Description
explains the risks weights and capital allocation as per BASEL norms. It includes the problems with BASEL 1 and how it was replaced by new basel capital accord. It also includes the implications of standardized approach.
Banking Risk: An Overview
Basel Norms: An Overview
Credit risk
Risk arising due to default or deterioration of the credit quality of the obligor/borrower
Market risk
Risk arising due to market movement of different benchmark rates.
Operational risk
Loss resulting due to errors instructing payments or setting transactions.
Credit Risk Component
Arises at two levels
Transaction level
At the sanction level – issues of appraisal, credit worthiness of the obligor etc.
Market Risk Component
Can arise due to movement of rates (e.g. interest rate, stock prices, exchange rate etc.) in different markets.
Bank may have exposure to different markets such as equity, foreign exchange, commodity etc. By far, interest rate risk is the most prominent component because
Most of the banks’ assets are benchmarked to interest rates which are deregulated.
Portfolio level
How to manage risk once the bank has built up its portfolio – does the individual obligor default? – if so, what is the probability of default? – in the event of default what is the expected and unexpected loss? – any cushion required?
1
Market Risk Contd..
Investment portfolio of banks consists of a substantial investment on treasury bonds (Gsecs) which are interest rate sensitive. Reasonable exposure to international benchmark interest rate such as LIBOR
Operational Risk Component
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Internal fraud External fraud Employment practices & workplace safety Clients, products & business practices Damage to physical assets Business disruption & system failures Execution, delivery & process management Includes legal risk. Excludes reputational and business/strategic risk.
Issues in market risk
Asset Liability Management (ALM) – impact of interest rate volatility on NII, NIM, Net Worth, Market Value of Equity (MVE) – marked to market positions – any cushion required?
Operational Risk Component
Internal process
Losses from failed transactions, settlements, e.g., data entry error/Unapproved access/Vendor disputes etc.
Operational Risk Component
Systems
Losses arising from disruption of business or system failure, e.g., hardware or software breakdown, telecommunication failure, programming error, computer virus etc.
People
Losses caused by an unauthorized trading, harassment etc. employee, e.g., internal fraud,
External events
Losses from the actions of third parties, e.g., natural disaster, terrorism, credit card fraud, etc.
2
Risk Based Capital Standard
Why do banks need to hold capital in order to do business?
Provides a cushion against unexpected loss that may arise due to credit/market/operational risk. Capital that needs to be maintained as a proportion of risk based assets is termed as risk based capital – otherwise termed as capital adequacy ratio (CAR). e.g., bank does not maintain any capital towards credit risk component of GoI bonds as it is non-existent.
Evolution of Capital Standard
Originated in July 1988 under the Bank for International Settlement (BIS) in Basel, Switzerland – popularly termed as Basel Committee.
Basel I defines a common measure of solvency, called the Cooke ratio which covers only credit risk – one size fits all policy. Specifies 8% (9% in India) capital charge on all exposures. Exposures being defined by respective risk weights 1988 accord is termed as Basel – I. Framework was to be implemented by end 1992
On-balance-sheet Items: The Cooke Ratio
N
Risk Weights and Capital Allocation
Risk weight (%) Asset Category (On-balance sheet) 0 Obligation on OECD government and US treasuries. PSEs with discretion with central banks Claims on OECD banks/securities issued by US government agencies/Claims on municipalities, NonOECD short-term inter-bank loans Residential mortgages
The total RWA = ? w i L i , where Li is the i=1 principal amount of ith item and wi is its risk weight The assets of a bank consist of $100 million of corporate loans, $10 million of OECD government bonds, and $50 million of residential mortgages. The total RWA is?
20
50
100
All other claims such as corporate debt/Claims on both OECD/Non-OECD, Non-OECD long term interbank loans, Commercial real estate etc.
