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Central Banking: Regulation & Supervision

Course code: B-406

REPORT on
Implementation of Basel Accords in Bangladesh Submitted to:
Mr. Shahidul Islam Zahid
Lecturer Department of Banking University of Dhaka Dhaka-1000

Submitted by:
Group 08
Members Name Rupa Debnath Md.Sultan Bayzid Sadia Noor Khan Md. Mojahidul Alam Israt Jahan Morzina Islam Id. No. 41 51 55 81 86 90

BBA 14th Batch Department of Banking University of Dhaka

Date of Submission: November 17, 2011

LETTER OF TRANSMITTAL

November 17, 2011 Mr. Shahidul Islam Zahid Lecturer Department of Banking University of Dhaka Dhaka-1000

Subject: Submission of Report writing


Sir, It gives us immense pleasure to submit the report on Implementation of Basel Accords in Bangladesh for the course Central banking: Regulation & Supervision a requirement of the

regular BBA course of the Department of Banking, University of Dhaka. Apart from the academic knowledge gained this report and preparation of report has given us the opportunity to acquaint ourselves with the different sectors of D.U. We believe that the experience we have acquired from this study will be an invaluable asset in our lives. It expresses our gratitude to you for providing us the opportunity to learn about the ethical expectation.. In spite of various shortcomings, we have been devoted to find out the core
information from different aspects. We hope you will appreciate our endeavor and find the report up to your expectation. It has to be mentioned further that without your expert advice and guidance and the contribution of all group members it would not have been possible to complete this term paper. We will be pleased to answer any sort of query you may have regarding this report. Thanking you, Group 08 Members Name Rupa Debnath Md.Sultan Bayzid Sadia Noor Khan Md. Mojahidul Alam Israt Jahan Morzina Islam BBA 14th Batch Department of Banking University of Dhaka Roll 41 51 55 81 86 90 Signature

ACKNOWLEDGMET
Compiling a report is a rewarding task that requires both mental stamina and attention to detail. The varied nature of the matters dealt with has entitled references too many sources, starting from books to websites and to all of these we gladly acknowledge our indebtness for the ideas and information they have provided. First of all we want to give thanks to the Almighty. We get a lot of help from Internet. Now, we are glad to thank our faculty Shahidul Islam Zahid, Lecturer, Department of Banking, University of Dhaka., whose vast support, advice, encouragement and guidance ensured that this project saw the light of day. Whenever we face any kind of obstacle, we went towards her and she never made us upset. We are really thankful to her for her humble attitude toward us.

Last but not the least, our group members whose devoted effort make it easy for all of us to accomplish the report within the time at an efficient manner. If they were not being so loyal to their work it would not be possible to systematize a high-quality project like that. After all, we wish to express our deepest gratitude to the Almighty Allah for giving us courage and ability to complete this task.

TABLE OF CONTENTS
EXECUTIVE SUMMARY

INTRODUCTION 1.1 1.2 1.3 1.4 1.5 1.6 Origin of the Study Background of the Study Scope of the Study Objectives of the Study Methodology of the Study Limitations of the Study

THEORETICAL PART Basel Accords 2.1 2.2 2.3 Basel I Basel II Basel III

Basel Committee 2.4 ANALYSIS PART 3.1 3.2 3.3 3.4 CONCLUSION 4.1 4.2 Findings Recommendation Implementation of Basel III Challenges for Implementation of Basel III Implementation of Basel Accords in Bangladesh Challenges for Implementation of Basel Accords in Bangladesh About Basel Committee

REFERENCES AND BIBLIOGRAPHY

EXECUTIVE SUMMERY

The report titled Implementation of Basel Accords in Bangladesh has prepared as a part of Central banking: Regulation & Supervision Course of BBA program of University of Dhaka. In this report we have conducted a depth analysis of Basel accords I, II & III. Basel accords purposes are strengthen the stability of international banking system, set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks, to enhance competitive equality and constitute a more comprehensive approach to addressing risks. The report also includes the details of Basel accords, comparison of Basel II & III, implementation road map of Basel III around the world, the implementation road map Basel III in Bangladesh, the challenges of implementing Basel accords around the world as well as Bangladesh. Basel III causes new Capital Structure, introducing a new global liquidity standard, introduction of a leverage ratio, development of countercyclical buffer, changes to credit risk assessment and ratings, introduction of wrong way risk as formal measure, full back testing of counterparty risk systems, on / off Balance Sheet switching, asset Quality Measurement and Security Fund, systemically Important Financial Institutions Charge, net Stable Funding Ratio. Finally we have find out some important point about the Basel accords and given our recommendation.

INTRODUCTION

1.1 Origin of the Report


The report is originated to make a study on the Central banking: Regulation & Supervision as a part of our BBA program of the department of Banking, Faculty of Business Studies. The report was prepared for Mr. Shahidul Islam Zahid, Lecturer, Department of Banking, University of Dhaka.

1.2 Background of the study


Report writing is a system by which we can accustom ourselves with the practical situation through the application of theoretical knowledge into real life, the gap between these two can be bridged up through this report writing procedure. Basel II is a continuation of the Basel I accord that was developed by the Basle Committee on Banking Supervision comprised of the representatives of G10 countries in 1988 to create a level playing field for internationally active banks. In this report we have discussed the implementation of BASEL Accords in Bangladesh.

1.3 Scope of the Study


Implementation of Basel Accords in Bangladesh is a big issue and a broad area to work on. With in the short time span it is virtually impossible to cover all details aspects of Implementation of expectation of the students. Again the collection of data of our concerning sectors, analysis of those sectors and the findings from the sectors has been discussed in our report. Necessary recommendation is also available in our report.

1.4 Objectives of the study

The objective is to have a clear idea about The concept of Basel Accords

Implementation of Basel Accords in Bangladesh Finding out the benefit of implementing Basel III Solution to make effective implementation of Basel Accords To facilitate our educational progress.

1.5 Methodology of the study


This report has been prepared on the basis of collection of information from both secondary sources and primary data collection survey. Determining the sources of information: In the next step, we needed to determine the sources of information that would be required for the study. We used both primary and secondary data to conduct my survey. Primary Data: I have collected primary data by interviewing students of University of Dhaka. We have collected primary data in the following way: Face to face interview of bankers. Secondary data: We have used different types of secondary data in our report. Sources of secondary data are as follows: Internal Source Prior research report

1.6 Limitation of the study


Limitations we had to face completing this report are:

1. Lack of available information. 2. Inconvenience in collecting information. 3. Difficulties in comparing and matching the different expectation of Basel in different bank. 4. There may have limitations in our knowledge, so that the in depth analysis is not possible into some extend. 5. Some other factors which are related to Basel Accords may have missed out in our report.

Theoretical Part

BASEL ACCORDS

Basel II is a continuation of the Basel I accord that was developed by the Basle Committee on Banking Supervision comprised of the representatives of G10 countries in 1988 to create a level playing field for internationally active banks. After the World War II banking sector become a very competitive industry with a lot of banks working in almost all the countries across the world. As a result banks were forced to lose their profit margin to keep pace with the competition in the local market. This reduced the earning of the banks significantly. To raise the earning amount banks entered into the international market. Banks throughout the world were lending extensively, while countries' external indebtedness was growing at an unsustainable rate. From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United States. Bank failures were particularly prominent during the '80s, a time which is usually referred to as the "savings and loan crisis." As a result the potential for the bankruptcy of the major international banks grew because of the low security against loan. In order to prevent this risk, the Basel Committee on Banking Supervision, comprised of central banks and supervisory authorities of 10 countries, met in 1987 in Basel, Switzerland. The committee drafted a first document to set up an international 'minimum' amount of capital that banks should hold. This minimum is a percentage of the total capital of a bank, which is also called the minimum risk-based capital adequacy. In 1988, the Basel I Capital Accord (agreement) was created. The Basel II Capital Accord follows as an extension of the former, and was implemented in 2007.

