The BASEL Capital Accord

MET League of Colleges-PG 2004-06

Introduction to BASEL Capital Accord

Shift towards risk-centric bank management Basel Capital Accord 1988 (Basel I) 0 % for Governments 20 % for Banks 100 % for Corporates

Rationale for a new Accord

The existing Accord (Basel I) Focus on a single risk measure One size fits all The proposed new Accord (Basel II) Emphasis on banks own internal methodologies Menu of approaches

Broad brush structure

More risk sensitivity

Promote safety and soundness in the financial system What? Continue to enhance competitive equality Complete recognition of all types of risk Orientation on the banks individual risk profile

How?

Who?

Focus on internationally active banks

Principles suitable for application on smaller banks

The Three Pillars of BASEL II

minimum capital requirement

supervisory review process

market discipline

Calculation of minimum capital requirements

The total capital ratio must be no lower than 8%

Tier 2 capital is limited to 100% of Tier 1 capital

A Birds eye view of BASEL II

Minimu m 8% unchang ed

Capital Ratio =

Total Capital Credit risk + Market Risk + Operational Risk

RWA Calculation s revised

No Change

New capital charges called for

Credit Risk
Credit Risk Calculations

Standardized Approach Internal Ratings Based (IRB) Foundation Approach

Internal Ratings Based (IRB) Advanced Approach

Standardized Approach
Overview External credit assessment institution (ECAI) Who decides? Eligibility criteria for ECAIs Objectivity Independence Disclosure Resources

International access

Credibility

Claims on sovereigns

Credit * Assessm ent

AAA A+ to to AAA-

BBB+ BB+ to to BBBB-

Belo w B-

Unrat ed

Risk Weight

0%

20%

50%

100% 150% 100%

* Notations used are followed by Standard & Poors

Claims on banks
Option 1
Credit Assessm ent

AAA A+ to to AAA-

BBB+ BB+ to to BBBB-

Below Unrat Bed

Risk Weight

20% 50%

100% 100% 150% 100% (cap) (cap) (cap)

Claims on banks
Option 2
Credit assessme nt of Banks
Risk weight under Option 2

AAA to AA-

A+ to A-

BBB+ to BBB-

BB+ to B-

Below B-

Unrated

20% 50%

50%

100% 150%

50% (cap)

Risk weight for short-term Claims under Option 2

20% 20%

20%

50%

150% (N.A.)

20%

Claims on MDBs
Option 2 for banks w/o preferential treatment for short-term claims 0% risk weight will be applied to claims on highly rated MDBs such as IFC, IBRD, ADB

Claims secured by mortgages on residential property

Claims secured by mortgages on residential property that is or will be occupied by the borrower will be risk-weighted @ 35 % Supervisory discretion

Claims secured by commercial real estate

100 % weightage

Exceptional cases 50 % weight for lower of 50 % of MV of loan or 60 % of LTV

Credit Risk the IRB approach

IRB approach

Foundation

Advanced

IRB Approach - Parameters

Probability of Default (PD) Exposure at Default (EAD)

Loss given Default (LGD)

Maturity (M)

Criteria Criteria

Standardized Standardized Approach Approach

Internal Internal Ratings Ratings Based Based (IRB) (IRB) Approach Approach Foundation Foundation Advanced Advanced
Internal Internal Internal Internal

Rating Risk Weight

External External

Caiberated Caiberated onon the the basis basis Function Function of PD, of PD, EAD, EAD, Function Function of PD, of PD, EAD, EAD, of external of external ratings ratings LGD andLGD M and M LGD andLGD M and M

Probability of Default (PD):

Exposure of Default (EAD): Loss Given Default (LGD):

tied to Tied to Provided Provided by by bank bank based based Provided Provided by by bank bank based based risk risk weights weights based based on on on own on estimates own estimates on own on estimates own estimates external external ratings ratings
tied to Tied to Supervisory Supervisory values values setset Provided Provided by by bank bank based based by on on own estimates risk risk weights weights based based on on by the the Basel Basel Committee Committee own estimates external external ratings ratings tied to Tied to Supervisory Supervisory values values setset Provided Provided by by bank bank based based risk risk weights weights based based on on the the Basel Basel Committee Committee on on own estimates; own extensive estimates; process and external external ratings ratings extensive internal control process requirements and internal control requirements Implicit recognition Supervisory values set Provided by bank based by the on own estimates Implicit recognition Supervisory Basel Committee values set Provided by bank based

