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BSPs NEW RISK-BASED

CAPITAL ADEQUACY FRAMEWORK


(Exposure draft)


























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Table of contents


Introduction 3
Part I: Risk-based capital adequacy ratio 4
Part II: Qualifying capital. 5
Part III: Credit risk-weighted assets.. 12
Part IV: Credit derivatives... __
Part V: Securitization __
Part VI: Market risk-weighted assets. 25
Part VII: Operational risk-weighted assets 28
Part VIII: Disclosures in the annual reports.. 30




































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BSPs NEW RISK-BASED CAPITAL ADEQUACY FRAMEWORK
(Exposure draft)

INTRODUCTION


This exposure draft outlines the Bangko Sentral ng Pilipinas (BSP) proposed
implementing guidelines of the revised International Convergence of Capital
Measurement and Capital Standards, or popularly known as Basel 2. Basel 2 is
the new international capital standards set by the Basel Committee on Banking
Supervision (BCBS)
1
. It aims to replace Basel 1, which was issued in 1988 with
an amendment in 1996, to make the risk-based capital framework more risk-
sensitive.

The contents of this exposure draft are borne out of BSPs nearly 4 years of
close monitoring of developments in the BCBS and close coordination with other
banking supervisors in the Asia-Pacific region through policy-oriented meetings.
This exposure draft also takes into account the results of the quantitative impact
study conducted by the BSP from late 2002 to early 2003.

This exposure draft applies to all universal banks and commercial banks, as well
as their thrift bank and rural bank subsidiaries and affiliates
2
. Other thrift banks
and rural banks shall continue to be subject to the current risk-based capital
adequacy framework, but with additional disclosure requirements. The
framework for these new disclosure requirements will be issued in due time.

The aim of this exposure draft is to solicit comments from all interested parties.
Comment period will be until end-September 2005. The new framework is set to
be implemented in 2007, as stated in the BSP memorandum to all banks dated
13 December 2004.








1
The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was
established by the central bank governors of the Group of Ten countries in 1975. It consists of senior
representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany,
Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the
United States. It usually meets at the Bank for International Settlements in Basel, Switzerland where its
permanent Secretariat is located.
2
This exposure draft applies only to thrift bank and rural bank affiliates that are 20% to 50% owned by the
parent universal bank or commecial bank.


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Part I. Risk-based capital adequacy ratio

1. The risk based capital adequacy ratio (CAR) of universal banks (UBs) and
commercial banks (KBs), expressed as a percentage of qualifying capital to
risk-weighted assets, shall not be less than ten per cent (10%).

2. Qualifying capital is computed in accordance with the provisions of Part II.
Risk weighted assets is the sum of (1) credit-risk weighted assets (Parts III,
IV.A., and ), (2) market risk weighted assets (Part VI), and (3) operational risk
weighted assets (Part VII)

3. The CAR requirement will be applied to all UBs and KBs on both solo and
consolidated bases. The application of the requirement on a consolidated
basis is the best means to preserve the integrity of capital in banks with
subsidiaries by eliminating double gearing. However, as one of the principal
objectives of supervision is the protection of depositors, it is essential to
ensure that capital recognized in capital adequacy measures is readily
available for those depositors. Accordingly, individual banks should likewise
be adequately capitalized on a stand-alone basis.

4. To the greatest extent possible, all banking and other relevant financial
activities (both regulated and unregulated) conducted by a bank and its
subsidiaries will be captured through consolidation. Thus, majority-owned or
-controlled financial allied undertakings should be fully consolidated.
Exemptions from consolidation shall only be made in cases where such
holdings are acquired through debt previously contracted and held on a
temporary basis, are subject to different regulation, or where non-
consolidation for regulatory capital purposes is otherwise required by law. All
cases of exemption from consolidation must be made with prior clearance
from the BSP.


















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Part II. Qualifying capital

1. Qualifying capital consists of Tier 1 (core) capital and Tier 2 (supplementary)
capital elements, net of required deductions from capital.

A. Tier 1 Capital

2. Tier 1 capital is the sum of:

a. Paid-up common stock;
b. Paid-up perpetual and non-cumulative preferred stock;
c. Common stock dividends distributable;
d. Perpetual and non-cumulative preferred stock dividends distributable;
e. Surplus;
f. Surplus reserves;
g. Undivided profits (for domestic banks only); and
h. Minority interest in the equity of subsidiary financial allied undertakings
which are less than wholly-owned: Provided, That a bank shall not use
minority interests in the equity accounts of consolidated subsidiaries as
avenue for introducing into its capital structure elements that might not
otherwise qualify as Tier 1 capital or that would, in effect, result in an
excessive reliance on preferred stock within Tier 1:

Less:

i. Common stock treasury shares;
ii. Perpetual and non-cumulative preferred stock treasury shares;
iii. Net unrealized losses on underwritten listed equity securities purchased;
iv. Unbooked valuation reserves and other capital adjustments based on the
latest report of examination as approved by the Monetary Board;
v. Total outstanding unsecured credit accommodations, both direct and
indirect, to directors, officers, stockholders and their related interests
(DOSRI);
vi. Deferred income tax; and
vii. Goodwill relating to subsidiary securities brokers/dealers and insurance
companies, and consolidated subsidiaries.

3. In the case of foreign banks, Tier 1 capital is equivalent to:

a. Permanently assigned capital including earnings not remitted to the head
office which the bank elects to consider as part of assigned capital (in
which case it can no longer be remitted to the head office); and
b. Net due to head office, branches, subsidiaries and other offices outside
the Philippines (inclusive of earnings not remitted to head office per
Subsec. X121.5.c of the MORB), up to the extent of 4x the permanently


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assigned capital, or 3x of permanently assigned capital for foreign bank
branches authorized to operate as UBs,

Less:
i. Unbooked valuation reserves and other capital requirements as may be
required by the BSP;
ii. Total outstanding unsecured credit accommodations, both direct and
indirect, to DOSRI;
iii. Deferred income tax, and
iv. Any balance in the Net due from account.

