Basel II -A

8/4/2019 Basel II -A

1/107

.

State Bank of Pakistan

Basel Capital Accord


2/107



Background

1. Bank for International Settlements Based in Basel and created in 1930, the BIS is the worlds oldest international

financial institution

Its mission is to foster cooperation among central banks and other agencies in

pursuit of monetary and financial stability

Fosters regulatory and supervisory convergence across jurisdictions and financial

sectors

2. Basel Committee on Banking Supervision Voluntary Association

No formal supra-national authority Output series of Broad supervisory guidelines and Statements of best practices

Desired outcome: Convergence in Standard

3. Most Significant guidelines of BCBS is Capital AdequacyStandards commonly known as Basel I & Basel II


3/107

A Standard for the Measurement of Risks in Banks,

and for the Allocation of Capital to cover those risks

Published by the Basel Committee on BankingSupervision



4/107

Why Capital requirement for banks

Unexpected

loss

Expected

Loss

Probabil

ity

Amount

Extreme Loss


5/107

Background Basel-I


Basel I or Capital Accord 1988o The First ever internationally accepted standard for minimum capital

requirement for Banks

o Though meant for G-10 countries, accepted and adopted by most of theeconomies.

o Prescribe a simple framework for the calculation of minimum capitalrequirement for banks.

Capital (Asset X Risk Weight) X 8%

Broadly defined risk weights on the basis of asset class : 0, 20, 50, 100% For instance

CashBalance with Banks

Mortgage Finance

0%20%

50%

Loans to private firms 100%


6/107

Capital > 8%

Risk weighted assets

The Basic Formula


7/107

Background Basel-I

Bank

Risk

Weights Risk Weighted Assets

Assets A B C A B CCash 10 5 35 0% 0 0 0

Balance with other Banks 65 45 20 20% 13 9 4

Investments

Government Securities 110 200 70 0% 0 0 0Private sector debentures, Bonds, PTCs etc. 30 30 80 100% 30 30 80

Other Investments 10 0 40 100% 10 0 40

Advances

Federal Government 80 10 50 0% 0 0 0

Private Sector 200 170 100 100% 200 170 100

Secured against mortgage of residential or commercial property 20 80 40 50% 10 40 20

Consumer Financing 80 100 200 100% 80 100 200

Other Assets 45 10 15 100% 45 10 15

Total Assets 650 650 650 388 359 459

Capital Requirements 10% of RWA 39 36 46


8/107

Basel II - Overview

Weaknesses of Basel I Did not assess capital adequacy in relation to a banks true risk profile

Broad-brushed risk weighting structure does not differentiate high risk orlow risk transactions within an asset class

Created an incentive to take some highest quality assets off the balancesheet

Covered only credit risk across bank and market risks only in trading book(Interest rate risk in banking book, credit concentration risk, etc were ignored and operational risk assumed to

be covered in credit risk capital charge)

Despite these weaknesses remained global standard for almost a decade

Firm X

Weak Financial positionRating BB

Firm Y

Strong Financial position

Rated AAA

Both assigned

100% risk Weight


9/107

Basel II - Overview

Greater Risk SensitivityBroad Brush

Menu of ApproachesOne Size Fits All

Three PillarsFocus on Single

Measure (Capital)

2005: Basel II1988: Basel I


10/107

Basel IIScope of Application


10

Diversified Financial Group

Holding Company

InternationallyActive Bank

Internationally

Active Bank

Internationally

Active Bank

Domestic

Bank

Securities

Firm


11/107

Basel IIOverall framework


Three Mutually Reinforcing Pillars

Pillar 3: Market

Discipline

Pillar 2: Supervisory

Review Process

Pillar 1: Minimum

Capital Requirement

Definition of CapitalRisk Weighted Assets

Credit Risk Market RiskOperational Risk

Internal

Rating Based

Basic Indicator

Approach

Standardized

ApproachAMA

Standardized

Approach

Internal Model

Based Approach

Supplementary

Capital

Core Capital

Standardized

Approach


12/107

Basel IIPillar 1 Capital Charge for Credit Risk

Each exposure is assigned a risk weight pursuant to the risk assessmentof External Rating agency

Least sophisticated capital calculations; generally highest capital burdens

Standardised Approach

Foundation IRB Approach

Advanced IRB Approach

Risk weights are calculated using a standard formula. Input parameters

to the formula known as risk components are

probability of default (PD) loss given default (LGD), exposure at default (EAD) and maturity (M).

More risk sensitive capital requirements

Same as FIRB Approach except the risk components are to be calculatedby the banks themselves

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

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


13/107

Basel IIMajor changes

Credit Risk + Market Risk + Operational Risk.

Total CapitalCapital Ratio =

8% Minimum CAR

Unchanged

New Risk CapitalCharge

DefinitionUnchanged

No

ChangeRWA Calculation

Revised

Major change is the calculation of risk weighted assets for credit risk

Besides Basel II prescribes a framework for risk management and

allocation of capital against other risks


14/107

Basel IIPillar 1 Minimum Capital Requirement

Definition of Capital (unchanged)

Tier 1 : Core Capital Equity

Disclosed reserves

Instruments eligible under October 1998 press release

Tier 2 : Supplementary Capital (limited to 100% Tier 1) Undisclosed reserves

Revaluation reserves

General provisions/general loan loss reserves

Hybrid instruments

Subordinated debt ( lower tier 2)

Tier 3 : ( for market risk) short term subordinated debt


15/10715

Based upon ECAIs long-term domestic rating for

domestic and foreign currency obligations.

