THE BANKER’S GUIDE TO THE BASEL II FRAMEWORK

December 2005

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FOREWORD

The Basel II document, formally The International Convergence of Capital Measurement and Capital Standards, published by the Basel Committee on Banking Supervision of the Bank for International Settlements (2004), had far reaching implications for banking in South Africa. The aim of this paper is to provide an introductory guide to this highly technical document and the vast amount of accompanying popular and scientific literature available on the web and in the press. This paper aims to provide a basic insight into the Basel II document for persons, e.g. new financial market analysts and financial journalist needing a basic understanding or introduction to the current bank supervision and regulation.

The paper was compiled from the original documents and reference to the paragraph numbers of the original documents is made in each section. The reader can therefore easily find the specific section in the original documents and read the detailed explanation not covered in this paper.

This paper is compiled from the Basel II documents by Prof. Paul Styger and Dr. Pieter G. Vosloo of the Centre for Business Mathematics and Informatics at the North-West University.

The Banking Association is the trade association for the banking industry in South Africa and can be located at www.banking.org.za

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TABLE OF CONTENTS

Page FOREWORD ii TABLE OF CONTENTS iii LIST OF FIGURES vi LIST OF TABLES vi LIST OF ABBREVIATIONS vii CHAPTERS 1. PART ONE: SCOPE OF APPLICATION 1 1.1 Introduction 1 1.2 Application Scope 3 1.2.1 Banking, securities and other financial subsidiaries 4 1.2.2 Significant minority investments in banking, securities and other

financial entities 4

1.2.3 Insurance entities 5 1.2.4 Significant investments in commercial entities 5 2. PART TWO: MINIMUM CAPITAL REQUIREMENTS 6 2.1 Calculation of minimum capital requirements 6 2.1.1 Definition 6 2.1.2 Regulatory capital 6 2.1.2.1 Capital elements 6 2.1.2.2 Definition of capital elements 7 2.1.2.2.1 Tier 1 7 2.1.2.2.2 Tier 2 7 2.1.2.2.3 Tier 3 8 2.1.3 Risk weighted assets 8 2.2 Credit risk 9 2.2.1 Introduction 9 2.2.2 Risk profile 9 2.2.3 Risk management and measurement 9 2.2.3.1 The standardised approach 10 2.2.3.1.1 Corporate, Bank and Sovereign exposures 10 2.2.3.1.2 Retail exposures 11 2.2.3.1.3 Higher risk categories 11 2.2.3.1.4 Other assets 11 2.2.3.1.5 Off-balance sheet items 11 2.2.3.1.6 External credit assessments 12 2.2.3.1.7 Credit risk mitigation 12 2.2.3.2 Internal ratings-based approach 13 2.2.3.2.1 Introduction 13

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2.2.3.2.2 Asset classes 14 2.2.3.2.3 Eligible purchased receivables 16 2.2.3.2.4 Unexpected and expected losses 16 2.2.3.2.5 Capital requirements under the IRB-approach 17 2.2.3.2.6 IRB-approach for specialised lending 18 2.2.3.2.7 IRB-approach for equity exposures 18 2.2.3.2.8 Implementation issues and requirements 19 2.2.3.3 Securitisation framework 20 2.2.3.3.1 Introduction 20 2.2.3.3.2 Standardised approach 21 2.2.3.3.3 Internal ratings-based approach 22 2.3 Operational risk 23 2.3.1 Definition 23 2.3.2 The measurement methodologies 24 2.3.2.1 Introduction 24 2.3.2.2 The basic indicator approach 25 2.3.2.3 The standardised approach 26 2.3.2.4 Advanced measurement approaches 27 2.3.2.5 Partial use – combinations 28 2.4 Trading book issues 28 2.4.1 Introduction 28 2.4.2 Basel II viewpoint 29 2.4.2.1 Definitions 29 2.4.2.2 Eligibility for trading book capital treatment 29 2.4.2.3 Valuation of the trading book 30 2.4.2.3.1 Marking to market 31 2.4.2.3.2 Marking to model 31 2.4.2.3.3 Independent price verification 31 2.4.3 Basel II applied to trading activities and the treatment of double

default effects 32

2.4.3.1 General 32 2.4.3.2 Measures of counterparty credit risk 33 2.4.3.3 The internal model method 33 2.4.3.4 Non-internal model methods 34 2.4.3.4.1 Current exposure method 34 2.4.3.4.2 Standardised method 35 3. PART THREE: THE SECOND PILLAR – THE SUPERVISORY

REVIEW PROCESS 37

3.1 Introduction 37 3.2 The importance of supervisory review 37 3.2.1 Introduction 37 3.2.2 Four key principles of supervisory review 38 3.2.2.1 Principle 1 38 3.2.2.1.1 Board and senior management oversight 38 3.2.2.1.2 Sound capital assessment 38 3.2.2.1.3 Comprehensive assessment of risks 39 3.2.2.1.4 Monitoring and reporting 40 3.2.2.1.5 Internal control review 41

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3.2.2.2 Principle 2 41 3.2.2.3 Principle 3 42 3.2.2.4 Principle 4 42 3.2.3 Specific issues to be addressed under the supervisory review

process 43

3.2.3.1 Introduction 43 3.2.3.2 Interest rate risk in the banking book 43 3.2.3.3 Credit risk 43 3.2.3.3.1 Stress tests under the IRB-approaches 43 3.2.3.3.2 Definition of default 43 3.2.3.3.3 Residual risk 44 3.2.3.3.4 Credit concentration risk 44 3.2.3.4 Operational risk 45 3.2.4 Other aspects of the supervisory review process 45 3.2.4.1 Supervisory transparency and accountability 45 3.2.4.2 Enhanced cross-border communication and cooperation 45 3.2.5 The supervisory review process for Securitisation 46 3.2.5.1 Introduction 46 3.2.5.2 Significance of risk transfer 46 3.2.5.3 Market innovation 46 3.2.5.4 Provision of implicit support 46 3.2.5.5 Residual risks 47 3.2.5.6 Call provisions 47 3.2.5.7 Early amortisation 47 4. PART FOUR: THE THIRD PILLAR – MARKET DISCIPLINE 49 4.1 Introduction 49 4.2 The disclosure requirements 50 4.2.1 General disclosure principle 50 4.2.2 Scope of application 50 4.2.3 Capital 50 4.2.4 Risk exposure and assessment 50 5. CONCLUSION 51 6. BIBLIOGRAPHY 52

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LIST OF FIGURES

Figure Page

1.1 Structure of The New Framework document 4

1.2 Illustration of the new scope and application of The New Framework

5

2.1 Valuation framework of the trading book 30

LIST OF TABLES

Table Page

2.1 Credit conversion factors 12

2.2 Risk Components 17

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LIST OF ABBREVIATIONS ABCP Asset-backed commercial paper ADC Acquisition, development and construction AMA Advanced measurement approaches ASA Alternative standardised approach CCF Credit conversion factor CDR Cumulative default rate CF Commodities finance CRM Credit risk mitigation EAD Exposure at default ECA Export credit agency ECAI External credit assessment institution EL Expected loss FMI Future margin income HVCRE High-volatility commercial real estate IAA Internal assessment approach IPRE Income-producing real estate I/O Interest-only strips IRB Internal ratings-based approach LGD Loss given default M Effective maturity MDB Multilateral development bank NIF Note issuance facility OF Object finance PD Probability of default PF Project finance PSE Public sector entity QRRE Qualifying revolving retail exposures RBA Ratings-based approach RUF Revolving underwriting facility SF Supervisory formula SL Specialised lending SME Small- and medium-sized entity SPE Special purpose entity UCITS Undertakings for collective investments in transferable securities UL Unexpected loss

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1. Part One: Scope of application

1.1. Introduction The Basel Committee (Committee on Banking Regulations and Supervisory Practices) was established by the Central Bank Governors of the Group of Ten countries at the end of 1974 in the aftermath of serious disturbances in international currency and banking markets (notably the failure of Bankhaus Herstatt in West Germany). After the initial meeting held in February 1975, regular meetings were held three to four times a year ever since. The Committee's members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States. Countries are represented by their respective central bank and/or the nominated authority with formal responsibility for the prudential supervision of banking business. The present Chairman of the Committee is Mr Jaime Caruana, Governor of the Bank of Spain.

The Committee provides a forum for regular cooperation on banking supervisory matters, between its member countries. Initially, it discussed modalities for international cooperation in order to close gaps in the supervisory net, but its wider objective has been to improve supervisory understanding and the quality of banking supervision worldwide. It seeks to do this in three principle ways: by exchanging information on national supervisory arrangements; by improving the effectiveness of techniques for supervising international banking business; and by setting minimum supervisory standards in areas where considered desirable.

The Committee does not possess any formal supranational supervisory authority. Its conclusions do not have, and were never intended to have, legal force. Rather, it formulates broad supervisory standards and guidelines and recommends statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements – statutory or otherwise – which are best suited to their own national systems. In this way, the Committee encourages convergence towards common approaches and common standards without attempting detailed harmonisation between the supervisory techniques of its members.

The topic to which most of the Committee's time has been devoted in recent years is capital adequacy. In the early 1980s, the Committee became concerned that the capital ratios of the main international banks were deteriorating just at the time that international risks, notably those vis-à-vis heavily-indebted countries, were growing. Backed by the Group of Ten Governors, the members of the Committee resolved to halt the erosion of capital standards in their banking systems and to work towards greater convergence in the measurement of capital adequacy. This resulted in the emergence of a broad consensus on a weighted approach to the measurement of risk, on and off the balance sheet.

There was a strong recognition within the Committee of the overriding need for a multinational accord to strengthen the stability of the international banking

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system and to remove a source of competitive inequality arising from differences in national capital requirements. Following comments on a consultative paper published in December 1987, a capital measurement system commonly referred to as the Basel Capital Accord (or the 1988 Accord) was approved by the G10 Governors and released to banks in July 1988. This system provided for the implementation of the framework with a minimum capital standard of 8 percent by end-1992. Since 1988, this framework has been progressively introduced not only in member countries but also in virtually all other countries with active international banks. In September 1993, a statement was issued confirming that all the banks in the G10 countries with material international banking business were meeting the minimum requirements laid down in the 1988 Accord. Some countries, like South Africa, even adopted higher capital adequacy requirements than specified.

The 1988 capital framework was not intended to be static but to evolve over time. In June 1999, the Committee issued a proposal for a new capital adequacy framework to replace the 1988 Accord, and this has been refined in the intervening years, culminating in the release of the New Capital Framework on 26 June 2004. Subsequent refinements on the new framework, e.g. The Application of Basel II to Trading Activities and the Treatment of Double default Effects (July 2005) are being published. The new framework consists of three pillars: minimum capital requirements, which seek to develop and expand on the standardised rules, set forth in the 1988 Accord; supervisory review of an institution's capital adequacy and internal assessment processes; and effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices. The Committee believes that, collectively, these three elements are the essential pillars of an effective capital framework.

