The Basel II Capital Accord

June 2005

Table of Contents
Chapter 1 ± Basel basics 
Executive Summary Basel I overview Basel II overview Timing Scope of application Capital components Types of Banks IRB Transition Period

7 8 9 10 13 14 16 18 21 24 27 30 33 34

Chapter 2 ± Basel II minimum capital charges ± First Pillar 
Sovereign exposures Bank exposures Corporate exposures Retail exposures Real estate exposures Covered bonds Specialised lending

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Table of Contents (cont¶d)
Chapter 2 ± Basel II capital charges (cont¶d) 
Off-balance sheet items Equity Non-performing loans Credit risk mitigation (CRM) Securitisation exposures Standardised banks

35 37 39 45

- Ratings based approach - Most senior exposures; second loss positions or better - Liquidity facilities - Overlapping exposures IRB banks - Ratings based approach - Internal assessments approach - Supervisory formula approach - Liquidity facilities - Top-down approach

51 52 53 55 57 58 61 63 64

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Table of Contents (cont¶d) Chapter 2 ± Basel II capital charges (cont¶d) Early amortisation structures Trading book 66 71 84 Chapter 3 ± Basel II operational risk charges Basic indicator approach Standardised approach Advanced measurement approach Chapter 4 ± Supervisory Review ± Second Pillar Four key principals of supervisory review Supervisory review process for securitisation 87 89 4 Source: Text .

Table of Contents (cont¶d) Chapter 5 ± Market discipline ± Third Pillar Qualitative disclosure Quantitative disclosure 92 93 Chapter 6 ± Some observations Open issues Impact on financial markets Impact on banks Impact on securitisation markets Impact on ABCP conduits 95 96 97 98 99 Contact Details 100 5 Source: Text .

Chapter 1 Basel II Basics .

Executive Summary  In effect since 1988. very simple in application Basel II introduced to:  combat regulatory arbitrage  exploit and improve bank risk Basel I  Easy to achieve significant capital reduction with little or no risk transfer management systems  Much more complex and risk sensitive Basel II First Pillar ± Minimum capital Second Pillar ± Supervisory review Third Pillar ± Market discipline Will profoundly alter bank behaviour  Treats exposures very unequally depending on exposure characteristics  Treats banks very unequally depending on sophistication of risk management systems 7 Source: Text .

deduction or 100% first loss (with national variations)  Unfunded commitments under one year: 0%  Unfunded commitments over one year: 50%  Everything else: 100% Sample capital calculation  ¼100 million corporate exposure  100% risk weight = ¼100 million risk weighted assets (RWA)  Capital charge = Capital = 8% minimum RWA  Capital charge: ¼8 million 8 Source: Text .Basel I ± Capital Charges Risk weights  OECD sovereigns: 0%  OECD banks: 20%  Residential mortgages: 50%  Synthetic: 20% super-senior. 0% cash-collateralised mezzanine.

Basel II ± Timing Basel II  Published June 2004  End 2006 for standardised and foundation IRB However  New rules will alter banks behaviour right away  Some countries will adopt prior to expected banks (¶ 2)  End 2007 for advanced IRB banks (¶ 2)  End 2009 (at earliest) before full IRB benefits implementation dates. at least in part  Implementation may be delayed in some countries  Reaction of US regulators to QIS 4 results achievable due to transition period (¶¶ 45-49)  Basel/IOSCO review (not yet final) will may cause delays  EU and member state adoption schedules change CRM rules and rules for trading book exposures Capital Requirements Directive (CRD)  Will implement Basel II within EU  Same adoption timing sought  May vary from Basel II (and thus from rules in not usually so quick  Implementation may not be uniform  140+ items subject to national discretion  Supervisory discretion  Lengthy adoption time permits lobbying US and elsewhere) in important respects Unless otherwise indicated. all references to paragraph numbers in these materials refer to paragraphs in June 2004 Basel II Accord 9 Source: Text .

some G10 countries will retain current risk (whether or not regulated) captured through consolidation (¶ 24)  Financial activities do not include weighting treatment (100% for standardised banks) for competitiveness reasons (¶ 31)  Supervisors may permit recognition by bank of excess insurance (¶ 24.Basel II ± Scope of Application Applied on consolidated basis to internationally active banks ( 20)*  All banking and other financial activities Insurance entities  Generally. fn. 5)  Majority-owned subsidiaries not consolidated: deduct equity and capital investments (¶ 27)  Significant minority investments without capital invested in insurance subsidiary over required amount (¶ 33) Commercial entities  generally deducted significant investments in control: deduct equity and capital investments (¶ 28)  Deduction of investments 50% from tier 1 commercial entities above materiality thresholds (¶ 35)  Significant investments in commercial entities below and 50% from tier 2 capital (¶ 37) * EU rules (CRD) will also apply to solo entities and to investment firms materiality thresholds risk weighted 100% (¶ 36) 10 Source: Text . deduct bank s equity and other capital investments in insurance subsidiaries ( 30)  However.

06 (subject to recalibration following QIS 4 and QIS 5) introduced to ensure same aggregate amount of capital remains in banking system following Basel II adoption (¶ 44.25% of risk-weighted assets (¶ 42)  IRB approach:  Securitisation and certain equity exposures: expected loss (EL) amount must first be deducted from capital (¶ 43)  Other exposures: bank must compare total eligible provisions against total EL amount and deduct any excess EL amount over eligible provisions (excess of provisions over EL amount may be added to tier 2 capital up to maximum of 0. ¶¶ 374386) Scaling Factor  Scaling factor of 1.Basel II ± Capital and Provisions Definition of regulatory capital unchanged ( 41) (but some changes anticipated going forward) Treatment of provisions  Standardised approach: general provisions can be included in tier 2 capital up to limit of 1. 11) 11 Source: Text .6% of risk-weighted assets (¶ 43. fn.

Basel II ± Three Pillars

First Pillar

Minimum Capital Charges: Minimum capital requirements based on market, credit and operational risk to (a) reduce risk of failure by cushioning against losses and (b) provide continuing access to financial markets to meet liquidity needs, and (c) provide incentives for prudent risk management (¶¶ 40-718)

Second Pillar

Supervisory Review: Qualitative supervision by regulators of internal bank risk control and capital assessment process (¶¶ 719-807), including supervisory power to require banks to hold more capital than required under the First Pillar

Third Pillar

Market Discipline: New public disclosure requirements to compel improved bank risk management (¶¶ 808-822)

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Basel II ± Capital Components
Credit risk charges (¶ 40-643) 
Revised  To ensure capital charges are more sensitive to risks of exposures in banking book  Enhancements to counterparty risk charges also applicable to trading book exposures

Operational risk charges (¶ 644-683) 
New  To require capital for operating risks (fraud, legal, documentation, etc.)

Market risk charges (¶ 684-718) 
Initially unchanged, but Basel/IOSCO review has proposed changes to specific risk

calculations and Second Pillar stress testing 
To require capital for exposures in trading book  Rules in Market Risk Amendment (1996)

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Basel II ± Types of Banks 

Standardised
Measure credit risk pursuant to fixed risk weights based on external credit assessments (ratings) Least sophisticated capital calculations; generally highest capital burdens Most Japanese banks will start Basel II as standardised banks Most US banks will stay under Basel I (or, more likely, will move to Basel 1½) Measure credit risk using sophisticated formulas using internally determined inputs of probability of default (PD) and inputs fixed by regulators of loss given default (LGD), exposure at default (EAD) and maturity (M). More risk sensitive capital requirements Most European banks will likely qualify for Foundation IRB status at start of Basel II Measure credit risk using sophisticated formulas and internally determined inputs of PD, LGD, EAD and M Most risk-sensitive (although not always lowest) capital requirements Transition to Advanced IRB status only with robust internal risk management systems and data Top 10 US banks expected to implement Advanced IRB at start of Basel II 

  

Foundation IRB 

 

Advanced IRB 

 

Under Basel II, banks have strong incentive to move to IRB status and reduce capital charges by improving risk management systems

14

External Ratings Criteria Recognition External credit assessment institution (ECAI)(rating agency) recognised/ approved by national supervisor on basis of objectivity. disclosure. transparency. unsolicited ratings recognised (¶ 108) 15 Source: Text . resources and credibility (¶ 91) If two assessments. higher risk weight applied (¶ 97) If three or more assessments. independence. two lowest risk weights referred to and higher of those two applied (¶ 98) Ratings assessment must take into account entire exposure (principal only ratings will not qualify) (¶ 100) Multiple ratings Assessment CRM Credit risk mitigation (CRM) not recognised if taken into account in rating (¶ 101) Solicited Subject to national discretion.

Transition Period (IRB Banks only) Foundation IRB capital requirements for credit risk. operational risk and market risk may not fall below 80% of the current minimum required for credit and market risks (¶ 46) 2007 2008 2009 2010 and after BIS Committee and/or national supervisors may extend floor if warranted (¶ 48) 16 Source: Text . operational risk and market risk may not fall below 90% of the current minimum required for credit and market risks (¶ 46) IRB capital requirements for credit risk. operational risk and market risk may not fall below 95% of the current minimum required for credit and market risks (¶ 46) IRB capital requirements for credit risk.