Credit

Assessment

AAA

to

AA-

A+

to

A-

BBB+

to

BBB -

BB+

to

B-

Below

B-

Un -rated

Risk

weighting

0% 20% 50% 100% 150% 100%

Claims on Sovereigns


16/10716

At national discretion, supervisors may allow the use of

ratings from Export Credit Agencies

Available for a far greater number of sovereigns.

ECA Risk

Score

1 2 3 4 to 6 7

Risk

Weighting

0% 20% 50% 100% 150%



17/107

17

National Discretion : Preferential treatment (e.g. 0%risk weight ) can apply to

Exposures in domestic currencies to a banks ownsovereign (and central bank ) under the condition that

exposures are also funded in national currency

Preconditions for the own sovereigni. Claim on the own sovereign

ii. Exposure denominated in domestic currency

iii. Exposure funded in domestic currency



18/107

18

Bank in Pakistan, exposure to Government of Pakistan,

denominated and funded in Pak Rupees

Pak. Rs. Pak. Rs. Pak.Rs.

Gov. 100

Other 600

US$ 200

Cap. 100

Liab. 200

US$ 600

Gov. $ 100

Other 600

US$ 200

Cap. 100

Liab. 200

US$ 600

Gov. $ 100

Other 600

US$ 200

Cap. 100

US$ 800

Preferential treatment for

government claim

Yes


government claim

No


government claim

No

Preferential Treatment: Example


19/107

19

Other supervisors may also permit their banks to applythe same risk weighting (i.e. if Pakistan applies 0%,

Hong Kong can follow)

Bank in Hong Kong

Assets Liabilities

Gov. of Pakistan 500 Pak.Rs.

Other assets 1,200 HK$

Capital 300 HK $

Liabilities 500 Pak.Rs.

Liabilities 900 HK $

Preferential Treatment: Example

Claims on central banks , BIS, ECB, IMF will receive the lowest risk weight

applicable to sovereigns


20/107

20

Two optionssupervisors must apply one

option to all banks in their jurisdiction

No unrated claim may receive a risk weight

less than that of its sovereign.

Claims on Banks


21/107

21

Banks are assigned a RW one category less favorable than that of its

country of incorporation.

RW cap at 100% except in countries rated below B-, in which case the

RW is 150%.

Credit

Assessment of

Sovereign

AAA

to

AA-

A +

to

A-

BBB+

to

BBB-

BB+

to B-

Below

B-

Unrated

Sovereign RW 0% 20% 50% 100% 150% 100%

Bank Risk

Weight

20% 50% 100% 100% 150% 100%

Claims on Banks including securities firms: Option 1


22/107

22

Based upon the credit assessment of the bank itself.At national discretion a preferential treatment exists for

claims of 3 months or less (original maturity), subject to a

floor of 20%. Not available to banks rated below B-.

Credit Assessment

of banks

AAA

to

AA-

A + to

A -

BBB+

to

BBB-

BB+

to

B-

Below B- Unrated

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

Risk Weight ST

claim

20% 20% 20% 50% 150% 20%

Claims on Banks including securities firms: :Option 2


23/107

23

Risk weighted similar to banks under option 2

0 % risk weight is possible ( as determined by the Basel

Committee) for MDBs

o Majority of the external assessments are AAA;

o Shareholder structure is significantly comprised of

sovereigns with long term issuer credit assessment of

AA or better;

o Strong shareholder support (i.e. amount of capital ,

amount of callable capital);

o Adequate level of capital and liquidity

Claims on MDBs


24/107

24

Generally treated as a claim on a bank (if using

option 2 , the ST preferential treatment is not

available to PSEs)

At national discretion may be treated as a claim

on the sovereign in the jurisdiction where

establishedExample : categorization of PSEs by revenue

raising power

Claims on PSEs


25/107

25

Based upon comments received from the industry, a 50%RW was added and expansion of 150% RW.

No unrated claim can receive a RW less than the sovereignRW.

CreditAssessment AAAto

AA-

A+to A- BBB +to BB- BelowBB- Un-rated

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

Claims on Corporate


26/107

26

Risk weight for unrated corporates(100%) is a floor.

Low rated ( below BB- ) corporates that

give up their rating in order that the bankcan have a 100 % capital charge will affectthe quality of the un rated borrowerpool;thus a higher RW (higher than 100%)may be necessary.

Claims on Corporate


27/107

27

At national discretion supervisory authorities maypermit banks to risk weight all corporate claims at100 % without regard to external ratings.

Where this discretion is exercised by supervisor,itmust ensure that banks apply a single consistentapproach i.e to use ratings wherever available or

not at all.

Claims on Corporate


28/107

28

New lower risk weight for retail portfolio,e.g 35% for residential mortgages

Past due mortgage loans are weighted at 100%

75 % for other retail ( 100 %)

Aggregate exposure to one counterpart cannot exceed0.2% of the overall regulatory retail portfolio

The banks total exposure to the firm must be less than

Euro 1 million Past Due claims do not qualify for this preferential

treatment

Rules for Retail


29/107

29

The unsecured portion of any loan (other thanqualifying residential mortgages loan ) that is pastdue for more than 90 days, net of specific provisions ,

will be risk weighted as follows:Where specific provisions are less than 20 % ofoutstanding loan amount : risk weight 150 %

Where specific provisions are no less than 20 % of

outstanding loan amount : risk weight 100 %Where specific provisions are no less than 50 % ofoutstanding loan amount : risk weight 100 % ,howevermay be reduced to 50 % with supervisory discretion.

