a study on basel ii framework

8/8/2019 A Study on Basel II Framework

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study on Basel IIFramework


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Contents


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Basel II - Introduction

Basel II is the second of the Basel Accords issued bythe Basel Committee on Banking Supervision

(BCBS).

Objective: Ensuring that capital allocation is more risk sensitive;

Separating operational risk from credit risk, and

quantifying both;

Attempting to align economic and regulatory capital

more closely

In India, implemented w.e.f. March 31, 2009


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Comparison with Basel-I

Basel I Basel IIFocused on Single riskMeasure

More emphasis on banks own internal riskmanagement methodologies, supervisoryreview and market discipline

Broad Brush structure More risk sensitive; Menu of approaches;Capital incentive for better riskmanagement; Granularity in the RW of assets


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Scope

Applicable to all Commercial Banks

Except Local Area Banks and RRBs

Applicable at both solo & consolidated level

Consolidated bank include all group entities

except :

Insurance

Business not pertaining to financial services


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Based on Three Pillars


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PILLAR - 1PILLAR - 1MINIMUM CAPITAL REQUIREMENTMINIMUM CAPITAL REQUIREMENT


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Pillar - 1


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Timelines

All banks (except Local Area Banks & RRB) to migrate tothe approaches prescribed by March 31, 2009.

Time schedule for the advanced approaches


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CRAR

Total CRAR =Eligible total capital fundsCredit Risk RWA + Market Risk RWA +

Operational Risk RWAMinimum 9% Tier 1 CRAR =

Eligible total capital fundsCredit Risk RWA + Market Risk RWA +Operational Risk RWA

Minimum 6%


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Elements of Tier I Capital

Paid-up equity capital, statutory reserves, andother disclosed free reserves

Capital reserves representing surplus arising out

of sale proceeds of assets Innovative perpetual debt instruments (IPDI)

Limited to 15% of total Tier I Capital

Perpetual Non-Cumulative Pref. Shares (PNCPS) Limited to 40% of total Tier I capital along with

innovative instruments


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Elements of Tier II Capital

Revaluation Reserves (at a discount of 55%) General Provisions & Loss Reserves Hybrid Debt Capital Instruments

Subordinated Debt Subjected to progressive discount as per their

maturity Limited to 50% of Tier I Capital

IPDI & PNCPS in excess of limit under Tier I

Tier II capital shall not exceed Tier I capital


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Capital Funds Deductions

Intangible assets & losses from Tier I Capital DTA:

Associated with accumulated losses

Balance DTA net of DTL If DTL > DTA, it cannot be adjusted/ added

Gain on sale arising due to securitization of standard assets, if recognized (from Tier I)

Securitization exposures, if unrated or rated B & below 50% from Tier I and 50% from Tier II


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Investment in financial entities (FE)

Consolidated Not -Consolidated

tain CRAR at consolidated levelInvt. > 30% of the paid up equityInvt.


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PILLAR - 1PILLAR - 1MINIMUM CAPITAL REQUIREMENTMINIMUM CAPITAL REQUIREMENTCREDIT RISK

OPERATIONAL RISK

MARKET RISK


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Credit Risk Approaches

Banks in India currently follow standardized approach

StandardizedApproach

StandardizedApproach

Foundation InternalRatings

Based Approach

Foundation InternalRatings

Based Approach

Advanced InternalRatings Based

Approach

Advanced InternalRatings Based

ApproachI N

C RE A

S E

D S OP HI S T I C AT I ON

R E D U C E D C A P I T A L R E Q U I R E M E N T

Risk weights are based onassessment by external creditrating agencies

Banks use internalestimations of probability of default (PD) to calculate riskweights for exposure classes.Other risk components arestandardized.

