Basel Accords

History of Bank Regulation

Pre-1988
1988: BIS Accord (Basel I)
1996: Amendment to BIS Accord
1999: Basel II first proposed
Basel III in response to the recent global
financial crisis
 Pre-1988
Banks were regulated using balance sheet measures
such as the ratio of capital to assets
Definitions and required ratios varied from country
to country
Enforcement of regulations varied from country to
country
Bank leverage increased in 1980s
Off-balance sheet derivatives trading increased
LDC debt was a major problem
Basel Committee on Bank Supervision set up
 1988: BIS Accord

Capital regulations under Basel I came into

effect in December 1992 (after development
and consultations since 1988).
The aims were:
to require banks to maintain enough capital to
absorb losses without causing systemic
problems,
to level the playing field internationally (to
avoid competitiveness conflicts).
 1988: BIS Accord

The assets: capital ratio must be less than

20. Assets includes off-balance sheet
items that are direct credit substitutes
such as letters of credit and guarantees

Cooke Ratio: Capital must be 8% of risk

weighted amount. At least 50% of capital
must be Tier 1.
 Types of Capital

Tier 1 Capital: common equity, non-

cumulative perpetual preferred shares

Tier 2 Capital: cumulative preferred

stock, certain types of 99-year
debentures, subordinated debt with an
original life of more than 5 years
 Risk-Weighted Capital
A risk weight is applied to each on-balance- sheet asset
according to its risk (e.g. 0% to cash and govt bonds;
20% to claims on OECD banks; 50% to residential
mortgages; 100% to corporate loans, corporate bonds,
etc.)

For each off-balance-sheet item we first calculate a

credit equivalent amount and then apply a risk weight

Risk weighted amount (RWA) consists of

sum of risk weight times asset amount for on-balance sheet
items
Sum of risk weight times credit equivalent amount for off-
balance sheet items
 Credit Equivalent Amount
The credit equivalent amount is
calculated as the current replacement
cost (if positive) plus an add on factor

The add on amount varies from

instrument to instrument (e.g. 0.5% for a
1-5 year swap; 5.0% for a 1-5 year
foreign currency swap)
 Add-on Factors
(% of Principal)

Remaining Interest Exch Equit Precious Other

Maturity rate Rate and y Metals Commoditie
(yrs) Gold except gold s
<1 0.0 1.0 6.0 7.0 10.0
1 to 5 0.5 5.0 8.0 7.0 12.0
>5 1.5 7.5 10.0 6.0 15.0

Example: A $100 million swap with 3 years to maturity

worth $5 million would have a credit equivalent
amount of $5.5 million
 The Math
N M
RWA wi Li w C j *
j
i 1 j 1

On-balance sheet Off-balance sheet items:

items: principal credit equivalent
times risk weight amount times risk
weight

For a derivative Cj = max(Vj,0) + ajLj where Vj is

value, Lj is principal and aj is add-on factor
G-30 Policy Recommendations
Influential publication from derivatives
dealers, end users, academics,
accountants, and lawyers

20 recommendations published in 1993

 Netting
Netting refers to a clause in derivatives
contracts that states that if a company
defaults on one contract it must default
on all contracts

In 1995 the 1988 accord was modified to

allow banks to reduce their credit
equivalent totals when bilateral netting
agreements were in place
 Netting Calculations
Without netting exposure is
N

max(V ,0)
j 1
j

With netting exposure is

N
max V j ,0
j 1

Net Replacement Ratio

Exposure with Netting
NRR
Exposure without Netting
 Netting Calculations continued
Credit equivalent amount modified from
N

