BASEL II AT GLANCE

Implementation of Basel II in Indonesia

Bank Indonesia
Directorate of Banking Research and Regulation

Table of Contents

Foreword
Basel II at a Gl ance
Bank Capi tal
The Capi tal Adequacy Rati o (CAR)
Defi ni ti on of Regul atory Capi tal
Minimum Capi tal Rati o
Ri sk Wei ghtings
S
Etructure of Basel II
Basel Capi tal Accord
Pillar 1Definition of Capi tal , Mitigati on of Credit Ri sk
Market Ri sk, Operational Ri sk
Pillar 2Supervi sory Review Process
Pill ar 3Market Disclosure
Frequentl y Answered Questi ons
Glossary

Foreword
The purpose of this book is to help readers understand the importance of capital, not
only for individual banks, but also in safeguarding financial system stability. Because of
this vital role, the regulation of bank capital is guided by international standards issued
by the Basel Committee on Banking Supervision. The Basel I standard, initially adopted
in 1988, has undergone numerous changes over time in response to the rapid
development of financial market instruments. Ultimately, agreement was reached on a
more risk sensitive standard for calculation of bank capital known as Basel II.
This simply-worded book is designed to inform readers of the process of change in
capital standards and the background to the issuance of Basel II, in which bank capital
adequacy is linked to the risk profile of the individual bank.
This book does not delve into the in depth technical detail on each aspect of Basel II, but
rather is aimed more at presenting a common line of thought for Basel II, that of
improving bank risk management in order to provide better assurance of financial
system stability, which will ultimately support economic growth.
Jakarta, September 2006

Basel II at a Glance
Improved Standard for Capital Adequacy
A bank provides an intermediation function for funds received from customers. Failure of
a bank will result in widespread impact affecting retail and institutional customers who
hold funds at the bank. This could trigger multiplier impacts on
t
he domestic and
international market. The importance of the banking role demands proper regulation, in
which the primary objective is to maintain customer confidence in the banking system.
An essential part of the regulatory framework for the banking system involves the
regulations governing bank capital, which functions as a buffer against losses.
In view of the importance of capital to banks, BIS issued a capital framework concept
more commonly known as the 1988 accord (Basel I). This system was designed as a
framework for measurement of credit risk and established a minimum capital standard at
8%. The Basel Committee designed Basel I as a simple standard requiring banks to
disaggregate their exposures into broader categories reflecting debtor similarities.
Exposures to customers of the same type (such as exposures to all corporate customers)
are subject to the same capital requirements without taking account of differences in
loan repayment capacity and specific risks associated with the individual customer.
More than a decade later, prompted by the evolution of banking worldwide and the
reality that the best method for calculating, managing and mitigating risks would be
different from bank to bank, the Basel Committee embarked on the initiative for revision
of Accord 1988. The growing diversity and sophistication of products in the banking
system led BIS to introduce improvements to the capital framework in the 1988 accord
with the launching of a new capital concept known as Basel II. The first proposal w as
released in 1999 and was slated for implementation at end-2006. The revised capital
accordBasel IIis a comprehensive agreement that establishes a spectrum of more
risk-sensitive capital allocation and incentive for improvements in the quality of risk
management at banks. This was achieved by adjusting capital requirements to credit risk
and operational risk, and introducing changes in calculation of capital to cover exposures
to risks of losses caused by operational failures. In addition to the calculation of
minimum bank capital, Basel II also provides for a supervisory review process to ensure
that banks maintain a level of capital commensurate to their risk profile and promotes
market discipline through disclosure requirements.

BASEL II

MARKET
DISCIPLINE

SUPERVISORY
REVIEW
PROCESS

MINIMUM
CAPITAL
REQUIREMEN

3 PI LL ARS

Providing a flexible, risk-sensitive capital

mana gement f ramework

The objective of Basel II is to strengthen the security and soundness of the financial
system by reinforcing the emphasis on risk-based calculation of capital, the supervisory
review process and market discipline. The Basel II Framework is based on a forward-