3
Off-balance-sheet Items
Credit Equivalent Amount (Cj) = max(V,0)+aL
N
Add-on Factors for Derivatives (a)
Remaining maturity (years) Interest rate Exchange Equity rate and gold Precious metals except gold Other commodit ies
RWA =
?w
j =1
* j
C
j
5
1.5
7.5
10.0
8.0
15.0
Risk Weights and Capital Allocation
Risk weight (%) 0 Asset Category (Off-balance sheet) OECD governments
A Closer Look into Basel I
Capital in regulatory context
Tier 1 Capital
Shareholders’ equity and disclosed reserves
Tier 2 Capital (Supplementary)
20 OECD banks and public sector entities Undisclosed reserves, Perpetual securities, unrealized gains on investment securities, hybrid capital instruments, long term subordinated debt and hidden reserves.
50
Corporate and other counterparties
Note: OBSIs include Letters of credit, guarantees, derivatives etc.
Total of tier 2 capital is limited to a maximum of 100% of the total tier 1 capital. Basel I requires tier 1 and tier 2 capital to be at least 8% of the total risk weighted assets.
4
Implementation of Basel I
Basel I does not have any legal force Accepted by G-10 and Non-G10 countries as global standard IMF assesses members’ compliance with financial sector codes and standards Market forces and rating agencies 125 countries had adopted Basel I Accord
What has happened since Basel I
Criticism of Basel I Liberalization and Transformation of the financial sector Various amendments to Basel I: the market risk amendment 1996 The revised capital accord or Basel II
Problems with Basel I
Systematic curtailment of lending and world recession of 1990 Change in priorities of banks, profit maximizing investments Led to financial bubbles, stock market and real estate booms and then crashes From commercial lending towards residential mortgages and public sector securities Commercial disadvantage of lending to highly rated borrowers w.r.t. other NBFCs
Problems with Basel I
Does not distinguish among different credit exposures
Both AAA and BBB assets attract the same capital charge.
Static measure of default risk.
Does not take into account the probability of default.
Does not allow operational risk.
any
capital
charge
for
5
Transformation of the Financial Sector
Securitization and other financial innovations Financial sector deregulation and exposure to stock market Breaking down of barriers between banks and other NBFCs Competition and capital moving towards the delivery of returns at higher risks Credit risk transfer techniques Cross border M & A
1996 Amendment to Incorporate Market Risk
1996 amendment treats trading positions in bonds, equity, foreign exchange and commodity in the market risk framework. Provides explicit capital charges on bank’s open position in each instrument Provides scope for BIS ‘standardized approach’ and ‘internal models approach’.
Banks can either choose BIS prescribed model or their own internal model (e.g. Value at Risk) to assess market risk subject to supervisory compliance.
1996 Amendment Contd..
Capital charge is to be made on the following
Held to maturity (HTM) category Available for sale Foreign exchange positions Trading positions in derivatives Derivatives entered into for hedging
1996 Amendment Contd..
Allows banks to use new ‘Tier 3’ capital
Includes short term subordinated debt to meet the market risk. Tier 3 capital being restricted only to market risk. No such capital can be repaid if that payment results in a bank’s overall capital being lower than a minimum capital requirement.
6
The New Basel Capital Accord
Replaced 1988 Basel Accord. Based on the consultative paper issued by Basel Committee on Banking Supervision (BCBS). Based on three mutually enforcing pillars. Specific reference to operational risk in banking. Implementation scheduled for 2007.
The New Basel Capital Accord
PILLAR I Minimum capital requirements Credit risk Market risk Operational risk PILLAR II Supervisory Review Review of the institution’s capital adequacy Review of the internal assessment process PILLAR III Market Discipline Enhancing transparency through rigorous disclosure norms.
The New Basel Capital Accord
Total Capital Credit + Market + Operational Risk Risk Risk
The New Basel Capital Accord
Credit Risk
Standardized approach Internal Rating Based (IRB) approach
Foundation vs. Advanced
= Capital Ratio (minimum 8%)
Operational Risk
Revised Unchanged New
The new Accord focuses on revising only the denominator (riskweighted assets), the definition and requirements for capital are unchanged from the original Accord.
