RESERVE BANK OF INDIA
       www.rbi.org.in
Capital Charge for
   Credit Risk
Basel 2


 
        Pillar 1            Pillar 2           Pillar 3
 
 
    Minimum Capital   Supervisory Review   Market ...
Definition of credit risk
•   Credit risk is defined as the possibility of losses
    associated with diminution in the cr...
Manifestation of credit risk
•   Direct lending: principal/and or interest amount may not be
    repaid;

•   Guarantees o...
Need for Basel 2
    Basel 1
      •   Not risk sensitive
      •   Broad Brush Approach
      •   Lack of flexibility & i...
Approaches for computing
                 Capital charge for
                    Credit Risk
 
 
 
 
 
    Standardised Ap...
Transition
•   Standardised Approach – by end December 2006


      Year end   Dec 05     Dec 06    Dec 07   Dec 08

     ...
Standardised Approach
•   Based on the risk weighted assets method followed
    under Basel 1 where risk weights are linke...
Standardised Approach (2)
•       Sovereigns
         Range - 0, 20, 50, 100, 150 (UR – 100)
         National discretio...
Standardised Approach (3)
•   Retail (75%) – qualification
      Orientation – exposures to individuals or small
       b...
Standardised Approach (4)
•   Unsecured portion of NPAs net of specific provisions
       150% RW if specific provisions ...
Standardised Approach – Sources
                of impact
•    Higher RW on sovereigns as per ratings other than country o...
Credit Risk Mitigation
•   Simple Approach
     As in 1988 Accord substitutes the risk weight of

      the collateral fo...
Credit Risk Mitigation (2)
•   Comprehensive Approach
      Allows a fuller offset of collateral against exposures

     ...
IRB Approaches
       Foundation Approach
          PD * LGD * EAD
          PD by the bank (minimum requirements)
    ...
IRB Approaches – Minimum
              requirements
•   Banks need supervisory approval to use IRB approaches
•   To be me...
IRB Approaches – phased roll-out
•   Phasing out permitted as under:
       Adoption across asset classes within the busi...
IRB Approaches – phased roll-out (2)
                                Year end   Dec 05      Dec 06     Dec 07   Dec 08
   ...
Basel 2 – Likely impact
              QIS 3 results of Non-G 10 Countries

•   The Sample for QIS of the above countries w...
Pillar 1 – Implementation Strategies –
         Advanced approaches
•   Many banks have recently adopted internal rating s...
Thank You
External Ratings
•       Ratings of recognised rating agencies

•       Disclose the chosen rating agencies

•       Consi...
Asset Classes
   •   Corporate (5)                   •   Sovereign
          Project finance             •   Bank
       ...
IRB Approaches – Rating system design
•   Two separate and distinct dimensions –
        Risk of borrower default
      ...
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Basel2 Seminar Credit Risk

