The document provides an overview of Basel II, including its background, main elements, and implementation process. It discusses: - The three pillars of Basel II - minimum capital requirements, supervisory review, and market discipline. - The different approaches for calculating capital requirements for credit, operational, and market risk. This includes standardized and internal ratings-based approaches. - The importance of the supervisory review process in Pillar 2 for banks to assess their capital adequacy beyond regulatory minimums. - The role of enhanced disclosure in Pillar 3 to improve market discipline. It emphasizes that countries should consider their own banking system's readiness before implementing Basel II and that there is no single approach, with

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 George
Financial Staiblilty Institute / Bank for International Settlements
Representative Office for Asia and the Pacific
Hong Kong SAR

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 for
regulatory capital and risk management than we have ever
known”
Former Basel Committee Chairman Jaime Caruana
11 May 2004
2

3. Capital Adequacy
Supervisors must set prudent and appropriate minimum
capital adequacy requirements for banks that reflect the risks
that the bank undertakes, and must define the components of
capital, bearing in mind its ability to absorb losses. At least for
internationally active banks, these requirements must not be
less than those established in the applicable Basel
requirement.
Core Principle 6, Core Principles for Effective Banking
Supervision, October 2006
3

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. 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. 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. Basel II: The Three Pillars
Three
pillars
approach
Minimum
Supervisory
capital Market discipline
review process
requirements
Perfect rules are not feasible
- no perfect measurement system
- difficult balance between accuracy and simplicity
7

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 Capital
Standardised Internal Basic Standardised Advanced Standardised Models
Approach Ratings-based Indicator Approach Measurement Approach Approach
Approach Approach Approaches
8

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. 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. 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. 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. 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. 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. 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. 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 one
discretion 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. Credit risk: IRB approach
Basic 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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 an
opportunity for banks and supervisors to strengthen the
resilience of the banking system…”
Basel Committee Chairman Nout Wellink
4 March 2008
28

29. Building the Road to the Implementation of Basel II
29

30. Necessary Steps for Building a Road
1) Assessing the current environment
2) 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 foundation
5) Constructing the road
30

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. 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. What Kind of Road are we Building?
33

34. What Kind of Road are we Building?
34

35. What Kind of Road are we Building?
The superhighway appears attractive, but traveling at
high speeds brings great risks!!
35

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. Big banks urge emerging …but the IMF board
markets to move cautions against moving
quickly… 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. 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. 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. 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. The Construction Process – Practical
Steps 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. 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. Think About the Intersections
43

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. 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 authorities
worldwide with a view to encouraging them to consider
adopting this revised Framework at such time as they believe
is consistent with their broader supervisory priorities.”
Basel II Framework, para 3
June 2006 45

46. Basel II Implementation in Asia
Implementation status
Credit Risk Operational Risk
Australia SA: 01.01.2008 BIA: 01.01.2008
FIRB: 01.01.2008 SA: 01.01.2008
AIRB: 01.01.2008 AMA: 01.01.2008
China SA: Not permitted BIA: Undecided
FIRB: 31.12.2010/2013* SA: Undecided
AIRB: 31.12.2010/2013* AMA: Undecided
Hong 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. Basel II Implementation in Asia
Implementation status
Credit Risk Operational Risk
India SA: 31.03.2008/2009* BIA: 31.03.2008/2009*
FIRB: Undecided SA: Undecided
AIRB: Undecided AMA: Undecided
Japan SA: 01.04.2007 BIA: 01.04.2007
FIRB: 01.04.2007 SA: 01.04.2007
AIRB: 01.04.2008 AMA: 01.04.2008
Korea 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. Basel II Implementation in Asia
Implementation status
Credit Risk Operational Risk
Malaysia SA: 01.01.2008 BIA: 01.01.2008/2010*
FIRB: 01.01.2010 SA: 01.01.2008/2010*
AIRB: 01.01.2010 AMA: Undecided
Singapore SA: 01.01.2008 BIA: 01.01.2008
FIRB: 01.01.2008 SA: 01.01.2008
AIRB: 01.01.2008 AMA: 01.01.2008
Thailand 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. Basel II Implementation - Other Regions
Implementation 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. Basel II Implementation in Asia
Implementation 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. 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 and
adapt to innovations in banking and financial markets…”
Federal Reserve Board Chairman Ben Bernanke
2 November 2007
51

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. Basel II and the Current Market Turmoil
Pillar 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. Basel II and the Current Market Turmoil
Pillar 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. Basel II and the Current Market Turmoil
Pillar 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. Overview of Basel II
- Why, What, How and When -
Jason George
Financial Stability Institute
Bank for International Settlements
Representative Office for Asia and the Pacific
Hong Kong SAR
jason.george@bis.org
(852) 2878 7109