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BASEL II AT GLANCE

Implementation of Basel II in Indonesia

Bank Indonesia

Directorate of Banking Research and Regulation


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Table of Contents

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Foreword

The purpose of this book is to help readers understand the importance of capital, not

only for individual banks, but also in safeguarding financial system stability. Because of

this vital role, the regulation of bank capital is guided by international standards issued

by the Basel Committee on Banking Supervision. The Basel I standard, initially adopted

in 1988, has undergone numerous changes over time in response to the rapid

development of financial market instruments. Ultimately, agreement was reached on a

more risk sensitive standard for calculation of bank capital known as Basel II.

This simply-worded book is designed to inform readers of the process of change in

capital standards and the background to the issuance of Basel II, in which bank capital

adequacy is linked to the risk profile of the individual bank.

This book does not delve into the in depth technical detail on each aspect of Basel II, but

rather is aimed more at presenting a common line of thought for Basel II, that of

improving bank risk management in order to provide better assurance of financial

system stability, which will ultimately support economic growth.

Jakarta, September 2006


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Basel II at a Glance

Improved Standard for Capital Adequacy

A bank provides an intermediation function for funds received from customers. Failure ofa bank will result in widespread impact affecting retail and institutional customers who

hold funds at the bank. This could trigger multiplier impacts ont he domestic andinternational market. The importance of the banking role demands proper regulation, in

which the primary objective is to maintain customer confidence in the banking system.An essential part of the regulatory framework for the banking system involves the

regulations governing bank capital, which functions as a buffer against losses.

In view of the importance of capital to banks, BIS issued a capital framework concept

more commonly known as the 1988 accord (Basel I). This system was designed as aframework for measurement of credit risk and established a minimum capital standard at8%. The Basel Committee designed Basel I as a simple standard requiring banks todisaggregate their exposures into broader categories reflecting debtor similarities.Exposures to customers of the same type (such as exposures to all corporate customers)are subject to the same capital requirements without taking account of differences in

loan repayment capacity and specific risks associated with the individual customer.

More than a decade later, prompted by the evolution of banking worldwide and thereality that the best method for calculating, managing and mitigating risks would be

different from bank to bank, the Basel Committee embarked on the initiative for revision

of Accord 1988. The growing diversity and sophistication of products in the bankingsystem led BIS to introduce improvements to the capital framework in the 1988 accord

with the launching of a new capital concept known as Basel II. The first proposal w as

released in 1999 and was slated for implementation at end-2006. The revised capitalaccord—Basel II—is a comprehensive agreement that establishes a spectrum of more

risk-sensitive capital allocation and incentive for improvements in the quality of risk

management at banks. This was achieved by adjusting capital requirements to credit riskand operational risk, and introducing changes in calculation of capital to cover exposures

to risks of losses caused by operational failures. In addition to the calculation of

minimum bank capital, Basel II also provides for a supervisory review process to ensurethat banks maintain a level of capital commensurate to their risk profile and promotes

market discipline through disclosure requirements.

The objective of Basel II is to strengthen the security and soundness of the financialsystem by reinforcing the emphasis on risk-based calculation of capital, the supervisory

review process and market discipline. The Basel II Framework is based on a forward-

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looking approach that enables improvements and changes to be made over time. In this

way, the Basel II framework is able to keep pace with changes in the marketplace anddevelopments in risk management.

At first glance, Basel II involves various complexities and preconditions that are difficultfor banks to meet. However, the extra effort is well justified in view of the benefits to

banks from more economic use of capital in covering their risks. Banks also benefit from

the international recognition of the Basel II standards, which enables a bank intending tooperate globally to be readily accepted on the international market, provided that these

standards are met.

Maximising the Benefits of Basel II

Basel II calculates the capital requirement according to the bank risk profile and contains

incentives for improvement in risk management within the banking system. By usingvarious approaches to measure credit risk, market risk and operational risk, the resultobtained is more risk-sensitive allocation of bank capital. In Basel II, the calculation of

bank capital is prescribed in Pillar 1 – the Minimum Capital Requirement. The alternativeapproaches can essentially be aggregated into two major groups: the standardised

models that apply to all banks and the more sophisticated internal models developed as

appropriate to the nature of business and risk profile of the individual bank.

A comparison between the two major approaches reveals that internal models can

generally be expected to generate more precise capital adequacy calculationsappropriate to the risks faced by the bank. This will offer banks an incentive that is

expected to promote sustained efforts to build the quality of risk management. In thisway, over time, banks will maximise the benefit of the more sophisticated approaches incalculating their capital requirement.