Chapter 2 Basel II ± First Pillar Minimum Capital Charges .

Basel II ± Sovereign Capital Charges Sovereigns ± In a Nutshell Basel I Type of Sovereign OECD nonOECD Risk Weight 0% External Rating 100% AA. Greece. FIRB bank risk weights* Poland Russia Turkey Bulgaria Czech Republic Hungary 25% 68% 141% 100% 24% 24% Rating A2/BBB+ Baa3/BBBB1/BBBa1/BBBA1/AA1/A- * Winners  non-OECD rated above BB+  Examples: Chile. China. Hungary. Thailand Losers  OECD rated below AA Examples: Czech Republic. Mexico. supervisory value for EAD and M of 2.5. Turkey Inputs: average rating agency values for PD. LGD of 45%. (Moody s rating applied if different from S&P)   18 Source: Text .or above A BBB BB+ to Bbelow Bunrated Standardised bank risk weights 0% 20% 50% 100% 150% 100% Country Basel II Sample est.

(ii) significant portion of shareholders are AA. (iii) funding is in form of paid-in equity with little or no leverage. other regulators may permit same risk weight 19 Source: Text .Basel II ± Sovereign Capital Charges Sovereigns ± Standardised Banks (¶¶ 53-59)  Risk weights for sovereign exposures: Rating Risk Weight AAA to AA0% A+ to A20% BBB+ to BBB50% BB+ to B100% Below B150% Unrated 100%  Risk weights may also be based on ECA risk scores  Claims on non-central government public sector entities based on corporate exposure risk weights  Claims on multilateral development banks have 0% risk weight if conditions are met. and (iv) conservative lending criteria  At national discretion. lower risk weight for banks exposures to their sovereign (or central bank) in domestic currency. if adopted.or better rated sovereigns. including: (i) majority of MDB s ratings are AAA.

2.5 x EAD  Capital requirement for defaulted exposure equals greater of zero and difference between exposure s LGD and bank s best estimate of loss  Input characteristics (applicable to all types of exposures) ( 285-325):  PD: internally determined one-year probability of default  LGD: .11852 ± 0.Basel II ± Sovereign Capital Charges Sovereigns ± IRB Banks (¶¶ 270-272)  Formula for exposure not in default: Correlation (R) = Maturity adjustment (b) = Capital requirement (K) = Risk-weighted assets (RWA) = 0.R))^0.AIRB: own estimates.5 × G (0.5) × b) K x 12.5 × G (PD) + (R / (1 .FIRB: 45% (senior)/75% (subordinated). 5 years 20 Source: Text . adjusted (LGD* = LGD x (E* / E) for CRM recognition .(1 . max.R)^-0.5 years for FIRB (6 months for repos).12 × (1 ± EXP (-50 × PD)) / (1 ± EXP (-50)) + 0.EXP(-50))] (0.5 x b)^ -1 × (1 + (M . own est. adjusted for CRM recognition  EAD: not less than sum of (a) amount by which bank capital would reduce if exposure written-off fully and (b) specific provisions and partial write-offs  M: 2.05478 × ln (PD))^2 [LGD × N [(1 .EXP(-50 × PD))/(1 . for AIRB for each exposure.24 × [1 .1.999)] ± PD x LGD] x (1 .

21 Source: Text .Basel II ± Bank Capital Charges Banks ± In a Nutshell Basel I Type of Bank OECD nonOECD Risk Weight 20% External Rating 100% AA. Public Bank Berhad Losers  OECD rated A or below under either option  Examples: Commerzbank.28% 38% . risk weights* 14% .197% 226% NA Winners  non-OECD rated above BB+ under Option 2  Examples: May Bank. HVB. SEB. *** Internal PD estimate to be applied.5.or above A+ to ABBB+ to BBBBB+ to Bbelow Bunrated Standardised Option 1 20% 50% 100% 100% 150% 100% Standardised Option 2 20% External Rating 50% 50% 100% 150% 50% AA. Bradesco Using inputs of average rating agency values for PD. ** Using inputs of rating agency values for PD.5.24% 24% . LGD of 45%. supervisory value for EAD and M of 2. supervisory value for EAD and M of 2.or above A+ to ABBB+ to BBBBB+ to Bbelow BUnrated*** * Basel II FIRB est. Mizuho.68% 100% . LGD of 10%.

Basel II ± Bank Capital Charges Banks ± Standardised Banks (¶¶ 60-65) 2 options. selected by national regulator to apply for all banks in jurisdiction:  Option 1: Banks risk weighted one category below risk weights of banks sovereigns: Rating Risk Weight AAA to AA20% A+ to A50% BBB+ to BBB100% BB+ to B100% Below B150% Unrated 100%  Option 2: At national discretion. banks risk weighted on basis of own external ratings (plus more favourable risk weight if claim maturity < 3 months) Rating Risk Weight AAA to AA20% A+ to A50% BBB+ to BBB50% BB+ to B100% Below B150% Unrated 50%  Local currency reduction: National regulators may reduce by one notch risk weight of local currency bank debt having maturity of less than 3 months. subject to floor of 20%  Exposures to securities firms treated as bank claims if regulatory arrangements comparable 22 Source: Text .

but with floor for PD of 0.03%  Effective floor of 16 to 48 basis points for highest quality credits (depending on maturity assumption) under Advanced IRB  Generally.03% floor (so floor must be used)  More realistic 10% LGD for Advanced IRB bank (rather than 45% supervisor-imposed LGD for Foundation IRB banks) results in significant capital reductions  Compare to 56 basis point floor for highest quality ABS 23 Source: Text . PD for high-quality bank debt will be below 0.Basel II ± Bank Capital Charges Banks ± IRB Banks (¶¶ 270-272)  Formulas for bank exposures same as for sovereign exposures.

24 Source: Text .5. LGD of 45%.68% 100% . risk weights* 14% .or above A BBB BB+ to Bbelow BUnrated** * Basel II FIRB est.Basel II ± Corporate Capital Charges Corporates ± In a Nutshell Basel I Risk Weight 100% AA. supervisory value for EAD and M of 2.197% 226% NA Winners  Corporates rated above BBB+ Losers  Corporates rated below BB- Using inputs of rating agency values for PD.28% 38% .or above External Rating A BBB+ to BBbelow BBunrated Standardised Option 1 20% 50% 100% 150% 100% Standardised Option 2 100% External Rating 100% 100% 100% 100% AA.24% 24% . ** Internal PD estimate to be applied.

selected by national regulator to apply for all banks in jurisdiction:  Option 1: Corporates risk weighted as set out in following chart (supervisory authority to increase 100% risk weight for unrated corporates where warranted by higher default rates): Rating Risk Weight AAA to AA20% A+ to A50% BBB+ to BB100% Below BB150% Unrated 100%  Option 2: At national discretion.Basel II ± Corporate Capital Charges Corporates ± Standardised Banks (¶¶ 66-68) 2 options. all corporates risk weighted at 100% without regard to external ratings  SME Adjustment: 75% risk weight for unrated SME if exposure under ¼1 million and either treated by bank as retail or guaranteed by individual  Includes claims on insurance companies 25 Source: Text .

24 × [1 . 20% reduction in risk weights (depending upon original creditworthiness)  Effective floor of 14% risk weighting for foundation IRB banks due to minimum PD of 0.EXP(-50))] ± 0.(1 . supervisors may allow banks to substitute total assets for total sales  SME adjustment generates approx.EXP(-50 × PD))/(1 .03% representing a capital charge of 112 bps 26 Source: Text .03%  SME Adjustment for firms setting total annual sales (S) at ¼50 million or and ¼5 million or more: Correlation (R) = 0.Basel II ± Corporate Capital Charges Corporates ± IRB Banks (¶¶ 270-274)  Formulas for corporate exposures same as for bank exposures.12 × (1 ± EXP (-50 × PD)) / (1 ± EXP (-50)) + 0.04 × (1 ± (S-5)/45)  Subject to national discretion. including floor for PD of 0.

respectively 27 Source: Text . respectively *** Using PD of 5% and LGDs of 40% and 60%.03% ** Using PD of 3% and LGD of 80% and PD of 5% and LGD of 90%. PD floor at 0.90%***  Internally determined PDs and LGDs under Foundation IRB * PD and LGD inputs provided by bank (¶ 331).110%** 60% .Basel II ± Retail Capital Charges Retail ± In a Nutshell Basel I Risk Weight 100% Standardised bank risk weights Generally Default 75% if conditions met From 150% to 50% depending on level of specific provisions against exposure Credit cards Other Retail Basel II FIRB est. risk weights* 70% .