Past Due Exposures


30/107

30

All other assets will continue at 100 %

National Supervisor may decide to applya 150% or higher risk weight to high riskassets (venture capital , private equity)

Other Claims


31/107

31

Off balance-sheet itemscurrent framework willremain in place with a few exceptions Credit conversion for ST commitments (upto one year)

will be 20 %: over one year 50% . A 0 % RW can be applied if the commitment is

unconditionally cancelable.

100% conversion factor applied to repo-styletransactions.

For short term self liquidating trade letters of credit , a20% CCF will be applied to both issuing and confirmingbanks.

Other Risk weight issues


32/107

32

ECAI must be recognized by the supervisor.ECAIs may be recognized on a limited basis (i.e. typeof claim or jurisdiction).

Process for recognizing ECAIs must be disclosed.

Eligibility critieria- Objectivity - Independence- International access - disclosure

(transparency)

- resources - credibility

External Credit Assessment Inst. (ECAI)


33/107

33

Mapping Process:- responsibility of the supervisor to map ratings to

RW in an objective manner;

- process for mapping must be disclosed bysupervisor;- disclosure by banks of ECAI used by type of claim

and % of RWA that are based on the assessmentof each ECAI.

Multiple assessments:- 2 ratingsuse the one resulting in a higher RW;- Multiple ratingsuse the two that correspond to

the lowest RW and choose the higher RW of thetwo.

Implementation considerations


34/107

34

if a high-quality (maps to a better than unrated RW)issue rating is available from another issue of the sameissuer, it may be used provided that the banks claimranks pari pasu or is more senior; otherwise the claimshould be treated as unrated;If there is an issuer rating, it will typically apply to

senior claims; consequently, only senior claims can usethe issuer assessment; otherwise, the claim should betreated as unrated.Issue or issuer low quality assessmentuse this rating.

Issuer versus issue assessment if there is no issuerating available for the banks particular investment:



35/107

35

if a high-quality (maps to a better than unrated RW)issue rating is available from another issue of the sameissuer, it may be used provided that the banks claimranks pari pasu or is more senior; otherwise the claimshould be treated as unrated;If there is an issuer rating, it will typically apply tosenior claims; consequently, only senior claims can usethe issuer assessment; otherwise, the claim should betreated as unrated.Issue or issuer low quality assessmentuse this rating.

Issuer versus issue assessment if there is no issuerating available for the banks particular investment:



36/107

36

External assessments from one entity in thecorporate group cannot be used to RW otherentities in the same group.

Unsolicited ratings- Generally should not be used- At national discretion, they may be used

- Supervisor should be aware of pressure

by the ECAI applied to the corporate toobtain a rating- Benefits could widen ratings coverage



37/107

37

Supervisors should disclose process for recognizing

ECAIs

Supervisors may choose to disclose list ofrecognized ECAIs

Aim: transparent process for recognizing ECAIs

Disclosure for supervsiors


38/107

38

Banks must disclose

Credit assessment institution(s) they use

Mapping process

Percentage of risk weighted assets mapped into

single grades

Disclosure for Banks


39/107

39

Grade 1 2 3 4 5 6 7

Rating AA

A

AA A BBB BB+ BB- B

R W % 20 20 50 100 100 100 150

% assets 15 10 20 25 15 10 5

Example


40/107

Rules for Equity Exposure

40

Co

mpany

Source: Text

Basel I

Equity Exposure

Non-consolequity

Type ofExposure

Risk Weight

100%

Standardised bank risk weights

Corporates

Banks

100%*

100%

* CRD has preferentialtreatment vs. Basel IIAccord; supervisors mayincrease to 150% for venturecapital and private equityinvestments ( 80)

PD/LGDModel**

Securitiesfirms 100%

92%***

81%***

264%

32%***

82%***

195%***

120%***

** Inputs: average ratingagency PDs, LGD of 90%,supervisory value for EADand M of 5.

DaimlerChrysler

Siemens

Fresenius Med. Care

GE

Sony

Vivendi Universal

Bertlesmann

290%

290%

290%

290%

290%

290%

290%

Basel II

For banking book exposures.National supervisors mayexempt from IRB treatmentfor up to ten years particularequity exposures held atpublication date of Basel IIaccord ( 267)

Simple Model* Rating

A3/BBB

Aa3/AA-

Ba1/BB+

Aaa/AAA

A1/A

Baa3/BBB-

Baa1/BBB+

*** Under Basel II ( 353) a floorrisk weight of 200% appliesto listed equities


41/107

Basel IIPillar 1 Capital Charge for Credit Risk

Standardized Approach - Risk Weighting Scheme (Past Due)Provision less than 20%

of Outstanding amount

Provision more than

20% but less than

50% of Outstanding

amount

Provision no less

than 50% of

Outstanding amount

All except retail 150% 100% 50%

Retail 150%


42/107

42

Collateralized TransactionA transaction where:

the bank has a credit exposure or potential credit exposureto a counter party; AND

the exposure is hedged in whole or in part by collateralposted by a counter party or by a third party on behalf of

the counter party.

