Description
This is a presentation describes basel accord 1 and basel 2 accord.
CAPITAL – ROLE, REGULATION AND ADEQUACY
OF ‘CAPITAL ‘ IMPORTANCE…
? Why
is ‘capital’ so important for banks? ? What does bank ‘capital’ constitute? ? When values of other assets and liabilities of a bank changes, what happens to the ‘capital’? ? What should ‘capital’ be ideally related to, in order to determine ‘safety’ of a bank?
BASLE ACCORD I
– „internationally active banks? in G10 countries – capital = at least 8% of assets measured according to risk profile ? Portfolio approach to risk – assets can have 0, 10, 20, 50, 100% risk weight ? Accord adopted world standard in 1990s – more than 100 countries
? 1988
BASLE ACCORD I - DRAWBACKS
? ?
One shoe fits all approach The regulatory measures were seen to be in conflict with increasingly sophisticated internal measures of economic capital ? The simple bucket approach with a flat 8% charge for claims on the private sector has resulted in banks moving high quality assets off their balance sheets, thus reducing the average asset quality ? The Accord did not sufficiently recognize credit risk mitigation techniques
BASLE II ACCORD
? Revised
framework - a spectrum of approaches ranging from simple to advanced for measurement of credit risks, market risks and operational risks, all of which could lead to asset quality and value deterioration. ? The framework also builds in incentives for better and more accurate risk management by individual banks.
BASLE II – THE THREE PILLARS
? Three
mutually reinforcing „pillars?, which together are expected to contribute to the safety and soundness of the international financial system ? First Pillar: Minimum Capital requirement ? Second Pillar: Supervisory Review ? Third Pillar: Market discipline and enhanced disclosures
BROAD DEFINITION OF CAPITAL
? Accounting
definition of capital as seen in banks? financial statements different from regulatory definition ? Regulatory capital set in two tiers ? Tier I – shareholders? equity and retained earnings ? Tier II – additional internal and external sources available to the bank
MINIMUM CAPITAL REQUIREMENTS
? ? ? ? ?
Capital required to compensate for credit risk, market risk [and operational risk] Capital ratio – regulatory capital to risk weighted assets Capital ratio not to be less than 8% Tier 2 capital should be limited to 100% of tier 1 capital Tier 3 capital will be limited to 250% of a bank's tier 1 capital that is required to support market risks.
BASLE II- PILLAR I – MINIMUM CAPITAL REQUIREMENTS
Capital for Credit risk: ? A] Standardized approach ? B] Internal Ratings Based [IRB] foundation ? C] IRB advanced Capital for Market Risk: ? A] Standardized approach [ maturity method] ? B] Standardized approach [duration method] ? C] Internal models method Capital for operational risk ? A] Basic indicator approach ? B] Standardized approach ? C] Advanced Measurement Approach [AMA]
DEFINITIONS OF RISKS
?
Credit risk is the probability that a borrower or a counterparty will fail to meet obligations in accordance with agreed terms ? Operational risk is the risk of loss from inadequate or failed internal processes, people, systems or external events. ? Market risk is the possibility of loss over a given period of time related to uncertain movements in market risk factors, such as interest rates, currencies, equities, and commodities. Also includes specific risk due to composition of bank’s investment portfolio
CREDIT RISK MANAGEMENT
? MEANS…..
?
?
?
Managing risks in individual credits or transactions Managing risks in the credit portfolio Managing the inter relationships between credit risk and other risks
EXPECTED LOSSES AND CREDIT RISK
? EL
CAN BE MODELLED ? EL = PD X EAD XLGD ? EL CAN BE AGGREGATED AT LEVEL OF INDIVIDUAL LOANS OR AT PORTFOLIO LEVEL ? DOES EL CONSTITUTE CREDIT RISK?
PROCESS FOR CALCULATING CREDIT RISK
? ?
?
?
?
Classify assets into risk categories and assign risk weights Convert off balance sheet commitments and guarantees to a notional on balance sheet ‘credit equivalent’, and classify these in the appropriate risk categories Multiply the rupee amount of assets in each risk category by the appropriate risk weight. The result equals ‘risk weighted assets’ Multiply the risk weighted assets by the minimum capital percentages required for it to be adequately capitalized. Compare this with the existing capital on the bank’s balance sheet. The process ensures that assets with the highest perceived risk have the highest risk weights and hence require the most capital. Another important feature of the risk-based standards is that a bank’s off balance sheet items should be supported by adequate capital.
