Description
The documentation about Basel II Norms for Banking Organisations
The Basel Committee of Banking Supervision was constituted by the Central Bank Governors of Group – 10 - Countries in the year 1975 primarily with the objective of under-taking diverse analysis of the working of Banks in various countries and to offer hand-made remedies on an ongoing basis. To begin with its mammoth task Basel Committee came out with its first document on International Convergence of capital Measurement and Capital Standards in July 1988 as a forerunner to tone-up the safety and stability of Commercial Banking in particular world over. Over time Basel Committee issued number of operational directives enabling Central Banking Authorities to consider and to implement the prescriptions as may be possible in their efforts of fine tuning its overall objectives mentioned above.
Basel Accord –
II was after strenuous efforts of the Basel Committee that finally in May 2004 the accord was born and the revised document-containing framework on International Convergence of Capital Measurement and Capital Standards was released over the Internet in June 2004. The rationale behind this accord alongside the existence of earlier Accord (Accord-I) lies with the efforts of the committee to develop a revised framework for further strengthening the soundness and stability of International Banking System with provision for sufficient consistency and further to ensure that capital adequacy regulation does not impose any element of competitive inequality among Internationally active Banks.
Basel Accord – II: Three dimensional approach
One of the most distinguishing features of the current Accord is with respect to its three dimensional approach. ?
Firstly Risk segments in Commercial Banking have been classified into three distinct categories Viz. Credit Risk, Market Risk and Operational Risk.
?
Further another direction of the Accord is with respect of development of three Pillars (Viz. Minimum Capital, Supervisory Review Process and Market Discipline).
An initial analysis of the Accord reflects that for professional management of all the three Risk Categories as above the element of capital requirements, regulatory review process, transparency and disclosures by way of market discipline form the basic super structure of a healthy, sound consistent and proactive Risk Management System in business entities.
Capital adequacy, which is an indicator of the financial health of the banking system, is measured by the Capital to Risk-weighted Asset Ratio (CRAR), defined as the ratio of a bank’s capital to its total risk-weighted assets. Basel II is a much more comprehensive framework of banking supervision. It not only deals with CRAR calculation, but has also got provisions for supervisory review and market discipline. The main objectives of BASEL II are: ? ?
Making capital allocation of banks more risk sensitive Separation of Operational Risk from Credit Risk and calculation of separate capital charges for each
? ?
Ensure that Regulatory Capital requirements are more in line with Economic Capital requirements of banks Encourage banks to use their internal systems for arriving at levels of Regulatory Capital
Thus, Basel II stands on three pillars: ? Minimum regulatory capital (Pillar 1): This is a revised and extensive framework for capital adequacy standards, where CRAR is calculated by incorporating credit, market and operational risks. ?
Supervisory review (Pillar 2): This provides key principles for supervisory review, risk management guidance and supervisory transparency and accountability. This enlarges the role of banking supervisors and gives them the power to review the bank’s risk management systems.
?
Market discipline (Pillar 3): This pillar encourages market discipline by developing a set of disclosure requirements that will allow market participants to assess key pieces of information on risk exposure, risk assessment process and capital adequacy of a bank.
The below diagram depicts the BASEL II framework i.e. the 3 pillars that constitute the BASEL II regulations.
Under Basel II, CRAR is calculated by taking into account three types of risks: ? ?
Credit risk: It is defined as “the risk of loss due to a debtor's non?payment of a loan or other line of credit (either the principal or interest (coupon) or both)” Market risk: It is defined as “the risk that the value of an investment will decrease due to moves in market factors.” The four standard market risk factors are: ? Equity risk: the risk that stock prices will change. ? Interest rate risk: the risk that interest rates will change. ? Currency risk: the risk that foreign exchange rates will change. ? Commodity risk: the risk that commodity prices (e.g. grains, metals) will change.
?
Operational risk: Basel II has introduced a new kind of risk called as the operational risk in calculating CRAR. It is defined as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.”
The Reserve Bank of India (RBI) has asked banks to move in the direction of implementing the Basel II norms, and in the process identify the areas that need strengthening. In implementing Basel II, the RBI is in favour of gradual convergence with the new standards and best practices. The aim is to reach the global best standards in a phased manner, taking a consultative approach rather than a directive one. The approaches for each one of these risks is shown below. Based on recommendations of the Steering Committee, in February 2005, RBI has proposed the “Draft Guidelines for Implementing New Capital Adequacy Framework” covering the capital adequacy guidelines of the Basel II accord. RBI expects banks to adopt the Standardized Approach for the measurement of Credit Risk and the Basic Indicator Approach for the assessment of Operational Risk.
Credit Risk
Standardized Approach Forward Internal Ratings Based Approach Advanced Internal Ratings Based Approach
Market Risk
Standardized Approach
Operational Risk
Basic Indicator Approach
Standardized Approach In house approach (eg VaR models) Advanced Measurement Approach
CREDIT RISK ? Standardized Approach Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk. The claims are weighted as per the ratings provided by these agencies.
?
Foundation Internal Ratings Based Approached (F-IRB) Under this approach the banks are allowed to develop their own empirical model to estimate the PD (probability of default) for individual clients or groups of clients. Banks can use this approach only subject to approval from their local regulators. Under F-IRB banks are required to use regulator's prescribed LGD (Loss Given Default) and other parameters required for calculating the RWA (Risk Weighted Asset). Then total required capital is calculated as a fixed percentage of the estimated RWA.
?