Basel II ± Retail Capital Charges
Retail ± Standardised Banks (¶¶ 69-71)
Generally 
75% risk weight if:  Exposure to individual or small business  Exposure takes form of revolving credit, line of credit, personal loan, lease, or small

business facility (mortgage loan excluded to extent otherwise covered (see below)) 
Portfolio diversified (granular); Basel II accord suggests no aggregate exposure to any one

counterparty should exceed 0.2% of overall portfolio 
Maximum aggregate counterparty exposure ¼1 million or less  Effective floor of 600 basis points

Past Due 
Unsecured portion of exposure past due for more than 90 days, net of specific provisions, risk

weighted as follows: 
150% when specific provisions less than 20% of outstanding amount of exposure  100% when specific provisions 20% or more of outstanding amount of exposure  100% when the specific provisions 50% or more of outstanding amount of exposure, with

supervisory discretion to reduce risk weight to 50% in such case

28
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Basel II ± Retail Capital Charges
Retail ± IRB Banks (¶¶ 326-338) 
Formula for qualifying revolving retail exposure not in default:
Correlation (R) = Capital requirement (K) = Risk-weighted assets (RWA) = 0.04 LGD × N[(1 - R)^-0.5 × G(PD) + (R / (1 - R))^0.5 × G (0.999)] ± PD × LGD K x 12.5 x EAD 

Formula for other retail exposure not in default:
Correlation (R) = Capital requirement (K) = Risk-weighted assets (RWA) = 0.03 × (1 ± EXP (-35 × PD)) / (1 ± EXP (-35)) + 0.16 × [1 - (1 - EXP(-35 × PD))/(1 - EXP(-35))] LGD × N[(1 - R)^-0.5 × G(PD) + (R / (1 - R))^0.5 × G (0.999)] ± PD × LGD K x 12.5 x EAD 

When only drawn balances securitised, bank must hold required capital against unfunded

commitment

29
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Basel II ± Real Estate Capital Charges
Real Estate ± In a Nutshell
Basel I Type of Exposure Residential Commercial Risk Weight 50% 100% Standardised bank risk weights Residential Commercial * Subject to conditions 35%* 100%** Residential Commercial Basel II FIRB est. risk weights 10% - 50%*** 20% - 90%**** *** Using PD of 1% and LGD of 10% and PD of 2% and LGD of 25% **** Using PD range of 0.07% and 2.1% and LGD of 35%

** Reduced 50% risk weight possible, subject to conditions

30
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Basel II ± Real Estate Capital Charges Real Estate ± Standardised Banks Residential Real Estate ( 72-73)  35% risk weight for exposures fully secured by mortgages on residential property occupied by the borrower or rented  Strict prudential criteria (including loan to value ratios) determined by national regulators  Supervisors may require increased risk weight if data warrant  Effective floor of 280 basis points Commercial Real Estate ( 74)  Generally 100% risk weight. (ii) losses on tranche do not exceed 0.5% in any year 31 Source: Text .3% in any year. given experience in numerous countries with troubled credits over the past few decades  However. and (iii) overall losses from commercial real estate in relevant market do not exceed 0. 50% risk weight possible in certain markets if (among other conditions): (i) tranche not greater than lower of 50% of market value and 60% of mortgage lending value.

5 x EAD  High volatility commercial real estate (HVCRE) (¶¶ 280-284): Supervisory Rating Risk Weight Strong 95% Good 120% Satisfactory 140% Weak 250% Default 0%  At national discretion.Basel II ± Real Estate Capital Charges Real Estate ± IRB Banks  Residential Mortgages ± Formula for exposure not in default (¶¶ 327-328): Correlation (R) = Capital requirement (K) = Risk-weighted assets (RWA) = 0.999)] ± PD × LGD K x 12. banks may assign preferential risk weights of 70% to ³strong´ and 95% to ³good´ where maturity is less than 2.5 × G (0.5 × G(PD) + (R / (1 .R))^0.R)^-0.15 LGD × N[(1 .5 years or supervisor determines bank s underwriting criteria and other risk characteristics are substantially stronger  Treated differently under CRD 32 Source: Text .

risk weights*** 4% 10% Italy.03%.03% PD of 0. Using inputs PD as noted. 33 Source: Text . Sweden.15% Basel II (CRD) FIRB est. supervisory value for EAD and M of 2.5%.Basel II ± Covered Bonds Capital Charges Covered Bonds ± In a Nutshell Basel I (CRD) Type of Exposure UCITS qualifying Exceptions* * EU Risk Weight 10% 20% Standardised bank risk weights Senior debt RW Covered bond RW * 20%* 10% 50%** 20% 100% 50% 150% 100% PD of 0. Portugal. UK Requires rating of AAA to AA- ** Requires rating of A+ to A.5% required in CRD with PD floor of 0.under Option 1 and rating of A+ to BBBunder Option 2 *** LGD of 12.5. LGD of 12.

115% for satisfactory. 90% for good. banks that do not meet requirements for estimation of PD will map internal grades to five supervisory categories (70% for strong. 250% for weak and 0% for default) (¶ 275) At national discretion.Basel II ± Specialised Lending Capital Charges Specialised Lending ± In a Nutshell Basel I Risk Weight All 100% Standardised bank risk weights ( 80) All 100% Basel II IRB bank risk weights ( 275-284) Five Classes of Specialised Lending:  Project finance  Object finance  Commodities finance  Income-producing real estate  High-volatility commercial real estate Generally: For exposures other than HVCRE.5 years or supervisor determines underwriting or other risk characteristics are substantially stronger (¶ 277) 34 Source: Text . supervisors may allow 50% for ³strong´ and 70% for ³good´ if remaining maturity less than 2.

Basel II ± Off Balance Sheet Items Off Balance Sheet Items ± Standardised Banks (¶¶ 82-89) Off-balance sheet items converted into credit exposure equivalents using credit conversion factor (CCF) Commitments  Original maturity of up to one year: 20% CCF  Original maturity in excess of one year: 50% CCF  Unconditionally cancelable: 0% CCF Securities lending  Lending of bank securities or posting as collateral (including repo and reverse repo transactions): 100% CCF Letters of Credit  Short-term self-liquidating trade letters of credit: 20% CCF Other commitments  As specified in Basel I Failed transactions  As specified by national regulators  Effect of failed transactions on off-balance sheet items subject to Basel/IOSCO review 35 Source: Text .

note issuance facilities (NIFs) and revolving underwriting facilities (RUFs)  CCF of 75% applicable to commitments.Basel II ± Off Balance Sheet Items Off Balance Sheet Items ± IRB Banks (¶¶ 310-316) Off-balance sheet items converted into exposure at default (EAD) input using credit conversion factor (CCF) under either foundation approach to EAD or advanced approach to EAD: Foundation approach to EAD  Types of instruments and CCFs same as for standardised approach (¶¶ 82-89) except for commitments. NIFs and RUFs regardless of maturity  CCF of 0% if commitment unconditionally cancelable Advanced approach to EAD  Banks allowed to use own estimates of CCF if allowed to use internal estimates for EAD (¶¶ 474-478)  But 100% CCF if required under foundation approach to EAD 36 Source: Text .

Basel II ± Equity Capital Charges Equity ± In a Nutshell Basel I Type of Exposure Non-consol equity Risk Weight 100% Standardised bank risk weights Corporates Banks Securities firms 100%* 100% Company 100% DaimlerChrysler Siemens Fresenius Med. LGD of 90%. Basel II Accord. supervisory value for EAD and M of 5. National supervisors may exempt from IRB treatment for up to ten years particular equity exposures held at publication date of Basel II accord (¶ 267) CRD has preferential treatment vs. *** Under Basel II (¶ 353) a floor risk weight of 200% applies to listed equities 37 Source: Text . Care GE Sony ‚ Basel II‚ Simple Model* 290% 290% 290% 290% 290% 290% 290% PD/LGD Model** 92%*** 81%*** 264% 32%*** 82%*** 195%*** 120%*** Rating A3/BBB Aa3/AABa1/BB+ Aaa/AAA A1/A Baa3/BBBBaa1/BBB+ For banking book exposures. supervisors may increase to 150% for venture capital and private equity investments (¶ 80) Vivendi Universal Bertlesmann * ** Inputs: average rating agency PDs.

use normal corporate exposure formulas if possible (results in risk weights substantially below 200% and 300% floor in Basel II)  If bank does not have sufficient information to use definition of default. subject to LGD of 90%.5 times difference between  99% percentile one-tail quarterly return and  Risk free rate over long-term sample period  Floor: capital charge under simple risk model but using 200% (traded) and 300% (not traded) PD/LGD method under CRD ( 350-361)  Generally. with reduced LGD of 65% for private equity exposures 38 Source: Text .Basel II ± Equity Capital Charges IRB Banks ± Three Approaches Simple risk method ( 344-345)  CRD: 190% risk weight for diversified private equity exposures (not in Basel II)  CRD: 290% risk weight for publicly traded exposures (300% in Basel II)  CRD: 370% risk weight for all other holdings (400% in Basel II) Internal models method ( 346-349)  Taken from VaR models as 12. then apply scaling factor of 1.5 to risk weights  Unfunded credit protection on equity exposure recognised.

