Chapter 2: Basel 2 regulatory framework 2.

1 Bank for International Settlements

The bank was established in 1930 with the main objective to act as a principal centre for international central bank cooperation. It was established in the context of the Young Plan (1930) where payments imposed on Germany by the Treaty of Versailles following the First World War to collect, administer and distribute annuities payable as reparations. The name is derived from this original role. The changing role of the Bank came about due to the need of cooperation amongst central banks and increasingly other agencies in pursuit of monetary and financial stability. Since 1980, there have been regular meetings in Basel of central bank governors and experts. In 1970s and 1980s, the general economy faced managing cross-border capital flows following the oil crisis and the international debt crisis. The 1970 crisis brought the issue of regulatory supervision of internationally active banks within the spotlight. The result was the 1988 Basel Capital Accord and its Basel II revision. The Head Office is in Basel. Switzerland and it has representative offices in Hong Kong, SAR and in Mexico City. There are several committees and organizations focusing on monetary and financial stability and the international financial system. The most important committees are: The Markets Committee (1962) The Committee on the Global Financial System (1971) The Basel Committee on Banking Supervision (1974) The Committee on Payment and Settlement Systems (1990)

The Basel Committee on Banking Supervision (BCBS) is of particular importance. It was established at the end of 1974 by the central bank governors of the Group of Ten countries which is made up of eleven countries: Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. The BCBS is represented by countries, by their central banks or the authority with formal responsibility for the supervision of banking business where there is no central bank. The

Basel Committee was established in the aftermath of serious disturbances in international currency and banking markets. BCBS formulates broad supervisory standards and guidelines and recommends statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements statutory or otherwise which are best suited to their own national systems. The committee does not possess any formal supernational supervisory authority. The conclusions do not have legal force. The committee encourages standards that do not attempt detailed harmonization of member countries. The committee meets regularly four times a year. It has about twenty-five technical working groups and task forces which also meet regularly.

2.2 The First Basel Capital Accord Banking organizations have to maintain at least a minimum level of capital. Where it serves as a cushion against its unexpected losses, provides credit even during downturns and promotes public confidence in the banking system. The challenge is how much capital is necessary to serve as a sufficient buffer? If capital levels are too low, banks may fail and put depositors funds at risk. If capital levels are too high, banks do not make the most efficient use of their resources and will not use the capital to earn money and make credit available. During 1840-1870 European banks had an average ratio of capital over assets of 24% to 36% (mean over 30%). As at 1900 it was 20%. Between World War 1 and World War 2 it was 12% to 16%. Before Basel 1 it was 6% to 8% and in some banks even below 4%. The average does not mean much but confidence problems leads to systematic risk. Regulatory capital is the minimum amount of capital like the 8% capital reserve (Basel 1). The economic capital is the necessary capital to stay in business and additional capital is needed for Low frequency/High impact events. Regulatory capital (RC) is the minimum capital required by the regulator and economic capital is the capital level bank shareholders would choose in absence of capital regulation. In line with Basel 2, Expected loss should be covered through the regulatory capital, whilst unexpected loss should be covered through the economic capital. Extreme events should be covered through the economic capital.
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Economic capital is a reserve for unexpected losses. It is important to remain solvent, attract counterparties, gain market confidence and for shareholders, bondholders, credit rating agencies and regulators. Early 1980s the capital ratios of the main international banks were deteriorating just at the time that international risks were growing. A strong recognition of the need for a multinational accord to strengthen the stability of the international banking system. A consultative paper published in December 1987 referred to as the capital measurement system commonly referred to as the Basel Capital Accord. It was approved by the G10 governors and released to banks in July 1988. Deadline for implementation was end 1992. The First Basel Capital Accord was set with a view to implementation as soon as possible. It is intended that national authorities should prepare papers setting out their views on the timetable and the manner in which this accord will be implemented in their respective countries. Circulated to supervisory authorities worldwide with a view to encouraging adoption of this framework in countries outside the G-10 in respect of banks conducting significant international business. The agreed framework for measuring capital adequacy and the minimum standard to be achieved which the national supervisory authorities intend to implement in their respective countries. Two fundamental objectives were established: The new framework should serve to strengthen the soundness and stability of the international banking system and the framework should have a high degree of consistency in its application to banks in different countries. The First Basel Capital Accord agreed framework is designed to establish minimum levels of capital for internationally active banks. National authorities will be free to adopt arrangements that set higher levels. There are many different kinds of risks. For most banks the major risk is credit risk, that is to say the risk of counterparty failure. But there are many other kinds of risks. The central focus of this framework is credit risk. The First Basel Capital Accord lays down individual supervisory authorities have discretion to build in certain other types of risk. No standardization has been attempted in the treatment of these other kinds of risk in the framework at the present stage. Further study is required to further work to develop a satisfactory method of measurement of risk for the business as a whole, including operational risk.

