Basel Accord

Objective

At the end of the session, you will be able to :

Interpret Basel Accord
Be acquainted with history of Basel accord and basel I
Learn the need for Basel II
Objectives
Specify the Implication for Basel II
Introduction

Basel accord had been originated in the year of 1988

with the objective to provide financial stability and
minimum prudential standards to an increasingly
international global banking system
It was enforced by law in the G 10 countries in 1992
Framework

Assets of banks were classified and grouped in five

categories according to credit risk, carrying risk weights
of zero, ten, twenty, fifty, and up to one hundred
percent.
Commercial loans, for example, were assigned to the 100%
risk weight category
Banks with international presence are required to hold
capital equal to 8% of the risk-weighted assets.
 0% Risk Weight
Cash,
Claims on central governments and central banks
denominated in national currency and funded in that
currency
Other claims on OECD countries, central governments and
central banks
Claims collateralized by cash of OECD government
securities or guaranteed by OECD Governments
 20% Risk Weight
Claims on multilateral development banks and claims
guaranteed or collateralized by securities issued by such
banks
Claims on, or guaranteed by, banks incorporated in the
OECD
Claims on, or guaranteed by, banks incorporated in
countries outside the OECD with residual maturity of up to
one year
Claims on non-domestic OECD public-sector entities,
excluding central government, and claims on guaranteed
securities issued by such entities
Cash items in the process of collection
 50 % Risk Weight
Loans fully securitized by mortgage on residential property
that is or will be occupied by the borrower or that is
rented.
 100% Risk Weight
Claims on the private sector
Claims on banks incorporated outside the OECD with residual
maturity of over one year
Claims on central governments outside the OECD (unless
denominated and funded in national currency)
Claims on commercial companies owned by the public sector
Premises, plant and equipment, and other fixed assets
Real estate and other investments
Capital instruments issued by other banks (unless deducted
from capital)
All other assets
Capital calculation

To calculate required capital, a bank would multiply the

assets in each risk category by the categorys risk weight
and then multiply the result by 8%
Thus a $100 commercial loan would be multiplied by 100%
and then by 8%, resulting in a capital requirement of $8
Example

A Bank has following asset calculate the capital for the

bank
Cash Rs. 50 Crores
Claims on securities backed by Bhutan Govt Rs. 100 Crore
Mortgage Loans Rs. 250 Crore
Cash Credit Rs.100 Crore
Limitation
Basel I was restricted to
Market Risk
Basic measures of credit risk
Basel I is too simplistic approach
Risk weights were based on what the parties to the
Accord negotiated rather than on the actual risk of
each asset
Capital Arbitrage

If a loan is calculated to have an internal capital charge

that is low compared to the 8% standard, the bank has a
strong incentive to undertake regulatory capital
arbitrage
Securitization is the main means used by U.S. banks to
engage in regulatory capital arbitrage
Example

Assume a bank has a portfolio of commercial loans with the

following ratings and internally generated capital requirements
AA-A: 3%-4% capital needed
B+-B: 8% capital needed
B- and below: 12%-16% capital needed
Under Basel I, the bank has to hold 8% risk-based capital against all
of these loans
To ensure the profitability of the better quality loans, the bank
engages in capital arbitrage--it securitizes the loans so that they are
reclassified into a lower regulatory risk category with a lower capital
charge
Lower quality loans with higher internal capital charges are kept on
the banks books because they require less risk-based capital than
the banks internal model indicates
Existence of Basel II

To overcome the limitations of Basel I, Basel Committee

on Banking Supervision issued a proposal for a new
capital adequacy framework to replace Basel I.
History

By the late 1990s, growth in the use of regulatory capital

arbitrage led the Basel Committee to begin work on a
new capital regime (Basel II)
Effort focused on using banks internal rating models and
internal risk models
June 1999: Committee issued a proposal for a new
capital adequacy framework to replace the 1998 Accord
Basel II

Basel II consists of three pillars:

Minimum capital requirements for credit risk, market risk
and operational riskexpanding the 1988 Accord (Pillar I)
Supervisory review of an institutions capital adequacy and
internal assessment process (Pillar II)
Effective use of market discipline as a lever to strengthen
disclosure and encourage safe and sound banking practices
(Pillar III)
Objectives

Continue to promote safety and soundness in the banking

system
Ensure capital adequacy is sensitive to the level of risks
borne by banks
Constitute a more comprehensive approach to addressing
risks
Continue to enhance competitive equality
The three Pillars of Basel II

B A S E L II
Minimum capital Supervisory review Market disclosure
requirements process
How is capital adequacy How will supervisory What and how should
measured particularly bodies assess, monitor banks disclose to
Issue

for Advanced and ensure capital external parties?

approaches? adequacy?

