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The Basel II Capital Accord

June 2005

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Chapter 1 Basel basics

Executive Summary 7

Basel I overview 8

Basel II overview

Timing 9

Scope of application 10

Capital components 13

Types of Banks 14

IRB Transition Period 16

Chapter 2 Basel II minimum capital charges First Pillar

Sovereign exposures 18

Bank exposures 21

Corporate exposures 24

Retail exposures 27

Real estate exposures 30

Covered bonds 33

Specialised lending 34

Source: Text

Table of Contents

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Chapter 2 Basel II capital charges (contd)

Off-balance sheet items 35

Equity 37

Non-performing loans 39

Credit risk mitigation (CRM) 45

Securitisation exposuresStandardised banks

- Ratings based approach 51

- Most senior exposures; second loss positions or better 52

- Liquidity facilities 53

- Overlapping exposures 55

IRB banks

- Ratings based approach 57- Internal assessments approach 58

- Supervisory formula approach 61

- Liquidity facilities 63

- Top-down approach 64

Source: Text

Table of Contents (contd)

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Chapter 2 Basel II capital charges (contd)

Early amortisation structures 66

Trading book 71

Chapter 3 Basel II operational risk charges 84

Basic indicator approach

Standardised approach

Advanced measurement approach

Chapter 4 Supervisory Review Second Pillar

Four key principals of supervisory review 87

Supervisory review process for securitisation 89

Source: Text


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Chapter 5 Market discipline Third Pillar

Qualitative disclosure 92

Quantitative disclosure 93

Chapter 6 Some observations

Open issues 95

Impact on financial markets 96

Impact on banks 97

Impact on securitisation markets 98

Impact on ABCP conduits 99

Contact Details 100

Source: Text


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Chapter 1

Basel II Basics

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Basel I

In effect since 1988; very

simple in application

Easy to achieve significant

capital reduction with little or no

risk transfer

Basel II introduced to:

combat regulatory arbitrage

exploit and improve bank risk

management systems

Basel II

Much more complex and risksensitive

First Pillar Minimum capital

Second Pillar Supervisory review

Third Pillar Market discipline

Treats exposures very unequallydepending on exposure

characteristics

Treats banks very unequally

depending on sophistication of risk

management systems

Will profoundly alter bank

behaviour

Source: Text

Executive Summary

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Risk weights

OECD sovereigns: 0%

OECD banks: 20%

Residential mortgages: 50%

Synthetic: 20% super-senior, 0% cash-collateralised mezzanine, deduction or 100% first

loss (with national variations)

Unfunded commitments under one year: 0%

Unfunded commitments over one year: 50%

Everything else: 100%

Sample capital calculation

100 million corporate exposure

100% risk weight = 100 million risk weighted assets (RWA) Capital charge = Capital = 8% minimum

RWA

Capital charge: 8 million

Source: Text

Basel I Capital Charges

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Basel II

Published June 2004

End 2006 for standardised and foundation IRB

banks ( 2)

End 2007 for advanced IRB banks ( 2)

End 2009 (at earliest) before full IRB benefits

achievable due to transition period ( 45-49)

Basel/IOSCO review (not yet final) will

change CRM rules and rules for trading

book exposures

Capital Requirements Directive (CRD)

Will implement Basel II within EU

Same adoption timing sought

May vary from Basel II (and thus from rules in

US and elsewhere) in important respects

However

New rules will alter banks behaviour right away

Some countries will adopt prior to expected

implementation dates, at least in part

Implementation may be delayed in some

countries

Reaction of US regulators to QIS 4 results

may cause delays

EU and member state adoption schedules

not usually so quick

Implementation may not be uniform

140+ items subject to national discretionSupervisory discretion

Lengthy adoption time permits lobbying

Source: Text

Basel II Timing

Unless otherwise indicated, all references to paragraph numbers in

these materials refer to paragraphs in June 2004 Basel II Accord

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Applied on consolidated basis to

internationally active banks ( 20)*

All banking and other financial activities

(whether or not regulated) captured

through consolidation ( 24)

Financial activities do not includeinsurance ( 24, fn. 5)

Majority-owned subsidiaries not

consolidated: deduct equity and capital

investments ( 27)

Significant minority investments without

control: deduct equity and capital

investments ( 28) Deduction of investments 50% from tier 1

and 50% from tier 2 capital ( 37)

Insurance entities

Generally, deduct bank s equity and other capital

investments in insurance subsidiaries ( 30)