Minimum Capital Ratio = 8% = Capital (Tier 1 + Tier 2 + Tier 3)

Risk-Weighted Assets

Market Risk Credit Risk OperationalRisk

Risk of loss fromon and off balance

sheet positionsfrom changes inmarket factors

(interest rates and

exchange rates)

No SignificantChanges

Risk of loss fromdefault bydebtors/

counterparties

SignificantChanges

Risk of loss directlyor indirectly causedby weaknesses orfailures in internalprocesses, human

resources and

systems and byexternal events

AdditionalRisk


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In assessing bank capital adequacy, it is not only necessary to allocate capital on the

basis of Pillar 1, but also capital to anticipate losses from other risks, such as liquidityrisk, strategic risk, interest rate risk in the banking book and other risks. This approach

is captured in Pillar 2, the Supervisory Review Process, and is referred to as the

Individual Capital Adequacy Assessment Process (ICAAP). It will pose an importantchallenge for banks and supervisors. Building of supervisor competence and capacity will

be essential, as also the support of the regulatory framework for bank supervision. With

time, supervisors will become effective in the assessment of risks other than thosecovered in Pillar 1 and may even order banks to add to their capital if bank capital is

deemed inadequate.

Furthermore, the active public role in scrutiny of banks is seen as crucial. From the

beginning, the public will also be expected to assess bank risks and ascertain the level ofcapital adequacy as envisaged in Pillar 3 – Market Discipline. The synergy of the three

Pillars in Basel II is integral to building a sound and stable banking industry and financialsystem.

Impact of Basel II on the Resilience of the Banking System

1. Will Basel II cause bank CAR to drop below the 8% minimum?

Bank Indonesia is now working together with a number of banks on a periodical

study of quantitative impact to assess thec onsequences of Basel II on bank capital.

For this reason, the impact of Basel II should be examined on an individual basis. It

is necessary to perform assessments and improve the effectiveness of risk

management from an early stage in order to gain maximum advantage from the

available incentives. A drop in the CAR could well occur for banks with a higher risk

profile. However, banks whose credit portfolios are dominated by retail loans and

home mortgages will see a reduction in their capital requirement because of the

lower risk weightings that will apply to retail loans and home mortgages.

2. Will Basel II be implemented for all commercial banks?

The focus of Basel II in Indonesia is development and improvement in riskmanagement within the national banking system. This was set out in Bank Indonesia

Regulation No. 5/8/PBI/2003 dated 19 May 2003 concerning Application of RiskManagement for Commercial Banks. These measures will apply to all banks

regardless of size, given that the risk management culture should become standard

practice in the banking business. Survey shows that banks would prefer Basel II tobe implemented across the board. The main reason is to minimise the negative

impact on competition that would arise from differentiations by ability and readinessof banks to implement and develop risk management and the associatedinfrastructure. Furthermore, all banks in Indonesia will be able to apply the standard

approaches in Basel II.

3. Could Basel II hamper the intermediation process?

Basel II is not intended to hamper the intermediation process currently in operationin the banking system. At the macro level, it also does not seek to reduce the

dominant role of the banking system in financing economic activities. The overall

thrust of the approaches put forward in Basel II is intended more as an effort to

reposition and redefine what has been achieved by the banking system, with focus on

improving risk management.

In regard to the intermediary function, Basel II is not a mechanical capital regime

with no room for tolerance. Room for flexibility is assured by a number of national

discretion clauses. While Basel II is expected to see reduced exposures to certain


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sectors (e.g. because of the use of ratings in lending to corporate entities), on the

other hand it will also encourage increased exposures to other sectors, such as retail

lending (e.g. small-scale business credit, personal loans and so on) and housing

mortgages through reduced risk weightings. It is understood that this shift in

exposures will bring some shock to banks, debtors and the economy as a whole.

Even so, this effect is not expected to last long, and will be no more than a fine

tuning customary to any economy.

4. What will be the impact for banks currently working on raising their capital

for the implementation of the Indonesian Banking Architecture?

Raising additional capital for the purposes of the Indonesian Banking Architecture will

not in itself provide the means for a bank to achieve full compliance with Basel II.

However, a n adequate capital base will enable a bank to develop the human

resources and information technology capabilities essential for Basel II. In this way,

the Rp 80 billion tier 1 capital requirement for commercial banks, to be met by the

end of 2007, and the Rp 100 billion requirement for the end of 2010 will not only

expand the economy of scale in conducting operations, but also provide opportunity

for the bank to strengthen its risk management capabilities for implementation of

Basel II.

5. What are the prerequisites for proper implementation of Basel II?

Conditions that must be satisfied for proper implementation of Basel II include:

- Application of risk management practices in the banking system as stipulated

in Bank Indonesia Regulation No. 5/8/PBI/2003 dated 19 May 2003

concerning Application of Risk Management for Commercial Banks

- Adjustments in accounting standards in keeping with international accounting

standards (IAS), including but not limited to IAS 32 and IAS 39

- Consolidated calculation of bank capital to cover companies in the same group

operating in the financial sector, with the exception of insurance companies

- Recognition of a rating agency to enable objective rating of bank debtors.

