New Capital Accord

PILLAR II

Objective
Framework is intended to ensure that banks have adequate capital to support all the risks to encourage banks to develop and use better risk management techniques in monitoring and managing their risks
June 2004 Basel_II_Pillar_II 2

Role of Bank Management

D ! "O# $% &%' R%$" ($#&'$" $)) ))M %' #RO( )) $%D ) ' ($#&'$" '$R* ') that are commensurate with the bank+s risk profile and control environment, %)-R '.$' '. B$%/ .$) $D 0-$' ($#&'$" to support its risks be1ond the core minimum requirements,
Basel_II_Pillar_II 3

June 2004

Risk Mana e!ent

" " " " " Risk Mana e!ent structure and strate # Risk Identi$ication Risk Measure!ent Risk Monitorin and control Risk re%iew

June 2004

Basel_II_Pillar_II

Role o$ 'uper%isors
'o !$"-$' how well B$%/) $R $)) ))&%* '. &R ($#&'$" % D) relative to their risks and to &%' R! % 2 3. R $##RO#R&$' , 'o FO)' R $% $('&! D&$"O*- between banks and supervisors such that when deficiencies are identified2 prompt and decisive action can be taken to reduce risk or restore capital, $dopt an approach to FO(-) MOR intensel1 O% '.O) B$%/) with risk profiles or operational e4perience '.$' 3$RR$%') )-(. $'' %'&O%,
June 2004 Basel_II_Pillar_II &

))*Role o$ 'uper%isors
" +,ree !ain areas o$ $ocus $or t,e super%ision process " Capital -s* Risk " 'uper%isor# Re%iew Process

June 2004

Basel_II_Pillar_II

#illar 56 three main areas

R&)/) considered under #illar 7 ($#'-R D B8 '. #&""$R 7
risk:; that are

%O' F-""8

process 9e,g,credit concentration

'hose F$('OR) %O' '$/ % &%'O $((O-%' B8 '. #&""$R 7 process 9e,g, interest rate risk in the banking book2
business and strategic risk:; and factors e4ternal to the bank 9e,g, business c1cle effects:,

of (OM#"&$%( 3&'. '. M&%&M-M )'$%D$RD) $%D D&)("O)-R R 0-&R M %') of the more advanced methods
$ further important aspect of #illar 5 is the assessment in #illar 72 in particular the &RB framework for credit risk and the $dvanced Measurement $pproaches for operational risk, )upervisors must ensure that these requirements are being met2 both as qualif1ing criteria and on a continuing basis,
June 2004 Basel_II_Pillar_II .

 R "$'&O%).&# e4ists B '3 % the amount of ($#&'$" held b1 the bank $%D its R&)/) and the strength and effectiveness of the bank+s risk management $%D &%' R%$" (O%'RO" #RO( )) ), .owever2 &%(R $) D ($#&'$" should %O' be viewed as the O%"8 O#'&O% for addressing increased risks

Capital %s Risk

confronting the bank, Other means for addressing risk2 such as strengthening risk management2 appl1ing internal limits2 strengthening the level of provisions and reserves2 and improving internal controls2 must also be considered, Furthermore2 capital should

)-B)'&'-' for addressing fundamentall1 &%$D 0-$' (O%'RO" or risk management processes,
June 2004 Basel_II_Pillar_II /

%O'

be

regarded

as

)upervisor1 Review #rocess

/ 8 #R&%(&#" ) of supervisor1 review R&)/ M$%$* M %' *-&D$%( )-# R!&)OR8 'R$%)#$R %(8 $((O-%'$B&"&'8 *-&D$%( relating to2 among other things2
< the treatment of interest rate risk in the banking book < credit risk 9stress testing2 definition of default2 residual risk2 and credit concentration risk: < operational risk < enhanced cross=border communication and cooperation2 < securitisation,
Basel_II_Pillar_II

June 2004

Four ke1 principles of supervisor1 review

'he (ommittee has identified four ke1 principles of supervisor1 review2 which those outlined in the e4tensive supervisor1 guidance that has been developed b1 the (ommittee2 the ke1stone
for

(OM#" M %'
of

which

is

the

(OR

#R&%(&#" )
(ore #rinciples

ffective Banking )upervision and the

$ "&)' OF '. )# (&F&( *-&D$%( R "$'&%* 'O '. M$%$* M %' OF B$%/&%* R&)/) is provided at the end of this #art of the Framework,
Methodolog1,,

June 2004

Basel_II_Pillar_II

10

+,e 4 Principles
BANK MANAGEMENT SHOULD ASSESS
their overall capital adequac1 and have a strateg1 for

MAINTAINing CAPITAL LEVELS SUPERVISORS SHOULD REVIEW THE PROCESS OF ASSESSMENT AND TAKE APPROPRIATE ACTION if the1 are not satisfied with
the results of the assessment,
)upervisors should ensure that the

CAPITAL MINIMUM
to do so,

BANKS OPERATE AT LEVELS ABOVE THE

required in accordance with the risks and have the abilit1

SUPERVISORS TO INTERVENE AT AN EARLY STAGE to Basel_II_Pillar_II prevent capital from falling below the June 2004 11
minimum levels

Principle 1
B n!" "#$%l& # 'e PROCESS FOR

ASSESSING (#eir $'er ll c pi( l &e)% c* in rel (i$n ($ (#eir ri"! pr$+ile STRATEGY FOR MAINTAINING n& THEIR

