Bank Regulation -

The Basel Capital

Accord
Lecture Week 13

BANK3011 BANK FINANCIAL MANAGEMENT

PAUL MARTIN
Overview
– Examine the regulatory management of Bank
risks
– The Regulatory Environment – Capital Regulation
• The role of various roles of Capital
• Brief description of Basel I ( implemented in 1989, with market
risk added in 1998)
– The overall approach
– The shortcomings of Basel I
• Basel II (Implemented in January 2008 in Australia)
– Standardised approaches; and
– Advanced approaches used to calculate adequate capital
according to internal rating based models of various risks
(particularly for credit risk).
• Basel III (Announced September 2010, implemented in
January 2013 in Australia) – the response to the banking
failures leading to the GFC
The Regulatory Environment - Capital
Regulation
– The Various Roles of Capital
– A means of transferring ownership
– This is part of the process of facilitating investment in a cost
effective manner. The more liquid the investment the lower
the cost of sourcing the capital funds.
– Funding the Business
– For many businesses this the principal function of capital
– Banks however do not require capital as a primary source
of funding – they can borrow whatever they need as part of
their normal activities and at much lower rates
– For banks, capital is the most expensive source of funds
– Basel says that capital is to:
– “Strengthen the soundness and stability of the international
banking system”
Regulatory Capital
and the Basel
Framework
A Definition of Bank Capital

“The amount held or required to be held by a bank or financial

institution to underpin the risk of loss in the value of
exposures, businesses etc., so as to protect depositors and
general creditors against loss.”
Bank for International Settlements

– Capital acts as a buffer to absorb future, unidentified losses

– How big should this buffer be – Basel Accord requires capital equal to
a minimum of 8% of “risk weighted” assets
– Capital also serves to:
– Protect FI insurance and depositor insurance schemes against loss
and ultimately to protect the taxpayer
– Lower the cost of borrowings by reducing the risk to lenders to an FI
– Fund the assets of the FI
Economic Capital vs. Book Capital
– Book Capital per share historical (accounting) value equals:
• Par value of capital issued
• Share premium accounts
• Retained earnings
• General reserves for loan losses
BVe = Par Value of Equity +Surpluses + Retained Earnings + Loan Reserves
Number of Shares
– Market or Economic Value per share
• Reflects the current value of assets and liabilities
• Reflects the amount that could be realised to meet potential
future losses
• We have used this throughout the course as the measure of
the Mve
MVe = Market Value of Equity Ownership Shares Outstanding
Number of Shares

– Basel uses Book Capital as the basis for assessing the

adequacy of capital to cover bank risks
Basel and Bank Capital Management

– The Basel Capital regulations have led to an

improvement in bank capital ratios
– BIS reported that in 1999 average capital in banks in G10
countries rose from 9.3% to 11.2% between 1988 and
1996.
– The minimum capital ratio also rose from 6.2% to 9.2%
– Capital management broadly involves:
– Ensuring the total capital available is consistent with current and
planned activity
• Involves not just Basel considerations but also Investor &
Credit Rating Agency factors
– Selecting the mix of capital assets
– Ensuring that adequate returns on capital
Capital Adequacy Compliance

– Basle (Basel I) Capital Accord (1988) required

compliance with minimum capital standards covering:
• Market risk
• Credit risk
– Basel II Proposals the first consultative paper was
issued in 1999 requires capital for:
• Market risk (unchanged from Basel I)
• Credit risk (new approaches from Basel I)
• Operational risk (completely new from Basel I)
– Basel III Proposals Issued in 2010
• The principal regulatory response to the GFC
Categories of Regulatory Capital
Regulatory Capital is a hybrid of Book Value Capital
– Tier 1 (Going Concern)
– Ordinary issued share capital of the Bank plus extras
• Ordinary Capital & Retained earnings
– Tier 2 - Supplementary Capital (Gone Concern)
– Subordinated to depositors and general creditors
– Subordinated debt, certain reserves and general provisions
– Some Key Capital Rules
– Tier 1 >= 6% of RWA (increased from 4% in Basel II)
– Capital and retained earnings (Common Equity) to be 4.5% of
RWA (increased from 50% of Tier 1 or 2% of RWA in Basel II)
– Tier 1 + Tier 2 >= 8% of RWA
– These increases have had significant impacts on banks
• All of the Australian majors had to raise additional capital as a
result of these changes.
Types of Regulatory Capital – Tier 1
Capital
– Issued and fully paid ordinary equity
– Retained earnings
– Share premium account
– Non-cumulative irredeemable preference
shares
– Disclosed general reserves
– Subject to criteria generally involving their transfer
via P&L
– Minority interests in subsidiaries
– Less Goodwill on minority interests
Types of Regulatory Capital – Tier 2
Capital

