Week 2 - Basel 2 Regulatory Framework

7/30/2019 Week 2 - Basel 2 Regulatory Framework

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Chapter 2: Basel 2 regulatory framework

2.1 Bank for International Settlements

The bank was established in 1930 with the main objective to act as a principal centre for

international central bank cooperation. It was established in the context of the Young Plan

(1930) where payments imposed on Germany by the Treaty of Versailles following the First

World War to collect, administer and distribute annuities payable as reparations. The name is

derived from this original role.

The changing role of the Bank came about due to the need of cooperation amongst central

banks and increasingly other agencies in pursuit of monetary and financial stability. Since

1980, there have been regular meetings in Basel of central bank governors and experts. In

1970s and 1980s, the general economy faced managing cross-border capital flows following

the oil crisis and the international debt crisis.

The 1970 crisis brought the issue of regulatory supervision of internationally active banks

within the spotlight. The result was the 1988 Basel Capital Accord and its Basel II revision.

The Head Office is in Basel. Switzerland and it has representative offices in Hong Kong,

SAR and in Mexico City.

There are several committees and organizations focusing on monetary and financial stability

and the international financial system. The most important committees are:

The Markets Committee (1962) The Committee on the Global Financial System (1971) The Basel Committee on Banking Supervision (1974) The Committee on Payment and Settlement Systems (1990)

The Basel Committee on Banking Supervision (BCBS) is of particular importance. It was

established at the end of 1974 by the central bank governors of the Group of Ten countries

which is made up of eleven countries: Belgium, Canada, France, Germany, Italy, Japan, the

Netherlands, Sweden, Switzerland, the United Kingdom and the United States.

The BCBS is represented by countries, by their central banks or the authority with formal

responsibility for the supervision of banking business where there is no central bank. The


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Basel Committee was established in the aftermath of serious disturbances in international

currency and banking markets.

BCBS formulates broad supervisory standards and guidelines and recommends statements of

best practice in the expectation that individual authorities will take steps to implement them

through detailed arrangements statutory or otherwise which are best suited to their own

national systems. The committee does not possess any formal supernational supervisory

authority. The conclusions do not have legal force.

The committee encourages standards that do not attempt detailed harmonization of member

countries. The committee meets regularly four times a year. It has about twenty-five technical

working groups and task forces which also meet regularly.

2.2 The First Basel Capital Accord

Banking organizations have to maintain at least a minimum level of capital. Where it serves

as a cushion against its unexpected losses, provides credit even during downturns and

promotes public confidence in the banking system. The challenge is how much capital is

necessary to serve as a sufficient buffer? If capital levels are too low, banks may fail and putdepositors funds at risk. If capital levels are too high, banks do not make the most effi cient

use of their resources and will not use the capital to earn money and make credit available.

During 1840-1870 European banks had an average ratio of capital over assets of 24% to 36%

(mean over 30%). As at 1900 it was 20%. Between World War 1 and World War 2 it was

12% to 16%. Before Basel 1 it was 6% to 8% and in some banks even below 4%. The

average does not mean much but confidence problems leads to systematic risk.

Regulatory capital is the minimum amount of capital like the 8% capital reserve (Basel 1).

The economic capital is the necessary capital to stay in business and additional capital is

needed for Low frequency/High impact events. Regulatory capital (RC) is the minimum

capital required by the regulator and economic capital is the capital level bank shareholders

would choose in absence of capital regulation.

In line with Basel 2, Expected loss should be covered through the regulatory capital, whilst

unexpected loss should be covered through the economic capital. Extreme events should becovered through the economic capital.


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Economic capital is a reserve for unexpected losses. It is important to remain solvent, attract

counterparties, gain market confidence and for shareholders, bondholders, credit rating

agencies and regulators.

Early 1980s the capital ratios of the main international banks were deteriorating just at the

time that international risks were growing. A strong recognition of the need for a

multinational accord to strengthen the stability of the international banking system. A

consultative paper published in December 1987 referred to as the capital measurement system

commonly referred to as the Basel Capital Accord. It was approved by the G10 governors and

released to banks in July 1988. Deadline for implementation was end 1992.

The First Basel Capital Accord was set with a view to implementation as soon as possible. It

is intended that national authorities should prepare papers setting out their views on the

timetable and the manner in which this accord will be implemented in their respective

countries. Circulated to supervisory authorities worldwide with a view to encouraging

adoption of this framework in countries outside the G-10 in respect of banks conducting

significant international business.

The agreed framework for measuring capital adequacy and the minimum standard to be

achieved which the national supervisory authorities intend to implement in their respectivecountries. Two fundamental objectives were established: The new framework should serve to

strengthen the soundness and stability of the international banking system and the framework

should have a high degree of consistency in its application to banks in different countries.

The First Basel Capital Accord agreed framework is designed to establish minimum levels of

capital for internationally active banks. National authorities will be free to adopt

arrangements that set higher levels. There are many different kinds of risks. For most banks

the major risk is credit risk, that is to say the risk of counterparty failure. But there are many

other kinds of risks. The central focus of this framework is credit risk.