Better align regulatory Internal process for Effective disclosure of:

capital with economic risk assessing capital in - Banks risk profiles
Evolutionary approach to relation to risk profile - Adequacy of capital
assessing credit risk Supervisors to review positions
Principle

- Standardised (external and evaluate banks

Specific qualitative and
factors) internal processes
quantitative disclosures
- Foundation Internal Supervisors to require
- Scope of application
Ratings Based (IRB) banks to hold capital in
- Advanced IRB excess of minimum to - Composition of capital
Evolutionary approach to cover other risks, e.g. - Risk exposure
operational risk strategic risk assessment
- Basic indicator Supervisors seek to - Capital adequacy
- Standardised intervene and ensure
- Adv. Measurement compliance
Capital Requirements

The first pillar deals with maintenance of regulatory

capital calculated for three major components of risk
that a bank faces: credit risk, operational risk,
and market risk. Other risks are not considered fully
quantifiable at this stage.
Credit risk computation

Credit Risk can be calculated in three different ways of

varying degree of sophistication
Standardized approach
Foundation IRB
Advanced IRB
Standardized approach

Under this approach the banks are required to use

ratings from External Credit Rating Agencies to quantify
required capital for credit risk. In many countries this is
the only approach the regulators are planning to approve
in the initial phase of Basel II Implementation
 Standardized Approach:
New Risk Weights (June 1999)
Assessment
Claim
AAA to A+ to A- BBB+ to BB+ to Below B- Unrated
AA- BBB- B-

Sovereigns 0% 20% 50% 100% 150% 100%

Option 11 20% 50% 100% 100% 150% 100%
Banks 3 3 3
Option 22 20% 50% 50% 100% 150% 50% 3

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

1 Risk weighting based on risk weighting of sovereign in which the bank is incorporated.
2 Risk weighting based on the assessment of the individual bank.
3 Claims on banks of a short original maturity, for example less than six months,
.
would receive a weighting that is one category more favourable than the usual risk
weight on the banks claims
Foundation IRB Approach

Under this approach the banks are allowed to develop

their own empirical model to estimate the requirement
of capital.
Lenders estimate a probability of default (PD) while the
supervisor provides set values for loss given default
(LGD), exposure at default (EAD) and maturity of
exposure (M). These values are plugged into the lender's
appropriate risk weight function to provide a risk
weighting for each exposure or type of exposure.
Calculating Credit Risk

Expected Loss = PD *EAD*LGD

Parameters
Probability of Default describes the likelihood of default
over a particular time zone
Exposure at default is the total value that a bank is exposed
to at the time of default.
Loss Given Default is the percentage of the EAD that is lost
in the event of a default
Example

A bank has granted unsecured loan to a company. This loan will

be paid off by a single payment of Rs. 100 million. The company
has a 6% chance of defaulting over the life of the transaction. A
bank indicates that if the company will default than 70% would
be recovered. if the bank is required to hold a reserve equal to
your expected credit loss, how much the bank should hold ?
100*.06*.3 = 1.8 million
Example

An investor holds a portfolio of Rs. 100 million. This

portfolio consists of A rated bonds (Rs.40 million) and
BBB rated bond (Rs. 60 million) . Assume that the
probability of default for A rated bond and BBB rated
bond is 3% and 5% respectively. If the recovery value for
A rate d bond and for BBB rated bond is 70% and 45%
respectively, what is the one year expected credit loss
from this portfolio ?
Foundation IRB Approach
(contd)
Key Features
Capital charge computation is dependent on probability of
default (PD), Loss given at default (LGD), exposure at default
(ED) and effective maturity (M).
The IRB approach computes the capital requirement of each
exposure directly.
Banks need to categorize banking book exposures into broad
classes of assets. The classes of assets are corporates,
sovereigns, banks, retail and equity. Within corporates and
retail, there are sub-clauses, which are separately identified.
Risk weighted assets are derived from the capital charge
computation. Banks must use the risk weight functions provided
by Basel II.
IRB approach does not allow banks to determine all elements.
Advanced IRB Approach

Lenders with the most advanced risk management and risk

modeling skills are able to move to the advanced IRB
approach
Under which the lender estimates PD, LGD, EAD and M. In
the case of retail portfolios only estimates of PD, LGD and
EAD are required and the approach is known as retail IRB.
Given that a key objective of Basel II is to improve risk
management culture, it is unsurprising that the regime
encourages lenders to move towards the IRB approach and
ultimately, the advanced or retail IRB approach. To this end,
most banks can expect to see a modest release of regulatory
capital in moving from the standardized to foundation IRB
approach and on to the advanced or retail IRB approach.
Foundation IRB approach V/S
Advanced IRB approach
Input parameter Foundation IRB Advanced IRB
Probability of default Provided by bank based Provided by bank based
(PD) on own estimates on own estimates

