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Commonly used terms in BASEL II

- A ready Reckoner

Specific Issues to be addressed


A number of important issues have been identified which require a special attention by
both the banks and the supervisors while carrying out the supervisory review. These are
issues which are not directly addressed under policy I. An important assessment that
supervisors should make to ensure the proper functioning of certain aspects of policy I.
1. Interest rate risk in the banking book
2. Credit risk
3. Operational risk

Advance Measurement Approach


The regulatory capital requirement will equal the risk measures generated by the banks
internal operation risk measurement system. The bank must meet quantitative and
qualitative criteria as set out in BASE II and must be approved by the supervisor.

Advanced IRB
In addition to PD, the bank adds other inputs such as exposure at default, loss given
default, and maturity. The requirements for this approach are exacting. Supervisor will
be required to validate.

The BASEL Committee


The BASEL Committee on banking supervision is a committee of banking supervisory
authorities that was established by Central Bank Governance of the Group of 10
countries in 1975. It constitutes of senior representatives of banks supervisory
authorities and Central Banks from Belgium, Canada, France, Germany, Italy,
Luxemburg, The Netherlands, Spain, Sweden, Switzerland, The United Kingdom and the
United States. It usually meets at the bank for international settlement in BASEL where
its permanent secretary is located.

The Basic Indicator Approach


It is a charge for operational risk as a fixed percentage known as the Alpha factor or
gross income which serves as a proxy for the banks risk exposure. Under this approach
the capital a bank must set aside to practically against loss arising from operational risk
is equal to a fixed percentage of average annual income over the previous three years.

BASEL I
In 1998 the BASEL committee introduced a capital measurement system, which
provided for the implementation of risk measurement framework with a minimum
capital change. This is commonly referred to as BASEL I

BASEL II
Subsequent to the introduction of BASEL I to specific changes in the banking industry,
which emerged, were the extended use of securitisation and derivatives in secondary
market and has a vastly improved risk management system. This had made BASEL I
established for banks operating on a global scale in virtually all financial markets
become outdated. In recognition of this the BASEL committee proposed a new capital
adequacy framework in June, 1999, commonly termed as BASEL II. This recommends a
more risk sensitive, minimum capital requirement for banking organisation. The new
framework was widely debated and discussed by regulatories of different countries and
the BASEL committee released its final document on June 26, 2004.

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Calculation of Capital Requirement
Total bank capital
Risk weighted assets + 12.5 x capital charges for market and operational risk > 8%

Capital Deficiency
A capital deficiency is the amount by which actual capital is less than the regulatory
capital requirement.

Counter Party
The term counter party is used to denote the party to whom the bank has an exposure
on or off balance sheet, Credit exposure or potential credit exposure. The exposure may
for e.g. Take the form of a loan of cash or securities.

Credit risk: general disclosures for all banks


The general qualitative disclosure requirement with respect to credit risk, including:
Definitions of past due and impaired (for accounting purposes);

Credit Risk - IRB Approach


The IRB approach recognises that banks generally know more than credit rating
agencies about their borrowers. This approach enables a bank to apply much finer
differentiation between risks than the seven risk weight buckets (0, 20, 25, 50, 75, 100
and 150%) in the standardized approach. There are two IRB approaches, both of which
are subject to strict methodological and disclosure standards, and the approval of the
supervisor.

Credit Risk - Standardized Approach


Under the standardized approach the bank allocates a risk weight to each asset and off
balance sheet position, producing a sum of risk weighted assets as follows:
Risk-weighted Asset = Amount of Exposure x Risk Weight
The allocation of each individual risk weight is based on the broad category of the
borrower (sovereign, bank or corporate), refined by reviewing the rating provided by an
external credit assessment institution. This assessment can be adjusted, based on
qualifying credit risk mitigates.
The standardized approach establishes risk weights corresponding to different types of
assets and makes use of external credit assessments to enhance risk sensitivity
compared to the current Accord. The risk weights for sovereign, interbank and
corporate exposures are differentiated based on external credit assessments.

Elements of Tier I capital


For Indian banks, Tier 1 capital would include the following elements:
i. Paid up capital, statutory reserves, and other disclosed free reserves, if
any.
ii. Capital reserves representing surplus arising out of sale proceeds of
assets For foreign banks in India,
Tier 1 capital would include the following elements:
i. Interest free funds from Head Office kept in a separate account in Indian books
specifically for the purpose of meeting the capital adequacy norms.
ii. Statutory reserves kept in Indian books
iii. Remittable surplus retained in Indian books which is not repatriable so long as the
bank functions in India
iv. Capital reserve representing surplus arising out of sale of assets in India held in a
separate account and which is not eligible for repatriation so long as the bank functions
in India.
v. Interest free funds remitted from abroad for the purpose of acquisition of property
and held in a separate account in Indian books.

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vi. The net credit balance, if any, in the inter office account with Head office/overseas
branches will not be reckoned as capital funds. However, any debit balance in Head
office account will have to be set off against the capital.

Elements of Tier II capital


1. It constitutes all undisclosed reserves and cumulative perpetual preference shares.
2. Revaluation reserves
3. General provisions and loss reserves
4. Hybrid debt capital instruments
5. Subordinated debt

Foundation IRB
The bank estimates the probability of default (PD) associated with each borrower, and
the supervisor supplies other inputs, such as loss given default and exposure at default.