The First Basel Capital Accord lays down individual supervisory authorities have discretion

to build in certain other types of risk. No standardization has been attempted in the treatment

of these other kinds of risk in the framework at the present stage. Further study is required to

further work to develop a satisfactory method of measurement of risk for the business as a

whole, including operational risk.


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Capital defined in two tiers. Capital must be readily available to absorb any losses. A bank

capital was defined as comprising two tiers. Tier 1 (core capital) is the core measure of

financial strengththe most reliable types of capital. Common stock published reserves from

post-tax retained earningsgeneral reserves, and reserves required by law. This should make

up at least 50% of a banks total capital base and at least 4% of the risk weighted assets.

Tier 2 supplementary capital is less reliable forms of capital. Tier 2 supplementary capital is

up to an amount equal to that of the core capital maximum of 50% of a banks capital.

National banking supervisory authorities decide which of the elements of supplementary

capital may be included.

Banks may at the discretion of their national authority employ a third tier of capital,

consisting of short-term subordinated debt for the sole purpose of meeting a proposition of

the capital requirements for market risks. Tier 3 capital will be limited to 250% of a banks

Tier 1 capital that is required to support market risks.

2.2.1 The risk weights and the risk-weight approach.

Risk weight functions translate a banks exposure into specific capital requirement. Not a

static requirement for capital - based on the risks. Assets are weighted by factors representing

their riskiness and potential for default. On and off-balance-sheet items are weighted for risk

with off-balance-sheet items converted to balance sheet equivalents (using credit-conversion

factors) before being allocated a risk weight. Weighted risk ratio - five weights are used - 0,

10, 20, 50 and 100%. Further information may be viewed in appendix 1.2.1.

Off balance sheet - an asset or debt or financing activity not on the company's balance sheet

Paper: The Management Of Banks Off-Balance-Sheet. Exposures (March 1986) -

www.bis.org/publ/bcbsc134.pdf. The main conclusion of this paper discusses the types of risk

associated with most off-balance-sheet business are in principle no different from those

associated with on balance-sheet business. Off-balance-sheet risks cannot and should not be

analysed separately from the risks arising from on balance-sheet business, but should be

regarded as an integral part of banks overall risk profiles. Accounting for off-balance-sheet

activities differs significantly from country to country. Items may be recorded:

on the balance sheet below the line
http://www.bis.org/publ/bcbsc134.pdfhttp://www.bis.org/publ/bcbsc134.pdfhttp://www.bis.org/publ/bcbsc134.pdf


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as notes to the accounts in supervisory reports within banks internal reporting systems

in some cases not at all

Information generally insufficient to give shareholders and depositors a reasonable picture of

banks activities. Off-balance-sheet engagementsBasel I. It is of great importance that all

off-balance-sheet activity should be caught within the capital adequacy framework. But

there is only limited experience in assessing the risks in some of the activities. All categories

of off-balance-sheet engagements will be converted to credit risk equivalents by multiplying

the nominal principal amounts by a credit conversion factor. Broad categories within which

member countries will have some limited discretion to allocate particular instruments

according to their individual characteristics in national markets:

Off-balance-sheet items under the standardized approach are converted into credit exposure

equivalents through the use of credit conversion factors (CCF). Letters of Credit - Short-term

self liquidating trade letters of credit: 20% CCF.

A minimum standard should be set which international banks will be expected to achieve by

the end of 1992 allowing a transitional period of more than 4 years for any necessary

adjustment by banks who need time to build up to those levels. The target standard ratio of

capital to weighted risk assets should be set at 8% (of which the core capital element will be

at least 4%). Since 1988, this framework has been progressively introduced not only in

member countries but also in virtually all other countries with active international banks.


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Basel I Amendments:

April 1993: package of proposed amendments to the 1988 accord

In addition to capital for credit risk, banks are required to hold capital for market risksand organization-wide foreign exchange exposures

Value at Risk April 1995: A revised proposal, Extension of market risk capital requirements to

cover commodities exposures

April 1995: A revised proposal Banks can use either a regulatory VaR measure or their own proprietary VaR measure

for computing capital requirements January 1996: Amendment designed to incorporate within the Accord the market risks

arising from banks' open positions in foreign exchange, traded debt securities,

equities, commodities and options.

http://www.bis.org/publ/bcbs24.pdf - Amendment to the Capital Accord to incorporate

Market Risks, Basle Committee on Banking Supervision, 1996

Banks will be expected to move to comprehensive value-at-risk models It was called the

1996 amendment, it went into effect in 1998.

2.3 The New Basel Capital Accord (Basel 2)

11 May 2004: The Basel Committee on Banking Supervision announces that it has achieved

consensus on the remaining issues regarding the proposals for a new international capital

standard. The group of central bankers and banking regulators who make up the Committee

met at the Bank for International Settlements in Basel, Switzerland, and decided to publish

the text of the new framework, widely known as Basel II, at the end of June 2004. This text

will serve as the basis for national rule-making Processes. The Committee confirmed that the

standardized and foundation approaches will be implemented from year end 2006. The

Committee said that one further year of impact analysis/parallel running will be needed for

the most advanced approaches, and these therefore will be implemented at year-end 2007.

