Project: Reviewing the Capital Adequacy RegulationTime: Thursday, 22 January 2008, 9:00 amLocation: Albanian Association of Banks

First Working Group Meeting

AGENDA

I. Welcome Note—Project Manager

II. Presentation of SPI Albania and Introduction of Participants .

III. Project Terms of Reference presentation (Discussion and approval)

IV. Presentation of the Draft Note on International Experience (Discussion and approval)

V. Presentation of the Scoping of the Problem Document (Discussion and approval)

VI. Presentation of the Cost-Benefit Analysis (Discussion and approval)

VII. Presentation of Intesa SanPaolo Bank on Credit Risk Methodology

VIII. Sub-working groups for each individual component of Capital Adequacy Framework:

a. Regulatory Capitalb. Credit Riskc. Operational Risk

IX. Conclusions and Distribution of Tasks

X. Closing Remarks

SPI Albania Secretariat Mrs. Anuela Ristani, Director of Operations, anuela.ristani@spi-albania.eu

Ms. Elona Bollano, Director of Analytics and Policy, elona.bollano@spi-albania.eu Address: Twin Tower I, Kati 6, Apt. A3. Tirana, Albania. Tel. +355 42 280 359; Fax. + 355 42 280 371

www.spi-albania.eu

INTRODUCTION IN SPI ALBANIA PROJECTS, PROCEDURES AND METHODOLOGIES

SPI Albania SecretariatFirst PWG meeting on Capital Adequacy

December 5, 2008

Agenda

I. SPI Albania Projects’ Progress a. The Impact of IFRS Implementation on the Banking Regulations b. Improving Auction Procedures for Immovable Collateral Under Foreclosure c. Reducing Cash Transactions

II. SPI Albania Project Management III.SPI Albania Methodology – EU Better Regulation

• The Impact of IFRS Implementation on the Banking RegulationsCurrent status: - The project is concluded with the approval from the PWG of the final document on Amending the Banking Regulations for IFRS Implementation.

- SPI Committee approved the PWG Recommendations as presented during the SPI Committee meeting, November 2008.

I. SPI Albania Projects’ Progress

Outputs

•Project Terms of Reference;•The implementation of IFRS 1-First time adoption, in Albania;•Note on the Albanian Legal Framework;•Note on the European Experience in implementing IFRS;•Note on the impact of IFRS implementation on banking regulations: Some of the main changes brought in Europe by implementing IFRS. •Note on the European Experience in applying IFRS, sent to NAC;•Report on Main Findings of the Survey on Banks readiness to IFRS;•Inventory of Banking Supervision framework: categorized according to the depth of change and importance of amendment;•Inventory of Banking Supervision framework: Specific issues of each regulation affected by the IFRS implementation and the sense of changes; •Scoping of the Problem document;•PWG Recommendation Document

a. The Impact of IFRS Implementation on the Banking Regulations

b. Improving Auction Procedures for Immovable Collateral Under ForeclosureCurrent status: - The PWG has approved the final PWG position document on the bailiff service and on CPC amendments.

- SPI Committee approved the PWG Recommendations as presented during the SPI Committee meeting, November 2008.

I. SPI Albania Projects’ Progress

Outputs

• Project Terms of Reference• Note on Enforcement of Collateral• Note on International Bailiff Experience• Questionnaire on Bank’s Difficulties in Dealing with the Bailiff Office• Aggregated individual contributions on the CPC and PWG Proposals• EBRD Albanian Mortgage Enforcement External Memo• Regulatory Impact Assessment Questionnaire Main findings• PWG Recommendations on Improving Bailiff Service• PWG Recommendations on CPC Amendments

b. Improving Auction Procedures for Immovable Collateral Under Foreclosure

c. Reducing Cash Transactions Current status: - The PWG is currently reviewing the Cost-Benefit Analysis on cash and non-cash payments and the note on international experience.

I. SPI Albania Projects’ Progress

Outputs

Project terms of reference agreed Presentation by the Italian Association of Banks (ABI) on their initiative in reducing cash transactions. Proposing a Survey on the causes and costs of using cash based on 3 different proposals. AAB to take a decision in November PWG agreed on Scoping the Problem document The need to involve third parties such as mobile communication operators, utilities etc.Cash management in the Banks

c. Reducing Cash Transactions

II. SPI Albania Project Management

10

SPI Committee

SPI Working Group 1 (Experts from public and

private institutions)

SPI Working Group 2(Experts from public and

private institutions)

SPI Working Group N (Experts from public and

private institutions)

…

Project Manager 1 Project Manager 2 Project Manager N…

Project Owner 1 Project Owner 2 Project Owner N…

SPI Secretariat

SOLUTION FINDING (Based on public-private consultations through RIA)

II. SPI ALBANIA PROJECT MANAGEMENT a. Framework

II. SPI ALBANIA PROJECT MANAGEMENT• PROJECT WORKING GROUPS

– Project Management Team• Composition & responsibilities:

– Project Owner - represents the main stakeholder at top management level and ensures the project oversight;

– Project Manager – is appointed by the Project Owner (usually out of the PO’s institution management staff) and ensures the management of the day-to day activities;

– Deputy Project Manager(s) – represent(s) the other main stakeholder(s) and second(s) the Project Manager in coordinating the day-to-day activities.

– Project Working Group• Composition: representatives of all stakeholders, with specific expertise profiles.• Responsibilities:

» Attending the meetings;» Actively participating in the meetings;» Providing individual contributions (their institutions’ experience, parts of documents);» Validation of RIA questionnaire;» Providing data/filling in questionnaires;» Validation of RIA findings;» Approval of position/policy documents;» Supporting enactment activities.

II. SPI ALBANIA PROJECT MANAGEMENT

• PROJECT PLANNING and PWG GATHERING• ToRs drafting:

– background information – interviews with stakeholders and research;

– project objective;– strategy;– methodology (steps, output, contributions)

• Drafting list of stakeholders • In PWG composition in cooperation with AAB – a fair

representation of big, medium and small banks• Drafting, getting signatures and sending invitation letters

BoAAMFMoFMoE SPI Secretariat

SPI Projects

SPI Committee – project approval

projects of public-private interest

EU priorities, other countries, interviews,

research

AAB1. Issue identification and selection

II. SPI ALBANIA PROJECT MANAGEMENT SPI Secretariat responsibilities by project phase

-Consult with authorities on their plans for regulatory changes-Conduct interviews with selected banks to identify the most critical issues that need a resolution in collaboration with authorities-Use preliminary RIA to prioritize issues

SPI pipeline

-Experts for PWG-Support for data collection and consultations -RIA findings validation

-Identifies the needed expertise-Searches for solutions in international experience/EU legislation - Identifies the needs for international/local consultants- Arranges for the consultants’ support- Prepares documents for discussions- Drafts RIA questionnaire (as part of the RIA)- Collects data and performs RIA calculations- Organizes seminars and other supporting events - Collects feedback from SPI stakeholders- Collects and aggregates individual contributions- Prepares documents presenting the solutions

2. Solution searching

BoAAABMoFMoEAMFOther stakeholders

SPI Secretariat

II. SPI ALBANIA PROJECT MANAGEMENT SPI Secretariat responsibilities by project phase

3. Consensus building

BoA- Revises proposed solutions

- Provides input on disputed issues- NBR Board endorsement for

final recommendation

AAB- Banks review solutions- Provide input on disputed issues-RBA Board endorsement forfinal recommendation

- Looks for international benchmarking in disputed solutions- Asks for independent opinions on disputed issues- Provides ideas for reaching solutions acceptable to all parties-Performs RIA for disputed issues in order to facilitate the best choice

SPI Secretariat

II. SPI ALBANIA PROJECT MANAGEMENT SPI Secretariat responsibilities by project phase

4. Solution enactment BoA, AAB and BoA, AAB and SPI SPI SecretariatSecretariat coordinatecoordinate

actions under actions under a a full range of SPI full range of SPI projectsprojects

SPI Secretariat

-Prepares the law / regulations enactment packages-Prepares SPI Committee letters to the legislative initiator or to the BoA Board for BoA regulations- Provides detailed description of RIA to the legislative initiator or to the BoA Board- Follows up with the legislative initiator- Notifies BoA on the initiation of the public consultation process- Sends SPI Secretariat submission under the public consultation process- Arranges and/or attends the meetings with institutions involved in the enactment process- Prepares other documents as required by the legislative initiator

II. SPI ALBANIA PROJECT MANAGEMENT SPI Secretariat responsibilities by project phase

III. SPI Albania Methodology

EU Better Regulation

• Content

1. EU Better Regulation Framework, General

Information

2. SPI Albania Methodology

3. Application of the methodology in practice

1. EU Better Regulation Framework General Information - a

• EU Better Regulation Approach, developed by the European Commission, aiming at: – simplifying and improving existing regulation;– better design new regulation; and – reinforcing the respect and the effectiveness of the

rules, in line with the EU proportionality principle

1. EU Better Regulation Framework General Information - b

• EC comprises a very wide range of issues but… • For Financial Services it has adapted the EU-Better

Regulation approach to reflect the more specialized nature of financial services policies and the specific development circumstances.

• “Better laws” - having a full picture of their economic, social and environmental impacts

• Impacts assessed through the structured Impact Assessment tool.

Impact assessment – IA - a set of logical steps which structure the preparation of policy proposals. IA enhances the policy making process through:

- providing a coherent framework to conduct evidence-based policy making, that spans the regulatory policy making process from beginning to end;

- the use of market and regulatory failure analysis ensures accurate identification of problems and the threats they pose to regulatory objectives, which are reflected in effective and efficient policy solutions amongst a wider range of possible policies;

- saving time in the long run by reducing the risk of regulatory failure;

- formal and informal consultation with stakeholders and by enhancing the transparency of the policy making process and keeping all affected parties informed that results in enhanced credibility and accountability of the policy making process.

Impact assessment is an aid to political decision-making, not a substitute for it.

1. EU Better Regulation Framework General Information -c

2. SPI Albania Methodology EU Better Regulation in 11 steps -a

The EU Better Regulation Approach Steps Purpose

Scoping of problem 1. Problem identification To understand if a market/regulatory failure creates the

case for regulatory intervention. 2. Definition of policy objectives To identify the effects of the market /regulatory failure to

the regulatory objectives. 3. Development of “do nothing option”

To identify and state the status quo.

