Moving Towards Basel Ii: Issues & Concerns

MOVING TOWARDS BASEL II
Issues & Concerns
Basel I was very simple in its approach. However, Basel II is complex There is belief that countries would adopt the options and approaches that are most appropriate for the state of their banking systems, their supervisory structures and their markets, Under the Basel II Accord, supervisors can adopt the framework on an evolutionary basis and use elements of national discretion to adapt it to their needs.
Under Basel I, banks were required to hold a uniform level of 8 per cent as minimum capital Now under the new accord, Basel II, supervisors have the discretion to ask banks to hold higher levels of minimum capital For example, in India the minimum capital requirement is at 9% level.

Basel Accord I : In 1988 the Basel Committee published a set of
minimal capital requirements for banks, known as Basel Accord I. It focused primarily on credit risk. Assets of the banks were classified into four risk buckets with risk weights of 0, 20, 50 and 100. Assets were to be classified into one of these risk buckets based on types of counter party (sovereign, banks, public sector and others). Banks were required to hold capital equal to 8% (in India presently 9%) of the risk-weighted value of assets. The accord provided definition of total capital as Total Capital = 0.08 x Risk Weighted Assets. These recommendations were introduced in India through Narasimham committee recommendations.

Basel Accord I:
An Example for Calculation of Capital Requirement
Exposure in an account Risk weight assigned to the account Minimum capital requirement Capital required is = (50x100x8)/(100x100)
Rs. 50 Cr 100% 8% = Rs. 4 Cr

Basel Accord II: The New Accord (Basel II) The Basel committee has issued a detailed document on capital measurement and capital standards on 26th June 2004. The framework of new accord consists of three pillars: Minimum capital requirements, which seeks to refine the standardised rules set forth in Accord I; Supervisory review process not only to ensure that banks have adequate capital but also to encourage banks to adopt better risk management techniques, and Market discipline with effective use of mandatory disclosure on risk management practices.
Major Differences Between Basle I and Basle II Accords

Old Accord - Basle I
New Accord - Basle II
"One Size Fits All" Broad Brush Single Risk Measure
Portfolio of approaches Emphasis on internal models, supervisory review and market discipline Flexible, incentive for better risk mgt. More risk sensitive
Comparison of Basel I and II

Under Basel II, the capital requirements are more risk sensitive as these are directly related to the credit rating of each counter-party instead of counter-party category (as was applicable under Basel I). Further, the New Accord requires banks to hold capital not only for Credit and Market Risk but also for Operational Risk (OR) and where warranted for interest rate risks, credit concentration risks, liquidity risks etc All these makes Basel II much more comprehensive than the earlier Basel I. Basel II recognizes a wider range of collaterals and provides incentives for improved risk management practices
Comparison of Basel I and II

An interesting point to note is that Basel II recognises the element of diversification of risk in the SME sector and has assigned a lower risk weight for retail SME exposure under Standardised Approach. The non-retail SME exposure would also attract a lower risk weight where they have better external ratings under the Standardised Approach. Shifting to Basel II, therefore, could be advantageous for economies whose banks have significant SME exposure.
Comparison of Basel I and II NEW ACCORD Capital Requirement
Minimum capital requirement depends on quality of risk management and will be measured as under: Banks capital adequacy ratio =
Total Capital ---------------------------------------------------------------------RWAs of Credit Risk+ Market Risk+ Op. Risk

- No change in definition of total capital - No change in 1996 approach for market risk
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DRAFT GUIDELINES FOR IMPLEMENTATION OF THE NEW CAPITAL ADEQUACY FRAMEWORK
RBI releases Draft guidelines on 14th February 2005. At a minimum, all banks in India to adopt Standardised Approach for Credit Risk and Basic Indicator Approach for Operational Risk w.e.f. 31st March 2007. Bank to have a parallel run w.e.f. 1 April 2006. Some banks to migrated to IRB approach after developing necessary skills and after obtaining specific approval of RBI. Bank to study these guidelines and furnish their feedback within 3 weeks.

