Professional Documents
Culture Documents
Basel II Capital Accord Report at SBP
Basel II Capital Accord Report at SBP
Internship Report
Basel II & Its Implementation in Pakistan Banking
Sector
Submitted To;
Chief Manager
SBP (BSC) Bank Faisalabad
Coordinator Officer;
Mr. Muhammad Rehan Submitted by;
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First of all I would like to thank that great entity that helped us to get through
this report safely, the one who was always there when no one was!
Would that I have words to pay tribute to our loving parents and teachers whose
invaluable prays salutary admire and embodying attitude kept our spirit alive to
strive for knowledge and integrity which enable us to reach milestone.
I would also like to express enormous gratitude to our respectable teacher “Mr.
Muhammad Rehan” for providing the direction for this project and for helping us
in refining our effort and ideas.
I also acknowledge the help and pleasant gathering of all our class fellows. I am
also thankful to all of those people who helped us in accomplishing our project.
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Abstract………….………………………………………….….06
Types of Risks…………………………………………………… 19
Credit Risk……………………………………………..... 20
Operational Risk …………………………………………25
Market Risk ………………………………………………30
5.0 Conclusion………………………………………….……47
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Basel II Capital Accord a revised Capital Framework used enhances the performance of the Banks. I
have to check out the implementation Issues, Challenge faced by the Pakistan and how effectively it
is being implemented in the foreign countries. I have to check out the role of State Bank of Pakistan
in the implementation of Basel II Accord. I have to check out the flaws and impediments in its
implementation process. Check out the role of Basel II in the performance appraisal of the
Commercial Banks.
Basel Capital Accord the 1st market Supervisory Framework implemented in 1988 covering only the
Market and Credit Risk. But in 1994 the Basel Committee on Banking Supervision stated to think
some more components in Credit Risk. Thus a need for a new Accord arises and in 2000 1 st
document on New Capital Accord was published and in its full form it published in 2004 comprises
of three pillars and revised credit and a new operational risk concept introduced in this New Accord.
From its introduction many countries started adopting to remain in the competitive market. Pakistan
also started adopting and make a complete plan to adopt it term by term due to its heavy cost of
implementation till 2009 the date extended later.
State Bank of Pakistan played a vital role in the implementation of this New Accord and a separate
department named Banking Surveillance Department was in action for its implementation and a
division name Basel II Implementation division and receive a greater response from the Banking
sector. All most Banks adopted Basel II term by term and some at initial stages of adoptions.
Main hurdle in its implementation is the cost of implementation. Developed countries like China has
not adopted Basel II at any instant, America also not adopted fully due to large operational cost.
Adoption of Basel II is the need of time to remain in the Market and avoid back warding from
foreign banks. In Pakistan it is implemented according to the time frame given by State Bank of
Pakistan.
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Basel Capital Accord
Basel capital accord introduced a system for implementing a credit risk framework for determining
the minimum amount of capital that a bank must hold as a cushion against risk.
Basel capital accord was adopted b y not only member countries, but virtually in all countries
operating international banks.
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Basic Structure
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Supplementary Capital
Tier 2 Capital (Supplementary Capital)
Revaluation reserve
Undisclosed reserve
Subordinated debt
General provision for loan losses
Hybrid capital instrument
Perpetual securities, unrealized gains on investment securities, hybrid capital instruments
and long term subordinated debt
Maximum Limit
Total of Tier 2 capitals is limited to a maximum of 100% of the total Tier 1 capital.
The subordinated debt will be limited to a maximum of 50% of equity (Tier 1)
Basel I requires Tier 1 and Tier 2 capitals to be at least 8% of the total risk weighted assets.
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proposals. As a result of these efforts, many valuable improvements have been made to the original
proposals. The present paper is now a statement of the Committee agreed by all its members. It sets
out the details of the agreed Framework for measuring capital adequacy and the minimum standard
to be achieved which the national supervisory authorities represented on the Committee will propose
for adoption in their respective countries.
