BASEL I II

Finance Management
 Contents

Contents..........................................................................................................2

Basel I Accord..................................................................................................3

Introduction...............................................................................................3

Main framework.........................................................................................3

Basel I pointers..........................................................................................4

An explanation by Investopedia.com.........................................................4

Basel II Accord.................................................................................................5

Introduction...............................................................................................5

The Accord in operation.............................................................................5

Need for Basel II:.......................................................................................6

Features of Basel II Norms:........................................................................6

Pillar I: Capital Adequacy Requirements:...................................................6

Pillar II: Supervisory Review:.....................................................................7

Pillar III: Market Discipline:........................................................................8

'Draft' guidelines for implementation of Basel II in India ..........................8

Implementation of the New Accord..................................................................9

Transition to the New Accord....................................................................9

Forward looking aspects..........................................................................10

Cross-border implementation..................................................................12
 Basel I Accord

Introduction

Basel I is the round of deliberations by central bankers from around the

world, and in 1988, the Basel Committee on Banking Supervision (BCBS) in
Basel, Switzerland, published a set of minimal capital requirements for
banks. This is also known as the 1988 Basel Accord, and was enforced by law
in the Group of Ten (G-10) countries in 1992 . Basel I is now widely viewed as
outmoded. Indeed, the world has changed as financial conglomerates,
financial innovation and risk management have developed. Therefore, a
more comprehensive set of guidelines, known as Basel II are in the process
of implementation by several countries and new updates in response to the
financial crisis commonly described as Basel III.

Background

The Committee was formed in response to the messy liquidation of a

Cologne-based bank (Herstatt) in 1974. On 26 June 1974, a number of banks
had released Deutsche Mark (German Mark) to the Bank Herstatt in
exchange for dollar payments deliverable in New York. On account of
differences in the time zones, there was a lag in the dollar payment to the
counter-party banks, and during this gap, and before the dollar payments
could be effected in New York, the Bank Herstatt was liquidated by German
regulators.

This incident prompted the G-10 nations to form towards the end of 1974,
the Basel Committee on Banking Supervision, under the auspices of the Bank
of International Settlements (BIS) located in Basel, Switzerland.

Main framework

Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk.
Assets of banks were classified and grouped in five categories according to
credit risk, carrying risk weights of zero (for example home country
sovereign debt), ten, twenty, fifty, and up to one hundred percent (this
category has, as an example, most corporate debt). Banks with international
presence are required to hold capital equal to 8 % of the risk-weighted
assets. However, large banks like JPMorgan Chase found Basel I's 8%
requirement to be unreasonable, and implemented credit default swaps so
that in reality they would have to hold capital equivalent to only 1.6% of
assets.

Since 1988, this framework has been progressively introduced in member

countries of G-10, currently comprising 13 countries, namely, Belgium,
Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain,
Sweden, Switzerland, United Kingdom and the United States of America.
Most other countries, currently numbering over 100, have also adopted, at
least in name, the principles prescribed under Basel I. The efficiency with
which they are enforced varies, even within nations of the Group of Ten.

Basel I pointers

• Aimed to standardized the computation of risk based Capital across

banks and across countries.
• Issued in 1988 by the Basel Committee on Banking Supervision, a
group of banking supervisors which secretariat is based at the Bank for
International Settlements in Basel, Switzerland.

An explanation by Investopedia.com

The first accord was the Basel I. It was issued in 1988 and focused mainly on
credit risk by creating a bank asset classification system. This classification
system grouped a bank's assets into five risk categories:

0% - cash, central bank and government debt and any OECD government
debt

0%, 10%, 20% or 50% - public sector debt

20% - development bank debt, OECD bank debt, OECD securities firm debt,
non-OECD bank debt (under one year maturity) and non-OECD public sector
debt, cash in collection

50% - residential mortgages

100% - private sector debt, non-OECD bank debt (maturity over a year), real
estate, plant and equipment, capital instruments issued at other banks

The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its
risk-weighted assets. For example, if a bank has risk-weighted assets of $100
million, it is required to maintain capital of at least $8 million.