However, some G10 countries will retain current risk

weighting treatment (100% for standardised banks) for

competitiveness reasons ( 31) Supervisors may permit recognition by bank of excess

capital invested in insurance subsidiary over required

amount ( 33)

Commercial entities

generally deducted significant investments in

commercial entities above materiality thresholds ( 35)

Significant investments in commercial entities below

materiality thresholds risk weighted 100% ( 36)

Source: Text

Basel II Scope of Application

* EU rules (CRD) will also apply to solo entit ies and to

investment firms

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Source: Text

Basel II Capital and Provisions

Definition of regulatory capital unchanged( 41) (but some changes anticipated going forward)

Treatment of provisions

Standardised approach: general provisions can be included in tier 2 capital up to limit of 1.25% of

risk-weighted assets ( 42)

IRB approach:

Securitisation and certain equity exposures: expected loss (EL) amount must first be

deducted from capital ( 43)

Other exposures: bank must compare total eligible provisions against total EL amount and

deduct any excess EL amount over eligible provisions (excess of provisions over EL amount

may be added to tier 2 capital up to maximum of 0.6% of risk-weighted assets ( 43, 374-

386)

Scaling Factor

Scaling factor of 1.06 (subject to recalibration following QIS 4 and QIS 5) introduced to ensure

same aggregate amount of capital remains in banking system following Basel II adoption ( 44,

fn. 11)

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Minimum Capital Charges: Minimum capital requirements based on market, credit

and operational risk to (a) reduce risk of failure by cushioning against losses and (b)

provide continuing access to financial markets to meet liquidity needs, and (c) provide

incentives for prudent risk management ( 40-718)

First Pillar

Second Pillar

Third Pillar

Basel II Three Pillars

Supervisory Review: Qualitative supervision by regulators of internal bank risk control

and capital assessment process ( 719-807), including supervisory power to require

banks to hold more capital than required under the First Pillar

Market Discipline: New public disclosure requirements to compel improved bank riskmanagement ( 808-822)

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Credit risk charges ( 40-643)

Revised

To ensure capital charges are more sensitive to risks of exposures in banking book

Enhancements to counterparty risk charges also applicable to trading book exposures

Operational risk charges ( 644-683)

New

To require capital for operating risks (fraud, legal, documentation, etc.)

Market risk charges ( 684-718)

Initially unchanged, but Basel/IOSCO review has proposed changes to specific riskcalculations and Second Pillar stress testing

To require capital for exposures in trading book

Rules in Market Risk Amendment (1996)

Source: Text

Basel II Capital Components

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Measure credit risk pursuant to fixed risk weights based on external credit assessments(ratings)

Least sophisticated capital calculations; generally highest capital burdens

Most Japanese banks will start Basel II as standardised banks

Most US banks will stay under Basel I (or, more likely, will move to Basel 1)

Standardised

Foundation IRB

Advanced IRB

Basel II Types of Banks

Measure credit risk using sophisticated formulas using internally determined inputs of

probability of default (PD) and inputs fixed by regulators of loss given default (LG

D), exposureat default (EAD) and maturity (M).

More risk sensitive capital requirements

Most European banks will likely qualify forFoundation IRB status at start of Basel II

Measure credit risk using sophisticated formulas and internally determined inputs of PD, LGD,EAD and M

Most risk-sensitive (although not always lowest) capital requirements

Transition to Advanced IRB status only with robust internal risk management systems and data

Top 10 US banks expected to implement Advanced IRB at start of Basel II

Under Basel II, banks have strong incentive to move to IRB status and reduce capital

charges by improving risk management systems

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Recognition

Multiple

ratings

External credit assessment institution (ECAI)(rating agency) recognised/

approved by national supervisor on basis of objectivity, independence,

transparency, disclosure, resources and credibility ( 91)

If two assessments, higher risk weight applied ( 97)

If three or more assessments, two lowest risk weights referred to and

higher of those two applied ( 98)

Assessment

CRM

Ratings assessment must take into account entire exposure (principal onlyratings will not qualify) ( 100)

Credit risk mitigation (CRM) not recognised if taken into account in rating

( 101)

Source: Text

External Ratings Criteria

Solicited Subject to national discretion, unsolicited ratings recognised ( 108)

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Foundation IRB capital requirements for credit risk, operational risk and market risk may

not fall below 95% of the current minimum required for credit and market risks ( 46)

