Basel

Basel 1 - Introduction
• The Basel Committee is part of the Bank of International Settlements (BIS)
located in Basel, Switzerland. BIS acts as a bank for central banks and
co-ordinates global measures for banking supervision. See:
http://www.bis.org/bcbs/index.htm
• It was set up in 1974 by G10 members following the Herstatt Bank failure,
which underlined how interdependent the financial system was to the
failure of an individual bank.
• By the late 1980s, there was growing recognition that a uniform global
standard on capital adequacy was needed. This followed concerns with
low levels of capital adequacy across the global banking system,
notably at major US and Japanese banks.
• In 1988, the Ctteeagreed the Basel I Accord which introduced a provisional
threshold of 8% for a new ‘BIS ratio’, calculated as capital / risk
weighted assets. Prior to this capital rules had varied wildly across
jurisdictions, often using simple leverage measures. Although the new
BIS ratio only applied to G10 member banks it was rapidly taken up by
jurisdictions outside the G10.
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 Basel 1 - Calculation
• Capital would broadly equal tangible shareholders equity. Because
Japanese banks had very low solvency, however, subordinated debt and
general provisions were allowed up to 50% of capital, leading to the Tier
1 anTier 2 distinction. This distinction became further complicated with
the emergence of hybrid debt.
• Risk weighted assets addressed only credit risk and was calculated by
applying simple weightings to exposures – eg 0% for ‘Zone A’
sovereigns, 20% for bank exposure, 50% for residential mortgage-
backed debt, and 100% for standard commercial loans and advances.
• There were many recognised shortcomings in the original Basel framework,
especially that did not cover market risk. This was highlighted by the
Barings collapse in 1995.
• In addition, the simple weightings approach did not adequately reflect
credit risk. For example, Singapore government debt received a 100%
risk weighting while Turkish bank debt received 20% as Turkey was in
Zone A. Nor was there any accounting for collateral. It was felt that
weightings should reflect a bank’s own rating approach, or at least
agency credit ratings.
• Various other risks were not covered – eg operational risk, legal risk.
• Trading book concession -
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 Market risk amendment
• In 1996, the Accord was amended to include a charge for market risk – ie
interest rate, currency, equity and commodity risks. This led to a
distinction between a daily marked trading book and an unmarked
cost-based banking book. Calculation of the trading book capital
requirement focused on using firms’ own internal VAR models to imply
an RWA equivalent. These models would first need to be ‘recognised’ (ie
approved) by local regulators; until then, risks in the trading book would
be subject to tougher standardised treatments. In the EU, the market
risk amendment led to the CAD or Capital Adequacy Directive. Classic
VAR model was JPM’s RiskMetrics 1995.
• http://www.bis.org/publ/bcbs24.pdf?noframes=1,
• Trading book credit risk is covered by interest rate risk, which was
broken down into ‘general risk’ (ie curve risk) and ‘specific risk’ (ie
spread risk). Where a model for specific risk has not been recognised
then an equivalent to the simple banking book weightings approach is
applied. The amount of credit risk charged under the trading book
increased greatly with the proliferation of credit derivatives and
increased market liquidity for bank and corporate debt. In addition
CVAR models became much more sophisticated, especially following the
publication of JP Morgan’s seminal CreditMetrics model in 1997, based
around agency ratings transitions.
• http://www.banque-france.fr/gb/publications/telechar/rsf/2006/etud1_0506.pdf
• http://www.bundesbank.de/download/bankenaufsicht/dkp/200814dkp_b_.pdf
 MRA - VAR models
• VaR defined as maximum expected loss for a given confidence level (eg 99%) and holding period
(eg 10 days).
• Key to VAR is risk diversification– the idea that risky positions in a portfolio will not be perfectly
correlated and therefore the risk of the overall portfolio will be less than the sum of the risks of
the individual positions.
• 3 types –
– Historical – Generate loss distribution from past movements in portfolio valuation. Very
simple. But ‘past is no guide to the future’. Unlikely to be accepted by regulators.
