basel ii implementation update - world...
TRANSCRIPT
Basel II Implementation Update
World Bank/IMF/Federal Reserve System Seminar for Senior Bank Supervisors from Emerging Economies15-26 October 2007
Elizabeth RobertsDirector, Financial Stability Institute
Agenda
Review of the Key Concepts of Basel IBasel II: A Brief OverviewBasel II: Implementation Considerations
Why adequate capital is important
Capital absorbs unexpected losses and provides time to address problems– Expected losses covered by reserves
Protects depositors, the insurance fund, and taxpayersDisciplines growthFosters financial stability
All other things being equal, higher capital levels reduce the likelihood that a bank will become insolvent.
What Factors Drive Capital Levels?
Management strategy– the level which management deems appropriate based
on internal assessmentsMarket views– e.g. counterparties, rating agencies
Shareholder expectations– Return on capital
Regulatory capital requirements– Basel Accord
The 1988 Basel Capital Accord
Established minimum capital requirements to cover credit risk only but with inherent buffer for other risksWhile the adoption of these standards was initially intended for large internationally active banks incorporated in Basel Committee countries, it is now applied in more than 100 jurisdictions around the worldIn many countries, it is applied to solely domestic banks as well as to the internationally active banks
Key Elements of the 1988 Capital Accord
Common definition of capital– Tier 1– Tier 2
Use of risk weights for categories of assets– 0, 20, 50 and 100 percent
Capital requirement for off-balance sheet itemsMinimum capital ratios– 4% tier 1 capital to total risk-weighted assets– 8% total capital to total risk-weighted assets
Definition of Capital
Tier 1: Core capital– Elements with the highest loss absorption capacity
Tier 2: Supplementary capital– A wide range of elements whose availability to cover
losses is more limited– Not all elements permitted in all countries– More of a menu of elements
Tier 3: Additional supplementary capital– Can only be used to meet a proportion of a bank’s
capital requirements for market risk
From Basel I to Basel II
Work since 19881996: Amendment to the Accord to incorporate market risks (implementation: end-1997)
Many additional clarifications and refinements
1999: a new capital framework – first discussion paper
2001: a revised draft
2003: the third draft of the proposed changes
June 2004: publication of the “final” document
Merits of the 1988 Accord
Substantial increases in capital ratios of internationally active banksRelatively simple structure Worldwide adoptionIncreased competitive equality among international banksGreater discipline in managing capitalA benchmark for assessment by market participants
Weaknesses of the 1988 Accord
Does not assess capital adequacy in relation to a bank’s true risk profile– Limited differentiation of credit risk– No explicit recognition of operational and other risks
Sovereign risk not appropriately addressedDoes not provide proper incentives for credit risk mitigation techniques (e.g. hedging)Enables regulatory arbitrage through securitisation, etc.
Key Changes in Basel II
Addition of two new pillars (supervisory review process and market discipline)More reliance on banks’ own assessments of riskGreater recognition of credit risk mitigation techniquesInclusion of a specific capital charge for operational risk
But…perfect rules are not possible– no ideal measurement system for different risks– difficult balance between accuracy and simplicity
Objectives of Basel II
Continue to promote safety and soundnessBetter align regulatory capital to underlying riskCover a more comprehensive range of risksEncourage banks to improve further their risk management systemsFormally recognise the role of supervisorsLeverage market disciplineProvide options for banks (focus is on internationally active banks but suitable for banks of varying levels of complexity and sophistication)
Why Is Basel II So Complex?
