BASEL I and BASEL

II: HISTORY OF AN
EVOLUTION
SEP 30, 2015

HISTORY OF CAPITAL
ADEQUACY RULES IN THE
U.S.
1900-late 1930s: Capital to Deposit Ratio

(The Office of Comptroller of the Currency

[OCC] adopted the 10% minimum)
Late 1930s: Capital to Total Assets (FDIC)
II WW: No capital ratios (Banks were buying
US Government bonds)
1945-late 1970s: Capital to Risk Assets
Ratio (FED and FDIC), Capital to Total
Assets Ratio (FDIC)

BANK SAFETY AND

SOUNDNESS
Capital adequacy requirements
i) provide a buffer against bank losses
ii) protects creditors in the event of
bank fails

iii) creates disincentive for excessive

risk taking

INTERNATIONAL
REGULATION

1988 Basel Accord (Basel-I)

1993 Proposal: Standard Model
1996 Modification: Internal Model
New Basel Accord (Basel-II)

THE FIRST BASEL ACCORD

The first Basel Accord (Basel-I)

was completed in 1988

WHY BASEL-I WAS

NEEDED?
The reason was 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 the same
amount of capital on the loans

1988 BASEL ACCORD

(BASEL-I)
1)The purpose was to prevent international
banks from building business volume
without adequate capital backing
2) The focus was on credit risk
3) Set minimum capital standards for banks
4) Became effective at the end of 1992

A NEW CONCEPT: RISK

BASED CAPITAL
Basel-I was hailed for
incorporating risk into the
calculation of capital requirements

COOKE RATIO
Named after Peter Cooke (Bank of England),
the chairman of the Basel committee)

Cooke Ratio=Capital/ Risk Weighted

Assets8%

Definition of Capital
Capital= Core Capital
+ Supplementary Capital
- Deductions

BASEL-I CAPITAL
REQIREMENTS
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

CALCULATION OF
REQUIRED CAPITAL

To calculate required capital, a

bank would multiply the assets in
each risk category by the
categorys risk weight and then
multiply the result by 8%
Thus a $100 commercial loan would be
multiplied by 100% and then by 8%,
resulting in a capital requirement of $8

CORE & SUPPLEMENTARY

CAPITAL
1)

Core Capital (Tier I Capital)

i) Paid Up Capital
ii) Disclosed Reserves (General and Legal Reserves)

2)

Supplementary Capital (Tier II Capital)

i) General Loan-loss Provisions
ii) Undisclosed Reserves (other provisions against
probable losses)
iii) Asset Revaluation Reserves
iv) Subordinated Term Debt (5+ years maturity)
v) Hybrid (debt/equity) instruments

DEDUCTIONS FROM THE

CAPITAL

Investments

in unconsolidated
banking and financial subsidiary
companies and investments in the
capital of other banks & financial
institutions

Goodwill

DEFINITION OF CAPITAL IN
BASEL-I
(1)
TIER 1

Paid-up share capital/common stock

Disclosed reserves (legal reserves,
surplus and/or retained profits)

DEFINITION OF CAPITAL IN
BASEL-I
(2)

TIER 2
Undisclosed reserves (bank has made a profit but this
has not appeared in normal retained profits or in
general reserves of the bank.)
Asset revaluation reserves (when a company has an
asset revalued and an increase in value is brought to
account)
General Provisions (created when a company is aware
that a loss may have occurred but is not sure of the
exact nature of that loss) /General loan-loss reserves
Hybrid debt/equity instruments (such as preferred
stock)
Subordinated debt

RISK WEIGHT CATEGORIES

IN BASEL-I (1)
0% Risk Weight:

Cash,
Claims on central governments and central

banks denominated in national currency

and funded in that currency
Other claims on OECD countries, central
governments and central banks
Claims collateralized by cash of OECD
government securities or guaranteed by
OECD Governments

RISK WEIGHT CATEGORIES

IN BASEL-I (2)
20% Risk Weight
Claims on multilateral development banks and
claims guaranteed or collateralized by securities
issued by such banks
Claims on, or guaranteed by, banks incorporated
in the OECD
Claims on, or guaranteed by, banks incorporated
in countries outside the OECD with residual
maturity of up to one year
Claims on non-domestic OECD public-sector
entities, excluding central government, and
claims on guaranteed securities issued by such
entities
Cash items in the process of collection

RISK WEIGHT CATEGORIES

IN BASEL-I (3)
50 % Risk Weight
Loans fully securitized by mortgage on
residential property that is or will be
occupied by the borrower or that is
rented.

