Basel Norms: An Overview
Why Regulate Banks?
Insurance for deposit holders
Leading to systemic risk
Should regulator bail out banks?
History of Bank Regulation
Pre-1988
1988: BIS Accord (Basel I)
1996: Amendment to BIS Accord
1999: Basel II first proposed
2010: Basel III first proposed
Pre-1988
Banks were regulated using balance sheet
measures such as the ratio of capital to assets
Definitions and required ratios varied from
country to country
Enforcement of regulations varied from
country to country
Bank leverage increased in 1980s
Off-balance sheet derivatives trading increased
LDC debt was a major problem
Basel Committee on Bank Supervision set up
1988: BIS Accord
Main Provisions:
Capital must be 8% (9% in India) of risk
weighted amount.
Framework was to be implemented by end 1992
At least 50% of capital must be Tier 1
Tier 1 Capital: common equity, non-cumulative
perpetual preferred shares
Tier 2 Capital: cumulative preferred stock,
certain
types
of
99-year
debentures,
subordinated debt with an original life of more
than 5 years
The Math
RWA
i 1
On-balance sheet
assets: principal
times risk weight
wi Li
j 1
w C
*
j
Derivatives and off-balance
sheet commitments: credit
equivalent amount times
risk weight
For a derivative Cj = max(Vj,0) + ajLj where Vj is
value, Lj is principal and aj is add-on factor
Risk Weights and Capital Allocation
Risk weight (%)
Asset Category (On-balance sheet)
10
Claims on domestic public sector entities
50
Residential mortgages
20
100
Obligation on OECD government and US treasuries.
Claims on OECD banks/securities issued by US
government agencies/Claims on municipalities, NonOECD short-term inter-bank loans
All other claims such as corporate debt/Claims on
both OECD/Non-OECD, Non-OECD long term interbank loans, Commercial real estate etc.
Add-on Factors (% of Principal)
Remaining
Maturity (yrs)
Interest
rate
Exch Rate
and Gold
Equity
<1
0.0
1.0
6.0
7.5
10.0
1 to 5
>5
0.5
1.5
5.0
8.0
Precious
Metals
except gold
Other
Commodities
7.0
10.0
6.0
15.0
7.0
12.0
Example: A $100 million interest rate swap with 3 years to maturity and with
market value of $5 million would have a credit equivalent amount of $5.5
million
Implementation of Basel I
Basel I does not have any legal force
Accepted by G-10 and Non-G10 countries
as global standard
IMF assesses members compliance with
financial sector codes and standards
Market forces and rating agencies
125 countries had adopted Basel I Accord
What has happened since Basel I
Criticism of Basel I
Liberalization and Transformation of the
financial sector
Various amendments to Basel I: the market
risk amendment 1996
The revised capital accord or Basel II
Problems with Basel I
Systematic curtailment of lending and world
recession of 1990
Change in priorities of banks, profit maximizing
investments
Led to financial bubbles, stock market and real
estate booms and then crashes
From commercial lending towards residential
mortgages and public sector securities
Commercial disadvantage of lending to highly
rated borrowers w.r.t. other NBFCs
Problems with Basel I
Does not distinguish among different credit
exposures
Both AAA and BBB assets attract the same
capital charge.
Static measure of default risk.
Does not take into account the probability of
default.
Incentive towards short term lending led to the
late 1990s financial crisis
1996 Amendment to Incorporate
Market Risk
1996 amendment treats trading positions in
bonds,
equity,
foreign
exchange
and
commodity in the market risk framework.
Provides explicit capital charges on banks open
position in each instrument
Provides scope for BIS standardized approach
and internal models approach.
Banks can either choose BIS prescribed model or
their own internal model (e.g. Value at Risk) to
assess
market
risk
subject
to
supervisory
compliance.
1996 Amendment Contd..
Capital charge is to be made on the
following
Held to maturity (HTM) category
Available for sale
Foreign exchange positions
Trading positions in derivatives
Derivatives entered into for hedging trading
book exposures.
The New Basel Capital Accord
Will replace 1988 Basel Accord.
