The Evolution to Basel IIXBRL and the Basel II Capital Accord

Donald Inscoe

Deputy Director

Division of Insurance and Research

U.S. Federal Deposit Insurance Corporation

XBRL International, Tokyo, Japan November 8, 2005

First Basel Accord

The first Basel Accord (Basel I) was completed in 1988 – Set minimum capital standards for banks– Standards focused on credit risk, the main risk

incurred by banks– Became effective end-year 1992

Reason for the Accord

To create a level playing field for internationally active banks– Banks from different countries competing for the

same loans would have to set aside roughly the same amount of capital on the loans

1988 Accord Capital Requirements

Capital was set at 8% and was adjusted by a loan’s credit risk weight

Credit risk was divided into 5 categories: 0%, 10%, 20%, 50%, and 100%– Commercial loans, for example, were assigned to

the 100% risk weight category

Risk-Based Capital

The Accord was hailed for incorporating risk into the calculation of capital requirements

Capital Calculation

To calculate required capital, a bank would multiply the assets in each risk category by the category’s risk weight and then multiply the result by 8%– Thus a $100 commercial loan would be multiplied

by 100% and then by 8%, resulting in a capital requirement of $8

Criticisms of the Accord

The Accord, however, was criticized for taking too simplistic an approach to setting credit risk weights and for ignoring other types of risk

Risk Weights

Risk weights were based on what the parties to the Accord negotiated rather than on the actual risk of each asset – Risk weights did not flow from any particular

insolvency probability standard, and were for the most part, arbitrary

Operational and Other Risks

The requirements did not explicitly account for operating and other forms of risk that may also be important– Except for trading account activities, the capital

standards did not account for hedging, diversification, and differences in risk management techniques

Banks Develop Own “Capital Allocation” Models

Advances in technology and finance allowed banks to develop their own capital allocation (internal) models in the 1990s

This resulted in more accurate calculations of bank capital than possible under Basel I

These models allowed banks to align the amount of risk they undertook on a loan with the overall goals of the bank

Internal Models and Basel I

Internal models allow banks to more finely differentiate risks of individual loans than is possible under Basel I– Risk can be differentiated within loan categories

and between loan categories– Allows the application of a “capital charge” to

each loan, rather than each category of loan

Variation in Credit Quality

Banks discovered a wide variation in credit quality within risk-weight categories– Basel I lumps all commercial loans into the 8%

capital category– Internal models calculations can lead to capital

allocations on commercial loans that vary from 1% to 30%, depending on the loan’s estimated risk

Capital Arbitrage

If a loan is calculated to have an internal capital charge that is low compared to the 8% standard, the bank has a strong incentive to undertake regulatory capital arbitrage

Securitization is the main means used by U.S. banks to engage in regulatory capital arbitrage

Example of Capital Arbitrage

Assume a bank has a portfolio of commercial loans with the following ratings and internally generated capital requirements

– AA-A: 3%-4% capital needed– B+-B: 8% capital needed– B- and below: 12%-16% capital needed

Under Basel I, the bank has to hold 8% risk-based capital against all of these loans

To ensure the profitability of the better quality loans, the bank engages in capital arbitrage--it securitizes the loans so that they are reclassified into a lower regulatory risk category with a lower capital charge

Lower quality loans with higher internal capital charges are kept on the bank’s books because they require less risk-based capital than the bank’s internal model indicates

New Approach to Risk-Based Capital

By the late 1990s, growth in the use of regulatory capital arbitrage led the Basel Committee to begin work on a new capital regime (Basel II)

Effort focused on using banks’ internal rating models and internal risk models

June 1999: Committee issued a proposal for a new capital adequacy framework to replace the 1998 Accord

Basel II

Basel II consists of three pillars:– Minimum capital requirements for credit risk,

market risk and operational risk—expanding the 1988 Accord (Pillar I)

– Supervisory review of an institution’s capital adequacy and internal assessment process (Pillar II)

– Effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices (Pillar III)

Pillar I

In the United States, all banks that will be required to conform to the new capital standard will use the Advanced Internal Ratings Based approach (AIRB)

AIRB Approach Requirements

Collect sufficient data on loans to develop a method for rating loans within various portfolios

Develop a Probability of Default (PD) for each rated loan

Develop a Loss Given Default (LGD) for each loan

Example: Safe v. Risky Loans

Safe loans:– Over a 1-year period, only 0.25% of these loans

default– If a loan defaults, the bank only loses 1% on the

outstanding amount Risky loans:

– Over a 1-year period, 1% of loans default every year– If a loan defaults, the bank loses 10% of the

outstanding amount

Example: Safe v. Risky Loans (continued)

For a $100 million portfolio of the safe loans, the bank would expect to see $250,000 in defaults in a year and a loss on the defaults of $2500– ($100 million X .25% = $250,000)– ($250,000 X 1% loss rate = $2500)

Example: Safe v. Risky Loans (continued)

For a $100 million in a risky portfolio the bank would expect to see $1 million in defaults in a year and a loss on the defaults of $100,000– ($100 million X 1% = $1 million)– ($1 million X 10% = $100,000)

Goal of Pillar I

Although simplistic, this example demonstrates what Pillar I is trying to achieve– If the bank’s own internal calculations show that

they have extremely risky, loss-prone loans that generate high internal capital charges, their formal risk-based capital charges should also be high

– Likewise, lower risk loans should carry lower risk-based capital charges

Complexity of Pillar I

Banks have many different asset classes each of which may require different treatment– Each asset class needs to be defined and the

approach to each exposure determined

Minimum standards must be established for rating system design, including testing and documentation requirements– The proposals must be tested in the real world