B. Tier 2 Capital

4. Tier 2 capital is the sum of upper Tier 2 capital and lower Tier 2 capital.

5. The total amount of lower Tier 2 capital that may be included in total Tier 2
capital shall be limited to a maximum of 50% of total Tier 1 capital (net of the
required deductions). The total amount of upper and lower Tier 2 capital that
may be included in total qualifying capital shall be limited to a maximum of
100% of total Tier 1 capital (net of required deductions).

6. Upper Tier 2 capital consists of:

a. Paid-up perpetual and cumulative preferred stock;
b. Paid-up limited life redeemable preferred stock issued with the condition
that redemption thereof shall be allowed only if the shares redeemed are
replaced with at least an equivalent amount of newly paid-in shares so
that the total paid-in capital stock is maintained at the same level prior to
redemption;
c. Perpetual and cumulative preferred stock dividends distributable;
d. Limited life redeemable preferred stock with the replacement
requirement upon redemption dividends distributable;
e. Appraisal increment reserve bank premises, as authorized by the
Monetary Board;
f. Net unrealized gains on underwritten listed equity securities purchased
subject to a 55% discount;
g. General loan loss provision, limited to a maximum of 1.25% of gross risk-
weighted assets, and any amount in excess thereof shall be deducted
from the total risk-weighted assets in computing the denominator of the
risk-based capital ratio;
h. With prior BSP approval, unsecured subordinated debt with a minimum
original maturity of at least ten (10) years issued subject to the conditions
in paragraph 10, in an amount equivalent to its book value discounted by
the following rates:




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Remaining maturity Discount factor
>5 years 0%
4 years to <5 years 20%
3 years to <4 years 40%
2 years to <3 years 60%
1 year to <2 years 80%
Less than 1 year 100%

i. Deposit for common stock subscription; and
j. Deposit for perpetual and non-cumulative preferred stock subscription:

Less:

i. Perpetual and cumulative preferred stock treasury shares;
ii. Limited life redeemable preferred stock treasury shares with the
replacement requirement upon redemption; and
iii. Sinking fund for redemption of limited life redeemable preferred stock
with the replacement requirement upon redemption.

7. Lower Tier 2 capital consists of:

a. Paid-up limited life redeemable preferred stock without the replacement
requirement upon redemption in an amount equivalent to its book value
discounted by the following rates:

Remaining maturity Discount factor
>5 years 0%
4 years to <5 years 20%
3 years to <4 years 40%
2 years to <3 years 60%
1 year to <2 years 80%
Less than 1 year 100%

b. Limited life redeemable preferred stock without the replacement
requirement upon redemption dividends distributable;
c. With prior BSP approval, unsecured subordinated debt with a minimum
original maturity of at least five (5) years, issued subject to the conditions
in paragraph 11, in an amount equivalent to its book value discounted by
the following rates:

Remaining maturity Discount factor
>5 years 0%
4 years to <5 years 20%
3 years to <4 years 40%


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2 years to <3 years 60%
1 year to <2 years 80%
Less than 1 year 100%

d. Deposit for perpetual and cumulative preferred stock subscription; and
e. Deposit for limited life redeemable preferred stock subscription with the
replacement requirement upon redemption.

Less:

i. Limited life redeemable preferred stock treasury shares without the
replacement requirement upon redemption; and
ii. Sinking fund for redemption of limited life redeemable preferred stock
without the replacement requirement upon redemption up to the extent of
the balance of redeemable preferred stock after applying the cumulative
discount factor.

C. Deductions from the total of Tier 1 and Tier 2 capital

8. The following items should be deducted from the total of Tier 1 and Tier 2
capital:

a. Investments in equity of unconsolidated subsidiary banks and other
financial allied undertakings, but excluding securities brokers/dealers
insurance companies (for solo basis);
b. Investments in debt capital instruments of unconsolidated subsidiary
banks (for solo basis);
c. Investments in equity of subsidiary insurance companies and non-
financial allied undertakings (for both solo and consolidated bases);
d. Significant minority investments (20%-50%) in financial allied
undertakings (for both solo and consolidated bases);
e. Capital shortfalls of unconsolidated subsidiary securities brokers/dealers
and insurance companies (for both solo and consolidated bases);
f. Reciprocal investments in equity of other banks/enterprises; and
g. Reciprocal investments in unsecured subordinated term debt instruments
of other banks/quasi-banks, in excess of the lower of (i) an aggregate
ceiling of 5% of total Tier 1 capital of the bank; or (ii) 10% of the total
outstanding unsecured subordinated term debt issuance of the other
bank/quasi-banks.

9. Any asset deducted from qualifying capital in computing the numerator of the
risk-based capital ratio shall not be included in the risk-weighted assets in
computing the denominator of the ratio.

