BAMAMFI REVIEWER (MIDTERMS)
TOPIC 1: BASEL 1, 2, and 3
Bank of International Settlements (BIS)
• Established in 1930
• World’s oldest international financial organization
• Central bank of central bank
• HQ at Basel, Switzerland
• Governed by a Board of Directors (19) and Exec Comm.
Roles
• Provides currency deposits to central banks
• Provides investment services to central banks
• Provides short term credits to central banks (usually on collateral basis)
• Forster cooperation among central banks and other agencies in pursuit of
monetary and financial stability
Basel Committee on Banking Supervision (BCBS)
• Founded in 1974 to ensure international cooperation among its members
• One of its best known publication is commonly referred to as the Basel
Capital Accord (BASEL 1), published in 1988
• BASEL 2 was published in June 2004 and become applicable in member
countries starting year-end 2006
BASEL 1, 2, 3
Basel 1
Basel I is a set of international banking regulations put forth by the
Basel Committee on Bank Supervision (BCBS) that sets out the minimum capital
requirements of financial institutions with the goal of minimizing credit risk.
Aimed to achieve better international supervisory standards for the
capital adequacy of internationally active banks (standardized the computation of
risk-based capital across banks and across countries). It is now applies in more than
100 countries around the world.
Made by: Your True Friend
Reasons for Creation of BASEL 1
• Increased Exposure of Banks
o Rapid increase in the size of banks of member countries’ exposures
for both on-balance and off-balance sheet items
• Lack of Common Regulatory Environment
o Formation of a level playing field among banks from different
countries
From 1950 to 1981 there were about six bank failures (or bankruptcies) per
year in the United States. Bank failures were particularly prominent during the
1980s, an era that is often referred to as the "savings and loan crisis."
As a result, the potential for the bankruptcy of the major international
banks because grew as a result of low security. 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. In 1988,
the Basel I Capital Accord was created.
KEY TAKEAWAYS
• Help strengthen the soundness and stability of the international banking
system
• Provide a common regulatory framework among international banks
• Basel I, followed by Basel II and III, laid a framework for banks to mitigate
risk as outlined by law.
• Basel I is considered too simplified, but was the first of the three "Basel
accords."
• Banks are classified according to their risk and are required to maintain
emergency capital based on that classification.
• Basel I is a set of international banking regulations that lay out the
minimum capital requirements for financial institutions with the goal of
minimizing credit risk and promoting financial stability,
 • To comply with Basel I, banks that operate internationally are required Risk Weight Assets of BASEL 1
to maintain a minimum amount (8%) of capital based on a percent of risk- The Basel I classification system groups a bank's assets into five risk
weighted assets. categories, classified as percentages: 0%, 10%, 20%, 50%, and 100%. A bank's assets are
• Basel I was seen as too simplistic and broad, and so was followed by Basel placed into a category based on the nature of the debtor.
II, and III, and together as the Basel Accords.
Category 1 (0%)
The 0% risk category is comprised of cash, central bank and government
BASEL l Framework debt, and any Organization for Economic Cooperation and Development (OECD)
government debt. Exposures deemed to bear no credit risk (those claims on central
governments with the highest credit quality). Public sector debt can be placed in
the 0%, 10%, 20% or 50% category, depending on the debtor.
Market Risk*
Credit Risk
Standardized Approach
Standardized Approach Category 2 (20%)
Internal Models
Cash items in the process of collection. Exposures like those claims on
banks incorporated in OECD countries and claims on other banks with a residual
*Added into BASEL 1 in 1996 maturity of up to one year. Development bank debt, OECD bank debt, OECD
securities firm debt, non-OECD bank debt (under one year of maturity), non-OECD
The basic achievement of Basel I has been to define bank capital and the public sector debt and cash in collection comprises the 20% category.
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 Category 3 (50%)
of capital was required. Indeed, before this international agreement, there was no The 50% category are loans fully secured by mortgages on residential
single definition of bank capital. The first step of the agreement was thus to define property that is rented or occupied (or intended to be) by the borrower.
it.
Category 4 (100%)
Risk-Based Capital Framework of BASEL l
The 100% category is represented by private sector debt, non-OECD bank
debt (maturity over a year), real estate, plant and equipment, and capital
Capital
100% Different risk
Risk
weights
Risk weights
charge instruments issued at other banks.
risk weight weights for Depend on
0% - 100% depends on Depends on
for all Different Internal
external Credit risk
Ratings
assets Asset class
ratings (PD/LGD)
modeling All other on-balance sheet assets not listed above, including loans to
private entities and individuals, some claims on non-OECD governments and banks,
real assets, and investments in subsidiaries, and all other types of claims or asset
1. OECD non OECD countries
types that represents a large proportion of a bank’s balance sheet.
2. OECD non OECD incorporated banks
3. Residential mortgage
4. Others