Basel II Accord

Introduction

Basel II is the second of the Basel Accords, which are recommendations on

banking laws and regulations issued by the Basel Committee on Banking
Supervision. The purpose of Basel II, which was initially published in June
2004, is to create an international standard that banking regulators can use
when creating regulations about how much capital banks need to put aside
to guard against the types of financial and operational risks banks face.
Advocates of Basel II believe that such an international standard can help
protect the international financial system from the types of problems that
might arise should a major bank or a series of banks collapse. In practice,
Basel II attempts to accomplish this by setting up rigorous risk and capital
management requirements designed to ensure that a bank holds capital
reserves appropriate to the risk the bank exposes itself to through its lending
and investment practices. Generally speaking, these rules mean that the
greater risk to which the bank is exposed, the greater the amount of capital
the bank needs to hold to safeguard its solvency and overall economic
stability.

The Accord in operation

Basel II uses a "three pillars" concept – (1) minimum capital requirements

(addressing risk), (2) supervisory review and (3) market discipline – to
promote greater stability in the financial system.

The Basel I accord dealt with only parts of each of these pillars. For example:
with respect to the first Basel II pillar, only one risk, credit risk, was dealt
with in a simple manner while market risk was an afterthought; operational
risk was not dealt with at all.
Need for Basel II:

The first accord by the name .Basel Accord I. was established in 1988 and
was implemented by 1992. It was the very first attempt to introduce the
concept of minimum standards of capital adequacy. Then the second accord
by the name Basel Accord II was established in 1999 with a final directive in
2003 for implementation by 2006 as Basel II Norms. Unfortunately, India
could not fully implement this but, is now gearing up under the guidance
from the Reserve Bank of India to implement it from 1 April, 2009.

Basel II Norms have been introduced to overcome the drawbacks of Basel I

Accord. For Indian Banks, it’s the need of the hour to buckle-up and practice
banking business at par with global standards and make the banking system
in India more reliable, transparent and safe. These Norms are necessary
since India is and will witness increased capital flows from foreign countries
and there is increasing cross-border economic & financial transactions.

Features of Basel II Norms:

Basel II Norms are considered as the reformed & refined form of Basel I
Accord. The Basel II Norms primarily stress on 3 factors, viz. Capital
Adequacy, Supervisory Review and Market discipline. The Basel Committee
calls these factors as the Three Pillars to manage risks.

Pillar I: Capital Adequacy Requirements:

Under the Basel II Norms, banks should maintain a minimum capital

adequacy requirement of 8% of risk assets. For India, the Reserve Bank of
India has mandated maintaining of 9% minimum capital adequacy
requirement. This requirement is popularly called as Capital Adequacy Ratio
(CAR) or Capital to Risk Weighted Assets Ratio (CRAR).

The first pillar deals with maintenance of regulatory capital calculated for
three major components of risk that a bank faces: credit risk, operational
risk, and market risk. Other risks are not considered fully quantifiable at this
stage.
The credit risk component can be calculated in three different ways of
varying degree of sophistication, namely standardized approach, Foundation
IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach".

For operational risk, there are three different approaches - basic indicator
approach or BIA, standardized approach or TSA, and the internal
measurement approach (an advanced form of which is the advanced
measurement approach or AMA).

For market risk the preferred approach is VaR (value at risk).

As the Basel 2 recommendations are phased in by the banking industry it will

move from standardized requirements to more refined and specific
requirements that have been developed for each risk category by each
individual bank. The upside for banks that do develop their own bespoke risk
measurement systems is that they will be rewarded with potentially lower
risk capital requirements. In future there will be closer links between the
concepts of economic profit and regulatory capital.

Credit Risk can be calculated by using one of three approaches:

1. Standardized Approach

2. Foundation IRB (Internal Ratings Based) Approach

3. Advanced IRB Approach

The standardized approach sets out specific risk weights for certain types of
credit risk. The standard risk weight categories are used under Basel 1 and
are 0% for short term government bonds, 20% for exposures to OECD Banks,
50% for residential mortgages and 100% weighting on unsecured
commercial loans. A new 150% rating comes in for borrowers with poor
credit ratings. The minimum capital requirement that is, the percentage of
risk weighted assets to be held as capital remains at 8%.

For those Banks that decide to adopt the standardized ratings approach they
will be forced to rely on the ratings generated by external agencies. Certain
Banks are developing the IRB approach as a result.