CAPITAL LEVELS,

June 2004

Basel_II_Pillar_II

12

'he #rocess
'he F&! M$&% F $'-R ) of a rigorous process are as follows6
< Board and senior management oversight; < )ound capital assessment; < (omprehensive assessment of risks; < Monitoring and reporting; and < &nternal control review,
June 2004 Basel_II_Pillar_II 13

B$ r& n& "eni$r - n .e-en( $'er"i.#(

Bank management is responsible for understanding the being taken b1 the bank and how this risk relates to adequate capital levels, &t is also responsible for ensuring that the formalit1 and sophistication of the risk management

%$'-R

$%D " ! " OF R&)/

#RO( )) )

$R

$##RO#R&$' in light of the risk profile and business plan, 'he )'R$' *&( #"$% should clearl1 outline the bank+s
capital needs2 anticipated capital e4penditures2 desirable capital level2 and e4ternal capital sources

,
Basel_II_Pillar_II 14

June 2004

S$%n& c pi( l ""e""-en(

FR$M 3OR/ ).O-"D &%("-D #O"&(& ) $%D #RO( D-R ) designed to ensure
that the bank identifies2 measures2 and reports all material risks;

R "$' ) ($#&'$" 'O '. " ! " OF R&)/; $ process that )'$' ) ($#&'$" $D 0-$(8 *O$") 3&'. R )# (' 'O R&)/2 taking account
$ process that of the bank+s strategic focus and business plan;

&%' R%$" (O%'RO")2 R !& 3) $%D $-D&' to ensure the integrit1 of the overall management process,
$ process of
Basel_II_Pillar_II 1&

June 2004

C$-pre#en"i'e ""e""-en( $+ ri"!"

$ll material risks faced b1 the bank should be addressed in the capital assessment process, 3hile the (ommittee recogni>es that not all risks can be measured precisel12 a process should be developed to estimate risks,
'herefore2 the following risk e4posures2 which b1 no means constitute a comprehensive

list of all risks2 should be considered,

June 2004

Basel_II_Pillar_II

1(

"ist of risks
(redit Operational Market &nterest rate risk in banking book "iquidit1 risk Other risks < Reputational risk < )trateg1 risk
Basel_II_Pillar_II 1.

June 2004

(redit risk

.$! M '.ODO"O*& ) '.$' enable them to $)) )) '. (R D&' R&)/ involved in e4posures
Banks should

< to &%D&!&D-$" BORRO3 R) or counterparties < as well as at the #OR'FO"&O " ! ",
For MOR )O#.&)'&($' D B$%/)2 the credit review assessment of capital adequac12 at a minimum2 should cover four areas6

< R&)/ R$'&%* )8)' M)2 < #OR'FO"&O $%$"8)&)?$**R *$'&O%2 < ) (-R&'&)$'&O% ?(OM#" @ (R D&' D R&!$'&! ) @#O)-R ) $%D R&)/ < "$R* (O%( %'R$'&O%),
June 2004 Basel_II_Pillar_II 1/

Credit Risk Ratin s

&nternal risk ratings
< should be adequate to support the e4posures

&D %'&F&($'&O% $%D M $)-R M %' of risk from all credit

< should be &%' *R$' D &%'O $% &%)'&'-'&O%+) O! R$"" $%$"8)&) OF (R D&' R&)/ $%D ($#&'$" $D 0-$(8, < should provide D '$&" D R$'&%*) FOR $"" $)) ')2 not onl1 for critici>ed or problem assets,

June 2004

Basel_II_Pillar_II

10

$nal1sis of credit risk

'he

$%$"8)&) OF (R D&' R&)/

" ! "2 R&)/, &%("-D&%* #OR'FO"&O (O%( %'R$'&O% OF

< should adequatel1 identif1 weaknesses at the

< should adequatel1 take into

(O%)&D R$'&O% '. R&)/) in mechanisms as ) (-R&'&)$'&O% $%D (OM#" @ (R D&' D R&!$'&! ),

< anal1sis of counterpart1 credit risk should include consideration of public evaluation of the supervisor+s compliance with the (ore #rinciples for ffective Banking )upervision,

"oan loss reserves should be included in the credit risk assessment for capital adequac1,

June 2004

Basel_II_Pillar_II

20

Operational risk
'he (ommittee believes that similar rigour should be applied to the management of operational risk2 as is done for the management of other significant banking risks, 'he failure to properl1 manage operational risk can result in a misstatement of an institution+s risk?return profile and e4pose the institution to significant losses,
June 2004 Basel_II_Pillar_II 21

Operational risk
'he bank should develop a polic1 A framework 'hat covers the bank+s appetite and 'O" R$%( FOR O# R$'&O%$" R&)/2 as specified
through the policies for managing this risk

R&)/ &) 'R$%)F RR D O-')&D the bank, &ncludes the bank+s $##RO$(. 'O &D %'&F8&%*2 $)) ))&%*2 MO%&'OR&%* $%D (O%'RO""&%* ? M&'&*$'&%* '. R&)/,
includes the e4tent and manner in which operational
Basel_II_Pillar_II 22

June 2004

Market risk
'.&) $)) ))M %' &) B$) D "$R* "8 O% '. B$%/+) O3% M $)-R OF !$"- =$'=R&)/ OR '. )'$%D$RD&) D $##RO$(. FOR M$R/ ' R&)/,
mphasis should also be placed on the institution performing

)'R )) ' )'&%* &% !$"-$'&%* '. $D 0-$(8 OF ($#&'$" 'O )-##OR' '. 'R$D&%* F-%('&O%
June 2004 Basel_II_Pillar_II 23

In(ere"( r (e ri"! in (#e / n!in. /$$!