The fundamental objective of the Committee’s revision of the 1988 Accord was to develop a framework that would further strengthen the soundness and stability of the international banking system while still maintaining sufficient consistency in capital adequacy regulation that it will not be a significant source of competitive inequality among internationally active banks. The Committee believes that the revised Framework will promote the adoption of stronger risk management practices by the banking industry, and views this as one of its major benefits. The Committee notes, in their comments on the proposals that banks and other interested parties have welcomed the concept and rationale of the three pillars approach (minimum capital requirements, supervisory review, and market discipline) on which the revised framework is based. More generally, they have expressed support for improving capital regulation to take into account changes in banking and risk management practices while at the same time preserving the benefits of a framework that can be applied as uniformly as possible at the national level.

The publication of the framework represents the culmination of nearly six years of challenging work. During those years, the Basel Committee consulted extensively with banks and industry groups in an attempt to develop significantly more risk-sensitive capital requirements that are conceptually sound. At the same time, the Committee considered the characteristics and needs of markets and supervisory systems in numerous countries. To achieve its aims, the Committee undertook a careful review of the existing rules and of the

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recent advances attained in the industry. It consulted widely and publicly with industry representatives, supervisory agencies, central banks, and outside observers. Through the medium of international conferences and the supervisory groupings referred to, the principles agreed by the Basel Committee have been widely disseminated. A large number of countries outside the Group of Ten have given their support to the fundamental objective of ensuring that no international banking activity should escape supervision.

The Committee has also recognised that home country supervisors have an important role in leading the enhanced cooperation between home and host country supervisors that will be required for effective implementation.

The Committee believes that the complexity of the new framework is a natural reflection of the advancements in the banking industry. Its underlying principles are intended to be suitable for application to banks of varying levels of complexity and sophistication. The goal of this effort has been to ensure that the principles embodied in the three pillars of the new framework are generally suitable to all types of banks around the globe. The Committee therefore expects the New Accord to be adhered to by all significant banks after a certain period of time.

The primary changes in the Basel II framework, compared to the 1988 document, are in the approach to credit risk and in the inclusion of explicit capital requirements for operational risk. A range of risk-sensitive options for addressing both types of risk is elaborated upon. While the new proposals provide capital reductions for various forms of transactions that reduce risk, they impose minimum operational standards in recognition that poor management of operational risks (including legal risks) could render such mitigants of effectively little or no value.

The Basel II document (The New Capital Framework) and this educational framework is divided into four parts. The first part, being the scope of application and details on how the capital requirements are to be applied within a banking group. In part two the calculation of the minimum capital requirements for credit risk and operational risk, as well as certain trading book issues is provided. The third and fourth parts outline expectations concerning supervisory review and market discipline, respectively. This structure of the document is presented in Figure 1.1 below.

1.2. Application scope

To ensure that risks within the entire banking group (i.e. holding company and its subsidiaries) are considered, the revised Accord will be extended and applied on a consolidated basis to internationally active banks, any holding company that is the parent entity within a banking group and to holding companies of banking groups excluding insurance subsidiaries.

Par 1 – 23 1

1 These numbers refer to the paragraph numbers in the Basel II document.

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The illustrative chart at the end of Part 1 provides the layout and scope of the New Capital Accord. The scope in terms of the application to subsidiaries, minority investments, insurance and investments in commercial entities, are summarised in the paragraphs to follow.

Figure 1.1 Structure of the New Capital Framework document

1.2.1. Banking, securities and other financial subsidiaries

All banking, majority-owned or -controlled banking entities, securities entities and other financial entities and other relevant financial activities

(both regulated and unregulated) conducted within a group containing an internationally active bank will be captured through consolidation.

Par 24 – 27

1.2.2. Significant minority investments in banking, securities and other financial entities Significant minority investments in banking, securities and other financial entities, where control does not exist, will be excluded from the banking group’s capital by deduction of the equity and other regulatory investments. It should however be noted that certain exceptions exist, for example, JV’s

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(Joint Ventures) or where parent companies are legally obliged to support another company, it should form part of the capital calculation.

Par 28 – 29

1.2.3. Insurance entities A bank that owns an insurance subsidiary bears the full entrepreneurial risks of the subsidiary and should recognise on a group-wide basis the risks included in the whole group. When measuring regulatory capital for banks, the Committee believes that at this stage it is, in principle, appropriate to deduct banks’ equity and other regulatory capital investments in insurance subsidiaries and also significant minority investments in insurance entities (The deduction approach will be 50% from Tier 1 and 50% from Tier 2 capital)Supervisors will ensure that majority-owned or controlled insurance subsidiaries, which are not consolidated and for which capital investments are deducted or subject to an alternative group-wide approach, are themselves adequately capitalised to reduce the possibility of future potential losses to the bank.

Par 30 -34

1.2.4. Significant investments in commercial entities Investments in significant minority- and majority-owned and -controlled commercial entities below the materiality levels, determined by national accounting and/or regulatory practices, will be risk-weighted at no lower than 100% for banks using the standardised approach. For banks using the IRB approach, the investment would be risk weighted in accordance with the methodology the Committee is developing for equities and would not be less than 100%.

Par 35 – 36

Figure 1.2 Illustration of the new scope and application of the New Framework

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2. Part 2: The First Pillar – Minimum Capital Requirements 2.1. Calculation of minimum Capital Requirements 2.1.1. Definition

Part 2 of Basel II (the New Capital Framework) describes the calculation of the total minimum capital requirements for credit, market and operational risk.

The capital adequacy ratio (CAR) is defined by the following formula:

CAR = Qualifying (Eligible) Regulatory Capital / Risk Weighted Assets

Basel II requires CAR > 8% 2

CAR will be calculated using the definition of regulatory capital and risk-weighted assets.

2.1.2. Regulatory capital The Basel I definition of eligible regulatory capital remains in place.

2.1.2.1. Capital elements Tier 1

(a) Paid-up share capital/common stock

(b) Disclosed reserves Tier 2

(a) Undisclosed reserves

(b) Asset revaluation reserves

(c) General provisions/general loan-loss reserves

(d) Hybrid (debt/equity) capital instruments

(e) Subordinated debt

Tier 3 (added in later Basel documents)

(a) Short-term subordinated debt.

2 Currently the SARB applies a capital adequacy ratio of 10%

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2.1.2.2. Definition of Capital elements 2.1.2.2.1. Tier 1

Includes only permanent shareholders' equity (issued and fully paid ordinary shares/common stock and perpetual non-cumulative preference shares) and disclosed reserves (created or increased by appropriations of retained earnings or other surplus, e.g. share premiums, retained profit, general reserves and legal reserves). In the case of consolidated accounts, this also includes minority interests in the equity of subsidiaries that are less than wholly owned. This basic definition of capital excludes revaluation reserves and cumulative preference shares.

2.1.2.2.2. Tier 2 (a) Undisclosed reserves are eligible for inclusion within supplementary elements provided these reserves are accepted by the supervisor. Such reserves consist of that part of the accumulated after-tax surplus of retained profits which banks in some countries may be permitted to maintain as an undisclosed reserve. This definition of undisclosed reserves excludes values arising from holdings of securities in the balance sheet at below current market prices.

(b) Revaluation reserves arise in two ways. Firstly, in some countries, banks (and other commercial companies) are permitted to revalue fixed assets, normally their own premises, from time to time in line with the change in market values. Revaluations of this kind are reflected on the face of the balance sheet as a revaluation reserve, including, at national discretion, allocations to or from reserve during the course of the year from current year's retained profit. Secondly, hidden values of "latent" revaluation reserves may be present as a result of long-term holdings of equity securities valued in the balance sheet at the historic cost of acquisition. Both types of revaluation reserve may be included in tier 2 provided that the assets are prudently valued, fully reflecting the possibility of price fluctuation and forced sale

(c) Hybrid (debt/equity) capital instruments. This heading includes a range of instruments that combine characteristics of equity capital and of debt. Their precise specifications differ from country to country, but they should meet the following requirements:

- they are unsecured, subordinated and fully paid-up;

- they are not redeemable at the initiative of the holder or without the prior consent of the supervisory authority;

- they are available to participate in losses without the bank being obliged to cease trading (unlike conventional subordinated debt);

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- although the capital instrument may carry an obligation to pay interest that cannot permanently be reduced or waived (unlike dividends on ordinary shareholders' equity), it should allow service obligations to be deferred (as with cumulative preference shares) where the profitability of the bank would not support payment.

(d) Subordinated term debt: includes conventional unsecured subordinated debt capital instruments with a minimum original fixed term to maturity of over five years and limited life redeemable preference shares. These instruments will be limited to a maximum of 50% of Tier 1.

2.1.2.2.3. Tier 3 (added in later Basel documents) Tier 3 capital will be subject to the following conditions:

a) It should have an original maturity of at least two years and will be limited to 250% of the bank's tier 1 capital that is allocated to support market risk.

b) It is only eligible to cover market risk, including foreign exchange risk and commodities risk.

c) Insofar as the overall limits in the 1988 Accord are not breached, tier 2 elements may be substituted for tier 3 up to the same limit of 250%.

d) It is subject to a "lock-in" provision which stipulates that neither interest nor principal may be paid if such payment means that the bank's overall capital would then amount to less than its minimum capital requirement.

2.1.3. Risk weighted assets The Committee considered in Basel I that a weighted risk ratio (where capital is related to different categories of asset or off-balance-sheet exposure, weighted according to broad categories of relative riskiness), is the preferred method for assessing the capital adequacy of banks.

In Basel II this approach is expanded. This is not to say that other methods of capital measurement are not also useful, but they are considered by the Committee to be supplementary to the risk-weight approach. The Committee believes that a risk ratio has the following advantages over the simpler gearing ratio approach:

o it provides a fairer basis for making international comparisons between banking systems whose structures may differ;

o it allows off-balance-sheet exposures to be incorporated more easily into the measure;

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o it does not deter banks from holding liquid or other assets which carry low risk.

The total risk-weighted assets are determined by multiplying the capital requirements for market risk and operational risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8%) and adding the resulting figures to the sum of risk-weighted assets for credit risk.

Par 40 – 44

The remainder of Part 2 is dedicated to the calculation of credit risk and operational risk and their associated capital charges, as well as a short discussion on trading issues that need to be addressed.

