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1 basel ii overview - islamabad

  1. 1. Overview of Basel II - Why, What, How and When -SAARCFINANCE Seminar on Basel II Implementation in South Asia Islamabad, Pakistan 26 June 2008 Jason GeorgeFinancial Staiblilty Institute / Bank for International Settlements Representative Office for Asia and the Pacific Hong Kong SAR
  2. 2. Agenda Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil“Basel II introduces a far more comprehensive framework forregulatory capital and risk management than we have everknown” Former Basel Committee Chairman Jaime Caruana 11 May 2004 2
  3. 3. Capital AdequacySupervisors must set prudent and appropriate minimumcapital adequacy requirements for banks that reflect the risksthat the bank undertakes, and must define the components ofcapital, bearing in mind its ability to absorb losses. At least forinternationally active banks, these requirements must not beless than those established in the applicable Baselrequirement.Core Principle 6, Core Principles for Effective BankingSupervision, October 2006 3
  4. 4. The Case for a Capital Framework Financial instability is costly to the economy, such as… – Disruption in the distribution of funds – Breakdown in the payment systems – Possibility of international contagion Therefore, the need for supervision and capital regulation – But the objective should not be to assure that banks will never fail Capital regulation can have competitive implications – The need to have internationally harmonised rules for internationally active banks competing with each other – International versus domestic banks 4
  5. 5. Benefits of Basel I … and Some Issues Created an internationally  Capital requirements not recognised standard always reflective of economic – Adopted world-wide risk Contributed to financial  Does not address innovation stability in risk measurement and – Reversed a downward management practices trend in international – Arbitrage opportunities (eg banks‟ capital levels through securitisation) – Promoted level playing • Little recognition of credit risk field among mitigants internationally-active banks  “OECD Club-Rule” Relatively simple 5
  6. 6. Objectives of Basel II  Greater use of the roles played by bank management (pillars 1 and 2) and the market (pillar 3)  Better align regulatory capital to underlying risk (economic capital)  Encourage banks to improve risk management capabilities  Comprehensive coverage of risks – Pillar 1: credit, market and operational risk – Pillar 2: all other risks, aspects of pillar 1 risks not captured in pillar 1, and external factors  Applicability to a wider range of banks and systems (menu of options) 6
  7. 7. Basel II: The Three Pillars Three pillars approach Minimum Supervisory capital Market discipline review processrequirements Perfect rules are not feasible - no perfect measurement system - difficult balance between accuracy and simplicity 7
  8. 8. Basel II: The Three Pillars Plus… Three Basic Pillars Minimum capital Supervisory review Market requirements process discipline Risk weighted Definition of assets capital Credit risk Operational Market Core Supplementary risk risks Capital CapitalStandardised Internal Basic Standardised Advanced Standardised Models Approach Ratings-based Indicator Approach Measurement Approach Approach Approach Approach Approaches 8
  9. 9. Relationship of the Three Pillars  Pillar 1: A quantitative approach to minimum capital requirements  Pillar 2: Banks should have a process for assessing their overall capital adequacy; supervisors will review this process and require additional capital if necessary  Pillar 3: Market participants should have better access to information regarding the credit standing of banks (ie enhanced disclosure)  All three pillars are mutually reinforcing 9
  10. 10. Potential Implications of Basel II Major improvement in capital regulation – Intended to enhance safety and soundness of the banking system – Implementation poses significant challenges Capital requirements more aligned to underlying risks – Less incentives for regulatory arbitrage – Transactions likely to be motivated more by funding and credit risk management needs – Better risk management and pricing by institutions – More efficient allocation of capital 10
  11. 11. Agenda Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil 11
  12. 12. Main elements of Basel II Based on three pillars Revised capital requirements for credit risk, new ones for operational risk, and hardly changed ones for market risks (1996 amendment) Menu of approaches for the measurement of risks More recognition of drivers of credit risk 12
  13. 13. Basel II: The three pillars Three pillars approach Minimum Supervisory capital Market discipline review process requirements• Credit risk • Bank ICAAP • Enhanced disclosure• Operational risk • Supervisory review• Market risk 13
  14. 14. Capital requirements for credit risk Several approaches to choose from – Standardised approach (SA) – Foundation internal ratings-based approach (FIRB) – Advanced internal ratings-based approach (AIRB) 14
