BASEL II

GHADEER OBEIDAT

Basel II
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Basel Committee proposed new rules in June 1999

that have become known as Basel II.

The new accord has been introduced to keep pace
with the increased sophistication of lenders
operations and risk management and overcome
some of the distortions in Basel I.
Implemented in 2007

USA vs European Implementation

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In US Basel II applies only to large international

banks
Small regional banks required to implement Basel
1A (similar to Basel I), rather than Basel II
European Union requires Basel II to be implemented
by securities companies as well as all banks

Basel II is based on three Pillars

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1. Minimum Capital Requirement

2. Supervisory Review
3. market discipline

Pillar #1:Minimum Capital Requirement

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The capital requirement for market risk remains

unchanged from the 1996 Amendment.

Credit Risk Capital under Basel II

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Three approaches were specified:

1. The Standardized Approach
2. The Foundation Internal Ratings Based (IRB)

Approach
3. The Advanced IRB Approach

The Standardized Approach

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Used by banks that are not sufficiently sophisticated(

in the eye of the regulatory) to use internal ratings

approach.
Similar to Basel I except for the calculation of risk
weights

New Capital Requirements

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Bank and corporations treated similarly (unlike

Basel I)

Example (1)
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Suppose that assets of a bank consist of $100 million

of loans to corporations rated A, $ 10 million of

government bonds rated AAA, and $50 million of
residential mortgages;
The total risk-weighted assets is :
0.5*100 + 0.0*10 + 0.35*50 = 67.5
$ 67.5 million compared to $ 125 million under Basel
I.

Adjustments for collateral

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Two ways banks can adjust risk weights for

collateral:
1. Simple Approach
2. Comprehensive Approach

Simple Approach
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The risk weight of the counterparty is replaced by

the risk weight of the collateral for the part of the

exposure covered by the collateral . For any exposure
not covered by the collateral, the risk weight of the
counterparty is used.

Example(2)
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Suppose that an $80 million exposure to a particular

counterparty is secured by collateral worth $70

million. The collateral consists of bonds issued by an
A-rated company. The counterparty has a rating of
B+. The risk weight for the counterparty is 150% and
the risk weight for the collateral is 50%;
The risk- weighted assets applicable to the exposure is:
0.5*70 + 1.5*10 = 50 or $ 50 million

Comprehensive Approach
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Under the comprehensive approach , banks adjust

the size of their exposure upward to allow for

possible increases in the exposure and adjust the
value of the collateral downward to allow for possible
decreases in the value of the collateral.

For a collateralized transaction, the exposure

amount after risk mitigation is calculated as

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follows:
E*=max{0,[E x (1+He) C x (1-Hc-Hfx)]}
where:

E*= the exposure value after risk mitigation

E = current value of the exposure
He = haircut appropriate to the exposure
C = the current value of the collateral received
Hc = haircut appropriate to the collateral
Hfx = haircut appropriate for currency mismatch between the collateral and
exposure

The exposure amount after risk mitigation will be

multiplied by the risk weight of the counterparty
to obtain the risk-weighted asset amount for the
collateralized transaction.

Continue of Example (2)

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Assume that the adjustment to exposure to allow for

possible future increases in the exposure is + 10%

and the adjustment to the collateral to allow for
possible future decreases in its value is -15% . The
new exposure is ;
1.1*80 0.85*70 = 28.5
Risk adjusted assets = 28.5 * 1.5 = $42.75 million

The IRB Approach

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The model underlying IRB approach is:

The capital required is therefore the value at risk

minus the expected loss.

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Value at Risk is calculated using the one-factor

Gaussian Copula Model.