D. Eligible unsecured subordinated debt



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10. Unsecured subordinated debt issuances by banks should comply with the
following minimum conditions in order to be eligible as upper Tier 2 capital:

a. It must not be secured nor covered by a guarantee of the issuer or
related party.
b. It must be subordinated in the right of payment of principal and interest to
all depositors and other creditors of the bank, except those creditors
expressed to rank equally with, or behind holders of the debt.
Subordinated creditors must waive their right to set off any amounts they
owe the bank against subordinated amounts owed to them by the bank.
The issue documentation must clearly state that the debt is
subordinated.
c. It must be fully paid-up. Only the net proceeds actually received from
debt issues can be included as capital. If the debt is issued at a
premium, the premium cannot be counted as part of capital.
d. It must not be redeemable at the initiative of the holder.
e. It must not contain any clause which requires acceleration of payment of
principal, except in the event of insolvency;
f. It must not be repayable prior to maturity without the prior consent of the
BSP, except that repayment may be allowed in connection with a call
option only after a minimum of five (5) years from issue date and only if

- The banks capital ratio is at least equal to the required minimum capital
ratio; and
- The debt is simultaneously replaced with issues of new capital which is
neither smaller in size nor of lower quality than the original issue;
g. It may allow a moderate step-up in the interest rate in conjunction with a
call option, only if the step-up occurs at a minimum of ten (10) years after
the issue date and if it results in an increase over the initial rate that
is not more than 100 basis points. Only one (1) rate step up shall be
allowed over the life of the instrument.
h. It must provide for possible conversion into common shares or preferred
shares or possible deferral of payment of principal and interest if the
banks capital ratio becomes less than the required minimum capital
ratio.
i. It must provide for the principal and interest on the debt to absorb losses
where the bank would not otherwise be solvent.
j. It must allow deferment of interest payment on the debt in the event of,
and at the same time as, the elimination of dividends on all outstanding
common or preferred stock of the issuer. It is acceptable for the deferred
interest to bear interest, but the interest rate payable on deferred interest
should not exceed market rates.
k. It must be underwritten by a third party not related to the issuer bank nor
acting in reciprocity for and in behalf of the issuer bank.
l. It must be issued in minimum denominations of at least five hundred
thousand pesos (P500,000.00) or its equivalent; and


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m. It must clearly state on its face that it is not a deposit and is not insured
by the Philippine Deposit Insurance Corporation (PDIC).

11. Unsecured subordinated debt issuances by banks should comply with the
following minimum conditions in order to be eligible as lower Tier 2 capital:

a. It must not be secured nor covered by a guarantee of the issuer or
related party.
b. It must be subordinated in the right of payment of principal and interest to
all depositors and other creditors of the bank, except those creditors
expressed to rank equally with, or behind holders of the debt.
Subordinated creditors must waive their right to set off any amounts they
owe the bank against subordinated amounts owed to them by the bank.
The issue documentation must clearly state that the debt is
subordinated.
c. It must be fully paid-up. Only the net proceeds actually received from
debt issues can be included as capital. If the debt is issued at a
premium, the premium cannot be counted as part of capital.
d. It must not be redeemable at the initiative of the holder.
e. It must not contain any clause which requires acceleration of payment of
principal, except in the event of insolvency.
f. It must not be repayable prior to maturity without the prior consent of the
BSP. However, repayment may be allowed in connection with a call
option only after a minimum of five (5) years from issue date and only if
? The banks capital ratio is at least equal to the required minimum
capital ratio, and
? The debt is simultaneously replaced with issues of new capital which
is neither smaller in size nor of lower quality than the original issue.
g. It may allow a moderate step-up in the interest rate in conjunction with a
call option, only if the step-up occurs at a minimum of five (5) years after
the issue date and if it results in an increase over the initial rate that is
not more than 100 basis points or 50% of the initial credit spread, at the
option of the bank. Only one (1) rate step up shall be allowed over the
life of the instrument.
h. It must be underwritten by a third party not related to the issuer bank nor
acting in reciprocity for and in behalf of the issuer bank.
i. It must be issued in minimum denominations of at least five hundred
thousand pesos (P500,000.00) or its equivalent.
j. It must clearly state on its face that it is not a deposit and is not insured
by the Philippine Deposit Insurance Corporation (PDIC).

12. Unsecured subordinated debt denominated in foreign currency shall be
revalued periodically (at least monthly) in Philippine peso at the prevailing
exchange rate using the same exchange rate used for revaluation of foreign
currency-denominated assets, liabilities and forward contracts under existing
regulations.


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13. For purposes of reserve requirement regulation, unsecured subordinated debt
shall not be treated as time deposit liability, deposit substitute liability or other
forms of borrowings.












































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Part III. Credit risk-weighted assets

A. Risk-weighting

1. Banking book exposures shall be risk-weighted based on third party credit
assessment of the individual exposure given by external credit assessment
institutions recognized as eligible for capital purposes by the BSP. Table 1
sets out the mapping of external credit assessments with the corresponding
risk weights for banking book exposures. Exposures that are not explicitly
addressed in this Section will retain the current treatment; however,
exposures related to credit derivatives and securitisation are dealt with in Part
IV and V, respectively. Exposures should be risk-weighted net of specific
provisions.

STANDARDIZED CREDIT RISK WEIGHTS
Credit Assessment
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AAA AA+ to
AA-
A+ to A- BBB+ to
BBB-
BB+ to
BB-
B+ to B- Below B- Unrated
Sovereigns 0% 0% 20% 50% 100% 100% 150% 100%
MDBs 0% 20% 50% 50% 100% 100% 150% 100%
Banks 20% 20% 50% 50% 100% 100% 150% 100%
Foreign PSEs 20% 20% 50% 50% 100% 100% 150% 100%
Corporates 20% 20% 50% 100% 100% 150% 150% 100%
Housing loans 50%
LGU Bonds
Qualified 50%
Others 100%
SME
Qualified portfolio 75%
Other SME
exposures 100%
Non-performing
exposures
Housing loans 100%
Others 150%
ROPOA 150%
All other assets 100%

Sovereign Exposures

2. These include all exposures to central governments and central banks of
foreign countries. All exposures to the Philippine National Government (NG)
and the Bangko Sentral ng Pilipinas (BSP) shall be risk weighted at 0%.


3
The notations follow the methodology of Standard & Poors, The mapping of ratings of all recognized
external rating agencies is in Part III.C.


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MDB Exposures

3. These include all exposures to multilateral development banks (e.g., the
World Bank Group, Asian Development Bank (ADB), Bank for International
Settlements (BIS), African Development Bank (AfDB), etc.).