'he measurement process should include $"" M$' R&$" &%' R )' R$' #O)&'&O%) $%D (O%)&D R $"" R " !$%' R #R&(&%* $%D M$'-R&'8 D$'$ )-(. $)
<
< < < < current balance and contractual rate of interest instruments and portfolios principal pa1ments interest reset dates maturities the rate inde4 used for re=pricing associated with the

< contractual interest rate ceilings or floors for adjustable=rate items,

'. )8)' M ).O-"D $")O .$!

< well=documented assumptions and techniques < 0ualit1 of data in terms of reliabilit1 and timeliness and approriateness
June 2004 Basel_II_Pillar_II 24

Li)%i&i(* ri"!
Banks+

($#&'$" #O)&'&O%) ($% .$! $% FF (' O% '. &R $B&"&'8 'O OB'$&% "&0-&D&'82 )# (&$""8 &% $ (R&)&), ach B$%/ M-)' .$! $D 0-$' )8)' M) for measuring2 monitoring and controlling
liquidit1 risk,

Banks should

!$"-$' '. $D 0-$(8 OF ($#&'$" given their own liquidit1 profile and the "&0-&D&'8 OF '. M$R/ ') in which the1
operate,
Basel_II_Pillar_II 2&

June 2004

O(#er ri"!"
2 )-(. $) R #-'$'&O% $%D )'R$' *&( R&)/2 $R %O' $)&"8 M $)-R$B" 2 &' @# (') &%D-)'R8 'O F-R'. R D ! "O# ' (.%&0- ) for managing all aspects of these risks,
$lthough the (ommittee recogni>es that Bother+ risks

June 2004

Basel_II_Pillar_II

2(

Monitoring and reporting

'he s1stem should !$"-$' '. " ! " $%D 'R %D OF M$' R&$" R&)/) $%D '. &R FF (' O% ($#&'$" " ! "); valuate the ) %)&'&!&'8 $%D R $)O%$B" % )) OF / 8 $))-M#'&O%) used in the capital assessment measurement s1stem; D ' RM&% '.$' '. B$%/ .O"D) )-FF&(& %' ($#&'$" against the various R&)/) and is in compliance with established ($#&'$" $D 0-$(8 *O$"); $)) )) &') F-'-R ($#&'$" R 0-&R M %') based on the bank+s reported risk profile and M$/ necessar1 $DC-)'M %') 'O '. B$%/+) )'R$' *&( #"$% accordingl1, June 2004 Basel_II_Pillar_II 2.
$ssess the affect of bank+s changing risk profile on capital i,e,

&nternal control review

ffective control of the capital assessment process includes an

&%D # %D %' R !& 3 and2 where appropriate2 the involvement of &%' R%$" OR @' R%$" $-D&'), 'he bank+s BO$RD OF D&R ('OR) .$) $ R )#O%)&B&"&'8 to ensure that management establishes a )8)' M for assessing the various risks2 develops a s1stem to R "$' R&)/ 'O '. B$%/+) ($#&'$" " ! "2 and establishes a method for MO%&'OR&%* (OM#"&$%( 3&'. &%' R%$" #O"&(& ), 'he board should regularl1 ! R&F8 whether its )8)' M OF &%' R%$" (O%'RO") &) $D 0-$' to ensure well=
ordered and prudent conduct of business,

June 2004

Basel_II_Pillar_II

2/

Risk Management #rocess

# R&OD&( R !& 3) of its risk management process to %)-R &') &%' *R&'82 $((-R$(82 $%D R $)O%$B" % )), $reas that should be reviewed include6
< $ppropriateness of the bank+s capital assessment process given the NATURE0 SCOPE AND COMPLE1ITY of its activities; < &dentification of <

LARGE E1POSURES AND RISK CONCENTRATIONS2 $ccurac1 and completeness of DATA INPUTS into the bank+s
assessment process;

< Reasonableness and validit1 of assessment process; and

SCENARIOS used in the

< STRESS TESTING and anal1sis of ASSUMPTIONS AND INPUTS,

June 2004 Basel_II_Pillar_II 20

Principle 3
)-# R!&)OR) ).O-"D R !& 3 and evaluate banks+ internal capital adequac1 assessments and strategies2 as well as their abilit1 to monitor and ensure their compliance with regulator1 capital ratios, )upervisors should '$/ $##RO#R&$' )-# R!&)OR8 $('&O% if the1 are not satisfied with the result of this process,

June 2004

Basel_II_Pillar_II

30

4,,Principle 3
'he )-B)'$%'&$" &M#$(' '.$' RROR) &% '. M '.ODO"O*8 or assumptions of formal anal1ses can have on resulting capital requirements requires a detailed review b1 supervisors of each bank+s internal anal1sis,

June 2004

Basel_II_Pillar_II

31

4,,Principle 3
THE SUPERVISOR should regularl1 R !& 3 '. #RO( )) b1 which a bank
< < < < assesses its capital adequac12 risk position2 resulting capital levels2 qualit1 of capital held,

!$"-$' the degree to which a bank has in place a sound &%' R%$" #RO( )) 'O $)) )) ($#&'$" $D 0-$(8, 'he M#.$)&) of the review should be on the 0-$"&'8 OF '. B$%/+) R&)/ M$%$* M %' and
)upervisors should also controls and should not result in supervisors functioning as bank management,