Banks use internalestimations of PD, lossgiven default (LGD)and exposure atdefault (EAD) tocalculate risk weightsfor exposure classes

PILLAR 1 FOR CREDIT RISK


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Risk Weights

Domestic Sovereigns - zero risk weight

Foreign Sovereigns - Risk weights as per the

rating

Exposures to Domestic Corporates/ Domestic

PSEs/ Primary Dealers

RW as per rating

Only solicited ratings can be used

Foreign Corporates / PSEs will be risk weighed as

per foreign ratings


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Provisions related to NBFC

Capital requirement against exposure to AFCs /

IFCs will depend on risk rating

Incentive for higher credit ratings

In case of AFCs, claims that attract RW of 150%

as per rating will be risk weighed at 100% only

Claims on other NBFC-ND-SI to be uniformly risk

weighed at 100%


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Risk Weights

Retail - Risk weight of 75%, in case:

Total customer exposure is


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Risk Weights Real Estate


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Risk Weights

Venture Capital Funds RW of 150% Invt. in equity of non-financial entities:

RW of 125%

Consumer credit (excl. Education loan) &

Capital market exposure RW of 125% or higher

Provide capital against all securitizationexposure As per risk rating of the issue


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Risk Weights for NPAs

The unsecured portion of NPA, net of specificprovisions will be risk-weighted as follows:

For the purpose of calculating secured portion, eligible

collateral will be the same as recognized for credit

risk mitigation purpose

Specific provisions RW Res.

Property

RW-Others

< 20% of the o/s amt. of the NPA

100% 150%> = 20% of the o/s amt. of the NPA

75% 100%> = 50% of the o/s amt. of the NPA

50% 50%


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Off-balance sheet items

Market related Non-market relatedIncludes interest ratecontracts & foreignexchange contracts

Credit equivalentamountis determinedusing current exposuremethod

Current exposureincludes:1) Current credit exposure MTM value of thecontract2) Future credit exposure

Includes direct creditsubstitutes, trade & performance related

contingent items,commitments withcertain drawdown, etc.Amount needs to be

multiplied with CreditConversion Factor (CCF)


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Credit Risk Mitigation

Allowed mitigants: Eligible financial securities & guarantees

Eligible financial securities:

Cash, fixed deposits, KVP/NSC, gold, central/stategovt. securities, Life Insurance policies (at surrender

value), debt instruments rated BBB- or better, units

of MF

Banks must conduct a sufficient legal review

Credit quality & collateral should not be positively

correlated


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Haircuts

Adjustments made for market movements:

For Exposure Works as a Premium factor

For Collateral Works as a Discount factor

Additional haircut, if exposure & collateral are

held in different currencies

Banks in India to use standard supervisory

haircuts set by Basel committee


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Credit Risk Mitigation - Guarantees

Only direct, unconditional, irrevocable and explicitguarantees are eligible

Protected portion of the counterparty exposure is

assigned RW of the guarantor Guarantor TreatmentCentral Govt. RW 0%State Govt. RW 20%

Corporate (only if minimum rating of AA)

RW as applicableto guarantor

PersonalGuarantees

Not eligible


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Maturity Mismatch

Occurs if residual maturity of collateral is less thanthat of underlying exposure

CRM not recognized, if maturity mismatch and: CRM has original maturity of < 1 year CRM has residual maturity of < = 3 months

In other cases, partial recognition as follows: Pa = P X (t-0.25) (T-0.25)

Where, Pa = Adjusted Credit protectionP = Credit protection

t = min (T, residual maturity of protection)

T = min (5, residual maturity of exposure)


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Calculation of Capital requirement

E* = max {0, [E x (1 + H e ) - C x (1 - H c - H fx )]}where:

E* = the exposure value after risk mitigation

E = current value of the exposure

He = haircut appropriate to the exposure

C = the current value of the collateral received

Hc = haircut appropriate to the collateral

Hfx = haircut appropriate for currency mismatch between the collateral and

exposure

Risk weighted asset (RWA) = E* x RW

Minimum Capital = RWA x 9%


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Internal Ratings based (IRB) approach

Banks rely on their own internal estimates of riskcomponents

Approach based on measure of expected losses(EL) & unexpected losses (UL)

The capital base is required to absorb the UL, asand when they arise.