2.2. Credit risk 2.2.1. Introduction

Pillar 1 of Basel II sets out the quantitative and qualitative requirements and formulae to calculate capital for credit risk. The overarching principle behind these requirements is that rating and risk estimation systems and processes provide for a meaningful assessment of borrower and transaction characteristics; a meaningful differentiation of risk; and reasonably accurate and consistent quantitative estimates of risk. Furthermore, the systems and processes must be consistent with internal use of these estimates. The Committee recognises that differences in markets, rating methodologies, banking products, and practices require banks and supervisors to customise their operational procedures. It is not the Committee’s intention to dictate the form or operational detail of banks’ risk management policies and practices. Each supervisor will develop detailed review procedures to ensure that banks’ systems and controls are adequate to serve as the basis for the IRB approach.

Par 389

2.2.2. Risk profile

Basel II improves the capital framework's sensitivity to the risk of credit losses generally by requiring higher levels of capital for those borrowers thought to present higher levels of credit risk, and vice versa. The formulae consider not only an estimate of the creditworthiness of borrowers, but also transaction characteristics such as collateral and maturity in order to arrive at the capital requirement.

2.2.3. Risk management and measurement

Three options are available to allow banks and supervisors to choose an approach that seems most appropriate for the sophistication of a bank's activities and

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internal controls. In order of increasing sophistication and risk sensitivity these options are:

• the Standardised Approach;

• the Internal Ratings Based (IRB) Foundation Approach (FIRB); and.

• the IRB Advanced Approach (AIRB).

Banks that engage in more sophisticated risk-taking and that have developed advanced risk measurement systems may, with the approval of their supervisors, select from one of two "internal ratings-based" ("IRB") approaches to credit risk. Under an IRB approach, banks rely partly on their own measures of a borrower’s credit risk to determine their capital requirements, subject to strict data, validation, and operational requirements.

The new regulations link the quality of a bank’s advances (credit) portfolio directly to a risk-based capital adequacy requirement. Importantly, the new regulations recognise sound collateral-taking (security) and recovery rates on defaulted debts.

2.2.3.1. The Standardised Approach The Standardised Approach is similar to the current Basel I approach where exposures are assigned to risk weight categories based on their characteristics. The Standardised Approach is supported by external credit assessments. The main supervisory categories in the Standardised Approach are claims on sovereigns, non-central government public sector entities, multilateral development banks, banks, corporates, retail loans, residential real estate and commercial real estate.

Par 50 - 52

2.2.3.1.1. Corporate, bank and sovereign exposures The individual borrower's quality is reflected by its external rating, as assigned by external rating agencies. If there is no external rating, the loan's risk is generally weighted with 100% (as under Basel I).

In order to calculate the credit risk capital requirement ratio, the loan amount is multiplied with the risk weight and the capital requirement of 8% (or currently 10% in South Africa).

Basel II has also enhanced the risk sensitivity of the Standardised Approach, from Basel l, by a substantial revision of the approach to credit risk mitigation. The 1988 Accord only recognised cash and government securities as collateral that was capable of reducing risk and therefore of reducing (or eliminating) the capital charge. There has been a considerable expansion of the range of collateral, guarantees, netting and credit derivatives that are eligible for risk mitigation purposes and the resulting reduction in the capital charge.

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Few corporates in South Africa are externally rated. Therefore, the simplified standardised approach can be applied, where a risk weight of 100% is assigned to all of these exposures.

Par 53 - 68

2.2.3.1.2. Retail exposures Retail exposures are generally weighted at 75% under the standardised approach. (The exception being past due loans, where risk weight percentage will depend on the level of specific provisions.) However, lending fully secured by mortgages on residential property, that is or will be occupied by the borrower, or that is rented, can be risk weighted at 35% once the supervisory authorities have satisfied themselves that the concession is applied for residential purposes only. Due to the impact of this concession, the difference in the capital charge between the Standardised Approach and the IRB Approach should be noted.

The criteria for an exposure to be recognized as part of the retail portfolio are based on the counterparty, the product type, the number of exposures in the portfolio, the value of the exposures and the collateral type (e.g. residential mortgages). For purposes of risk weighting, past due loans are to be excluded from the overall regulatory retail portfolio (granularity criterion).

Par 70 - 78

2.2.3.1.3. Higher risk categories Basel II also identifies certain higher risk assets which are weighted at 150%. These include, (inter alia), sovereigns and banks rated below B- and corporates rated below BB-.

Par 79 - 80

2.2.3.1.4. Other assets All other assets (except securitisation assets) are risk weighted at 100%, as in Basel l.

2.2.3.1.5. Off-balance sheet items Off-balance-sheet items under the standardised approach are converted into credit exposure equivalents through the use of credit conversion factors (CCF).

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Table 2.1 Credit conversion factors

Credit conversion factors Commitments -original maturity up to one year*

20%

Commitments -original maturity over one year*

50%

Securities lending (including where these arise out of repo-style transactions)

100%

Short-term self-liquidating letters of credit

20%

* Except any commitments that are unconditionally cancellable at any time by the bank without prior notice, or that effectively provide for automatic cancellation due to deterioration in a borrower's creditworthiness (which will receive a 0% CCF). CCFs not specified remain as defined in the 1988 Accord (e.g. performance guarantees at 50%).

Par 82 - 89

2.2.3.1.6. External credit assessments As mentioned above, external credit assessments (credit ratings) are used to determine the risk weightings of corporate, bank and sovereign exposures under the standardised approach. The regulator will have to determine whether an external credit assessment institution (rating agency) meets the criteria of Basel II which include objectivity, independency, transparency and credibility.

Par 90 -108

2.2.3.1.7. Credit risk mitigation Basel II allows for more recognition of credit risk mitigation instruments, in line with the philosophy of a more risk sensitive capital regime. The following is a brief overview of the different credit risk mitigation techniques:

Collateralised transactions

A collateralised transaction is one in which banks have a credit exposure or potential credit exposure; and that credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty. Banks must have clear and robust procedures for the timely liquidation of collateral to ensure that any legal conditions

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required for declaring the default of the counterparty and liquidating the collateral are observed, and that collateral can be liquidated promptly. A capital requirement will be applied to a bank on either side of the collateralized transaction: for example, both repos and reverse repos will be subject to capital requirements. Likewise, both sides of securities lending and borrowing transactions will be subject to explicit capital charges, as will the posting of securities in connection with a derivative exposure or other borrowing.

On-balance sheet netting

Where banks have legally enforceable netting arrangements for loans and deposits they may calculate capital requirements on the basis of net credit exposures.

Guarantees and credit derivatives

Where guarantees or credit derivatives are direct, explicit, irrevocable and unconditional, and supervisors are satisfied that banks fulfil certain minimum operational conditions relating to risk management processes they may allow banks to take account of such credit protection in calculating capital requirements.

Maturity mismatch

Where the residual maturity of the CRM (Credit Risk Mitigation) is less than that of the underlying credit exposure a maturity mismatch occurs. Where there is a maturity mismatch and the CRM has an original maturity of less than one year, the CRM is not recognised for capital purposes. In other cases where there is a maturity mismatch, partial recognition is given to the CRM for regulatory capital purposes. Under the simple approach for collateral maturity mismatches will not be allowed. For purposes of calculating risk weighted assets in the Standardised Approach, a maturity mismatch occurs when the residual maturity of a hedge is less than that of the underlying exposure.

Miscellaneous

Treatments for pools of credit risk mitigants and first- and second-to-default credit derivatives are explained.

Par 109- 210

2.2.3.2. The Internal Ratings-Based Approach 2.2.3.2.1. Introduction

The two main principles behind the Internal Ratings Based (IRB) Approaches (Foundation and Advanced) are the usage of banks’ own information about the credit quality of their assets and the promotion

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of best practices in risk measurement and risk management. This is in contrast to the current approach and the Standardised Approach under Basel II, which is mainly dependent on supervisory inputs to determine the capital requirement.

The IRB Approach is based on measures of Unexpected Loss and Expected Loss. The risk weight functions produce capital requirements for the Unexpected Loss portion. Under the IRB Approach, banks must categorise banking book exposures into broad classes of assets with different underlying risk characteristics, being corporate, sovereign, bank, retail and equity. These are discussed in greater detail later in this document.

Par 211 - 217

For each of the asset classes covered under the IRB framework, there are three key elements:

• Risk components ─ estimates of risk parameters provided by banks some of which are supervisory estimates. These are Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Maturity (M) that are discussed in more detail below.

• Risk-weight functions ─ the means by which risk components are transformed into risk-weighted assets and therefore capital requirements.

• Minimum requirements ─ the minimum standards that must be met in order for a bank to use the IRB approach for a given asset class.

For many of the asset classes, the Basel Committee has made available two broad approaches: a foundation and an advanced. Under the foundation approach, as a general rule, banks provide their own estimates of PD and rely on supervisory estimates for other risk components. Under the advanced approach, banks provide their own estimates of PD, LGD and EAD, and their own calculation of M, subject to meeting minimum standards. For both the foundation and advanced approaches, banks must always use the risk-weight functions provided in this Framework for the purpose of deriving capital requirements.

Par 244 - 262 2.2.3.2.2. Asset classes

The main asset classes are:

Corporate (with further sub-classes for specialised lending)

In general, a corporate exposure is defined as a debt obligation of a corporation, partnership, or proprietorship. Banks are permitted to

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distinguish separately exposures to small- and medium-sized entities (SME). Five sub-classes of specialised lending are identified, namely, project finance, object finance, commodity finance, income-producing commercial real estate and high-volatility commercial estate.

Sovereign

This asset class covers all exposures to counterparties treated as sovereigns under the standardised approach.

Bank

This asset class covers exposures to banks and securities firms, where the latter are subject to supervisory and regulatory arrangements that are compatible to the arrangements as advocated by the new framework.

Retail (with further sub-classes i.t.o. products) needs to meet the following criteria:

• Exposures to individuals – such as revolving credits and lines of credit (e.g. credit cards, overdrafts, and retail facilities secured by financial instruments) as well as personal term loans and leases (e.g. instalment loans, auto loans and leases, student and educational loans, personal finance, and other exposures with similar characteristics).

• Residential mortgage loans (including first and subsequent liens, term loans and revolving home equity lines of credit) are eligible for retail treatment regardless of exposure size so long as the credit is extended to an individual that is an owner-occupier of the property (with the understanding that supervisors exercise reasonable flexibility regarding buildings containing only a few rental units ─ otherwise they are treated as corporate).

• Loans extended to small businesses and managed as retail exposures are eligible for retail treatment.

• The exposure must be one of a large pool of exposures, which are managed by the bank on a pooled basis.

Equity

In general, equity exposures are defined on the basis of the economic substance of the instrument. They include both direct and indirect ownership interests, whether voting or non-voting, in the assets and income of a commercial enterprise or of a financial institution that is not consolidated or deducted pursuant to Part 1 of the Framework.

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Debt obligations and other securities, partnerships, derivatives or other vehicles structured with the intent of conveying the economic substance of equity ownership are considered an equity holding.

2.2.3.2.3. Eligible purchased receivables

Eligible purchased receivables are divided into retail and corporate receivables as defined below.