BASEL I

Basel I represents A set of international banking regulations put forth by the Basel Committee on Bank Supervision in the year 1988, which set out the minimum capital requirements of financial institutions with the goal of minimizing credit risk. Banks that operate internationally are required to maintain a minimum amount (8%) of capital based on a percent of risk-weighted assets. The Purpose of Basel I

In 1988, the Basel I Capital Accord was created. The general purpose was to: 1. Strengthen the stability of international banking system. 2. Set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks. The basic achievement of Basel I have been to define bank capital and the so-called bank capital ratio. In order to set up a minimum risk-based capital adequacy applying to all banks and governments in the world, a general definition of capital was required. Indeed, before this international agreement, there was no single definition of bank capital. The first step of the agreement was thus to define it. Two-Tiered Capital Basel I defines capital based on two tiers: 1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or shareholders equity) and declared reserves, such as loan loss reserves set aside to cushion future losses or for smoothing out income variations. 2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as gains on investment assets, long-term debt with maturity greater than five years and hidden reserves (i.e. excess allowance for losses on loans and leases). However, short-term unsecured debts (or debts without guarantees), are not included in the definition of capital. Credit Risk is defined as the risk weighted asset (RWA) of the bank, which are banks assets weighted in relation to their relative credit risk levels. According to Basel I, the total capital should represent at least 8% of the bank's credit risk (RWA). In addition, the Basel agreement identifies three types of credit risks: 1. The on-balance sheet risk. 2. The trading off-balance sheet risk. These are derivatives, namely interest rates, foreign exchange, equity derivatives and commodities. 3. The non-trading off-balance sheet risk. These include general guarantees, such as forward purchase of assets or transaction-related debt assets.

Let's take a look at some calculations related to RWA and capital requirement. Figure 1 displays predefined categories of on-balance sheet exposures, such as vulnerability to loss from an unexpected event, weighted according to four relative risk categories. Risk weight 0% 20% Asset class Cash and gold held in the bank. Obligation on OEVD government and U.S. treasuries. Claims on OECD banks. Securities issued by U.S. government agencies. 50% 100% Claims on municipalities. Residential mortgages All other claims such as corporate bonds, less-developed countries debt, claim on non-OECD banks, equities, real estate, plant and equipment. Figure 1: Basel's Classification of risk weights of on-balance sheet assets As shown in Figure 2, there is an unsecured loan of $1,000 to a non-bank, which requires a risk weight of 100%. The RWA is therefore calculated as RWA=$1,000 100%=$1,000. By using Formula 2, a minimum 8% capital requirement gives 8% RWA=8% $1,000=$80. In other words, the total capital holding of the firm must be $80 related to the unsecured loan of $1,000. Calculation under different risk weights for different types of assets are also presented in Figure 2. Asset Category Risk Weight Treasury Bond Municipal Bond Residential 0% 20% 50% Capital Ratio 8% 8% 8% $1000 $1000 $1000 $0 $200 $500 Amount RWA Minimal Capital Requirement $0 $16 $40

Mortgage Unsecured Loan 100% 8% $1000 $1000 $80 Figure 2: Calculation of RWA and capital requirement on-balance sheet assets Market risk includes general market risk and specific risk. The general market risk refers to changes in the market values due to large market movements. Specific risk refers to changes in the value of an individual asset due to factors related to the issuer of the security.

There are four types of economic variables that generate market risk. These are Interest Rates Foreign Exchanges Equities Commodities

The market risk can be calculated in two different manners: The standardized Basel model Internal value at risk (VAR) models of the banks

These internal models can only be used by the largest banks that satisfy qualitative and quantitative standards imposed by the Basel agreement. Moreover, the 1996 revision also adds the possibility of a third tier for the total capital, which includes short-term unsecured debts. This is at the discretion of the central banks. Limitations of Basel I Basel I Capital Accord has been criticized on several grounds. The main criticisms include the following: Limited differentiation of credit risk There are four broad risk weightings (0%, 20%, 50% and 100%), as shown in Figure1, based on an 8% minimum capital ratio. Static measure of default risk The assumption that a minimum 8% capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk. No recognition of term-structure of credit risk The capital charges are set at the same level regardless of the maturity of a credit exposure. Simplified calculation of potential future counterparty risk

The current capital requirements ignore the different level of risks associated with different currencies and macroeconomic risk. In other words, it assumes a common market to all actors, which is not true in reality. Lack of recognition of portfolio diversification effects In reality, the sum of individual risk exposures is not the same as the risk reduction through portfolio diversification. Therefore, summing all risks might provide incorrect judgment of risk. A remedy would be to create an internal credit risk model - for example, one similar to the model as developed by the bank to calculate market risk. This remark is also valid for all other weaknesses. These listed criticisms have led to the creation of a new Basel Capital Accord, known as Basel II, which added operational risk and also defined new calculations of credit risk. Operational risk is the risk of loss arising from human error or management failure. Basel II Capital Accord was implemented in 2007. The Basel I Capital Accord aimed to assess capital in relation to credit risk, or the risk that a loss will occur if a party does not fulfill its obligations. It launched the trend toward increasing risk modeling research; however, its over-simplified calculations, and classifications have simultaneously called for its disappearance, paving the way for the Basel II Capital Accord and further agreements as the symbol of the continuous refinement of risk and capital. Nevertheless, Basel I, as the first international instrument assessing the importance of risk in relation to capital, will remain a milestone in the finance and banking history.

BASEL II
Basel II (also cited as Basel 2), also known as the International Convergence of Capital Measurement and Capital Standards, helps international banks and financial institutions safeguard themselves against operational and financial risks. It does this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds enough capital reserves on hand to offset its risks. While risk management has always been a core banking function, banks were earlier permitted to develop their own risk methodologies. For this reason it was very tough to compare risk position of two different banks. With Basel II, each bank has to follow minimum risk methodology

standards, develop their own risk management framework and ensure regulatory supervision. This brings the banks under one umbrella to understand risk position. Objectives of Basel II: There were four key objectives of the new framework, namely: 1. The Accord should continue to promote safety and soundness of the financial system 2. The Accord should continue to enhance competitive equality 3. The Accord should constitute a more comprehensive approach to addressing risks 4. The Accord should focus on internally active banks, although its underlying principles should be suitable for application to banks of varying levels of complexity and sophistication. Components of Basel II: There are four main components to the new framework: 1. It is more sensitive to the risks that firms face: The new framework includes an explicit measure for operational risk and includes more risk sensitive risk weightings against credit risk. 2. It reflects improvements in firms risk management practices. 3. It provides incentives for firms to improve their risk management practices, with more risk sensitive risk weights as firms adopt more sophisticated approaches to risk management. 4. The new framework aims to leave the overall capital held by banks collectively broadly unchanged. Three pillars of Basel II: In Basel II we have three Pillars: Pillar 1: Minimum capital requirement: Pillar 1 has to do with the calculation of the minimum capital requirements for credit, market and operational risk. Regulatory capital: i) Tier 1 Capital:

Tier 1 capital, also called Core Capital, comprises of highest quality capital elements and shall include: Paid up capital/capital deposited with BB Non-repayable share premium account Statutory Reserve General Reserve Retained Earnings Minority Interest in subsidiaries Non-Cumulative irredeemable Preference Shares Dividend Equalization Account

ii) Tier 2 Capital: Tier 2 capital, also called Supplementary Capital, represents other elements which fall short of some of the characteristics of the Core capital but contribute to the overall strength of a bank and shall include: General Provision Asset Revaluation Reserves All other Preference Shares Perpetual Subordinated Debt Exchange Equalization Account Revaluation Reserves for Securities

iii) Tier 3 Capital: Tier 3 capital, also called Additional Supplementary Capital, consisting of shortterm subordinated debt (original/residual maturity less than or equal to five years but

greater than or equal to two years) is meant solely for the purpose of meeting a proportion of the capital requirements for market risk. Conditions for maintaining regulatory capital: The computation of the amount of Core (Tier 1) and Supplementary (Tier 2 and Tier 3) Capitals shall be subject to the following conditions: 1. Eligible Tier 2 plus Tier 3 capital shall not exceed total Tier 1 capital. 2. Fifty percent (50%) of Asset Revaluation Reserves shall be eligible for Tier 2 i.e. Supplementary Capital. 3. A minimum of about 20% of market risk needs to be supported by Tier 1 capital. Supporting of Market Risk from Tier 3 capital shall be limited up to a maximum of 250% of a banks Tier 1 capital that is available after meeting credit risk capital requirement. 4. Up to 50% of Revaluation Reserves for Securities shall be eligible for Supplementary Capital. 5. Subordinated debt shall be limited to a maximum of 30% of the amount of Tier 1 capital and shall also include rated and listed subordinated debt instruments/bonds raised in the capital market. Risk weighted asset: Total risk-weighted assets are determined by multiplying the capital requirements for market risk and operational risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8%) and adding the resulting figures to the sum of risk-weighted assets for credit risk. There are different approaches for measuring risk: a. The standardized approach to credit risk: Banks rely on external measures of credit risk (like the credit rating agencies) to assess the credit quality of their borrowers. b. The Internal Ratings-Based (IRB) approaches to credit risk: Banks rely partly or fully on their own measures of counterpartys credit risk, and determine their capital requirements using internal models.

