basel ii implications_2

8/4/2019 Basel II Implications_2

1/36

MOVING TOWARDS BASEL II

Issues & Concerns


2/36


Basel I was very simple in its approach. However, Basel II is complex

There is belief that countries would adopt the

options and approaches that are most appropriate

for the state of their banking systems, their

supervisory structures and their markets,

Under the Basel II Accord, supervisors can adopt

the framework on an evolutionary basis and useelements of national discretion to adapt it to their

needs.


3/36


Under Basel I, banks were required to hold a

uniform level of 8 per cent as minimum capital

Now under the new accord, Basel II, supervisors

have the discretion to ask banks to hold higher

levels of minimum capital

For example, in India the minimum capital

requirement is at 9% level.


4/36


Basel Accord I : In 1988 the Basel Committee published a set of

minimal capital requirements for banks, known as Basel Accord I. It focused primarily on credit risk.

Assets of the banks were classified into four risk buckets

with risk weights of 0, 20, 50 and 100. Assets were to be

classified into one of these risk buckets based on types of

counter party (sovereign, banks, public sector and others).

Banks were required to hold capital equal to 8% (in India

presently 9%) of the risk-weighted value of assets.

The accord provided definition of total capital as Total Capital =

0.08 x Risk Weighted Assets. These recommendations wereintroduced in India through Narasimham committee

recommendations.


5/36


Basel Accord I:

An Example for Calculation of Capital Requirement

Exposure in an account Rs. 50 Cr

Risk weight assigned to the account 100%

Minimum capital requirement 8%

Capital required is =

(50x100x8)/(100x100) = Rs. 4 Cr


6/36


Basel Accord II:

The New Accord (Basel II) The Basel committee has issued adetailed document on capital measurement and capital standards

on 26th June 2004. The framework of new accord consists of

three pillars:

Minimum capital requirements, which seeks to refine thestandardised rules set forth in Accord I;

Supervisory review process not only to ensure that banks have

adequate capital but also to encourage banks to adopt better risk

management techniques, and Market discipline with effective use of mandatory disclosure on

risk management practices.


7/36

Major Differences Between Basle I and Basle II Accords

Old Accord - Basle I

"One Size Fits All"

Broad Brush

Single Risk Measure

New Accord - Basle II

Portfolio ofapproaches

Emphasis on internalmodels, supervisoryreview and marketdiscipline

Flexible, incentive forbetter risk mgt.

More risk sensitive


8/36

Comparison of Basel I and II

Under Basel II, the capital requirements are more risksensitive as these are directly related to the credit rating

of each counter-party instead of counter-party category(as was applicable under Basel I).

Further, the New Accord requires banks to hold capital

not only for Credit and Market Risk but also forOperational Risk (OR) and where warranted for interestrate risks, credit concentration risks, liquidity risks etc

All these makes Basel II much more comprehensivethan the earlier Basel I.

Basel II recognizes a wider range of collaterals andprovides incentives for improved risk management

practices


9/36


An interesting point to note is that Basel II recognises

the element of diversification of risk in the SME sectorand has assigned a lower risk weight for retail SMEexposure under Standardised Approach.

The non-retail SME exposure would also attract alower risk weight where they have better external ratings

under the Standardised Approach.

Shifting to Basel II, therefore, could be advantageousfor economies whose banks have significant SMEexposure.


10/36


NEW ACCORD Capital Requirement

Minimum capital requirement depends on quality ofrisk management and will be measured as under:

Banks capital adequacy ratio =

Total Capital

----------------------------------------------------------------------

RWAs of Credit Risk+ Market Risk+ Op. Risk

- No change in definition of total capital

- No change in 1996 approach for market risk10


11/36

DRAFT GUIDELINES FOR IMPLEMENTATION OF THE NEW CAPITAL ADEQUACY

FRAMEWORK

RBI releases Draft guidelines on 14th February2005.

At a minimum, all banks in India to adoptStandardised Approach for Credit Risk and Basic

Indicator Approach for Operational Risk w.e.f.31st March 2007. Bank to have a parallel run w.e.f. 1 April 2006. Some banks to migrated to IRB approach after

developing necessary skills and after obtainingspecific approval of RBI.

