Basel II – Quick Review

Ali BELCAID – Managing Consultant

It is intended toward people who are looking for a quick review of the major components of Basel II.

Basel II history

1975 Report to the Governors on the Supervision of Banks’ Foreign Establishments

1988 Internal Convergence of Capital Measurement and Capital Standards

The Basle I Capital Accord 1996 Amendment to the Capital Accord to Incorporate Market Risks

2004 Internal Convergence of Capital Measurement and Capital Standards : A Revised Framework

The Basle II Capital Accord

Main Objectives

More risk sensitive: better reflection of risk

More comprehensive: assesment of additional risks

Taking into account increasing financial innovation

Recognising improvment in risk measurement and control

Putting more emphasis on market discipline

Maintaining the overall level of regulatory capital

Basel II - StructureBasel II Capital Accord

Pillar 1Minimum capital

requirements

Pillar 3Market discipline

Credit risk

Securitization Standardized Approach

Pillar 2Supervisory review

process

Operational risk

BasicIndicator Approach

Advanced Measurement Approaches

Standardized Approach

IRB Advanced

IRB Foundation

Market risk

Standardized Approach

Internal Model

Approach

Pillar 1 – Capital Ratio

Regulatory capital(Definition unchanged)

Credit Risk Exposure

(Measure revised)

Risk-weighted assets(Measure revised)

Minimum required capital ratio

(8% minimum unchanged)

=

Basle II Pillar 1 - Capital Requirement

+Market Risk

Exposure(Measure unchanged)

Operational Risk Exposure

(Measure added)

+

Pillar 1 - Credit Risk

Different approaches are now recognised to compute the credit risk exposure and the associated capital requirement.

Standardised approach

New weighting categories

Recognition of external credit assesment (external ratings)

Internal Rating Based approach (IRB)

Foundation IRB

Advanced IRB

Standardized Approach : Rating

S&P Moody’s InterpretationProbability of default (1Y)

Investment GradeAAA Aaa Superior quality – very strong 0,00%AA+ Aa1

Good quality 0,01%AA Aa2AA- Aa3A+ A1

Good Capacity to service the debt 0,05%A A2A- A3

BBB+ Baa1Appropriate payment capacity 0,37%BBB+ Baa2

BBB- Baa3Speculative Grade

BB+ Ba1Probable but uncertain service of the debt

1,36%BB Ba2BB- Ba3B+ B1

Risky debt, speculatif 6,08%B B2B- B3

CCC – C Caa1 - C Vulnerable, probable default 30,85%D - Default 100%

Standardized Approach : Risk Weight

Risk Weighting categories

Based on S&P classification

AAA to AA-

A+ to A-

BBB+ to BBB-

BB+ to BB-

B+ to B-

Below B-

Unrated

Sovereigns 0% 20% 50% 100% 100% 150% 100%

Banks

Option 1 20% 50% 100% 100% 100% 150% 100%

Option 2 ST 3m

20% 20%

50% 20%

50% 20%

100% 50%

100% 50%

150% 150%

50% 20%

Corporates 20% 50% 100% 100% 150% 150% 100%

Retail Portfolio 75%

Asset securitisation tranches

20% 50% 100% 350%1250

%1250

%1250%

Pillar 1 - IRB Approach

Under IRB approaches, capital charges are computed on basis of expected credit losses and unexpected credit losses.

Capital charges for expected losses are a function of the difference between the estimation of these losses and the general provisions constituted by the bank.

3 risk components for the computation of unexpected losses:

PD = probability of default: over a 1-year time horizon

LGD = loss given default: prediction of the economic loss after a default has occured

EAD = exposure at default: potential exposure of a credit facility at the moment of default

M = effective maturity

Pillar 1 - IRB ApproachIn

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Summary of different approaches for credit risk exposure computations

Standardised Approach

IRB Foundation

IRB Advanced

Exposure x Risk Weight = RWA

EAD LGD MPD

MPDEAD LGD

External Valorisation rules – Defined by the Basle Committee and the supervisory authority

Internal Valorisation rules – Computed by the banks’ risk management system

Pillar 1 - Credit Risk – Risk Mitigation

Credit risk mitigation techniques are recognised and allowed by the regulator.

3 types of risk mitigation:

Transaction with collateral

Bank has a claim from a debitor that is fully or partially covered by a guarantee provided by the debitor

Simple or comprehensive approach

Netting

Bank’s loans and deposits with one signle counterparty are compensated

Guarantees and credit derivatives

Pillar 2 – Supervisory Review Process

The second pillar refers to the supervisory review process and risk management guidance. This applies to all risks that a financial institution is facing, regardless of whether there is a minimum capital requirement.

The supervisory review process requires regulators to ensure that each bank has a sound Financial Risk Management methodology, which enables such institution to be able to assess the adequate capital requirement.

Supervisors would be responsible for evaluating how banks are assessing their capital adequacy needs relative to their risks.

Supervisors should require remedial actions when capital requirements are not met. These could include: improve the Risk Management process, improve internal controls, or increase the regulatory capital.

Pillar 2 – Supervision Process

Four Key Principles

1. Banks should have an internal process for assessing their capital in relation to their risk profile.

2. Supervisors should review and evaluate banks internal process as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate action if they are not satisfied with the results of this process.

3. Supervisors should expect banks to operate above the minimum regulatory capital ratios.

4. Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required.

Pillar 3 – Market Discipline

The third pillar of the new framework aims to bolster market discipline through enhanced disclosure by financial institutions.

Effective disclosure allows the stake-holders of financial institutions to better understand the risk profiles and to better assess the adequacy of capital reserves, of such institutions.

Disclosure of quantitative and qualitative information in four key areas:

Scope of application

Composition of capital

Risk exposure assessment & management processes (information per risk category)

Capital adequacy

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