IRB capital requirements for credit risk, operational risk and market risk

may not fall below 90% of the current minimum required for credit and

market risks ( 46)

IRB capital requirements for credit risk, operational risk

and market risk may not fall below 80% of the current

minimum required for credit and market risks ( 46)

BIS Committee and/or national supervisors

may extend floor if warranted ( 48)

Source: Text

Transition Period (IRB Banks only)

2007

2008

2009

2010

and after

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Chapter 2

Basel II First Pillar

Minimum Capital Charges

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Basel II Sovereign Capital Charges

Basel I

OECD

non-OECD

Type of

SovereignRisk Weight

0%

100%

Sovereigns In a Nutshell

ExternalRating

AA- or

above

A

BBB

BB+ to

B-

0%

20%

50%

100%

150%

100%

below B-

unrated

Standardised bank risk weights

25%

68%

141%

100%

24%

24%

Sample est. FIRB bank risk weights*

Basel II

* Inputs: average rating agency valuesfor PD, LGD of 45%, supervisory value

for EAD and M of 2.5. (Moody

s rating

applied if different from S&P)

Poland

Russia

Turkey

Bulgaria

Czech Republic

Hungary

Country

Winners

non-OECD rated

above BB+

Examples: Chile,

China, Thailand

Losers

OECD rated below

AA-

Examples: Czech

Republic, Greece,

Hungary, Mexico,

Turkey

Rating

A2/BBB+

Baa3/BBB-

B1/BB-

Ba1/BBB-

A1/A-

A1/A-

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RatingAAA to

AA-

A+ to

A-

BBB+ to

BBB-

BB+ to

B-

Below

B-Unrated

Risk Weight 0% 20% 50% 100% 150% 100%

Risk weights may also be based on ECA risk scores

Claims on non-central government public sector entities based on corporate exposure risk

weights

Claims on multilateral development banks have 0% risk weight if conditions are met,

including: (i) majority of MDBs ratings are AAA, (ii) significant portion of shareholders are

AA- or better rated sovereigns, (iii) funding is in form of paid-in equity with little or noleverage, and (iv) conservative lending criteria

At national discretion, lower risk weight for banks exposures to their sovereign (or central

bank) in domesticcurrency; if adopted, other regulators may permit same risk weight

Sovereigns Standardised Banks ( 53-59)

Risk weights for sovereign exposures:

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Capital requirement for defaulted exposure equals greater of zero and difference between exposures LGDand bank s best estimate of loss

Input characteristics (applicable to all types of exposures) ( 285-325):

PD: internally determined one-year probability of default

LGD:

- FIRB: 45% (senior)/75% (subordinated); adjusted (LGD* = LGD x ( E* / E) for CRM recognition- AIRB: own estimates; adjusted for CRM recognition

EAD: not less than sum of (a) amount by which bank capital would reduce if exposure written-off fully

and (b) specific provisions and partial write-offs

M: 2.5 years forFIRB (6 months for repos); own est. for AIRB for each exposure; max. 5 years

Sovereigns IRB Banks ( 270-272)

Formula for exposure not in default:

Correlation (R) = 0.12 (1 EXP (-50 PD)) / (1 EXP (-50)) +

0.24 [1 - (1 - EXP(-50 PD))/(1 - EXP(-50))]

Maturity adjustment (b) = (0.11852 0.05478 ln (PD))^2

Capital requirement (K) = [LG

D N [(1 - R)^-0.5 G

(PD) + (R / (1 - R))^0.5 G

(0.999)] PD x LGD] x (1 - 1.5 x b)^ -1 (1 + (M - 2.5) b)

Risk-weighted assets (RWA) = K x 12.5 x EAD

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Basel II Bank Capital Charges

Basel I

OECD

non-OECD

Type of

BankRisk Weight

20%

100%

Banks In a Nutshell

20%

50%

100%

100%

150%

100%

AA- or

above

A+ to A-

BBB+ to

BBB-

BB+ to

B-

below B-

unrated

Basel II

* Using inputs of average rating agency

values for PD, LGD of 45%,supervisory va lue for EAD and M of

2.5.

