Basel I to Basel III

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    Basel I to Basel III

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    Why Bank Capital?

    A bank can finance its operations and carry out lendingand investment activity either with debt (borrowings anddeposits) or own funds (equity)

    Borrowings (including primarily insured deposits)generate contractual liabilities, which if not paid whendue can cause the bank to fail.

    In contrast, equity can gain or lose value without causingthe bank to default

    The greater the proportion of equity relative to debt in abanks capital structure, the more likely the bank will beable to meet its obligations, especially during periods ofeconomic adversity

    Thus, regulatory emphasis on Capital Adequacy as akey element of banks Safety and Soundness

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    Why Bank Capital?

    However, equity capital comes at a much higher cost

    Higher regulatory requirements of equity capital canconstrain the banks capacity to lend and have broadermacroeconomic effects on availability of credit

    Higher bank capital requirements can also reduce banksability to take advantage of higher financial leverage andtax benefits of debt capital to increase ROE

    In a competitive market place, if banks ROE is

    depressed, capital will migrate to other higher returnindustries / sectors

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    How Much Bank Capital?

    Prior to 1980s, there were no specific numerical capitaladequacy standards, only subjective, qualitativeregulatory assessments of banks

    Equity capital to total assets ratio of some of the largest

    banks in the US had reached a low of 4% In the 1970s and early 1980s, failures of large number of

    banks in the US and Europe, including large banks,combined with economic recession in 1881 changedregulatory and supervisory perceptions of bank capital

    Since the late 1980s, bank supervisors, stimulated inpart by concerns arising out of bank failures and bankingcrises attempted to precisely define numerical minimumcapital adequacy standards for banks

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    How Much Bank Capital?

    Issues

    Banking business defined differently indifferent countries

    Banks moving away from safe, low yieldassets to riskier on balance sheet assets andoff-balance activities which were difficult toquantify

    Regulators in different countries set capitalstandards individually, without convergence toany common norms

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    The Basel Capital Accord

    In December 1987 International convergence of capitalmeasures and capital standards was achieved.

    In July 1988,the Basel I Capital Accord was created andadopted by the Basel Committee for BankingSupervision (BCBS) comprising the Central Bankgovernors of the Group of Ten (G-10) countries

    Key objectives of Basel I Set minimum regulatory capital adequacy requirements for

    banks that reflect the risks of the banks

    Define the components of regulatory capital, bearing in mind the

    ability to absorb losses Applicable in its original version to large, internationally

    active commercial and investment banks

    Applicable, with suitable modifications by localregulators, to domestically operational banks

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    Minimum Capital Adequacy

    Standards

    Capital Adequacy Ratio (CAR) =

    Regulatory Capital Funds

    --------------------------------------------Risk Weighted Assets (On B/S & Off B/S)

    Minimum CAR under Basel I = 7.25% by 1990 and 8%

    by 1992

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    Components of Regulatory Capital

    Common Equity &Retained earnings

    Lower Tier IISubordinated debt (Dated)

    Upper Tier IISubordinated debt(Dated & Perpetual)

    Corecapital

    Supplem

    entarycapital

    Tier I

    Hybrid Tier I innovative

    Cost/Riskfor investor

    High

    LowTier IIISubordinated debt (Dated)

    Regulatory

    Capital

    Approved by BIS in 1996

    Approved by BIS in 1988

    Approved by BIS in 1988

    Approved by BIS in 1998 Max up to 15% of Tier I

    Max up to 50% of Tier I

    Max up to 100% of Tier I(along with Lower Tier II

    50% at least ofminimum capitalratio of 8%

    LossAbsorption

    High

    Low

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    Risk Weighted Assets

    Basel I recommended risk weights to be assigned todifferent broad categories of assets or off balance sheetexposures based on the relative riskiness of thoseexposures

    The risk weighted approach was preferred over a simplegearing ratio because: (i) it provides a fairer basis for making international comparisons

    between banking systems whose structures may differ;

    (ii) it allows off-balance-sheet exposures to be incorporated moreeasily into the measure;

    (iii) it does not deter banks from holding liquid or other assetswhich carry low risk.