Roadmap for Basel II in Indonesia: What Bank Indonesia and the Banking

System Must Do to Prepare

Basel II states that each supervisory authority must weigh priorities before adopting

Basel II. In implementing Basel II, Bank Indonesia is essentially seeking to strengthenrisk management so that banks willb ecome more resistant to domestic, regional and

international shocks. Bank Indonesia has developed a realistic format to be followed inthe implementation of Basel II that takes account of the current condition of the bankingindustry. For this reason, the default mode for implementation will be to take the

simplest path, i.e. the standardised approach. This means that all banks will makeadjustments to their capital adequacy calculations on the basis of the Basel II guidelines.

Basel II also provides for national discretion, in which some matters are decided by thelocal supervisory authority. Judgements can therefore be made for the condition of theIndonesian banking system and complexity of Indonesia's banking products.

As part of the ongoing consultations on the substance of Basel II, including nationaldiscretion, Bank Indonesia has set up a working group together with the banking system

to develop recommendations on the most appropriate regulatory framework. These

recommendations will then be set out in a Consultative Paper (CP) to be distributed tostakeholders and especially banks in order to invite opinions, suggestions and inputs.


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Q2/2011Q4/2010Q2/2011Start Q1/2010Q4/2009 AMA 3)Q2/2011Q4/2010Q4/2010Start Q1/2010Q4/2009Standardised 3)Q1/2009Q4/2008Q1/2009Q1/2008 – Q1/2009Q3/2007Basic Indicator

Operational Risk

Q2/2011Q4/2010Q4/2010Start Q1/2010Q4/2009IRBA 3)Q1/2009Q4/2008Q1/2009Q1/2008 – Q1/2009Q3/2007Standardised

Credit Risk

Q1/2009Q2/2008Q2/2008Start Q3/2007Q3/2007Internal Model 3)

Q1/2009Q1/2009Q3/2007Q4/2008Q1/2009Q1/2008 – Q4/2008Q3/2007Standardised2)

Market Risk

Publish BIRegulations

CAR MethodEffective

Issue BIRegulations

Online System

TransparencyOther Risks 4)Improvementsto CommercialBank Report

CARMethod

Effective

Parallel Run(Standardised) 1) or

Validation Process(Internal Model)


PILLAR 3PILLAR 2PILLAR 1Use of Risk Calculation

Approach

Q2/2011Q4/2010Q2/2011Start Q1/2010Q4/2009 AMA 3)Q2/2011Q4/2010Q4/2010Start Q1/2010Q4/2009Standardised 3)Q1/2009Q4/2008Q1/2009Q1/2008 – Q1/2009Q3/2007Basic Indicator

Operational Risk

Q2/2011Q4/2010Q4/2010Start Q1/2010Q4/2009IRBA 3)Q1/2009Q4/2008Q1/2009Q1/2008 – Q1/2009Q3/2007Standardised

Credit Risk

Q1/2009Q2/2008Q2/2008Start Q3/2007Q3/2007Internal Model 3)

Q1/2009Q1/2009Q3/2007Q4/2008Q1/2009Q1/2008 – Q4/2008Q3/2007Standardised2)

Market Risk


CAR MethodEffective

Issue BIRegulations

Online System

TransparencyOther Risks 4)Improvementsto CommercialBank Report

CARMethod

Effective

Parallel Run(Standardised) 1) or

Validation Process(Internal Model)


PILLAR 3PILLAR 2PILLAR 1Use of Risk Calculation

Approach

There have been widespread misunderstandings among bankers that banks will be

required to adopt more advanced approaches demanding heavier investment inexpensive IT and databases, a requirement that would obviously place banks under

financial strain. In principle, banks are given flexibility to adopt more advanced

approaches, such as IRB, provided that the necessary preparations in IT, humanresources and systems are complete and the bank risk profile offers assurance that the

use of a more advanced approach would offer benefits for the bank. In these cases,

banks may apply to Bank Indonesia for approval. The BI supervisors will validate thestate of preparedness of the bank before permitting the bank to calculate capital

adequacy using internal models. Bank Indonesia is now providing special training tobank supervisors who will become validators of market risk and validators of credit risk.

Implementation of Basel II in Other Countries

In contrast to the G-10 countries, non G-10 nations do not come under any deadline forimplementation of Basel II. This is consistent with the underlying nature of Basel II,

which does not constitute a legally binding document imposing sanctions on non-

complying countries. Furthermore, assessment of a country’s financial sector stability willnot be based on implementation of Basel II, but more on that country’s compliance with

the 25 B asel Core Principles for Effective Banking Supervision (BCP). For this purpose,

Indonesia has made steady improvements in compliance with the BCP in recent years.