Made by: Your True Friend

Three-Tiered Capital Framework
The Basel I agreement defines capital based on three tiers:
BASEL l Capital Framework
Regulatory Capital
Tier 2 Capital – Upper Level
Tier 1 Core Capital
Tier 2 Supplementary Capital
Upper Tier 2 Supplemental Capital
Lower Tier 2 Supplemental Capital
• Paid-up perpetual and cumulative preferred stock and its distributable
dividends
• Paid-up limited life redeemable preferred stock
• Appraisal increment reserve – bank premises
• Net unrealized gains on underwritten listed equity securities purchased
• General loan loss provision
• With prior BSP approval, unsecured subordinated debt with a minimum
original maturity of at least ten years
• Deposit for common stock subscription
• Deposit for perpetual and non-cumulative preferred stock subscription

Tier 3 Additional Supplementary Capital

Tier 1 (Core Capital): Tier 1 capital includes stock issues (or shareholder
equity) and declared reserves, such as loan loss reserves set aside to cushion future
losses or for smoothing out income variations.
• Paid-up perpetual and non-cumulative preferred stock and its
distributable dividends
• Paid-up common stock and its distributable dividends
• Surplus and surplus reserves
• Undivided profits
• Minority interest in the equity of subsidiary financial allied undertakings
that are less than wholly owned
These items have the highest capacity to absorb losses while allowing the
bank to continue to operate.
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.
Made by: Your True Friend
Tier 2 – Lower Level
• Paid-up limited life redeemable preferred stock without the replacement
upon redemption and its distributable dividends
• Unsecured subordinated debt with a minimum original maturity of at
least five years
• Deposit for perpetual and non-cumulative preferred stock subscription
• Deposit for limited life redeemable preferred stock subscription with the
replacement upon redemption
These items are inferior compared to Tier 1 and are less able to absorb
losses. Total Tier 2 capital cannot exceed 100% of Tier 1 capital. Lower Tier 2 capital
cannot exceed 50% of Tier 1 capital.
Tier 3 (Additional Supplementary Capital): Capital in which many banks
hold to support their market risk, commodities risk, and foreign currency risk,
derived from trading activities. Tier 3 capital includes a greater variety of debt
than tier 1 and tier 2 capital but is of a much lower quality than either of the
two.

BASEL l Capital Framework
Supervisory Risk Weights
Used for on-balance sheet items
An estimate of the credit risk associated with an
exposure
Expressed as a %
Used to translate the nominal amount of a credit
exposure into a risk-weighted asset (RWA)
Supervisory Risk Weights
and
Conversion Factors
Conversion Factors
For off-balance sheet items, they need to be
converted to credit risk equivalents using credit
risk conversion factors (CCFs) before a risk
weight can be applied
Regulatory Capital
- Intended to ensure a bank can withstand major potential losses without
causing systemic risks
- Composed 3 TIERS
- Each tier represents a certain capacity to absorb losses
- Listing of item in the tiers depends on the criteria set by regulators
Credit risk is defined as the risk weighted asset, or RWA, of the bank,
which are a bank's 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:
• The on-balance-sheet risk
• The trading off-balance-sheet risk: These are derivatives, namely interest
rates, foreign exchange, equity derivatives and commodities.
• The non-trading off-balance-sheet risk: These include general guarantees,
such as forward purchase of assets or transaction-related debt assets.
The 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 Figure 1, based on an 8%
minimum capital ratio. Risk weights assignments under BASEL 1 is crude
• 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 an
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.
• BASEL 1 framework only accounts for credit and market risks, while
operational risk is not included
Credit Conversion Factors - BASEL l
Credit Conversion Factors for Interest Rate and
Foreign Exchange Contracts in Computing
Potential Exposure
Remaining Interest Rate Exchange Rate
Maturity Contracts Contracts

1. Less than one year 0% 1.0%

Pitfalls of Basel I
2. One to five years 0.5% 5.0%

3. Over five years 1.5% 7.5%

Made by: Your True Friend

 Minimum Capital Adequacy Ratios - BASEL l
There are 2 main capital adequacy ratios relating capital
to risk-weighted assets
Minimum Tier l Ratio
Total Core Capital (Tier I)
Total Credit Risk-weighted Assets
Minimum Total Capital Ratio
Total Regulatory Capital (Tier 1 + Tier 2)
Total Credit Risk-weighted Assets
Standardized Approach Basel I
Credit Risk-Adjusted Asset Value of Off-Balance-Sheet
Derivative Securities with Netting
= Net Potential Exposure + Net Current Exposure
4%
Net Potential Exposure
Anet = (0.4 x Agross ) + (0.6 x NGR x Agross )
Where:
Anet - net potential exposure (or adjusted sum of potential future
8% credit exposures)
Agross - sum of the potential exposures of each contract
NGR - ratio of net current exposure to gross current exposure
0.6 - amount of potential exposure reduced as a result of netting

Minimum Capital Adequacy Ratios - BASEL l

In the Philippines (BSP Circular 280)
Minimum Total Capital Ratio
Total Regulatory Capital (Tier I + Tier II) 10%*
Total Credit Risk-weighted Assets
*Equal to existing Philippine standard ratio before
adoption of BIS capital ratio which is to maintain a net
worth to risk assets (NWRA) ratio of at least 10% as per
Sec. 22 of RA No. 337
Net Current Exposure
- net sum of all positive and negative replacement costs (or mark-to-market values
of the individual derivative contracts)
- if the sum of the replacement costs is positive, then the net current exposure
equals the sum
- if it’s negative, the net current exposure is zero.
Basel 2
Basel II is a set of international banking regulations put forth by the Basel
Committee on Bank Supervision, which leveled the international regulation field
with uniform rules and guidelines. Basel II expanded rules for minimum capital
requirements established under Basel I, the first international regulatory accord,
and provided the framework for regulatory review, as well as set disclosure
requirements for assessment of capital adequacy of banks.

