International Convergence of Capital Measurement & Capital Standards
Basel II Understanding the framework
Basel II
International Convergence of Capital
Measurement and Capital Standards
(A revised framework, June 2004)
Is a European standard It will be difficult for banks to be
internationally active and competitive unless they comply with these standards Is complex and will take time to achieve Yes, the OECD countries will be initial beneficiaries
Let us look at the basic drivers
Business / economic rationale driving regulatory evolution
Banks need Capital
Need for Capital
To fund a banks need for intrastructure Capital position acceptable to depositors
shareholder willingness to put own funds at
risk
Capital is needed to deal with losses
when revenue from asset shrinks capital
provides cushion to continue servicing
Losses come from the manifestation of Risk
Credit Risk Operations Risk Market Risk ALM Risks: Interest Rate Risk, Liquidity
Risk
Transaction Risk Exchange Risk Economic Risk Political Risk Strategic Risk Reputational Risk These are subsidiary risks that impact/ are subset of primary risk groups Mentioned above
Enterprise wide impact
Types of Loss
Expected Loss Unexpected Loss
Economic Loss Accounting Loss
Treatment of Expected Loss
Treatment of Unexpected Loss
Need for Capital is to meet the loss If EL is not treated in a commercially
acceptable manner, subject to regulatory review, EL should receive same consideration as UL.
Capital Adequacy Measure
Capital Base How much of this base can be loan capital Risk weighted assets on the balance sheet CB/RWA= Risk Asset Ratio Tier 1 Capital : Equity + free reserves Tier 2: undisclosed reserves, subordinate 50% of Tier 1 can be sub debt Tier 2 cannot exceed Tier 1
Capital Adequacy Norms
Tier one/ Primary Capital Tier two /Secondary Capital which can
include loan capital: capital issues the terms of issue of which are such that it behaves exactly like equity, giving preference to depositor money: subordinated debt
Capital Adequacy Ratio
Should be 8/9% (CB/RWA) The higher it is, the safer the bank is The higher it is, the more is idle capital and
so, lower is the profitability The lower it is, the higher is profitability but higher is the risk This adds to the drive toward non-capital consuming (fee) income opportunities
Return on Capital
Shareholders seek return on capital Enhancing return requires greater interest
income: which itself requires greater capital You need to find sources which consume less capital Or reduce the capital you need for your current activities
RISK MANAGEMENT
RISK TYPES
RISK EVENT WITHIN THE TYPE
EXPECTED LOSSES
FACTORED INTO BUSINESS Analyse Monitor Mitigate Review
NOT FACTORED
UNEXPECTED LOSS
Use Basel II, RBI defined Metrics to provide Capital charge
Capital Adequacy Under the Old / First Accord
Total capital (unchanged) Risk Weighted Assets
= The banks capital ratio 8/9%
Capital Adequacy under first accord
Risk weights for different facilities
Funded limits: 100% of Rs. 100 = Rs 100 Usance l/cs 50% of Rs. 100 = Rs 50 Sight l/cs
20% of Rs. 100 = Rs 20 = Rs 170
Total of risk weighted assets (as against total assets of Rs. 300)
The shortcomings of this approach
It goes only with the facility not with the
quality of a borrower So capital weight for a good borrower is same as for a bad borrower Which implies unexpected losses would be the same Does not take into account other events that cause loss: market risk, operations risk
Capital Adequacy Under the Old / First Accord
Total capital (unchanged) Risk Weighted Assets
= The banks capital ratio 8/9%
Capital Adequacy Under the New / Basel II Accord
Total capital (unchanged) Credit Risk + Market Risk + Operational Risk
= The banks capital ratio 8/9%
A bank will determine the proportion of its capital that it must keep in reserve based on this calculation:
Total capital (unchanged)
= The banks capital ratio 8/9%
Credit Risk + Market Risk+ Operational Risk
Credit Credit Risk Risk Banking Banking Book Book The 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 Market Risk Risk Trading Trading Book Book The market risk element of the denominator is the market risk requirement relating to trading books.
These rules were introduced in the the 1996 1996 Market Market Risk Risk amendment amendment to to Basel Basel 1 1 and and are are unchanged unchanged under under Basel Basel 2. 2.