For securitisation exposures or the PD/LGD approach for equity exposures. 563 and 386.Basel II ± Non-Performing Loan Capital Charges Non-Performing Loans (NPLs) ± In a Nutshell Basel I No uniform rules:  In Europe ± combination Basel II/CRD Standardised bank risk weights ( 75-78) IRB bank risk weights Generally: capital requirement for defaulted exposure is equal to greater of zero and difference between LGD (described in para. bank must first deduct EL amounts under paras. at national discretion risk weight reduced to 50% of specific provisions 20% or greater Commercial Mortgages: weighted at 100% unexpected loss risk- 39 Source: Text . 468) and bank s best estimate of expected loss ( 272) Under IRB approach. net of specific provisions. respectively (¶ 43) ¡ ¡ ¡ ¡ ¡ of general and specific provisions  In Generally: Unsecured portion of exposure past due for more than 90 days. risk weighted as follows:  150% when specific provisions less than 20% US five-tier ranking system derives capital of outstanding amount of exposure  100% when specific provisions 20% or more of outstanding amount of exposure  100% when specific provisions 50% or more of outstanding amount of exposure. bank must compare (i) total amount of eligible provisions with (ii) total expected losses and deduct excess (if any) of expected losses over 380-383) provisions ( 43. for asset classes other than securitisation. with supervisory discretion to reduce risk weight to 50% in such case Residential Mortgages: risk weighted at 100% net of specific provisions.

eligible collateral and guarantees will be recognised as under CRM rules for performing loans  Capital charges depend on level of specific provisions held against loan 40 .Basel II ± Non-Performing Loan Capital Charges Non-performing loans ± Generally Essentials:  Non-performing loan under Basel II is any loan that is past due for more than 90 days. but subject to national variation  For purposes of defining secured portion of non-performing loan.

If such loans are past due but specific provisions are no less than 20% of their outstanding amount. net of specific provisions.Basel II ± Non-Performing Loan Capital Charges Non-performing loans ± Standardised Approach Unsecured non-performing loan:  Unsecured portion of non performing loan will be risk-weighted as follows:  150% when specific provisions less than 20% of outstanding amount of exposure  100% when specific provisions 20% or more of outstanding amount of exposure  100% when specific provisions 50% or more of outstanding amount of exposure. with supervisory discretion to reduce risk weight to 50% in such case Secured non-performing loan:  Qualifying residential mortgage loans risk weighted at 100%. the risk weight applicable to the remainder of the loan can be reduced to 50% at national discretion  Commercial mortgages: unexpected loss risk weighted at 100%  Non-performing loans fully secured by forms of collateral not recognized under Basel II (eligible financial collateral) risk weighted at 100% when provisions reach 15% of outstanding amount of loan 41 .

Basel II ± Non-Performing Loan Capital Charges Non-performing loans ± IRB Approach General Rules:  Capital charges to cover unexpected losses  Bank must cover expected losses with specific provisions Consequences:  Fixed LGD at 45% for non-retail assets and senior exposures may result in risk weights as follows:  565% when no specific provisions of outstanding amount of exposures  400% when specific provisions 20% of outstanding amount of exposure  0% when the specific provisions 50% or more of outstanding amount of exposure 42 .

6 5.Basel II ± Non-Performing Loan Capital Charges Non-performing loans ± sample capital calculation (¼100 million NPL) Specific Provisions Net exposure Capital Charges Basel I Standardised Approach IRB Approach Advanced IRB Approach Risk Weights Basel I Standardised Approach IRB Approach Advanced IRB Approach Assumptions: 0% 100 30% 70 >50% <50 80% 20 8.8 0.0 3.0 5.0 1.0 45.6 0.0 0.0 12.0 0.6 15.2 1.6 0.0 100% 150% 565% 380% 100% 100% 270% 0% 100% 50% 0% 0% 100% 50% 0% 0%    Supervisory discretion allows use of 50% risk weight if exposure has specific provision of 50% or better LGD in Advanced IRB Approach is 30% IRB Approach and Advanced IRB Approach are approximated 43 .0 0.0 30.

2005)  German NPL market development to increase to estimated ¼20 billion this year and possible average of ¼15 billion per year after 2007 (Boersenzeitung 18.Basel II ± Non-Performing Loan Capital Charges Non-performing loans ± Originator´s point of view and market outlook Motivations to sell non-performing loan portfolios:  Reduce capital supporting non-performing loans  Reduce negative carry by eliminating financing needs  Shift capital and resources into more profitable businesses  Optimize bank s balance sheet  Improve bank s credit ratings  Reduce operating costs due to smaller work-out departments Market outlook  Basel II will motivate banks to sell NPLs  German NPL market estimated between ¼160 billion and ¼300 billion (Boersenzeitung 18.2.2.2005)  No capital charges required if investors not banks 44 .

. adjust for maturity and currency mismatches Basel II IRB banks Generally: CRM reduces PD or LGD inputs Same as simple approach under Basel II for standardised banks (i. substitution) ‚ ** Maturity of < one year Subject to considerable change due to Basel/IOSCO review.Basel II ± Credit Risk Mitigation Credit Risk Mitigation (CRM) ± In a Nutshell Basel I Type of Exposure OECD sovereign OECD bank Non-OECD bank** * Risk Weight* 0% 20% 20% Standardised banks Simple approach: Risk weight of CRM is substituted for risk weight of unsupported exposure Comprehensive approach: Adjust value of both amount of exposure and value of CRM with either supervisory or own-estimate ³haircuts´.e. including introduction of ³double default´ recognition for certain exposures rather than substitution approach 45 Source: Text .

purchased derivatives) Protection Buyer Protection Seller Treat as cash position in underlying  First to default and second to default protection (¶¶ 207-210) Specific Adjustments  Proportional cover (¶ 190(c)..g.Basel II ± Credit Risk Mitigation Credit Risk Mitigation ± General Rules (¶¶ 109-210) Determine capital as provided on following page. except determine capital pursuant to securitisation rules (following) if credit risk protection tranched (e. type of transaction and frequency of mark-to-market and remargining (¶ 135) 46 . ¶ 198))  Maturity and currency mismatches: size of haircut depends on type of instrument.

only limited double-default recognition proposed under Basel/IOSCO review (¶¶ 140-142. subject to certain conditions (¶ 183) Comprehensive Approach ( 130-138)  Supervisory or own-estimate haircuts adjust both amount of exposure and value of collateral received (¶ 130)  Further adjustments for maturity mismatches (square root of time formula) and currency mismatches (¶ 135) Guarantees and credit derivatives recognised. only limited double-default recognition proposed under Basel/IOSCO review (¶ 301) VaR models permitted subject to supervisory approval (¶ 292) On-balance sheet netting recognised (¶ 292) 47 Standardised Banks IRB Banks .g.. with exceptions. 182-185)  Risk weight of CRM substituted for risk weight of unsupported exposure (¶ 129)  Subject to floor of 20%. ¶¶ 178-181) On-balance sheet netting recognised (¶ 139. ¶ 188) Generally  Collateral reduces PD or LGD input (reducing required capital) (¶¶ 289-307) Guarantees and credit derivatives recognised. e.Basel II ± Credit Risk Mitigation Credit Risk Mitigation ± Capital Calculation Method Simple Approach ( 129. core market participant floor is 0%. ¶¶189-193) VaR models permitted subject to supervisory approval (¶ 138.

Basel II ± Credit Risk Mitigation Credit Risk Mitigation . unrated debt securities issued by bank if listed on recognised     exchange and all other bank issues are BBB. real estate and other collateral meeting minimum requirements (¶ 289) All items recognised as collateral in banking book can also be recognised in trading book No correlation Collateral must not have material positive correlation with underlying exposure (¶ 124)  First-to-default: First-to-Default Second-to-Default  recognised if bank obtains protection for entire basket. credit event triggers contract. and notional of underlying less than contract (¶¶ 207208).or higher.or higher Equities included in main index or listed on recognised exchange UCITS/mutual funds where price quoted daily and UCITS/fund only invests in above instruments For IRB banks only: receivables. other BBB.Eligible Financial Collateral Eligible Collateral ( 145-146)  Cash and gold  Rated debt securities (sovereign BB.or higher)  Senior. regulatory capital relief for asset with lowest risk-weight in the basket Second-to-default: recognised if bank obtains first-to-default protection as above or if one asset already defaulted (¶¶ 209-210) 48 .

irrevocable and unconditional  Mandatory credit events not determined solely by protection provider: (a) failure to pay. r=risk weight of counterparty  Being changed to model-based approach under Basel/IOSCO review 49 Source: Text . public sector entities. may not be unreasonably withheld Eligible protection providers ( 195)  Sovereigns. underlying/reference obligation must be pari passu and protection must contain cross-default/cross-acceleration  Cash settlement permitted if robust valuation process  If protection purchaser s right to transfer underlying subject to obligor consent. add-on= as determined under Basel I. CA=volatility adjusted collateral amount. direct claim on provider.Other Criteria Recognition of credit derivatives ( 191-194)  Legally binding documentation. and banks and securities firms with lower risk weighting than underlying exposure (not SPEs) Counterparty risk charges for OTC derivatives ( 186-187)  Counterparty credit risk charge = [(RC + add-on) ± CA] x r x 8% where: RC=replacement cost. (b) insolvency and (c) Restructuring (recognition up to 60% of underlying if no restructuring)  If asset mismatch.Basel II ± Credit Risk Mitigation Credit Risk Mitigation .