Factors affecting credit risk:

Exposure at default (EAD) Probability of default (PD) Loss given default (LGD) Effective Maturity (M)


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IRB Approach

Categorise banking-book exposures into broad classes of assets with different underlying risk characteristics

Key elements Risk components

Risk weight functions Minimum requirement

Foundation approach Banks provide their own estimate of PD

Rely on supervisory estimates for other risk components Advanced approaches

Banks provide more of their own estimates of PD, LGD andEAD


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PILLAR - 1PILLAR - 1

MINIMUM CAPITAL REQUIREMENTMINIMUM CAPITAL REQUIREMENTCREDIT RISK

OPERATIONAL RISK

MARKET RISK


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Operational risk

Risk of loss resulting from inadequate or failed internalprocesses, people and systems or from external events

Banks in India to begin with Basic Indicator approachKBIA = [ (GI 1n x )]/n

Where:

KBIA = the capital charge under the Basic Indicator Approach

GI = annual gross income, where positive, over the previous

three yearsn = number of the previous three years for which gross

income is positive

= 15 per cent, which is set by the BCBS


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Operational Risk Other Approaches

The Standardised Approach: Banks activities are divided into 8 business lines

Capital charge is calculated separately for each business line

using separate factors

Advanced Measurement Approach:

Banks are allowed to develop their own empirical model to

quantify required capital for operational risk

Use of statistical methods like VaR, Monte Carlo, etc.


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PILLAR - 1PILLAR - 1

MINIMUM CAPITAL REQUIREMENTMINIMUM CAPITAL REQUIREMENTCREDIT RISK

OPERATIONAL RISK

MARKET RISK


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Market Risk

Risk of losses due to market price movements

ted instruments & equities in the trading book Foreign Exchange risk Trading & Bankin

Specific Risk General Market Risk

ments - defined as % of exposure based on issuer & maturityts 9% capital charge

Standardised method Internal models metho

Maturity method Duration method


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General Market Risk Standardised method


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General Market Risk Internal Models Method

Qualitative Criteria: Independent Risk Control Unit responsible for design and

implementation of Banks risk management systems

Regular Back-Testing

Initial and on-going Validation of Internal Model

Model must be integrated into Management decisions

To be used in conjunction with Trading and Exposure Limits.

Stress Testing

Well documented

Independent review by internal audit

Board and senior management should be actively involved


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General Market Risk Internal Models Method

Quantitative Criteria: Banks can use their own VaR models as basis for capital

requirement for Market Risk

VaR computation be based on following inputs : Holding period of 10 Trading days

99% confidence level

Observation period at least 1 year historical data

Recognise correlation within Categories as well as across

categories

General Market Risk charge shall be Higher of previous

days VaR or Avg VaR over last 60 business days X

Multiplier factor K (absolute floor of 3)


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PILLAR - 2PILLAR - 2SUPERVISORY REVIEW OF CAPITAL ADEQUACYSUPERVISORY REVIEW OF CAPITAL ADEQUACYINTERNAL CAPITAL ADEQUACY ASSESSMENT PROCESS (ICAAP)


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Supervisory Review & Evaluation Process

Objective Ensure that banks have adequate capital to support all

the risks Develop and use better risk management techniques

Main aspects: Risks that are not fully captured under Pillar I Risks that are not taken into account by Pillar I Factors external to the bank

Risks not covered by Pillar-I Residual risk, concentration risk, liquidity risk,

reputation risk, strategic risk, interest rate risk in thebanking book


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ICAAP Principles

Every bank must have a process for assessing its capitaladequacy relative to its risk profile

Should comprise a complete process with proper oversightand controls

Decisions regarding the design and operation of the ICAAPshould reflect sound risk management

The institutions capital policy should be fully documented,and the management body should take responsibility for the

ICAAP. The ICAAP should form an integral part of the management

process and decision making culture of the institution. The ICAAP should be forward looking and reviewed regularly


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ICAAP Maturity Ladder


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ICAAP - Benefits

Provides holistic view of the underlying risks Enhances Managements ability to understand

how much capital flexibility exists

Enhances banks reputation

Builds and supports linkage between risk &

capital and ties performance to both

Move to a regime in which internal models will

be relied upon by the regulators.