This makes it vastly more complex than the original accord. Basel II has multiple
approaches for different types of risk. It has multiple approaches for securitization
and for credit risk mitigants (such as collateral). It also contains formulas that
require a financial engineer.

Made by: Your True Friend

 • Assessments are utilized more to determine regulatory capital by external
Some countries have implemented basic versions of the new accord, but in the credit agency like S&P, Moody’s, Fitch, Phil Ratings
United States, Basel II is seeing a painful, controversial and prolonged deployment
(even as large banks have been working for years to meet its terms). Many of the
problems are inevitable: The agreement tries to coordinate bank capital
Basel II Framework
requirements across countries and across bank sizes. Three
Basic Pillars

The main difference between Basel II and Basel I is that Basel II incorporates credit Minimum capital Supervisory review Market
requirements process discipline
risk of assets held by financial institutions to determine regulatory capital ratios.
Risk weighted Definition of
assets capital
Based on three main pillars: minimal capital requirements, regulatory supervision,
and enhanced disclosure (market discipline). Minimal capital requirements play the Credit risk Operational
risk
Market
risk
Core
Capital
Supplementary
Capital

most important role in Basel II and obligate banks to maintain minimum capital
Basic Advanced
ratios of regulatory capital over risk-weighted assets. Standardised Foundation IRB
Approach Approach
Advanced IRB
Approach
Indicator
Approach
Standardised
Approach
Measurement
Approaches
Standardised
Approach
Internal Models
Approach

• Pillar 1
o Banks should have sufficient regulatory capital for their risk Pillar 1 - Credit Risk
profile
• Pillar 2 Credit Risk
o Banks should assess the risks they are undertaking under
supervision of the central bank Standardized Internal Ratings
• Pillar 3 Approach
(RSA)
Based Approach
(IRBA)

o Banks should be transparent and disclose pertinent information

Foundation Advanced
Approach Approaches
Advantages of BASEL II
• More flexible than BASEL l Securitization
Framework
• Offers list of risk sensitive methods to determine minimum capital
requirements
• Has a supervisory review process for banks to maintain regulatory capital
according to their risk profile
• Transparency by requiring disclosure of pertinent information
• Requires less regulatory capital allocated to higher rated counterparties,
while more for the lower rated counterparties

Made by: Your True Friend

 Pillar 1 - Operational Risk Market discipline is based on enhanced disclosure of risk. This may be an important
pillar due to the complexity of Basel. Under Basel II, banks may use their own
internal models (and gain lower capital requirements) but the price of this is
Operational Risk
transparency.

BASEL ll Regulatory Capital

Advanced
Measurement
Approach

Standardized
Approach

Basic
Indicator
Approach

Basel II Risk-Based Capital Framework

Risk Capital
100% Different risk Risk weights
weights charge
risk weight weights for depend on
0% - 100% depends on Depends on
for all Different Internal
external Credit risk
assets Asset class Ratings
ratings modeling
(PD/LGD)

Standardized IRB
Approach Approach BASEL ll Regulatory Capital
Minimum Capital Risk Weighted
Requirement ≥ 8% of Exposures

Minimum capital is the technical, quantitative heart of the accord. Banks must Market Risk Credit Risk Operational Risk
hold capital against 8% of their assets, after adjusting their assets for risk.
Risk of direct or
Potential that a bank
Risk of losses in on- indirect losses
Supervisor review is the process whereby national regulators ensure their home borrower or counter-
and off-balance sheet resulting from
party will fail to meet
positions arising from inadequate or failed
country banks are following the rules. If minimum capital is the rulebook, the movements in market
its obligations in
internal processes,
accordance with
second pillar is the referee system. prices
agreed terms
people and systems
or external events

Made by: Your True Friend

 Basel II Selected CAR Levels – Loans to sovereigns with an external credit rating of BBB+ to BBB-
– Loans to banks and corporates with an external credit rating of A+ to A-
Country Minimum CAR
Minimum Capital Adequacy Ratio (CAR) of selected countries
Australia 8.0% Category 4 (100%)
Cambodia 20.0% – Loans to sovereigns with an external credit rating of BB+ to B-
Canada 8.0% – Loans to banks with a credit rating of BBB+ to B-
Hong Kong 10.0% – Loans to corporates with a credit rating of BBB+ to BB-
Indonesia 12.0% – All other on-balance sheet assets not listed above, including loans to private
Lebanon 12.0% entities and individuals
Philippines 10.0% – Some claims on non-OECD governments and banks, real assets, and investments in
Singapore 12.0% subsidiaries
South Korea 8.0% – All other types of claims or asset types – representing a large proportion of a
Sri Lanka 10.0% bank’s balance sheet – receive a risk weight of 100 percent which is the standard
Thailand 8.50% risk weight