must deduct unrated exposure from capital 50 Source: Text . then deduct from capital except in case of:  Most senior exposure (look-through to average Basel II IRB banks Hierarchy of approach:  If exposure rated must determine risk weight based on ratings based approach (RBA)  If unrated exposure to ABCP conduit may use risk weight of pool)  Second loss position or better (look-through to higher of 100% and highest risk weight of pool)  Liquidity facilities (credit conversion factors internal assessments approach (IAA) if conditions met  If unrated exposure may use supervisory depending on type and length of liquidity commitment) formula approach (SFA) if can determine inputs (including using top down methodology)  If unrated exposure and RBA. may use exceptional ³look through´ approach with regulator consent on temporary basis for liquidity facilities  Otherwise. If exposure unrated. IAA and SFA unavailable.Basel II ± Securitisation Capital Charges Securitisation ± In a Nutshell Basel I Type of Exposure Generally First loss Unfunded < one year Risk Weight 100% Deduct 0% Standardised banks Risk weights based on rating of position.

or above A BBB BB+ to BBB+ or below unrated 20% 50% 100% 350%* Deduct Deduct * Originating banks must deduct BB+ to BB.Basel II ± Securitisation Capital Charges Securitisation ± Standardised Banks ± Ratings Based Approach Short Term Ratings Standardised bank risk weights ( 567) A-1/P-1 External Rating A-2/P-2 A-3/P-3 All other ratings/ unrated 20% External Rating 50% 100% Deduct Long Term Ratings Standardised bank risk weights ( 567) AA.exposures (¶ 569) 51 Source: Text .

provided that the composition of the pool is known at all times Second loss positions or better ( 574-575)  Qualifying exposures provided by sponsor banks in ABCP programs that are in second loss position or better may apply a risk weight equal to the greater of (x) 100% and (y) the highest risk weight assigned to any exposure in underlying pool. the bank that holds or guarantees that position may ³look through´ to the underlying pool to determine the risk weight (and may assign a risk weight equal to average of risk weight assigned to exposures in underlying pool). but only if:  The first loss position provides significant credit protection  The associated credit risk is investment grade or better  The bank holding the exposure does not hold the first loss position Eligible liquidity facilities ( 576)  Banks may apply risk weight to eligible liquidity facilities equal to highest risk weight assigned to any exposure in underlying pool 52 Source: Text .Basel II ± Securitisation Capital Charges Securitisation ± Standardised Banks Except as provided below. unrated securitisation exposures must be deducted ( 567) Most senior exposures ( 572-573)  If the most senior tranche is unrated.

where more than one SPE across different transactions is unable to roll over maturing commercial paper ± i.e. not as result of impairment in credit quality of specific SPE or its pool)  Commitment must be secured by underlying assets and rank pari passu with conduit s securities 53 Source: Text .e. including rated commitments Increase from 0% under Basel I  Regulators believe liquidity absorbs more than just liquidity risks Credit conversion factor of 0% theoretically possible if:  Commitment qualifies as ³eligible liquidity´  Commitment can only be drawn if general market disruption (i.Basel II ± Securitisation Capital Charges Securitisation ± Standardised Banks Liquidity facilities ( Generally  20% credit conversion factor (CCF) for eligible liquidity commitments with an original 579-580) maturity of one year or less  50% CCF for eligible liquidity commitments of more than one year  100% CCF for all other liquidity commitments...

it must be rated at least investment grade at time of draw  Facility cannot be drawn after all applicable credit enhancement to which liquidity facility has access has been exhausted  Repayment of draws must not be subordinated to interests of any conduit security holder 54 Source: Text .Basel II ± Securitisation Capital Charges Securitisation ± Standardised Banks ³Eligible Liquidity´ ( 578)  Documentation must identify and limit circumstances of draw. if funding based on rating of underlying asset. and amounts drawn must be limited to amount likely to be repaid from underlying assets and sellerprovided credit enhancement  No incurred losses should be covered and draw should not be automatic  Asset quality test should not cover defaulted assets as defined in paragraphs 452-459 (including receivables more than 90 days past due unless extended up to 180 days by national regulators).

for overlapping portion sponsor should hold capital against exposure with highest credit conversion factor Query  How to allocate partial credit enhancement  How to allocate programme-wide credit enhancement Eligible servicer advances ( 582)  Servicers may contractually agree to advance cash to insure uninterrupted payments to investors if full reimbursement right is senior to other claims  At national discretion. CCF of 0% for facility cancellable without prior notice 55 Source: Text .Basel II ± Securitisation Capital Charges Securitisation ± Standardised Banks Overlapping Exposures ( 581) For example. if conduit sponsor provides programme-wide liquidity and credit enhancement to ABCP conduit:  If funding one exposure precludes funding the other exposure. sponsor need not hold capital against both exposures  Instead.

bank may use IRB capital requirement for underlying exposures (¶ 610) Hierarchy ( 609)  IRB bank must use ratings based approach (RBA) to calculate capital if external rating or inferred rating available  Where RBA not available.Basel II ± Securitisation Capital Charges Securitisation ± IRB Banks Options  IRB bank must calculate capital on basis of:  external ratings pursuant to ratings based approach (RBA)  inputs into supervisory formula (SF) approach  internal assessments approach (IAA)  Cap: If IRB would require more capital for securitisation exposure than had the position not been securitised. position must be deducted 56 Source: Text . bank may use SF or IAA if available  Where neither RBA nor SF or IAA are available. bank may use look-through approach (see below) in paragraph 639  Otherwise.

Basel II ± Securitisation Capital Charges Securitisation ± IRB Banks ± Ratings Based Approach Short Term Ratings IRB bank ratings-based risk weights ( Most senior External Rating A-1/P-1 A-2/P-2 A-3/P-3 All other ratings/ unrated 7% 12% 60% Base case 12% 20% 75% 616) Long Term Ratings IRB bank ratings-based risk weights ( Most senior AAA AA A+ A External Rating Deduct Deduct Deduct ABBB+ BBB BBBBB+ BB BB<BB.or unrated Source: Text 615) Non-granular 20% 35% 75% Base case 12% 15% 18% 20% 35% 50% 75% 100% 250% 425% 650% Deduct Non-granular 20% 25% 35% 35% 35% 50% 75% 100% 250% 425% 650% Deduct 57 7% 8% 10% 12% 20% 35% 60% 100% 250% 425% 650% Deduct .

Basel II ± Securitisation Capital Charges Securitisation ± IRB Banks Internal Assessments Approach ( 619-622) IRB bank may use IAA if conditions satisfied  Only available for exposures to ABCP programmes  Internal assessments mapped to equivalent external ratings and exposures assigned resulting risk weights  Supervisor may suspend bank s use of IAA until deficiencies (if any) are corrected Conditions  ABCP issued by conduit must be externally rated  Internal assessment must be based on ratings criteria for each asset type and be equivalent of investment grade when exposure is funded  Bank s supervisors must be satisfied that internal ratings meet required criteria in paragraphs 90-108 and with relevant external ratings criteria  Bank must show that internal criteria matches external criteria 58 Source: Text .

Basel II ± Securitisation Capital Charges Securitisation ± IRB Banks Conditions (cont¶d)  Supervisor may. disallow any seller provided recourse. bank may discuss applying IAA with supervisor 59 Source: Text . guarantees or excess spread or any other first loss enhancement  Internal assessment must identify gradations of risk that can be mapped to external ratings gradations  Internal assessment process. if warranted. and particularly stress factors. must be at least as conservative as publicly available ratings criteria from rating agencies rating ABCP programme:  Bank must choose most conservative of two or more external criteria if two or more criteria apply  Bank must not choose only ratings agencies with less restrictive methodologies to rate ABCP programme and must keep up with methodology changes  Bank cannot use a non-public ratings methodology but may consider more conservative non-publicly available methodology  For new or unique transactions.

etc. lockbox arrangements. etc. or bank s internal credit review or risk management function must perform regular reviews of internal assessment process.Basel II ± Securitisation Capital Charges Securitisation ± IRB Banks Conditions (cont¶d)  Internal and external auditors.  ABCP programme should have collections processes established that consider operational capability and credit quality of servicer. they must be independent of ABCP business line  Bank must track and adjust internal processes over time  ABCP programme must have credit and investment guidelines (which should cover issues specified by supervisor)  Credit analysis of seller s risk profile must be performed  ABCP programme must have minimum asset eligibility criteria that exclude defaulted assets.  All sources of risk must be considered (including credit and dilution)  Structural features must be included such as wind down events 60 Source: Text . limit concentrations. if internal reviews are used. a rating agency. limit asset tenor.

including residual interests (such as a cash collateral account)  Reserves against assets in pool do not reduce notional amount of the pool in determining KIRB.Basel II ± Securitisation Capital Charges Securitisation ± IRB Banks Supervisory formula approach ( 623-636) Capital charge determined under supervisory formula (see following page) on basis of five inputs (with 56 basis point floor):  Regulatory capital of exposure if held on balance sheet (KIRB)  Degree of credit enhancement supporting exposure (L)  Exposure s thickness (T)  Effective number of exposures in the securitised pool (N)  Pool s exposure-weighted average loss given default (LGD) Definition of KIRB  KIRB is ratio (expressed as a decimal) of  the IRB capital requirement for the underlying exposures in the pool to  the notional amount of such exposures  For structures involving SPE. all SPE assets must be included in pool. but can count as credit enhancement 61 Source: Text .