Bank Exposures

4. These include all exposures to foreign- and Philippine-incorporated banks, as
well as Philippine-incorporated quasi-banks.

Foreign PSE Exposures

5. These include all exposures to non-central government public sector entities
of foreign countries.

Corporate Exposures

6. These include all exposures to business entities, which are not considered as
SMEs, whether in the form of a corporation, partnership, or sole-
proprietorship. These also include all exposures to financial institutions not
falling under the definition of Bank above.

Housing Loans

7. These include all current loans for housing purpose, fully secured by first
mortgage on residential property that is or will be occupied by the borrower.

LGU Bonds

Qualified

8. Local government unit (LGU) bonds which are covered by Deed of
Assignment of Internal Revenue Allotment of the LGU and guaranteed by the
LGU Guarantee Corporation.

Others

9. All other LGU bonds not included in paragraph 8 above.

SME

10. An exposure must meet the following criteria to be considered as a SME
exposure:



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a) The exposure must be to a small, medium or micro business enterprise as
defined under existing BSP regulations (i.e., business enterprises with
asset size of P100 million and below); and

b) The exposure must be in the form of direct loans, or unavailed portion of
committed credit lines and other business facilities such as outstanding
guarantees issued and unused letters of credit, provided that the credit
equivalent amounts thereof shall be determined in accordance with the
methodology for off-balance sheer items.

Qualified portfolio

11. For a banks portfolio of SME exposures to be considered as qualified, it must
be a highly diversified portfolio, i.e., it has at least 500 borrowers that are
distributed over a number of industries. Moreover, the SME portfolio must
have a past due ratio not exceeding 5% for each of the immediately
preceding three (3) years.

Others

12. All other SME exposures not belonging to qualified portfolios as defined in
paragraph 11 above.

Non-performing Exposures

Housing loans

13. These include non-performing loans for housing purpose, fully secured by first
mortgage on residential property that is or will be occupied by the borrower.

Others

14. These include all other non-performing loans, as well as non-performing debt
securities.

15. Non-performing debt securities are defined as follows:

a) For zero-coupon debt securities, and debt securities with quarterly, semi-
annual, or annual coupon payments, they shall be considered non-
performing when principal and or coupon payment is unpaid for thirty (30)
days or more after due date.

b) For debt securities with monthly coupon payments, they shall be
considered non-performing when three (3) or more coupon payments are
in arrears: Provided, however, That when the total amount of arrearages
reaches twenty percent (20%) of the total outstanding balance of the debt


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security, the total outstanding balance of the debt security shall be
considered as non-performing.

ROPOA

16. All real and other properties owned and acquired.

Other assets

17. The standard risk weight for all other assets will be 100%. The treatment of
credit derivatives and securitisation exposures are presented separately in
Part IV and V, respectively. Investments in equity or regulatory capital
instruments issued by banks or other financial institutions will be risk weighted
at 100%, unless deducted from the capital base according to Section I.

Off-balance sheet items

18. For off-balance sheet items, the risk-weighted amount shall be calculated
using a two-step process. First, the credit equivalent amount of an off-
balance sheet item shall be determined by multiplying its notional principal
amount by the appropriate credit conversion factor, as follows:

a) 100% credit conversion factor - this shall apply to direct credit
substitutes, e.g., general guarantees of indebtedness (including standby
letters of credit serving as financial guarantees for loans and securities)
and acceptances (including endorsements with the character of
acceptances), and shall include:

i. Outstanding guarantees issued foreign loans;
ii. Outstanding guarantees issued other than foreign loans and
shipside bonds/airway bills; and
iii. Export letters of credit confirmed

b) 50% credit conversion factor this shall apply to certain transaction-
related contingent items, e.g., performance bonds, bid bonds, warranties
and standby letters of credit related to particular transactions, and shall
include:

i. Standby letters of credit domestic (net of margin deposit),
established as a guarantee that a business transaction will be
performed; and
ii. Standby letters of credit foreign (net of margin deposit)

This shall also apply to

i. Note issuance facilities and revolving underwriting facilities; and


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ii. Other commitments, e.g., formal standby facilities and credit lines
with an original maturity of more than one (1) year. This shall
include underwritten accounts unsold.

c) 20% credit conversion factor this shall apply to short-term, self-
liquidating trade-related contingencies, e.g., documentary credits
collateralized by the underlying shipments, and shall include:

i. Outstanding guarantees issued shipside bonds/airways bills;
ii. Domestic letters of credit outstanding (net of margin deposit);
iii. Sight import letters of credit outstanding (net of margin deposit);
iv. Usance import letters of credit outstanding (net of margin deposit);
v. Deferred letters of credit (net of margin deposit);
vi. Revolving letters of credit (net of margin deposit) arising from
movement of goods and/or services; and
vii. Export letters of credit (net of margin deposit).

This shall also apply to commitments with an original maturity of up to
one (1) year, and shall include committed credit line for commercial
paper issues.

d) 0% credit conversion factor this shall apply to commitments which can
be unconditionally cancelled at any time, and shall include committed
credit line for commercial paper issues.

This shall also apply to those not involving credit risk, and shall include:

i. Inward bills for collection;
ii. Outward bills for collection;
iii. Items held for safekeeping/custodianship;
iv. Trust department accounts;
v. Late deposits/payments received;
vi. Items held as collaterals;
vii. Travelers checks; etc.

19. The credit equivalent amount shall be treated like any on-balance sheet
asset and shall be assigned the appropriate risk weight, i.e., according to
the third party credit assessment of the counterparty exposure.

20. For derivative contracts, the credit equivalent amount shall be the sum of the
current credit exposure (or replacement cost) and an estimate of the
potential future credit exposure (or add-on). However, the following shall not
be included in the computation:

a) Instruments which are traded in an exchange where they are subject to
daily receipt and payment of cash variation margin; and


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b) Exchange rate contract with original maturity of 14 calendar days or less.