– Undisclosed reserves - often referred to as

hidden reserves
– Revaluation reserves
– General loan loss reserves
– Hybrid instruments such as convertible bonds
– Subordinated debt, subject to
– A maximum of 50% of Tier 1
– Discounted if < 5 years residual maturity
The Three Pillars of Basel II and III
– Pillar 1- Minimum Capital Requirements
• Market risk – largely unchanged from Basel I
• Credit Risk – significant changes from Basel I
• Operational Risk – not covered in Basel I
– Pillar 2 - Supervisory Review
• Bank management to establish risk & capital management
processes & strategies
• Review of these by regulators
• Supervisors to be more pro-active
– Pillar 3 - Market Discipline
• Increased disclosure requirements
• Market discipline through competitors, customers and
participants in the capital markets
Capital Requirements
– Pillar 1
 Capital Requirements under Basel

– Capital for Trading Risk

– Basic Method
• Trading 8% of potential loss weighting factors to calculate the
potential loss (See pp329 to 332 not examinable)
–Internal Model Method
• Use of VaR potential loss weighting factors to calculate the
potential loss & required capital (see pages 332 to 334 for
information)
– Capital for Credit Risk (the major focus of Basel Accords)
• Based on the risk weighted value of the credit exposure
• 8% weighting is then applied to the weighted risk to determine
the required capital
For Information – Not Examinable
Basle I Credit Risk Weightings
– 0% for cash and OECD government risk
– 10% for public sector entities
– 20% OECD banks, or non-OECD banks for less than
one-year
– 50% for certain types of secured lending
• E.g. mortgage lending
– 100% for most corporate exposures
– Contingent (OBS) non-market claims are multiplied by
a conversion factor
• 100% for guarantees and standbys
• 50% for performance bonds
• 20% for Letters of Credit
– The weightings seen as far too broad
Reasons for Basel II

– The risk weights were seen as far too broad

– The risk weights did not reflect the relative risk of assets
within the same class
– e.g. - all loans were for example treated as 100% irrespective
of their creditworthiness
– The advances in credit risk assessment were not
reflected in Basel I
– The methods to calculate the probability of default, and
– Credit modelling
• These were examined earlier in the course.
– The credit risk assessment approaches have been
carried over into Basel III
 Key Aspects of Basel II and Basel III
– Focus is on Enterprise-Wide-Risk-Management (ERM)
aiming to move regulatory capital closer to economic capital
– Rating agencies given a prominent role via the use of
ratings to asses credit risk under the standardised method
– New area of risk introduced – Operational Risk
– Greater use of modeling techniques allows the use of
internal rating based models for credit risk
– The development of the “3 Pillars” which include:
– Greater and proactive involvement of regulators and
supervisors
– Market discipline through greater transparency via risk reporting
– The definition of Regulatory Capital, however, remained
unchanged from that in Basel I
 The Reasons for Basel III

– The key Regulatory response to the 2007/08 GFC

– The level of capital available to absorb losses was
seen as inadequate
– The capital framework was seen as pro-cyclical
– In the midst of the crisis banks were
deleveraging and this amplified the crisis, but
– During the booms leverage was allowed to
expand, thus further fuelling the boom.
– To an extent an unexpected outcome of the
(Internal Ratings Based Model) IRB – see later
slides
 The Key Changes in Basel III –
Regulatory Capital
– Whilst the definition of regulatory capital in Basel II is
unchanged, the level of Regulatory Capital changed
– Minimum common capital increased (See Table 18.3 and
earlier slide) from:
– 2% of RWA that applied under Basel I and II
– Increased to 4.5% by January 2015 (2013 in Australia)
– Establishing an additional capital conservation buffer
(counter cyclical buffer) of 2.5% of RWA
– To be phased in but not commencing until 2016 internationally
– This will bring the common capital ratio to 7% (4.5% +
2.5%) of RWA by 2019 (2016 in Australia) and a minimum
total capital ratio of 10.5% of RWA
– i.e. the current 8% ratio plus the 2.5% conservation ratio.
 Pillar 1 – In Summary

