International Convergence of Capital Measurement & Capital Standards

Basel II Understanding the framework

Basel II
International Convergence of Capital Measurement and Capital Standards
(A revised framework, June 2004)

Is a European standard It will be difficult for banks to be internationally active and competitive unless they comply with these standards Is complex and will take time to achieve Yes, the OECD countries will be initial beneficiaries

Let us look at the basic drivers

Business / economic rationale driving regulatory evolution

Banks need Capital

Need for Capital

To fund a banks need for intrastructure Capital position acceptable to depositors
shareholder willingness to put own funds at risk

Capital is needed to deal with losses

when revenue from asset shrinks capital provides cushion to continue servicing

Losses come from the manifestation of Risk

Credit Risk Operations Risk Market Risk ALM Risks: Interest Rate Risk, Liquidity Risk
Transaction Risk Exchange Risk Economic Risk Political Risk These are subsidiary risks that impact/ are subset of primary risk groups Mentioned above

Strategic Risk Reputational Risk

Enterprise wide impact

Types of Loss
Expected Loss Unexpected Loss

Economic Loss Accounting Loss

Treatment of Expected Loss

Treatment of Unexpected Loss

Need for Capital is to meet the loss If EL is not treated in a commercially acceptable manner, subject to regulatory review, EL should receive same consideration as UL.

Capital Adequacy Measure

Capital Base How much of this base can be loan capital Risk weighted assets on the balance sheet CB/RWA= Risk Asset Ratio Tier 1 Capital : Equity + free reserves Tier 2: undisclosed reserves, subordinate 50% of Tier 1 can be sub debt Tier 2 cannot exceed Tier 1

Capital Adequacy Norms

Tier one/ Primary Capital Tier two /Secondary Capital which can include loan capital: capital issues the terms of issue of which are such that it behaves exactly like equity, giving preference to depositor money: subordinated debt

Capital Adequacy Ratio

Should be 8/9% (CB/RWA) The higher it is, the safer the bank is The higher it is, the more is idle capital and so, lower is the profitability The lower it is, the higher is profitability but higher is the risk This adds to the drive toward non-capital consuming (fee) income opportunities

Return on Capital
Shareholders seek return on capital Enhancing return requires greater interest income: which itself requires greater capital You need to find sources which consume less capital Or reduce the capital you need for your current activities

RISK MANAGEMENT
RISK TYPES
RISK EVENT WITHIN THE TYPE
EXPECTED LOSSES

FACTORED INTO BUSINESS Analyse Monitor Mitigate Review

NOT FACTORED

UNEXPECTED LOSS

Use Basel II, RBI defined Metrics to provide Capital charge

Capital Adequacy Under the Old / First Accord

Total capital (unchanged) Risk Weighted Assets

= The banks capital ratio 8/9%

Capital Adequacy under first accord

Risk weights for different facilities
Funded limits: 100% of Rs. 100 = Rs 100 Usance l/cs 50% of Rs. 100 = Rs 50 Sight l/cs 20% of Rs. 100 = Rs 20 Total of risk weighted assets
(as against total assets of Rs. 300)

= Rs 170

The shortcomings of this approach

It goes only with the facility not with the quality of a borrower So capital weight for a good borrower is same as for a bad borrower Which implies unexpected losses would be the same Does not take into account other events that cause loss: market risk, operations risk

Capital Adequacy Under the Old / First Accord

Total capital (unchanged) Risk Weighted Assets

= The banks capital ratio 8/9%

Capital Adequacy Under the New / Basel II Accord

Total capital (unchanged) Credit Risk + Market Risk + Operational Risk

= The banks capital ratio 8/9%

A bank will determine the proportion of its capital that it must keep in reserve based on this calculation:

Total capital (unchanged)

= The banks capital ratio 8/9%

Credit Risk + Market Risk+ Operational Risk

Credit Risk Banking Book The credit risk element of the denominator is the risk-weighted assets. The risk-weighted assets are calculated through either the Standardised, or the Internal Ratings Based (IRB) approaches. Market Risk Trading Book The market risk element of the denominator is the market risk requirement relating to trading books.
These rules were introduced in the 1996 Market Risk amendment to Basel 1 and are unchanged under Basel 2.

