Basel II

Basel I

The first Basel agreement came in 1988, following

events like the Third World debt crisis.

Basel I was intended to save the banks from the

same fate by asking them to keep more capital
(8% capital adequacy).

It focused mainly on Credit risk and set minimum

levels of capital for banks.
 Existing Capital Adequacy Framework: Basel I
The international standards in the field of banking supervision are set
by the Basel Committee on Banking Supervision (BCBS).

Basel I has improved capital adequacy of banks globally and fostered

competitive equality.

However, recent technological advancement, innovations in financial

products and further globalization have underscored the limitations
of the current framework:

Risk weightings are too broad-brush and insufficiently risk-sensitive

It does not provide incentives for risk mitigation techniques
 Shortcomings of Basel I
 Under the current Accord, capital requirements are only moderately related
to a bank’s risk taking.

 The requirement on a credit exposure is the same whether the borrower’s

credit rating is AAA or CCC.

 During this period (1988-1998), markets for credit derivatives and

securitizations grew rapidly, as banks were employing these to take
advantage of shortcomings in the 1988 Accord's crude system of risk
weights.

 Banks are encouraged to structure transactions to minimize regulatory

requirements or, in some cases, to undertake transactions whose main
purpose is to reduce capital requirements with no commensurate
reduction in actual risk taking.
 Difference between Basel I and Basel II
Basel I Basel II
1. Stress on Capital 1. Emphasis on Capital
Adequacy Enhancement and
2. Broad Brush Approach Capital Optimization
3. Lack of flexibility and 2. Risk Sensitive
incentives for better Risk 3. Risk weightage to assets
Management assigned on the basis of
4. Use of arbitrary risk ratings and strength of
categories and risk
weightage the assets
5. All assets within the same 4. Incentives for better
category assigned equal Risk Management
risk weightage techniques, especially
6. Capital Charge only for for Credit Risk
Credit Risk and Market 5. Capital Charge for
Risk Operational Risk also
Risk management has emerged as a key area of focus for
banks in recent times especially due to Basel II accord

Corporate Bank Sovereign Retail Project Equity

Finance

Internal
Process
Interest Rate
Credit Risk – in banking
and trading
People books

Foreign
Operational Types of Risks Market
Exchange
Risk Risk
External Equity
Factors
Information Commodity
Risk

Systems Risk Security and Integrity

Risk
Agenda

 Understanding the global trends

 Evolution of Basel II
 Basel II – The Three Pillars
 Capital Adequacy Calculation
 Overview of the New Basel Capital Accord
 Credit Risk Measurement Approaches under Pillar I
 Operational Risk Measurement Approaches under Pillar I
 Strategic implications on Banking sector
 Challenges in Basel II implementation
 Phased approach to migration to Basel II implementation
 Basel II Survey
 Conclusions
Top 10 concerns of bankers *

1. Complex Financial Instruments

2. Credit risk
3. Macro economy
4. Insurance
5. Business continuation
6. International regulation
7. Equity markets
8. Corporate governance
9. Interest rates
10.Political shocks

* Banana Skins 2003 – The CSFI’s annual survey of the risks facing banks
Regulatory developments – Basel II and IFRS

1. Complex Financial Instruments IFRS

2. Credit risk Basel II
3. Macro economy Basel II
4. Insurance
5. Business continuation
6. International regulation IFRS Basel II
7. Equity markets
8. Corporate governance Basel II
9. Interest rates Basel II
10.Political shocks
Agenda

 Understanding the global trends

 Evolution of Basel II
 Basel II – The Three Pillars
 Capital Adequacy Calculation
 Overview of the New Basel Capital Accord
 Credit Risk Measurement Approaches under Pillar I
 Operational Risk Measurement Approaches under Pillar I
 Strategic implications on Banking sector
 Challenges in Basel II implementation
 Phased approach to migration to Basel II implementation
 Basel II Survey
 Conclusions
The Basel Accord is a constant WIP

July 1988 “Basel Accord”

Nov 1991 Amendments for general provisions
July 1994 Amendment for re-structured country debt
April 1995 Netting amendments for derivatives
Jan 1996 Market risk amendments
April 1998 Securities firms added to “OECD banks” cat
June 1999 CP 1
Jan 2002 CP 2
Apr 2003 CP 3
Jun 2004 Final accord
Existing Basel Capital Accord – Why Changes ?