Pillar II: Supervisory Review:

Banks majorly encounter with 3 Risks, viz. Credit, Operational & Market
Risks.
Basel II Norms under this Pillar wants to ensure that not only banks have
adequate capital to support all the risks, but also to encourage them to
develop and use better risk management techniques in monitoring and
managing their risks. The process has four key principles:

a) Banks should have a process for assessing their overall capital adequacy
in relation to their risk profile and a strategy for monitoring their capital
levels.

b) Supervisors should review and evaluate bank's internal capital adequacy

assessment and strategies, as well as their ability to monitor and ensure
their compliance with regulatory capital ratios.

c) 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.

d) Supervisors should seek to intervene at an early stage to prevent capital

from falling below minimum level and should require rapid remedial action if
capital is not mentioned or restored.

Pillar III: Market Discipline:

Market discipline imposes banks to conduct their banking business in a safe,

sound and effective manner. Mandatory disclosure requirements on capital,
risk exposure (semiannually or more frequently, if appropriate) are required
to be made so that market participants can assess a bank's capital
adequacy. Qualitative disclosures such as risk management objectives and
policies, definitions etc. maybe also published.

'Draft' guidelines for implementation of Basel II in India

The Basel Committee on Banking Supervision (BCBS) has released the

document, "International Convergence of Capital Measurement and Capital
Standards: A Revised Framework" on June 26, 2004. The revised Framework
has been designed to provide options for banks and banking systems, for
determining the capital requirements for credit risk and operational risk and
enables banks / supervisors to select approaches that are most appropriate
for their operations and financial markets. The Framework is expected to
promote adoption of stronger risk management practices in banks.
The Revised Framework, popularly known as Basel II, builds on the current
framework to align regulatory capital requirements more closely with
underlying risks and to provide banks and their supervisors with several
options for assessment of capital adequacy. Basel II is based on three
mutually reinforcing pillars - minimum capital requirements, supervisory
review, and market discipline. The three pillars attempt to achieve
comprehensive coverage of risks, enhance risk sensitivity of capital
requirements and provide a menu of options to choose for achieving a
refined measurement of capital requirements.

The Revised Framework consists of three-mutually reinforcing Pillars, viz.

minimum capital requirements, supervisory review of capital adequacy, and
market discipline. Under Pillar 1, the Framework offers three distinct options
for computing capital requirement for credit risk and three other options for
computing capital requirement for operational risk. The approaches for credit
and operational risks are based on increasing risk sensitivity that allows
banks to select an approach that is most appropriate to the stage of
development of bank's operations.

The approaches available for computing capital for credit risk are
Standardized Approach, Foundation Internal Rating Based Approach and
Advanced Internal Rating Based Approach. The approaches available for
computing capital for operational risk are Basic Indicator Approach,
Standardized Approach and Advanced Measurement Approach.

With a view to ensuring migration to Basel II in a non-disruptive manner, the

Reserve Bank has adopted a consultative approach. A Steering Committee
comprising of senior officials from 14 banks (private, public and foreign) has
been constituted where Indian Banks' Association is also represented.

Keeping in view the Reserve Bank's goal to have consistency and harmony
with international standards it has been decided that at a minimum, all
banks in India will adopt Standardized Approach for credit risk and Basic
Indicator Approach for operational risk with effect from March 31, 2007. After
adequate skills are developed, both in banks and at supervisory levels, some
banks may be allowed to migrate to IRB Approach after obtaining the specific
approval of Reserve Bank.

Implementation of the New Accord

Transition to the New Accord

The Committee believes the proposals contained in CP3 are suitable for a
wide range of banks in different countries. Within the G10, Committee
members have agreed to a common implementation date for the New
Accord of year-end 2006. In these countries, the implementation of the new
Accord is intended to encompass internationally active banks, and other
significant banks as national supervisors deem appropriate. In a number of
G10 countries, the Basel II framework will be applied to the entire banking
system. National supervisors in the G10 will ensure that banks not
implementing Basel II will be subject to prudent capital adequacy regulation.

While the New Accord has been designed to provide options for banks and
banking systems worldwide, the Committee acknowledges that outside the
G10 moving to the new framework in full in the near future may not be the
first priority for all supervisors in terms of what they need to do to
strengthen their supervision. Where this is the case, each national supervisor
should consider carefully the benefits of the new framework in the context of
its domestic banking system when developing a timetable and approach to
implementation.

Given resource constraints and other priorities, it should be neither

surprising nor inappropriate for these timetables, particularly in non-G10
countries, to extend beyond 2006. That said, supervisors should consider
implementing key elements of the supervisory review and market discipline
components of the New Accord even if the Basel II minimum capital
requirements will be implemented after year-end 2006.