Winners

non-OECD rated above

BB+ underOption 2

Examples: May Bank,

Public Bank Berhad

Losers

OECD rated A or below

under either option

Examples:

Commerzbank, HVB,

SEB, Mizuho, Bradesco

Standardised

Option 1

20%

50%

50%

100%

150%

50%

Standardised

Option 2

ExternalRating

AA- or

above

A+ to A-

BBB+ to

BBB-

BB+ to B-

below B-

Unrated***

FIRB est. risk weights*

14% - 24%

24% - 28%

38% - 68%

100% - 197%

226%

NA

** Using inputs of rating agency values

for PD, LGD of 10%, supervisory value

for EAD and M of 2.5.

ExternalRating

*** Internal PD estimate to be applied.

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Option 2: At national discretion, banks risk weighted on basis of own external ratings (plus

more favourable risk weight if claim maturity < 3 months)

Banks Standardised Banks ( 60-65)

2 options,selected by national regulator to apply for all banks in jurisdiction:

Option 1: Banks risk weighted one category below risk weights of banks sovereigns:

RatingAAA to

AA-

A+ to

A-

BBB+ to

BBB-

BB+ to

B-

Below

B-Unrated

Risk Weight 20% 50% 50% 100% 150% 50%

RatingAAA to

AA-

A+ to

A-

BBB+ to

BBB-

BB+ to

B-

Below

B-Unrated

Risk Weight 20% 50% 100% 100% 150% 100%

Local currency reduction: National regulators may reduce by one notch risk weight of local

currencybank debt having maturityof less than 3 months, subject to floor of 20%

Exposures to securities firms treated as bank claims if regulatory arrangements comparable

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Banks IRB Banks ( 270-272)

Formulas for bank exposures same as for sovereign exposures, but with floor for PD of 0.03%

Effective floor of 16 to 48 basis points for highest quality credits (depending on maturity

assumption) underAdvanced IRB

Generally, PD for high-qualitybank debt will be below 0.03% floor (so floor must be used)

More realistic 10% LGD for Advanced IRB bank (rather than 45% supervisor-imposed LGDforFoundation IRB banks) results in significant capital reductions

Compare to 56 basis point floor for highestqualityABS

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Basel II Corporate Capital Charges

Risk

Weight100%

Corporates In a Nutshell

20%

50%

100%

150%

100%

ExternalRating

AA- or

above

A

BBB+ to

BB-

below

BB-

unrated

Basel II

* Using inputs of rating agency values

for PD,LGD of 45%, supervisory valuefor EAD and M of 2.5.Winners

Corporates rated

above BBB+

Losers

Corporates rated

below BB-

Standardised

Option 1

100%

100%

100%

100%

100%

Standardised

Option 2

ExternalRating

AA- or

above

A

BBB

BB+ to B-

below B-

Unrated**


14% - 24%

24% - 28%

38% - 68%

100% - 197%

226%

NA

** Internal PD estimate to be applied.

Basel I

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Option 2: At national discretion, all corporates risk weighted at 100% without regard to

external ratings

SME Adjustment: 75% risk weight for unrated SME if exposure under1 million and either

treated by bank as retail or guaranteed by individual Includes claims on insurance companies

Corporates Standardised Banks ( 66-68)

2 options,selected by national regulator to apply for all banks in jurisdiction:

Option 1: Corporates risk weighted as set out in following chart (supervisory authority toincrease 100% risk weight for unrated corporateswhere warranted by higher default rates):

Rating AAA toAA-

A+ toA-

BBB+ toBB-

BelowBB-

Unrated

Risk Weight 20% 50% 100% 150% 100%

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Corporates IRB Banks ( 270-274)

Formulas for corporate exposuressame as for bank exposures, including floor for PD of 0.03%

SME Adjustment for firms setting total annual sales (S) at 50 million or and 5 million or more:

Subject to national discretion, supervisors may allow banks to substitute total assets for totalsales

SME adjustment generates approx. 20% reduction in risk weights (depending upon originalcreditworthiness)

Effective floor of 14% risk weighting for foundation IRB banks due to minimum PD of 0.03%representing a capital charge of 112 bps

Correlation (R) = 0.12 (1 EXP (-50 PD)) / (1 EXP (-50)) +

0.24 [1 - (1 - EXP(-50 PD))/(1 - EXP(-50))] 0.04 (1 (S-5)/45)

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Basel II Retail Capital Charges