    Broad brush, judgemental weights were applied todifferent types of assets and the framework of weightswas kept as simple as possible.

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    Risk Weights Under Basel I

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    Off Balance Sheet Exposures

    Off-balance sheet contingent contracts, such as letters of

    credit, loan commitments and derivative instruments,

    which are traded over the counter, needed to be first

    converted to a credit equivalent based on regulatory

    specified credit conversion factors (CCF) and thenassigned appropriate risk weights

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    Benefits of Basel I

    Basel I acted as a stabilizing force in the internationalbanking systems

    Measured on-balance-sheet capital ratios increasedsince the Accord's provisions took effect in 1992 to reachindustry average of 8% in 1993, without any evidentcontraction in credit availability as a result

    Since the implementation of Basel I, banks equitycapital, and also reserves and income increased, furtherstrengthening banks total level of protection from creditlosses

    Banks consciously held capital well in excess ofregulatory minimum requirements, to avoidconsequences of regulatory sanctions that could beimposed during times of adversity

    There was a marked decline in bank failures

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    Criticism of Basel I

    Could not create a level playing field among banks fromdifferent countries due to differences in regulatoryactions, tax laws, disclosure requirements, insolvencylaws and others

    Used a one-size-fit-all risk weight approach for allcategories of banks irrespective of their risk profile

    Created incentives for regulatory capital arbitrage usingsecuritisation and off-balance sheet derivatives

    Failed to recognize the loss reducing effects (riskmitigating effects) of collateralised exposures

    Assigning favourable weights to claims on OECD banksand countries implied a biased treatment which was nottruly a reflection of the risks of such exposures

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    1996 Amendment to Basel I

    An explicit capital cushion for the price risks to whichbanks are exposed, particularly those arising from theirtrading activities.

    The amendment introduced different approaches to the

    measurement of market risks arising from banks openpositions in foreign exchange, traded debt securities,traded equities, commodities and options.

    For the first time, banks were allowed to use, as analternative to the standardized risk weight approach,

    their internal models for measuring the capital charge formarket risk

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    Basel II

    Basel Capital Accord II - International Convergence of

    Capital Measurement and Capital Standards, June 2004

    Initiation of revised framework in June 1999; additional

    proposals in Jan 2001 and April 2003; latest version

    endorsed by Central Bank Governors and heads of

    Banking Supervision of G - 10 Countries

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    Basel II

    To align capital adequacy assessment more closely with

    the key elements of banking risk

    3 Pillars to ensure safety and soundness of the banking

    system

    Minimum Capital Requirements

    Supervisory Review Process

    Use of Market Discipline

    Focus on internationally active banks but can be applied

    suitably to all types of banks

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    Basel II

    Greater emphasis on banks own assessment of risks to

    which they are exposed, with special importance to

    credit and operational risk

    Banks management ultimately responsibility for

    managing risks & ensuring that CAR is consistent with

    the banks risk profile

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    Basel II

    Capital Adequacy Ratio =

    Regulatory Capital Funds

    --------------------------------------------------

    Risk Weighted Assets (On & Off B/S)= Minimum 8%

    Total Risk Weighted Assets =

    12.5 X [Capital Required for Mkt risk + Operationalrisk + Credit Risk]

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    Credit Risk in Basel II

    Applicable to credit exposures like loans and advances

    in the banking book and investments in corporate bonds

    Three Approaches for Credit Risk Capital Charge

    Standardized approach based on external rating agency ratings

    Foundation IRB approach based on bank specific internal ratings

    and

    Advanced IRB approach based on bank specific internal ratings

    and measures of loss

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    Credit Risk in Basel I

    Provide incentives for banks to enhance their riskmeasurement and management techniques

    Is more risk sensitive as compared to the previousstandardized approach

    wider differentiation of risk weights wider recognition of credit risk mitigation techniques

    Reduce incentives for capital arbitrage

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    Standardized Approach Credit

