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MSC BANKING AND FINANCE 2013
Changes in Basel II
BANKING AND FINANCIAL MARKETSACCF 5301
SUBMITTED TO: Mr N. Ramdoyal
SUBMITTED BY: Dookarane Mevika (130075)
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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 R ISK APPROACH................................................................................................ 6
3.1.1.1 STANDARDIZED APPROACH TO MEASURING CREDIT REQUIREMENT ......................... 7
3.1.1.2 INTERNAL R ATE BASED (IRB) APPROACHES ............................................................. 7
3.1.1.3 OPERATIONAL R ISK APPROACHES ............................................................................. 8
3.2 PILLAR II: SUPERVISORY R EVIEW PROCESS........................................................................... 8
3.3 PILLAR III: MARKET DISCIPLINE.......................................................................................... 10
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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 InternationalStandards 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.
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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.
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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.
Doesn’t take into consideration the increasing operational risk of banks, (higher
complexity in bank activities)
Doesn’t 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.
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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
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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)
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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 risk-
weighted 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 appr oach 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 r ecoveries are insufficient to cover the bank’s exposure, this
gives rise to loss given the default (LGD) of the borrower (expressed as a percentage of the
exposure).
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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.
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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 bank’ s 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 bank’s 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.
I nterest 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.
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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.
Supervisor’s 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.
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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 assetsecuritization. For each of these types of risks, the Committee defines quantitative and
qualitative disclosure requirements.