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Basel II Capital Accord Report at SBP

Basel II Capital Accord Report at SBP

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Published by Aamir Raza
University of Sargodha (State Bank of (Pakistan)
University of Sargodha (State Bank of (Pakistan)

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Published by: Aamir Raza on Dec 14, 2010
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04/01/2013

A Closer Look into Basel-I

Tier 1 (Core capital)
Supplementary Capital

Tier 2

Tier 3

Capital in Regulatory Context

Tier 1 Capital (Core Capital) also called Equity

Share capital equity and disclosed reserves

Capital deposited with SBP by foreign banks

Premium on shares

Reserve for bonus shares

General reserve

Un appropriated profit

Deductions

Intangible assets like goodwill

Investment in the equity of subsidiary which are not consolidated

Shortfall in provisions

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Supplementary Capital

Tier 2 Capital (Supplementary Capital)

Revaluation reserve

Undisclosed reserve

Subordinated debt

General provision for loan losses

Hybrid capital instrument

Perpetual securities, unrealized gains on investment securities, hybrid capital instruments

and long term subordinated debt

Tier 3 Capital (Supplementary Capital)

Short term subordinated debt

Only to meet capital charge for market risk

Maximum Limit

Total of Tier 2 capitals is limited to a maximum of 100% of the total Tier 1 capital.
The subordinated debt will be limited to a maximum of 50% of equity (Tier 1)
Basel I requires Tier 1 and Tier 2 capitals to be at least 8% of the total risk weighted assets.

Qualification for Basel I Accord

To qualify for Tier-1 or supplementary capital, capital must be unsecured, free from terms,
restrictions etc

Calculation of Capital Charge

Sum of the directly calculated risk charge for each of the market risk subcategories

Interest rate risk
Equity price risk
Foreign exchange risk
Commodity price risk

Page 10 of 48

Merits of Basel I Accord

Relatively simple structure
Initiated substantial increase in capital ratios of international banks
Strengthened the soundness and stability of the international banking system
World wide adoption
Enhanced the competitive equality among international banks
Provide a benchmark for market assessment

Weakness of Basel Capital Accord

It looks a one size fits for all approach
Do not discuss capital adequacy in relation to a banks true risk profile
Broad bushed risk weighting structure
Created an incentive to take some highest quality assets off the balance sheet
Cover only credit and market risk
Does not distinguish among different credit exposures
Both AAA and BBB assets attract the same capital charge
Does not allow any capital charge for operational risk
It was not adequate for modern risk situation

Basel II Capital Accord

Basel II is a framework, and the standards it contains have been endorsed by the Central Bank

Governors and Heads of Banking Supervision of the Group of Ten countries. It presents the outcome

of the Basel Committee on Banking Supervision‟s work over recent years to secure international

convergence on revisions to supervisory regulations governing the capital adequacy of

internationally active banks. Following the publication of the Committee‟s first round of proposals

for revising the capital adequacy framework in June 1999, an extensive consultative process was set

in train in all member countries and the proposals were also circulated to supervisory authorities

worldwide. The Committee subsequently released additional proposals for consultation in January

2001 and April 2003 and furthermore conducted three quantitative impact studies related to its

Page 11 of 48

proposals. As a result of these efforts, many valuable improvements have been made to the original

proposals. The present paper is now a statement of the Committee agreed by all its members. It sets

out the details of the agreed Framework for measuring capital adequacy and the minimum standard

to be achieved which the national supervisory authorities represented on the Committee will propose

for adoption in their respective countries.

History of Basel II Capital Accord

Basel II is a round of deliberations by central bankers from around the world, under auspices of

Basel Communities on Banking supervision (BCBS) in Basel (Switzerland) aimed at producing

uniformity in the way banks and banking regulations approach risk management across boarders.

The Basel Committee on Banking Supervision formulated and issued a revised capital framework

referred to as Basel II in June 2004 which became available for implementation among its 13

member countries to G-10 countries from end-2006 and from end 2007 for the most advanced

approaches.