looking approach that enables improvements and changes to be made over time. In this
way, the Basel II framework is able to keep pace with changes in the marketplace and
developments in risk management.
At first glance, Basel II involves various complexities and preconditions that are difficult
for banks to meet. However, the extra effort is well justified in view of the benefits to
banks from more economic use of capital in covering their risks. Banks also benefit from
the international recognition of the Basel II standards, which enables a bank intending to
operate globally to be readily accepted on the international market, provided that these
standards are met.
Maximising the Benefits of Basel II
Basel II calculates the capital requirement according to the bank risk profile and contains
incentives for improvement in risk management within the banking system. By using
various approaches to measure credit risk, market risk and operational risk, the result
obtained is more risk-sensitive allocation of bank capital. In Basel II, the calculation of
bank capital is prescribed in Pillar 1 the Minimum Capital Requirement. The alternative
approaches can essentially be aggregated into two major groups: the standardised
models that apply to all banks and the more sophisticated internal models developed as
appropriate to the nature of business and risk profile of the individual bank.
A comparison between the two major approaches reveals that internal models can
generally be expected to generate more precise capital adequacy calculations
appropriate to the risks faced by the bank. This will offer banks an incentive that is
expected to promote sustained efforts to build the quality of risk management. In this
way, over time, banks will maximise the benefit of the more sophisticated approaches in
calculating their capital requirement.

Minimum Capital Ratio = 8% =

Capital (Tier 1 + Tier 2 + Tier 3)

Risk-Weighted Assets

Market Risk

Credit Risk

Operational
Risk

Risk of loss from

on and off balance
sheet positions
from changes in
market factors
(interest rates and
exchange rates)

Risk of loss from

default by
debtors/
counterparties

Risk of loss directly

or indirectly caused
by weaknesses or
failures in internal
processes, human
resources and
systems and by
external events

Significant
Changes

Additional
Risk

No Significant
Changes

In assessing bank capital adequacy, it is not only necessary to allocate capital on the
basis of Pillar 1, but also capital to anticipate losses from other risks, such as liquidity
risk, strategic risk, interest rate risk in the banking book and other risks. This approach
is captured in Pillar 2, the Supervisory Review Process, and is referred to as the
Individual Capital Adequacy Assessment Process (ICAAP). It will pose an important
challenge for banks and supervisors. Building of supervisor competence and capacity will
be essential, as also the support of the regulatory framework for bank supervision. With
time, supervisors will become effective in the assessment of risks other than those
covered in Pillar 1 and may even order banks to add to their capital if bank capital is
deemed inadequate.
Furthermore, the active public role in scrutiny of banks is seen as crucial. From the
beginning, the public will also be expected to assess bank risks and ascertain the level of
capital adequacy as envisaged in Pillar 3 Market Discipline. The synergy of the three
Pillars in Basel II is integral to building a sound and stable banking industry and financial
system.
Impact of Basel II on the Resilience of the Banking System
1. Will Basel II cause bank CAR to drop below the 8% minimum?
Bank Indonesia is now working together with a number of banks on a periodical
study of quantitative impact to assess thec onsequences of Basel II on bank capital.
For this reason, the impact of Basel II should be examined on an individual basis. It
is necessary to perform assessments and improve the effectiveness of risk
management from an early stage in order to gain maximum advantage from the
available incentives. A drop in the CAR could well occur for banks with a higher risk
profile. However, banks whose credit portfolios are dominated by retail loans and
home mortgages will see a reduction in their capital requirement because of the
lower risk weightings that will apply to retail loans and home mortgages.
2. Will Basel II be implemented for all commercial banks?
The focus of Basel II in Indonesia is development and improvement in risk
management within the national banking system. This was set out in Bank Indonesia
Regulation No. 5/8/PBI/2003 dated 19 May 2003 concerning Application of Risk
Management for Commercial Banks. These measures will apply to all banks
regardless of size, given that the risk management culture should become standard
practice in the banking business. Survey shows that banks would prefer Basel II to
be implemented across the board. The main reason is to minimise the negative
impact on competition that would arise from differentiations by ability and readiness
of banks to implement and develop risk management and the associated
infrastructure. Furthermore, all banks in Indonesia will be able to apply the standard
approaches in Basel II.
3. Could Basel II hamper the intermediation process?
Basel II is not intended to hamper the intermediation process currently in operation
in the banking system. At the macro level, it also does not seek to reduce the
dominant role of the banking system in financing economic activities. The overall
thrust of the approaches put forward in Basel II is intended more as an effort to
reposition and redefine what has been achieved by the banking system, with focus on
improving risk management.
In regard to the intermediary function, Basel II is not a mechanical capital regime
with no room for tolerance. Room for flexibility is assured by a number of national
discretion clauses. While Basel II is expected to see reduced exposures to certain

sectors (e.g. because of the use of ratings in lending to corporate entities), on the
other hand it will also encourage increased exposures to other sectors, such as retail
lending (e.g. small-scale business credit, personal loans and so on) and housing
mortgages through reduced risk weightings. It is understood that this shift in
exposures will bring some shock to banks, debtors and the economy as a whole.
Even so, this effect is not expected to last long, and will be no more than a fine
tuning customary to any economy.
4. What will be the impact for banks currently working on raising their capital
for the implementation of the Indonesian Banking Architecture?
Raising additional capital for the purposes of the Indonesian Banking Architecture will
not in itself provide the means for a bank to achieve full compliance with Basel II.
However, a n adequate capital base will enable a bank to develop the human
resources and information technology capabilities essential for Basel II. In this way,
the Rp 80 billion tier 1 capital requirement for commercial banks, to be met by the
end of 2007, and the Rp 100 billion requirement for the end of 2010 will not only
expand the economy of scale in conducting operations, but also provide opportunity
for the bank to strengthen its risk management capabilities for implementation of
Basel II.
5. What are the prerequisites for proper implementation of Basel II?
Conditions that must be satisfied for proper implementation of Basel II include:
-