This will also provide additional time for supervisors and the industry to develop a consistent

approach for implementation.


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Central bank governors and the heads of bank supervisory authorities in the Group of Ten

(G10) countries met and endorsed the publication of the International Convergence of Capital

Measurement and Capital Standards: a Revised Framework, the new capital adequacy

framework commonly known as Basel II. The meeting took place at the Bank for

International Settlements in Basel, Switzerland, one day after the Basel Committee on

Banking Supervision, the author of the text, approved its submission to the governors and

supervisors for review.

November 2005: Updated Version: International Convergence of Capital Measurement and

Capital Standards - A Revised Framework, Updated November 2005. Updated version of

the revised Framework. Additional guidance, developed jointly with the International

Organization of Securities Commissions (IOSCO) and demonstrates the capacity of the

revised Framework to evolve with time.

June 2006: Updated Version International Convergence of Capital Measurement and Capital

Standards - A Revised Framework, Comprehensive Version. A compilation of the June 2004

Basel II Framework the elements of the 1988 Accord that were not revised during the Basel II

process. The 1996 Amendment to the Capital Accord to Incorporate Market Risks. The 2005

paper on the Application of Basel II to Trading Activities and the Treatment of double

Default Effects.

2.3.1: Credit risk (CR)

The risk that a borrower or counterparty might not honour its contractual obligations. Credit

risk is main source of problems at banks. The measurement of credit risk implies assessing

theborrowers creditworthiness - a loan should be priced to reflect how much risk it involves.

Basel II: We have a direct relationship between the cost of the loan and the borrowers credit

rating.

Under the first Accord, there is a static relationship between the type of borrower, and the

regulatory capital requirement. The new Accord seeks to make the relationship dynamic, with

greater emphasis on the credit quality of the borrower. This process should better align the

banks regulatory capital with the underlying risk.


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2.3.2 Market risk (MR):

The risk of adverse price movements such as exchange rates, the value of securities, and

interest rates. Market Risk is the risk that the value of on balance sheet or off balance sheet

positions will be adversely affected by movements in equity and interest rate markets,

currency exchange rates and commodity prices. Nasdaq stock index: Lost 65% between

March 2000 and March 2001. Interest rate risk - the exposure of a bank's financial condition

to adverse movements in interest rates. Exchange rate risk - the exposure of a bank's financial

condition to adverse movements in exchange rates. Market risks arising from banks open

positions in equities, traded debt securities, foreign exchange, commodities and options.

Capital requirements for banks' exposures to certain trading-related activities, including

counterparty credit risk, and the treatment of double default effects. (Double default risk is

the risk that both the borrower and the protection provider will default). Banks are permitted

to use internal models as a basis for measuring their market risk capital requirements. Banks

may (at the discretion of their national authority) employ a third tier of capital (Tier 3). The

sum of tier 2 and tier 3 capitals for market risk capital charge may not exceed 250% of tier 1

capital for market risk capital charge. The sum of tier 2 and tier 3 capital may not exceed

100% of tier 1 capital.

2.3.3 Purpose of Basel 2:

It is a set of regulatory standards targeting not only a sound capital ratio for credit, market

and operational risk but also good governance through emphasis on risk management and

internal controls. Risk based pricing: The purpose of the Basel Accord is not to guarantee

profitable business for individual banks but to guarantee safe and sound financial system.

(You need economic capital over and above regulatory capital).

The goal for the Basel II Framework is:

to promote the adequate capitalization of banks to encourage improvements in risk management to strengthen the stability of the financial system to accomplish this goal, there are three pillars in the framework


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2.3.4 Pillar 1 - Minimum Capital Requirements

A revision of the 1988 Accords guidelines:

Now the minimum capital requirements are more close to each banks actual risk ofeconomic loss

The calculation of the total minimum capital requirements for credit, market andoperational risk

The total capital ratio must be no lower than 8% Tier 2 capital is up to 100% of Tier 1 capital More sensitivity to the risk of credit losses higher levels of capital for borrowers

that present higher levels of credit risk.

There are three approaches to credit riskbanks need to choose the most appropriatefor them:

1. The standardized approach to credit risk: banks that engage in less complexforms of lending and credit underwriting and that have simpler control structures may

use external measures of credit risk to assess the credit quality of their borrowers for

regulatory capital purposes.

2. and 3. The two internal ratings-based (IRB) approaches to credit risk: Banks that

engage in more sophisticated risk-taking and that have developed advanced risk

measurement systems may, with the approval of their supervisors, select from one of

two internal ratings-based (IRB) approaches to credit risk.


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Under an IRB approach, banks rely partly on their own measures of a borrowerscredit risk to determine their capital requirements. (i) Foundation Internal Rating

Based Approach. And (ii) Advanced Internal Rating Based Approach.

2.3.5 Approaches to measure credit risk: The Standardized Approach

Banks rely on external credit assessment institutions These institutions issue opinions about firms and securities The upgrading or downgrading has substantial impact on the business opportunities of

rated firms

Rating agencies help reduce the asymmetry of information, which exists betweenfirms and investors.