– Variance/covariance model – Construct a portfolio probability distribution based on the
distributions of underlying securities. Theoretically ideal. But covariance terms
between securities rapidly multiply as the number of securities increase. So
individual securities are mapped on to a limited set of risk factors which are then
eigenvectored and a VaR inferred. Still limited to relatively simple underlying
distributions (eg normal, lognormal). EG: JPM RiskMetrics.
– Monte Carlo – Technique which uses brute iterative force to calculate the portfolio
distribution. This is easier and more flexible than parametric VCV as can handle fat
tails, transition matrices and complex stochastic series like GARCH. Three steps (1)
random scenario is generated (eg based on VCV risk factor model, transition
matrices), (2) portfolio valued, and (3) value put on a histogram. Millions of random
generations allow a distribution to be implied. EG: JPM CreditMetrics.
• Some links: http://www.investopedia.com/articles/04/092904.asp,
http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/VAR.pdf,
http://finance.wharton.upenn.edu/~benninga/mma/MiER74.pdf,
http://www.algorithmics.com/EN/media/pdfs/Algo-NF0905-FSR05Sept.pdf
• RiskMetrics/CreditMetrics: http://pascal.iseg.utl.pt/~aafonso/eif/rm/TD4ePt_3.pdf,
http://www.ma.hw.ac.uk/~mcneil/F79CR/CMTD1.pdf
• GARCH model – Generalised Autoregressive Conditional Heteroskedasticity. Means var/cov changes
over time. Popular basis for VaR models as captures shifts in market volatility.
• Stress-testing – Valuing the portfolio under assumed extreme market movements (eg Asian crisis,
50% fall in FTSE, etc). Sometimes scenario testing is distinguished from stress-testing when a
 MRA - VAR regulatory
treatment
• Models only ‘recognised’ following a formal assessment process, which can be
arduous.
• Standard is 10 day VAR at 99%. 10 days is relatively long holding period to be
on the safe side – assumes it can take up to 10 days to trade out of a
position.
• Different models (eg 1 day 97.5%) can be used but must be scaled to 10 day
99%. Holding period typically scaled using a ‘root time’ transformation.
• Charge is higher of previous days VAR or average of last 60 days x ‘multiplier’
(3 or over)
• Multiplier is there as to account for model error, especially in respect of ‘fat tail’
events. Can be scaled up in line with a firms control environment or in line
with back testing / stress testing results.
• Back-testing. Review of daily VAR estimates with outcomes over 1 year (250
trading days). ‘Traffic light system’: green zone<5 exceptions -> OK, yellow
zone: 5-9 exceptions -> uncertain (refer to supervisor), red zone: >9
exceptions -> increase scaling factor by +1.
• Stress testing (or scenario analysis) conducted as a sanity check on the VAR
figure. Scenarios vary.
• Note: Multiplier of 3x considered too lenient in light of credit crunch extreme tail
-> plans to increase by further multiple of 3-4x under Basel 2.5
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• Some links:
 Basel 2 - Introduction
• After years of wrangling, Basel 2 was agreed in June 2004.
http://www.bis.org/publ/bcbs107.pdf?noframes=1
• It was implemented in the EU as the CRD (Capital Requirement Directive).
• The main objectives were to:
– Reform credit risk weightings, making them more risk sensitive and in line with
bank practices
– Introduce a capital charge for operational risk
• Other objectives:
– Harmonize local interpretations of regulatory capital deductions
– Treatment of equity risk in the banking book
• Objective was not to alter the overall level of capital in the system – quantitative ‘QIS’
studies assessing impact of Basel 2 on bank capital requirements were carried out over
2004-2006 to calibrate parameters. EG: QIS 5, http://www.bis.org/bcbs/qis/qis5results.pdf,
http://www.riskprofessional-digital.com/riskprofessional/200904/?pg=39
• 3 Pillars:
– Pillar 1 – the minimum capital charge & calculation of RWA
– Pillar 2 – ‘supervisory review’ – ie national discretion for higher capital charge /
other measures
– Pillar 3 – disclosure – ie banks must make a comprehensive statement on how they
do regulatory capital
• Pillar 1 implemented over transitional period in Europe:
– 2005-2006: Data Collection for Basel 2 (minimum 2 years of data)
– 2007: Basel 2 used for charging, subject to a 95% floor of the Basel 1 charge
– 2008: 90% Basel 1 floor
– 2009: 85% Basel 1 floor
– 2010: Basel 2 on its own, subject to local Basel 1 floors if necessary
• US banks delayed implementation for 2 years, and only applied to ‘internationally active’
banks due to OCC/FDIC resistance. The latter prefer a simpler leverage test, which is
already in operation in the US.
