The Importance of Capital and

Methods of Measuring Its Adequacy

World Bank/IMF/Federal Reserve Seminar for
Senior Bank Supervisors from Emerging Economies
Washington, D.C.
October 2004
Elizabeth Roberts, Director
Financial Stability Institute

Agenda

z Risks in Banking
z Basic Concepts of Capital Adequacy
z Capital Adequacy Regulation: Some Background
z Key elements of Basel II

Risks in Banking
z A bank that does not take risks is not a bank
z Risk taking is the crucial economic role of banks and the

reason for their existence

z Therefore, it is critical that these risks be adequately
managed
z This has, over time, become more difficult and complex

Risks in Banking

Credit risk
Market risk
Liquidity risk
Operational risk
Interest Rate risk
Reputational risk

5%
30%

60%
5%

Credit Risk
Market Risk
Operational Risk
Other Risks

Why Do Banks Need Capital?

z Source of funds (growth!)

z Buffer against future, unidentified losses
z Cushion that protects depositors and creditors
z Provides a level of confidence

What Factors Drive Capital Levels?

z Management strategy

the level which management deems appropriate based

on internal assessments
z Market views
e.g. counterparties, rating agencies
z Shareholder expectations
Return on capital
z Regulatory capital requirements
Basel Accord

What is Capital Adequacy?

z It relates the absolute amount of capital (numerator),

however defined, to either:

Total assets
Risk-weighted assets
Other defined denominator

Why Was the First Basel Capital Accord

Necessary?
Developments in the 70s and 80s
z Volatility (especially in exchange and interest rates)
z Deregulation
z Globalisation
z Innovation (especially the use of off-balance-sheet

instruments)
z Latin American debt crisis

Lead to the erosion of the capital base of

most major banks worldwide

Capital Adequacy Framework

The 1988 Capital Accord
z Uniform definition of capital (Tier 1 and Tier 2)
z Risk-weights applied to categories of assets based on
perceived risk (0, 20, 50 and 100%)
z Off-balance sheet exposures converted to an on-balance
sheet amount with appropriate risk weight applied
z Minimum of 8 percent capital set for internationally-active
banks in the G-10 countries (Capital/RWA 8%)

Definition of Capital (i.e. numerator)

z

Tier 1: Core capital

Equity

Disclosed reserves

Tier 2: Supplementary capital (limited to 100% Tier 1)

Undisclosed reserves

Revaluation reserves

General provisions/general loan loss reserves

Hybrid instruments

Subordinated debt (lower Tier 2)

Tier 3: Short-term Subordinated Debt

Why use risk weighted assets

z A better reflection of the riskiness of a banks activities
A straight measure of equity as a proportion of assets does
not provide insight into relative risk

What are risk weighted assets?

z Each asset and off-balance sheet item is assigned to a

risk weight category based on the perceived risk

z Risk weight categories:
0%: cash and claims on OECD central governments
20%: ST claims on banks; LT claims on OECD banks
50%: loans secured by first liens on residential property
100%: the standard RW - most claims fall into this category

Capital Adequacy Framework

Work since 1988
z 1996: Amendment to the Accord to incorporate market
risks (implementation: end-1997)
z Many additional clarifications and refinements
z 1999: A new Capital Adequacy Framework - discussion
paper
z 2001: A new Capital Adequacy Framework - revised draft
z Spring 2003: the third draft of the proposed changes
z June 2004: publication of the final document

Merits of the 1988 Accord

z Substantial increases in capital ratios of internationally
z
z
z
z
z

active banks
Relatively simple structure
Worldwide adoption
Increased competitive equality among international banks
Greater discipline in managing capital
A benchmark for assessment by market participants

Weaknesses of the 1988 Accord

z Does not assess capital adequacy in relation to a banks

true risk profile

Limited differentiation of credit risk
No explicit recognition of operational and other risks
z Sovereign risk not appropriately addressed
z Does not provide proper incentives for credit risk mitigation
techniques (hedging, etc)
z Enables regulatory arbitrage through securitisation, etc.

Objectives of the Proposed New Capital

Adequacy Framework
z Continue to promote safety and soundness
z Better align regulatory capital to underlying risk
z Encourage banks to improve further their internal risk

management systems
z Focus on internationally active banks but should be
suitable for banks of varying levels of complexity and
sophistication

Why Is Basel II So Complex?

z More risk sensitivity means more detail
z It is applicable to all banks, so in many cases there are

more options
Banks in different jurisdictions
Banks of all sizes and levels of sophistication
z It is much more comprehensive: two new pillars plus
operational risk

The Organization of the New Accord

Three Basic Pillars

Minimum capital
requirements

Supervisory
Review
Process

Market
Discipline

Outline of the New Accord - Basic Structure

Three
Basic Pillars
Minimum capital
requirements

Supervisory review
process

Risk weighted
assets
Credit risk

Standardised
Approach

Internal
Ratings-based
Approach

Definition of
capital

Operational
risk
Basic
Indicator
Approach

Standardised
Approach

Market
discipline

Market
risks
Advanced
Measurement
Approaches

Standardised
Approach

Core
Capital
Models
Approach

Supplementary
Capital

The Treatment of Credit Risk in

Pillar 1

Risk Sensitivity
z What factors are driving credit risk?