Bank to study these guidelines and furnish theirfeedback within 3 weeks.


12/36


NEW ACCORD (BASLE II) IS BASED ON THREE PILLARS :

Pillar 1 : Minimum Capital

Advanced methods for capital allocation

Capital charge for operational risk

Pillar 2 : Supervisory Review Focus on internal capabilities

Supervisors to review banks internal

assessment and strategiesPillar 3 : Market Discipline

Focus on disclosures


13/36

13

Certify internal

models

Integrated Supervisory Regime- Basel II

Pillar IMinimum Capital

Requirements

Credit Risk

Market Risk

Operational Risk

Pillar IISupervisory

Impact

Evaluate banks

capital adequacystrategies

AdditionalCapital

Adjustments

Pillar IIIMarket Discipline

InformationDisclosures

Core &

Supplementary



14/36


WHAT DOES THREE PILLARS INDICATE ?

PILLAR-1: MINIMUM CAPITAL

Market risk

Unchanged from existing Basel I Accord

Credit risk

Significant change from existing Basel Accord

Three different approaches to the calculation of minimum capital requirements

Capital incentives to move to more sophisticated credit risk managementapproaches based on internal ratings

Sophisticated approaches have systems / controls and data collection requirements

Operational risk

Not covered in Basel I Accord Three different approaches to the calculation of minimum capital requirements

Adoption of each approach subject to compliance with defined qualifying criteria


15/36



Market risk

Market Risk is defined as the possibility of loss to a bank caused by

changes in the market variables. Basel defines market risk as The

risk that the value of on or off balance sheet position will be

adversely affected by movements in equity and interest rate

market , currency exchange rates and commodity prices. Various

market risk are liquidity, interest rate, forex, equity, commodities

and other prices, etc.


16/36



Credit risk Credit risk is defined as possibility that a borrower or counter party will fail

to meet its obligation in accordance the agreed terms.

Credit Risk is composed of Default risk, Exposure Risk and Recovery Risk

Probability of Default (PD) : It is the probability that a borrower will fail to meet its

obligation in accordance with the agreed terms.

Exposure at Default (EAD): It is a level of exposure to a borrower at the time of

default.

Loss Given Default (LGD) : It is loss which the bank may sustain in case of default by a

borrower.


17/36



Operational risk

Risk is defined as the risk of loss resulting from

inadequate or failed internal processes, people,

and system or from external events. This includes

legal risk, but excludes strategic and reputational

risk The operational risk identification and

measurement is still in an evolutionary stage ascompared to the maturity that market and credit

risk measurement have achieved.


18/36



Operational risk Most important types of operational risk involve

breakdowns in internal controls and corporategovernance

Such breakdowns can lead to financial losses through Error

Fraud

Failure to perform in a timely manner

Cause the interest of the bank to be compromised likeexceeding authority, conducting business in an unethical orrisky manner

Other aspects of operational risk include failure of IT

Systems or events such as fires or other disasters


19/36


Operational risk

Cause Definition

Internal

Processes

Losses from failed transactions, client accounts, settlements and

every day business processes.

People Losses caused by an employee or involving employees (intentionalor unintentional), or losses caused through the relationship or

contact that a firm has with its clients, shareholders, third parties,

or regulators.

Systems Losses arising from disruption of business or system failure due to

unavailability of infrastructure or IT.

External

Events

Losses from the actions of 3rd parties including external fraud, or

damage to

property or assets, or from change in regulations that would alter

thefirms

ability to continue doing business.


20/36


WHAT DOES THREE PILLARS INDICATE ?

PILLAR 2 - SUPERVISORY REVIEW

Banks should have a process for assessing their overallcapital adequacy and strategy for maintaining capital levels

Supervisors should review and evaluate banks internalcapital adequacy assessment and strategies

Supervisors should expect banks to operate above theminimum capital ratios and should have the ability torequire banks to hold capital in excess of the minimum

Supervisors should seek to intervene at an early stage to

prevent capital falling below minimum levels


21/36


22/36

Basel II

22

THREE BASIC PILLARS

MinimumCapital

Requirement

SupervisoryReview

Process

Market

Discipline

Market RiskCredit Risk

Definition of

CapitalWeighted Risks

Operational Risk

Standardised

Approach (SA)