Capital defined in two tiers. Capital must be readily available to absorb any losses. A bank capital was defined as comprising two tiers. Tier 1 (core capital) is the core measure of financial strength the most reliable types of capital. Common stock published reserves from post-tax retained earnings general reserves, and reserves required by law. This should make up at least 50% of a banks total capital base and at least 4% of the risk weighted assets. Tier 2 supplementary capital is less reliable forms of capital. Tier 2 supplementary capital is up to an amount equal to that of the core capital maximum of 50% of a banks capital. National banking supervisory authorities decide which of the elements of supplementary capital may be included. Banks may at the discretion of their national authority employ a third tier of capital, consisting of short-term subordinated debt for the sole purpose of meeting a proposition of the capital requirements for market risks. Tier 3 capital will be limited to 250% of a banks Tier 1 capital that is required to support market risks.

2.2.1 The risk weights and the risk-weight approach. Risk weight functions translate a banks exposure into specific capital requirement. Not a static requirement for capital - based on the risks. Assets are weighted by factors representing their riskiness and potential for default. On and off-balance-sheet items are weighted for risk with off-balance-sheet items converted to balance sheet equivalents (using credit-conversion factors) before being allocated a risk weight. Weighted risk ratio - five weights are used - 0, 10, 20, 50 and 100%. Further information may be viewed in appendix 1.2.1.

Off balance sheet - an asset or debt or financing activity not on the company's balance sheet Paper: The Management Of Banks Off-Balance-Sheet. Exposures (March 1986) www.bis.org/publ/bcbsc134.pdf. The main conclusion of this paper discusses the types of risk associated with most off-balance-sheet business are in principle no different from those associated with on balance-sheet business. Off-balance-sheet risks cannot and should not be analysed separately from the risks arising from on balance-sheet business, but should be regarded as an integral part of banks overall risk profiles. Accounting for off-balance-sheet activities differs significantly from country to country. Items may be recorded: on the balance sheet below the line
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as notes to the accounts in supervisory reports within banks internal reporting systems in some cases not at all

Information generally insufficient to give shareholders and depositors a reasonable picture of banks activities. Off-balance-sheet engagements Basel I. It is of great importance that all off-balance-sheet activity should be caught within the capital adequacy framework. But there is only limited experience in assessing the risks in some of the activities. All categories of off-balance-sheet engagements will be converted to credit risk equivalents by multiplying the nominal principal amounts by a credit conversion factor. Broad categories within which member countries will have some limited discretion to allocate particular instruments according to their individual characteristics in national markets:

Off-balance-sheet items under the standardized approach are converted into credit exposure equivalents through the use of credit conversion factors (CCF). Letters of Credit - Short-term self liquidating trade letters of credit: 20% CCF.

A minimum standard should be set which international banks will be expected to achieve by the end of 1992 allowing a transitional period of more than 4 years for any necessary adjustment by banks who need time to build up to those levels. The target standard ratio of capital to weighted risk assets should be set at 8% (of which the core capital element will be at least 4%). Since 1988, this framework has been progressively introduced not only in member countries but also in virtually all other countries with active international banks.

Basel I Amendments: April 1993: package of proposed amendments to the 1988 accord In addition to capital for credit risk, banks are required to hold capital for market risks and organization-wide foreign exchange exposures Value at Risk April 1995: A revised proposal, Extension of market risk capital requirements to cover commodities exposures April 1995: A revised proposal Banks can use either a regulatory VaR measure or their own proprietary VaR measure for computing capital requirements January 1996: Amendment designed to incorporate within the Accord the market risks arising from banks' open positions in foreign exchange, traded debt securities, equities, commodities and options. http://www.bis.org/publ/bcbs24.pdf - Amendment to the Capital Accord to incorporate Market Risks, Basle Committee on Banking Supervision, 1996 Banks will be expected to move to comprehensive value-at-risk models It was called the 1996 amendment, it went into effect in 1998.

2.3

The New Basel Capital Accord (Basel 2)

11 May 2004: The Basel Committee on Banking Supervision announces that it has achieved consensus on the remaining issues regarding the proposals for a new international capital standard. The group of central bankers and banking regulators who make up the Committee met at the Bank for International Settlements in Basel, Switzerland, and decided to publish the text of the new framework, widely known as Basel II, at the end of June 2004. This text will serve as the basis for national rule-making Processes. The Committee confirmed that the standardized and foundation approaches will be implemented from year end 2006. The Committee said that one further year of impact analysis/parallel running will be needed for the most advanced approaches, and these therefore will be implemented at year-end 2007. This will also provide additional time for supervisors and the industry to develop a consistent approach for implementation.

Central bank governors and the heads of bank supervisory authorities in the Group of Ten (G10) countries met and endorsed the publication of the International Convergence of Capital Measurement and Capital Standards: a Revised Framework, the new capital adequacy framework commonly known as Basel II. The meeting took place at the Bank for International Settlements in Basel, Switzerland, one day after the Basel Committee on Banking Supervision, the author of the text, approved its submission to the governors and supervisors for review. November 2005: Updated Version: International Convergence of Capital Measurement and Capital Standards - A Revised Framework, Updated November 2005. Updated version of the revised Framework. Additional guidance, developed jointly with the International Organization of Securities Commissions (IOSCO) and demonstrates the capacity of the revised Framework to evolve with time. June 2006: Updated Version International Convergence of Capital Measurement and Capital Standards - A Revised Framework, Comprehensive Version. A compilation of the June 2004 Basel II Framework the elements of the 1988 Accord that were not revised during the Basel II process. The 1996 Amendment to the Capital Accord to Incorporate Market Risks. The 2005 paper on the Application of Basel II to Trading Activities and the Treatment of double Default Effects.