The Basel Committee on Banking Supervision formulated and issued a revised capital framework
referred to as Basel II in June 2004 which became available for implementation among its 13
member countries to G-10 countries from end-2006 and from end 2007 for the most advanced
approaches.
Basel II a new capital accord which aims to align banks with their basic risk profiles.
It is very elaborate and far superior in terms of its coverage and detail
Exploit effectively a new frontier of risk management
It seeks to give impetus to the development of a sound risk management system which hopefully
will promote a more efficient, equitable and prudent allocation of resources
When the banking company recognizes that Basel I fail to properly align capital with actual risk
profiles of the bank. This has laid the foundation of very long drawn process of Basel II, which
recognizes the perceived shortcomings of Basel I and progressively address its inherent weakness,
while gearing the risk management framework for the emerging financial engineering and
innovation.
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Objectives of Basel II
The relevance and significance of Basel II steps from its ability to recognize effectively the different
types of risk facing industry and the new product as well as off balance sheet transactions. Some
salient characteristics of Basel II are note worthy;
BASEL I BASEL II
Focus on Single Risk Measure More emphasis on Bank’s internal
methodologies, supervisory review &
One Size fits all market discipline
Flexibility, menu of approaches. Provides
Operational Risk not considered incentives for better risk management
Introduces approaches for Credit risk &
Broad Brush Structure Operational risk in addition to Market risk
introduced earlier
More Risk Sensitivity
To maintain safety and soundness in the financial system and therefore to maintain at least the
current level of capital in the system
To enhance competitive equality
To introduce a more risk sensitive framework that closely aligns internal economic capital with
regulatory capital
To focus on internationally active banks
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Risk Based Capital Standard
Why do banks need to hold capital in order to do business?
Provides a cushion against unexpected loss that may arise due to credit/market/operational risk.
Capital that needs to be maintained as a proportion of risk based assets is termed as risk based
capital – otherwise termed as capital adequacy ratio (CAR).
E.g. bank does not maintain any capital towards credit risk component of Go I bonds as it is non-
existent.
Scope of Application
Basel II has become an international competition for consultants, How to help banks allocate less
capital
Basel II creates incentives for banks to more risky assets to unregulated parts of the holding
companies
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The New Basel Capital Accord
The new Accord focuses on revising only the denominator (Risk-weighted assets), the definition and
requirements for capital are unchanged from the original Accord. General requirement for banks to
hold total capital equivalent to at least 8% of their Risk weighted assets.
Ranges of options are available for determining capital requirement for;
Credit risk
Operational risk
Market risk
Framework also allows “Limited degree of National Discretion”
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3.0 Building Blocks of Basel II Accord
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The three pillars together are intended to achieve a level of capital commensurate with a bank‟s
overall risk profile
• Correlation between required capital and effectiveness of bank‟s risk management
• Increased capital is not the only way to effectively addressing an increase in risks
• Strengthen risk management
• Apply internal limits
• Improve internal controls
Wide range of credit risk mitigants has also been developed for the 1st time
Capital changes in relation to operational risk considered for the 1st time Due to;
Number of areas
New complex financial products & strategies
Specialized processing operations
Reliance on rapidly evolving technology
Outsources and recent bank failures
For assessing the bank‟s specific risk situation and appropriate capital resources exist
Part 2 of Basel II (the New Capital Framework) describes the calculation of the total minimum
capital requirements for credit, market and operational risk.
The capital adequacy ratio (CAR) is defined by the following formula:
CAR > 8% = Qualifying Regulatory Capital / Risk Weighted Assets Basel II requires CAR
(CAR will be calculated using the definition of regulatory Capital and Risk-weighted asset)
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Regulatory Capital
The Basel I definition of eligible regulatory capital remains in place. The capital which is necessary
for the covering of probability of default of given risk is called regulatory capital.
Undisclosed reserves
Asset revaluation reserves
General provisions/general loan-loss reserves
Hybrid (debt/equity) capital instruments
Subordinated debt
Revaluation reserve
It should have an original maturity of at least two years and will be limited to 250% of the bank's Tier
1 Capital that is allocated to support Market Risk.
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It is only eligible to cover market risk, including foreign exchange risk and commodities risk.
