basel slides

7/29/2019 Basel Slides

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Bank Capital Requirements

The Basel Rules

Basel I: 1988Basel II: 2002

Basel II: 2010


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Overall Basel Framework

Pillar 1: Minimum capital requirements Credit risk:

Standardized approach Relies on bond rating agencies

Internal ratings-based (IRB) approach

Allows bank estimates of probability of default and loss givendefault

Securitization framework

Operational risk

Market risk

Pillar 2: Supervisory review process

Pillar 3: Market discipline


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Minimum Capital

Requirements

Equity protects the deposit insurer:

E / A 8%

Issues: Definition / character of E

Are assets A a valid proxy for risk?


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The Basel Formula

Tier1 Capital Tier II Capital 8%12.5(Mkt.Risk Capital Op.Risk Capital) Risk W eightedAssets

Risk Weights x OnBSAssetsRisk WeightedAssets

Conv.Factor x Risk Wts x OffBSCommitments


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Constituents of Capital

Tier I Core Tier 1: Common stock and retained earnings

Less: Goodwill

Less: Deferred tax assets

Less: Investments in nonconsolidated subsidiaries

Core Tier 1 must be 4.5% of RWA

Other Tier 1: Perpetual instruments junior to subordinateddebt Total Tier 1 must be 6.0% of RWA [8.0% for large banks]

Tier II General loan loss reserves up to 1.25% RWA

Subordinated debt up to 50% of Tier I Original term 5 yrs

Amortized for remaining term < 5 yrs


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Risk-Weighted Assets

Off-balance-sheet items are given a

balance-sheet equivalent using a credit

conversion factor (CCF).

All assets and CCF equivalents are thenmultiplied by a risk weight and summed:

Face

Amount

CCF Risk

Weight

Risk

Weighted

Assets

8% Capital

Required for

Credit Risk

Home mortgage loan 1000 35% 350

3-year loan commitment 1000 50% 100% 500

2-year FX forward

contract with AA-rated

bank

1000 5% 20% 10

Total 3000 860 69


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Standardized Corporates

Rating:AAA to

AA-A+ to A-

BBB+ to

BB-

Below

BB-Unrated

Risk

weight: 20% 50% 100% 150% 100%

Basel

Capital: 1.6% 4.0% 8.0% 12.0% 8.0%


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Standardized Sovereign Risk

Rating

Agency:

AAA to

AA-

A+

to A-

BBB+ to

BBB-

BB+

to B-Below B-

Unrated

ECA

Score:1 2 3 4 to 6 7

RiskWeight:

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

Banks

Option 120% 50% 100% 100% 150% 100%

Banks

Option 220% 50% 50% 100% 150% 50%

3m w/Option 2

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


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Standardized Retail

Exposures

Risk weight = 75% provided:

Individual or small business borrower

Loans, not securities

Sufficient diversification (e.g. all < 0.2%)

Low value of exposures (e.g. all


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Credit Conversion Factors (CCFs)

for Off-Balance-Sheet Items

Direct credit substitutes CCF = 100%

NIFs, RUFs, CP backup CCF = 50%

Performance bonds, bid bonds CCF = 50%

Trade credit, CCF = 20%

Loan commitments Unconditionally cancelable, CCF = 0%

1 year, CCF = 20%

> 1 year, CCF = 50%

Securities lending or posting as collateral, CCF = 100%

Forward FX contracts 1 year, CCF = 1.0%

1-5 years, CCF = 5.0%

> 5 years, CCF = 7.5%

NB: These are CCFs from Basel I. Basel II encourages

banks to set their own CCFs here, but many continue touse Basel I.


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Forms of Credit Risk

Mitigation

Collateral Securities, receivables, inventories, real

estate

Agreement to net deposits against loanexposure

Amount of collateral < amount of loan?

Guarantees Sovereign or corporate (bank)

Credit derivatives Full term, partial term

Rating of counterparty


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Credit Risk Mitigation

E* = max{0, [E(1+He) C(1-Hc-Hfx)]}where:

E* = exposure after risk mitigation

E = current value of exposureHe = haircut appropriate to exposure

C = current value of collateral

Hc = haircut appropriate to collateralHfx = haircut appropriate to FXmismatch


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Standardized Haircuts (%)

Rating Maturity Sovereigns Others

AAA to AA- 1 year 0.5 1

AAA to AA- 1-5 years 2 4

AAA to AA- > 5 years 4 8A+ to BBB- 1 year 1 2

A+ to BBB- 1-5 years 3 6

A+ to BBB- > 5 years 6 12

BB+ to BB- All 15 15

Equities, Gold 15 15

Minor Equities 25 25

Mutual Funds Highest Highest

Cash 0 0


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Examples of Mitigation

100 of 5-year corporate loan rated BBB-with full guarantee by A rated corporation:

E* = 100(1.06) 100(0.94) = 12 100 of 5-year corporate loan rated BBB-

with collateral of 80 in equities:

E* = 100(1.06) 80(0.85) = 38 100 of 5-year corporate loan rated BBB-

with guarantee of A rated sovereign:E* = 100(1.06) 100(0.97) = 9


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Ratings Issues

Ratings are central to the Basel II

standardized approach.

But corrupted ratings were at the heart ofthe 2008-9 financial crisis.

Basel III tries to backpedal:

Banks should assess credit risks directly. If banks have a specific assessment they can

use it.

Bank supervisors should authorize ratings

firms.


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The Internal Ratings-Based

Approach (IRB)

The preferred direction is toward

banks making their own credit

assessments.

But should regulators allow any

internal model to be used in setting

capital?