Internal Ratings Based

Approach (IRBA) Basic

Indicator

Approach

(BIA)

Standar-

dised

Approach

(SA)

Advanced

Measurement

Approach

(AMA)Foundation

Approach(FIRB)

Advanced

Approach (AIRB)


23/36

Credit Risk Measurement Approaches under Basel II

Pillar 3 - Market Discipline

Market discipline reinforces efforts to promotesafety and soundness in banks

Core disclosures (basic information) andsupplementary disclosures to make marketdiscipline more effective

Criteria Internal Ratings Based (IRB) Approach

StandardizedApproach

FoundationApproach

AdvancedApproach

Rating External Internal Internal

Risk Weight

Calibrated on the basis

of external ratings by

the Basel Committee

Function provided by

the Basel Committee

Function provided

by the Basel

Committee


24/36






Standardized Approach Foundation Approach Advanced Approach

Probability of Default

(PD) i.e. the likelikhood

that a borrower will

default over a given timeperiod

Implicitly provided by the

Basel Committee, tied to risk

weights based on external

ratings

Provided by bank based on

own estimates

Provided by the Bank

based on own estimates

Exposure of Default

(EAD) : For loans, the

amount of the facility that

is likely to be drawn if a

default occurs

Supervisory values set by the

Basel Committee

Supervisory values set by

the Basel Committee

Provided by bank based

on own estimates.

Loss Given Default

(LGD) : the proportion of

the exposure that will be

lost if a default occurs

Implicitly provided by the

Basel Committee, tied to risk

weights based on external

ratings


the Basel committee

Provided by bank based

on own estimates;

extensive process and

internal control

requirement


25/36







Maturity i.e. the

remaining economic

maturity of the

exposure

Implicitly recognition


the Basel Commitee

or

At rational discretion,

provided by bank based on

own estimates (with an

allowance to exclude certain

exposures)

Provided by the bank

based on own estimates(with an allowance to

exclude certain

exposures)

Data Requirements

Provision dates Default events

exposure data

customer segmentation

Data collateral

segmentation

External Ratings

Collateral data

Rating data

Default events

Historical data to

estimate PDs (5 years)

Collateral data

Same as IRB Foundation,

plus :

Historical loss data to

estimate LGD (7

years)

Historical exposure

data to estimate EAD

(7 years)


26/36

Credit Risk Measurement Approaches under Basel -II






Credit Risk Mitigation

techniques (CRMT)

Defined by the supervisory

regulator; including financial

collateral, guarantees, credit

derivatives, "netting" (on and

off balance sheet) and real

estate.

All collaterals from

Standardized approach;

receivables from goods and

services; other physical

securities if certain criteria

are met.

All types of collaterals

if bank can prove a

CRMT by internal

estimation.

Maturity : the

remaining economic

maturity of the

exposure

Minimum requirements for

collateral management(administration /

evaluation)

Provisioning process

Same as Standardized

Approach; plus minimum

requirements to ensurequality of internal ratings

and PD estimate on and

their use in the risk

management process.

Same as IRB

foundation, plus

minimum requirements

to ensure quality of

estimation of all

parameters.


27/36

Operational Risk Measurement Approaches under Basel -II




Calculation of

Capital Charge

Basic Indicator

Approach

Standard Approach

Advanced

Measurement

Approach

Calculation of capital

charge

Average of gross income

over three years as

indicator

Capital charge equals 15%

of that indicator

Gross income perregulatory business line

as indicator

depending on business

line, 12%, 15% or 18%

of that indicator as

capital charge

Total capital chargeequals sum of charge

per business line

Capital charge

equals internally

generated measure

based on (a) internal

loss data; (b)

External loss data;

(c) Scenario

analysis; (d)

Business

environment andinternal control

factors;

Recognition of risk

mitigation (up to

20% possible)


28/36

Operational Risk Measurement Approaches under Basel -II


Market discipline reinforces efforts to promote

safety and soundness in banks

Calculation ofCapital Charge

Basic IndicatorApproach

Standard Approach

Advanced

MeasurementApproach

Qualifying Criteria

No specific criteria;

compliance with the Basel

Committee's "Sound

Practices for the

Management and

Supervision of Operational

Risk" recommended

Active involvement of

board of directors andsenior management;

existence of

Operational Risk

Management function

Sound Operational Risk

management system Systematic tracking of

loss data

Market discipline

reinforces efforts topromote safety and

soundness in banks;

Core disclosures

(basic information)

and supplementary

disclosures to makemarket discipline

more effective.