4. Alternative policy options To identify and state alternative policies (among them the “market solution”).

Analysis of impact 5. Costs to users To identify and state the costs borne by consumers 6. Benefits to users To identify and state the benefits yielded by consumers 7. Costs to regulated firms and regulator

To identify and state the costs borne by regulator and regulated firms

8. Benefits to regulated firms and regulator

To identify and state the benefits yielded by regulator and regulated firms

9. Data Questionnaire To collect market structure data to perform a quantitative cost and benefit analysis

Consultations 10. Policy Document To learn market participant opinions on various policy

options Conclusion

11. Final Recommendations Final report to decision-makers, based on Cost Benefit Analysis and market feedback

2. SPI Albania Methodology -b

Scoping of the Problem+ Qualitative & quantitative CB Analysis= Impact Assessment Analysis Document - IAAD

+ Consultations with Stakeholders = Final PWG Policy Recommendations

2. SPI Albania Methodology - c

• Scoping of the Problem Document (steps 1–4) 1.Problem identification

- What is the problem? Is it due to Market or Regulatory Failures?

2. Definition of policy objectives -General objectives (objectives of the authorities)-Specific objectives (objectives of the project)-Operational objectives (deliverables, actions of the project)

3. Development of “do nothing option” 4. Alternative policy options

2. SPI Albania Methodology – EU Better Regulation -d

• IAAD Document (steps 1 – 9) 5. Costs to users 6. Benefits to users 7. Costs to regulated firms and regulator 8. Benefits to regulated firms and regulator 9. Data Questionnaire

5-9 Analysis on the incremental costs & benefits of the identified policy options

2. SPI Albania Methodology - e

• Consultations with stakeholders (step 10)10.1. Consultation questionnaire10.2. Consultations feed-back

• Final document – PWG Recommendation (step 11)

2. SPI Albania Methodology – f Market Failures

• MF are reflected by market inefficiencies and welfare losses, due to:– Information asymmetry – one part of a transaction

lack important information. Information is costly to obtain or too complex.

– Externalities – Production of a good affects parties other than the original producers and consumers. These effects are not reflected in the price.

– Market power – Companies can persistently raise prices above the “competitive level”

3. Application of the Methodology in Practice Regulatory / Supervisory Failures - a

• regulation has unforeseen and unintended effects arising from interaction with a specific characteristic of the market affected,

• or when a supervisory practice is no longer adapted to the realities of a rapidly evolving market

3. Application of the Methodology in Practice What is the problem & MRF (Bailiff) -b

International institutions assessed that the secured transactions legal framework in Albania is appropriate & sound but its effectiveness is hampered by the slow enforcement system and flaws in the administrative system. Banks – the largest users of the enforcement system in Albania - complain on the effectiveness of the enforcement system and institutions. EURALIUS has identified insufficient professional expertise, scarce infrastructure and working conditions, lack of professional and financial incentives in the Bailiff offices. The problems in the Bailiff Service combined with the deficiencies in the legal framework produce an inefficient enforcement system.The low efficiency in the current enforcement system is result of a regulatory and administrative / management failure. The current regulation is not appropriately prescribed for the market. This regulatory failure generates additional uncertainty and costs to all the users of the enforcement system.

3. Application of the Methodology in Practice Objectives (CPC) - c

General Objectives:To improve the economy competitiveness;To increase the opportunities to engage in transactions.

Specific objectives:To improve the efficiency of the enforcement system;To stimulate the development of lending activity;To decrease in the cost of bank products and services.

Operational objectives:To steady increase the execution rate of court orders;To secure the timely execution of the court orders; To ensure rapid recovery of bad debts.

3. Application of the Methodology in Practice “Do nothing” Option (IFRS) -d

The non-revision of all banking regulations with the international accounting principles would make banks to maintain two evidences of their activity: one based on national accounting standards, in order to comply with banking regulatory provisions, and one based on international standards, in order to comply with the general legal requirements. This situation would involve additional costs for banks and confusion among the market participants.

Impact of the “Do Nothing” option to the various stakeholders Regulated firms / Banks: Additional costs on human capital generated by double reporting (BoA & IFRS).Consumers:Non informed consumers might be confused.Authorities:There are no additional costs.

3. Application of the Methodology in Practice Alternative Options (Reducing Cash) - e

The volumes of cash transactions within the banking system might be further reduced by:

Option 1: Self regulatory measuresEstablish a common policy among banks that will aim: a) the reduction of cash transaction by creating disincentives for

cash use; combined withb) the increase of non-cash transactions by creating incentives

for the costumers to use alternatives to cash.

Option 2: Regulatory measures

Option 3: The combination between the regulatory and self regulatory measures

3. Application of the Methodology in Practice - f Qualitative Cost & Benefit Analysis (CPC)

Impact Comments Costs Lower One-off Slightly

higher

Human resources

New staff = No additional staff needed to comply with the new legal provisions Trainings for existing staff =+ Due to the amendments in CPC, there might be the need to spend time to acknowledge them. On going Lower Human resources = Expenses

Procedural

- Under the art. 525 the creditor should pay for each procedure (when required by the law) and will be reimbursed at the end of the process by the proceedings of the sale. Given the low rate of successful auctions and the low price that the bank is very often forced to liquidate the property, in the end of the process if might happen that the bank is not able to recover all the payables. The amendment of art.525 on expenses by adding– the creditor will pay only for the initial fee, is expected to reduce the number of appeals by the debtors and reduce the expenses paid.

“Purchase” costs - More transparent and objective selecting rules and procedures for the appraisers would end in more realistic market value for the foreclosed immovable, diminishing thus banks’ losses from exchanging the good for the loan within auction procedures and re-selling them for a lower price.

Benefits higher Additional loans –

immovable property backed + The more rapid recovery of bad debts would give the possibility to re-place those sources in

additional loans. Furthermore, banks would be more willing to enter into mortgage-backed transactions.

Cost saving / + revenues + By increasing effectiveness and fairness in the procedures more third parties will be willing to enter in the auction and bid to purchase the immovable property, accordingly banks will not be obliged to take the property in exchange of the loan

Equity relief = Total impact Less costs

more benefits

A more effective foreclosure process will generate direct and indirect benefits.

ALBANIAN SHOQATA

TERMS OF REFERENCE

Project: Reviewing the Capital Adequacy Regulation

Project Owner: Mr. Indrit Bank, Bank of Albania, Supervision Department.

Project Manager: Mrs. Miranda Ramaj, Bank of Albania,

Supervision Department.

Deputy Project Managers: Mrs. Adela Xhemali, Intesa SanPaolo Bank

Technical Anchor (TAN): One or two peer reviewers from Central Banks in the region.

Project Working Group: BoA – Supervision Department, Legal Department, Banks, AMF.

I - Background - Identification of the problem

BoA is seeking to improve and to expand the coverage of the regulation on capital adequacy in order to capture a wider range of risks faced by the banks. The current regulation on Capital Adequacy establishes the regulatory capital to risk weighted assets and off-balance sheet items ratio, and sets the minimum required limit for this ratio. More specifically: the numerator of the adequacy ratio, bank’s regulatory capital, is composed of core capital and supplementary capital 1; the denominator of this ratio consist of the risk-weighted amounts of the balance sheet assets, off balance sheet items representing term financial instruments contracts related to interest and exchange rates and other balance sheet items.

The methodology used in the current framework calculates the (minimum) regulatory capital to cover only for credit risk. Other risk typologies, such as operational risk, have not been addressed yet. Therefore BoA intends to improve risk management in line with Basel II, first pillar of the capital adequacy framework, by enhancing the methodology for calculating risk weighted assets to credit risk and by including the operational risk in calculating the capital requirement.

1 More on the definition and calculation method of the regulatory bank capital is provided on the “Guideline on Regulatory Bank Capital” issued by Bank of Albania. Regulatory bank capital is composed of core capital and supplementary capital.

DRAFTSUBJECT TO PWG AGREEMENT

Basel Committee defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, the risk related, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements, but excludes strategic and reputational risk.

Basel Committee permits banks to choose among broad methodologies for calculating their capital requirements to cover credit and operational risks.

For calculating credit risk charges banks can choose between two broad methodologies. One alternative is to measure credit risk in a standardized manner using the Standardized Approach. The other alternative, the Internal Ratings-based Approach, allows banks to use their internal rating systems for credit risk management. This approach is subject to the explicit approval of the bank’s supervisor.

For calculating operational risk charges the Committee provides three methods: (i) the Basic Indicator Approach; (ii) the Standardized Approach; and (iii) Advanced Measurement Approaches (AMA).

Given the current status of developments of the banking industry and the internal capacities, BoA has considered that the Simplified Standardized Approach2 or the Standardized Approach as the most appropriate method for calculating credit risk charges. In line with the simplified standardized approach Basel Committee suggests the Basic Indicator Approach for operational risk.

I.2 Legal Framework.

The legal framework built up by BoA on capital requirements for banks consists of laws, regulations and guidelines. In order to implement the new methodologies on credit risk and operational risk a thorough investigation of the current framework is necessary.

The preliminary legal framework.

Existing framework Actions to be followed: Review / Amendment / Issue

Law No. 9662 Nr. 9662, dated 18.12.2006 “On Banks of the Republic of Albania”.

Review: Chapter V “Risk Management”, art. 58 “Regulations for risk management”.

Regulation on Capital Adequacy approved and amended by BoA’s Supervisory Council.

a) Amend: The methodology for Credit risk charges calculation. Proposed methodology: Simplified Standardized Approach.b) Issue: The methodology for Operational risk calculation. Proposed methodology: Basic Indicator Approach.

Guideline on Regulatory Bank Capital approved and amended by BoA’s

Amend: Chapter I “General”, art. 3, “Purpose”

2 This approach is not considered as another approach per se for determining regulatory capital, it rather collects in one place the simplest options for calculating risk-weighted assets.

2

Supervisory Council.Issue a guideline on Credit Risk Management Issue a guideline on Operational Risk ManagementComply with Basel Committee guidance on Sound Practices for the Management and Supervision of Operational Risk

Other

II - Project Objective – Definition of policy goals

Within the policy goal of improving the capital adequacy to the credit risk and to the operational risk according to Basel II, First pillar, the project objective is to prepare the necessary regulatory amendments and to define an implementation timeframe.