21. The current credit exposure shall be the positive mark-to-market value of the
contract (or zero if the mark-to-market value is zero or negative). The
potential future credit exposure shall be the product of the notional principal
amount of the contract multiplied by the appropriate potential future credit
conversion factor, as indicated below:


Residual Maturity
Interest
Rate Contract
Exchange
Rate Contract

One (1) year or less 0.0% 1.0%
Over one (1) year to five
(5) years
0.5% 5.0%
Over five (5) years 1.5% 7.5%

Provided, That:

a) For contracts with multiple exchanges of principal, the factors are to be
multiplied by the number of remaining payments in the contract;

b) For contracts that are structured to settle outstanding exposure following
specified payment dates and where the terms are reset such that the
market value of the contract is zero on these specified dates, the residual
maturity would be set equal to the time until the next reset date, and in
the case of interest rate contracts with remaining maturities of more than
one (1) year that meet these criteria, the potential future credit
conversion factor is subject to a floor of five tenths percent (0.5%); and

c) No potential future credit exposure shall be calculated for single currency
floating/floating interest rate swaps, i.e., the credit exposure on these
contracts would be evaluated solely on the basis of their mark-to-market
value. However, for contracts with multiple exchanges of principal, the
factors are to be multiplied by the number of remaining payments in the
contract.

22. The credit equivalent amount shall be treated like any on-balance sheet
asset, and shall be assigned the appropriate risk weight, i.e., according to
the third party credit assessment of the counterparty exposure.

B. Credit risk mitigation

23. Banks use a number of techniques to mitigate the credit risks to which they
are exposed. For example, exposures may be collateralized by first priority


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claims, in whole or in part with cash or securities, or a loan exposure may be
guaranteed by a third party.

24. In order for banks to obtain capital relief for any use of CRM techniques, all
documentation used in collateralized transactions and for documenting
guarantees must be binding on all parties and legally enforceable in all
relevant jurisdictions. Banks must have conducted sufficient legal review to
verify this and have a well-founded legal basis to reach this conclusion, and
undertake such further review as necessary to ensure continuing
enforceability.

25. The effects of CRM will not be double counted. Therefore, no additional
supervisory recognition of CRM for regulatory capital purposes will be
granted on claims for which an issue-specific rating is used that already
reflects that CRM.

26. While the use of CRM techniques reduces or transfers credit risk, it
simultaneously may increase other risks (residual risks). Residual risks
include legal, operational, liquidity and market risks. Therefore, it is
imperative that banks employ robust procedures and processes to control
these risks, including strategy; consideration of the underlying credit;
valuation; policies and procedures; systems; control of roll-off risks; and
management of concentration risk arising from the banks use of CRM
techniques and its interaction with the banks overall credit risk profile.

27. The disclosure requirements under Part VIII of this document must also be
observed for banks to obtain capital relief (i.e., adjustments in the risk
weights of collateralized or guaranteed exposures) in respect of any CRM
techniques.

Collateralized transactions

28. A collateralized transaction is one in which:

a) banks have a credit exposure or potential credit exposure; and

b) that credit exposure or potential credit exposure is hedged in whole or in
part by collateral posted by a counterparty
4
or by a third party in behalf of
the counterparty.

29. For collateral to be recognized for regulatory capital purposes, the collateral
must be pledged for at least the life of the exposure and it must be marked

4
Counterparty refers to a party to whom a bank has an on- or off-balance sheet credit exposure or a
potential credit exposure.


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to market and revalued with a minimum frequency of six months. Moreover,
the collateral should have the same denomination as the exposure.

30. In addition to the general requirement for legal certainty set out in paragraph
24, the legal mechanism by which collateral is pledged or transferred must
ensure that the bank has the right to liquidate or take legal possession of it,
in a timely manner, in the event of default, insolvency or bankruptcy (or one
or more otherwise-defined credit events set out in the transaction
documentation) of the counterparty (and, where applicable, of the custodian
holding the collateral). Furthermore, banks must take all steps necessary to
fulfill those requirements under the law applicable to the banks interest in
the collateral for obtaining and maintaining an enforceable security interest,
e.g., by registering it with a registrar, or for exercising a right to net or set off
in relation to title transfer collateral.

31. In order for collateral to provide protection, the credit quality of the
counterparty and the value of the collateral must not have a material positive
correlation. For example, securities issued by the counterparty or by any
related group entity would provide little protection and so would be
ineligible.

32. Banks must have clear and robust procedures for the timely liquidation of
collateral to ensure that any legal conditions required for declaring the
default of the counterparty and liquidating the collateral are observed, and
that collateral can be liquidated promptly.

33. Where the collateral is held by a custodian, the BSP will only recognize the
collateral for regulatory capital purposes if it is held by BSP-authorized third
party custodians.

34. A capital requirement will be applied to a bank on either side of the
collateralized transaction: for example, both repos and reverse repos will be
subject to capital requirements. Likewise, both sides of a securities lending
and borrowing transaction will be subject to explicit capital charges, as will
the posting of securities in connection with a derivative exposure or other
borrowing.

35. Where banks take eligible collateral, as listed in paragraph 36 below, and
satisfies the requirements under paragraphs 29 to 34, they are allowed to
apply the risk weight of the collateral to the collateralized portion of the credit
exposure.

36. The following are the eligible collateral instruments:

a) Cash;
b) Debt securities issued by the NG and the BSP;


20
c) Debt securities issued by central governments and central banks of
foreign countries with external credit ratings of at least BBB- or its
equivalent; and
d) Other debt securities with external credit ratings of at least AA- or its
equivalent.

