Download - Basel II Implications_2
-
8/4/2019 Basel II Implications_2
1/36
MOVING TOWARDS BASEL II
Issues & Concerns
-
8/4/2019 Basel II Implications_2
2/36
MOVING TOWARDS BASEL II
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 useelements of national discretion to adapt it to their
needs.
-
8/4/2019 Basel II Implications_2
3/36
MOVING TOWARDS BASEL II
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.
-
8/4/2019 Basel II Implications_2
4/36
MOVING TOWARDS BASEL II
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 wereintroduced in India through Narasimham committee
recommendations.
-
8/4/2019 Basel II Implications_2
5/36
MOVING TOWARDS BASEL II
Basel Accord I:
An Example for Calculation of Capital Requirement
Exposure in an account Rs. 50 Cr
Risk weight assigned to the account 100%
Minimum capital requirement 8%
Capital required is =
(50x100x8)/(100x100) = Rs. 4 Cr
-
8/4/2019 Basel II Implications_2
6/36
MOVING TOWARDS BASEL II
Basel Accord II:
The New Accord (Basel II) The Basel committee has issued adetailed 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 thestandardised 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.
-
8/4/2019 Basel II Implications_2
7/36
Major Differences Between Basle I and Basle II Accords
Old Accord - Basle I
"One Size Fits All"
Broad Brush
Single Risk Measure
New Accord - Basle II
Portfolio ofapproaches
Emphasis on internalmodels, supervisoryreview and marketdiscipline
Flexible, incentive forbetter risk mgt.
More risk sensitive
-
8/4/2019 Basel II Implications_2
8/36
Comparison of Basel I and II
Under Basel II, the capital requirements are more risksensitive 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 forOperational Risk (OR) and where warranted for interestrate risks, credit concentration risks, liquidity risks etc
All these makes Basel II much more comprehensivethan the earlier Basel I.
Basel II recognizes a wider range of collaterals andprovides incentives for improved risk management
practices
-
8/4/2019 Basel II Implications_2
9/36
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 sectorand has assigned a lower risk weight for retail SMEexposure under Standardised Approach.
The non-retail SME exposure would also attract alower risk weight where they have better external ratings
under the Standardised Approach.
Shifting to Basel II, therefore, could be advantageousfor economies whose banks have significant SMEexposure.
-
8/4/2019 Basel II Implications_2
10/36
Comparison of Basel I and II
NEW ACCORD Capital Requirement
Minimum capital requirement depends on quality ofrisk 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 risk10
-
8/4/2019 Basel II Implications_2
11/36
DRAFT GUIDELINES FOR IMPLEMENTATION OF THE NEW CAPITAL ADEQUACY
FRAMEWORK
RBI releases Draft guidelines on 14th February2005.
At a minimum, all banks in India to adoptStandardised 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 obtainingspecific approval of RBI.
Bank to study these guidelines and furnish theirfeedback within 3 weeks.
-
8/4/2019 Basel II Implications_2
12/36
MOVING TOWARDS BASEL II
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 strategiesPillar 3 : Market Discipline
Focus on disclosures
-
8/4/2019 Basel II Implications_2
13/36
13
Certify internal
models
Integrated Supervisory Regime- Basel II
Pillar IMinimum Capital
Requirements
Credit Risk
Market Risk
Operational Risk
Pillar IISupervisory
Impact
Evaluate banks
capital adequacystrategies
AdditionalCapital
Adjustments
Pillar IIIMarket Discipline
InformationDisclosures
Core &
Supplementary
Comparison of Basel I and II
-
8/4/2019 Basel II Implications_2
14/36
MOVING TOWARDS BASEL II
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 managementapproaches 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
-
8/4/2019 Basel II Implications_2
15/36
MOVING TOWARDS BASEL II
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.
-
8/4/2019 Basel II Implications_2
16/36
MOVING TOWARDS BASEL II
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.
-
8/4/2019 Basel II Implications_2
17/36
MOVING TOWARDS BASEL II
PILLAR-1: MINIMUM CAPITAL
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 ascompared to the maturity that market and credit
risk measurement have achieved.
-
8/4/2019 Basel II Implications_2
18/36
MOVING TOWARDS BASEL II
PILLAR-1: MINIMUM CAPITAL
Operational risk Most important types of operational risk involve
breakdowns in internal controls and corporategovernance
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 likeexceeding authority, conducting business in an unethical orrisky manner
Other aspects of operational risk include failure of IT
Systems or events such as fires or other disasters
-
8/4/2019 Basel II Implications_2
19/36
MOVING TOWARDS BASEL II
Operational risk
Cause Definition
Internal
Processes
Losses from failed transactions, client accounts, settlements and
every day business processes.
People Losses caused by an employee or involving employees (intentionalor unintentional), or losses caused through the relationship or
contact that a firm has with its clients, shareholders, third parties,
or regulators.
Systems Losses arising from disruption of business or system failure due to
unavailability of infrastructure or IT.
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
thefirms
ability to continue doing business.
-
8/4/2019 Basel II Implications_2
20/36
MOVING TOWARDS BASEL II
WHAT DOES THREE PILLARS INDICATE ?