Operational Risk The operational risk element of the denominator is the operational risk requirement which can be calculated using either the Basic Indicator, the Standardised of Advanced Measurement Approaches

Emergence of risk sensitive environment

Events Complexity of products Complex financial organisations Technology and related systems reliance Exposure to other currency zones Exposures in other economic / political zones Increase in volumes Outsourcing and related issues

Risk Sensitivity
Started with regulators Regulations have deeper economic and fundamental reasons Awareness amongst banks that profits must be regarded in a risk reward context

Risk Management
Identify analyse and manage risks Eliminate risks you do not like Identify risks you are going to take Determine components of risk Monitor the risk you are taking-thru compo Ensure you earn in proportion to the risk you run

RBIs stipulations
Judicious mix of both sides Provides adequate wider framework Does not use the BCBS framework out of context, in fact sets the tone on a wider context Is getting banks to move on both sides Moving on both sides of the piece is essential for truly meeting international standards Quality of regulatory environment is recognised under Basel II as one of the determinants

The overall approach is statistically intense as an exercise

But is driven by business issues Till you handle the business issues you cant go for the measurement issues That is indeed RBIs approach

Structure of New Basel Accord

Pillar 1 Minimum capital requirements Pillar 2 Supervisory review
Supervisors to review

Pillar 3 Market discipline

Detailed disclosure

Establishes minimum

standards for management of capital on a more risk-sensitive basis

banks internal capital assessment

Supervisors should have

requirements and recommendations

Capital

Market + Credit + Operational

Credit Risk Mitigation &

power to set capital ratio above the minimum

Supervisors should

Securitisation related issues are addressed in the Accord

intervene at an early stage

The new capital accord will place greater reliance on internal modeling, used by all world class banks to calculate economic capital.

Methodologies
Standard Approach
If a bank was to do nothing but start on Basel II Cannot meet statistically demanding reqmts

Foundation / Basic Approach

Some of the issues can be addressed

Advanced approach
Internal processes are refined / defined Data availability BCBS criteria are fully met

Business Structure

Ability to define Each business line

Business Line Processes & Methods

Business Line Risk Management

Empirical evidence and Data For refining existing methods

Risk Events Losses Loss Data

RBI Stipulations
Basic method But in preparation is asking banks to address all business issues that will enable the banks to go for advanced approach That is indeed the role of the regulator

Credit Risk
There is adequate experience in India, perhaps more than most countries The emphasis is on reorganising the business Putting a structure to credit processes Adopt rating methodologies Work out capital allocation based on rating: external or internal

 There are two broad methodologies for calculating credit risk capital. Internal Ratings Based Approach Increasing sophistication Internal Ratings Based Approach
Calculate risk-weighted assets for banking books using ratings generated from internal rating systems. Risk weights are calculated using specific risk measures Probability of Default (PD) Loss Given Default (LGD) Exposure at Default (EAD) Banking book exposures are divided into six categories: Sovereigns, Banks, Corporate, Retail Equity and Purchased Receivables

Advanced PD, LGD, EAD and Maturity (M)are measured internally. This varies slightly between categories of exposures.

Internal Ratings Based Approach Foundation Depending on the exposure category, PD is measured internally LGD and EAD are provided by the banking regulator

Standardised Approach
Calculate risk-weighted assets for banking books for sovereigns, banks and corporates using ratings from external credit assessment institutions e.g. Standard & Poors, Moodys, Fitch.