Risk Weight Assets of BASEL 1 Category 5 (150%)

Category 1 (0%)
– Cash
– Exposures receiving a risk weight of 0% are deemed to bear no credit risk (those
claims on central governments with the highest credit quality)
– Loans to sovereigns with an external credit rating of AA- or better
– Loans to sovereigns, banks, and securities firms with an external credit rating
below B-
– Loans to corporates with a credit rating below BB-
Standardized Approach
Example: Computing Risk-Based Capital Ratios under Basel I

Category 2 (20%) Arizona Bank, a US commercial bank has the following on-balance sheet assets (in millions of USD):
Weight Assets
– Cash items in the process of collection 0% Cash
Balances due from Fed
8
13

– Exposures receiving a risk weight of 20% (those claims on banks incorporated in Treasury bills
Long Term Treasury Securities
60
50
L ng e m g agencie (GNMA ) 42
OECD countries and claims on other banks with a residual maturity of up to one 20% Items in process of collection 10
L ng e m g agencie (FNMA ) 10
year 50%
Munis (general obligation)
University dorm bonds (revenue)
20
34
– Loans to sovereigns with an external credit rating of A+ to A- 100%
Residential 1- 4 family mortgages
AA+ rated loan to Bank of America
308
10

– Loans to banks and corporates with an external rating of AA- or better Commercial loans, AAA- rated
Commercial loans, A rated
55
75
Commercial loans, BB+ rated 390
Commercial loans, CCC+ rated 10
Third World loans, B+ rated 108
Category 3 (50%) Premises, equipment 22
Not Applicable Reserve for loan losses (10)
– Loans fully secured by mortgages on residential property that is rented or Total assets 1,215

occupied (or intended to be so) by the borrower receive a risk weight of 50%
Off-Balance Sheet Items
USD 80 MM in 2 year loan commitments to a large BB+ rated US corporation
100% USD 10 MM direct credit substitute standby letters of credit issued to a BBB rated US corporation

– Other (revenue) municipal bonds 50%

USD 50 MM in commercial letters of credit issued to a BBB- rated US corporation
One fixed-floating interest rate swap for 4 years with notional dollar value of USD 100 MM and replacement cost
of USD 3 MM
One two year Euro $ contract with a replacement cost of USD 1 MM

Made by: Your True Friend

 Standardized Approach Basel I Standardized Approach Basel I and Basel II
Example: Example: Credit risk-adjusted off-balance-sheet assets
Credit
Credit risk-adjusted on-balance-sheet assets = OBS Item Face Value Conversion Factor Equivalent Amount
Two year loan USD 80 MM x 50% = USD 40 MM
0% x (USD 8 MM + USD 13 MM + USD 60 MM + USD 50 MM + USD 42 MM) commitment
Standby Letter USD 10 MM x 100% = USD 10 MM
20% x (USD 10 MM + USD 10 MM + USD 20 MM) of Credit
Commercial Letter USD 50 MM x 20% = USD 10 MM
50% x (USD 34 MM + USD 308 MM) of Credit

100% x (USD 10 MM + USD 55 MM + USD 75 MM + USD 390 MM + USD 10 MM

Credit Equivalent Risk Risk-adjusted Assets
+ + USD 108 MM + USD 22 MM)
OBS Item Amount Weight Amount
Two year loan USD 40 MM x 100% = USD 40 MM
= USD 849 MM
commitment
Standby Letter USD 10 MM x 100% = USD 10 MM
of Credit
Standardized Approach Basel I and Basel II Commercial Letter USD 10 MM x 100% = USD 10 MM
of Credit
Total USD 60 MM
Credit Conversion Factors for Off-Balance-Sheet Contingent or
Guaranty Contracts

100% Sale and repurchase agreements and assets sold with

Standardized Approach Basel I and Basel II
recourse that are not included on the balance sheet
Potential Exposure Conversion Factors for Interest Rate and
100% Direct credit substitute standby letters of credit
Foreign Exchange Contracts
50% Performance related standby letters of credit
50% Unused portion of loan commitments with original Interest Rate Foreign Exchange
maturity of more than one year Remaining Maturity Contracts Contracts
20% Commercial letters of credit
20% Bankers acceptances conveyed 1. Less than one year 0% 1.0%
10% Other loan commitments 2. One to five years 0.5% 5.0%
3. Over five years 1.5% 7.5%

Because banking regulations significantly varied among countries before

the introduction of Basel accords, a unified framework of Basel I and, subsequently,
Basel II helped countries alleviate anxiety over regulatory competitiveness and
drastically different national capital requirements for banks.

The accord recognizes three big risk buckets: credit risk, market risk, and
operational risk. In other words, a bank must hold capital against all three types
of risks. A charge for market risk was introduced in 1998.

