OVERVIEW OF RISK

MANAGEMENT

AND

BASEL II ACCORD

SUMMARY

BASEL I – Merits and Weaknesses

BASEL II - Objectives

Risk Management and Basel II

BASEL II – Structure of the New Accord

PILLAR 1

PILLAR 2

PILLAR 3

BASEL II – Impact on banks business

BASEL II – Implications

BASEL II – Next Steps

BASEL II – Timetable

BASEL I - MERITS:

First BASEL Accord in 1988 introduced capital requirements for Credit

Risk, followed by Amendment in 1996 for Market Risk.

The merits of the Old Accord:

Substantial increases in capital ratios of internationally active

banks;

Relatively simple structure;

Worldwide adoption;

Greater discipline in managing capital;

A benchmark for assessment by market participants.

BASEL I - WEAKNESSES :

Uniform, ignoring individual risk profiles, based on size of the business;

Only considered credit risk;

No explicit recognition of operational or other risks;

Does not assess capital adequacy in relation to a bank’s true risk profile;

The OECD/non-OECD distinction does not properly address country

risk;

Does not provide proper incentives for credit risk mitigation techniques;

Enables regulatory arbitrage through securitization etc.

BASEL II - OBJECTIVES :

To maintain at least the current level of capital in the system;

To enhance competitive equality;

To emphasize the responsibility of directors and senior management;

To focus on internationally active banks;

To contain approaches to capital adequacy that are appropriately

sensitive to the degree of risk involved in a bank’s positions and activities.

RISK MANAGEMENT AND BASEL II (1) :

Risk Management Function

Traditional View Modern View

Risk management was perceived

as:

Return, risk and capital are

linked

A cost centre – placing constraints

on revenue generators

You must achieve an adequate

return for the risks you are

taking

A reporting centre – with no

operational responsibilities Risk management is evolving

from the measurement of Risk

to the integral management of

risk

Staffed with relatively lowly-skilled

people

RISK MANAGEMENT AND BASEL II (2)

Risk Management Function

Risk management has become a strategic competitive weapon

allowing institutions to:

measure their risk on a consistent global basis;

calculate the risk-return performance of different business

units;

allocate scarce resources to their optimal use;

With the new BASEL Accord, Risk Management will become

increasingly important within banks.

BASEL II – Structure of the New Accord :

The considerably increased scope of the regulations in the New BASEL

Capital Accord is represented in a framework of three complementary

pillars that will help make the banking system SAFER, SOUNDER, and

MORE EFFICIENT.

Pillar 1: Minimum Capital Requirement:

Credit Risk, Market Risk, Operational Risk.

Pillar 2: Increased Supervisory Review

Segregation of duties and increased dialogue between banks

and supervisors.

Pillar 3: Market Discipline (Disclosure)

Enhance quality of disclosures;

Improved information and transparency.

PILLAR 1 – MINIMUM CAPITAL :

Basel II establish minimum standards for management of capital on a

more risk sensitive basis.

BASEL I Ratio: BASEL II Ratio:

Regulatory Capital

-------------------------= >8

Weighted assets

Regulatory Capital

---------------------------------------------- = >8%

(Credit Risk+Market Risk+Operational Risk)

It results that all types of risks must be

quantified

Pillar 1: Minimum Capital Requirements

Total capital (Tier-1 + Tier-2)

Credit Risk + Market Risk + Operational Risk

= The bank’s capital ratio ≥ 10%

Credit Risk – Banking BookThe credit risk element of the denominator

is the risk-weighted assets. The risk-

weighted assets are calculated through

either the Standardised, or the Internal

Ratings Based (IRB) approaches.

Market Risk – Trading BookThe market risk element of the

denominator is the market risk

requirement relating to

trading books.

These rules were introduced in

the 1996 Market Risk

amendment to Basel I and are

unchanged under Basel II.

Operational Risk

The operational risk element of

the denominator is the

operational risk requirement

which can be calculated using

either the Basic Indicator, the

Standardised of Advanced

Measurement Approaches

18/09/2020 10

Tier 1 Capital

Paid-up share capital

Irredeemable Preference Shares

Share premium

General Reserves (Retained

profit)

SMEEIS Reserves

Statutory Reserves

Other reserves as CBN

Tier-2Supplementary capital

Revaluation reserve

Undisclosed reserves

Hybrid instruments

Subordinated term debt

Pillar 1 Pillar 2 Pillar 3

Minimum Capital Requirements

Supervisory ReviewProcess

Market Discipline

Establishes minimum standards for management of capital on a more risk-sensitive basis and specifically addresses:

• Credit risk• Market Risk• Operational risk

Increases the responsibilities and

levels of discretion for supervisory

reviews and controls covering:

• Processes for capital and risk

profile management

• Capital adequacy

• Level of capital charge

• Proactive monitoring of

capital levels and ensuring

remedial action

Expands the content and improves the transparency of financial disclosures to the market, with disclosure of:

• Description of risk management approaches

• Levels of capital• Analysis of risk

exposures and capital by businesses / segments

Basel II Capital Accord consists of three mutually enforcing pillars. All three pillars need to be applied by

banks.

18/09/2020

1. ICAAP

2. Supervisory Review

Process

11

Structure of Basel II Capital Accord

PILLAR I – CAPITAL REQUIREMENTS FOR CREDIT RISK (1) :

The old Accord:

did not permit internal models;

was extremely credit insensitive with fixed risk percentages applied

to certain, pre-defined risk categories: 0%, 20%, 50%, 100%;

no perception of Economic Capital.

The new Accord:

EC is the true capital required to off-set Unexpected Losses.