Advanced IRB approach Under this approach the banks are allowed to develop their own empirical model to quantify required capital for credit risk. Banks can use this approach only subject to approval from their local regulators. Under A-IRB banks are supposed to use their own quantitative models to estimate PD (probability of default), EAD (Exposure at Default), LGD (Loss Given Default) and other parameters required for calculating the RWA (Risk Weighted Asset). Then total required capital is calculated as a fixed percentage of the estimated RWA.
MARKET RISK ? Value at Risk (VaR) It is a widely used measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level.
OPERATIONAL RISK ? Basic Indicator Approach (BIA) Basic indicator approach is much simpler compared to the alternative approaches and this has been recommended for banks in the initial phases. Based on the original Basel Accord, banks using the basic indicator approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive annual gross income. The fixed percentage ‘alpha’ is typically 15 percent of annual gross income. ?
Standardized Approach (TSA) Based on the original Basel Accord, under the Standardized Approach, banks’ activities are divided into eight business lines: corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. Within each business line, gross income is a broad indicator that serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line. Beta serves as a proxy for the industry-wide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line. The total capital charge is calculated as the three-year average of the simple summation of the regulatory capital charges across each of the business lines in each year. In any given year, negative capital charges (resulting from negative gross income) in any business line may offset positive capital charges in other business lines without limit.
?
Advanced Measurement Approach (AMA) Under this approach the banks are allowed to develop their own empirical model to quantify required capital for operational risk. Banks can use this approach only subject to approval from their local regulators.
Calculating CRAR The calculation of capital (for use in capital adequacy ratios) requires some adjustments to be made to the amount of capital shown on the balance sheet. Two types of capital are measured are called tier one capital and tier two capital. ? Tier one capital is capital which is permanently and freely available to absorb losses without the bank being obliged to cease trading. An example of tier one capital is the ordinary share capital of the bank. Tier one capital is important because it safeguards both the survival of the bank and the stability of the financial system. ? Tier two capital is capital which generally absorbs losses only in the event of a windingup of a bank, and so provides a lower level of protection for depositors and other creditors. It comes into play in absorbing losses after tier one capital has been lost by the bank. Tier two capital is sub-divided into upper and lower tier two capital. Upper tier two capital has no fixed maturity, while lower tier two capital has a limited life span, which makes it less effective in providing a buffer against losses by the bank.
For the purpose of calculating regulatory capital requirement, banks are required to classify their capital into three tiers as follows; Tier 1 Capital Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves (or retained earnings), but may also include irredeemable non?cumulative preferred stock.
The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk?weighted assets. Risk?weighted assets are the total of all assets held by the bank which are weighted for credit risk. Tier 1 capital is also seen as a metric of a bank's ability to sustain future losses.
Hence Tier I capital is said to comprise of the below capital elements: ? ? ? ? ? Fully paid up capital / capital deposited with SBP Balance in share premium account Reserve for Issue of Bonus Shares General Reserves as disclosed on the balance-sheet Un-appropriated / un-remitted profits (net of accumulated losses, if any)
Tier 2 Capital Tier 2 capital is a measure of a bank's financial strength with regard to the second most reliable form of financial capital, from a regulator's point of view. There are several classifications of Tier 2 capital. In the Basel I Accord, Tier 2 capital is composed of supplementary capital, which is categorized as undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt. Supplementary capital can be considered tier 2 capital up to an amount equal to that of the core capital.
The Tier 2 capital shall include; ? ? ? ? ? General Provisions or General Reserves for loan losses Revaluation Reserves Exchange translation Reserves Undisclosed Reserves Subordinated debt.
Tier 3 Capital The Tier 3 capital consisting of short-term subordinated debt would be solely for the purpose of meeting a proportion of the capital requirements for market risk. Tier 2 and Tier 3 capital are also called as Upper and Lower tier 2 capital.
Capital Deductions In order to obtain the eligible regulatory capital for the purpose of calculating Minimum Capital Requirements, banks are required to make following deductions from their Tier-1 capital; o Book value of goodwill. o Shortfall in provisions required against classified assets irrespective of any relaxation allowed by SBP. o Remaining deficit on account of revaluation of investments held in “Available for Sale” category after netting off from any other surplus on AFS securities.
On-balance sheet credit exposures differ in their degree of riskiness (e.g. Government Stock compared to personal loans). Capital adequacy ratio calculations recognize these differences by requiring more capital to be held against more risky exposures. This is done by weighting credit exposures according to their degree of riskiness. A broad brush approach is taken to defining degrees of riskiness. The type of debtor and the type of credit exposures serve as proxies for degree of riskiness (e.g. Governments are assumed to be more creditworthy than individuals, and residential mortgages are assumed to be less risky than loans to companies). The Reserve Bank defines seven credit exposure categories into which credit exposures must be assigned for capital adequacy ratio calculation purposes.
Off-balance sheet contracts (e.g. guarantees, foreign exchange and interest rate contracts) also carry credit risks. As the amount at risk is not always equal to the nominal principal amount of the contract, off-balance sheet credit exposures are first converted to a "credit equivalent amount". This is done by multiplying the nominal principal amount by a factor which recognizes
the amount of risk inherent in particular types of off-balance sheet credit exposures. After deriving credit equivalent amounts for off-balance sheet credit exposures, these are weighted according to the riskiness of the counterparty, in the same way as on-balance sheet credit exposures. Nine credit exposure categories are defined to cover all types of off-balance sheet credit exposures.