Made by: Your True Friend

 - reflects the credit risk if the counterparty to the contract defaults in the
Basel II divides the eligible regulatory capital of a bank into three tiers. future.
The higher the tier, the less subordinated securities a bank is allowed to include - probability of default depends on future volatility of either interest rates for
in it. Each tier must be of a certain minimum percentage of the total regulatory an interest rate contract or exchange rates for an exchange rate contract
capital and is used as a numerator in the calculation of regulatory capital ratios. - potential exposure conversion factors are larger for FX contracts than for
interest rate contracts due to higher volatility for FX contracts
BASEL II Capital Requirement
Current Exposure
Tier 1 Capital Ratio = 4% - reflects the cost of replacing a contract at today’s prices or if a counterparty
Core Tier 1 Capital Ratio = 2% defaults today
- bank computes this replacement cost or current exposure by replacing the rate
or price initially in the contract with the current rate or price for a similar
Difference between total capital of 8% contract and recomputes all current and future cash flows that would have been
and Tier 1 requirement can be met generated under current rate or price terms
with Tier 2 capital - bank discounts any future cash flows to give a current present value measure
of the contract’s replacement costs
Three Tiered Capital - if the contract’s replacement cost is negative (the bank is out-of-the-money and
Tier 1 capital is the most strict definition of regulatory capital that is potentially losing the contract and profits if the counterparty defaults),
subordinate to all other capital instruments, and includes shareholders' equity, regulation requires replacement cost (current exposure) to be set to zero
disclosed reserves, retained earnings and certain innovative capital instruments. - if the contract’s replacement cost is positive (the contract is in-the- money but
it’s harmed if the counterparty defaults, this value is used as the measure for
Tier 2 is Tier 1 instruments plus various other bank reserves, hybrid current exposure
instruments, and medium- and long-term subordinated loans.
Standardized Approach Basel I and Basel II
Tier 3 consists of Tier 2 plus short-term subordinated loans.
Example: Credit Equivalent Amount of Off-Balance-Sheet
Derivative Security Items
Credit Equivalent Amount of Off-Balance-Sheet Derivative
Security Items Type of Potential
Contract Exposure Credit
(remaining Notional Conversion Potential Replacement Current Equivalent
FORMULA maturity) Principal x Factor = Exposure Cost Exposure = Amount

= Potential Exposure + Current Exposure 4 year fixed- USD 100 MM x 0.5% = USD 0.5 MM USD 3 MM USD 3 MM = USD 3.5 MM
floating interest
rate swap

Potential Exposure 2 year forward USD 40 MM x 5.0% = USD 2 MM - USD 1 MM USD 0 MM = USD 2 MM
FX contract