Based on three mutually enforcing
pillars.
Specific reference to operational risk in
banking.
Implementation scheduled for 2007.
The New Basel Capital Accord
PILLAR I
Minimum capital
requirements
Credit risk
Market
Market risk
Operational risk
PILLAR II
Supervisory
Review
Review of the
institutions
capital adequacy
Review of the
internal
assessment
process
PILLAR III
Market
Discipline
Enhancing
transparency
through
rigorous
disclosure
norms.
The New Basel Capital Accord
Total Capital
Credit + Market + Operational
Risk
Risk
Risk
Revised
Unchanged
= Capital Ratio (minimum 8%)
New
The new Accord focuses on revising only the denominator (riskweighted assets), the definition and requirements for capital are
unchanged from the original Accord.
The New Basel Capital Accord
Credit Risk
Standardized approach
Internal Rating Based (IRB) approach
Foundation vs. Advanced
Operational Risk
Basic indicator approach
Standardized approach
Advanced measurement appraoch
Credit Risk and Standardized
Approach
Standardized approach(0% to 150%)
The capital required is estimated as
Exposure at Default (EAD) Risk weight (RW)
8%
The risk weights are standardized under Basel II.
Credit Risk and Standardized
Approach
Risk weights of sovereigns
Credit
Assessment
AAA to A+ to
AAA-
Risk
0
weights (%)
20
BBB+ to
BBB-
BB+ to B- Below
B-
Unrated
50
100
100
150
Credit Risk and Standardized
Approach
Risk weights of corporates
AAA to AA- A+ to
ARisk weights 20
(%)
50
BBB+
to
BB-
100
Below Unrated
BB150
Risk weights of retail exposure at 75%
Credit derivatives are considered
100
Implications of the Standardized
Approach
Emphasis on credit ratings increase difficulty in
accessing bank finance for unrated companies,
especially SMEs
Loans to SMEs may be classified under retail
exposures, 75% risk weight
Higher capital requirements during recession
Credit Risk and IRB Approach
IRB approach is based on four key
parameters
Probability of default (PD)
Loss given default (1 recovery rate)
Exposure at default (EAD)
Effective Maturity
Credit Risk and IRB Approach
Foundation approach
Only PDs are internally estimated and all
other parameters such as LGD and EAD are
standardized as per supervisory estimates
Advanced approach
All parameters are internally determined
including the LGD.
Operational Risk
Basic indicator approach
Sets the charge for operational risk as 15%
of positive annual gross income averaged
over the previous three years.
Thus links to the risk of an expected loss
due to internal or external events.
Operational Risk
Basic indicator approach
KBIA = EI*
Where
KBIA = the capital charge under the Basic Indicator
Approach
EI = the level of an exposure indicator for the whole
institution, provisionally gross income
= a fixed percentage, set by the Committee, relating
the industry-wide level of required capital to the
industry-wide level of the indicator
Operational Risk
Standardized approach
Requires that the institution partition its
operation into different lines of business.
The capital charge is estimated as an
exposure indicator for each line of business
multiplied by a coefficient.
Provisionally, the Basel committee intends to
use gross income for this purpose.
Operational Risk
Standardized approach
KTSA = (EI*)
Where:
KTSA
= the capital charge under the Standardized
Approach
EI
= the level of an exposure indicator for each of
the 8 business lines
= a fixed percentage, set by the Committee, relating
the level of required capital to the level of the gross
income for each of the 8 business lines
Operational Risk
Business Lines
Corporate finance
Trading and sales
Retail banking
Commercial banking
Payment and settlement
Agency services
Asset management
Retail brokerage
Beta Factor
18%
18%
12%
15%
18%
15%
12%
12%
Operational Risk
Advanced measurement approach (AMA)
Capital requirement is based on banks
internal
operational
risk
measurement
system.
Focuses
on
both
measurement
and
management of operational risk.
Requires supervisory approval based on
qualitative and quantitative standards.
