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8/8/2019 Reynolds Printable

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How Basel II is changing the world

Diane Reynolds

Sr. Director, Economic Capital Solutions

Algorithmics Inc.


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2007 Algorithmics Incorporated. All rights reserved. 2

Agenda

Context

- What is capital and why does it matter to a bank?

Basel II

- What is Basel II and why is it important?

Impact

- What has changed because of Basel II?


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Context


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Who are the stakeholders in a bank?

How is this different from other firms?


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Typical Stakeholders

Its shareholders

Represented by equity analysts

Its bondholders and those to whom it owes money

Represented by rating analysts

Its depositors

Represented by deposit insurance schemes & governments

The public

Represented by regulators & governments


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The Regulatory Perspective

fundamental objective: to develop a framework that would further strengthenthe soundness and stability of the international banking system

While maintaining sufficient consistency that capital adequacy regulation will notbe a significant source of competitive inequality among internationally activebanks.

major benefit: promote the adoption of stronger risk management practices bythe banking industry,

improving capital regulation to take into account changes in banking and riskmanagement practices

preserving the benefits of a framework that can be applied as uniformly aspossible at the national level.

Definition from Basel II document, paragraph 4.


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What is capital?

What do you need it for?


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Accounting

Capital

= Equity

= Assets - Liabilities


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Regulatory Capital

Tier 1 Capital

Tier I capital is core capital, this includes equity capital and disclosed reserves.

Equity capital includes instruments that can't be redeemed at the option of theholder.

Tier 2 Capital

Tier II capital is secondary bank capital that includes items such as undisclosedreserves, general loss reserves, subordinated term debt, and more.


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Risk-based Capital

Measures how much you need, not how much you have

Why do you need capital?

To ensure that the business can continue

To cover unexpected events that lead to losses

To reassure investors (and the markets)

To reassure depositors (and the regulators)


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Three Pillars & Three Risks

Three Pillars of Basel II:

Minimum Capital Requirements

Supervisory Review

Market Discipline

Three Major Sources of (Quantifiable) Risk:

Market Risk

Credit Risk

Operational Risk

I

II

III


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Credit

Standardized

Foundation

IRB

Advanced

IRB

Pillar 1: Minimum Capital

Operational

BasicIndicator

Standardized

AdvancedMeasurement

Market

Standardized

InternalModels

Risks

Soph

istication

Bank

Provides RiskComponents

SupervisorProvides RiskComponents

Approaches to Regulatory Capital Calculations


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Basel II

RWA = Risk Weighted Assets

RWA

= RWA (Market Risk)

+ RWA (Credit Risk)

+ RWA (Operational Risk)

Capitalization RequirementsTier 1 Capital > 4% of RWA

(Tier 1 + Tier 2) Capital > 8% of RWA


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Impact


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A change in philosophy

Capital is related to risk!

Capital alone is not sufficient: Pillars 2 and 3.

Credit risk divides into at least three elements:

PD

LGD

EAD

Operational risk is a measurable risk.

Risk is a key determinant of performance and a factor in measuring reward.


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A change in emphasis

Sr. management and boards are:

More aware of risk management

More accountable for the risks they take not having realized it is a risk is no longer a

defense! Spending more money on identifying, quantifying, managing and mitigating risks

Risk became such a cost centre that

Costs had to be viewed as investments

Many people are looking for ways to leverage that investment

USbank spending on Basel II-related risk management IT will increase 30% over the nexttwo years to exceed $1bn in 2009, according to Aite Group.


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HSBC Annual Report 2006

2006 2002


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How Basel II is changing the world

Diane Reynolds

Sr. Director, Economic Capital Solutions

Algorithmics Inc.

[email protected]

+1 416 217 4126

reynolds printable

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