2.3.1: Credit risk (CR) The risk that a borrower or counterparty might not honour its contractual obligations. Credit risk is main source of problems at banks. The measurement of credit risk implies assessing the borrowers creditworthiness - a loan should be priced to reflect how much risk it involves. Basel II: We have a direct relationship between the cost of the loan and the borrowers credit rating.

Under the first Accord, there is a static relationship between the type of borrower, and the regulatory capital requirement. The new Accord seeks to make the relationship dynamic, with greater emphasis on the credit quality of the borrower. This process should better align the banks regulatory capital with the underlying risk.

2.3.2 Market risk (MR): The risk of adverse price movements such as exchange rates, the value of securities, and interest rates. Market Risk is the risk that the value of on balance sheet or off balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices. Nasdaq stock index: Lost 65% between March 2000 and March 2001. Interest rate risk - the exposure of a bank's financial condition to adverse movements in interest rates. Exchange rate risk - the exposure of a bank's financial condition to adverse movements in exchange rates. Market risks arising from banks open positions in equities, traded debt securities, foreign exchange, commodities and options.

Capital requirements for banks' exposures to certain trading-related activities, including counterparty credit risk, and the treatment of double default effects. (Double default risk is the risk that both the borrower and the protection provider will default). Banks are permitted to use internal models as a basis for measuring their market risk capital requirements. Banks may (at the discretion of their national authority) employ a third tier of capital (Tier 3). The sum of tier 2 and tier 3 capitals for market risk capital charge may not exceed 250% of tier 1 capital for market risk capital charge. The sum of tier 2 and tier 3 capital may not exceed 100% of tier 1 capital.

2.3.3 Purpose of Basel 2: It is a set of regulatory standards targeting not only a sound capital ratio for credit, market and operational risk but also good governance through emphasis on risk management and internal controls. Risk based pricing: The purpose of the Basel Accord is not to guarantee profitable business for individual banks but to guarantee safe and sound financial system. (You need economic capital over and above regulatory capital).

The goal for the Basel II Framework is: to promote the adequate capitalization of banks to encourage improvements in risk management to strengthen the stability of the financial system to accomplish this goal, there are three pillars in the framework

2.3.4 Pillar 1 - Minimum Capital Requirements A revision of the 1988 Accords guidelines: Now the minimum capital requirements are more close to each banks actual risk of economic loss The calculation of the total minimum capital requirements for credit, market and operational risk The total capital ratio must be no lower than 8% Tier 2 capital is up to 100% of Tier 1 capital More sensitivity to the risk of credit losses higher levels of capital for borrowers that present higher levels of credit risk. There are three approaches to credit risk banks need to choose the most appropriate for them: 1. The standardized approach to credit risk: banks that engage in less complex

forms of lending and credit underwriting and that have simpler control structures may use external measures of credit risk to assess the credit quality of their borrowers for regulatory capital purposes. 2. and 3. The two internal ratings-based (IRB) approaches to credit risk: Banks that engage in more sophisticated risk-taking and that have developed advanced risk measurement systems may, with the approval of their supervisors, select from one of two internal ratings-based (IRB) approaches to credit risk.

Under an IRB approach, banks rely partly on their own measures of a borrowers credit risk to determine their capital requirements. (i) Foundation Internal Rating Based Approach. And (ii) Advanced Internal Rating Based Approach.

2.3.5 Approaches to measure credit risk: The Standardized Approach Banks rely on external credit assessment institutions These institutions issue opinions about firms and securities The upgrading or downgrading has substantial impact on the business opportunities of rated firms Rating agencies help reduce the asymmetry of information, which exists between firms and investors. These are credit rating agencies and export credit agencies. A Credit Rating Agency is a company that rates the ability of a company to pay back a loan. An Export Credit Agency is an agency established by a country that provides government-backed loans, guarantees and insurance to corporations that seek to do business overseas in developing countries and emerging markets to finance goods, investment, and services. Banks are required to slot their credit exposures into supervisory categories. There are fixed risk weights corresponding to each supervisory category.

Basel ii contains guidance for use by national supervisors in determining whether a particular source of external ratings should be eligible for banks to use. The Basel ii Accord makes national supervisors responsible for determining whether the assessments of a particular rating company / agency can be used for risk weighting purposes. After that, banks may choose the rating company / agency (one or more of them) they will use, among those validated by their supervisor (Conditional on supervisory approval) banks may disregard all these external assessments and risk-weight all their corporate exposures at 100%.