Operational Risk
Advanced measurement approach
KIMA = (EIij*PEij*LGEij*ij)
KIMA = the capital charge under the Internal Measurement
Approach
EIij = the level of an exposure indicator for each business line and
event type combination
PEij = the probability of an event given one unit of exposure, for
each business line and event type combination
LGEij = the average size of a loss given an event for each business
line and event type combination
ij = the ratio of capital to expected loss for each business line and
event type combination
Market Risk
Risk of loss due to movements in market
prices of assets
Asset categories
Fixed income vs. others
Principal risk
Interest rate and volatility risk
Market Risk for Fixed Income
Standardized Approach
Internal Model Based Approach
VaR could be used for market risk
Market Risk for Other Assets
Standardized Approach
Classify assets based on type, origin,
maturity, and volatility
Assign weights from 2.25% to 100%
Scenario analysis is must
Internal Model Approach
VaR with a 10-day time horizon and at 99%
confidence level
Market Risk Charge
The capital requirement for market risk is
Max(VaRt-1 , mc * VaRavg ) + SRC
where mc = multiplicative factor, minimum is 3
SRC = specific risk charge
Back Testing and Capital Charge
Basel II and Total Capital
Total Capital = 0.08 * (credit risk
RWA + market risk RWA +
operational risk RWA)
Supervisory Review Process
Four basic principles
Banks should have a process for assessing
their overall capital
Supervisory review of banks internal capital
adequacy and compliance
Supervisor must expect the banks to
operate
above
the
minimum
capital
requirements.
Appropriate intervention on behalf of the
supervisor before it gets too late!
Market Discipline
Comprehensive disclosure is essential for
market participants to understand the
relationship between risk profile and
capital of an institution.
Includes the disclosure of capital
structure,
capital
adequacy,
risk
exposure such as market, credit and
operational etc.
Basel II Limitations
Capital charge for specific risk (credit risk)
in market risk framework (trading book)
was lower than capital charge for credit
risk in banking book
Lower capital charge for trading book led to
scope for capital arbitrage
Capital charge for counterparty credit risk
for derivative positions also covered only
the default risk and migration risk was
not captured
Basel II Limitations cont
The global financial crisis mostly
happened in the areas of trading book
/off balance sheet derivatives / market
risk and inadequate liquidity risk
management
Banks suffered heavy losses in their
trading book
Banks did not have adequate capital to
cover the losses
Basel III
Objectives
Improving banking sectors ability to absorb
shocks
Reducing risk spillover to the real economy
Fundamental reforms proposed in the
areas of
Micro prudential regulation at individual bank
level
Macro prudential regulation at system wide
basis
Basel III
Key characteristic of the financial crisis
was
inaccurate
and
ineffective
management of liquidity risk
Two standards/ratios proposed
Liquidity Coverage Ratio (LCR) for short
term (30 days) liquidity risk management
under stress scenario
Net Stable Funding Ratio (NSFR) for
longer term structural liquidity mismatches
Basel III
Liquidity Coverage Ratio (LCR)
Ensuring enough liquid assets to survive an
acute stress scenario lasting for 30 days
Defined as stock of high quality liquid assets
/ Net cash outflow over 30 days > 100%
Stock of high quality liquid assets: Cash +
central bank reserves + high quality sovereign
paper (also in foreign currency supporting
banks operation) + state govt., & PSE assets
and high rated corporate/covered bonds at a
discount of 15%
Level 2 liquid assets with a cap of 40%
Basel III
Net Stable Funding Ratio (NSFR)
To promote medium to long term structural
funding of assets and activities
Defined as Available amount of stable
funding / Required amount of stable
funding > 100%
Basel III: Capital Rules
Capital Conservation Buffer
Make certain that banks accumulate capital
buffers in times of low financial stress
Use the same during financial stress
Counter Cyclical Buffer
Capital
requirements
must
consider
macroeconomic environment and credit
growth in the economy
Impact on Indian banks
Most of Indian banks are not trading banks,
so not much increase in enhanced risk
coverage for counterparty credit risk
Whether our SLR securities can be part of
liquid assets?
Indian banks are generally not as highly
leveraged as their global counterparts
The leverage ratio of Indian banks would be
comfortable