June 2004

Basel_II_Pillar_II

32

'uper%isor# Re%iew !et,ods

O%=)&' e4aminations or inspections; OFF=)&' review; D&)(-))&O%s with bank management; R !& 3 OF 3OR/ DO% B8 @' R%$" $-D&'OR) 9provided it is adequatel1
focused on the necessar1 capital issues:; and #eriodic

R #OR'&%*,

June 2004

Basel_II_Pillar_II

33

)upervisor1 assessment and review

Review of adequac1 of R&)/ $)) ))M %' $ssessment of ($#&'$" $D 0-$(8 $)) ))M %' %!&RO%M %' )upervisor1 review of (OM#"&$%( 3&'. OF '. (O%'RO"

M&%&M-M )'$%D$RD) )-# R!&)OR8 R )#O%)

June 2004 Basel_II_Pillar_II 34

Re'ie5 $+ &e)% c* $+ ri"! ""e""-en(

)upervisors should assess
the degree to which internal targets and processes incorporate the full

R$%* OF M$' R&$" R&)/) faced b1 the bank,

the adequac1 of risk measures used in assessing internal

($#&'$" $D 0-$(8
the e4tent to which these risk measures are also used operationall1 in

) ''&%* "&M&')2 evaluating business line performance2

and evaluating and controlling risks more generall1, consider the results of

) %)&'&!&'8 $%$"8) ) and

Basel_II_Pillar_II 3&

stress tests conducted b1 the institution and how these results relate to capital plans,
June 2004

$ssessment of capital adequac1

'$R* ' ($#&'$" " ! "
< &s comprehensive and relevant to the current operating environment < &s properl1 monitored and reviewed b1 senior management < has provided for une4pected events in setting its capital levels
'he

(OM#O)&'&O% OF ($#&'$" is appropriate for the nature and

scale of the bank+s business,

'he

)O#.&)'&($'&O% OF ' (.%&0- ) and stress tests

used should be commensurate with the bank+s activities, 'his anal1sis should cover a

3&D R$%* OF @' R%$" (O%D&'&O%) $%D )( %$R&O)

June 2004 Basel_II_Pillar_II 3(

$ssessment of the control environment

)upervisors should consider 'he qualit1 of the bank+s M$%$* M %' &%FORM$'&O% R #OR'&%* $%D )8)' M) 'he manner in which business R&)/) and activities are $**R *$' D Management+s record in R )#O%D&%* 'O M R*&%* OR (.$%*&%* R&)/) ($#&'$" !), B$%/+) R&)/ #ROF&" $dequac1 of its R&)/ M$%$* M %' #RO( )) $%D &%' R%$" (O%'RO") 4ternal factors such as B-)&% )) (8(" FF (') $%D '. M$(RO (O%OM&( %!&RO%M %',
June 2004 Basel_II_Pillar_II 3.

)upervisor1 review of compliance with minimum standards

'he (ommittee regards this review of minimum standards and qualif1ing criteria as an integral part of the supervisor1 review process under #rinciple 5,

< &f INTERNAL METHODOLOGIES2

credit risk mitigation techniques and asset securitisations are to be recognised for regulator1 capital purposes2 banks will need to meet a number of requirements2 including risk

<

management standards and disclosures, $s regards STANDARDISED APPROACHES use of various instruments that can reduce #illar 7 capital requirements are utilised and
understood as part of a sound2 tested2 and properl1 documented risk management process,

June 2004

Basel_II_Pillar_II

3/

)upervisor1 response
.aving carried out the review process described above2 )-# R!&)OR) ).O-"D '$/ $##RO#R&$' $('&O% if the1 are not satisfied with the results of the bank+s own risk assessment and capital allocation, )upervisors should consider a range of actions2 such as those set out under #rinciples D and E ,

June 2004

Basel_II_Pillar_II

30

Principle 6
)upervisors should 'O O# R$' $BO! @# (' B$%/) '. M&%&M-M

R *-"$'OR8 ($#&'$" R$'&O) and should have the $B&"&'8 'O R 0-&R banks to hold capital in e4cess of the minimum,

June 2004

Basel_II_Pillar_II

40

(apital under #illar & A && 'he distinction

#&""$R 7 ($#&'$" R 0-&R M %') 3&"" B-FF R FOR -%( R'$&%'& ) )-RRO-%D&%* '. B$%/) $) $ 3.O" ,
< &t is anticipated that such buffers under #illar 7 will be set to provide reasonable assurance that a bank with good internal s1stems and controls2 a well=diversified risk profile and a business profile well covered b1 the #illar 7 regime2 will meet the minimum goals for soundness embodied in #illar 7,

B$%/=)# (&F&( -%( R'$&%'& ) 'R $' D -%D R #&""$R 5,

< )upervisors will need to consider whether the particular features of the markets for which the1 are responsible are adequatel1 covered,

June 2004

Basel_II_Pillar_II

41

Rationale for #illar 5 capital

#illar 7 minimums are anticipated to be set to

$(.& !

