Basel II and Capital

Adequacy
Week - 2

Financial Regulation
and Need for the New
Accord

To bring more confidence in depositors

To avoid flight to quality

To bring uniformity in financial regulation

globally because financial crisis are often
contagious

To bring market based approach to manage

financial institutions

Bring in transparency in the system

Last but not least to strengthen Risk

Management

The Basel Accords

In 1974, Collapse of Colonge based Bank,

Herstatt, asked for increased regulation on
banking capital and improvement in
payment system

1988 Basel Committee for banking

supervision introduced Basel I

This accord for banking regulation set

minimum capital requirement for the banks

The main criticisms that have been directed

on the first Basel Accord can be summarized
as follows:

The Basel Accords

The same formula is applied to all institutions - a one-size-fits-all

approach is taken, irrespective of the banks' ability to manage their
own risk or the risk management techniques used

The approach does not examine the actual risk embodied within the
asset portfolio - issues relating to variance-covariance of returns on
assets may be noted

Diversification within risk buckets, where risk is reduced, is not

rewarded through the regulatory capital requirement

Risk taking may be encouraged - there is a type of moral hazard

created

The capital ratios and risk weights appear to be arbitrary

Much discretion is left with national supervisors; e.g. setting of

target/trigger ratios

Treatment of operational risk is arbitrary

The Basel Accords

In response to the criticism discussed

above, the Basel Committee on banking
supervision amended the old accord to bring
more strength in the banking industry

In June 2004, a new set of regulations was

introduced as Basel II

Implementation of Basel II actually started

in January 2007

Basel II and Need of

Capital

Basel II implements in the best possible way,

capital requirement for an economy dominated
by services industries and financial instruments

In a real economy, capital is used to build up

production tools through the traditional
industrial methods

In the service economy, the purpose of capital

is utterly different

Capital is built up to meet economic cycles than

to produce returns

Basel II and Need of

Capital

A Service economy brings up the need to

face longer term future uncertainties
seriously

A more forward looking view on expected

and unexpected losses, where later are
more dominant

Emphasizes on future risks and future cash

flows

Basel II The Three

Pillars

Pillar I Capital Adequacy

Pillar II Supervision

Pillar III Market Discipline (Disclosure)

Capital Adequacy
Pillar I

Maintaining minimum capital required by regulator

The minimum capital can be worked out using;

Standardized Approach

Foundation IRB (Internal Rating Based) approach

Advanced IRB approach

The basic objective of Pillar I is that banks or credit

institutions are well capitalized

In practice from 8% to 10% of capital against risk

weighted assets is considered as well capitalized

Below 8% are considered undercapitalized while below

5% are considered significantly undercapitalized

Similarly, holding way higher economic capital than

required regulatory capital would mean in efficient use of
capital

Capital Adequacy
Pillar I

What does Capital mean under Basel II?

Capital under Basel II takes three Tiers i.e. Tier I,

Tier II and Tier III

Tier I Capital is most pure form of capital i.e. Equity

Tier II Capital takes form of subordinate debts e.g.

directors loan, syndicated financing

Tier III Capital consists of general reserves i.e.

reserves not allocated to any specific requirement

Detail discussion on regulatory capital and

economic capital will be in next weeks lecture

Risks covered under Pillar I are Credit, Market and

Operational Risks

Supervision Pillar II

Since the banks are given the freedom of

choosing appropriate method for computing
capital adequacy, supervision is even more
important

Supervising the capital adequacy is over and

above the existing supervisory duties

The Basel Committee on banking supervision

has established the Accord Implementation
Group (AIG)

AIG is a global platform for interpretation of the

accord and helps in implementation of Basel II

Supervision Pillar II

The regulator monitors risk management practices of

financial institutions regularly

Reports like stress testing of banks balance sheet

and Internal Capital Adequacy Assessment Procedure
(ICAAP) are required to submit to the regulator
periodically

Audits are carried out to ensure the quality of risk

management being practiced

The more advance technique the institution uses to

effectively allocate capital, the more regulator needs
to monitor the institutions risk management
practices

Examples of risks covered under Pillar II are

reputational and legal risks

Disclosure Pillar III

Pillar III requires transparent financial reporting

by financial institutions

Transparent reporting creates market competition

Depositors are in better position to decide where

to place money with justified returns

Stakeholders in FI are more informed about the

financial health of the institution

Regulators ask institutions to report in prescribed

formats

Internationally acceptable principles like IAS and

GAAP are widely being adopted by the regulators

Basel II and Internal

Control

Source: D. N. Chorafas,
page 6

Standardized
Approach

Basel II integrates credit risk, market risk and operational

risk, into a comprehensive system of supervision

Bank must assure the capital adequacy against each of its

exposures

For operational risk, under standardized approach, capital

charge is given at 15% of three years average profits

For counterparty risk, banks use the external ratings by

independent reputable rating agencies such as PACRA, JCR,
Moodys, Standard & Poors etc