Basic indicator approach Standardized approach Advanced measurement appraoch
7
Credit Risk and Standardized Approach
Standardized approach(0% to 150%)
The capital required is estimated as
Credit Risk and Standardized Approach
Risk weights of sovereigns
Credit Assessment AAA to A+ to AAA20 BBB+ to BBB50 BB+ to B- Below B100 150 Unrated
Exposure at Default (EAD) × Risk weight (RW) × 8%
The risk weights are standardized under Basel II.
Risk 0 weights (%)
100
Credit Risk and Standardized Approach
Risk weights of corporates
AAA to AA- A+ to ARisk weights 20 (%) 50 BBB+ to BB100 Below Unrated BB150 100
RBI’s Recommendation for Risk Weights
Risk weights of retail exposure at 75% Credit derivatives are considered
8
Implications of the Standardized Approach
Emphasis on credit ratings increase difficulty in accessing bank finance for unrated companies, especially SMEs Loans to SMEs may be classified under retail exposures, 75% risk weight Higher capital requirements during recession
Credit Risk and IRB Approach
IRB approach is based on four key parameters
Probability of default (PD) Loss given default (1 – recovery rate) Exposure at default (EAD) Effective Maturity (M)
Credit Risk and IRB Approach
Foundation approach
Only PDs are internally supplied and all other parameters such as LGD, M, and EAD are standardized as per supervisory estimates
Operational Risk
Basic indicator approach
Sets the charge for operational risk as 15% of positive annual gross income averaged over the previous three years. Thus links to the risk of an expected loss due to internal or external events.
Advanced approach
All parameters are internally determined including the LGD.
9
Operational Risk
Basic indicator approach
Operational Risk
Standardized approach
Requires that the institution partition its operation into different lines of business. The capital charge is estimated as an exposure indicator for each line of business multiplied by a coefficient. Provisionally, the Basel committee intends to use gross income for this purpose.
KBIA = EI*?
Where KBIA = the capital charge under the Basic Indicator Approach EI = the level of an exposure indicator for the whole institution, provisionally gross income ? = a fixed percentage (0.15), set by the Committee, relating the industry-wide level of required capital to the industry-wide level of the indicator
Operational Risk
Standardized Approach Business Lines
Corporate finance Trading and sales Retail banking Commercial banking Payment and settlement Agency services Asset management Retail brokerage
Operational Risk
Standardized approach
KTSA = ?(EI1-8*?1-8)
Where: KTSA = the capital charge under the Standardized Approach EI1-8 = the level of an exposure indicator for each of the 8 business lines ?1-8 = a fixed percentage, set by the Committee, relating the level of required capital to the level of the gross income for each of the 8 business lines
10
Operational Risk
Advanced measurement approach (AMA)
Capital requirement is based on bank’s internal operational risk measurement system. Focuses on both measurement and management of operational risk. Requires supervisory approval based on qualitative and quantitative standards.
Operational Risk
Advanced measurement approach KIMA = ?(EIij*PEij*LGEij*?ij)
KIMA = the capital charge under the Internal Measurement Approach EIij = the level of an exposure indicator for each business line and event type combination PEij = the probability of an event given one unit of exposure, for each business line and event type combination LGEij = the average size of a loss given an event for each business line and event type combination ?ij = the ratio of capital to expected loss for each business line and event type combination
Supervisory Review Process
Four basic principles
Banks should have a process for assessing their overall capital Supervisory review of bank’s internal capital adequacy and compliance Supervisor must expect the banks to operate above the minimum capital requirements. Appropriate intervention on behalf of the supervisor before it gets too late!
Market Discipline
Comprehensive disclosure is essential for market participants to understand the relationship between risk profile and capital of an institution. Includes the disclosure of capital structure, capital adequacy, risk exposure such as market, credit and operational etc.
11
Higher Global Minimum Capital Standards, 12 September 2010
Minimum common equity requirement will increase from 2% to 4.5% Tier I capital requirement will increase from 4% to 6% Banks are required to maintain capital conservation buffer of 2.5% Banks are required to maintain a countercyclical buffer within a range of 0% - 2.5% according to national circumstances
Higher Global Minimum Capital Standards, 12 September 2010
Phase-in Arrangements
(dates as of Jan 1)
Thank you!