$ " ! " OF B$%/

that is below the level of creditworthiness sought b1 man1 banks for their own reasons, For e4ample2 most international banks appear to prefer to be highl1 rated b1 internationall1 recognised rating agencies, 'hus2 banks are likel1 to choose to operate above #illar 7 minimums for competitive reasons,
&n the normal course of business2 the t1pe and volume of activities will change2 as will the different risk e4posures2 causing

F"-('-$'&O%) &% '. ($#&'$" R$'&O,

O! R$""

June 2004

Basel_II_Pillar_II

42

Rationale for #illar 5 capital

&t

(O)'"8 for banks 'O R$&) $DD&'&O%$" ($#&'$"2 especiall1 if this needs to be done quickl1 or at a '&M when market conditions are
ma1 be unfavourable,

For banks to

M$8 #"$( B$%/) &% BR $(. OF '. R " !$%' "$3 and?or prompt non=discretionar1
requirements is a serious matter, &t corrective action on the part of supervisors, 'here ma1 be

F$""

below minimum regulator1 capital

R&)/)2 either )# (&F&( 'O &%D&!&D-$" B$%/)2 or more generall1 to an

econom1 at large2 that are not taken into account in #illar 7,
Basel_II_Pillar_II 43

June 2004

&mplementation
'here are to supervisors for ensuring that individual banks are operating with adequate levels of capital the supervisor ma1

) ! R$" M $%) $!$&"$B" ,

) ' 'R&** R $%D '$R* ' ($#&'$" R$'&O) D F&% ($' *OR& ) above minimum ratios 9e,g,
well capitalised and adequatel1 capitalised: for identif1ing the capitalisation level of the bank

June 2004

Basel_II_Pillar_II

44

Principle 7
)upervisors should seek

'O &%' R! % $' $%

$R"8 )'$* 'O #R ! %' ($#&'$" FROM F$""&%* B "O3 '. M&%&M-M " ! ") required to support the
risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored

June 2004

Basel_II_Pillar_II

4&

Range of actions
&%(R $) ($#&'$", 'hese ma1 include
< intensif1ing the monitoring of the bank < restricting the pa1ment of dividends < requiring the bank to prepare and implement a satisfactor1 capital adequac1 restoration plan < requiring the bank to raise additional capital immediatel1,
)upervisors should have the D&)(R '&O% to use the tools best suited to the circumstances of the bank and its operating environment, )ome # RM$% %' M $)-R ) 9such as improving s1stems and controls: ma1 be implemented = increased capital might be used as an interim measure

June 2004

Basel_II_Pillar_II

4(

Speci+ic i""%e"
'he (ommittee has identified a number of important issues that banks

)-# R!&)OR) ).O-"D #$R'&(-"$R"8 FO(-) on when carr1ing out the supervisor1 review process, 'hese issues include )OM / 8 R&)/) 3.&(. $R %O' D&R ('"8 $DDR )) D -%D R #&""$R 7 $%D &M#OR'$%' $)) ))M %') that
and supervisors should make to ensure the proper functioning of certain aspects of #illar 7,

June 2004

Basel_II_Pillar_II

4.

$, &nterest rate risk in the banking book

'. R &) (O%)&D R$B" . ' RO* % &'8 in terms of the nature of the
underl1ing risk and the processes for monitoring and managing it,

. %( 2 it is at this time most appropriate to treat interest rate risk in the banking book -%D R #&""$R 5,
%evertheless2 supervisors who consider that there is

)-FF&(& %' .OMO* % &'8 within their

banking populations regarding the nature and methods for monitoring and measuring this risk

(O-"D )'$B"&). $ M$%D$'OR8 M&%&M-M ($#&'$" R 0-&R M %',

June 2004 Basel_II_Pillar_II 4/

F,&nterest rate risk in the banking book

= PRINCIPLES FOR THE MANAGEMENT AND SUPERVISION OF INTEREST RATE RISK, Banks would have to provide the results of their internal measurement, 3. R (O%OM&( !$"- D ("&% ) B8 MOR '.$% 5GH of the sum of 'ier 7 and 'ier 5 capital as a result of a standardised &%' R )' R$' ).O(/ 95GG B$)&) #O&%'):
'he revised guidance

June 2004

Basel_II_Pillar_II

40

B,7, (redit risk )tress tests under the &RB

&n respect of a stress test performed as part of the #illar 7 &RB minimum requirements 9paragraphs EDE to EDI:,

< )upervisors

MAY WISH TO REVIEW HOW THE STRESS TEST HAS BEEN CARRIED OUT

to consider whether a bank has sufficient capital for these purposes, < )upervisor will react appropriatel1, 'his will usuall1 involve

REDUCE ITS RISKS AND8OR TO HOLD ADDITIONAL CAPITAL 8PROVISIONS2 so that e4isting capital
requiring the bank to
resources could cover the #illar requirements plus the result of a recalculated stress test,

June 2004

Basel_II_Pillar_II

&0

B,5, (redit risk < Definition of Default

$ bank must use the reference definition of default for its

&%' R%$"
and $D,

)'&M$'&O%) OF #D
as detailed in paragraph

and?or "*D national

.owever2

EJE2

)-# R!&)OR) 3&"" &))

on how the reference definition of default is to be interpreted in their jurisdictions, )upervisors will assess individual banks+ application of the reference definition of default and its impact on capital requirements, &n particular2

*-&D$%(

FO(-) O% '. &M#$(' OF D !&$'&O%) FROM '. R F R %( D F&%&'&O% according to paragraph EJK 9use of e4ternal data
supervisors will or historic internal data not full1 consistent with the reference definition of default:,
June 2004 Basel_II_Pillar_II &1