Retail receivables

Purchased retail receivables, provided the purchasing bank complies with the IRB rules for retail exposures, are eligible for the top-down approach as permitted within the existing standards for retail exposures. The bank must also apply the minimum operational requirements.

Corporate receivables

In general, for purchased corporate receivables, banks are expected to assess the default risk of individual obligors consistent with the treatment of other corporate exposures. However, the top-down approach may be used, provided that the purchasing bank’s programme for corporate receivables complies with both the criteria for eligible receivables and the minimum operational requirements of this approach.

The IRB approach provides formulae to calculate the risk weights of the assets. In principle, higher risk (as determined by the risk components discussed below) will result in a higher capital requirement.

The IRB approach also sets minimum qualitative requirements covering issues such as governance, independent review and data quality and must be met in order to be able to apply the IRB Approach for a given asset class.

Par 218 – 243

2.2.3.2.4. Unexpected losses and expected losses The IRB risk weight functions produce capital requirements that should cover the unexpected losses of the bank. The expected losses are calculated separately and are compared to the total allowable provisions (specific and general credit provisions). Any shortfalls or excesses of provisions over expected losses could be adjusted to or recognized as capital under Basel II, subject to certain limits.

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2.2.3.2.5. Capital requirements under the Internal Ratings Based Approach

For both the Internal Rating Based Approaches, the following diagram depicts the interaction of the risk components and the capital requirement:

Table 2.2 Risk components Risk components

Foundation Advanced PD Bank calculates Bank calculates LGD Prescribed Bank calculates EAD Prescribed Bank calculates M Prescribed/calculated Bank calculates

⇓ Risk weight functions

Risk weight = PD (x capital factor) x LGD

⇓ Capital requirements Capital requirement = Risk weight x exposure (EAD) x 8% (currently 10% in South Africa)

Below are descriptions of the risk components mentioned above:

• Probability of default (PD): one-year probability that a borrower will default on its debt obligations.

• Loss given default (LGD): the loss in the event of default, i.e. expected average loss per unit of exposure. This will depend on the collateral, both financial and physical. For the FIRB, prescribed LGD’s are given by Basel II. For the AIRB, the bank will use its own estimates of loss.

• Exposure at default (EAD): for on balance sheet transactions, the exposure at default will be the amount of the exposure. For off balance sheet items, credit conversion factors are used to obtain credit equivalent amounts. For the FIRB, the EAD measures are provided, and for AIRB the bank will use its own estimates.

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• Maturity (M): Maturity is based on contractual cash flows. All other things being equal, the longer the maturity of an exposure, the higher the risk. Maturity is capped at 5 years.

For retail exposures, banks must provide their own estimates for PD, LGD and EAD, and thus there is no distinction between the Foundation and Advanced Approaches.

Banks must use information and techniques that take appropriate account of the long-run experience when estimating the average PD for each rating grade. Basel II sets out three specific techniques for PD estimation, namely internal default experience, mapping to external data and statistical default models. For retail exposures, banks must regard internal data as the primary source of information for estimating loss characteristics. At least five years of data are required to estimate PD’s. The history requirements for LGD and EAD data are a minimum of seven years (LGD data = 5 years for retail and 7 years for corporate).

Par270 - 338

2.2.3.2.6. IRB Approach for specialised lending The Specialised Lending Approach will be applicable to project finance, object finance, commodities finance, income-producing commercial real estate and high-volatility commercial real estate.

Banks that do not meet the requirements for the estimation of PD under the corporate foundation approach for their specialised lending (SL) assets are required to map their internal risk grades to five supervisory categories, each of which is associated with a specific risk weight. (This is referred to as the Supervisory Slotting Criteria Approach).

Should the bank be able to meet the requirements for the estimation of PD on the SL portfolio, the Foundation Approach can be used where the corporate risk weights are used for these assets (with the exception of high volatility commercial real estate).

If the bank meets the requirements for the estimation of PD, LGD and EAD, it can use the Advanced Approach with the corporate risk weights for all classes of SL (with the exception of high volatility commercial real estate).

Par 275 - 284

2.2.3.2.7. IRB Approach for equity exposures Two approaches are available, namely, a market-based approach and a PD/ LGD approach. Under market-based approach two methods are available, namely, a simple risk weight method and an internal models method. Under the simple weight method, a risk weight of

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300% is to be applied to publicly traded equities and 400% to all other equities.

With regards to the internal models method, banks may use – or national supervisors may require – a VAR-type model to derive capital and requirements, subject to a floor risk weight of 200% for publicly traded equities and 300% for other equities.

As a final option, banks may use, or supervisors may require the use of the same PD/LGD approach used for calculating capital requirements for corporate exposures. However, an LGD of 90% would be assumed, compared with a supervisory estimate of 45% for LGD on ordinary corporate lending exposures.

Par 339 - 358

2.2.3.2.8. Implementation issues and minimum requirements Once a bank adopts an IRB Approach for part of its assets, it is expected to extend this across the entire banking group, although this does not have to be done simultaneously. The bank will have to produce an implementation plan, detailing when it intends to roll out the selected approach across material asset classes. Immaterial asset classes can be exempt subject to supervisory approval.

By relying on internally generated inputs to the Basel II risk weight functions, there is bound to be some variation in the way in which the IRB Approach is carried out. To ensure significant comparability across banks, Basel II has established minimum qualifying criteria for use of the IRB Approaches that cover the comprehensiveness and integrity of banks’ internal credit risk assessment capabilities. While banks using the Advanced IRB Approach will have greater flexibility relative to those relying on the Foundation IRB Approach, at the same time they must also satisfy a more stringent set of minimum standards.

To be eligible for the IRB Approach the bank must demonstrate to the supervisor that it meets certain minimum requirements at the outset and on an ongoing basis. Many of these requirements are in the form of objectives that a qualifying bank’s risk rating system must fulfil. The focus on bank’s abilities to rank order and quantify risk in a consistent, reliable and valid fashion. The overarching principle behind these requirements is that rating and risk estimation systems and processes provide for a meaningful differentiation of risk; and reasonably accurate and consistent quantitative estimates of the risk. Furthermore, the systems and the processes must be consistent with internal use of these estimates.

Specific requirements have been set out by the Basel II framework on the design of the rating system incorporating the rating structure, criteria and documentation standards. Data maintenance will have to

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ensure effective support to the internal credit risk measurement and management processes. The bank will have to implement adequate corporate governance and oversight processes around the rating system used under the IRB Approaches to qualify to use these approaches.

Par 387 – 537.

2.2.3.3. Securitisation Framework 2.2.3.3.1. Introduction

Securitisation is defined in Basel II as:

• Traditional Securitisation:

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 reflecting different degrees of credit risk. Payments to the investors depend upon the performance of the specified underlying exposures, as opposed to being derived from an obligation of the entity originating those exposures.

• Synthetic Securitisation:

is a structure with at least two different stratified risk positions or tranches that reflect different degrees of credit risk where credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of funded (e.g. credit-linked notes) or unfunded (e.g. credit default swaps) credit derivatives or guarantees that serve to hedge the credit risk of the portfolio. Accordingly, the investors’ potential risk is dependent upon the performance of the underlying pool.

Banks’ securitisation exposures can include:

o Asset-backed securities,

o Mortgage-backed securities,

o Credit enhancements,

o Liquidity facilities,

o Interest rate and currency swaps,

o Credit derivatives, and

o Tranched cover.

The capital treatment of a securitisation exposure must be determined on the basis of its economic substance rather than its legal form because securitisations may be structured in many different ways.

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The underlying instruments in the pool that is being securitised may include:

o Loans

o Commitments

o Asset-backed and mortgage-backed securities,

o Corporate bonds,

o Equity securities, and

o Private equity investments

Par 538 – 542

2.2.3.3.2. The Standardised Approach Banks applying the Standardised Approach to measure the credit risk for the same type of products as those used in the securitisation, must also use the Standardised Approach under the securitisation framework.

• Basel prescribes a set of risk weights. The risk-weighted asset amount of the securitisation exposure is computed by multiplying the amount of the position by the appropriate risk weight. Unrated securitisation exposures must be deducted except when it is the most senior exposure or an eligible liquidity facility. When the most senior exposure in a traditional or synthetic securitisation is unrated the bank that holds or guarantees the exposure may use the look-through method to determine the risk-weight. This implies that the unrated most senior exposure receives the average risk weight of the underlying exposures, subject to supervisory review. All off-balance sheet exposures receive a CCF of 100% except those that qualify as ‘eligible liquidity facility’ or as ‘eligible servicer cash advance facility’ in which case a lower CCF will be applied.

• When a bank other than the originator provides credit risk mitigants on a securitisation, such as guarantees, credit derivatives, collateral and on-balance sheet netting, it must calculate the capital requirement on the covered exposure as if it were an investor in that securitisation.

• Early amortisation provisions in securitisation allow investors to be paid out prior to the originally stated maturity of the securities issued. For a bank subjected to the early amortisation treatment, the total capital charge for all its positions will be subjected to a cap equal to the greater of that required for retained securitisation purposes, or the capital requirement that would apply had the exposures not been securitised.

Par 566 – 605

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2.2.3.3.3. The Internal Ratings-based Approach (IRB) The securitisation IRB Approach to securitisation of the Ratings Based Approach (RBA), Internal Assessment Approach (IAA) and the Supervisory Formula (SF). Banks must use the IRB Approach for securitisations when they have received approval to used the IRB Approach for the type of underlying exposures securitised (e.g. their retail portfolio). If the bank uses the IRB and Standardised Approaches for different exposures in the underlying pool, it should use the approach used for the largest part of the exposure. When there is no specific IRB method for a specific underlying asset type, the originating bank must use the Standardised Approach and investing banks must use the RBA.

The capital charge for securitisation exposures that are rated must be calculated using the RBA. Where an external or internal rating is not available, the SF or IAA must be used in the calculation. The maximum capital requirement when using the IRB approach for securitisation will be equal to the IRB capital requirement for the same exposures when they are not securitised.

Par 606 - 610

The RBA

o Specific risk weights are provided for this method

o The risk weights depend on

The external rating grade or available inferred rating;

Whether the credit rating (external or inferred) represents a short- or long-term credit rating;

The granularity of the underlying pool; and

The seniority of the position.

Par 611 - 618

The IAA

o A bank may use its internal assessments of the credit quality of the securitisation exposures it extends if the internal assessment meets the requirements.

o Internal assessments of exposures provided to ABCP (Asset-backed commercial paper) programmes must be mapped to equivalent external ratings of an ECAI (External credit assessment institution).

o The risk weight appropriate to the credit rating equivalent must be used with the notional amount of the securitisation exposure to the ABCP programme.