Application of risk management practices in the banking system as stipulated

in Bank Indonesia Regulation No. 5/8/PBI/2003 dated 19 May 2003
concerning Application of Risk Management for Commercial Banks

Adjustments in accounting standards in keeping with international accounting

standards (IAS), including but not limited to IAS 32 and IAS 39

Consolidated calculation of bank capital to cover companies in the same group

operating in the financial sector, with the exception of insurance companies

Recognition of a rating agency to enable objective rating of bank debtors.

Roadmap for Basel II in Indonesia: What Bank Indonesia and the Banking
System Must Do to Prepare
Basel II states that each supervisory authority must weigh priorities before adopting
Basel II. In implementing Basel II, Bank Indonesia is essentially seeking to strengthen
risk management so that banks willb ecome more resistant to domestic, regional and
international shocks. Bank Indonesia has developed a realistic format to be followed in
the implementation of Basel II that takes account of the current condition of the banking
industry. For this reason, the default mode for implementation will be to take the
simplest path, i.e. the standardised approach. This means that all banks will make
adjustments to their capital adequacy calculations on the basis of the Basel II guidelines.
Basel II also provides for national discretion, in which some matters are decided by the
local supervisory authority. Judgements can therefore be made for the condition of the
Indonesian banking system and complexity of Indonesia's banking products.
As part of the ongoing consultations on the substance of Basel II, including national
discretion, Bank Indonesia has set up a working group together with the banking system
to develop recommendations on the most appropriate regulatory framework. These
recommendations will then be set out in a Consultative Paper (CP) to be distributed to
stakeholders and especially banks in order to invite opinions, suggestions and inputs.

There have been widespread misunderstandings among bankers that banks will be
required to adopt more advanced approaches demanding heavier investment in
expensive IT and databases, a requirement that would obviously place banks under
financial strain. In principle, banks are given flexibility to adopt more advanced
approaches, such as IRB, provided that the necessary preparations in IT, human
resources and systems are complete and the bank risk profile offers assurance that the
use of a more advanced approach would offer benefits for the bank. In these cases,
banks may apply to Bank Indonesia for approval. The BI supervisors will validate the
state of preparedness of the bank before permitting the bank to calculate capital
adequacy using internal models. Bank Indonesia is now providing special training to
bank supervisors who will become validators of market risk and validators of credit risk.
Use of Risk Calculation
Approach

PILLAR 1
Publish BI
Regulations

Parallel Run
(Standardised) 1) or
Validation Process
(Internal Model)

CAR
Method
Effective

Improvements
to Commercial
Bank Report

PILLAR 2

PILLAR 3

Other Risks 4)

Transparency

Online System

Issue BI
Regulations

CAR Method
Effective

Publish BI
Regulations

Q3/2007

Q1/2009

Q1/2009

Market Risk
Standardised 2)

Q3/2007

Q1/2008 Q4/2008

Q1/2009

Q4/2008

Internal Model 3)

Q3/2007

Start Q3/2007

Q2/2008

Q2/2008

Q1/2009

Credit Risk
Standardised
IRBA 3)

Q3/2007
Q4/2009

Q1/2008 Q1/2009
Start Q1/2010

Q1/2009
Q4/2010

Q4/2008
Q4/2010

Q1/2009
Q2/2011

Basic Indicator
Standardised 3)

Q3/2007
Q4/2009

Q1/2008 Q1/2009
Start Q1/2010

Q1/2009
Q4/2010

Q4/2008
Q4/2010

Q1/2009
Q2/2011

AMA 3)

Q4/2009

Start Q1/2010

Q2/2011

Q4/2010

Q2/2011

Operational Risk

Implementation of Basel II in Other Countries

In contrast to the G-10 countries, non G-10 nations do not come under any deadline for
implementation of Basel II. This is consistent with the underlying nature of Basel II,
which does not constitute a legally binding document imposing sanctions on noncomplying countries. Furthermore, assessment of a countrys financial sector stability will
not be based on implementation of Basel II, but more on that countrys compliance with
the 25 B asel Core Principles for Effective Banking Supervision (BCP). For this purpose,
Indonesia has made steady improvements in compliance with the BCP in recent years.
Indeed, the sheer diversity of preparations and policies means that each country will
follow a unique path in implementing Basel II. The condition, structure and business
complexity of the banking system and quality of bank supervision are the main factors
that will be taken into account in establishing these policies. In the United States, for
example, the advanced IRB (A-IRB) will be adopted by only the 10 leading banking
groups widely known for their international operations. Other banks will apply a Basel II
format known as Basel 1A.

