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BASEL I Risk management Capital adequacy, sound supervision and regulation Transparency of operations Unquestionably accepted by developed and developing countries –Capital requirement 8% of assets –Tier 1 capital at 4% –Tier 2 capital at 4%
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Basel Committee Norms
Basel Framework
• Basel Committee set up in 1974
• Objectives
– Supervision must be adequate
– No foreign bank should escape supervision
BASEL I
• Risk management
• Capital adequacy, sound supervision and regulation
• Transparency of operations
• Unquestionably accepted by developed and developing
countries
– Capital requirement 8% of assets
– Tier 1 capital at 4%
– Tier 2 capital at 4%
BASEL I
• Focused on credit risk
• In 1996, the accord was amended to include market risk
• Did not recognize risk exposure according to credibility
of borrowers
• No recognition of operational risk
BASEL II
• Following the South East Asian currency crisis, the Basel
Committee met in June 1999 and came up with Basel II.
• Short term funds played a major role in Asian currency
crisis.
• Risk weights accordingly adjusted under Basel II.
BASEL II
• Brings order, discipline and safety to banking institutions.• Involves complex calculations based on huge data.• Provides a number of approaches for risk measurement.• Flexibility for banks to choose an approach in line with
their risk profile.• Incentives for stronger and more accurate risk
measurement.
The Three Pillars
• Supervisory review process
• Minimum capital
• Market discipline
Capital Adequacy
• Supervisors can impose additional capital
• Early intervention by regulators in case of problem
Market Discipline
• Disclosure of information
– Capital structure
– Capital adequacy
– Different types of risk
Minimum Capital RequirementBASEL II
• Banks can choose from different methods
• Credit risk
– Standardized approach
– Internal ratings based approach
• Market risk
– Standardized approach
– Internal models approach
Minimum Capital RequirementBASEL II
• Operational risk
– Basic indicator approach
– Standardized approach
– Advanced measurement approach
Measurement of Credit Risk
• Standardized approach
• Internal ratings based approach
– Foundation
– Advanced
Standardised Approach
• Useful for less sophisticated banks
• Concept of capital ratio
• Numerator is amount available
• Denominator is the measure of risk faced by the bank
• Risk weights – 0, 20%, 50%, 100%, 150%
Internal Ratings Based Approach
• Prime objectives of IRB approach
– Allocation of capital based on internal ratings
– More sensitivity to drivers of credit risk
• Encouraging banks to continue to improve their internal
risk management process
• Foundation and advanced IRB approach
• Segments portfolios according to bank’s own criteria
Internal Ratings Based Approach
• Apply formula to determine capital ratio for each segment
• Foundation IRB approach
– Banks indicate only Probability of Default (PD) and loss in
each segment
– Supervisory estimates other components of loss
• Advanced IRB approach
– Banks provide estimates of Loss Given Default (LGD) and
Exposure at Default (EAD) and maturity
– Requirement of reliable database
Internal Ratings Based Approach
• Probability of default – Likelihood that customers will
default in the next 12 months.
• Exposure at default – Expected amount of exposure at
the point of default.
• Loss given default – Likely financial loss associated with
the default.
Internal Ratings Based Approach
• Banks can use their internal estimates of borrower credit
worthiness to assess credit risk
• Credit risk = Exposure x Probability of Default x Loss
given Default
Measurement of Market Risk
• Standardized approach
• Internal model approach
Market Risk
• Interest rate sensitive position
– General market risk, Duration or Maturity method
– Specific market risk, Net position x weight factor
• Equity instruments
– General market risk – 8% of net position per market
– Specific market risk – 8% of net position per issue
• Precious metals: 10% of net position
Market Risk
• Currencies
– 10% of all net long or short positions whichever is
greater
• Commodities
– 20% of net position per commodity group + 3% of net
position of all commodity groups
Measurement of Operational Risk
Any risk not characterized as market or credit risk
• Risk arising out of human or technical error
• Settlement or payment risk
• Business interruption risk
• Inadequate systems, controls, processes
• Fraud
Measurement of Operational Risk
Exists almost anywhere in the organization
– Can be high occurrence low value or low occurrence
high value
• Basic indicator approach
• Standardized approach
• Advanced measurement approach
Types of Operational Risk
Based on causes
– People oriented
– Process oriented
– Technology oriented
– External
Types of Operational Risk
Based on effect
– Legal liability
– Regulatory compliance and taxation penalties
– Loss or damage to assets
Types of Operational Risk
• Based on event
– Internal fraud
– External fraud
– Employment practices and workplace safety
– Clients, products and business practices
– Business disruption and systems failures
– Execution, delivery and process management
Basic Indicator Approach
• Capital allocation is based on a single indicator
– Gross income as a proxy for operational risk
– Regulatory norm (%) X Gross income
• Easy to implement
• Limited responsiveness to firm specific needs and
characteristics
• Applicable for smaller size domestic banks
Standardised Approach
• More complex than basic indicator approach• Better able to reflect the differing risk profiles across
banks• Within each business line, a broad indicator can be
chosen• Bank activities segregated into eight business lines
Standardised Approach (Example)Business Line Percentage
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%
Standardised Approach
• Split gross income into business lines
• Multiply average gross income for three years by the
regulator stated beta
• In a simplified approach, split gross income across
traditional banking (commercial and retail) and other
activities.
Advanced Measurement Approach
• Bank uses internal measurement using both quantitative and
qualitative criteria
• Internal loss data is used in determining required capital
• Qualitative criteria
– Independent function
– Involvement of Board
– Reporting of exposure and loss experience
Advanced Measurement Approach
• Documentation of risk management system• Quantitative criteria• Stress testing• Approximate risk measurement• Expected loss and unexpected loss• Minimum 5 years of observation period of internal loss
data