evolution to basel ii(fdic)
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First Basel Accord
The first Basel Accord (Basel I) was
completed in 1988 Set minimum capital standards for banks
Standards focused on credit risk, the main riskincurred by banks
Became effective end-year 1992
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Reason for the Accord
To create a level playing field for
internationally active banks Banks from different countries competing for the
same loans would have to set aside roughly thesame amount of capital on the loans
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1988 Accord Capital Requirements
Capital was set at 8% and was adjusted by a
loans credit risk weight Credit risk was divided into 5 categories: 0%,
10%, 20%, 50%, and 100%
Commercial loans, for example, were assigned to
the 100% risk weight category
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Risk-Based Capital
The Accord was hailed for incorporating risk
into the calculation of capital requirements
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Risk Weights
Risk weights were based on what the parties
to the Accord negotiated rather than on theactual risk of each asset
Risk weights did not flow from any particularinsolvency probability standard, and were for the
most part, arbitrary
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Operational and Other Risks
The requirements did not explicitly account
for operating and other forms of risk that mayalso be important
Except for trading account activities, the capitalstandards did not account for hedging,
diversification, and differences in riskmanagement techniques
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Banks Develop Own Capital
Allocation Models
Advances in technology and finance allowed
banks to develop their own capital allocation(internal) models in the 1990s
This resulted in more accurate calculations ofbank capital than possible under Basel I
These models allowed banks to align theamount of risk they undertook on a loan withthe overall goals of the bank
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Internal Models and Basel I
Internal models allow banks to more finely
differentiate risks of individual loans than ispossible under Basel I
Risk can be differentiated within loan categoriesand between loan categories
Allows the application of a capital charge toeach loan, rather than each category of loan
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Variation in Credit Quality
Banks discovered a wide variation in credit
quality within risk-weight categories Basel I lumps all commercial loans into the 8%
capital category
Internal models calculations can lead to capital
allocations on commercial loans that vary from1% to 30%, depending on the loans estimatedrisk
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Capital Arbitrage
If a loan is calculated to have an internal
capital charge that is low compared to the8% standard, the bank has a strong incentiveto undertake regulatory capital arbitrage
Securitization is the main means used by U.S.
banks to engage in regulatory capitalarbitrage
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Example of Capital Arbitrage
Assume a bank has a portfolio of commercial loans with the followingratings and internally generated capital requirements AA-A: 3%-4% capital needed
B+-B: 8% capital needed B- and below: 12%-16% capital needed
Under Basel I, the bank has to hold 8% risk-based capital against all ofthese loans
To ensure the profitability of the better quality loans, the bank engagesin capital arbitrage--it securitizes the loans so that they are reclassifiedinto a lowerregulatory risk category with a lower capital charge
Lower quality loans with higher internal capital charges are kept on thebanks books because they require less risk-based capital than thebanks internal model indicates
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New Approach to Risk-Based Capital
By the late 1990s, growth in the use of
regulatory capital arbitrage led the BaselCommittee to begin work on a new capitalregime (Basel II)
Effort focused on using banks internal rating
models and internal risk models June 1999: Committee issued a proposal for
a new capital adequacy framework to replacethe 1998 Accord
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Basel II
Basel II consists of three pillars: Minimum capital requirements for credit risk,
market risk and operational riskexpanding the1988 Accord (Pillar I)
Supervisory review of an institutions capitaladequacy and internal assessment process (Pillar
II) Effective use of market discipline as a lever to
strengthen disclosure and encourage safe andsound banking practices (Pillar III)
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Pillar I
In the United States, all banks that will be
required to conform to the new capitalstandard will use the Advanced InternalRatings Based approach (AIRB)
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AIRB Approach Requirements
Collect sufficient data on loans to develop a
method for rating loans within variousportfolios
Develop a Probability of Default (PD) foreach rated loan
Develop a Loss Given Default (LGD) for eachloan
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Example: Safe v. Risky Loans
Safe loans:
Over a 1-year period, only 0.25% of these loansdefault
If a loan defaults, the bank only loses 1% on theoutstanding amount
Risky loans:
Over a 1-year period, 1% of loans default everyyear
If a loan defaults, the bank loses 10% of theoutstanding amount
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Example: Safe v. Risky Loans
(continued)
For a $100 million in a risky portfolio the
bank would expect to see $1 million indefaults in a year and a loss on the defaultsof $100,000
($100 million X 1% = $1 million)
($1 million X 10% = $100,000)
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Goal of Pillar I
Although simplistic, this example
demonstrates what Pillar I is trying to achieve If the banks own internal calculations show thatthey have extremely risky, loss-prone loans thatgenerate high internal capital charges, theirformal risk-based capital charges should also behigh
Likewise, lower risk loans should carry lower risk-based capital charges
