PRESTIGE INSTITUTE OF MANAGEMENT AND

RESEARCH INDORE (M.P.)

ASSIGNMENT
OF
BANK MANAGEMENT
ON
BASEL COMMITTEE

SUBMITTED TO: SUBMITTED BY:

Prof. Shailendra Gangrade Priyanka Rai
MBA (FA) II sem
INTRODUCTION

Banks have a vital function in the economy. They have easy access to funds
through collecting savers money, issuing debt securities, or borrowing on the
inter-bank markets. The funds collected are invested in short-term and long-term
risky assets, which consist mainly of credits to various economic actors
(individuals, companies, governments ) Through centralizing any money surplus
and injecting it back into the economy, large banks are the heart maintaining the
blood supply of our modern capitalist societies. So, it is no surprise that they are
subject to so much constraint and regulations.
But if banks often consider regulation only as a source of the costs that they have
to assume to maintain their licenses, their attitudes are evolving under the
pressure of two factors.
First, risk management discipline has seen significant development since the
1970s, thanks to the use of sophisticated quantification techniques. This
revolution first occurred in the field of market risk management, and more
recently credit risk management has also reached a high level of sophistication.
Risk management has evolved from a passive function of risk monitoring, limit-
setting, and risk valuation to a more proactive function of performance measure,
risk-based pricing, portfolio management, and economic capital allocation.
Modern approaches desire not only to limit losses but to take an active part in the
process of shareholder value creation, which is (or, at least, should be) the main
goal of any companys top management.
The second factor is that banking regulation is currently under review.
The banking regulation frameworks in most developed countries are currently
based on a document issued by a G10 central bankers working group.
This document, International convergence of capital measurement and capital
standards, was a brief set of simple rules that were intended to ensure financial
stability and a level playing field among international banks. As it quickly
appeared that the framework had many weaknesses, and even sometimes
perverse effects, and thanks to the evolution that we mentioned above, a revised
proposition saw the light in 1999. After three rounds of consultation with the
sector, the last document, supposed to be the final one (often called the
Basel 2 Accord) was issued in June 2004 (Basel Committee on Banking
Supervision, 2004d, p. 239). The level of sophistication of the proposed revision is
a tremendous progress by comparison with the 1988 text, which can be seen just
by looking at the documents size (239 pages against 28). The formulas used to
determine the regulatory capital requirements are based on credit risk portfolio
models that have been known in the literature for some years but that few banks,
except the largest, have actually implemented. Those two factors represent an
exceptional opportunity for banks that wish to improve their risk management
frameworks to make investments that will both match the regulators new
expectations and, by adding a few elements, be in line with state-of-the-art
techniques of shareholder value creation through risk management.
The goal of this book is to give a broad outline of the challenges that
will have to be met to reach the new regulatory standards, and at the
same time to give a practical overview of the two main current techniques used in
the field of credit risk management: credit scoring and credit value at risk. The
book is intended to be both pedagogic and practical, which is why we include
concrete examples and furnish an accompanying website
(www.creditriskmodels.com) that will permit readers to move from abstract
equations to concrete practice. We decided not to focus on cutting-edge
research, because little of it ends up becoming an actual market standard.
Rather, we preferred to discuss techniques that are more likely to
be tomorrows universal tools.
The Basel 2 Accord is often criticized by leading banks because it is said not to go
far enough in integrating the latest risk management techniques. But those
techniques usually lack standardization, there is no market consensus on which
competing techniques are the best, and the results are highly sensitive to model
parameters that are hard to observe. Our sincere belief is that todays main
objective of the sector should be the wide-spread integration of the main building
blocks of credit risk management techniques (as has been the case for market risk
management since the 1990s); to be efficient for everyone, these techniques
need wide and liquid secondary credit markets,
where each bank will be able to trade its originated credits efficiently
to construct a portfolio of risky assets that offers the best riskreturn profile as a
function of its defined risk tolerance. Many initiatives of various banks,
researchers, or risk associations have contributed to the educational and
standardization work involved in the development of these markets, and this
book should be seen as a small contribution to this common effort.
 Current Banking Regulation

Definition of BASEL Committee:

The Basel Committee on Banking Supervision (BCBS) is a committee of banking
supervisory authorities that was established by the central bank governors of
the Group of Ten countries in 1974. It provides a forum for regular cooperation on
banking supervisory matters. Its objective is to enhance understanding of key
supervisory issues and improve the quality of banking supervision worldwide. The
Committee frames guidelines and standards in different areas - some of the
better known among them are the international standards on capital adequacy,
the Core Principles for Effective Banking Supervision and the Concordat on cross-
border banking supervision. The Committee's Secretariat is located at the Bank
for International Settlements (BIS) in Basel, Switzerland. However, the BIS and the
Basel Committee remain two distinct entities.

History of BASEL:
Founded in 1974
At a glance
The Basel Committee - initially named the Committee of Banking Regulations and
Supervisory Practices - was established by the central bank Governors of the
Group of Ten countries at the end of 1974 in the aftermath of serious
disturbances in international currency and banking markets (notably the failure of
Bankhaus Herstatt in West Germany).

The Committee, headquartered at the Bank for International Settlements in Basel,

was established to enhance financial stability by improving the quality of banking
supervision worldwide, and to serve as a forum for regular cooperation between
its member countries on banking supervisory matters. The Committee's first
meeting took place in February 1975, and meetings have been held regularly
three or four times a year since.

Since its inception, the Basel Committee has expanded its membership from the
G10 to 45 institutions from 28 jurisdictions. Starting with the Basel Concordat,
first issued in 1975 and revised several times since, the Committee has
established a series of international standards for bank regulation, most notably
its landmark publications of the accords on capital adequacy which are commonly
known as Basel I, Basel II and, most recently, Basel III.

Laying the foundation: international cooperation between banking supervisors

At the outset, one important aim of the Committee's work was to close gaps in
international supervisory coverage so that (i) no banking establishment would
escape supervision; and (ii) supervision would be adequate and consistent across
member jurisdictions. A first step in this direction was the paper issued in 1975
that came to be known as the "Concordat". The Concordat set out principles for
sharing supervisory responsibility for banks' foreign branches, subsidiaries and
joint ventures between host and parent (or home) supervisory authorities. In May
1983, the Concordat was revised and re-issued as Principles for the supervision of
banks' foreign establishments.
In April 1990, a supplement to the 1983 Concordat was issued. This
supplement, Exchanges of information between supervisors of participants in the
financial markets, aimed to improve the cross-border flow of prudential
information between banking supervisors. In July 1992, certain principles of the
Concordat were reformulated and published as the Minimum standards for the
supervision of international banking groups and their cross-border
establishments. These standards were communicated to other banking
supervisory authorities, which were invited to endorse them.
In October 1996, the Committee released a report on The supervision of cross-
border banking, drawn up by a joint working group that included supervisors from
non-G10 jurisdictions and offshore centres. The document presented proposals
for overcoming the impediments to effective consolidated supervision of the
cross-border operations of international banks. Subsequently endorsed by
supervisors from 140 countries, the report helped to forge relationships between
supervisors in home and host countries.
The involvement of non-G10 supervisors also played a vital part in the
formulation of the Committee's Core principles for effective banking
supervision in the following year. The impetus for this document came from a
1996 report by the G7 finance ministers that called for effective supervision in all
important financial marketplaces, including those of emerging market economies.
When first published in September 1997, the paper set out 25 basic principles
that the Basel Committee believed should be in place for a supervisory system to
be effective. After several revisions, most recently in September 2012, the
document now includes 29 principles, covering supervisory powers, the need for
early intervention and timely supervisory actions, supervisory expectations of
banks, and compliance with supervisory standards.

Basel I: the Basel Capital Accord

With the foundations for supervision of internationally active banks laid, capital
adequacy soon became the main focus of the Committee's activities. In the early
1980s, the onset of the Latin American debt crisis heightened the Committee's
concerns that the capital ratios of the main international banks were
deteriorating at a time of growing international risks. Backed by the G10
Governors, Committee members resolved to halt the erosion of capital standards
in their banking systems and to work towards greater convergence in the
measurement of capital adequacy. This resulted in a broad consensus on a
weighted approach to the measurement of risk, both on and off banks' balance
sheets.

There was strong recognition within the Committee of the overriding need for a
multinational accord to strengthen the stability of the international banking
system and to remove a source of competitive inequality arising from differences
in national capital requirements. Following comments on a consultative paper
published in December 1987, a capital measurement system commonly referred
to as the Basel Capital Accord was approved by the G10 Governors and released
to banks in July 1988.
The 1988 Accord called for a minimum ratio of capital to risk-weighted assets of
8% to be implemented by the end of 1992. Ultimately, this framework was
introduced not only in member countries but also in virtually all countries with
active international banks. In September 1993, the Committee issued a statement
confirming that G10 countries' banks with material international banking business
were meeting the minimum requirements set out in the Accord.

The Accord was always intended to evolve over time. It was amended
in November 1991 to more precisely define the general provisions or general loan
 loss reserves that could be included in the capital adequacy calculation. In April
1995, the Committee issued another amendment, to take effect at the end of that
year, to recognise the effects of bilateral netting of banks' credit exposures in
derivative products and to expand the matrix of add-on factors. In April
1996, another document was issued explaining how Committee members
intended to recognise the effects of multilateral netting.
The Committee also refined the framework to address risks other than credit risk,
which was the focus of the 1988 Accord. In January 1996, following two
consultative processes, the Committee issued the Amendment to the Capital
Accord to incorporate market risks (or Market Risk Amendment), to take effect at
the end of 1997. This was designed to incorporate within the Accord a capital
requirement for the market risks arising from banks' exposures to foreign
exchange, traded debt securities, equities, commodities and options. An
important aspect of the Market Risk Amendment was that banks were, for the
first time, allowed to use internal models (value-at-risk models) as a basis for
measuring their market risk capital requirements, subject to strict quantitative
and qualitative standards. Much of the preparatory work for the market risk
package was undertaken jointly with securities regulators.

Basel II: the New Capital Framework

In June 1999, the Committee issued a proposal for a new capital adequacy
framework to replace the 1988 Accord. This led to the release of a revised capital
framework in June 2004. Generally known as "Basel II", the revised
framework comprised three pillars:
1. minimum capital requirements, which sought to develop and expand the
standardised rules set out in the 1988 Accord
2. Supervisory review of an institution's capital adequacy and internal assessment
process.
3. Effective use of disclosure as a lever to strengthen market discipline and
encourage sound banking practices.
The new framework was designed to improve the way regulatory capital
requirements reflect underlying risks and to better address the financial
innovation that had occurred in recent years. The changes aimed at rewarding
and encouraging continued improvements in risk measurement and control.
The framework's publication in June 2004 followed almost six years of intensive
preparation. During this period, the Basel Committee consulted extensively with
banking sector representatives, supervisory agencies, central banks and outside
observers in order to develop significantly more risk-sensitive capital
requirements.