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Par 619 – 622

The SF

o As in the IRB Approaches, risk-weighted assets generated through the use of the SF are calculated by multiplying the capital charge by 12.5. Under the SF, the capital charge for a securitisation tranche depends on five bank-supplied inputs: the IRB capital charge had the underlying exposures not been securitised (KIRB); the tranche’s credit enhancement level (L) and thickness (T); the pool’s effective number of exposures (N); and the pool’s exposure-weighted average loss-given-default (LGD). The capital charge is calculated as follows:

Tranche’s IRB capital charge = the amount of exposures that have been securitised times the greater of (a) 0.0056*T, or (b) (S [L+T] – S [L])

o If there is credit risk mitigation for the securitisation exposures, the banks are required to apply the CRM techniques of the foundation IRB Approach, when applying the SF.

o The capital charge attributed to investors’ interest, for early amortisation provisions, is determined by the product of the investors’ interest; the appropriate CCF and the ratio of (a) the IRB capital requirement including the EL portion for the underlying exposures in the pool to (b) the exposure amount of the pool (e.g. the sum of drawn amounts related to securitised exposures plus the EAD associated with undrawn commitments related to securitised exposures.

Par 623 – 643

2.3. Operational risk 2.3.1. Definition

The Basel II definition of operational risk is “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 reputation risk for capital charge purposes”. Legal risk in turn includes (but is not limited to), exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements.

In arriving at the definition, it is acknowledged that the exact approach for operational risk management that a bank chooses “will depend on a range of factors, including its size and sophistication and the nature and complexity of its activities.” Notwithstanding individual differences, the new regime demands clearly documented strategies and oversight by the board and senior

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management, a strong operational risk culture and internal control culture (including, among other things, clear lines of responsibility and segregation of duties), effective internal escalation and reporting and contingency planning.

The definition refers to loss resulting from the following four sources, which are now explained in more detail in order to aid understanding of the definition:

• Inadequate or failed internal processes. Financial institutions operate a myriad of processes to deliver their products to customers. Process risk can arise at any stage of an end to end process in the value chain. For example, marketing material can be mailed to the wrong customers, account opening documentation can turn out not to be robust, transactions can be processed incorrectly, etc.

• People Operational risk losses can occur due to worker compensation claims, violation of employee health and safety rules, organized labour activities and discrimination claims. People risks can also include inadequate training and management, human error, lack of segregation, reliance on key individuals, lack of integrity, honesty, etc.

• Systems

The growing dependence of financial institutions on IT systems is a key source of operational risk. Data corruption problems, whether accidental or deliberate, are regular sources of embarrassing and costly operational mistakes.

• External events

This source of operational risk has at least two discernible dimensions to it, firstly the extent to which a chosen business strategy pursued by a bank may expose it to adverse external events, and secondly external events that impact it independently, emanating from the business environment in which it operates.

Par 644

2.3.2. The measurement methodologies

2.3.2.1. Introduction Depending on the level of sophistication of individual banks, the Basel Accord permits three methods for calculating operational risk capital charges in a continuum of increasing sophistication and risk sensitivity:

• the Basic Indicator Approach, resulting in a capital charge indicated by KBIA;

• the Standardised and Alternative Standardised Approach, resulting in a capital charge indicated by KTSA/TASA; and

• Advanced Measurement Approach (AMA).

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Banks are encouraged to move along the spectrum of approaches and will be allowed to use a combination of approaches for different business lines (partial use). Once an approach is chosen, a bank will not be permitted to revert to a less sophisticated approach. More sophisticated approaches should permit greater benefits, both in terms of the capital charge as well as in terms of more effective and efficient business practices.

As a general point to note, the Accord provides for supervisors to review the capital requirement produced by the operational risk approach used by a bank (whether Basic Indicator Approach, Standardised Approach or AMA) for general credibility, especially in relation to a firm’s peers. In the event that credibility is lacking, appropriate supervisory action under Pillar 2 will be considered.

Par 645-648

2.3.2.2. The Basic Indicator Approach

Essentially, this approach uses gross income as a proxy for operational risk, with the capital charge equal to 15% of the average of gross income for the last three years.

No specific qualifying criteria are specified, but banks are encouraged to comply with the Basel Committee’s proposed practices as documented in the Sound Practices for the Management and Supervision of Operational Risk, published in February 2003. These principles in fact form the underlying foundation for all three the methodologies, as well as the qualifying criteria that participating banks should adhere to when adopting a particular approach.

The Accord specifies the calculation of the charge as follows:

Banks using the Basic Indicator Approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted alpha) of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average.

The Accord is specific about what constitutes gross income, defining it as net interest income plus net non-interest income, with the intention that it should:

• be gross of any provisions (e.g. for unpaid interest);

• be gross of operating expenses, including fees paid to outsourcing service providers;

• exclude realised profits/losses from the sale of securities in the banking book; and

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• exclude extraordinary or irregular items as well as income derived from insurance.

Par 649 - 651

2.3.2.3. The Standardised Approach In the Standardised Approach, gross income is again a proxy measure for operational risk, but in this case it is broken out by eight standard business lines, each with a different beta factor to calculate capital. The business lines, which are defined in detail in Annexure 6 of the Accord, are:

• corporate finance,

• trading & sales,

• retail banking,

• commercial banking,

• payment & settlement,

• agency services,

• asset management, and

• retail brokerage.

The total capital charge under this approach is the sum of the product of the relevant business line gross income and the beta factor, with the beta factor being a proxy for the assumed industry-wide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line. It should be noted that in the Standardised Approach gross income is measured for each business line, not the whole institution, for example, in corporate finance, the indicator is the gross income generated in the corporate finance business line.

For retail and commercial banking there is also an Alternative Standardised Approach (ASA) available, introduced to eliminate double counting of risks. Banks, at the national supervisor’s discretion, may be permitted to substitute an alternative measure in the case of retail and commercial banking. In this case, the volume of outstanding loans will be multiplied by the beta factor and the result multiplied by 3.5%.

The Accord specifies the calculation of the charge as follows:

Banks using the Standardised Approach must hold capital for operational risk equal to the three-year average of the simple summation of the regulatory capital charges across each of the business lines in each year. In any given year, negative capital charges (resulting from negative gross income) in any business line may offset positive capital charges in other business lines without limit. However, where the aggregate capital charge across all business lines within a given year is negative, then the input to

27

the numerator for that year will be zero. In order to qualify for the standardised approach, banks need to comply with a set of minimum entry standards, the most important one being undoubtedly the active involvement of the board of directors and senior management.

Par 652 – 654

2.3.2.4. Advanced Measurement Approaches (AMA)

More exacting quantitative and qualitative entry standards are required before a bank is permitted to qualify as an advanced measurement approach bank. Under the AMA approach the regulatory capital requirement will equal the risk measure generated by the bank’s internal operational risk measurement system, which should be based on:

• Internal loss data

• External loss data

• Scenario analysis, and

• Business environment and internal control factors

As a general principle, the Accord does not prescribe an exact capital required methodology under the advanced measurement approach. Banks are encouraged to develop their own methods provided the measure calculates capital that covers both expected loss and unexpected loss – it must however be able to demonstrate that its approach captures potentially severe ‘tail’ loss events. Whatever approach is used, a bank must demonstrate that its operational risk measure meets a soundness standard comparable to that of the internal ratings-based approach for credit risk, (i.e. comparable to a one year holding period and a 99.9% confidence interval).

One of the methods being used is the loss distribution approach, which embodies some of the following aspects:

• Banks will calculate two distributions: one for frequency and one for severity

• Frequency distributions are usually binomial, negative binomial or Poisson

• Event severity distributions are wider in choice: log normal, Pareto, Weibull or Inverse Gaussian

• A compound distribution is calculated using Monte Carlo simulation (in Statistical terms, the convolution of the frequency and severity distributions).

• Estimate the mean and the 99.9 percentile from the resulting distribution, the latter being equal to the 1 year Value at Risk)

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• The calculated risk measure will have to comply with various sets of criteria for the AMA in addition to those for the standardised approach. The different types of criteria are:

• General (minimum) criteria

• Qualitative criteria

• Quantitative criteria

• Risk mitigation

• The Accord addresses some other specific issues, such as how to determine capital requirements for international subsidiaries and the incorporation of diversification benefits.

Par 655 – 679

2.3.2.5. Partial use - combinations A bank will be permitted to use an AMA for some parts of its operations and the Basic Indicator Approach or Standardised Approach for the balance (partial use), provided that the following conditions are met:

• All operational risks of the bank’s global, consolidated operations are captured;

• All of the bank’s operations that are covered by the AMA meet the qualitative criteria for using an AMA, while those parts of its operations that are using one of the simpler approaches meet the qualifying criteria for that approach;

• On the date of implementation of an AMA, a significant part of the bank’s operational risks are captured by the AMA; and

• The bank provides its supervisor with a plan specifying the timetable to which it intends to roll out the AMA across all but an immaterial part of its operations. The plan should be driven by the practicality and feasibility of moving to the AMA over time, and not for other reasons.

Par 680

2.4. Trading book issues 2.4.1. Introduction

Since 1998 banks have been required to measure and apply capital charges in respect of their market risks.

Market risk is the risk of financial loss relating to a bank’s trading activities, where the bank may act on its own account or on behalf of its clients in the commodity, foreign exchange, equity, capital and money markets. Market risk

29

arises where there are adverse movements in market prices e.g. interest and foreign exchange rates, equity, bond and commodity prices.

In essence, capital charges, with respect to market risks, have been applied as follows:

• In the case of interest rate related instruments and equities to the current market value of banks’ trading books.

• In the case of foreign exchange and commodities risk to banks’ total currency and commodity positions.

2.4.2. Basel II (The New Framework)

Banks will be seeking approval from their supervisory authority for use of their internal risk models to calculate the capital charge to be held for market risks. A bank however, has to fulfil a number of requirements before it may be eligible to use its internal risk models in applying this capital treatment.

2.4.2.1. Definitions In terms of Basel II the definition of trading book has been redefined.

A trading book consists of:

• positions in financial instruments and commodities

• held either with trading intent or

• in order to hedge other elements of the trading book.

• Positions held with trading intent are those:

• held intentionally for short-term resale and/or

• with the intent of benefiting from actual or expected short-term price movements

• and may include for example proprietary positions, positions arising from client servicing and market making.

• A hedge is a position that:

• materially or entirely offsets the component risk elements of another trading book position or portfolio.

Par 684 -687, 689

2.4.2.2. Eligibility for trading book capital treatment

To be eligible for trading book capital treatment financial instruments must either be freely tradable or able to be hedged completely.

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A bank must have:

• A clearly documented trading strategy for the position/instrument or portfolios, approved by senior management.