Estimation of the likelihood that the borrower will

default
Recovery rate if a borrower were to default
Likelihood of a credit line being drawn upon
Maturity of the loan

Risk Sensitivity

z The main impact on banks

Capital requirements will (better) reflect their riskiness

And, therefore, there will be winners and losers

Risk Sensitivity
Basel Capital Ratio (1988 ) =

$ 40 billion
= 12 . 5 %
$ 320 billion

z Under the New Basel Accord, risk-weighted assets should decline

for less-risky banks

$ 40 billion
Capital Ratio =
= 13 .3 %
$ 300 billion
z and rise for those with more risk

$ 40 billion
Capital Ratio =
= 11 .4 %
$ 350 billion

Risk Components
Key components
z Borrower risk

Probability of default (PD)

z Transaction risk

Loss given default (LGD)

z Exposure

Exposure at default (EAD)

Other important elements

z Maturity
z Borrower size
z Level of concentration/diversification

Risk Components

z How are the risk components recognised in the New

Accord?
z There are several approaches for calculating capital

requirements
z New Accord should be applicable to

Banks in different jurisdictions and

Banks of all sizes and levels of sophistication

Menu of Options

z Simplified standardised approach

Closest to current Accord

z Standardised approach

Based on external assessments of risks

z Foundation internal ratings-based approach

Banks own assessment of probability of default

z Advanced internal ratings-based approach

Banks own assessment of all risk factors

Standardised Approach
z Objective is to align regulatory capital with economic

capital and key elements of risk by introducing a wider

differentiation of risk weights and credit risk mitigation
techniques
z Balance between simplicity and accuracy
z Simplest of the three approaches to credit risk
z Will be used by most banks in the foreseeable future

The Standardised Approach

Main Features:
z Continue to slot exposures into risk-weighted buckets
based on broad distinctions of risk determined by
supervisors
z Risk-weights now more sensitive to inherent risks
based on external credit assessments
introduction of additional risk weight categories
more refined treatment of credit risk mitigation

Risk Weights - Standardized Approach

z Continue to be set by supervisors
z Risk weights determined by category of borrower:

sovereign
bank
corporate
z Risk weights dependent upon external credit assessments

Claims on Sovereigns

z Based upon ECAIs long-term domestic rating for domestic

and foreign currency obligations

Credit
Rating

AAA to
AA-

Risk
Weights

0%

A+ to BBB+ to BB+ to
ABBBB-

Below Unrated
B-

20%

150%

50%

100%

100%

Claims on Sovereigns
z At national discretion, supervisors may allow the use of

ratings from Export Credit Agencies

z Available for a far greater number of sovereigns
z Assessments must be publicly available

ECA Risk
Score
Risk
Weight

4 to 6

0% 20% 50% 100% 150%

Preferential Treatment for Domestic Claims

National Discretion: Preferential treatment (e.g. 0% risk
weight) can apply to exposures to a bank's own sovereign
(and central bank)
Preconditions for preferential treatment
1. Exposure denominated in domestic currency
2. Exposure funded in domestic currency

Preferential Treatment for Domestic Claims

z Other supervisors may also permit their banks to

apply the same risk weighting (i.e. if South Africa

applies 0%, Botswana can follow)
z This is provided that the claim on the sovereign is
denominated and funded in the national currency of
that sovereign (i.e., bank in Botswana has a claim on
the government of South Africa denominated in SA
Rand and funded in SA Rand)

Claims on Banks
z Two options:

based on assessment of sovereign

based on assessment of bank
z Supervisors must apply one option to all banks in their
jurisdiction
z No unrated claim may receive a risk weight less than the
sovereign of incorporation

Claims on Banks - Option 1

z Banks are assigned a RW one category less favorable

than the country of incorporation

z RW cap at 100% except in countries rated below B-, in

which case the RW is 150%

Credit Assessment AAA to A+ to
of Sovereign
AAA-

BBB+ to
BBB-

BB+
to B-

Below Unrated
B-

Sovereign Risk
Weight

0%

20%

50%

100%

150%

100%

Bank Risk Weight

20%

50%

100%

100%

150%

100%

Claims on Banks - Option 2

z Based upon the credit assessment of the bank itself
z At national discretion a preferential treatment exists for

claims of 3 months or less (original maturity), subject to a

floor of 20% (not available to banks rated below B-)
Credit Assessment AAA to A+ to
of Banks
AAA-