37. A credit risk capital requirement should also be applied to banks
counterparty exposures in the trading book (e.g., repo-like transactions and
derivatives contracts). Where banks take eligible collateral for these trading
book transactions, as listed in paragraph 36 above, and satisfies the
requirements under paragraphs 29 to 34, they are to compute for the credit
risk capital requirement according to the following paragraphs.

38. For collateralized transactions in the trading book, the exposure amount
after risk mitigation is calculated as follows:

E* = max {0, [E x (1 + H
e
) C x (1 H
c
)]}

Where:

E* = the exposure value after risk mitigation

E = the current value of the exposure

H
e
= haircut appropriate to the exposure

C = the current value of the collateral received

H
c
= haircut appropriate to the collateral

39. These are the haircuts to be used, expressed as percentages:

Issue rating for debt
securities
5

Residual maturity Haircut
= 1 year 1
> 1 year, = 5 years 4 AAA to AA-
> 5 years 8
= 1 year 2
> 1 year, = 5 years 6 A+ to BBB-
> 5 years 12
BB+ below and unrated
securities

15

5

5
The notations follow the methodology of Standard & Poors, The mapping of ratings of all recognized
external rating agencies is in Part III.C.



21
Equities 25
Securities issued by the
Philippine national
government and BSP,
and central
governments and
central banks of foreign
countries with a credit
rating of at least AA-

0
Cash 0

40. The exposure amount after risk mitigation will be multiplied by the risk
weight of the counterparty to obtain the risk-weighted asset amount for the
collateralized transaction.

41. Where the collateral is a basket of assets, the haircut on the basket will be H
= ? a
i
H
i
, where a
i
is the weight of the asset in the basket and H
i
is the
haircut applicable to that asset.

Guarantees

42. Where guarantees are direct, explicit, irrevocable and unconditional, banks
may be allowed to take account of such credit protection in calculating
capital requirements.

43. A guarantee must represent a direct claim on the protection provider and
must be explicitly referenced to specific exposures or a pool of exposures,
so that the extent of the cover is clearly defined and incontrovertible. Other
than non-payment by a protection purchaser of money due in respect of the
credit protection contract, the guarantee must be irrevocable; there must be
no clause in the contract that would allow the protection provider unilaterally
to cancel the credit cover or that would increase the effective cost of cover
as a result of deteriorating credit quality in the hedged exposure. It must
also be unconditional; there should be no clause in the protection contract
outside the direct control of the bank that could prevent the protection
provider from being obliged to pay out in a timely manner in the event that
the original counterparty fails to make the payment(s) due.

44. In addition to the legal certainty requirement in paragraph 24, in order for a
guarantee to be recognized, the following conditions must be satisfied:

a) On the qualifying default/non-payment of the counterparty, the bank may
in a timely manner pursue the guarantor for any monies outstanding
under the documentation governing the transaction. The guarantor may
make one lump sum payment of all monies under such documentation to
the bank, or the guarantor may assume the future payment obligations of


22
the counterparty covered by the guarantee. The bank must have the
right to receive any such payments from the guarantor without first
having to take legal actions in order to pursue the counterparty for
payment;

b) The guarantee is an explicitly documented obligation assumed by the
guarantor; and

c) The guarantee must cover all types of payments the underlying obligor is
expected to make under the documentation governing the transaction,
for example, notional amount, margin payments, etc. Partial guarantees,
e.g., guarantees that cover payment of principal only, shall not be
recognized.

45. Where the banks exposure is guaranteed by an eligible guarantor, as listed
in paragraph 46 below, and satisfies the requirements under paragraphs 42
to 44, the bank is allowed to apply the risk weight of the guarantor to the
guaranteed portion of the credit exposure, throughout the life of the
guarantee.

46. The following are the eligible guarantors:

a) NG and BSP;
b) Central governments and central banks of foreign countries with external
credit ratings of at least BBB- or its equivalent; and
c) Other financial or non-financial institutions with external credit ratings of
at least AA- or its equivalent.

47. Where a bank provides a credit protection to another bank in the form of a
guarantee that a third party will perform on its obligations, the risk to the
guarantor bank is the same as if the bank had entered into the transaction
as a principal. In such circumstances, the guarantor bank will be required to
calculate capital requirement on the guaranteed amount according to the
risk weight corresponding to the third party exposure.

D. Use of third party credit assessments

48. The following third party credit assessment agencies are recognized by the
BSP for regulatory capital purposes:

International credit assessment agencies:

a) Moodys;
b) Standard & Poors;
c) FitchRatings; and
d) Such other rating agencies as may be approved by the Monetary Board.


23

Domestic credit assessment agencies:

a) PhilRatings; and
b) Such other rating agencies as may be approved by the Monetary Board.

49. The tables below set out the mapping of ratings given by the recognized
credit assessment agencies:

Agency R A T I N G S
S&P AAA AA+ AA AA- A+ A A-
Moodys Aaa Aa1 Aa2 Aa3 A1 A2 A3
Fitch AAA AA+ AA AA- A+ A A-
PhilRatings AAA Aa+ Aa Aa- A+ A A-

Agency R A T I N G S
S&P BBB+ BBB BBB- BB+ BB BB- B+
Moodys Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1
Fitch BBB+ BBB BBB- BB+ BB BB- B+
PhilRatings Baa+ Baa Baa- Ba+ Ba Ba- B+

Agency R A T I N G S
S&P B B-
Moodys B2 B3
Fitch B B-
PhilRatings B B-


Multiple assessments

50. If an exposure has only one rating by any of the BSP recognized credit
assessment agencies, that rating shall be used to determine the risk weight
of the exposure; in cases where there are two or more ratings which map
into different risk weights, the higher of the two lowest risk weights should be
used.