  15. 15. Credit risk: Standardised approach Main characteristics – Closest to 1988 Capital Accord – OECD/non-OECD distinction for claims on sovereigns replaced – Riskiness determined by external credit assessments – Lower risk weights for claims on retail and residential mortgages – Significantly more recognition of credit risk mitigation techniques 15
  16. 16. Credit risk: Standardised approach Claim Assessment AAA - BBB+ - A + - A- BB+ - B- Below B- Unrated AA- BBB- Sovereigns 0% 20% 50% 100% 150% 100% (Export credit agencies) (0-1) (2) (3) (4-6) (7) 1 Option 1 20% 50% 100% 100% 150% 100% Banks 2 20% 50% 50% 100% 150% 50% Option 2 3 3 3 3 3 3 (20%) (20%) (20%) (50%) (150%) (20%) BB+ - BB- Below BB- Corporates 20% 50% 100% 100% 100% 150% Mortgages 35% Retail Other retail 75% Area of national 1 Risk weighting based on risk weights of sovereign in which the bank is incorporated, but onediscretion category less favourable. 2 Risk weighting based on the assessment of the individual bank. 3 Claims on banks of an original maturity of less than three months generally receive a weighting that is one category more favourable than the usual risk weight on the bank‟s claim. 16
  17. 17. Credit risk: IRB approachBasic principles Relies on a bank„s internal ratings system Based on three main elements – Risk components (e.g. PD, LGD, EAD) – Risk weight functions – Minimum requirements Separate approaches for each portfolio of assets Subject to supervisory validation and approval 17
  18. 18. Credit risk: IRB approach risk weights 200% 180% 160% 140% 120%Risk weight 100% 80% 60% 40% 20% 0% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Probability of defailt Corporates SME 5mn Retail 18
  19. 19. Operational risk: Definition Risk of loss resulting from:  Inadequate or failed – Internal processes – People – Systems  Or from external events Includes, but not limited to, exposure to fines,  Includes legal risk penalties, or punitive damages resulting from  Excludes strategic and supervisory actions, as reputational risk well as private settlements 19
  20. 20. Operational risk: It is not new …. however, New complex financial products and strategies Growing reliance on automated technology Cost reduction strategies Mergers Migration to outsourcing Banks are increasing their operational risk exposure 20
  21. 21. Operational risk: Pillar 1 approaches Choice of three approaches… – Basic indicator (15% of average gross income over 3 years) – Standardised approach (based on separate scaling factors for gross income from defined business lines between 12% and 18% gross income) – Range of advanced methods based on loss experience, subject to additional risk control criteria 21
  22. 22. Pillar 2 – Supervisory review process• The three pillars together are intended to achieve a level of capital commensurate with a bank„s overall risk profile• Pillar 2 is based on four key principles: – Banks„ own assessment of capital adequacy – Supervisors„ review of banks„ capital adequacy assessment – Capital above regulatory minimums – Supervisory intervention Foundation = existing supervisory guidance, especially Core Principles for Effective Banking Supervision 22
  23. 23. Rationale for Pillar 2 Encourage banks to utilise better risk management techniques Ensure banks have adequate capital to support all risks Focus on internal, not regulatory, capital Accommodate differences between banks 23
  24. 24. Capital above regulatory minimums Pillar 1 requirements include a buffer for uncertainties that affect the banking population as a whole All banks are expected to operate ABOVE the minimum requirement (i.e. not just at 8%!) Supervisors will need to consider whether the particular features of their banks/markets are adequately covered 24
  25. 25. Pillar 3 – Market Discipline Disclosure requirements allow market participants to assess key information relating to: – Scope of application – Capital – Risk exposures – Risk assessment process Both quantitative and qualitative disclosures Some disclosures are required in order to use the more advanced Pillar 1 approaches 25
  26. 26. Pillar 3 – Market Discipline Particularly relevant because internal methodologies allow banks discretion in assessing capital requirements Disclosures should be consistent with how management and the board assess and manage risks Pillar 3 disclosures based upon Basel II framework inform the market about a bank‟s exposure to risk in a consistent and understandable manner (ie enhanced comparability) 26
  27. 27. Pillar 3 - Achieving Appropriate Disclosures Supervisors have different powers available to achieve disclosure requirements – Disclosure on safety and soundness grounds – Disclosure of regulatory reports Mechanisms to enforce requirements – Moral suasion (to change behavior) – Enforcement actions – Financial penalties Nature of exact measures will depend upon legal powers of the supervisor and nature of any deficiency Refer to Basel Committee Disclosure Surveys 27
  28. 28. Agenda Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil“The implementation of the Basel II framework provides anopportunity for banks and supervisors to strengthen theresilience of the banking system…” Basel Committee Chairman Nout Wellink 4 March 2008 28
  29. 29. Building the Road to the Implementation of Basel II 29
