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Basel I Ii Iii Report Submitted by Sachin Todur (B0924) : Financial Management Phase III Igtc Bangalore
Basel I Ii Iii Report Submitted by Sachin Todur (B0924) : Financial Management Phase III Igtc Bangalore
Bangalore
Basel I II III
Report submitted
by
Sachin Todur (B0924)
Introduction
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Basel I is the round of deliberations by central bankers from around the world, and
in 1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set of
minimal capital requirements for banks. This is also known as the 1988 Basel
Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992 .
Basel I is now widely viewed as outmoded. Indeed, the world has changed as
financial conglomerates, financial innovation and risk management have developed.
Therefore, a more comprehensive set of guidelines, known as Basel II are in the
process of implementation by several countries and new updates in response to the
financial crisis commonly described as Basel III.
Background
This incident prompted the G-10 nations to form towards the end of 1974, the Basel
Committee on Banking Supervision, under the auspices of the Bank of International
Settlements (BIS) located in Basel, Switzerland.
Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of
banks were classified and grouped in five categories according to credit risk,
carrying risk weights of zero (for example home country sovereign debt), ten,
twenty, fifty, and up to one hundred percent (this category has, as an example,
most corporate debt). Banks with international presence are required to hold capital
equal to 8 % of the risk-weighted assets.
Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of
banks were classified and grouped in five categories according to credit risk,
carrying risk weights of zero (for example home country sovereign debt), ten,
twenty, fifty, and up to one hundred percent (this category has, as an example,
most corporate debt). Banks with international presence are required to hold capital
equal to 8 % of the risk-weighted assets. However, large banks like JPMorgan Chase
found Basel I's 8% requirement to be unreasonable, and implemented credit default
swaps so that in reality they would have to hold capital equivalent to only 1.6% of
assets.
Since 1988, this framework has been progressively introduced in member countries
of G-10, currently comprising 13 countries, namely, Belgium, Canada, France,
Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland,
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United Kingdom and the United States of America. Most other countries, currently
numbering over 100, have also adopted, at least in name, the principles prescribed
under Basel I. The efficiency with which they are enforced varies, even within
nations of the Group of Ten.
Basel II is the second of the Basel Accords, which are recommendations on banking
laws and regulations issued by the Basel Committee on Banking Supervision. 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. Advocates of Basel II believe that such an
international standard can help protect the international financial system from the
types of problems that might arise should a major bank or a series of banks
collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk
and capital management requirements designed to ensure that a bank holds capital
reserves appropriate to the risk the bank exposes itself to through its lending and
investment practices. Generally speaking, these rules mean that the greater risk to
which the bank is exposed, the greater the amount of capital the bank needs to
hold to safeguard its solvency and overall economic stability.
Objective
While the final accord has largely addressed the regulatory arbitrage issue,
there are still areas where regulatory capital requirements will diverge from
the economic.
Basel II has largely left unchanged the question of how to actually define
bank capital, which diverges from accounting equity in important respects.
The Basel I definition, as modified up to the present, remains in place.
The Basel I accord dealt with only parts of each of these pillars. For example: with
respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple
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manner while market risk was an afterthought; operational risk was not dealt with
at all.
For operational risk, there are three different approaches - basic indicator
approach or BIA, standardized approach or TSA, and the internal
measurement approach (an advanced form of which is the advanced
measurement approach or AMA).
1. Standardised Approach
The standardised approach sets out specific risk weights for certain types of
credit risk. The standard risk weight categories are used under Basel 1 and
are 0% for short term government bonds, 20% for exposures to OECD Banks,
50% for residential mortgages and 100% weighting on unsecured
commercial loans. A new 150% rating comes in for borrowers with poor
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For those Banks that decide to adopt the standardised ratings approach they
will be forced to rely on the ratings generated by external agencies. Certain
Banks are developing the IRB approach as a result.
BASEL III (sometimes "Basel 3") refers to a new update to the Basel Accords
that is under development. The term appeared in the literature as early as
2005 and is now in common usage anticipating this next revision to the
Basel Accords. The Bank for International Settlements (BIS) itself began
referring to this new international regulatory framework for banks as "Basel
III" in September 2010.
• First, the quality, consistency, and transparency of the capital base will
be raised.
o Tier 1 capital: the predominant form of Tier 1 capital must be
common shares and retained earnings
o Tier 2 capital instruments will be harmonised
o Tier 3 capital will be eliminated.