=1000 and = 20 ) )(1.0056 and (b) (S [L+T] ± S [L]) S[L] = L if L<= KIRB.a. a.b]c) Beta [L.KIRB) KIRB +0.b]L+ Beta[L.KIRB /LGD)N c= KIRB /(1-h) v =((LGD.b]) K[L]=(1-h)((1-Beta[L.KIRB) KIRB ± v )/(1-h) g=((1-c)c)/f -1 a=gc b=g(1-c) d=1-(1-h)(1-Beta[KIRB. else.b] refers to the cumulative beta distribution with parameters a and b evaluated at L. S[L]= KIRB +K[L] ±K[KIRB] +(d.25(1-LGD) KIRB )/N f=((v + KIRB 2 )/(1-h) ± c 2 ) + (((1. KIRB / L)/ KIRB)) Where h=(1.a+1.exp( *(KIRB ± 62 Source: Text .a.Basel II ± Securitisation Capital Charges Securitisation ± IRB Banks Supervisory Formula ( 624-626): IRB Capital charge = greater of (a) 0.

all liquidity facilities have 100% CCF. bank may rely on rating provided it uses 100% CCF  If facility is unrated. the bank must use 50% CCF for commitments of one year or less and 100% for commitments in excess of a year. temporarily apply highest risk weight of pool under standardised approach to individual exposures covered by eligible liquidity facility  In such a case. on an exceptional basis and subject to supervisory approval. bank may use IAA if qualifying  If facility is unrated and IAA unavailable.Basel II ± Securitisation Capital Charges Securitisation ± IRB Banks Liquidity facilities ( 637-639) Generally  ³Eligible´ liquidity facilities only drawn in event of general market disruption (as defined in ¶ 580) have a 20% CCF  Otherwise. 100% CCF permits IRB banks to provide multi-year liquidity or ³structured´ liquidity without additional capital requirements Determination of capital  If facility is externally rated. bank may. bank must determine KIRB either using ³bottom-up´ approach or ³top-down´ approach and apply SF ³Look-through´ procedure  If not practical to use ³bottom-up´ or ³top-down´. or 20% CCF for market disruption liquidity 63 Source: Text .

but may also be used for appropriate on-balance sheet exposures Eligible Corporate Receivables ( 241-243)  Eligible corporate receivables must satisfy following conditions for application of top-down approach:  Bank has not directly or indirectly originated receivables (and has purchased them from unrelated third parties)  Receivables generated on arms length basis (and not subject to inter-company contra accounts)  Purchasing bank must have claim on all proceeds from pool or a ratable interest  National supervisors to develop concentration limits  Recourse to seller does not automatically disqualify transaction as long as cash flows from assets are primary source of repayment (plus certain other requirements) 64 Source: Text .Basel II ± Securitisation Capital Charges Securitisation ± IRB Banks Top-Down Approach ( 362-373)  For use in determining KIRB in SF  Generally  Top-down approach available provided bank s programme complies with criteria for eligible receivables and minimum operational requirements  Intended mainly for asset-backed securitisation exposures.

bank must attribute inferred rating to unrated exposure:  Reference rated exposure must be subordinate in all respects to unrated exposure  Credit enhancements must be taken into account in determining subordination (for example. if reference position benefits from third party guarantee but unrated position does not.Basel II ± Securitisation Capital Charges Securitisation ± IRB Banks Inferred Ratings ( 617-618)  When following conditions are met. then latter may not be assigned inferred rating)  Maturity of reference position must be equal to or longer than that of unrated position  Inferred rating must be updated continuously to reflect changes in external rating of reference position  External rating must satisfy general requirements for recognition of external ratings in securitisation transactions 65 Source: Text .

where the risk does not return to the originating bank)  Structures securitising credit lines where the investors remain liable to fund future draws by borrowers after amortisation events  The early amortisation clause is triggered solely by events unrelated to the performance of the pool or the originator 66 .Basel II ± Early Amortisation Structures Securitisation ± Early Amortisation Provisions Originating banks are required to hold capital against investors interests in a securitisation when  It sells assets into a structure containing an early amortisation feature and  The exposures sold are of a revolving nature Banks are not required to apply the early amortisation rules to:  Replenishment structures where the underlying exposures do not revolve and the early amortisation ends the bank s ability to add new exposures  Transactions of revolving assets containing early amortisation features that mimic term structures (i..e.

Basel II ± Early Amortisation Structures Securitisation ± Early Amortisation Provisions Applicable capital charge  equals (1) the notional amount of the investors interest times (2) the applicable credit conversion factor times (3) the risk weight for the underlying credits  but capitalised assets (such as future margin income) are treated separately and will typically be deducted from capital Capped at the greater of:  the capital required for retained securitisation exposures  the capital required had the exposures not been securitised Applicable credit conversion factor based on whether  the amortisation is ³controlled´ or ³non-controlled´  the securitised exposures are (i) uncommitted retail credit lines that are unconditionally cancellable or (ii) any other type of exposure 67 .

including the amortisation period. expenses. principal. there is a pro rata sharing of interest. losses and recoveries based on the balances of receivables outstanding at the beginning of each month  The amortisation period fixed by the bank is sufficient for 90% of the total debt outstanding at the beginning of the period to have been repaid or to have been recognised as in default  The pace of repayment is not any more rapid than would be allowed under straight-line amortisation over the period fixed as described above 68 .Basel II ± Early Amortisation Structures Securitisation ± Early Amortisation Provisions A ³controlled´ amortisation must meet the following conditions:  The originator has in place a capital/liquidity plan to ensure it has sufficient capital and liquidity if early amortisation occurs  Throughout the transaction.

5% above the early amortisation trigger if no trapping)  The three month average excess spread for the transactions  Divide the excess spread level by the trapping point and look up the CCF for the transaction on the following page 69 .Basel II ± Early Amortisation Structures Securitisation ± Early Amortisation Provisions Credit conversion factors (CCF)  For structures with controlled amortisation  0% to 40% for uncommitted retail lines (see next page)  90% for committed retail lines  90% for all non-retail lines (whether committed or uncommitted) ‡ For structures with non-controlled early amortisation  0% to 100% for uncommitted retail lines (see next page)  100% for committed retail lines  100% for all non-retail lines (whether committed or uncommitted) For uncommitted retail credits  Calculate two points:  The point at which the bank is required to trap excess spread (or 4.

33% or more Less than 133.33% to 100% Less than 100% to 75% Less than 75% to 50% Less than 50% to 25% Less than 25% CCF for Uncommitted Retail Exposures in Controlled Structures 0% 1% 2% 10% 20% 40% CCF for Uncommitted Retail Exposures in NonControlled Structures 0% 5% 15% 50% 100% 100% 70 .Basel II ± Early Amortisation Structures Securitisation ± Early Amortisation Provisions 3 month average excess spread as % of trapping point 133.

Basel II (MRA. positions marked to market at least daily. Accord 864-718) Essentially unchanged. but including credit counterparty risk in trading book or banking book. position limits set and monitored. positions actively monitored and managed on trading desk. except for revisions to:  Definition of trading book: excluding debt and equity securities in trading book and all positions in commodities. and adjusted add-on factors for single name credit derivatives (see below) Basel/IOSCO review will change trading book treatment significantly 71 Source: Text . plus  Capital charges for specific risk and general market risk ³positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book´ documented trading strategy. repo-style and other transactions booked in trading book. positions reported to senior management  Basic requirements for trading book treatment: clearly under either standardised measurement method or internal models method (or combination thereof)  Capital charges for specific risks in connection with * Paragraph references in materials below on trading book are to 1996 Market Risk Amendment (MRA) unless otherwise noted interest rate risk (see below)  Specific risk capital charge offsets for positions hedged by credit derivatives (see below)  New counterparty credit risk charges for OTC derivatives.Basel II ± Trading Book Capital Charges Trading Book ± In a Nutshell* Basel I (1996 Market Risk Amendment) Minimum capital requirement:  Credit risk requirements under regulatory capital rules.

II.1 ± I..4)  Bank must first calculate capital for credit risk..2)  At discretion of national regulators banks may employ third tier of capital for sole purpose of meeting proportion of capital requirements for market risks  Tier 3 capital limited to 250% of bank s tier 1 capital required to support market risks..14) 72 Source: Text . and only afterwards calculate market risk requirement Capital requirement to be met on continuous basis ± at close each business day (MRA Intro.3 ± I. subordinated and fully paid up  Have original maturity of at least two years  Not be repayable prior to maturity date unless bank s supervisor agrees  Be subject to lock-in clause stipulating that neither interest nor principal may be paid at maturity if payment would cause bank to fall below minimum capital requirements Calculation of Capital (MRA Intro. II. tier 2 capital may be substituted for tier 3 capital up to same 250% limit subject to overall limits for tier 2 capital in Basel II Accord  For subordinated debt to be eligible as tier 3 capital it must be available to absorb losses in event if insolvency and must at minimum:  Be unsecured.Basel II ± Trading Book Capital Charges Capital Requirement Definition of Capital (MRA Intro. I.