Insofar as the overall limits in the 1988 Accord are not breached, tier 2 elements may be substituted
for tier 3 up to the same limit of 250%.
It is subject to a "lock-in" provision which stipulates that neither interest nor principal may be paid if
such payment means that the bank’s overall capital would then amount to less than its minimum
capital requirement.
Standardized approach
Internal Rating Based (IRB) Approach
Foundation vs. Advanced
Operational Risk
Loss resulting due to errors instructing payments or setting transactions
Standardized
Internal Model Based
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1. Credit Risk
Credit risk refers to the risk that a counter party or borrower may default on contractual obligations
or agreements. Pillar 1 of Basel II sets out the quantitative and qualitative requirements and formulae
to calculate capital for credit risk. The overarching principle behind these requirements is that rating
and risk estimation systems and processes provide for a meaningful assessment of borrower and
transaction characteristics; a meaningful differentiation of risk; and reasonably accurate and
consistent quantitative estimates of risk. Furthermore, the systems and processes must be consistent
with internal use of these estimates. The Committee recognizes that differences in markets, rating
methodologies, banking products, and practices require banks and supervisors to customize their
operational procedures. It is not the Committee‟s intention to dictate the form or operational detail of
banks‟ risk management policies and practices. Each supervisor will develop detailed review
procedures to ensure those banks‟ systems and controls are adequate to serve as the basis for the
Interest Rating Based approach.
Transaction level
At the sanction level–Issues of appraisal, credit worthiness of the obligor etc
Portfolio level
How to manage risk once the bank has built up its portfolio – does the individual obligor
default? – If so, what is the probability of default? In the event of default what is the
expected and unexpected loss? Any cushion required?
Approaches to Calculation
1. Standardized Approach
2. Foundation Internal Rating Based
3. Advanced IRB
Focuses on the cash value of the collateral taking into account price volatility
In Comprehensive approach banks need to calculate their adjusted exposure (against a
counterparty) by taking into account of the effects of that collateral.
Banks need to adjust the exposure amount and the price of the collateral by adjusting both
against the future fluctuation in the value of each.
Simple Approach
Developed for banks that only engage to a limited extent in collateralized transactions
Maintains the substitution approach in the current accord
Will generate higher capital requirements than the comprehensive approach
Unlike Basel I each asset or portfolio of similar assets is assigned risk weight.
Risk weights determined by category of borrower: sovereign (no distinction based
upon OECD membership), bank, and corporate
Risk weights dependent upon external credit assessments
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The Causes of Credit Risk
1. The underlying causes of the credit risk include the performance health of
counterparties or borrowers
2. Unanticipated changes in economic fundamentals
3. Changes in regulatory measures
4. Changes in fiscal and monetary policies and in political conditions
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2. Internal Ratings Based Approach
The two main principles behind the Internal Ratings Based (IRB) Approaches (Foundation and Advanced) are
the usage of banks’ own information about the credit quality of their assets and the promotion of best
practices in risk measurement and risk management. This is in contrast to the current approach and the
Standardized Approach under Basel II, which is mainly dependent on supervisory inputs to determine the
capital requirement.
The IRB Approach is based on measures of Unexpected Loss and Expected Loss. The risk weight
functions produce capital requirements for the Unexpected Loss portion. Under the IRB Approach,
banks must categories banking book exposures into broad classes of assets with different underlying
risk characteristics, being corporate, sovereign, bank, retail and equity. These are discussed in
greater detail later in this document. For each of the asset classes covered under the IRB framework,
there are three key elements:
Risk components estimate of risk parameters provided by banks some of which are supervisory
estimates. These are Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD)
and Maturity (M) that are discussed in more detail below
Risk-weight functions the means by which risk components are transformed into risk-weighted
assets and therefore capital requirements
Minimum requirements the minimum standards that must be met in order for a bank to use the IRB
approach for a given asset class
For many of the asset classes, the Basel Committee has made available two broad approaches: a
foundation and an advanced. Under the foundation approach, as a general rule, banks provide their
own estimates of PD and rely on supervisory estimates for other risk components. Under the
advanced approach, banks provide their own estimates of PD, LGD and EAD, and their own
calculation of Maturity, subject to meeting minimum standards. For both the foundation and
advanced approaches, banks must always use the risk-weight functions provided in this Framework
for the purpose of deriving capital requirements.