1988 Capital Accord served the industry well, but

– Severe limitations
• Insufficiently sensitive to risk (broad categories)
• Very limited account of risk mitigation

– Perverse incentives leading to regulatory arbitrage

• To lend to poorer quality credits
• To securitise better quality assets

– No incentive structure to improve risk measurement and risk

management practice
Basel II : A Major Paradigm Shift

The Existing Accord The New Accord

• Focus on a single risk • More emphasis on banks’

measure internal methodologies,
supervisory review &
market discipline

• One size fits all • Flexibility, menu of

approaches, capital
incentives for good risk
management

• Broad brush structure • Increased risk sensitivity

Agenda

 Understanding the global trends

 Evolution of Basel II
 Basel II – The Three Pillars
 Capital Adequacy Calculation
 Overview of the New Basel Capital Accord
 Credit Risk Measurement Approaches under Pillar I
 Operational Risk Measurement Approaches under Pillar I
 Strategic implications on Banking sector
 Challenges in Basel II implementation
 Phased approach to migration to Basel II implementation
 Basel II Survey
 Conclusions
Basel II – The Three Pillars

Basel II
Three Pillars

Minimum Supervisor Market

Capital y Review Discipline
Requiremen
ts

Providing a flexible, risk-sensitive capital

management framework
 The Basel Committee recommendations urge banks to
adopt more risk sensitive approaches to Risk
Management…

The new Basel Accord is based on Three Pillars

Minimum Capital Supervisory Review Market Discipline

 Advanced methods for  Focus on internal  Focus on disclosure

capital allocation capabilities
 Capital charge for  Supervisors to review
operational risk banks internal
assessment and
strategies

…and has proposed a challenging implementation deadline of 2006 for

internationally active banks
BASEL II Structure
Agenda

 Understanding the global trends

 Evolution of Basel II
 Basel II – The Three Pillars
 Capital Adequacy Calculation
 Overview of the New Basel Capital Accord
 Credit Risk Measurement Approaches under Pillar I
 Operational Risk Measurement Approaches under Pillar I
 Strategic implications on Banking sector
 Challenges in Basel II implementation
 Phased approach to migration to Basel II implementation
 Basel II Survey
 Conclusions
Risk Components to Capital Adequacy Calculation

Unchanged

Total Capital
Credit Risk + Market Risk + Operational Risk ≥ 8%

Significantly Relatively New

Refined Unchanged
Capital Adequacy under Basel II – Pillar I

Market risk – as per Basel Accord

Credit risk
 (a) Standardised approach – more granular version of Basel I
 (b) Foundation IRB – uses banks’ own credit ratings
 (c) Advanced IRB – other inputs also determined by bank

Operational risk
 (a) Basic indicator approach - % of revenue
 (b) Standard indicator approach - % of revenue/assets, by line
of business
 (c) Advanced Measurement Approach – internal models etc
 The credit portfolio of ABC Bank has undergone
a uniform downgrade as on 31-3- 2008
after an economic downturn. The position prior
to the downgrade is given below:
The minimum capital required after downgrade is …………..

Rating Scale Risk Weight (%) Exposure Extent of downgrade

Rs. In crores

AAA 20 200 20 %

AA 50 200 20 %

A 50 100 20 %

BBB 100 200 20 %

BB& Below 150 100  

    800  

Minimum capital under Basel II Rs.48.60 crores    

Rating
Scale
Working
Risk Weight Exposure RWA Exposure after
Before down grade Downgrade
RWA
AFTER DOWNGRADE

