importance of basel 1 & 2

7/31/2019 Importance of Basel 1 & 2

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The Significance of Basel 1 and Basel 2 for theFuture of The Banking Industry

with Special

Emphasis on Credit Information



This presentation examines the significance

of Basel 1 and Basle 2 for the future of the

banking industry.

Both accords promote safety and soundness inthe financial system with Basel 2 utilize

approaches to capital adequacy that are

appropriately sensitive to the degree of risk

involved in a banks’ positions and

activities..

Abstract



The soundness of the banking system is one ofthe most important issues for the regulatory

authorities.

Q 1 How should banking “soundness” be defined

and measured?

Q 2

What should be the minimum level of soundness

set by regulators?

Introduction



The soundness of a bank can be defined as the

likelihood of a bank becoming insolvent. Thelower this likelihood the higher is the

soundness of a bank.

Bank capital essentially provides a cushion

against failure. If bank losses exceed bank

capital the bank will become capital

insolvent. Thus, the higher the bank capitalthe higher is the solvency of a bank



LEVERAGE RATIO = CARITAL

TOTAL ASSETS

The larger this ratio, the larger is the cushionagainst failure

The problem with the previous ratio is that it

doesn’t distinguish between the assetsaccording to its risks. The asset risk of a bank

can increase and the capital can stay the same

if the bank satisfies the minimum leverage ratio

Up until the 1990s bank regulator based their capital

adequacy policy principally on this simple leverage ratio



In 1988 the Basel committee introduced the

Basel 1 accord to deal with the weaknesses inthe leverage ratio as a measure for solvency.

The definition of capital is set in two tiers:

Tier 1 : being shareholders’ equity and retainedearnings

Tier 2 : being additional internal and external

resources available to the bank

A portfolio approach was taken to the measure of

risk, with assets classified into four buckets

(0%, 20%, 50% and 100%) according to the debtor

category



According to the Basel accord the risk-based

capital ratio can be measured as:

Risk-Based Capital Ratio = CARITAL Risk-Adjusted Assets

Over time the accord has become internationallyaccepted with more than 100 countries applying

the Basel framework to their banking system



After ten years, many weaknesses appear in the

Basel 1 accord :

•Because of a flat 8% charge for claims on the private

sector, banks have an incentive to move high quality

assets off the balance sheet through securitization.

Thus, reducing the average quality of bank loan

portfolios

•The accord do not take into consideration the

operational risk of banks, which become increasinglyimportant with the increase in the complexity of bank

activities.

•The accord does not sufficiently recognize credit risk

mitigation techniques, such as collateral and guarantees



• Promote safety and soundness in the financial system

• Enhance competitive equality

• Constitute a more comprehensive approach to

addressing risks

• Develop approaches to capital adequacy that are

appropriately sensitive to the degree of risk involved

in a banks’ positions and activities

• Focus on internationally active banks, and at the

same time keep the underlying principles suitable for

application to banks of varying levels of complexity

and sophistication.

Basel II objectives



Risk-Based CARITAL Capital Ratio

Credit Risk+ Market Risk+ Operational Risk

Main Characteristics of the New Accord Basel II consists

of three pillars:

1. Minimum capital requirement.2. Supervisory review process.

3. Market discipline



1 Minimum capital requirement

The first pillar deals with maintenance ofregulatory capital calculated for three major

components of risk that a bank faces: creditrisk, operational risk and market risk.



standardized approach:

exposures to various types of counter parties,

e.g. sovereigns, banks and corporates, will be

assigned risk weights based on assessments by

external credit assessment institutions. Tomake the approach more risk sensitive an

additional risk bucket (50%) for corporate

exposures will be included.

Further, certain categories of assets have been

identified for the higher risk bucket

(150%).



The foundation approach

subject to adherence to rigorous minimum

supervisory requirements Estimates of additional

risk factors to calculate the risk weights would

be derived through the application of

standardized supervisory rules.

The advance approach

banks that meet even more rigorous minimumrequirements will be able to use a broader set of

internal risk measures for individual exposures.



2 Supervisory Review Process

The second pillar deals with the regulatoryresponse to the first pillar, giving regulators

much improved 'tools' over those available to

them under Basel I. It also provides a framework

for dealing with all the other risks a bank may

face, such as systemic risk, pension risk,

concentration risk, strategic risk, reputation

risk, liquidity risk and legal risk, which theaccord combines under the title of residual

risk.

It gives banks a power to review their risk

management system.



3 Market Discipline

The third pillar greatly increases the

disclosures that the bank must make. This is

designed to allow the market to have a better

picture of the overall risk position of the

bank and to allow the counterparties of the

bank to price and deal appropriately.



3. Measuring Credit Risk and Credit Information

requirements:The Standardized approach for credit risk

in the standardized approach The bank allocates a risk-

Weight to each of its assets and off-balance-sheet

positions and produces a sum of risk-weighted asset value

A risk weight of 100% means that an exposure is included

in the calculation of risk weighted assets at its full

Value, which translates into a capital charge equal to

8% of that value Similarly, a risk weigh of 20% results in

a capital charges of 1.6%



Under Basel. Individual risk weights depend on the board

Category of borrower

under Basel 2. the risk weights are to be refined by

reference to a rating provided by an external credit

Assessment institution that meet strict standards.

For example for corporate lending, the existing Accord

Provides only one risk weigh category of 100% but the

New Accord will provide four categories (20%,50%,100%150%)



Operational requirements for the standardized

approach:In standardized approach, supervisor and banks are

Responsible for evaluating the methodologies used by

External credit assessment institutions and the quality of

The ratings produced.

They will use some criteria in Recognizing ECAIs as;

objectivety,independence,transparencey resources and

credibility.

The assessments must be applied consistently for both risk

Weighting and risk management purposes.



Internal ratings-based approach:

The IRB approach provides a similar treatment forCorporate, bank and separate framework for retail.

The treatment is based on three main elements:

• Risk components

• Risk-weight function

• Set of minimum requirements that a bank must meet to be

Eligible for IRB treatment.



• Risk Components:

Most banks base their rating methodologies on the risk ofBorrower default and typically assign a borrower to a

Rating grade. A bank would then estimate the probability

Of default(PD)associated with borrowers in each of these

Internal grades.

Banks measure also how much they will lose if default

Occur, this will depend on how much per unit it is

Expected to recover from the borrower if recoveries are

Insufficient to cover this will give rise to loose given

The default(LGD)



• The Risk-Weight Function:

IRB risk weights are expressed as a single continuousFunction of :

THE PD,LGD,M

This function provides a mechanism by which the risk

Components converted into regulatory risk weights.



The function of the risk weight can be defined as follows:

Correlation (R) 0.10 1- EXP(-50 PD) / 1 EXP( 50)+

0.20 [1 (1 EXP( 50 PD))/(1 EXP( 50))]

Maturity factor (M) = 1+ .047× ((1- PD)/PD.44 )

Capital requirement (K) = LGD×M× N[(1− R)−.5 ×G(PD)

+ (R/(1− R)).5 ×G(.999)]

EXP=stands for the natural exponential function



• N=stands for the standard normal distribution function

• G=stands for the inverse standard normal cumulative

distribution function

• It allows for greater risk differention and

accommodates the different rating grade structures.



Conclusions:

The soundness of the banking system is one of the most

important issues for the regulatory authorities and for

the financial system stability.

Banks should start the preparation process for the

implementation of the new accord by reviewing the

requirements it satisfy, the requirements need toattain based on the chosen approaches.

importance of basel 1 & 2

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