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.

Risk Sensitive 3. Risk weightage to assets assigned on the basis of ratings and strength of the assets 4.Difference between Basel I and Basel II Basel I 1. Lack of flexibility and incentives for better Risk Management 4. especially for Credit Risk 5. Emphasis on Capital Enhancement and Capital Optimization 2. Use of arbitrary risk categories and risk weightage 5. Stress on Capital Adequacy 2. Capital Charge for Operational Risk also . Capital Charge only for Credit Risk and Market Risk Basel II 1. All assets within the same category assigned equal risk weightage 6. Incentives for better Risk Management techniques. Broad Brush Approach 3.

Risk management has emerged as a key area of focus for banks in recent times especially due to Basel II accord Corporate Bank Sovereign Retail Project Equity Finance Internal Process Credit Risk People Operational Risk External Factors Information Risk Systems Risk Security and Integrity Risk Interest Rate – in banking and trading books Types of Risks Market Risk Foreign Exchange Equity Commodity .

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 Instruments 2. Macro economy 4. International regulation 7. Interest rates 10. Equity markets 8.Political shocks * Banana Skins 2003 – The CSFI’s annual survey of the risks facing banks . Credit risk 3. Corporate governance 9. Insurance 5. Business continuation 6.

Equity markets 8. Business continuation 6.Regulatory developments – Basel II and IFRS 1.Political shocks IFRS Basel II Basel II IFRS Basel II Basel II Basel II . Interest rates 10. Credit risk 3. Insurance 5. Complex Financial Instruments 2. International regulation 7. Macro economy 4. Corporate governance 9.

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 .

The Basel Accord is a constant WIP July 1988 Nov 1991 July 1994 Jan 1996 June 1999 Jan 2002 Apr 2003 Jun 2004 “Basel Accord” Amendments for general provisions Amendment for re-structured country debt Market risk amendments CP 1 CP 2 CP 3 Final accord April 1995 Netting amendments for derivatives April 1998 Securities firms added to “OECD banks” cat .

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 .Existing Basel Capital Accord – Why Changes ? 1988 Capital Accord served the industry well.

Basel II : A Major Paradigm Shift The Existing Accord The New Accord • Focus on a single risk measure • More emphasis on banks’ internal methodologies. menu of approaches. capital incentives for good risk management • Increased risk sensitivity • One size fits all • Broad brush structure . supervisory review & market discipline • Flexibility.

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 .

Basel II – The Three Pillars Basel II Three Pillars Minimum Capital Requiremen ts Supervisor y Review Market Discipline Providing a flexible. risk-sensitive capital management framework .

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 Capital Supervisory Review Market Discipline  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 …and has proposed a challenging implementation deadline of 2006 for internationally active banks .

BASEL II Structure .

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 .

Risk Components to Capital Adequacy Calculation Unchanged Total Capital Credit Risk + Market Risk + Operational Risk ≥ 8% Significantly Refined Relatively Unchanged New .

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 .

Rating Scale Risk Weight (%) Exposure Rs.60 crores     . 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.The credit portfolio of ABC Bank has undergone a uniform downgrade as on 31-3. The position prior to the downgrade is given below: The minimum capital required after downgrade is ………….2008 after an economic downturn..48.

Rating Scale Risk Weight Exposure Working RWA Exposure after Before down grade Downgrade RWA AFTER 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 .

6 crores .6 crores C]60.6 crores D]62.7 crores* B]58.The Capital required will be A]56.

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 .

Overview of the New Basel Capital Accord Pillar 1 – Minimum capital requirements Pillar 2 – Supervisory Review Market risk Unchanged from existing Basel Accord Credit risk  Significant change from existing Basel Pillar 3 – Market Discipline  Market discipline reinforces  Banks should have a process for assessing their overall capital adequacy and strategy for maintaining capital levels  Supervisors should review and efforts to promote safety and soundness in banks  Core disclosures (basic Accord  Three different approaches to the calculation of minimum capital requirements  Capital incentives to move to more evaluate banks’ internal capital adequacy assessment and strategies  Supervisors should expect banks information) and supplementary disclosures to make market discipline more effective 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 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 calculation of minimum capital requirements  Adoption of each approach subject to intervene at an early stage to prevent capital falling below minimum levels compliance with defined ‘qualifying criteria’ .

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 .

tied to risk weights based on external ratings Supervisory values set by the Basel Committee Provided by bank based on own estimates.Credit Risk Measurement Approaches under Pillar I Internal Ratings Based (IRB) Approach Criteria Rating Standardized Approach External Foundation Approach Internal Advanced Approach Internal 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 Exposure of Default (EAD): for loans. tied to risk weights based on external ratings Provided by bank based on own estimates Provided by bank based on own estimates Supervisory values set by the Basel Committee Supervisory values set by the Basel Committee Provided by bank based on own estimates Loss Given Default (LGD). the proportion of the exposure that will be lost if a default occurs Maturity: the remaining economic maturity of the exposure Implicitly provided by the Basel Committee. 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) . the amount of the facility that is likely to be drawn if a default occurs Implicitly provided by the Basel Committee. extensive process and internal control requirement Implicitly recognition Supervisory values set by the Basel Committee Or At national discretion.