Following the June 2004 release, which focused primarily on the banking book,
the Committee turned its attention to the trading book. In close cooperation with
the International Organization of Securities Commissions (IOSCO), the
international body of securities regulators, the Committee published in July 2005
a consensus document governing the treatment of banks' trading books under the
new framework. For ease of reference, this new text was integrated with the June
2004 text in a comprehensive document released in June 2006: Basel II:
International convergence of capital measurement and capital standards: A
revised framework - Comprehensive version.
Committee members and several non-members agreed to adopt the new rules,
albeit on varying timescales. One challenge that supervisors worldwide faced
under Basel II was the need to approve the use of certain approaches to risk
measurement in multiple jurisdictions. While this was not a new concept for the
supervisory community - the Market Risk Amendment of 1996 involved a similar
requirement - Basel II extended the scope of such approvals and demanded an
even greater degree of cooperation between home and host supervisors. To help
address this issue, the Committee issued guidance on information-sharing in
2006, followed by advice on supervisory cooperation and allocation
mechanisms in the context of the advanced measurement approaches for
operational risk.

Towards Basel III

Even before Lehman Brothers collapsed in September 2008, the need for a
fundamental strengthening of the Basel II framework had become apparent. The
banking sector entered the financial crisis with too much leverage and inadequate
liquidity buffers. These weaknesses were accompanied by poor governance and
risk management, as well as inappropriate incentive structures. The dangerous
combination of these factors was demonstrated by the mispricing of credit and
liquidity risks, and excess credit growth.
 Responding to these risk factors, the Basel Committee issued Principles for sound
liquidity risk management and supervision in the same month that Lehman
Brothers failed. In July 2009, the Committee issued a further package of
documents to strengthen the Basel II capital framework, notably with regard to
the treatment of certain complex securitisation positions, off-balance sheet
vehicles and trading book exposures. These enhancements were part of a broader
effort to strengthen the regulation and supervision of internationally active banks,
in the light of weaknesses revealed by the financial market crisis.
In September 2010, the Group of Governors and Heads of Supervision
(GHOS) announced higher global minimum capital standards for commercial
banks. This followed an agreement reached in July regarding the overall design of
the capital and liquidity reform package, now referred to as "Basel III". In
November 2010, the new capital and liquidity standards were endorsed at the
G20 Leaders' Summit in Seoul and subsequently agreed at the December 2010
Basel Committee meeting.
The proposed standards were issued by the Committee in mid-December 2010
(and have been subsequently revised). The December 2010 versions were set out
in Basel III: International framework for liquidity risk measurement, standards and
monitoring and Basel III: A global regulatory framework for more resilient banks
and banking systems. The enhanced Basel framework revised and strengthen the
three pillars established by Basel II. It also extended the framework with several
innovations:
an additional layer of common equity - the capital conservation buffer - that, when
breached, restricts pay-outs to help meet the minimum common equity
requirement
a countercyclical capital buffer, which places restrictions on participation by banks
in system-wide credit booms with the aim of reducing their losses in credit busts
a leverage ratio - a minimum amount of loss-absorbing capital relative to all of a
bank's assets and off-balance sheet exposures regardless of risk weighting
liquidity requirements - a minimum liquidity ratio, the Liquidity Coverage Ratio
(LCR), intended to provide enough cash to cover funding needs over a 30-day period
of stress; and a longer-term ratio, the Net Stable Funding Ratio (NSFR), intended to
address maturity mismatches over the entire balance sheet
additional proposals for systemically important banks, including requirements for
supplementary capital, augmented contingent capital and strengthened
arrangements for cross-border supervision and resolution
 In January 2012, the GHOS endorsed a comprehensive process proposed by the
Committee to monitor members' implementation of Basel III. The Regulatory
Consistency Assessment Programme (RCAP) consists of two distinct but
complementary workstreams to monitor the timely adoption of Basel III
standards, and to assess the consistency and completeness of the adopted
standards including the significance of any deviations from the regulatory
framework.
These tightened definitions of capital, significantly higher minimum ratios and the
introduction of a macroprudential overlay represent a fundamental overhaul for
banking regulation. At the same time, the Basel Committee, its governing body
and the G20 Leaders have emphasised that the reforms will be introduced in a
way that does not impede the recovery of the real economy.

In addition, time is needed to translate the new internationally agreed standards

into national legislation. To reflect these concerns, a set of transitional
arrangements for the new standards was announced in September 2010,
although national authorities are free to impose higher standards and shorten
transition periods where appropriate.
The strengthened definition of capital will be phased in over five years: the
requirements were introduced in 2013 and should be fully implemented by the
end of 2017. Capital instruments that no longer qualify as Common Equity Tier 1
capital or Tier 2 capital will be phased out over a 10-year period, beginning 1
January 2013.

Turning to the minimum capital requirements, the higher minimums for Common
Equity and Tier 1 capital were phased in from 2013, and became effective at the
beginning of 2015. The schedule is as follows:

The minimum common equity and Tier 1 requirements increased from 2% and 4%
to 3.5% and 4.5%, respectively, at the beginning of 2013.
The minimum common equity and Tier 1 requirements rose to 4% and 5.5%,
respectively, at the beginning of 2014.
The final requirements for common equity and Tier 1 capital were set at 4.5% and
6%, respectively, at the beginning of 2015.
The 2.5% capital conservation buffer, which will comprise common equity and is
in addition to the 4.5% minimum requirement, will be phased in progressively
starting on 1 January 2016, and will become fully effective by 1 January 2019.
The leverage ratio will also be phased in gradually. The test (the so-called "parallel
run period") began in 2013 and will run until 2017, with a view to migrating to a
Pillar 1 treatment on 1 January 2018 based on review and appropriate calibration.
The exposure measure of the leverage ratio was finalised in January 2014.

The liquidity coverage ratio (LCR) will be phased in from 1 January 2015 and will
require banks to hold a buffer of high-quality liquid assets sufficient to deal with
the cash outflows encountered in an acute short-term stress scenario as specified
by supervisors. To ensure that banks can implement the LCR without disruption to
their financing activities, the minimum LCR requirement began at 60% in 2015,
rising in equal annual steps of 10 percentage points to reach 100% on 1 January
2019.

The other minimum liquidity standard introduced by Basel III is the Net Stable
Funding Ratio. This requirement, which takes effect as a minimum standard by 1
January 2018, will promote longer-term funding mismatches and provide
incentives for banks to use stable funding sources.

BASEL I
What is 'Basel I'
Basel I is a set of international banking regulations put forth by the Basel
Committee on Bank Supervision (BCBS) that sets out the minimum capital
requirements of financial institutions with the goal of minimizing credit risk. Banks
that operate internationally are required to maintain a minimum amount (8%) of
capital based on a per cent of risk-weighted assets. Basel I is the first of three sets
of regulations known individually as Basel I, II and III and together as the Basel
Accords.

Main Framework:
Basel I, that is, the 1988 Basel Accord, is primarily focused on credit risk and
appropriate risk-weighting of assets. Assets of banks were classified and grouped
in five categories according to credit risk, carrying risk weights of 0% (for example
cash, bullion, home country debt like Treasuries), 20% (securitisations such
as mortgage-backed securities (MBS) with the highest AAA rating), 50% (municipal
revenue bonds, residential mortgages), 100% (for example, most corporate debt),
and some assets given No rating. Banks with an international presence are
required to hold capital equal to 8% of their risk-weighted assets (RWA).
The tier 1 capital ratio = tier 1 capital / all RWA
The total capital ratio = (tier 1 + tier 2 + tier 3 capital) / all RWA
Leverage ratio = total capital/average total assets
Banks are also required to report off-balance-sheet items such as letters of credit,
unused commitments, and derivatives. These all factor into the risk weighted
assets. The report is typically submitted to the Federal Reserve Bank as HC-R for
the bank-holding company and submitted to the Office of the Comptroller of the
Currency (OCC) as RC-R for just the bank.
From 1988 this framework was progressively introduced in member countries of
G-10, comprising 13 countries as of 2013
Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain,
Sweden, Switzerland, United Kingdom and the United States of America.
Implementation of Basel I
The BCBS regulations do not have legal force. Members are responsible for their
implementation in their home countries. Basel I originally called for the minimum
capital ratio of capital to risk-weighted assets of 8% to be implemented by the
end of 1992. In September 1993, the BCBS issued a statement confirming that
G10 countries' banks with material international banking business were meeting
the minimum requirements set out in Basel I.

According to the BCBS, the minimum capital ratio framework was introduced in
member countries and in virtually all other countries with active international
banks.

BASEL ACCORD:
The Basel Accords are three sets of banking regulations (Basel I, II and III) set by
the Basel Committee on Bank Supervision (BCBS), which provides
recommendations on banking regulations in regards to capital risk, market risk
and operational risk. The purpose of the accords is to ensure that financial
institutions have enough capital on account to meet obligations and absorb
unexpected losses.
Basel I
The first Basel Accord, known as Basel I, was issued in 1988 and focuses on the
capital adequacy of financial institutions. The capital adequacy risk (the risk that a
financial institution will be hurt by an unexpected loss), categorizes the assets of
financial institutions into five risk categories (0%, 10%, 20%, 50% and 100%).
Under Basel I, banks that operate internationally are required to have a risk
weight of 8% or less

POSITIVE IMPACTS
Despite a lot of criticism, the Basel 1 Accord was successful in many ways. The
first and incontestable achievement of the initiative was that it created a
worldwide benchmark for banking regulations. Designed originally for
internationally active banks of the G10 countries, it is now the basis of the
inspiration for banking regulations in more than 100 countries and is often
imposed on national banks as well. Detractors will say that it does not
automatically produce a level playing field for banks, which was one of the Accord
targets, because banks with different risk profiles can end up with the same
capital requirement. But, at least, international banks are now facing a uniform
set of rules, which avoids them having to discuss with each national regulator
what the correct capital level should be for conducting the same business in many
different countries. Additionally, banks of different countries competing on the
same markets have equivalent regulatory capital requirements. That is clearly an
improvement in comparison with the situation before 1988.
The introduction of different risk-weights for different assets classes, although
not reflecting completely the true risks of banks credit portfolios, is a clear
improvement on the previous regulatory ratios that were used in some countries
such as equity: assets or equity: deposits ratios.
Has the Basel 1 Accord succeeded in making the banking sector a safer place? Lot
of research has been carried out on the subject but the answer is still unclear. The
capital ratios of most banks indeed increased at the beginning of the 1990s (the
capital ratios of the large G10 banks went from an average of 9.3 percent in 1988
to 11.2 percent in 1996), and bank failures diminished (for instance, yearly
failures of FDIC-insured banks in the US went from 280 in 1988 to fewer than 10 a
year between 1995 and 2000). But to what extent this amelioration of the
situation is attributable to Basel 1 or to other factors (such as better economic
conditions) is still an open question. But even without empirical evidence, one can
reasonably think that the capital ratio has forced banks under the 8 percent value
to get some fresh capital (or to decrease their risk exposures) and that the G10
initiative has contributed to a greater focus and a better understanding of the
risks associated with banking activities.