Operational Operational Risk 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
Emergence of risk sensitive environment
Events Complexity of products Complex financial organisations Technology and related systems reliance Exposure to other currency zones Exposures in other economic / political
zones Increase in volumes Outsourcing and related issues
Risk Sensitivity
Started with regulators Regulations have deeper economic and
fundamental reasons Awareness amongst banks that profits must be regarded in a risk reward context
Risk Management
Identify analyse and manage risks Eliminate risks you do not like Identify risks you are going to take Determine components of risk Monitor the risk you are taking-thru compo Ensure you earn in proportion to the risk
you run
RBIs stipulations
Judicious mix of both sides Provides adequate wider framework Does not use the BCBS framework out of
context, in fact sets the tone on a wider context Is getting banks to move on both sides Moving on both sides of the piece is essential for truly meeting international standards Quality of regulatory environment is recognised under Basel II as one of the
The overall approach is statistically intense as an exercise
But is driven by business issues Till you handle the business issues you cant go for the measurement issues That is indeed RBIs approach
Structure of New Basel Accord
Pillar 1 Minimum capital requirements Pillar 2 Supervisory review
Supervisors to review
Pillar 3 Market discipline
Detailed disclosure
Establishes minimum
standards for management of capital on a more risk-sensitive basis
banks internal capital assessment
Supervisors should have
requirements and recommendations
Capital
Market + Credit + Operational
Credit Risk Mitigation &
power to set capital ratio above the minimum
Supervisors should
Securitisation related issues are addressed in the Accord
intervene at an early stage
The new capital accord will place greater reliance on internal modeling, used by all world class banks to calculate economic capital.
Methodologies
Standard Approach If a bank was to do nothing but start on Basel II Cannot meet statistically demanding reqmts Foundation / Basic Approach
Some of the issues can be addressed
Advanced approach Internal processes are refined / defined Data availability BCBS criteria are fully met
Business Structure
Ability to define Each business line
Business Line Processes & Methods
Business Line Risk Management
Empirical evidence and Data For refining existing methods
Risk Events Losses Loss Data
RBI Stipulations
Basic method But in preparation is asking banks to
address all business issues that will enable the banks to go for advanced approach That is indeed the role of the regulator
Credit Risk
There is adequate experience in India,
perhaps more than most countries The emphasis is on reorganising the business Putting a structure to credit processes Adopt rating methodologies Work out capital allocation based on rating: external or internal
There are two broad methodologies for calculating
credit risk capital.
Increasing sophistication Internal Internal Ratings Ratings Based Based Approach Approach
Calculate Calculate risk-weighted risk-weighted assets assets for for banking banking books books using using ratings ratings generated generated from from internal internal rating rating systems. systems. Risk Risk weights weights are are calculated calculated using using specific specific risk risk measures measures Probability Probability of of Default Default (PD) (PD) Loss Loss Given Given Default Default (LGD) (LGD) Exposure Exposure at at Default Default (EAD) (EAD) Banking Banking book book exposures exposures are are divided divided into into six six categories: categories: Sovereigns, Sovereigns, Banks, Banks, Corporate, Corporate, Retail Retail Equity Equity and and Purchased Purchased Receivables Receivables
Internal Internal Ratings Ratings Based Based Approach Approach Advanced Advanced PD, LGD, EAD and Maturity (M)are measured internally. This varies slightly between categories of exposures.
Internal Internal Ratings Ratings Based Based Approach Approach Foundation Foundation Depending on the exposure category, PD is measured internally LGD and EAD are provided by the banking regulator
Standardised Standardised Approach Approach
Calculate Calculate risk-weighted risk-weighted assets assets for for banking banking books books for for sovereigns, sovereigns, banks banks and and corporates corporates using using ratings ratings from from external external credit credit assessment assessment institutions institutions e.g. e.g. Standard Standard & & Poors, Poors, Moodys, Moodys, Fitch. Fitch.