As a general rule, no transaction should receive a

RW higher than an unsecured claim.


43/107

43

No capital relief if the following conditions are notmet.

Legal certainty: All documentation used in the collateralized transactions must

be binding on all parties and legally enforceable in all relevant

jurisdictions. Legal opinion on enforceability should be obtained and

updated.

Legal mechanism must ensure that the bank has clear rightsover the collateral and may liquidate or take legal possessionsof it in the event of default, insolvency, or bankruptcy of thecounter party.

Banks must take all steps necessary to fulfill local requirementsfor obtaining and maintaining an enforceable security interest.

l


44/107

Basel II - Pillar 1 Capital Charge for Credit Risk

Standardized Approach - Risk Mitigation

Eligible Collaterals1. Cash/ Cash Equivalent

2. Debt Securities (Rated)

3. Debt securities (Unrated) subject to following conditions:

Issued by a bank; and Listed on a recognized exchange; and

Qualify as senior debt; and

All other rated issues by the issuing bank are rated at least BBB- or A3/ P3; and

The lending bank has no information to suggest that the issue justifies a rating below BBB- or A3/ P3;and

4. Equities included in a main index

5. Listed Undertakings in Collective Investments in Transferable Securities (UCITS)/Mutual funds

Additionally in Comprehensive approach followings are also recognized

Equity not included in a main index, but listed on a recognized exchange

UCITS/ mutual funds which include such equities

B l II


45/107


1. Simple approach: Same as in Basel I, However allows only liquid collaterals eligible.

It follows a substitution mechanism whereby the value of eligible collateral isdeducted from exposure amount and risk weight is to be calculated on

residual amount developed for banks that only engage to a limited extent in collateralized

transactions


Example loan: 100, collateral: 80 bonds,

risk weight of borrower: 100%

risk weight of bond: 50% (A rated)

risk weighted assets of covered portion: 80 x 50% = 40

risk weighted assets of uncovered portion: 20 x 100% = 20

total risk weighted assets: 40 + 20= 60

B l II


46/107



2. Comprehensive Approach:focuses on the cash value of the collateral taking into accountprice volatility

The exposure amount after risk mitigation is calculated as follows,

Using standard supervisory or own estimates haircutsE* = max {0, [E x (1 + He)C x (1HcHfx)]}where:E* = the exposure value after risk mitigation

E = current value of the exposureHe = haircut appropriate to the exposureC = the current value of the collateral receivedHc = haircut appropriate to the collateralHfx = haircut for currency mismatch


47/107

47

HaircutsWill depend on type of exposure/ collateral,rating,remaining maturity, and frequency of mark- to- marketand re-margining

1. Standard supervisory haircuts

Fixed by Basel Committee2. Own- estimate haircuts Based on banks internal estimates of market price and FX

volatilities Permission will be conditional on the satisfaction of minimum

qualitative and quantitative standards.

Comprehensive Approach

B l II


48/107




49/107

49

Type Minimum HoldingPeriod

Condition

Repo StyleTransactions

5 days Daily

remargining

Other CapitalMarket Transactions

10 days Daily

remargining

Secured Lending 20 days Daily

RevaluationH = HM

TM

NR + (TM-1)


Hm = haircut for the min holding period

Nr = no of days between remargining

Tm = min holding period for the type of transaction


50/107

50

Collateral only recognized if original maturity more than a

year and residual maturity of more than 3 months.

Maturity mismatch not allowed in simple approach

When there is a maturity mismatch following adjustment is

required in collateral value:

Pa = P x (t-0.25)/(T-0.25)

Where Pa = value of collateral after maturity mismatch adjustment

P = value of collateral

t= min( T, residual maturity of collateral in years)

T = min (5, residual maturity of exposures in years)

Maturity Mismatch


51/107

51

Currency MismatchWhere the credit protection is denominated in a currency

different from that in which the exposure is denominated i.e.

there is a currency mismatch the amount of the exposure

deemed to be protected will be reduced by the application of a

haircutHFX, i.e.


52/107

52

2. Own- estimate haircuts (Continued)

Quantitative Criteria

99 th percentile one- tailed confidence interval is to be used

The minimum holding period will depend on the type oftransaction and the frequency of remargining or MTM

Banks must take into account the illiquidity of lower- quality assetsby adjusting holding period upwards and should identify wherehistorical data may understate potential volatility.

The choice of historical observation period for calculating haircuts

shall be a minimum of one year. Banks should update their data sets at least once every 3 months

and reassess them whenever market prices are subject tomaterial changes.



53/107

53

2. Own- estimate haircuts (Continued)

Qualitative Criteria

The estimated volatility data (and holding period) must be usedon the day- to- day risk management process of the bank.

Banks should have robust processes in place for ensuringcompliance with internal policies, controls and proceduresconcerning the operation of risk measurement system.

The risk management system should be used in conjunction withinternal exposure limits.

An independent review of the risk management system shouldbe carried out regularly at the banks own internal auditing

process (ideallyat least once a year).