TOTAL RISK WEIGHTED ASSETS
? ARRIVED
?
AT BY
?
MULTIPLYING MARKET RISK AND OPERATIONAL RISK BY 12.5 [RECIPROCAL OF MINIMUM CAPITAL RATIO OF 8%] AND ADDING THE RESULTING FIGURE TO CREDIT RISK
Credit risk- standardized approach
?
Salient features
?
?
The Standardized approach for credit risk retains some part of the 1988 Accord, such as the definition of „capital?. However, the existing risk weighting scheme is replaced by a system where risk weights are determined by the borrower?s rating, defined by an external credit rating agency such as Standard & Poor?s or Moody?s, or by Export Credit Agencies [ECAs] recognized by the respective country?s central bank.
Credit risk – IRB approach
?
Salient features
?
?
?
Banks can use their internal estimates of borrower creditworthiness to assess credit risk [subject to stringent methodological and disclosure standards] Distinct analytical frameworks are applicable to different types of loan exposures whose loss characteristics are different. These banks may rely on their own internal estimates of risk components in determining the capital requirement for a given exposure. The risk components include measures of the following: Probability of Default [PD], Loss given /Default [LGD], Exposure at default [EAD], Effective Maturity [M]
THE IRB APPROACH - CONTD
?
Banks may be required to use values prescribed by supervisors in lieu of internal estimates for some of the risk components. ? The approach is based on measures of Unexpected Losses [UL] and Expected Losses [EL]. The risk weight functions account for capital for the UL portion. ? Banks would categorize banking-book exposures into broad classes of assets with different underlying risk characteristics, such as, (a) corporate, (b) sovereign, (c) bank, (d) retail, and (e) equity. Within each asset class, sub-classes of specialized lending are identified.
IRB APPROACH- CONTD
?
For each of the asset classes covered under the IRB framework, there are three key elements: ? Risk components ? estimates of risk parameters provided by banks some of which are supervisory estimates. ? Risk-weight functions ? the means by which risk components are transformed into riskweighted assets and therefore capital requirements. ? Minimum requirements ? the minimum standards that must be met in order for a bank to use the IRB approach for a given asset class.
CREDIT RISK- IRB APPROACH
?
Two broad approaches for many asset classes„foundation? and „advanced? ? Under the foundation approach banks generally provide their own estimates of PD and rely on supervisory estimates for other risk components. ? Under the advanced approach, banks provide more of their own estimates of PD, LGD and EAD, and their own calculation of M, subject to meeting minimum standards.
MARKET RISK
?
Capital required for both general market risk as well as specific market risk. ? General market risk - the impact of broad market movements on the market value of on balance sheet assets and off balance sheet items, including risks common to all securities, such as changes in the general level of interest rates, exchange rates, commodity prices or stock prices. ? Specific market risk- inherent risks of a particular security, such as the credit risk of the institution, which issued the security.
OPERATIONAL RISK
?
BASIC INDICATOR APPROACH
? ? ?
?
?
?
KBIA = [S(GI1…n x a)]/n Where KBIA = the capital charge under the Basic Indicator Approach GI = annual gross income, where positive, over the previous three years n = number of the previous three years for which gross income is positive a = 15%, which is set by the Committee, relating the industry wide level of required capital to the industry wide level of the indicator.
OPERATIONAL RISKSTANDARDIZED APPROACH
? ?
?
?
Banks’ activities 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.
OPERATIONAL RISK- AMA
? Under
the AMA, the regulatory capital requirement will equal the risk measure generated by the bank?s internal operational risk measurement system using the quantitative and qualitative criteria for the AMA. ? Use of the AMA is subject to supervisory approval.
Capital requirements
? Banks?
?
overall minimum capital requirement would be
CREDIT RISK requirements as laid down in Basel II, EXCLUDING debt and equity positions in the trading book and all positions in commodities, but INCLUDING credit counterparty risk in all OTC derivatives in both trading and banking books, PLUS Capital charge for MARKET RISK, PLUS Capital charge for OPERATIONAL RISK
? ?