Bank Capital
For banks, as for companies in general, capital functions not only as the main resource
for financing operations, but also provides a buffer against possible losses. Capital also
helps to maintain public confidence in the ability of a bank to operate in the
intermediation of customer funds.
The bank supervision authority is responsible for ensuring a minimum adequacy of bank
capital by establishing rules concerning this issue. Regulatory Capital is the capital
requirement prescribed by the supervisory authority as a buffer against potential losses.
The requirements applying to Regulatory Capital are a key component of bank
supervision and are reflected in the definition of regulatory capital and the capital
adequacy ratio (CAR).
Definition of Regulatory Capital
A general definition of capital was first introduced in Basel I, the first broad approach to
capital adequacy. This definition has remained unchanged and is retained in Basel II.
The definition states that regulatory capital is divided into three tiers. An item may be
grouped into one of these tiers, provided that it satisfies certain criteria. The definition of
regulatory capital sets out the criteria for categorisation as an element of capital, and
thus ensures consistency of capital adequacy among different nations. This has
promoted more common understanding among banks in general and the more
internationally active banks in particular.
Under Basel I and Basel II, regulatory capital is divided into three levels or tiers of
capital as follows:
o

Tier 1 capital. This tier c onsists of instruments with the greatest capacity to absorb
losses arising at any time.

Tier 2 capital. This tier consists of a broad mix of equity components and hybrid
capital/debt instruments. Total Tier 2 capital is restricted to 100% of Tier 1 and is
divided into two categories:
?
Upper Tier 2, restricted to 100% of Tier 1 capital,
?
Lower Tier 2, restricted to 50% of Tier 1 capital.

Tier 3 capital was added in 1996 , and is used only to meet capital requirements for
market risk.

The Capital Adequacy Ratio (CAR)

The objective of this ratio is to ensure that banks are capable of absorbing losses
incurred in the course of their activities. The existing regulatory ratio is the 8%
minimum. This links bank capital to the risk weightings of assets held by the bank.
Supervisor risk weighting is the percentage used to convert the nominal value of credit
exposures to a specific value reflecting level of risk. The risk weighting for each asset is
prescribed in a Bank Indonesia regulation. The capital that must be allocated to cover
potential loss in relation to the exposures is obtained by multiplying the exposure value
by the weighting for the assets and the minimum capital requirement (i.e. 8%).

Some banks have begun using capital adequacy assessment approaches as a risk
management function. Banks will normally assess the amount of capital required to
cover loss up to a certain level of probability. The development of these approaches has

been driven by evidence that capital is a very costly resource for a bank. The bank must
therefore have strong incentives to manage capital as effectively as possible. Since the
mid-1990s, some of the world's largest and most sophisticated institutions have
developed various measures of economic capital and have specifically combined these
with risk management systems for more efficient management of risks and capital.
The objective of bank supervision is to ensure that banks conduct their operations in line
with prudent, sound principles. To this end, banks must maintain adequate capital and
reserves to offset risks arising in the course of business. The main principles of the Basel
Committee on Banking Supervision (BCBS) state that bank supervisors must establish a
safe and appropriate level of minimum capital requirement for all banks. The ultimate
goal of all authorities involved in bank supervision is to protect the stability and
soundness of the financial system. Since the end of 1980, standardised calculations of
bank capital based on the BCBS guidelines have come into widespread international use
in support of this goal.
Compliance with the minimum capital requirement (or solvency ratio) is determined by
two components as follows:
o The risk weightings for bank assetsi.e. all bank exposures converted into assets
with each exposure then multiplied by the supervisor risk weighting, based on level
of risk
o 2 minimum ratios (or limits) in which regulatory capital is linked to asset risk
weightings:
Regulatory capital divided by risk-weighted assets must be equal to or greater
than 8%
Tier 1 capital divided by risk-weighted assets must equal at least 4%.

