Description
This is a presentation about basel basics, four pillars of basel 2 i.e. basel 2 minimum capital capital requirements, basel 2 operational risk charges, supervisory review and market discipline.
Global Economy
BASEL II & Raghuram Rajan committee executive summary
10th September 2008
Presented by:
•30166 Kaashika Bhalla •30161 Aanchal Agarwal •30168 Darshil Bhatt •30175 Jude D’souza
The Basel II Capital Accord
June 2005
Flow of Presentation
Basel basics Basel II minimum capital charges – First Pillar Basel II operational risk charges Supervisory Review – Second Pillar Market discipline – Third Pillar Some observations
Executive Summary
? In effect since 1988; very simple in application
Basel I
? Easy to achieve significant capital reduction with little or no risk transfer ? Much more complex and risk sensitive
Basel II
?First Pillar – Minimum capital
Basel II introduced to:
? combat regulatory arbitrage ? exploit and improve bank risk management systems
?Second Pillar – Supervisory review
?Third Pillar – Market discipline ? Treats exposures very unequally depending on exposure characteristics ? Treats banks very unequally depending on sophistication of risk management systems
? Will profoundly alter bank behaviour
4
Basel II – Timing
• Basel II – Published June 2004 – End 2006 for standardized and foundation IRB banks – End 2007 for advanced IRB banks – End 2009 (at earliest) before full IRB benefits achievable due to transition period – Basel/IOSCO review (not yet final) will change CRM rules and rules for trading book exposures • – – – – However New rules will alter banks’ behaviour right away Some countries will adopt prior to expected implementation dates, at least in part Implementation may be delayed in some countries Implementation may not be uniform • 140+ items subject to national discretion • Supervisory discretion • Lengthy adoption time permits lobbying
*Unless otherwise indicated, all references to paragraph numbers in these materials refer to paragraphs in June 2004 Basel II Accord 5
Basel II – Scope of Application
• Applied on consolidated basis to internationally active banks • Insurance entities – Generally, deduct bank’s equity and other capital investments in insurance subsidiaries – However, some G10 countries will retain current risk weighting treatment (100% for standardised banks) for competitiveness reasons – Supervisors may permit recognition by bank of excess capital invested in insurance subsidiary over required amount • Commercial entities – generally deducted significant investments in commercial entities above materiality thresholds – Significant investments in commercial entities below materiality thresholds risk weighted 100%
– All banking and other financial activities (whether or not regulated) captured through consolidation
– Financial activities do not include insurance
– Majority-owned subsidiaries not consolidated: deduct equity and capital investments
– Significant minority investments without control: deduct equity and capital investments – Deduction of investments 50% from tier 1 and 50% from tier 2 capital
6
Basel II – Three Pillars
Minimum Capital Charges: Minimum capital requirements based on market, credit and operational risk to (a) reduce risk of failure by cushioning against losses and (b) provide continuing access to financial markets to meet liquidity needs, and (c) provide incentives for prudent risk management
First Pillar
Second Pillar
Supervisory Review: Qualitative supervision by regulators of internal bank risk control and capital assessment process , including supervisory power to require banks to hold more capital than required under the First Pillar
Third Pillar
Market Discipline: New public disclosure requirements to compel improved bank risk management
8
Basel II – Capital Components
• Credit risk charges – Revised
– To ensure capital charges are more sensitive to risks of exposures in banking book
– Enhancements to counterparty risk charges also applicable to trading book exposures • Operational risk charges
– New
– To require capital for operating risks (fraud, legal, documentation, etc.) • Market risk charges
– Initially unchanged, but Basel/IOSCO review has proposed changes to specific risk calculations and Second Pillar stress testing
– To require capital for exposures in trading book – Rules in Market Risk Amendment (1996)
9
Basel II – Risks in Banking
– Credit Risk
• Default risk • Country Risk • Settlement risk
– Market Risk
– Liquidity Risk
– Interest Rate Risk – Operational risk – Reputational Risk
10
Basel II – Credit Risk
RBI definition
: Credit risk is defined as the possibility of losses associated with diminution in the
credit quality of borrowers or counterparties.
In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality.
External factors changes in government policies - trade policy - fiscal policy - import-export policy slow down in economy changes in market variables Internal factors -Business failure risk -Business management risk -Financial management risk -Settlement/pre-settlement risk on derivative products Portfolio risk -Adverse distribution -Adverse concentration -Large exposure -Correlation between industry sectors
11
Willful default
Basel II – Credit Risk
Size of Expected Loss “Expected Loss“ = EL = 1. What is the probability of a counterparty going into default?
“Probability of Default”
=
PD X
2. How much will that customer owe the bank in the case of default? (Expected Exposure)
“Loan Equivalency” (Exposure at Default)
=
EaD X
3. How much of that exposure is the bank going to lose?
“Severity” (Loss Given Default)
=
LGD
12
Basel II – Operational Risk Charges
Defined as risk of loss from inadequate or failed internal processes, people and systems, or from external events Examples of risks covered
? Internal and external fraud ? Legal risks ? Damages to customers ? Losses arising out of labour, health and safety, diversity, personal injury, etc.