Once these adjustments are made, Capital adequacy ratio is calculated based on the below formula:
CAR = Capital / Risk
If risk weighted assets are used, then CAR is given by:
CAR = (Tier 1 capital + Tier 2 capital)/ a where a = weighted assets
Because off-balance sheet credit exposures are included in calculations, capital adequacy ratios cannot be calculated by reference to the balance sheet alone. Even the calculation of capital adequacy ratios to cover on-balance sheet credit exposures usually cannot be done by using published balance sheets, as these will probably not provide sufficient detail about who the bank has lent to, or the issuers of securities held by the bank.
To illustrate the process a bank goes through in calculating its capital adequacy ratios, a simple worked example is contained in below tables. The steps in the calculation are explained below. The balance sheet information and the off-balance sheet credit exposures on which the calculations are based are set out below.
BALANCE SHEET LIABILITIES & EQUITY
Deposits Subordinated term debt Shareholder’s Funds Ordinary Capital Redeemable Preference Shares Retained Earnings Revaluation reserve 182 2
ASSETS
Cash 5 year government stock Lending to Banks Housing Loans with Mortgages Commercial Loans Goodwill Shareholding in other bank Fixed assets General Provision for bad debts TOTAL 11 20 30 52 64 3 3 25 -2
7 3 8 4
TOTAL
206
206
Off Balance Sheet Exposures
Nominal Principal Amount Direct credit substitute (guarantee of financial obligations) Asset sale with recourse Commitment with certain drawdown (forward purchase of assets) Transaction related contingent item (performance bond) Underwriting facility Short term self liquidating trade related contingency 6 month forward foreign exchange contract (replacement cost = 4) 4 year interest rate swap (replacement cost = 4) TOTAL 10 18 23 8 28 30 100 200 417
Note: The foreign exchange contract and interest rate swap are with banks. All other transactions are with non-bank customers.
First Step - Calculation of Capital The composition of the categories of capital is as follows:
Tier One Capital In general, this comprises: ? ? ? ? ? The ordinary share capital (or equity) of the bank; and Audited revenue reserves e.g. retained earnings; less Current year's losses; Future tax benefits; and Intangible assets, e.g. goodwill.
Upper Tier Two Capital In general, this comprises: ? ? ? ? ? ? ? ? Unaudited retained earnings; Revaluation reserves; General provisions for bad debts; Perpetual cumulative preference shares (i.e. preference shares with no maturity date whose Dividends accrue for future payment even if the bank's financial condition does not support Immediate payment); Perpetual subordinated debt (i.e. debt with no maturity date which ranks in priority behind all Creditors except shareholders).
Lower Tier Two Capital In general, this comprises: ? ? Subordinated debt with a term of at least 5 years; Redeemable preference shares which may not be redeemed for at least 5 years.
Total Capital This is the sum of tier 1 and tier 2 capital less the following deductions: ? ? ? Equity investments in subsidiaries; Shareholdings in other banks that exceed 10 percent of that bank's capital; Unrealized revaluation losses on securities holdings.
CALCULATION OF CAPITAL
TIER 1 Ordinary Capital Retained Earnings Less Goodwill TOTAL TIER 1 CAPITAL 7 8 -3 12
TIER 2 UPPER TIER 2 General bad debt provision Revaluation reserve 2 4
LOWER TIER 2 Subordinated debt Redeemable preference shares TOTAL TIER 2 CAPITAL 2 3 11
DEDUCTION Shareholding in other banks -3
TOTAL CAPITAL
20
Second Step - Calculation of Credit Exposures
On-Balance Sheet Exposures The categories into which all credit exposures are assigned for capital adequacy ratio purposes, and the percentages the balance sheet numbers are weighted by, are as follows:
Credit Exposure Type Cash Short Term claims on governments Long Term claims on governments (> 1 year) Claims on banks Claims on public sector entities Residential mortgage All other credit exposures
Percentage Risk Weighting 0 0 10 20 20 50 100
Off-Balance Sheet Credit Exposures
(1) Calculation of Credit Equivalents Listed below are the categories of credit exposures, and their associated "credit conversion factor". The nominal principal amounts in each category are multiplied by the credit conversion factor to get a "credit equivalent amount":
Credit Exposure Type Direct credit substitutes e.g. guarantees, bills of exchange, letter of credit, risk participations Asset sales with recourse Commitments with certain drawdown e.g. forward purchases, partly paid shares
Percentage Risk Weighting 100
100 100
Transaction related contracts e.g. performance bonds, bid bonds Underwriting and sub-underwriting facilities Other commitments with an original maturity more than 1 year Short term trade related contingencies e.g. letters of credit Other commitments with an original maturity of less than 1 year or which can be unconditionally cancelled at any time
50
50 50
20
0
The final category of off-balance sheet credit exposures, market related contracts (i.e. interest rate and foreign exchange rate contracts), is treated differently from the other categories. Credit equivalent amounts are calculated by adding the following: ? Current exposure - this is the market value of a contract i.e. the amount the bank could get by selling its rights under the contract to another party (counted as zero for contracts with a negative value); and ? Potential exposure i.e. an allowance for further changes in the market value, which is calculated as a percentage of the nominal principal amount as follows: o Interest rate contracts < 1 year 0% o Interest rate contracts > 1 year 0.5% o Exchange rate contracts < 1 year 1% o Exchange rate contracts > 1 year 5%
Although the nominal principal amount of market related contracts may be large, the credit equivalent amounts are usually small, and so may add very little to the amount of credit exposures to be risk weighted.
(2) Calculation of Risk Weighted Credit Exposures The credit equivalent amounts of all off-balance sheet exposures are multiplied by the same risk weightings that apply to on-balance sheet exposures (i.e. the weighting used depends on the type of counterparty), except that market related contracts that would otherwise be weighted at 100 percent are weighted at 50 percent.