00%  Qualifying:  Other:  Offsetting restricted to matched positions in identical issue (including positions in derivatives).25% (residual term to final maturity 6 months or less) 1.00% (residual term to final maturity between 6 and 24 months) 1.00% Other rating: 8.00% (residual term to final maturity between 6 and 24 months) 1.1. no offsetting if issuer same but not same issue  ³Government´ category includes all forms of government paper  ³Qualifying´ category includes securities rated investment grade by at least two recognised rating agencies or (subject to supervisory approval) unrated but either of comparable investment quality (standardised banks) or rated equivalent by bank s internal systems and exchange listed (IRB banks) (Accord 712)  National regulatory may impose higher specific risk charge on ³other´ category and/or disallow offsetting 73 Source: Text .I. Accord  Specific risk charge:  Government: AAA to AAA+ to BBB- 710) 0.60% (residual term to final maturity exceeding 6 months) 8.25% (residual term to final maturity 6 months or less) 1.Basel II ± Trading Book Capital Charges Standardised Measurement Method ± Interest rate risk Specific risk (MRA Part A.00% 0.60% (residual term to final maturity exceeding 6 months) 0.

Basel II ± Trading Book Capital Charges Standardised Measurement Method ± Interest rate risk (cont d) General market risk (MRA Part A.II)  Generally  Two methods: maturity method and duration method  Capital charge is sum of four components: net short or long position.1. small proportion of matched positions in each time band (vertical disallowance). larger proportion of matched positions across different time bands (horizontal disallowance). net charge for positions in options  Maturity method  Opposite positions of same amount in same issue may be omitted from framework  Positions weighted by prescribed price sensitivity factor  Partial offset (10% capital charge) for weighted longs and shorts in each time band  Two rounds of horizontal partial offsetting between time bands pursuant to prescribed scale  Duration method  Calculate price sensitivity on basis of prescribed interest rate change depending on maturity  Slot resulting sensitivity measures into duration-based ladder within time bands  Subject long and short positions to 5% vertical disallowance  Carry forward net positions for horizontal offsetting as above 74 Source: Text .

III)  Convert derivatives into positions in relevant underlying subject to specific and general market risk charges as above  Futures: treated as combination of long and short position in notional government security  Swaps: treated as two notional positions in government securities with relevant maturities  No specific risk charge for most interest rate derivatives  General market risk charge generally same as for cash positions.Basel II ± Trading Book Capital Charges Standardised Measurement Method ± Interest rate risk (cont d) Interest rate derivatives (MRA Part A. subject to exemption for very closely matched positions in identical instruments Counterparty credit risk charge add-on factors for single name credit derivative (Accord 707)  If reference asset is qualifying: 5% for protection buyer and 5% for protection seller  If reference asset is not qualifying: 10% for protection buyer and 10% for protection seller 75 Source: Text .1.

limits on next interest fixing date  No offsetting for positions in different currencies But modified by Accord (see next page) 76 Source: Text .. futures (identical products maturing within 7 days of each other). same nominal value and same currency ± e.g.1. swaps and forward rate agreements (identical reference rate and coupon within 15 basis points). coupon. offset only permitted if future or forward move in close alignment  Offset may be allowed for opposite positions in same category of instruments if same underlying.. currency and maturity.III)  Banks may exclude long and short positions (both actual and notional) in identical instruments with exactly the same issuer. and may fully offset a matched position in a future or forward and its underlying  If choice of underlying deliverable instruments (e.Basel II ± Trading Book Capital Charges Standardised Measurement Method ± Interest rate risk (cont d) Offsetting for interest rate derivatives (MRA Part A. cheapest-to-deliver).g.

to extent that transaction transfers risk.g. specific risk capital charge for both sides of transaction 77 Source: Text .. long cash position hedged by total rate of return swap with exact match between reference obligation and underlying)  80% specific offset recognised when value of two legs always moves in opposite direction but not broadly to same extent (e. identical instruments. 80% risk offset for side with higher capital charge and zero specific risk requirement on other side  Partial allowance where value of two legs usually moves in opposite direction (e. asset mismatch between reference and underlying)  Otherwise. long cash position hedged by credit default swap or credit-linked note with exact match between reference obligation and underlying).Basel II ± Trading Book Capital Charges Standardised Measurement Method ± Interest rate risk (cont d) Specific risk capital charges for positions hedged by credit derivatives (Accord 713-718)  No specific risk capital charge for either side of the position if values of full legs always move in the opposite direction and generally to the same extent (e.g..g..

in which case 4%  General market risk charge  Defined as difference between sum of longs and sum of shorts.2. calculated on national market-by-market basis  8% unless portfolio both liquidity and well-diversified.II)  Convert derivatives into positions in relevant underlying  Matched positions may be fully offset  Index risk: Further capital charge of 2% against net long or short position in index contract comprising diversified portfolio of equities to cover factors such as execution risk  Arbitrage: Additional 2% capital charge in qualifying futures-related arbitrage strategies may be applied only to one index with opposite position exempt from capital charge 78 Source: Text .2.Basel II ± Trading Book Capital Charges Standardised Measurement Method ± Equity position risk Specific risk and general market risk (MRA Part A. also calculated on national market-by-market basis  8% Equity derivatives (MRA Part A.I)  Specific risk charge  Defined as bank s gross equity position.

expenses accrued. net delta-based equivalent of total book of foreign currency options  Positions taken to hedge capital ratio may be excluded if ³structural´ (non-dealing) nature.3.I)  Measured by summing: net spot position (including interest earned but not received.Basel II ± Trading Book Capital Charges Standardised Measurement Method ± Foreign exchange risk Two processes (MRA Part A. guaranties certain to be called and likely to be irrevocable. net future income/expenses not yet accrued but already fully hedged (at bank discretion). does no more than protect bank capital ratio Measuring foreign exchange risk (MRA Part A. net forward position. and expenses not yet accrued but certain).3)  Measure exposure in single currency position  Measure risks inherent in mix of long and short positions in different currencies Measuring positions in single currency (MRA Part A.II)  Two alternatives:  ³shorthand´ method treating all currencies equally ± capital charge is 8% times overall net open position determined by converting nominal amount (or net present value) of net position in each currency into reporting currency  internal models approach (see below) 79 Source: Text . applied consistency.3.

4)  Defined as physical product which is or can be traded on a secondary market  More complex and volatile.6% of net position carried forward  15% capital charge against resulting long or short position Simplified approach (MRA Part A. simplified approach Measurement system (maturity ladder) approach (MRA Part A. and less liquid  Variety of additional risks.4.II)  Express commodity position in standard unit of measurement (barrel. interest rate risk and forward gap risk 80 Source: Text . subject to surcharge equal to 0. etc.III)  Same capital charge for directional risk as under measurement approach  Additional capital charge of 3% of gross positions in each commodity for basis risk.)  Convert net position at current spot rates into national currency  Assess capital charge against matched long and short positions in specified time bands and specified spread rates  Residual net positions in nearer time banks may be carried forward to offset exposures in later time bands. measurement system. forward gap risk (risk that forward price may change other than due to interest rate changes)  Three options: models (see below). including basis risk (risk that relationship between prices of similar commodities varies over time).4.Basel II ± Trading Book Capital Charges Standardised Measurement Method ± Commodities risk Generally (MRA Part A. interest rate risk (risk of cost of carry).

I)  Long cash and long put.5. foreign exchange and gold (Part A.4 depending on whether option underlying is debt security or interest rate instrument (Part A.5. or short cash and long call: Capital charge is market value of underlying multiplied by sum of specific and general market risk charges for underlying less amount option is in money (if any) bounded by zero  Long call or long put: Capital charge is lesser of (a) market value of underlying multiplied by sum of specific and general market risk charges for underlying and (b) market value of option Delta-plus (intermediate) approach (MRA Part A.II) (for more sophisticated banks)  Capital charge determined by calculating changes in option value at various points along ³grid´ of ranges of changes in option portfolio s risk factors 81 Source: Text .5.1).3) or commodities (Part A.1 through A.II)  Options reported as position equal to market value of underlying multiplied by delta  Delta-weighted capital charge: Determined pursuant to Parts A. use either one of the intermediate approaches (see below) or internal model (see below) Simplified approach (MRA Part A.2). equity (Part A.5)  Banks with purchased options only permitted to use simplified approach  Otherwise.Basel II ± Trading Book Capital Charges Standardised Measurement Method ± Options Generally (MRA Part A.4)  Additional capital charges for gamma (measuring rate of change of delta) and vega (measuring sensitivity of value of option to change in volatility) Scenario (intermediate) approach (MRA Part A.

stress-testing. external validation. update data sets no less frequently than every three months. convenience yield (commodities risk) 82 Source: Text . with instantaneous price shock equivalent to 10 day movement in prices).1)  Conditional upon explicit approval of supervisor Conditions to use of internal model (MRA Parts B.2 ± B. integration with day-to-day risk management of bank.Basel II ± Trading Book Capital Charges Internal models method (MRA Part B) Generally (MRA Part B. discretion to recognise empirical correlations within broad risk categories. foreign exchange exposures (foreign exchange risk). market movements in equities (equity risk).7)  Qualitative standards: independent risk control unit. back-testing. one-tailed confidence interval. no particular type of model prescribed (but must accurately capture option risks). multiplication factor based on supervisor judgment of quality of bank s risk management system  Market risk factors: risk measurement system that models yield curve (interest rate risk). compliance function. trading limits. independent review  Quantitative standards: value-at-risk calculated daily (to 99th percentile. daily calculation of capital requirement.