Basel II a new capital accord which aims to align banks with their basic risk profiles.

It is very elaborate and far superior in terms of its coverage and detail
Exploit effectively a new frontier of risk management
It seeks to give impetus to the development of a sound risk management system which hopefully
will promote a more efficient, equitable and prudent allocation of resources

When the banking company recognizes that Basel I fail to properly align capital with actual risk

profiles of the bank. This has laid the foundation of very long drawn process of Basel II, which

recognizes the perceived shortcomings of Basel I and progressively address its inherent weakness,

while gearing the risk management framework for the emerging financial engineering and

innovation.

Page 12 of 48

Objectives of Basel II

The relevance and significance of Basel II steps from its ability to recognize effectively the different

types of risk facing industry and the new product as well as off balance sheet transactions. Some

salient characteristics of Basel II are note worthy;

To promote safety and soundness in the financial system
Aligns capital of banks with their basic risk profiles
It is elaborate and far superior in terms of its coverage and detail
To render capital adequacy more risk-sensitive
To provide incentives for banks to enhance their risk measurement capabilities
Introduce a capital charge for operational risk
Treatment of equity risk in the banking book

To allow banks to use in-house methods

To continue to enhance completive equality
To constitute a more comprehensive approach to addressing risks
Reform credit risk weightings making them more risk sensitive in line with bank practices

To cover all essential banking risks with theoretically grounded, flexible and operable

requirements which create incentives for advanced implementation

Rationale for Basel II

The original accord was based on "actual" banking risk (i.e. credit risk). The Basel Committee began

revising the original accord in 1999 named New Basel Capital accord (Basel II) with the following

objectives:

Enhance the risk sensitivity of capital requirement

Accord 1988: Four brad risk weighting categories

Align regulatory capital requirements closer to the actual risk profile of banks

Accord 1988: Credit risk assessed by supervisors only

Comprehensive coverage of risks

Accord 1988: Credit risk plus 1996 market risks

More powers to supervisors and the market

Page 13 of 48

Accord 1988: Only minimum capital requirement

Relatively Complex Rules

Accord 1988: Comparatively Simple

Present a menu of options to chose from

Accord 1988: One size fits all approach

Comparison of Basel I and Basel II

BASEL I

BASEL II

Focus on Single Risk Measure

One Size fits all

Operational Risk not considered

Broad Brush Structure

More emphasis on Bank’s internal

methodologies, supervisory review &
market discipline
Flexibility, menu of approaches. Provides
incentives for better risk management
Introduces approaches for Credit risk &
Operational risk in addition to Market risk
introduced earlier
More Risk Sensitivity

Salient Features and Overview

The objectives of accord are;

To maintain safety and soundness in the financial system and therefore to maintain at least the
current level of capital in the system
To enhance competitive equality
To introduce a more risk sensitive framework that closely aligns internal economic capital with
regulatory capital
To focus on internationally active banks

Page 14 of 48

Risk Based Capital Standard

Why do banks need to hold capital in order to do business?

Provides a cushion against unexpected loss that may arise due to credit/market/operational risk.
Capital that needs to be maintained as a proportion of risk based assets is termed as risk based
capital – otherwise termed as capital adequacy ratio (CAR).

E.g. bank does not maintain any capital towards credit risk component of Go I bonds as it is non-

existent.

Purpose behind the New Accord

The fundamental objective of the committee`s work has been to develop a framework that would

further strengthen the soundness and stability of the international banking system while remaining

sufficient consistency that capital adequacy regulation will not be a significant source of competitive

inequality among international active banks.

Capital requirement should increase for banks that hold risky assets and decrease significantly for

banks that hold safer portfolios.

Scope of Application

Basel II has become an international competition for consultants, How to help banks allocate less

capital

Basel II creates incentives for banks to more risky assets to unregulated parts of the holding

companies

The new capital accord will be applied on a consolidated basis to;

Holding companies of banking groups on a consolidated basis
All internationally active banks at every level in the banking group
Individual banks must also be adequately; capitalized on a stand alone basis

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