B,D, (redit risk < Residual risk

-se of

credit risk mitigation

9(RM: techniques like collateral2

guarantees or credit derivatives to reduce their credit risk and hnce capital2

give rise to risks effective,

that ma1 render the overall risk reduction less

$ccordingl1 these risks 9e,g, legal risk2 documentation risk2 or liquidit1 risk: to which banks are e4posed are of

supervisor1 concern,

June 2004

Basel_II_Pillar_II

&2

B,D, (redit risk < Residual risk

@$M#" ) OF R )&D-$" R&)/
< &nabilit1 to sei>e2 or realise in a timel1 manner2 collateral pledged 9on default of the counterpart1:; < Refusal or dela1 b1 a guarantor to pa1; < &neffectiveness of untested documentation,

$##RO#R&$' 3R&'' % (RM #O"&(& ) $%D #RO( D-R ) in order to control these residual risks, $ bank ma1 be required to )-BM&' '. ) #O"&(& ) $%D #RO( D-R ) 'O )-# R!&)OR) and
)upervisors will require banks to have in place must regularl1 review their appropriateness2 effectiveness and operation,

June 2004

Basel_II_Pillar_II

&3

B,D, (redit risk < Residual risk

3here supervisors are not satisfied as to the robustness2 suitabilit1 or application of these policies and procedures the1 ma1 direct the bank to

take immediate remedial action6

< Make adjustments to the assumptions on the own haircuts approach:; < *ive " )) '.$% F-"" R (O*%&'&O% of credit risk mitigants 9on the whole credit portfolio or b1 specific product line:; < .old a specific

.O"D&%* # R&OD)2 )-# R!&)OR8 .$&R(-')2 OR !O"$'&"&'8 9in

$DD&'&O%$" $MO-%' OF ($#&'$"

June 2004

Basel_II_Pillar_II

&4

B,D, (redit risk < (oncentration risk

&M#OR'$%' ($-) OF M$COR #ROB" M) in banks Risk concentrations can arise in a bank+s $)) ')2 "&$B&"&'& )2 OR OFF=B$"$%( ). ' &' M) Because " %D&%* &) '. #R&M$R8 $('&!&'8 of most banks2 credit risk concentrations are often the most
Risk concentrations are arguabl1 the single most
material risk concentrations within a bank based on common or

(ORR "$' D R&)/

F$('OR)2 which2 in times of stress2 have an adverse effect

June 2004 Basel_II_Pillar_II &&

B,D, (redit risk < (oncentration risk

)ignificant < supervisors define a limit for e4posures of this nature, < Banks might also establish an aggregate limit for the management and control of all of its large e4posures

)&%*" ?*RO-# @#O)-R )2

(O%OM&( ) ('OR OR * O*R$#.&( R *&O%;

(redit e4posures to same (redit e4posures to counterparties whose financial performance is dependent on the

(OMMOD&'8;

)$M

$('&!&'8

OR

&ndirect credit e4posures arising from a

$('&!&'& )
June 2004

B$%/+) (RM

9e,g, e4posure to a single collateral t1pe or to credit protection provided b1 a single counterpart1:,

Basel_II_Pillar_II

&(

FB,D, (redit risk < (oncentration risk

$ bank+s framework for managing credit risk concentrations should be

(" $R"8 DO(-M %' D and should include

< a definition of the credit risk concentrations =how calculated, < "imits should be defined in relation to a bank+s capital2 total assets or2 where adequate measures e4ist2 its overall risk level, < )tress tests
(onduct periodic )'R and review the results

)) ' )')

of its major credit risk concentrations

&D %'&F8 $%D R )#O%D to potential changes in M$R/ ' (O%D&'&O%) that could adversel1 impact the bank, (OM#"& ) 3&'. PRINCIPLES for the Management of Cre !t R!"# 9)eptember 5GGG:
June 2004 Basel_II_Pillar_II &.

FB,D, (redit risk < (oncentration risk

)-# R!&)OR) should $)) )) the e4tent of a bank+s credit risk concentrations2 how the1 are M$%$* D2 and the e4tent to which the bank considers them in its internal assessment of ($#&'$" $D 0-$(8 under #illar 5, )uch assessments should include R !& 3) of the results of a bank+s )'R )) ' )'), '$/ $##RO#R&$' $('&O%) where the risks arising
from a bank+s credit risk concentrations are not adequatel1 addressed b1 the bank,

June 2004

Basel_II_Pillar_II

&/

(, Operational risk
*ross income2 used in the Basic &ndicator and )tandardised $pproaches for operational risk2 is onl1 a pro41 for the scale of operational risk e4posure of a bank and can in some cases 9e,g, for

"O3 M$R*&%) OR -%D R )'&M$' '. %

for operational risk,

B$%/) 3&'. #ROF&'$B&"&'8: D FOR ($#&'$"

Pra%t!%e" for the

3ith reference to the (ommittee document on So$n Management an

S$&er'!"!on of O&erat!onal R!"# 9Februar1 5GGD:( the

)-# R!&)OR 3. '. R '.

other banks of similar
June 2004 O# R$'&O%),

).O-"D (O%)&D R ($#&'$" R 0-&R M %' )&L $%D 3&'. )&M&"$R

&0

generated b1 the #illar 7 calculation gives a consistent picture of the individual bank+s operational risk e4posure2 for e4ample in comparison with
Basel_II_Pillar_II

O(#er "pec(" $+ (#e "%per'i"$r* re'ie5 pr$ce""

S%per'i"$r* (r n"p renc* n& cc$%n( /ili(* En# nce& cr$""9/$r&er c$--%nic (i$n n& c$$per (i$n