Loss given default Supervisory values set Provided by bank based

(LGD) by the Committee on own estimates

Exposure at default Supervisory values set Provided by bank based

(EAD) by the Committee on own estimates

Maturity Supervisory values set Provided by bank based

by the Committee on own estimates (with
an allowance to
exclude certain
exposures)
Operational Risk computation

There are three approaches

Basic indicator approach (BIA)
Standardized approach (TSA)
Advanced measurement approach
Basic Indicator approach

Basic indicator approach is much simpler compared to

the alternative approaches and this has been
recommended for banks without significant international
operations.
Banks using the basic indicator approach must hold
capital for operational risk equal to the average over the
previous three years of a fixed percentage of positive
annual gross income.
The fixed percentage alpha is typically 15 percent of
annual gross income
Standardized approach (TSA)

In comparison with the Basic Indicator Approach (BIA), The

Standardized Approach (TSA) is a more advanced method to
determine the capital required for covering operational risk
losses
Under this approach banks activity are divided in to 8
business lines . Within each business line, gross income is a
broad indicator that serves as a proxy for the scale of
business operations and thus the likely scale of operational
risk exposure with in each of these business lines.
The capital charge for each business line is calculated by
multiplying gross income by a factor (denoted beta) assigned
to that business line.
Beta serves as a proxy for the industry-wide relationship
between the operational risk loss experience for a given
business line and the aggregate level of gross income for
that business line.
Standardized approach (TSA)
In order to qualify for use of the
Business Line Beta Factor standardized approach, a bank
Corporate must satisfy its regulator that, at
18%
finance a minimum:
Trading and sales 18% Its board of directors and senior
management, as appropriate, are
Retail banking 12% actively involved in the oversight of
Commercial the operational risk management
15%
banking framework;
Payment and It has an operational risk
18% management system that is
settlement
conceptually sound and is
Agency services 15% implemented with integrity; and
Asset It has sufficient resources in the use
12%
Management of the approach in the major business
Retail Brokerage 12% lines as well as the control and audit
areas.
Advanced measurement approach

Under this approach the banks are allowed to develop

their own empirical model to quantify required capital
for operational risk.
In order to qualify for use of the AMA a bank must satisfy
its supervisor that, at a minimum:
Its board of directors and senior management, as
appropriate, are actively involved in the oversight of
the operational risk management framework;
It has an operational risk management system that is
conceptually sound and is implemented with integrity; and
It has sufficient resources in the use of the approach in the
major business lines as well as the control and audit areas.
Market risk Computation

Preferred approach is VaR (value at risk).

Four key principles of supervisory review

Principle 1: Banks should have process for

assessing overall capital adequacy in relation to
risk profile and strategy for maintaining capital
levels. Five main features of rigorous process:
Board and senior management oversight
Sound capital assessment
Comprehensive risk analysis (credit risk,
operational risk, market risk, interest rate
risk in banking book, liquidity risk, other
risk)
Monitoring and reporting
Internal control review
Four key principles of supervisory review

Principle 2: Supervisors should review and

evaluate banks internal capital adequacy
assessments and strategies, as well as
ability to monitor and ensure compliance
with ratios. Supervisors should take
appropriate action if not satisfied.
Principle 3: Supervisors should expect
banks to operate above minimum ratios and
should have ability to require banks to hold
capital in excess of minimum
Principle 4: Supervisors should seek to
intervene at early stage and require rapid
remedial action
Market Discipline

Market Discipline to ensure controls and soundness of

Bank

Core disclosures, increasing transparency among banking

institution

No change since basel I

Criticism of Basel II accord

Problems with Pillar I

No concentration penalty in Pillar 1
Single global risk factor
Different treatment of financial promises: complete markets in
credit undermine capital weighting approaches
Bank capital market activities
Pro-cyclicality
Subjective inputs
Unclear and inconsistent definitions

Problems with Pillar II and III

Supervisors cant be forward looking
Markets just arent efficient
Basel II.5

An additional chargeincremental risk charge (or IRC)

was introduced. This was introduced to estimate and
capture default and credit migration risk. Credit
migration risk is when a customer moves his loan from
one bank to another bank.
An additional charge for comprehensive risk measure was
introduced.
Basel II.5 introduced stressed value at risk (or SVaR) as
an additional requirement to calculate capital
requirements.
Basel II.5 also introduces standardized charges for
securitization and re-securitization positions.
Recap

At the end of the session, you learned to :

Interpret Basel Accord
Be acquainted with history of Basel accord and basel I
Learn the need for Basel II
Objectives
Specify the Implication for Basel II
Features of Basel II.5
Questions
Thank You