• Clearly defined policies and procedures for the active management of the position, which must include:

o positions are managed on a trading desk;

o position limits are set and monitored for appropriateness;

o dealers have the autonomy to enter into/manage the position within agreed limits and according to the agreed strategy;

o positions are marked to market at least daily;

o positions are reported to senior management as an integral part of the institution’s risk management process; and

o positions are actively monitored with reference to market information sources.

• Clearly defined policy and procedures to monitor the positions against the bank’s trading strategy

• Furthermore, positions should be frequently and accurately valued, and the portfolio should be actively managed.

Par 688

2.4.2.3. Valuation of the trading book

A framework for prudent valuation practices has been laid out and should at a minimum include the following:

Figure 2.1 Valuation framework of the trading book

The valuation framework must provide confidence that the valuation estimates are prudent and reliable. The valuation framework must be

Valuation framework

Systems and controls • Adequate

• Reliable

Methodologies • Marking to market

• Marking to model

• Independent price

Valuation adjustment or reserves

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integrated with other risk management systems within the organisation (such as credit analysis). It must include documented policies and procedures for the process of valuation, as well as clear and independent (i.e. independent of front office) reporting lines for the department accountable for the valuation process.

Par 690 - 692

There are a number of valuation methodologies that a bank may apply. These include: Marking to market, Marking to model and Independent price verification.

2.4.2.3.1. Marking to market o The daily valuation of positions at readily available close out

prices (that are sourced independently).

o Examples of readily available close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers.

2.4.2.3.2. Marking to model o Where marking-to-market is not possible, banks may mark-to-

model e.g. where the instrument is not readily tradable such as an option on X written by Y for 2020.

o Marking-to-model is defined as any valuation, which has to be benchmarked, extrapolated or otherwise calculated from a market input e.g. the use of a Black and Scholes model to calculate the value of the option written.

o Marking to model must be demonstrated to be prudent as there is naturally a degree of assumption involved.

o The model should be subject to periodic review to determine the accuracy of its performance e.g. assessing continued appropriateness of the assumptions

2.4.2.3.3. Independent price verification o Independent price verification is distinct from daily mark-to-

market.

o It is the process by which market prices or model inputs are regularly verified for accuracy.

o While daily marking-to-market may be performed by dealers, verification of market prices or model inputs should be performed by a unit independent of the dealing room, at least monthly.

Par 693 - 697

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Procedures for considering adjustments or reserves must be established and maintained to mitigate against the risks arising from (for example):

o Inaccuracies in valuation methods and models.

o Operational risk.

o Reduced liquidity in a position arising from market event.

The valuation adjustments must impact the regulatory capital.

Par 698 – 705

2.4.3. Basel II applied to the Trading Activities and the Treatment of

Double Default Effects

2.4.3.1. General The document: The Application of Basel II to Trading Activities and the Treatment of Double Default Effects, to update the prescriptions for the trading book, was published by the Basel Committee in July 2005. Only the main focus of the document will be highlighted here and reference here is to the new document’s relevant paragraph numbers. Two areas that the Basel Committee identified where immediate work should be done are: (1) finding a prudentially sound treatment under the Revised Framework for exposures to double default,” where the risk of both a borrower and a guarantor defaulting on the same obligation may be substantially lower than the risk of only one of the parties defaulting; and (2) applying the Revised Framework to certain exposures arising from trading activities.

This document describes a proposal to address five specific issues related to double default and trading activities prior to the implementation of the Revised Framework. These issues consist of the following:

• the treatment of counterparty credit risk for over-the-counter derivatives, repo-style and securities financing transactions; and the treatment of cross-product netting arrangements;

• the treatment of double-default effects for covered transactions;

• the short-term maturity adjustment in the internal ratings-based approach;

• improvements to the current trading book regime, especially with respect to the

• treatment of specific risk; and

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• the design of a specific capital treatment for failed transactions and transactions that are not settled through a delivery-versus-payment framework.

2.4.3.2. Measures of Counterparty Credit Risk (CCR) Positions that give rise to CCR exposures share certain generic characteristics. They generate a credit exposure, which is defined as the cost of replacing the transaction if the counterparty defaults assuming there is no recovery of value. In addition, credit exposure depends on one or more underlying market factors.

Banks use several measures to manage their exposure to CCR including potential future exposure (PFE), expected exposure (EE), and expected positive exposure (EPE). PFE is the maximum exposure estimated to occur on a future date at a high level of statistical confidence. Banks often use PFE when measuring CCR exposure against counterparty credit limits. EE is the probability-weighted average exposure estimated to exist on a future date. EPE is the time-weighted average of individual expected exposures estimated for given forecasting horizons (e.g. one year). Banks typically compute EPE, EE, and PFE using a common stochastic model.

Consistent with the industry’s general practice for computing exposures to CCR, banks are required to estimate the exposure amount or EAD, and calculate the associated capital charge, on the basis of one or more defined bilateral “netting sets.” A “netting set” is a group of transactions with a single counterparty that are subject to a legally enforceable bilateral netting arrangement and permitted to be netted under the provisions of the 1988 Accord, as amended.

Par 1 – 25

2.4.3.3. The internal model method (IM) The Basel Committee has articulated the principle that banks should be allowed to use the output of their “own estimates” developed through internal models in an advanced EAD approach. To achieve that principle, qualifying institutions are permitted to employ internal estimates of the EPE of defined netting sets of their counterparty exposures in computing the exposure amount or EAD for capital purposes under the Revised Framework. In general, internal models commonly used for CCR estimate a time profile of EE over each point in the future, which equals the average exposure, over possible future values of relevant market risk factors, such as interest rates, foreign exchange rates, etc.

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Consistent with the Revised Framework’s requirement for the use of a one-year probability of default (PD) time horizon, Effective EPE is to be measured as the average of Effective EE over one year. If all contracts in the netting set mature before one year, Effective EPE is the average of Effective EE until all contracts in the netting set mature, for example, if the longest-maturity contract in the netting set matures in six months, Effective EPE would be the average of Effective EE over six months. The alpha multiplier provides a means of conditioning internal estimates of EPE on a “bad state” of the economy consistent with the determination of credit risk under the Revised Framework. In addition, it acts to adjust internal EPE estimates for both (1) correlations of exposures across counterparties exposed to common risk factors and (2) the potential lack of granularity across a firm’s counterparty exposures. The alpha multiplier is also viewed as a method to offset model error or estimation error. EEs can be calculated based on either the risk-neutral distribution of a risk factor or the actual distribution of a risk factor. To the extent that a bank recognises collateral in EAD via current exposure, a bank would not be permitted to recognise the benefits in its estimates of loss given default (LGD). As a result, the bank would be required to use an LGD of an uncollateralized facility. Par 26 - 48

2.4.3.4. Non-internal model methods

2.4.3.4.1. The Current Exposure Method (CEM) Supervisors have also explored alternative methods for computing capital requirements for CCR that would apply to those banks that do not qualify for the use of internal models. Given the multiple capital treatments available for SFTs in the Revised Framework, supervisors have focused only on the treatment of OTC derivatives.

The existing CEM incorporated in the 1988 Accord and the Revised Framework remains an alternative method for computing capital requirements for CCR for banks that do not qualify for the IMM.

The existing CEM takes the form of the following equation:

Counterparty Capital Charge = [(RC + add-on) – volatility adjusted collateral] * Risk Weight * 8%

Where:

RC is the Current Replacement Cost

Add-on is the estimated amount of potential future exposure calculated under the 1988 Accord as amended.

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Volatility adjusted collateral is the value of collateral.

Risk Weight is the risk weight of the counterparty.

Under the CEM, exposure amount or EAD is equal to [(RC + add-on) – volatility adjusted collateral].

2.4.3.4.2. The Standardised Method (SM) The SM is also available for banks that do not qualify to estimate the EPE associated with OTC derivatives but that would like to adopt a more risk-sensitive method than the CEM set out in the 1988 Basel Accord, as amended. The SM is designed to capture certain key features of the IMM for CCR. At the same time, it seeks to provide a method that is simple to implement compared to the IMM.

The SM entails a number of simplifying assumptions. For example, CCR exposures are expressed in risk positions that reference short-term changes in valuation parameters (e.g. modified duration for debt instruments, delta concept for options). It also assumes that the positions that are open under a short-term forecasting horizon of, for example, one day remain open and unchanged throughout the forecasting horizon. There is no recognition of diversification effects.

Under the SM, the exposure amount represents the product of (i) the larger of the net current market value or a “supervisory EPE,” times (ii) a scaling factor, termed beta. The first factor captures two key features of the IMM: (1) for netting sets that are deep in the money, the EPE is primarily determined by the current market value of the netting set; and (2) for netting sets that are at the money, the current market value is not relevant, and CCR is driven only by the potential change in the value of the transactions. Neither of these features is applicable in the CEM. By summing the current exposure with the computed add-ons, the CEM essentially assumes that the netting set is at the money and deep in the money at the same time.

The second factor, beta, serves the same purpose as the alpha scaling factor used in the IMM. As such, it implicitly conditions the exposure amount or EAD on a “bad” state of the economy, addresses stochastic dependency of market values of exposures across counterparties, and addresses estimation and modelling error. Beta also helps to ensure an appropriate incentive for banks to choose the IMM over the standardised method, particularly when a bank’s derivative transactions are diversified and not narrowly focused on certain risk areas (e.g. domestic interest rates, certain commodities). As a result beta facilitates the recognition of a risk-sensitive treatment for banks that are actively using OTC derivative transactions.

The exposure amount or EAD for a counterparty is the sum of the exposure amounts or EADs across netting sets with that

36

counterparty. The calibration of the CCFs has been made assuming at-the-money forwards or swaps and given a forecasting horizon of one year. The forecasting horizon of one year is chosen to conform to the IRB approach to credit risk under the Revised Framework, which requires the use of a one-year probability of default (PD) time horizon.

Par 49 – 74

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3. Part 3: The Second Pillar – The Supervisory Review Process 3.1. Introduction

The Supervisory Review Process is defined as the “Second Pillar” of Basel II and as such represents an important key element of the Basel II document and the approach to ensure safer and sound banking. The focus on supervision is, however, not new to the Basel Committee. This part of the Report is the culmination of 20 documents on supervision published by the Basel Committee, the first being Part B of the Amendment to the Capital Accord to incorporate market risks, published in January 1996 and the twentieth being the Sound practices for the management and supervision of operational risk, published in February 2003.

The aim of this part of the Basel II document is to discuss and describe the key principles of supervisory review; risk management guidance; and supervisory transparency and accountability.

3.2. The importance of supervisory review 3.2.1. Introduction

The focus here is, firstly, on the responsibility of bank management in developing an internal capital assessment process and setting appropriate capital targets for the bank’s risk profile and control environment. Secondly, supervisors should evaluate how well the banks are assessing their capital needs, relative to their risks, and to intervene where appropriate.

