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BASEL
I, II, III
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BASEL
A set of international banking regulations put
forth by the Basel Committee on Bank
Supervision, which set out the minimum
capital requirements of financial institutions
with the goal of minimizing credit risk.
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Basle concordat
Basle agreement was originated by a committeeof central bank members of the bank for
international settlement (BIS) in 1975 and since
then amended.
The major amendments were done in 1983; the
agreement stipulates standards and guidelines
for international banking supervision.
The amendments also provide guidelines forsupervision for both domestic and cross-border
banking; a system of loan classification and a
system of provisions of bad loans.
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Basle Capital Accord
Basle capital accord of 1988 and its amendmentsprovide internationally acceptable standards forcapital adequacy of banking institutions andstipulates constituent elements of banks core
and supplementary capital, providing a uniformstandard for banks concerning their financialevaluation, performance and reporting.
These capital adequacy standards are beingwidely adopted by many countries, includingPakistan. (see capital adequacy; capital, core,supplementary)
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Calculation of Capital
Tier One Capital
the ordinary share capital (or equity) of the
bank; and
audited revenue reserves e.g.. retained
earnings; less
current year's losses; future tax benefits; and
intangible assets, e.g. goodwill.
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Calculation of Capital
Upper Tier Two Capital
Un-audited retained earnings;
revaluation reserves;
general provisions for bad debts; perpetual cumulative preference shares (i.e.
preference shares with no maturity date whosedividends accrue for future payment even if the
bank's financial condition does not supportimmediate payment);
perpetual subordinated debt (i.e. debt with nomaturity date which ranks in priority behind all
creditors except shareholders).
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Calculation of Capital
Lower Tier Two Capital
Subordinated debt with a term of at least 5
years;
Sedeemable preference shares which may not
be redeemed for at least 5 years.
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Capital Adequacy
Capital Adequacy: for a bank, adequacy is thesufficiency of capital of a bank to sustain itslending operations and other activities; inparticular, sufficiency of capital of a bank as
determined by central bank or supervisoryauthority to meet its obligation as they falldue, and to meet its loan losses as they arise,or to absorb unexpected trading losses from abanks asset portfolio and its off-balance sheetcommitments.
Capital adequacy for banks is measured in
terms of the ratio of banks capital.
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Capital Adequacy Ratio
CAR is calculated as the sum of tier 1 and tier
2 capital divided by the sum of risk weighted
assets in the balance sheet and credit
equivalents of off- balance sheet assets.
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BASEL I The first accord was the Basel I. It was issued in 1988 and focused
mainly on credit risk by creating a bank asset classification system. Thisclassification system grouped a bank's assets into five risk categories:
0% - cash, central bank and government debt and any OECD
government debt
20% - development bank debt, OECD bank debt, non-OECD bank debt(under one year maturity) and non-OECD public sector debt
50% - residential mortgages
100% - private sector/corporate debt (maturity over a year), real
estate, plant and equipment, capital instruments issued at other banks
Banks with international presence are required to hold capital equal to 8
% of the risk-weighted assets.
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Member Countries
Since 1988, this framework has been
progressively introduced in member countries
of G10, currently comprising 13 countries, na
mely;
Belgium, Canada, France,Germany, Italy, Japan
, Luxembourg, Netherlands, Spain, Sweden, S
witzerland, UK and USA.
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Basel II
The purpose of Basel II, which was initially
published in June 2004, is to create an
international standard that banking regulators
can use when creating regulations about how
much capital banks need to put aside to guard
against the types of financial and operational
risks banks face.
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Basel II
In practice, Basel II attempts to set up rigorousrisk and capital management requirementsdesigned to ensure that a bank holds capitalreserves appropriate to the risk the bank
exposes itself to through its lending andinvestment practices.
Generally speaking, these rules mean thatthe greater risk to which the bank is exposed,the greater the amount of capital the bank needsto hold to safeguard its solvency and overalleconomic stability.
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Basel I to Basel II
New credit risk approaches
o Market risk - unchanged
o Add operational risk portion
3 Pillars
1) Minimum capital requirements
2) Supervisory review
3) Market discipline
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The Basel II Framework
Pillar 1:
Minimum capital
requirements
Pillar 2:Supervisory
review
Pillar 3:Market
discipline
A guiding
principle
for banking
supervision
Credit Risk
Market Risk
Operational Risk
Disclosure
requirements
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Pillar 1: Minimum Capital
Requirements
The calculation of regulatory minimum capital
requirements:
%8assetsweighted-riskTotal
capitalofamountthe
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The Capital and Assets
Definition of capital:
Tier 1 capital + Tier 2 capital (with someadjustments)
Total risk-weighted assets are determined by:
Risk weighted assets of credit risk
plus
12.5* capital requirement for market riskplus
12.5* capital requirement for operational risk
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Minimum Capital Adequacy Ratios
Tier one capital to total risk weighted credit
exposures to be not less than 4 %;
Total capital (i.e. tier one plus tier two less
certain deductions) to total risk weighted
credit exposures to be not less than 8%
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Credit Risk
Standardized Approach
IRB Approach
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Credit Risk -
Standardized Approach
In determining the risk weights in the
standardized approach, banks may use
assessments by external credit assessment
institutions.