Losses on transactions are broken up into:

Expected (in a statistical sense) losses

Unexpected losses - Losses with a low degree of profitability

Economic Capital = Unexpected loss - Expected Loss.

PILLAR I – CAPITAL REQUIREMENTS FOR CREDIT RISK (2)

With the new Accord, Banks are allowed to choose one of the

following three measurement approaches:

A. The Standardized Approach:

Risk weightings given for certain classes of

instruments.

B. The Internal Ratings Based (IRB) Approach:

Risk weightings based on internal risk assessments;

Can differentiate more finely between classes of risk;

Takes additional risk factors into account.

C. Advanced IRB.

PILLAR I – CAPITAL REQUIREMENTS FOR MARKET RISK (1) :

The Old Accord:

1. Concentrated purely on Interest Rate Risk;

2. Based upon either maturity or duration bands;

3. Amended to include FX and Equity Risks.

Value-at-Risk (VaR) is the most popular internal model.

PILLAR 1 – CAPITAL REQUIREMENTS FOR OPERATIONAL RISK (1)

Required for the first time. Rolled opaquely into credit charge

under the old Accord.

Definition – Operational risk:

The risk of direct or indirect loss resulting from inadequate orfailed internal processes, people and systems or from externalevents.

This includes legal risk, but not strategic and reputational risk

as regulators recognise the difficulties of measuring indirect

losses.

PILLAR 1 – CAPITAL REQUIREMENTS FOR OPERATIONAL RISK (2):

BASEL II pointed out the following operational risks:

Business disruption and system failures;

External fraud;

Integration problems;

Lack of training and controls;

As well as the necessity of Business Continuity Plan and

Disaster Recovey Plan.

The New Basel Capital Accord requires a capital charge of 15% of

economic capital for the operational risk.(there are discussions to

reduce this percentage)

Banks are allowed to choose one of the following three

measurement approach:

The main challenge in the area of operational risk consist in

setting up an efficient IT infrastructure to monitor and measure

the operational risk.

PILLAR 1 – CAPITAL REQUIREMENTS FOR OPERATIONAL RISK (3)

Basic Indicator Approach

Standardised Approach

Advanced Measurement Approach

Key premise: Supervisors should be able to require (penalize)

banks to hold capital above the minimum.

Pillar 2 stresses:

Banks must develop their own internal models, based on

evolving best practice;

Supervisory must conduct regular review to ensure

adequate capital if review fails, supervisor should increase

capital charge.

Hence, responsibility for adequate capital rests with the bank’s

management.

Pillar 2 intended to encourage development and use of better

risk management practices.

BASLE II – PILLAR 2 - INCREASED SUPERVISORY REVIEW

Two types of disclosures:

Mandatory disclosures: group approach of BASEL II, amount

and quality of group capital, extensive information

regarding the measurement methods of risks, etc.

Supplementary disclosures, at request of regulator.

Concerns:

Disclosure overload – too much information;

Enforceability in some jurisdictions;

Timeliness;

Auditability and its link with IFRS 9 and IAS 39;

Cost;

Market response to disclosure of perceived bad news.

BASLE II – PILLAR 3 – MARKET DISCIPLINE (1)

Credit and Operational Risk Data becomes a valuable asset.

Need of sophisticated measurement tools (credit, market andoperational risk).

High investments in Risk Management methodologies, systemsand people

BASEL II – IMPACT ON BUSINESS (1)

Capital will be increasingly a scarce resource:

As capital providers demand fair returns;

Businesses will be charged on their contribution to total risk capital;

Assets will be allocated on that basis;

Hence risk measures will be on the same level as profit measures,especially as more complex risks are being captured.

Banks need to check BASEL II impact on:

Future Business, Strategy and Objectives;

Competitors;

Capital Charge.

Risk Management become an important senior management issue.

BASEL II – IMPACT ON BUSINESS (2)

The new capital requirements specified in the New Basel Capital

Accord have important implications for the bank.

BASEL II represents a major improvement compared to BASEL I but

the most difficult part is to implement it. Its implementation

requires a considerable human and financial effort i.e.

methodological changes, new software, new hardware capacities,

training, etc.

The new regulations requires changes in the general structure and

process organization within banks.

BASEL II - IMPLICATIONS

Banks are required to commence a parallel run of both

Basel I and II minimum capital adequacy computation

based on the requirements of these guidelines effective

from January, 2014.

The minimum capital adequacy computation under

Basel II rules commenced in June 2014.

Furthermore, Nigerian banks are required to comply

with the Basel II Pillar 3 disclosure requirements on a bi-

annual basis.

BASEL II - TIMETABLE

This the Basel II Pillar 3 disclosure requirements is to

provide an overview of the risk profile and risk

management practices of Nigerian banks.

It is also expected to contain detailed information on

the underlying drivers of (i) Risk weighted assets, (ii)

Banks capital structure, and (iii) the capital adequacy

ratio.

The objective of this disclosure is to encourage market

discipline and allow stakeholders to assess accurate

information on banks risk exposures and risk

assessment processes.

Banks are required to report in accordance with Pillar III

Disclosure requirements under the following regulatory

guidelines:

DISCLOSURE REPORT REQUIRED BY THE CBN (1/2)

I. The Central Bank of Nigeria’s (CBN) framework on

Regulatory Capital Measurement and Management for

the Nigerian Banking System for the implementation of

Basel II in Nigeria;

II. The Basel Committee on Banking Supervision’s

(BCBS) Revised Pillar 3 Disclosure Requirements;

III. The Central Bank of Nigeria’s (CBN) Revised

guidance on Pillar 3 Disclosure Requirement.

DISCLOSURE REPORT REQUIRED BY THE CBN (2/2)

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