Six criteria to be satisfied by external credit assessment institutions: (i) objectivity, (ii) independence,(iii) international access/transparency, (iv) disclosure, (v) resources and (vi) credibility. These criteria are very similar to those used by the US SEC to designate nationally recognized statistical rating organizations. Moodys, S&P and Fitch are the only credit rating companies/agencies accepted by the national authorities of all member countries of the Basel Committee:
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www.moodys.com www.fitchratings.com www.standardandpoors.com

Banks must disclose which companies / agencies they use. Banks are not allowed to cherry pick among the assessments of different companies / agencies to lower their capital requirements. The Basel Committee has developed guidelines on multiple assessments for banks working with several external credit assessment institutions. Example: A bank working with two companies / agencies if there are two different risk-weights, banks must use the higher risk-weight. When the bank works with three or more companies /agencies, the bank must use the higher of the two lowest risk-weights. The use of external ratings for the evaluation of corporate exposures, is considered to be an optional element of the framework. Where no external rating is applied to an exposure, a risk weight of 100% will be used, implying a capital requirement of 8% as in the current Accord. An important innovation of the standardised approach is the requirement that loans considered past-due be risk weighted at 150%. Risk weights will continue to be determined by the category of the borrower sovereign, bank or corporate.

2.3.5.1 Claims on sovereigns

Sovereign risk: Risk that a government or sovereign power will default on its payment obligations, risk of default on a sovereign loan.

Basel i: OECD (The Organisation for Economic Co-operation and Development) government debt was weighted 0% debt of non-OECD governments, was weighted 100%. Basel ii Winners: Non-OECD rated above BB+ (China, Thailand) Basel ii Losers: Czech Republic, Hungary, Mexico At national discretion, a lower risk weight may be applied to banks exposures to their sovereign or central bank, when it is denominated and funded in the domestic currency.
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Where this discretion is exercised, other national supervisory authorities may also permit their banks to apply the same risk weight to domestic currency exposures to this sovereign (or central bank) funded in that currency. Sovereign risk reflects the ability and willingness of a government issuer to meet its future debt obligations. Absence of binding international bankruptcy legislation, creditors have only limited legal redress against sovereign borrowers. The rating agencies periodically update the list of the numerous economic, social and political factors that underlie sovereign credit ratings. It is difficult to quantify every risk or to determine the relative weights.

2.3.5.2 Claims on banks: For the treatment of claims on banks, there are two options. National supervisors will apply one option to all banks in their jurisdiction. Claims on banks First Option: All banks incorporated in a given country will be assigned a risk weight one category less favorable than that assigned to claims on the sovereign of that country. For claims on banks in countries with sovereigns rated BB+ to B- and on banks in unrated countries the risk weight will be capped at 100%.

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Claims on banks Second Option: External credit assessment of the bank itself. Claims on unrated banks risk-weighted at 50%. Risk weight one category more favourable may be applied to inter-bank claims with an original maturity of three months or less.

Basel i: OECD bank debt was weighted 20%. Non-OECD bank debt including corporate debt and the debt of non-OECD governments, was weighted 100%. Basel ii Winners: Non-OECD rated above BB+ under Option 2 Basel ii Losers: OECD rated A or below under either option Since the 1988 Accord five countries have joined the OECD and have lower risk weights.

Basel II makes the risk weighting for claims on banks dependent on the credit rating of their sovereign of incorporation. Option 1 for claims on banks: Banks in unrated countries will be risk weighted at not less than 100%. At national discretion, supervisory authorities may permit banks to risk weight all corporate claims at 100% without regard to external ratings.

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2.3.5.3 The Standardized Approach: Retail Exposures Retail exposures are to be risk weighted at a special rate of 75 per cent. Why? Because such exposures offer a potentially high level of risk diversification if they are small and uncorrelated. Conditions are imposed: The exposure is to an individual person or persons or to a small business Product criterion Y The exposures are credits and lines of credit (including credit cards and overdrafts), personal term loans and leases (e.g. instalment loans, auto loans and leases, student and educational loans, personal finance) and small business facilities and commitments. Securities (such as bonds and equities), whether listed or not, are specifically excluded from this category. No aggregate exposure to a single counterpart can exceed 0.2% of the overall retail portfolio. The maximum aggregated retail exposure to one counterparty cannot exceed 1 million

Claims secured by residential property or commercial real estate. Residential property. Lending fully secured by mortgages on residential property that is or will be occupied by the borrower, or that is rented, will be risk weighted at 35% (50 per cent risk weight in Basel I). National supervisory authorities should evaluate whether the risk weights are too low Commercial real estate. In numerous countries commercial property lending has been a recurring cause of troubled assets in the banking industry risk weighted at 100%

2.3.5.4 Off Balance Sheet Items Must be converted into credit exposure equivalents using credit conversion factor (CCF) Commitments: Original maturity of up to one year: CCF = 20% Original maturity in excess of one year: CCF = 50% Unconditionally cancellable: CCF = 0% Letters of Credit Short-term self-liquidating trade letters of credit arising from the movement of goods: CCF = 20%

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2.3.5.5 Claims on corporates Basel i vs. Basel ii Basel i: Corporate debt was weighted 100% Basel ii Winners: Corporates rated above BBB+ Basel ii Losers: Corporates rated below BB

2.3.5.6 Risk weights: Claims on sovereigns, PSEs (public sector entities), banks, and securities firms rated below BClaims on corporates rated below BBCategories of past due loans (for more than 90 days) National supervisors may decide to apply a 150% or higher risk weight reflecting the higher risks associated with some other assets, such as venture capital and private equity investments

2.3.5.7 Securitization Securitization - gathering a group of debt obligations such as mortgages into a pool dividing that pool into portions that can be sold as securities. Converting loans, leases, mortgages, car loans, credit card debt into securities. Securitization rated between BB+ and BB- will be risk weighted at 350%. Asset securitization is a mechanism for transferring credit risk with the use of securities. Example: Transfer of a pool of assets or obligations to a third party (like a Special Purpose Entity, SPE) which then issues securities that are claims against the pool backed solely by the assets (collateral) transferred and payments derived from those assets.

