MSC BANKING AND FINANCE 2013

Changes in Basel II
BANKING AND FINANCIAL MARKETS ACCF 5301
SUBMITTED TO: Mr N. Ramdoyal

SUBMITTED BY: Dookarane Mevika (130075)

TABLE OF CONTENTS 1. INTRODUCTION ........................................................................................................................... 2 2. BASEL ACCORD .......................................................................................................................... 3 2.1 CRITICISM OF BASEL ACCORD ............................................................................................. 4 3. BASEL II: THREE PILLARS ......................................................................................................... 5 3.1 PILLAR I: MINIMUM CAPITAL REQUIREMENT...................................................................... 6 3.1.1 CREDIT RISK APPROACH ................................................................................................ 6 3.1.1.1 STANDARDIZED APPROACH TO MEASURING CREDIT REQUIREMENT ......................... 7 3.1.1.2 INTERNAL RATE BASED (IRB) APPROACHES ............................................................. 7 3.1.1.3 OPERATIONAL RISK APPROACHES ............................................................................. 8 3.2 PILLAR II: SUPERVISORY REVIEW PROCESS........................................................................... 8 3.3 PILLAR III: MARKET DISCIPLINE .......................................................................................... 10

1. INTRODUCTION

TIMELINE FOR THE HISTORY OF BASEL

Bank for International Settlements [BIS] Headquartered in Basel, Switzerland Represents G10 Central Banks 1974- Basel Committee on banking supervision July, 1988, Introduction of Basel 1 ( Basel Accord) June, 1999, the Basel committee proposes more risk sensitive framework 2006, Deadline for implementation of Basel II According to Bascom (1997), the essential objectives of regulatory and supervisory policy are to promote bank safety and soundness and to maintain confidence in the banking system as a whole. In 1975, Central Bank governors of the G-10 countries established the BCBS which is a committee of banking supervisory authorities that provides a forum for regular cooperation on banking supervisory matters and whose objectives are to establish a comprehensive framework for bank supervision with a view to strengthen the stability of financial institutions and banks. The BCBS formulates guidelines and standards in different areas such as the International Standards on Capital Adequacy, the Core Principles for Effective Banking Supervision and the Concordat on cross-border banking supervision and recommends best practices in banking supervision. Member authorities take the initiative of implementing the rules in their own national system. The purpose of BCBS is to encourage convergence towards common standards by developing policy solutions that are not binding in nature. This is due to the fact that the Committee is not a classical multilateral organisation since there is no founding treaty. In 1988, bank supervisors from the major industrialized countries agreed on a new set of capital guidelines for commercial banks that became known as the Basel Accord, this after the Swiss City where the BIS is located. Central focus on this relatively simple financial template was Credit Risk and as a further aspect of credit risk, country transfer risk- a legacy of Latin American Debt Crisis.

New bank capital were hailed as important tool to avoid sudden financial shocks and the ultimate bogey man, systemic risk, which has haunted the financial markets since the collapse of Penn Square Bank in July of 1982. Other similar financial shocks during the two subsequent decades; predominantly the market meltdown in October 1987 and the default by Russia in October 1988 only served to validate the decision to implement original Basel Accord, which is generally agreed to increase stability of the international financial system by requiring banks to have a minimum capital requirement, that is., a minimum level of capital to serve as a buffer against losses. Until the 1990s, the principal way of measuring capital adequacy was the computation of leverage ratio. Leverage ratio = Capital / Total Asset The higher the leverage ratio the higher the cushion against default. However, the leverage ratio proved to be poor facing the growing volatile financial markets. Especially regarding the severe debt crisis of the 1980s where banks lend out vast amounts of unsecured loans without proper credit risk procedures. The main inadequacy with the leverage ratio proved to be its simplicity, it does not differ between assets according to its risks.

2. Basel Accord Basel I accord: Capital requirement ratio In 1988 the Bank of International Settlements (BIS) introduced the Basel 1 to deal with the weaknesses of the simple leverage ratio and to strengthen the international banking system. G10 countries were to hold capital equal to at least 8% of a basket of assets measured in different ways according to their riskiness. Moreover, the new capital requirement approach provided a more sensitive regulation of capital for G10 banks.

The Basel I accord got shortly adopted by over 100 countries. In light of the vast internationalization of the banking sector the past decade the Basel I capital requirement proved extremely important in terms of bank regulation and secure markets. However, since the introduction of Basel I the rapid technological, financial and institutional changes, many weaknesses appear in the Basel and proved less lucrative. 2.1 Criticism of Basel Accord Flat 8% charge for claims on the private sector, incentive to move high quality assets off the balance sheet (capital arbitrage) through securitization. Reducing quality of bank loan portfolios. Doesnt take into consideration the increasing operational risk of banks, (higher complexity in bank activities) Doesnt sufficiently recognize credit risk mitigation techniques, such as collateral and guarantees. With the development of new methods in measuring risk in combination with the evolution of new technology in the financial markets the Basel I accord topped its limitations. Moreover, the Basel I approach tended to create turmoil in the financial decisions due to the lack of risk sensitivity according to the different assets held by the institution. The standard approach simply does not provide an efficient way in allocating capital. Though banks are still to maintain an 8% capital adequacy ratio, the standard method of measuring capital risk have been abandoned by most modern financial institutions. In June 1999, the Basel Committee proposes a more risk-sensitive framework.