– Basel I
Capital Ratio min 8% = Total Capital
Credit Risk (old) + Market Risk

– Basel II

Capital Ratio min 8% = Total Capital

Credit Risk (new1) + Market Risk + Op Risk (new2)

1 New standardised risk weightings and the implementation of the

Internal Ratings Based (IRB) method
2 New risk area driven by events such as Barings
Calculating the Capital Charge for Credit
under Basel II and Basel III
Two alternative approaches exist:
1. The Standardised Approach
– An enhanced version of the approach used in Basel I
– Involves applying risk weights all credit sensitive assets
2. The Internal Ratings Based (IRB) Model
Approach
– Allows banks to use their assessments of:
• Probability of Default
• Loss Given Default (involves assessing recovery rates)
• Exposure at Default, requires estimating the amount of
potential credit risk at the time of default – in the future
Calculating the Basel II Capital Charge
for Credit Risk
1. Standardised Approach – Risk Weight Changes
– Sovereign Risk
• Now determined on the basis of rating
• Previously were zero weighted
– Banks
• Now determined on the basis of rating or rating of the
sovereign of the home country
• Previously were all weighted at 20%
– Corporates
• Now determined on the basis of rating
• Weighting for below BB- is 150%, unrated 100%
 For Information Basel II
Sample Standardised Risk Weights*
– Corporates
– 20% for corporates AA- and above Lange Table 18.5
– 50% for corporates A- to A+
– 100% for corporates BB- to BBB+
– 150% for corporates D to B+
– Standard Mortgages Loan to Valuation Ratio (LVR) (Table 18.6
– 35% up to 80% LVR
– 50% 80% to 90% LVR
– 75% 90% to 100% LVR
– 100% over 100% LVR
– Contingent (non-market OBS) claims conversion factor (Table
18.7)
• 100% for guarantees and standbys
• 50% for performance bonds
• 20% for Letters of Credit

* These weights will be provided in any exam question and DO NOT need to be memorized.
 Capital Charge for Credit Risk
on Market Related Transactions pp636-641
– This applies to FX, Interest Rate and Commodity and Credit
Derivative contracts
– Credit Risk (current exposure method) is counterparty risk
and reflects:
– Current (mark-to-market profit*) Exposure plus
– Potential Exposure, using the following sample credit conversion
factors (see Table 18.7 for more details)

Residual Maturity Interest Rates FX Contracts Equity Contracts

Derivatives

< 1 Year 0% 1.0% 6.0%

1 – 5 Years 0.5% 5.0% 8.0%

> 5 Years 1.5% 7.5% 10.0%

* Note if the Bank has a loss the current value is set to zero
Calculation of the Capital Charge for
Credit Risk – an example
– A loan of $10,000,000 to a BBB rates manufacturing
company
– Credit weighting 100%, weighted exposure is therefore $10 million
– Capital Required @ 8% is $800,000
– An interest rate derivative of $10 million with a term of 2
yrs. with a bank having no current credit exposure
– Potential exposure
• Assessed risk $10,000,000 * 0.5% = $50,000
• Credit weighting 20%*, weighted risk = $10,000
• Capital required @ 8% is $800
The above derivative in effect “consumes” 1,000 times less capital
than the proposed loan