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The SPE funds its obligations by issuing securities and using the proceeds to purchase the assets from the originating bank The transferred assets can be on-balance sheet (loans) off-balance sheet (loan commitments) credit derivatives (synthetic securitization) Banks use securitization to convert illiquid assets to cash transfer risk to third parties (like investors)

2.3.5.8 Problems The use of different external credit assessment institutions may lead to differences in capital requirements. Credit ratings are subjective assessments. There are differences in the methodology and the rating scales. External credit assessment institutions do not have the same coverage across rating markets and across countries counterparties which are not rated by an ECAI are assigned a risk-weight by default. Smaller credit rating agencies tend to assign more favourable credit ratings. Example: In Japan banks often rely on the ratings of two local agencies, Japan Credit Rating Agency and Rating and Investment Information Inc These agencies rate most domestic firms between one and two notches higher than Moodys Section 702 of the Sarbanes-Oxley Act: Understanding the possible problems, requires the Commission (SEC) to conduct a study of the role and function of credit rating agencies in the operation of the securities markets. The credit rating agencies declare that the overall hierarchy of sovereigns versus banks versus corporates is illogical. A BBB rated counterparty has the same risk profile whether it be a sovereign, bank or corporate.

2.3.6 The 2 Internal Ratings-Based Approaches (IRB) Two variants: a foundation version and an advanced version. The IRB approach differs substantially from the standardized approach in that banks internal assessments of key risk drivers serve as primary inputs to the capital calculation. Potential for more risk sensitive capital requirements is substantial: Internal credit risk rating systems A strong rating system is designed to differentiate among the degrees of risk in a banks portfolio The number of grades represents how hard a rating system is working to distinguish risk
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Large banks use four or five pass grades - the best rating systems use 20 or more grades, including +/- modifiers (like those used by the rating agencies) Supervisors will tend to look for some minimum number of grades

IRB 5 classes of assets: Banks must categorize banking-book exposures into broad classes of assets with different underlying risk characteristics: The classes of assets are (i) corporate, (ii) sovereign, (iii) bank, (iv) retail, and (v) equity. Within the (i) corporate asset class, five sub-classes of specialised lending are separately identified Within the (iv) retail asset class, three sub-classes are separately identified The classification of exposures in this way is broadly consistent with established bank practice

Within the (i) corporate asset class, the five sub-classes of specialised lending (SL) are:

1. Project finance (PF) A single project is both the source of repayment and the security for the exposure Usually for large, complex and expensive installations Examples: Power plants, chemical processing plants, mines, transportation infrastructure, environment, and telecommunications infrastructure Financing of the construction of a new capital installation, or refinancing of an existing installation

2. Object finance (OF) Funding the acquisition of physical assets (ships, aircraft, satellites, railcars, and fleets) The repayment of the exposure is dependent on the cash flows generated by the specific assets A primary source of these cash flows might be rental or lease contracts with one or several third parties

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3. Commodities finance (CF) Short-term lending to finance reserves, inventories, or receivables of exchange-traded commodities (e.g. crude oil, metals, or crops) The exposure will be repaid from the proceeds of the sale of the commodity and the borrower has no independent capacity to repay the exposure The borrower has no other activities and no other material assets on its balance sheet the financing is designed to compensate for the weak credit quality of the borrower

4. Income-producing real estate (IPRE) Providing funding to real estate such as, office buildings to let, retail space, multifamily residential buildings, industrial or warehouse space, and hotels The prospects for repayment and recovery on the exposure depend primarily on the cash flows generated by the asset.

5. High-volatility commercial real estate (HVCRE) Financing of commercial real estate that exhibits higher loss rate volatility for example, secured by properties that are categorized by the national supervisor as sharing higher volatilities in portfolio default rates or loans financing any of the land acquisition, development and construction (ADC) or loans financing ADC of any other properties where the repayment is either the future uncertain sale of the property or cash flows whose source of repayment is substantially uncertain

With the (ii) sovereign asset class: This asset class covers all exposures to counterparties treated as sovereigns. This includes: Sovereigns (and their central banks) Certain PSEs (public sector entities) that are treated as sovereigns by the national supervisor MDBs (multilateral development banks) that meet the criteria for a 0% (external assessment AAA)

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Examples: International Bank for Reconstruction and Development (IBRD), the Islamic Development Bank (IDB), the Asian Development Bank (ADB), the European Bank for Reconstruction and Development (EBRD The Bank for International Settlements, the International Monetary Fund, the European Central Bank and the European Community

With the exposures to (iii) banks and securities firms that are subject to supervisory and regulatory arrangements comparable to those under this Framework (including, in particular, risk-based capital requirements). (Otherwise such claims would follow the rules for claims on corporates). Bank exposures include claims on domestic PSEs that are not treated as sovereigns by the national supervisor and MDBs that do not meet the criteria for a 0% risk weight.