10

STRUCTURE OF BASEL II

The new capital adequacy framework - Basel II - offers greater flexibility by establishing
a number of risk-sensitive approaches and incentives for improved risk management.
Banks are asked to allocate less capital for counterparties with higher ratings and more
capital for those with higher risk. The framework consists of three pillars as follows:
o
o

Pillar 1 (Minimum Capital Requirement) deals with the required minimum capital that
each bank must provide to cover credit, market and operational exposures.
Pillar 2 ( Supervisory Review Process) establishes the supervisory review process
aimed at ensuring an adequate level of bank capital to cover the full scope of bank
risks.
Pillar 3 (Market Discipline) addresses market discipline and the specifics of minimum
limits of public disclosure.

I. Pillar 1 - Minimum Capital Requirement

Pillar 1 establishes the minimum capital requirement in relation to credit risk, market
risk and operational risk. In Basel II, the required level of bank capital is at least 8% of
risk-weighted assets. Within this context, capital is divided into several categories:
o

o
o

Tier 1 capital, i.e. the most basic level of capital consisting of shares plus noncumulative preferential shares and reserves, subtracted by goodwill. Tier 1 capital
must comprise at least 50 percent of bank capital.
Tier 2 capital, consisting of asset revaluation value, general reserves, hybrid capital
instruments and subordinated loans. This tier may not exceed 50 percent of capital
Tier 3 capital, was added in the 1996 Capital Accord Amendment, but is used only to
cover the portion of the bank capital requirement allocated to market risk. This
category consists of special types of short-term subordinated loans.

I.1. Credit Risk

Basel II allows a financial institution to calculate credit risk for compliance with capital
regulations by one of the following two methods:
o Under the Standardised Approach (SA), the bank uses a list of risk weightings to
calculate the credit risk for its assets. The risk weightings are linked to ratings issued
for the government, financial institutions and companies by an external rating
agency.
o The Internal Rating Based Approach (IRB) allows banks to use their own internal
models for counterparties and exposures. This allows for more specific differentiation
of risk among various exposures, producing a level of capital more commensurate to
risk.
Credit RiskStandardised Approach (SA)
Under this approach, the bank allocates certain risk weightings for each category of
assets and off-balance sheet items to arrive at a total figure for risk-weighted assets as
follows:
Risk-Weighted
weighting

Assets

Total

exposures

risk

11

Allocations for each risk weighting are based on general debtor categories (government,
bank or corporate), which subsequently classified further according to ratings issued by
an external credit rating agency. The standardised approach prescribes risk weightings
based on differences in the nature of the assets and external credit ratings to produce a
more risk-sensitive result in comparison to the current Accord. The risk weightings for
the government, other banks and corporate exposures are differentiated according to the
external credit ratings. A 100 percent risk weighting produces a capital charge at 8% of
the exposure value. Similarly, a 20% risk weighting produces an equivalent capital
charge of 1.6% (20% x 8%).
Other risk weightings have also been established according to differences in the nature
of exposure. Examples of risk weightings for these categories in use are:
-

35% for exposures to residential housing complying with strict prudential criteria;

75% for retail exposures (loans to small and medium enterprises meeting certain
criteria enabling them to be treated as retail businesses);

100% for exposures to commercial properties, with limited exemptions under

certain conditions;

150% for high risk exposures, such as loans past due; and

350% for securitised components rated BB+ and BB-.

Credit RiskInternal Rating Based Approach (IRB)

The IRB approach recognises that banks are customarily better informed of their debtors
than a rating agency. This approach enables a bank to apply more precise
differentiations for each risk in comparison to the seven risk categories (0%, 20%, 35%,
50%, 75%, 100% and 150%) in the standardised approach.
There are two approaches used in the IRB, both of which are based on strict
measurement standards and methodology and require supervisor approval:
-

Foundation IRB the bank calculates probability of default (PD) for each debtor
and the supervisor provides other input, such as loss given default (LGD) and
exposure at default (EAD).

Advanced IRB in addition to PD, the bank includes other inputs such as EAD, LGD
and maturity (M). Stricter requirements apply for using this approach in comparison
to foundation IRB.

Major parameters in the IRB approach:

- Probability of Default is the likelihood that a debtor will default on obligations. All
banks must provide an internal model of PD for each debtor category.
- Loss Given Default (LGD) is the estimated percentage of loss that would occur in the
event of a debtor's default.
- Exposure at Default (EAD) is the estimated exposure to a particular debtor in the
event of default.
- Maturity (M) is the effective tenor (in years) of a bank exposure.

Asset Categories in the IRB Approach

-

Corporate Exposures debt liabilities owed by companies or arising from

partnerships or ownership. This category is divided into five sub-assets: project
financing, purchase financing, commodity financing, income-generating real estate
and high volatility commercial real estate.

Bank Exposures exposures to banks and securities companies.