c. Banks have to allocate capital to cover the Operational Risk (risk of loss because of errors, fraud, disruption of IT systems, external events, litigation etc.). This can be a difficult exercise. d. The Basic Indicator Approach links the capital charge to the gross income of the bank. In the Standardized Approach, we split the bank into 7 business lines, and we have 7 different capital allocations, one per business line. The Advanced Measurement Approaches are based on internal models and years of loss experience. Minimum capital requirement: Banks shall maintain a minimum Capital Adequacy Ratio (CAR) of at least 10% of Risk Weighted Assets (RWA) with core capital (Tier-1) not less than 5% of RWA. CAR would be derived dividing total Eligible Regulatory Capital by RWA and multiplied by 100. CAR = (Eligible Regulatory Capital/RWA)*100 Total RWA = RWA for Credit Risk + 10 (Capital Charge for Market Risk + Capital Charge for Operational Risk) Pillar 2: Supervisory Review: Pillar 2 covers the Supervisory Review Process. The supervisory review process of the Framework is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks. The supervisory review process recognizes the responsibility of bank management in developing an internal capital assessment process and setting capital targets that are commensurate with the banks risk profile and control environment. In the Framework, bank management continues to bear responsibility for ensuring that the bank has adequate capital to support its risks beyond the core minimum requirements. Supervisors are expected to evaluate how well banks are assessing their capital needs relative to their risks and to intervene, where appropriate. This interaction is intended to foster an active

dialogue between banks and supervisors such that when deficiencies are identified, prompt and decisive action can be taken to reduce risk or restore capital. Accordingly, supervisors may wish to adopt an approach to focus more intensely on those banks with risk profiles or operational experience that warrants such attention. There are three main areas that might be particularly suited to treatment under Pillar 2: 1. Risks considered under Pillar 1 that are not fully captured by the Pillar 1 process (e.g. Credit concentration risk); 2. Those factors not taken into account by the Pillar 1 process (e.g. Interest rate risk in the banking book, business and strategic risk); and 3. Factors external to the bank (e.g. Business cycle effects). A further important aspect of Pillar 2 is the assessment of compliance with the minimum standards and disclosure requirements of the more advanced methods in Pillar 1, in particular the IRB framework for credit risk and the Advanced Measurement Approaches for operational risk. Supervisors must ensure that these requirements are being met, both as qualifying criteria and on a continuing basis. Four key principles of supervisory review: Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels. Principle 2: Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process. Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum. Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristic of a

particular bank and should require rapid remedial action if capital is not maintained or restored. Pillar 3: Market Discipline: Pillar 3 covers transparency and the obligation of banks to disclose meaningful information to all stakeholders. Clients and shareholders should have a sufficient understanding of the activities of banks, and the way they manage their risks. The purpose of Pillar 3 market discipline is to complement the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2). It is aimed to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution. It has been believed that such disclosures have particular relevance under the Framework, where reliance on internal methodologies gives banks more discretion in assessing capital requirements. In principle, banks disclosures should be consistent with how senior management and the board of directors assess and manage the risks of the bank. Under Pillar 1, banks use specified approaches/methodologies for measuring the various risks they face and the resulting capital requirements. It has been believed that providing disclosures that are based on this common framework is an effective means of informing the market about a banks exposure to those risks and provides a consistent and understandable disclosure framework that enhances comparability.

Each of the three pillars are complimentary to each other and are required for supervising both the overall financial health of the banking industry and that of the individual institution as well, though it must be highlighted that none can substitute for effective bank management. The rationale behind adopting the new Accord is that it is believed by the committee that the new

framework has the potential to meet challenges of innovations in increasingly complex financial markets.

BASEL III
After the current global financial crisis the Basel committee feels the importance to improve the current Basel II accord and start to work for developing a new capital framework known as the Basel III. "Basel III" is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to: Improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source. Improve risk management and governance. Strengthen banks' transparency and disclosures.

Key points of Basel III accord: Banks will have to increase their core tier-one capital ratio to 4.5% by 2015. In addition, they will have to carry a further "counter-cyclical" capital conservation buffer of 2.5% by 2019. Any bank that fails to meet the new requirements is expected to be banned from paying dividends to shareholders until it has improved its balance sheet. Financial supervision: The G20 wants closer supervision of systemic risk at local and international levels. Derivatives: The G20 has called for greater standardization and central clearing of privately arranged, over-the-counter contracts by the end of 2012. Hedge funds: US reforms are in line with the G20 pledge that funds above a certain size should be authorized and obliged to report data to supervisors. A draft EU law includes private equity groups and restrictions on non-EU fund managers seeking European investors. Accounting: The G20 wants common global accounting rules by mid-2011.

Credit rating agencies: The G20 wants them registered and supervised by the end of 2009. The EU has adopted a law mandating registration and direct supervision that takes effect this year. US legislation passed this year includes similar provisions. Pay: The G20 has endorsed principles designed to stop bonus schemes in banks from encouraging too much short-term risk-taking. Total Regulatory Capital Ratio of Basel III = [Tier 1 Capital Ratio] + [Capital Conservation Buffer] + [Countercyclical Capital Buffer] + [Capital for Systemically Important Banks]

One summary with respects to the differences in capital between Basel II and Basel III was pulled together by Kate Strachnyi as shown below.

Figure: Basel II to Basel III Capital Comparison Breakdown of Basel III

BASEL COMMITTEE
ABOUT BASEL COMMITTEE
The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision.

The Committee's members come from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The present Chairman of the Committee is Mr Stefan Ingves, Governor of Sveriges Riksbank. The Committee encourages contacts and cooperation among its members and other banking supervisory authorities. It circulates to supervisors throughout the world both published and unpublished papers providing guidance on banking supervisory matters. Contacts have been further strengthened by an International Conference of Banking Supervisors (ICBS) which takes place every two years. The Committee's Secretariat is located at the Bank for International Settlements in Basel, Switzerland, and is staffed mainly by professional supervisors on temporary secondment from member institutions. In addition to undertaking the secretarial work for the Committee and its many expert sub-committees, it stands ready to give advice to supervisory authorities in all countries. Mr Stefan Walter is the Secretary General of the Basel Committee.

Main Expert Sub-Committees The Committee's work is organized under four main sub-committees:

The Standards Implementation Group The Policy Development Group The Accounting Task Force The Basel Consultative Group

More information on each sub-committee is provided below.

The Standards Implementation Group(SIG) was originally established to share information and promote consistency in implementation of the Basel II Framework. In January 2009, its mandate was broadened to concentrate on implementation of Basel Committee guidance and standards more generally. It is chaired by Mr Ryozo Himino, Deputy Commissioner for International Affairs at the Financial Services Agency, Japan. Currently the SIG has four subgroups or task forces that work on specific implementation issues. The Operational Risk Subgroup addresses issues related primarily to banks' implementation of advanced measurement approaches for operational risk. Mr Mitsutoshi Adachi, Deputy Head at the Bank of Japan, chairs the group. The Task Force on Colleges brings forward the Basel Committee's work on supervisory colleges by developing guidance that enhances the effectiveness in the use and functioning of supervisory colleges and assisting supervisors in implementing such guidance in practice. The Task Force is chaired by Mr Ian Tower, Head of the Overseas Banks Department at the Financial Services Authority, United Kingdom. The Task Force on Remuneration contributes to promote the adoption of sound remuneration practices. Its main focus is on the implementation of the relevant principles of the supplemental Pillar 2 guidance issued by the Committee in July 2009 which are consistent with the Financial Stability Board's Principles for Sound Compensation Practices. The Task Force is chaired by Mr Fernando Vargas, Associate Director General of Banking Supervision at the Bank of Spain. The Standards Monitoring Procedures Task Force supports the implementation of Basel Committee standards and guidelines by developing tools and procedures that help promote greater effectiveness and consistency in standards monitoring and implementation. The Task Force is chaired by Mr Ben Gully, Managing Director of the Basel Implementation Division at the Office of the Superintendent of Financial Institutions, Canada.

