Bank Regulation and Basel I, II, III

Bank Regulation and
Basel I, II, III
Chapter 7
Risk Management and Financial Institutions, Chapter 7, Copyright © John C. Hull 2006 7.1
Why regulate bank capital
 Goal: to provide reliable banking system where

bank failures are rare and depositors are
protected
 Crash of 1929/FDIC/Glass-Steagall Act
 The ability of a bank to absorb unexpected
losses dependent on equity and other forms of
capital
 Capital should cover the difference between
expected losses and “worst-case losses”
The Model used by Regulators
(Figure 7.1, page 166)
Expected X% Worst
Loss Case Loss
Required
Capital
Loss over time

horizon
0 1 2 3 4
Why regulate bank capital
 Competition: insurance/banks/securities firms –
regulatory arbitrage
 CRD – EU Capital Requirements Directive
 Is bank regulation unnecessary?
 Sistemic risk – “ripple effect”
 Deposit insurance – moral hazard?
 Therefore: necessary to combine deposit
insurance with regulations on the capital banks
must hold
History of Bank Regulation
 Pre-1988
 1988: BIS Accord (Basel I)
 1995: netting
 1996: Amendment to BIS Accord
 1999: Basel II first proposed
 2006: Basel II
 2009: Basel 2.5
 2010: Basel III
Pre-1988
 Banks were regulated using balance sheet measures
such as capital : assets (capital to total assets)
 Definitions of capital and required ratios varied from
country to country (posibility for “regulatory arbitrage”)
 Enforcement of regulations varied from country to
country
 Bank transactions became more complicated. Bank
leverage increased in 1980s.
 Off-balance sheet derivatives trading increased
 Total assets was no longer a good indicator of the total
risk being taken.
 Basel Committee on Bank Supervision set up
1988: BIS Accord – Basel I
 First standard: Assets/Capital must be less
than 20. Assets includes off-balance sheet
items that are direct credit substitutes such
as letters of credit and guarantees
 Second standard: Cooke Ratio: Capital
must be 8% of risk weighted assets. At
least 50% of capital must be Tier 1.
Basel I: Risk Weights
Risk-Weighted Capital
 A risk weight is applied to each on-balance-
sheet asset according to its risk (e.g. 0% to
cash and govt bonds; 20% to claims on OECD
banks; 50% to residential mortgages; 100% to
corporate loans, corporate bonds, etc.)
N
RWA    i Li
i 1
 N - number of on-balance-sheet items, Li –
principal amount of the ith item, ωi – risk weight
Risk-Weighted Capital
 For each off-balance-sheet item we first
calculate a credit equivalent amount and
then apply a risk weight
 Risk weighted amount (RWA) consists of
 sum of risk weight times asset amount for on-
balance sheet items
 Sum of risk weight times credit equivalent
amount for off-balance sheet items
Credit Equivalent Amount
 The credit equivalent amount is calculated
as the current replacement cost (if
positive) plus an add on factor
 The add on amount varies from instrument
to instrument (e.g. 0.5% for a 1-5 year
swap; 5.0% for a 1-5 year foreign currency
swap)
Add-on Factors (% of Principal)
Table 7.2, page171
Remaining Interest Exch Equity Precious Other

Maturity rate Rate and Metals Commodities
(yrs) Gold except gold
<1 0.0 1.0 6.0 7.0 10.0
1 to 5 0.5 5.0 8.0 7.0 12.0
>5 1.5 7.5 10.0 6.0 15.0
Example: A $100 million swap with 3 years to maturity worth $5 million

would have a credit equivalent amount of $5.5 million
The Math
N M
RW A  
i 1
i Li  
j 1
*
j C j
On-balance sheet Off-balance sheet items:

items: principal credit equivalent
times risk weight 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-weighted assets
N
  i Li
i 1
For on-ballance-sheet items, Example 7.1
For off-balance-sheet items we use credit equivalent amount (Cj).