TABLE shows an example of a calculation of risk weighted assets.
Calculation of risk weighted exposures On-balance sheet Exposure Type Amount X Risk Weight = Risk weighted Exposure Cash 5 Year Govt Stock Lending to Banks Home Loans Commercial Loans Fixed assets 25 100% 25 52 64 50% 100% 26 64 30 20% 6 11 20 0% 10% 0 2
TOTAL
123
Off balance sheet Exposure Type Amount X Credit Conversion Factor Guarantee Asset sale with 10 18 100% 100% 100% 100% 10 18 X Risk Weight = Risk weighted exposure
recourse Forward purchase Performance Bond Underwriting facility Trade contingency 30 20% 100% 6 28 50% 100% 14 8 50% 100% 4 23 100% 100% 23
Exposure Type
Replacement Cost (+)
Potential Exposure (*)
X
Risk weight
= Risk weighted exposure
Forward FX contract Interest rate swap
4
1
20%
1
4
1
20%
1
TOTAL
77
TOTAL RISK WEIGHTED EXPOSURES
200
Third Step - Calculation of Capital Adequacy Ratios Capital adequacy ratios are calculated by dividing tier one capital and total capital by risk weighted credit exposures. Figure shows an example of a calculation of capital adequacy ratios.
Tier 1 Capital to total weighted exposures = 12 / 200 = 6%
Total capital to total risk weighted exposures = 20 / 200 = 10%
BASEL II and INDIA
India adopted Basel I norms for scheduled commercial banks in April 1992, and its implementation was spread over the next three years. It was stipulated that foreign banks operating in India should achieve a CRAR of 8 per cent by March 1993 while Indian banks with branches abroad should achieve the 8 per cent norm by March 1995. All other banks were to achieve a capital adequacy norm of 4 per cent by March 1993 and the 8 per cent norm by March 1996. In its mid-term review of Monetary and Credit Policy in October 1998, the Reserve Bank of India (RBI) raised the minimum regulatory CRAR requirement to 9 per cent, and banks were advised to achieve this 9 per cent CRAR level by March 31, 2009 Thus, the capital adequacy norm for India’s commercial banks is higher than the internationally accepted level of 8 per cent.
The RBI has announced the implementation of Basel II norms in India for internationally active banks from March 2008 and for the domestic commercial banks from March 2009. The final RBI guidelines on Basel II implementation were released on April 27, 2007. According to these guidelines, banks in India will initially adopt SA for credit risk and BIA for operational risk. RBI has provided the specifics of these approaches in its guidelines. After adequate skills are developed, both by banks and RBI, some banks may be allowed to migrate towards more sophisticated approaches like IRB.
Under the revised regime of Basel II, Indian banks will be required to maintain a minimum CRAR of 9 per cent on an ongoing basis. Further, banks are encouraged to achieve a tier I CRAR of at least 6 per cent by March 2010. In order to ensure a smooth transition to Basel II, RBI has advised the banks to have a parallel run of the revised norms along with the currently applicable norms.
Table provides the capital adequacy ratios of some of the leading banks in India since 2008.
BANK Syndicate Bank State Bank of India Bank of India Bank of Baroda Punjab National Bank IDBI Bank State Bank of Mysore Corporation Bank Oriental Bank of Commerce Vijaya Bank ICICI Bank HDFC Bank Citibank Axis Bank ING Vysya
2007-08 11.22 12.64 12.04 12.91 13.46 11.95 11.73 12.09 12.12 11.22 13.97 13.60 12.00 13.73 10.20
2008-09 11.37 14.25 13.01 12.88 14.03 11.57 13.38 13.66 12.98 13.08 15.53 15.10 13.58 13.69 11.65
Basic Issues in implementation in Indian context
Basel II accord is applicable for Internationally Active banks. No specific criteria of identification of such Banks has been laid down. But there are certain issues. ? ?
The guidelines as framed are quite extensive and presuppose a compact techno-savvy environment and sound MIS in Banks. Staff Skill Development in Banks to handle the various new issues / technicalities in Risk Management on an ongoing basis remains a focus area. With the emigration of large number of skilled personnel from Public Sector Banks under VRS, energetic steps need be taken to upgrade skill of existing personnel and also to bring in specialist personnel from open market on
appropriate pay package. ? ? Risk culture on enterprise basis has to be developed with more active involvement of Top Executives. Business proposals of significant value must pass through Risk Management criteria. To take care of newly developed Operational Risk parameters Bank would to have to relook to their existing guidelines / instructions on operational areas. Their Manual of Instructions / Book of Instructions may have to be substantially updated. ? Clear-cut Credit Risk Policy Market Risk Policy and Operational Risk Policy must be developed with necessary flexibility of their operations and provision of Updation preferably on annual basis. ? ? Quarterly Risk Management meetings of Zonal / Regional Heads must take place with TOP Officials of Corporate Office so as to monitor Risk Management implications of the entire Bank. RBI also in turn should organize similar quarterly Risk Management meetings with each Bank’s Top Officials so that their supervision Review Process role under Pillar III is discharged smoothly.
Some Conflicting Areas Default of counterparties on payment of interest / installment generates Credit Risk. Interest rate charged comes under Market Risk Category. If arising out of upward revision of rate of interest in a borrowal account from time to time due to market volatility, there is any default – which risk category it will come under: Credit Risk or Market Risk? ?