With the exposures to (iv) retail asset class, exposures to individuals such as credit cards, retail facilities secured by financial instruments, personal term loans and leases like auto loans and leases, student and educational loans, personal finance. Supervisors may wish to establish exposure thresholds to distinguish between retail and corporate exposures. Residential mortgage loans are eligible for retail treatment so long as the credit is extended to an individual that is an owner occupier of the property (if not corporate).

With the exposures to (iv) retail asset class, exposures to small businesses and managed as retail exposures are eligible for retail treatment provided the total exposure of the banking group to a small business borrower (on a consolidated basis where applicable) is less than 1 million. Supervisors must provide flexibility in the practical application of such thresholds such that banks are not forced to develop extensive new information systems simply for the purpose of ensuring perfect compliance.

With the exposures to (iv) retail asset class, exposures to the retail asset class category, banks are required to identify separately three sub-classes of exposures: exposures secured by residential properties

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qualifying revolving retail exposures like exposures that are revolving, unsecured, and uncommitted - customers outstanding balances are permitted to fluctuate based on their decisions to borrow and repay, up to a limit established by the bank the exposures are to individuals the maximum exposure to a single individual in the subportfolio is 100,000 or less

all other retail exposures

With the exposures to (v) equity, direct and indirect ownership interests in the assets and income of a commercial enterprise or of a financial Institution. Indirect equity interests include holdings of derivative instruments tied to equity interests, and holdings in corporations, partnerships, limited liability companies.

2.3.7 Expected / Unexpected Loss - BIS BIS - An Explanatory Note on the Basel II IRB Risk Weight Functions, July 2005. A bank can forecast the average level of credit losses it can reasonably expect to experience. These losses are referred to as Expected Losses (EL). Expected Losses: A cost component of doing business. Unexpected Losses: Peak losses that exceed expected levels. Peak losses do not occur every year, but when they occur, they can potentially be very large. Unexpected Losses (UL) institutions know they will occur now and then, but they cannot know in advance their timing or severity. Capital is needed to cover the risks of such peak losses.

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Expected Losses (EL), Unexpected Losses (UL)

Expected Losses (EL) regulatory capital, Unexpected Losses (UL) economic capital

The likelihood that losses will exceed the sum of Expected Loss (EL) and Unexpected Loss (UL) is the likelihood that a bank will not be able to meet its own credit obligations. This likelihood equals the hatched area under the right hand side of the curve. 100% minus this likelihood is called the confidence level and the corresponding threshold is called Value-atRisk (VaR). Capital is set to maintain a supervisory fixed confidence level.

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If capital is set according to the gap between EL and VaR, and if EL is covered by provisions or revenues then the likelihood that the bank will remain solvent over a one-year horizon is equal to the confidence level. The confidence level is fixed at 99.9%. This confidence level might seem rather high, but Tier 2 does not have the loss absorbing capacity of Tier 1. The high confidence level protects against estimation errors that might inevitably occur from banks internal PD, LGD and EAD estimation as other model uncertainties. The confidence level is included into the Basel risk weight.

Expected Loss Basel ii does not provide a definition of Expected Loss. There are three different interpretations of EL: EL is predicted on the basis of past experience, e.g. for credit card fraud, past experience of losses allows a projection of future losses, which is budgeted/priced for. A mathematical definition in which EL is equated to the mean (50th percentile) of a loss distribution.

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EL describes losses expected from identified events, for which a reserve has been established - Example: A legal cost is anticipated, but the exact amount of the legal settlement is not yet known.

Expected Loss UK (FSA) Interpretation 1: Typical Loss (TL) Typical Loss: Reoccurring losses that are expected in the normal course of business Interpretations 2: Mean Loss (ML) Mean Loss: is the mathematical mean derived from the loss distribution over a one year period.

Internal Ratings-Based Approaches (IRB) Two broad approaches: a foundation and an advanced Under the foundation approach, banks provide their own estimates of PD and rely on supervisory estimates for other risk components. Under the advanced approach, banks provide more of their own estimates of PD, LGD and EAD, and their own calculation of M.

Internal Ratings-Based Approaches (IRB). IRB approach is based on four key parameters used to estimate credit risks. PD - The probability of default LGD - The loss given default EAD - Exposure at default
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M -Maturity

Credit Risk: The Internal Ratings-Based Approaches (IRB)

Probability of Default (PD): The likelihood that a loan will not be repaid and fall into default the risk that the obligor will default in the coming 12 months. PD must be calculated for each company who have a loan. Quantitative information: Balance sheet, income statement, cash flow. Qualitative information: Quality of management, ownership structure. Decisions are based on credit history and creditworthiness of the counterparty nature of the investment external rating. Some banks will use external ratings agencies such as Standard and Poor's banks can use their own Internal Rating Methods.

