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Basel Capital Adequacy Framework

Eric FalkensteinVice President

ICM Credit Risk Management for Asian Financial InstitutionsJune 28, 2000

eric.falkenstein@moodys.com212.553.7231

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TopicsTopics

The current capital regulations The current Basel dialogue Next Steps

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What is Bank Capital?

Bank Capital is: Bank Capital is not: - Common Equity - Customer Deposits - Preferred Equity - Short-term Debt - Subordinated Debt - Other Liabilities - Loan Loss Reserve - Goodwill

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Regulatory Capital MeasuresRegulatory Capital Measures

A) Tier I or Core Capital Ratio- Tier I equity divided by risk-weighted assets- Risk-weighted assets have 100% weighting for loans, 20% weighting

for OECD bank debt, 0% for Treasury debt- Tier I equity consists mainly of common stock, perpetual preferred

stock, minus intangibles

B) Total Capital Ratio- Tier I + Tier II equity divided by risk-weighted assets. Tier II capital

consists mainly of qualifying subordinated debt and long-term preferred stock, plus Loan Loss Reserve (up to 1.25% of risk-weighted assets)

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Regulatory Requirements for Risk-based Capital Regulatory Requirements for Risk-based Capital RatiosRatios

Basic “Well-Capitalized”

Tier 1 or Core Capital 4% 6%

Tier 1 + Tier 2 or Total Capital 8% 10%

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Limitations of the Current Risk-based Limitations of the Current Risk-based Capital ApproachCapital Approach

Risk-weightings are not truly risk sensitive: an Aaa loan has the same risk-weighting as a B loan.

Capital methodology falling behind financial innovations: securitization, derivatives, netting, etc.

Ignores capital needed for operating, interest rate, market and other risks.

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Credit Risk Modeling: Current Practice Credit Risk Modeling: Current Practice and Applicationsand Applications

Purpose:

1) Provide summary of best practices of credit models

2) Assess the potential applications and limitations of credit risk models for supervisory and regulatory purposes

3) Solicit feedback

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Basel, Key LiteratureBasel, Key Literature

No. 4 International Convergence of Capital Measurement and Capital Standards, July 1988 (the Basel Capital Accord)

No. 55 Credit Risk Modeling: Current Practices and Applications, April 1999

No. 50, A new capital adequacy framework, June 1999 No. 71, Summary of responses received on the report "Credit Risk

Modeling: Current Practices and Applications", May 2000

download at www. bis.org

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Credit Risk Modeling: Current Practice Credit Risk Modeling: Current Practice and Applications (4/99)and Applications (4/99)

Current credit management methods potentially rational direction for future refinements, yet there are limitations:

1) Lack of Data.2) Validation (see #1).

Key quotes:“Regulators would have to be confident that models were used to actively manage risk, and

that conceptually sound, empirically validated, and produce capital assessments comparable across financial institutions.”

“Significant hurdles, principally concerning data availability and model validation, still need to be cleared before these objectives can be met, and the Committee sees difficulties in overcoming these hurdles in the timescale envisaged for amending the capital Accord."

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A New Capital Adequacy Framework (6/99)

3 pillars to the revised capital framework

1) minimums (most of the focus)

2) supervisory review (probably more important!)

3) market discipline (good idea, but need broad liquid debt markets)

New ideas: May have more or less than 100% weightings on corporate loans Internal credit models could guide capital allocations Address derivatives and netting agreements more logically

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A New Capital Adequacy Framework 6/99

Aaa to Aa3 A1 to A3 Baa1 to Baa3

Ba1 to B3 Below B3 Unrated

Sovereigns 0% 20% 50% 100% 150% 100%Option 1 20% 50% 100% 100% 150% 100%Option 2 20% 50% 50% 100% 150% 50%

Corporates 20% 100% 100% 100% 150% 100%* option 1 is a risk weighting depending on the sovereign* option 2 is a risk weighting depending on the individual bank

Banks

Claim Assessment

An example of the new refinements put forth by Basel:

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Summary of Responses (5/00)

Subject: Loss Given Default

comment: US and European data is all that's really available

Subject: Shape of the density function of losses

comment: Unknown (lognormal? Normal?), but not considered a major limitation

Subject: Conditional upon the economy

comment: Need sound linkage

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Summary of Responses (5/00)

Subject: Conceptual Approaches

Comments: Credit Value-at-Risk and/or Scenario

Subject: Default mode and Mark-to-Market Mode

Comments: Mark-to-market superior perhaps

Subject: Horizon

Comments: Not a big issue, 1 year likely

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Summary of Responses (5/00)

Subject: Parameter SpecificationsComments:

US corporate bond rating information goodUse conservative assumptions when missing dataProxiesStart collecting data as soon as possible

Subject: ValidationComments:

Stress testsPanel data set compiled from regulatory bodies

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Summary of Responses (5/00)

Subject: Supervision and Regulatory Application

Comments:

Portfolio by portfolio

Link evaluation of credit models to how models are actually used

General comment:

Simple models not necessarily bad

Don't use US data to parameterize models

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Next StepsNext Steps

Best Case Scenario:

Basel will make preliminary proposal by February 2001.

Phase-in will start in January 2003.

Probable Scenario: year or two later...