CAPITAL REQUIREMENTS
? Definition
?
of capital
?
?
Step 1- calculate minimum capital requirements for credit and operational risks Step 2 – assess market risk requirement Step 3 –establish how much tier 1 and tier 2 capital available for market risk
General market risk – standardized method
? Duration
?
method – steps
?
?
Calculate the price sensitivity [mod dur] of each instrument Apply the assumed change in yield to the mod dur [table 17 of RBI circular 2008] depending on instrument?s maturity Slot the resulting capital charge measures into a maturity ladder with 15 time bands as in table 17
General market risk
?
Subject long and short positions (short position is not allowed in India except in derivatives) in each time band to a 5 per cent vertical disallowance designed to capture basis risk ? Example: if the sum of the weighted longs in a time-band is Rs100 crore and the sum of the weighted shorts Rs90 crore, the “vertical disallowance” for that time band would be 5% on the smaller of the positions, ie Rs90 crore – working out to Rs4.5 crore
General market risk
? Next,
carry forward the net positions in each time-band for horizontal offsetting subject to the disallowances set out in Table – 18 of RBI circular ? How is this done?
General market risk
?
The result of the above calculations is to produce two sets of weighted positions, the net long or short positions in each time-band (Rs10 crore long in the earlier example) and the vertical disallowances, which have no sign. ? In addition, banks will be allowed to conduct two rounds of “horizontal offsetting”, first between the net positions in each of three zones (zero to one year, one year to four years and four years and over),and subsequently between the net positions in the three different zones.
General market risk
?
The offsetting will be subject to a scale of disallowances expressed as a fraction of the matched positions, as set out in table 18 of the RBI circular. ? The weighted long and short positions in each of three zones may be offset, subject to the matched portion attracting a disallowance factor that is part of the capital charge. ? The residual net position in each zone may be carried over and offset against opposite positions in other zones, subject to a second set of disallowance factors
doc_573674482.ppt
This is a presentation describes basel accord 1 and basel 2 accord.
CAPITAL – ROLE, REGULATION AND ADEQUACY
OF ‘CAPITAL ‘ IMPORTANCE…
? Why
is ‘capital’ so important for banks? ? What does bank ‘capital’ constitute? ? When values of other assets and liabilities of a bank changes, what happens to the ‘capital’? ? What should ‘capital’ be ideally related to, in order to determine ‘safety’ of a bank?
BASLE ACCORD I
– „internationally active banks? in G10 countries – capital = at least 8% of assets measured according to risk profile ? Portfolio approach to risk – assets can have 0, 10, 20, 50, 100% risk weight ? Accord adopted world standard in 1990s – more than 100 countries
? 1988
BASLE ACCORD I - DRAWBACKS
? ?
One shoe fits all approach The regulatory measures were seen to be in conflict with increasingly sophisticated internal measures of economic capital ? The simple bucket approach with a flat 8% charge for claims on the private sector has resulted in banks moving high quality assets off their balance sheets, thus reducing the average asset quality ? The Accord did not sufficiently recognize credit risk mitigation techniques
BASLE II ACCORD
? Revised
framework - a spectrum of approaches ranging from simple to advanced for measurement of credit risks, market risks and operational risks, all of which could lead to asset quality and value deterioration. ? The framework also builds in incentives for better and more accurate risk management by individual banks.
BASLE II – THE THREE PILLARS
? Three
mutually reinforcing „pillars?, which together are expected to contribute to the safety and soundness of the international financial system ? First Pillar: Minimum Capital requirement ? Second Pillar: Supervisory Review ? Third Pillar: Market discipline and enhanced disclosures
BROAD DEFINITION OF CAPITAL
? Accounting
definition of capital as seen in banks? financial statements different from regulatory definition ? Regulatory capital set in two tiers ? Tier I – shareholders? equity and retained earnings ? Tier II – additional internal and external sources available to the bank
MINIMUM CAPITAL REQUIREMENTS
? ? ? ? ?