12

Government Exposures exposures to the government, the central bank, public

sector entities and MDBs.

Retail Exposures retail loans including loans to individuals and small-scale

businesses, credit card operations, working capital loans, home mortgages and fixed
instalment loans. Basel II identifies two sub-categories: exposures guaranteed by
residential property and retail exposures meeting certain qualifications, including
other retail credit.

Equity Exposures ownership interests in companies, partnerships and other

corporate business.

Incentives
The capital rules are designed to encourage banks to shift from the
standardised approach to the IRB and from Foundation IRB to
Advanced IRB. By switching to a more advanced approach, many
banks will benefit from reduced capital allocation under the capital
rules as a result of the more accurate linkage between capital and risk.
Nevertheless, the possibility remains that bank portfolios are on
average higher risk and the IRB approach demands a higher standard
than the standardised approach.
Mitigation of Credit Risk
A lender can mitigate credit risk if a debtor provides collateral or a third party
underwrites the debtors obligations or the bank buys credit protection, for example
through credit derivatives, or by other means. Compared to the Accord 88, Basel II
provides for broader recognition of credit risk mitigation techniques. Basel II allows
banks to recognise the following forms of collateral:
- Cash
- Designated securities issued by the government, public sector entities, banks,
companies and securities companies
- Designated negotiable equities
- Designated mutual funds
- Gold
For banks using the standardised approach to calculate credit risk, Basel II offers two
possible methods for credit risk mitigation:
-

The simple approach, which enables

g
uaranteed claims to be assigned a risk
weighting against the collateral instrument, subject to a minimum limit of 20%.

The comprehensive approach, focused on the cash value of collateral. This approach
uses the haircut to calculate volatility of collateral value. This may be the standard
haircut as determined by the Basel Committee or an estimate of collateral volatility
prepared by the bank.

If a bank is approved for use of an internal model, the options of the simple approaches
described above are not available. In the case of banks using the IRB approach, the LGD
component is also adjusted to reflect the benefit of using collateral to reduce losses.
Asset Securitisation
Securitisation is a technique employed by banks to transfer risk while raising liquidity.
Traditionally, bank assets are pooled and then sold by issuing securities guaranteed by
that pool of assets. In Basel II, banks must use the securitisation framework in

13

calculating their capital requirements against exposures arising from traditional

securitisation and syntheses or similar structures with these features.
Because of the many different methods of securitisation, the determination of the capital
required to cover securitisation exposures must be based on economics substance over
form. The same principle also applies to supervisors, who must give greater emphasis to
economics substance in determining whether the exposure fit within the securitisation
framework for calculating bank capital adequacy.
In securitisation, the bank may act as the original creditor or investor for the securitised
assets. In either of the two categories, the bank role can vary widely. Whatever the
form, Basel II stresses that banks must allocate capital to cover various forms of
securitisation.
I.2. Ma rket Risk
On 1 January 1998, banks in the
G
-10 countries were
required to allocate capital to cover market risk (as
stipulated in the market risk amendment to the Basel
Accord). The bank capital requirement for market risk is
determined by two methods.

The first is the standardised approach, which applies a building block approach for
interest rate and equity instrument-related transactions. This approach differentiates
between calculation of capital charges for specific risks and general market risk.
The second is the internal model approach, which enables banks to use internal
methods complying with the qualitative and quantitative criteria determined by the Basel
Committee, subject to approval from the supervisory authority. This approach sets
capital charges at a higher level than the previous day's VaR or the average daily VaR for
60 working days multiplied by three minimum factors. Banks must calculate the VaR on
the basis of daily value with
-

one-tailed confidence interval of 99%

10-day minimum holding period

one-year minimum observation period.

The internal model used by the bank must accurately cover certain risks related to
options and option-like instruments.

14

I.3. Operational Risk

The Basel Committee defines operational risk as the risk that originates directly or
indirectly from inability or failure of internal processes, persons and systems, as well as
from external events." Three approaches may be used to determine the capital charges
for operational risk:
o

The Basic Indicator Approach calculates capital charges for operational risks on
the basis of a certain percentage (alpha factor) of gross income used as an estimate
for bank risk exposures. Under this approach, the capital that must be allocated by
the bank to cover losses arising from operational risks equals a certain percentage of
average gross income over a three year period.

The Standardised Approach requires an institution to disaggregate its activities

into eight standard business lines. The capital charge for each business line is
calculated by multiplying its gross income by a certain predetermined constant (beta
factor) that is different for each business line.

In the Advanced Measurement Approach, the calculation of the capital

requirement is the same as the risk measurement generated by a model for
measuring operational risk developedi nternally by the bank. The bank must meet
the qualitative and quantitative criteria stipulated in Basel II and must have approval
from the supervisory authority.