Indeed, the sheer diversity of preparations and policies means that each country willfollow a unique path in implementing Basel II. The condition, structure and businesscomplexity of the banking system and quality of bank supervision are the main factors

that will be taken into account in establishing these policies. In the United States, forexample, the advanced IRB (A-IRB) will be adopted by only the 10 leading banking

groups widely known for their international operations. Other banks will apply a Basel IIformat known as Basel 1A.


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Bank Capital

For banks, as for companies in general, capital functions not only as the main resource

for financing operations, but also provides a buffer against possible losses. Capital also

helps to maintain public confidence in the ability of a bank to operate in the

intermediation of customer funds.

The bank supervision authority is responsible for ensuring a minimum adequacy of bank

capital by establishing rules concerning this issue. Regulatory Capital is the capitalrequirement prescribed by the supervisory authority as a buffer against potential losses.

The requirements applying to Regulatory Capital are a key component of bank

supervision and are reflected in the definition of regulatory capital and the capitaladequacy ratio (CAR).

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A general definition of capital was first introduced in Basel I, the first broad approach to

capital adequacy. This definition has remained unchanged and is retained in Basel II.

The definition states that regulatory capital is divided into three tiers. An item may be

grouped into one of these tiers, provided that it satisfies certain criteria. The definition ofregulatory capital sets out the criteria for categorisation as an element of capital, and

thus ensures consistency of capital adequacy among different nations. This has

promoted more common understanding among banks in general and the more

internationally active banks in particular.

Under Basel I and Basel II, regulatory capital is divided into three levels or tiers of

capital as follows:

o Tier 1 capital. This tier c onsists of instruments with the greatest capacity to absorb

losses arising at any time.

o Tier 2 capital. This tier consists of a broad mix of equity components and hybrid

capital/debt instruments. Total Tier 2 capital is restricted to 100% of Tier 1 and is

divided into two categories:

Upper Tier 2, restricted to 100% of Tier 1 capital,

Lower Tier 2, restricted to 50% of Tier 1 capital.

o Tier 3 capital was added in 1996 , and is used only to meet capital requirements for

market risk.

The Capital Adequacy Ratio (CAR)

The objective of this ratio is to ensure that banks are capable of absorbing losses

incurred in the course of their activities. The existing regulatory ratio is the 8%

minimum. This links bank capital to the risk weightings of assets held by the bank.

Supervisor risk weighting is the percentage used to convert the nominal value of credit

exposures to a specific value reflecting level of risk. The risk weighting for each asset is

prescribed in a Bank Indonesia regulation. The capital that must be allocated to cover

potential loss in relation to the exposures is obtained by multiplying the exposure value

by the weighting for the assets and the minimum capital requirement (i.e. 8%).

Some banks have begun using capital adequacy assessment approaches as a riskmanagement function. Banks will normally assess the amount of capital required to

cover loss up to a certain level of probability. The development of these approaches has


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been driven by evidence that capital is a very costly resource for a bank. The bank must

therefore have strong incentives to manage capital as effectively as possible. Since themid-1990s, some of the world's largest and most sophisticated institutions have

developed various measures of economic capital and have specifically combined these

with risk management systems for more efficient management of risks and capital.

The objective of bank supervision is to ensure that banks conduct their operations in line

with prudent, sound principles. To this end, banks must maintain adequate capital andreserves to offset risks arising in the course of business. The main principles of the Basel

Committee on Banking Supervision (BCBS) state that bank supervisors must establish asafe and appropriate level of minimum capital requirement for all banks. The ultimate

goal of all authorities involved in bank supervision is to protect the stability and

soundness of the financial system. Since the end of 1980, standardised calculations of bank capital based on the BCBS guidelines have come into widespread international use

in support of this goal.

Compliance with the minimum capital requirement (or solvency ratio) is determined by

two components as follows:o The risk weightings for bank assets—i.e. all bank exposures converted into assets

with each exposure then multiplied by the supervisor risk weighting, based on level

of risko 2 minimum ratios (or limits) in which regulatory capital is linked to asset risk

weightings:Regulatory capital divided by risk-weighted assets must be equal to or greater

than 8%

Tier 1 capital divided by risk-weighted assets must equal at least 4%.


