BASEL II THE NEW ACCORD

CHAPTER 16

Learning Objectives

Scope of Application of Accord Minimum capital requirements for credit risk

Credit risk mitigation

The standardized approach The internal ratings based approach Corporate, sovereign and bank exposures under IRB Retail exposures under IRB Equity exposures under IRB CRM under the standardized approach CRM under the foundation approach CRM under the advanced approach

Management of Financial Institutions by Dr. Meera Sharma

Learning Objectives

Minimum capital requirements for operational risk

Basic indicator approach Standardized approach Advanced measurement approaches

The second pillar supervisory review The third pillar market discipline

Management of Financial Institutions by Dr. Meera Sharma

The new Basel accord

Basel II
Pillar 1 Minimum Capital Requirements

Credit risk Standardized approach IRB foundation approach IRB Advanced Approach

Pillar 2 (new) Supervisory Review Process Operational risk

Increasing sophistication

Pillar 3 (new) Market Discipline

Market risk
Standardized measurement method Internal models approach

Basic Indicator Approach Standardized approach Advanced measurement approach

Management of Financial Institutions by Dr. Meera Sharma

The new Basel accord

Capital adequacy ratio (CAR) = Regulatory capital (Tier I + Tier II) / Total risk weighted assets

Management of Financial Institutions by Dr. Meera Sharma

The new Basel accord

Total risk weighted assets =

Risk weighted assets for credit risk + 12.5(Capital required for market and operational risks)

Management of Financial Institutions by Dr. Meera Sharma

MINIMUM CAPITAL FOR CREDIT RISK

The Standardized Approach The risk weights depend on the credit assessments of an external credit assessment institution

Management of Financial Institutions by Dr. Meera Sharma

MINIMUM CAPITAL FOR CREDIT RISK

The Standardized Approach

of AAA to AA0% A+ to A20% BBB+ to BBB50% BB+ to B100% Below B150% Unrated 100%

Claims on sovereigns and their central banks Credit Assessment sovereign Risk weight Claims on corporates Credit assessment corporate Risk weight of AAA to AA20% A+ to A50% BBB+ to BB100% Below BB150% Unrated 100%

Claims included in the regulatory retail portfolios Risk weight Claims secured by residential property Risk weight Claims secured by commercial real estate Risk weight
Management of Financial Institutions by Dr. Meera Sharma

75%

35%

100%

MINIMUM CAPITAL FOR CREDIT RISK

The Internal Approach

Ratings

Based

The internal ratings based approach allows banks to use their internal estimates of probability of default, loss given default rate, exposure at default and effective maturity subject to approval by the regulator

Management of Financial Institutions by Dr. Meera Sharma

MINIMUM CAPITAL FOR CREDIT RISK

The Internal Ratings Based Approach The IRB approach categorizes exposures in the banking book as follows:

Corporate, Sovereign, Bank, Retail and Equity

Management of Financial Institutions by Dr. Meera Sharma

MINIMUM CAPITAL FOR CREDIT RISK

Risk Components Probability of Default Exposure at Default Maturity Loss given default rate

Risk Weight Function provided by the Accord

Unexpected loss = Capital requirement

Management of Financial Institutions by Dr. Meera Sharma

MINIMUM CAPITAL FOR CREDIT RISK

CREDIT RISK MITIGATION

Credit risk mitigation under standardized approach

Financial collateral Simple approach Rating of collateral substitutes rating of counterparty

Credit derivatives and guarantees Rating of guarantor Comprehensive substitutes rating of approach counterparty Exposure amount is adjusted through haircuts Own estimates of haircuts

On-balance sheet netting of loans and deposits Comprehensive approach for financial collateral used with adjustments

Standard supervisory haircuts

Management of Financial Institutions by Dr. Meera Sharma

MINIMUM CAPITAL FOR OPERATIONAL RISK

Basic Indicator Approach The Standardized Approach Advanced Measurement Approaches

Management of Financial Institutions by Dr. Meera Sharma

THE SECOND PILLAR SUPERVISORY REVIEW PROCESS

The four principles of supervisory review laid down in the second pillar to guide supervisors in their review process are laid out below:

Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels. Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.

Management of Financial Institutions by Dr. Meera Sharma

THE SECOND PILLAR SUPERVISORY REVIEW PROCESS

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. Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

Management of Financial Institutions by Dr. Meera Sharma

THE SECOND PILLAR SUPERVISORY REVIEW PROCESS

Risks not captured fully by pillar Risks not covered under pillar I Risks external to the bank not covered under pillar I Compliance by bank with minimum standards

Management of Financial Institutions by Dr. Meera Sharma

THE THIRD PILLAR MARKET DISCIPLINE

The disclosure requirements encompass the following broad areas:

Scope of application of the accord Capital structure of bank Capital adequacy of bank Credit risk disclosures including credit risk mitigation Counterparty credit risk disclosures Disclosures for securitized exposures Market risk disclosures Operational risk disclosures Disclosures for equity risk in the banking book Disclosures for interest rate risk in the banking book
Management of Financial Institutions by Dr. Meera Sharma