III – Intended Strategy – Description of the BR 9 steps

=========Scoping of Problem========║======Analysis ====║= Policy =║=Conclusion= Of Impact Consultation

* See attachment

The project management group (Project Owner, Project Manager, Deputy Project Manager, supported by the SPI Secretariat) will act based on the mandate received from the SPI Committee to review the Capital Adequacy regulation, to modify the methodology on credit risk and to introduce operational risk in calculating capital requirements.

The project working group (PWG), with the support of SPI Albania Secretariat, will work to revise the existing Capital Adequacy and bring it in line with the developments in banking system and with Basel II requirement on capital adequacy.

Planned steps to achieve project’s objective:

1. To identify the legal framework that regulates the capital requirements for banks 2. To acquire a clear understanding on the provisions of Basel II and EU respective

directives and international experience on capital adequacy framework, focused on credit and operational risk;

3. Based on the gained expertise, to formulate the proposal for amendments in the existing legal framework and/or for issuing new regulations and guidelines in order to have a comprehensive regulatory framework;

4. To assess the possible impact of the new methodologies on credit and operational risk and run consultations on the regulatory design and impact;

3

ProblemIdentification

1*

Regulatory context

Policyobjectives

2

Proposedregulatory

action3-4

Cost and Benefit analysis

5-8

Cost and Benefit

questionnaire9

Policy document for consultations

10

PWG Policy recommendation

11

5. To propose an implementation plan.

IV- Methodology: from kick off to the accomplishment of the project

A. First PWG Meeting

Preparation of PWG 1st meeting (PM/DPM and SPI Secretariat)

The Project Owner will appoint PM and AAB will appoint the DPM. SPI Secretariat will draft the invitation letter.

PMG and SPI Secretariat to prepare: a. a background note on current situation, including regulatory context; b. a note on international experience (Basel II provisions and experience in European countries). Output: First Draft of “Scoping of Problem” for PWG discussion

After PMG clearance and before the 1st meeting, SPI Secretariat will send to PWG members the following documents:1. Draft present TORs.2. Draft of “Scoping of Problem” document.

PWG 1st meeting

Objectives: a. To understand the current context and the policy goals; b. To formulate recommendations on policy implementation;

c. To analyze the impact for users, regulated firms and regulators of changing the capital requirements.

Output: Information to complete a document comprising the Scoping of the Problem and the Impact Assessment (Impact Assessment Analysis Document - IAAD) to be endorsed in PWG 2nd meeting. The IAAD covers steps 1-8 of the Better Regulation Template.

PM/DPM establishes homework: SPI Secretariat will prepare the minutes of the meeting

B. Second PWG Meeting

Preparation of PWG 2nd meeting (PM/DPM and SPI Secretariat)

4

ProblemIdentification

1

Regulatory context

Policyobjectives

2

Proposedregulatory

action3-4

Cost and Benefit analysis

5-8

Cost and Benefit

questionnaire9

Policy document for consultations

10

PWG Policy recommendation

11

ProblemIdentification

1

Regulatory context

Policyobjectives

2

Proposedregulatory

action3-4

Cost and Benefit analysis

5-8

Cost and Benefit

questionnaire9

Policy document for consultations

10

PWG Policy recommendation

11

ProblemIdentification

1

Regulatory context

Policyobjectives

2

Proposedregulatory

action3-4

Cost and Benefit analysis

5-8

Cost and Benefit

questionnaire9

Policy document for consultations

10

PWG Policy recommendation

11

PMG and SPI Secretariat to draft the questionnaire for data collection.

PWG 2nd meeting

Objective: To discuss and agree on the cost and benefit questionnaire;

Output: (a) Endorsement of IAAD (1-8) and (b) Final questionnaire.

PM/DPM establishes homework:• SPI Secretariat: will prepare the minutes of the meeting will integrate the

individual contributions on the cost and benefit questionnaire.

C. Third PWG Meeting

Preparation of PWG 3rd meeting (PM/DPM and SPI Secretariat)

SPI Secretariat to: collect data from PWG participating banks; and summarize questionnaire results and prepare draft “summary impact assessment” for PWG discussion and endorsement.PMG and SPI Secretariat: to draft policy option consultation paper, including regulatory amendment proposals.

PWG 3rd meeting

Objectives: (a) To endorse Impact Assessment Analysis Document including “Summary Impact Assessment”; b) To finalize policy option consultation paper.

Output: a) IAAD; b) final policy option consultation paper.

D. Forth PWG Meeting

Preparation of PWG 4th meeting (PM/DPM and SPI Secretariat :

PM/DPM and SPI Secretariat to: a. Run consultations with stakeholders based on the policy option consultation paper; b. Draft feedback document.

PWG 4th meeting

5

ProblemIdentification

1

Regulatory context

Policyobjectives

2

Proposedregulatory

action3-4

Cost and Benefit analysis

5-8

Cost and Benefit

questionnaire9

Policy document for consultations

10

PWG Policy recommendation

11

ProblemIdentification

1

Regulatory context

Policyobjectives

2

Proposedregulatory

action3-4

Cost and Benefit analysis

5-8

Cost and Benefit

questionnaire9

Policy document for consultations

10

PWG Policy recommendation

11

Objective: a) To discuss the consultation feedback document and the policy document; and b) To agree on the policy recommendations.Output: Policy recommendations.

Following PWG 4th meeting:

Preparation of the SPI Committee paper.

VI - Project Team

The team is composed of:

• Bank of Albania • Banks

VII – Tentative PWG meeting schedule

• First meeting October 2008

Second meeting November 2008

Third meeting November 2008

Fourth meeting December 2008

VIII – Consulted documents

- Basel Committee on Banking Supervision, 2006, International Convergenceof Capital Measurement and Capital Standards, A Revised Framework, June 2006.- Basel Committee, 2003, Guidance on Sound Practices for the Management and Supervision of Operational Risk, February 2003.- Law N0. 9662, dated 18.12.2006 “On Banks on the Republic of Albania”.- Regulation on Capital Adequacy.- Guideline on Regulatory Bank Capital.

6

Attachment

The EU Better Regulation ApproachSteps Purpose

Scoping of problem1. Problem identification To understand if a market/regulatory failure creates the

case for regulatory intervention.2. Definition of policy objectives To identify the effects of the market /regulatory failure to

the regulatory objectives. 3. Development of “do nothing option”

To identify and state the status quo.

4. Alternative policy options To identify and state alternative policies (among them the “market solution”).

Analysis of impact5. Costs to users To identify and state the costs borne by consumers6. Benefits to users To identify and state the benefits yielded by consumers7. Costs to regulated firms and regulator

To identify and state the costs borne by regulator and regulated firms

8. Benefits to regulated firms and regulator

To identify and state the benefits yielded by regulator and regulated firms

9. Data Questionnaire To collect market structure data to perform a quantitative cost and benefit analysis

Consultations10. Policy Document To learn market participant opinions on various policy

optionsConclusion

11. Final Recommendations Final report to decision-makers, based on Cost Benefit Analysis and market feedback

Source: CESR-CEBS-CEIOPS 3L3 Guidelines, adjusted by the Convergence Program based on experience.

7

DRAFT

Document prepared by Elona Bollano, SPI Director for Analytics and Policy

NoteOn

The European Experience with the Capital Adequacy Framework

Content

I. European and International Initiatives on Capital Requirements for Credit Institutions

II. Credit risk and operational risk approaches

III.Capital adequacy according to the Simplified Standardized Approach

IV. Possible regulatory options – the Polish and the Romanian cases

Summary

In the international level the Basel Committee on Banking Supervision has a mandate to secure international convergence of supervisory regulations governing the capital adequacy of international banks. The revised framework on Capital Accord Basel II is a more comprehensive and extensive compared to Basel I. This framework describes more exhaustive measures and minimum standards for capital adequacy.

At the European level, the European Commission in 2006 issued two directives on capital requirements for credit institutions.

On credit risk, banks can choose between two broad methodologies for calculating their capital requirements for credit risk, the Standardized Approach and the Internal Ratings-based Approach; and on operational risk banks have a choice among three broad methodologies for calculating their capital requirements for operational risk: (i) the Basic Indicator Approach, (ii) the Standardized Approach and (iii) Advanced Measurement Approaches (AMA). Banks are requested to move along this spectrum ranging from

SPI Albania Secretariat Mrs. Anuela Ristani, Director of Operations, anuela.ristani@spi-albania.eu

Ms. Elona Bollano, Director of Analytics and Policy, elona.bollano@spi-albania.eu Address: Twin Tower I, Kati 6, Apt. A3. Tirana, Albania. Tel. +355 42 280 359; Fax. + 355 42 280 371

simple to more complex and more risk-sensitive approaches and further develop their models for measuring and controlling operational risks.

European countries have followed different approaches in transposing the capital requirement directive in their banking regulatory framework. In some countries the National Supervision Authority has amended the banking legal framework related to capital requirements to reflect the capital adequacy principles and requirements. As alternative, other countries have included all the changes brought by the new directive on capital adequacy in one single document.

I. International and European Initiatives on Capital Requirements for Credit Institutions

I.1. Initiatives of the Basel Committee on Banking Supervision regarding capital adequacy for credit institutions

Basel Committee on Banking Supervision1 has been working for a long period of time to secure international convergence of supervisory regulations governing the capital adequacy of international banks.

In the early format of the capital framework, Basel I set out the details of the agreed framework for measuring capital adequacy and the minimum standard to be achieved when the national supervisory authorities represented in the Committee implemented capital requirements in their respective countries.

Anyhow, the framework on capital adequacy has evolved since its conception. The revised framework in the New Capital Accord Basel II is more comprehensive and extensive compared to Basel I. The new framework describes more exhaustive measures and minimum standards for capital adequacy. It seeks to improve on the existing rules by aligning the regulatory capital requirements more closely to the underlying risks that banks are facing. In addition, it intends to promote a more forward-looking approach to capital supervision, one that encourages banks to identify the risks they may face, today and in the future, and to develop or improve their ability to manage those risks. As a

1 At the international level the Bank for International Settlement (BIS) has a mandate to foster

international monetary and financial cooperation and serves as a bank for central banks. One of the key objectives of BIS is to promote monetary and financial stability. To pursue this objective the Basel Committee on Banking Supervision is established. The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters, with objective to enhance understanding of key supervisory issues and to improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable.