More risk sensitivity means more detailIt 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
It is much more comprehensive: two new pillars plus operational risk
The Organisation of the New Accord
Minimum capitalrequirements
SupervisoryReviewProcess
MarketDiscipline
Three Basic Pillars
Outline of the New Accord - Basic Structure
StandardisedApproach
InternalRatings-based
Approach
Credit risk
BasicIndicatorApproach
StandardisedApproach
AdvancedMeasurementApproaches
Operationalrisk
StandardisedApproach
ModelsApproach
Marketrisks
Risk weightedassets
CoreCapital
SupplementaryCapital
Definition ofcapital
Minimum capitalrequirements
Supervisory reviewprocess
Marketdiscipline
ThreeBasic Pillars
Menu of Options for Credit Risk
Standardised approach– based on external assessments of risks
Foundation internal ratings-based approach– based on banks’ own assessments of probability of
defaultAdvanced internal ratings-based approach– based on banks’ own assessments of all risk factors
Drivers of Credit Risk
Type of risk
• Riskiness of borrower
• Riskiness of transaction
• Likely amount of exposure
• Time dimension risk
• Concentration
Driver
Probability of default
Loss given default
Exposure at default
Maturity
Correlations
Recognition of Drivers of Credit Risk
Type of risk
Riskiness of borrower
Riskiness of transaction
Likely amount of exposure
Time dimension risk
Diversification/Concentration
Example: Loan to General Motors of € 500,000, of which € 300,000 is undrawn commitment, € 100,000 iscollateralised by US Treasury Bonds, maturity 3 years
Recognition of Drivers of Credit Risk
Preset correlations
Preset correlationsNot explicitly recognised
Not explicitly recognised
Correlations
Banks‘ own assessments or 2.5 years
2.5 years or banks‘ own assessments
Hardly recognisedHardly recognisedMaturity
Banks‘ own assessments
Credit conversion factors, fixed EADs
Credit conversion factors
Credit conversion factors
Exposure at default
Banks‘ own assessments
Fixed LGDsExpanded list of CRMs
Few CRMs recognised
Loss given default
Banks‘ own assessments
Banks‘ own assessments
External Credit assessment Inst.
Basel CommitteeProbability of default
AIRBFIRBStandardised approach
1988 Accord
The Standardised Approach
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 techniquesBalance between simplicity and accuracySimplest of the three approaches to credit riskWill be used by most banks in the foreseeable future
The Standardised Approach
Main Features:Continue to slot exposures into risk-weighted buckets based on broad distinctions of risk determined by supervisorsRisk-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 - Standardised Approach
Continue to be set by supervisorsRisk weights determined by category of borrower: – sovereign – bank– corporate– retail
Risk weights dependent upon external credit assessments
Claims on Retail
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 bank’s total exposure to the firm must be less than the equivalent of €1 million
• Past due claims do not qualify for this preferentialtreatment
Other Risk Weighting Issues
The unsecured portion of past due assets (90 days or more), net of specific provisions, will be risk weighted at 150%Other assets will continue to be weighted at 100%Maturity is a factor relevant to the assessment of credit risk, but would make the standardized approach more complex
1 Risk weighting based on risk weights of sovereign in which the bank is incorporated, but one category less favourable.
2 Risk weighting based on the assessment of the individual bank.3 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 bank’s claim.
Claim Assessment AAA -
AA- A+ - A- BBB+ - BBB- BB+ - B- Below B- Unrated
Sovereigns (Export credit agencies)
0% (1)
20% (2)
50% (3)
100% (4-6)
150% (7) 100%
Option 11 20% 50% 100% 100% 150% 100%
Banks Option 22 20%
(20%)3 50%
(20%)350%
(20%)3 100% (50%)3
150% (150%)3
50% (20%)3
Corporates 20% 50% 100% BB+ - BB- 100%
Below BB- 150% 100%
Mortgages 35% Retail
Other retai l
75%
Standardised Approach – Risk Weights
The fundamental question: Who is the best judge of a bank‘s exposure to credit risk?
The supervisor?A rating agency?The bank itself?