The primary objective of the Policy Development Group (PDG) is to support the Committee by identifying and reviewing emerging supervisory issues and, where appropriate, proposing and

developing policies that promote a sound banking system and high supervisory standards. The group is chaired by Mr Stefan Walter, Secretary General of the Basel Committee. Seven working groups report to the PDG: the Risk Management and Modelling Group (RMMG), the Research Task Force (RTF), the Working Group on Liquidity, the Definition of Capital Subgroup, the Capital Monitoring Group, the Trading Book Group (TBG) and the Cross-border Bank Resolution Group. The Risk Management and Modelling Group serves as the Committee's point of contact with the industry on the latest advances in risk measurement and management. It focuses on assessing the range of industry risk management practices and the development of supervisory guidance to promote enhanced risk management practices. The Research Task Force serves as a forum for research economists from member institutions to exchange information and engage in research projects on supervisory and financial stability issues. It also acts as a mechanism for facilitating communication between economists at member institutions and in the academic sector. It is chaired by Mr Paul Kupiec, Associate Director of the Federal Deposit Insurance Corporation's Division of Insurance and Research and Co-Director of the FDIC Center for Financial Research. The Trading Book Group conducts a fundamental review of the trading book capital framework. Part of the review is whether or not the distinction between the banking and the trading book should be maintained, how trading activities are defined and how risks in trading books (and possibly market risk more generally) should be captured by regulatory capital. Furthermore, it addresses implementation issues relating to the Revisions to the Basel II market risk framework. The group is co-chaired by Ms Norah Barger, Associate Director, Board of Governors of the Federal Reserve System, United States, and Mr Alan Adkins, Head of Prudential Cross Sectoral Department, Financial Services Authority, United Kingdom. The Working Group on Liquidity serves as a forum for information exchange on national approaches to liquidity risk regulation and supervision. In September 2008, the Working Group issued Principles for Sound Liquidity Risk Management and Supervision, the global standards for liquidity risk management and supervision. The Working Group is also examining the scope

for additional steps to promote more robust and internationally consistent liquidity approaches for cross-border banks. The group is co-chaired by Mr Thomas Wiedmer, Deputy Head at the Swiss National Bank, and Mr Marc Saidenberg, Senior Vice President in the Banking Supervision Group of the Federal Reserve Bank of New York, United States. The Definition of Capital Subgroup explores emerging trends in eligible capital instruments in member jurisdictions. It currently is reviewing issues related to the quality, consistency and transparency of capital with a particular focus on Tier 1 capital. The group is co-chaired by Mr Hirotaka Hideshima, Director, Deputy Head of the International Affairs Section at the Bank of Japan, and Mr Richard Thorpe, Head of Capital Adequacy Policy Department and Accounting and Audit Sector Leader at the Financial Services Authority, United Kingdom. Since the implementation of Basel II, national supervisors are monitoring capital requirements to ensure that banks in their jurisdiction maintain a solid capital base throughout the economic cycle. The Basel Committee has established the Capital Monitoring Group that shares national experiences in monitoring capital requirements. This group is chaired by Mr Klaus Dllmann, Head of Banking Supervision Research at the Deutsche Bundesbank. Cross-border Bank Resolution Group: the CBRG is comparing the national policies, legal frameworks and the allocation of responsibilities for the resolution of banks with significant cross-border operations. It is co-chaired by Ms Eva Hpkes, Head of Regulation, Swiss Financial Market Supervisory Authority (FINMA), and Mr Michael H Krimminger, Special Advisor for Policy to the Chairman of the Federal Deposit Insurance Corporation. The Accounting Task Force(ATF) works to help ensure that international accounting and auditing standards and practices promote sound risk management at banks, support market discipline through transparency, and reinforce the safety and soundness of the banking system. To fulfil this mission, the task force develops prudential reporting guidance and takes an active role in the development of international accounting and auditing standards. Ms Sylvie Mathrat, Deputy Director General, Bank of France, chairs the ATF. The Audit Subgroup, a working group of the Accounting Task Force, promotes reliable financial information by exploring key audit issues from a banking supervision perspective. It focuses on

responding to international audit standards-setting proposals, other issuances of the International Auditing and Assurance Standards Board and the International Ethics Standards Board for Accountants, and audit quality issues. The Subgroup is chaired by Mr Marc Pickeur, Advisor for Supervisory Policy at the National Bank of Belgium. The Basel Consultative Group(BCG) provides a forum for deepening the Committee's engagement with supervisors around the world on banking supervisory issues. It facilitates broad supervisory dialogue with non-member countries on new Committee initiatives early in the process by gathering senior representatives from various countries, international institutions and regional groups of banking supervisors that are not members of the Committee. The BCG is chaired by Mr Karl Cordewener, Deputy Secretary General of the Basel Committee. Coordination with other standard setters Formal channels for coordinating with supervisors of non-bank financial institutions include the Joint Forum, for which the Basel Committee Secretariat provides the secretariat function, and the Coordination Group. The Joint Forum was established in 1996 to address issues common to the banking, securities and insurance sectors, including the regulation of financial conglomerates. The Coordination Group is a senior group of supervisory standard setters comprising the Chairmen and Secretaries General of the Committee, the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS), as well as the Joint Forum Chairman and Secretariat. The Coordination Group meets twice annually to exchange views on the priorities and key issues of interest to supervisory standard setters. The position of chairman and the secretariat function for the Coordination Group rotate among the member representatives of the three standard setters every two years.

Analysis Part

IMPLEMENTATION OF BASEL III IN BANGLADESH

Multiple ApproachesOne Destination Implementing Basel III creates a unique set of challenges for every organization, regardless of the organizations starting point. Because Basel III is more a set of principles than a minutely detailed set of rules, there is no cut-and-dried solution when implementing it. This flexibility allows banks a great deal of latitude in how they adopt the requirements. Two basic approaches are open to banks that are implementing the regulations. Which approach is the most suitable for each organization will depend on the stability and performance of the organizations current environment and the speed at which the organization wishes to implement the regulations, as well as what resources are available. I. Enhancing the Current Environment

In some cases, the best option will be to upgrade the existing environment to the necessary standard by adding additional modules to handle additional requirements, whether it be leverage and liquidity management, stress testing, data warehousing, or reporting. Enhancing or upgrading the current environment allows an organization to adopt the regulations at a pace that the organization can tolerate and that is less disruptive to business operations. This means that the implementation could be less costly to the business, because in many ways it is easier to map the regulatory environment to the business than to shape the business around the regulations. This approach allows banks to capitalize on their existing investment, and for some organizations it might be the least costly and least disruptive approach to complying. The key issue here is that a bank must have a very clear idea of how its environment is configured. This can be a significantly greater challenge than one might realize, especially if a regulatory system has been in place for some time and where there have been significant changes in the business. After the current environment is defined, a gap analysis will identify where the main compliance effort needs to be focused. II. Deploying a New Regulatory Environment For other organizations, the most cost-effective option will be to replace their existing regulatory model with a new, purpose-built solution that delivers Basel III out of the boxwithout needing extensive customization. Although this might appear to be the most costly and disruptive solution, in some ways it might be the most cost effective, because it allows the organization to map itself onto the regulations, embedding Basel III within its processes. This approach could conceivably lower the lifetime costs of Basel III to a bank, if the regulations form part of the banks corporate modus operandi. The key to a successful deployment is defining the optimal architecture for managing Basel III, and then defining the co-existence and migration strategy from the existing environment. It might be possible to take a modular approach to migrationmoving specific systems to the new environment one by onewhich would reduce the risks that are involved in taking this approach.