Retail In a Nutshell


Basel II

Risk

Weight100%

75% if conditions metGenerally

From 150% to 50% depending on

level of specific provisions

against exposure

Default

** Using PD of 3% and LGD of 80% and

PD of 5% and LGD of 90%,

respectively

Credit cards

Other Retail


70% - 110%**

60% - 90%***

*** Using PD of 5% and LGDsof 40%and

60%, respectively

* PD and LGD inputs provided by bank

( 331); PD floor at 0.03%

Basel I

Internally

determined PDs

and LGDs under

Foundation IRB

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Retail Standardised Banks ( 69-71)

Generally

75% risk weight if:

Exposure to individual or small business

Exposure takes form of revolving credit, line of credit, personal loan, lease, or small

business facility (mortgage loan excluded to extent otherwise covered (see below)) Portfolio diversified (granular); Basel II accord suggests no aggregate exposure to any one

counterparty should exceed 0.2% of overall portfolio

Maximum aggregate counterparty exposure 1 million or less

Effective floor of 600 basis points

Past Due

Unsecured portion of exposure past due for more than 90 days, net of specific provisions, risk

weighted as follows: 150% when specific provisions less than 20% of outstanding amount of exposure

100% when specific provisions 20% or more of outstanding amount of exposure

100% when the specific provisions 50% or more of outstanding amount of exposure, with

supervisory discretion to reduce risk weight to 50% in such case

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Retail IRB Banks ( 326-338)

When only drawn balances securitised, bank must hold required capital against unfundedcommitment

Correlation (R) = 0.04

Capital requirement (K) = LGD N[(1 - R ) -0 .5 G(PD) + (R / (1 - R))^0.5 G (0.999)] PD

LGD


Formula for qualifying revolving retail exposure not in default:

Correlation (R) = 0.03 (1 EXP (-35 PD)) / (1 EXP (-35)) + 0.16 [1 - (1 - EXP(-35

PD))/(1 - EXP(-35))]

Capital requirement (K) = LGD N[(1 - R)^-0.5 G(PD) + (R / (1 - R))^0.5 G (0.999)] PD

LGD


Formula for other retail exposure not in default:

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Basel II Real Estate Capital Charges

Basel I

Real Estate In a Nutshell

Residential

Commercial

Type of

ExposureRisk Weight

50%

100%


Residential

Commercial

35%*

100%**

* Subject to conditions

** Reduced 50% risk weight possible,

subject to conditions

Residential

Commercial

Basel II

*** Using PD of 1% and LGD of 10%

and PD of 2% and LGD of 25%

FIRB est. risk weights

10% - 50%***

20% - 90%****

**** Using PD range of 0.07% and 2.1%

and LGD of 35%

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Real Estate Standardised Banks

Residential Real Estate ( 72-73)

35% risk weight for exposures fully secured by mortgages on residential property occupied by

the borrower or rented

Strict prudential criteria (including loan to value ratios) determined by national regulators

Supervisors may require increased risk weight if data warrant

Effective floor of 280 basis points

Commercial Real Estate ( 74)

Generally 100% risk weight, given experience in numerous countries with troubled credits over

the past few decades

However, 50% risk weight possible in certain markets if (among other conditions): (i) tranche not

greater than lower of 50% of market value and 60% of mortgage lending value, (ii) losses ontranche do not exceed 0.3% in any year, and (iii) overall losses from commercial real estate inrelevant market do not exceed 0.5% in any year

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Real Estate IRB Banks

Correlation (R) = 0.15

Capital requirement (K) = LGD N[(1 - R)^-0.5 G(PD) + (R / (1 - R))^0.5 G (0.999)] PD

LGD


Residential Mortgages Formula for exposure not in default ( 327-328):

High volatility commercial real estate (HVCRE) ( 280-284):

Supervisory

RatingStrong Good Satisfactory Weak Default

Risk Weight 95% 120% 140% 250% 0%

At national discretion, banks may assign preferential risk weights of 70% to strong and95% to good where maturity is less than 2.5 years or supervisor determines bank s

underwritingcriteria and other risk characteristics are substantially stronger

Treated differently under CRD

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Basel II Covered Bonds Capital Charges

Basel I (CRD)

Covered Bonds In a Nutshell

UCITS

qualifying

Exceptions*

Type of

Exposure

EU Risk

Weight

10%

20%


Senior debt

RW

Covered bondRW

20%* 50%** 100% 150% PD of 0.03%

PD of 0.15%

FIRB est. risk weights***

4%

10%

* Italy, Portugal, Sweden, UK

10% 20% 50% 100%

* Requires rating of AAA to AA-

** Requires rating of A+ to A- under

Option 1 and rating of A+ to BBB-

underOption 2

Basel II (CRD)

*** LGD of 12.5% required in CRD with

PD floor of 0.03%. Using inputs PD as

noted, LGD of 12.5%, supervisory

value for EAD and M of 2.5.