Basel II Overall framework


54/107




Pillar 3: Market

Discipline


Review Process

Pillar 1: Minimum

Capital Requirement



Internal

Rating Based Approach

(IRB)

Basic Indicator

Approach

Standardized

ApproachAMA

Standardized

Approach

Internal Model

Based Approach

Supplementary

Capital

Core Capital

tandardized

Approach

I t l R ti B d A h

B i C t


55/107

Internal Rating Based ApproachBasic Concept


Credit rating is a symbolic representation of the risk

profile of an obligor or an exposure

Moodys DR S&P DR

Aaa 0% AAA 0%

Aa .01% AA .01%

A .02% A .06%

Baa .11% BBB .23%

Ba .6% BB 1%

Caa 2.73% B 4.57%

Ca-c 10.50% CCC 25.59%

Probability of Default (PD)

Loss Given Default (LGD)

Exposure at Default (EAD)

I t l R ti B d A h

B i C t


56/107



Expected

Loss (EL)

Unexpected

Loss at 99%(UL)

Unexpected loss

beyond 99%

Probability

Amount

EL = PD x LGD x EAD

I t l R ti B d A h

B i C t


57/107



Borrower default if the value of its assetsfalls below its obligation or a default

threshold

There relationship between distance todefault and PD can be described by

normal distribution function.

1 Yr

Distribution of

asset value at

horizon

Asset

Value

Today

EDF

Time

Value

Default PointDistance-to-Default =3 Standard deviations

Asset Volatility

(1 Std Dev)

B l II


58/107



Internal Rating Based Approach

The capital requirement is calculated on the basis of risk assessed by the bankitself

The risk Assessment is based on internal risk rating of exposures which are used to

calculate following inputs parameters called risk components

Borrower risk: Probability of default (PD)

Transaction risk: Loss given default (LGD)

Exposure: Exposure at default (EAD)

I t l R ti B d A h

B i C t


59/107



The appropriate default threshold for average conditions is determined byapplying the inverse normal distribution function to the average PD

Further , the required appropriately conservative value of the systematic riskfactor can be derived by applying the inverse of the normal distribution function to

the predetermined supervisory confidence level.

A correlation-weighted sum of the default threshold and the conservative value ofthe systematic factor yields a conditional (or downturn) default threshold.

In a second step, the conditional default threshold is used as an input into theoriginal Merton model and is put forward in order to derive a conditional PD.

Mechanics of the IRB approach


60/107



Calculation of Provisions

maximum of 1.25% of total Risk Weighted Assets.

Total Provisions = specific + general provisionprovision (equity)

Expected loss to be calculated for

1. assets subject to IRB Approach

2. Equity Exposure subject to PD LGD Approach

3. Equities subject to PD/LGD Approach

4. Specialized lending using supervisory slotting criteria for IRB

5. HVCRE

Expected Loss = PD x LGD x EAD



61/107



Expected lossall provisions

If there is surplus, it can be part of tier 2 subject to a maxof 0.6% of RWA

If there is a deficit it will deducted 50% from tier 1 and50% from tier 2

EL for equity exposures to be deducted 50% from tier 1and 50% from tier 2

Partial Adoption of IRB: provisions should be calculatedon pro rata basis



62/107



Categorization of exposures

Corporate

Sovereign

Bank

Retail

Equity.

1. Project Finance2. Object Finance

3. Commodities Finance4. Income Producing Real Estate

5. High Volatile Commercial Real

Estate

1. Residential Mortgage

2. Qualifying Retail Exposure3. Other Retails

Mechanics of the IRB approach Types


63/107

Mechanics of the IRB approach- Types


1. Foundation IRBbanks provide their own estimates of PD and rely on

supervisory estimates for other risk components.

2. Advanced IRBbanks provide more of their own estimates of PD, LGD

and EAD, and their own calculation of M, subject to

meeting minimum standards.

For both the foundation and advanced approaches,

banks must always use the risk-weight functions



64/107



Adoption of the IRB approach across asset classes1. Once a bank adopts an IRB approach for part of its holdings

2. supervisors may allow banks to adopt a phased rollout of the IRB

approach across the banking group. The phased rollout includes

a. adoption of IRB across asset classes within the samebusiness unit (or in the case of retail exposures across

individual sub-classes)

b. adoption of IRB across business units in the samebanking group and

c. move from the foundation approach to the advanced

approach for certain risk components.

Rules for corporate sovereign and bank exposures


65/107

Rules for corporate, sovereign, and bank exposures


Formula for derivation of risk-weighted assets

Firm-size adjustment for small- and medium-sized entities (SME)

Rules for Assets subject to double Default


66/107

Rules for Assets subject to double Default


Formula for derivation of risk-weighted assets

Specialized Lending


67/107

Specialized Lending


Mapping of Supervisory categories with ECAIs

50% 70%

70% 95%

Rules for Equity Exposures


68/107

Rules for Equity Exposures


1. Market-based approach

Simple risk weight method

Internal models method

2. PD/LGD approach

Similar to risk weight calculation for corporate subject following

conditions

LGD floor is kept at 90%

For long term equity holdings the risk weight floor will be100%

For short term holding the same floor is 200% for publically

traded and 300% for non traded equity holdings.

300% 400%

200% 300%

Rules for Retail Exposures


69/107

Rules for Retail Exposures


Residential mortgage exposures

Qualifying revolving retail exposures

Other retail exposures

IRB approach- Risk Components Revisited


70/107



1. Probability of Default (PD)Measured in percentage over a time horizon of 1 year

a. Actual Default Observed

b. Mapping with the ECAIs

c. Statistical Model



71/107



2. Loss Given DefaultThe percentage of exposure that bank will loose in case of default.

Sub-ordinate 75%

Unsecured = 45%

In addition to comprehensive approach following collaterals are also eligible

3. Exposure at Default



72/107



Loan in cash of 1000, with a remaining maturity of 5 years, to a corporate with an

internal grade of 3 (pd .05). The loan is secured by debt securities issued by a bank with

an external rating of AA. The debt securities have a remaining maturity of 7 years and amarket value of USD 500. Additional collateral, in the form of commercial real estate,

with a market value of 500 and a mortgage lending value of 300 secures the loan.

