Key Features of Basel I

Introduced in 1988, Accord sets out “simple rules” for

calculation of minimum regulatory capital by using a risk
weighting framework.

Regulatory capital ratio must be at least 8% of RWA Applied to

Credit Risk Exposures only

All assets assigned a risk weight to reflect their “Riskiness”

Example risk weightings:

Corporate 100%
Banks 20% 1
Central Government 0%
Basel I – Key Weaknesses

• Lack of Risk Sensitivity – same capital

requirement for AAA rated and CC rated
counterparties
• Limited recognition of risk mitigation
• Inability to cope with developing products
• Perverse incentives leading to regulatory
arbitrage:
- Securitisation of “higher quality” exposures
- Lower quality assets left on balance sheet
• No incentive structure to improve risk
measurement and management framework.
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The 1996 Amendment

• 1996 Amendment requires a Market Risk charge for debt

and equity positions in the trading book, and foreign
exchange and commodity positions in both the banking
book and trading book

• Capital ratio now: Total Regulatory Capital

> 8%
Credit Risk + Market Risk

• Regulatory capital now includes Tier II capital,

comprising of short term subordinated debt.
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Definition of Capital (unchanged)

• Tier 1: Core Capital

- Equity
- Disclosed reserves

• Tier 2: Supplementary Capital (limited to 100% Tier 1)

- Undisclosed reserves
- Revaluation reserves
- General provisions/general loan loss reserves
- Subordinated debt

• Tier 3: (for market risk) short term subordinated debt.

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 The Revised Framework – More Flexibility

The Revised Framework

The Existing Capital Accord
(Basel-II)

• Focus on single risk • More emphasis on banks’

measure own Internal Risk
Management methodologies,
supervisory review and
• One size fits all market discipline.

• Broad brush structure • Flexibility, menu of

approaches, capital
incentives for better risk
management.

• More risk sensitivity. 5

• The Basel II Capital Accord, the most
complex and far-reaching regulatory
measure ever hit world financial institutions,
demands that banks understand and act
upon new standards of risk management and
capital efficiency. Banks must adopt the new
requirements by the beginning of 2007. Most
banks have already started the long and
difficult process of adjusting to the new rules
for measuring risk and determining
regulatory capital.
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 BASEL II

Individual Asset
eg. loan to Company XYZ

Risk Weight

Risk Weighted Assets

CAR = Capital
RWA

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BASEL II

• Basel II (The New Basel Capital Accord) –

formulated on three pillars; (i) minimum capital
requirements (ii) supervisory review of capital
adequacy, and (iii) market discipline through
disclosure.

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Basel II initiatives:

• Inclusion of operations risk (market and credit risks already

accounted for in 1988 accord).

• Provision of multiple methods for measuring risks and not just

one

• Stress testing and supervisory review feedback for enabling

banks reduce risks or make available capital for additional
exposure.

• Drive towards market discipline through public disclosures

while ensuring that such disclosures do not conflict with
broader accounting standards

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The Three Pillar Approach

PILLAR 1 PILLAR 2
PILLAR 3

Supervisory Review
Minimum Capital Process Market Discipline
Requirements
Assessment of other Additional Reporting
Credit Risk risks including Requirements
Interest Rate Risk
Market Risk Concentration Risk
Liquidity Risk
Operational Risk Reputational Risk
Etc.
Establish minimum
standards for Increase the Expand the content and
management of
responsibilities and improve the
capital on a more risk levels of discretion transparency of financial
sensitive basis. for supervisory disclosures to the
review and control market 10
Pillar 1 – Minimum Capital Requirement
• Introduces 3 approaches for measuring credit risk, in order
of risk sophistication:
– Standardised
– Foundation Internal Ratings Based (FIRB)
– Advanced Internal Ratings Based (AIRB)

• Refines the market risk amendment, including the treatment

of counterparty credit risk in the trading book.

• Introduces 3 approaches for measuring operational risk in

order of sophistication.
– Basic Indicator Approach (BIA)
– Standardised Approach (SA)
– Advanced Measurement Approach (AIMA)

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Calculation of Risk Weighted Assets

• Credit Risk
- Basic formula: Exposure x risk weight = risk
weighted asset
• Market Risk
- Basic formula: Capital charges for interest rate
risk, equity position risk, foreign exchange risk
directly calculated.
• Operational Risk
- Basic formula: Capital charge for operational
risk directly calculated.

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Pillar 2 – Supervisory Review Process:

• “…… intended not only to ensure that banks have

adequate capital to support all risks… but also to
encourage banks to develop and use better risk
management techniques in monitoring their risks”

• Fundamentally, if banks cannot prove that they

manage risks appropriately, the regulator will
intervene and potentially impose an additional
capital charge.

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Pillar 3: Market Discipline

• “….. Encourage market discipline through a set of disclosure

requirements which will allow market participants to assess
key pieces of information on ….. capital, risk exposures, risk
assessment and capital adequacy….,

• Therefore, if a bank wishes to use internal risk quantification to

measure capital requirement, it must publicly disclose relevant
data to support its calculations.

• Information to be disclosed includes the breakdown of the

bank’s credit risk profile, a description of the internal ratings
process and a comparison of actual losses to estimated
losses.

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 BASEL II: Basic Structure

Three Mutually Reinforcing Pillars

Pillar 1: Minimum Pillar 2: Supervisory Pillar 3: Market

Capital Requirements Review Process Discipline
Core Capital
Risk Weighted Assets Definition of Capital
Definition of Capital

Credit Risk Operational Risk Market Risk

Standardized Internal Basic Indicator Standardized Standardized Internal Model

Approach AMA
Approach Rating Based Approach Approach Based

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Pakistan Basel II Implementation

• The State Bank of Pakistan released its “Roadmap for the

implementation of Basel II in Pakistan” in March 2005.

• Basel II implementation dates are as follows:

2006 2007 2008 2009 2010 2011

Standardised Credit Risk Parallel Run Adoption of Basel II

BIA/SA Operational Risk

IRB Parallel Run Adoption of IRB

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