Capital required to compensate for credit risk, market risk [and operational risk] Capital ratio – regulatory capital to risk weighted assets Capital ratio not to be less than 8% Tier 2 capital should be limited to 100% of tier 1 capital Tier 3 capital will be limited to 250% of a bank's tier 1 capital that is required to support market risks.
BASLE II- PILLAR I – MINIMUM CAPITAL REQUIREMENTS
Capital for Credit risk: ? A] Standardized approach ? B] Internal Ratings Based [IRB] foundation ? C] IRB advanced Capital for Market Risk: ? A] Standardized approach [ maturity method] ? B] Standardized approach [duration method] ? C] Internal models method Capital for operational risk ? A] Basic indicator approach ? B] Standardized approach ? C] Advanced Measurement Approach [AMA]
DEFINITIONS OF RISKS
?
Credit risk is the probability that a borrower or a counterparty will fail to meet obligations in accordance with agreed terms ? Operational risk is the risk of loss from inadequate or failed internal processes, people, systems or external events. ? Market risk is the possibility of loss over a given period of time related to uncertain movements in market risk factors, such as interest rates, currencies, equities, and commodities. Also includes specific risk due to composition of bank’s investment portfolio
CREDIT RISK MANAGEMENT
? MEANS…..
?
?
?
Managing risks in individual credits or transactions Managing risks in the credit portfolio Managing the inter relationships between credit risk and other risks
EXPECTED LOSSES AND CREDIT RISK
? EL
CAN BE MODELLED ? EL = PD X EAD XLGD ? EL CAN BE AGGREGATED AT LEVEL OF INDIVIDUAL LOANS OR AT PORTFOLIO LEVEL ? DOES EL CONSTITUTE CREDIT RISK?
PROCESS FOR CALCULATING CREDIT RISK
? ?
?
?
?
Classify assets into risk categories and assign risk weights Convert off balance sheet commitments and guarantees to a notional on balance sheet ‘credit equivalent’, and classify these in the appropriate risk categories Multiply the rupee amount of assets in each risk category by the appropriate risk weight. The result equals ‘risk weighted assets’ Multiply the risk weighted assets by the minimum capital percentages required for it to be adequately capitalized. Compare this with the existing capital on the bank’s balance sheet. The process ensures that assets with the highest perceived risk have the highest risk weights and hence require the most capital. Another important feature of the risk-based standards is that a bank’s off balance sheet items should be supported by adequate capital.
TOTAL RISK WEIGHTED ASSETS
? ARRIVED
?
AT BY
?
MULTIPLYING MARKET RISK AND OPERATIONAL RISK BY 12.5 [RECIPROCAL OF MINIMUM CAPITAL RATIO OF 8%] AND ADDING THE RESULTING FIGURE TO CREDIT RISK
Credit risk- standardized approach
?
Salient features
?
?
The Standardized approach for credit risk retains some part of the 1988 Accord, such as the definition of „capital?. However, the existing risk weighting scheme is replaced by a system where risk weights are determined by the borrower?s rating, defined by an external credit rating agency such as Standard & Poor?s or Moody?s, or by Export Credit Agencies [ECAs] recognized by the respective country?s central bank.
Credit risk – IRB approach
?
Salient features
?
?
?
Banks can use their internal estimates of borrower creditworthiness to assess credit risk [subject to stringent methodological and disclosure standards] Distinct analytical frameworks are applicable to different types of loan exposures whose loss characteristics are different. These banks may rely on their own internal estimates of risk components in determining the capital requirement for a given exposure. The risk components include measures of the following: Probability of Default [PD], Loss given /Default [LGD], Exposure at default [EAD], Effective Maturity [M]
THE IRB APPROACH - CONTD
?
Banks may be required to use values prescribed by supervisors in lieu of internal estimates for some of the risk components. ? The approach is based on measures of Unexpected Losses [UL] and Expected Losses [EL]. The risk weight functions account for capital for the UL portion. ? Banks would categorize banking-book exposures into broad classes of assets with different underlying risk characteristics, such as, (a) corporate, (b) sovereign, (c) bank, (d) retail, and (e) equity. Within each asset class, sub-classes of specialized lending are identified.
IRB APPROACH- CONTD
?