IRB Approach Minimum Requirement


73/107



Rating system designThe term ratingsystem comprises all of the methods, processes,

controls, and data collection and IT systems that support the

assessment of credit risk, the assignment of internal risk ratings, and

the quantification of default and loss estimates

Perceived and measured risk must increase as credit quality

declines from one grade to the next

A bank must define risk of each grade and the criteria used todistinguish that level of credit risk



74/107



Rating dimensions-corporate, sovereign and bank exposuresA qualifying IRB rating system must have two separate and distinct dimensions:

the risk of borrower default

transaction-specific factors.

foundation IRB banks, this requirement can be fulfilled by the

existence of a facility dimension, which reflects both borrower and

transaction-specific factors. Where a rating dimension reflects ELand does not separately quantify LGD, the supervisory estimates of

LGD must be used.



75/107



Rating dimensions-Retail exposures

1. must be oriented to both borrower and transaction risk2. Banks must assign each retail exposure for IRB purposes into a particular

pool. Each pool gives a meaningful differentiation of risk

3. For each pool, banks must estimate PD, LGD, and EAD.

4. Multiple pools may share identical PD, LGD and EAD estimates.

5. At a minimum, banks should consider the following risk drivers whenassigning exposures to a pool:

Borrower risk characteristics (e.g. borrower type, demographics such as

age/occupation);

Transaction risk characteristics, including product and/or collateraltypes (e.g. Loan to value measures, seasoning, guarantees; and seniority

(first vs. second lien)).

Delinquency of exposure: Banks are expected to separately identify

exposures that are delinquent and those that are not.



76/107



Rating structure

1. Standards for corporate, sovereign, and bank exposuresA bank must have a meaningful distribution of exposures across grades with no

excessive concentrations, on both its borrower-rating and its facility-rating

scales.

must have a minimum of seven borrower grades for non-defaulted

borrowers and one for those that have defaulted.

Banks using the supervisory slotting criteria for the SL asset classes must

have at least four grades for non-defaulted borrowers, and one for

defaulted borrowers.

There is no specific minimum number of facility grades

2. Standards for Retail exposures

For each pool identified, the bank must be able to provide quantitative measures of

loss characteristics (PD, LGD, and EAD) for that pool.



77/107



Rating assignment horizon

Although the time horizon used in PD estimation is one year,banks are expected to use a longer time horizon in assigning

ratings.

rating must represent the borrowers ability and willingness to

contractually perform despite adverse economic conditions or the

occurrence of unexpected events.

Use of models The burden is on the bank to satisfy that a model or procedure has good predictive

power

The bank must have in place a process for vetting data the judgment must take into account all relevant and material information not

considered by the mode

The bank must have procedures for human review of model-based rating

assignments.

The bank must have a regular cycle of model validation



78/107



Documentation of rating system design

Banks must document in writing their rating systems design andoperational details

If statistical models are used, the bank must document their

methodologies

outline of the theory, assumptions and/or mathematical and

empirical basis of the assignment of estimates of

Establish a rigorous statistical process

Indicate any circumstances under which the model does not

work

Use of a model obtained from a third-party vendor that claimsproprietary technology is not a justification for exemption

from documentation



79/107



Risk rating system operations

Coverage of ratings

Integrity of rating process

Overrides

Data maintenance

Stress tests used in assessment of capital adequacy

Corporate governance and oversight

Use of internal ratings

Risk quantification



80/107

Basel II Pillar 1 Capital Charge for Credit Risk


Internal Rating Based Approach

Basel II prescribes a risk weight function which gives capital requirement & RWAusing the risk components

Example: Risk Weight Function & other formulas for Corporate Sovereign and BankExposures

Correlation (R) = 0.12 x (1-exp(-50xPD))/(1-exp(-50))+0.24 x [1-(1-exp(-

50xPD)/(1-exp(-50))]Capital Requirement (K) = LGD x N[(1-R)^-0.05 x G(PD) + (R/(1-R)^0.5 x G(0.999)]PD x

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

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

Similar formulas with slight modifications are for other exposure types (Retail, SMEs etc) The difference between FIRB & AIRB is the calculation of Risk Components PD, LGD

Foundation IRB Only PD to be calculated by bank Risk components LGD & EAD

Advanced IRB All Risk components to be calculated by bank itself


81/107


Capital Charge For Market Risk



82/107



Pillar 3: Market

Discipline


Review Process

Pillar 1: Minimum

Capital Requirement



Internal

Rating Based Approach

(IRB)

Basic Indicator

Approach

Standardized

ApproachAMA

Standardized

Approach

Internal Model

Based Approach

Supplementary

Capital

Core Capital

tandardized

Approach

Capital Charge For Market Risk


83/107


p g

Definition:

Market risk is the risk of loss in on and off-balance

sheet positions due to adverse movement of market

factors. Consequently it encompass;

Interest rate risk

Equity Price Risk

Foreign Exchange risk &

Commodity price risk.