Made by: Your True Friend

Criticisms of BASEL I & II
• Ignores credit risk portfolio diversification opportunities
• Capital adequacy plans are linear risk measures ignoring correlations or
covariances among assets and asset group credit risks like between
residential mortgages and commercial loans
• Each asset is risk-weighted and then add those numbers to get an overall
measure of credit risk
• Covariances among asset risks between different counterparties (or risk
weights) are ignored
• Each country have different tax, accounting, and safety net rules
affecting the comparability of banks of different countries
• Bank lending’s may be reduced due to high risk weights of commercial
loans discouraging banks from lending
• Does not include other risks like FX risks, liquidity risks, interest rate
risks
Basel 3
Basel III is a set of international banking regulations developed by the
Bank for International Settlements to promote stability in the international
financial system. The Basel III regulations are designed to reduce damage to the
economy by banks that take on excess risk.
Basel III is a 2009 international regulatory accord that introduced a set
of reforms designed to mitigate risk within the international banking sector, by
requiring banks to maintain proper leverage ratios and keep certain levels of
reserve capital on hand.
Problems with the original accord became evident during the subprime
crisis in 2007. Members of the Basel Committee on Banking Supervision agreed on
Basel III in November 2010. Regulations were initially be introduced from 2013 until
2015, but there have been several extensions to March 2019 and January 2022.
KEY TAKEAWAYS
Made by: Your True Friend
• Basel III is a set of international banking regulations developed by the
Bank for International Settlements to promote stability in the
international financial system.
• The effect of Basel III on stock markets is uncertain although it is likely
that increased banking regulation will be positive for bond market
investors.
• The ultimate impact of Basel III will depend upon how it is implemented
in the future, but the ideal situation is an overall safer international
financial system.
• Basel III is an international regulatory accord that introduced a set of
reforms designed to improve the regulation, supervision, and risk
management within the banking sector.
• Basel III is an iterative step in the ongoing effort to enhance the banking
regulatory framework.
• A consortium of central banks from 28 countries published Basil III in
2009, largely in response to the credit crisis resulting from the 2008
economic recession.
• Higher Common Equity Required
• Introduction of Leverage Ratio
• Introduction of Framework for Counter-Cyclical Capital Buffers above
the minimum requirement
• Limits Counterparty Risk
• Introduction of Minimum Standards for Funding Liquidity using Short
and Medium Term Quantitative Liquidity Ratios
Basel III, which is alternatively referred to as the Third Basel Accord or Basel
Standards, is part of the continuing effort to enhance the international banking
regulatory framework. On a more granular level, Basel III seeks to strengthen the
resilience of individual banks in order to reduce the risk of system-wide shocks
and prevent future economic meltdowns.
Minimum Capital Requirements by Tiers
Banks have two main silos of capital that are qualitatively different from one
another. Tier 1 refers to a bank's core capital, equity, and the disclosed reserves
that appear on the bank's financial statements. In the event that a bank experiences BASEL III Capital Requirement
significant losses.
Capital conservation buffer of 2.5% is
BASEL III Capital Requirements
on top of Tier 1 capital
• Greater emphasis on common equity part of Tier 1
• Tier 2 simplified Core Tier 1 Capital Requirement will
• Tier 3 eliminated increase from 4% to 4.5%
• Detailed regulatory capital disclosure requirements
• Greater capital requirements for counterparty risks especially derivatives BASEL III Capital Component
• Changes to non-risk adjusted leverage ratio TIER 1
• Steps to improve countercyclical capital framework • Must consist of predominantly common shares and retained earnings
• Definition of Tier 1 moving towards “Tangible Common Equity”*
BASEL III Capital Requirement *FI’s book value after deducting intangible assets, goodwill, preferred equity costs
(essentially assets that would not be worth anything in liquidation)
Tier 1 Capital Ratio = 6% • Going concern capital
Core Tier 1 Capital Ratio (after • Must consist primarily of:
deductions) = 4.5%
BASEL III Capital Requirement Common Equity
+ Retained Earnings
Difference between total capital - Regulatory Adjustments*
requirement of 8% and Tier 1 Tier 1 Capital
requirement can also be met with Tier
2 capital * Deductions on Tangible Assets
• Several innovative Tier 1 instruments like:
Banks required to hold capital o Step-Up Instruments Cumulative Preferred
conservation buffer of 2.5% to o Stock
withstand future periods of turmoil o Trust Preferred Stock
lifting total common equity would be phased out
requirement to 7%
• Minimum requirement will be increased from 2% of risk weighted assets
before deductions under the present rules to 4.5% after deductions
• Overall Tier 1 Capital (including qualifying subordinated debt instruments)
will increase from 4% to 6%
• Both changes will be phased in by January 1, 2015
Made by: Your True Friend
 By contrast, Tier 2 refers to a bank's supplementary capital, such as
Tier 1 capital provides a cushion that allows it to weather stress and undisclosed reserves and unsecured subordinated debt instruments that must have
maintain a continuity of operations. an original maturity of at least five years.

Basel III likewise introduced leverage and liquidity requirements aimed at

Total Capital safeguarding against excessive borrowing, while ensuring that banks have
• Total Capital will be maintained at 8% of risk weighted assets sufficient liquidity during periods of financial stress. In particular, the leverage
• But if buffers are added in, the total capital required will increase to ratio, computed as Tier 1 capital divided by the total of on and off-balance assets
10.5% of risk weighted assets by January 1, 2019 minus intangible assets, was capped at 3%.

Hybrid Capital Basel III introduced new requirements with respect to regulatory capital
• Limit types of hybrid instruments qualifying as Tier 1 capital with which large banks can endure cyclical changes on their balance sheets. During
o Due to observation during crisis hybrid instruments did not periods of credit expansion, banks must set aside additional capital. During times
provide sufficient “loss absorbency” during periods of great of credit contraction, capital requirements can be relaxed.
financial stress
The new guidelines also introduced the bucketing method, in which banks
Contingent Capital are grouped according to their size, complexity, and importance to the overall
• Recommends additional studies should be made on contingent capital economy. Systematically important banks are subject to higher capital
requirements.
TIER 2
• Tier 2 Capital will be simplified Basel III and Banks
o Simplified to one single Tier 2 Banks must hold more capital against their assets, thereby decreasing the
o Upper and Lower Tier 2 will be eliminated size of their balance sheets and their ability to leverage themselves. While
o Tier 2 must be subordinated to depositors and general creditors regulations were under discussion before the financial crisis, the events magnified
• Not secured the need for change.
• Not guaranteed
• Have original maturity of 5 years Basel III regulations contain several important changes for banks' capital
• Callable by the issuer only after minimum of 5 years structures. First, the minimum amount of equity, as a percentage of assets,
increased from 2% to 4.5%. There is also an additional 2.5% buffer required, bringing
the total equity requirement to 7%. This buffer can be used during times of
• Tier 3 Capital will be eliminated financial stress, but banks doing so will face constraints on their ability to pay
dividends and otherwise deploy capital.

Made by: Your True Friend

 It is possible that banks will be less profitable in the future due in part An understanding of Basel III regulations will allow investors to understand the
to these regulations. The 7% equity requirement is a minimum, and it is likely that financial sector going forward while also assisting them in formulating
many banks will strive to maintain a somewhat higher figure to give themselves macroeconomic opinions on the stability of the international financial system and
a cushion. the global economy.

