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Thursday June 29, 2006

In Focus

Banking sector: What is in the Basel II Accord?

Basel II is an international Accord developed by the Basel Committee onBanking Supervision. This 284-page document outlines the new globalstandard for how banks and certain other financial institutions measurerisk and allocate capital.

Pillar 1 describes the “Quantitative” aspect of the accord- basically theMinimum Capital Requirements. These can be either standardized or apre-approved internal rating based approach, the latter is likely to beused by the likes of Metropolitan (METBK) and Askari (ACBL) thattraditionally rely on internal credit ratings systems.

Pillar 2 says that banks must increase their capital cushions if national

supervisors consider them too thin, even if they are above the minimum.

Pillar 3 stresses the importance of “market forces”, and says that banksshould become more transparent about their risk exposures and their capital positions and profitability

Banks such as Habib Bank (HBL), KASB Bank (KASBB), Mybank (MYBL)and Union Bank (UNBL), currently have the Misys system, bankingsystem, which may aid in BASEL II compliance and reporting.

Robust risk management is crucial to the long-term health of the economy. Thussupervisors take extra care and make specific rules, to ensure banks havesufficient capital to match and protect the bank against ‘risky’ assets.

The current rules, Basel I, are almost twenty years old, drawn up in 1988 andimplemented in 1992. They require a bank's capital to be at least 8% of its risk-weighted assets. Currently, as the risk-management systems for a typical bankhave become more advanced, the time is right for a new global standard for howbanks and certain other financial institutions measure risk and allocate capital. ThisBasel II accord has been developed by the Basel Committee on BankingSupervision, requires the same 8% capital adequacy but as its weighting systemwill change, the required capital adequacy for banks will also change.

Interesting the banks with a high degree of consumer business may see theirminimum capital requirements falling. This is because previously a retail book of say, revolving credit, personal loans and autos loans would have required a 100%risk-weighting, in the new accord this has been reduced to a 75% risk-weighting as

long as they continue performing. Furthermore the risk weighting for Mortgages,was very high at 50% despite the good collateral they have, and so this has beenreduced to 35%. Thus banks with a lot of retail business — except for sub-primelending and perhaps credit cards—can expect its minimum capital to fall.

The new accord has three “pillars”.

Pillar 1 is the “Quantitative” one, which sets the minimum capitalrequirements (MCR). The required capital will be broken into three parts, to matchcredit risk, market risk and a new operational risk part. The latter says a banks'capital should reflect the risk of mistakes and wrongdoing, such as data entry orinternal fraud, so institutions that do little lending such as asset managementcompanies will now require more capital.

I - MCR measurement involves measuring these three credit, market andoperational risks. Credit risk measurement is outlined below, but how do you definethe ‘market’ and ‘operational’ risk weighted assets? Well you work backwards andtake the outline d MCR for the two and multiply by 12.5 (the inverse of 8%), then

Overweight

Nausheen T. Saira Azad

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+92 21 111 262 111 Ext. 2058





In Focus

add the sum of risk weighted assets in credit risk and you have your total RWA. Formeasuring credit risk, banks will have three options: a simple “standardized”approach using external data, from credit-rating agencies and others or its own“internal ratings based” (IRB) approach, either in a simple form called “foundationIRB” or a more sophisticated form “Advanced IRB”. All three require a lot of data tobe collected and processed, such as statistical data on historical lending anddefault, so compliance costs are high, and US analysts have been estimated this at0.05% of Assets.

II. Credit risk - Standardized approach This method uses external credit riskassessments, depending on whether the asset is of a country, a bank, a securitiescompany, corporate or retail client - the debt will get given a risk weighting rangingfrom 0% (if it’s a safe triple A sovereign debt) – to 100% (for unsecured consumer

exposures) and 150% (for those loans 90 days past due).

III. Credit risk- internal ratings based approach Subject to certain conditions anddisclosure requirements, banks that have received supervisory approval to use theIRB approach may use on their own internal estimates of risk components todetermine the capital requirements for a given exposure. This is likely to be usedby the likes of Metropolitan (METBK) and Askari (ACBL) that traditionally rely oninternal credit ratings systems.

IV. Credit risk securitization framework

V. Operational risk is the risk of loss resulting from inadequate or failed internaland external processes, people, and systems. Key to this section will be measuring

“Information risk” such as the Systems Risk and Security and Integrity Risk.

VI. Trading Book Issues look at the Market risk, such as trading losses and theadverse price movements of exchange rates, the value of securities, and interestrates, derivatives and commodities.

Pillar 2 is the “Qualitative” one, that outlines the Supervisory ReviewProcess. It says that banks must plump up their capital cushions if nationalsupervisors consider them too thin, even if they are above the minimum. Stresses Board and management oversight for monitoring and reporting and soundcapital assessment, particularly on the interest rate risk on the banking book.

Pillar 3 is the “Market Forces” one, that says that banks should become moretransparent about their risk exposures and their capital positions andprofitability. It outlines the disclosure requirements for Capital structure, Riskexposures and Capital adequacy.

In terms of compliance, certain banks may have an edge. Misys is one of the top 5global banking software and services vendors. The Mysis Banking Systemssupport 1,400 banks in 134 countries including 49 of the world’s top 50 banks.Locally banks such as Habib Bank (HBL), Mybank (MYBL) and Union Bank (UNBL)and recently KASB Bank (KASBB) have implemented the Misys system. Thusthese banks can more easily look towards efficiently achieving Basel II compliancefor all three pillars, through products like Mysis’s Basel II complete and integratedsolution that provides Basel II Analytics, Advanced Analysis, Basel II DataWarehouse, and Basel II Reporting. Though these packages must initially be

adjusted to the local needs and requirements of the clients at significant initial andmaintenance cost, the availability of such global expertise does present anadvantage to the banks that already have such IT systems in place.





In Focus

Figure 1: The BASEL II Document Contents

IV- Credit risksecuritizationframework

III- Credit risk

Internal ratingsbased (IRB)

approach

I. Calculation of MCR Requires the same 8% capitaladequacy but its weighting systemwill change

II- Credit RiskStandardizedApproach

V- Operational

risk

VI- Tradingbook issues(Market risk)

Pillar II

Supervisory Review

Stresses Board andmanagement oversightfor monitoring andreporting and soundcapital assessment,particularly on theinterest rate risk on thebanking book.

Basel II

Pillar III

Market Discipline

Outlines disclosurerequirement for capitalstructure, riskexposure and capitaladequacy.

Pillar I

MinimumCapital

Requirements

In Focus 29 Jun 06 Edit

Documents

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