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SSTTR R UUCCTTUUR R EE OOFF BBAASSEELL IIII

The new capital adequacy framework - Basel II - offers greater flexibility by establishing

a number of risk-sensitive approaches and incentives for improved risk management.Banks are asked to allocate less capital for counterparties with higher ratings and more

capital for those with higher risk. The framework consists of three pillars as follows:

o Pillar 1 (Minimum Capital Requirement) deals with the required minimum capital that

each bank must provide to cover credit, market and operational exposures.

o Pillar 2 ( Supervisory Review Process) establishes the supervisory review processaimed at ensuring an adequate level of bank capital to cover the full scope of bank

risks.o Pillar 3 (Market Discipline) addresses market discipline and the specifics of minimum

limits of public disclosure.

I. Pillar 1 - Minimum Capital Requirement

Pillar 1 establishes the minimum capital requirement in relation to credit risk, market

risk and operational risk. In Basel II, the required level of bank capital is at least 8% of

risk-weighted assets. Within this context, capital is divided into several categories:

o Tier 1 capital, i.e. the most basic level of capital consisting of shares plus non-

cumulative preferential shares and reserves, subtracted by goodwill. Tier 1 capitalmust comprise at least 50 percent of bank capital.

o Tier 2 capital, consisting of asset revaluation value, general reserves, hybrid capitalinstruments and subordinated loans. This tier may not exceed 50 percent of capital

o Tier 3 capital, was added in the 1996 Capital Accord Amendment, but is used only to

cover the portion of the bank capital requirement allocated to market risk. Thiscategory consists of special types of short-term subordinated loans.

I.1. Credit Risk

Basel II allows a financial institution to calculate credit risk for compliance with capital

regulations by one of the following two methods:

o Under the Standardised Approach (SA), the bank uses a list of risk weightings tocalculate the credit risk for its assets. The risk weightings are linked to ratings issued

for the government, financial institutions and companies by an external rating

agency.o The Internal Rating Based Approach (IRB) allows banks to use their own internal

models for counterparties and exposures. This allows for more specific differentiationof risk among various exposures, producing a level of capital more commensurate to

risk.

Credit Risk—Standardised Approach (SA)Under this approach, the bank allocates certain risk weightings for each category of

assets and off-balance sheet items to arrive at a total figure for risk-weighted assets asfollows:

Risk-Weighted Assets = Total exposures x risk

weighting


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Allocations for each risk weighting are based on general debtor categories (government,

bank or corporate), which subsequently classified further according to ratings issued byan external credit rating agency. The standardised approach prescribes risk weightings

based on differences in the nature of the assets and external credit ratings to produce a

more risk-sensitive result in comparison to the current Accord. The risk weightings forthe government, other banks and corporate exposures are differentiated according to the

external credit ratings. A 100 percent risk weighting produces a capital charge at 8% of

the exposure value. Similarly, a 20% risk weighting produces an equivalent capitalcharge of 1.6% (20% x 8%).

Other risk weightings have also been established according to differences in the natureof exposure. Examples of risk weightings for these categories in use are:

- 35% for exposures to residential housing complying with strict prudential criteria;

- 75% for retail exposures (loans to small and medium enterprises meeting certain

criteria enabling them to be treated as retail businesses);

- 100% for exposures to commercial properties, with limited exemptions under

certain conditions;

- 150% for high risk exposures, such as loans past due; and

- 350% for securitised components rated BB+ and BB-.

Credit Risk—Internal Rating Based Approach (IRB)

The IRB approach recognises that banks are customarily better informed of their debtorsthan a rating agency. This approach enables a bank to apply more precise

differentiations for each risk in comparison to the seven risk categories (0%, 20%, 35%,50%, 75%, 100% and 150%) in the standardised approach.

There are two approaches used in the IRB, both of which are based on strict

measurement standards and methodology and require supervisor approval:

- Foundation IRB – the bank calculates probability of default (PD) for each debtor

and the supervisor provides other input, such as loss given default (LGD) and

exposure at default (EAD).

- Advanced IRB – in addition to PD, the bank includes other inputs such as EAD, LGD

and maturity (M). Stricter requirements apply for using this approach in comparison

to foundation IRB.

Major parameters in the IRB approach:

- Probability of Default is the likelihood that a debtor will default on obligations. All

banks must provide an internal model of PD for each debtor category.

- Loss Given Default (LGD) is the estimated percentage of loss that would occur in theevent of a debtor's default.

- Exposure at Default (EAD) is the estimated exposure to a particular debtor in theevent of default.

- Maturity (M) is the effective tenor (in years) of a bank exposure.

Asset Categories in the IRB Approach

- Corporate Exposures – debt liabilities owed by companies or arising from

partnerships or ownership. This category is divided into five sub-assets: project

financing, purchase financing, commodity financing, income-generating real estate

and high volatility commercial real estate.

- Bank Exposures – exposures to banks and securities companies.


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- Government Exposures – exposures to the government, the central bank, public

sector entities and MDBs.

