Basel II – Quick Review Ali BELCAID – Managing ConsultantIt is intended toward people who are looking for a quick review of the major components of Basel II.
Basel II history 1975 Report to the Governors on the Supervision of Banks’ Foreign Establishments 1988 Internal Convergence of Capital Measurement and Capital Standards The Basle I Capital Accord 1996 Amendment to the Capital Accord to Incorporate Market Risks 2004 Internal Convergence of Capital Measurement and Capital Standards : A Revised Framework The Basle II Capital Accord
Main Objectives More risk sensitive: better reflection of risk More comprehensive: assesment of additional risks Taking into account increasing financial innovation Recognising improvment in risk measurement and control Putting more emphasis on market discipline Maintaining the overall level of regulatory capital
Basel II - Structure Basel II Capital Accord Pillar 1 Pillar 2 Pillar 3 Minimum capital Supervisory review Market discipline requirements process Credit risk Operational Market risk risk Standardized IRB IRB Basic AdvancedSecuritization Standardized Approach Foundation Advanced Indicator Measurement Approach Approach Approaches Internal Standardized Model Approach Approach
Pillar 1 – Capital Ratio Basle II Pillar 1 - Capital Requirement Regulatory capital (Definition unchanged) Minimum required = capital ratio Risk-weighted assets (8% minimum unchanged) (Measure revised)Credit Risk Market Risk Operational Risk Exposure + Exposure + Exposure(Measure revised) (Measure unchanged) (Measure added)
Pillar 1 - Credit RiskDifferent approaches are now recognised to compute the credit risk exposureand the associated capital requirement. Standardised approach New weighting categories Recognition of external credit assesment (external ratings) Internal Rating Based approach (IRB) Foundation IRB Advanced IRB
Standardized Approach : Rating Probability of S&P Moody’s Interpretation default (1Y)Investment Grade AAA Aaa Superior quality – very strong 0,00% AA+ Aa1 AA Aa2 Good quality 0,01% AA- Aa3 A+ A1 A A2 Good Capacity to service the debt 0,05% A- A3 BBB+ Baa1 BBB+ Baa2 Appropriate payment capacity 0,37% BBB- Baa3Speculative Grade BB+ Ba1 Probable but uncertain service of BB Ba2 1,36% the debt BB- Ba3 B+ B1 B B2 Risky debt, speculatif 6,08% B- B3 CCC – C Caa1 - C Vulnerable, probable default 30,85% D - Default 100%
Pillar 1 - IRB Approach Under IRB approaches, capital charges are computed on basis of expected credit losses and unexpected credit losses. Capital charges for expected losses are a function of the difference between the estimation of these losses and the general provisions constituted by the bank. 3 risk components for the computation of unexpected losses: PD = probability of default: over a 1-year time horizon LGD = loss given default: prediction of the economic loss after a default has occured EAD = exposure at default: potential exposure of a credit facility at the moment of default M = effective maturity
Pillar 1 - IRB ApproachSummary of different approaches for credit risk exposure computations Standardised Exposure x Risk Weight = RWA Increasing complexity Approach Decreasing capital IRB Foundation EAD PD LGD M IRB EAD PD LGD M AdvancedExternal Valorisation rules – Defined by the Basle Committee and the supervisory authorityInternal Valorisation rules – Computed by the banks’ risk management system
Pillar 1 - Credit Risk – Risk Mitigation Credit risk mitigation techniques are recognised and allowed by the regulator. 3 types of risk mitigation: Transaction with collateral Bank has a claim from a debitor that is fully or partially covered by a guarantee provided by the debitor Simple or comprehensive approach Netting Bank’s loans and deposits with one signle counterparty are compensated Guarantees and credit derivatives
Pillar 2 – Supervisory Review Process The second pillar refers to the supervisory review process and risk management guidance. This applies to all risks that a financial institution is facing, regardless of whether there is a minimum capital requirement. The supervisory review process requires regulators to ensure that each bank has a sound Financial Risk Management methodology, which enables such institution to be able to assess the adequate capital requirement. Supervisors would be responsible for evaluating how banks are assessing their capital adequacy needs relative to their risks. Supervisors should require remedial actions when capital requirements are not met. These could include: improve the Risk Management process, improve internal controls, or increase the regulatory capital.
Pillar 2 – Supervision ProcessFour Key Principles1. Banks should have an internal process for assessing their capital in relation to their risk profile.2. Supervisors should review and evaluate banks internal process as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate action if they are not satisfied with the results of this process.3. Supervisors should expect banks to operate above the minimum regulatory capital ratios.4. Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required.
Pillar 3 – Market Discipline The third pillar of the new framework aims to bolster market discipline through enhanced disclosure by financial institutions. Effective disclosure allows the stake-holders of financial institutions to better understand the risk profiles and to better assess the adequacy of capital reserves, of such institutions. Disclosure of quantitative and qualitative information in four key areas: Scope of application Composition of capital Risk exposure assessment & management processes (information per risk category) Capital adequacy
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