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Basel2 Seminar Credit Risk

  1. 1. RESERVE BANK OF INDIA www.rbi.org.in
  2. 2. Capital Charge for Credit Risk
  3. 3. Basel 2     Pillar 1 Pillar 2 Pillar 3     Minimum Capital Supervisory Review Market Discipline   Requirement Capital for Capital for Capital for Credit Risk Market Risk Operational Risk
  4. 4. Definition of credit risk • Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counterparties.  In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions.  Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality.
  5. 5. Manifestation of credit risk • Direct lending: principal/and or interest amount may not be repaid; • Guarantees or Letters of credit: funds may not be forthcoming from the constituents upon crystallization of the liability; • Treasury operations: the payment or series of payments due from the counter parties under the respective contracts may not be forthcoming or ceases; • Securities trading businesses: funds/ securities settlement may not be effected; • Cross-border exposure: the availability and free transfer of foreign currency funds may either cease or restrictions may be imposed by the sovereign.
  6. 6. Need for Basel 2 Basel 1 • Not risk sensitive • Broad Brush Approach • Lack of flexibility & incentives for better risk management • No incentives for credit risk mitigation techniques Thus Basel I uses arbitrary risk categories and arbitrary risk weights having no relation to default rates. All assets are considered within one category as equally risky Basel 2 • More risk sensitive • Provides a range of options for estimating regulatory capital for credit risk • Provides incentives to improved credit risk management
  7. 7. Approaches for computing Capital charge for Credit Risk           Standardised Approach Internal Ratings Based (Option 1) Approach Foundation IRB Advanced IRB Approach Approach (Option 2) (Option 3)
  8. 8. Transition • Standardised Approach – by end December 2006 Year end Dec 05 Dec 06 Dec 07 Dec 08 FIRB Parallel 95% 90% 80% AIRB Parallel/ Parallel 90% 80% impact • Capital floor, as above, will apply to banks adopting IRB Approaches up to year ending December 2008
  9. 9. Standardised Approach • Based on the risk weighted assets method followed under Basel 1 where risk weights are linked to external ratings of counter-party • Sovereign, banks, PSUs, corporate  Risk weight linked to external rating of the counter-party (0 to 150% RW)  Better the credit rating, lesser the risk weight  Unrated exposures attract 100% RW  Ratings below threshold levels attract 150% RW • Portfolio approach adopted for following exposures  Regulatory retail (75% RW)  Residential mortgage (35% RW)  Commercial real estate (100% RW)  NPAs (100 or 150% RW) • Maximum risk weight is 350%
  10. 10. Standardised Approach (2) • Sovereigns  Range - 0, 20, 50, 100, 150 (UR – 100)  National discretion for exposure to sovereign of incorporation  National discretion to keep claims on certain domestic PSUs on par with claims on sovereign • Banks & PSUs  Two options  Linked to rating of the sovereign (Range – 20, 50, 100, 150 (UR – 100)  Rating of the bank; with lower RW for exposures of 3 months or less (Range – 20, 50, 100, 150 (UR – 50) • Corporates  Range - 20, 50, 100, 150 (UR – 100)  National discretion to increase RW for unrated claims > 100 in countries where corp. NPA level is high  NPAs (> 90 days) – 150 %
  11. 11. Standardised Approach (3) • Retail (75%) – qualification  Orientation – exposures to individuals or small business  Product criterion – specified types of financial assistance (including non fund based)  Granularity criterion – Aggregate exposure to one counter-party to be within 0.2% of overall retail portfolio  Absolute threshold – Not to exceed Euro 1 million • Residential Property (35%)  Residential property – self occupied or rented  Existence of substantial margin based on strict valuation norms • Commercial real estate (100%)  Mortgage of office or multi purpose commercial premises
  12. 12. Standardised Approach (4) • Unsecured portion of NPAs net of specific provisions  150% RW if specific provisions are less than 20% of the outstanding loan amount  100% RW if specific provisions are no less than 20% of the outstanding loan amount  100% RW if specific provisions are no less than 50% of the outstanding loan amount, but can be reduced to 50% RW at the discretion of the supervisor • Higher risk categories – 150 % or more RW
  13. 13. Standardised Approach – Sources of impact • Higher RW on sovereigns as per ratings other than country of incorporation (<=20% at present) • Higher RW on banks as per ratings (20% at present) • Benefit of lower RW for corporates limited – since majority are unrated • Benefits of lower risk weights for residential mortgages & retail sector • Higher RW on unsecured, unprovided NPA of > 90 days • Higher RW for high risk ventures (150) • Operational risk
  14. 14. Credit Risk Mitigation • Simple Approach  As in 1988 Accord substitutes the risk weight of the collateral for the risk weight of the counter party  Eligible collaterals  Cash, Deposit with lending banks, CDs issued by lending banks  Gold  Debt securities meeting criteria  Equities included in a main index  Units meeting criteria
  15. 15. Credit Risk Mitigation (2) • Comprehensive Approach  Allows a fuller offset of collateral against exposures  Eligible collaterals  All included under simple approach  Other listed equities  Other Units which include above equities • Collateral valuation as prescribed • Eligibility as per qualifying standards  Legal certainty  No material positive correlation  Clear & robust procedures for liquidation of collateral • On balance sheet netting (margin money, deposits) • Guarantees and credit derivatives