The 99.9% worst case default rate is:

99.9 % VaR is approximately:

EAD x LGD x WCDR

Numerical Results for WCDR

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The expected loss from default is :

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EAD x LGD x PD
Therefore the capital required is the excess of the
99.9% worst-case loss over the expected loss;
EAD x LGD x ( WCDR PD )

Dependence of on PD
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For corporate, sovereign and bank exposure

1 e 50 PD
1 e 50 PD
50 PD
0.12

0
.
24

0
.
12
[
1

e
]

50
50
1 e
1 e

Capital Requirements
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Capital EAD LGD (WCDR PD) MA

1 (M 2.5) b
where MA
1 1.5 b
M is the effective maturity and
b [0.11852 0.05478 ln( PD)]2
The risk - weighted assets are 12.5 times the Capital
so that Capital 8% of RWA

Example (3)
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Suppose that the assets of a bank consist of $100 million

of loans to A-rated corporations. The PD for the

corporations is estimated as 0.1% and the LGD is 60%.
The average maturity is 2.5 years for the corporate loans.
This means that;
b= [0.11852-0.05478*ln(0.001)]2 = 0.247
So that;
MA = 1/(1-1.5*0.247) = 1.59
So the risk-weighted assets for the corporate loans are
12.5 x 100 x 0.6 x (0.034-0.001) x 1.59 = $39.3 million

Retail Exposures
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Capital EAD LGD (WCDR PD)

For residential mortgages 0.15
For revolving retail exposures 0.04
For other retail exposures

1 e 35PD
1 e 35PD
0.03
0.16 1

35
1 e
1 e 35

0.03 0.13e - 35 PD
There is no distinction between Foundation and Advanced IRB approaches.
Banks estimate PD, LGD, and EAD in both cases

Guarantees
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Traditionally the Basel Committee has used the

credit substitution approach (where the credit rating

of the guarantor is substituted for that of the
borrower)
However this overstates the credit risk because both
the guarantor and the borrower must default for
money to be lost
Alternative proposed by Basel Committee: capital
equals the capital required without the guarantee
multiplied by 0.15+160PDg where PDg is probability
of default of guarantor

Operational Risk Capital Under Basel II

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There are three approaches to calculating capital for

operational risk:
1. The Basic Indicator Approach
2. The Standardized Approach
3. The Advanced Measurement Approach

Pillar # 2: Supervisory Review

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Four key principles of supervisory review are specified:

1. 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.
2. Supervisors should review and evaluate banks internal capital
adequacy assessments and strategies, as well as their ability to
monitor and ensure compliance with regulatory capital ratios.
3. Supervisors should expect banks to operate above the minimum
regulatory capital and should have the ability to require banks to
hold capital in excess of this minimum.
4. 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.

Pillar # 3:Market Discipline

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Concerned with increasing disclosure by a bank of its risk assessment

procedures and capital adequacy.

Among items that banks should disclose are:

1. The entities in the banking group to which Basel II is applied and
2.
3.
4.
5.
6.
7.

adjustments made for entities to which it is not applied

The terms and conditions of the main features of all capital instruments
A list of the instruments consisting Tier 1 capital and the amount of capital
provided by each item
The total amount of Tier 2 capital
Capital requirements for credit,market,and operational risk
Other general information on the risks to which a bank is exposed and the
assessment methods used by the bank for different categories of risk
The structure of the risk management function and how it operates

Solvency II
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It is regulations for insurance companies.

It considers calculating capital for investment risks and

operational risks as well unlike Solvency I which

calculates capital only for underwriting risks.
Similar three pillars to Basel II
Pillar I specifies the minimum capital requirement
(MCR) and solvency capital requirement (SCR)
If capital falls below SCR the insurance company must
submit a plan for bringing it back up to SCR.
If capital; drops below MCR supervisors are likely to
prevent the insurance company from taking new
business

There are two ways to calculate the SRC:

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The standardized approach

Internal model approach(IMA)

The IMA involves a VaR calculation with a one year

time horizon and a 99.5% confidence limit.

The SCR involves a capital charge for investment risk(market

,credit), underwriting risk(risk arising from life insurance , nonlife insurance, health), and operational risk.
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