BASEL II – An Overview Girish V S

Economic Objectives Efficiency : best use of capital across business lines, impetus for risk based pricing and operational cost savings Stability : ensure capital protection consistent with shareholder value optimization

Efficiency : best use of capital across business lines, impetus for risk based pricing and operational cost savings

Stability : ensure capital protection consistent with shareholder value optimization

Economic Objectives Growth sustainability : balanced Portfolio risk and return Equity : level competitive playing field across(big and small) banks

Growth sustainability : balanced Portfolio risk and return

Equity : level competitive playing field across(big and small) banks

The Three Pillars The First Pillar - Minimum Capital Requirements The Second Pillar - Supervisory Review Process The Third Pillar - Market Discipline

The First Pillar - Minimum Capital Requirements

The Second Pillar - Supervisory Review Process

The Third Pillar - Market Discipline

Pillar 1 Calculation of the total minimum capital requirements for credit, market and operational risk. The minimum capital requirements are composed of three fundamental elements: a definition of regulatory capital, risk weighted assets and the minimum ratio of capital to risk weighted assets.

Calculation of the total minimum capital requirements for credit, market and operational risk.

The minimum capital requirements are composed of three fundamental elements: a definition of regulatory capital, risk weighted assets and the minimum ratio of capital to risk weighted assets.

RISK BASED SUPERVISION

BASEL II : CAPITAL CHARGE

Credit Risk The standardised approach The Internal Ratings-Based Approach Foundation Advanced

The standardised approach

The Internal Ratings-Based Approach

Foundation

Advanced

CREDIT RISK WEIGHTS

Credit Exposure Classes Sovereigns - countries, central banks and multilaterals with 0% risk Banks and non-banks- banks, investment houses, securities firms Retail -individuals/persons & their guarantees(credit card, personal loan, rem, small business) or pools of these loans with similar characteristics

Sovereigns - countries, central banks and multilaterals with 0% risk

Banks and non-banks- banks, investment houses, securities firms

Retail -individuals/persons & their guarantees(credit card, personal loan, rem, small business) or pools of these loans with similar characteristics

Credit Exposure Classes Sme - exposure to individual owner, partners and enterprises owned by group usually with government incentives or programs

Sme - exposure to individual owner, partners and enterprises owned by group usually with government incentives or programs

Coverage And Compliance 110 signatory countries (ye 2003). All banks, investment houses and securities firms, asset/fund management companies and bank owned/controlled insurance companies.

110 signatory countries (ye 2003).

All banks, investment houses and securities firms, asset/fund management companies and bank owned/controlled insurance companies.

C & C Banking areas affected : regulatory compliance, audits, risk management practices, accounting standards, financial products and services, human resources, it/systems

Banking areas affected : regulatory compliance, audits, risk management practices, accounting standards, financial products and services, human resources, it/systems

Standardized Approach

Internal Ratings Based

FIRB VS. AIRB

IRB Borrower risk rating - inherent creditworthiness without considering facility type or security arrangements. Transformed into a PD Facility risk rating -risk rating considering the various security arrangements or credit risk mitigation techniques(thus lower LGD values)

Borrower risk rating - inherent creditworthiness without considering facility type or security arrangements. Transformed into a PD

Facility risk rating -risk rating considering the various security arrangements or credit risk mitigation techniques(thus lower LGD values)

IRB Collaterals Netting Guarantees and credit derivatives

Collaterals

Netting

Guarantees and credit derivatives

LGD Valuations FOUNDATION IRB CI REAL ESTATE= 35% RECEIVABLES FULLY SECURED LOANS=35% OTHER PHYSICAL COLLATERALS=40% UNSECURED LOANS=50% FINANCIAL ASSETS (SCALED BY HAIRCUTS)= 0.5-15% SUBORDINATED CLAIMS=75% ADVANCED IRB BANK OWN ESTIMATES

FOUNDATION IRB

CI REAL ESTATE= 35%

RECEIVABLES FULLY SECURED LOANS=35%

OTHER PHYSICAL COLLATERALS=40%

UNSECURED LOANS=50%

FINANCIAL ASSETS (SCALED BY HAIRCUTS)= 0.5-15%

SUBORDINATED CLAIMS=75%

ADVANCED IRB

BANK OWN ESTIMATES

Credit Risk Mitigants Collateral Standard haircuts(issuer,rating, tenor, type) Mark to market Operational risks(eg. Legal) Concentration risks

Collateral

Standard haircuts(issuer,rating, tenor, type)

Mark to market

Operational risks(eg. Legal)

Concentration risks

Credit Risk Mitigants Netting Master netting legal agreements(net positions) Marked to market all Transactions Currency and maturity mismatches Creditderivatives/guarantees Counterparty/issuer risks Derivatives documentation (legal) Market risks

Netting

Master netting legal agreements(net positions)

Marked to market all

Transactions

Currency and maturity mismatches

Creditderivatives/guarantees

Counterparty/issuer risks

Derivatives documentation (legal)

Market risks

Credit Risk Impact

Credit Risk Impact IRB estimated to reduce credit risk capital charges by 2-3% versus standardized approach. Another possible 10-20% capital charge reduction versus foundation approaches.

