A brief introduction of the Basel Accord (Basel I, II and II).

1. The Regulation of Banking
Industry (Basel Accord)
AMRITA DEBNATH
ID# 708
MBA
DEPT. OF BANKING AND INSURANCE
UNIVERSITY OF DHAKA

2. Basel
The Basel Agreement
o An international agreement on new capital standards
o Designed to keep their capital positions strong
o Reduce inequalities in capital requirements among different countries
o Promote fair competition
o Catch up with recent changes in financial services and financial innovation
o In particular, the expansion of off-balance-sheet commitments
o Formally approved in July 1988
o Included countries such as:
 The United States, Belgium, Canada, France, Germany, Italy, Japan, the
Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and
Luxembourg

3. Objectives of Basel I
Objectives
• Strengthening the soundness and stability of the international
banking system
• Providing an internationally consistent level playing field with a
view to diminishing an existing source of competitive inequality
among international banks.

4. Components of Basel I
• Definition of capital
• Deduction regime
• A risk weighting approach
• A solvency ratio capital to weighted risk asset

5. Definition of Capital
Tier 1 (core) capital
o Common stock and surplus, undivided profits (retained
earnings), qualifying noncumulative perpetual preferred stock,
minority interest in the equity accounts of consolidated
subsidiaries, and selected identifiable intangible assets less
goodwill and other intangible assets
Tier 2 (supplemental) capital
o Allowance (reserves) for loan and lease losses, subordinated
debt capital instruments, mandatory convertible debt,
intermediate-term preferred stock, cumulative perpetual
preferred stock with unpaid dividends, and equity notes and
other long-term capital instruments that combine both debt
and equity features

6. Definition of Capital
For a bank to qualify as adequately capitalized, it must have:
 A ratio of core capital (Tier 1) to total risk-weighted assets of at
least 4 percent
 A ratio of total capital (the sum of Tier 1 and Tier 2 capital) to
total risk-weighted assets of at least 8 percent, with the
amount of Tier 2 capital limited to 100 percent of Tier 1 capital

7. Deduction Regime
• Deduction of accounting goodwill
• Investments in other regulated financial institutions
• Certain accounting items were deducted but then treated as tier 2
capita
• Revaluation of reserve of holding of equity instrument as tier 2

8. Risk Weighting Approach
• Risk weighting summary
Risk Weight Loans and Investment
0% Cash and OECD
10% Some public sector entities
20% Banks in the OECD and short term loans to non OECD
banks
50% Residential mortgages
Long term unfunded commitments
100% Most other assets, including corporate and retailing;
non OECD governments and long term loans to non-
OECD banks; real estate and equity exposure

9. Calculating Risk Weight Asset
Each asset item on a bank’s balance sheet and each off-balance-sheet
commitment it has made are multiplied by a risk-weighting factor
o Designed to reflect its credit risk exposure
The most closely watched off-balance-sheet items are standby letters of credit
and long-term, legally binding credit commitments
To compute this bank’s risk-weighted assets:
o Compute the credit-equivalent amount of each off-balance-sheet (OBS)
item
o Multiply each balance sheet item and the credit-equivalent amount of
each OBS item by its risk weight

10. Ratio capital to weighted risk asset
• Minimum Capital requirement is 8%

11. Modification
• In 1996, Basel I include the capital charges for market risk
• Value at Risk (VaR) Models Responding to Market Risk

12. Objectives of Basel 2
 To improve the risk management
 Resilience banking industry
 Make capital requirements more risk sensitive and therefore relevant
 Utilize the information, resources and judgments of the banks
themselves

13. The Three-pillar Approach
• 1. Minimum capital requirements
• 2. Supervisory review
• 3. Market discipline

14. Minimum Capital Requirement
• Pillar 1 is sum of three components
a. Credit Risk
b. Market Risk
c. Operational risk

15. Credit risks
• Elements of expected loss calculation
 Default probability
 Exposure of default
 Loss given default
 Maturity of the exposure
 Type of lending

16. Risk-weighting of Corporate Loans
Credit Rating of Corporate Risk-weight of Exposure (Under Basel II)
AAA to AA- 20%
A+ to A- 50%
BBB+ to BB- 100%
Below BB- 150%
Unrated 100%

17. Market Risk
• General market risk VaR model is used.
• Risk on a day to day basis VaR is useful but it is used in extreme
situations.

18. Operational Risk
• Operational risks that are operation in nature
 Fraud
 System failure
 Fire
• It includes legal risk but excludes strategic and reputational risk.

19. Pillar 2: Supervisory Review
Pillar 2 risk types
 interest risk
 Residual risk
 Liquidity risk
 Business risk
 Pension risk

20. Pillar 3: Market Discipline
• The committee aims to encourage market discipline by developing a
set of disclosure requirements which will allow market participants to
assess key pieces of information on the scope of application, capital,
risk exposures.

21. Critiques of Basel 2
1. Complexity
2. Liquidity
3. Incomplete implementation
4. Over reliance on credit rating agencies
5. Market risk module not fit for purpose

22. Basel III
• The third installment of the Basel Accords was developed in response
to the deficiencies in financial regulation revealed by the financial
crisis of 2007–08
• Unlike Basel I and Basel II, which focus primarily on the level of bank
loss reserves that banks are required to hold, Basel III focuses
primarily on the risk of a run on the bank, requiring differing levels of
reserves for different forms of bank deposits and other borrowings
• On 17 Dec. 2009, the Basel Committee published its ‘Consultative
Proposals to Strengthen the Resilience of the Banking Sector’

23. Capital Requirements
Basel II Basel III
Deductions Largely from Tier I and total capital All deductions from CET1
Denominator Basel II RWAs Basel III RWAs
CET1 2% 4.5%
Tier 1 4% 6%
Total Capital 8% 8%

24. Capital Requirements (Contd.)
 A mandatory “Capital Conservation Buffer", equivalent to 2.5% of
risk-weighted assets. Considering the 4.5% CET1 capital ratio
required, banks have to hold a total of 7% CET1 capital, from 2019
onwards.
 A “Discretionary Counter-cyclical Buffer", allowing national
regulators to require up to an additional 2.5% of capital during
periods of high credit growth. The level of this buffer ranges between
0% and 2.5% of RWA and must be met by CET1 capital.

25. Leverage Ratio
• This is a non-risk-based leverage
ratio and is calculated by
dividing Tier 1 capital by the
bank's average total
consolidated assets (sum of the
exposures of all assets and non-
balance sheet items)
• The banks are expected to
maintain a leverage ratio in
excess of 3% under Basel III.

26. Liquidity Requirements
• The "Liquidity Coverage Ratio"
was supposed to require a bank
to hold sufficient high-quality
liquid assets to cover its total net
cash outflows over 30 days.
• The Net Stable Funding
Ratio was to require the
available amount of stable
funding to exceed the required
amount of stable funding over a
one-year period of extended
stress.

27. Major Issues with Basel III
 Incremental and an Excessive Focus on Capital and Liquidity
Regulation
 Excessive Complexity
 New Risks: Sovereign Debt, CCPs and Shadow Banking
 Timing: Risk of a Credit Crunch
 Continued Reliance on the Credit Assessment of Either Internal
Models or External Ratings Agencies

28. Thank You.