Basel i, II, III Sec k

7/30/2019 Basel i, II, III Sec k

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BASEL

I, II, III


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BASEL

A set of international banking regulations put

forth by the Basel Committee on Bank

Supervision, which set out the minimum

capital requirements of financial institutions

with the goal of minimizing credit risk.


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Basle concordat

Basle agreement was originated by a committeeof central bank members of the bank for

international settlement (BIS) in 1975 and since

then amended.

The major amendments were done in 1983; the

agreement stipulates standards and guidelines

for international banking supervision.

The amendments also provide guidelines forsupervision for both domestic and cross-border

banking; a system of loan classification and a

system of provisions of bad loans.


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Basle Capital Accord

Basle capital accord of 1988 and its amendmentsprovide internationally acceptable standards forcapital adequacy of banking institutions andstipulates constituent elements of banks core

and supplementary capital, providing a uniformstandard for banks concerning their financialevaluation, performance and reporting.

These capital adequacy standards are beingwidely adopted by many countries, includingPakistan. (see capital adequacy; capital, core,supplementary)


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Calculation of Capital

Tier One Capital

the ordinary share capital (or equity) of the

bank; and

audited revenue reserves e.g.. retained

earnings; less

current year's losses; future tax benefits; and

intangible assets, e.g. goodwill.


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Upper Tier Two Capital

Un-audited retained earnings;

revaluation reserves;

general provisions for bad debts; perpetual cumulative preference shares (i.e.

preference shares with no maturity date whosedividends accrue for future payment even if the

bank's financial condition does not supportimmediate payment);

perpetual subordinated debt (i.e. debt with nomaturity date which ranks in priority behind all

creditors except shareholders).


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Lower Tier Two Capital

Subordinated debt with a term of at least 5

years;

Sedeemable preference shares which may not

be redeemed for at least 5 years.


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Capital Adequacy

Capital Adequacy: for a bank, adequacy is thesufficiency of capital of a bank to sustain itslending operations and other activities; inparticular, sufficiency of capital of a bank as

determined by central bank or supervisoryauthority to meet its obligation as they falldue, and to meet its loan losses as they arise,or to absorb unexpected trading losses from abanks asset portfolio and its off-balance sheetcommitments.

Capital adequacy for banks is measured in

terms of the ratio of banks capital.


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Capital Adequacy Ratio

CAR is calculated as the sum of tier 1 and tier

2 capital divided by the sum of risk weighted

assets in the balance sheet and credit

equivalents of off- balance sheet assets.


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BASEL I The first accord was the Basel I. It was issued in 1988 and focused

mainly on credit risk by creating a bank asset classification system. Thisclassification system grouped a bank's assets into five risk categories:

0% - cash, central bank and government debt and any OECD

government debt

20% - development bank debt, OECD bank debt, non-OECD bank debt(under one year maturity) and non-OECD public sector debt

50% - residential mortgages

100% - private sector/corporate debt (maturity over a year), real

estate, plant and equipment, capital instruments issued at other banks

Banks with international presence are required to hold capital equal to 8

% of the risk-weighted assets.


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Member Countries

Since 1988, this framework has been

progressively introduced in member countries

of G10, currently comprising 13 countries, na

mely;

Belgium, Canada, France,Germany, Italy, Japan

, Luxembourg, Netherlands, Spain, Sweden, S

witzerland, UK and USA.


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Basel II

The purpose of Basel II, which was initially

published in June 2004, is to create an

international standard that banking regulators

can use when creating regulations about how

much capital banks need to put aside to guard

against the types of financial and operational

risks banks face.


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Basel II

In practice, Basel II attempts to set up rigorousrisk and capital management requirementsdesigned to ensure that a bank holds capitalreserves appropriate to the risk the bank

exposes itself to through its lending andinvestment practices.

Generally speaking, these rules mean thatthe greater risk to which the bank is exposed,the greater the amount of capital the bank needsto hold to safeguard its solvency and overalleconomic stability.


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Basel I to Basel II

New credit risk approaches

o Market risk - unchanged

o Add operational risk portion

3 Pillars

1) Minimum capital requirements

2) Supervisory review

3) Market discipline


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The Basel II Framework

Pillar 1:

Minimum capital

requirements

Pillar 2:Supervisory

review

Pillar 3:Market

discipline

A guiding

principle

for banking

supervision

Credit Risk

Market Risk

Operational Risk

Disclosure

requirements


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Pillar 1: Minimum Capital

Requirements

The calculation of regulatory minimum capital

requirements:

%8assetsweighted-riskTotal

capitalofamountthe


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The Capital and Assets

Definition of capital:

Tier 1 capital + Tier 2 capital (with someadjustments)

Total risk-weighted assets are determined by:

Risk weighted assets of credit risk

plus

12.5* capital requirement for market riskplus

12.5* capital requirement for operational risk


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Minimum Capital Adequacy Ratios

Tier one capital to total risk weighted credit

exposures to be not less than 4 %;

Total capital (i.e. tier one plus tier two less

certain deductions) to total risk weighted

credit exposures to be not less than 8%


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Credit Risk

Standardized Approach

IRB Approach


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Credit Risk -

Standardized Approach

In determining the risk weights in the

standardized approach, banks may use

assessments by external credit assessment

institutions.