* Assumes the counterparty is a Bank

Calculating the Basel II Capital Charge
for Credit Risk (Cont.)
2. Internal Ratings Based Approach
see also http://www.apra.gov.au/adi/Documents/Internal-ratings-based-
approach-to-credit-risk-July-2005.pdf
– Foundation and Advanced Versions
– Internal rating systems should be able to identify
qualitative as well as quantitative measures of credit
risk
– Based on quantitative systems to assess:
• Probability of Default (PD)
• Exposure at Default (EAD)
• Loss Given Default (LGD)
– Expected Loss = PD x EAD x LGD, then IRB used to
calculate UL (Unexpected Loss) using a predetermined
distribution function set by BIS, where EL is the mean
– IRB was one of the most significant changes in Basel II
Calculation of Default Probability
based on a Poisson Distribution (from Week 10)
ܲ‫ି ݁ = ݏݐ݈ݑ݂ܽ݁ܦ ݊ ݂݋ ݕݐ݈ܾܾ݅݅ܽ݋ݎ‬௠ ݉௡ /݊!
n 0 1 2 3 4 5 6 7 8 9 10
Probability 13.53% 27.07% 27.07% 18.04% 9.02% 3.61% 1.20% 0.34% 0.09% 0.02% 0.00%

No of defaults (m) 2
e 2.7183
Severity 10000

Probability of Default Distribution

30.0000%

25.0000%

20.0000%
A confidence level
can then be applied
Probability

15.0000%

10.0000%

5.0000%

0.0000%
0 10000 20000 30000 40000 50000 60000 70000 80000 90000 100000110000120000
Loss Value

Note: Both m and n are expressed as number of defaults per 100 loans but
incorporated into the model as an integer
 Underpinnings of IRB Approach

Source: APRA Paper No3. Internal ratings-based approach to credit risk 28 July
2005
 Implementing the Internal Ratings Based
Approach
– PD in both Foundation and Advanced methods is
determined by the Bank
– EAD
– Foundation method the nominal value of the facility, but
may include undrawn amounts. Based on BIS
parameters.
– Advanced method is determined by the bank
– LGD
– Foundation method uses BIS parameters e.g. 50%
unsecured, 75% subordinated facilities
– Advanced method is determined by the bank
Risk Weightings from the use of IRB

Source Appendix 17A Lange 2nd Edition

Operational Risk
Calculating the Basel II and III
Capital Charge for Operational Risk
– Basic Indicator Approach
• Average gross income (over the last 6 half yearly periods)
• Capital charge is 15% of this amount
– Standardised Approach
• Average Gross income per regulatory business line
• Capital charge is 12% (retail), 15% (commercial) or 18% (other)
based on business line
– Advanced Measurement Approach
• Calculated by the bank based on
– Internal and external loss data
– Scenario analysis
– Business environment and internal control factors
Concluding Comments
Criticisms of BIS Approaches
Refer to Appendix 18b for more details
– Risk Weights
– Tend to still be largely arbitrary
– Use of rating Agencies
– Often lag rather than lead economic cycles
– Portfolio aspects
– A portfolio of assets reduce aggregate risk, but Basel focuses on
discrete assets.
– Disincentives
– Weightings for corporates reduce attractiveness, has forced
changes for SME’s, concern that Basel may discourage lending
activities
– Competitiveness
– No level playing field, accounting rules for the treatment of
capital for example still differ
Other Initiatives in Basel III
– Capital requirements for complex securitisation
exposures increased
– Credit variables (PD and LGD) in the IRB to be
based on “stressed inputs”
– The promotion of centralised clearing houses for
OTC transactions
– Potentially zero credit weighting for such exposures
– The risk on OTC’s cleared would be equivalent to futures
– Provisions to be based on “Expected Loss”
– New rules in (International Accounting Standard) IAS39
– Based on the probability weighted PV of expected
cashflows of assets
Basel II and the GFC
– Basel II has been criticised because of its failure to
avert the GFC.
– Basel II failed to ensure that Banks were sufficiently
capitalised in order to sustain the loan losses
– Basel II seen to have contributed to the growth of
securitised assets
– Basel III is the regulatory response to these failures
– Note BIS do not consider that Basel II itself failed, but rather
– Consider that capital levels need to be increased
• Much of the drive of Basel II was, however, to encourage
enhanced risk management through capital relief
(reduction)
– Basel is subject to continuing upgrade and
enhancements
– APRA has very much taken a leading position and has
implemented requirements on Australian banks earlier than
mandated by BIS