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Complexity of Pillar I
Banks have many different asset classes
each of which may require different treatment Each asset class needs to be defined and theapproach to each exposure determined
Minimum standards must be established for
rating system design, including testing anddocumentation requirements
The proposals must be tested in the real world
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Assessing Basel II
To determine if the proposed rules are likely
to yield reasonable risk-based capitalrequirements within and between countriesfor banks with similar portfolios, fourquantitative impact studies (QIS) have been
undertaken
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Operational Risk
Pillar I also adds a new capital componentfor operational risk Operational risk covers the risk of loss due to
system breakdowns, employee fraud ormisconduct, errors in models or natural or man-made catastrophes, among others
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Pillars II and III
Progress has also been made on Pillars IIand III
Pillar II focuses on supervisory oversight
Pillar III looks at market discipline and publicdisclosure
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Pillar II
Supervisory Oversight
Requires supervisors to review a banks capitaladequacy assessment process, which mayindicate a higher capital requirement than Pillar Iminimums
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Pillar III
Market discipline and public disclosure
The United States is currently in the forefront ofdisclosure of financial data SEC disclosure requirements for publicly traded banks
Bank regulators require quarterly filing of call reports forall banks
U.S. authorities are currently considering whatbanks should publicly disclose about their Basel IIcalculations
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U.S. Implementation of Basel II
Based on results for QIS4, which show thepotential for substantial declines in capital,the U.S. banking regulators have proposed arevised implementation timeline
The revised timeline includes a minimum three-
year transition period
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Revised U.S. Timeline for Basel II
Implementation
Year Transistional Arrangements
2008 Parallel Run
2009 95% floor
2010 90% floor
2011 85% floor
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Basel I-A: The Search for Equal
Capital Treatment
In the U.S., concerns that Basel II could givethose banks operating under it a competitiveadvantage over other banks has resulted in aproposal called Basel 1-A
Basel 1-A is designed to modernize the way
allU.S. banks and thrifts calculate theirminimum capital requirements
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Implications
The practices in Basel II represent severalimportant departures from the traditional
calculation of bank capital The very largest banks will operate under a
system that is different than that used by otherbanks
The implications of this for long-term competitionbetween these banks is uncertain, but meritsfurther attention
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Implications
The proposed Accord will elevate theimportance of human judgment in theprocess of capital regulation
Despite its quantitative basis, much will dependon the judgment of banks in formulating theirestimates and of supervisors in validating theassumptions used by banks in their models
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I li i
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ImplicationsAdditional Data Needed to Counterbalance to Changes inEnvironment
Higher
Leverage
Unproven
Rating
Systems
Evolving
Control
Structures
Three Year
Floors/Leverage
Ratio
Improved RiskManagement
Changes in environment
necessitate changes in riskanalysis for banks and
supervisors/insurers
Additional information will be
needed to:
Inform policy development.
Supplement other sources of
risk information used in
supervisory resource planningand overall risk assessments
Serve as an input into deposit
insurance pricing and overall
insurance funds adequacy
analyses
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Why XBRL ?
Internal ratings based and standard approachmeasures require complex data model Common data requirements flow from Accord and
Quantitative Impact Studies (QIS I IV)
Domestic and international comparisons needed to ensureconsistent application
Taxonomy needed to compare banks internal ratings of
similar and diverse risks
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Common Data Elements Flow from Accord:Standardized Internal Risk Estimates
Exposure
Internal RiskEstimate
P
D
LG
D
EA
D
M
Other
Wholesale X X X X -
Retail X X X - -
Securitization - - - - X
Equity - - - - X
Market Risk - - - - X
Operational
Risk
- - - - X
Data Types Reporting Granularity
Portfolio
Level Data
Individual
Exposure Data for
All Transactions
Summary
Data
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Why XBRL ?
Internal ratings based measures and standard approach requirecomplex data model
Supervisors need detailed information to qualify banks foradvanced approaches (IRB, AMA, and Market Risk)
Data can be shared across different supervisory regimes
- Independent of systems, platforms, geography and languagetranslation
Consistent data needed to help identify risk estimates
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Consistent data needed to help identify risk estimatesthat may be inconsistent with peer estimates.
Follow-up: Can differences between Banks PD and benchmark be adequately
explained by differences in risk?
0
5
10
15
20
25
30
35
40
AA or better A to AA BBB to A BB to BBB B to BB >B
Banks PD Distribution Mapped to S&P Rating Scale
Peer Banks PD Distribution Mapped to S&P Rating Scale
% of Wholesale Exposures
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Why XBRL ?
XBRL provides a framework for complex datamodel
Open standard facilitates reuse and innovation
Analysts can spend more time analyzing data
Reduced reporting burden, especially for
organizations operating in multiple jurisdictions
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Why XBRL ?
FINIS