REGULATORY WEAKNESSES AND CAPITAL ARBITRAGE

Aside from the merits that we have emphasized above, we have to recognize that
the Basel 1988 Accord has a lot of deficiencies, which are only increasing as time
passes, bringing a constant flow of innovations in financial markets. Since the
1990s, research on credit risk management-related topics has brought
tremendous innovations in the way that banks handle their risk. Quantification
techniques have allowed sophisticated banks to make continuously more reliable
and precise estimates of their internal economic capital needs. Economic capital
(EC), as opposed to the regulatory capital that is required by the regulating
bodies, is the capital needed to support the banks risk-taking activities as
estimated by the bank itself. It is based on the banks internal models and risk
parameters. The result is that when a bank estimates that its economic capital is
above the regulatory capital level, there is no problem. But if the regulatory
capital level is higher than economic capital, it means that the bank has to
maintain a capital level in excess of what it estimates as an adequate level,
thereby destroying shareholder value. The response of sophisticated banks is
what is called capital arbitrage. This means making an arbitrage between
regulatory and economic capital to align them more closely it can be done by
engaging in new operations that consume more economic than regulatory capital.
As long as these new operations are correctly priced, they will increase the
returns to the shareholders. Capital arbitrage in itself is not a bad thing, as it
allows banks to correct the regulatory constraints weaknesses that are
recognized even by the regulators themselves. However, the more this practice
spreads and the more it is facilitated by financial innovations, the less the 1988
Basel Capital Accord remains efficient.
Banks use various capital arbitrage techniques. The simpler one consists of
investing, inside a risk-weight band, in riskier assets. For instance, if the bank
wants to buy bonds on the capital markets, it can buy speculative-grade bonds
that provide high interest rates while requiring the same regulatory capital as
investment-grade bonds (that they could sell to finance the operation).
The economic capital consumed by the deal should be higher than the regulatory
capital, allowing the bank to use the excess economic capital it has to hold
because of regulatory constraints. The more sophisticated techniques that are
now used are recourse to securitization and to credit derivatives. The banks show
an innovative spirit in creating new financial instruments that allow them to lower
their capital requirements even if they dont really lower their risk. The regulators
then adapt the 1988 rules to cover these new instruments, but always with some
delay.

Securitization
Securitization consists generally of transferring some illiquid assets, such as loans,
to an independent company called a Special Purpose Vehicle (SPV).
The SPV buys the loans to the bank and funds itself by issuing securities that are
backed by them (Asset Backed Securities, ABS). Usually, the bank provides some
form of credit enhancement to the structure by, for instance, granting a
subordinated loan to the SPV. Or, simply, the SPV-issued debts are structured in
various degrees of seniority, and the bank buys the lowest one. The result is that
the repayment of the SPVs debts is made with the cash flows generated by the
securitized loans. The more senior loans are paid first, and so on, until the so-
called equity tranche (the more junior loans) that is often kept by the bank. The
securities bought by investors have a better quality than the underlying loans
because the first losses of the pool are absorbed by the equity tranche. This
creates attractive investment opportunities for investors but it means that the
main part of the risk is still in the banks balance sheet.

Other main weaknesses of the Accord, besides the possibility to lower

Capital requirements while keeping the risk level almost unchanged are:

The lack of risk sensitivity. For instance, a corporate loan to a small

company with high leverage consumes the same regulatory capital as a
loan to a AAA-rated large corporate company (8 per cent, because they are
both risk-weighted at 100 per cent).
A limited recognition of collateral. As we saw in Chapter 1, the list of
eligible collateral and guarantors is rather limited in comparison to those
effectively used by the banks to mitigate their risks.
An incomplete coverage of risk sources. Basel 1 focused only on credit risk.
The 1996 Market Risk Amendment filled an important gap, but there are still
other risk types not covered by the regulatory requirements: operational risk,
reputation risk, strategic risk. A one-size-fits all approach. The requirements are
virtually the same, whatever the risk level, sophistication, and activity type, of the
bank.

An arbitrary measure:

The 8 per cent ratio is arbitrary and not based on explicit solvency targets.

No recognition of diversification:

The credit-risk requirements are only additive and diversification through

granting loans to various sectors and regions is not recognized.

In conclusion, although Basel 1 was beneficial to the industry, the time has come
to move to a more sophisticated regulatory framework. The Basel 2 proposal,
despite having already received its share of criticism, is a major step in the right
direction. It addresses a lot of Basel 1s criticisms and, in addition to ameliorating
the way the 8 per cent capital ratio is calculated, emphasizes the role of
regulators and of banks internal risk management systems. It creates a positive
ascending spiral that is forcing many actors in the sector to increase their
knowledge level, or at least for those that already use sophisticated approaches
to discuss openly the various existing techniques that are far from receiving a
consensus among either industry or researchers.

BREAKING DOWN 'Basel Accord'

The BCBS was founded in 1974 as a forum for regular cooperation between its
member countries on banking supervisory matters. The BCBS describes its original
aim as the enhancement of "financial stability by improving supervisory knowhow
and the quality of banking supervision worldwide." Later on, it turned its
attention to monitoring and ensuring the capital adequacy of banks and the
banking system.
BREAKING DOWN 'Basel I'
The BCBS was founded in 1974 as an international forum where members could
cooperate on banking supervision matters. The BCBS aims to enhance "financial
stability by improving supervisory know-how and the quality of banking
supervision worldwide." This is done through regulations known as accords. Basel
I was the first accord. It was issued in 1988 and focused mainly on credit risk by
creating a bank asset classification system.
Bank Asset Classification System
The Basel I classification system groups a bank's assets into five risk categories,
classified as percentages: 0%, 10%, 20%, 50% and 100%. A bank's assets are
placed into a category based on the nature of the debtor.

The 0% risk category is comprised of cash, central bank and government debt, and
any Organization for Economic Cooperation and Development (OECD)
government debt. Public sector debt can be placed in the 0%, 10%, 20% or 50%
category, depending on the debtor. Development bank debt, OECD bank debt,
OECD securities firm debt, non-OECD bank debt (under one year of maturity),
non-OECD public sector debt and cash in collection comprises the 20% category.
The 50% category is residential mortgages, and the 100% category is represented
by private sector debt, non-OECD bank debt (maturity over a year), real estate,
plant and equipment, and capital instruments issued at other banks.

The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-
weighted assets. For example, if a bank has risk-weighted assets of $100 million, it
is required to maintain capital of at least $8 million.

BASEL II:

Basel II is a set of international banking regulations put forth by the Basel

Committee on Bank Supervision, which levelled the international regulation field
with uniform rules and guidelines. Basel II expanded rules for minimum capital
requirements established under Basel I, the first international regulatory accord,
and provided framework for regulatory review, as well as set disclosure
requirements for assessment of capital adequacy of banks. The main difference
between Basel II and Basel I is that Basel II incorporates credit risk of assets held
by financial institutions to determine regulatory capital ratios.

Basel II is an international business standard that requires financial institutions to

maintain enough cash reserves to cover risks incurred by operations. The Basel
accords are a series of recommendations on banking laws and regulations issued
by the Basel Committee on Banking Supervision (BSBS). The name for the accords
is derived from Basel, Switzerland, where the committee that maintains the
accords meets.

Basel II improved on Basel I, first enacted in the 1980s, by offering more complex
models for calculating regulatory capital. Essentially, the accord mandates that
banks holding riskier assets should be required to have more capital on hand than
those maintaining safer portfolios. Basel II also requires companies to publish
both the details of risky investments and risk management practices. The full title
of the accord is Basel II: The International Convergence of Capital Measurement
and Capital Standards - A Revised Framework.

The three essential requirements of Basel II are:

1. Mandating that capital allocations by institutional managers are more risk

sensitive.
2. Separating credit risks from operational risks and quantifying both.
3. Reducing the scope or possibility of regulatory arbitrage by attempting to align
the real or economic risk precisely with regulatory assessment.
Basel II has resulted in the evolution of a number of strategies to allow banks to
make risky investments, such as the subprime mortgage market. Higher risks
assets are moved to unregulated parts of holding companies. Alternatively, the
risk can be transferred directly to investors by securitization, the process of taking
a non-liquid asset or groups of assets and transforming them into a security that
can be traded on open markets.
The Basel II Accord:
The Basel ii Accord (or, the International Convergence of Capital Measurement
and Capital Standards: A Revised Framework) presents the outcome of the Basel
Committee on Banking Supervision's ("the Committee") 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 proposals.
As a result of these efforts, many valuable improvements have been made to the
original proposals.

The Basel II Accord sets out the details of the agreed Framework for measuring
capital adequacy and the minimum standard to be achieved. This Framework and
the standard it contains have been endorsed by the Central Bank Governors and
Heads of Banking Supervision of the Group of Ten countries.

The fundamental objective of the Committee's work to revise the 1988

Accord has been to develop a framework that would further strengthen the
soundness and stability of the international banking system while maintaining
sufficient consistency that capital adequacy regulation will not be a significant
source of competitive inequality among internationally active banks. The
Committee believes that the revised Framework will promote the adoption of
stronger risk management practices by the banking industry, and views this as
one of its major benefits. The Committee notes that, in their comments on the
proposals, banks and other interested parties have welcomed the concept and
rationale of the three pillars (minimum capital requirements, supervisory review,
and market discipline) approach on which the revised Framework is based.
More generally, they have expressed support for improving capital regulation to
take into account changes in banking and risk management practices while at the
same time preserving the benefits of a framework that can be applied as
uniformly as possible at the national level.

In developing the revised Framework, the Committee has sought to arrive at

significantly more risk-sensitive capital requirements that are conceptually sound
and at the same time pay due regard to particular features of the present
supervisory and accounting systems in individual member countries. It believes
that this objective has been achieved.

The Committee is also retaining key elements of the 1988 capital adequacy
framework, including the general requirement for banks to hold total capital
equivalent to at least 8% of their risk-weighted assets; the basic structure of the
1996 Market Risk Amendment regarding the treatment of market risk; and the
definition of eligible capital.

A significant innovation of the revised Framework is the greater use of

assessments of risk provided by banks' internal systems as inputs to capital
calculations. In taking this step, the Committee is also putting forward a detailed
set of minimum requirements designed to ensure the integrity of these internal
risk assessments. It is not the Committee's intention to dictate the form or
operational detail of banks' risk management policies and practices.

Each supervisor will develop a set of review procedures for ensuring that banks'
systems and controls are adequate to serve as the basis for the capital
calculations. Supervisors will need to exercise sound judgements when
determining a bank's state of readiness, particularly during the implementation
process. The Committee expects national supervisors will focus on compliance
with the minimum requirements as a means of ensuring the overall integrity of a
bank's ability to provide prudential inputs to the capital calculations and not as an
end in itself.

The revised Framework provides a range of options for determining the capital
requirements for credit risk and operational risk to allow banks and supervisors to
select approaches that are most appropriate for their operations and their
financial market infrastructure.

In addition, the Framework also allows for a limited degree of national

discretion in the way in which each of these options may be applied, to adapt the
standards to different conditions of national markets. These features, however,
will necessitate substantial efforts by national authorities to ensure sufficient
consistency in application.

The Committee intends to monitor and review the application of the Framework
in the period ahead with a view to achieving even greater consistency. In
particular, its Accord Implementation Group (AIG) was established to promote
consistency in the Framework's application by encouraging supervisors to
exchange information on implementation approaches.

The Committee has also recognised that home country supervisors have an
important role in leading the enhanced cooperation between home and host
country supervisors that will be required for effective implementation.