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2.3.8 Loss Given Default (LGD) The assessment of Transaction Risk is measured by the magnitude of likely loss on the exposure a percentage of the exposure. It is the amount of loss after the borrower has defaulted. Driving factors: collateral, guarantees, recovery time, haircuts, the nature of the product, Borrower risk and transaction risk measures.

Haircuts: Haircut is the portion of an assets value that cannot be used as collateral. If 80 percent of an assets value can be used as collateral for a loan, the haircut is 20 percent (collateral must be valued in excess of the amount of the loan to protect the lender against a possible decrease in the value of the collateral) The size of the haircut reflects the perceived riskiness associated with the assets. Example: Haircut 30% for equity securities

Haircuts: Two ways to calculate the haircuts: standard supervisory haircuts, using parameters set by the Committee, and
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own-estimate haircuts, using banks own internal estimates. Supervisors will allow banks to use own-estimate haircuts only when they 26orpor certain qualitative and quantitative criteria. A bank may choose to use standard or own-estimate haircuts *independently* of the choice it has made between the standardised approach and the foundation.

Foundation IRB: LGD is estimated through the application of standard supervisory rules which differentiate the level of LGD based upon the characteristics of the underlying transaction. Under the foundation approach, senior claims on corporate, sovereigns and banks not secured by recognised collateral will be assigned a 45% LGD. All subordinated claims (debt that is unsecured or has a lesser priority than that of an additional debt claim on the same asset) on corporate, sovereigns and banks will be assigned a 75% LGD.

Advanced IRB: The bank itself determines the appropriate LGD to be applied to each exposure. Banks differentiate LGD values on the basis of a borrower characteristics. Banks need to persuade supervisors and to have the corporate governance elements in place. Banks are allowed to recognize a much wider array of collateral, guarantees and hedges than under Basel i. Banks systematically use collateral or guarantees to reduce LGDs. PDs as reflecting characteristics of the borrower and LGDs as reflecting characteristics of the loan.

2.3.9 Exposure at default (EAD) Is defined as the amount of exposure at the time of default. The amount (not %) to which the bank was exposed to the borrower at the time of default for the period of 1 year or until maturity (whichever is soonest). For certain facilities will include an estimate of future lending prior to default (!).

For on-balance sheet items such as commercial loans, the EAD estimate generally equates to the current drawn amount (the EAD on a $1 million loan is generally $1 million). For offbalance sheet exposures, such as unused loan commitments, banks apply credit conversion factors (CCFs) to the unused exposure amount in order to generate an EAD. Credit conversion factors reflect the estimated size and likely occurrence of the credit exposure. Foundation IRB: EAD is estimated through the use of standard supervisory rules. Advanced IRB: The bank using internal EAD estimates will differentiate EAD values on the basis of

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transaction characteristics (e.g. product type) as well as borrower characteristics. Banks will need to persuade supervisors.

2.3.10 Effective Maturity: Effective maturity (M) can reflect that long-term credits are riskier than short-term credits. For banks using the foundation approach for corporate exposures, effective maturity (M) will be 2.5 years except for repo-style transactions where the effective maturity will be 6 months. (Repo: A holder of securities sells these securities to an investor with an agreement to repurchase them at a fixed price on a fixed date). The average portfolio effective maturity is set by the Basel Committee at 2.5 years.

2.3.11: Examples Expected Loss (EL): EL(PORTFOLIO) = ELi(COUNTERPARTIES) ELi(EACH COUNTERPARTY) = PDi x LGDi x EADi $(EL) = % (PD) x % (LGD) x $ (EAD) [Size of Expected Loss] = [% probability of counterparty going into default] x [% how much is the bank going to lose] x [$ how much will he owe the bank]. EL = PD * LGD (if expressed as a percentage figure of the EAD)

Conditional Expected Loss (CEL) is the product of a conditional PD and a downturn LGD. The conditional PDs are derived from banks average PDs - under normal business conditions. The downturn LGD is the LGD under economic downturn conditions. During economic downturns the LGDs are higher. In the A-IRB approaches banks are required to estimate their own downturn LGDs.

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Internal Ratings Based Approach: Capital Requirements Basel Paper

K = Min. Regulatory Capital Requirements R = Asset Correlation (the correlation between an individual loan and the global state of the world economy) N[ ] = the cumulative distribution for a standard normal variable G[ ] = the inverse cumulative distribution for a standard normal variable LGD = Loss Given Default, PD = Probability of Default, M= Maturity of the loan, b (PD) = Smoothed regression maturity function

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Asset correlations: The asset correlations show the dependence of the asset value of a borrower on the general state of the economy. All borrowers are linked to each other by this single risk factor. Strong correlation among 1. The individual exposures within the portfolio and 2. With the systematic risk factor of the ASRF model Interactions between borrowers are high, and where borrower defaults are strongly linked to the status of the overall economy.