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PILLAR - 3PILLAR - 3MARKET DISCIPLINEMARKET DISCIPLINE


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Guidelines for disclosures

Disclosures in line with how senior management & theBoard assess and manage the risks of the bank

To have a formal Board approved disclosure policy

Implement a process for assessing theappropriateness of the disclosures

Applies at the top consolidated level of the banking

group

Apply materiality concept in determining which

disclosures are relevant

Format prescribed by RBI


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IMPACT STUDYIMPACT STUDY


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Challenges in implementation

Advanced approaches require lot of historical data Use of sophisticated models

IT challenges

Embedding risk management practices into day today business processes

Human resources with required skill sets

Robust legal systems Capital requirement may increase


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Basel I Vs Basel II HDFC Bank


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Basel I Vs Basel II ICICI Bank


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Basel I Vs Basel II SBI Bank


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COMPARISON WITH NBFCCOMPARISON WITH NBFC


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Capital Adequacy- Banks Vs NBFC

Particulars Banks NBFCCRAR 9% 12% by Mar,

2010 15% byMar, 2011Credit Risk

mitigation

A wider range of

credit riskmitigants allowed

Limited

Capitalrequirement forOperational Risk

Applicable Not applicable

Capitalrequirement forMarket Risk

Applicable Not applicable

ICAAP Required Not required

Indicates lower capital requirement for NBFC

Indicates higher capital requirement for NBFC


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Capital Adequacy- Banks Vs NBFC

Particulars Banks NBFCRisk Weightage 1) Use of credit

ratings to defineRW

2) Retail 75%RW can be higherthan 100% inselect exposuresLoans to staff 20% / 75%Investment in nonFE RW of 125%

1) RW defined asper asset classes2) Mostly 100%

for all assetclassesLoans to staff 0%


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THANK YOU


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Risk Weights

Long termCRISIL ICRA FITCH CARE Short termCRISIL ICRA FITCH CARE Risk-weight

AAA LAAA AAA (ind) CARE AAA P1+ A1+ F1+(ind)

PR1+ 20%

AA LAA AA (ind) CARE AA P1 A1 F1(ind)

PR1 30%

A LA A(ind)

CARE A P2 A2 F2(ind)

PR2 50%

BBB LBBB BBB(ind) CAREBBB P3 A3 F3(ind) PR3 100%

BB+/ LBB+/ BB+(ind)/ CARE BB+ or below, including D P4/ P5/ A4/ A5/ F4(ind)/ F5(ind)/ PR4/ PR5 150%

Unrated 100%

For unrated, risk weight can be higher than 100% if warranted


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Securitisation Exposure

Risk weight mapping to Long-Term Ratings

Commercial Real Estate Securitization Exposure Risk

weight mapping to Long Term Ratings

* Deduction 50% each from Tier I & Tier II


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Calculation of capital requirement

Details of a corporate borrower rated by External Ratingagency as A

Nature Out standing

Cash Credit 600

Term Loan 500LC 200

Collateral SeNature


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Calculation of capital requirement

Adjustment for the collateral valueFacility Amt. CCF

Haircut

ConvertedExposure

CollateralType Amt.

Haircut

Adj.value of collateral

Netexposure

1 2 3 4 5=(2*3)+4 6 7 8 9=7-(8*7)

5-9

CC 600 NA NA 600 FDR 50 NA 50 55

TL 500 NA NA 500 AA ratedbond

300 8% 276 22

LC 200 100% NA 200 20

Total 1300 350 326 97

Amt. O/s aft


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General Market Risk Standardized Approach

Duration method Time Bands & Assumed changes in yield


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Horizontal Disallowances


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a study on basel ii framework

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