29/36


Implementation in India

In India, RBI is instrumental to ensureimplementation of Basel II. The reformprocess started in early nineties of the lastcentury have proved a boon for migrating to

Basel II. With the commencement of thebanking sector reforms in the early 1990s, theRBI has been consistently upgrading the Indian

banking sector by adopting international bestpractices.

The minimum capital adequacy requirementunder the Basel standard is 8%. However, in

India, RBI has stipulated and achieved a


30/36


Banks in India have now even implementedcapital charge for market risk prescribed in the

Basel document w.e.f. 31/03/2006.

As a prudent measure RBI had put in placeseveral surrogates for market risk, e.g. IFR (

Investment Fluctuation Reserve) of 5% of the

investment portfolio, both in the AFS and HFTcategories plus a 2.5% risk weight on the

entire investment portfolio.


31/36


Commercial banks in India have startedimplementing Basel II with effect from March 31,2007. They are initially adopting theStandardised. Approach for credit risk and theBasic Indicator Approach for operational risk.After adequate skills are developed, both by the

banks and also by the supervisors, some banksmay be allowed to migrate to the Internal RatingBased (IRB) Approach.

Implementation of Basel II will require more capital

for banks in India due to the fact that operationalrisk is not captured under Basel I, and the capitalcharge for market risk was not prescribed untilrecently. Though the cushion available in thesystem, which at present has a CRAR of over 12per cent, is comforting, banks are exploring


32/36


RBI has been expanding the area of disclosures

so as to have greater transparency with regardto the financial position and risk profile of

banks. Illustratively, with a view to enhancing

further transparency, all cases of penaltyimposed by the RBI on the banks as also

directions issued on specific matters, including

those arising out of inspection, are to be

placed in the public domain. Such proactive

disclosures by the Regulator are expected to

have a salutary effect on the functioning of

the banking system


33/36


Major Regulatory Initiatives taken in India :

The regulatory initiatives taken by the ReserveBank of India include:

Ensuring that the banks have suitable riskmanagement framework oriented towards their

requirements dictated by the size and complexityof business, risk philosophy, market perceptionsand the expected level of capital. The frameworkadopted by banks would need to be adaptable to

changes in business size, market dynamics andintroduction of innovative products by banks infuture.

Introduction of Risk Based Supervision (RBS) in 23banks on a ilot basis.


34/36


Major Regulatory Initiatives taken in India :

Encouraging banks to formalize their CapitalAdequacy Assessment Programme (CAAP) inalignment with business plan and performancebudgeting system. This, together with adoption ofRisk Based Supervision would aid in factoring the

Pillar II requirements under Basel II. Enhancing the area of disclosures (Pillar III), so as

to have greater transparency of the financialposition and risk profile of banks.

Improving the level of corporate governancestandards in banks.

Building capacity for ensuring the regulatorsability for identifying and permitting eligible banks

to adopt IRB / Advanced Measurement


35/36


Major Challenges Envisaged in Implementation

of Basel II Accord in India : a. Higher capital requirements

b. Improved IT architecture/MIS

c. Consolidation d. Data issues

e. Capacity Building

(f) External ratings (g) Use of national discretion

(h) Validating the concept of economic capital

(i) Improving governance standards and


36/36


Conclusion

Basel II is expected to foster financial stability through its risk

sensitive framework which will encourage banks to adoptimproved risk management practices; require supervisors toreview the efficiency of banks risk management practicesand capital allocation methodologies; and empower marketparticipants to make informed judgements on the efficiency

of banks and accordingly punish or reward banks. While it is true that implementation of Basel II is not the be

all and end all on the subject of financial stability it must berecognised that banks are "special". Their sound and efficientfunctioning is critical not only to the growth of the real sector

but also for strengthening the social infrastructure.Internationally, therefore, banks have moved centre-stageand their performance is the cynosure of all eyes.

basel ii implications_2

Documents