IRB estimated to reduce credit risk capital charges by 2-3% versus standardized approach. Another possible 10-20% capital charge reduction versus foundation approaches.

Key Basel Compliance Requirements Reliable historical credit statistics: default rates, recoveries (e.G. Market valuation of collaterals), portfolio concentration data, financial statement analysis/ratio history and projections, exposure valuation) Intensive credit risk analysis and portfolio modeling Skills Integrated central exposure system with on line Analysis/processing functions

Reliable historical credit statistics: default rates, recoveries (e.G. Market valuation of collaterals), portfolio concentration data, financial statement analysis/ratio history and projections, exposure valuation)

Intensive credit risk analysis and portfolio modeling Skills

Integrated central exposure system with on line Analysis/processing functions

Key Compliance Requirements Robust internal ratings Appropriate use of credit risk/var models Appropriate credit risk rating and modelling software

Robust internal ratings

Appropriate use of credit risk/var models

Appropriate credit risk rating and modelling software

Market Risk Compliance Timely and accurate daily mark to market accounting/data and valuation of fx and securities portfolio Reliable and robust value at risk model Including historical simulation/ backtesting And stress testing results Integrated on line market risk monitoring And control system Well trained users(back, front and middle Office)

Timely and accurate daily mark to market accounting/data and valuation of fx and securities portfolio

Reliable and robust value at risk model Including historical simulation/ backtesting And stress testing results

Integrated on line market risk monitoring And control system

Well trained users(back, front and middle Office)

Ops Risk The Basic Indicator Approach The Standardised Approach Advanced Measurement Approach

The Basic Indicator Approach

The Standardised Approach

Advanced Measurement Approach

Ops Risk Impact

Operating Risk Compliance High awareness level of operational risk and Control inherent in all business processes, their Likelihood and financial loss impact significance Timely and reliable information /monitoring of key Operational risk indicators/events (transaction Volume, financials, tat, system downtimes, control Exceptions, process errors etc) to form part of Operational event loss data base

High awareness level of operational risk and Control inherent in all business processes, their Likelihood and financial loss impact significance

Timely and reliable information /monitoring of key Operational risk indicators/events (transaction Volume, financials, tat, system downtimes, control Exceptions, process errors etc) to form part of Operational event loss data base

Operating Risk Compliance Establishing minimum risk control Benchmarks/standards and gaps versus actuals Intensive operational risk & control training Robust operational risk models (loss given event, Probability of loss, exposure indicators)

Establishing minimum risk control Benchmarks/standards and gaps versus actuals

Intensive operational risk & control training

Robust operational risk models (loss given event, Probability of loss, exposure indicators)

Pillar 2 – Supervisory Review Intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks. Supervisors are expected to evaluate how well banks are assessing their capital needs relative to their risks and to intervene, where appropriate.

Intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.

Supervisors are expected to evaluate how well banks are assessing their capital needs relative to their risks and to intervene, where appropriate.

Pillar 2 Three main areas suited to treatment under Pillar 2: Risks considered under Pillar 1 that are not fully captured by the Pillar 1 process (e.g. credit concentration risk) Those factors not taken into account by the Pillar 1 process (e.g. interest rate risk in the banking book, business and strategic risk) Factors external to the bank (e.g. business cycle effects).

Three main areas suited to treatment under Pillar 2:

Risks considered under Pillar 1 that are not fully captured by the Pillar 1 process (e.g. credit concentration risk)

Those factors not taken into account by the Pillar 1 process (e.g. interest rate risk in the banking book, business and strategic risk)

Factors external to the bank (e.g. business cycle effects).

Four Key Principles of Supervisory Review 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.

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.

Four Key Principles 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.

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.

Four Key Principles 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.

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.

Four Key Principles 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.

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.

Pillar 3 Market Discipline The purpose of Pillar 3 - market discipline is to complement the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2). 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 purpose of Pillar 3 - market discipline is to complement the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2).

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.

Challenges Establishing a sound credit risk Rating system Enhancing risk management Infrastructure: var based Measurement using central data Repository and risk engines Capital allocation by Business:higher returns to Compensate higher risks Establishing a risk based culture

Establishing a sound credit risk Rating system

Enhancing risk management Infrastructure: var based Measurement using central data Repository and risk engines

Capital allocation by Business:higher returns to Compensate higher risks

Establishing a risk based culture