Maturity

Criteria

Standardized Approach

Internal Ratings Based (IRB) Approach

Foundation Advanced
Same as IRB Foundation, plus: Historical loss data to estimate LGD (7 years) Historical exposure data to estimate EAD (7 years)

Data Requirement s

Provision dates Default events Exposure data Customer segmentation External ratings Collateral data

Rating data Default events Historical data to PDs (5 years) Collateral data

Process Requirement s

Provisioning process

Same as Standardized, plus minimum requirements to ensure quality of internal ratings and PD estimation and their use in the risk management process

Same as IRB Foundation, plus minimum requirements to ensure quality of estimation of all parameters

Categorization of exposures
Banking book exposures
Corporate Sovereign Bank Retail Equity

Market Risk
The BIS defines market risk as
the risk that the value of on-or off-balancesheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices

Market Risk
Introduction Asset-Liability Management Committee (ALCO) Liquidity Risk Management

Interest Rate Risk (IRR) Management

Foreign Exchange Risk Management

Treatment of Market Risk in the Proposed Basel Capital Accord

Risk weight of 2.5 % for Investment in G-Secs
Risk weight of 100 % on open positions in forex and gold

Operational Risk
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events This definition includes legal risk which includes exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements

Operational Risk Menu of Approaches

Operational Risk Calculations

Basic Indicator Approach

Standardised Approach

Advanced Measurement Approaches (AMA)

Basic Indicator Approach

capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted alpha) of positive annual gross income. 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 charge may be expressed as follows: KBIA = [(GI1n x )] /n
Where KBIA = the capital charge under the Basic Indicator Approach GI = annual gross income, where positive, over the previous three years n = number of the previous three years for which gross income is positive = 15%, which is set by the Committee

Standardised Approach
Banks Activities :
corporate finance

payment & settlement

trading & Sales agency services retail banking asset management

commercial banking retail brokerage

Standardised Approach
Within each biz. line regulatory charge is calculated and is indicative of operational risk exposure within these lines

KTSA={ years 1-3 max[(GI1-8 x 1-8),0]} / 3

Where: KTSA = the capital charge under the Standardised Approach GI1-8 = annual gross income in a given year, as defined above in the Basic Indicator Approach, for each of the eight business lines

1-8 = a fixed percentage, set by the Committee, relating the level of required capital to the level of the gross income for each of the eight business lines.
Business Lines Corporate finance (1) Trading and sales (2) Retail banking (3) Commercial banking (4) Beta Factors 18% Payment and settlement (5) 18% Agency services (6) 12% Asset management (7) Retail brokerage (8) 12% 15% 18% Business Lines Beta Factors

15%

12%

Advanced Measurement Approach

Internal loss data
minimum five-year observation period captures all material activities and exposures from all appropriate subsystems and geographic locations gross loss amounts, date of the event, any recoveries of gross loss amounts , drivers or causes of the loss event

External data
either public data and / or pooled industry data when there is reason to believe that the bank is exposed to infrequent, yet potentially severe, losses

Expected Loss & Unexpected Loss

Confidence level 99 %
Probability of Loss

Expected Loss

Level of Loss

Unexpected Loss

Stress Loss

Covered by Provisions

Covered by Economic Capital

Prudential Norms

Non-performing Assets - A credit facility wherein the repayment of

the installment of principal and/or interest has remained due for specified period of time (90 days)

When consider NPA?