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Asset correlations: Residential Mortgages: Asset Correlation (R) = 0.15 Qualifying Revolving Retail Exposures (QRRE): Asset Correlation (R) = 0.04 (QRRE are exposures to individuals the maximum exposure to a single individual in the subportfolio is 100,000 or less)

Maturity Adjustment: Long-term credits are riskier than short-term credits Basel maturity adjustments - by applying a credit risk model. B(pd) = (0.11852 0.05478 X log (PD)2 The adjustments reflect the potential credit quality deterioration of loans with longer maturities. 1 + 2.5 () 1 1.5 ()

Basel I: $100,000 x 100% x 8% = $8,000 Basel II Standardized Approach: Retail, 75% risk weighting 100,000 x 75% x 8% = $6,000 of capital Basel II Standardized Approach: Corporate, 20%, 50%, 100%, 150% risk-weighting 100,000 x 20% x 8% = $1,600 of capital 100,000 x 50% x 8% = $4,000 of capital 100,000 x 100% x 8% = $8,000 of capital 100,000 x 150% x 8% = $12,000 of capital Basel ii Compliance Professionals Association (BCPA) Example: Capital required for $100,000 loan Basel II, IRB approach

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Example: Credit Cards Basel I: , Based on the minimum capital to risk-assets ratio of 8%, every $1,000 of credit card lending required a minimum 1,000 x 100% x 8% = $80 of capital to support it. Basel II, Standardized approach: Retail lending such as credit cards qualifies (subject to certain conditions) for a lower 75% risk-weighting. 1,000 x 75% x 8% = $60 of capital but the lower risk-weighting for credit risk is partly offset by the capital charge under Basel II for operational risk. If we have a higher PD and LGD X we have higher risk weighting. Riskier a portfolio X more capital required to support it. Basel II, IRB approach: Do we need more or less capital in comparison to Basel I? It depends: For a LGD of 85%: If the PD is under 5%, we need less capital - If the PD is over 5%, we need more capital. Basel ii does not mean lower capital requirements.

Basel ii does not mean lower capital requirements

2.3.12 IRB approach across some asset classes. Once a bank adopts an IRB approach for part of its holdings, it is expected to extend it across the entire banking group. The Committee recognizes that it may not be practicable for various reasons to implement the IRB approach across all material asset classes and business units at the same time. Data limitations may mean that banks can meet the standards for the use of own estimates of LGD and EAD for some but not all of their asset classes/business units at the same time. Supervisors may allow banks to adopt a phased rollout of the IRB approach across the banking group.
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The phased rollout includes: (i) adoption of IRB across asset classes within the same business unit (or in the case of retail exposures across individual sub-classes) (ii) adoption of IRB across business units in the same banking group (iii) move from the foundation approach to the advanced approach for certain risk components.

A bank must produce an implementation plan, specifying to what extent and when it intends to roll out IRB approaches across significant asset classes (or subclasses in the case of retail) and business units over time. The plan should be agreed with the supervisor. It should be driven by the practicality and feasibility of moving to the more advanced approaches, and not motivated by a desire to adopt a Pillar 1 approach that minimizes its capital charge. Some exposures in non-significant business units as well as asset classes (or subclasses in the case of retail) that are immaterial in terms of size and perceived risk profile may be exempt from the requirements in the previous two paragraphs subject to supervisory approval. Capital requirements for such operations will be determined according to the standardised approach.

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Appendix 1.2.1: Risk weighted approach Risk weights by category of on balance sheet asset Examples Weighted risk ratios 0% - Cash 0% - Claims on central governments and central banks denominated in national currency and funded in that currency 20% - Claims on domestic public-sector entities, excluding central government, and loans guaranteed by such entities 50% - Loans fully secured by mortgage on residential property that is or will be occupied by the borrower or that is rented 100% - Claims on commercial companies owned by the public sector 100% - Claims on the private sector 100% - Claims on commercial companies owned by the public sector OECD (Organisation for Economic Co-operation and Development) countries were considered to be of the highest creditworthiness - zero weight. Claims on central governments and central banks outside the OECD attract zero weight only when such loans are denominated in the national currency and funded in the same currency. Why? No foreign exchange risk! OECD government debt was weighted 0%, OECD bank debt was weighted 20%, and other debt, including corporate debt and the debt of non-OECD governments, was weighted 100%.

Not risk sensitive: Regulatory Capital = Exposure Weight 8% Regulatory Capital = Risk-Weighted-Assets x 8% Banks must hold the same amount of capital for many commercial loans, regardless of the risk of the borrower A $100,000 commercial loan with a AAA credit rating would necessitate $100,000 x 100% x 8% = $8,000 capital charge A $100,000 commercial loan with a B credit rating would necessitate $100,000 x 100% x 8% = $8,000 the same capital charge
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Basel II: Credit rating is more accurate and very important in determining capital charges. In Basel II, a $100,000 commercial loan with a AAA credit rating would necessitate less capital charge, even $370 (Advanced IRB). It depends on the approach. In Basel II, a $100,000 commercial loan with a B credit rating would necessitate more capital charge, even $42,000!. Basel II: Capital requirements increase for banks that hold risky assets and decrease significantly for banks that hold safer portfolios.

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