AAA 20% 200 40 160 80

AA 50% 200 100 200 100

A 50% 100 50 120 60

BBB 100% 200 200 180 180

BB & below 150% 100 150 140 210

540 630
The Capital required will be

A]56.7 crores*
B]58.6 crores
C]60.6 crores
D]62.6 crores
Agenda

 Understanding the global trends

 Evolution of Basel II
 Basel II – The Three Pillars
 Capital Adequacy Calculation
 Overview of the New Basel Capital Accord
 Credit Risk Measurement Approaches under Pillar I
 Operational Risk Measurement Approaches under Pillar I
 Strategic implications on Banking sector
 Challenges in Basel II implementation
 Phased approach to migration to Basel II implementation
 Basel II Survey
 Conclusions
 Overview of the New Basel Capital Accord
Pillar 1 – Minimum capital requirements Pillar 2 – Supervisory Review
Market risk
Unchanged from existing Basel Accord
Credit risk
 Significant change from existing Basel
Accord
 Three different approaches to the
calculation of minimum capital
requirements
 Capital incentives to move to more
sophisticated credit risk management
approaches based on internal ratings
 Sophisticated approaches have
systems / controls and data collection
requirements
Operational risk
 Not covered in existing Basel Accord
 Three different approaches to the
calculation of minimum capital
requirements
 Adoption of each approach subject to
compliance with defined ‘qualifying
criteria’
Pillar 3 – Market Discipline
 Banks should have a process for  Market discipline reinforces
assessing their overall capital efforts to promote safety and
adequacy and strategy for soundness in banks
maintaining capital levels  Core disclosures (basic
 Supervisors should review and information) and supplementary
evaluate banks’ internal capital disclosures to make market
adequacy assessment and discipline more effective
strategies
 Supervisors should expect banks
to operate above the minimum
capital ratios and should have the
ability to require banks to hold
capital in excess of the minimum
(cf. trigger / target ratios in UK)
 Supervisors should seek to
intervene at an early stage to
prevent capital falling below
minimum levels
Agenda

 Understanding the global trends

 Evolution of Basel II
 Basel II – The Three Pillars
 Capital Adequacy Calculation
 Overview of the New Basel Capital Accord
 Credit Risk Measurement Approaches under Pillar I
 Operational Risk Measurement Approaches under Pillar I
 Strategic implications on Banking sector
 Challenges in Basel II implementation
 Phased approach to migration to Basel II implementation
 Basel II Survey
 Conclusions
 Credit Risk Measurement Approaches under Pillar I
Criteria
Rating
Risk Weight
Probability of Default (PD)
the likelihood that a
borrower will default over
a given time period
Exposure of Default (EAD): for
loans, the amount of the facility
that is likely to be drawn if a
default occurs
Loss Given Default (LGD);
the proportion of the
exposure that will be lost
if a default occurs
Maturity: the remaining
economic maturity of the
exposure
Standardized Approach
External
Calibrated on the basis of external
ratings by the Basel Committee
Implicitly provided by the Basel
Committee; tied to risk weights
based on external ratings
Supervisory values set by the
Basel Committee
Implicitly provided by the Basel
Committee; tied to risk weights
based on external ratings
Implicitly recognition
Internal Ratings Based (IRB) Approach
Foundation Approach
Internal
Function provided by the Basel
Committee
Provided by bank based on own
estimates
Supervisory values set by the
Basel Committee
Supervisory values set by the
Basel Committee
Supervisory values set by the
Basel Committee
Or
At national discretion, provided by
bank based on own estimates
(with an allowance to exclude
certain exposures
Advanced Approach
Internal
Function provided by the Basel
Committee
Provided by bank based on own
estimates
Provided by bank based on own
estimates
Provided by bank based on own
estimates; extensive process and
internal control requirement
Provided by bank based on own
estimates (with an allowance to
exclude certain exposures)
 Credit Risk Measurement Approaches under Pillar I
(contd..)
Criteria Standardized Approach
Data Requirements  Provision dates
 Default events
 Exposure data
 Customer segmentation
 Data collateral segmentation
 External ratings
 Collateral data
Credit Risk Mitigation Defined by the supervisory
Techniques (CRMT) regulator; including financial
collateral, guarantees, credit
derivatives, “netting” (on and off
balance sheet), and real estate
Maturity: the remaining  Minimum requirements for
economic maturity of the collateral management
exposure (administration/evaluation)
 Provisioning process
Internal Ratings Based (IRB) Approach
Foundation Approach
 Rating data
 Default events
 Historical data to estimate
PDs (5 years)
 Collateral data
All collaterals from Standardized
Approach; receivables from
goods and services; other
physical securities if certain
criteria are met
Same as Standardized, plus
minimum requirements to
ensure quality of internal ratings
and PD estimation and their use
in the risk management process
Advanced Approach
Same as IRB Foundation, plus:
 Historical loss data to estimate
LGD (7 years)
 Historical exposure data to
estimate EAD (7 years)
All types of collaterals if bank can
prove a CRMT by internal estimation
Same as IRB Foundation, plus
minimum requirements to ensure
quality of estimation of all
parameters
Agenda