The AIG is developing practical arrangements for cooperation and coordination

that reduce implementation burden on banks and conserve supervisory
resources.Based on the work of the AIG, and based on its interactions with
supervisors and the industry, the Committee has issued general principles for the
cross-border implementation of the revised Framework and more focused
principles for the recognition of operational risk capital charges under advanced
measurement approaches for home and host supervisors.

It should be stressed that the revised Framework is designed to establish

minimum levels of capital for internationally active banks. As under the 1988
Accord, national authorities will be free to adopt arrangements that set higher
levels of minimum capital.

Moreover, they are free to put in place supplementary measures of capital

adequacy for the banking organisations they charter. National authorities may use
a supplementary capital measure as a way to address, for example, the potential
uncertainties in the accuracy of the measure of risk exposures inherent in any
capital rule or to constrain the extent to which an organisation may fund itself
with debt.

Where a jurisdiction employs a supplementary capital measure (such as a

leverage ratio or a large exposure limit) in conjunction with the measure set forth
in this Framework, in some instances the capital required under the
supplementary measure may be more binding. More generally, under the second
pillar, supervisors should expect banks to operate above minimum regulatory
capital levels.

The revised Framework is more risk sensitive than the 1988 Accord, but countries
where risks in the local banking market are relatively high nonetheless need to
consider if banks should be required to hold additional capital over and above the
Basel minimum. This is particularly the case with the more broad brush
standardised approach, but, even in the case of the internal ratings-based (IRB)
approach, the risk of major loss events may be higher than allowed for in this
Framework.

The Committee also wishes to highlight the need for banks and supervisors to give
appropriate attention to the second (supervisory review) and third (market
discipline) pillars of the revised Framework.It is critical that the minimum capital
requirements of the first pillar be accompanied by a robust implementation of the
second, including efforts by banks to assess their capital adequacy and by
supervisors to review such assessments. In addition, the disclosures provided
under the third pillar of this Framework will be essential in ensuring that market
discipline is an effective complement to the other two pillars.

GOALS OF THE ACCORD

It is instructive to look at the three stated Committee objectives:

To increase the quality and the stability of the international banking
system.
To create and maintain a level playing field for internationally active banks.
 To promote the adoption of more stringent practices in the risk
management field.
The first two goals are those that were at the heart of the 1988Accord. The last is
new, and is said by the Committee itself to be the most important. This is the sign
of the beginning of a shift from ratio-based regulation, which is only a part of the
new framework, towards a regulation that will rely more and more on internal
data, practices, and models. This evolution is similar to what happened in market-
risk regulation, where internal models became allowed as the basis for capital
requirements. That is why, backstage, people are already speaking of a Basel 3
Accord that would fully recognize internal credit risk models. Numerous contacts
had to be created between regulators and the sector through joint forums and
consultations to set up Basel 2; this built precious communications structures that
are expected to be maintained even after Basel 2s implementation date to keep
working on what will be the regulation for the 2010s. This evolution is even
highlighted in the final text itself:
The Committee understands that the IRB [Internal Rating-Based] approach
represents a point on the continuum between purely regulatory measures of
credit risk and an approach that builds more fully on internal credit risk models. In
principle, further movements along that continuum are foreseeable, subject to an
ability to address adequately concerns about reliability, comparability, validation
and competitive equity. (Basel Committee on Banking Supervision, 2004d)

OPEN ISSUES

At the time of writing, there are still some open issues that the Committee plans
to fix before the implementation date. The five most important ones are:
The recognition of double default. In a nutshell, the current proposal treats
exposures that benefit from a guarantee or that are covered by a credit
derivative (which means that to lose money the bank would have to incur a
double default, that of its counterparty and that of its protection
provider) as if the exposure was directly held against the guarantor. Of
course, this treatment understates the true protection level as it supposes
a perfect correlation between the risk of the counterparty and the risk of
 the hedge. This could lead to a weak incentive for banks to effectively
hedge their risk from a regulatory capital consumption perspective.
The definition of Potential Future Exposures (PFEs). This point has been
actively debated with IOSCO as it is especially important for banks with
large trading books of derivative exposures (securities firms). Since the new
Accord introduces a credit risk capital requirement for some trading book
positions, the way PFE are evaluated will have a material impact on this
sector.
The definition of eligible capital. The definition currently applicable is the
one of 1988 updated by a 1998 press release: Instruments eligible for
inclusions in Tier 1 capital (Basel Committee on Banking Supervision, 1998)
but further work is expected on this issue.
The scaling factor. As mentioned above, the regulators target is to
maintain the global level of capital in the banking sector. As the last tests
made on QIS 3 data seem to show a small decrease under the IRB approach
(following the Madrid Compromise that accepted that capital requirements
could be based only on the unexpected loss part of a credit portfolio,
excluding the expected loss: we shall discuss this in detail later the
regulators should require a scaling factor currently estimated at 1.06. This
means that IRB capital requirements would be scaled up by 6 percent. The
exact value of this adjustment will be fixed after the parallel run period.
Accounting issues. The Committee is aware of possible distortions arising
from the application of the same rules under different accounting regimes,
and will keep on monitoring these issues. The trend is toward international
standardization, mainly with the new International Accounting Standards
(IAS) that will be implemented in banks in the same time frame as the new
Accord. But if this helps to limit the problems associated with different
accounting practices, it raises new questions, one of the most important
being the definition of capital, that could become a much more volatile
element if all gains and losses on assets and liabilities are valued MTM and
passed through the profit and loss (P&L) accounts, as required by the
controversial IAS 39 rule.
SCOPE OF APPLICATION

As with the 1988 Accord, Basel 2 is only a set of recommendations for the G10
countries. But as with the 1988Accord also, it is expected to be translated into
laws in Europe, North America, and Japan, and should reach finally the same
coverage, which means that it will be the basis of regulation in more than 100
countries. The Accord is supposed to be applied on a consolidated basis for
internationally active banks, including at the levels of the holdings.
National banks that are not within the scope of the Accord are, however,
supposed to be under the supervision of their national authorities that should
ensure that they have a sufficient capital level. That is the theory. In practice, the
Accord will be mandatory for all banks and securities firms, even at the national
level, in many countries. This will certainly be the case in Europe. On the other
hand, in the US, the most advanced options of Basel 2 will be imposed only on a
small group of very large banks (it is the position of US regulating bodies at the
time of writing) while all the others will remain subject to the current approach
(the 1988 Accord).

TREATMENT OF PARTICIPATIONS

The risk of double gearing has always been an issue for the regulators.
Important participations that are not consolidated are treated as a function of
their nature in the way.
Majority-owned financial companies that are not consolidated have to be
deducted from equity. If the subsidiary has any capital shortfall, it will also be
deducted from the parent companys capital base. Minority investments that are
significant (to be defined by the national regulators, in Europe the criterion is
between 20 percent and 50 percent) have to be deducted or can be consolidated
on a pro rata basis when the regulators are convinced that the parent company is
prepared to support the entity on a proportionate basis.
Significant participations in insurance companies have in principle to be deducted
from equity. However, some G10 countries will apply other methods because of
competitive equality issues. In any case, the Committee requires that the method
include a group-wide perspective and avoid double counting of capital.
Participations in commercial companies receive a normal risk-weight
(With a minimum of 100 percent) up to an individual (15 percent of capital) and
an aggregated (60 percent of capital) threshold. Amounts above those reference
values (or a stricter level at national discretion) will have to be deducted from the
capital base.

STRUCTURE OF THE ACCORD

The Basel 2 Accord is structured in three main pillars (pillars 13) the three
complementary axes designed to support the global objectives of financial
stability and better risk management practices (see Figure 4.5 opposite).

Pillar 1

This is the update of the 1988 solvency ratio. Capital: RWA is still viewed as the
most relevant control ratio, as capital is the main buffer against losses when
profits become negative. The 8 percent requirement is still the reference value,
but the way assets are weighted has been significantly refined.
The 1988 values were rough estimates while the Basel 2 values are directly and
explicitly derived from a standard simplified credit risk model. Capital
requirements should now be more closely aligned to internal economic capital
estimates (the adequate capital level estimated by the bank itself, through its
internal models). There are three approaches, of increasing complexity, to
compute the risk-weighted assets (RWA) for credit risk. The more advanced are
designed to consume less capital while they impose heavier qualitative and
quantitative requirements on internal systems and processes. This is an incentive
for banks to increase their internal risk management practices. As well as more
explicit capital requirements by function of risk levels, an important extension of
the types of collateral that are recognized to offset the risks is another incentive
to produce a more systematic collateral management practice. This is also
significant improvement on the current Accord, where the scope of eligible
collateral is rather limited.
Another important innovation in pillar 1 is a new requirement for operational risk.
In the new Accord there is an explicit capital requirement for risks related to
possible losses arising from errors in processes, internal frauds, information
technology (IT) problems . . . Again, there are three approaches, of increasing
complexity, that are available. The eligible capital must cover at least 8 percent of
the risk-weighted requirements related to three broad kinds of risks .
Pillar 2

The second axis of the regulatory framework is based on internal controls and
supervisory review. It requires banks to have internal systems and models to
evaluate their capital requirements in parallel to the regulatory framework and
integrating the banks particular risk profile. Banks must also integrate the types
of risks not covered (or not fully) by the Accord, such as reputation risk and
strategic risk, concentration credit risk, interest rate risk in the banking book
(IRBBB) . Under pillar 2, regulators are also expected to see that the requirements
of pillar 1 are effectively respected, and evaluate the appropriateness of the
internal models set up by the banks. If the regulators consider that capital is not
sufficient, they can take various actions to remedy the situation. The most
obvious are requiring the bank to increase its capital base, or restricting the
amount of new credits that can be granted, but measures can also focus on
increasing the quality of internal controls and policies.
The new Accord states explicitly those banks are expected to operate under a
capital level higher than 8 percent, as pillar 2 has to capture additional risk
sources.
Pillar 2 is very flexible because it is not very prescriptive (it represents 8 pages out
of the 239 of the full Accord). Some have argued that this is a weakness, as
regulators are left with too much subjectivity, which could undermine the level
playing field objective. But it is at the same time the most interesting part of the
framework, as it will oblige regulators and banks to cooperate closely on the
evaluation of internal models. No doubt the regulators will use benchmarking as
one of the tools to evaluate the banks different approaches. This will create the
dynamic necessary to standardize and better understand the heterogeneous ways
credit risks are currently evaluated, and will ultimately pave the way to internal
model recognition and its use as a basis for calculating capital requirements, as
happened with market risk.
Pillar 3

This concerns market-discipline, and the requirements are related to disclosures.

Banks are expected to build comprehensive reports on their internal risk
management systems and on the way the Basel 2 Accord is being implemented.
Those reports will have to be publicly disclosed to the market at least twice a
year. This raises some confidentiality issues in the sector, since the list of
elements to be published is impressive: description of risk management
objectives and policies; internal loss experience, by risk grade; collateral
management policies; exposures, by maturity, by industry, and by geographical
location; options chosen for Basel 2 . . . The goal is to let the market place an
additional pressure on banks to improve their risk management practices. No
doubt bank credit and equity analysts, bond investors, and other market
participants will find the disclosed information very useful in evaluating a banks
soundness.