RISK WEIGHT CATEGORIES

IN BASEL-I (4)

100% Risk Weight

Claims on the private sector
Claims on banks incorporated outside the OECD with
residual maturity of over one year
Claims on central governments outside the OECD
(unless denominated and funded in national currency)
Claims on commercial companies owned by the public
sector
Premises, plant and equipment, and other fixed assets
Real estate and other investments
Capital instruments issued by other banks (unless
deducted from capital)
All other assets

RISK WEIGHT CATEGORIES

IN BASEL-I (5)
At National Discretion (0,10,20 or
50%)

Claims on domestic public sector

entities, excluding central governments,
and loans guaranteed by securities
issued by such entities

CRITIQUE OF BASEL-I
Basel-I accord was criticized
i) for taking a too simplistic
approach to setting credit risk
weights
and
ii) for ignoring other types of risk

THE PROBLEM WITH THE

RISK WEIGHTS
Risk weights were based on what the
parties to the Accord negotiated rather
than on the actual risk of each asset

Risk weights did not flow from any

particular insolvency probability
standard, and were for the most part,
arbitrary.

OPERATIONAL AND OTHER

RISKS
The requirements did not explicitly
account for operating and other
forms of risk that may also be
important
Except for trading account activities, the
capital standards did not account for
hedging, diversification, and differences
in risk management techniques

1993 PROPOSAL:
STANDARD MODEL
Total Risk= Credit Risk+ Market Risk
Market Risk= General Market Risk+
Specific Risk

General Market Risk= Interest Rate

Risk+ Currency Risk+ Equity Price Risk

+ Commodity Price Risk

Specific Risk= Instruments Exposed to

Interest Rate Risk and Equity Price Risk

1996 MODIFICATION:
INTERNAL MODEL
Internal Model Value at Risk
Methodology

Tier III Capital (Only for Market Risk)

i) Long Term subordinated debt
ii) Option not to pay if minimum
required capital is <8%

BANKS 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

of bank capital than possible under Basel-I

These models allowed banks to align the

amount of risk they undertook on a loan

with the overall goals of the bank

INTERNAL MODELS AND

BASEL I
Internal models allow banks to more
finely differentiate risks of individual
loans than is possible under Basel-I
Risk can be differentiated within loan
categories and between loan categories

Allows the application of a capital

charge to each loan, rather than each
category of loan

VARIATION IN RISK 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 from 1% to 30%, depending
on the loans estimated risk

CAPITAL ARBITRAGE
If a loan is calculated to have an
internal capital charge that is low
compared to the 8% standard, the
bank has a strong incentive to
undertake regulatory capital arbitrage

Securitization is the main means used

especially by U.S. banks to engage in
regulatory capital arbitrage

EXAMPLES OF CAPITAL
ARBITRAGE
Assume a bank has a portfolio of commercial loans with

the following ratings 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 of these loans
To ensure the profitability of the better quality loans, the
bank engages in capital arbitrage--it securitizes the loans
so that they are reclassified into a lower regulatory risk
category with a lower capital charge
Lower quality loans with higher internal capital charges
are kept on the banks books because they require less
risk-based capital than the banks internal model indicates

NEW APPRACH TO RISKBASED CAPITAL

By the late 1990s, growth in the use of
regulatory capital arbitrage led the Basel
Committee to begin work on a new capital
regime (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
replace the 1998 Accord

BASEL-II

BASEL-II
Basel-II consists of three pillars:

Minimum capital requirements for credit

risk, market risk and operational risk

expanding the 1988 Accord (Pillar I)

Supervisory

review of an institutions
capital adequacy and internal assessment
process (Pillar II)

Effective use of market discipline as a lever

to strengthen disclosure and encourage

safe and sound banking practices (Pillar III)

IMPLEMENTATION OF THE
BASEL II ACCORD
Implementation

of the Basel II Framework

continues to move forward around the globe. A
significant number of countries and banks already
implemented the standardized and foundation
approaches as of the beginning of 2007.
In many other jurisdictions, the necessary
infrastructure (legislation, regulation, supervisory
guidance, etc) to implement the Framework is
either in place or in process, which will allow a
growing number of countries to proceed with
implementation of Basel IIs advanced approaches
in 2008 and 2009.
This progress is taking place in both Basel
Committee member and non-member countries.