These are credit rating agencies and export credit agencies. A Credit Rating Agency isa company that rates the ability of a company to pay back a loan. An Export Credit

Agency is an agency established by a country that provides government-backed loans,

guarantees and insurance to corporations that seek to do business overseas in

developing countries and emerging markets to finance goods, investment, and

services. Banks are required to slot their credit exposures into supervisory categories.

There are fixed risk weights corresponding to each supervisory category.

Basel ii contains guidance for use by national supervisors in determining whether a particular

source of external ratings should be eligible for banks to use. The Basel ii Accord makes

national supervisors responsible for determining whether the assessments of a particular

rating company / agency can be used for risk weighting purposes. After that, banks may

choose the rating company / agency (one or more of them) they will use, among those

validated by their supervisor (Conditional on supervisory approval) banks may disregard all

these external assessments and risk-weight all their corporate exposures at 100%.

Six criteria to be satisfied by external credit assessment institutions: (i) objectivity, (ii)

independence,(iii) international access/transparency, (iv) disclosure, (v) resources and (vi)

credibility. These criteria are very similar to those used by the US SEC to designate

nationally recognized statistical ratingorganizations. Moodys, S&P and Fitch are the only

credit rating companies/agencies accepted by the national authorities of all member countries

of the Basel Committee:


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www.moodys.com www.fitchratings.com www.standardandpoors.com

Banks must disclose which companies / agencies they use. Banks are not allowed to cherry

pick among the assessments of different companies / agencies to lower their capital

requirements. The Basel Committee has developed guidelines on multiple assessments for

banks working with several external credit assessment institutions. Example: A bank working

with two companies / agencies if there are two different risk-weights, banks must use the

higher risk-weight. When the bank works with three or more companies /agencies, the bank

must use the higher of the two lowest risk-weights. The use of external ratings for the

evaluation of corporate exposures, is considered to be an optional element of the framework.

Where no external rating is applied to an exposure, a risk weight of 100% will be used,

implying a capital requirement of 8% as in the current Accord. An important innovation of

the standardised approach is the requirement that loans considered past-due be risk weighted

at 150%. Risk weights will continue to be determined by the category of the borrower -

sovereign, bank or corporate.

2.3.5.1 Claims on sovereigns

Sovereign risk: Risk that a government or sovereign power will default on its payment

obligations, risk of default on a sovereign loan.

Basel i: OECD (The Organisation for Economic Co-operation and Development) government

debt was weighted 0% debt of non-OECD governments, was weighted 100%.

Basel ii Winners: Non-OECD rated above BB+ (China, Thailand)

Basel ii Losers: Czech Republic, Hungary, Mexico

At national discretion, a lower risk weight may be applied to banks exposures to their

sovereign or central bank, when it is denominated and funded in the domestic currency.


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Where this discretion is exercised, other national supervisory authorities may also permit

their banks to apply the same risk weight to domestic currency exposures to this sovereign (or

central bank) funded in that currency. Sovereign risk reflects the ability and willingness of a

government issuer to meet its future debt obligations. Absence of binding international

bankruptcy legislation, creditors have only limited legal redress against sovereign borrowers.

The rating agencies periodically update the list of the numerous economic, social and

political factors that underlie sovereign credit ratings. It is difficult to quantify every risk or to

determine the relative weights.

2.3.5.2 Claims on banks:

For the treatment of claims on banks, there are two options. National supervisors will apply

one option to all banks in their jurisdiction.

Claims on banksFirst Option:

All banks incorporated in a given country will be assigned a risk weight one category less

favorable than that assigned to claims on the sovereign of that country. For claims on banks

in countries with sovereigns rated BB+ to B- and on banks in unrated countries the risk

weight will be capped at 100%.


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Claims on banksSecond Option:

External credit assessment of the bank itself. Claims on unrated banks risk-weighted at 50%.

Risk weight one category more favourable may be applied to inter-bank claims with an

original maturity of three months or less.

Basel i: OECD bank debt was weighted 20%. Non-OECD bank debt including corporate debt

and the debt of non-OECD governments, was weighted 100%.

Basel ii Winners: Non-OECD rated above BB+ under Option 2

Basel ii Losers: OECD rated A or below under either optionSince the 1988 Accord five countries have joined the OECD and have lower risk weights.

Basel II makes the risk weighting for claims on banks dependent on the credit rating of their

sovereign of incorporation.

Option 1 for claims on banks: Banks in unrated countries will be risk weighted at not less

than 100%. At national discretion, supervisory authorities may permit banks to risk weight all

corporate claims at 100% without regard to external ratings.


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2.3.5.3 The Standardized Approach: Retail Exposures

Retail exposures are to be risk weighted at a special rate of 75 per cent. Why? Because such

exposures offer a potentially high level of risk diversification if they are small and

uncorrelated. Conditions are imposed:

The exposure is to an individual person or persons or to a small business Product criterion Y The exposures are credits and lines of credit (including credit

cards and overdrafts), personal term loans and leases (e.g. instalment loans, auto loans

and leases, student and educational loans, personal finance) and small business

facilities and commitments. Securities (such as bonds and equities), whether listed or

not, are specifically excluded from this category.