AssetsofValusBookAssetsfortRisk Weigh


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Risk Weight for Assets

Credit

Assessment

Claims on sovereigns Claims on banks and securities firms

Claims on

corporatesECA risk

scores

Risk

Weight

Credit

assessment of

Sovereign

Credit assessment of Banks

Risk weight

Risk weight

for short-term

AAA to AA- 1 0% 20% 20% 20% 20%

A+ to A- 2 20% 50% 50% 20% 50%

BBB+ to BBB- 3 50% 100% 50% 20% 100%

BB+ to BB- 4~6 100% 100% 100% 50% 100%

B+ to B- 4~6 100% 100% 100% 50% 150%

Below B- 7 150% 150% 150% 150% 150%

Unrated - 100% 100% 50% 20% 100%


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Credit Risk - IRB Approach

In the internal ratings-based (IRB) approach,

its based on banks internal assessment.

The approach combines the quantitative

inputs provides by banks and formula

specified by the Committee.


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Four quantitative inputs (risk components):

Probability of default (PD)

Loss given default (LGD) Exposure at default (EAD)

Maturity (M)

Use formula of the Committee to calculate theminimum requirements.


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Data Input Foundation IRB Advanced IRB

Probability of default

(PD)

From banks From banks

Loss given default

(LGD)Set by the Committee

From banks

Exposure at default

(EAD) Set by the Committee

From banks

Maturity (M) Set by the Committee or

from banks

From banks


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Market Risk

Standardised method

- the standards of the Committee

Internal models

- use banks internal assessments


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Operational Risk

The risk of losses results from inadequate or

failed internal processes, people and system,

or external events.

Basic Indicator Approach

Standardised Approach

Advanced Measurement Approaches(AMA)


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Operational Risk -

Basic Indicator Approach

GI = average annual gross income(three years,

excepted the negative amounts)

= 15%

GIKBIA


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Operational Risk -

Standardised Approach

GI 1-8 = average annual gross income frombusiness line from one to eight (three years,excepted the negative amounts)

= A fixed percentage set by the Committee

81GIKTSA


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Beta of Business Lines

Business Lines Beta Factors

Corporate finance (1) 18%

Trading and sales (2) 18%

Retail banking (3) 12%

Commercial banking (4) 15%

Payment and settlement (5) 18%

Agency services (6) 15%

Asset management (7) 12%

Retail brokerage (8) 12%


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Operational Risk - Advanced

Measurement Approaches

Under the AMA, the regulatory capital

requirement will equal the risk measure

generated by the banks internal operational

risk measurement system using thequantitative and qualitative criteria for the

AMA.

Use of the AMA is subject to supervisoryapproval.


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Pillar 2: Supervisory Review

Principle 1: Banks should have a process for

assessing and maintaining their overall capital

adequacy.

Principle 2: Supervisors should review and

evaluate banks internal capital adequacy

assessments and strategies.


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Supervisory Review

Principle 3: Supervisors should expect banks

to operate above the minimum regulatory

capital ratios.

Principle 4: Supervisors should intervene at an

early stage to prevent capital from falling

below the minimum levels.


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Pillar 3: Market Discipline

The purpose of pillar three is to complement

the pillar one and pillar two.

Develop a set of disclosure requirements to

allow market participants to assess

information about a banks risk profile and

level of capitalization.


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Basel III BIS began referring to this new international regulatory framework

for banks as "Basel III in September 2010. The draft Basel III

regulations include:

"tighter definitions of Tier 1 capital; banks must hold 4.5%by January 2015, then a further 2.5%, totalling 7%.

the introduction of a leverage ratio,- (Put a floor under the build-upof leverage in the banking sector)

Promote more forward looking provisions;

a framework for counter-cyclical capital buffers,

and short and medium-term quantitative liquidity ratios.(isintroducing a global minimum liquidity standard for internationally active banks )


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What is procyclicality?

In particular, the financial regulations ofthe Basel II Accord have been criticized fortheir possible procyclicality.

The accord requires banks to increasetheir capital ratios when they face greaterrisks. Unfortunately, this may require them tolend less during a recession or a credit crunch,which could aggravate the downturn.

Basel i, II, III Sec k

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