Internal Ratings-based Approach
Basic Elements of the IRB Approach
Relies on a bank‘s assessment of risk factorsBased on three main elements– Risk components (probability of default, loss-given
default, exposure at default, maturity)– Risk weight function– Minimum requirements
Separate approaches for each portfolio of assetsSubject to supervisory validation and approval
IRB MethodologyIRB replaces the set risk weights (0, 20, 50, & 100 percent) with continuous risk functions (smooth upward sloping curves), which are calibrated by supervisorsFor each wholesale exposure and segment of retail exposures, a bank will estimate four risk parameters– PD, LGD, EAD and Maturity (for each wholesale
exposure)The function maps these variables to capital requirement and risk-weighted asset amounts– Mapping based on the type of exposure (e.g., corporate,
retail) and (potentially) other characteristics (e.g. firm size)– Separate risk weight function for different portfolios
IRB Approach – Risk Components
Component
• Probability of default
• Loss-given-default (LGD)
• Exposure-at-default (EAD)
• Maturity
• Correlations
Recognition
BankFoundation Advanced
45% Bank
100% Bank
2 ½ years Bank
Built into risk weight function (Fixed numbers)
Probability of default (PD)
Risk Components (PD)
Assessment of Borrower Risk
Quantitative information– e.g. balance sheet, income statement, cash flow
Qualitative information– e.g. quality of management, ownership structure
Measures
Loss-given-default (LGD)
Risk Components (LGD)
Assessment of Transaction Risk
Factors: collateral, seniority, recovery time, etc.Two-dimensional rating systems (matrix)– Borrower risk and transaction risk
Measures
Exposure at default (EAD)
Risk Components (EAD)
Amount of Exposure at the Time of DefaultNominal amount for simple structuresFor lines of credit:Amount outstanding + a portion of committed but undrawn lines
Measures
IRB - Categories of Exposures
Corporates– Traditional (sovereigns and banks in principle subject to
same risk weight curve)– SMEs– Specialised lending– High-volatility commercial real estate
Retail– Residential mortgages– Qualifying revolving exposures– Other retail
Equities
Risk Weight Function
“IRB” does not always mean lower capital requirements
0%
5%
10%
15%
20%
25%
0% 2% 4% 6% 8% 10%
PD
Cha
rge Charge
Charge
C & I
Small and medium-sized enterprises (SMEs)
8% (= current Accord
Risk Weight Function
0%
5%
10%
15%
20%
0% 2% 4% 6% 8% 10%
PD
Cha
rge
Other retail (LGD 85%)
Mortgages (LGD 25%)
Revolving (LGD 85%)
Different kinds of assets rely on different risk weight functions (curves)
8% (= current Accord
Concluding Thoughts on Credit Risk
Basel II‘s main goal: more risk sensitivityBasel II offers a range of options for the treatment of credit riskThe Committee is moving away from a „one-size-fits-all“ approach to capital regulationThe IRB approach is primarily aimed at sophisticated banks, with well developed risk management systems in placeThe Standardised Approach is fully valid and beneficial for smaller and less complex banks
Menu of Options for Operational Risk
Basic Indicator Approach– 15% of average gross income over 3 years
Standardised Approach– based on gross income across 8 business lines with
separate scaling factors between 12% and 18% Advanced Measurement Approaches– a variety of approaches based on loss experience;
subject to strict qualitative and quantitative criteria
Pillar 2: Supervisory Review Process
Supporting Pillar 1– Dimensions of risks not considered, e.g. large
exposures and concentrations– Risks not taken into account (liquidity risk, interest rate
risk)– External factors to the bank
Fostering improvements in risk management and in supervisionEnsuring compliance with Pillar 1 requirements – both quantitative and qualitative
Pillar 2: Supervisory Review Process
Pillar 2 is based on four key principles:
1. Bank’s own assessment of capital adequacy2. Supervisory review process3. Capital above regulatory minima4. Supervisory intervention
Pillar 3: Market Discipline
The role of market discipline– A lever to strengthen the safety and soundness of the
system– Reliable and timely information allowing well founded
counterparty risk assessmentsSpecific requirements for disclosure of certain information– composition of capital– risk exposures (credit, market, others)– capital adequacy
Implementation of Basel II
Focus has shifted from drafting the rules to implementation
Implementation will be a major undertaking
Several issues to deal with, including– Implementing the rules– National discretion areas– Cross-border implementation
Basel Committee issued a paper on “practical considerations” in July 2004 – intended as a roadmap for implementation
Accord Implementation Group also seeks to provide guidance
Accord Implementation Group
Mandate: to share information and thereby promote consistency in implementation of the new framework
It is: a forum for discussion and sharing of experiences; collector of information; occasional creator of elaboration and guidance
It is not: a creator of vast amounts of new rules; central control; guarantor of uniformity in application of the new framework
Close contact with non-member countries mainly through regional sessions
What is the time schedule for implementation?
26 June 2004
2004 – 2006
End 2006
End 2007
2007 - ?
• Release of Basel II Framework
• National processes– Impact studies (QIS 5 at end 2005)– Legislation and national rule making
• Committee member implementation of simpler approaches
• Committee member implementation of advanced approaches
• Extended transition period for other countries
FSI 2006 Survey – Implementation of Basel II
Based on a questionnaire sent to 115 jurisdictions
More than 90 countries intend to adopt Basel II
The vast majority of countries will be offering the simpler approaches in the near to medium term
A significant number of countries stated that they intend to adopt the more advanced approaches in the medium to long term
Some countries showed a small delay in selected aspects of implementation from the 2004 survey
One of the major drivers cited: implementation by foreign banks
When should it be implemented?