12
doc_765605689.pdf
explains the risks weights and capital allocation as per BASEL norms. It includes the problems with BASEL 1 and how it was replaced by new basel capital accord. It also includes the implications of standardized approach.
Banking Risk: An Overview
Basel Norms: An Overview
Credit risk
Risk arising due to default or deterioration of the credit quality of the obligor/borrower
Market risk
Risk arising due to market movement of different benchmark rates.
Operational risk
Loss resulting due to errors instructing payments or setting transactions.
Credit Risk Component
Arises at two levels
Transaction level
At the sanction level – issues of appraisal, credit worthiness of the obligor etc.
Market Risk Component
Can arise due to movement of rates (e.g. interest rate, stock prices, exchange rate etc.) in different markets.
Bank may have exposure to different markets such as equity, foreign exchange, commodity etc. By far, interest rate risk is the most prominent component because
Most of the banks’ assets are benchmarked to interest rates which are deregulated.
Portfolio level
How to manage risk once the bank has built up its portfolio – does the individual obligor default? – if so, what is the probability of default? – in the event of default what is the expected and unexpected loss? – any cushion required?
1
Market Risk Contd..
Investment portfolio of banks consists of a substantial investment on treasury bonds (Gsecs) which are interest rate sensitive. Reasonable exposure to international benchmark interest rate such as LIBOR
Operational Risk Component
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Internal fraud External fraud Employment practices & workplace safety Clients, products & business practices Damage to physical assets Business disruption & system failures Execution, delivery & process management Includes legal risk. Excludes reputational and business/strategic risk.
Issues in market risk
Asset Liability Management (ALM) – impact of interest rate volatility on NII, NIM, Net Worth, Market Value of Equity (MVE) – marked to market positions – any cushion required?
Operational Risk Component
Internal process
Losses from failed transactions, settlements, e.g., data entry error/Unapproved access/Vendor disputes etc.
Operational Risk Component
Systems
Losses arising from disruption of business or system failure, e.g., hardware or software breakdown, telecommunication failure, programming error, computer virus etc.
People
Losses caused by an unauthorized trading, harassment etc. employee, e.g., internal fraud,
External events
Losses from the actions of third parties, e.g., natural disaster, terrorism, credit card fraud, etc.
2
Risk Based Capital Standard
Why do banks need to hold capital in order to do business?
Provides a cushion against unexpected loss that may arise due to credit/market/operational risk. Capital that needs to be maintained as a proportion of risk based assets is termed as risk based capital – otherwise termed as capital adequacy ratio (CAR). e.g., bank does not maintain any capital towards credit risk component of GoI bonds as it is non-existent.
Evolution of Capital Standard
Originated in July 1988 under the Bank for International Settlement (BIS) in Basel, Switzerland – popularly termed as Basel Committee.
Basel I defines a common measure of solvency, called the Cooke ratio which covers only credit risk – one size fits all policy. Specifies 8% (9% in India) capital charge on all exposures. Exposures being defined by respective risk weights 1988 accord is termed as Basel – I. Framework was to be implemented by end 1992
On-balance-sheet Items: The Cooke Ratio
N
Risk Weights and Capital Allocation
Risk weight (%) Asset Category (On-balance sheet) 0 Obligation on OECD government and US treasuries. PSEs with discretion with central banks Claims on OECD banks/securities issued by US government agencies/Claims on municipalities, NonOECD short-term inter-bank loans Residential mortgages
The total RWA = ? w i L i , where Li is the i=1 principal amount of ith item and wi is its risk weight The assets of a bank consist of $100 million of corporate loans, $10 million of OECD government bonds, and $50 million of residential mortgages. The total RWA is?
20
50
100
All other claims such as corporate debt/Claims on both OECD/Non-OECD, Non-OECD long term interbank loans, Commercial real estate etc.