For an OTC derivative, (Cj) is:
m ax V , 0   aL Example 7.2
Total risk-weighted assets for a bank with N on-balance-sheet and

M off-balance sheet items
N M
 L   C
i 1
i i
i 1

j j Example 7.3
Types of Capital (page 172)
 Tier 1 Capital: common equity, non-
cumulative perpetual preferred shares,
less goodwill
 Tier 2 Capital: cumulative perpetual
preferred stock, certain types of 99-year
debentures, subordinated debt with an
original life of more than 5 years
G-30 Policy Recommendations
(page 172-3)
 Influential publication from derivatives

dealers, end users, academics,
accountants, and lawyers
 20 recommendations published in 1993
 Report itself is not a regulatory document
but has been very influential in the
development of risk managment practices.
Netting (page 174-5)
 Netting refers to a clause in derivatives
contracts that states that if a company
defaults on one contract it must default on
all contracts
 In 1995 the 1988 accord was modified to
allow banks to reduce their credit
equivalent totals when bilateral netting
agreements were in place
Netting Calculations
 Without netting exposure is
N
 max(V ,0)
j 1
j
 With netting exposure is

 N 
max   V j , 0 
 j 1 
 Net replacement ratio NRR 

Exposure with Netting
Exposure without Netting
Netting Calculations continued
 Credit equivalent amount modified from
N
 [max(V ,0)  a L ]
j 1
j j j
 To
N N
max(V j ,0)   a j L j (0.4  0.6  NRR )
j 1 j 1
1996 Amendment (page 176)
 Implemented in 1998
 Distinguishes between bank’s trading book
and banking book
 Requires banks to measure and hold
capital for market risk for all instruments in
the trading book including those off
balance sheet (This is in addition to the
BIS Accord credit risk capital)
The Market Risk Capital
 Standardized approach
 Internal Model Based Approach – IMBA
 VaR
 Benefit of diversification
Total capital = 0,08 x (Credit risk RWA + Market risk RWA)
The Market Risk Capital
 The capital requirement is
k  VaR  SRC
 Where k is a multiplicative factor chosen
by regulators (at least 3), VaR is the 99%
10-day value at risk, and SRC is the
specific risk charge (primarily for debt
securities held in trading book)
Basel II
 Implemented in 2007
 Three pillars
 New minimum capital requirements for credit
and operational risk
 Supervisory review: more thorough and
uniform
 Market discipline: more disclosure
New Capital Requirements
 Risk weights will be based on on either
external credit rating (standardized
approach) or a bank’s own internal credit
ratings (IRB approach)
 Recognition of credit risk mitigants
 Separate capital charge for operational
risk
Total capital = 0,08 x (Credit risk RWA + Market risk RWA +
Operational risk RWA)
USA vs European Implementation
 In US Basel II will apply only to large
international banks
 Small regional banks required to
implement “Basel 1A’’ (similar to Basel I),
rather than Basel II
 European Union requires Basel II to be
implemented by securities companies as
well as banks
Basel II Credit Risk
 Standardized Approach
 Foundation IRB
 Advanced IRB
Standardized Approach, Table 7.4, page 180
Banks counterparties are treated similarly to corporations. Under Basel

I corporations are assumed to be substantially less creditworthy
Rating AAA A+ to A- BBB+ to BB+ to B+ to B- Below Unrated

to AA- BBB- BB- B-
Country 0% 20% 50% 100% 100% 150% 100%
Banks 20% 50% 50% 100% 100% 150% 50%
Corporates 20% 50% 100% 100% 150% 150% 100%
Adjustments for Collateral
 Two approaches
 Simple approach: risk weight of counterparty
replaced by risk weight of collateral
 Comprehensive approach: exposure adjusted
upwards to allow to possible increases; value
of collateral adjusted downward to allow for
possible decreases; new exposure equals
excess of adjusted exposure over adjusted
collateral; counterparty risk weight applied to
the new exposure
IRB Approach for corporate, banks and sovereign
exposures
 Basel II provides a formula for translating PD

(probability of default), LGD (loss given default),
EAD (exposure at default), and M (effective
maturity) into a risk weight
 Under the Advanced IRB approach banks
estimate PD, LGD, EAD, and M
 Under the Foundation IRB approach banks
estimate only PD and the Basel II guidelines
determine the other variables for the formula
Key Model (Gaussian Copula)
 The 99.9% worst case default rate is
 N -1 ( PD)    N -1 (0.999) 
WCDR  N  
 1  
Numerical Results for WCDR
Table 7.5, page 183
PD=0.1% PD=0.5% PD=1% PD=1.5% PD=2%

r=0.0 0.1% 0.5% 1.0% 1.5% 2.0%
r=0.2 2.8% 9.1% 14.6% 18.9% 22.6%

r=0.4 7.1% 21.1% 31.6% 39.0% 44.9%
r=0.6 13.5% 38.7% 54.2% 63.8% 70.5%
r=0.8 23.3% 66.3% 83.6% 90.8% 94.4%
IRB approach
 In a general portfolio of loans, there is a 99,9%
chance that the total loss will be less than the
sum of
EAD  LGD  WCDR