PILLAR 2 - SUPERVISORY REVIEW
Banks should have a process for assessing their overallcapital adequacy and strategy for maintaining capital levels
Supervisors should review and evaluate banks internalcapital adequacy assessment and strategies
Supervisors should expect banks to operate above theminimum capital ratios and should have the ability torequire 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
-
8/4/2019 Basel II Implications_2
21/36
-
8/4/2019 Basel II Implications_2
22/36
Basel II
22
THREE BASIC PILLARS
MinimumCapital
Requirement
SupervisoryReview
Process
Market
Discipline
Market RiskCredit Risk
Definition of
CapitalWeighted Risks
Operational Risk
Standardised
Approach (SA)
Internal Ratings Based
Approach (IRBA) Basic
Indicator
Approach
(BIA)
Standar-
dised
Approach
(SA)
Advanced
Measurement
Approach
(AMA)Foundation
Approach(FIRB)
Advanced
Approach (AIRB)
-
8/4/2019 Basel II Implications_2
23/36
Credit Risk Measurement Approaches under Basel II
Pillar 3 - Market Discipline
Market discipline reinforces efforts to promotesafety and soundness in banks
Core disclosures (basic information) andsupplementary disclosures to make marketdiscipline more effective
Criteria Internal Ratings Based (IRB) Approach
StandardizedApproach
FoundationApproach
AdvancedApproach
Rating External Internal Internal
Risk Weight
Calibrated on the basis
of external ratings by
the Basel Committee
Function provided by
the Basel Committee
Function provided
by the Basel
Committee
-
8/4/2019 Basel II Implications_2
24/36
Credit Risk Measurement Approaches under Basel II
Pillar 3 - Market Discipline
Market discipline reinforces efforts to promotesafety and soundness in banks
Core disclosures (basic information) andsupplementary disclosures to make marketdiscipline more effective
Criteria Internal Ratings Based (IRB) Approach
Standardized Approach Foundation Approach Advanced Approach
Probability of Default
(PD) i.e. the likelikhood
that a borrower will
default over a given timeperiod
Implicitly provided by the
Basel Committee, tied to risk
weights based on external
ratings
Provided by bank based on
own estimates
Provided by the Bank
based on own estimates
Exposure of Default
(EAD) : For loans, the
amount of the facility that
is likely to be drawn if a
default occurs
Supervisory values set by the
Basel Committee
Supervisory values set by
the Basel Committee
Provided by bank based
on own estimates.
Loss Given Default
(LGD) : the proportion of
the exposure that will be
lost if a default occurs
Implicitly provided by the
Basel Committee, tied to risk
weights based on external
ratings
Supervisory values set by
the Basel committee
Provided by bank based
on own estimates;
extensive process and
internal control
requirement
-
8/4/2019 Basel II Implications_2
25/36
Credit Risk Measurement Approaches under Basel II
Pillar 3 - Market Discipline
Market discipline reinforces efforts to promotesafety and soundness in banks
Core disclosures (basic information) andsupplementary disclosures to make marketdiscipline more effective
Criteria Internal Ratings Based (IRB) Approach
Standardized Approach Foundation Approach Advanced Approach
Maturity i.e. the
remaining economic
maturity of the
exposure
Implicitly recognition
Supervisory values set by
the Basel Commitee
or
At rational discretion,
provided by bank based on
own estimates (with an
allowance to exclude certain
exposures)
Provided by the bank
based on own estimates(with an allowance to
exclude certain
exposures)
Data Requirements
Provision dates Default events
exposure data
customer segmentation
Data collateral
segmentation
External Ratings
Collateral data
Rating data
Default events
Historical data to
estimate PDs (5 years)
Collateral data
Same as IRB Foundation,
plus :
Historical loss data to
estimate LGD (7
years)
Historical exposure
data to estimate EAD
(7 years)
-
8/4/2019 Basel II Implications_2
26/36
Credit Risk Measurement Approaches under Basel -II
Pillar 3 - Market Discipline
Market discipline reinforces efforts to promotesafety and soundness in banks
Core disclosures (basic information) andsupplementary disclosures to make marketdiscipline more effective
Criteria Internal Ratings Based (IRB) Approach
Standardized Approach Foundation Approach Advanced Approach
Credit Risk Mitigation
techniques (CRMT)
Defined by the supervisory
regulator; including financial
collateral, guarantees, credit
derivatives, "netting" (on and
off balance sheet) and real
estate.
All collaterals from
Standardized approach;
receivables from goods and
services; other physical
securities if certain criteria
are met.
All types of collaterals
if bank can prove a
CRMT by internal
estimation.
Maturity : the
remaining economic
maturity of the
exposure
Minimum requirements for
collateral management(administration /
evaluation)
Provisioning process
Same as Standardized
Approach; plus minimum
requirements to ensurequality of internal ratings
and PD estimate on and
their use in the risk
management process.
Same as IRB
foundation, plus
minimum requirements
to ensure quality of
estimation of all
parameters.