No aggregate exposure to a single counterpart can exceed 0.2% of the overall retailportfolio.

The maximum aggregated retail exposure to one counterparty cannot exceed 1million

Claims secured by residential property or commercial real estate. Residential property.

Lending fully secured by mortgages on residential property that is or will be occupied by the

borrower, or that is rented, will be risk weighted at 35% (50 per cent risk weight in Basel I).

National supervisory authorities should evaluate whether the risk weights are too low

Commercial real estate. In numerous countries commercial property lending has been a

recurring cause of troubled assets in the banking industry risk weighted at 100%

2.3.5.4 Off Balance Sheet Items

Must be converted into credit exposure equivalents using credit conversion factor(CCF) Commitments:

Original maturity of up to one year: CCF = 20% Original maturity in excess of one year: CCF = 50% Unconditionally cancellable: CCF = 0% Letters of Credit Short-term self-liquidating trade letters of credit arising from the movement of goods:

CCF = 20%


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2.3.5.5 Claims on corporates Basel i vs. Basel ii

Basel i: Corporate debt was weighted 100%

Basel ii Winners: Corporates rated above BBB+ Basel ii Losers: Corporates rated below BB

2.3.5.6 Risk weights:

Claims on sovereigns, PSEs (public sector entities), banks, and securities firms ratedbelow B-

Claims on corporates rated below BB- Categories of past due loans (for more than 90 days) National supervisors may decide to apply a 150% or higher risk weight reflecting the

higher risks associated with some other assets, such as venture capital and private

equity investments

2.3.5.7 Securitization

Securitization - gathering a group of debt obligations such as mortgages into a pooldividing that pool into portions that can be sold as securities.

Converting loans, leases, mortgages, car loans, credit card debt into securities. Securitization rated between BB+ and BB- will be risk weighted at 350%. Asset

securitization is a mechanism for transferring credit risk with the use of securities.

Example: Transfer of a pool of assets or obligations to a third party (like a SpecialPurpose Entity, SPE) which then issues securities that are claims against the pool

backed solely by the assets (collateral) transferred and payments derived from those

assets.


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The SPE funds its obligations by issuing securities and using the proceeds to purchasethe assets from the originating bank

The transferred assets can be on-balance sheet (loans) off-balance sheet (loancommitments) credit derivatives (synthetic securitization)

Banks use securitization to convert illiquid assets to cash transfer risk to third parties(like investors)

2.3.5.8 Problems

The use of different external credit assessment institutions may lead to differences in capital

requirements. Credit ratings are subjective assessments. There are differences in the

methodology and the rating scales. External credit assessment institutions do not have the

same coverage across rating markets and across countries counterparties which are not rated

by an ECAI are assigned a risk-weight by default. Smaller credit rating agencies tend to

assign more favourable credit ratings. Example: In Japan banks often rely on the ratings of

two local agencies, Japan Credit Rating Agency and Rating and Investment Information Inc

These agencies rate most domestic firms between one and two notches higher than Moodys

Section 702 of the Sarbanes-Oxley Act: Understanding the possible problems, requires the

Commission (SEC) to conduct a study of the role and function of credit rating agencies in the

operation of the securities markets. The credit rating agencies declare that the overall

hierarchy of sovereigns versus banks versus corporates is illogical. A BBB rated

counterparty has the same risk profile whether it be a sovereign, bank or corporate.

2.3.6 The 2 Internal Ratings-Based Approaches (IRB)

Two variants: a foundation version and an advanced version. The IRB approach differssubstantially from the standardized approach in that banks internal assessments of key risk

drivers serve as primary inputs to the capital calculation. Potential for more risk sensitive

capital requirements is substantial:

Internal credit risk rating systems A strong rating system is designed to differentiate among the degrees of risk in a

banks portfolio

The number of grades represents how hard a rating system is working to distinguishrisk


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Large banks use four or five pass grades - the best rating systems use 20 or moregrades, including +/- modifiers (like those used by the rating agencies)

Supervisors will tend to look for some minimum number of grades

IRB5 classes of assets: Banks must categorize banking-book exposures into broad classes

of assets with different underlying risk characteristics:

The classes of assets are (i) corporate, (ii) sovereign, (iii) bank, (iv) retail, and (v)equity.

Within the (i) corporate asset class, five sub-classes of specialised lending areseparately identified

Within the (iv) retail asset class, three sub-classes are separately identified The classification of exposures in this way is broadly consistent with established bank

practice

Within the (i) corporate asset class, the five sub-classes of specialised lending (SL) are:

1. Project finance (PF)

A single project is both the source of repayment and the security for the exposure Usually for large, complex and expensive installations Examples: Power plants, chemical processing plants, mines, transportation

infrastructure, environment, and telecommunications infrastructure

Financing of the construction of a new capital installation, or refinancing of anexisting installation

2. Object finance (OF)

Funding the acquisition of physical assets (ships, aircraft, satellites, railcars, andfleets)

The repayment of the exposure is dependent on the cash flows generated by thespecific assets

A primary source of these cash flows might be rental or lease contracts with one orseveral third parties


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3. Commodities finance (CF)

Short-term lending to finance reserves, inventories, or receivables of exchange-tradedcommodities (e.g. crude oil, metals, or crops)

The exposure will be repaid from the proceeds of the sale of the commodity and theborrower has no independent capacity to repay the exposure

The borrower has no other activities and no other material assets on its balance sheet -the financing is designed to compensate for the weak credit quality of the borrower

4. Income-producing real estate (IPRE)

Providing funding to real estate such as, office buildings to let, retail space,multifamily residential buildings, industrial or warehouse space, and hotels

The prospects for repayment and recovery on the exposure depend primarily on thecash flows generated by the asset.