[max(V ,0) a L ]
j 1
j j j

To
N N
max( V j ,0) a j L j (0.4 0.6 NRR )
j 1 j 1
 1996 Amendment

Implemented in 1998

Requires banks to measure and hold

capital for market risk for all
instruments in the trading book including
those off balance sheet (This is in
addition to the BIS Accord credit risk
capital)
 The Market Risk Capital
The capital requirement is

k VaR SRC
Where k is a multiplicative factor chosen
by regulators (at least 3), VaR is the 99%
10-day value at risk, and SRC is the
specific risk charge for idiosyncratic risk
related to specific companies
 Problem with Basel I
Regulatory arbitrage was rampant

Basel I gave banks the ability to control the amount of

capital they required by shifting between on-balance
sheet assets with different weights, and by securitising
assets and shifting them off balance sheet a form of
disintermediation

Banks quickly accumulated capital well in excess of the

regulatory minimum and capital requirements, which,
in effect, had no constraining impact on bank risk
taking.
 Basel II
Implemented in 2007

Three pillars
New minimum capital requirements for
credit and operational risk
Supervisory review: more thorough and
uniform
Market discipline: more disclosure
 New Capital Requirements
Risk weights based on either external credit
rating (standardized approach) or a banks
own internal credit ratings (IRB approach)

Recognition of credit risk mitigants

Separate capital charge for operational risk

 Basel II: Pillar 1
Pillar 1 of the Basel II system defines minimum
capital to buffer unexpected losses.
Total RWA (risk weighted assets) are based on a
complex system of risk weighting that applies to
credit
market (MR)
operational risk (OR)
These risks are calculated separately and then
added:

RWA= {12.5(OR+MR) + 1.06w(i)A(i)}

 USA vs European
Implementation
In US Basel II applies only to large
international banks
Small regional banks required to implement
Basel 1A (similar to Basel I), rather than
Basel II
European Union requires Basel II to be
implemented by securities companies as well as
all banks
 New Capital Requirements
Standardized Approach
Bank and corporations treated similarly (unlike Basel I)

Rating AAA A+ to BBB+ BB+ to B+ to Below Unrated

to A- to BB- B- B-
AA- BBB-

Country 0% 20% 50% 100% 100% 150% 100%

Banks 20% 50% 50% 100% 100% 150% 50%

Corporates 20% 50% 100% 100% 150% 150% 100%

 New Capital Requirements
IRB Approach for corporate, banks and
sovereign exposures
Basel II provides a formula for translating PD
(probability of default), LGD (loss given default), EAD
(exposure at default), and M (effective maturity) into a
risk weight

Under the Advanced IRB approach banks estimate PD,

LGD, EAD, and M

Under the Foundation IRB approach banks estimate

only PD and the Basel II guidelines determine the other
variables for the formula
 Model for Loan Portfolio
We map the time to default for company i, Ti, to a
new variable Ui and assume

U i ai F 1 a Z i2
i

where F and the Zi have independent standard

normal distributions
Define Qi as the cumulative probability distribution
of Ti
Prob(Ui<U) = Prob(Ti<T) when N(U) = Qi(T)
 The Model continued
U a F
Prob(U i U F ) N i

1 ai
2

Hence
N 1 Q (T ) a F
Prob(Ti T F ) N i i

1 ai2

Assuming the Q' s and a' s are the same for all companies
N 1 Q (T ) F
Prob(Ti T F ) N
1
where is the copula correlation
 The Model continued
The worst case default rate for portfolio for a
time horizon of T and a confidence limit of X is

N 1[Q (T )] N 1 ( X )
WCDR(T,X) N

1

The VaR for this time horizon and confidence

limit is
VaR(T , X ) L (1 R) WCDR(T , X )

where L is loan principal and R is recovery rate

 Key Model in Basel II IRB
(Gaussian Copula)
The 99.9% worst case default rate is
N -1 ( PD) N -1 (0.999)
WCDR N
1

PD probability of default

We are 99.9% certain not to exceed

WCRD next year
 The Loss on the Portfolio
There is 99.9% chance that the loss on the
portfolio will be less than