 Understanding the global trends

 Evolution of Basel II
 Basel II – The Three Pillars
 Capital Adequacy Calculation
 Overview of the New Basel Capital Accord
 Credit Risk Measurement Approaches under Pillar I
 Operational Risk Measurement Approaches under Pillar I
 Strategic implications on Banking sector
 Challenges in Basel II implementation
 Phased approach to migration to Basel II implementation
 Basel II Survey
 Conclusions
 Operational Risk Measurement Approaches under Pillar I
Calculation of Capital Charge
Calculation of Capital
charge
Qualifying Criteria
Basic Indicator Approach
 Average of gross income over
three years as indicator
 Capital charge equals 15% of
that indicator
 No specific criteria
 Compliance with the Basel
Committee’s “Sound Practices
for the Management and
Supervision of Operational
Risk” recommended
Standardized Approach
 Gross income per regulatory
business line as indicator
 Depending on business line,
12%, 15%, or 18% of that
indicator as capital charge
 Total capital charge equals
sum of charge per business
line
 Active involvement of board
of directors and senior
management
 Existence of OpRisk
management function
 Sound OpRisk management
system
 Systematic tracking of loss
data
Advanced Measurement Approach (AMA)
 Capital charge equals internally
generated measure based on:
– Internal loss data
– External loss data
– Scenario analysis
– Business environment and
internal control factors
 Recognition of risk mitigation (up
to 20% possible)
 Market discipline reinforces
efforts to promote safety and
soundness in banks
 Core disclosures (basic
information) and supplementary
disclosures to make market
discipline more effective
 Operational risk is inherent to banking business and not
received adequate attention in past
Banking

Commercial Payment and Treasury

Retail Banking
Banking Settlement (Trading & Sales)

Retail Deposits & Payments and

Project Finance Sales
Lending Collections

Private Banking Trade Finance Funds Transfer Market Making

ACTIVITY

Card Services Working Capital Clearing and Proprietary

Finance Settlement Positions

Treasury
Advisory Services

Internal External Employment Clients, Physical Business Execution,

Fraud Fraud Practices & Products & Damage to Disruption and Delivery &
Operation Risk Workplace Business Assets System Process
categories Safety Practices Failures Management
 Designing and implementing action plans for operational risk management could be in many forms,
Basel accord
depending requires
on the bank’s needs . . . Practices for Management and Supervision of
Sound
operational Risk

 Establish a structured risk management framework for the

bank
 Redesign process and approach
 Strengthen existing controls, policies and procedures
 Invest in staff training
 Automate processes
 Acceptance of risk as cost of doing business
 Transfer risk through subcontracting
 Contingency plan - Insurance
 Create risk awareness culture

…based on a cost-benefit assessment

Agenda

 Understanding the global trends

 Evolution of Basel II
 Basel II – The Three Pillars
 Capital Adequacy Calculation
 Overview of the New Basel Capital Accord
 Credit Risk Measurement Approaches under Pillar I
 Operational Risk Measurement Approaches under Pillar I
 Strategic implications on Banking sector
 Challenges in Basel II implementation
 Phased approach to migration to Basel II implementation
 Basel II Survey
 Conclusions
 Strategic implications on Banking sector

Capital requirements Products

Capital release:  Focus on key products / those with
 Prime mortgages best return on regulatory capital
 High quality corporate lending  Impact of differing capital treatment
 High quality liquidity portfolios and return transparency will impact
 Collaterised & hedged exposures product design
Capital absorption:  Increased risk based product pricing
 Leveraged finance for those on sophisticated credit risk
 Specialised lending approaches
 Small business  Those with less sophisticated risk
 Commitments & pipeline approaches may be priced out of the
Opportunities to use surplus capital market

Wider market Customers

Basel II
 Significant barriers to entry as a bank  Increased transparency of account
 Increased competition for low risk profitability
customers  Risk-differentiated customer
 Disclosure under Pillar III management through:
 Peer group pressure will lead to adoption - Winners:
of more advanced approaches - Prime mortgage customers
 Risk Transfer: - Well rated entities
- Outside Basel regulated banking - Losers:
system e.g. insurance industry - Small & medium sized businesses
- Higher credit risk individuals
Agenda

 Understanding the global trends

 Evolution of Basel II
 Basel II – The Three Pillars
 Capital Adequacy Calculation
 Overview of the New Basel Capital Accord
 Credit Risk Measurement Approaches under Pillar I
 Operational Risk Measurement Approaches under Pillar I
 Strategic implications on Banking sector
 Challenges in Basel II implementation
 Phased approach to migration to Basel II implementation
 Basel II Survey
 Conclusions
 Challenges in Basel II implementation

Constituent Challenges

Banks  Interpret new regulations and understand effects on business

 Secure and maintain board and senior management sponsorship
 Face new expectations from regulators, rating agencies, and customers
 Need to consider whether to target certain customers/products or eliminate others

Customers  Face new costs resulting from need to provide lenders with new, timely information
 Use key performance indicators to monitor performance
 Face request for better collateralization
 Manage rating process

Regulators  Need well-trained, educated professionals to fill roles.