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Basel II Specialised Lending Capital Charges

Specialised Lending In a Nutshell

Basel I

All

Risk Weight

100%

Standardised bank risk weights ( 80)

All 100% Five Classes of Specialised Lending:

Project finance

Object finance

Commodities finance

Income-producing real estate

High-volatility commercial real estate

IRB bank risk weights ( 275-284)

Generally: For exposures other than HVCRE, banks

that do not meet requirements for estimation of PD will

map internal grades to five supervisory categories

(70% for strong, 90% for good, 115% for satisfactory,

250% for weak and 0% for default) ( 275)

At national discretion, supervisors may allow 50%

for strong and 70% for good if remaining maturity

less than 2.5 years or supervisor determines

underwriting or other risk characteristics are

substantially stronger ( 277)

Basel II

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Basel II Off Balance Sheet Items

Off Balance Sheet Items Standardised Banks ( 82-89)

Off-balance sheet items converted into credit exposure equivalents using credit

conversion factor (CCF)

Commitments

Original maturity of up to one year: 20% CCF

Original maturity in excess of one year: 50% CCF

Unconditionally cancelable: 0% CCF

Securities lending

Lending of bank securities or posting as collateral (including repo and reverse repo

transactions): 100% CCF

Letters of Credit

Short-term self-liquidating trade letters of credit: 20% CCF

Other commitments

As specified in Basel I

Failed transactions

As specified by national regulators

Effect of failed transactions on off-balance sheet items subject to Basel/IOSCO review

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Basel II Off Balance Sheet Items

Off Balance Sheet Items IRB Banks ( 310-316)

Off-balance sheet items converted into exposure at default (EAD) input using credit conversion factor

(CCF) under either foundation approach to EAD or advanced approach to EAD:

Foundation approach to EAD

Types of instruments and CCFs same as for standardised approach ( 82-89) except forcommitments, note issuance facilities (NIFs) and revolving underwriting facilities (RUFs)

CCF of 75% applicable to commitments, NIFs and RUFs regardless of maturity

CCF of 0% if commitment unconditionally cancelable

Advanced approach to EAD

Banks allowed to use own estimates of CCF if allowed to use internal estimates for EAD (

474-478)

But 100% CCF if required under foundation approach to EAD

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Company

Source: Text

Basel II Equity Capital Charges

Basel I

Equity In a Nutshell

Non-consol

equity

Type of

ExposureRisk Weight

100%


Corporates

Banks

100%*

100%

* CRD has preferential

treatment vs. Basel II

Accord; supervisors may

increase to 150% for venture

capita l and pr ivate equity

investments ( 80)

PD/LGD

Model**

Securities

firms100%

92%***

81%***

264%

32%***

82%***

195%***

120%***

** Inputs: average rating

agency PDs, LGD of 90%,

supervisory value for EAD

and M of 5.

DaimlerChrysler

Siemens

Fresenius Med. Care

GE

Sony

Vivendi Universal

Bertlesmann

290%

290%

290%

290%

290%

290%

290%

Basel II

For banking book exposures.

Nat ional supervisors may

exempt from IRB treatment

for up to ten years particularequity exposures held at

publication date of Basel II

accord ( 267)

Simple Model* Rating

A3/BBB

Aa3/AA-

Ba1/BB+

Aaa/AAA

A1/A

Baa3/BBB-

Baa1/BBB+

*** Under Basel II ( 353) a floor

risk weight of 200% applies

to listed equities

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Basel II Equity Capital Charges

IRB Banks Three Approaches

Simple risk method ( 344-345)

CRD: 190% risk weight for diversified private equity exposures (not in Basel II)

CRD: 290% risk weight for publicly traded exposures (300% in Basel II)

CRD: 370% risk weight for all other holdings (400% in Basel II)

Internal models method ( 346-349) Taken from VaR models as 12.5 times difference between

99% percentile one-tail quarterly return and

Risk free rate over long-term sample period

Floor: capital charge under simple risk model but using 200% (traded) and 300% (not traded)

PD/LGD method under CRD ( 350-361)