AssetsofValusBookAssetsfortRisk Weigh
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Risk Weight for Assets
Credit
Assessment
Claims on sovereigns Claims on banks and securities firms
Claims on
corporatesECA risk
scores
Risk
Weight
Credit
assessment of
Sovereign
Credit assessment of Banks
Risk weight
Risk weight
for short-term
AAA to AA- 1 0% 20% 20% 20% 20%
A+ to A- 2 20% 50% 50% 20% 50%
BBB+ to BBB- 3 50% 100% 50% 20% 100%
BB+ to BB- 4~6 100% 100% 100% 50% 100%
B+ to B- 4~6 100% 100% 100% 50% 150%
Below B- 7 150% 150% 150% 150% 150%
Unrated - 100% 100% 50% 20% 100%
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Credit Risk - IRB Approach
In the internal ratings-based (IRB) approach,
its based on banks internal assessment.
The approach combines the quantitative
inputs provides by banks and formula
specified by the Committee.
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Credit Risk - IRB Approach
Four quantitative inputs (risk components):
Probability of default (PD)
Loss given default (LGD) Exposure at default (EAD)
Maturity (M)
Use formula of the Committee to calculate theminimum requirements.
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Credit Risk - IRB Approach
Data Input Foundation IRB Advanced IRB
Probability of default
(PD)
From banks From banks
Loss given default
(LGD)Set by the Committee
From banks
Exposure at default
(EAD) Set by the Committee
From banks
Maturity (M) Set by the Committee or
from banks
From banks
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Market Risk
Standardised method
- the standards of the Committee
Internal models
- use banks internal assessments
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Operational Risk
The risk of losses results from inadequate or
failed internal processes, people and system,
or external events.
Basic Indicator Approach
Standardised Approach
Advanced Measurement Approaches(AMA)
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Operational Risk -
Basic Indicator Approach
GI = average annual gross income(three years,
excepted the negative amounts)
= 15%
GIKBIA
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Operational Risk -
Standardised Approach
GI 1-8 = average annual gross income frombusiness line from one to eight (three years,excepted the negative amounts)
= A fixed percentage set by the Committee
81GIKTSA
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Beta of Business Lines
Business Lines Beta Factors
Corporate finance (1) 18%
Trading and sales (2) 18%
Retail banking (3) 12%
Commercial banking (4) 15%
Payment and settlement (5) 18%
Agency services (6) 15%
Asset management (7) 12%
Retail brokerage (8) 12%
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Operational Risk - Advanced
Measurement Approaches
Under the AMA, the regulatory capital
requirement will equal the risk measure
generated by the banks internal operational
risk measurement system using thequantitative and qualitative criteria for the
AMA.
Use of the AMA is subject to supervisoryapproval.
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Pillar 2: Supervisory Review
Principle 1: Banks should have a process for
assessing and maintaining their overall capital
adequacy.
Principle 2: Supervisors should review and
evaluate banks internal capital adequacy
assessments and strategies.
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Supervisory Review
Principle 3: Supervisors should expect banks
to operate above the minimum regulatory
capital ratios.
Principle 4: Supervisors should intervene at an
early stage to prevent capital from falling
below the minimum levels.
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Pillar 3: Market Discipline
The purpose of pillar three is to complement
the pillar one and pillar two.
Develop a set of disclosure requirements to
allow market participants to assess
information about a banks risk profile and
level of capitalization.
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Basel III BIS began referring to this new international regulatory framework
for banks as "Basel III in September 2010. The draft Basel III
regulations include:
"tighter definitions of Tier 1 capital; banks must hold 4.5%by January 2015, then a further 2.5%, totalling 7%.
the introduction of a leverage ratio,- (Put a floor under the build-upof leverage in the banking sector)
Promote more forward looking provisions;
a framework for counter-cyclical capital buffers,
and short and medium-term quantitative liquidity ratios.(isintroducing a global minimum liquidity standard for internationally active banks )
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What is procyclicality?
In particular, the financial regulations ofthe Basel II Accord have been criticized fortheir possible procyclicality.
The accord requires banks to increasetheir capital ratios when they face greaterrisks. Unfortunately, this may require them tolend less during a recession or a credit crunch,which could aggravate the downturn.