- Retail Exposures – retail loans including loans to individuals and small-scale

businesses, credit card operations, working capital loans, home mortgages and fixed

instalment loans. Basel II identifies two sub-categories: exposures guaranteed by

residential property and retail exposures meeting certain qualifications, including

other retail credit.- Equity Exposures – ownership interests in companies, partnerships and other

corporate business.

IInncceennttiivveess

The capital rules are designed to encourage banks to shift from the

standardised approach to the IRB and from Foundation IRB toAdvanced IRB. By switching to a more advanced approach, many

banks will benefit from reduced capital allocation under the capital

rules as a result of the more accurate linkage between capital and risk.Nevertheless, the possibility remains that bank portfolios are on

average higher risk and the IRB approach demands a higher standardthan the standardised approach.

Mitigation of Credit Risk

A lender can mitigate credit risk if a debtor provides collateral or a third partyunderwrites the debtor’s obligations or the bank buys credit protection, for example

through credit derivatives, or by other means. Compared to the Accord 88, Basel II

provides for broader recognition of credit risk mitigation techniques. Basel II allowsbanks to recognise the following forms of collateral:

- Cash

- Designated securities issued by the government, public sector entities, banks,companies and securities companies

- Designated negotiable equities- Designated mutual funds

- Gold

For banks using the standardised approach to calculate credit risk, Basel II offers twopossible methods for credit risk mitigation:

- The simple approach, which enablesg uaranteed claims to be assigned a risk

weighting against the collateral instrument, subject to a minimum limit of 20%.

- The comprehensive approach, focused on the cash value of collateral. This approach

uses the haircut to calculate volatility of collateral value. This may be the standard

haircut as determined by the Basel Committee or an estimate of collateral volatility

prepared by the bank.

If a bank is approved for use of an internal model, the options of the simple approachesdescribed above are not available. In the case of banks using the IRB approach, the LGDcomponent is also adjusted to reflect the benefit of using collateral to reduce losses.

AAsssseett SSeeccuurriittiissaattiioonn

Securitisation is a technique employed by banks to transfer risk while raising liquidity.

Traditionally, bank assets are pooled and then sold by issuing securities guaranteed by

that pool of assets. In Basel II, banks must use the securitisation framework in


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calculating their capital requirements against exposures arising from traditional

securitisation and syntheses or similar structures with these features.

Because of the many different methods of securitisation, the determination of the capital

required to cover securitisation exposures must be based on economics substance over

form. The same principle also applies to supervisors, who must give greater emphasis to

economics substance in determining whether the exposure fit within the securitisation

framework for calculating bank capital adequacy.In securitisation, the bank may act as the original creditor or investor for the securitised

assets. In either of the two categories, the bank role can vary widely. Whatever the

form, Basel II stresses that banks must allocate capital to cover various forms of

securitisation.

II..22.. MMaarrkkeett R R iisskk

On 1 January 1998, banks in theG -10 countries were

required to allocate capital to cover market risk (as

stipulated in the market risk amendment to the Basel

Accord). The bank capital requirement for market risk isdetermined by two methods.

The first is the standardised approach, which applies a building block approach for

interest rate and equity instrument-related transactions. This approach differentiates

between calculation of capital charges for specific risks and general market risk.

The second is the internal model approach, which enables banks to use internal

methods complying with the qualitative and quantitative criteria determined by the Basel

Committee, subject to approval from the supervisory authority. This approach sets

capital charges at a higher level than the previous day's VaR or the average daily VaR for

60 working days multiplied by three minimum factors. Banks must calculate the VaR on

the basis of daily value with

- one-tailed confidence interval of 99%

- 10-day minimum holding period

- one-year minimum observation period.

The internal model used by the bank must accurately cover certain risks related to

options and option-like instruments.


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II..33.. OOppeerraattiioonnaall R R iisskk

The Basel Committee defines operational risk as the “risk that originates directly or

indirectly from inability or failure of internal processes, persons and systems, as well as

from external events." Three approaches may be used to determine the capital charges

for operational risk:

o The Basic Indicator Approach calculates capital charges for operational risks on

the basis of a certain percentage (alpha factor) of gross income used as an estimate

for bank risk exposures. Under this approach, the capital that must be allocated by

the bank to cover losses arising from operational risks equals a certain percentage of

average gross income over a three year period.

o The Standardised Approach requires an institution to disaggregate its activities

into eight standard business lines. The capital charge for each business line is

calculated by multiplying its gross income by a certain predetermined constant (beta

factor) that is different for each business line.

o In the Advanced Measurement Approach, the calculation of the capital

requirement is the same as the risk measurement generated by a model for

measuring operational risk developedi nternally by the bank. The bank must meet

the qualitative and quantitative criteria stipulated in Basel II and must have approval

from the supervisory authority.