 Basel 2 - Credit Risk
• 3 options:
– Standardised: RWs assigned by credit type (eg bank, govt), ECR & M.
National options.
– Foundation IRB (FIRB): Bank models determine PD, with pre-assigned LGD,
EAD and M
– Advanced IRB (AIRB): Bank models determine PD, LGD, EAD, M

• IRB models based on underlying credit framework determined by rating agencies:

– EL (Expected Loss) = PD (Prob. of Default) x LGD (Loss Given Default) x EAD
(Exp. at Default)
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• Generally, FIRB applied to large corporate loan portfolios, AIRB applied to large retail
portfolios. Anything not covered by an IRB model (eg banking book treasury
assets) get the standardised treatment.
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• IRB versus CVAR models: The key advantage of a CVAR model is the way the portfolio
effect can be modeled, with a reduction in expected loss. IRB models also have
an embedded portfolio effect (iea credit’s correlation factor - R). However, R is
determined by Basel 2 and not at bank’s discretion. R will vary by credit type and
be either fixed (eg4%), or calculated as function of PD, Sales or Assets. In
addition there is no offsetting of risk across portfolio under Basel 2. The IRB
models are therefore not generally as powerful as CVAR models from a portfolio
diversification perspective.
 Basel 2 – Standardised
• approach
Wholesale – tougher!
– Sovereigns: AAA / AA = 0%; A = 20%; BBB = 50%; BB / B = 50%; C or worse = 150%;
Unrated = 100%
– Banks > 3 months: AAA / AA = 20%; A = 50%; BBB = 50%; BB / B = 100%; C or worse
= 150%; Unrated = 50%
– Banks < 3 months: AAA / AA = 20%; A = 20%; BBB = 20%; BB / B = 50%; C or worse =
150%; Unrated = 20%
– Countries have option to classify claims on banks as one category worse than sovereigns
– Corporates: AAA / AA = 20%; A = 50%; BBB / BB = 100%; B or worse = 150%; Unrated
= 100%
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• Retail – lighter!
– Residential mortgages & MBS: 35% RW: subject to maximum LTV policy (set in UK at
80%)
– Consumer loans & related ABS: 75% RW provided iorientation, product, granularity &
‘low value’ criteria satisfied.
– CRE loans & related ABS: 100% RW (due to high perceived volatility -> no diversification
benefit)
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• Impaired loans – tougher!

– > 90 days past due then 150% RW unless more than 20% provided
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• Commitments & contingents – tougher!
– Immediately cancellable = 0% CCF; < 1 yr = 20% CCF; > 1 yr = 50% CCF
– FX or IRS swaps – Acknowledged need for capital charge on MTM and PFE ctpty risk but
did not dictate one.


• Collateralised capital markets exposures (eg repos) – difficult to assess!:

– Simple approach: As per Basel 1. Only available for banking book. Replace RW of
counterparty with RW of ‘eligible’ collateral (ie cash, IG debt, main equities, UCITS
funds)
– Comprehensive approach: Used for either banking/trading book. Haircuts for lent asset
and collateral depending on:
 Basel 2 - IRB Models
• RWA = EAD x Risk Weight
Risk weight = function (PD, LGD, M)
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• Exposures must form ‘a large pool of exposures’ which are managed on a pooled basis.
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• Complicated risk weight formulas for different asset class:
– Retail – Mortgages, Revolving Credits, Other (SME can be retail if <E1mn)
– Specialised lending – Project Finance, Commodities Finance, Real Estate, HVCRE
– Corporates, sovereigns and banks
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• Foundation IRB:
– Banks must use standard figures for LGD, EAD, M.