Assessing Basel II

To determine if the proposed rules are likely to yield reasonable risk-based capital requirements within and between countries for banks with similar portfolios, four quantitative impact studies (QIS) have been undertaken

Results of Quantitative Impact Studies

Results of the QIS studies have been troubling– Wide swings in risk-based capital requirements– Some individual banks show unreasonably large

declines in required capital

As a result, parts of the Accord have been revised

Operational Risk

Pillar I also adds a new capital component for operational risk– Operational risk covers the risk of loss due to

system breakdowns, employee fraud or misconduct, errors in models or natural or man-made catastrophes, among others

Pillars II and III

Progress has also been made on Pillars II and III– Pillar II focuses on supervisory oversight– Pillar III looks at market discipline and public

disclosure

Pillar II

Supervisory Oversight– Requires supervisors to review a bank’s capital

adequacy assessment process, which may indicate a higher capital requirement than Pillar I minimums

Pillar III

Market discipline and public disclosure– The United States is currently in the forefront of

disclosure of financial data SEC disclosure requirements for publicly traded banks Bank regulators require quarterly filing of call reports for

all banks

– U.S. authorities are currently considering what banks should publicly disclose about their Basel II calculations

U.S. Implementation of Basel II

Based on results for QIS4, which show the potential for substantial declines in capital, the U.S. banking regulators have proposed a revised implementation timeline– The revised timeline includes a minimum three-

year transition period

Revised U.S. Timeline for Basel II Implementation

Year Transistional Arrangements

2008 Parallel Run

2009 95% floor

2010 90% floor

2011 85% floor

U.S. Implementation of Basel II (Continued)

After 2011, an institution’s primary federal supervisor will assess the institution’s readiness to operate under Basel II– Institutions will be assessed on a case-by-case

basis– Further revisions to the floors are anticipated– Both Prompt Corrective Action and leverage

capital requirements will remain

Basel I-A: The Search for Equal Capital Treatment

In the U.S., concerns that Basel II could give those banks operating under it a competitive advantage over other banks has resulted in a proposal called Basel 1-A

Basel 1-A is designed to modernize the way all U.S. banks and thrifts calculate their minimum capital requirements

Implications

The practices in Basel II represent several important departures from the traditional calculation of bank capital– The very largest banks will operate under a

system that is different than that used by other banks

– The implications of this for long-term competition between these banks is uncertain, but merits further attention

Implications

Basel II’s proposals rely on banks’ own internal risk estimates to set capital requirements– This represents a conceptual leap in determining

adequate regulatory capital

For regulators, evaluating the integrity of bank models will be a significant step beyond the traditional supervisory process

Implications

The proposed Accord will elevate the importance of human judgment in the process of capital regulation– Despite its quantitative basis, much will depend

on the judgment of banks in formulating their estimates and of supervisors in validating the assumptions used by banks in their models

Work Continues

During the past 3 years the FDIC has expressed its concern that the proposed Accord will result in banks having too little risk-based capital

Work continues on recalibrating the proposals and a workable solution is expected

Implications Additional Data Needed to Counterbalance to Changes in Environment

H ig h e rL e v e ra g e

Un pro v e nR a t in g

S y s te m s

Ev o lv in gC o n tro l

S tru ctu re s

Th re e Y e a rFlo o rs /L e v e ra g e

R a t io

I m pro v e d R is kM a n a g e m e n t

• Changes in environment necessitate changes in risk analysis for banks and supervisors/insurers

• Additional information will be needed to:

Inform policy development.

Supplement other sources of risk information used in supervisory resource planning and overall risk assessments

Serve as an input into deposit insurance pricing and overall insurance funds adequacy analyses

Why XBRL ?

Internal ratings based and standard approach measures require complex data model

– Common data requirements flow from Accord and Quantitative Impact Studies (QIS I – IV)

– Domestic and international comparisons needed to ensure consistent application

– Taxonomy needed to compare banks’ internal ratings of similar and diverse risks

Common Data Elements Flow from Accord:Standardized Internal Risk Estimates

Exposure

Internal Risk EstimateP

DLG

DE

AD

M Other

Wholesale X X X X -

Retail X X X - -

Securitization - - - - X

Equity - - - - X

Market Risk - - - - XOperational

Risk- - - - X

Data Types Reporting Granularity

Portfolio Level Data

Individual Exposure Data for

All Transactions

Summary Data

Why XBRL ?

Internal ratings based measures and standard approach require complex data model

– Supervisors need detailed information to qualify banks for advanced approaches (IRB, AMA, and Market Risk)

– Data can be shared across different supervisory regimes

- Independent of systems, platforms, geography and language translation

Consistent data needed to help identify risk estimates that may be inconsistent with peer estimates.

Follow-up: Can differences between Bank’s PD and benchmark be adequately explained by differences in risk?

0

5

10

15

20

25

30

35

40

AA or better A to AA BBB to A BB to BBB B to BB >B

Bank’s PD Distribution Mapped to S&P Rating Scale

Peer Banks’ PD Distribution Mapped to S&P Rating Scale

% of Wholesale Exposures

Why XBRL ?

XBRL provides a framework for complex data model

– Open standard facilitates reuse and innovation– Analysts can spend more time analyzing data– Reduced reporting burden, especially for

organizations operating in multiple jurisdictions

Why XBRL ?

A standard is needed in any case.

Why XBRL ?

FINIS