THE TIMETABLE

The timetable for implementation is year-end 2006 for Standardized and IRBF
Approaches and year-end 2007 for the IRBA and the Advanced Measurement
Approach (AMA) methods (it has been delayed several times since the Accord was
first issued) (see Table 4.1). Before those dates, parallel calculations will be
required (calculations of capital requirements under the Basel 1988 and the Basel
2 methods). In the early years after implementation, floors will be fixed that will
prevent banks having new required capital levels below those calculated with the
current approach multiplied by a scaling factor.

The six most noteworthy innovations of Basel 2 are the:

Increased sensitivity of capital requirements to risk levels. Introduction of
regulatory capital needs for operational risk. Important flexibility of the Accord,
through several options being left at the discretion of the national regulators.
Increased power of the national regulators, as they are expected under pillar 2 to
evaluate a banks capital adequacy considering its specific risk profile.
Better recognition of risk reduction techniques:
Detailed mandatory disclosures of risk exposures and risk policies. Those
measures should help the global industry to progress in its general understanding
of credit risk management issues and constitute the intermediary step before full
internal model recognition.

Basel 2 requirements

Basel 2 requirements cover both traditional securitizations and synthetic

securitizations.

Traditional securitizations

Traditional securitizations are structures were the cash flows from an underlying
pool are used to service at least two different tranches of a debt structure that
bear different levels of credit risk (as the cash flows are used first to repay the
more senior debt, then the second layer, and so on ). The difference with
classical senior and subordinated debts is that lower tranches of the debt
structure can absorb losses while the others are still serviced, whereas classical
senior and subordinated debt is an issue of priority only in the case of the
liquidation of a company.

Synthetic securitizations

Synthetic securitizations are structures where the underlyings are not

physically transferred out of the balance sheet of the originating bank, but only
the credit risk is covered through the use of funded (e.g. credit-linked notes) or
unfunded (e.g. credit default swaps) credit derivatives.
Originating and investing banks involved in a securitization structure can be either
an originator or an investor.

Originating banks

Originating banks are those that originate, directly or indirectly, the securitized
exposures, or that serve as a sponsor on an Asset-Backed Commercial Paper
(ABCP) program (as a sponsor, the bank will usually manage or advise on the
program, place securities in the market, or provide liquidity and/or credit
enhancements). Originating banks can exclude securitized exposures from the
calculation of the RWA if they meet certain operational requirements.
For cash securitization, the assets have to be effectively transferred to an SPV and
the bank must not have any direct or indirect control on the assets transferred.
For synthetic securitization (where assets are effectively not transferred to a third
party but their credit risk is hedged through credit derivatives), the credit risk
mitigates used to transfer the credit risk must fulfill the requirements of the
Standardized Approach. Eligible collateral and guarantors are those of the
Standardized Approach, and the instruments used to transfer the risk may not
contain terms or conditions that limit the amount of risk.
Effectively transferred (e.g. clauses that increase the banks cost of credit
protection in response to any deterioration in the pools quality).
Originating banks that provide implicit support to the securitized exposures (they
would buy them back if the structure was turning sour) in order to protect their
reputation, must compute their capital requirements as if the underlying
exposures were still in their balance sheet. Clean-up calls (options that permit an
originating bank to call the securitized exposures before they have been repaid
when the remaining amount falls below some threshold) may be subject to
regulatory capital requirements.
To avoid this, they must not be mandatory (but at the discretion of originating
banks), they must not be structured to provide credit enhancement, and they
must be allowed only when less than 10 percent of the original portfolio value
remains. If those conditions are not respected, exposures must be risk-weighted
as if they were not securitized.

Investing banks

Investing banks are those that bear the economic risk of a securitization exposure.
Those exposures can arise from the provision of credit risk mitigates to a
securitization transaction, investment in asset-backed securities, retention of a
subordinated tranche, and extension of a liquidity facility or credit enhancement.

The Standardized Approach

Banks that apply the Standardized Approach to credit risk for the type of
underlying exposures securitized must use the Standardized Approach under the
securitization framework. The RWA of the exposure is then a function of its
external rating.
Banks that invest in exposures that they originate themselves that receive an
external rating below BBB must deduct them from their capital base.
For off-balance sheet exposures, CCF are used (if they are externally rated, the
CCF is 100 percent). This is usually 100 percent except for eligible liquidity
facilities.

There are three exceptions to the deduction of unrated securitization exposures.

First, the most senior tranche can benefit from a look through approach if the
composition of the underlying pool is known at all times.
This means that it receives the average risk-weight of the securitized assets (if it
can be determined).
Secondly, second loss or better in ABCP programs that have an associated credit
risk equivalent to investment grade, and when the bank does not hold the first
loss, can receive the higher risk-weight assigned to any of the individual
exposures (with a minimum of 100 percent).
Thirdly, eligible liquidity facilities can receive the higher risk-weight assigned to
any of the individual exposures covered by the facility. Eligible liquidity facilities
are off-balance sheet exposures that meet the following four requirements:
Draws under the facility must be limited to the amount that is likely to be repaid
fully from the liquidation of the underlying exposures: it must not be drawn to
provide credit enhancement.
The facility must not be drawn to cover defaulted assets, and funded exposures
that are externally rated must be at least investment grade (at the time the
facility is drawn). When all credit enhancements that benefit the liquidity line are
exhausted, the facility cannot be drawn any longer. Repayment of draws on the
facility must not be subordinated to any interest of any holder in the program or
subject to deferral or waiver. Eligible liquidity facilities can benefit from a 20
percent CCF if they have an original maturity less than one year and a 50 percent
CCF if their original maturity is greater than one year (instead of the default 100
percent CCF).
In three other special cases, eligible liquidity facilities can receive a
0 percent CCF: When they are available only in case of market disruption (e.g.
when more than one securitization vehicle cannot roll over maturing commercial
paper for other reasons than credit-quality problems). When there are
overlapping exposures: in some cases, the same bank can provide several facilities
that cannot be drawn at the same time (when one is drawn the others cannot be
used). In those cases, only the facility with the highest CCF is taken into account,
the other not being risk-weighted.
Certain servicer cash advance facilities can also receive a 0 percent CCF
(Subject to national discretion), if they are cancellable without prior notice and
have senior rights on all the cash flows until they are reimbursed.
Credit risk mitigants can offset the risk of securitization exposures. Eligible
collateral is limited to that recognized in the Standardized Approach. The early
amortization provision is an option that allows investors to be repaid before the
original stated maturity of the securities issued. They can be controlled or not.
They are considered as controlled when:
The bank has a capital/liquidity plan to cover early amortization.
Throughout the duration of the transaction, including the amortization period,
there is the same pro rata sharing of interest, principal, expenses, losses, and
recoveries based on the banks and investors relative shares of the receivables
outstanding at the beginning of each month. The bank has set a period for
amortization that would be sufficient for at least 90 percent of the total debt
outstanding at the beginning of the early amortization period to have been repaid
or recognized as in default. The pace of repayment should not be any more rapid
than would be allowed by straight-line amortization over the period set out.
Originating banks are required to hold capital against investors interests when
the structure contains an early amortization provision and when the exposures
sold are of a revolving nature. Four exceptions are: Replenishment structures,
where the underlying exposures do not revolve and the early amortization ends
the ability of the bank to add new exposures.
Transactions of revolving assets containing early amortization features that mimic
term structures (i.e. where the risk on the underlying facilities does not return to
the originating bank) .
Structures where a bank securitizes one or more credit line(s) and where
investors remain fully exposed to future draws by borrowers even after an early
amortization event has occurred.
The early amortization clause is triggered solely by events not related to the
performance of the securitized assets or the selling bank such as material
changes in tax laws or regulations.
In other cases, the capital requirement is equal to the product of the revolving
part of the exposures, the appropriate risk-weight (as if it had not been
securitized), and a CCF. The CCF depends upon whether the early amortization
repays investors through a controlled or non-controlled mechanism, and upon the
nature of the securitized credit lines (uncommitted retail lines or not). Its level is a
function of the average three-months excess spread (gross income of the
structure minus certificate interest, servicing fees, charge-offs, and other
expenses), and the excess spread trapping point (the point at which the bank is
required to trap the excess spread as economically required by the structure, by
default 4.5 percent).
IRB approaches Banks that have received approval to use the IRB Approach for
the type of exposures securitized must use the IRB approach to securitization.
Under the IRB Approach, there are three sub-approaches: The Rating-Based
Approach (RBA), that must be applied when the securitized tranche has external
or internal ratings.
The Supervisory Formula (SF), used when there are no available ratings.
The Internal Assessment Approach (IAA), also used when there are no available
ratings but only for exposures extended to ABCP programs.
The capital requirements are always limited to a maximum corresponding to the
capital requirements had the exposures not been securitized.
In the RBA, a risk-weight is assigned by function of an external or internal inferred
rating (that can be assigned with reference to an external rating already given to
another tranche that is of equal seniority or more junior and of equal or shorter
maturity), the granularity of the pool, and the seniority of the position. The
granularity is determined by calculating the effective number of positions N, with
the following formula:

IRB approaches banks that have received approval to use the IRB Approach for
the type of exposures securitized must use the IRB Approach to securitization.
Under the IRB Approach, there are three sub-approaches:
The Rating-Based Approach (RBA), that must be applied when the securitized
tranche has external or internal ratings.
The Supervisory Formula (SF), used when there are no available ratings.
The Internal Assessment Approach (IAA), also used when there are no available
ratings but only for exposures extended to ABCP programs.
The capital requirements are always limited to a maximum corresponding to the
capital requirements had the exposures not been securitized.
In the RBA, a risk-weight is assigned by function of an external or internal inferred
rating (that can be assigned with reference to an external rating already given to
another tranche that is of equal seniority or more junior and of equal or shorter
maturity), the granularity of the pool, and the seniority of the position. The
granularity is determined by calculating the effective number of positions N.
The IAA applies only to ABCP programs. Banks can use their internal ratings if they
meet three operational requirements:
_ The ABCP must be externally rated (the underlying, not the securitized
tranche).
_ The internal assessment of the tranche must be based on ECAI criteria
and used in the banks internal risk management systems.
_ A credit analysis of the asset sellers risk profile must be performed.
The risk-weight associated with the internal rating is then the same as in the RBA
The SF is used when there is no external rating, no inferred internal rating, and no
internal rating given to an ABCP program. The capital requirement is a function of:
the IRB capital charge had the underlying exposures not been securitized (KIRB),
the tranches credit enhancement level (L) and thickness (T), the pools effective
number of exposures (N), and the pools exposure-weighted average loss given
default (LGD).