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Basic Principles of Interest Rating Based (IRB)
Maturity (M)
Maturity is based on contractual cash flows. All other things being equal, the longer the maturity of an
exposure, the higher the risk. Maturity is capped at 5 years.
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2. Operational risk
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and
systems or from external events.
Peoples
Financial institutions operate a myriad of processes to deliver their products to customers. Process
risk can arise at any stage of an end to end process in the value chain. For example, marketing
material can be mailed to the wrong customers, account opening documentation can turn out not to
be robust, transactions can be processed incorrectly, etc.
People
Operational risk losses can occur due to worker compensation claims, violation of employee health
and safety rules, organized labour activities and discrimination claims. People risks can also include
inadequate training and management, human error, lack of segregation, reliance on key individuals,
lack of integrity, honesty, etc.
Systems
The growing dependence of financial institutions on IT systems is a key source of operational risk.
Data corruption problems, whether accidental or deliberate, are regular sources of embarrassing and
costly operational mistakes.
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External Events
This source of operational risk has at least two discernible dimensions to it, firstly the extent to
which a chosen business strategy pursued by a bank may expose it to adverse external events, and
secondly external events that impact it independently, emanating from the business environment in
which it operates.
Internal fraud
External fraud
Employment practices & workplace safety
Clients, products & business practices
Damage to physical assets
Business disruption & system failures
Execution and delivery
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Operational Risk and the New Capital Accord
Operational risk is now to be considered as a fully recognized risk category on the same footing as
credit and market risk.
It is dealt with in every pillar of Accord, i.e., Minimum Capital Requirements, Supervisors Review and
Disclosure Requirements
Essentially, this approach uses gross income as a proxy for operational risk, with the capital charge
equal to 15% of the average of gross income for the last three years. Basic Indicator Approach
(BIA) is very straightforward and does not require any change to the business.
No specific qualifying criteria are specified, but banks are encouraged to comply with the Basel
Committee‟s proposed practices as documented in the Sound Practices for the Management and
Supervision of Operational Risk, published in February 2003. These principles in fact form the
underlying foundation for all three the methodologies, as well as the qualifying criteria that
participating banks should adhere to when adopting a particular approach.
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Figures for any year in which annual gross income is negative or zero should be excluded from both
the numerator and denominator when calculating the average.
The Accord is specific about what constitutes gross income, defining it as net interest income plus
net non-interest income, with the intention that it should:
In the Standardized Approach, gross income is again a proxy measure for operational risk, but in this
case it is broken out by eight standard business lines, each with a different beta factor to calculate
capital. The business lines, which are defined in detail in Annexure 6 of the Accord, are:
Corporate finance
Trading & sales
Retail banking
Commercial banking
Payment & settlement
Agency services
Asset management
Retail brokerage
The total capital charge under this approach is the sum of the product of the relevant business line
gross income and the beta factor, with the beta factor being a proxy for the assumed industry-wide
relationship between the operational risk loss experience for a given business line and the aggregate
level of gross income for that business line. It should be noted that in the Standardized Approach
gross income is measured for each business line, not the whole institution, for example, in corporate
finance, the indicator is the gross income generated in the corporate finance business line.
For retail and commercial banking there is also an Alternative Standardized Approach (ASA)
available, introduced to eliminate double counting of risks. Banks, at the national supervisor‟s
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discretion, may be permitted to substitute an alternative measure in the case of retail and commercial
banking. In this case, the volume of outstanding loans will be multiplied by the beta factor and the
result multiplied by 3.5%.
AMA approach is a step-change for many banks not only in terms of how they calculate capital
charges, but also how they manage operational risk on a day-to-day basis.