Generally, use normal corporate exposure formulas if possible (results in risk weights substantially

below 200% and 300% floor in Basel II) If bank does not have sufficient information to use definition of default, then apply scaling factor

of 1.5 to risk weights

Unfunded credit protection on equity exposure recognised, subject to LGD of 90%, with

reduced LGD of 65% for private equity exposures

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Basel II Non-Performing Loan Capital Charges

Basel I

Non-Performing Loans (NPLs) In a Nutshell

Standardised bank risk weights ( 75-78) IRB bank risk weightsNo uniform rules:

In Europe combination

of general and specific

provisions

In US five-tier ranking

system derives capital

Basel II/CRD

Generally: Unsecured portion of exposure past due

for more than 90 days, net of specific provisions, risk

weighted as follows:

150% when specific provisions less than 20%

of outstanding amount of exposure

100% when specific provisions 20% or more of

outstanding amount of exposure

100% when specific provisions 50% or more of

outstanding amount of exposure, with

supervisory discretion to reduce risk weight to

50% in such case

Residential Mortgages: r isk weighted at 100% net

of specif ic provisions; at national discretion riskweight reduced to 50% of specific provisions 20% or

greater

Commercial Mortgages: unexpected loss risk-

weighted at 100%

Generally: capital requirement for defaulted exposure

is equal to greater of zero and difference between LGD

(described in para. 468) and bank

s best est imate ofexpected loss (

272)

Under IRB approach, for asset c lasses other than

securitisation, bank must compare (i) total amount of

el igible provisions with (ii) total expected losses and

deduct excess (if any) of expected losses over

provisions (

43,

380-383)

For securitisation exposures or the PD/LGD approach

for equity exposures, bank must first deduct EL amounts

under paras. 563 and 386, respectively ( 43)

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Non-performing loans Generally

Essentials:

Non-performing loan under Basel II is any loan that is past due for more than 90 days, but

subject to national variation

For purposes of defining secured portion of non-performing loan, eligible collateral and

guarantees will be recognised as under CRM rules for performing loans

Capital charges depend on level of specific provisions held against loan


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Unsecured non-performing loan:

Unsecured portion of non performing loan will be risk-weighted as follows:

150% when specific provisions less than 20% of outstanding amount of exposure

100% when specific provisions 20% or more of outstanding amount of exposure 100% when specific provisions 50% or more of outstanding amount of exposure, with

supervisory discretion to reduce risk weight to 50% in such case

Secured non-performingloan:

Qualifying residential mortgage loans risk weighted at 100%, net of specific provisions. If such

loans are past due but specific provisions are no less than 20% of their outstanding amount, the

risk weight applicable to the remainder of the loan can be reduced to 50% at national discretion

Commercial mortgages: unexpected loss risk weighted at 100%

Non-performing loans fully secured by forms of collateral notrecognized under Basel II (eligiblefinancial collateral) risk weighted at 100% when provisions reach 15% of outstanding amount of

loan

Non-performing loans Standardised Approach


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General Rules:

Capital charges to cover unexpected losses

Bank must cover expected losses with specific provisions

Consequences:

Fixed LGD at 45% for non-retail assets and senior exposures may result in risk weights asfollows:

565% when no specific provisions of outstanding amount of exposures

400% when specific provisions 20% of outstanding amount of exposure

0% when the specific provisions 50% or more of outstanding amount of exposure

Non-performing loans IRB Approach


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Non-performing loans sample capital calculation (100 million NPL)

Specific Provisions 0% 30% >50% 80%

Net exposure 100 70

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Motivations to sell non-performing loan portfolios:

Reduce capital supporting non-performing loans

Reduce negative carry by eliminating financing needs

Shift capital and resources into more profitable businesses

Optimize bank s balance sheet

Improve bank s credit ratings

Reduce operating costs due to smaller work-out departments

Market outlook

Basel II will motivate banks to sell NPLs

German NPL market estimated between 160 billion and 300 billion (Boersenzeitung

18.2.2005)

German NPL market development to increase to estimated20 billion this year and possible

average of15 billion per year after 2007 (Boersenzeitung18.2.2005)

No capital charges required if investors not banks

Non-performing loans Originators point of view and market outlook


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Basel II Credit Risk Mitigation

Basel I

Credit Risk Mitigation (CRM) In a Nutshell

OECD

sovereign

OECD bank

Type of

ExposureRisk Weight*

0%

20%

Basel II

Non-OECD

bank**20%

* Same as simple

approach under Basel II

for standardised banks

(i.e., substitution)