3
Off-balance-sheet Items
Credit Equivalent Amount (Cj) = max(V,0)+aL
N
Add-on Factors for Derivatives (a)
Remaining maturity (years) Interest rate Exchange Equity rate and gold Precious metals except gold Other commodit ies
RWA =
?w
j =1
* j
C
j
5
1.5
7.5
10.0
8.0
15.0
Risk Weights and Capital Allocation
Risk weight (%) 0 Asset Category (Off-balance sheet) OECD governments
A Closer Look into Basel I
Capital in regulatory context
Tier 1 Capital
Shareholders’ equity and disclosed reserves
Tier 2 Capital (Supplementary)
20 OECD banks and public sector entities Undisclosed reserves, Perpetual securities, unrealized gains on investment securities, hybrid capital instruments, long term subordinated debt and hidden reserves.
50
Corporate and other counterparties
Note: OBSIs include Letters of credit, guarantees, derivatives etc.
Total of tier 2 capital is limited to a maximum of 100% of the total tier 1 capital. Basel I requires tier 1 and tier 2 capital to be at least 8% of the total risk weighted assets.
4
Implementation of Basel I
Basel I does not have any legal force Accepted by G-10 and Non-G10 countries as global standard IMF assesses members’ compliance with financial sector codes and standards Market forces and rating agencies 125 countries had adopted Basel I Accord
What has happened since Basel I
Criticism of Basel I Liberalization and Transformation of the financial sector Various amendments to Basel I: the market risk amendment 1996 The revised capital accord or Basel II
Problems with Basel I
Systematic curtailment of lending and world recession of 1990 Change in priorities of banks, profit maximizing investments Led to financial bubbles, stock market and real estate booms and then crashes From commercial lending towards residential mortgages and public sector securities Commercial disadvantage of lending to highly rated borrowers w.r.t. other NBFCs
Problems with Basel I
Does not distinguish among different credit exposures
Both AAA and BBB assets attract the same capital charge.
Static measure of default risk.
Does not take into account the probability of default.
Does not allow operational risk.
any
capital
charge
for
5
Transformation of the Financial Sector
Securitization and other financial innovations Financial sector deregulation and exposure to stock market Breaking down of barriers between banks and other NBFCs Competition and capital moving towards the delivery of returns at higher risks Credit risk transfer techniques Cross border M & A
1996 Amendment to Incorporate Market Risk
1996 amendment treats trading positions in bonds, equity, foreign exchange and commodity in the market risk framework. Provides explicit capital charges on bank’s open position in each instrument Provides scope for BIS ‘standardized approach’ and ‘internal models approach’.
Banks can either choose BIS prescribed model or their own internal model (e.g. Value at Risk) to assess market risk subject to supervisory compliance.
1996 Amendment Contd..
Capital charge is to be made on the following
Held to maturity (HTM) category Available for sale Foreign exchange positions Trading positions in derivatives Derivatives entered into for hedging
1996 Amendment Contd..
Allows banks to use new ‘Tier 3’ capital
Includes short term subordinated debt to meet the market risk. Tier 3 capital being restricted only to market risk. No such capital can be repaid if that payment results in a bank’s overall capital being lower than a minimum capital requirement.
6
The New Basel Capital Accord
Replaced 1988 Basel Accord. Based on the consultative paper issued by Basel Committee on Banking Supervision (BCBS). Based on three mutually enforcing pillars. Specific reference to operational risk in banking. Implementation scheduled for 2007.
The New Basel Capital Accord
PILLAR I Minimum capital requirements Credit risk Market risk Operational risk PILLAR II Supervisory Review Review of the institution’s capital adequacy Review of the internal assessment process PILLAR III Market Discipline Enhancing transparency through rigorous disclosure norms.
The New Basel Capital Accord
Total Capital Credit + Market + Operational Risk Risk Risk
The New Basel Capital Accord
Credit Risk
Standardized approach Internal Rating Based (IRB) approach
Foundation vs. Advanced
= Capital Ratio (minimum 8%)
Operational Risk
Revised Unchanged New
The new Accord focuses on revising only the denominator (riskweighted assets), the definition and requirements for capital are unchanged from the original Accord.