) Internal Ratings Based (IRB) Approach Criteria Standardized Approach Foundation Approach Advanced Approach 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. “netting” (on and off balance sheet). plus:   Historical loss data to estimate LGD (7 years) Historical exposure data to estimate EAD (7 years) Credit Risk Mitigation Techniques (CRMT) Defined by the supervisory regulator.. plus minimum requirements to ensure quality of estimation of all parameters . including financial collateral. 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.Credit Risk Measurement Approaches under Pillar I (contd. receivables from goods and services. guarantees. credit derivatives. and real estate All collaterals from Standardized Approach. plus minimum requirements to ensure quality of internal ratings and PD estimation and their use in the risk management process Same as IRB Foundation.

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 .

15%. or 18% of that indicator as capital charge Total capital charge equals sum of charge per business line Advanced Measurement Approach (AMA)  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) 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     . 12%.Operational Risk Measurement Approaches under Pillar I Calculation of Capital Charge Calculation of Capital charge   Basic Indicator Approach Average of gross income over three years as indicator Capital charge equals 15% of that indicator   Standardized Approach Gross income per regulatory business line as indicator Depending on business line.

Operational risk is inherent to banking business and not received adequate attention in past Banking Retail Banking Retail Deposits & Lending ACTIVITY Private Banking Card Services Commercial Banking Project Finance Trade Finance Working Capital Finance Advisory Services Payment and Settlement Payments and Collections Funds Transfer Clearing and Settlement Treasury (Trading & Sales) Sales Market Making Proprietary Positions Treasury Operation Risk categories Internal Fraud External Fraud Employment Practices & Workplace Safety Clients. Products & Business Practices Physical Business Damage to Disruption and Assets System Failures Execution. Delivery & Process Management .

. depending on the bank’s needs . policies and procedures Invest in staff training Automate processes Acceptance of risk as cost of doing business Transfer risk through subcontracting Contingency plan . .Designing and implementing action plans for operational risk management could be in many forms.Insurance Create risk awareness culture …based on a cost-benefit assessment . Basel accord requires Sound Practices for Management and Supervision of operational Risk          Establish a structured risk management framework for the bank Redesign process and approach Strengthen existing controls.

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 .

Strategic implications on Banking sector Capital requirements 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 Wider market  Significant barriers to entry as a bank  Increased competition for low risk Products  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 Basel II profitability Customers  Increased transparency of account  Risk-differentiated customer customers  Disclosure under Pillar III  Peer group pressure will lead to adoption of more advanced approaches  Risk Transfer: .Outside Basel regulated banking system e.Winners: .Losers: .Small & medium sized businesses .Well rated entities .g.Higher credit risk individuals . insurance industry management through: .Prime mortgage customers .

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 .

Challenges in Basel II implementation Constituent Challenges  Interpret new regulations and understand effects on business  Secure and maintain board and senior management sponsorship  Face new expectations from regulators. rating agencies.  Create regulation that reflects the linkages among risks  Provide incentives for banks to evaluate risks through stress-testing and scenario analysis Rating Agencies Financial institutions out of Basel II’s scope  Seek to improve reputation (national agencies)  Maintain high quality of ratings  Interpret new regulations and understand effects on business and risk management  Demonstrate quality as Basel II emerges as a best practice standard . educated professionals to fill roles. timely information  Use key performance indicators to monitor performance  Face request for better collateralization  Manage rating process Regulators  Need well-trained. and customers  Need to consider whether to target certain customers/products or eliminate others Banks Customers  Face new costs resulting from need to provide lenders with new.

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 .

Phased approach to migration to Basel II implementation ASSESS AND PLAN Phase 1 DESIGN AND IMPLEMENT Phase 2 AND APPROVAL Phase USE 3 TEST Phase MONITOR 4 AND CONTROL ORGANIZATION Basel II Implementation Approach Corporate Governance/ Risk Management Gap Analysis PROCESSES Operational Risk Market and Other Risks Capital Planning (including linkage to IFRS) METHODS DATA Disclosure SYSTEMS Supervisory Review Process BASEL II PROJECT MANAGEMENT Monitor and Control Credit Risk Use Test and Approval Basel II Roll-Out Plan Impact Analysis Basel II implementation Master Plan .

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 .

most from Asia-Pacific Survey conducted by Ernst & Young in conjunction with AsiaRisk from mid November to early December 2004 .Basel II Survey 245 participants.

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             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 .

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. require much more preparation and pose several challenges for both the banks as well as the supervisors. the post Basel II era will belong to the banks who manage their risks effectively.Conclusions   Basel II generally favors retail lending over corporate lending The implementation of Advanced Approaches. .      The manpower skills. 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 banks would require to meet the minimum requirements relating to internal ratings at the outset and on an ongoing basis. such as IRB Approach for credit risk and Advanced Measurement Approach for Operational Risk.

Conclusions Basel II will make the world less risky .

Sign up to vote on this title
UsefulNot useful