2

result, the capital regulatory framework is more flexible and better able to evolve with advances in markets and risk management practices.

Basel II lays in a three pillar structure: - The First Pillar on the minimum capital requirements provides the methodologies to calculate the minimum capital requirements for credit risk, operation risk and market risk; - The Second Pillar on supervisory review process provides the key principles of super-visory review, risk management guidance and supervisory transparency and accountabili-ty produced by the Committee with respect to banking risks, including guidance relating to, among other things, the treatment of interest rate risk in the banking book, credit risk (stress testing, definition of default, residual risk, and credit concentration risk), opera-tional risk, enhanced cross-border communication and cooperation, and securitization;

- The Third Pillar on market discipline complements the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2). The Committee aims to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution. The Committee believes that such disclosures have particular relevance under the Frame-work, where reliance on internal methodologies gives banks more discretion in assessing capital requirements.

It is critical that the minimum capital requirements of the first pillar be accompanied by a robust implementation of the second, including efforts by banks to assess their capital ad-equacy and by supervisors to review such assessments. In addition, the disclosures pro-vided under the third pillar of this Framework will be essential in ensuring that market discipline is an effective complement to the other two pillars.

I.2. Initiative of the European Commission regarding capital adequacy for credit institutions

Enhancing the single market in financial services in European Union has been a crucial part of the Lisbon Strategy for Growth and Jobs and essential for the EU’s international competitiveness.The Financial Services Action Plan 1999-2005 (FSAP) aimed at reinforcing the founda-tions for a strong financial market in the EU by pursuing three strategic objectives:– ensuring a Single Market for wholesale financial services;– open and secure retail markets and– state-of-the-art prudential rules and supervision.

Together with other measures of the plan, a review of the legislation governing the capi-tal framework for credit institutions (banks) and investment firms was undertaken in or-der to align it with market developments and work of the G-10 Basel Committee on Banking Supervision. Basel II framework was reflected in the EU as a new capital re-

3

quirements framework that was adopted in June 2006 as the Capital Requirements Direc-tive (CRD) this comprises Directives 2006/48/EC2 and 2006/49/EC3.

The CRD lays out the so-called three-pillar structure:• Pillar 1 covers the capital required for credit risk, operational risk and market

risk; the minimum capital requirements became much more risk-sensitive and comprehensive than in the past, facilitating better coverage of the real risks run by a credit institution;

• Pillar 2 covers the review and evaluation of the credit institution's compliance with the requirements of the CRD by the supervisor and any resulting action; new rules include requirements for an ‘internal capital assessment’ by financial institu-tions, whereby they would need to assess their capital needs considering all the risks they face. These rules also require supervisors to evaluate institutions’ over-all risk profile to ensure that they hold adequate capital;

• Pillar 3 covers the disclosure by institutions and facilitates a better understanding of the soundness and stability of financial institutions.

The new framework also enhanced the role of the ‘consolidating supervisor’ (the national supervisory authority in the Member State where a group’s parent institution is autho-rized) by assigning it responsibilities and powers in coordinating the supervision of cross-border.

II. Credit and operational risk approaches

II.1. Credit risk approaches

The Committee permits banks a choice between two broad methodologies for calculating their capital requirements for credit risk, the Standardized Approach and the Internal Rat-ings-based Approach.

In the Standardized Approach, credit risk is measured in a standardized manner, sup-ported by external credit assessments. In determining the risk weights in the standardized approach, banks may use assessments by external credit assessment institutions recog-nized as eligible for capital purposes. It is the responsibility of the national supervisors to determine whether an external credit assessment institution (ECAI) meets the defined re-quirements / criteria. Exposures should be risk-weighted net of specific provisions.

The alternative methodology is the Internal Ratings-based Approach. This methodolo-gy is subject to the explicit approval of the bank’s supervisor and would allow banks to use their internal rating systems for credit risk.The risk components include measures of the probability of default (PD), loss given de-fault (LGD), the exposure at default (EAD), and effective maturity (M). In some cases,

2 Directive 2006/48/EC relating to the taking up and pursuit of the business of credit institutions.

3 Directive 2006/49/EC on the capital adequacy of investment firms and credit institutions.4

banks may be required to use a supervisory value as opposed to an internal estimate for one or more of the risk components.The IRB approach is based on measures of unexpected losses (UL) and expected losses (EL). The risk-weight functions produce capital requirements for the UL portion.

II.2. Operational risk approaches

Basel Committee introduced the operational risk in 2001 and created the ground for tak-ing into account this risk category in the requirements for risk management and capital adequacy.

Definition of the operational risk

Basel Committee defines operational risk as “…the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.” EU Directive [2006/48/EC] provides the same definition.

Operational risks exist as a company is using employees and/or systems in processes or is subject to external impacts and, therefore, they emerge long before credit or market risks. By its nature, operational risk is characterized:- as inherent to business, i.e. inseparably linked with almost all business activities;- as specific, i.e. its precise form and, therefore, all measures to control and mitigate it

strongly depend on the specific company profile; and- as a cultural risk, because the handling of so varied and networked risks, summarized

under the heading of operational risk, is a question of a company’s risk culture, i.e. its approach and practices in treating risks especially in day-to-day business.

There are major conceptual differences to credit and market risks:- Operational risk does not involve a clear relation between risk and income, i.e. higher

operational risks, as a rule, do not lead to better income prospects;- In contrast to other banking risks, a major part of operational risk is fully located in-

side financial institutions and it is understandable – for competition reasons alone – that banks take care not to draw attention to their own weaknesses. On one hand, this results in a lack of event data for building an appropriately broad statistical database, which may be further aggravated by a generally bad database for certain loss event types in specific business lines. On the other hand, loss events of one bank are not necessarily transferable to other banks – due to differences in business activities, practices or internal control;

- In the case of credit and market risks, risk factors, i.e. determining circumstances, and risk potentials, i.e. existing exposures, can be better differentiated due to the generally deliberate acceptance of risks. It is relatively easy to measure and, thus, control the latter risks, while it is much more difficult to establish a link between risk factors and the probability/severity of losses for operational risk;

- Very high operational losses potentially threatening the stability of a credit institution are relatively infrequent.

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The Basel Committee permits banks a choice between three broad methodologies for cal-culating their capital requirements for operational risk: (i) the Basic Indicator Approach, (ii) the Standardized Approach and (iii) Advanced Measurement Approaches (AMA). These methods strongly differ with regard to their complexity and risk sensitivity and form the basis of calculating the capital requirements for operational risks. Banks are re-quested to move along this spectrum ranging from simple to more complex and more risk-sensitive approaches and further develop their models for measuring and controlling operational risks. In this sense, the different approaches follow an evolutionary design (Austrian National Bank, 2006).

Chart 1: Operational risk

III. Capital adequacy according to the simplified standardized approach

In the Simplified Standardized Approach the Basel Committee suggests for the credit risk to be applied a set of general rules for risk weights and for operational risk to be applied the basic indicator approach.

III.1. Credit Risk

The credit risk framework comprises:

a. Credit risk ─ general rules for risk weights

In order to calculate capital requirements for credit risk the Committee has classified the claims for the public and private institutions and on-balance sheet items and off-balance sheet items. Each group of claims is weighted with a predefined risk weight.

b. Credit risk mitigation

Basic Indicator Approach

StandardizedApproach AMA

Capital Requirement

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Banks use a number of techniques to mitigate the credit risks to which they are exposed. Exposure may be collateralized in whole or in part with cash or securities, or a loan expo-sure may be guaranteed by a third party.Where these various techniques meet the operational requirements below credit risk miti-gation (CRM) may be recognized.The Committee has defined the framework that is applicable to the banking book expo-sures under the simplified standardized approach.The use of CRM techniques reduces or transfers credit risk, but it simultaneously may in-crease other risks to the bank, such as legal, operational, liquidity and market risks. Therefore, it is imperative that banks employ robust procedures and processes to control these risks, including strategy; consideration of the underlying credit; valuation; policies and procedures; systems; control of roll-off risks; and management of concentration risk arising from the bank’s use of CRM techniques and its interaction with the bank’s overall credit risk profile.

c. Credit risk — Securitization framework

A traditional securitization is a structure where the cash flow from an underlying pool of exposures is used to service at least two different stratified risk positions or tranches re-flecting different degrees of credit risk. Payments to the investors depend upon the per-formance of the specified underlying exposures, as opposed to being derived from an obligation of the entity originating those exposures. The stratified/tranched structures that characterize securitizations differ from ordinary senior/subordinated debt instruments in that junior securitization tranches can absorb losses without interrupting contractual pay-ments to more senior tranches, whereas subordination in a senior/subordinated debt struc-ture is a matter of priority of rights to the proceeds of a liquidation.Banks’ exposures to securitization are referred to as “securitization exposures”.When the simplified standardized approach to credit risk is used, banks are permitted to use a simplified version of the standardized approach under the securitization frame-workThe standard risk weight for securitization exposures for an investing bank will be 100%. For first loss positions acquired, deduction from capital will be required. The deduction will be taken 50% from Tier 1 and 50% from Tier 2 capital.

III.2. Operational Risk – Basic indicator approach

The basic indicator approach (BIA) is considered the simplest method of calculating the regulatory capital requirements for a bank’s operational risk.

Basel II principles on Basic Indicator ApproachAccording to Basel Committee banks using the Basic Indicator Approach must hold capi-tal for operational risk equal to a fixed percentage (denoted alpha) of the average positive annual gross income4 over the previous three years. In calculating the average value, the

4 The simplified standardised approach for operational risk is the Basic Indicator Approach under which banks must hold capital equal to a fixed percentage (15%) of average annual gross income, where positive, over the previous three years.

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figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator. The charge may be expressed as follows:

KBIA = [ Σ (GI1…n * α] / n

where:KBIA the bank’s capital requirement under BIA,GI annual gross income, where positive, over the previous three years,N number of the previous three years for which gross income is positive,α 15%, which is set by the Committee, relating the industry wide level of required

capital to the industry wide level of the indicator.

Gross income is defined as net interest income plus net non-interest income5. It is intend-ed that this measure should: (i) be gross of any provisions (e.g. for unpaid interest);(ii) be gross of operating expenses, including fees paid to outsourcing service providers;6

(iii) exclude realized profits/losses from the sale of securities in the banking book;7 and(iv) exclude extraordinary or irregular items as well as income derived from insurance.