More exacting quantitative and qualitative entry standards are required before a bank is permitted to
qualify as an advanced measurement approach bank. Under the AMA approach the regulatory
capital requirement will equal the risk measure generated by the bank‟s internal operational risk
measurement system, which should be based on:
As a general principle, the Accord does not prescribe an exact capital required methodology under
the advanced measurement approach. Banks are encouraged to develop their own methods provided
the measure calculates capital that covers both expected loss and unexpected loss – it must however
be able to demonstrate that its approach captures potentially severe „tail‟ loss events. Whatever
approach is used, a bank must demonstrate that its operational risk measure meets a soundness
standard comparable to that of the internal ratings-based approach for credit risk, (i.e. comparable to
a one year holding period and a 99.9% confidence interval)
One of the methods being used is the loss distribution approach, which embodies some of the
following aspects:
Banks will calculate two distributions: one for frequency and one for severity
Frequency distributions are usually binomial, negative binomial or Poisson
Event severity distributions are wider in choice: log normal, Pareto, Weibull or Inverse Gaussian
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A compound distribution is calculated using Monte Carlo simulation (In Statistical terms, the
convolution of the frequency and severity distributions)
Estimate the mean and the 99.9 percentile from the resulting distribution, the latter being equal to
the 1 year Value at Risk)
Convergence of Economies
Easy and faster flow of information
Skill Enhancement
Increasing Market activity
Increased Volatility
Need for measuring and managing Market Risks
Regulatory focus
Profiting from Risk
Can arise due to movement of rates (e.g. Interest rate, Stock prices, exchange rate etc.) in different
markets.
Bank may have exposure to different markets such as equity, foreign exchange, commodity etc.
By far, interest rate risk is the most prominent component because
Most of the banks’ assets are benchmarked to interest rates which are deregulated.
Investment portfolio of banks consists of a substantial investment on treasury bonds (G-Secs) which
are interest rate sensitive.
Reasonable exposure to international benchmark interest rate such as LIBOR (London Interbank
Offer Rate)
Under this pillar, banks are required to set aside adequate capital to cover all the business risks they
face including those outside credit, market and operational risks. Supervisors on the other hand are
required to assess the internal capital adequacy process that banking institutions have put in place.
The Supervisory Review Process is defined as the “Second Pillar” of Basel II and as such represents
an important key element of the Basel II document and the approach to ensure safer and sound
banking. The focus on supervision is, however, not new to the Basel Committee. This part of the
Report is the culmination of 20 documents on supervision published by the Basel Committee, the
first being Part B of the Amendment to the Capital Accord to incorporate market risks, published in
January 1996 and the twentieth being the Sound practices for the management and supervision of
operational risk, published in February 2003.
The aim of this part of the Basel II document is to discuss and describe the key principles of
supervisory review; risk management guidance; and supervisory transparency and accountability.
Supervisory Review Principle 1
“Banks should have a process for assessing their overall capital adequacy in relation to their risk
profile and a strategy for maintaining their capital levels”
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Regulatory ratios and requirements
Peer comparisons
Concentrations of credit and other risks
Strategic planning
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Supervisory Review Principle 4
“Supervisors should seek to intervene at an early stage to prevent capital from falling below
the minimum levels required to support the risk characteristics of a particular bank and
should require rapid remedial action if capital is not maintained or restored.”
Intervening actions:
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What Risks Does Pillar 2 Encompass?
Quality of systems & controls, including:
Management quality
Policies procedures & controls
Risk management
IT
Outsourcing
Business continuity
Corporate governance
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The Purpose of Pillar 3
Market discipline is to complement the minimum capital requirements (Pillar 1) and the supervisory
review process (Pillar 2). The Basel Committee aims to encourage market discipline by developing
a set of disclosure requirements which will allow market participants to assess key pieces of
information on the scope of application, capital, risk exposures, risk assessment processes, and
hence the capital adequacy of the institution. The banks‟ disclosures should be consistent with how
senior management and the board of directors assess and manage the risks of the bank. These
disclosures are also a qualifying criterion under Pillar 1 to obtain lower risk weightings and/or to
apply specific methodologies.