BBB+ to
BBB-

BB+
to B-

Below Unrated
B-

Risk Weight

20%

50%

50%

100%

150%

50%

Risk Weight for

ST Claims

20%

20%

20%

50%

150%

20%

Claims on Multilateral Development Banks

z Risk weighted similar to banks under option 2
z 0% risk weight is possible (as determined by the Basel

Committee) for MDBs that fulfill certain criteria:

majority of external assessments are AAA
shareholder structure is significantly comprised of
sovereigns with long term issuer credit assessments of
AA or better
strong shareholder support (i.e. amount of capital,
amount of callable capital)
adequate level of capital and liquidity

Claims on Corporates
z Based upon comments received from the industry, a 50%

RW was added and expansion of 150% RW

z Elimination of sovereign floor
z No unrated claim can receive a RW less than the

sovereign RW
Credit Assessment AAA to A+ to
of Corporates
AAARisk Weight

20%

50%

BBB+ to
BB100%

Below Unrated
BB150%

100%

Claims on Corporates

z Floor for unrated corporates is 100% risk-weight

z Low-rated (below BB-) corporates that give up their rating

in order that the bank can have a 100% capital charge will
affect the quality of the unrated borrower pool; thus a
higher RW (higher than 100%) may ultimately be
necessary

Claims on Retail
z New lower risk weight for retail portfolio, e.g.

35% for residential mortgages (currently 50%)

Past due mortgage loans are weighted at 100%
75% for other retail (currently 100%)
The banks total exposure to the firm must be less
than 1 million
Past due claims do not qualify for this preferential
treatment

Other Risk Weighting Issues

z The unsecured portion of past due assets (90 days or

more), net of specific provisions, will be risk weighted at

150%
z Other assets will continue at 100%
z Maturity is a factor relevant to the assessment of credit

risk, but making the standardized approach more complex

increases the cost

Standardised Approach Risk Weights

Cl aim

Assessment
AAA AA-

Sovereigns
(Export credit agenci es)
Option 1

Option 2

Banks

Corporat es
Ret ai l

A+ - A-

BBB+ BBB-

BB+ - B-

Bel ow B-

Unrated

100%
( 4- 6)

150%
(7)

100%

150%

100%

0%
(1)

20%
(2)

50%
( 3)

20%

50%

100%

100%

20%
3
(20%)

50%
3
(20%)

50%
3
( 20%)

100%
3
( 50%)

20%

50%

100%

BB+ - BB100%

150%
3
( 150%)

50%
3
( 20%)

Bel ow BB150%

100%

Mortgages

35%

Other retail

75%

Risk weighting based on risk weights of sovereign in which the bank is incorporated, but one category less
favourable.

Risk weighting based on the assessment of the individual bank.

Claims on banks of an original maturity of less than three months generally receive a weighting that is one
category more favourable than the usual risk weight on the banks claim.

External Credit Assessment Institutions (ECAI)

z Not a perfect solution but

Provides better differentiation of risks

Better than present OECD criterion
Most sovereigns are rated
No valid alternative proposed

Historical Default Rates

Main reason for using ECAIs: increases the risk sensitivity
High correlation between ratings and default rates
S & Ps PD over 5-year horizon
50
40
30
Default

20
10
0

AAA

AA

A+

A-

BBB BB+

BB-

CCC

External Credit Assessment Institutions

z ECAIs must be recognized by the supervisor
z ECAIs may be recognized on a limited basis (i.e. type of

claim or jurisdiction)
z Process for recognizing ECAIs must be disclosed
z Eligibility critieria
- objectivity
- international access
(transparency)
- resources

- independence
- disclosures
- credibility

Simplified Standardised Approach

z Extract from Standardised Approach
z Close to the current Accord
z Not based on external assessments
z Sovereign risk weights based on assessment from

export credit agencies

z Banks get one risk weight worse than the sovereign (i.e.

50% if sovereign is 20%)

z New risk buckets for mortgages (35%) and retail (75%)
z 150% weighting band for past due

Internal Ratings-based Approach

The fundamental question
Who is the best judge of a banks exposure to credit risk?
z The supervisor?
z A rating agency?
z The bank itself?