Failure of people taking usual precautions falls under Operational risk. Suppose if due to defective/inadequate documentation a Bank is not in a position to recover its loan – which category of Risk will apply – Credit Risk or Operational Risk?
doc_698977100.docx
The documentation about Basel II Norms for Banking Organisations
The Basel Committee of Banking Supervision was constituted by the Central Bank Governors of Group – 10 - Countries in the year 1975 primarily with the objective of under-taking diverse analysis of the working of Banks in various countries and to offer hand-made remedies on an ongoing basis. To begin with its mammoth task Basel Committee came out with its first document on International Convergence of capital Measurement and Capital Standards in July 1988 as a forerunner to tone-up the safety and stability of Commercial Banking in particular world over. Over time Basel Committee issued number of operational directives enabling Central Banking Authorities to consider and to implement the prescriptions as may be possible in their efforts of fine tuning its overall objectives mentioned above.
Basel Accord –
II was after strenuous efforts of the Basel Committee that finally in May 2004 the accord was born and the revised document-containing framework on International Convergence of Capital Measurement and Capital Standards was released over the Internet in June 2004. The rationale behind this accord alongside the existence of earlier Accord (Accord-I) lies with the efforts of the committee to develop a revised framework for further strengthening the soundness and stability of International Banking System with provision for sufficient consistency and further to ensure that capital adequacy regulation does not impose any element of competitive inequality among Internationally active Banks.
Basel Accord – II: Three dimensional approach
One of the most distinguishing features of the current Accord is with respect to its three dimensional approach. ?
Firstly Risk segments in Commercial Banking have been classified into three distinct categories Viz. Credit Risk, Market Risk and Operational Risk.
?
Further another direction of the Accord is with respect of development of three Pillars (Viz. Minimum Capital, Supervisory Review Process and Market Discipline).
An initial analysis of the Accord reflects that for professional management of all the three Risk Categories as above the element of capital requirements, regulatory review process, transparency and disclosures by way of market discipline form the basic super structure of a healthy, sound consistent and proactive Risk Management System in business entities.
Capital adequacy, which is an indicator of the financial health of the banking system, is measured by the Capital to Risk-weighted Asset Ratio (CRAR), defined as the ratio of a bank’s capital to its total risk-weighted assets. Basel II is a much more comprehensive framework of banking supervision. It not only deals with CRAR calculation, but has also got provisions for supervisory review and market discipline. The main objectives of BASEL II are: ? ?
Making capital allocation of banks more risk sensitive Separation of Operational Risk from Credit Risk and calculation of separate capital charges for each
? ?
Ensure that Regulatory Capital requirements are more in line with Economic Capital requirements of banks Encourage banks to use their internal systems for arriving at levels of Regulatory Capital
Thus, Basel II stands on three pillars: ? Minimum regulatory capital (Pillar 1): This is a revised and extensive framework for capital adequacy standards, where CRAR is calculated by incorporating credit, market and operational risks. ?
Supervisory review (Pillar 2): This provides key principles for supervisory review, risk management guidance and supervisory transparency and accountability. This enlarges the role of banking supervisors and gives them the power to review the bank’s risk management systems.
?
Market discipline (Pillar 3): This pillar encourages market discipline by developing a set of disclosure requirements that will allow market participants to assess key pieces of information on risk exposure, risk assessment process and capital adequacy of a bank.
The below diagram depicts the BASEL II framework i.e. the 3 pillars that constitute the BASEL II regulations.
Under Basel II, CRAR is calculated by taking into account three types of risks: ? ?
Credit risk: It is defined as “the risk of loss due to a debtor's non?payment of a loan or other line of credit (either the principal or interest (coupon) or both)” Market risk: It is defined as “the risk that the value of an investment will decrease due to moves in market factors.” The four standard market risk factors are: ? Equity risk: the risk that stock prices will change. ? Interest rate risk: the risk that interest rates will change. ? Currency risk: the risk that foreign exchange rates will change. ? Commodity risk: the risk that commodity prices (e.g. grains, metals) will change.
?
Operational risk: Basel II has introduced a new kind of risk called as the operational risk in calculating CRAR. It is defined as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.”
The Reserve Bank of India (RBI) has asked banks to move in the direction of implementing the Basel II norms, and in the process identify the areas that need strengthening. In implementing Basel II, the RBI is in favour of gradual convergence with the new standards and best practices. The aim is to reach the global best standards in a phased manner, taking a consultative approach rather than a directive one. The approaches for each one of these risks is shown below. Based on recommendations of the Steering Committee, in February 2005, RBI has proposed the “Draft Guidelines for Implementing New Capital Adequacy Framework” covering the capital adequacy guidelines of the Basel II accord. RBI expects banks to adopt the Standardized Approach for the measurement of Credit Risk and the Basic Indicator Approach for the assessment of Operational Risk.
Credit Risk
Standardized Approach Forward Internal Ratings Based Approach Advanced Internal Ratings Based Approach
Market Risk
Standardized Approach
Operational Risk
Basic Indicator Approach
Standardized Approach In house approach (eg VaR models) Advanced Measurement Approach
CREDIT RISK ? Standardized Approach Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk. The claims are weighted as per the ratings provided by these agencies.
?
Foundation Internal Ratings Based Approached (F-IRB) Under this approach the banks are allowed to develop their own empirical model to estimate the PD (probability of default) for individual clients or groups of clients. Banks can use this approach only subject to approval from their local regulators. Under F-IRB banks are required to use regulator's prescribed LGD (Loss Given Default) and other parameters required for calculating the RWA (Risk Weighted Asset). Then total required capital is calculated as a fixed percentage of the estimated RWA.
?