Market risk is dealt-with the Market Risk Amendment 1996

(MRA)

Operational risk has simple treatment, charge of 15% of

average Gross Income for last three years

The Risk Weights

ECA = External Credit Assessment

The Risk Weights

The Risk Weights

The Risk Weights

Claims on any other business would have

100% weight

Other businesses includes SME and

individuals

The only way to reduce the weight is to

have cash collateral or lien on cash
equivalent to the exposure

This will have 0% weight but your returns

will be reduced

Comparison of Three
Methods

Source: D. N. Chorafas,
page 8

Basel II The Cost

Benefit Issues

Change of internal culture, building of sophisticated

models, much finer mesh of credit ratings and
management control every thing has cost

How much will it cost?

What kind of benefits will it provide?

While answering the first question, CEO of Barclays

Bank publicly said Basel II will cost his institution
more than 100 million ($160 million) over the
implementation period

Average cost of implementation was expected

between US$ 50 to US$ 100 million

Basel II The Cost

Benefit Issues

Some benefits which are expected out of

those heavy investments are:

Better risk pricing

More efficient processes

Increased profits

Better risk management practices

Benefits from Risk

Based Pricing and
Rating Targets

By encouraging risk-based pricing, Basel II provides an option

to bank to get benefit from rocket science and high technology

Credit institutions are in better position to manage their capital

with increased business

This has also brought a competitive change in the banking

industry which ultimately resulted in better management and
appropriate internal controls

Another benefit provided by Basel II is the flexibility it gives in

its terms of implementation

The best way to measure, manage and mitigate risk differs

from one bank to another

But you surely needs an approval from regulator before putting

any new methodology in place

Basel II Objectives and

the effect of Leverage

Capital is used to bear risk and absorb losses, is a

messenger to market and is a signal that the bank is
managed in a safe and sound manner

Capital must be calculated considering both the

expected and unexpected losses

However, regulatory capital only requires expected

losses, unexpected losses can be taken into account
while working out economic capital

While working out economic capital, due

consideration must be given to changing risk
appetite of the bank over time, survivability of major
clients, and the macro-economy factors

The Need for devils advocate in Risk

Management

Regulatory capital cannot be computed effectively and

economic capital cannot be allocated efficiently unless
the function is closely related to the risk management

Another pre-requisite is that they are closely monitored

through internal control

Remember the main elements of Committee of

Sponsoring Organizations (COSO) frame work?

Control Environment

Risk Assessment

Control Activities

Information and communication

Monitoring activities

The Need for devils advocate in Risk

Management

Damage prevention and damage control are

foremost risk management goals

But there is more to be done for an effective

risk management

Paraphrasing Dr Ben Gurion, risk management

must have some brilliant operators assigned
to the permanent doubting role of devils
advocate. Their mission should be to
challenge possibly wrong hypotheses and
assumptions, which might look solid but in
reality they are hollow

The Need for devils advocate in Risk

Management

Professor Urs Birchler says, Market Discipline

does not bring us to paradise, but can
prevent us from going to hell

The risk management should be well above

the cacophony of clans and tribes in the
banks risk taking operating units

The reason why RM, economic capital and

regulatory capital are correlated is that only
when we are in control of our exposure, we
can be confident of having enough resources
to face adversity and crisis

The Need for devils advocate in Risk

Management

When reviewing the proposal from any

business unit, the devils advocates
objections could be:

Portfolio mix is poorly done

Borrower ratings are incorrect or out dated

Economic condition worsen

There is customer or an industry concentration

There are many exception to risk limits

End of First Session

FRS Project

Each of the group will be given a commercial

banks balance sheet

You need to compose your own balance sheets

assets side with the given funds

Liability side of the balance sheet will be given

and cannot be changed

Distribute the given funds in assets in a proper

mix taking into account the risk and overall
portfolio return

Rate of return will be given to you accordingly

FRS Project

You can search around and look few commercial banks

balance sheets to see the BS composition

This will give you the good idea where you need to place
how much cash

Once the BS is composed, we will do the Capital Adequacy

assessment for each of the group and see how much
Economic Capital you hold with the returns on your assets

Regulatory capital requirement is 10%

maintenance of good EC and CAR would add up to your

grades

Remember! Maintaining unnecessarily high EC is a can be

a negative point

FRS Project

Done with capital adequacy procedure (Pillar I) we

will move towards Pillar II

In Pillar II each of the group will be asked to put

some efforts towards the risk measurement and your
views on how you think you can improve the internal
control/procedures to make your bank less risky

Groups will need to find out appropriate solutions for

risk measurement and allocation of economic capital
to various risks

We will try to stress out your asset portfolios and see

how you CAR perform under the stressed scenarios

FRS Project

Discussions will also be held on Pillar III i.e.

disclosures

Grades will be given on your methodologies

of risk measurement, EC allocation and
maintenance of CAR