    Risk

    AAA to

    AA-

    A+ to

    A-

    BBB+ to

    BBB-

    BB+ to

    BB-

    B+ to

    B-

    Below

    B- Unrated

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

    Sovereign 0% 20% 50% 100% 100% 150% 100%Banks Option I 20% 50% 100% 100% 100% 150% 100%

    Banks Option IIa 20% 50% 50% 100% 100% 150% 50%

    Banks Option IIb 20% 20% 20% 50% 50% 150% 20%

    Risk weights based on external credit assessments

    Banks Option I : Risk Weighting based on risk weighting of sovereign in which Bank is incorporated

    Banks Option IIa: Risk weighting based on assessment of individual bank

    Banks Option IIb: Risk weighting based on assessment of individual bank with claims of originalmaturity < 3 months

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    Market Risk in Basel I

    Applicable to Trading books of banks which are affected

    by price and interest rate variations

    Two Approaches for Market Risk Capital Charge

    Standardized Measurement Method (SMM) based on

    regulatory standards for price and interest rate

    variations

    Internal Models Approach (IMA) based on banks

    internal Value at Risk Models for assessing market

    risk related losses and capital requirements

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    Operational Risk in Basel II

    Operational risk has been defined as the risk of loss

    resulting from inadequate or failed internal processes,

    people and systems or from external events.

    Three Approaches for Operational Risk Capital Charge

    Basic Indicator Approach (BIA)

    The Standardised Approach (TSA)

    Advanced Measurement Approaches (AMA)

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    Supervisory Review in Basel II

    Banks must implement an Internal Capital AdequacyAssessment Process (ICAAP) in relation to their riskprofile

    This includes stress testing for credit, market andoperational risk and aligning their capital to the stressed

    requirements Banks must also outline a strategy for maintaining their

    capital levels

    Pillar 2 also requires the supervisory authorities tosubject all banks to an evaluation process and to impose

    any necessary supervisory measures based on theevaluations.

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    Market Discipline in Basel II

    Market discipline is imposed by a set of

    disclosure requirements included in the Basel II

    framework to allow market participants assess

    the capital adequacy of the bank based oninformation on the capital, risk exposures, risk

    assessment processes etc.

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    Basel III

    In September 2010, the Basel Committee's

    oversight body - the Group of Central Bank

    Governors and Heads of Supervision (GHOS) -

    agreed on the broad framework, measures andtransition to stronger capital adequacy measures

    of Basel III

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    Basel III: Greater Emphasis on

    Common Equity Increase of the minimum common equity requirement to

    4.5%, much higher than the minimum ratio of 2% underBasel II

    The Tier 1 minimum capital requirement increased to 6%as compared to a minimum ratio of 4% under Basel II

    Banks will also be required to hold an additional capitalconservation buffer of 2.5% of common equity towithstand future periods of stress.

    The closer a banks capital level gets to the minimumrequirement, the more constrained its earnings

    distribution (eg dividend payments, share buybacks andbonuses) will be until capital is replenished.

    Thus, during normal periods the total common equityrequirements for banks will be effectively brought to atleast 7%.

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    Basel III: RWA

    Increased the capital required for trading book andcomplex structured products

    The risk-based capital requirement measures will besupplemented by a non-risk-based leverage ratio,

    That is, the risk based capital adequacy ratio will bebenchmarked to a non-risk based leverage ratio whichuses the banks total non-weighted assets plus offbalance sheet exposures

    This is expected to help contain the build-up ofexcessive leverage in the system, serve as a backstop tothe risk-based requirements and address model risk.

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    Basel III: Pro-cyclicality

    Basel III will promote the build-up of capital buffers ingood times that can be drawn down in periods of stress.

    The countercyclical capital buffer, which has beencalibrated in a range of 02.5%, would build up during

    periods of rapid aggregate credit growth if, in thejudgment of national authorities, this growth isaggravating system-wide risk.

    Conversely, the capital held in this buffer could bereleased in the downturn of the cycle. This would, for

    instance, reduce the risk that available credit could beconstrained by regulatory capital requirements.

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    Basel III