Basic indicator approach Standardized approach Advanced measurement appraoch
7
Credit Risk and Standardized Approach
Standardized approach(0% to 150%)
The capital required is estimated as
Credit Risk and Standardized Approach
Risk weights of sovereigns
Credit Assessment AAA to A+ to AAA20 BBB+ to BBB50 BB+ to B- Below B100 150 Unrated
Exposure at Default (EAD) × Risk weight (RW) × 8%
The risk weights are standardized under Basel II.
Risk 0 weights (%)
100
Credit Risk and Standardized Approach
Risk weights of corporates
AAA to AA- A+ to ARisk weights 20 (%) 50 BBB+ to BB100 Below Unrated BB150 100
RBI’s Recommendation for Risk Weights
Risk weights of retail exposure at 75% Credit derivatives are considered
8
Implications of the Standardized Approach
Emphasis on credit ratings increase difficulty in accessing bank finance for unrated companies, especially SMEs Loans to SMEs may be classified under retail exposures, 75% risk weight Higher capital requirements during recession
Credit Risk and IRB Approach
IRB approach is based on four key parameters
Probability of default (PD) Loss given default (1 – recovery rate) Exposure at default (EAD) Effective Maturity (M)
Credit Risk and IRB Approach
Foundation approach
Only PDs are internally supplied and all other parameters such as LGD, M, and EAD are standardized as per supervisory estimates
Operational Risk
Basic indicator approach
Sets the charge for operational risk as 15% of positive annual gross income averaged over the previous three years. Thus links to the risk of an expected loss due to internal or external events.
Advanced approach
All parameters are internally determined including the LGD.
9
Operational Risk
Basic indicator approach
Operational Risk
Standardized approach
Requires that the institution partition its operation into different lines of business. The capital charge is estimated as an exposure indicator for each line of business multiplied by a coefficient. Provisionally, the Basel committee intends to use gross income for this purpose.
KBIA = EI*?
Where KBIA = the capital charge under the Basic Indicator Approach EI = the level of an exposure indicator for the whole institution, provisionally gross income ? = a fixed percentage (0.15), set by the Committee, relating the industry-wide level of required capital to the industry-wide level of the indicator
Operational Risk
Standardized Approach Business Lines
Corporate finance Trading and sales Retail banking Commercial banking Payment and settlement Agency services Asset management Retail brokerage
Operational Risk
Standardized approach
KTSA = ?(EI1-8*?1-8)
Where: KTSA = the capital charge under the Standardized Approach EI1-8 = the level of an exposure indicator for each of the 8 business lines ?1-8 = a fixed percentage, set by the Committee, relating the level of required capital to the level of the gross income for each of the 8 business lines
10
Operational Risk
Advanced measurement approach (AMA)
Capital requirement is based on bank’s internal operational risk measurement system. Focuses on both measurement and management of operational risk. Requires supervisory approval based on qualitative and quantitative standards.
Operational Risk
Advanced measurement approach KIMA = ?(EIij*PEij*LGEij*?ij)
KIMA = the capital charge under the Internal Measurement Approach EIij = the level of an exposure indicator for each business line and event type combination PEij = the probability of an event given one unit of exposure, for each business line and event type combination LGEij = the average size of a loss given an event for each business line and event type combination ?ij = the ratio of capital to expected loss for each business line and event type combination
Supervisory Review Process
Four basic principles
Banks should have a process for assessing their overall capital Supervisory review of bank’s internal capital adequacy and compliance Supervisor must expect the banks to operate above the minimum capital requirements. Appropriate intervention on behalf of the supervisor before it gets too late!
Market Discipline
Comprehensive disclosure is essential for market participants to understand the relationship between risk profile and capital of an institution. Includes the disclosure of capital structure, capital adequacy, risk exposure such as market, credit and operational etc.
11
Higher Global Minimum Capital Standards, 12 September 2010
Minimum common equity requirement will increase from 2% to 4.5% Tier I capital requirement will increase from 4% to 6% Banks are required to maintain capital conservation buffer of 2.5% Banks are required to maintain a countercyclical buffer within a range of 0% - 2.5% according to national circumstances
Higher Global Minimum Capital Standards, 12 September 2010
Phase-in Arrangements
(dates as of Jan 1)
Thank you!
12
doc_765605689.pdf