Chapter 3 Basel II ± First Pillar Operational Risk Capital Charges .

diversity.  Damage to physical assets  Business interruption Examples of risks not covered  Reputational risk  Strategic errors 84 Source: Text . etc. or from external events (¶ 644) Examples of risks covered  Internal and external fraud  Legal risks  Damages to customers  Losses arising out of labour.Basel II ± Operational Risk Charges Defined as risk of loss from inadequate or failed internal processes. people and systems. personal injury. health and safety.

664-679)  Calculated on basis of internal operational risk management system approved by national 85 Source: Text .Basel II ± Operational Risk Charges Basic Indicator Approach ( Standardised Approach ( 649-651) 652-654. 660-663)  15% of bank s average annual gross income over previous three years  Capital charge for each of 8 business lines calculated against average annual gross income for business line times:  18% for corporate finance (15% transitional charge within EU if major activity)  18% for trading and sales (15% transitional charge within EU if major activity)  12% for retail banking  15% for commercial banking  18% for payment and settlement  15% for agency services  12% for asset management  12% for retail brokerage Advanced Measurement Approach ( regulator 655-659.

Chapter 4 Basel II ± Second Pillar Supervisory Review .

Supervisors should expect banks to operate above minimum ratios and should have ability to require banks to hold capital in excess of minimum Supervisors should seek to intervene at early stage and require rapid remedial action  Principle 3:  Principle 4: 87 Source: Text . operational risk.Basel II ± Supervisory review Four key principles of supervisory review ( 725-760)  Principle 1: Banks should have process for assessing overall capital adequacy in relation to risk profile and strategy for maintaining capital levels. other risk)  Monitoring and reporting  Internal control review  Principle 2: Supervisors should review and evaluate banks internal capital adequacy assessments and strategies. Supervisors should take appropriate action if not satisfied. market risk. Five main features of rigorous process:  Board and senior management oversight  Sound capital assessment  Comprehensive risk analysis (credit risk. liquidity risk. interest rate risk in banking book. as well as ability to monitor and ensure compliance with ratios.

definition of default used to determine PD and/or LGD and EAD. credit concentration risk and operational risk Other issues ( 779-783)  Supervisory transparency and accountability: Supervisors should make publicly available criteria used in review of banks internal capital assessments pragmatic provision of close and continuous dialogue between industry participants and supervisors.  Enhanced cross-border communication and cooperation: Basel Committee supports 88 Source: Text . residual risk.Basel II ± Supervisory review Specific issues ( 761-778)  Interest rate risk in banking book: Basel II treats interest rate risk under Second Pillar of supervisory review (rather than First Pillar of regulatory capital) due to differences in methods banks use to handle risk  Credit risk: Supervisory review is appropriate to regulate stress tests under IRB approach. as well as between supervisors (without changing legal responsibilities of national regulators).

.e. (b) applying conversion factor to all securitised assets so as to hold capital against them. supervisors must require disclosure and may apply one or more of (a) refusing further capital relief for securitised assets. where risk transfer is insufficient or non-existent supervisors can deny capital relief  Market innovations: Supervisors can take account of new features either through First Pillar changes in minimum capital requirements or Second Pillar supervisory action  Implicit Support: If banks engage in implicit support more than once. or (c) requiring banks to hold capital in excess of minimum requirements 89 Source: Text . with ability to increase capital if correlation not appropriately reflected  Significant risk transfer: Although securitisation may occur for reasons other than risk transfer (i. funding). for period of time or permanently.Basel II ± Supervisory review Supervisory review process for securitisation ( 784-807)  Economic substance: Supervisory capital requirements may vary from those specified in First Pillar if would not adequately and sufficiently reflect risks of exposure  Maturity: Supervisors will review documentation to ensure that maturity mismatches not artificially created to reduce capital requirements  Correlation: Supervisors may review banks assessment of actual correlations between assets in pools and how that is reflected in capital calculation.

as those losses not usually transferred in securitisation  Call provisions: May not be used to absorb losses or asset deterioration.Basel II ± Supervisory review Supervisory review process for securitisation ( 784-807) (cont d)  Residual risks: Supervisors will expect banks to consider expected losses in economic capital. monitor and manage risks associated with securitisations of revolving facilities. following factors should be considered when analysing excess spread triggers:  interest payments by borrowers on underlying receivables  other fees and charges to be paid  gross charge-offs  principal payments  recoveries on charged-off loans  interchange income  interest paid on investors certificates  relevant macro-economic factors 90 Source: Text . supervisors may require review of bank s decision to call prior to exercise  Early amortisation: Supervisors should review how banks internally measure.

Chapter 5 Basel II ± Third Pillar Market Discipline .

and roles played by it in. securitisation process  Bank s accounting objectives for securitisation  Whether treated as sales or financings  Whether bank recognises gain on sale  Key assumptions used by bank for valuing retained interests  Bank s treatment of synthetic securitisations  Names of rating agencies used by bank and types of exposures rated by each agency 92 Source: Text .Basel II ± Disclosure (Securitisation) Objective ( 809-810)  Impose market discipline on banks by requiring disclosure of key information relevant to banks risks and capital Qualitative Disclosures for Securitisation ( 820. Table 8)  Bank s objectives for.

broken down by exposure type  Aggregate amount of securitisation exposures retained or purchased by bank. broken down by ³reasonable number´ of risk bands (deducted exposures disclosed separately)  Aggregate amount of securitised revolving exposures segregated by originator s interest and investors interest  Summary of current year s securitisation activity. Table 8)  Total outstanding exposures securitised by bank subject to securitisation framework  For exposures securitised by bank subject to framework (in each case broken down by exposure type):  Amount of impaired/past due assets  Losses recognised by bank during current period  Aggregate amount of securitisation exposures retained or purchased by bank. including aggregate amount of exposures securitised and gain or loss on sale.Basel II ± Disclosure (Securitisation) Quantitative Disclosures for Securitisation ( 820. by asset type 93 Source: Text .

Chapter 6 Some Observations .

non-regulated financial companies)  Will regulators provide recognition of double-default effects for pools of exposures or stick with substitution?  Will impractical operational requirements for IAA be addressed?  Will the definition of defaulted assets be extended beyond 90 days? 95 Source: Text . vs. securities firms. vs. vs.Basel II ± Observations Open Issues  Will banks cope (implementing systems)?  Will regulators cope (monitoring systems and data)?  Will inconsistencies be minimised?  Inconsistent rules in Basel II itself (e. corporate risk weights vs.g. securitisation risk weights)  Inconsistent national rules finally adopted by regulators  Inconsistent application by supervisors (including different supervision of banks. insurance companies.

non-core high operating cost activities (asset management) 96 Source: Text .Basel II ± Observations Impact on financial markets  Spread tightening as capital costs of holding ³winners´ drops:  ABS tranches rated BBB and higher  Corporates rated BBB or higher  Non-OECD sovereigns rated above BB+  Spread widening/credit tightening as capital costs of holding ³losers´ increases:  Lower rated banks.(but banks may hold for liquidity purposes anyway)  Non-bank equities. corporates and ABS  OECD sovereigns rated below AA.

larger banks for credit- based lending 97 Source: Text .Basel II ± Observations Impact on banks  Banks with more Basel II winners in portfolio benefit  Banks with more Basel II losers in portfolio suffer  Possible divestitures of capital-heavy businesses  Insurance  Asset management  Non-bank equities  Impact on corporate lending activities  Return of high-quality corporates to banks as borrowers  Credit less available to lower-quality borrowers  Tiering of SME market ± local banks for relationship lending.

Basel II ± Observations Impact on securitisation markets  Will motivate banks to securitise higher risk weighted assets and keep lower risk weighted assets  Will cost more to securitise. due to higher capital for lower rated tranches and unfunded commitments (motivating banks to seek non-regulated investor base and lower cost liquidity alternatives)  Higher costs may slow growth of securitisation generally. then covered bonds advantages over securitisation  But will regulators limit quantity of covered bond issuances? (FSA s 4% suggestion) 98 Source: Text . reducing banks ability to disperse credit risks throughout the financial system  Securitisation volumes may rise in certain products to remove them from banks balance sheets:  Credit cards ± due to capital held against unfunded commitments  Commercial mortgages ± due to higher capital charges against lower quality exposures  Loans ± due to higher capital charges against lower quality exposures  Covered bonds  If cheaper to hold mortgages on balance sheet under Basel II.

repos 99 Source: Text .g.g.Basel II ± Observations Impact on ABCP conduits  Motivation to hold assets in ABCP conduit (rather than on-balance sheet for risk-based capital purposes) not as strong under Basel II  IRB banks have much lower capital for many exposures on balance sheet  Use of ABCP conduits may still help banks meet accounting objectives and generates non-lending income for sponsor bank  New capital costs for liquidity may motivate move away from traditional 0% liquidity commitments  Less liquidity  Liquidity provided in new forms: e. trading book positions  Funding provided in new forms: e. market value swaps...

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