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Basel II requires banks to allocate capital at 8% of risk-weighted assets, calculated

according to the following formula:

For example, a bank has USD10 billion in risk-weighted assets, a USD300 million capital

charge for market risk and a USD100 million capital charge for operational risk. The

minimum capital requirement for the bank is:

= [USD10 billion + 12.5 x (USD300 million + USD100 million)] x 8% = USD1.2 billion

This means that the bank must allocate capital of at least USD1.2 billion.

IIII.. PPiillllaarr 22 -- TThhee SSuuppeerrvviissoorryy R R eevviieeww PPrroocceessss

Pillar 2 focuses on the review process within the supervisory framework that is aimed at

ensuring that banks maintain levels of capital commensurate to their risk profile. Thesupervisory review process seeks to ensure that banks calculate their capital adequacy

to cover the full scope of risk and supervisors assess and take any necessary actions to

respond to the capital calculations made by the bank.

The supervisor may ask the bank to set aside capital in excess of the minimum capital

ratio or take remedial measures such as strengthening of risk management or other

actions. If a higherr atio becomes necessary, the supervisor may intervene if bank

capital is below that limit.


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Pillar 2 requires banks to conduct regular stress testing to

estimate how much capital would be required under crisis

conditions. The bank and the supervisor must use the test results

to ensure that bank capital is at an adequate level.

Pillar 2 encompasses four key principles:

o Banks must have a process for calculating overall capital adequacy based on their

risk profile and a strategy for maintaining their level of capital;

o The supervisor must review and evaluate the strategy and capital adequacy

calculations made internally by the bank and the ability of the bank to monitor and

ensure compliance with the prescribed capital ratio;

o The supervisor may order a financial institution to operate above the prescribed

capital ratio and has the authority to order a bank to allocate capital above the

minimum limit; and

o The supervisor may intervene at an early stage to prevent decline in bank capital

below the minimum limit and to ensure that the bank takes remedial measures if the

level of capital is not maintained or sinks to its former level.

IIIIII.. PPiillllaarr 33:: MMaarrkkeett DDiisscclloossuurree

Pillar 3 requires banks to disclose adequate information for market

players to understand the risks involved in the banks. This enables

market players to assess the key information on the scope of risk,

capital, risk exposures, risk measurement process and bank capital

adequacy.

In some cases, disclosure serves as a special criteria in Pillar 1 enabling the bank to

apply a lower risk weighting and/or use a particular methodology. This is expected to

operate as a form of direct sanction because of failure to comply with the disclosure

requirements (e.g., not permitted to apply lower risk weightings or use certain

methodologies). Pillar 3 also discusses the issues of the role of significant information,

frequency of disclosure and issues regarding proprietary information.


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FFrreeqquueennttllyy AAsskkeedd QQuueessttiioonnss

1. What is BIS?

The Bank for International Settlements (BIS) is an international organisation that

promotes international monetary and financial cooperation and operates as the bank for

central banks. To meet its responsibilities, BIS carries out a number of key activities.o As a forum for promoting discussions and policy analyses among central banks

and within the international financial system.o As a research centre for economics and monetary policy

o As a leading partner for central banks in financial transactions

o As an agent or representative for central bank dealings in international financialactivities.

2. What is the Basel Committee on Banking Supervision?

The Basel Committee on Banking Supervision (BCBS), better known as the Basel

Committee, was established in a voluntary action by the monetary authorities of the G-

10 countries and a number of other nations. The committee has no official reach as an

international supervisory authority and its decisions are never intended to be legally

binding.

The Basel Committee was set up by central bank governors from the G-10 countries at

the end of 1974 and convenes four times a year. These countries are represented by

their central banks and also the authorities responsible for supervision of the banking

business if not under the powers of the central bank. The Committee develops policy

guidelines that national supervisory authorities may decide on as appropriate to the

supervisory policy to be implemented by the individual country.

The Basel Committee formulates supervision standards and guidelines of ag eneral

nature and issues statements with broad application on best practices. This is intended

to enable each authority to take measures for applying these standards within a legal

and regulatory framework appropriate to the individual country’s system.

The most important output of the Basel Committee is the ruling on minimum capitalstandards for banks worldwide. The Basel Capital Accord was first announced in July

1988 and was implemented by all members of the Basel Committee in 1992. Although

the accord was initially targeted at internationally active banks, it ultimately gained

broad international acceptance among banks and supervisory authorities. More than 100

countries around the world have now adopted the Basel Accord.