Calculation of Capital Adequacy

Basel II requires banks to allocate capital at 8% of risk-weighted assets, calculated
according to the following formula:

For example, a bank has USD10 billion in risk-weighted assets, a USD300 million capital
charge for market risk and a USD100 million capital charge for operational risk. The
minimum capital requirement for the bank is:
= [USD10 billion + 12.5 x (USD300 million + USD100 million)] x 8% = USD1.2 billion
This means that the bank must allocate capital of at least USD1.2 billion.
II. Pillar 2 - The Supervisory Review Process
Pillar 2 focuses on the review process within the supervisory framework that is aimed at
ensuring that banks maintain levels of capital commensurate to their risk profile. The
supervisory review process seeks to ensure that banks calculate their capital adequacy
to cover the full scope of risk and supervisors assess and take any necessary actions to
respond to the capital calculations made by the bank.
The supervisor may ask the bank to set aside capital in excess of the minimum capital
ratio or take remedial measures such as strengthening of risk management or other
actions. If a higher
r atio becomes necessary, the supervisor may intervene if bank
capital is below that limit.

15

Pillar 2 requires banks to conduct regular stress testing to

estimate how much capital would be required under crisis
conditions. The bank and the supervisor must use the test results
to ensure that bank capital is at an adequate level.
Pillar 2 encompasses four key principles:
o

Banks must have a process for calculating overall capital adequacy based on their
risk profile and a strategy for maintaining their level of capital;

The supervisor must review and evaluate the strategy and capital adequacy
calculations made internally by the bank and the ability of the bank to monitor and
ensure compliance with the prescribed capital ratio;

The supervisor may order a financial institution to operate above the prescribed
capital ratio and has the authority to order a bank to allocate capital above the
minimum limit; and

The supervisor may intervene at an early stage to prevent decline in bank capital
below the minimum limit and to ensure that the bank takes remedial measures if the
level of capital is not maintained or sinks to its former level.

III. Pillar 3: Market Disclosure

Pillar 3 requires banks to disclose adequate information for market
players to understand the risks involved in the banks. This enables
market players to assess the key information on the scope of risk,
capital, risk exposures, risk measurement process and bank capital
adequacy.
In some cases, disclosure serves as a special criteria in Pillar 1 enabling the bank to
apply a lower risk weighting and/or use a particular methodology. This is expected to
operate as a form of direct sanction because of failure to comply with the disclosure
requirements (e.g., not permitted to apply lower risk weightings or use certain
methodologies). Pillar 3 also discusses the issues of the role of significant information,
frequency of disclosure and issues regarding proprietary information.

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Frequently Asked Questions

1. What is BIS?
The Bank for International Settlements (BIS) is an international organisation that
promotes international monetary and financial cooperation and operates as the bank for
central banks. To meet its responsibilities, BIS carries out a number of key activities.
o As a forum for promoting discussions and policy analyses among central banks
and within the international financial system.
o As a research centre for economics and monetary policy
o As a leading partner for central banks in financial transactions
o As an agent or representative for central bank dealings in international financial
activities.
2. What is the Basel Committee on Banking Supervision?
The Basel Committee on Banking Supervision (BCBS), better known as the Basel
Committee, was established in a voluntary action by the monetary authorities of the G10 countries and a number of other nations. The committee has no official reach as an
international supervisory authority and its decisions are never intended to be legally
binding.
The Basel Committee was set up by central bank governors from the G-10 countries at
the end of 1974 and convenes four times a year. These countries are represented by
their central banks and also the authorities responsible for supervision of the banking
business if not under the powers of the central bank. The Committee develops policy
guidelines that national supervisory authorities may decide on as appropriate to the
supervisory policy to be implemented by the individual country.
The Basel Committee formulates supervision standards and guidelines gof a eneral
nature and issues statements with broad application on best practices. This is intended
to enable each authority to take measures for applying these standards within a legal
and regulatory framework appropriate to the individual countrys system.
The most important output of the Basel Committee is the ruling on minimum capital
standards for banks worldwide. The Basel Capital Accord was first announced in July
1988 and was implemented by all members of the Basel Committee in 1992. Although
the accord was initially targeted at internationally active banks, it ultimately gained
broad international acceptance among banks and supervisory authorities. More than 100
countries around the world have now adopted the Basel Accord.
3. What are the differences between Basel I and Basel II?
Basel II builds on the basic structure of the 1998 accord (Basel I) to determine capital
requirements in relation to credit and market risk and to develop a more risk-sensitive
capital framework. This has been achieved by adjusting capital requirements to credit
risk and also by introducing changes in the method for calculating capital to cover
exposures from risk of losses attributable to operational failures.
Even so, in broad terms the Basel Committee has retained the aggregate level of the
minimum capital requirement and establishes incentives for application of the more
advanced risk-sensitive approaches within the Basel II framework. Basel II combines the
minimum capital requirement with supervisory review and market discipline to promote
improvement in risk management.

