basel Accord Three different approaches to the

calculation of minimum capital requirements

Capital incentives to move to more sophisticated credit risk management approaches based on internal ratings

Sophisticated approaches have systems / controls and data collection requirements

Operational risk Not covered in existing Basel

Accord Three different approaches to the

calculation of minimum capital requirements

Adoption of each approach subject to compliance with defined ‘qualifying criteria’

Pillar 1 – Minimum capital requirements Banks should have a process for

assessing their overall capital adequacy and strategy for maintaining capital levels

Supervisors should review and evaluate banks’ internal capital adequacy assessment and strategies

Supervisors should expect banks to operate above the minimum capital ratios and should have the ability to require banks to hold capital in excess of the minimum (cf. trigger / target ratios in UK)

Supervisors should seek to intervene at an early stage to prevent capital falling below minimum levels

Pillar 2 – Supervisory Review Market discipline reinforces

efforts to promote safety and soundness in banks

Core disclosures (basic information) and supplementary disclosures to make market discipline more effective

Pillar 3 – Market Discipline

Agenda


Credit Risk Measurement Approaches under Pillar I

Rating

Criteria

External

Standardized Approach

Internal

Foundation Approach

Internal

Advanced Approach Internal Ratings Based (IRB) Approach

Risk Weight Calibrated on the basis of external ratings by the Basel Committee

Function provided by the Basel Committee

Function provided by the Basel Committee

Probability of Default (PD) the likelihood that a borrower will default over a given time period

Implicitly provided by the Basel Committee; tied to risk weights based on external ratings

Provided by bank based on own estimates


Exposure of Default (EAD): for loans, the amount of the facility that is likely to be drawn if a default occurs

Supervisory values set by the Basel Committee



Loss Given Default (LGD); the proportion of the exposure that will be lost if a default occurs

Implicitly provided by the Basel Committee; tied to risk weights based on external ratings


Provided by bank based on own estimates; extensive process and internal control requirement

Maturity: the remaining economic maturity of the exposure

Implicitly recognition Supervisory values set by the Basel CommitteeOrAt national discretion, provided by bank based on own estimates (with an allowance to exclude certain exposures

Provided by bank based on own estimates (with an allowance to exclude certain exposures)

Credit Risk Measurement Approaches under Pillar I (contd..)

Criteria Standardized Approach Foundation Approach Advanced Approach Internal Ratings Based (IRB) Approach

Credit Risk Mitigation Techniques (CRMT)

Defined by the supervisory regulator; including financial collateral, guarantees, credit derivatives, “netting” (on and off balance sheet), and real estate

All collaterals from Standardized Approach; receivables from goods and services; other physical securities if certain criteria are met

All types of collaterals if bank can prove a CRMT by internal estimation

Maturity: the remaining economic maturity of the exposure

Minimum requirements for collateral management (administration/evaluation)

Provisioning process

Same as Standardized, plus minimum requirements to ensure quality of internal ratings and PD estimation and their use in the risk management process

Same as IRB Foundation, plus minimum requirements to ensure quality of estimation of all parameters

Data Requirements Provision dates Default events Exposure data Customer segmentation Data collateral

segmentation External ratings Collateral data

Rating data Default events Historical data to

estimate PDs (5 years) Collateral data

Same as IRB Foundation, plus: Historical loss data to

estimate LGD (7 years) Historical exposure data to

estimate EAD (7 years)

Agenda


Operational Risk Measurement Approaches under Pillar I

Calculation of Capital charge

Calculation of Capital Charge

Average of gross income over three years as indicator

Capital charge equals 15% of that indicator

Basic Indicator Approach

Gross income per regulatory business line as indicator

Depending on business line, 12%, 15%, or 18% of that indicator as capital charge

Total capital charge equals sum of charge per business line

Standardized Approach

Capital charge equals internally generated measure based on:

– Internal loss data– External loss data– Scenario analysis– Business environment and

internal control factors Recognition of risk mitigation

(up to 20% possible)

Advanced Measurement Approach (AMA)

Qualifying Criteria No specific criteria Compliance with the Basel

Committee’s “Sound Practices for the Management and Supervision of Operational Risk” recommended

Active involvement of board of directors and senior management

Existence of OpRisk management function

Sound OpRisk management system

Systematic tracking of loss data

Market discipline reinforces efforts to promote safety and soundness in banks

Core disclosures (basic information) and supplementary disclosures to make market discipline more effective

Operational risk is inherent to banking business and not received adequate attention in past

Banking

Commercial BankingRetail Banking Payment and

SettlementTreasury

(Trading & Sales)

Sales

Market Making

Proprietary Positions

Treasury

Retail Deposits & Lending

Private Banking

Card Services

Project Finance Payments and Collections

Internal Internal FraudFraud

External External FraudFraud

Employment Employment Practices & Practices & Workplace Workplace

SafetySafety

Clients, Clients, Products Products

& & Business Business PracticesPractices

Physical Physical Damage Damage to Assetsto Assets

Business Business Disruption Disruption

and and System System FailuresFailures

Execution, Execution, Delivery & Delivery &

Process Process ManagemenManagemen

tt

Funds Transfer

Clearing and Settlement

Trade Finance

Working Capital Finance

Advisory Services

ACTIVITY

Operation Risk

categories

Designing and implementing action plans for operational risk management could be in many forms, depending on the bank’s needs . . .