Considerations However banks choose to implement the regulations, some banks will pursue implementation aggressively. They will see rapid implementation and adoption as providing customers, shareholders, and regulators with the reassurance that they are taking positive steps to put capital in place, to improve their liquidity positions, and to manage risk better. Early adopters will be able to use their stance to differentiate themselves from competitors. Others might take a more measured approach, aware that the deadline for full implementation is a (seemingly) distant 2019. A further consideration about choosing the right model is what will happen after Basel III is widely implemented. At best, Basel III will require adjustments so that over time it evolves into Basel IV, Basel V, and so on, as the BIS seeks to resolve the theory of Basel III and its realworld use (as happened under Basel I and Basel II). Regulators are already thinking about a fundamental review of market risk and trading book rules that could be the starting point for Basel IV. An Integrated Approach Regardless of the approach that organizations take, the solution that they deliver needs to be completely integrated, so that it fully reflects the structure of the regulations themselves. The ideal solution would consolidate, calculate, test, and report an organizations capital and liquidity risk from a single platform. It would seamlessly integrate with other source systems,

and it would have strong data quality checking and storage capabilities. Fast calculation engines would facilitate weekly and even daily calculations and would feed integrated and comprehensive regulatory reporting that is mapped to the local supervisors exact requirements. Implementing all this would streamline the process, allowing risk managers to focus their attention toward primary risk management activities rather than the time-consuming data extraction, quality, and reporting. This approach is Use of Automation. An additional considerationwhichever of the preceding options a bank selectsis the extent to which the new environment should encompass the use of automation. Many banks still make use of manual processes, to a lesser or greater extent, in managing their regulatory compliance. The greater workload of Basel III will make it difficult, if not impossible, for a bank to justify the greater overhead of manual processes, compared to that of automation. The increased regulatory overhead, together with the greater scale and scope of banking operations, will make it harder to justify the continued use of manual processes, which can be time consuming, expensive, and prone to human error. However banks choose to implement the regulations, some banks will pursue implementation aggressively. They will see rapid implementation and adoption as providing customers, shareholders, and regulators with the reassurance that they are taking positive steps to put capital in place, to improve their liquidity positions, and to manage risk better. Early adopters will be able to use their stance to differentiate themselves from competitors. Others might take a more measured approach, aware that the deadline for full implementation is a (seemingly) distant 2019. A further consideration about choosing the right model is what will happen after Basel III is widely implemented. At best, Basel III will require adjustments so that over time it evolves into Basel IV, Basel V, and so on, as the BIS seeks to resolve the theory of Basel III and its realworld use (as happened under Basel I and Basel II). Regulators are already thinking about a fundamental review of market risk and trading book rules that could be the starting point for Basel IV. An Integrated Approach Regardless of the approach that organizations take, the solution that they deliver needs to be completely integrated, so that it fully reflects the structure of the regulations themselves.

The ideal solution would consolidate, calculate, test, and report an organizations capital and liquidity risk from a single platform. It would seamlessly integrate with other source systems, and it would have strong data quality checking and storage capabilities. Fast calculation engines would facilitate weekly and even daily calculations and would feed integrated and comprehensive regulatory reporting that is mapped to the local supervisors exact requirements. Implementing all this would streamline the process, allowing risk managers to focus their attention toward primary risk management activities rather than the time-consuming data extraction, quality, and reporting. This approach is given in the picture below.

The central data repository houses the critical risk data that is required for Basel III compliance. It should be able to collect data, providing the complete enterprise-wide regulatory risk picture. End usersincluding line of business and corporate risk managers, finance teams, compliance staff, and analystsalso need to leverage the system.

This consolidated approach means that it is much easier to calculate and store the critical capital adequacy, liquidity, and leverage ratios that underpin the Basel III framework. It also means that stress testing can be delivered using the same coherent, integrated dataset. The final stage is to deliver the critical reports both to the business and to the regulator. This task will be significantly more onerous under Basel III. Pillar 1 reports, which cover capital adequacy, need to be delivered in the right format to the relevant national regulators. Pillar 3 reports, which cover similar but not identical ground, need to be created for the regulator and for the wider market stakeholders in the interests of market transparency and confidence. Any subsequent requests for additional information from the regulator can easily be accommodated using this consolidated approach. The business also needs to receive management reports, often daily, to understand how the business is performing against its commercial objectives and to provide the essential business insight that makes Basel III an opportunity as much as an overhead. Achieving this with data that is distributed across multiple silos is much more difficult, more prone to error, and more time consuming. A consolidated, integrated, yet open data repository is the only way to deliver true enterprise risk management.

CHALLENGES FOR IMPLEMENTATION OF BASEL III IN BANGLADESH


Basel III is an evolution rather than a revolution for many banks. It was developed from the existing Basel II framework, and the most significant differences for banks are the introduction of liquidity and leverage ratios, and enhanced minimum capital requirements.

An effective implementation of Basel III will demonstrate to regulators, customers, and shareholders that the bank is recovering well from the global banking crisis of 2008. A speedy implementation will also contribute to a banks competitiveness by delivering better management insight into the business, allowing it to take advantage of future opportunities. Although implementing Basel III will only be an evolutionary step for many organizations, the impact of Basel III on banks and the banking sector should not be underestimated, because it will drive significant challenges that need to be understood and addressed. For every bank, working out the most cost-effective model for implementing Basel III will be a critical issue. The Main Challenges of Basel III 1. A New Risk and Finance Management Culture Basel III is changing the way that banks address the management of risk and finance. The new regime seeks much greater integration of the finance and risk management functions. This will probably drive the convergence of the responsibilities of CFOs and CROs in delivering the strategic objectives of the business. However, the adoption of a more rigorous regulatory stance might be hampered by a reliance on multiple data silos and by a separation of powers between those who are responsible for finance and those who manage risk. The new emphasis on risk management that is inherent in

Basel III requires the introduction or evolution of a risk management framework that is as robust as the existing finance management infrastructures. As well as being a regulatory regime, Basel III in many ways provides a framework for true enterprise risk management, which involves covering all risks to the business. 2. Managing Basel II: Different Geographies, Different Issues Different regions and countries face different challenges in applying Basel III. The EU has been consistent in its adoption of past Bank of International Settlements (BIS) regulations and therefore will hope to seamlessly migrate from Basel II to Basel III. The EU plans to deliver a unified set of rules across Europe, to discourage gold plating, and ensure that there is a level playing field, removing scope for regulatory arbitrage. The US effectively skipped Basel II, so it will be making a fresh start, building on the foundations of Basel I, facilitated by the Dodd-Frank Act. The extent to which other countries in the world have adopted one iteration or another varies considerably: Japan, Hong Kong, Singapore, and Australia are well advanced, on a par with the EU. The picture in Russia and countries in Eastern Europe, the Middle East, Africa, and Asia Pacific is less clear. Some might choose to start with a clean sheet and implement the full set of rules. Others might opt to use Basel III merely as a direction of travel, without embracing the full package. For example, Russia recently announced that it will move from the standardized approach to calculating credit risk, to the internal ratings based (IRB) approach by 2015. Some Middle Eastern countries are currently in the process of moving towards the IRB model. Some countries might also have other regulatory legacies, which in some cases might mean that some national regulations will be superseded by Basel III but might need to be maintained in parallel. Some might choose to adopt the Basel III requirements in their own way, gold-plating the requirements if they feel that Basel III does not meet a particular countrys requirement. This could create idiosyncratic requirements and processes that need to be addressed during implementation.

This global complexity adds further complication because banks might need to manage different regulations in different jurisdictions; and a bank might be obliged to report under Basel II in one country and Basel III in another, depending on where the bank is domiciled. Adding further multi-national complexity, many regulators also demand banks continue to submit reports under the Basel I framework, using the standardized model for calculating credit risk. This allows regulators to have a consistent framework to compare all the banks they regulate, regardless of whether the banks themselves use the IRB or standardized models. In Europe, for banks using IRB, regulators stipulate that this Basel I floor must be in the region of 80-90% of the calculation using the more costly standardized approach. In the US, the floor is 100%. This may actually mean that banks have to handle compliance across a mix of Basel I, II and III, depending on where they do business and the demands of the local regulators. The reports will need to convey a consistent message so as not to mislead the regulator and the market. Organizations with a fragmented data model will be burdened with additional cost and overhead compared to those with a more centralized approach to collecting, consolidating and submitting reports under Basel I, II and III. This diverse picture needs to be considered carefully when applying the principles of Basel III to a bank and implementing a solution.