 Create regulation that reflects the linkages among risks
 Provide incentives for banks to evaluate risks through stress-testing and scenario
analysis

Rating Agencies  Seek to improve reputation (national agencies)

 Maintain high quality of ratings

Financial  Interpret new regulations and understand effects on business and risk management
institutions out of  Demonstrate quality as Basel II emerges as a best practice standard
Basel II’s scope
Agenda

 Understanding the global trends

 Evolution of Basel II
 Basel II – The Three Pillars
 Capital Adequacy Calculation
 Overview of the New Basel Capital Accord
 Credit Risk Measurement Approaches under Pillar I
 Operational Risk Measurement Approaches under Pillar I
 Strategic implications on Banking sector
 Challenges in Basel II implementation
 Phased approach to migration to Basel II implementation
 Basel II Survey
 Conclusions
 Phased approach to migration to Basel II implementation

Phase Phase Phase Phase

1 2 USE 3
TEST 4
MONITOR
ASSESS AND PLAN DESIGN AND IMPLEMENT AND AND
APPROVAL CONTROL

Corporate Governance/
ORGANIZATION Risk Management

Basel II Implementation

Use Test and Approval

Basel II Roll-Out Plan
Credit Risk

Monitor and Control

implementation
Impact Analysis

PROCESSES
Gap Analysis

Master Plan
Approach Operational Risk
Basel II
METHODS Market and Other Risks

Capital Planning
DATA
Disclosure
(including linkage to IFRS)

SYSTEMS Supervisory Review Process

BASEL II PROJECT MANAGEMENT

Agenda

 Understanding the global trends

 Evolution of Basel II
 Basel II – The Three Pillars
 Capital Adequacy Calculation
 Overview of the New Basel Capital Accord
 Credit Risk Measurement Approaches under Pillar I
 Operational Risk Measurement Approaches under Pillar I
 Strategic implications on Banking sector
 Challenges in Basel II implementation
 Phased approach to migration to Basel II implementation
 Basel II Survey
 Conclusions
Basel II Survey

245 participants, most from Asia-Pacific

Survey conducted by Ernst & Young in conjunction with AsiaRisk from

mid November to early December 2004
Basel II Survey

Two third of respondents indicated that they are either in early

stages of implementation or have not yet started
Basel II Survey

Internal rating and its linkage to business processes were

identified as key concerns for credit risk management
Basel II Survey

Operational risk management has progressed, while concerns

were raised in some quantitative areas
Basel II Survey

Most institutes expect major benefits from Basel II beyond

regulatory capital reduction
Agenda

 Understanding the global trends

 Evolution of Basel II
 Basel II – The Three Pillars
 Capital Adequacy Calculation
 Overview of the New Basel Capital Accord
 Credit Risk Measurement Approaches under Pillar I
 Operational Risk Measurement Approaches under Pillar I
 Strategic implications on Banking sector
 Challenges in Basel II implementation
 Phased approach to migration to Basel II implementation
 Basel II Survey
 Conclusions
Conclusions

 Basel II generally favors retail lending over corporate lending

 The implementation of Advanced Approaches, such as IRB Approach for
credit risk and Advanced Measurement Approach for Operational Risk,
require much more preparation and pose several challenges for both the
banks as well as the supervisors.
 The banks would require to meet the minimum requirements relating to
internal ratings at the outset and on an ongoing basis.
 The manpower skills, the IT infrastructure and MIS at the banks would
have to be upgraded substantially
 The supervisors would require developing skills in validation and back
testing of models.
 The banks would need to improve the disclosure practices and adhere to
international standards
 With the focus on regulation and risk management in the Basel II
framework gaining prominence, the post Basel II era will belong to the banks
who manage their risks effectively.
Conclusions

Basel II will make the world less risky