3. What are the differences between Basel I and Basel II?

Basel II builds on the basic structure of the 1998 accord (Basel I) to determine capital

requirements in relation to credit and market risk and to develop a more risk-sensitivecapital framework. This has been achieved by adjusting capital requirements to credit

risk and also by introducing changes in the method for calculating capital to cover

exposures from risk of losses attributable to operational failures.

Even so, in broad terms the Basel Committee has retained the aggregate level of the

minimum capital requirement and establishes incentives for application of the moreadvanced risk-sensitive approaches within the Basel II framework. Basel II combines the

minimum capital requirement with supervisory review and market discipline to promote

improvement in risk management.


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4. What are the objectives of the Basel Capital Accords?

The objectives of Basel I and Basel II are essentially the same. First, the Basel Iframework was designed to improve soundness and stability of the international banking

system. Secondly, the Basel I framework was expected to create a level playing field

among different countries with a high level of consistency in perceptions to reducesources of unfair competition among internationally active banks. In the Basel II

framework, the Committee believes that the changes to the existing approaches will

encourage the banking industry to use the improved risk management methods.

5. Is it compulsory for a nation to implement Basel II?

No country is required to implement Basel II. No policy issued by BIS is legally binding

on any country. For this reason, implementation of Basel II is a decision at the individualcountry level, taking into account the state of preparedness of that country's banking

system.

6. What impact does Basel II have on a nation?

When a country implements Basel II, this action is expected to strengthen financial

system stability by promoting advancement in risk management and capital adequacy in

the banking system. Furthermore, Basel II is also expected to:

o Improve corporate governance and risk managemento Create more efficient capital allocation and build a robust capital structure

o Strengthen standards of transparencyo Improve bank supervision in regard to processes and implementation.

7. Can Basel II be implemented in Indonesia?

Yes. Basel II is a broad policy framework consisting of a set of best practices appliedworldwide. The concepts in Basel II can therefore be applied in any country, including

Indonesia.

8. Why must Basel II be implemented in Indonesia?

Basel II prescribes a more risk-sensitive framework for calculation of the capital

requirement. These capital adequacy calculations also take into account the various risksinvolved on a more comprehensive scale. This will encourage banks to improve theirrisk management in order to obtain a more precise value of economic capital. It will also

encourage supervisors and market players to play a greater role in financial systemstability.

9. Is it appropriate for Indonesia to implement Basel in the near future?

Yes. Since the introduction of Basel I, the Indonesian banking system has undergone farreaching changes from:

o Globalisationo Developments in technology

o Innovations in the financial world

Furthermore, Basel I focuses only on credit risk and market risk, thereby simplifyingassumptions of risks in a way that will not protect bank soundness.

Basel II provides a framework capable of maintaining the soundness and stability of the

banking system through:o Strengthening of internal processes

o Promoting the use of more advanced and sophisticated risk management

practiceso Risk measurements more accurately depicting the true level of risks carried by

the banko Improvements in transparency.


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10. What approach will be used in Indonesia?

Bank I ndonesia will introduce the standardised, internal rating-based and advanced

approaches. These approaches will be phased in over time. The decision on the approachto be used will be made by individual banks with approval from the supervisor.

11. May banks choose the approach they use?Yes, banks may choose the approach they wish to use. However, the use of anyapproach other than the standardised approach must be approved by the bank

supervisor. If a bank has already used the internal rating based or advanced approach, it

will not be permitted to replace the approach in use with the standardised approachwithout approval from the bank supervisor.

12. Will banks be required to use the Internal Rating-Based or Advanced

approach?

No, banks are not required to use either the internal rating-based or the advanced

approach. The decision about which approach to use is entirely at the discretion of the

individual bank. If a bank is unable to implement an internal rating-based or advanced

approach, it will be encouraged to remain with the standardised approach.


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- Pillar 1: Rules establishing a minimum ratio of capital to risk-weighted assets.

- Pillar 2: The supervisory review pillar, requiring supervisors to perform a qualitative

review of the capital allocation techniques used by the bank and compliance with

relevant standards.- Pillar 3: Disclosure requirements that facilitate market discipline.

- Internal Rating: Result of a bank’s risk measurement of its credit portfolio.

- External Credit Rating: Rating issued by an external rating agency.

- Consolidation: Measurement of bank risk encompassing the entire business group

linked to the bank.

- Operational Risk: Risk arising directly or indirectly from the inability or failure of

internal processes, persons or system or from external events.

- Credit Risk: Risk of loss arising from default by a debtor or counterparty.

- Market Risk: Risk of loss arising from a trading position when prices undergo change.

- Mitigation of Credit Risk: A set of techniques enabling a bank to protect part of itsposition from counterparty default (for example, by taking over collateral or

encashing a guarantee or purchasing hedging instruments).

- Asset Securitisation: Aggregation of assets or liabilities into securities for sale to thirdparties.

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