Only national authorities can answer this questionTiming should be determined by a country‘s own circumstancesBasel II may be a lesser priority compared to other effortsBasel II Framework (June 2004)
– “This document is being circulated to supervisory authorities worldwide with a view to encouraging them to consider adopting this revised Framework at such time as they believe is consistent with their broader supervisory priorities.“ (Paragraph 3)
Some Implementation Issues
Implementation is a domestic/national issueNational discretion areas provide room for adaptation to national circumstancesThe Basel Committee will not judge implementation in individual jurisdictionsIMF and World Bank (through FSAPs) will judge against the text of Core Principle 6 (capital adequacy)
– they will only judge Basel II implementation if you have formally adopted it
There is no single way to implement Basel II
What are supervisors around the world doing?
1. Learning about Basel II2. Reviewing options3. Assessing staffing needs/skills4. Forming Basel II teams5. Talking to banks6. Talking to other supervisors7. Making announcements8. Pursuing legislation, if necessary9. Doing nothing (is this still an option?)
1. Learning about Basel II
Very complex documentWide range of options under national discretionTrying to digest all of the details– Reading and discussing the June 2004 document– Attending seminars, conferences, etc.– Perhaps taking FSI Connect tutorials on Basel II
2. Reviewing options
Stay with Basel IImplement parts of Basel II and if so,– Which parts?– Under what time frame?
Implement all options under Basel II and if so,– Under what time frame?
What to do about the numerous areas of national discretion?
3. Assessing staffing needs/skills
Are more staff required? – In particular, Pillar 2 has staffing implications
Do current staff have the necessary skills?If not, can their skills be enhanced?Demand for vs. supply of individuals with the skills for the more advanced aspects of Basel II
4. Forming Basel II teams
Complexity of Basel II makes it very difficult for one person to be an expert on every aspectConsequently, many supervisory authorities are forming Basel II teams– Everyone has a general awareness of the various
components– Individuals or groups of individuals specialising in
specific aspects of Basel II
Divide and Conquer!
5. Talking to banks
Understanding bank practices and implementation challenges is criticalWhat are banks in your jurisdiction able to do?– Current range of practice in risk management– Readiness of banks (data, staffing, etc)
Industry consultations– Domestic banks– Local subs of foreign banks
• what they will do globally may differ from what they will do locally
Impact on local branches of foreign banks
6. Talking to other supervisors
Home-host supervisory relationship will be critical under Basel II so bilateral discussions should be taking place nowConsultations (and competition!) among supervisors– Regional groups playing a key role in this regard– On the agendas of many regional group meetings– Some regions are even coming up with a plan for
implementation on a regional basis
Cross-border Implementation – Key Challenges
Initial and on-going validation of advanced Pillar 1 approachesRecognition of external ratings in different jurisdictionsSupervisory review process under Pillar 2Banks to focus on managing their risks rather than managing the demands of different supervisorsNeed to develop enhanced cooperation agreementsSome countries are essentially host supervisors only
Cross-border Implementation - Guidance
Committee has provided guidance – High-level principles for cross-border implementation
(August 2003)– Principles for the home-host recognition of AMA
operational risk capital (January 2004)– Enhanced cross-border cooperation (May 2004 press
release)
7. Making announcements
Letting the rest of the world know of their intentions regarding implementation of Basel IIFor example:– United States– European Union– China
Be careful about what you believe in the press!Check supervisory authority websites
8. Pursuing legislation
In many jurisdictions, capital requirements are built into banking legislationIn some jurisdictions, supervisors do not have the necessary legal authority to implement certain aspects of Basel II, especially as it relates to Pillar IIGetting legislation passed can be a lengthy process
9. Doing nothing
It used to be a valid option but:– It is becoming harder to do now that the framework has
been finalised– Will delay important activities such as data collection– In the long run, domestic banks operating
internationally will be penalised– Foreign banks operating locally will not know what is
expected of them by the national supervisor
Conclusion
Publication of June 2004 Framework was only the beginning of a new phase: implementation
Supervisors should have a strategy for implementing Basel II
– It is their decision whether and how to implement Basel II
Cross-border implementation requires a high degree of cooperation and coordination between home and host country supervisors
Capital requirements must be viewed in conjunction with other important standards– The Core Principles– Accounting standards– Risk management
Capital adequacy is only one part of the puzzle
Not every country should be moving to Basel II and not all should be moving to Basel II immediately
Keeping Basel II in Context
Questions?
Elizabeth RobertsDirectorFinancial Stability InstituteBank for International Settlements