NEW ACCORD (BASLE II) IS BASED ON THREE PILLARS :
Pillar 1 : Minimum Capital Advanced methods for capital allocation Capital charge for operational risk Pillar 2 : Supervisory Review Focus on internal capabilities Supervisors to review banks internal assessment and strategies Pillar 3 : Market Discipline Focus on disclosures
Comparison of Basel I and II Integrated Supervisory Regime - Basel II
Pillar I Minimum Capital Requirements

Credit Risk
Pillar II Supervisory Impact Evaluate banks capital adequacy strategies
Pillar III Market Discipline
Market Risk
Certify internal models Additional Capital Adjustments
Information Disclosures Core & Supplementary
Operational Risk
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WHAT DOES THREE PILLARS INDICATE ? PILLAR-1: MINIMUM CAPITAL
Market risk Unchanged from existing Basel I Accord Credit risk Significant change from existing Basel Accord Three different approaches to the calculation of minimum capital requirements Capital incentives to move to more sophisticated credit risk management approaches based on internal ratings Sophisticated approaches have systems / controls and data collection requirements Operational risk Not covered in Basel I Accord Three different approaches to the calculation of minimum capital requirements Adoption of each approach subject to compliance with defined qualifying criteria

PILLAR-1: MINIMUM CAPITAL Market risk Market Risk is defined as the possibility of loss to a bank caused by changes in the market variables. Basel defines market risk as The risk that the value of on or off balance sheet position will be adversely affected by movements in equity and interest rate market , currency exchange rates and commodity prices. Various market risk are liquidity, interest rate, forex, equity, commodities and other prices, etc.

PILLAR-1: MINIMUM CAPITAL
Credit risk
Credit risk is defined as possibility that a borrower or counter party will fail to meet its obligation in accordance the agreed terms.
Credit Risk is composed of Default risk, Exposure Risk and Recovery Risk Probability of Default (PD) : It is the probability that a borrower will fail to meet its obligation in accordance with the agreed terms. Exposure at Default (EAD): It is a level of exposure to a borrower at the time of default. Loss Given Default (LGD) : It is loss which the bank may sustain in case of default by a borrower.

Operational risk
Risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and system or from external events. This includes legal risk, but excludes strategic and reputational risk The operational risk identification and measurement is still in an evolutionary stage as compared to the maturity that market and credit risk measurement have achieved.

Operational risk
Most important types of operational risk involve breakdowns in internal controls and corporate governance Such breakdowns can lead to financial losses through
Error Fraud Failure to perform in a timely manner Cause the interest of the bank to be compromised like exceeding authority, conducting business in an unethical or risky manner
Other aspects of operational risk include failure of IT Systems or events such as fires or other disasters

Operational risk
Cause Internal Processes Definition Losses from failed transactions, client accounts, settlements and every day business processes.
People
Losses caused by an employee or involving employees (intentional or unintentional), or losses caused through the relationship or contact that a firm has with its clients, shareholders, third parties, or regulators. Losses arising from disruption of business or system failure due to unavailability of infrastructure or IT.
Systems
External
Events
Losses from the actions of 3rd parties including external fraud, or damage to property or assets, or from change in regulations that would alter the firms ability to continue doing business.

WHAT DOES THREE PILLARS INDICATE ? PILLAR 2 - SUPERVISORY REVIEW
Banks should have a process for assessing their overall capital adequacy and strategy for maintaining capital levels Supervisors should review and evaluate banks internal capital adequacy assessment and strategies Supervisors should expect banks to operate above the minimum capital ratios and should have the ability to require banks to hold capital in excess of the minimum
Supervisors should seek to intervene at an early stage to prevent capital falling below minimum levels

WHAT DOES THREE PILLARS INDICATE ?
PILLAR 3 - MARKET DISCIPLINE
Market discipline reinforces efforts to promote safety and soundness in banks Core disclosures (basic information) and supplementary disclosures to make market discipline more effective
Basel II
Minimum Capital Requirement
THREE BASIC PILLARS

Supervisory Review Process
Market Discipline
Weighted Risks
Definition of Capital
Credit Risk
Market Risk
Operational Risk
Standardised Approach (SA)
Internal Ratings Based Approach (IRBA)
Basic Indicator Approach (BIA)
Standardised Approach (SA)
Advanced Measurement Approach (AMA)