European Commission - EU Directive [2006/48/EC] provisions on basic indicator approach Under the BIA, the capital requirement for operational risk is equal to 15% of the indica-tor defined as follows:- The relevant indicator is the average over three years of the sum of net interest income and net non-interest income;- The three-year average is calculated on the basis of the last three twelve-monthly obser-vations at the end of the financial year. When audited figures are not available, business estimates may be used;- If for any given observation, the sum of net interest income and net non-interest income is negative or equal to zero, this figure shall not be taken into account in the calculation of the three-year average. The relevant indicator shall be calculated as the sum of positive figures divided by the number of years with positive figures.

Based on the accounting categories for the profit and loss account of credit institutions (under Article 27 of Directive 86/635/EEC), the relevant indicator shall be expressed as the sum of the elements from 1 to 7(with their positive or negative sings) as presented be-low:1. Interest receivable and similar income;2. Interest payable and similar charges;3. Income from shares and other variable/fixed-yield securities;4. Commissions and fees receivable;5. Commissions and fees payable;5 As defined by national supervisors and/or national accounting standards.6 In contrast to fees paid for services that are outsourced, fees received by banks that provide outsourcingservices shall be included in the definition of gross income.7 Realized profits/losses from securities classified as “held to maturity” and “available for sale”, which typically constitute items of the banking book (e.g. under certain accounting standards), are also excluded from the definition of gross income.

8

6. Net profit or net loss on financial operations;7. Other operating income.

The above stated elements may need to be adjusted in order to reflect these qualifications:i) The indicator shall be calculated before the deduction of any provisions and

operating expenses.Operating expenses shall include fees paid for outsourcing services rendered by third par-ties which are not a parent or subsidiary of the credit institution or a subsidiary of a par-ent which is also the parent of the credit institution.Expenditure with the outsourcing of services rendered by third parties may reduce the rel-evant indicator if the expenditure is incurred from an undertaking subject to supervision under, or equivalent to, this Directive.

ii) The following elements shall not be used in the calculation of the indicator:- realized profits/losses from the sale of non-trading book items,- income from extraordinary or irregular items, and- income derived from insurance.

IV. Possible implementation regulatory options – The Polish and the Romanian cases

Regarding the transposition of the EU Capital Requirements Directive, EU member states have followed different patterns in revising their regulatory framework. In some countries (e.g. Romania illustrated bellow), the supervisory authorities for banking and for securities have amended the entire legal framework (banking law, regulations, and orders), in cascade, in order to reflect the capital adequacy principles and requirements.

Another group of countries have included all the changes brought by the new directive on capital adequacy in one single document. Poland is one of the countries that have issued a single document on the capital requirements against particular risks and the detailed principles to be applied in determining those requirements, in a very comprehensive resolution on capital.

Illustration – Transposition of the EU Capital Requirement Directive in the banking regulatory framework in Romania

The regulatory framework on capital adequacy comprises the following banking law, regulations and orders:• Government Emergency Ordinance no. 99/2006 on credit institutions and the capi-

tal adequacy, approved and completed by Law no. 227/2007• NBR and NSC Regulation no. 13/18/2006 on determining the minimum capital re-

quirements for credit institutions and investment companies

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• NBR and NSC Regulation no. 14/19/2006 on the credit risk treatment for credit in-stitutions and investment companies according to the standard approach

• NBR and NSC Regulation no.15/20/2006 on the treatment of the credit risk for credit institutions and investment companies according to internal rating models approach

• NBR and NSC Regulation no. 21/26/2006 on the treatment of the credit risk at-tached to the securitized exposures and to the positions from securitization

• NBR and NSC Regulation no. 22/ 27/ 2006 on the capital adequacy of the credit in-stitutions and investment companies

• NBR and NSC Regulation no. 23/28/2006 on the technical criteria for risk treat-ment and on the technical criteria used by competent authorities for its verification and evaluation

• NBR and NSC Regulation no. 24/29/2006 on determining the minimum capital re-quirements for credit institutions and investment companies for the operational risk

• NBR Order no. 9/2007 on credit institutions reporting on the capital adequacy situ-ation at individual level

• NBR Order no. 12/2007 on the reporting of the minimum capital requirement for credit institutions

• NBR Regulation no. 5/2008 on approving the utilization of the standard approach or of the alternative standard approach for the operational risk

Bibliography

Austrian National Bank & Financial Market Authority (2006) “Guidelines on Operational Risk Management”.

Basel Committee on Banking Supervision (2006), “International Convergence of Capital Measurement and Capital Standards - A Revised Framework Comprehensive Version”.

Official Journal of the European Union, EU Directive [2006/48/EC].

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DRAFT

Document prepared by Elona Bollano, SPI Director for Analytics and Policy

“Scoping of Problem” Document

Project: Reviewing the Capital Adequacy Regulation

Section 1Project information

PUBLIC-PRIVATE FINANCIAL SECTOR MODERNIZATION MATRIX

Italian Banking Association CRITERIA

European Central Bank CRITERIA

Asymmetric information reduction

Completeness of the market

Increased opportunities to engage in

financial transactions

Reduced transaction

costs

Increased competition

Business developmentIndustry competitiveness

X

Industry reputation

Short description of the context [from project matrix]: BoA is seeking to improve and to expand the coverage of the regulation on capital adequacy in order to capture a wider range of risks faced by the banks. The methodology used in the current frameworks calculates the (minimum) regulatory capital to cover only for credit risk. Other risk typologies, such as operational risk, have not been addressed yet. Therefore BoA proposes to improve risk management by improving the methodology for calculating risk weighted assets, by improving the existing methodology on credit risk and by including the operational risk.

Stakeholder proposing the project: Bank of Albania

Other Stakeholders involved (sponsors): AAB and Banking community, AMF.Project objectives:

1. To prepare the necessary regulatory amendments for a sounder prudential risk management through the improvement of credit risk measurement and the introduction of the operational risk measurement.

2. To align better Bank of Albania’s capital requirements with Basel II, first pillar, framework.

SPI Albania Secretariat Mrs. Anuela Ristani, Director of Operations, anuela.ristani@spi-albania.eu

Ms. Elona Bollano, Director of Analytics and Policy, elona.bollano@spi-albania.eu Address: Twin Tower I, Kati 6, Apt. A3. Tirana, Albania. Tel. +355 42 280 359; Fax. + 355 42 280 371

www.spi-albania.eu

3. To define an implementation timeframe for the regulatory amendments.

Description of the project contribution toward financial modernization: The new methodologies for calculation of risk charges will provide tools for a better identification, measurement, monitoring and control of the risks credit and operational. The better adjustment of the capital to risks will promote the banking system stability, will decrease the probability of banks’ default and will give thus an enhanced consumer protection.

Project Working Group:Bank of Albania (PO & PM)Intesa SanPaolo Bank (DPM)Intesa SanPaolo Bank (member)Banka e Pare e Investimeve (member)Banka ProCredit (member) Banka Kombetare Greke (member)Banka Popullore (member)FSA (member)

2

The EU Better Regulation ApproachSteps Purpose

Scoping of problem1. Problem identification To understand if a market/regulatory failure creates the

case for regulatory intervention.2. Definition of policy objectives To identify the effects of the market /regulatory failure to

the regulatory objectives. 3. “Do nothing” option To identify and state the status quo.

4. Alternative policy options To identify and state alternative policies (among them the “market solution”).

Section 1:Scoping the problem

1.1. Problem identificationBackground Information BoA is seeking to improve and to expand the coverage of the regulation on capital adequacy in order to capture a wider range of risks faced by the banks. The current regulation on Capital Adequacy establishes the regulatory capital to risk weighted assets and off-balance sheet items ratio, and sets the minimum required limit for this ratio. More specifically: the numerator of the adequacy ratio, bank’s regulatory capital, is composed of core capital and supplementary capital 1; the denominator of this ratio consist of the risk-weighted amounts of the balance sheet assets, off balance sheet items representing term financial instruments contracts related to interest and exchange rates and other balance sheet items.

The methodology used in the current framework calculates the (minimum) regulatory capital to cover only for credit risk. Other risk typologies, such as operational risk, have not been addressed yet. Therefore BoA intends to improve risk management in line with Basel II, first pillar of the capital adequacy framework, by enhancing the methodology for calculating risk weighted assets to credit risk and by including the operational risk in calculating the capital requirement.Basel Committee defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, the risk related, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements, but excludes strategic and reputation risk.

Basel Committee permits banks to choose among broad methodologies for calculating their capital requirements to cover credit and operational risks. For calculating credit risk charges banks can choose between two broad methodologies. 1 More on the definition and calculation method of the regulatory bank capital is provided on the “Guideline on Regulatory Bank Capital” issued by Bank of Albania. Regulatory bank capital is composed of core capital and supplementary capital.

3

One alternative is to measure credit risk in a standardized manner using the Standardized Approach. The other alternative, the Internal Ratings-based Approach, allows banks to use their internal rating systems for credit risk management. This approach is subject to the explicit approval of the bank’s supervisor.

For calculating operational risk charges the Committee provides three methods: (i) the Basic Indicator Approach; (ii) the Standardized Approach; and (iii) Advanced Measurement Approaches (AMA).

Given the current status of developments of the banking industry and the internal capacities, BoA has considered that the Simplified Standardized Approach2 or the Standardized Approach as the most appropriate method for calculating credit risk charges. In line with the simplified standardized approach Basel Committee suggests the Basic Indicator Approach for operational risk.

1.1.2 Market Analysis

General market: Banking marketSpecific segment: Risk management under prudential frameworkSub segment: Credit market and operational activities

1.1.3 Legal framework

- Law No. 9662 Nr. 9662, dated 18.12.2006, “On Banks of the Republic of Albania”. - Regulation no. 59, dated 05.05.1999 changed, on “Capital Adequacy”.- Guideline No. 57, dated 05.05.1999 changed on “Bank’s Regulatory Capital”.1.1.4 Stakeholders - Institutional framework

• Bank of Albania. According to the law “On banks” Bank of Albania shall determine through by-laws the structure, the integral elements and methods for the calculation of banks’ regulatory capital (art 59.2). Accordingly, the ratio of regulatory capital adequacy is determined through by-laws of Bank of Albania and since June 2007 this ratio should not be less than 8 %.

• Commercial banks. The Albanian banking system consists of 16 commercial banks. For 2007 the capital adequacy ratio for the banking system was 17.5%.