5. High-volatility commercial real estate (HVCRE)

Financing of commercial real estate that exhibits higher loss rate volatility forexample, secured by properties that are categorized by the national supervisor as

sharing higher volatilities in portfolio default rates or loans financing any of the land

acquisition, development and construction (ADC) or loans financing ADC of any

other properties where the repayment is either the future uncertain sale of the property

or cash flows whose source of repayment is substantially uncertain

With the (ii) sovereign asset class: This asset class covers all exposures to counterparties

treated as sovereigns. This includes:

Sovereigns (and their central banks) Certain PSEs (public sector entities) that are treated as sovereigns by the national

supervisor

MDBs (multilateral development banks) that meet the criteria for a 0% (externalassessment AAA)


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qualifying revolving retail exposures like exposures that are revolving, unsecured, anduncommitted - customers outstanding balances are permitted to fluctuate based on

their decisions to borrow and repay, up to a limit established by the bank the

exposures are to individuals the maximum exposure to a single individual in the sub-

portfolio is 100,000 orless

all other retail exposures

With the exposures to (v) equity, direct and indirect ownership interests in the assets and

income of a commercial enterprise or of a financial Institution. Indirect equity interests

include holdings of derivative instruments tied to equity interests, and holdings in

corporations, partnerships, limited liability companies.

2.3.7 Expected / Unexpected Loss - BIS

BIS - An Explanatory Note on the Basel II IRB Risk Weight Functions, July 2005. A bank

can forecast the average level of credit losses it can reasonably expect to experience. These

losses are referred to as Expected Losses (EL). Expected Losses: A cost component of doing

business. Unexpected Losses: Peak losses that exceed expected levels.

Peak losses do not occur every year, but when they occur, they can potentially be very

large.

Unexpected Losses (UL) institutions know they will occur now and then, but they cannot

know in advance their timing or severity. Capital is needed to cover the risks of such peak

losses.


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Expected Losses (EL), Unexpected Losses (UL)

Expected Losses (EL)regulatory capital, Unexpected Losses (UL)economic capital

The likelihood that losses will exceed the sum of Expected Loss (EL) and Unexpected Loss

(UL) is the likelihood that a bank will not be able to meet its own credit obligations. This

likelihood equals the hatched area under the right hand side of the curve. 100% minus this

likelihood is called the confidence level and the corresponding threshold is called Value-at-

Risk (VaR). Capital is set to maintain a supervisory fixed confidence level.


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If capital is set according to the gap between EL and VaR, and if EL is covered by provisions

or revenues then the likelihood that the bank will remain solvent over a one-year horizon is

equal to the confidence level. The confidence level is fixed at 99.9%. This confidence level

might seem rather high, but Tier 2 does not have the loss absorbing capacity of Tier 1. The

high confidence level protects against estimation errors that might inevitably occur from

banks internal PD, LGD and EAD estimation as other model uncertainties. The confidence

level is included into the Basel risk weight.

Expected Loss Basel ii does not provide a definition of Expected Loss. There are three

different interpretations of EL:

EL is predicted on the basis of past experience, e.g. for credit card fraud, pastexperience of losses allows a projection of future losses, which is budgeted/priced

for.

A mathematical definition in which EL is equated to the mean (50th percentile) of aloss distribution.


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EL describes losses expected from identified events, for which a reserve has beenestablished - Example: A legal cost is anticipated, but the exact amount of the legal

settlement is not yet known.

Expected LossUK (FSA) Interpretation 1: Typical Loss (TL)

Typical Loss: Reoccurring losses that are expected in the normal course of business Interpretations 2: Mean Loss (ML) Mean Loss: is the mathematical mean derived from the loss distribution over a one

year period.

Internal Ratings-Based Approaches (IRB)

Two broad approaches: a foundation and an advanced Under the foundation approach, banks provide their own estimates of PD and rely on

supervisory estimates for other risk components.

Under the advanced approach, banks provide more of their own estimates of PD,LGD and EAD, and their own calculation of M.

Internal Ratings-Based Approaches (IRB). IRB approach is based on four key parameters

used to estimate credit risks.

PD - The probability of default LGD - The loss given default EAD - Exposure at default


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M -Maturity

Credit Risk: The Internal Ratings-Based Approaches (IRB)

Probability of Default (PD): The likelihood that a loan will not be repaid and fall into default

the risk that the obligor will default in the coming 12 months. PD must be calculated for each

company who have a loan. Quantitative information: Balance sheet, income statement, cash

flow. Qualitative information: Quality of management, ownership structure. Decisions are

based on credit history and creditworthiness of the counterparty nature of the investment

external rating. Some banks will use external ratings agencies such as Standard and Poor's -

banks can use their own Internal Rating Methods.