Advanced IRB approach Under this approach the banks are allowed to develop their own empirical model to quantify required capital for credit risk. Banks can use this approach only subject to approval from their local regulators. Under A-IRB banks are supposed to use their own quantitative models to estimate PD (probability of default), EAD (Exposure at Default), LGD (Loss Given Default) and other parameters required for calculating the RWA (Risk Weighted Asset). Then total required capital is calculated as a fixed percentage of the estimated RWA.
MARKET RISK ? Value at Risk (VaR) It is a widely used measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level.
OPERATIONAL RISK ? Basic Indicator Approach (BIA) Basic indicator approach is much simpler compared to the alternative approaches and this has been recommended for banks in the initial phases. Based on the original Basel Accord, banks using the basic indicator approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive annual gross income. The fixed percentage ‘alpha’ is typically 15 percent of annual gross income. ?
Standardized Approach (TSA) Based on the original Basel Accord, under the Standardized Approach, banks’ activities are divided into eight business lines: corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. Within each business line, gross income is a broad indicator that serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line. Beta serves as a proxy for the industry-wide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line. The total capital charge is calculated as the three-year average of the simple summation of the regulatory capital charges across each of the business lines in each year. In any given year, negative capital charges (resulting from negative gross income) in any business line may offset positive capital charges in other business lines without limit.
?
Advanced Measurement Approach (AMA) Under this approach the banks are allowed to develop their own empirical model to quantify required capital for operational risk. Banks can use this approach only subject to approval from their local regulators.
Calculating CRAR The calculation of capital (for use in capital adequacy ratios) requires some adjustments to be made to the amount of capital shown on the balance sheet. Two types of capital are measured are called tier one capital and tier two capital. ? Tier one capital is capital which is permanently and freely available to absorb losses without the bank being obliged to cease trading. An example of tier one capital is the ordinary share capital of the bank. Tier one capital is important because it safeguards both the survival of the bank and the stability of the financial system. ? Tier two capital is capital which generally absorbs losses only in the event of a windingup of a bank, and so provides a lower level of protection for depositors and other creditors. It comes into play in absorbing losses after tier one capital has been lost by the bank. Tier two capital is sub-divided into upper and lower tier two capital. Upper tier two capital has no fixed maturity, while lower tier two capital has a limited life span, which makes it less effective in providing a buffer against losses by the bank.
For the purpose of calculating regulatory capital requirement, banks are required to classify their capital into three tiers as follows; Tier 1 Capital Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves (or retained earnings), but may also include irredeemable non?cumulative preferred stock.
The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk?weighted assets. Risk?weighted assets are the total of all assets held by the bank which are weighted for credit risk. Tier 1 capital is also seen as a metric of a bank's ability to sustain future losses.
Hence Tier I capital is said to comprise of the below capital elements: ? ? ? ? ? Fully paid up capital / capital deposited with SBP Balance in share premium account Reserve for Issue of Bonus Shares General Reserves as disclosed on the balance-sheet Un-appropriated / un-remitted profits (net of accumulated losses, if any)
Tier 2 Capital Tier 2 capital is a measure of a bank's financial strength with regard to the second most reliable form of financial capital, from a regulator's point of view. There are several classifications of Tier 2 capital. In the Basel I Accord, Tier 2 capital is composed of supplementary capital, which is categorized as undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt. Supplementary capital can be considered tier 2 capital up to an amount equal to that of the core capital.
The Tier 2 capital shall include; ? ? ? ? ? General Provisions or General Reserves for loan losses Revaluation Reserves Exchange translation Reserves Undisclosed Reserves Subordinated debt.
Tier 3 Capital The Tier 3 capital consisting of short-term subordinated debt would be solely for the purpose of meeting a proportion of the capital requirements for market risk. Tier 2 and Tier 3 capital are also called as Upper and Lower tier 2 capital.
Capital Deductions In order to obtain the eligible regulatory capital for the purpose of calculating Minimum Capital Requirements, banks are required to make following deductions from their Tier-1 capital; o Book value of goodwill. o Shortfall in provisions required against classified assets irrespective of any relaxation allowed by SBP. o Remaining deficit on account of revaluation of investments held in “Available for Sale” category after netting off from any other surplus on AFS securities.
On-balance sheet credit exposures differ in their degree of riskiness (e.g. Government Stock compared to personal loans). Capital adequacy ratio calculations recognize these differences by requiring more capital to be held against more risky exposures. This is done by weighting credit exposures according to their degree of riskiness. A broad brush approach is taken to defining degrees of riskiness. The type of debtor and the type of credit exposures serve as proxies for degree of riskiness (e.g. Governments are assumed to be more creditworthy than individuals, and residential mortgages are assumed to be less risky than loans to companies). The Reserve Bank defines seven credit exposure categories into which credit exposures must be assigned for capital adequacy ratio calculation purposes.
Off-balance sheet contracts (e.g. guarantees, foreign exchange and interest rate contracts) also carry credit risks. As the amount at risk is not always equal to the nominal principal amount of the contract, off-balance sheet credit exposures are first converted to a "credit equivalent amount". This is done by multiplying the nominal principal amount by a factor which recognizes
the amount of risk inherent in particular types of off-balance sheet credit exposures. After deriving credit equivalent amounts for off-balance sheet credit exposures, these are weighted according to the riskiness of the counterparty, in the same way as on-balance sheet credit exposures. Nine credit exposure categories are defined to cover all types of off-balance sheet credit exposures.