Pillar 2 also addresses the treatment of risks considered under Pillar 1, but not fully captured by the Pillar 1 process (e.g. credit concentration risk); factors not taken into account in Pillar 1 (e.g. interest rate risk in the banking book); and factors external to the bank (e.g. business cycle effects).

Lastly, Pillar 2 addresses the assessment of the banks’ compliance with the minimum standards and disclosure requirements of the more advanced methods of Pillar 1.

Par 720 - 724

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3.2.2. Four key principles of supervisory review

The Basel Committee has identified four key principles of supervisory review

3.2.2.1. Principle 1 Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.

Banks must be able to demonstrate that the chosen internal capital targets are well founded and consistent with their overall risk profile and operating environment. Bank management bears the primary responsibility for ensuring that the bank has adequate capital to support its risks. The Basel Committee outlines five main features of the rigorous process that banks should follow, namely, board and senior management oversight, sound capital assessment, comprehensive assessment of risks, monitoring and reporting and internal control review. These five features will briefly be discussed below.

3.2.2.1.1. Board and senior management oversight A sound risk management process is the foundation for an effective assessment of the adequacy of a bank’s capital position. The analysis of a bank’s current and future capital requirements in relation to its strategic objectives is a vital element of the strategic planning process. The strategic plan should clearly outline the bank’s capital needs, anticipated capital expenditures, desirable capital level, and external capital sources. Senior management and the board should view capital planning as a crucial element in being able to achieve its desired strategic objectives.

The bank’s board of directors has responsibility for setting the bank’s tolerance for risks. It should also ensure that management establishes a framework for assessing the various risks, develops a system to relate risk to the bank’s capital level, and establishes a method for monitoring compliance with internal policies. It is likewise important that the board of directors adopts and supports strong internal controls and written policies and procedures and ensures that management effectively communicates these throughout the organisation.

Par 728 – 730

3.2.2.1.2. Sound capital assessment The fundamental elements of sound capital assessment include:

• Policies and procedures designed to ensure that the bank identifies, measures, and reports all material risks;

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• A process that relates capital to the level of risk;

• A process that states capital adequacy goals with respect to risk, taking account of the bank’s strategic focus and business plan; and

• A process of internal controls reviews and audits to ensure the integrity of the overall management process.

Par 731

3.2.2.1.3. Comprehensive assessment of risks All material risks faced by the bank should be addressed in the capital assessment process. The following exposures, by no means a complete list, should be considered:

• Credit risk

Banks should have methodologies that enable them to assess the credit risk involved in exposures to individual borrowers or counterparties as well as at the portfolio level. For more sophisticated banks, the credit review assessment of capital adequacy, at a minimum, should cover four areas: risk rating systems, portfolio analysis/aggregation, securitisation/complex credit derivatives, and large exposures and risk concentrations.

Internal risk ratings should support the identification and measurement of risk from all credit exposures, and should be integrated into an institution’s overall analysis of credit risk and capital adequacy. The analysis of credit risk should adequately identify any weaknesses at the portfolio level, including any concentrations of risk.

• Operational risk

A bank should develop a framework for managing operational risk and evaluate the adequacy of capital given this framework. The framework should cover the bank’s appetite and tolerance for operational risk, as specified through the policies for managing this risk, including the extent and manner in which operational risk is transferred outside the bank. It should also include policies outlining the bank’s approach to identifying, assessing, monitoring and controlling/mitigating the risk.

• Market risk

This assessment is based largely on the bank’s own measure of value-at-risk or the standardised approach for market risk. Emphasis should also be placed on the institution performing stress testing in evaluating the adequacy of capital to support the trading function.

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• Interest rate risk in the banking book

The measurement process should include all material interest rate positions of the bank and consider all relevant repricing and maturity data. Such information will generally include current balance and contractual rate of interest associated with the instruments and portfolios, principal payments, interest reset dates, maturities, the rate index used for repricing, and contractual interest rate ceilings or floors for adjustable-rate items. The system should also have well-documented assumptions and techniques. Regardless of the type and level of complexity of the measurement system used, bank management should ensure the adequacy and completeness of the system.

• Liquidity risk

Liquidity is crucial to the ongoing viability of any banking organisation. Banks’ capital positions can have an effect on their ability to obtain liquidity, especially in a crisis. Each bank must have adequate systems for measuring, monitoring and controlling liquidity risk.

• Other risks

Although the Basel Committee recognises that ‘other’ risks, such as reputational and strategic risk, are not easily measurable, it expects industry to further develop techniques for managing all aspects of these risks.

Par 732 – 742

3.2.2.1.4. Monitoring and reporting The bank’s senior management or board of directors should, on a regular basis, receive reports on the bank’s risk profile and capital needs. These reports should allow senior management to:

• Evaluate the level and trend of material risks and their effect on capital levels

• Evaluate the sensitivity and reasonableness of key assumptions used in the capital assessment measurement system;

• Determine that the bank holds sufficient capital against the various risks and is in compliance with established capital adequacy goals, and

• Assess its future capital requirements based on the bank’s reported risk profile and make necessary adjustments to the bank’s strategic plan accordingly

Par 743

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3.2.2.1.5. Internal control review The bank’s board of directors has a responsibility to ensure that management establishes a system for assessing the various risks, develops a system to relate risk to the bank’s capital level, and establishes a method for monitoring compliance with internal policies. The board should regularly verify whether its system of internal controls is adequate to ensure well-ordered and prudent conduct of business. The bank should conduct periodic reviews of its risk management process to ensure its integrity, accuracy, and reasonableness. Areas that should be reviewed include:

• Appropriateness of the bank’s capital assessment process given the nature, scope and complexity of its activities;

• Identification of large exposures and risk concentrations;

• Accuracy and completeness of data inputs into the bank’s assessment process;

• Reasonableness and validity of scenarios used in the assessment process; and

• Stress testing and analysis of assumptions and inputs.

Par 744 – 745

3.2.2.2. Principle 2 Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.

The supervisory authorities should regularly review the process by which a bank assesses its capital adequacy, risk position, resulting capital levels, and quality of capital held. Supervisors should also evaluate the degree to which a bank has in place a sound internal process to assess capital adequacy. The emphasis of the review should be on the quality of the bank’s risk management and controls and should not result in supervisors functioning as bank management. The periodic review can involve some combination of:

• On-site examinations or inspections;

• Off-site review;

• Discussions with bank management;

• Review of work done by external auditors (provided it is adequately focused on the necessary capital issues); and

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• Periodic reporting.

The supervisors’ detailed analysis of each bank’s internal risk analysis should include:

• A review of adequate risk assessment;

• An assessment of capital adequacy;

• Assessment of the control environment;

• A supervisory review of compliance with minimum standards; and

• A supervisory response.

Par 746 - 756

3.2.2.3. Principle 3 Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.

Pillar 1 capital requirements will include a buffer for uncertainties surrounding the Pillar 1 regime that affect the banking population as a whole. Bank-specific uncertainties will be treated under Pillar 2. There are several means available to supervisors for ensuring that individual banks are operating with adequate levels of capital. Among other methods, the supervisor may set trigger and target capital ratios or define categories above minimum ratios (e.g. well capitalised and adequately capitalised) for identifying the capitalisation level of the bank.

Par 757

3.2.2.4. Principle 4 Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

The permanent solution to banks’ difficulties is not always increased capital. However, some of the required measures (such as improving systems and controls) may take a period of time to implement. Therefore, increased capital might be used as an interim measure while permanent measures to improve the bank’s position are being put in place.

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Par 759 – 760

3.2.3. Specific issues to be addressed under the supervisory review

process

3.2.3.1. Introduction The Basel Committee has identified a number of important issues that banks and supervisors should particularly focus on when carrying out the supervisory review process.

3.2.3.2. Interest rate risk in the banking book The Basel Committee remains convinced that interest rate risk in the banking book is a potentially significant risk which merits support from capital. The Basel Committee has concluded that it is at this time most appropriate to treat interest rate risk in the banking book under Pillar 2 of the Framework.

The revised guidance on interest rate risk recognises banks’ internal systems as the principal tool for the measurement of interest rate risk in the banking book and the supervisory response. To facilitate supervisors’ monitoring of interest rate risk exposures across institutions, banks would have to provide the results of their internal measurement systems, expressed in terms of economic value relative to capital, using a standardised interest rate shock.

Supervisors should be particularly attentive to the sufficiency of capital of ‘outlier banks’ where economic value declines by more than 20% of the sum of Tier 1 and Tier 2 capital as a result of a standardised interest rate shock (200 basis points) or its equivalent.

Par 762 – 764

3.2.3.3. Credit risk 3.2.3.3.1. Stress tests under the IRB-approaches

A bank should ensure that it has sufficient capital to meet the Pillar 1 requirements. The results of the stress test will thus contribute directly to the expectation that a bank will operate above the Pillar 1 minimum regulatory capital ratios. The supervisors may therefore wish to review how the stress test has been carried out.

3.2.3.3.2. Definition of default A bank must use the reference definition of default (90 days past due) for its internal estimations of PD and/or LGD and EAD. The

44

national supervisors will issue guidance on how the reference definition of default is to be interpreted in their jurisdictions. Supervisors will assess individual banks’ application of the reference definition of default and its impact on capital requirements.

3.2.3.3.3. Residual risk The Framework allows banks to offset credit or counterparty risk with collateral, guarantees or credit derivatives, leading to reduced capital charges. While banks use credit risk mitigation (CRM) techniques to reduce their credit risk, these techniques give rise to risks that may render the overall risk reduction less effective. Accordingly these risks (e.g. legal risk, documentation risk, or liquidity risk) to which banks are exposed are of supervisory concern. Where such risks arise, and irrespective of fulfilling the minimum requirements set out in Pillar 1, a bank could find itself with greater credit risk exposure to the underlying counterparty than it had expected. Therefore, supervisors will require banks to have in place appropriate written CRM policies and procedures in order to control these residual risks.

3.2.3.3.4. Credit concentration risk A risk concentration is any single exposure or group of exposures with the potential to produce losses large enough (relative to a bank’s capital, total assets, or overall risk level) to threaten a bank’s health or ability to maintain its core operations. Risk concentrations can arise in a bank’s assets, liabilities, or off-balance sheet items, through the execution or processing of transactions (either product or service), or through a combination of exposures across these broad categories.

Credit risk concentrations, by their nature, are based on common or correlated risk factors, which, in times of stress, have an adverse effect on the creditworthiness of each of the individual counterparties making up the concentration. Such concentrations are not addressed in the Pillar 1 capital charge for credit risk. Banks should have in place effective internal policies, systems and controls to identify, measure, monitor, and control their credit risk concentrations. Banks should explicitly consider the extent of their credit risk concentrations in their assessment of capital adequacy under Pillar 2.

In the course of their activities, supervisors should assess the extent of a bank’s credit risk concentrations, how they are managed, and the extent to which the bank considers them in its internal assessment of capital adequacy under Pillar 2.