Considerations
Risk Weight Credit Risk Mitigants
Collateral taken reduces the exposure What is acceptable collateral

Exposure Adjustments
Drawn, undrawn Committed, uncommitted

Risk Weights for Corporate, sovereign, bank and Retail exposures under revised Standardized Approach
Risk weightings by credit assessment

Credit assessment Claims on Sovereign Banks Corporates Retail Residential mortgage Commercial mortgage Past due loans1 with specific provisions: Less than 20% More than 20% More than 50% 150% 100% 100%/50%2 150% 100% 100%/50%2 150% 100% 100%/50%2 150% 100% 100%/50%2 150% 100% 100%/50%2 150% 100% 100%/50%2 AAA to AA0% 20% 20% N.A. N.A. N.A. A+ to A20% 50% 50% N.A. N.A. N.A. BBB+ to BBB50% 50% 100% N.A. N.A. N.A. BB+ to B100% 100% 100% N.A. N.A. N.A. Below B150% 150% 150% N.A. N.A. N.A. Unrated 100% 50% 100% 75% 35% 100%

90 days or more past due (applies only to unsecured exposure net of provisions) Can be reduced to 50% at national discretion

Basel IIs revised risk weightings under the standardized approach demonstrate a greater degree of risk sensitivity than Basel I
Note: For additional details please refer to Part . or page of the consultative document The New Basel Capital Accord

Business Issues in IRB

Define lending business in following categories
Corporate Sovereign Bank Retail Equity

Determining Capital Charge

PD LGD EAD M

K = fn (PD, LGD, EAD, M) It is a regression equation

Credit Rating Internal (Business Issue)

Rating System Design

Rating Systems Operations

Corporate Governance and Oversight Risk Quantification Validation of Internal Estimates Supervisory LGD & EAD Estimates

Calculation of Capital Charges for Equity Exposures

Disclosure Requirements

Retail exposures
For Retail exposures, there is only one type of IRB approach for all exposures:
Exposures are assigned an internal rating based on both the borrower and facility characteristics Exposures with similar ratings are grouped together into segments or pools and the risk components are then determined for each pool rather than for each exposure.

Retail exposures
Exposure

Borrower Characteristic

Facility Characteristic

Rating

Segment 1 PD1, LGD1

Segment 2 PD2, LGD2

Segment 3 PD3, LGD3

Segment 4 PD4, LGD4

Retail risk components

Internally measured The bank must estimate an average PD for each internal risk segment To estimate the average PD, the bank must consider the following: Internal loss experience Mapping to external data sets (if internal data is scarce) Statistical loss models (for the forward looking aspect)

PD

LGD

Internally measured The bank must estimate an LGD for each internal risk segment For retail products with uncertain future exposures, e.g. credit cards, the history

and or expectation of additional drawings prior to default must be taken into consideration when calibrating loss estimates

EAD

Internally measured The bank must estimate EAD for each transaction For on balance sheet items, EAD must be estimated at no less than the current

drawn amount

Non-retail exposures
For non-retail exposures there are two approaches Foundation and Advanced. For both approaches:
Each borrower is assigned an internal rating or borrower grade A grade is defined as an assessment of borrower risk on the basis of a specified and distinct set of rating criteria There must be at least six different grades for good loans and at least one grade for defaulted loans Exposures are then assigned to a borrower grade There must be a meaningful distribution across the borrower grades Risk components are determined for each exposure

Definition
The possibility of loss to a bank caused by changes in the market variables.

The risk that the value of

on or off balance sheet positions will be adversely affected by movements in
interest rate markets equity markets currency exchange rates commodity prices.

Trading Book covers

Securities included under the Held for Trading category Securities included under the Available for Sale category Open gold position limits Open foreign exchange position limits Trading positions in derivatives, and Derivatives entered into for hedging trading book exposures.

Two components of risk exposure on Trading book

Counterparty risk: credit risk

Market Risk

Interest rate/ equity / currency / commodity risks

Put briefly
Just as you need to set aside capital for loss due to NPAs You are asked to set aside capital for losses due to change in value of your investment book

How determine probability of loss in investment book?