for the individal loans
Corporate, Sovereign and Bank
Exposures
 Capital required:
 EAD x LGD x (WCDR – PD) x MA
 MA – Maturity adjustment is designed to allow
for the fact if an instrument lasts longer than one
year, there is a one-year credit exposure arising
from a possible decline in the creditworthiness of
the counterparty
 RWA = 12.5 x EAD x LGD x (WCDR – PD) x MA
Retail Exposures
 Capital required:
 EAD x LGD x (WCDR – PD)
 RWA = 12.5 x EAD x LGD x (WCDR – PD)
Credit Risk Mitigants
 Credit risk mitigants (CRMs) include
collateral, guarantees, netting, the use of
credit derivatives, etc
 The benefits of CRMs increase as a bank
moves from the standardized approach to
the foundation IRB approach to the
advanced IRB approach
Guarantees
 Traditionally the Basel Committee has used the
credit substitution approach (where the credit
rating of the guarantor is substituted for that of
the borrower)
 However this overstates the credit risk because
both the guarantor and the borrower must
default for money to be lost
 Alternative proposed by Basel Committee:
capital equals the capital required without the
guarantee multiplied by 0.15+160×PDg where
PDg is probability of default of guarantor
Operational Risk Capital
 Basic Indicator Approach: 15% of gross
income
 Standardized Approach: different
multiplicative factor for gross income
arising from each business line
 Internal Measurement Approach: assess
99.9% worst case loss over one year.
PILLAR II: Supervisory Review
 Banks should have a process for assesing their overall
capital adequacy in relation to their risk profile
 Supervisors should review and evaluate bank’s internal
capital adequacy assesments and strategies
 Supervisors should have the ability to require banks to
hold capital in excess of minimum regulatory
requirement
 Similar amount of thoroughness in different countries
 Local regulators can adjust parameters to suit local
conditions
 Importance of early intervention stressed
PILLAR II: particular attention
 Interest rate risk in the banking book
 Credit risk
 stress tests used,
 default definitions used,
 credit risk concentration,
 risks associated with the use of colateral,
guarantees, and credit derivatives
 Operational risk
PILLAR III: Market Discipline
 To encourage banks to increase disclosure of
risk assessment procedures and capital
adequacy
 Banks will be required to disclose
 Scope and application of Basel framework within the
banking group
 Nature and components of capital (Tier 1, 2, 3)
 Capital requirements for credit, market, op. risk
 Nature of institution’s risk exposures
 Structure of the risk management function and how it
operates
Basel III : Capital
 Quality – min 4,5% equity
 Capital loss absorption at the point of non-
viability
 Capital conservation buffer – 2,5% equity
 Countercyclical buffer – up to 2,5%
Basel III: Risk Coverage
 Securitization
 Trading book
 Counterparty credit risk
 Bank exposure to central counterparties
(CCPs)
 SIFIs: progressive Common Equity Tier 1
capital 1% - 2,5%
 Leverage ratio
Basel III: Liquidity
 Liquidity coverage ratio (LCR): sufficient
high liquidity to sustain 30 day stress
scenario
 Net stable funding ration (NSFR): longer
term structural ratio designed to address
liquidity mismatches.

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Bank Regulation and Basel I, II, III

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Bank Regulation and

Basel I, II, III

 Goal: to provide reliable banking system where

Loss over time

Remaining Interest Exch Equity Precious Other

<1 0.0 1.0 6.0 7.0 10.0

1 to 5 0.5 5.0 8.0 7.0 12.0

>5 1.5 7.5 10.0 6.0 15.0

Example: A $100 million swap with 3 years to maturity worth $5 million

On-balance sheet Off-balance sheet items:

For a derivative Cj = max(Vj,0)+ajLj where Vj is value,

For off-balance-sheet items we use credit equivalent amount (Cj).

Total risk-weighted assets for a bank with N on-balance-sheet and

 Influential publication from derivatives

 With netting exposure is

 Net replacement ratio NRR 

Total capital = 0,08 x (Credit risk RWA + Market risk RWA)

Banks counterparties are treated similarly to corporations. Under Basel

Rating AAA A+ to A- BBB+ to BB+ to B+ to B- Below Unrated

Country 0% 20% 50% 100% 100% 150% 100%

Banks 20% 50% 50% 100% 100% 150% 50%

Corporates 20% 50% 100% 100% 150% 150% 100%

 Basel II provides a formula for translating PD

 The 99.9% worst case default rate is

PD=0.1% PD=0.5% PD=1% PD=1.5% PD=2%

r=0.2 2.8% 9.1% 14.6% 18.9% 22.6%

EAD  LGD  WCDR

 RWA = 12.5 x EAD x LGD x (WCDR – PD)

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