Many national supervisors have already begun to plan for the transition to
Basel II. To assist in this process, the Committee has asked a group of
supervisors from around the world, with IMF and World Bank participation, to
develop a framework for assisting non-G10 supervisors and banks in the
transition to both the standardized and foundation IRB approaches of the
New Accord. The Committee believes that continued co-operation along
these lines is essential to ensuring a successful transition to the New Accord.

Forward looking aspects

The Committee sees frequent exchanges of information between banks and

supervisors and between supervisors in different jurisdictions as critical for
the successful implementation of Basel II. To promote consistency in the
implementation of the New Accord across jurisdictions, the Committee
established the Accord Implementation Group (AIG) for national supervisors
to exchange information on the practical implementation challenges of Basel
II and on the strategies they are using to address these issues. The AIG also
will work closely with the Committee’s Capital Task Force (CTF), the body
responsible for considering substantive modifications to and interpretations
of the New Accord.

The Committee believes that the Accord will continue to evolve following the
implementation of Basel II. This evolution is necessary to ensure that the
framework keeps pace with emerging market developments and advances in
risk management practices.

Nonetheless, it is not the intent of the Committee for the New Accord to be a
moving target prior to implementation. Priorities in the period prior to end-
2006 will include reconciling any major, unintended inconsistencies in the
treatment of similar exposures across the approaches for determining capital
for a given risk. Additionally, the Committee will seek to close any loopholes
and unintended effects of the new framework.

The Committee recognizes that the need for such actions may only come to
light after banks have begun to rely on the Basel II requirements. Those
banks adopting the more advanced approaches to risk assessment (the IRB
approach for credit risk and the AMA for operational risk) will be required to
run them in parallel with the existing Accord for one year prior to the
implementation of Basel II. The Committee believes that this parallel
calculation will provide banks and supervisors with valuable information on
the potential impact of the New Accord and allow issues to be brought up
prior to formal implementation.

The CTF will take responsibility for considering new banking products and
implications of advances in risk management processes on the new
framework beyond yearend 2006. The Committee is aware that industry
practices change over time with some areas evolving more rapidly than
others do. In particular, the IRB approaches and the AMA are meant to reflect
sound industry practice. Other areas of the new framework, for example, the
capital treatment of securitisation should be flexible enough to adapt to new
developments when necessary. The Committee also intends to consider
issues, such as a revised treatment of potential exposures associated with
OTC derivatives that it was unable to include in Basel II.

The Committee has benefited greatly from its ongoing and extensive
dialogue with industry participants. As a means of continuing this productive
interaction, it will look for enhanced opportunities for the industry to assist in
the development of proposals for aligning regulatory capital requirements
with sound industry practice. Future exchanges of views between banks and
supervisors on developments in risk management will help the Committee to
make decisions that will keep the new framework relevant for years to come.

Cross-border implementation

Effective supervision of large banking organizations necessarily entails a

closer more co-operative partnership between industry participants and
supervisors. Under the New Accord, cross-border issues are likely to receive
even greater attention than they do today.

The Committee believes existing cross-border responsibilities of supervisors,

as set out in the Basel Concordat and Minimum Standards documents will
continue to apply as the New Accord is being implemented. Nevertheless,
the New Accord will require enhanced cooperation between supervisors on a
practical basis, especially for the cross-border supervision of complex
international banking groups. In particular, the Committee believes that,
wherever possible, supervisors should avoid performing redundant and
uncoordinated approval and validation work in order to reduce the
implementation burden for banks, and to conserve supervisory resources.
Consequently, in implementing the New Accord, the Committee believes that
supervisors should communicate as clearly as possible to affected banking
groups about the respective roles of home- and host-country supervisors so
that practical arrangements are understood.
Cross-border implementation of the New Accord will not change the legal
responsibilities of supervisors for the regulation of their domestic banking
organizations and the arrangements of consolidated supervision. This said,
the Committee recognizes that home country supervisors may not have the
ability alone to gather the information necessary for effective
implementation of the revised Accord. Consequently, the AIG is developing a
set of principles to facilitate closer practical co-operation and information
exchange among supervisors.

The Committee broadly supports the principle of “mutual recognition” for

internationally active banks as a key basis for international supervisory co-
operation. This principle implies the need for recognizing common capital
adequacy approaches when considering the branching of internationally-
active banks into host jurisdictions, as well as the desirability of minimizing
differences in the national capital adequacy regulations between home and
host jurisdictions so that subsidiary banks are not subjected to excessive
burden.