Issuer versus issue assessments

51. Any reference to credit rating shall refer to issue-specific rating; the issuer
rating may be used only if the exposure being risk-weighted is:

a) a senior obligation of the issuer and is of the same denomination
applicable to the issuer rating (e.g., local currency issuer rating may be
used for risk weighting local currency denominated senior claims);

b) short-term; and


24

c) in cases of guarantees.

52. For loans, risk weighting shall depend on either the rating of the borrower or
the rating of the unsecured senior obligation of the borrower: Provided, That
the loan is of the same denomination applicable to the borrower rating or
rating of the unsecured senior obligation.

Domestic versus international debt issuances

53. Domestic debt issuances may be rated by BSP-recognized domestic credit
assessment agencies or international credit assessment agencies who may
have a national rating scale acceptable to the BSP, while international debt
issuances should be rated by BSP-recognized international credit
assessment agencies only.




Part IV. Credit derivatives

Part V. Securitization


























25
Part VI. Market risk-weighted assets

A. Definition of the trading book

1. A trading book consists of positions in financial instruments held either with
trading intent or in order to hedge other elements of the trading book. To be
eligible for trading book capital treatment, financial instruments must either be
free of any restrictive covenants on their tradability or able to be hedged
completely. In addition, positions should be frequently and accurately valued,
and the portfolio should be actively managed.

2. A financial instrument is any contract that gives rise to both a financial asset
of one entity and a financial liability or equity instrument of another entity.
Financial instruments include both primary financial instruments (or cash
instruments) and derivative financial instruments. A financial asset is any
asset that is cash, the right to receive cash or another financial asset; or the
contractual right to exchange financial assets on potentially favorable terms,
or an equity instrument. A financial liability is the contractual obligation to
deliver cash or another financial asset or to exchange financial liabilities
under conditions that are potentially unfavorable.

3. Positions held with trading intent are those held intentionally for short-term
resale and/or with the intent of benefiting from actual or expected short-term
price movements or to lock in arbitrage profits, and may include for example
proprietary positions, positions arising from client servicing (e.g. matched
principal broking) and market making.

4. The following will be the basic requirements for positions eligible to receive
trading book capital treatment:

a) Clearly documented trading strategy for the position/instrument or
portfolios, approved by senior management (which would include
expected holding horizon);

b) Clearly defined policies and procedures for the active management of the
position, which must include:

i. positions are managed on a trading desk;
ii. position limits are set and monitored for appropriateness;
iii. dealers have the autonomy to enter into/manage the position within
agreed limits and according to the agreed strategy;
iv. positions are marked to market at least daily, and when marking to
model the parameters must be assessed on a daily basis;
v. positions are reported to senior management as an integral part of
the institutions risk management process; and


26
vi. positions are actively monitored with reference to market
information sources (assessment should be made of the market
liquidity or the ability to hedge positions or the portfolio risk
profiles). This would include assessing the quality and availability
of market inputs to the valuation process, level of market turnover,
sizes of positions traded in the market, etc.

c) Clearly defined policy and procedures to monitor the positions against the
banks trading strategy including the monitoring of turnover and stale
positions in the banks trading book.

5. The documentations of the basic requirements of paragraph 4 above should
be submitted to the BSP.

6. In addition to the above documentation requirements, the bank should also
submit to the BSP a documentation of their valuation methodologies, as well
as policies and procedures for transferring positions between the trading and
the banking books.

B. Measurement of capital charge

7. The market risk capital charge for banks trading book positions shall be
computed according to the methodology set under Circular No. 360 dated 3
December 2002, as amended, subject to certain modifications as outlined in
the succeeding paragraphs.

8. The specific risk weights for trading book positions in debt securities and debt
derivatives shall depend on the third party credit assessment of the issue or
the type of issuer, as may be appropriate, as follows:

Credit ratings of debt
securities/derivatives
issued by central
governments and
central banks of foreign
countries
Credit ratings of debt
securities/derivatives
issued by other entities
Unadjusted specific
risk weight
AAA to AA- 0.00%
A+ to BBB- AAA to BBB-
Residual maturity = 6
months
Residual maturity = 6
months
0.25%
Residual maturity > 6
months, = 24 months
Residual maturity > 6
months, = 24 months
1.00%
Residual maturity > 24
months
Residual maturity > 24
months
1.60%
Debt securities/derivatives issued by the Philippine
national government and BSP
0.00%


27
LGU Bonds covered by Deed of Assignment of
Internal Revenue Allotment and guaranteed by LGU
Guarantee Corporation
4.00%
All other debt securities/derivatives 8.00%

9. A security, which is the subject of a repo-like transaction, shall be treated as if
it were still owned by the seller/lender of the security, i.e., to be reported by
the seller/lender. In addition, a credit risk capital charge should be applied to
banks counterparty exposures in repo-like transactions as well as derivatives
contracts. The computation of the credit risk capital charge for counterparty
exposures arising from trading book positions are discussed in Part III (Credit
risk-weighted assets).

C. Measurement of risk-weighted assets

10. Market risk-weighted assets are determined by multiplying the market risk
capital charge by 10 (i.e., the reciprocal of the minimum capital ratio of 10%).































28
Part VII. Operational risk-weighted assets

A. Definition of operational risk

1. Operational risk is defined as the risk of loss resulting from inadequate or
failed internal processes, people and systems or from external events. This
definition includes legal risk, but excludes strategic and reputational risk.

B. Measurement of capital charge

2. In computing for the operational risk capital charge, banks may use either the
basic indicator approach or the standardized approach.

3. Under the basic indicator approach, banks must hold capital for operational
risk equal to 15% of the average gross income over the previous three years
of positive annual gross income. Figures for any year in which annual gross
income is negative or zero should be excluded from both the numerator and
denominator when calculating the average.