  30. 30. Necessary Steps for Building a Road1) Assessing the current environment2) Making a plan: a) Where should the road lead to? b) What kind of road are we building?3) Setting up a project: a) What is the time schedule for building the road? b) What is required to build the road to Basel II?4) Testing (and, if need be, improving) the foundation5) Constructing the road 30
  31. 31. Where Should the Road Lead To? Adequately capitalised banks A sounder and safer banking (and financial) system as a precondition for a stable economy and economic growth 31
  32. 32. Readiness on the Regulators’ Side Basel II framework Control over  Risk  Banks‟  Account-  On-site, off- bank‟s structure management internal ing and site – Licensing and capital control and disclosure monitoring – Ownership – Provisioning governance  Remedial – Activities, – Large actions acquisitions exposure  Consolidated – Related party supervision exposure  Home-host – Liquidity cooperation  Institutional setting of the supervisor – Independence, governance, accountability, transparency – Resources, legal power  Preconditions – Sound macro-economic policies – Legal, accounting, auditing and payment systems – Systemic protection 32
  33. 33. What Kind of Road are we Building? 33
  34. 34. What Kind of Road are we Building? 34
  35. 35. What Kind of Road are we Building?The superhighway appears attractive, but traveling at high speeds brings great risks!! 35
  36. 36. What Kind of Road are we Building? Approaches for credit risk – Simplified standardised approach – Standardised approach – Foundation internal ratings-based approach – Advanced internal ratings-based approach Approach for operational risk – Basic Indicator approach – Standardised approach – Alternative standardised approach – Advanced measurement approaches There is not one way to implement Basel II 36
  37. 37. Big banks urge emerging …but the IMF boardmarkets to move cautions against movingquickly… too quickly… IIF Steering Committee on  IMF Executive Board (Nov Regulatory Capital (Nov 2005) 2005) …member banks believe that, (The Directors) urged staff to be as soon as reasonably completely candid when asked to possible, they and their local assess countries‟ readiness to jurisdictions should aim to take move to Basel II and to indicate advantage of … the Internal clearly the risks of moving too quickly and too ambitiously. Ratings Based (IRB) Approaches. 37
  38. 38. Basel II Implementation…(when do we build the road?)  When should Basel II be implemented? – Only national authorities can answer this question – Basel II may be a lesser priority compared to other efforts  Depending on a bank„s business, the 1988 Accord may remain an alternative – But principles of Basel II are valuable for supervisors and banks in all markets  In their assessments of a country‟s compliance with Core Principle 6 the IMF and the World Bank will not assess compliance based on whether or not a country has implemented Basel II. (IMF staff note, 23 April 2004) 38
  39. 39. What is Required to Build the Basel II Road? Implementing Basel II is a major challenge for banks and supervisors Assessing resource and training needs – Human resources – Financial resources – Information systems Ongoing communication between supervisors and between supervisors and banks 39
  40. 40. Solid Foundation A solid foundation is essential for building a road Basel II requires an appropriate infrastructure – Otherwise there could be a false sense of financial stability Preconditions for Core Principles are fundamental Compliance with Core Principles is crucial – System of effective supervision must exist in a country – Sound accounting and provisioning standards 40
  41. 41. The Construction Process – PracticalSteps for Implementation Transform the framework into enforceable rules Implementation – Minimum capital ratio – is 8% enough (the speed limit) – Deciding on the use of national discretion – Accord Implementation Group – Determining the scope of application of Basel II Paper on “practical considerations” published in July 2004 – Intended as a “roadmap” for implementation 41
  42. 42. Areas of National Discretion Recognises countries„ different realities Essential part to ensure that the implementation is to be a success Supervisors should develop policy decisions on the whole range of issues (Annex of “practical considerations paper“) – Draw upon domestic market practice and experience – Be consistent with the Basel II principles Share information with other supervisors 42
  43. 43. Think About the Intersections 43
  44. 44. Think About the Intersections Cross-border implementation as a major issue Relationship between home and host supervisor Examples – HSBC has offices over 80 countries and jurisdictions – Citigroup has offices in approximately 90 countries and jurisdictions – Barclays has offices in over 60 countries 44
  45. 45. Agenda Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil“This document is being circulated to supervisory authoritiesworldwide with a view to encouraging them to consideradopting this revised Framework at such time as they believeis consistent with their broader supervisory priorities.” Basel II Framework, para 3 June 2006 45