The Basel Committee recognizes the need for a Pillar 3 disclosure framework that does not conflict
with requirements under accounting standards, which are broader in scope. The Basel Committee
has made a considerable effort to see that the narrower focus of Pillar 3, which is aimed at disclosure
of bank capital adequacy, does not conflict with the broader accounting requirements. Pillar 3
disclosures will not be required to be audited by an external auditor, unless otherwise required by
accounting standards setters, securities regulators or other authorities.
For those disclosures that are not mandatory under accounting or other requirements, management
may choose to provide the Pillar 3 information through other means such as on a publicly accessible
internet website or in public regulatory reports filed with bank supervisors. However, institutions
are encouraged to provide all related information in one location. A bank should decide which
disclosures are relevant for it based on the materiality concept. Information would be regarded as
material if its omission or misstatement could change or influence the assessment or decision of a
user relying on that information for the purpose of making economic decisions.
General Disclosure Principle
“Banks should have a formal disclosure policy approved by the board of directors . In addition ,
banks should implement a process for assessing the appropriateness of their disclosures , including
validation and frequency of them.”
Disclosure Requirements
Attached to the use of a particular methodology or instrument
Pre-condition for the use of some methodologies
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Internal ratings-based approach
Asset securitization
Recognition of external credit assessment institutions
Types of Disclosures
Qualitative
Quantitative
1. Qualitative Disclosures
2. Quantitative Disclosures
Structure of Capital
Publicly disclose its capital ratio and other relevant capital adequacy information on a
consolidated basis
Disclose measures of risk exposures calculated in accordance with the methodology set out in
the New Basel Capital Accord
Banks have to hold less capital against assets that are inherent low risk & higher capital against those
contain high level of risk
RM is a prerequisite for the implementation of Basel II. Since good RM will result in less capital
requirement. (A driving force for improvement of RM framework of banks)
It covers all types of risks as well as liquidity, IRB, in banking book concentration risks etc
6. Flexibility
Maintaining adequate capital is not just the purpose of Basel II, rather it requires banks to establish
better system to quantify risk.
Basel II requires greater public disclosure. Thus market discipline has a key role to play in
reinforcing appropriate behavior by market participants.
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Cross border challenges & Problems of adverse selection
Cost and volume of capital
Relevance of Basel II assumptions in the Asian context
Pakistan adopted standardized approach for credit risk from January 1, 2008
Basic indicator approach for operations risk from January 1, 2008
Banks/DFI`s will be required to adopt a parallel run of one and a half year for standardized
approach and two years for IRB approach starting from July 1, 2006 and January 1, 2008.
State Bank of Pakistan has also issued a roadmap for implementation of Basel II requiring all
Banks/DFI`s to ensure completion of the action s on their part within specified timeframe.
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Supervision Financial institutions in Pakistan are regulated and supervised by State Bank of Pakistan
(SBP) and the Securities and Exchange Commission of Pakistan (SECP). SBP is primarily
responsible for regulating and supervising the scheduled banks (both conventional & Islamic), Micro
Finance Banks, Development Financial Institutions (DFIs) and Exchange Companies. The rest of
Financial Institutions including investment banks, leasing companies, Modarabas, discount douses,
venture capitals, asset management companies, mutual funds, housing finance companies, insurance
companies, and stock exchanges are regulated and supervised by Securities and Exchange
commission of Pakistan.
The National Saving Schemes are managed by the Central Directorate of National Savings, a
department of the Ministry of Finance.
Financial Reforms
The structure of banking sector has substantially changed since early 1990s particularly by
privatization of state owned banks. In 1990, Pakistan‟s banking sector was dominated by five
commercial banks which were all state owned but with the amendments of Banking Companies
Ordinance financial sector reforms were launched with privatization of two state owned banks MCB
(1991) & ABL (1993). These reforms were subsequently delayed for several years and resumed in
yearly 2000 with privatization of third large bank UBL in 2002. Privatization of the second largest
bank HBL commenced in 2004 and with that the banking system assets held by the public sector
commercial banks decreased to less than 25 percent. The largest bank of
country NBP remains state owned while government divested approximately 25 percent of its
shareholding. The privatization of state owned banks was accompanied by liberalization in the
financial system and openness to domestic and foreign competition. The number of banks and
NBFIs grew rapidly from 1990 to 1995. The moratorium was imposed in 1995 on establishment of
new banks as worries on health and soundness of small banks increased.