4. Banks that have the capability to map their income accounts into the various
business lines may use the standardized approach subject to prior BSP
approval. Operational risk capital charge for each business line corresponds
to a certain fraction (beta factor) of the average gross income over the
previous three years of positive annual gross income for each business line.
Similar to the basic indicator approach, figures for any year in which annual
gross income of the business line is negative or zero should be excluded from
both the numerator and denominator when calculating the average. Total
operational risk capital charge is the sum for all business lines.

5. The business lines and their corresponding beta factors are listed below:

Business lines Activity Groups Beta
factors
Corporate finance Mergers and acquisitions, underwriting,
privatizations, securitization, research,
debt (government, high yield), equity,
syndications, IPO, secondary private
placements
18%
Trading and sales Fixed income, equity, foreign exchanges,
commodities, credit, funding, own position
securities, lending and repos, brokerage,
debt, prime brokerage
18%
Retail banking 1) Retail lending and deposits, banking
services, trust and estates; 2) Private
lending and deposits, banking services,
trust and estates, investment advice; 3)
12%


29
Merchant/commercial/corporate cards,
private labels and retail
Commercial banking Project finance, real estate, export
finance, trade finance, factoring, leasing,
lending, guarantees, bills of exchange
15%
Payment and settlement Payments and collections, funds transfer,
clearing and settlement
18%
Agency services Escrow, depository receipts, securities
lending (customers) corporate actions,
issuer and paying agents
15%
Asset management Discretionary and non-discretionary fund
management, whether pooled,
segregated, retail, institutional, closed,
open, private equity
12%
Retail brokerage Execution and full service 12%


6. Gross income, for the purpose of computing for operational risk capital
charge, is defined as net interest income plus non-interest income.

7. Advanced approaches for computing operational risk capital charge may be
allowed in the future, but banks shifting to the advanced approaches must
comply with the Basel Committee on Banking Supervisions guidance on
Sound Practices for the Management and Supervision of Operational Risk
(February 2003).

C. Measurement of risk-weighted assets

8. Operational risk-weighted assets are determined by multiplying the
operational risk capital charge by 10 (i.e., the reciprocal of the minimum
capital ratio of 10%).

















30

Part VIII. Disclosures in the annual reports

1. This section lists the specific information that banks have to disclose, at a
minimum, in their annual reports. It is designed to give a listing of the
minimum qualitative and quantitative information on risk exposures required
under Circular 212, Series of 1999.

2. Full compliance of these disclosure requirements is a prerequisite before
banks can obtain any capital relief (i.e., adjustments in the risk weights of
collateralized or guaranteed exposures) in respect of any credit risk mitigation
techniques.

A. Capital structure and capital adequacy

3. The following information with regard to banks capital structure and capital
adequacy have to be disclosed in banks annual reports:

a) The amount of Tier 1 capital and a breakdown of its components;

b) The amount of Tier 2 capital and a breakdown of its components;

c) Deductions from capital;

d) Total qualifying capital;

e) Capital requirements for credit risk;

f) Capital requirements for market risk;

g) Capital requirements for operational risk;

h) Capital adequacy ratio; and

i) A summary discussion of the banks internal approach to assessing the
adequacy of its capital to support current and future activities, if any.

B. Risk exposures and assessments

4. For each separate risk area (credit, market, operational, interest rate risk in
the banking book), banks must describe their risk management objectives
and policies, including:

a) Strategies and processes;

b) The structure and organization of the relevant risk management function;


31

c) The scope and nature of risk reporting and/or measurement systems; and

d) Policies for hedging and/or mitigating risk and strategies, and processes
for monitoring the continuing effectiveness of hedges/mitigants.

Credit risk

5. Aside from the general disclosure requirements stated in paragraph 4, the
following information with regard to credit risk have to be disclosed in banks
annual reports:

a) Total credit risk-weighted assets broken down by type of exposures as
defined in Part III;

b) Names of external credit assessment institutions used, and the types of
exposures for which they were used;

c) Types of eligible credit risk mitigants used;

d) For banks with exposures to securitization structures, credit derivatives,
and other structured products, aside from the general disclosure
requirements stated in paragraph 4, the following minimum information
have to be disclosed:

i. Accounting policies for these activities;
ii. Total outstanding exposures securitized by the bank;
iii. Total amount of securitization exposures retained or purchased
broken down by exposure type.
iv. Total outstanding amount of credit protection obtained and given by
the bank through credit derivatives broken down by type of
reference exposures; and
v. Total outstanding amount of other types of structured products
issued or purchased by the bank broken down by type.

Market risk

6. Aside from the general disclosure requirements stated in paragraph 4, the
following information with regard to market risk have to be disclosed in banks
annual reports:

a) Total market risk-weighted assets broken down by type of exposures
(interest rate, equity, foreign exchange, and options); and

b) For banks using the internal models approach, the following information
have to be disclosed:


32

i. The characteristics of the models used;
ii. A description of stress testing applied to the portfolio;
iii. A description of the approach used for backtesting/validating the
accuracy and consistency of the internal models and modeling
processes;
iv. The scope of acceptance by the BSP; and
v. A comparison of VaR estimates with actual gains/losses
experienced by the bank, with analysis of important outliers in
backtest results.

Operational risk

7. Aside from the general disclosure requirements stated in paragraph 4, banks
have to disclose their operational risk-weighted assets in their annual reports.

Interest rate risk in the banking book

8. Aside from the general disclosure requirements stated in paragraph 4, the
following information with regard to operational risk have to be disclosed in
banks annual reports:

a) Internal measurement of interest rate risk in the banking book, including
assumptions regarding loan prepayments and behavior of non-maturity
deposits, and frequency of measurement; and

b) The increase (decline) in earnings or economic value (or relevant measure
used by management) for upward and downward rate shocks according to
internal measurement of interest rate risk in the banking book.

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