June 2004

Basel_II_Pillar_II

(0

S%per'i"$r* (r n"p renc* n& cc$%n( /ili(*

D&)(R '&O%$R8

'he supervision of banks is not an e4act science2 and therefore

" M %') within supervisor1 review process are &% !&'$B" ,

the

)upervisors must take care to carr1 out their obligations in a

'R$%)#$R %' $%D $((O-%'$B" M$%% R, )upervisors should make #-B"&("8 $!$&"$B" '. (R&' R&$ to be used in the review of banks+ internal capital assessments,
Basel_II_Pillar_II (1

June 2004

 &f

'$R* ' OR 'R&** R R$'&O) OR 'O ) ' ($' *OR& ) OF ($#&'$" in e4cess of the
a supervisor chooses to set

)upervisor1 transparenc1 and accountabilit1

regulator1 minimum2 factors that ma1 be considered in doing so should be publicl1 available, 3here the capital requirements are set above the minimum for an individual bank2 the supervisor should

'. B$%/ (.$R$(' R&)'&() '. B$%/ which resulted in the requirement and an1
remedial action necessar1,
June 2004 Basel_II_Pillar_II (2

@#"$&% 'O '. R&)/ )# (&F&( 'O

Si.ni+ic nce $+ ri"! (r n"+er

#illar 7 principle = banks should take account of the

(O%OM&( )-B)'$%( of transactions in their D ' RM&%$'&O% OF ($#&'$"

adequac16 supervisor1 authorities will monitor2 as appropriate2 whether banks have done so adequatel1, &f the risk transfer arising from a securitisation has deemed to be

($% R 0-&R '. $##"&($'&O% OF $ .&*. R ($#&'$" R 0-&R M %' than

%O' significant b1 the national supervisor1 authorit12 it prescribed under #illar 7 or2 alternativel12 ma1 den1 a bank from obtaining an1 capital relief from the securitisations,

June 2004

Basel_II_Pillar_II

(3

Si.ni+ic nce $+ ri"! (r n"+er

R '$&%&%* OR R #-R(.$)&%* )&*%&F&($%' securitisation e4posures might undermine the
intent of a securitisation to transfer credit risk, < supervisor1 authorities might e4pect that a significant portion of the credit risk and of the nominal value of the pool be transferred to at least one independent third part1 at inception and on an ongoing basis,

3here banks repurchase risk for M$R/ ' M$/&%* #-R#O) )2

< supervisors could find it appropriate for an originator to bu1 part of a transaction but not2 for e4ample2 to repurchase a whole tranche, < supervisors would e4pect these positions should be resold within an appropriate period2 thereb1 remaining true to the initial intention to transfer risk,
June 2004 Basel_II_Pillar_II (4

Si.ni+ic nce $+ ri"! (r n"+er

$nother implication of realising onl1 a non= significant risk transfer2 especiall1 if related to good qualit1 unrated e4posures2 is that both the poorer qualit1 unrated assets and most of the credit risk embedded in the e4posures underl1ing the securitised transaction are likel1 to remain with the originator,
< the supervisor1 authorit1 ma1 increase the capital requirement for particular e4posures or even increase the overall level of capital the bank is required to hold,

June 2004

Basel_II_Pillar_II

(&

M r!e( inn$' (i$n"

$s the minimum capital requirements for securitisation ma1 not be able to address all #O' %'&$" &))- )2 supervisor1 authorities are e4pected to consider new features of securitisation transactions as the1 arise, and2 where appropriate2 take appropriate action under #illar 5, $ #illar 7 response ma1 be formulated to take account of M$R/ ' &%%O!$'&O%), )uch a response ma1 take the form of a set of operational requirements and?or a specific capital treatment,
June 2004 Basel_II_Pillar_II ((

Pr$'i"i$n $+ i-plici( "%pp$r(

(O%'R$('-$" )-##OR'
i,e, credit enhancements provided at the inception of a securitised transaction: can include over collateralisation2 credit derivatives2 spread accounts2 contractual recourse obligations2 subordinated notes2 credit risk mitigants provided to a specific tranche2 the subordination of fee or interest income or the deferral of margin income2 and clean=up calls that e4ceed 7G H of the initial issuance,
4amples of include the purchase of deteriorating credit risk e4posures from the underl1ing pool2 the sale of discounted credit risk e4posures into the pool of securitised credit risk e4posures2 the purchase of underl1ing e4posures at above market price or an increase in the first loss position according to the deterioration of the underl1ing e4posures,

&M#"&(&' )-##OR'

June 2004

Basel_II_Pillar_II

(.

Pr$'i"i$n $+ i-plici( "%pp$r(

3hen a bank has been found to provide implicit support to a securitisation2 it will be required to hold capital against all of the
underl1ing e4posures associated with the structure as if the1 had not been securitised

, disclose publicl1

&t will also be required to that it was found to have provided non=contractual support2 as well as the resulting increase in the capital charge 9as noted above:,

hold capital against e4posures for which the1 assume the credit risk2 and to discourage them from providing non=contractual support,
'he is to require banks to
June 2004 Basel_II_Pillar_II (/

aim

Pr$'i"i$n $+ i-plici( "%pp$r(

R # $' D #RO!&)&O% OF &M#"&(&' )-##OR'
< the bank is required to <

DISCLOSE ITS TRANSGRESSIONL the bank ma1 be PREVENTED FROM GAINING FAVOURABLE CAPITAL TREATMENT on securitised assets
for a period of time to be determined b1 the national supervisor;

< the bank ma1 be RE:UIRED TO HOLD ($#&'$" against all securitised assets as though the bank had created a commitment to them2 b1 appl1ing a conversion factor to the risk weight of the underl1ing assets; < for purposes of capital calculations2 the bank ma1 be required to