VaR(99.99%,1 year) EAD i LGD i WCDR

i
EADi exposure given default, i.e. the dollar amount
that is expected to be owed by the ith counterparty at
the time of default
LGDi loss given default, i.e. the percentage of EAD
expected to be lost at default
The Expected Loss and Capital
Requirements
The expected loss from default is:

EL EAD i LGD i PD
i

The capital requirement is worst case loss

minus the expected loss:

EAD LGD (WCDR PD)

i
i i
The Model Used by Regulators:
The loss probability density function and the
capital required by a financial institution
Expected X% Worst
Loss Case Loss

Required
Capital

Loss over time

horizon

0 1 2 3 4
 Numerical Results for WCDR
PD=0.1% PD=0.5% PD=1% PD=1.5% PD=2%

=0.0 0.1% 0.5% 1.0% 1.5% 2.0%

=0.2 2.8% 9.1% 14.6% 18.9% 22.6%
=0.4 7.1% 21.1% 31.6% 39.0% 44.9%
=0.6 13.5% 38.7% 54.2% 63.8% 70.5%
=0.8 23.3% 66.3% 83.6% 90.8% 94.4%
 Dependence of on PD
For corporate, sovereign and bank exposure

1 e 50PD 1 e 50PD 50PD

0.12 50
0.24 1 50
0.12[1 e ]
1 e 1 e

PD 0.1% 0.5% 1.0% 1.5% 2.0%

WCDR 3.4% 9.8% 14.0% 16.9% 19.0%

(For small firms is reduced)

 Capital Requirements
Capital EAD LGD (WCDR PD) MA
where MA - - maturity adjustment
1 (M 2.5) b
MA
1 1.5 b
where M is the effective maturity and
b [0.11852 0.05478 ln(PD)]2

The risk - weighted assets are 12.5 times the Capital

so that Capital 8% of RWA
 Retail Exposures
Capital EAD LGD (WCDR PD)
For residentia l mortgages 0.15
For revolving retail exposures 0.04
For other retail exposures
1 e 35 PD 1 e 35 PD
0.03 35
0.16 1 35
1 e 1 e
0.03 0.13e - 35 PD

There is no distinction between Foundation and Advanced IRB approaches .

Banks estimate PD, LGD, and EAD in both cases
Two Types of Losses and Two
Types of Capital under Basel II
Expected Loss (EL)
Unexpected losses (UL)
UL(T) = VaR(,T) EL(T)

Regulatory capital (Tier 1 and 2) is applied to EL

which are expected to occur but are of smaller
consequence.
Economic capital is for UL which are low
frequency but have significant magnitude. UL is
very sensitive to the shape of the loss distribution.
 UL is Connected to VaR and
Inherits its Shortcomings
UL of the portfolio can be great than sum of the ULs of
its components. This is because VaR is not sub-
additive.

Star-Treck problem of VaR: How do we estimate

something where we have never even gone before.
VaR depends on the tail of the loss distribution for
which we have no data. 99.99% cutoff is arbitrary.

VaR is know to depend on the number of samples

generated in Mode Carlo simulations. The greater
sampling increases the number of outlier observations
and stretches out the tail.

If you want to reduce UL simulate less.

Components of Credit Risk Losses

If each element comes from a distribution, there

are issues of Jensens inequality. That means that
inputs are correlated with each other.

Foundation IRB (F-IRB) vs Advanced IRB (A-

IRB): In the former, LGD is mandated by
regulator.
 Granularity and Aggregation

n=210 = 1024 normalized assets

Portfolio P: w = 1/n, mean 0, variance = w' w
2

Expected loss:

As the assets get clubbed into portfolios, within

portfolio diversification needs to be offset by
higher correlations across groups; correlation
must be a function of granularity (not fixed).
Table: Expected loss, unexpected loss and Value-
at-Risk for varying levels of granularity and
aggregation
The first column shows the number of business units
The second column gives the number of assets within each portfolio.
Each asset has a standard normal distribution. :Corr is the average
pairwise correlation between portfolio values.
 Credit Risk Mitigants
Credit risk mitigants (CRMs) include
collateral, guarantees, netting, the use of
credit derivatives, etc