– For PD banks either:
• Use their own PD’s if their methodology is recognised
• Use ‘slotting mechanism’ provided by regulator – ie maps internal credit
scores on to PDs
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• Advanced IRB:
– Banks can estimate LGD, EAD, M and PD.
– If banks choose IRB they should apply it to as much of their credit book as possible
– Must back it up with stress testing
 Basel 2 - Securitisations
• Basel 1: Normal RW except first loss tranche = deduction from capital (ie 1250% RW)
• Basel 2 standardised approach:
– RBA (RW based Approach): AAA / AA = 20%; A = 50%; BBB = 100%; BB =
350% (or deduct if bank=originator); B+ or worse = deduct from capital.
Same as corporate RW, if investment grade.
– If unrated, then deduction from capital, unless
• Senior or 2nd loss position – look through to underlying assets
(100% floor for 2nd loss)
• Liquidity facility – 0% under Basel 1. Under Basel 2, apply CCF: < 1
year=20%; > 1 year=50% if eligible (ie pari passu with other
securities and not automatic) and 100% if not eligible; some
scope for 0% CCF if liquidity facility senior to other liabilities or
in ‘general market disruption’
• Basel 2 IRB:
– Use IRB RBA if available, or SF (Supervisory Formula) or IAA (Internal
Assessment Approach) if not.
– If neither SF or IAA available, then use look through or deduct from capital.
– IRB RBA
• Base Case: AAA=12%, AA=15%... A=20%... BBB-=100%...
BB=425%... <BB- or unrated=deduct
• Weightings lower (eg AAA=7%) for ‘most senior’ and higher (eg
AAA=20%) if ‘non-granular’
– IAA – Map internal ratings to RBA. Like FIRB.
– SF – Complex function dependent on K (reg capital charge if held on balance
sheet), L (Degree of enhancement), T (Thickness), N (Pool number),
exposure weighted av. loss given default (LGD)
• Early amortisation provisions:
– If early amortisation provision exists, then capital held against investors
 Basel 2 – Operational risk
• Operational Risk = Risk of loss resulting from inadequate or failed internal processes,
people and systems or from external events. This includes legal risk, but not
strategic, reputational or systemic risk.
• Main objective of including Operational Risk in Basel II is to incentivise banks to
improve internal risk management by integrating control areas like audit &
compliance into the capital charge and therefore pricing. EG if a BU gets adverse
audit rating then RWA goes up, capital ratios down and RoE falls if more capital
raised. Typically, the objective is a fully integrated enterprise-wide risk
management system.
• Given the varying abilities of different banks to undertake this sort of thing, 3 options
were proposed: a simple ‘basic indicator’ approach, a ‘standard’ approach, and an
Advanced Measurement approach (AMA). Most banks tried to opt for the basic
indicator approach and larger banks had to be forced to use AMA.
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 Basel 2 – Operational risk
• Basic Indicator Approach : Capital Charge = Average Gross Income over last 3 years x
Alpha (=15%)
• Standard Approach: Same as Basic Indicator, except the ‘Alpha’ becomes ‘Beta’ for
different business lines.
– Betas: Corporate Finance/Trading/Settlement = 18%; Commercial Banking = 15%;
Retail Banking = 12%
– For Retail & Commercial banking, Loans & Advances x 3.5% is used instead of
Gross Income
• Advanced Measurement Approach: 99.9% VAR for 1 year holding period
– Detailed review of risk management processes & 5 years of data needed – big
task!
– Measurement techniques – usually a mixture of both qualitative and quantitative
• Qualitative – eg Scorecarding
– Control environment is assessed through audited
questionnaires and KRIs
– Integrates well with existing management and control
structures
– Difficult to get common standards across firms and BU’s
– Insufficient on its own to construct a credible loss
distribution.