Beta refers to the cumulative Beta distribution. Parameters and equal,

respectively, 1,000 and 20. KIRB is the ratio of the IRB requirement including EL
for the underlying exposures of the pool and the total exposure amount of the
pool. L is the ratio of the amount of all securitization exposures subordinate to
the tranche in question to the amount of exposures in the pool.
T is measured as the ratio of the nominal size of the tranche of interest to the
notional amount of exposures in the pool.
The securitization framework of Basel 2 is an important improvement over the
current rules. This is a critical issue, as many capital arbitrage operations under
the current Accord rules are done through securitization. Coming from simplified
propositions at the beginning of the consultative process, the regulators ended
with much more refined approaches in the final document thanks to an intense
debate with the sector. This debate helped the sector itself to progress in its
understanding of the main risk drivers of securitization. The SF is directly derived
from a model proposed by Gordy (interested readers can consult Gordy and
Jones, 2003; a detailed description of the model specifications is available on the
BIS website). It integrates the underlying pool granularity, credit quality, asset
correlation, and tranche thickness. Of course, each deal has its own specific
structure and features that make it unique and it is very hard to find an analytical
formula that captures precisely its risks; only a full-blown simulation approach
(Monte Carlo simulations) can offer enough flexibility to be adapted to each
operation. Even the RBA integrates the fact that a corporate bond AAA is not a
securitized exposure AAA. It is widely recognized that a securitization tranche
with a good rating is less risky than its corporate bond counterpart (except
perhaps in leveraged structures), and that a securitization tranche with a low
rating is much more risky than a corporate bond with the same rating.
Looking at the risk-weighting given by the regulators we can see that it is
integrated in the risk-weighting scheme). Of course, not everybody agrees with
the given weights (especially the 7 percent floor of a minimum RWA in both the
RBA and SF approaches), but as we said the main risk drivers are incorporated in
the formula and the approach is significantly improved compared to current rules.
And before putting the new framework to the test the industry had to admit that
there were still (even if the situation has improved over recent years) a lot of
market participants, even among banks, that invest in securitization without
having fully understood all the risks involved in such deals. The debate catalyzed
by Basel 2 and the relative sophistication of the proposed formula will without
any doubt help in the diffusion of a better understanding of these issues.
OPERATIONAL RISK
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 reputation risk.
Capital requirements can be defined using three approaches, that have each their
own specific quantitative and qualitative requirements.
Basic Indicator Approach (BIA) The simplest method considers only that the
amount of operational risk is proportional to the size of the banks activities,
estimated through their gross income (net interest and commission income gross
of provisions and operating expenses, and excluding profit/losses from the sale of
securities in the banking book and extraordinary items). The capital requirement
is then the average positive gross income over the last three years multiplied by
15 percent. There are no specific requirements for banks to be allowed to use the
BIA.
Standardized Approach (SA):
This is close to the BIA, except that banks activities are divided into eight business
lines and each one has its own capital requirement as a function of its specific
gross income. Again, the average gross income over the last three years must be
calculated. But this time the negative gross income of one business line can offset
the capital requirements of another (as long as the sum of capital requirements
over the year is positive)
To be allowed to use the SA Approach, banks must fulfill a number of operational
requirements: Board of directors and senior management must be actively
involved in the supervision of the operational risk framework. Banks must have
sufficient resources involved in Operational Risk Management (ORM) in each
business line and in the audit department. There must be an independent ORM
function, with clear responsibilities for tracking and monitoring operational risks.
There must be a regular reporting of operational risk exposures and material
losses. The banks ORM systems must be subject to regular review by external
auditors and/or supervisors. Advanced Measurement Approach (AMA) as with
VAR models for market risk and internal rating systems, the regulators offer the
banks the opportunity with the AMA Approach to develop internal models for a
self-assessment of the level of operational risk. There is no specific model
recommended by the regulators. In addition to the qualitative requirements that
are close to those of the SA Approach the models have to respect some
quantitative requirements:
The model must capture losses due to operational risk over a one-year period
with a confidence interval of 99.9 percent (the expected loss is in principle not
deducted).
The model must be sufficiently granular to capture tail events i.e. events with very
low probability of occurrence.
The model can use a mix of internal (minimum five years) and external data and
scenario analysis.
The bank must have robust procedures to collect operational loss historical data,
store them, and allocate them to the correct business line. Regarding risk
mitigation, banks can incorporate the effects of insurance to mitigate operational
risk up to 20 percent of the operational risk capital requirements.
Operational risk is an innovation, as currently no capital is required to cover this
type of risk, and it has been very controversial. For market risk, a lot of historical
data are available to feed and back-test the models; for credit risk, data are
already scarce; and for operational risk there are very few banks that have any
efficient internal databases showing operational loss events. This is the more
qualitative type of risk, as it is closely linked to procedures and control systems
and depends significantly on experts opinions. Many people in the industry
consider that it cannot be captured through quantitative requirements the BIA
and SA above all, requiring a fixed percentage of gross income as operational risk
capital, are considered as very poor estimates of what should be the correct level
of capital.
The AMA is more interesting from a conceptual point of view, but as the major
part of model parameters (loss frequencies and severities, correlation between
loss types) cannot be inferred from historical data but have to be estimated by
experts, it is hard to be sanguine as we work with such a high confidence level as
99.9 percent. But perhaps the regulators requirements are a necessary step to
oblige banks to take a closer look at the operational risks associated with their
businesses. We have to recognize that, even if the final amount of capital is open
to discussion, many banks have gained a deeper understanding of the nature and
the magnitude of such risks, and as they involve the whole organization (and not
only market and credit risk specialists) it is an opportunity to spread risk
consciousness throughout all financial groups.

Internal model method (IMM):

Banks can finally use the IMM. In this approach, no particular model is prescribed
and banks are free to develop their internal effective EPE measurement approach
as long as they fulfill certain requirements and convince their regulators that their
approach is adequate (as in the AMA for operational risk). The effective EPE is
then also multiplied by a regulatory factor Alpha () (in Principle, 1.4, but it can be
changed by the regulator). Under specific conditions, banks can also estimate
themselves the Alpha factor in their internal model (but there is a minimum of
1.2). To do this, banks should have a fully integrated credit and market risk model,
and compare the economic capital allocated with a full simulation with the
economic capital allocated on the basis of EPE
(Banks have to demonstrate that the potential correlation between credit and
market risks has been captured).
The basic requirements for model approval are quite close to those for the VAR
model under the Market Risk Amendment, but with some additional features (to
work on a longer horizon, as one year is the reference, pricing models can be
different from those used for short-term VAR, with regular back-testing, use tests,
stress testing ).
The IMM can also try to integrate the margin calls, but such novelizations are
complicated, and will come under close scrutiny from the regulators.
If the CEM and SM are limited to OTC derivatives, the IMM can also be used for
Securities Financing Transactions (SFT) such as repurchase/ reverse-repurchase
agreements, securities lending and borrowing, margin lending.
The choice of one of the two more advanced approaches has additional impacts
on pillar 2 (more internal controls, audit of the models by the regulators) and
pillar 3 (specific disclosures on the selected framework)
The IMM can be chosen just for OTC derivatives, just for SFT transactions, or for
both. But, once selected, the bank cannot return to simpler approaches.
The two advanced approaches can also be chosen as if the bank is using an IRB or
a Standardized Approach (SA). Inside a financial group, some entities can use
advanced approaches on a permanent basis and others the CEM. Inside an entity,
all portfolios have to follow the same approach.

BREAKING DOWN 'Basel II'

Basel II is a second international banking regulatory accord that is based on three
main pillars: minimal capital requirements, regulatory supervision and market
discipline. Minimal capital requirements play the most important role in Basel II
and obligate banks to maintain minimum capital ratios of regulatory capital over
risk-weighted assets. Because banking regulations significantly varied among
countries before the introduction of Basel accords, a unified framework of Basel I
and, subsequently, Basel II helped countries alleviate anxiety over regulatory
competitiveness and drastically different national capital requirements for banks.

Minimum Capital Requirements:

Basel II provides guidelines for calculation of minimum regulatory capital ratios
and confirms the definition of regulatory capital and 8% minimum coefficient for
regulatory capital over risk-weighted assets. Basel II divides the eligible regulatory
capital of a bank into three tiers. The higher the tier, the less subordinated
securities a bank is allowed to include in it. Each tier must be of certain minimum
percentage of the total regulatory capital and is used as a numerator in the
calculation of regulatory capital ratios.
Tier 1 capital is the most strict definition of regulatory capital that is subordinate
to all other capital instruments, and includes shareholders' equity, disclosed
reserves, retained earnings and certain innovative capital instruments. Tier 2 is
Tier 1 instruments plus various other bank reserves, hybrid instruments, and
medium- and long-term subordinated loans. Tier 3 consists of Tier 2 plus short-
term subordinated loans.

Another important part in Basel II is refining the definition of risk-weighted assets,

which are used as a denominator in regulatory capital ratios, and are calculated
by using the sum of assets that are multiplied by respective risk weights for each
asset type. The riskier the asset, the higher its weight. The notion of risk-weighted
assets is intended to punish banks for holding risky assets, which significantly
increases risk-weighted assets and lowers regulatory capital ratios. The main
innovation of Basel II in comparison to Basel I is that it takes into account the
credit rating of assets in determining risk weights. The higher the credit rating, the
lower risk weight.

Regulatory Supervision and Market Discipline

Regulatory supervision is the second pillar of Basel II that provides the framework
for national regulatory bodies to deal with various types of risks, including
systemic risk, liquidity risk and legal risks. The market discipline pillar provides
various disclosure requirements for banks' risk exposures, risk assessment
processes and capital adequacy, which are helpful for users of financial
statements.
BASEL III:
BASEL III is an international regulatory accord that introduced a set of reforms
designed to improve the regulation, supervision and risk management within the
banking sector. The Basel Committee on Banking Supervision published the first
version of Basel III in late 2009, giving banks approximately three years to satisfy
all requirements. Largely in response to the credit crisis, banks are required to
maintain proper leverage ratios and meet certain minimum capital requirements.

The Basel III Accord:

Basel III is a comprehensive set of reform measures, developed by the Basel
Committee on Banking Supervision, to strengthen the regulation, supervision and
risk of the banking sector.

The Basel Committee is the primary global standard-setter for the prudential
regulation of banks and provides a forum for cooperation on banking supervisory
matters. Its mandate is to strengthen the regulation, supervision and practices of
banks worldwide with the purpose of enhancing financial stability.

The Committee reports to the Group of Governors and Heads of Supervision

(GHOS). The Committee seeks the endorsement of GHOS for its major decisions
and its work programme.

The Committee's members come from Argentina, Australia, Belgium, Brazil,

Canada, China, European Union, France, Germany, Hong Kong SAR, India,
Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia,
Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the
United Kingdom and the United States.

The Basel III reform measures aim to:

1. Improve the banking sector's ability to absorb shocks arising from financial
and economic stress, whatever the source
2. Improve risk management and governance
 3. Strengthen banks' transparency and disclosures.

The reforms target:

A. Bank-level, or micro prudential, regulation, which will help raise the resilience
of individual banking institutions to periods of stress.

B. Macro prudential, system wide risks that can build up across the banking sector
as well as the procyclical amplification of these risks over time.

These two approaches to supervision are complementary as greater resilience at

the individual bank level reduces the risk of system wide shocks.

From 1993 to 2008 the total assets of a sample of what we call global systemically
important banks saw a twelve-fold increase (increasing from $2.6 trillion to just
over $30 trillion). But the capital funding these assets only increased seven-
fold, (from $125 billion to $890 billion). Put differently, the average risk weight
declined from 70% to below 40%.

The problem was that this reduction did not represent a genuine reduction in
risk in the banking system.

One of the main reasons the economic and financial crisis became so severe was
that the banking sectors of many countries had built up excessive on and off-
balance sheet leverage. This was accompanied by a gradual erosion of the level
and quality of the capital base.