3. Managing the Data To deliver compliance against Basel III, all banks must now ensure that risk and finance teams have quick and easy access to centralized, clean, and accurate data. This data must reflect their banks credit, market, concentration, operational, impairment, and liquidity risk. All banks will also need to calculate the enhanced capital, new liquidity ratios, and new leverage ratios to be in a position to start reporting to local supervisorsin the multiple formats that the various national regulators requirestarting as early as 2013. The data management requirements of Basel III are significant. For the bank, the regulator, and the wider market to get an accurate picture of the banks position, the data must be accurate, up to date, and consistent. Delivering this cost effectively is difficult if the data is dispersed across different silos. Furthermore, the data must be carefully defined and managed to ensure that it delivers the correct ratio calculations for capital adequacy, leverage, and liquidity every time. This requirement combined with the significantly greater reporting requirements of Basel IIIin terms of granularity and frequencymeans that the effort required to manage data within Basel III is greater than ever. Ensuring that a banks regulatory data is of the right quality and in the right place at the right time is probably the single most important criterion in deciding whether a banks Basel III project meets its objectives or not. 4. Auditing the Data Once a regulatory report has been submitted, it is highly likely that a regulator will follow up with the bank to clarify critical issues about how the results were calculated and how the rules were applied. This will require the bank to identify, check, approve and submit the data, quickly and accurately. These extra submissions need to be consistent with the rest of the report, be delivered in the same format and must be completed as cost effectively as possible, without impacting other business activities. This audit process will be especially difficult for banks whose data is dispersed across multiple silos and systems, as it will take longer to search for the relevant information. Banks with a centralized data model will be able to respond faster and more efficiently to these enquiries, further streamlining their compliance and reporting processes. 5. Stress Testing

Stress testingthe ability to understand the impact of significant market events on the key ratios receives greater significance under Basel III. Stress testing will be required more often, performed across more data, and delivered in more depth. This will be difficult to deliver if organizations have their data distributed across multiple silos. It will take longer, it will require more effort, and it will deliver less accurate results, compared with having a data model where all the critical information is held in a central repository. Placing all the data in a central repository will allow banks to run a wide array of complex stress tests that meet the needs of the business - to deliver insight and also meet the needs of the regulator - to deliver compliance. 6. Taking an Integrated Approach The Basel III regulations reflect the integrated nature of banks and banking. A Basel III management solution must enable the demands of integration; otherwise, compliance will create significantly greater overhead than necessary. Given the way that banks have grown, developed new services (and the systems to support them), and merged activities, it will be challenging to deliver a truly integrated system without disrupting the business of the bank. The ideal management solution would consolidate, calculate, and report the organizations capital, liquidity, and leverage ratios from a single, centralized reporting platform. It would seamlessly integrate with other source systems and have strong data quality checking and storage capabilities. This approach would streamline the process, allowing risk managers to focus their attention toward primary risk management activities rather than the time-consuming data extraction, quality, and reporting issues. Fast calculation engines would facilitate weekly and even daily calculations and would feed integrated and comprehensive regulatory reporting that is mapped to the local supervisors exact requirements, and provide additional business insight for the bank. Delivering against this ideal would be demanding for any bank. When this issue is understood in the context of the other issues highlighted above, it is clear why it is all too easy to underestimate the challenges of implementing Basel III. Nevertheless, when these issues are understood in the context of the way a bank is organized, it is possible to conceive a solution that allows a bank to implement the regulations on time and on budget, given the right approach and toolset.

IMPLEMENTATION OF BASEL ACCORD IN BANGLADESH

Capital Adequacy:
Maintaining Capital Adequacy remained a top priority for banks of Bangladesh. The Basel II now being implemented requires raising of capital to a satisfactory level as it continues to grow. Due to fall of small and large banks in USA and Europe, the Basel II requirement of capital is no longer considered adequate. They are expecting more stringent policies under Basel II requirement of capital in the days ahead .In banks of Bangladesh, they considered this issue well ahead of others. Current capital adequacy ratio of the bank remains at comfortable level. However, the management of the banks of Bangladesh has taken adequate steps to raise capital to allow them to remain resilient at all time. Prime Bank issued subordinated Bonds for Taka 250 crore as Tier II capital. They were the first bank to raise this fund successfully. The other instruments to raise capital are under active consideration of the bank. All banks of Bangladesh assure shareholders that their bank would maintain the capital adequacy as part of sound management policy. The banking sector in Bangladesh is undergoing significant changes. Basel II Accord, which may be under review, is going to be implemented from 2010 (parallel 2009), placing heavy reliance on internal risk assessment and management techniques for the purpose of quantifying and allocating capital for credit, market and operational risks. Continued success of banks of Bangladesh depends on its ability to prepare for unexpected and potentially much less favorable, events and outcomes. The banks of Bangladesh has trained members of its staff at various levels on Basel II. Capital adequacy symbolizes the financial strength and stability of a bank. It limits the extent up to which banks can expand their business in terms of risk weighted assets. Like all commercial institutions, banks too constantly look at ways of expanding their operations by acquiring property, plant & equipment, opening branches, in addition to mobilizing deposits, providing

loans and investing in other assets. Regulatory capital requirements are therefore necessary to prevent banks from expanding beyond their ability to manage (over trading), to improve the quality of banks assets, to control the ability of the banks to leverage their growth and to lead to higher earnings on assets, leading to peace of mind of all the stakeholders. The banks of Bangladesh keeps a careful check on its capital adequacy ratios.

Eligible Regulatory Capital:


In order to obtain the Eligible Regulatory Capital for the purpose of calculating Minimum Capital Requirements (MCR), banks are required to make following deductions from their Tier-1 capital: i) Book value of goodwill ii) Shortfall in provisions required against classified assets iii) Remaining deficit on account of revaluation of investments in securities after netting off any other surplus on the securities. Eligible Tier-2 capital will be derived after deducting components, if any, qualified for deduction. Total Eligible Regulatory Capital will be calculated adding the eligible Tier-1, eligible Tier-2 and Tier-3 capital i.e. Total Eligible Regulatory Capital = (Eligible Tier-1 Capital + Eligible Tier-2 Capital + Eligible Tier-3 Capital)

Capital Charge against Credit Risk:


As per Bangladesh Banks guidelines RWA for Credit Risk includes both Balance Sheet ad OffBalance Sheet exposure. The RWA is again subdivided under Banking Book and Trading Book. For calculating Capital Charge on Market Risk, Trading Book outstanding is used. Risk mitigation techniques including haircut of collaterals and exposures allowed by Bangladesh Bank were also applied for determining the capital requirement. For Credit risk, banks of Bangladesh adopted Standardized approach as suggested by Bangladesh Bank. According to the standardized approach of Basel II framework, the risk weight will be based on the risk assessment (hereinafter called credit rating) made by External Credit Assessment Institutions

(ECAIs) duly recognized by Bangladesh Bank. Risk weights are based on external rating or a fixed weight that is broadly aligned with the likelihood of counterparty default. Bangladesh Bank has mapped its risk grading (ranging from 1 to 6, where 1 is the highest grading) with that of recognized ECAIs. Where an exposure is secured by guarantee or eligible financial collateral, it may reduce its capital charge by taking benefit of the risk mitigation described in the guidelines of Bangladesh Bank. However, in the absence of credit rating the Risk Weight against loans and advances would be 125%. During 2009 the rating of the companies could not be completed and as such the risk weight used was 125%.

Capital Charge against Market Risk:


Market risk is the possibility of losses of assets in balance sheet and off-balance sheet positions arising out of volatility in market variables i.e. interest rate, exchange rate and price. Allocation of capital is required in respect of the exposure to risks deriving from changes in interest rates and equity prices in the banks trading book, in respect of exposure to risks deriving from changes in foreign exchange rates and commodity price in the overall banking activity. The total capital requirement for banks against their market risk shall be the sum of capital charges against i. interest rate risk ii. Equity position risk iii. Foreign exchange (including gold) position risk throughout the banks balance sheet.