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4. What are the objectives of the Basel Capital Accords?

The objectives of Basel I and Basel II are essentially the same. First, the Basel I
framework was designed to improve soundness and stability of the international banking
system. Secondly, the Basel I framework was expected to create a level playing field
among different countries with a high level of consistency in perceptions to reduce
sources of unfair competition among internationally active banks. In the Basel II
framework, the Committee believes that the changes to the existing approaches will
encourage the banking industry to use the improved risk management methods.
5. Is it compulsory for a nation to implement Basel II?
No country is required to implement Basel II. No policy issued by BIS is legally binding
on any country. For this reason, implementation of Basel II is a decision at the individual
country level, taking into account the state of preparedness of that country's banking
system.
6. What impact does Basel II have on a nation?
When a country implements Basel II, this action is expected to strengthen financial
system stability by promoting advancement in risk management and capital adequacy in
the banking system. Furthermore, Basel II is also expected to:
o Improve corporate governance and risk management
o Create more efficient capital allocation and build a robust capital structure
o Strengthen standards of transparency
o Improve bank supervision in regard to processes and implementation.
7. Can Basel II be implemented in Indonesia?
Yes. Basel II is a broad policy framework consisting of a set of best practices applied
worldwide. The concepts in Basel II can therefore be applied in any country, including
Indonesia.
8. Why must Basel II be implemented in Indonesia?
Basel II prescribes a more risk-sensitive framework for calculation of the capital
requirement. These capital adequacy calculations also take into account the various risks
involved on a more comprehensive scale. This will encourage banks to improve their
risk management in order to obtain a more precise value of economic capital. It will also
encourage supervisors and market players to play a greater role in financial system
stability.
9. Is it appropriate for Indonesia to implement Basel in the near future?
Yes. Since the introduction of Basel I, the Indonesian banking system has undergone far
reaching changes from:
o Globalisation
o Developments in technology
o Innovations in the financial world
Furthermore, Basel I focuses only on credit risk and market risk, thereby simplifying
assumptions of risks in a way that will not protect bank soundness.
Basel II provides a framework capable of maintaining the soundness and stability of the
banking system through:
o Strengthening of internal processes
o Promoting the use of more advanced and sophisticated risk management
practices
o Risk measurements more accurately depicting the true level of risks carried by
the bank
o Improvements in transparency.

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10.What approach will be used in Indonesia?

Bank I ndonesia will introduce the standardised, internal rating-based and advanced
approaches. These approaches will be phased in over time. The decision on the approach
to be used will be made by individual banks with approval from the supervisor.
11.May banks choose the approach they use?
Yes, banks may choose the approach they wish to use. However, the use of any
approach other than the standardised approach must be approved by the bank
supervisor. If a bank has already used the internal rating based or advanced approach, it
will not be permitted to replace the approach in use with the standardised approach
without approval from the bank supervisor.
12.Will banks be required to use the Internal Rating-Based or Advanced
approach?
No, banks are not required to use either the internal rating-based or the advanced
approach. The decision about which approach to use is entirely at the discretion of the
individual bank. If a bank is unable to implement an internal rating-based or advanced
approach, it will be encouraged to remain with the standardised approach.

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GLOSSARY
-

Pillar 1: Rules establishing a minimum ratio of capital to risk-weighted assets.

Pillar 2: The supervisory review pillar, requiring supervisors to perform a qualitative

review of the capital allocation techniques used by the bank and compliance with
relevant standards.

Pillar 3: Disclosure requirements that facilitate market discipline.

Internal Rating: Result of a banks risk measurement of its credit portfolio.

External Credit Rating: Rating issued by an external rating agency.

Consolidation: Measurement of bank risk encompassing the entire business group

linked to the bank.

Operational Risk: Risk arising directly or indirectly from the inability or failure of
internal processes, persons or system or from external events.

Credit Risk: Risk of loss arising from default by a debtor or counterparty.

Market Risk: Risk of loss arising from a trading position when prices undergo change.

Mitigation of Credit Risk: A set of techniques enabling a bank to protect part of its
position from counterparty default (for example, by taking over collateral or
encashing a guarantee or purchasing hedging instruments).

Asset Securitisation: Aggregation of assets or liabilities into securities for sale to third
parties.

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