Once these adjustments are made, Capital adequacy ratio is calculated based on the below formula:
CAR = Capital / Risk
If risk weighted assets are used, then CAR is given by:
CAR = (Tier 1 capital + Tier 2 capital)/ a where a = weighted assets
Because off-balance sheet credit exposures are included in calculations, capital adequacy ratios cannot be calculated by reference to the balance sheet alone. Even the calculation of capital adequacy ratios to cover on-balance sheet credit exposures usually cannot be done by using published balance sheets, as these will probably not provide sufficient detail about who the bank has lent to, or the issuers of securities held by the bank.
To illustrate the process a bank goes through in calculating its capital adequacy ratios, a simple worked example is contained in below tables. The steps in the calculation are explained below. The balance sheet information and the off-balance sheet credit exposures on which the calculations are based are set out below.
BALANCE SHEET LIABILITIES & EQUITY
Deposits Subordinated term debt Shareholder’s Funds Ordinary Capital Redeemable Preference Shares Retained Earnings Revaluation reserve 182 2
ASSETS
Cash 5 year government stock Lending to Banks Housing Loans with Mortgages Commercial Loans Goodwill Shareholding in other bank Fixed assets General Provision for bad debts TOTAL 11 20 30 52 64 3 3 25 -2
7 3 8 4
TOTAL
206
206
Off Balance Sheet Exposures
Nominal Principal Amount Direct credit substitute (guarantee of financial obligations) Asset sale with recourse Commitment with certain drawdown (forward purchase of assets) Transaction related contingent item (performance bond) Underwriting facility Short term self liquidating trade related contingency 6 month forward foreign exchange contract (replacement cost = 4) 4 year interest rate swap (replacement cost = 4) TOTAL 10 18 23 8 28 30 100 200 417
Note: The foreign exchange contract and interest rate swap are with banks. All other transactions are with non-bank customers.
First Step - Calculation of Capital The composition of the categories of capital is as follows:
Tier One Capital In general, this comprises: ? ? ? ? ? The ordinary share capital (or equity) of the bank; and Audited revenue reserves e.g. retained earnings; less Current year's losses; Future tax benefits; and Intangible assets, e.g. goodwill.
Upper Tier Two Capital In general, this comprises: ? ? ? ? ? ? ? ? Unaudited retained earnings; Revaluation reserves; General provisions for bad debts; Perpetual cumulative preference shares (i.e. preference shares with no maturity date whose Dividends accrue for future payment even if the bank's financial condition does not support Immediate payment); Perpetual subordinated debt (i.e. debt with no maturity date which ranks in priority behind all Creditors except shareholders).
Lower Tier Two Capital In general, this comprises: ? ? Subordinated debt with a term of at least 5 years; Redeemable preference shares which may not be redeemed for at least 5 years.
Total Capital This is the sum of tier 1 and tier 2 capital less the following deductions: ? ? ? Equity investments in subsidiaries; Shareholdings in other banks that exceed 10 percent of that bank's capital; Unrealized revaluation losses on securities holdings.
CALCULATION OF CAPITAL
TIER 1 Ordinary Capital Retained Earnings Less Goodwill TOTAL TIER 1 CAPITAL 7 8 -3 12
TIER 2 UPPER TIER 2 General bad debt provision Revaluation reserve 2 4
LOWER TIER 2 Subordinated debt Redeemable preference shares TOTAL TIER 2 CAPITAL 2 3 11
DEDUCTION Shareholding in other banks -3
TOTAL CAPITAL
20
Second Step - Calculation of Credit Exposures
On-Balance Sheet Exposures The categories into which all credit exposures are assigned for capital adequacy ratio purposes, and the percentages the balance sheet numbers are weighted by, are as follows:
Credit Exposure Type Cash Short Term claims on governments Long Term claims on governments (> 1 year) Claims on banks Claims on public sector entities Residential mortgage All other credit exposures
Percentage Risk Weighting 0 0 10 20 20 50 100
Off-Balance Sheet Credit Exposures
(1) Calculation of Credit Equivalents Listed below are the categories of credit exposures, and their associated "credit conversion factor". The nominal principal amounts in each category are multiplied by the credit conversion factor to get a "credit equivalent amount":
Credit Exposure Type Direct credit substitutes e.g. guarantees, bills of exchange, letter of credit, risk participations Asset sales with recourse Commitments with certain drawdown e.g. forward purchases, partly paid shares
Percentage Risk Weighting 100
100 100
Transaction related contracts e.g. performance bonds, bid bonds Underwriting and sub-underwriting facilities Other commitments with an original maturity more than 1 year Short term trade related contingencies e.g. letters of credit Other commitments with an original maturity of less than 1 year or which can be unconditionally cancelled at any time
50
50 50
20
0
The final category of off-balance sheet credit exposures, market related contracts (i.e. interest rate and foreign exchange rate contracts), is treated differently from the other categories. Credit equivalent amounts are calculated by adding the following: ? Current exposure - this is the market value of a contract i.e. the amount the bank could get by selling its rights under the contract to another party (counted as zero for contracts with a negative value); and ? Potential exposure i.e. an allowance for further changes in the market value, which is calculated as a percentage of the nominal principal amount as follows: o Interest rate contracts < 1 year 0% o Interest rate contracts > 1 year 0.5% o Exchange rate contracts < 1 year 1% o Exchange rate contracts > 1 year 5%
Although the nominal principal amount of market related contracts may be large, the credit equivalent amounts are usually small, and so may add very little to the amount of credit exposures to be risk weighted.
(2) Calculation of Risk Weighted Credit Exposures The credit equivalent amounts of all off-balance sheet exposures are multiplied by the same risk weightings that apply to on-balance sheet exposures (i.e. the weighting used depends on the type of counterparty), except that market related contracts that would otherwise be weighted at 100 percent are weighted at 50 percent.