Considerations
Risk Weight Credit Risk Mitigants
Collateral taken reduces the exposure What is acceptable collateral
Exposure Adjustments
Drawn, undrawn Committed, uncommitted
Risk Weights for Corporate, sovereign, bank and Retail exposures under revised Standardized Approach
Risk weightings by credit assessment Risk weightings by credit assessment Claims on Sovereign Banks Corporates Retail Residential mortgage Commercial mortgage Past due loans with specific provisions: Less than 20% More than 20% More than 50% 150% 100% 100%/50%2 150% 100% 100%/50%2 150% 100% 100%/50%2 150% 100% 100%/50%2 150% 100% 100%/50%2 150% 100% 100%/50%2
1
Credit assessment AAA to AA0% 20% 20% N.A. N.A. N.A. A+ to A20% 50% 50% N.A. N.A. N.A. BBB+ to BBB50% 50% 100% N.A. N.A. N.A. BB+ to B100% 100% 100% N.A. N.A. N.A. Below B150% 150% 150% N.A. N.A. N.A. Unrated 100% 50% 100% 75% 35% 100%
90 days or more past due (applies only to unsecured exposure net of provisions) Can be reduced to 50% at national discretion
Basel IIs revised risk weightings under the standardized approach demonstrate a greater degree of risk sensitivity than Basel I
Note: For additional details please refer to Part . or page of the consultative document The New Basel Capital Accord
Business Issues in IRB
Define lending business in following
categories
Corporate Sovereign Bank Retail Equity
Determining Capital Charge
PD LGD EAD M K = fn (PD, LGD, EAD, M) It is a regression equation
Credit Rating Internal (Business Issue)
Rating System Design Rating Systems Operations Corporate Governance and Oversight Risk Quantification Validation of Internal Estimates Supervisory LGD & EAD Estimates Calculation of Capital Charges for Equity
Exposures
Disclosure Requirements
Retail exposures
For Retail exposures, there is only one type of IRB
approach for all exposures:
Exposures are assigned an internal rating based on both the
borrower and facility characteristics
Exposures with similar ratings are grouped together into
segments or pools and the risk components are then determined for each pool rather than for each exposure.
Retail exposures
Exposure
Borrower Characteristic
Facility Characteristic
Rating
Segment 1 PD1, LGD1
Segment 2 PD2, LGD2
Segment 3 PD3, LGD3
Segment 4 PD4, LGD4
Retail risk components
Internally measured The bank must estimate an average PD for each internal risk segment To estimate the average PD, the bank must consider the following: Internal loss experience Mapping to external data sets (if internal data is scarce) Statistical loss models (for the forward looking aspect)
PD
LGD
Internally measured The bank must estimate an LGD for each internal risk segment For retail products with uncertain future exposures, e.g. credit cards, the history and or expectation of additional drawings prior to default must be taken into consideration when calibrating loss estimates
EAD
Internally measured The bank must estimate EAD for each transaction For on balance sheet items, EAD must be estimated at no less than the current drawn amount
Non-retail exposures
For non-retail exposures there are two
approaches Foundation and Advanced. For both approaches:
Each borrower is assigned an internal rating or
borrower grade A grade is defined as an assessment of borrower risk on the basis of a specified and distinct set of rating criteria There must be at least six different grades for good loans and at least one grade for defaulted loans Exposures are then assigned to a borrower grade There must be a meaningful distribution across the borrower grades
Definition
The possibility of loss to a bank caused
by changes in the market variables.
on or off balance sheet positions will be adversely affected by movements in interest rate markets equity markets currency exchange rates commodity prices.
The risk that the value of
Trading Book covers
Securities included under the Held for
Trading category Securities included under the Available for Sale category Open gold position limits Open foreign exchange position limits Trading positions in derivatives, and Derivatives entered into for hedging trading book exposures.
Two components of risk exposure on Trading book
Counterparty risk: credit risk
Market Risk
Interest rate/ equity / currency / commodity risks
Put briefly
Just as you need to set aside capital for loss
due to NPAs You are asked to set aside capital for losses due to change in value of your investment book
How determine probability of loss in
investment book?