Capital Required = Sum of Capital Charge for all these 4 Risk sub categories

Tier 3 Capital


84/107

p


Short term subordinated debt with a minimum

maturity of 2 years is allowed to be tier 3 capital.

It shall be exclusively for market risk

Shall be limited to 250% of tier 1 that is availableto support market risk i.e. at least 28.5% of capitalrequirement against Market Risk has to be metfrom tier 1.

Tier 2 elements may be substituted for tier 3provided tier 3 capital will be limited to 250% oftier 1 that is required to support market risk.

Calculation of CAR (Cont..)


85/107


The first step is to calculate risk weighted assets (for credit risk)

Then,

The second step is to calculate risk weighted assets subject to market risk capitalcharge. The methodology provides calculation of market risk capital chargedirectly. So in order to ensure consistency assuming this capital charge is 8% ofrisk weighted assets, it is multiplied by 12.5 to obtain risk weighted assets for

market risk. Then overall CAR is,CAR ( credit risk) =

Tier 1 + Tier 2

Risk weighted assets

CAR ( overall ) =

Tier 1 + Tier 2 + Tier 3

RWA( credit) + RWA( Market)

Min 28.5% of

Capital chargeFor market risk

To be covered

By tier 2

>250% of tier 1

i.e. 72% of

Capital charge

For market risk

Charge.

two broad methodologies for calculation of risk charge


86/107


1. Standardized Approach.

2. Internal Model Based Approach

Banks are allowed to adopt any of the two methodologies subject

to approval of national supervisory authority. However the laterrequire certain preconditions such as bank have proper riskmanagement framework, models being used to measure risk haveproven track record and bank regularly conducts stress tests etc.


87/107


The capital requirement against interest rate risk apply

only on trading book positions

The minimum capital for IRR is sum of two separately

calculated charges i.e.

Specific Risk. Apply to each security position whether it is

short or long (basically to cover credit risk)

General Market risk. It is the capital requirement onportfolio basis, where long and short positions can be

offset subject to certain conditions

Capital charge for IRR - Specific Risk


88/107


Government

qualifying

other

0.00%

0.25% (residual term to finalmaturity 6 months or less)

1.00% (residual term to finalmaturity between 6 and 24months)

1.60% (residual term to finalmaturity exceeding 24 months)

8.00%.

The specific risk charge is graduated in five broadcategories as follows:

Capital charge for IRR general Market Risk


89/107


p g g

All debt securities and other sources of interest rateexposures including derivatives are slotted into amaturity ladder comprising of thirteen time bands

The general market risk is the sum of

a. A small portion of matched position in each time band(vertical disallowance)

b. A larger portion of the matched position across differenttime bands (horizontal disallowance)

c. The net short or long position in the whole trading book

Capital charge for IRR general Market Risk


90/107


Before calculating net positions within timebands or across time bands all long and shortpositions are multiplied with certain sensitivityweights. There are two methodologies to do so

1.Maturity method, wherein these sensitivitynumbers are predefined

2.Duration method wherein these sensitivityweights are duration of the asset calculated onthe bases of assumed change in yield prescribedby Basel I.

Maturity method


91/107


y

Coupon 3% or more Coupon less than 3% Weights %

1 month or less 1 month or less 0

1 to 3 months 1 to 3 months 0.2



1 to 2 years 1 to 2 years 1.25

2 to 3 years 2 years2 to 3 years 1.75





Duration Method


92/107


Example IRR-General market Risk


93/107


Example IRR General market Risk

Suppose a bank has following positions in its trading portfolio;

A 4% government bond having market value 15 million and residual maturityof 6 months.

A 3% qualifying bond having market value 12 million, residual maturity 2months.

An interest rate swap, Rs 150 million, bank receives floating rate interest andpays fixed next fixing after 9 months, residual life of swap 8 years.

An interest rate swap with face value Rs 30 million and residual maturity 2.5years. Bank receives fixed at 7% and pays floating rate of 5.5%. Next repricing

after 4 months.

A nine versus fifteen, Forward Rate Agreement sold on 6 months KIBOR withnominal amount Rs 20 million and settlement date after nine months.

Example (Cont..)Zone 1 Zone 2 Zone 3


94/107

Time

Band0-1 1-3 3-6 6-12 1-2 2-3 3-4 4-5 5-7 7-10 10-15 15-20 Over 20

Position +12 -30 +150 +20 +30 +15 -150

-20

Weights

%0 0.2 0.4 0.7 1.25 1.75 2.25 2.75 3.25 3.75 4.5 5.25 6

Weighted

positions

0.024 -0.12 1.05

-0.14

0.25 0.525 0.488 -5.625

Vertical

Disallowance

0.14 x

10%=0.014

Position

AfterV D0.024 -0.12 0.91 0.25 0.525 0.488 -5.625

H.D 1 = 0.12 x 40% = 0.048 0.488 X 40% = 0.195

position 0.814 0.775 -5.137

H D 2 0.814 = 0.775 x 40% = 0.31 Remaining Position = - 4.362

H D 3 0.814 X 100% = 0.814 Remaining position = - 3.548

Capital Required = V. D +H. D + overall open position

Capital Charge for Equity Price risk


95/107


The instruments covered include common stocks,

convertible securities that behave like equities, andcommitments to buy or sell equity securities. The Capitalrequirement is sum of

1.specific risk capital charge that is against individual stock/security

(netting not allowed) which will be 4%2.General market risk is calculated on portfolio basis i.e. net positionin a market which shall be 8%

Both calculated on market value of positions. Further theAsset subject to this capital requirement shall be given 0%Risk weight while calculating credit risk capital charge.