At the same time, many banks were holding insufficient liquidity buffers.

The banking system therefore was not able to absorb the resulting systemic
trading and credit losses nor could it cope with the reinter mediation of large off-
balance sheet exposures that had built up in the shadow banking system.
The crisis was further amplified by a procyclical deleveraging process and by
the interconnectedness of systemic institutions through an array of complex
transactions.

During the most severe episode of the crisis, the market lost confidence in the
solvency and liquidity of many banking institutions. The weaknesses in the
banking sector were rapidly transmitted to the rest of the financial system and
the real economy, resulting in a massive contraction of liquidity and credit
availability.

Ultimately the public sector had to step in with unprecedented injections of

liquidity, capital support and guarantees, exposing taxpayers to large losses.

The effect on banks, financial systems and economies at the epicentre of the crisis
was immediate. However, the crisis also spread to a wider circle of
countries around the globe. For these countries the transmission channels were
less direct, resulting from a severe contraction in global liquidity, cross-border
credit availability and demand for exports.

Given the scope and speed with which the recent and previous crises have been
transmitted around the globe as well as the unpredictable nature of future
crises, it is critical that all countries raise the resilience of their banking sectors to
both internal and external shocks.

The G20 Leaders at the Seoul Summit endorsed the Basel III framework and the
Financial Stability Boards (FSB) policy framework for reducing the moral hazard of
systemically important financial institutions (SIFIs), including the work processes
and timelines set out in the report submitted to the Summit.

SIFIs are financial institutions whose disorderly failure, because of their size,
complexity and systemic interconnectedness, would cause significant disruption
to the wider financial system and economic activity.

We read in the final G20 Communiqu:

"We endorsed the landmark agreement reached by the Basel Committee on the
new bank capital and liquidity framework, which increases the resilience of the
global banking system by raising the quality, quantity and international
consistency of bank capital and liquidity, constrains the build-up of leverage and
maturity mismatches, and introduces capital buffers above the minimum
requirements that can be drawn upon in bad times.

The framework includes an internationally harmonized leverage ratio to serve as a

backstop to the risk-based capital measures.

With this, we have achieved far-reaching reform of the global banking system.

The new standards will markedly reduce banks' incentive to take excessive risks,
lower the likelihood and severity of future crises, and enable banks to withstand -
without extraordinary government support - stresses of a magnitude associated
with the recent financial crisis.

This will result in a banking system that can better support stable economic
growth.

We are committed to adopt and implement fully these standards within the
agreed timeframe that is consistent with economic recovery and financial
stability.

The new framework will be translated into our national laws and regulations, and
will be implemented starting on January 1, 2013 and fully phased in by January 1,
2019."

To ensure visibility of the implementation of reforms, the Basel Committee has

been regularly publishing information about members adoption of Basel III to
keep all stakeholders and the markets informed, and to maintain peer
pressure where necessary.
It is especially important that jurisdictions that are home to global systemically
important banks (G-SIBs)make every effort to issue final regulations at the earliest
possible opportunity.

But simply issuing domestic rules is not enough to achieve what the G20 Leaders
asked for: full, timely and consistent implementation of Basel III. In response to
this call, in 2012 the Committee initiated what has become known as the
Regulatory Consistency Assessment Programme (RCAP).

The regular progress reports are simply one part of this programme,
which assesses domestic regulations compliance with the Basel standards, and
examines the outcomes at individual banks.

The RCAP process will be fundamental to ensuring confidence in regulatory ratios

and promoting a level playing field for internationally-operating banks.

It is inevitable that, as the Committee begins to review aspects of the regulatory

framework in far more detailthan it (or anyone else) has ever done in the
past, there will be aspects of implementation that do not meet the G20s
aspiration: full, timely and consistent.

The financial crisis identified that, like the standards themselves, implementation
of global standards was not as robust as it should have been.

This could be classed as a failure by global standard setters.

To some extent, the criticism can be justified not enough has been done in the
past to ensure global agreements have been truly implemented by national
authorities.

However, just as the Committee has been determined to revise the Basel
framework to fix the problems that emerged from the lessons of the crisis, the
RCAP should be seen as demonstrating the Committees determination to also
find implementation problems and fix them.
BREAKING DOWN 'Basel III':
Basel III is part of the continuous effort to enhance the banking regulatory
framework. It builds on the Basel I and Basel II documents, and seeks to improve
the banking sector's ability to deal with financial stress, improve risk
management, and strengthen the banks' transparency. A focus of Basel III is to
foster greater resilience at the individual bank level in order to reduce the risk of
system-wide shocks.

Minimum Capital Requirements:

Basel III introduced tighter capital requirements in comparison to Basel I and
Basel II. Banks' regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is
subdivided into Common Equity Tier 1 and additional Tier 1 capital. The
distinction is important because security instruments included in Tier 1 capital
have the highest level of subordination. Common Equity Tier 1 capital includes
equity instruments that have discretionary dividends and no maturity, while
additional Tier 1 capital comprises securities that are subordinated to most
subordinated debt, have no maturity, and their dividends can be cancelled at any
time. Tier 2 capital consists of unsecured subordinated debt with an original
maturity of at least five years.

Basel III left the guidelines for risk-weighted assets largely unchanged from Basel
II. Risk-weighted assets represent a bank's assets weighted by coefficients of risk
set forth by Basel III. The higher the credit risk of an asset, the higher its risk
weight. Basel III uses credit ratings of certain assets to establish their risk
coefficients.

In comparison to Basel II, Basel III strengthened regulatory capital ratios, which
are computed as a percent of risk-weighted assets. In particular, Basel III
increased minimum Common Equity Tier 1 capital from 4% to 4.5%, and minimum
Tier 1 capital from 4% to 6%. The overall regulatory capital was left unchanged at
8%.
Countercyclical Measures:
Basel III introduced new requirements with respect to regulatory capital for large
banks to cushion against cyclical changes on their balance sheets. During credit
expansion, banks have to set aside additional capital, while during the credit
contraction, capital requirements can be loosened. The new guidelines also
introduced the bucketing method, in which banks are grouped according to their
size, complexity and importance to the overall economy. Systematically important
banks are subject to higher capital requirements.

Leverage and Liquidity Measures:

Additionally, Basel III introduced leverage and liquidity requirements to safeguard
against excessive borrowings and ensure that banks have sufficient liquidity
during financial stress. In particular, the leverage ratio, computed as Tier 1 capital
divided by the total of on and off-balance assets less intangible assets, was
capped at 3%.

Comparison between BASEL I, BASEL II & BASEL III:

Banks are one among the major triggers in most of the economic crises. Banks are
the veins of circulation of money in an economy. So the soundness of banking
system is imperative to prevent the collapse of the system. The premature
liberalization of the local financial markets and the failure to keep adequate
checks on lending functions of the banks are the major reasons for the Asian
economic crisis of 1997. Absence of effective regulation and supervision led to
large capital inflows in the domestic short term debt market. Banks lent on long
term basis using the foreign inflows. Later when signs of pessimism became
visible foreign inflows to economies such as Philippines, Malaysia etc... Started to
decline. (Buckley n.d.) Similarly, in the year 2008 the reckless lending of US banks
like Lehman brothers and securitization of the sub-standard loans into
instruments known as CDO-s (Collateral Debt Obligations) and trading of the
securities in the stock market led to the sub-prime crisis of 2008 and resultant
recession in the follow-up. Thus a perfect regulation and prudential supervision of
banks is tellingly important for the smooth sailing of an economy.
Basel I

Capital is the last recourse that would be available for any bank to prevent its
failure. In the year 1974, after the failure of Herstatt bank in Germany the need
for better regulation of banking sector was felt by G-10 countries. They
constituted the Basel Committee for Banking Supervisory practices (BCBS) under
the aegis of Bank for International Settlements (BIS). Basel I was recommended
for implementation by the BCBS for mainly addressing the issue of Credit risk in
the year 1988. Credit risk implies the risk involved in the recovery of loans that
were lent. In order to address the issue BCBS fixed a minimum capital adequacy
requirement to be maintained by the banks. It pegged the Capital adequacy ratio
(CAR) at 8%. (Tarullo n.d.) Capital Adequacy Ratio (CAR) = Tier 1 Capital + Tier 2
Capital/ Risk Weighted Assets Tier 1 capital represents the capital that is more
permanent in nature and is more reliable. Tier 1 capital or core capital of a bank
includes the normal paid up share capital of the bank and other disclosed reserves
as reduced by the intangible assets of the bank such as Goodwill, fictitious assets
such as debit balance to the Profit and loss account, any expenditure that is not
written off and the deferred tax asset. The Tier 1 capital should form at least 50%
of the banks total capital base. Tier 2 represents the capital that is not as much
reliable as the Tier 1 capital because of the lack of corroborated ownership as in
the case of Tier 1 capital. Tier 2 or Supplementary capital consists of Undisclosed
reserves, Cumulative non-redeemable preference share capital, General
provisions and loss reserves written back as surplus if the actual loss or
diminution is found to be in excess of the provision or loss reserves created
earlier, Revaluation reserves, Hybrid capital instruments and Subordinated debt
with minimum maturity of 5 years. There are also restrictions such as
subordinated debts could not exceed 50% of the core capital, general provisions
and loss reserves could not exceed 1.25% of the total risk weighted assets. Risk
weighted assets is the value of the assets adjusted for the risk of the asset failing
to liquidate as valued. Risk Weights Under Basel I, risk weights were classified into
5 Categories namely, 0%, 0% to 50%, 20, 50%, 100%. (Tarullo n.d.)

The weight of zero per cent was assigned to assets such as loans lent to
OECD states, Investment with OECD central governments securities,
loans to borrowers, who are backed by the guaranties of the OECD states
or who had given the securities of the OECD countries as collateral. Since
OECD states are considered to be developed countries their securities
were assigned zero credit risk. Loans to non OECD countries and central
 banks too were assigned 0% risk weights, provided loans advanced to
them were in their own currency i.e., in the currency of the borrowing
country. This is done to eliminate the risk of exchange rate movements
on the loans advanced in view of the probable depreciation of the
currencies of the non-OECD countries.
Loans or investment with domestic public sector enterprises that remain
outside the ambit of central government were given risk weights ranging
from 0% to 50% at the discretion of nations regulator , which could be
0%, 10%, 20% and 50%.
Loans or investment with institutions such as Multilateral development
banks, OECD banks, Non-OECD banks with tenor extending upto 1 year,
loans guaranteed by OECD incorporated banks, short term loans
guaranteed by non-OECD banks were assigned a weight of 20%.
Loans to non-OECD banks given on a tenor of more than 1 year are
assigned a weight of 50%.
Loans or investment with private sector enterprises, Non OECD banks
with tenor more than one year, capital market instruments issued by
other banks were assigned a weight of 100%.
In order to capture the risk that resides with the off balance sheet items
such as contingent liabilities, a new parameter called "Credit conversion
factor" (CCF) was deployed. For instance :
o General guarantees against loans were assigned 0%
o Letter of credits against Shipments were assigned 20%
In 1996, in response to the financial innovations, as instruments like derivatives
were started to be widely used, a new factor called market risk was introduced to
strengthen the standards. Market risk is the risk of losses on account of
movements in market prices with the on-balance sheet and off-balance sheet
positions. (Basel Committee on Banking Supervision 2005) The way CAR would be
calculated was modified to factor in Market risk and a new category of capital
called as Tier 3 capital. The Tier 3 capital is composed of Short term subordinated
bonds that would exclusively cover market risks. Market risk consists of interest
rate risk, equity position risk, foreign exchange risk and commodities risk. For
measuring market risk, BCBS proposed two approaches namely Standardized
approach, where the principles of gauging the market risk were completely
prescribed by the BCBS and Internal grading based approach, where a certain
degree of independence was granted to banks in assessing market risk.
BASEL II:
As years passed by, Basel II evolved. Basel II was given approval in the year 2004.
The norms of Basel II accord were on three fronts, which are given by the three
pillars viz: 1.The minimum capital requirement; 2.The supervisory review; 3.The
market discipline. The level of minimum capital requirement was continued to be
maintained at 8% under the new framework. A new benchmark of risk called
Operational risk was introduced. Operational risk is defined as the risk of loss
resulting from the failure of internal processes or from the external events. For
instance, Operational risk includes employee frauds, sabotage of assets of the
bank, external frauds etc Put simply, the losses that the bank may suffer, other
than, in the normal course of business.