If financial institutions are perceived as safer, the cost of capital for Transparency
banks would actually decrease. More stable banks can issue debt at a lower cost. At • Require disclosure of formation of capital
the same time, the stock market might assign a higher P/E multiple to banks that • Separate disclosure of all regulatory adjustments
have a less risky capital structure.
Counterparty Credit Risk
It is likely that increased bank regulation is positive for bond market • Refers to regulatory capital treatment of counterparty credit risk coming
investors. That is because higher capital requirements will make bonds issued by from the FI’s derivatives, repos, and securities financing activities
banks safer investments. At the same time, greater financial system stability will
provide a safer backdrop for bond investors even if the economy grows at a slightly Strengthening Counterparty Credit Risk
slower pace as a result. • Banks should determine capital charges for counterparty credit risks
using stress tests
Basel III and Stock Markets • Capital charge for mark to market losses linked to the deterioration of
Finally, the effect of Basel III on stock markets is uncertain. If investors creditworthiness of the counterparty
value enhanced financial stability above slightly higher growth fueled by credit, • Higher capital charges for over the counter (OTC) exposures to FIs
stock prices are likely to benefit from Basel III (all else being equal). Furthermore,
greater macroeconomic stability will allow investors to focus more on individual Rating Agencies
company or industry research while worrying less about the economic backdrop • Declining reliance on ratings
or the possibility of broad-based financial collapse. • Banks will be required to perform their own internal assessments of
externally rated exposures
Basel III was not expected to be a panacea. However, in combination with other • Banks need to undertake their own risk mitigation measures
measures, the regulations have produced a more stable financial system. In turn,
greater financial stability has spurred steady economic growth. Leverage Ratio
• Supplementary measure
Basel III should result in a safer financial system while restraining future economic • Ratio would require minimum level of capital relative to total assets
growth to a small degree. For investors, the impact is likely to be diverse, but it • Intended to limit overall leverage levels
should result in safer markets for bond investors and greater stability for stock
• Introduce additional safeguards against model risks
market investors.
• Uses simpler measure based on gross exposures
• Capital Measure

Made by: Your True Friend

 Liquidity Coverage Ratio
o Numerator of leverage ratio should consist of only high quality o Ratio will be used to ensure bank maintains adequate levels of
capital unencumbered high quality assets to meet its liquidity needs
• Total Exposure Measure
o Denominator of leverage ratio (total exposures) would be LCR = High Quality Liquid Assets1
determined in accordance with applicable accounting rules
Net Cash Outflows Over a 30 Day Period2
• High quality liquid assets means cash and cash like instruments
• Securitization exposures would be quantified in a manner consistent with
accounting treatment Net Stable
1Cash, BSPFunding Ratio
Reserves that can(NSFR)
be accessed
• Derivatives exposures would be either use the current exposure method during crisis, marketable securities, ROPs
or the applicable accounting method 2C ed g ce a - ff fac
• Other off-balance sheet items are included like: Focuses on medium and long term
o Commitments • Net Stable Funding(over
funding Ratio a year)
o Unconditionally cancellable commitments o Focuses on medium and long term funding (over a year)
o (E.g., credit lines)
o Direct Credit Substitutes NSFR = Available Amount of Stable Funding
Required Amount of Stable Funding
Loan Loss Provisioning
• Promote stronger provisioning practices (Forward Looking Provisioning) o Ratio of available stable funding over required stable funding
must equal or exceed 100%
• Advocates Expected Loss (EL) Approach
• Monitoring Tools
Countercyclical Capital Buffers o Intends to improve assessments of liquidity risks of FIs
o Tools looks at:
• 2.5% of risk weighted assets
§ Contractual maturity mismatch
• Stress Tested Capital Buffers and Capital Distribution Limits
§ Funding Concentration
• Requires use of long term data to estimate default probabilities (PDs)
§ Available unencumbered assets
§ Market related monitoring tools
Capital Buffers
• Requires FIs to hold capital buffers above regulatory minimum capital
Available Stable Funding
requirements
• Available Stable funding refers to total amount of the bank’s capital,
• Requires banks to put up capital conservation standards
preferred stock with a maturity of 1 year or more, liabilities with
• Intended to limit excessive credit growth
maturities of 1 year or more, term deposits with maturity of less than 1
year
Liquidity Ratios
• Liquidity Coverage Ratio

Made by: Your True Friend

Required Stable Funding o Expected Losses
• Sum of value of assets held by the bank, after converting some off- balance - Average credit loss that would be expected from an exposure over a
sheet exposures to asset equivalents, multiplied by a required stable given period of time.
127
funding (RSF) factor reflecting the monetization value of the asset in
times of stress Expected Loss (EL)
Measuring Expected Loss Single Exposure
Impact on Banks =

• Will likely require banks to raise more capital Expected Loss

o Thru asset sales PD

o Thru capital raising 1. What is the probability of a

x
Probability of Default
• Will likely increase cost of capital of FIs counterparty defaulting?
EE
• May limit dividend payments 2. If the counterparty defaults, Expected Exposure x
• May increase funding costs and reduce leverage due to additional charges Wha i he ba e e?
LGD
for various counterparty credit risks
3. How much of the exposure Loss Given Default 128
amount do we expect to lose?