For each of the asset classes covered under the IRB framework, there are three key elements: ? Risk components ? estimates of risk parameters provided by banks some of which are supervisory estimates. ? Risk-weight functions ? the means by which risk components are transformed into riskweighted assets and therefore capital requirements. ? Minimum requirements ? the minimum standards that must be met in order for a bank to use the IRB approach for a given asset class.
CREDIT RISK- IRB APPROACH
?
Two broad approaches for many asset classes„foundation? and „advanced? ? Under the foundation approach banks generally provide their own estimates of PD and rely on supervisory estimates for other risk components. ? Under the advanced approach, banks provide more of their own estimates of PD, LGD and EAD, and their own calculation of M, subject to meeting minimum standards.
MARKET RISK
?
Capital required for both general market risk as well as specific market risk. ? General market risk - the impact of broad market movements on the market value of on balance sheet assets and off balance sheet items, including risks common to all securities, such as changes in the general level of interest rates, exchange rates, commodity prices or stock prices. ? Specific market risk- inherent risks of a particular security, such as the credit risk of the institution, which issued the security.
OPERATIONAL RISK
?
BASIC INDICATOR APPROACH
? ? ?
?
?
?
KBIA = [S(GI1…n x a)]/n Where KBIA = the capital charge under the Basic Indicator Approach GI = annual gross income, where positive, over the previous three years n = number of the previous three years for which gross income is positive a = 15%, which is set by the Committee, relating the industry wide level of required capital to the industry wide level of the indicator.
OPERATIONAL RISKSTANDARDIZED APPROACH
? ?
?
?
Banks’ activities 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.
OPERATIONAL RISK- AMA
? Under
the AMA, the regulatory capital requirement will equal the risk measure generated by the bank?s internal operational risk measurement system using the quantitative and qualitative criteria for the AMA. ? Use of the AMA is subject to supervisory approval.
Capital requirements
? Banks?
?
overall minimum capital requirement would be
CREDIT RISK requirements as laid down in Basel II, EXCLUDING debt and equity positions in the trading book and all positions in commodities, but INCLUDING credit counterparty risk in all OTC derivatives in both trading and banking books, PLUS Capital charge for MARKET RISK, PLUS Capital charge for OPERATIONAL RISK
? ?
CAPITAL REQUIREMENTS
? Definition
?
of capital
?
?
Step 1- calculate minimum capital requirements for credit and operational risks Step 2 – assess market risk requirement Step 3 –establish how much tier 1 and tier 2 capital available for market risk
General market risk – standardized method
? Duration
?
method – steps
?
?
Calculate the price sensitivity [mod dur] of each instrument Apply the assumed change in yield to the mod dur [table 17 of RBI circular 2008] depending on instrument?s maturity Slot the resulting capital charge measures into a maturity ladder with 15 time bands as in table 17
General market risk
?
Subject long and short positions (short position is not allowed in India except in derivatives) in each time band to a 5 per cent vertical disallowance designed to capture basis risk ? Example: if the sum of the weighted longs in a time-band is Rs100 crore and the sum of the weighted shorts Rs90 crore, the “vertical disallowance” for that time band would be 5% on the smaller of the positions, ie Rs90 crore – working out to Rs4.5 crore
General market risk
? Next,
carry forward the net positions in each time-band for horizontal offsetting subject to the disallowances set out in Table – 18 of RBI circular ? How is this done?
General market risk
?
The result of the above calculations is to produce two sets of weighted positions, the net long or short positions in each time-band (Rs10 crore long in the earlier example) and the vertical disallowances, which have no sign. ? In addition, banks will be allowed to conduct two rounds of “horizontal offsetting”, first between the net positions in each of three zones (zero to one year, one year to four years and four years and over),and subsequently between the net positions in the three different zones.
General market risk
?
The offsetting will be subject to a scale of disallowances expressed as a fraction of the matched positions, as set out in table 18 of the RBI circular. ? The weighted long and short positions in each of three zones may be offset, subject to the matched portion attracting a disallowance factor that is part of the capital charge. ? The residual net position in each zone may be carried over and offset against opposite positions in other zones, subject to a second set of disallowance factors
doc_573674482.ppt