FSAP
Financial sector assessment programme is an assessment conducted by IMF to examine
the banking system with the relevant principles of a central bank of the country. India is
one of the early countries which subjected itself voluntarily to FSAP and its banking
system was assessed to be in high compliance with relevant principles.

Geographic Distribution of Exposure


Geographical areas may comprise individual countries, groups of countries or region or
regions within countries. Banks might choose to define the geographical area based on
the way that the banks portfolio is geographically managed. The criteria used to allocate
the zones to geographical areas should be specified.

Hybrid Debt Capital Instrument


A capital instrument which combines certain characteristics of equity and certain
characteristics of debt is termed as the hybrid debt capital instrument. This has a broad
feature which can be considered to effect its quality as capital. Where these instruments
have close similarities to equity in particular than they are able to support loss on an
ongoing basis without triggering liquidity. Such instruments may be included in the tier
two capital.

Internal Rate Based Approach (IRB)


IRB is a rating approach where banks use their own internal rating of counter parties
and exposures which permit a final differentiation of risk for various exposures and
hence delivers capital requirements that are better lined to the degree of risks.

Internationally Active Banking


A banking group that extensively carries on banking activity both deposit taking and
lending beyond the borders of the country of incorporation is called an Internationally
Active Bank.

Operational Risk
Operational risk is defined as the risk of direct or indirect loss resulting from inadequate
or failed internal process, people and systems or from external funds.

Outlier Banks
Banks whose economic value declines by more than 20% of the sum of Tier I and Tier II
Capitals as a result of a standardized interest rate shock of 200 basis points or its
equivalent are considered as Outlier banks and the supervisors need to give special
attention to the capital sufficiency of these banks.

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Pillars of BASEL II
To accomplish the goal of adequate capitalisation of the banks the BASEL II framework
has introduced 3 Pillars that reinforce each other and enhance the quality of processes,
viz, the 1st Pillar is minimum capital requirement, 2nd Pillar is the supervisory review
process and the third Pillar is marketing discipline.

Pillar I (Minimum capital requirement)


It relates to the minimum capital requirement, which Each bank must hold to cover its
exposure to credit, market and operational risk.

Pillar II (Supervisory review)


Pillar II is concerned with supervisory reviews that aim to ensure that a banks capital
level is sufficient to cover its offer of risk.

Pillar III (Market discipline)


Pillar III relates to market discipline and details minimum levels of public disclosures.
The rationale for Pillar III is sufficiently strong to warrant the introduction of the
disclosure requirement for banks using the framework. Supervisors have an array of
measures that they can use to require banks to make such disclosures. The guiding
principle for market discipline is to compliment the other two pillars, viz, minimum
capital requirement and supervisory review process. The main aim is to encourage
market discipline by developing a set of disclosure requirements which will allow market
participants to assess key basis of information on the scope of application capital risk
exposures, risk assessment process and hence the capital adequacy of the institution.
In principle a bank’s disclosures should be in consonance with how senior management
and the board of directors assess and manage the risks of the bank.

Qualitative Disclosures
Description of approaches followed for specific and general allowances and statistical
methods;
Discussion of the bank credit risk management policy; and For banks that have partly,
but not fully adopted either the foundation IRB or the advanced IRB approach, a
description of the nature of exposures within each portfolio that are subject to the 1.
standardized IRB, 2. foundation IRB, and 3. advanced IRB approaches and of
managements plans and timing for migrating exposures to full implementation of the
applicable approach

Risk Adjusted Return on Capital (RAROC)


RAROC is a risk adjusted profitability measurement and management framework for
measuring risk adjusted financial performance. These concepts are mainly used within
banks to measure ratio of return to economic capital.

Significant Bank (SA)


A significant bank can be considered as a large enough one, that if it were to collapse, it
would have systemical implications for banks and the broader economy in its home
country and possibly world wide.

Standard Approach
Banks use a risk-weighting schedule for measuring the credit risk of banks assets. The
risk weightings are linked to ratings given to Sovereigns financial institutions by
external credit rating. This is called the Standard Approach.

The Supervisory Review Process


It is a process which encompasses the key numbers of supervisory review, risk
management guidance and supervisory transparency and accountability produced by

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the committee with respect to banking risk, including a guidance relating to, many other
aspects like:
the treatment of interest rate in the banking book, credit risk, operational risk,
enhanced cross border indication and corporation and securitisations. The supervisory
review process of the framework is intended not only to ensure that the banks have
quality capital to support all the risks in their business but also to encourage banks to
develop and use better risk management techniques in monitoring and managing the
risk. It recognizes the responsibility of bank management in developing internal capital
assessment process and setting capital targets that rather commensurate with the
banks risk profits and control environment. In the framework, bank management
continues to bear responsibility for ensuring that the bank has adequate capital to
support its risks, beyond the core minimum requirement. The four principles of
supervisory review are listed below:
1. Banks should have members for assessing their overall capital adequacy in relation to
their risk profile and a strategy for monitoring their capital levels.
2. Supervisors should review and evaluate banks internal capital adequacy assessments
and strategies as well as the ability to monitor and ensure their compliance with
regulatory capital ratios. Supervisors should take appropriate supervisory action if they
are not satisfied with the result of the process.
3. Supervisors should expect banks to operate minimum regulatory capital ratios and
should have the ability to require banks to hold capital in excess of the minimum
4. Supervisors should seek to intervene at an early stage to prevent capital from
following below the minimum levels required to support risks characteristics of a
particular bank and should require rapid remedial action if capital is not maintained or
restored.