  16. 16. IRB Approaches  Foundation Approach  PD * LGD * EAD  PD by the bank (minimum requirements)  LGD & EAD by the Regulator (rules)  Advanced Approach  PD * LGD * EAD  All three by the bank  To be validated by the regulator  General provisions/ general loan loss reserves not eligible for capital status  If EL is more than provisions held, difference should be deducted from capital funds  Maximum risk weight 1250%
  17. 17. IRB Approaches – Minimum requirements • Banks need supervisory approval to use IRB approaches • To be met at the outset and on an on-going basis • Separate treatment for different Asset classes • Credit risk management practices must be consistent with the evolving sound practice guidelines issued by the BCBS and supervisors • Internal rating system should meet minimum requirements • Objectives which the qualifying bank’s risk rating systems must satisfy  Focus will be on the bank’s abilities to rank order and quantify risk in a consistent, reliable and valid fashion  Systems and processes must be consistent with internal use of the risk estimates • Have in place sound back testing/ stress testing processes • Disclosure requirements under Pillar 3
  18. 18. IRB Approaches – phased roll-out • Phasing out permitted as under:  Adoption across asset classes within the business unit  Adoption across business units in the same banking group  Move from FIRB to AIRB for some risk components • Realistic implementation plan to be settled with the supervisor • Once IRB approach is adopted, it should be continued to be employed and no reversal without the approval of the supervisor
  19. 19. IRB Approaches – phased roll-out (2) Year end Dec 05 Dec 06 Dec 07 Dec 08 FIRB Parallel 95% 90% 80% AIRB Parallel/ Parallel 90% 80% • Parallel calculation AIRB Parallel/ impact Parallel 90% • Corporate, sovereign, bank & retail exposures  Banks must have used a rating system broadly in line with the minimum requirements for at least three years prior to qualification  Data to estimate PD for five years for C,S & B  Data to estimate PD & LGD for five years for RE  LGD for RE not less than 10%  Mapping of internal ratings to supervisory risk category for SL • Similar transition allowed for PD/ LGD for equity exposures • Must have at least two years of data at the time of implementation and will increase by one year with each of the three years of transition
  20. 20. Basel 2 – Likely impact QIS 3 results of Non-G 10 Countries • The Sample for QIS of the above countries was - 111 banks from 18 countries on Standardized Approach - 25 banks from 6 countries on FIRB, and - 9 banks from 3 countries on AIRB • SA: An average increase in RWA at 13%. This reflects impact of the new operational risk charge (+11%) plus a credit risk contribution (+2%) • FIRB : An average increase in RWA under the FIRB at 4%. This reflects impact of the new operational risk charge of (+) 7% and a credit risk contribution (-) 3% • AIRB (For G-10 countries): An average decrease in RWA under the AIRB at (-) 2%. This reflects impact of the new operational risk charge (+) 11% and a credit risk contribution (-) 13%
  21. 21. Pillar 1 – Implementation Strategies – Advanced approaches • Many banks have recently adopted internal rating systems. They are in the process of building up data banks and in due course will have data on default probabilities, rating migration, LGD etc. • Acceptable PD history on rating scales • Asset classes & Business line definition & reporting within banks • Validation of internal rating systems/ models • Cost of implementation – a relevant factor • Desirability of having some banks on SA and others on IRB • Home and Host supervisor issues • Pro-cyclicality – how to address • Evolution of LGD by RBI • Upgradation of supervisory skills
  22. 22. Thank You
  23. 23. External Ratings • Ratings of recognised rating agencies • Disclose the chosen rating agencies • Consistent use of ratings by chosen agencies • Cherry picking of ratings not permitted  If two ratings: higher of the two  If more than two ratings: higher of the lowest two • Issue rating Vs issuer rating – general principles • Domestic currency rating Vs foreign currency rating
  24. 24. Asset Classes • Corporate (5) • Sovereign  Project finance • Bank  Object finance • Retail (3) – managed as a pool; Exposures to  Commodities finance individuals  Income producing real  Exposures secured estate by residential  High-volatility properties commercial real estate  Qualifying revolving retail exposures  All other retail • Equity Key elements for each asset class • Risk components – estimates of risk parameters • Risk weight functions – means by which risk components are transformed to RWAs • Minimum requirements – the minimum standards that must be met by the bank for using IRB Approach for a given asset class
  25. 25. IRB Approaches – Rating system design • Two separate and distinct dimensions –  Risk of borrower default  Transaction specific factors • At least Seven grades for non-default borrowers and one for default category • Significant concentration in one grade/ grades must be supported by convincing empirical evidence • Separate PDs for each grade • Banks using AIRB approach should have sufficient number of facility grades to avoid grouping facilities with widely varying LGDs into a single grade. • These banks should have facility-wise LGD • The minimum requirements are broadly classified in the following sub systems:  Rating dimensions  Rating structure  Rating criteria  Rating assignment horizon  Use of models  Documentation of rating system design

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