• Quantitative type – eg LDA / Actuarial
– Explicitly estimates a loss distribution to derive both EL and,
more importantly, UL
– EL - internal data OK for high frequency small losses but
definitional differences across firms/BUs
– UL - very difficult to estimate a fat tail (ie UL) from internal
data –> need to enrich the data:
» External data – vendors, sharing with other banks,
 Basel 2 – Equity in banking
book
• Simple risk method
– RW = 300% for publicly traded, 400% for non-traded (was 100% in Basel 1)
– CRD adjusted these to 290% & 370% and introduced a lower 190% charge for
diversified holdings
• Internal models method
– RWA = 12.5 x the 99% quarterly VAR (calculated as one-tail qtly return versus the
risk free rate)
– Floor: 200% for traded equity and 300% for non-traded
• PD/LGD method
– Treat equity under IRB-Foundation approach to loans - gives much lower risk
weight – egc.30% for AAA-rated customers, 120% for BBB+.
– LGD of 90% is assumed, M is 5 years
– Scaling factor of 1.5x to risk weights if bank has no internal rating.
– Floor: 100% for public equities where bank has a LT relationship, or private
equities where returns are based on cash flow, not capital gains. 200% for
other public equities, 300% for other equities.
• Exclusions from RWA
– Equity holdings can be excluded at national supervisor discretion if zero weight or
immaterial (ie <10% of T1+T2 for diversified equity holdings, or <5% of T1+T2
for <10 holdings).
– Some scope to exclude equity where holding is part of a government’s legislative
subsidy program.
• Deductions from Capital
– Note also 15/60% of T1+T2 test on individual and aggregate significant
investments in commercial firms for capital deduction purposes.
 Basel 2 – Provisions &
• Capital
EL = expected loss
– the mean of the loss distribution
– Taken through P&L
– Deducted from B/S valuations so no
need for capital charge
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• UL = unexpected loss
– the tail end of a loss distribution
– set at 99.9% over holding period
– Not part of valuations so
needs a capital charge


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• Charges are already made to capital for credit losses as part of normal provisioning.
In particular, General Provisions do not just represent EL, but also UL – especially
with dynamic provisioning. Therefore, banks should get some credit for GP when
adjusting regulatory capital.
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• Under Basel 1, this was done by allowing General Provisions into UT2 up to 1.25% of
RWA.
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• Under Basel 2, for IRB models, a more complex framework was chosen along EL/UL
principles:
– General Provisions can no longer count towards UT2 capital
– Specific + General Provisions are measured against modeled EL = ∑(PD x
LGD x EAD).
– Any surplus is treated as a reserve against UL and goes into UT2 at up to
0.6% of credit RWA.
– Any deficit is treated as a ‘shortfall’ in cover for EL and is deducted
50% from T1 and 50% from T2.
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• There is no change to the treatment of provisions under the standardised model -
general provisions can be included up to 1.25% of RWA.
 Basel 2 - Other capital
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issues
• Capital (ie the numerator of the capital ratio) was not the focus of Basel 2. But it was
decided to harmonise the varying treatments across regulators in a number of
areas, typically through 50/50 deductions.
• Unconsolidated banking & securities subsidiaries – 50% deduction from T1, 50% from
T2
• Significant minorities in banking & securities firms – 50/50 deduction or pro rata (if
20-50% stake)
• Significant minorities in commercial entities – 50/50 deduction of excess over
materiality levels: (i) 15% of total capital for individual stake, (ii) 60% of total
capital for aggregate stakes.
• Insurance subsidiaries: Local supervisors have 2 options:
– Deduction – 50/50 deduction of all investments in insurers from bank
capital. Subject to 2012 transition – until then deducted from total
capital. In addition, any capital deficit in an insurance subsidiary should
be either removed quickly or deducted from group capital.
– Aggregation plus – Surplus capital in insurers counts towards overall group
capital on a pro rata basis. A number of tests need to be applied though
– ie can capital be upstreamed, tax implications etc. For example, in UK
capital cannot generally be up-streamed out of a with profits fund as it is
ring-fenced for policy holders.
 Exceptionally, some regulators are allowed to risk weight 100% of insurance
assets.
• Goodwill – Reiteration that this needs to be deducted in same way that it would on
consolidation.
• T2 limits based on T1 after goodwill deduction, deductions for securitisations, the