Consolidation
Within the banking sector, the ownership structure which had gradually moved from public to
private. The share of private and foreign ownership has substantially increased due to lucrative
return on investment in the banking sector. The private sector now controls nearly 80 percent of the
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system assets, as opposed to the early 1990s when 90 percent of the system assets were controlled by
the government. At the same time process of consolidation has been more pronounced in this sector.
Banking sector stability and robustness is of critical importance to financial sector stability. In
essence, the process of consolidation was driven by the need to bring to surface economies of scale
and scope, and efficiencies driven by competition and innovation. The consolidation process was
focused on three primary factors i.e. i) proactive Merger & Acquisitions (both domestic and
foreigner), ii) moratorium on licensing of conventional banks, and iii) minimum capital requirements
for banks and DFIs which have been stringently implemented by the SBP. All three factors have
helped, however the impact of the consolidation process has been diluted somewhat by the liberal
licensing of Islamic banks and Microfinance institutions, which are being promoted as an active
policy of the SBP with its focus on financial inclusion.
The ongoing mergers and acquisitions have exerted a profound impact on the ownership structure of
the financial sector. The financial sector is now led by private sector. Foreign Direct Investment in
the banking sector is on the rise and contributing factor in this trend is the growing interest of foreign
banks in the Islamic banking industry. As a result of these developments, foreign stake in the
banking sector increased to an all time high. The liberalized environment of the past few years drove
Merger & Acquisition activity in the banking sector, resulting in 36 transactions from 2001 to 2007.
Basel-II in Pakistan
Keeping in view the global response towards Basel-II, SBP decided to adopt Basel-II in Pakistan and
issued proposed Roadmap for the implementation of Basel II in Pakistan in March 2005. While
preparing this Roadmap, SBP conducted a survey to assess the existing capacity of the banks and
their financial position to meet additional capital requirement. The plans of other countries for
adoption of Basel II were reviewed. Efforts were made to draw a realistic timeline so as to give
banks sufficient time to prepare themselves for meeting the requirement of Basel-II.
In addition to above survey, SBP also conducted a quantitative impact study (QIS) of Basel-II
(Standardized Approach) based on data as of 31-12-2003. The study was based on the assumption
that there would not be any major variation in the capital requirement of banks against their credit
risk as in absence of external ratings most of the loans will fall under the category of unrated claims
and attract 100% risk weight. The capital requirement under Basel II of individual banks was
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therefore calculated by adding capital charge for market risk and operational risk. The result of the
study revealed that there would not be any significant increase in required capital and most of the
banks will be able to meet capital requirement under Basel II rules.
Historically, credit risk has been the major risk causing heavy losses to banks operating in Pakistan.
Credit risk arises from the potential that an obligor is either unwilling to perform on an obligation or
its ability to perform such obligation is impaired resulting in economic loss to the bank. Bank‟s
failure to assess and manage credit risk proactively may be detrimental to the financial health of a
bank and may lead to severe losses to the bank. SBP has also issued guidelines to establish two tier
internal credit risk rating system.
Keeping in view the size, sophistication, nature and complexity of operations of each bank/DFI,
adoption of clear-cut strategies and introduction of strong internal controls and effective reporting
will remain critical factors in preventing this and other types of operational risk events and resultant
losses. In view of the importance of frauds prevention/mitigation strategy in overall operational risk
framework and to improve the mechanism for active supervisory response, SBP has formulated the
revised reporting requirement for banks/DFIs on frauds/forgeries/dacoities cases. Submission of
complete and timely information on revised formats enables the State Bank to remain apprised of
developments at banks/DFIs and monitor follow-up action taken by them for all medium and high
severity frauds/forgeries including the emergency reported cases.