BASEL III Capital Requirement Loss Given Default (LGD)

• Loss Given Default
Total Regulatory Capital Ratio - LGDLGD
is theisestimation
the estimation of the loss
of the expected expected lossthat a default
in the event
in the event that a default occurs.
occurs
= Tier 1 Capital Ratio + Capital
Conservation Buffer + Countercyclical LGD = V - R ( L + A )

Buffer + Capital for Systemically where

LGD = loss given default
Important Banks L = outstanding principal of the loan
A = accrued interest
R = expected recovery rate
TOPIC 2: PFRS 9 V = no-default value of the loan
Bank Accounting
• Adoption of Market Value Accounting Computing ECL under PFRS 9
o Book Value
• Identifying scenarios where a loan or receivable defaults
§ The amount you paid for an asset minus depreciation
• Estimate the cash shortfall that would be incurred in each scenario if a
o Market Value
default were to happen
§ What an asset would sell for in the current market
• Multiplying that loss by the probability of default happening
• Summing the results of all such possible default events
• Adoption of PFRS 9 Impairment of Credit Losses
Made by: Your True Friend
 132 134

Solution:
Example of Expected Credit Loss (ECL) New Concept of Impairment under PFRS 9
Estimated future cash 1,000 Traditional New Concept
flows at initial recognition Approach
assuming borrower pays Total Cash P 110,250 P 110,250
as Anticipated, discounted Flows
a he l a effec i e
interest rate Unearned (P 10,250) (P 6,090)
Interest Income
Estimated future cash flows 100
if borrower defaults, Loan P0 (P 4,160)
discounted Impairment
Cash shortfall 900 Allowance
Probability of default 1% Carrying Value P 100,000 P 100,000 135
of Loan
Expected Credit Loss (ECL) 9 (900 x 1%)
133 Computations
Example of Impairment under PFRS 9 Interest Income
1st year Interest Income = P 100,000 x (1 + 0.05)1
ABC Bank lends P 100,000 for 2 years at 5% = P 5,000
compounded annually with P + I payable at
2 year Interest Income = P 105,000 x (1 + 0.05)1
nd
maturity. Probability of default of borrower is 3%.
= P 5,250
Compute for the 2 year impairment allowance
under PFRS 9. Probability of Default at 3%
1st year Interest Recognized = P 100,000 x 3%
= P 3,000
nd
2 year Interest Recognized = P 103,000 x 3%
CALCU: https://docs.google.com/spreadsheets/d/1MFf-
hWVR0wboUrudU68hdTrCJR8TMW7I3vTIBWGVNo0/edit?fbclid=IwAR0DalT- = P 3,090
7MVFxeB_r0vW-ZO2QK33D6nlOdGLQh3SDPhi42RbPE-KX5uFA-k#gid=0

Made by: Your True Friend

 136

Computations Credit VaR

Impairment Allowance Unexpected credit loss (UCL) at 99.9% level
1st year Impairment Allowance = P 5,000 P 3,000
Deviation from the Expected Credit Loss (ECL)
= P 2,000
2nd year Impairment Allowance = P 5,250 P 3,090
= P 2,160 CVaR = UCL = WCL ECL

Total Impairment Allowance = P 2,000 + P 2,160 where WCL = Worst Credit Loss
= P 4,160

TOPIC: BASEL CREDIT RISK APPROACH- CREDIT VALUE AT RISK (CREDIT VAR)
Unexpected Loss (UL) • 7
Should be viewed as economic capital to be held by bank as buffer against
• Unexpected Loss (UL) or Unexpected Credit Loss (UCL) is the maximum unexpected losses
default loss at the selected level of confidence • CVaR is not additive across obligors nor can it be aggregated over time
Unexpected Loss (UL)
• UCL or UL is also known as the default VaR unlike expected credit loss which is
• Measured over a target horizon like one year which is deemed enough time
Measuring Unexpected Loss Single Exposure for a bank to take corrective actions should credit problems develop at
the bank
Une pected Loss UL E pos re LGD EDF EDF ) • Corrective actions can mean exposure, reduction or adjustment of economic
capital Credit VaR
Unexpected
(assuming a fixed rate loss severity) Loss (UL)
Universal Commercial bank has an outstanding loan of
Measuring Unexpected Loss Portfolio Exposure P 100 million.

Unexpected Loss (UL) % Expected loan losses based on historical data is P 15 million and
N N N
no recovery is expected. Based on the 95th percentile
= w2 2 + wi wj confidence level, loan losses would be P 40 million.
i j i, j
i=1 i=1 i=1

Credit VaR
What would be the Credit VaR or Unexpected Loan Losses?
where
N = number of facilities 5 Credit VaR = Worst Credit Loss Expected Loss
w = weight of the facility in relation to the portfolio
= P 40 million P 15 million
= P 25 million 12

Made by: Your True Friend 6