<

TREAT ALL SECURITISED ASSETS AS IF THEY REMAINED ON THE BALANCE SHEET; the bank ma1 be required to HOLD REGULATORY CAPITAL IN E1CESS of the minimum risk=based capital ratios,
Basel_II_Pillar_II (0

June 2004

Re"i&% l ri"!"
)upervisors will R !& 3 the appropriateness of protection recognised against first loss credit enhancements, )upervisors will e4pect banks+ policies to take account of this in determining their (O%OM&( ($#&'$", $ction where supervisors do not consider the approach to protection recognised as adequate2 ma1 include &%(R $)&%* '. ($#&'$" R 0-&R M %' against a particular transaction or class of transactions,
June 2004 Basel_II_Pillar_II .0

(all provisions
)upervisors e4pect a bank

%O' 'O M$/ -) OF ("$-) ) '.$' %'&'" ) &' 'O ($"" the securitisation transaction or the overage of credit protection prematurel1 if this would increase the bank+s
e4posure to losses or deterioration in the credit qualit1 of the underl1ing e4posures,
)upervisors e4pect banks to

O%"8

@ (-'

(" $%=-# ($"")

such as when the cost of servicing the outstanding credit e4posures e4ceeds the benefits of servicing the underl1ing credit e4posures,

June 2004

Basel_II_Pillar_II

.1

(all provisions
)upervisors ma1 require a of the rationale for and impact of the e4ercise of the call on the bank+s regulator1 capital ratio and also require a follow=up transaction2 if necessar12 depending on the bank+s overall risk profile2 and e4isting market conditions, Date related calls should be set at a date no earlier than the duration or the weighted average life of the underl1ing securitisation e4posures

#R&OR R !& 3

June 2004

Basel_II_Pillar_II

.2

including an assessment of the risk and likelihood of earl1 amortisation of such transactions, $t a minimum2 supervisors should ensure that banks have

E rl* -$r(i" (i$n )upervisors should R !& 3 .O3 B$%/) &%' R%$""8 M $)-R 2 MO%&'OR2 $%D M$%$* R&)/) $))O(&$' D 3&'. ) (-R&'&)$'&O%) OF R !O"!&%* (R D&' F$(&"&'& )2
implemented

R $)O%$B" M '.OD) FOR $""O($'&%* (O%OM&( ($#&'$" against the economic substance of the credit
risk arising from revolving securitisations? earl1 amortisation and should e4pect banks to have adequate capital and liquidit1 contingenc1 plans,

June 2004

Basel_II_Pillar_II

.3

G%i& nce Rel (e& ($ (#e S%per'i"$r* Re'ie5 Pr$ce"" ;P%/li"#e& /* (#e B "el C$--i((ee $n B n!in. S%per'i"i$n<

1, #art B of the $mendment to the (apital $ccord to &ncorporate Market Risks Canuar1 7MMK2 F!nal 3, (ore #rinciples for ffective Banking )upervision )eptember 7MMI2 F!nal 6, 'he (ore #rinciples Methodolog1 October 7MMM2 F!nal 7, Risk Management *uidelines for Derivatives Cul1 7MME2 F!nal =, Management of &nterest Rate Risk )eptember 7MMI2 F!nal >, Risk Management for lectronic Banking March 7MMN2 F!nal ?, Framework for &nternal (ontrols )eptember 7MMN2 F!nal
June 2004 Basel_II_Pillar_II .4

G%i& nce Rel (e& ($ (#e S%per'i"$r* Re'ie5 Pr$ce"" ;P%/li"#e& /* (#e B "el C$--i((ee $n B n!in. S%per'i"i$n< @, )ound #ractices for Banks+ &nteractions with .ighl1 "everaged &nstitutions Canuar1 7MMM2 F!nal A, nhancing (orporate *overnance $ugust 7MMM2 F!nal 1B, )ound #ractices for Managing "iquidit1 Februar1 5GGG2 F!nal 11, #rinciples for the Management of (redit Risk )eptember 5GGG2 F!nal 13, )upervisor1 *uidance for Managing )ettlement Risk in Foreign 4change 'ransactions )eptember 5GGG2 F!nal 16, #rinciples for the Management and )upervision of &nterest Rate Risk Canuar1 5GG72 For Comment 17, Risk Management #rinciples for lectronic Banking Ma1 5GG72 For Comment 1=, &nternal $udit in Banks and the )upervisorOs Relationship with $uditors $ugust 5GG72 F!nal 1>, (ustomer Due Diligence for Banks October 5GG72 F!nal
June 2004 Basel_II_Pillar_II .&

G%i& nce Rel (e& ($ (#e S%per'i"$r* Re'ie5 Pr$ce"" ;P%/li"#e& /* (#e B "el C$--i((ee $n B n!in. S%per'i"i$n< 1?, 'he Relationship Between Banking )upervisors and Banks+ 4ternal $uditors Canuar1 5GG52 F!nal 1@, )upervisor1 *uidance for Dealing with 3eak Banks March 5GG52 F!nal 1A, Management and )upervision of (ross=border lectronic Banking $ctivities October 5GG52 For Comment 3B, )ound #ractices for the Management and )upervision of Operational Risk Februar1 5GGD2 F!nal

%ote6 the papers are available 9www,bis,org?bcbs?publ?inde4,htm:,

from

the

B&)

website

June 2004

Basel_II_Pillar_II

.(