Measurement Methodology:
As banks in Bangladesh are now in a stage of developing risk management models, BB suggested the banks for using Standardized Approach for credit risk capital requirement for banking book and Standardized (rule based) Approach for market risk capital charge in their trading book. The banks of Bangladesh using the Maturity Method as prescribed by Bangladesh Bank in determining capital against market risk. In the maturity method, long or short positions in debt securities and other sources of interest rate exposures, including derivative instruments, are slotted into a maturity ladder comprising 13 time-bands (or 15 time-bands in case of low coupon

instruments). Fixed-rate instruments are allocated according to the residual term to maturity and floating-rate instruments according to the residual term to the next repricing date. In Standardized (rule based) Approach the capital requirement for various market risks (interest rate risk, price, and foreign exchange risk) is determined separately. The total capital requirement in respect of market risk is the sum of capital requirement calculated for each of these market risk sub-categories. e.g., a) Capital Charge for Interest Rate Risk = Capital Charge for Specific Risk + Capital Charge for General Market Risk b) Capital Charge for Equity Position Risk = Capital Charge for Specific Risk + Capital Charge for General Market Risk c) Capital Charge for Foreign Exchange Risk = Capital Charge for General Market Risk d) Capital Charge for Commodity Position Risk = Capital Charge for General Market Risk The methodology to calculate capital requirement under Standardized (rule based) Approach for each of these market risk categories is as follows.

Capital Charges for Interest Rate Risk:


A. Capital charges for Specific risk Capital charge for specific risk against interest related instruments is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer. B. Capital charge for General market risk: The capital requirement for general market risk is designed to capture the risk of loss arising from changes in market interest rates. In this regard the capital charge will be calculated on the basis of the following considerations: 1. Banks underlying trading issues may exist in long or both in long and short position (i.e., related to interest rate derivative/hedge). Where trading issues relate to only long position then total capital charge is to be calculated using the capital

Capital Charges for Equity Position Risk:


(a) As with debt securities, the minimum capital standard for equities is expressed in terms of two separately calculated charges the specific risk and the general market risk for the holdings. (b) The capital charge, for both specific risk and the general market risk charge will be 10%.

Capital Charge for Foreign Exchange Risk:


a) The capital charge for foreign exchange risk will be 10% of banks overall foreign exchange exposure. The banks net open position in each currency should be calculated by summing: i) The net spot position (i.e. all asset items less all liability items, including accrued interest, denominated in the currency in question); ii) the net forward position (i.e. all amounts to be received less all amounts to be paid under forward foreign exchange transactions, including currency futures and the principal on currency swaps not included in the spot position); iii) Guarantees (and similar instruments) that are certain to be called and are likely to be irrecoverable; iv) Net future income/expenses not yet accrued but already fully hedged (at the discretion of the reporting bank); v) Any other item representing a profit or loss in foreign currencies; b) The overall foreign exchange exposure is measured by aggregating the sum of the net short positions or the sum of the net long positions, whichever is the greater, regardless of sign. The capital charge will be 10% of the overall net open position.

Capital Charge against Operational Risk:


Operational Risk is defined as the risk of losses resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk. 2) Measurement Methodology

Banks operating in Bangladesh shall compute the capital requirements for operational risk under the Basic Indicator Approach (BIA). Under BIA, the capital charge for operational risk is a fixed percentage, denoted by (alpha) of average positive annual gross income of the bank over the past three years. Figures for any year in which annual gross income is negative or zero, should be excluded from both the numerator and denominator when calculating the average. The capital charge may be expressed as follows: K = [(GI 1 + GI2 + GI3) ]/n Where:K = the capital charge under the Basic Indicator Approach GI = only positive annual gross income over the previous three years (i.e. negative or zero gross income if any shall be excluded) = 15% n = number of the previous three years for which gross income is positive. b) Gross income: Gross Income (GI) is defined as Net Interest Income plus Net non-Interest Income. It is intended that this measure should: (i) be gross of any provisions; (ii) Be gross of operating expenses, including fees paid to outsourcing service providers; (iii) Exclude realized profits/losses from the sale of securities held to maturity in the banking book; (iv) Exclude extraordinary or irregular items; (v) Exclude income derived from insurance. Gross income = Net profit (+) Provisions & contingencies (+) operating expenses () items (iii) to (v) above.

Capital Management and Basel II:


As per Basel II guidelines issued by Bangladesh Bank, banks of bangladesh has been continuously assessing its capital requirement both in terms of Tier I and Tier II. All the options have been weighed in order to keep a strong capital base as well as ensure increased shareholders value;

In order to support the business growth stress was given for internal capital generation by maintaining strong profitability for the shareholders. In addition, the option for external capital generation was also considered in the form of issuance of subordinated bond of Tk. 2,500 million; Basel II Implementation Committee has been formed for proper implementation of the guidelines As per Basel II guidelines following methodology will be followed by the banks in Bangladesh: Standardized approach for credit and Market risk Basic indicator approach for operational risk Supervisory review Market discipline Banks will maintain capital as per Basel-II and calculate capital requirement on quarterly basis from the year 2010.

Consideration of banks to implement Basel III

IMPACT OF BASEL ACCORD IN BANGLADESH

Qualitative Impact:

Impact on individual banks


Weaker banks crowded out In a rising tide there were many organizations that could stay along for the ride. As conditions deteriorate and the regulatory position gets ever more intensive, the weaker banks will find it more difficult to raise the required capital and funding, leading to a reduction in different business models and potentially in competition. Significant pressure on profitability and ROE Increased capital requirements, increased cost of funding and the need to reorganise and deal with regulatory reform will put pressure on margins and operating capacity. Investor returns will decrease at a time when fi rms need to encourage enhanced investment to rebuild and restore buffers. Change in demand from short term to long term funding The introduction of two intensive liquidity ratios to address the short and long term nature of liquidity and funding will drive firms away from sourcing shorter term funding arrangements and more towards longer term funding arrangements with the consequent impact on the pricing and margins that are achievable. Legal entity reorganization Increased supervisory focus on local capitalization and local funding, matched with the treatment of minority investments and investments in financial institutions is likely to drive group reorganizations, including M&A and disposals of portfolios, entities or parts of entities where possible.

Impact on the financial system


Reduced risk of a systemic banking crisis

The enhanced capital and liquidity buffers together with the focus on enhanced risk management standards and capability should lead to reduced risk of individual bank failure and also reduced interconnectivity between institutions. Reduced lending capacity Although the extended implementation timeline is intended to mitigate the impact, significant increases to capital and liquidity requirements may lead to a reduction in the capacity for banking activity or at the very least a significant increase in the cost of provision of such lending. Reduced investor appetite for bank debt and equity Investors may be less attracted by bank debt or equity issuance given that dividends are likely to be reduced to allow firms to re-build capital bases; ROE and profitability of organizations will decrease significantly; and some of the proposals on non-equity instruments (if implemented) could start to make debt instruments loss-absorbing prior to liquidation for the first time. This will become evident through investor sentiment in the cost of new capital issuance and the inter-bank lending rate. Inconsistent implementation of the Basel 3 proposals leading to international arbitrage If different jurisdictions implement Basel 3 in different ways, issues we saw under Basel 1 and Basel 2 with respect to international regulatory arbitrage may continue to disrupt the overall stability of the financial system. Quantitative impact: The enhanced capital ratios prescribed by the BCBS relate to the ratio of a firms eligible regulatory capital divided by a regulatory prescribed calculation of risk weighted assets. As set out in Figure 1, all three parts of this have changed putting more pressure on a firms compliance with the ratio. The capital ratio requirement has increased; the eligibility of capital has been tightened so reducing the amount of capital firms have to meet the required ratio; and the calculation of risk weighted assets has changed leading to an increase for many organizations. While much is firm specific, estimates of the impact on the eligible capital forecast as much as a 60%1 reduction arising from the changes to the deductions from capital, for items such as

minority interests, investments in financial institutions and deferred tax. Managing the potential increase to the RWA figure in the denominator is also crucial to mitigating the impact of Basel 3 on a firms portfolios. It is very difficult to estimate for each firm. Figure 01

Figure 2 shows the possible percentage range of increases to the RWA arising from three of the key capital changes in Basel 3, together with some estimate of the percentage range of mitigation of the potential RWA increase that many believe might occur2. In addition, firms face shortfalls in their long term funding needs of up to 50%3 as a result of the new Net Stable Funding Ratio (NSFR) liquidity proposals.