Par 765 – 777

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3.2.3.4. Operational risk Gross income, used in the Basic Indicator and Standardised Approaches for operational risk, is only a proxy for the scale of operational risk exposure of a bank and can in some cases (e.g. for banks with low margins or profitability) underestimate the need for capital for operational risk. The supervisor should, therefore, consider whether the capital requirement generated by the Pillar 1 calculation gives a consistent picture of the individual bank’s operational risk exposure, for example in comparison with other banks of similar size and with similar operations.

Par 778

3.2.4. Other aspects of the supervisory review process

3.2.4.1. Supervisory transparency and accountability The supervision of banks is not an exact science, and therefore, discretionary elements within the supervisory review process are inevitable. Supervisors must take care to carry out their obligations in a transparent and accountable manner. Supervisors should make publicly available the criteria to be used in the review of banks’ internal capital assessments.

Par 779

3.2.4.2. Enhanced cross-border communication and cooperation The Framework will not change the legal responsibilities of national supervisors for the regulation of their domestic institutions or the arrangements for consolidated supervision as set out in the existing Basel Committee standards. The home country supervisor is responsible for the oversight of the implementation of the Framework for a banking group on a consolidated basis. Host country supervisors are responsible for the supervision of those entities operating in their countries. In implementing the Framework, supervisors should communicate the respective roles of home country and host country supervisors as clearly as possible to banking groups with significant cross-border operations in multiple jurisdictions. The Basel Committee supports a pragmatic approach of mutual recognition for internationally active banks as a key basis for international supervisory co-operation.

Par 780 – 783

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3.2.5. The supervisory review process for securitisation

3.2.5.1. Introduction Pillar 1 requires that banks should take account of the economic substance of transactions in their determination of capital adequacy. The supervisory authorities will monitor, as appropriate, whether banks have done so adequately. As a result, regulatory capital treatments for specific securitisation exposures might differ from those specified in Pillar 1 of the Framework, and these issues are addressed in Pillar 2.

Par 784 – 785

3.2.5.2. Significance of risk transfer Securitisation transactions may be carried out for purposes other than credit risk transfer (e.g. funding). Where this is the case, there might still be a limited transfer of credit risk. However, for an originating bank to achieve reductions in capital requirements, the risk transfer arising from a securitisation has to be deemed significant by the national supervisory authority. Therefore, the capital relief that can be achieved will correspond to the amount of credit risk that is effectively transferred.

Par 786 – 788

3.2.5.3. Market innovations As the minimum capital requirements for securitisation may not be able to address all potential issues, supervisory authorities are expected to consider new features of securitisation transactions as they arise.

Par 789

3.2.5.4. Provision of implicit support Support to a transaction, whether contractual (i.e. credit enhancements provided at the inception of a securitised transaction) or non-contractual (implicit support) can take numerous forms. For instance, contractual support can include over collateralisation, credit derivatives, spread accounts, etc. Examples of implicit support include the purchase of deteriorating credit risk exposures from the underlying pool, the sale of discounted credit risk exposures into the pool of securitised credit risk exposures, etc.

The provision of implicit (or non-contractual) support, as opposed to contractual credit support (i.e. credit enhancements), raises significant supervisory concerns. For traditional securitisation structures the provision of implicit support undermines the clean break criteria, which when

47

satisfied would allow banks to exclude the securitised assets from regulatory capital calculations. For synthetic securitisation structures, it negates the significance of risk transference.

When a bank has been found to provide implicit support to a securitisation, it will be required to hold capital against all of the underlying exposures associated with the structure as if they had not been securitised. Supervisors will be vigilant in determining implicit support and will take appropriate supervisory action to mitigate the effects.

Par 790 – 794

3.2.5.5. Residual risks As with credit risk mitigation techniques more generally, supervisors will review the appropriateness of banks’ approaches to the recognition of credit protection. In particular, with regard to securitisations, supervisors will review the appropriateness of protection recognised against first loss credit enhancements. On these positions, expected loss is less likely to be a significant element of the risk and is likely to be retained by the protection buyer through the pricing. Therefore, supervisors will expect banks’ policies to take account of this in determining their economic capital. Where supervisors do not consider the approach to protection recognised is adequate, they will take appropriate action.

Par 795

3.2.5.6. Call provisions Supervisors expect a bank not to make use of clauses that entitles it to call the securitisation transaction or the coverage of credit protection prematurely if this would increase the bank’s exposure to losses or deterioration in the credit quality of the underlying exposures. Besides the general principle stated above, supervisors expect banks to only execute clean-up calls for economic business purposes, such as when the cost of servicing the outstanding credit exposures exceeds the benefits of servicing the underlying credit exposures.

Par 796 – 800

3.2.5.7. Early amortisation Supervisors should review how banks internally measure, monitor, and manage risks associated with securitisations of revolving credit facilities, including an assessment of the risk and likelihood of early amortisation of such transactions. At a minimum, supervisors should ensure that banks have implemented reasonable methods for allocating economic capital

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against the economic substance of the credit risk arising from revolving securitisations. The supervisors should expect banks to have adequate capital and liquidity contingency plans that evaluate the probability of an early amortisation occurring and address the implications of both scheduled and early amortisation.

Banks should consider the effects that changes in portfolio management or business strategies may have on the levels of excess spread and on the likelihood of an early amortisation event. Supervisors expect that the sophistication of a bank’s system in monitoring the likelihood and risks of an early amortisation event will be commensurate with the size and complexity of the bank’s securitisation activities that involve early amortisation provisions.

For controlled amortisations specifically, supervisors may also review the process by which a bank determines the minimum amortisation period required to pay down 90% of the outstanding balance at the point of early amortisation. Where a supervisor does not consider this adequate it will take appropriate action.

Par 801 - 807

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4. Part 4: The Third Pillar – Market Discipline 4.1. Introduction

Market discipline can contribute to a safe and sound banking environment, and supervisors require firms to operate in a safe and sound manner. Under safety and soundness grounds, supervisors could require banks to disclose information. Alternatively, supervisors have the authority to require banks to provide information in regulatory reports.

The purpose of Pillar 3 ─ market discipline is to complement the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2). The Basel 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 banks’ disclosures should be consistent with how senior management and the board of directors assess and manage the risks of the bank. These disclosures are also a qualifying criterion under Pillar 1 to obtain lower risk weightings and/or to apply specific methodologies.

The Basel Committee recognises the need for a Pillar 3 disclosure framework that does not conflict with requirements under accounting standards, which are broader in scope. The Basel Committee has made a considerable effort to see that the narrower focus of Pillar 3, which is aimed at disclosure of bank capital adequacy, does not conflict with the broader accounting requirements. Pillar 3 disclosures will not be required to be audited by an external auditor, unless otherwise required by accounting standards setters, securities regulators or other authorities.

For those disclosures that are not mandatory under accounting or other requirements, management may choose to provide the Pillar 3 information through other means such as on a publicly accessible internet website or in public regulatory reports filed with bank supervisors. However, institutions are encouraged to provide all related information in one location. A bank should decide which disclosures are relevant for it based on the materiality concept. Information would be regarded as material if its omission or misstatement could change or influence the assessment or decision of a user relying on that information for the purpose of making economic decisions.

The disclosures set out in Pillar 3 should be made on a semi-annual basis. Qualitative disclosures that provide a general summary of a bank’s risk management objectives and policies, reporting system and definitions may be published on an annual basis.

The Basel Committee believes that the requirements set out in Pillar 3, strike an appropriate balance between the need for meaningful disclosure and the protection of proprietary and confidential information.

Par 808 – 819

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4.2. The disclosure requirements 4.2.1. General disclosure principle

Banks should have a formal disclosure policy approved by the board of directors that addresses the bank’s approach for determining what disclosures it will make and the internal controls over the disclosure process.

Par 820 – 821

4.2.2. Scope of application

Pillar 3 applies at the top consolidated level of the banking group to which the Framework applies. Disclosures related to individual banks within the groups would not generally be required to fulfil the disclosure requirements. An exception to this arises in the disclosure of Total and Tier 1 Capital Ratios by the top consolidated entity where an analysis of significant bank subsidiaries within the group is appropriate.

Par 822

4.2.3. Capital

A both qualitative and qualitative disclosure on Total, Tier 1 and Tier 2 capital, as well as capital adequacy is required.

Par 822

4.2.4. Risk exposure and assessment

The risks to which banks are exposed and the techniques that banks use to identify, measure, monitor and control those risks are important factors market participants consider in their assessment of an institution. In Pillar 3, several key banking risks are considered: credit risk, market risk, interest rate risk and equity risk in the banking book and operational risk. Also included are disclosures relating to credit risk mitigation and asset securitisation, both of which alter the risk profile of the institution. Where applicable, separate disclosures are set out for banks using different approaches to the assessment of regulatory capital.

Par 823 – 826

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5. Conclusion

Never in the past did a document have the impact on financial institutions and regulators alike, which the Basel II proposals had. Not only does it constitute best practice in terms of risk management, but in order to be globally competitive, banks need to adopt these requirements to ensure survival.

The aim of this paper was to provide an introductory guide to this highly technical document and the vast amount of accompanying popular and scientific literature available on the web and in the press. This paper provided a basic insight into the Basel II document for persons, e.g. new financial market analysts and financial journalist needing a basic understanding or introduction to the current bank supervision and regulation.

This paper was compiled from the original documents and reference to the paragraph numbers of the original documents was made in each section.

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6. Bibliography

Title Publisher / Author The Basel Handbook: A Guide for Financial Practitioners

Michael K. Ong

International Convergence of Capital Measurement and Capital Standards

Basel Committee on Banking Supervision – June 2004

Managing Bank Capital (Second Edition) - Capital Allocation & Performance Measurement

Chris Patten John Wiley & Sons - 2000

A Practitioner’s Guide to The Basel Accord PricewaterhouseCoopers LLP John Tattersall and Richard Smith

Credit Risk Models & the Basel Accords Donald R. Van Deventer Kenji Imai

An Explanatory Note on the Basel II IRB Risk Weight Functions

Basel Committee on Banking Supervision – October 2004

Studies on the Validation of Internal Rating Systems

Basel Committee on Banking Supervision - Working Paper No. 14

Economic Capital: A Practitioner Guide Ashish Dev Risk Books

Websites www.baselalert.com www.riskwaters.com www.bis.org

www.federalreserve.gov <http://www.federalreserve.gov> www.apra.gov.au <http://www.apra.gov.au> www.info.gov.hk/hkma <http://www.info.gov.hk/hkma> Committee of European Banking Supervisors - http://www.c-ebs.org/ www.erisk.com <http://www.erisk.com> www.kamakuraco.com

Some additional general B2 references include: Global Risk Regulator (website) www.globalriskregulator.com Managing Bank Capital - Chris Matten