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Foundation Approach(FIRB)
Advanced Approach (AIRB)
Credit Risk Measurement Approaches under Basel II
Criteria
Pillar 3 - Market DisciplineBased (IRB) Approach Internal Ratings
Market discipline reinforces efforts to promote Standardized Foundation Advanced safety and soundness in banks Approach Approach Approach Rating External Internal Internal Core disclosures (basic information) and Calibrated on the basis Function supplementary disclosures to make market provided Function provided by Risk Weight of external ratings by disciplinethe Basel Committee the Basel Committee by the Basel more effective Committee
Credit Risk Measurement Approaches under Basel II Criteria Internal Ratings Based (IRB) Approach
Standardized Approach Foundation Approach Advanced Approach
Probability of Default Implicitly provided by the (PD) i.e. the likelikhood Basel Committee, tied to risk Provided by bank based on Provided by the Bank that a borrower will weights based on external own estimates based on own estimates default over a given time ratings period
Pillar 3 - Market Discipline
Market discipline reinforces efforts to promote safety and soundness in banks
Exposure of Default (EAD) : For loans, the Supervisory values set by the Supervisory values set by amount of the facility that Basel Committee the Basel Committee is likely to be drawn if a default occurs
Provided by bank based on own estimates. Core disclosures (basic information) and supplementary disclosures to make market discipline more effective Provided by bank based Loss Given Default Implicitly provided by the
(LGD) : the proportion of Basel Committee, tied to risk Supervisory values set by the exposure that will be weights based on external the Basel committee lost if a default occurs ratings
on own estimates; extensive process and internal control requirement
Credit Risk Measurement Approaches under Basel II
Criteria
Standardized Approach
Internal Ratings Based (IRB) Approach
Pillar 3 - Market Discipline Foundation Approach
Advanced Approach
Market discipline reinforces efforts to promote Maturity i.e. the remaining economic safety and soundness in banks Implicitly recognition maturity of the
exposure
Same as IRB Foundation, Core disclosuresdates Provision (basic information) and plus : Default events supplementary disclosures to make marketHistorical loss data to Rating data exposure data estimate LGD (7 discipline more effective Default events to customer segmentation Data Requirements Historical data years)

Supervisory values set by the Basel Commitee Provided by the bank or based on own estimates At rational discretion, (with an allowance to provided by bank based on exclude certain own estimates (with an exposures) allowance to exclude certain exposures)
Data collateral segmentation External Ratings Collateral data
estimate PDs (5 years) Collateral data
Historical exposure data to estimate EAD (7 years)
Credit Risk Measurement Approaches under Basel -II Criteria

Standardized Approach
Internal Ratings Based (IRB) Approach
Credit Risk Mitigation techniques (CRMT)
Market discipline reinforces efforts to promote safety and soundness in banks
Defined by the supervisory All collaterals from regulator; including financial Standardized approach; All types of collaterals collateral, guarantees, credit receivables from goods and if bank can prove a derivatives, "netting" (on and services; other physical CRMT by internal off balance sheet) and real securities if certain criteria estimation. estate. are met.
Foundation Approach Advanced Approach
Same as Standardized Same as IRB Minimum requirements for Approach; plus minimum foundation, plus collateral (basic requirements to and Maturity : the Core disclosures managementinformation) ensure minimum requirements remaining economic (administration / maturity of the supplementary disclosures quality ofestimatemarket ensure quality of to PD internalon and to make ratings evaluation) and exposure estimation of all Provisioning process their use in the risk discipline more effective parameters.
management process.
Operational Risk Measurement Approaches under Basel -II Calculation of Capital Charge Basic Indicator Approach Advanced Standard Approach Measurement Approach
Capital charge equals internally generated measure based on (a) internal loss data; (b) External loss data; (c) Scenario analysis; (d) Business environment and internal control factors; Recognition of risk mitigation (up to 20% possible)
Market discipline reinforces Gross incometo promote efforts per safety and soundness in banks business line regulatory

Calculation of capital charge
Core disclosures (basic information) and supplementary disclosures to make market discipline more effective

Average of gross income over three years as indicator Capital charge equals 15% of that indicator
as indicator depending on business line, 12%, 15% or 18% of that indicator as capital charge Total capital charge equals sum of charge per business line
Operational Risk Measurement Approaches under Basel -II Advanced Standard Approach Measurement Approach
Calculation of Capital Charge
Basic Indicator Approach