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2.3.8 Loss Given Default (LGD)

The assessment of Transaction Risk is measured by the magnitude of likely loss on the

exposure a percentage of the exposure. It is the amount of loss after the borrower has

defaulted. Driving factors: collateral, guarantees, recovery time, haircuts, the nature of the

product, Borrower risk and transaction risk measures.

Haircuts: Haircut is the portion of an assets value that cannot be used as collateral.

If 80 percent of an assets value can be used as collateral for a loan, the haircut is 20percent

(collateral must be valued in excess of the amount of the loan to protect the lenderagainst a possible decrease in the value of the collateral)

The size of the haircut reflects the perceived riskiness associated with the assets. Example: Haircut 30% for equity securities

Haircuts: Two ways to calculate the haircuts:

standard supervisory haircuts, using parameters set by the Committee, and


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own-estimate haircuts, using banks own internal estimates. Supervisors will allowbanks to use own-estimate haircuts only when they 26orpor certain qualitative and

quantitative criteria. A bank may choose to use standard or own-estimate haircuts

*independently* of the choice it has made between the standardised approach and the

foundation.

Foundation IRB: LGD is estimated through the application of standard supervisory rules

which differentiate the level of LGD based upon the characteristics of the underlying

transaction. Under the foundation approach, senior claims on corporate, sovereigns and banks

not secured by recognised collateral will be assigned a 45% LGD. All subordinated claims

(debt that is unsecured or has a lesser priority than that of an additional debt claim on the

same asset) on corporate, sovereigns and banks will be assigned a 75% LGD.

Advanced IRB: The bank itself determines the appropriate LGD to be applied to each

exposure. Banks differentiate LGD values on the basis of a borrower characteristics. Banks

need to persuade supervisors and to have the corporate governance elements in place. Banks

are allowed to recognize a much wider array of collateral, guarantees and hedges than under

Basel i. Banks systematically use collateral or guarantees to reduce LGDs. PDs as reflecting

characteristics of the borrower and LGDs as reflecting characteristics of the loan.

2.3.9 Exposure at default (EAD)

Is defined as the amount of exposure at the time of default. The amount (not %) to which the

bank was exposed to the borrower at the time of default for the period of 1 year or until

maturity (whichever is soonest). For certain facilities will include an estimate of future

lending prior to default (!).

For on-balance sheet items such as commercial loans, the EAD estimate generally equates to

the current drawn amount (the EAD on a $1 million loan is generally $1 million). For off-

balance sheet exposures, such as unused loan commitments, banks apply credit conversion

factors (CCFs) to the unused exposure amount in order to generate an EAD. Credit

conversion factors reflect the estimated size and likely occurrence of the credit exposure.

Foundation IRB: EAD is estimated through the use of standard supervisory rules. Advanced

IRB: The bank using internal EAD estimates will differentiate EAD values on the basis of


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transaction characteristics (e.g. product type) as well as borrower characteristics. Banks will

need to persuade supervisors.

2.3.10 Effective Maturity:

Effective maturity (M) can reflect that long-term credits are riskier than short-term credits.

For banks using the foundation approach for corporate exposures, effective maturity (M) will

be 2.5 years except for repo-style transactions where the effective maturity will be 6 months.

(Repo: A holder of securities sells these securities to an investor with an agreement to

repurchase them at a fixed price on a fixed date). The average portfolio effective maturity is

set by the Basel Committee at 2.5 years.

2.3.11: Examples

Expected Loss (EL):

EL(PORTFOLIO) = ELi(COUNTERPARTIES)

ELi(EACH COUNTERPARTY) = PDi x LGDi x EADi

$(EL) = % (PD) x % (LGD) x $ (EAD)

[Size of Expected Loss] = [% probability of counterparty going into default] x [% how much

is the bank going to lose] x [$ how much will he owe the bank].

EL = PD * LGD (if expressed as a percentage figure of the EAD)

Conditional Expected Loss (CEL) is the product of a conditional PD and a downturn LGD.

The conditional PDs are derived from banks average PDs - under normal business

conditions. The downturn LGD is the LGD under economic downturn conditions. During

economic downturns the LGDs are higher. In the A-IRB approaches banks are required to

estimate their own downturn LGDs.


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Internal Ratings Based Approach: Capital RequirementsBasel Paper

K = Min. Regulatory Capital Requirements

R = Asset Correlation (the correlation between an individual loan and the global state of the

world economy)

N[ ] = the cumulative distribution for a standard normal variable

G[ ] = the inverse cumulative distribution for a standard normal variable

LGD = Loss Given Default, PD = Probability of Default,

M= Maturity of the loan,

b (PD) = Smoothed regression maturity function


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Asset correlations: The asset correlations show the dependence of the asset value of a

borrower on the general state of the economy. All borrowers are linked to each other by this

single risk factor. Strong correlation among

1. The individual exposures within the portfolio and

2. With the systematic risk factor of the ASRF model

Interactions between borrowers are high, and where borrower defaults are strongly linked to

the status of the overall economy.