Pillar 1

Basel II provided three different approaches for credit risk determination. They
are:

1. Standardized approach
2. Foundation internal rating based approach (F-IRB)
3. Advanced internal rating based approach (A-IRB).
The standardized approach provides that the risk weights should be assigned
based on the ratings given by the External Credit Rating Institutions (ECAI). Under
the new approach risk weights may range from 0% to 150%. Unlike Basel I, where
loans to OECD central banks and OECD states where assigned a lower risk weights
considering their credibility, in Basel II ratings assigned by the external credit
rating agencies were considered as benchmarks and loans to foreign banks were
assigned risk weights based on the ratings given by them. However when a
foreign bank that is operating in a country lends to the central bank of the
country, where it is incorporated then a lower risk weight may be applied to such
asset provided the loan is funded and denominated in the domestic currency of
the foreign bank. Another prominent feature of the Basel II accord is a corporate
may get rated by an ECAI and be assigned a lower risk weight based on the
ratings. This stands in contrast to the Basel I accord, where all the corporates
were assigned a uniform risk weight of 100%. This might cause the banks to infer
that lending to SME-s (Small and Medium Scale Enterprise) may prove to be
expensive. (Francis n.d.) Internal ratings based approach allows the banks to
devise their own models to assess the risk. Under the other two approaches,
Banks use their own model to measure the parameters like PD (Probability of
default), EAD (Exposure at default), LGD (Loss given default), which are used in
calculating the Risk weighted assets (RWA). To cover operational risk of loss, Basel
II prescribes three approaches namely basic indicator approach, standardized
approach and advanced measurement approach.

Basic indicator approach and standardized approach requires an

appropriation of 15%, 12% to 18% respectively of banks average annual
gross income to the reserves in the preceding three years.
Under the standardized approach, banks activities are divided into eight
business lines each possessing a different "Denoted beta" ranging from
the 12% to 18%. The past three years average of the gross annual income
of each business line is multiplied with the respective beta to arrive at the
capital charge.
Under the Advanced measurement approach banks can quantify the
capital to cover operational risk using their own internal model taking
into account internal risk variables and profiles.

Pillar 2:
Pillar 2 specifies the norms for regulatory authorities. The banks should have
deployed a system for assessing the stability of the capital and preclude any fall
below the standard level. The regulator should mandate the banks to operate
above the minimum capital requirement and should prevent the capital of the
banks from falling below the minimum level, which is specified. Pillar 3 Under the
Pillar 3, banks are required to follow a formal disclosure policy. Disclosures
regarding capital adequacy, credit risk mitigation, the internal ratings systems
that it follows under the IRB approach were all specified under Pillar 3.

Basel III:
Basel III was introduced in December 2010. It came as a response to the sub-
prime crisis in the year 2008. As of now, its implementation has been extended to
31st March 2019.

The Key modifications happened with Basel III are as follows:

 The requirement of minimum Tier 1 capital has been increased from 4%
in Basel II to 6%
A new buffer called as Capital conservation buffer with Tier 1 capital
needs to maintained and the requirement level for this has been pegged
at 2.5% of the RWA.
The total "Capital adequacy ratio" requirement has been maintained at
8%
But when combined with the newly introduced conservation buffer, the
requirement of capital increases to 10.5%
At the discretion of the central banks of the countries, banks may be
required to maintain a "Counter cyclical buffer" ranging from 0% to 2.5%
depending on the economic conditions.
A new measure called leverage ratio is introduced. It measures the
proportion of Tier 1 capital to the total exposure of the bank ( Not RWA).
A minimum ratio of 3% is to be maintained.

How Basel 1 Affected Banks:

From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the
United States. Bank failures were particularly prominent during the '80s, a time
which is usually referred to as the "savings and loan crisis." Banks throughout the
world were lending extensively, while countries' external indebtedness was
growing at an unsustainable rate.

(For related reading, see Analysing A Bank's Financial Statements.)

As a result, the potential for the bankruptcy of the major international banks
because grew as a result of low security. In order to prevent this risk, the Basel
Committee on Banking Supervision, comprised of central banks and supervisory
authorities of 10 countries, met in 1987 in Basel, Switzerland.

The committee drafted a first document to set up an international 'minimum'

amount of capital that banks should hold. This minimum is a percentage of the
total capital of a bank, which is also called the minimum risk-based capital
adequacy. In 1988, the Basel I Capital Accord (agreement) was created. The Basel
II Capital Accord follows as an extension of the former, and was implemented in
2007. In this article, we'll take a look at Basel I and how it impacted the banking
industry.

The Purpose of Basel I:

In 1988, the Basel I Capital Accord was created. The general purpose was to:

1. Strengthen the stability of international banking system.

2. Set up a fair and a consistent international banking system in order to decrease

competitive inequality among international banks.

The basic achievement of Basel I have been to define bank capital and the so-
called bank capital ratio. In order to set up a minimum risk-based capital
adequacy applying to all banks and governments in the world, a general definition
of capital was required. Indeed, before this international agreement, there was no
single definition of bank capital. The first step of the agreement was thus to
define it.

Two-Tiered CAPITAL:
Basel I define capital based on two tiers:

1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or shareholders equity)
and declared reserves, such as loan loss reserves set aside to cushion future
losses or for smoothing out income variations.

2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as
gains on investment assets, long-term debt with maturity greater than five years
and hidden reserves (i.e. excess allowance for losses on loans and leases).
However, short-term unsecured debts (or debts without guarantees), are not
included in the definition of capital.

Credit Risk is defined as the risk weighted asset (RWA) of the bank, which are
banks assets weighted in relation to their relative credit risk levels. According to
Basel I, the total capital should represent at least 8% of the bank's credit risk
(RWA). In addition, the Basel agreement identifies three types of credit risks:

The on-balance sheet risk (see Figure 1 for example).

The trading off-balance sheet risk. These are derivatives, namely interest
rates, foreign exchange, equity derivatives and commodities.
The non-trading off-balance sheet risk. These include general guarantees,
such as forward purchase of assets or transaction-related debt assets.

Let's take a look at some calculations related to RWA and capital requirement.
Figure 1 displays predefined category of on-balance sheet exposures, such as
vulnerability to loss from an unexpected event, weighted according to four
relative risk categories.
 Figure 1: Basel\'s Classification of risk weights of on-balance sheet assets

As shown in Figure 2, there is an unsecured loan of $1,000 to a non-bank, which

requires a risk weight of 100%. The RWA is therefore calculated as RWA=$1,000
100%=$1,000. By using Formula 2, a minimum 8% capital requirement gives 8%
RWA=8% $1,000=$80. In other words, the total capital holding of the firm must
be $80 related to the unsecured loan of $1,000. Calculation under different risk
weights for different types of assets are also presented in Table 2.

Figure 2: Calculation of RWA and capital requirement on-balance sheet assets

Market risk includes general market risk and specific risk. The general market risk
refers to changes in the market values due to large market movements. Specific
risk refers to changes in the value of an individual asset due to factors related to
the issuer of the security. There are four types of economic variables that
generate market risk. These are interest rates, foreign exchanges, equities and
commodities. The market risk can be calculated in two different manners: either
with the standardized Basel model or with internal value at risk (VaR) models of
the banks. These internal models can only be used by the largest banks that
satisfy qualitative and quantitative standards imposed by the Basel agreement.
Moreover, the 1996 revision also adds the possibility of a third tier for the total
capital, which includes short-term unsecured debts. This is at the discretion of
the central banks.

Pitfalls of Base I:
Basel I Capital Accord has been criticized on several grounds. The main criticisms
include the following:

Limited differentiation of credit risk

There are four broad risk weightings (0%, 20%, 50% and 100%), as shown in
Figure1, based on an 8% minimum capital ratio.

Static measure of default risk. The assumption that a minimum 8% capital

ratio is sufficient to protect banks from failure does not take into account
the changing nature of default risk.

No recognition of term-structure of credit risk. The capital charges are set

at the same level regardless of the maturity of a credit exposure.

Simplified calculation of potential future counterparty risk the current

capital requirements ignore the different level of risks associated with
different currencies and macroeconomic risk. In other words, it assumes a
common market to all actors, which is not true in reality.

Lack of recognition of portfolio diversification effects In reality, the sum of

individual risk exposures is not the same as the risk reduction through
portfolio diversification. Therefore, summing all risks might provide
incorrect judgment of risk. A remedy would be to create an internal credit
risk model - for example, one similar to the model as developed by the
bank to calculate market risk. This remark is also valid for all other
weaknesses.

These listed criticisms have led to the creation of a new Basel Capital Accord,
known as Basel II, which added operational risk and also defined new calculations
of credit risk. Operational risk is the risk of loss arising from human error or
management failure. Basel II Capital Accord was implemented in 2007.

Conclusion:
The Basel I Capital Accord aimed to assess capital in relation to credit risk, or the
risk that a loss will occur if a party does not fulfil its obligations. It launched the
trend toward increasing risk modelling research; however, its over-simplified
calculations, and classifications have simultaneously called for its disappearance,
paving the way for the Basel II Capital Accord and further agreements as the
symbol of the continuous refinement of risk and capital. Nevertheless, Basel I, as
the first international instrument assessing the importance of risk in relation to
capital, will remain a milestone in the finance and banking history.

BASEL IV:

Basel IV as it is dubbed by the financial industry is a proposed standard on capital

reserves for banks, to mitigate against the risk of financial crisis. It is expected to
follow the third Basel accords (Basel III) , and would require more stringent capital
requirements and greater financial disclosure.

Requirements:
Basel 4 is likely to include:

Requiring banks to meet higher maximum leverage ratios (an initial leverage
ratio maximum is likely to be set as part of the completion of the Basel III
package);
Emphasising simpler or standardised models, rather than banks' internal
models, for calculation of capital requirements (the Basel committee has
 made initial proposals on simpler models as part of the completion of the
Basel III framework);
More detailed disclosure of reserves and other financial statistics.
British banks alone may have to set aside another 50Bn of reserves to meet
Basel 4 requirements.