Capital charge for Foreign Exchange Risk.


96/107


Capital charge for Foreign Exchange Risk.

The capital charge for foreign exchange risk apply to FCYexposures throughout banks balance sheet.

It is simply 8% of the overall net open position of the bank

The calculation of open position is the same as prescribed inF.E manual.

Howevera.Banks that have foreign currency business, defined as the greater of thesum of its gross long positions and the sum of its gross short positions inall foreign currencies, does not exceed 100% of eligible capital andb. their overall net open position does not exceed 2% of eligible capital

are exempted from holding capital against F.E risk.

Internal Model Based Approach.


97/107


1

2

- 1

- 2

Time (days)

Suppose portfolio of a single asset. The price volatility of asset over past hundred days

is as plotted below.

Internal Model Based Approach


98/107


If Assets Value is 60 million and 5% of times the

return are below 3% ThanOne day VaR at 95% confidence level

= 60 x 3% = 1.8 m

- 4 - 3 - 2 - 1 0 1 2 3 4

No

of

Occurrences

Daily Return

5% of area



99/107


Banks that are allowed by their supervisory agency touse internal models to calculate capital requirementshould hold capital

Equivalent to previous day var amount or

Average of past 60 days var multiplied by aconstant factor (minimum 3) whichever is higher.

VaR is required to be calculate at 99% confidencelevel at 10 day time horizon.



100/107


Quantitative Standards

VaR is computed on daily basis

Confidence interval 99%,

Bank can use any model

Stress testing

External validation



101/107


1. Qualitative standards e.g Board and senior management oversight

Independent risk control unit

Routine and rigorous stress testing

Independent review of the risk measurement

system

Basel II - Pillar 1 Capital Charge for Operational Risk


102/107


Defined as risk of loss from inadequate or failed internal processes, people andsystems, or from external events

Examples of risks covered

Internal and external fraud

Legal risks

Damages to customers

Losses arising out of labour, health and safety, diversity, personal injury, etc.

Damage to physical assets

Business interruption

Examples of risks not covered

Reputational risk

Strategic errors

Basel II - Pillar 1 Capital Charge for Operational Risk


103/107


Basic Indicator Approach

15% ofbanks average annual gross income over previous three years

Standardised Approach

Capital charge for each of 8 business lines calculated against average annual gross income for

business line times:

18% for corporate finance

18% for trading and sales

12% for retail banking

15% for commercial banking

18% for payment and settlement

15% for agency services

12% for asset management

12% for retail brokerage

Advanced Measurement Approach

Calculated on basis of internal operational risk management system approved by national

regulator

Basel IIPillar II Supervisory Review Process


104/107


Four key principles of supervisory review

Principle 1: Banks should have process for assessing overall capital adequacy in relation to riskprofile and strategy for maintaining capital levels. Five main features of rigorous process:

Board and senior management oversight

Sound capital assessment

Comprehensive risk analysis (credit risk, operational risk, market risk, interest rate risk in

banking book, liquidity risk, other risk)

Monitoring and reporting

Internal control review

Principle 2: Supervisors should review and evaluate banks internal capital adequacy assessments

and strategies, as well as ability to monitor and ensure compliance with ratios. Supervisors should

take appropriate action if not satisfied.

Principle 3: Supervisors should expect banks to operate above minimum ratios and should have

ability to require banks to hold capital in excess of minimum

Principle 4: Supervisors should seek to intervene at early stage and require rapid remedial action

Basel IIPillar II Supervisory Review Process


105/107


Specific issues Interest rate risk in banking book: Basel II treats interest rate risk under Second Pillar of

supervisory review (rather than First Pillar of regulatory capital) due to differences in methods

banks use to handle risk

Credit risk: Supervisory review is appropriate to regulate stress tests under IRB approach,

definition of default used to determine PD and/or LGD and EAD, residual risk, credit

concentration risk and operational risk

Other issues Supervisory transparency and accountability: Supervisors should make publicly

available criteria used in review ofbanks internal capital assessments

Enhanced cross-border communication and cooperation: Basel Committee supportspragmatic provision of close and continuous dialogue between industry participants

and supervisors, as well as between supervisors (without changing legal

responsibilities of national regulators).

Basel IIPillar III Market Discipline


106/107


Impose market discipline on banks by requiring disclosure of key information relevant to

banks risks and capital

Why Enhanced Disclosure? Complements regulatory capital requirements and the supervisory review

process

Reliable and timely information allowing well founded counterparty riskassessments

Provides banks with an incentives to maintain a strong capital base

Enhance role of market participants in encouraging banks to hold adequate

levels of capital

General Disclosure PrincipleBanks should have a formal disclosure policy approved by the board of directors . In

addition , banks should implement a process for assessing the appropriateness of their

disclosures , including validation and frequency of them.

Basel II - Overview


107/107

Disclosure Requirements

Attached to the use of a particular methodology or instrument

Pre-condition for the use of some methodologies

Internal ratings-based approach

Asset securitization

Recognition of external credit assessment institutions

Types of Disclosures Qualitative

Quantitative

Documents

Basel II -A