2 This approach is not considered as another approach per se for determining regulatory capital, it rather collects in one place the simplest options for calculating risk-weighted assets.

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This ratio has shown a decreasing trend since 2003, reflecting the rapid development of the banking activity.

Table: Regulatory indicators for the banking system, 2004 – 2007

0

100

200

300

0

10

20

30

40

Regulatory capital Adjusted assets Capital adequacy ratio Minimum rate

Source: Bank of Albania

1.2. Market/regulatory failure analysis (nature and evidence)

The regulatory framework has not been updated to the new realities and complexity of the banking activities and the capital requirements are not covering currently all the types of risks. According to our assessment this situation, in the near future, will lead in a regulatory failure, as the regulation would be wrongly prescribed for the market. There is no evidence for this regulatory failure in terms of banking bankruptcies, but the central bank should act in a visionary and prudent manner and prevent the occurrence of these situations in the future.

1.3. Policy Goal(s) threatened by the failure [e.g. financial stability, market integrity, market confidence, consumer protection, facilitating innovation, enhancing

competition]General Objectives:

- To ensure the banking system stability.Specific objectives:

- To establish a coherent supervision function of the Supervisory Authority.- To ensure sound prudential risk management techniques for more adequately

preventing financial disruptions and protecting the depositors.- To improve the comparability and to make a step further in the process of

convergence with international capital measurements and standardsOperational:

- To improve the methodology on credit risk charges requirements.- To introduce the operational risk concept and establish the methodology on

operational risk charges for capital requirements.

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1.4. “Do nothing” option

1.4.1 Possible medium-term (max 2 years) self – corrective market actions (e.g. mechanisms through which the “Do Nothing” option would address the market/regulatory failure).

In the current status of development of the banking system, the capital requirements in place reflect and cover for the potential and possible risks related to the credit activity. Integration with the global markets and the expected fast developments in the banking activities of the banking will introduce more complex typologies of banking activities and products that will introduce as well more volatility.

In addition, the current regulatory framework on capital adequacy does not reflect the latest international developments in the process of convergence with the international capital standards and measurements.

To respond to these developments banks might introduce voluntarily operational risk charges or even use more sophisticated methods to account for credit risk. Given that a large share of banks operating in Albania are part of international groups, some banks (or the respective parent) might have already introduced operational risk when defining the strategy or are planning to introduce it in the near future. Anyhow the intervention from the central supervisory authority is essential in order to establish and apply a uniform methodology that would correctly reflect the prudential concerns on credit and operational risk.

1.4.2. Impact of the “Do Nothing” option to the various stakeholders (to be filled only if the “Do Nothing” option could be taken into further consideration)

Impact on regulated firms/ banks:- Vulnerability to operational risk and to credit risk.- Risk of undercapitalization.

Impact on consumers:- More exposure to the risk of bank bankruptcy.

1.5. Alternative policy option(s)

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1.5.1. Broad description of the regulatory or self-regulatory action(s) needed to remedy the market or regulatory failure and hence achieve the policy goal(s)

Bank of Albania is seeking to develop the regulatory framework on capital adequacy by improving the credit risk methodology and introducing the operational risk methodology for banks when calculating the capital requirements. These developments are a step further in the process of convergence toward international capital measures and standards, as provided by the Basel Committee on Banking Supervision.

1.5.2. Possible operational regulatory or self-regulatory actions to achieve the policy goal- to identify the regulations that will be affected.

- to perform a banking survey on the impact of the change in capital requirements.

- to set up the implementation process of the regulatory changes.

1.5.3. General description of various Options[please give here a general sense of what each option could look like – it will be a guide to understand what Option 1 and Option 2 actually are. ]

The Basel Committee permits banks a choice between two broad methodologies for calculating their capital requirements for credit risk, the Standardised Approach or the Internal Ratings-based Approach. Regarding the methodologies on calculating the capital requirements for operational risk, the Committee proposes three methods: (i) the Basic Indicator Approach, (ii) the Standardised Approach and (iii) Advanced Measurement Approaches (AMA). For the operational risk banks are encouraged to move along from the spectrum of available approaches [starting from (i)] as they develop more sophisticated operational risk measurement systems and practices.

1.5.3. Detailed description of Option 1:For Credit Risk Methodology: To introduce the Standardised Approach and the Internal Ratings-based Approach.

For Operational Risk Methodology To introduce the Basic Indicator Approach, the Standardised Approach and Advanced Measurement Approaches (AMA). Banks are encouraged to move along the spectrum of available approaches as they develop more sophisticated operational risk measurement systems and practices. For the Standardised Approach and AMA banks have to fulfill some qualifying criteria and the application of these methodologies has to be approved by the Supervisory Authority.

1.5.4. Detailed description of Option 2For Credit Risk Methodology: To update the current credit risk methodology with the latest guidelines as provided by the Basel Committee on Banking Supervision in the Simplified Standardised Approach.

For Operational Risk Methodology To introduce the Basic Indicator Approach.

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Summary Problem ScopingAuction procedures under foreclosure for immovable collateral

Market failureAsymmetricinformation

Market power Positive externalities

Negative externalities

(Existing) Regulatory failureRegulation wrongly prescribed for the market

Regulations succeeded in addressing the failure; a different market failure (e.g. side effect)

Regulation made it worse

Regulation so far has failed to work; maybe in due course

x

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Impact of the Capital Adequacy Framework RevisionsQualitative Cost – Benefit Analysis

Bank of Albania is seeking to develop the regulatory framework on capital adequacy by improving the credit risk methodology and introducing the operational risk methodology for banks when calculating the capital requirements.

The Basel Committee on Banking Supervision for credit risk permits banks a choice between two broad methodologies for calculating their capital requirements, the Standardized Approach or the Internal Ratings-based Approach, while for operational risk, are proposed three methods: (i) the Basic Indicator Approach, (ii) the Standardized Approach and (iii) Advanced Measurement Approaches (AMA). For the operational risk banks are encouraged to move along from the spectrum of available approaches [starting from (i)] as they develop more sophisticated operational risk measurement systems and practices.

Given the current status of development of the banking activity and the directives of the Committee, Bank of Albania for credit risk methodology will update the current credit risk methodology with the latest guidelines as provided by the Basel Committee on Banking Supervision in the Simplified Standardized Approach and will introduce the Basic Indicator Approach on operational risk.

Regulated firmsImpact Comments

Costs HigherOne-off HigherOperational + The modifications in the CA framework will

require training of the (i) technical staff (ii) high strategic management staff and potential revisions in the strategy

Infrastructure + Accounting and reporting + The modification of the CA framework will

require changes in the methodologies of calculation of capital requirements to credit and operational risks

Other + Some banks might need to add capital in order to comply with the increased capital adequacy requirements.Other extra costs related to the modification of the credit risk methodology and the first time implementation of the operation risk methodology

On going LowerHuman resources + Increased complexity in of the prudential

reporting framework and in a better risk management will generate a growth in the time

allocated to this activity.

Benefits HigherAdditional products / additional business

= No direct impact on the business strategy.

Cost saving / + revenues +/= Better coverage of banking activities - credit and operational risk with capital, with little effect on cost savings.

Equity requirements =/+ Banks will have to account for the operational risk. Some banks might have already considered operational risk, or more sophisticated credit risk methodologies for capital requirements, based on their parent bank / group requirements. For some of the banks, introducing the operational risk might ask for an increase in the capital.

Total impact Higher costs and Higher benefits

Higher costs during the implementation process, and higher long run benefits

ConsumersImpact Comments

Costs Slightly lower costs

Higher risks - Safer banking system, would reduce risk / increase protection for depositors and investors

Higher prices +/= The additional one off costs could be reflected on the prices (cost transfer from the banks), but no significant effect.

Lower quality of service = No direct effect

Benefits No effect No direct effect Better choice =Price reduction =Improved access =Total impact Lower costs Lower costs as consequence of a better

capitalized and hedged banking activity.

AuthoritiesImpact Comments

Costs HigherOne-off + Higher costs of the Banking Supervision

Authority related to the drafting, enactment and implementation the modified regulations.

2

Higher costs related to the training of the supervisors and/or external assistance.

On going + Direct Indirect

+=

The supervision process will be more complex

Benefits HigherStatutory goals ++ The banking supervisory authority

accomplishes its statutory obligations of ensuring the financial stability.

Increase income to state budget = No direct effectOthers = No direct effectTotal impact Higher

costs and higher benefits

One-off costs related to the process of new regulations, but the benefits are much higher.

Summary of CBA of the PWG recommendations for the CPC

Stakeholders Costs Benefits TotalRegulated firms Higher Higher HigherConsumers Slightly

lowerNo effect Lower

Authorities Higher Higher HigherOverall economy More benefits

Some costs

Legend: + increase- decrease= no effect

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Basel II

Simplified Calculation example

STANDARDIZED APPROACH

2

Composition of Supervisory Capital

Supervisory capital is composed of Tier 1 capital and Tier 2 capital, net of deductions.

11,926,000,000 Supervisory capital (Tier 1 + Tier 2)

300,000,000 Total other negative elementsNet gains on participating interest

300,000,000 Hybrid capital instruments and subordinated liabilities

Valuation reserves Tier 2 capital 11,626,000,000 Total (80,000,000)Negative Tier 1 capital prudential filters

Losses carried forward and from the current year (200,000,000)Intangible assets**

GoodwillOwn sharesnegative elements to be deducted

6,000,000 Positive Tier 1 capital prudential filters 1,000,000,000 Net income for the period 900,000,000 Reserves including the share premiums account 10,000,000,000 Paid up capital * Tier 1 capital

Amounts SUPERVISORY CAPITAL The calculation method is very similar to current CB regulation.

The main difference related to items currently applicable to all banks consists on the P&L of the period, which can be entirely included.

*The paid up capital can also include shares that entitle for increased dividend.