3. Basel II: Three pillars The Basel II framework is built around three mutually reinforcing pillars:

Pillar 1 describes the calculation for regulatory capital for credit, operational and market risk. Credit risk regulatory capital requirements are more risk based than the 1988 Accord. An explicit operational risk regulatory capital charge is introduced for the first time.

Pillar 2 is intended to bridge the gap between regulatory and economic capital requirements and gives supervisors discretion to increase regulatory capital requirements if weaknesses are found in a lender's internal capital assessment process.

The intention of pillar 3 is to allow market discipline to operate by requiring lenders to publicly provide details of their risk management activities, risk rating processes and risk distributions.

Plan on the 3 highlighting pillars of Basel II

3.1 Pillar I: Minimum capital requirement The minimum 8% capital requirement to risk-weighted assets remains the equivalent; however the calculation approaches will be of far greater sensitivity. Tier 2 capital will continue to be limited to 100% of Tier 1 capital.

To introduce greater risk sensitivity, Basel 2 introduces capital charge for operational risk (for example, the risk of loss from computer failures, poor documentation or fraud). Many major banks now allocate 20% or more of their internal capital to operational risk.

Under Basel I individual risk weights depend on a board category of borrower. Under Basel II the risk weights are to be refined by reference to a rating provided by an external credit assessment institution, such as a rating agency, or by relying on internal rating based (IRB) approaches where the banks provide the inputs for the risk weights. Both the external credit risk assessment and the internal rating approaches entail credit information and minimum requirement the banks have to achieve it. 3.1.1 Credit Risk Approach Similar to 1988 Accord: the risk-weights are determined by category of borrower (sovereign, bank, corporate)

Risk-weights now based on external credit ratings Improved risk sensitivity Targeted at banks desiring a simplified capital framework

3.1.1.1 Standardized approach to measuring credit requirement The standardised approach is similar to the current Accord in that banks are required to insert their credit exposures into supervisory categories based on observable characteristics of the exposures (e.g. whether the exposure is a corporate loan or a residential mortgage loan). The standardised approach establishes fixed risk weights corresponding to each supervisory category. Risk-weight allocated to different assets depending on external ratings, producing a sum of riskweighted asset values. Where no external rating is applied to an exposure, the standardised approach mandates that in most cases a risk weighting of 100% to be used, implying a capital requirement of 8% as in the current Accord. Because of its simplicity it is expected that it will be used by a large number of banks around the globe for calculating minimum capital requirements.

3.1.1.2 Internal Rate Based (IRB) Approaches The IRB framework for exposures builds on current best practices in credit risk measurement and management. One of the new aspects of the New Accord is the approach to credit risk, which includes two variants: a foundation version and an advanced version. The IRB approach differs substantially from the standardized approach in that banks internal assessments of key risk drivers serve as primary inputs to the capital calculation. Because the approach is based on banks internal assessments, the potential for more risk sensitive capital requirements is substantial. 1. Risk of borrower default by internal rating. 2. Estimation of the probability of default (PD) associated within rated borrowers. 3. Measurement of hypothetical loss for defaults. Depending on how much per unit it is expected to recover from the borrower. If recoveries are insufficient to cover the banks exposure, this gives rise to loss given the default (LGD) of the borrower (expressed as a percentage of the exposure).

PD and LGD values will be created by credit risk models that use inputs from underlying transactions/facilities. 3.1.1.3 Operational Risk Approaches To introduce greater risk sensitivity, Basel 2 introduces capital charge for operational risk (for example, the risk of loss from computer failures, poor documentation or fraud). Many major banks now allocate 20% or more of their internal capital to operational risk. Three methods for calculating operational risk: (i) Basic Indicator Approach; Banks using the Basic Approach must hold capital for operational risk equal to a fixed percentage of 16% (denoted alpha) of average annual gross income over the previous three years. (ii) Standardised Approach: Banks activities are divided into 8 business lines. The capital charge is calculated by multiplying gross income by a factor (beta) assigned to each business line: Corporate finance (18%), Trading and sales (18%), Retail banking (12%), Commercial banking (15%), Payment and settlement (18%), Agency services (15%), Asset management (12%), Retail brokerage (12%) (iii) Advanced Measurement Approach: The regulatory capital requirement will equal the risk measure generated by the banks internal operational risk measurement system using outlined quantitative and qualitative criteria.