An intuitive understanding of duration
If interest rates are moving today, over
what period will I be able to reprice my balance sheet to meet todays cost structure All deposits must expire, renew at new rates All advances must expire, renew, new rates When will this happen? Over a prd of time The average of that period of time= duration
Investment Risk/VAR
Value of the investment portfolio that is
exposed due to possible changes in mkt rate Probability that mkt rates will change Impact of that on the portfolio value=VAR Over what time period What percent confidence interval
Modified duration is used to arrive at the price sensitivity of an interest rate related instrument. For all the securities listed below, date of reporting is taken as 31/3/2003. (Rs. in crore) Party Maturity dt Govt. 01/03/2004 Govt. 01/05/2003 Govt. 31/05/2003 Govt. 01/03/2015 Govt. 01/03/2010 Govt. 01/03/2009 Govt. 01/03/2005 Banks 01/03/2004 Banks 01/05/2003 Banks 31/05/2003 Banks 01/03/2006 Banks 01/03/2007 Others 01/03/2004 Others 01/05/2003 Others 31/05/2003 Total Val 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 1500 Coup Charge 12.50 0.84 12.00 0.08 12.00 0.16 12.50 3.63 11.50 2.79 11.00 2.75 10.50 1.35 12.50 0.84 12.00 0.08 12.00 0.16 12.50 1.77 11.50 2.29 12.50 0.84 12.00 0.08 12.00 0.16 Rs 17.82 equals Rs 198 crores in val
A bank will determine the proportion of its capital that it must keep in reserve based on this calculation:
Total capital (unchanged)
= The banks capital ratio 8/9%
Credit Risk + Market Risk +
Operational Risk
Credit Credit Risk Risk Banking Banking Book Book The 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 Market Risk Risk Trading Trading Book Book The market risk element of the denominator is the market risk requirement relating to trading books.
These rules were introduced in the the 1996 1996 Market Market Risk Risk amendment amendment to to Basel Basel 1 1 and and are are unchanged unchanged under under Basel Basel 2. 2.
Operational Operational Risk 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
Operational Risk
Defined
the risk of loss
resulting from inadequate or failed Internal processes, people systems or Resulting from external events.
Includes legal risk Excludes strategic, reputational risk
Broad categories
Internal fraud. For example, intentional
misreporting of positions, employee theft, and insider trading on an employees own account. External fraud. For example, robbery, forgery, cheque kiting, and damage from computer hacking. Employment practices and workplace safety. For example, workers compensation claims, violation of employee health and safety rules, organised labour activities, discrimination claims, and general liability. Clients, products and business practices . For example, fiduciary breaches, misuse of confidential customer information, improper trading activities on the banks account, money laundering, and sale of unauthorised products.
Damage to physical assets. For example, terrorism, vandalism, earthquakes, fires and floods. Business disruption and system
failures.
For example, hardware and software failures,
telecom problems, and utility outages.
Execution, delivery and process
management.
For example: data entry errors, collateral
management failures, incomplete legal documentation, and unauthorized access given to client accounts, non-client counterparty misperformance, and vendor disputes.
Risk enhancers
Highly Automated Technology - transforms risks from
manual processing errors to system failure risks Emergence of E- Commerce internal and external fraud and system securities issues) Emergence of banks as large volume service providers creates the need for continual maintenance of highgrade internal controls and back-up systems. Outsourcing Large-scale acquisitions, mergers, de-mergers and consolidations test the viability of new or newly integrated systems. Banks may engage in risk mitigation techniques (e.g. collateral, derivates, netting arrangements and asset securitisations) to optimise their exposure to market risk and credit risk, but which in turn may produce other forms of risk (eg. legal risk). Fee products are typically transaction / ops risk intensive
RBI stipulations on ORM
Organisational set-up and Key
responsibilities for Operational Risk Policy requirements and strategic approach Identification and Assessment of Operational Risk Monitoring of Operational Risk Controls / Mitigation of Operational Risk Independent evaluation of Operational Risk Management
Business Structure
Organisation reqmts
Board of Directors Risk Management Committee of the Board ORM Committee ORM Department Operational Risk Managers Support Group for operational risk
management
Business Structure
Capital requirements
measurement issue
Basic approach Standardised Advanced
Basel requirements
RBIs document essentially follows Basels
recommendations for following the Advanced approach But on the capital side, follows the Basic approach
Clear signal of intent of the regulator to
adopt fully international standards