Term loan> 90 Days

Overdraft/cash credit
i) O/s bal Continuously in excess of sanctioned limit ii)No credits continuously for 90 days

Bills purchased and discounted

> 90 Days

Agricultural Advance
i) Short duration crops: Two crop season ii) Long duration crops: One crop season

Any other credit facility

Income Recognition

When received not on accrual basis

Asset Classification of NPAs

Sub-standard Assets
- NPA for less than or equal to 12 months

Doubtful Assets
- Remained in sub-standard category for 12 months

Loss Assets
- Loss is identified by bank,auditors or the RBI inspection but amount is not w/off wholly

Treatment for various assets

Accounts with temporary deficiency not an NPA Upgradation of loans classified as NPA - Arrears of Interest and principal paid Accounts Regularised near b/s date deemed NPA Asset classification borrower-wise & not facility-wise - Except advances to PACS under on-lending system

Treatment continued
Advances under consortium - NPA if remittances not parted to member banks Accounts where there is erosion in the value of security - treated as NPA Advances against Term deposits,NSCs.. - not treated as NPA Loans with moratorium for payment of Interest

Provisioning For NPAs

Take out finance Post shipment Suppliers credit

Export project finance

Provision Norms
Loss Assets - w/off or 100% of outstanding Doubtful Assets - 100% if uncovered - 20% to 100% of secured portion Sub-standard Assets - General Provision of 10% when secured - Additional 10% for unsecured exposures i.e 20%

Doubtful Assets
Period for which the advance has remained in doubtful category Upto 1 year Provision requirement (%)

20%

One to Three years

30%

More than Three years

60% (4th year) 75% (5th year) 100%(6th year onwards)

The Second Pillar Supervisory Review Process

risks considered under Pillar 1 that are not fully captured by the Pillar 1 process those factors not taken into account by the Pillar 1 process factors external to the bank

MET League of Colleges-PG 2004-06

Importance of Supervisory Review

Risk management techniques Evaluation of capital in relation to risk

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.

Board and Senior Management oversight Sound capital assessment Comprehensive assessment of risks Monitoring and Reporting Internal control review

Principle 2: Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios.

on-site examinations or inspections off-site review discussions with bank management review of work done by external auditors periodic reporting

Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.

Creditworthiness Fluctuations in overall capital ratio Raising additional capital Minimum regulatory capital Risks not taken into consideration

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

intensifying the monitoring of the bank restricting the payment of dividends prepare and implement a satisfactory capital adequacy restoration plan requiring the bank to raise additional capital immediately

Pillar 3 Market Discipline

Achieving appropriate disclosure Interaction with accounting disclosures Materiality Frequency Proprietary and confidential information Scope of application

General qualitative disclosure requirement

For each separate risk area strategies and processes of risk mgmnt; the structure and organization of the relevant risk management function; the scope and nature of risk reporting and/or measurement systems; policies for hedging and/or mitigating risk strategies and processes for monitoring the effectiveness of hedges/mitigants.

Implementation of Basel II in Advanced Countries

High Cost lending and Reduced lending to Emerging Economies
The Vicious Circle of Curtailment of Credit to Emerging Countries Higher Interest Costs & Competitive advantage of corporate borrowers Impact on Infrastructure development
MET League of Colleges-PG 2004-06

Implementation of Basel II in Advanced Countries

Shorter Term to maturity of lending
Impact on capital flows Impact on Companies

Implementation of Basel II in Emerging Economies

Standardised Approach and External Credit Rating Problems Difficulties in Implementation of IRB based Credit Risk ManagementApproach Costs of Implementation: IT spending & Training Costs Multiple Supervisory bodies

Impacts of Basel II
Improved Risk Management & Capital Adequacy Curtailment of Credit to Infrastructure Projects Preference for Mortgage Credit to Consumer Credit Basel II: Advantage Big Banks IT spending: Advantage Indian IT companies Consolidation in the banking Industries Non-implementation could impact Sovereign rating

Recommendations
Incorporation of Anti Cyclical measures Stronger Equity Markets & regulatory environment Clear Roadmap for implementation Capitalisation & depreciation of IT expenditure Revision of Curricula to incorporate Risk Management & retraining Consolidation within Banking Industry

Thank you!!

A humble effort by :
Ruby Mohan Sweta Vaishnav Nidhi Agarwal 04138 04170 04178

PGeMBA Finance 2004-06 Under the guidance of Prof. Paradkar