The Internal Ratings-Based Approach

(IRB) has two variants:

Foundations Approach

Advanced Measurement Approach


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Banks Provide Numerical

Parameters

Numerous specific asset classes

Estimates needed for each class of:

probability of default (PD) loss given default (LGD)

exposure at default (EAD)

effective maturity (M)

In the foundations approach, bankestimates PD only; in advancedmeasurement, all.

F d ti A h


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Foundations Approach:

PD and Capital

RequirementsProbability of Default Capital Requirement

0.03% 1.4%

0.10% 2.7%

0.25% 4.3%

0.50% 5.9%

0.75% 7.1%

1.00% 8.0%

1.25% 8.7%

1.50% 9.3%

2.00% 10.3%


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Further Elements of IRB

Separate formulas and prescriptions for each assetclass.

IRB system must assess both borrower andtransaction.

Bank must have sufficient internal data and range ofexposures (favors large banks).

Assessment must include subjective factors as wellas mathematical models.

IRB system must be documented and frequently

back-tested and reviewed by management. Bank must have independent credit function.

Board must approve IRB system.

Senior management must understand and usesystem.


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But What Model to Use?

Many are available KMV

CreditMetrics

Credit Risk+ Credit Portfolio View

All of these are portfolio-specific The risk of any asset depends on the

portfolio in which it is embedded.

Should regulators allow banks to usetheir own models to set capital

requirements?


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The Basel II Design

Design requirements: Regulatory model should be portfolio-

invariant.

It should depend on the banks PD andLGD estimates.

Only one class of model meets these

requirements: Single risk factor, like CAPM

Infinitely diversified, also like CAPM


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So: Second Best

Basel supplies a universal model Key property: VaR contributions are

incremental

The idea is to capture systematic riskonly

Banks supply the parameter values


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Advanced Measurement

Approach

Correlation R = 0.12 * (1-e-50*PD) / (1-e-50)

+ 0.24 * [1 - (1-e-50*PD) / (1-e-50)]

Term adjustment b = (0.08451 -

0.05898*ln(PD))2

Capital requirement:

K = LGD*N[(1-R)-G(PD) +(R/(1-R))G(0.999)]

* (1-1.5b)-1 * (1+(M-2.5)*b)

Risk-weighted assets RWA = 12.5 * K * EAD


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Securitization Framework

Applies to actual and syntheticsecuritizations, independent of legalform.

Low-rated or unrated first-lossexposures are to be deducted fromcapital, half from Tier 1 and half fromTier 2:

Rating AAA toAA-

A+ toA-

BBB+ toBBB-

BB+ toBB-

B+ orunrated

Risk

Weight

20% 50% 100% 350% Deduct


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Operational Risk

Risk of (financial) loss resulting from

inadequate or failed internal processes,

people and systems, or externalevents.

Three approaches: Basic Indicator,

Standardized, and AdvancedMeasurement.

Banks encouraged to keep moving up

this spectrum.


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Basic Indicator Approach

K = 15% of gross income

RWA increased by 12.5*K

Gross income = net interest income

plus non-interest income (before lossprovisions, excluding securities salesor extraordinary gains and losses)


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Standardized Approach

Corporate finance 18%

Sales & trading 18%

Retail banking 12%

Commercial banking 15%

Payment & settlement 18%Agency services 15%

Asset management 12%

Retail brokerage 12%


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Advanced Measurement Approach

Independent operational risk

management function, closely linked to

daily operations of the bank.

Regular reporting of operating loss

exposures and outcomes.

System must be documented and

audited.

Must use scenario analysis (stress

testing).


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Market Risk

Additional capital is required (beyond

that required for credit and operational

risk) to cover the risk of market

movements.

This applies to interest rate exposures

and equity exposures in the trading

book only.

Applies to foreign exchange risk and

commodities price risk throughout the

bank.


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Foreign Exchange Risk

Sum the net long exposures.

Sum the net short exposures.

Capital required for net foreign

exchange risk = 8% of the larger ofthese two.

RWA equivalent = 12.5x capital

required.


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Total Capital Requirement

Compute capital for credit risk: Excluding debt & equity securities in

trading book and all commodities.

But including all credit counterparty riskon all over-the-counter derivatives.

Add the capital for operational risk.

Add capital for market risk.


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Basel III

Basel III supplements Basel II. Crisis-inspired changes:

Redefinition of tier 1

Increases in risk weightings forsecuritizations, trading book and counterpartyrisk

Dividend restraints

Overall leverage ratio: Tier I 3% (A + OBS)

Capital buffers: 2.5% extra common equityTier I

Liquidity requirements Liquidity coverage ratio

Net stable funding ratio


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BIS Basel III Documents

A. Strengthening the global capitalframework

1. Raising the quality, consistency and transparency of the capital base

2. Enhancing risk

coverage

3. Supplementing the risk-based capital requirement with a leverage ratio

4. Reducing procyclicality and promoting countercyclical buffers

Cyclicality of the minimum requirement

Forward looking

provisioning

Capital conservation

Excess credit growth

5. Addressing systemic risk and interconnectedness

B. Introducing a global liquidity standard

1. Liquidity Coverage

Ratio

2. Net Stable Funding


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Quantitative Impact Study,

12/10 263 banks from 23 jurisdictions were

studied, including 94 large banks.

In large banks, trading profitability is

much reduced (ROAE MorganStanley est.):

Tier 1

before

Tier I after Liquidity

Coverage

Stable

Funding

Large banks 11.1% 5.7% 83% 93%

Smaller

banks

10.7% 7.8% 98% 103%

Equities

Basel II

Equities

Basel III

Fixed

Income

Basel II

Fixed

Income

Basel III

2010 19.1% 16.5% 14.1% 8.3%

2012 est. 21.3% 18.9% 16.1% 10.3%


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Implementation Schedule