BASEL-II (1)
Minimum Capital Requirement (MCR)
Capital
MCR
8%
Credit Risk Market Risk Operational Risk

BASEL-II (2)
PILLAR I: Minimum Capital Requirement

1) Capital Measurement: New Methods

2) Market Risk: In Line with 1993 & 1996
3) Operational Risk: Working on new
methods

BASEL-II (3)
Pillar I is trying to achieve

If the banks own internal calculations

show that they have extremely risky,
loss-prone loans that generate high
internal capital charges, their formal
risk-based capital charges should also be
high

Likewise, lower risk loans should carry

lower risk-based capital charges

BASEL-II (4)
Credit Risk Measurement
1) Standard Method: Using external rating for
determining risk weights
2) Internal Ratings Method (IRB)
a) Basic IRB: Bank computes only the
probability of
default
b) Advanced IRB: Bank computes all risk
components
(except effective maturity)

BASEL-II (5)
Operational Risk Measurement
1) Basic Indicator Approach
2) Standard Approach
3) Internal Measurement Approach

BASEL-II (6)
Pillar I also adds a new capital

component for operational risk

Operational risk covers the risk of

loss due to system breakdowns,

employee fraud or misconduct, errors
in models or natural or man-made
catastrophes, among others

BASEL-II (7)
PILLAR 2: Supervisory Review Process

1) Banks are advised to develop an internal

capital assessment process and set targets
for capital to commensurate with the
banks risk profile

2) Supervisory authority is responsible for

evaluating how well banks are assessing
their capital adequacy

BASEL-II (8)
PILLAR 3: Market Discipline
Aims to reinforce market discipline
through enhanced disclosure by banks.
It is an indirect approach, that assumes
sufficient
competition
within
the
banking sector.

ASSESSING BASEL-II

To determine if the proposed rules

are likely to yield reasonable riskbased capital requirements within
and between countries for banks
with similar portfolios, four
quantitative impact studies (QIS)
have been undertaken

RESULTS OF
QUANTITATIVE IMPACT
STUDIES (QIS)
Results of the QIS studies have
been troubling
Wide swings in risk-based capital
requirements

Some individual banks show unreasonably

large declines in required capital

As a result, parts of the Basel II

Accord have been revised

IMPLICATIONS OF BASELII (1)

The practices in Basel II represent
several important departures from the
traditional calculation of bank capital

The very largest banks will operate

under a system that is different than
that used by other banks

The implications of this for long-term

competition between these banks is
uncertain, but merits further attention

IMPLICATIONS OF BASEL-II
(2)
Basel IIs proposals rely on banks own
internal risk
requirements

estimates

to

set

capital

This represents a conceptual leap in

determining adequate regulatory capital

For regulators, evaluating the integrity of

bank models is a significant step beyond
the traditional supervisory process

IMPLICATIONS OF BASEL-II
(3)
Despite Basel IIs quantitative basis, much
will still depend on the judgment
1) of banks in formulating their estimates
and
2) of supervisors in validating the
assumptions used by banks in their models

PRO-CYCLICALITY OF THE
CAPITAL ADEQUACY
REQUIREMENT
In a downturn, when a banks capital base is

likely being eroded by loan losses, its existing

(non-defaulted)
borrowers
will
be
downgraded by the relevant credit-risk
models, forcing the bank to hold more capital
against its current loan portfolio. To the
extent that it is difficult or costly for the bank
to raise fresh external capital in bad times, it
will be forced to cut back on its lending
activity, thereby contributing to a worsening
of the initial downturn.