The benefits of CRMs increase as a bank

moves from the standardized approach to
the foundation IRB approach to the
advanced IRB approach
 Adjustments for Collateral
Two approaches

Simple approach: risk weight of counterparty

replaced by risk weight of collateral

Comprehensive approach: exposure adjusted

upwards to allow to possible increases; value of
collateral adjusted downward to allow for
possible decreases; new exposure equals excess of
adjusted exposure over adjusted collateral;
counterparty risk weight applied to the new
exposure
 Guarantees
Traditionally the Basel Committee has used the
credit substitution approach (where the credit
rating of the guarantor is substituted for that of the
borrower)
However this overstates the credit risk because both
the guarantor and the borrower must default for
money to be lost
Alternative proposed by Basel Committee: capital
equals the capital required without the guarantee
multiplied by 0.15+160PDg where PDg is
probability of default of guarantor
 Operational Risk Capital

Basic Indicator Approach: 15% of gross

income
Standardized Approach: different
multiplicative factor for gross income
arising from each business line
Internal Measurement Approach: assess
99.9% worst case loss over one year.
 Supervisory Review Changes
Similar amount of thoroughness in
different countries

Local regulators can adjust parameters

to suit local conditions

Importance of early intervention stressed

 Market Discipline
Banks will be required to disclose

Scope and application of Basel framework

Nature of capital held
Regulatory capital requirements
Nature of institutions risk exposures
Comparison of Basel I and
Basel II
 Solvency II
Similar three pillars to Basel II
Pillar I specifies the minimum capital
requirement (MCR) and solvency capital
requirement (SCR)
If capital falls below SCR the insurance
company must submit a plan for bringing it
back up to SCR.
If capital; drops below MCR supervisors are
likely to prevent the insurance company from
taking new business
 Solvency II continued

Internal models vs standardized

approach
One year 99.5% confidence for internal
models
Capital charge for investment risk,
underwriting risk, and operational risk
Three types of capital
 Problems With Basel II
Portfolio invariance.
Single global risk factor.
Financial system promises are not treated
equallyregulatory arbitrage facilitated by
complete markets in credit (the CDS market
particularly).
Pro-cyclicality.
Subjective inputs.
Unclear and inconsistent definitions.
Example of Regulatory Arbitrage
Bank A lends $1000 to a BBB rated company, 100%
risk weighted, by buying a bond and would have to
hold $80 capital. Bank A holds a promise by the
company to pay a coupon and redeem at maturity.

Bank A buys a CDS from Bank B on the bond, shorting

the bond and passing the promise to redeem from the
company to Bank B.

Because B is a bank, which carries a 20% capital

weight, Bank A reduces its required capital to 20% of
$80, or $16.

Bank B underwrites the risk with a reinsurance

company outside of the banking system; the promise to
redeem is now outside the banks and the BIS capital
rules dont apply.
 Example of Regulatory Arbitrage
(cont.)
Bank Bs capital required for counterparty risk is only 8% of an
amount determined as follows:
the CDS spread price of say $50 (500bps)
plus a regulatory surcharge coefficient of 1.5% of the face value of
the bond (i.e. $15)
all multiplied by the 50% weighting for off balance sheet
commitments. That is, $2.60 (i.e. 0.08*$65*0.5).

So jointly the banks have managed to reduce their capital required from
$80 to $18.60 a 70.6% fall.

In effect, in this example, the CDS contracts make it possible to reduce

risky debt to some combination of the lower bank risk weight and a
small weight that applies to moving the risk outside of the bank sector

There is little point in defining an ex ante risk bucket

of company bond as 100% risk weighted in the first place.
Shifting the Promises Example
of Regulatory Arbitrage (cont.)