  46. 46. Basel II Implementation in AsiaImplementation status Credit Risk Operational RiskAustralia SA: 01.01.2008 BIA: 01.01.2008 FIRB: 01.01.2008 SA: 01.01.2008 AIRB: 01.01.2008 AMA: 01.01.2008China SA: Not permitted BIA: Undecided FIRB: 31.12.2010/2013* SA: Undecided AIRB: 31.12.2010/2013* AMA: UndecidedHong Kong SA: 01.01.2007 BIA: 01.01.2007 FIRB: 01.01.2007 SA: 01.01.2007 AIRB: 01.01.2008 AMA: Not permitted* Only for internationally active banks; banks can implement IRB as early as 31.12.2010 but must have implemented it by 31.12.2013. 46
  47. 47. Basel II Implementation in AsiaImplementation status Credit Risk Operational RiskIndia SA: 31.03.2008/2009* BIA: 31.03.2008/2009* FIRB: Undecided SA: Undecided AIRB: Undecided AMA: UndecidedJapan SA: 01.04.2007 BIA: 01.04.2007 FIRB: 01.04.2007 SA: 01.04.2007 AIRB: 01.04.2008 AMA: 01.04.2008Korea SA: 01.01.2008 BIA: 01.01.2008 FIRB: 01.01.2008 SA: 01.01.2008 AIRB: 01.01.2009 AMA: 01.01.2009* 31.03.2008 for Indian banks having foreign presence and foreign banks operating in India; 31.03.2009 for all other domestic banks. 47
  48. 48. Basel II Implementation in AsiaImplementation status Credit Risk Operational RiskMalaysia SA: 01.01.2008 BIA: 01.01.2008/2010* FIRB: 01.01.2010 SA: 01.01.2008/2010* AIRB: 01.01.2010 AMA: UndecidedSingapore SA: 01.01.2008 BIA: 01.01.2008 FIRB: 01.01.2008 SA: 01.01.2008 AIRB: 01.01.2008 AMA: 01.01.2008Thailand SA: 31.12.2008 BIA: 31.12.2008 FIRB: 31.12.2008 SA: 31.12.2008 AIRB: 31.12.2009 AMA: Not permitted* 01.01.2008 for Malaysian banks that are adopting the SA for credit risk; 01.01.2010 for banks that are adopting an IRB approach for credit risk. 48
  49. 49. Basel II Implementation - Other RegionsImplementation status Credit Risk Operational Risk Basel Committee SA: 01.01.2007 BIA: 01.01.2007 (ex US and Japan) FIRB: 01.01.2007 SA: 01.01.2007 AIRB: 01.01.2008 AMA: 01.01.2008 United States  Currently only applies to the 10-15 largest banks (core banks)*  Only advanced approaches permitted  Parallel run to begin 2009(?); minimum four quarters of testing, followed by a …  Three year transitional period (capital floors)  01.10.2008 implementation plan adoption* US regulators will publish rules permitting the use of standardised approach for non-core banks 49
  50. 50. Basel II Implementation in AsiaImplementation challenges Supervisory infrastructure (laws, regulations, accounting standards, supervisory guidance, Core Principles, etc) Pillar 2 – Banks: developing a robust ICAAP – Supervisors: understanding how to assess an ICAAP and developing appropriate & proportionate responses Common reporting framework (eg Pillar 3) Data Resources and training 50
  51. 51. Agenda Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil“The new framework is designed to evolve over time andadapt to innovations in banking and financial markets…” Federal Reserve Board Chairman Ben Bernanke 2 November 2007 51
  52. 52. Basel II and the Current Market Turmoil The build-up to, and unfolding of the financial turmoil took place in a Basel I environment – Lack of risk sensitivity – Inflexibility to rapid innovation – Perverse incentives to move exposures off the balance sheet – Failure to fully capture important elements of a bank‟s risk exposures Basel II needs timely implementation – The starting point for improving capital adequacy in banks is the timely implementation of Basel II 52
  53. 53. Basel II and the Current Market TurmoilPillar 1 (minimum capital requirements) The Basel Committee will revise Basel II to… – Establish higher capital requirements for complex structured products • These have produced a majority of the losses – Strengthen the capital treatment of liquidity facilities extended to support off-balance sheet vehicles (2008) – Strengthen the capital requirements in the trading book • Trading assets, especially complex, less liquid products, have increased significantly 53
  54. 54. Basel II and the Current Market TurmoilPillar 2 (risk management practices) The market turmoil has revealed significant risk management weaknesses in financial institutions Pillar 2 provides supervisors with tools to assess risk management and internal capital management processes The Basel Committee will issue Pillar 2 guidance to help strengthen risk management and supervisory processes – Management of firm-wide risks – Stress testing practices and capital planning processes – Management of off-balance sheet exposures – Supervisory assessment of valuation practices 54
  55. 55. Basel II and the Current Market TurmoilPillar 3 (disclosure practices) Weaknesses in bank transparency for complex products contributed to the build-up of concentrations in illiquid structured credit products Enhanced disclosures relating to (2009)… – Complex securitisation exposures – ABCP conduits – Sponsorship of off-balance sheet vehicles (eg SIVs)Other The Basel Committee will assess the level and cyclicality of capital requirements over time (2008) 55
  56. 56. Overview of Basel II- Why, What, How and When - Jason George Financial Stability Institute Bank for International SettlementsRepresentative Office for Asia and the Pacific Hong Kong SAR jason.george@bis.org (852) 2878 7109