Basic Elements of the IRB Approach

z Relies on a banks assessment of risk factors
z Based on three main elements

Risk components (probability of default, loss-given default,

exposure at default, maturity)
Risk weight function
Minimum requirements
z Separate approaches for each portfolio of assets
z Subject to supervisory validation and approval

IRB Approach Risk Components

Component
Probability of default

Recognition
Bank
Foundation
Advanced

Loss-given-default (LGD)

45%

Bank

Exposure-at-default (EAD)

100%

Bank

Maturity

2 years

Bank

Correlations

Built into risk weight function

(Fixed numbers)

Risk Components (PD)

Assessment of Borrower Risk
z Quantitative information

e.g. balance sheet, income statement, cash flow

z Qualitative information
e.g. quality of management, ownership structure
Measures

Probability of default (PD)

Risk Components (LGD)

Assessment of Transaction Risk
z Factors: collateral, seniority, recovery time etc.
z Two-dimensional rating systems (matrix)

Borrower risk and transaction risk

Measures

Loss-given-default (LGD)

Risk Components (EAD)

Amount of Exposure at the Time of Default
z Nominal amount for simple structures
z For lines of credit:
Amount outstanding + a portion of committed but
undrawn lines
Measures

Exposure at default (EAD)

IRB - Categories of Exposures

z Corporates
Traditional (sovereigns and banks in principle subject to
same risk weighting curve)
SMEs
Specialised lending
High-volatility commercial real estate
z Retail
Residential mortgages
Qualifying revolving exposures
Other retail
z Equities

Risk Weight Function

25%
C&I

Charge

20%

)
(SMEs
s
e
is
r
terp
ized en
s
m
iu
ed
and m
Small

15%
10%
5%

Charge
Charge

8% (= current Accord

0%
0%

2%

4%

6%

8%

10%

PD

IRB does not always mean lower capital requirements

Risk Weight Function

20%

Other retail (LGD 85%)

Charge

15%
Mortgages (LGD 25%)
10%
8% (= current Accord

5%

Revolving (LGD 85%)

0%
0%

2%

4%

6%

8%

10%

PD

Different kinds of assets rely on different risk weight functions (curves)

Probability Density Function of Credit Losses

Expected
loss
0

Economic capital

Unexpected loss

Capital, Reserves

Chosen
confidence
level

Frequency of loss

Provisions

Stress
loss
Amount of loss

Concluding Thoughts on Credit Risk

z The New Accords main goal: more risk sensitivity
z The New Accord offers a range of options for the treatment of

credit risk
z The Committee is moving away from a one-size-fits-all

approach to capital regulation

z The IRB approach is primarily aimed at sophisticated banks,

with well developed risk management systems in place

z The revised Standardised Approach is fully valid and beneficial

for smaller and less complex banks

The Treatment of Operational

Risk in Pillar 1

Outline of the New Accord - Basic Structure

Three
Three
Basic Pillars
Basic Pillars

Minimum capital
Minimum capital
requirements
requirements

Supervisory review
Supervisory review
process
process

Market
Market
discipline
discipline

Risk weighted
Risk weighted
assets
assets

Operational
Operational
risk
risk

Credit risk
Credit risk

Standardised
Standardised
Approach
Approach

Internal
Internal
Ratings-based
Ratings-based
Approach
Approach

Definition of
capital

Basic
Basic
Indicator
Indicator
Approach
Approach

Standardised
Standardised
Approach
Approach

Market
risks

Advanced
Advanced
Measurement
Measurement
Approaches
Approaches

Standardised
Approach

Core
Capital

Models
Approach

Supplementary
Capital

Definition of operational risk

z The risk of loss resulting from inadequate or failed

internal processes
people
systems
or from external events

Operational risk event types

z Internal fraud
z External fraud
z Employment practice and workplace safety
z Clients, products and business practices
z Damage to physical assets
z Business disruptions and system failures
z Execution, delivery and process management

How big is operational risk?

z 2002 operational risk loss data collection exercise

89 banks took part

47 banks holding economic capital for operational risk
Ranges from 0% to 40% of current MRC
Mean 15%

Treatment of other risks

Pillar 1
Other
risks
Operational
risks
(including
legal risk)

Interest rate
risk in the banking book

Liquidity
risk

Pillar 2 and Pillar 3

Strategic,
Reputational
etc..

Continuum of approaches
lower

sophistication

Basic Indicator Approach

Standardised Approach

risk-sensitivity

higher

Advanced Measurement Approaches

Continuum of approaches
Basic Indicator Approach (BIA)

Basic Indicator Approach

z Capital charge is based on single indicator multiplied by fixed

percentage ()
z Proposed indicator: gross income

Capital charge = x indicator

z Calibrated to 12% of current MRC
z CP3 : = 15%
z Three year average
z No qualifying criteria encouraged to comply with Sound

Practices
z Generally not for internationally active banks

Continuum of approaches
Basic Indicator Approach (BIA)

Standardised Approach (TSA)

Standardised Approach
z Activities divided into 8 business lines
z Indicator: gross income
z Capital charge for each business line calculated by

multiplying gross income by a factor (beta)

z Total capital charge simple sum of capital charges for each
business line

Capital charge = (GI1-8 x 1