CHALLENGES FOR IMPLEMENTATION OF BASEL ACCORD IN BANGLADESH

1. External Credit Rating Agencies (ECAIs) for supervision: The Standardized Approach for credit risk leans heavily on the external credit ratings. While there are a few rating agencies operating in Bangladesh, the rating penetration in Bangladesh is rather low. It is doubtful without a solid base of ECAIs operating in country how effective the implementation will be. There is also a consideration whether the ratings of International Credit Rating Agencies would be accepted in capital calculations. International ECAIs like Moodys, S&P usually rate the head-office of the multinational corporations. Whether that rating would be acceptable for their Bangladesh subsidiaries is a point to ponder. Furthermore, there would always be a wide gap between the rating of an International agency and a local agency. In general, International agencies have much stricter rating practices, which, if accepted as a norm, would generally result in a capital requirement significantly higher than Basel I for the Bangladeshi banks. This creates an incentive for some of the bank clients to remain unrated since such entities receive a lower risk weight of 100 per cent vis--vis 150 per cent risk weight for a lower rated client. This might specially be the case if the unrated client expects a poor rating. 2. Market Readiness: The disclosure requirements under the Pillar 3 of Basel II are quite extensive in nature. They are probably designed to suit advanced markets where there are numerous analysts to analyze and understand the disclosures and take investment decisions based on that. It is doubtful whether the market of Bangladesh is at all ready to take benefit such extensive disclosures. If not, then requiring banks to adhere to of such disclosure requirements would overburden the banks without any practical benefit. 3. Banking vs. non-banking financial institutions (NBFIs):

Since only banking institutions are subject to Basel II requirements, banks may find themselves in competitive disadvantage against specialized financial institutions, especially, leasing companies, microfinance institutions, foreign exchange remittance facilitating institutions and mutual funds. More specifically where banks provide services similar to these organizations, they may find it difficult to compete due to additional capital requirement which NBFIs would not have. This may create an asymmetry in the industry. 4. Higher capital requirement The new accord might, in some cases, lead to an increase in the overall regulatory capital requirements for the banks, particularly under the simpler approaches to be adopted in Bangladesh, if the additional capital required for the operational risk is not offset by the capital relief available for the credit risk. This would, of course, depend upon the risk profile of the banks' portfolios and also provide an incentive for better risk management but the banks would need to be prepared to augment their capital through strategic capital planning. 5. Increased competition for better rated clients: The new framework could also intensify the competition for the best clients with high credit ratings, which attract lower capital charge. This could put pressure on the margins of the banks. The banks would, therefore, need to streamline and reorient their client acquisition and retention strategy. 6. Changes in banking practices: The use-test requirement of Basel II dictates that banks must use the capital calculations in their management decisions like selection of clients, pricing banking products etc. This would require changes in banking practices often resulting in over-dependence on the external ratings of the clients. The larger local banks including the nationalized banks may have a very difficult time implementing changes.

7. Increased competition for the efficient officials: The human minds are needed to interpret the data for decision-making. Just as bias can affect the collection of data, it can also effect its interpretation. Those who are skilled at decision-making will give better results than those whose judgments are poor. The human resources are the tools for the gradual implementation of Basel II. This will cause a great need for efficient banking official which may cause instability in banking sector as well as increase the cost of the bank. 8. Expensive software: Software solutions for Basel II calculations available in the international market are quite expensive. While international banks can probably take advantage of software solutions procured by their head office, the local banks may find it burdensome to procure or develop such software. 9. Competitive disadvantage for smaller banks: Smaller banks with a concentration on higher risk client group may find it to their further competitive disadvantage to implement Basel II as this may require them to maintain relatively higher capital than bigger banks with less risky client base. While this is a strong incentive to improve bank's risk management practices, some of the smaller banks in the Bangladesh industry, which are already finding it challenging to operate, may be further marginalized due to Basel II requirements. 10. Higher capital requirement for SMEs and Retail clients: Another important problem is the accessibility of finance by the marginalized, underserved, and less privileged segments of the society, the SME and Retail clients. It is argued that banks would require higher capital allocation for putting money to the higher credit risk.

Conclusion

FINDINGS
When Basel III implements Weaker banks crowded out In a rising tide there were many organizations that could stay along for the ride. As conditions deteriorate and the regulatory position gets ever more intensive, the weaker banks will find it more difficult to raise the required capital and funding, leading to a reduction in different business models and potentially in competition. Significant pressure on profitability and ROE Increased capital requirements, increased cost of funding and the need to reorganize and deal with regulatory reform will put pressure on margins and operating capacity. Investor returns will decrease at a time when firms need to encourage enhanced investment to rebuild and restore buffers. Change in demand from short term to long term funding The introduction of two intensive liquidity ratios to address the short and long term nature of liquidity and funding will drive firms away from sourcing shorter term funding arrangements and more towards longer term funding arrangements with the consequent impact on the pricing and margins that are achievable. Legal entity reorganization Increased supervisory focus on local capitalization and local funding, matched with the treatment of minority investments and investments in financial institutions is likely to drive group reorganizations, including M&A and disposals of portfolios, entities or parts of entities where possible. Reduced risk of a systemic banking crisis The enhanced capital and liquidity buffers together with the focus on enhanced risk management standards and capability should lead to reduced risk of individual bank failure and also reduced interconnectivity between institutions. Reduced lending capacity Although the extended implementation timeline is intended to mitigate the impact, significant increases to capital and liquidity requirements may lead to a reduction in the capacity for banking activity or at the very least a significant increase in the cost of provision of such lending. Reduced investor appetite for bank debt and equity Investors may be less attracted by bank debt or equity issuance given that dividends are likely to be reduced to allow firms to re-build capital bases; ROE and profitability of organizations will decrease significantly; and some of the proposals on non-equity instruments (if implemented) could start to make debt instruments loss-absorbing prior to

liquidation for the first time. This will become evident through investor sentiment in the cost of new capital issuance and the inter-bank lending rate

RECOMMENDATIONS
1. Bangladesh bank should issue detailed Basel II Guidance, including all national discretions carefully evaluating their impact on the industry. 2. Bangladesh bank should take initiatives to develop efficient credit rating system for the local agencies and having a closer look on their rating. 3. Bangladesh bank should monitor and take decisions on Home-Host issues for international banks through continuous dialogue with supervisors in other countries. 4. Bangladesh bank should take steps to identify how much discloser of information is adequate for the banks in Bangladesh for maintaining Basel II. 5. Steps should be taken to reduce the inequality between banking and non-banking financial institutions 6. Banks should be given adequate time to fulfill their capital requirement. 7. Business schools and institutions should design specialized courses for preparing specialists on Basel II implementation. 8. Bangladesh bank should develop Human Resource and IT Infrastructure to review and evaluate banks' capital calculations. 9. Government or Bangladesh bank should come forward to develop software program for Basel II implementation and distribute it among the local banks to help them manage their risks and assets in more efficient way. 10. Bangladesh bank should supervise banks under Pillar 2 of Basel II. 11. Bangladesh bank should implement special regulation for SME and Retail loans to encourage bankers to provide these loans.

12. Bangladesh bank should Decide Pillar 3 disclosure requirements and monitoring practices.

REFERENCES AND BIBLIOGRAPHY

REFERENCES:
Banking Law and Practice, By P.N. Varshney. Official website of Prime Bank Ltd. Official website of Bangladesh Bank. Md. Abdul Hye, Senior Vice President, Head of Lease Financing, Prime Bank Ltd. Md. Jamil Chowdhury, Senior Executive Vice President, Head of Credit Risk Management (CRM), Prime Bank Ltd. The Daily Star (Online Edition).

BIBLIOGRAPHY:

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