TABLE shows an example of a calculation of risk weighted assets.
Calculation of risk weighted exposures On-balance sheet Exposure Type Amount X Risk Weight = Risk weighted Exposure Cash 5 Year Govt Stock Lending to Banks Home Loans Commercial Loans Fixed assets 25 100% 25 52 64 50% 100% 26 64 30 20% 6 11 20 0% 10% 0 2
TOTAL
123
Off balance sheet Exposure Type Amount X Credit Conversion Factor Guarantee Asset sale with 10 18 100% 100% 100% 100% 10 18 X Risk Weight = Risk weighted exposure
recourse Forward purchase Performance Bond Underwriting facility Trade contingency 30 20% 100% 6 28 50% 100% 14 8 50% 100% 4 23 100% 100% 23
Exposure Type
Replacement Cost (+)
Potential Exposure (*)
X
Risk weight
= Risk weighted exposure
Forward FX contract Interest rate swap
4
1
20%
1
4
1
20%
1
TOTAL
77
TOTAL RISK WEIGHTED EXPOSURES
200
Third Step - Calculation of Capital Adequacy Ratios Capital adequacy ratios are calculated by dividing tier one capital and total capital by risk weighted credit exposures. Figure shows an example of a calculation of capital adequacy ratios.
Tier 1 Capital to total weighted exposures = 12 / 200 = 6%
Total capital to total risk weighted exposures = 20 / 200 = 10%
BASEL II and INDIA
India adopted Basel I norms for scheduled commercial banks in April 1992, and its implementation was spread over the next three years. It was stipulated that foreign banks operating in India should achieve a CRAR of 8 per cent by March 1993 while Indian banks with branches abroad should achieve the 8 per cent norm by March 1995. All other banks were to achieve a capital adequacy norm of 4 per cent by March 1993 and the 8 per cent norm by March 1996. In its mid-term review of Monetary and Credit Policy in October 1998, the Reserve Bank of India (RBI) raised the minimum regulatory CRAR requirement to 9 per cent, and banks were advised to achieve this 9 per cent CRAR level by March 31, 2009 Thus, the capital adequacy norm for India’s commercial banks is higher than the internationally accepted level of 8 per cent.
The RBI has announced the implementation of Basel II norms in India for internationally active banks from March 2008 and for the domestic commercial banks from March 2009. The final RBI guidelines on Basel II implementation were released on April 27, 2007. According to these guidelines, banks in India will initially adopt SA for credit risk and BIA for operational risk. RBI has provided the specifics of these approaches in its guidelines. After adequate skills are developed, both by banks and RBI, some banks may be allowed to migrate towards more sophisticated approaches like IRB.
Under the revised regime of Basel II, Indian banks will be required to maintain a minimum CRAR of 9 per cent on an ongoing basis. Further, banks are encouraged to achieve a tier I CRAR of at least 6 per cent by March 2010. In order to ensure a smooth transition to Basel II, RBI has advised the banks to have a parallel run of the revised norms along with the currently applicable norms.
Table provides the capital adequacy ratios of some of the leading banks in India since 2008.
BANK Syndicate Bank State Bank of India Bank of India Bank of Baroda Punjab National Bank IDBI Bank State Bank of Mysore Corporation Bank Oriental Bank of Commerce Vijaya Bank ICICI Bank HDFC Bank Citibank Axis Bank ING Vysya
2007-08 11.22 12.64 12.04 12.91 13.46 11.95 11.73 12.09 12.12 11.22 13.97 13.60 12.00 13.73 10.20
2008-09 11.37 14.25 13.01 12.88 14.03 11.57 13.38 13.66 12.98 13.08 15.53 15.10 13.58 13.69 11.65
Basic Issues in implementation in Indian context
Basel II accord is applicable for Internationally Active banks. No specific criteria of identification of such Banks has been laid down. But there are certain issues. ? ?
The guidelines as framed are quite extensive and presuppose a compact techno-savvy environment and sound MIS in Banks. Staff Skill Development in Banks to handle the various new issues / technicalities in Risk Management on an ongoing basis remains a focus area. With the emigration of large number of skilled personnel from Public Sector Banks under VRS, energetic steps need be taken to upgrade skill of existing personnel and also to bring in specialist personnel from open market on
appropriate pay package. ? ? Risk culture on enterprise basis has to be developed with more active involvement of Top Executives. Business proposals of significant value must pass through Risk Management criteria. To take care of newly developed Operational Risk parameters Bank would to have to relook to their existing guidelines / instructions on operational areas. Their Manual of Instructions / Book of Instructions may have to be substantially updated. ? Clear-cut Credit Risk Policy Market Risk Policy and Operational Risk Policy must be developed with necessary flexibility of their operations and provision of Updation preferably on annual basis. ? ? Quarterly Risk Management meetings of Zonal / Regional Heads must take place with TOP Officials of Corporate Office so as to monitor Risk Management implications of the entire Bank. RBI also in turn should organize similar quarterly Risk Management meetings with each Bank’s Top Officials so that their supervision Review Process role under Pillar III is discharged smoothly.
Some Conflicting Areas Default of counterparties on payment of interest / installment generates Credit Risk. Interest rate charged comes under Market Risk Category. If arising out of upward revision of rate of interest in a borrowal account from time to time due to market volatility, there is any default – which risk category it will come under: Credit Risk or Market Risk? ?
Failure of people taking usual precautions falls under Operational risk. Suppose if due to defective/inadequate documentation a Bank is not in a position to recover its loan – which category of Risk will apply – Credit Risk or Operational Risk?
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