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Asset correlations:

Residential Mortgages: Asset Correlation (R) = 0.15

Qualifying Revolving Retail Exposures (QRRE): Asset Correlation (R) = 0.04

(QRRE are exposures to individuals the maximum exposure to a single individual in the sub-

portfolio is 100,000 orless)

Maturity Adjustment: Long-term credits are riskier than short-term credits Basel maturity

adjustments - by applying a credit risk model. B(pd) = (0.118520.05478 X log (PD)2

The adjustments reflect the potential credit quality deterioration of loans with longer

maturities.

1 + 2.5()

1 1.5 ()

Basel I: $100,000 x 100% x 8% = $8,000

Basel II Standardized Approach: Retail, 75% risk weighting

100,000 x 75% x 8% = $6,000 of capital

Basel II Standardized Approach: Corporate, 20%, 50%,

100%, 150% risk-weighting

100,000 x 20% x 8% = $1,600 of capital

100,000 x 50% x 8% = $4,000 of capital

100,000 x 100% x 8% = $8,000 of capital

100,000 x 150% x 8% = $12,000 of capital

Basel ii Compliance Professionals Association (BCPA)

Example: Capital required for $100,000 loan

Basel II, IRB approach


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Example: Credit Cards

Basel I: , Based on the minimum capital to risk-assets ratio of 8%, every $1,000 of credit card

lending required a minimum 1,000 x 100% x 8% = $80 of capital to support it.

Basel II, Standardized approach: Retail lending such as credit cards qualifies (subject to

certain conditions) for a lower 75% risk-weighting.

1,000 x 75% x 8% = $60 of capital but the lower risk-weighting for credit risk is partly

offset by the capital charge under Basel II for operational risk. If we have a higher PD and

LGD X we have higher risk weighting. Riskier a portfolio X more capital required to support

it. Basel II, IRB approach: Do we need more or less capital in comparison to Basel I? It

depends: For a LGD of 85%: If the PD is under 5%, we need less capital - If the PD is over

5%, we need more capital. Basel ii does not mean lower capital requirements.

Basel ii does not mean lower capital requirements

2.3.12 IRB approach across some asset classes.

Once a bank adopts an IRB approach for part of its holdings, it is expected to extend it across

the entire banking group. The Committee recognizes that it may not be practicable for various

reasons to implement the IRB approach across all material asset classes and business units at

the same time. Data limitations may mean that banks can meet the standards for the use of

own estimates of LGD and EAD for some but not all of their asset classes/business units at

the same time. Supervisors may allow banks to adopt a phased rollout of the IRB approach

across the banking group.


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The phased rollout includes:

(i) adoption of IRB across asset classes within the same business unit (or in the case of retail

exposures across individual sub-classes)

(ii) adoption of IRB across business units in the same banking group

(iii) move from the foundation approach to the advanced approach for certain risk

components.

A bank must produce an implementation plan, specifying to what extent and when it intends

to roll out IRB approaches across significant asset classes (or subclasses in the case of retail)

and business units over time. The plan should be agreed with the supervisor. It should be

driven by the practicality and feasibility of moving to the more advanced approaches, and not

motivated by a desire to adopt a Pillar 1 approach that minimizes its capital charge. Some

exposures in non-significant business units as well as asset classes (or subclasses in the case

of retail) that are immaterial in terms of size and perceived risk profile may be exempt from

the requirements in the previous two paragraphs subject to supervisory approval. Capital

requirements for such operations will be determined according to the standardised approach.


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Appendix 1.2.1: Risk weighted approach

Risk weights by category of on balance sheet assetExamples

Weighted risk ratios

0% - Cash 0% - Claims on central governments and central banks denominated in national

currency and funded in that currency

20% - Claims on domestic public-sector entities, excluding central government, andloans guaranteed by such entities

50% - Loans fully secured by mortgage on residential property that is or will beoccupied by the borrower or that is rented

100% - Claims on commercial companies owned by the public sector 100% - Claims on the private sector 100% - Claims on commercial companies owned by the public sector OECD (Organisation for Economic Co-operation and Development) countries were

considered to be of the highest creditworthiness - zero weight. Claims on central

governments and central banks outside the OECD attract zero weight only when such

loans are denominated in the national currency and funded in the same currency.

Why? No foreign exchange risk!

OECD government debt was weighted 0%, OECD bank debt was weighted 20%, andother debt, including corporate debt and the debt of non-OECD governments, was

weighted 100%.

Not risk sensitive:

Regulatory Capital = Exposure Weight 8% Regulatory Capital = Risk-Weighted-Assets x 8% Banks must hold the same amount of capital for many commercial loans, regardless of

the risk of the borrower

A $100,000 commercial loan with a AAA credit rating would necessitate $100,000 x100% x 8% = $8,000 capital charge

A $100,000 commercial loan with a B credit rating would necessitate $100,000 x100% x 8% = $8,000the same capital charge


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Week 2 - Basel 2 Regulatory Framework

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