** Intangible assets go net of related reserves, if measured at fair value.

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Composition of RWA for Credit RiskThe application of the basic method for calculating the capital requirement for credit risk necessitates of:

1) the assignment of exposures to different classes based on the nature of the counterparty or the technical characteristics of the transaction or the manner in which it is carried out. The exposure classes are:

16. other exposures.15. exposures belonging to regulatory high-risk categories;14. past due exposures;13. exposures in the form of covered bonds;12. exposures secured by real estate property;11. securitization positions;10. collective investment undertakings (CIUs);9. short-term exposures to supervised institutions and corporates;8. retail exposures;7. corporates and other persons;6. international organizations;5. multilateral development banks;4. non-commercial and public sector entities;3. regional governments and local authorities;2. supervised institutions;1. central governments and central banks;

2) the assignment of diversified risk weights to each portfolio

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Ratings for Credit Risk - BanksBasel II links each Risk Weight with a Credit Quality Step. The latter is used by the rating agencies as well, matching to each Credit Quality Step the letters with which we all are familiar with. Below is the one used in the example: Moody’s.

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Ratings for Credit Risk - Banks

According to Moody’s Investors Service for the first sovereign rating assigned to Albania, June 29, 2007, the ratings to be used for local exposures are:

Baa1FCY

B2LCY

 Bank Deposit CeilingB1FCY

A3LCY

Government Debt ObbligationBa1FCY Bonds

A3LCY Bonds

Moody’s Country Ceiling Albania

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RWA Credit Risk – BanksThere are 8 main groups applicable in our example as is shown in the following tables:

  - 0% 746 Security issued from multirateral

development banks 

 List of MDBs is provided.

-   746 Assets to multilateral development

banks6

11 20% 57 Escrow accounts 

372 100% 372 Nostro accounts + placements

1,079 20% 5,396 Placemenets (Intercompany)

1,556 20% 7,780 Nostro accounts + placements

32 20% 162 Security (Intercompany)

2,118 100% 2,118 Security FCY, other

750 20% 3,751 Security FCY, issuer banks and

financial institutions

Exposures to supervised institutions shall be assigned a risk weight corresponding to the credit quality step assigned to exposures to the central gov. of the jurisdiction in which these institutions are established. However, preferential weights are applied to short term exp.

5,919   19,636 Assets to supervised institutions2

3,200 100% 3,200 Obligatory reserve in other currency 

- 0% 5,100 Obligatory reserve LCY

80 20% 400 Securities denominated in other FCY

- 0% 20,000 Securities

- 0% 14,000 Treasury Bills

Where the superv. auth. of a non-Member State assigns a lower risk weight than indicated in BII to exposures to their cen.gov. or cen.bank in the domestic ccy, banks shall assign the same risk weight to such exposures.OR in Fcy – B1 (100%)

3,280   42,700 Assets to Central goverments and

central banks1

NotesWeighted value of net exposure

Risk weight %

Exposure adjusted with collateralsOn balance sheet - Assets

 

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RWA Credit Risk – Other BSH ItemsThere are 8 main groups applicable in our example as is shown in the following table:

31,523  86,974 TOTAL 2,032 100%2,032 Tangible assets as by regulations

applicable to banks 

202 20%1,012 Cash items in process of collections- 0%157 Current accounts with Central bank- 0%1,191 Cash and cash equivalent

2,234  

4,392 Other assets (exposures)151,861 100%1,861 Non performing loans (individually

impaired, including the provisions) 

1,861  

1,861 Past due assets 13

771 35%

2,202 Assets secured by mortgages on residental property

 

a) the residential property is or will be occupied or is or will be rented by the owner; b) the borrower’s capacity to repay does not materially depend on cash flows generated by the property serving as collateral, but on other sources; c) the amount of the exposure does not exceed 80% of the value of the property; this limit may be raised to 100%

771  

2,202 Assets secured by real estate property

115,696 75%7,594 Loans to customers (retail) 

A risk weight of 75% shall apply to exposures in the retail class given certain conditions.

5,696  

7,594 Retail exposure (includes unsecured exposures, SME and other)

811,763 150%7,842 Loans to customers (corporates) 

Bank Deposit Ceiling used from the mapping provided.

11,763

7,842

Assets to corporates and other persons

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NotesWeighted value of net exposure

Risk weight %

Exposure adjusted with collaterals

On balance sheet - Assets 

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RWA Credit Risk – Off BSH ItemsIn order to calculate the credit risk associated with guarantees and commitments

issued, the bank shall first calculate the credit equivalent amount of the exposure. The credit equivalent amount shall be calculated by applying credit conversion factors that take account of the higher or lower probability that the guarantee or commitment could be transformed into an on-balance-sheet exposure. Specifically, one of the following credit conversion factors shall be applied to the exposures: (i) low risk, 0%; (ii) medium-low risk, 20%; (iii) medium risk, 50%; (iv) full risk, 100%.

1,35424,365  18,668  21,836 TOTAL OFF BSH 

- 0%

- 0%959 Forex spot and forwards with customers

 

- 522 20%2,612 100%2,612 Guaranttees for customer with

Counterguaranttees from HO

1,266 23,805 150%15,870 100%15,870 Guaranttees/Commitments to customers

1,266 24,327  

18,482   19,441

Assets to corporates and other persons7

-

- 0%

- 0%2,000 Forex spot and forwards with banks 

88 37 20%186 100%186 Gurantees to credit institutions

88 37 186 2,395

Assets to supervised institutions

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Value of collateral net of prudential haircuts (comprehensive method)

Weighted value of net exposure

Risk weight %

Credit equivalent of guaranttees and commitments

Credit conversition factor %

Exposure adjusted with collaterals

Off balance sheets

 

SPI Project on Reviewing the Capital Adequacy Regulation

Minutes

Attendees: Miranda Ramaj, BoA (PM)Adela Xhemali, ISPB (DPM)Admir Ramadani, FIB (member)Entela Gjyzari, BP (member)Sokol Pellumbi, BKT (member)Majlinda Gjata, RB (member)Plator Ulqinaku, UB (member)Lyela Rama, AMF (member)Ermira Curri, BoA (member)Altin Koci, ICB (member) Adela Leka, PCB (member)Jola Dima, ISPB (member)Gerond Ziu, BoA (observer)

SPI Albania Secretariat Mrs. Anuela Ristani, Director of Operations, anuela.ristani@spi-albania.eu

Ms. Elona Bollano, Director of Analytics and Policy, elona.bollano@spi-albania.eu Address: Twin Tower I, Kati 6, Apt. A3. Tirana, Albania. Tel. +355 42 280 359; Fax. + 355 42 280 371

www.spi-albania.eu

Project Objective

Within the policy goal of improving the capital adequacy to the credit risk and to the operational risk according to Basel II, First pillar, the project objective is to prepare the necessary regulatory amendments and to define an implementation timeframe

Project Management TeamProject Owner (PO): Indrit Banka, Supervision Director, BoAProject Manager (PM): Miranda Ramaj, Supervision Deputy Director, BoADeputy Project Manger (DPM): Adela Xhemali, VP, Head of Finance Department,

Intesa San Paolo Bank

Second meetingJanuary 22, 2009—AAB premises

Elvis Zaimi, BoA(observer)Gerti Caushi, BoA (observer)Ervin Sahatciu, BoA (observer)Elvana Troqe, BoA (observer)

Elona Bollano, SPI Albania, Director of Analysis and PolicyAnuela Ristani, SPI Albania, Director of Operations

AGENDA

I. Welcome Note—Project Manager

II. Presentation of SPI Albania and Introduction of Participants.

III. Project Terms of Reference presentation (Discussion and approval)

IV. Presentation of the Draft Note on International Experience (Discussion and approval)

V. Presentation of the Scoping of the Problem Document (Discussion and approval)

VI. Presentation of the Cost-Benefit Analysis (Discussion and approval)

VII. Presentation of Intesa SanPaolo Bank on Credit Risk Methodology

VIII. Sub-working groups for each individual component of Capital Adequacy Framework:

a. Regulatory Capitalb. Credit Riskc. Operational Risk

IX. Conclusions and Distribution of Tasks

X. Closing Remarks

I. Welcome Note and Introduction of the Participants

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PM and SPI Secretariat welcomed all the PWG members and introduced the PMT, and the SPI Albania Secretariat. All members introduced themselves and the institutions they were representing. Upon the suggestion of the PMT and initial PWG members, of the SPI Secretariat sent invitation to all banks out of which 14 appointed their representatives to participate as Project Working Group Members.

II. Presentation of SPI Albania

In order for the PWG members to have a better understanding on the SPI work process. SPI Secretariat held a short presentation focusing on the SPI Albania Project management and Methodologies.

The SPI Secretariat presented to the PWG the organizational and Project Management structures that lead all the SPI project initiatives from the conception of the project proposal until the enactment procedures for each project outcome. The partnership is lead by a high level public private Committee with representatives from BoA (First Deputy Governor), AAB (Chairman) and the Head of Convergence Program (World Bank) as well as 3 Permanent Observers (MoF, AMF and Market Surveillance Department-MoE). SPI Secretariat orchestrates different working groups for each SPI Project.

SPI Secretariat presented the role and responsibilities of the PMT and PWG members as well as the role of the Secretariat throughout the entire project process from the initial initiative to enactment monitoring.

SPI Secretariat shortly presented the methodology followed for every SPI Albania – EU Better Regulation Approach and its 11 steps which will be applied for this project as well as for every other SPI Albania project.

III. Project Terms of Reference presentation (Discussion and approval)

SPI Secretariat presented the Project Terms of Reference as the outlining document that will guide the PWG through all the project steps.

BoA is seeking to improve and to expand the coverage of the regulation on capital adequacy in order to capture a wider range of risks faced by the banks. The current regulation on Capital Adequacy establishes the regulatory capital to risk weighted assets and off-balance sheet items ratio, and sets the minimum required limit for this ratio.

The methodology used in the current framework calculates the (minimum) regulatory capital to cover only for credit risk. BoA intends to improve risk management in line with Basel II, by enhancing the methodology for calculating risk weighted assets to credit risk and by including the operational risk in calculating the capital requirement. In this way in the banking regulations the first pillar on minimum capital requirements of Basel II will be introduced.

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Basel Committee recommendations for calculating credit risk charges permit banks to choose between two broad methodologies to measure credit risk: the Standardized Approach and the Internal Ratings-based Approach; the second approach is subject to the explicit approval of the banks’ supervisor.

For calculating operational risk charges the Committee provides three methods: (i) the Basic Indicator Approach; (ii) the Standardized Approach; and (iii) Advanced Measurement Approaches (AMA).