The information so collected is used to develop a database of frauds, forgeries, and dacoities events,
which will be used for measuring operational risk and determining capital requirements there
against. All banks/DFIs submit a quarterly statement of frauds/forgeries/dacoities which includes all
actual as well as attempted fraud cases even if the bank may not have sustained any monetary loss.
Therefore, the cases where bank recovers the entire amount involved and does not suffer any loss are
also reported to SBP.
3. Financial Derivatives
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In Pakistan, though derivatives have been a relatively new concept until recently, the derivative
volume has increased manifold amidst the changing market and regulatory environment. In response
to the evolving market dynamics and in order to develop an Over the Counter financial derivatives
market in the country, SBP issued Financial Derivatives Business Regulations in November 2004.
Prior to this, banks were allowed to undertake the business of financial derivatives after getting
specific approvals from SBP. Now banks/ DFIs obtain Authorized Derivatives Dealer or Non Market
Maker Institution status from SBP after meeting the eligibility criteria and they have been allowed to
undertake derivatives business. The grant of such status is based on the capacity of the applicant to
undertake derivatives transactions based on both onsite and offsite analysis. The regulations allow
three types of transactions viz. Interest Rate Swaps, Forward Rate Agreements and FX options.
Provide input/clarification on regulatory/policy issues relating to capital requirement for banks and
other financial institutions under Basel II
Participating and arranging in capacity building of Banking Industry to adapt and implement Basel II
Accord.
Ensure compliance with Basel Core Principles of Banking Supervision.
Coordinate with banking industry for implementation of Basel-II and core principles and also give
impetus for adoption of new best international practices relating to capital standard and risk
management
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The Basel II Accord Division oversees the Basel II Implementation in Pakistan. The main
deliverables for the division are guidelines/ clarifications to banks, recognition of External Credit
Assessment Institutions, coordination with SECP, monitoring progress towards Advanced
Approaches, validations of models to be used in Advanced Approaches, monitor Minimum Capital
Requirements both in terms of absolute amount and the Capital Adequacy Ratio, give clearance to
banks with respect to raising subordinated debt through TFCs; capacity building within SBP as well
as in banking industry. Currently the division comprises of five units.
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Standardized Approach for credit risk and Basic indicator / Standardized Approach for operational
risk from 1st January 2008.
Banks interested in adopting Internal Ratings Based Approach may approach SBP for the purpose. Their
request will be considered on case-to-case basis.
For the smooth, realistic and undisrupted transition from Basel-I capital adequacy framework
towards more risk sensitive new capital adequacy framework – the Basel II, all banks/DFIs were
required to designate one senior officer from their institution who would supervise all activities
relating to Basel II within the bank and will serve as a focal point between SBP and that particular
bank. It is anticipated that in coming years commercial banks would continue to develop their
infrastructure, technology and human resource capacities to adopt and implement Basel-II in a
phased manner.
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After all my work and research on Basel II in Pakistan and international sector I found that
the need to implement Basel II in the banking sector is much needed due to the relevance and
significance of Basel II steps from its ability to recognize effectively the different types of risk
facing industry and the new product as well as off balance sheet transactions.
The fallowing characteristics made the need to implement Basel II as its draft prepared;
These objectives create the need to implement Basel II in the Pakistani Banking sector and it
enhances the risk sensitivity of Banks due to which Probability of loses are avoided.
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http://www.bis.org/bcbs/index.htm
http://www.bis.org/publ/bcbs24.pdf?noframes=1,
http://www.banque-france.fr/gb/publications/telechar/rsf/2006/etud1_0506.pdf
http://www.bundesbank.de/download/bankenaufsicht/dkp/200814dkp_b_.pdf
http://finance.wharton.upenn.edu/~benninga/mma/MiER74.pdf,
http://www.bionicturtle.com/learn/article/basel_ii_market_risk/
http://www.bionicturtle.com/learn/article/basel_ii_backtesting_the_var_model_with_t
he_traffic_light
http://www.riskprofessional-digital.com/riskprofessional/200904/?pg=39
http://www.bis.org/publ/bcbs107.pdf?noframes=1
http://www.bis.org/bcbs/qis/qis5results.pdf,
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