Standardised banks IRB banks

Simple approach: Risk weight of CRM is

substituted for risk weight of unsupported exposure

Comprehensive approach: Adjust value of both

amount of exposure and value of CRM with either

supervisory or own-estimate haircuts; adjust for

maturity and currency mismatches

Generally: CRM reduces PD or LGD inputs

** Maturity of < one year

Subject to considerable change due to

Basel/IOSCO review, including introduction of

double default recognition for certain exposures

rather than substitution approach

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Determine capital as provided on following page, exceptdetermine capital pursuant to securitisation rules (following) ifcredit risk protection tranched (e.g., purchased derivatives)

Protection Buyer


Credit Risk Mitigation General Rules ( 109-210)

Treat as cash position in underlyingProtection Seller

First to default and second to default protection

( 207-210)

Proportional cover ( 190(c), 198))

Maturity and currency mismatches: size of

haircut depends on type of instrument, type oftransaction and frequency of mark-to-market and

remargining ( 135)

Specific Adjustments

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Simple Approach ( 129, 182-185)

Risk weight of CRM substituted for risk weight of unsupported exposure ( 129)

Subject to floor of 20%, with exceptions, e.g., core market participant floor is 0%,subject to certain conditions ( 183)

Comprehensive Approach ( 130-138)

Supervisory or own-estimate haircuts adjust both amount of exposure and valueof collateral received ( 130)

Further adjustments for maturity mismatches (square root of time formula) andcurrency mismatches ( 135)

Guarantees and credit derivatives recognised; only limited double-defaultrecognition proposed under Basel/IOSCO review ( 140-142, 189-193)

VaR models permitted subject to supervisory approval ( 138, 178-181)

On-balance sheet netting recognised ( 139, 188)

Standardised Banks

Generally

Collateral reduces PD or LGD input (reducing required capital) ( 289-307)

Guarantees and credit derivatives recognised; only limited double-defaultrecognition proposed under Basel/IOSCO review ( 301)

VaR models permitted subject to supervisory approval ( 292)

On-balance sheet netting recognised ( 292)

IRB Banks


Credit Risk Mitigation Capital Calculation Method

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Cash and gold

Rated debt securities (sovereign BB- or higher; other BBB- or higher)

Senior, unrated debt securities issued by bank if listed on recognisedexchange and all other bank issues are BBB- or higher

Equities included in main index or listed on recognised exchange

UCITS/mutual funds where price quoted daily and UCITS/fund only invests in

above instruments For IRB banks only: receivables, real estate and other collateral meeting

minimum requirements ( 289)

All items recognised as collateral in banking book can also be recognised intrading book

Eligible Collateral

( 145-146)

First-to-default: recognised if bank obtains protection for entire basket, creditevent triggers contract, and notional of underlying less than contract ( 207-

208); regulatory capital relief for asset with lowest risk-weight in the basket

Second-to-default: recognised if bank obtains first-to-default protection asabove or if one asset already defaulted ( 209-210)

First-to-Default

Second-to-Default


Credit Risk Mitigation - Eligible Financial Collateral

Collateral must not have material positive correlation with underlying exposure

( 124)No correlation

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Credit Risk Mitigation - Other Criteria

Recognition of credit derivatives ( 191-194)

Legally binding documentation; direct claim on provider; irrevocable and unconditional

Mandatory credit events not determined solely by protection provider: (a) failure to pay,

(b) insolvency and (c) Restructuring (recognition up to 60% of underlying if no

restructuring)

If asset mismatch, underlying/reference obligation must be paripassu and protection

must contain cross-default/cross-acceleration

Cash settlement permitted if robust valuation process

If protection purchaser s right to transfer underlying subject to obligor consent, may not

be unreasonably withheld

Eligible protection providers ( 195)

Sovereigns, public sector entities, and banks and securities firms with lower riskweighting than underlying exposure (not SPEs)

Counterparty risk charges forO

TC derivatives ( 186-187) Counterparty credit risk charge = [(RC + add-on) CA] x r x 8% where: RC=replacement

cost; add-on= as determined under Basel I; CA=volatility adjusted collateral amount;

r=risk weight of counterparty

Being changed to model-based approach under Basel/IOSCO review

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Basel II Securitisation Capital Charges

Basel I

Securitisation In a Nutshell

Basel II

Generally

First loss

Type of

ExposureRisk Weight

100%

Deduct

0%Unfunded

Basel2_Jun05

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