An intuitive understanding of duration

If interest rates are moving today, over what period will I be able to reprice my balance sheet to meet todays cost structure All deposits must expire, renew at new rates All advances must expire, renew, new rates When will this happen? Over a prd of time The average of that period of time= duration

Investment Risk/VAR
Value of the investment portfolio that is exposed due to possible changes in mkt rate Probability that mkt rates will change Impact of that on the portfolio value=VAR Over what time period What percent confidence interval

Modified duration is used to arrive at the price sensitivity of an interest rate related instrument. For all the securities listed below, date of reporting is taken as 31/3/2003. (Rs. in crore) Party Maturity dt Govt. 01/03/2004 Govt. 01/05/2003 Govt. 31/05/2003 Govt. 01/03/2015 Govt. 01/03/2010 Govt. 01/03/2009 Govt. 01/03/2005 Banks 01/03/2004 Banks 01/05/2003 Banks 31/05/2003 Banks 01/03/2006 Banks 01/03/2007 Others 01/03/2004 Others 01/05/2003 Others 31/05/2003 Total Val 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 1500 Coup Charge 12.50 0.84 12.00 0.08 12.00 0.16 12.50 3.63 11.50 2.79 11.00 2.75 10.50 1.35 12.50 0.84 12.00 0.08 12.00 0.16 12.50 1.77 11.50 2.29 12.50 0.84 12.00 0.08 12.00 0.16 Rs 17.82 equals Rs 198 crores in val

A bank will determine the proportion of its capital that it must keep in reserve based on this calculation:

Total capital (unchanged)

= The banks capital ratio 8/9%

Credit Risk + Market Risk +

Operational Risk
Credit Risk Banking Book The credit risk element of the denominator is the risk-weighted assets. The risk-weighted assets are calculated through either the Standardised, or the Internal Ratings Based (IRB) approaches. Market Risk Trading Book The market risk element of the denominator is the market risk requirement relating to trading books.
These rules were introduced in the 1996 Market Risk amendment to Basel 1 and are unchanged under Basel 2.

Operational Risk The operational risk element of the denominator is the operational risk requirement which can be calculated using either the Basic Indicator, the Standardised of Advanced Measurement Approaches

Operational Risk

Defined
the risk of loss
resulting from inadequate or failed Internal processes, people systems or Resulting from external events.

Includes legal risk Excludes strategic, reputational risk

Broad categories
Internal fraud. For example, intentional misreporting of positions, employee theft, and insider trading on an employees own account. External fraud. For example, robbery, forgery, cheque kiting, and damage from computer hacking. Employment practices and workplace safety. For example, workers compensation claims, violation of employee health and safety rules, organised labour activities, discrimination claims, and general liability. Clients, products and business practices. For example, fiduciary breaches, misuse of confidential customer information, improper trading activities on the banks account, money laundering, and sale of unauthorised products.

 Damage to physical assets.

For example, terrorism, vandalism, earthquakes, fires and floods.

Business disruption and system failures.

For example, hardware and software failures, telecom problems, and utility outages.

Execution, delivery and process management.

For example: data entry errors, collateral management failures, incomplete legal documentation, and unauthorized access given to client accounts, non-client counterparty misperformance, and vendor disputes.

Risk enhancers
Highly Automated Technology - transforms risks from manual processing errors to system failure risks Emergence of E- Commerce internal and external fraud and system securities issues) Emergence of banks as large volume service providers creates the need for continual maintenance of high-grade internal controls and back-up systems. Outsourcing Large-scale acquisitions, mergers, de-mergers and consolidations test the viability of new or newly integrated systems. Banks may engage in risk mitigation techniques (e.g. collateral, derivates, netting arrangements and asset securitisations) to optimise their exposure to market risk and credit risk, but which in turn may produce other forms of risk (eg. legal risk). Fee products are typically transaction / ops risk intensive

RBI stipulations on ORM

Organisational set-up and Key responsibilities for Operational Risk Policy requirements and strategic approach Identification and Assessment of Operational Risk Monitoring of Operational Risk Controls / Mitigation of Operational Risk Independent evaluation of Operational Risk Management
Business Structure

Organisation reqmts
Board of Directors Risk Management Committee of the Board ORM Committee ORM Department Operational Risk Managers Support Group for operational risk management
Business Structure

Capital requirements
measurement issue

Basic approach Standardised Advanced

Basel requirements
RBIs document essentially follows Basels recommendations for following the Advanced approach But on the capital side, follows the Basic approach

Clear signal of intent of the regulator to adopt fully international standards