Establish a structured risk management framework for the bank

Redesign process and approach

Strengthen existing controls, policies and procedures

Invest in staff training

Automate processes

Acceptance of risk as cost of doing business

Transfer risk through subcontracting

Contingency plan - Insurance

Create risk awareness culture

Basel accord requires Sound Practices for Management and Supervision of operational Risk

…based on a cost-benefit assessment

Agenda


Strategic implications on Banking sector

Capital release: Prime mortgages High quality corporate lending High quality liquidity portfolios Collaterised & hedged exposures

Capital absorption: Leveraged finance Specialised lending Small business Commitments & pipeline

Opportunities to use surplus capital

Capital requirements

Significant barriers to entry as a bank Increased competition for low risk

customers Disclosure under Pillar III Peer group pressure will lead to adoption

of more advanced approaches Risk Transfer:

- Outside Basel regulated banking system e.g. insurance industry

Wider market

Focus on key products / those with best return on regulatory capital

Impact of differing capital treatment and return transparency will impact product design

Increased risk based product pricing for those on sophisticated credit risk approaches

Those with less sophisticated risk approaches may be priced out of the market

Products

Increased transparency of account profitability

Risk-differentiated customer management through:- Winners:

- Prime mortgage customers- Well rated entities

- Losers:- Small & medium sized businesses- Higher credit risk individuals

CustomersBasel II

Agenda


Challenges in Basel II implementation

Banks

Constituent

Interpret new regulations and understand effects on business Secure and maintain board and senior management sponsorship Face new expectations from regulators, rating agencies, and customers Need to consider whether to target certain customers/products or

eliminate others

Challenges

Customers Face new costs resulting from need to provide lenders with new, timely information

Use key performance indicators to monitor performance Face request for better collateralization Manage rating process

Regulators Need well-trained, educated professionals to fill roles. Create regulation that reflects the linkages among risks Provide incentives for banks to evaluate risks through stress-testing and

scenario analysis

Rating Agencies Seek to improve reputation (national agencies) Maintain high quality of ratings

Financial institutions out of Basel II’s scope

Interpret new regulations and understand effects on business and risk management

Demonstrate quality as Basel II emerges as a best practice standard

Agenda


Phased approach to migration to Basel II implementation

Phase 1

Phase 2

Phase 3

Phase 4

B A S E L I I P R O J E C T M A N A G E M E N T

ORGANIZATION

PROCESSES

METHODS

DATA

SYSTEMS

ASSESS AND PLAN DESIGN AND IMPLEMENTUSE TEST

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Corporate Governance/Risk Management

Credit Risk

Operational Risk

Market and Other Risks

Capital Planning

Disclosure(including linkage to IFRS)

Supervisory Review Process

Agenda


Basel II Survey

245 participants, most from Asia-Pacific

Survey conducted by Ernst & Young in conjunction with AsiaRisk from mid November to early December 2004

Basel II Survey

Two third of respondents indicated that they are either in early stages of implementation or have not yet started

Basel II Survey

Internal rating and its linkage to business processes were identified as key concerns for credit risk management

Basel II Survey

Operational risk management has progressed, while concerns were raised in some quantitative areas

Basel II Survey

Most institutes expect major benefits from Basel II beyond regulatory capital reduction

Agenda


Conclusions

Basel II generally favors retail lending over corporate lending The implementation of Advanced Approaches, such as IRB Approach for credit risk and Advanced Measurement Approach for Operational Risk, require much more preparation and pose several challenges for both the banks as well as the supervisors. The banks would require to meet the minimum requirements relating to internal ratings at the outset and on an ongoing basis. The manpower skills, the IT infrastructure and MIS at the banks would have to be upgraded substantially The supervisors would require developing skills in validation and back testing of models. The banks would need to improve the disclosure practices and adhere to international standards With the focus on regulation and risk management in the Basel II framework gaining prominence, the post Basel II era will belong to the banks who manage their risks effectively.

Conclusions

Basel II will make the world less risky

BASEL II

Documents

Transcript of BASEL II