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In some cases, vendors provide multiple models as part of a “suite” within a single
product offering. The alternative models may reflect differing measures of the credit
event (such as different measures of default or delinquency), or may be based on
different methods or different sets of variables. In other cases, modelling
alternatives are offered as distinct products from a given vendor, or are marketed
and supported by different organisational units within a single vendor firm. Banks
using vendor models thus must choose not only among competing vendors, but
among the models offered by a particular vendor. Since the most appropriate model
generally varies depending on the specific business application, having a choice of
models is valuable; however, the larger the number of choices, and the smaller the
differences between the various alternatives, the more complicated the decision
becomes for potential users.
The number of users varies widely between models. Some models had few current
clients, although this was unusual and may have simply reflected an early stage of
the product’s life cycle. A few models have been widely adopted across the financial
industry, although in some cases vendors appear to count firms as clients even if
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the model was purchased only for testing purposes, or was being used in a limited
way by staff in one part of a large firm.
Most products provide clear and intuitive output to model users. The output of many
vendor products includes not only the essential modelling results, but also other
information to support interpretation and use, such as key factors that determine
the final result, benchmarks for comparison or mapping between different risk
scales (such as between ratings or scores and default probabilities). In a few cases,
ease of use appears to be one of the main “value propositions” of the vendor
model, particularly where the product reflects simple or well-known methods and
publicly available data.
One potential barrier to use of any vendor product is the need for a technological
platform, one that meets relevant technical requirements. For most vendor models,
technical infrastructure requirements on the user side are modest. This is
understandable, since placing significant hardware or other technical requirements
on users would tend to raise the cost for clients, limiting the potential market and
placing the vendor at a competitive disadvantage. Vendors generally find low-
burden ways to deliver and maintain products. Many models are web-based; this
form of delivery typically requires little or no specialised IT infrastructure on the part
of clients.
Conclusions
Certain aspects of the observations described in this report suggest potential points
of future emphasis or improvement, particularly for vendors or for model users. In
many cases, there is an element of tension between the natural desire of vendors to
protect proprietary elements of models and the needs of model users to have
enough information about models to comply with regulatory expectations and
principles of sound model use. These tensions likely will always exist to some
extent, and the commercial interests of vendors cannot and should not be ignored.
However, there appear to be a number of areas in which a modest amount of
additional disclosure by vendors could significantly enhance the ability of
institutions to use credit risk models in ways that conform more closely to
supervisory expectations and sound management practices.
Incomplete documentation or undocumented model features sometimes make it
difficult for model users to properly evaluate models, especially on a prospective
basis.
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Vendor documentation can provide valuable information, but often reflects an
inherent bias, and publications by staff or affiliated researchers are sometimes cited
as if they are written by disinterested third parties.
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Limitations of reference data sets create a need for caution when applying models
to obligors or exposures that differ markedly or systematically from observations in
development samples.
Models generally are suitable for use in some cases but not in others, and vendors
may be able to use their insight into the development and operation of models to
better indicate for clients any specific business uses for which the vendors’ products
are not suitable.
Model users may need to adjust model results (or their business use) for definitions
of default or loss that differ from those required under Basel II, and vendors could
provide valuable information to support appropriate adjustments.
Comparisons between competing models could be valuable, but are difficult to do
and in practice are rarely performed in an informative way.
Vendors often are in the best position to conduct certain aspects of model
validation, but may lack the proper incentives to conduct credible, unbiased testing.
Out-of-sample validation is valuable, but is not a common practice among vendors.
Regular, periodic re-validation is a sound practice for model vendors, but actual
approaches to the frequency of re-validation vary.
While some vendors provide explicit support for highly important end-user
validation of models, others provide little or no support.
Vendors can help clients understand which aspects of models can be modified, and
the implications of those modifications for model applicability and performance.
Certain elements of models or their documentation might be modified to better
support stress testing.
As the market for vendor credit-risk models develops and matures, vendors and end
users may encounter opportunities to consider the implications of some of the
points discussed in this report, and in particular to balance the legitimate
proprietary interests of model vendors against the benefits of greater transparency.
As noted above, improvements in practices related to vendor models, whether
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driven by vendors or by their clients, will help promote better credit risk
management.