3.2 Pillar II: Supervisory Review Process The lineaments described in Pillar II are aimed at providing with a dynamic regulation of banking risks; as well as at encouraging a strong coordination between banks and supervisory entities. In this sense, it is expected that banks develop their own strategies and methodologies to assess their risk profiles and set capital requirement targets accordingly with its extent. Besides, the continuous coordination between banks and regulatory entities will allow the improvement of regulatory processes. Finally, Pillar II states that supervisory process should widen to asses topics that were not discussed (e.g. concentration credit risk) or well developed (e.g. interest rate risk in banking books) in Pillar I, as well as external risks, like business cycles.

In the Third Consultative Package released in March 2003, the Committee has based the Second Pillar in four main Principles: Principle 1: Banks should develop their own internal processes, methods and strategies to manage their risks. This principle relies mainly on the fact that management is responsible of the risks taken by the bank. Principle 2: Supervisors should review banks processes continuously and be proactive if they are not satisfied. Within this principle, the Basel Committee expects Supervisory entities to evaluate the quality of the risk management processes adopted by the banks as well as their control procedure; however Supervisors should never behave as the banks management. Principle 3: Supervisors must have the ability to demand capital requirements above the minimum. This principle reinforces the previous one, as it states that Supervisors must have enough power to require banks the improvement of their capital and ratio targets. Supervisors should encourage banks to keep capital above legal minimum levels. Principle 4: Supervisors should intervene at an early stage to prevent capital requirements to fall below minimum. After the review process, if Supervisors consider that any banking institutions should make some improvements or modifications, there must be different means to make this possible. Under Pillar II lineaments, both Supervisors and banking entities should focus in specific topics that are not well addressed in Pillar I.

Interest rate risk in the banking book: Given that the Basel Committee recognizes that there is high heterogeneity regarding interest rate risk among international banks, it did not include capital requirements for interest rate risk in Pillar I.

Operational Risk: Considering the supporting document released by the Basel Committee, Supervisors are encouraged to assess the accuracy of the capital requirements for Operational Risk obtained from the Standardized and IRB approaches of Pillar I.

Credit Risk: As this risk is the highest faced by banks, Pillar II provides an in depth analysis of how to supervise it by breaking it into several topics: a) Stress tests under IRB: Supervisors should be highly interest in reviewing the procedures of the stress tests under the IRP requirements described in Pillar I. Banks must ensure their ability to fulfill the requirements resulting from the application of this approach. b) Definition of Default: Although banks are able to use the reference definition of default in order to find the PD, LGD and/or EAD, Supervisory entities may give guidance on how these definitions should be interpreted locally. c) Residual Risk: According to Basel I, banks can compensate counterparty risk by using Credit Risk Mitigation (CRM) techniques; d) Credit Concentration Risk: This kind of credit risk is the most materialized risk faced by banks; it can arise within the banks liabilities and assets, as well as within off-the-balance sheet items. e) Securitization: Although risk on securitized assets is well described in Pillar I, Supervisors should review the level of risk in each case in order to find out any inconsistencies.

3.3 Pillar III: Market Discipline With Pillar III, the Basel Committee intends to complement the capital requirement features (Pillar I) and the supervisory review process (Pillar II). This pillar is aimed at encouraging banking institutions to disclose relevant information regarding the risks they face and how they manage them. As a consequence, market participants will be able to assess the scope of application of Basel II in each institution, as well as the capital risk exposures and its assessment. Given that with Basel II, banking institutions select risk measures more discretionary, the requirement of information disclosures is particularly needed. Supervisors ability to demand the disclosure of information varies widely among countries; however, the Committee is confident that there are various means to encourage information disclosure. Furthermore, the implementation of some approaches defined in Pillar I, obliges the disclosure of relevant information.

Disclosure Requirements In this section, the Committee tries to define and deeply explain the disclosure requirements. General Disclosure Principle: Bank management should have an approved disclosure policy, which contains the frequency of release, the subject of disclosure and the control processes. Scope of Application: Generally speaking, the information to be disclosed should be applicable to consolidated data. However, individual disclosures are required when breaking down Tier 1 and 2. Qualitative and quantitative requirements define the scope of application of Basel II for a financial group and the several capital figures that are added/deducted to calculate weighted risks assets or regulatory capital. Capital and Capital Adequacy: Within this topic banks must make a brief summary of the characteristics of capital instruments included in Tier 1, as well as the specification of their approach to risk. In a quantitative level, the bank must disclose all calculations of Tier 1 and 3, as well as capital requirements for credit, market and operational risk. Risk exposure and assessment: This section intends to widen the information regarding the identification of the specific risk that entities face as well as the way they handle and control them. Among the topics to be discussed are credit risk, market risk, interest rate and equity risk in banking books, operational risk, credit risk mitigation and asset securitization. For each of these types of risks, the Committee defines quantitative and qualitative disclosure requirements.