Given the current status of developments of the banking industry and the internal capacities, BoA has considered that the Simplified Standardized Approach as the most appropriate method for calculating credit risk charges. In line with the simplified standardized approach, Basel Committee suggests the Basic Indicator Approach for operational risk.Committee encourages banks to move along from the spectrum of available approaches [starting from (i)] as they develop more sophisticated operational risk measurement systems and practices. The other more sophisticated approaches require long time data series and experience in operational risk identification and management

Therefore, the project objective is to prepare the necessary regulatory amendments to introduce the above two mentioned risk management methodologies and to define an implementation timeframe. The objective of the project will be achieved by undertaking the following actions:

1. The identification the legal framework that regulates the capital requirements for banks

2. The acquisition of a clear understanding on the provisions of Basel II and EU respective directives and international experience on capital adequacy framework, focused on credit and operational risk;

3. Based on the gained expertise, to formulate proposal for amendments in the existing legal framework and/or for issuing new regulations and guidelines in order to have a comprehensive regulatory framework;

4. The assessment of the possible impact of the new methodologies on credit and operational risk and run consultations on the regulatory design and impact;

5. The identification of the implementation plan.

The PWG members representing the banks stressed the degree of difficulty in applying Basel II. There are different challenges arising from the standards of data recording before any other calculation/estimation is made. Since the Banks have different data entry systems, it comes as a need that they enter the data manually in order for these data to represent the same information for the entire system. Raiffeisen has started to prepare for the implementation of Basel II earlier than all the banks and they might provide for a valuable case-study for BoA and the PWG to assess the methodology and procedures to be followed. Raiffeisen has already started to apply the Standardized approach and by 2012 they will be ready for partial AMA application.

PWG representing the banks expressed their interest in developing an implementation strategy. BoA is committed to make this timeline acceptable and adaptable for all second level banks in Albania, considering the fact that some of them (RB), based on

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the experience of their parent companies, have already started to work for the adaptation of AMA in calculating capital charges in line with Basel II for internal purposes, and others who have not. RB representative invited the PMT and SPI Secretariat to have a meeting in order to study and share more of their information and implementation studies as well as steps followed so far on Basel II.

After agreeing on the objectives, the PWG approved the Project Terms of Reference

IV. Presentation of the Draft Note on International Experience

Basel Committee on Banking Supervision has the mandate to establish the framework on capital adequacy for credit institutions. The revised framework on Capital Accord Basel II is a comprehensive and extensive framework that describes exhaustive measures and minimum standards for capital adequacy. While in Europe, in 2006 the European Commission issued two directives on capital requirements for credit institutions. The European Directives reflect Basel II and are mandatory for the EU member countries.

The Committee permits banks a choice between two broad methodologies for calculating their capital requirements for credit risk, the Standardized Approach and the Internal Ratings-based Approach.

In the Standardized Approach, credit risk is measured in a standardized manner, supported by external credit assessments. In determining the risk weights in the standardized approach, banks may use assessments by external credit assessment institutions recognized as eligible for capital purposes. It is the responsibility of the national supervisors to determine whether an external credit assessment institution (ECAI) meets the defined requirements / criteria. Exposures should be risk-weighted net of specific provisions.

The alternative methodology is the Internal Ratings-based Approach. This methodology is subject to the explicit approval of the bank’s supervisor and would allow banks to use their internal rating systems for credit risk.The risk components include measures of the probability of default (PD), loss given default (LGD), the exposure at default (EAD), and effective maturity (M). In some cases, banks may be required to use a supervisory value as opposed to an internal estimate for one or more of the risk components.The IRB approach is based on measures of unexpected losses (UL) and expected losses (EL). The risk-weight functions produce capital requirements for the UL portion.Basel Committee introduced the operational risk in 2001 and defines it as “…the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.” EU Directive [2006/48/EC] provides the same definition.

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Operational risks exist as a company is using employees and/or systems in processes or is subject to external impacts and, therefore, they emerge long before credit or market risks. By its nature, operational risk is characterized:- as inherent to business, i.e. inseparably linked with almost all business activities;- as specific, i.e. its precise form and, therefore, all measures to control and mitigate

it strongly depend on the specific company profile; and- as a cultural risk, because the handling of so varied and networked risks,

summarized under the heading of operational risk, is a question of a company’s risk culture, i.e. its approach and practices in treating risks especially in day-to-day business.

The Basel Committee permits banks a choice between three broad methodologies for calculating their capital requirements for operational risk: (i) the Basic Indicator Approach, (ii) the Standardized Approach and (iii) Advanced Measurement Approaches (AMA).

PWG discussed further the methods on credit and operational risk. With regards to the credit risk, BoA considers the Simplified Approach and/or Simplified and Standardized Approach and for Operational Risk the Basic Indicator Approach (BIA) approach as most suitable for initiating the Basel II implementation process. For credit risk, BoA intends to adopt the General rules for risk weights presented in the Simplified and Standardized Approach, Annex 11 of the International Convergence of Capital Measurement and Capital Standards, (Basel II, new Capital Accord)..

Regarding the transposition of the Capital Requirements Directive, EU member states have followed different patterns in revising their regulatory framework. In some countries, like Romania, the supervisory authorities for banking and for securities have amended the entire legal framework (banking law, regulations, and orders), in cascade, in order to reflect the capital adequacy principles and requirements.

Another group of countries have included all the changes brought by the new directive on capital adequacy in one single document. Poland and the Czech Republic for example, have issued a single document on the capital requirements against particular risks and the detailed principles to be applied in determining those requirements, in a very comprehensive resolution on capital.

PWG members considered the note as very useful and suggested BoA to consider the idea of opening the possibility for AMA implementation by the more advanced banks.

V. Presentation of the Scoping of the Problem Document (Discussion and approval)

This document analyzes the market, the participants and the regulatory framework that governs this market. In the analysis it is specified that the regulatory framework on capital requirements has not been updated to the new realities and complexity of the banking activities and the capital requirements are not covering currently all the types of risks. According to SPI Secretariat’s assessment, this situation, in the near future, will lead in a regulatory failure, as the regulation would be wrongly prescribed for the market. There is no evidence for this regulatory failure in terms of banking

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bankruptcies, but the central bank should act in a visionary and prudent manner and prevent the occurrence of such situations in the future. This regulatory failure threats Bank of Albania’s objective to ensure the banking stability.

To respond to these developments banks might introduce voluntarily operational risk charges or even use more sophisticated methods to account for credit risk. Given that a large share of banks operating in Albania are part of international groups, some banks (or the respective parent) might have already introduced operational risk when defining the strategy or are planning to introduce it in the near future. Anyhow the intervention from the central supervisory authority is essential in order to establish and apply a uniform methodology that would correctly reflect the prudential concerns on credit and operational risk.The capital adequacy framework might be revised in a comprehensive manner (Option 1) by transposing the two methodologies in credit risk and the three methodologies in operational risk or (Option 2) in a more tailored manner by improving the credit risk methodology and, as suggest by the Basel Committee, by introducing in the first stage the Basic Indicator Approach for operational risk and in a latter stage complete the operational risk requirements by introducing the two other approaches.

The PWG agreed with the assessments made by the SPI Secretariat in Scoping of the Problem document and approved it without objections. .

VI. Presentation of the Cost-Benefit Analysis (Discussion and approval)

The calculation of the Cost and Benefits to stakeholders is done individually. For regulated firms the costs will be mainly operational, infrastructural and on human resources, while the benefits will consist in additional products/business, savings and equity requirements. For the regulated firms the costs will be higher during the implementation process but they will translate in higher benefits in the long run. For consumers the costs will consist on higher risks, higher prices, lower quality of service while the benefits will be better choices, price reductions, improved product access. All considered, for the consumers there will be lower costs as a consequence of a better capitalized and hedged banking activity. For the authorities the costs will mainly consist on training and external assistance, while the benefits imply statutory goals achievements, increase income to state budget and together with other indirect benefits, For the Authorities there will be one-off costs related to the process of new regulations, but also higher benefits as a result.All stakeholders considered, PWG generally agreed that there will be some costs related to the initial implementation of the revised framework, but in the long run the benefits, in monetary and non-monetary terms, will exceed by far the identified costs.

VII. Presentation of Intesa San Paolo Bank on Credit Risk Methodology

ISP Bank made a presentation of their simplified technique for the capital requirements for credit risk under the standardized approach, as asked and instructed by their mother company.

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The first step was the calculation of the supervisory capital. The calculation method is very similar to current CB regulation.The main difference related to items currently applicable to all banks consists on the P&L of the period, which can be entirely included.The second step is to calculate capital requirements for credit risk which include: the assignment of exposures to 16 classes of assets based on the nature of the counterparty or the technical characteristics of the transaction or the manner in which it is carried out and the assignment of diversified risk weights to each portfolio. Basel II links each Risk Weight with a Credit Quality Step. The latter is used by the rating agencies as well, matching to each Credit Quality Step rating. ISP assigned the weights according to Moody’s Investors Service for the first sovereign rating assigned to Albania, June 29, 2007. In order to calculate the credit risk associated with guarantees and commitments issued, the bank shall first calculate the credit equivalent amount of the exposure. The credit equivalent amount shall be calculated by applying credit conversion factors that take account of the higher or lower probability that the guarantee or commitment could be transformed into an on-balance-sheet exposure. Specifically, one of the following credit conversion factors shall be applied to the exposures: (i) low risk, 0%; (ii) medium-low risk, 20%; (iii) medium risk, 50%; (iv) full risk, 100%. This was ISP first attempt towards Basel II, but a good example of how to get started for the banks that have little or no experience. The main limitation in the ISP application was that the assets portfolio is not considered item by item but in its entirety (e.g. the retail loans and mortgage loans were not considered individually but all together).

PWG will receive this presentation for their reference along with all other meeting documents.

VIII. Conclusions and distribution of tasks

The sub-working groups will be created during the next PWG meeting after the PMT consultation with RB. PMT appreciated that the implementation examples provided by Raiffeisen Bank could help in a better shaping of these sub-working groups.

SPI Secretariat will coordinate with RB and PMT to organize a meeting with RB for the purpose of RB experience sharing in Basel II application.

SPI Secretariat will draft the cost-benefit questionnaire (Impact on the banking system of the new Capital Adequacy Framework) and will seek for PMT’s and Raiffeisen Bank PWG member’s validation before distributing it to the PWG.

VII. Closing Remarks

The second PWG meeting is preliminarily scheduled to take place in February 2009.

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