-
8/4/2019 Basel II Implications_2
27/36
Operational Risk Measurement Approaches under Basel -II
Pillar 3 - Market Discipline
Market discipline reinforces efforts to promotesafety and soundness in banks
Core disclosures (basic information) andsupplementary disclosures to make marketdiscipline more effective
Calculation of
Capital Charge
Basic Indicator
Approach
Standard Approach
Advanced
Measurement
Approach
Calculation of capital
charge
Average of gross income
over three years as
indicator
Capital charge equals 15%
of that indicator
Gross income perregulatory business line
as indicator
depending on business
line, 12%, 15% or 18%
of that indicator as
capital charge
Total capital chargeequals sum of charge
per business line
Capital charge
equals internally
generated measure
based on (a) internal
loss data; (b)
External loss data;
(c) Scenario
analysis; (d)
Business
environment andinternal control
factors;
Recognition of risk
mitigation (up to
20% possible)
-
8/4/2019 Basel II Implications_2
28/36
Operational Risk Measurement Approaches under Basel -II
Pillar 3 - Market Discipline
Market discipline reinforces efforts to promote
safety and soundness in banks
Calculation ofCapital Charge
Basic IndicatorApproach
Standard Approach
Advanced
MeasurementApproach
Qualifying Criteria
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 andsenior management;
existence of
Operational Risk
Management function
Sound Operational Risk
management system Systematic tracking of
loss data
Market discipline
reinforces efforts topromote safety and
soundness in banks;
Core disclosures
(basic information)
and supplementary
disclosures to makemarket discipline
more effective.
-
8/4/2019 Basel II Implications_2
29/36
MOVING TOWARDS BASEL II
Implementation in India
In India, RBI is instrumental to ensureimplementation of Basel II. The reformprocess started in early nineties of the lastcentury have proved a boon for migrating to
Basel II. With the commencement of thebanking sector reforms in the early 1990s, theRBI has been consistently upgrading the Indian
banking sector by adopting international bestpractices.
The minimum capital adequacy requirementunder the Basel standard is 8%. However, in
India, RBI has stipulated and achieved a
-
8/4/2019 Basel II Implications_2
30/36
MOVING TOWARDS BASEL II
Banks in India have now even implementedcapital charge for market risk prescribed in the
Basel document w.e.f. 31/03/2006.
As a prudent measure RBI had put in placeseveral surrogates for market risk, e.g. IFR (
Investment Fluctuation Reserve) of 5% of the
investment portfolio, both in the AFS and HFTcategories plus a 2.5% risk weight on the
entire investment portfolio.
-
8/4/2019 Basel II Implications_2
31/36
MOVING TOWARDS BASEL II
Commercial banks in India have startedimplementing Basel II with effect from March 31,2007. They are initially adopting theStandardised. Approach for credit risk and theBasic Indicator Approach for operational risk.After adequate skills are developed, both by the
banks and also by the supervisors, some banksmay be allowed to migrate to the Internal RatingBased (IRB) Approach.
Implementation of Basel II will require more capital
for banks in India due to the fact that operationalrisk is not captured under Basel I, and the capitalcharge for market risk was not prescribed untilrecently. Though the cushion available in thesystem, which at present has a CRAR of over 12per cent, is comforting, banks are exploring
-
8/4/2019 Basel II Implications_2
32/36
MOVING TOWARDS BASEL II
RBI has been expanding the area of disclosures
so as to have greater transparency with regardto the financial position and risk profile of
banks. Illustratively, with a view to enhancing
further transparency, all cases of penaltyimposed 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
-
8/4/2019 Basel II Implications_2
33/36
MOVING TOWARDS BASEL II
Major Regulatory Initiatives taken in India :
The regulatory initiatives taken by the ReserveBank of India include:
Ensuring that the banks have suitable riskmanagement framework oriented towards their
requirements dictated by the size and complexityof business, risk philosophy, market perceptionsand the expected level of capital. The frameworkadopted by banks would need to be adaptable to
changes in business size, market dynamics andintroduction of innovative products by banks infuture.
Introduction of Risk Based Supervision (RBS) in 23banks on a ilot basis.
-
8/4/2019 Basel II Implications_2
34/36
MOVING TOWARDS BASEL II
Major Regulatory Initiatives taken in India :
Encouraging banks to formalize their CapitalAdequacy Assessment Programme (CAAP) inalignment with business plan and performancebudgeting system. This, together with adoption ofRisk 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 financialposition and risk profile of banks.
Improving the level of corporate governancestandards in banks.
Building capacity for ensuring the regulatorsability for identifying and permitting eligible banks
to adopt IRB / Advanced Measurement
-
8/4/2019 Basel II Implications_2
35/36
MOVING TOWARDS BASEL II
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
-
8/4/2019 Basel II Implications_2
36/36
MOVING TOWARDS BASEL II
Conclusion
Basel II is expected to foster financial stability through its risk
sensitive framework which will encourage banks to adoptimproved risk management practices; require supervisors toreview the efficiency of banks risk management practicesand capital allocation methodologies; and empower marketparticipants 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 berecognised that banks are "special". Their sound and efficientfunctioning is critical not only to the growth of the real sector
but also for strengthening the social infrastructure.Internationally, therefore, banks have moved centre-stageand their performance is the cynosure of all eyes.