Market discipline reinforces efforts to promote Qualifying Criteria safety and soundness in banks
No specific criteria; compliance with the Basel Committee's "Sound Practices for the Management and Supervision of Operational Risk" recommended
Active involvement of board of directors and senior management; existence of Operational Risk Management function Sound Operational Risk management system Systematic tracking of loss data
Market discipline reinforces efforts to promote safety and soundness in banks; Core disclosures (basic information) and supplementary disclosures to make market discipline more effective.
Implementation in India In India, RBI is instrumental to ensure implementation of Basel II. The reform process started in early nineties of the last century have proved a boon for migrating to Basel II. With the commencement of the banking sector reforms in the early 1990s, the RBI has been consistently upgrading the Indian banking sector by adopting international best practices. The minimum capital adequacy requirement under the Basel standard is 8%. However, in India, RBI has stipulated and achieved a
Banks in India have now even implemented capital charge for market risk prescribed in the Basel document w.e.f. 31/03/2006. As a prudent measure RBI had put in place several surrogates for market risk, e.g. IFR ( Investment Fluctuation Reserve) of 5% of the investment portfolio, both in the AFS and HFT categories plus a 2.5% risk weight on the entire investment portfolio.
Commercial banks in India have started implementing Basel II with effect from March 31, 2007. They are initially adopting the Standardised. Approach for credit risk and the Basic Indicator Approach for operational risk. After adequate skills are developed, both by the banks and also by the supervisors, some banks may be allowed to migrate to the Internal Rating Based (IRB) Approach. Implementation of Basel II will require more capital for banks in India due to the fact that operational risk is not captured under Basel I, and the capital charge for market risk was not prescribed until recently. Though the cushion available in the system, which at present has a CRAR of over 12 per cent, is comforting, banks are exploring
RBI has been expanding the area of disclosures so as to have greater transparency with regard to the financial position and risk profile of banks. Illustratively, with a view to enhancing further transparency, all cases of penalty imposed by the RBI on the banks as also directions issued on specific matters, including those arising out of inspection, are to be placed in the public domain. Such proactive disclosures by the Regulator are expected to have a salutary effect on the functioning of the banking system
Major Regulatory Initiatives taken in India : The regulatory initiatives taken by the Reserve Bank of India include: Ensuring that the banks have suitable risk management framework oriented towards their requirements dictated by the size and complexity of business, risk philosophy, market perceptions and the expected level of capital. The framework adopted by banks would need to be adaptable to changes in business size, market dynamics and introduction of innovative products by banks in future. Introduction of Risk Based Supervision (RBS) in 23 banks on a pilot basis.
Major Regulatory Initiatives taken in India : Encouraging banks to formalize their Capital Adequacy Assessment Programme (CAAP) in alignment with business plan and performance budgeting system. This, together with adoption of Risk Based Supervision would aid in factoring the Pillar II requirements under Basel II. Enhancing the area of disclosures (Pillar III), so as to have greater transparency of the financial position and risk profile of banks. Improving the level of corporate governance standards in banks. Building capacity for ensuring the regulators ability for identifying and permitting eligible banks to adopt IRB / Advanced Measurement
Major Challenges Envisaged in Implementation of Basel II Accord in India : a. Higher capital requirements b. Improved IT architecture/MIS c. Consolidation d. Data issues e. Capacity Building (f) External ratings (g) Use of national discretion (h) Validating the concept of economic capital (i) Improving governance standards and
MOVING TOWARDS BASEL II Conclusion Basel II is expected to foster financial stability through its risk sensitive framework which will encourage banks to adopt improved risk management practices; require supervisors to review the efficiency of banks risk management practices and capital allocation methodologies; and empower market participants to make informed judgements on the efficiency of banks and accordingly punish or reward banks. While it is true that implementation of Basel II is not the be all and end all on the subject of financial stability it must be recognised that banks are "special". Their sound and efficient functioning is critical not only to the growth of the real sector but also for strengthening the social infrastructure. Internationally, therefore, banks have moved centre-stage and their performance is the cynosure of all eyes.

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MOVING TOWARDS BASEL II

Issues & Concerns