? Damage to physical assets
? Business interruption
Examples of risks not covered
? Reputational risk ? Strategic errors
13
Basel II – Operational Risk Charges
Basic Indicator Approach
? 15% of bank’s average annual gross income over previous three years
Standardised Approach
? Capital charge for each of 8 business lines calculated against average annual gross income for business line times: ? 18% for corporate finance (15% transitional charge within EU if major activity) ? 18% for trading and sales (15% transitional charge within EU if major activity)
? 12% for retail banking
? 15% for commercial banking ? 18% for payment and settlement ? 15% for agency services ? 12% for asset management ? 12% for retail brokerage
Advanced Measurement Approach
? Calculated on basis of internal operational risk management system approved by national regulator
14
Basel II – Rating Charges
15
Basel II –Risk Charges
16
Basel II – Indian Banks: Preparedness
17
Basel II – Second Pillar Supervisory Review
Four key principles of supervisory review ? Principle 1: Banks should have process for assessing overall capital adequacy in relation to risk profile and strategy for maintaining capital levels. Five main features of rigorous process:
? Board and senior management oversight ? Sound capital assessment ? Comprehensive risk analysis (credit risk, operational risk, market risk, interest rate risk in banking book, liquidity risk, other risk) ? Monitoring and reporting
? Internal control review ? Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as ability to monitor and ensure compliance with ratios. Supervisors should take appropriate action if not satisfied. ? Principle 3: Supervisors should expect banks to operate above minimum ratios and should have ability to require banks to hold capital in excess of minimum ? Principle 4: Supervisors should seek to intervene at early stage and require rapid remedial action
18
Basel II – Supervisory review
Specific issues ? Interest rate risk in banking book: Basel II treats interest rate risk under Second Pillar of supervisory review (rather than First Pillar of regulatory capital) due to differences in methods banks use to handle risk ? Credit risk: Supervisory review is appropriate to regulate stress tests under IRB approach, definition of default used to determine PD and/or LGD and EAD, residual risk, credit concentration risk and operational risk Other issues ? Supervisory transparency and accountability: Supervisors should make publicly available criteria used in review of banks’ internal capital assessments ? Enhanced cross-border communication and cooperation: Basel Committee supports pragmatic provision of close and continuous dialogue between industry participants and supervisors, as well as between supervisors (without changing legal responsibilities of national regulators).
Source:
Text
19
Basel II – Supervisory review
Supervisory review process for securitisation) ? Economic substance: Supervisory capital requirements may vary from those specified in First Pillar if would not adequately and sufficiently reflect risks of exposure ? Maturity: Supervisors will review documentation to ensure that maturity mismatches not artificially created to reduce capital requirements ? Correlation: Supervisors may review banks’ assessment of actual correlations between assets in pools and how that is reflected in capital calculation; with ability to increase capital if correlation not appropriately reflected ? Significant risk transfer: Although securitisation may occur for reasons other than risk transfer (i.e., funding), where risk transfer is insufficient or non-existent supervisors can deny capital relief ? Market innovations: Supervisors can take account of new features either through First Pillar changes in minimum capital requirements or Second Pillar supervisory action ? Implicit Support: If banks engage in implicit support more than once, supervisors must require disclosure and may apply one or more of (a) refusing further capital relief for securitised assets, for period of time or permanently, (b) applying conversion factor to all securitised assets so as to hold capital against them, or (c) requiring banks to hold capital in excess of minimum requirements
20
Basel II – Third Pillar Market Discipline
Objective ? Impose market discipline on banks by requiring disclosure of key information relevant to banks’ risks and capital Qualitative Disclosures for Securitisation ? Bank’s objectives for, and roles played by it in, securitisation process ? Bank’s accounting objectives for securitisation ? Whether treated as sales or financings ? Whether bank recognises gain on sale ? Key assumptions used by bank for valuing retained interests ? Bank’s treatment of synthetic securitisations ? Names of rating agencies used by bank and types of exposures rated by each agency
21
Basel II – Disclosure
Quantitative Disclosures for Securitisation ? Total outstanding exposures securitised by bank subject to securitisation framework ? For exposures securitised by bank subject to framework (in each case broken down by exposure type): ? Amount of impaired/past due assets ? Losses recognised by bank during current period ? Aggregate amount of securitisation exposures retained or purchased by bank, broken down by exposure type ? Aggregate amount of securitisation exposures retained or purchased by bank, broken down by “reasonable number” of risk bands (deducted exposures disclosed separately) ? Aggregate amount of securitised revolving exposures segregated by originator’s interest and investors’ interest ? Summary of current year’s securitisation activity, including aggregate amount of exposures securitised and gain or loss on sale, by asset type
22
Some Observations
Basel II – Observations
Open Issues
? Will banks cope (implementing systems)? ? Will regulators cope (monitoring systems and data)? ? Will inconsistencies be minimised? ? Inconsistent rules in Basel II itself (e.g. corporate risk weights vs. securitisation risk weights) ? Inconsistent national rules finally adopted by regulators ? Inconsistent application by supervisors (including different supervision of banks, vs. securities firms, vs. insurance companies, vs. non-regulated financial companies)
? Will regulators provide recognition of double-default effects for pools of exposures or stick with substitution?
? Will impractical operational requirements for IAA be addressed? ? Will the definition of defaulted assets be extended beyond 90 days?
24
Basel II – Observations
Impact on financial markets
? Spread tightening as capital costs of holding “winners” drops: ? ABS tranches rated BBB and higher ? Corporates rated BBB or higher ? Non-OECD sovereigns rated above BB+
? Spread widening/credit tightening as capital costs of holding “losers” increases: ? Lower rated banks, corporates and ABS ? OECD sovereigns rated below AA- (but banks may hold for liquidity purposes anyway) ? Non-bank equities; non-core high operating cost activities (asset management)
25
Basel II – Observations
Impact on banks
? Banks with more Basel II winners in portfolio benefit ? Banks with more Basel II losers in portfolio suffer ? Possible divestitures of capital-heavy businesses ? Insurance ? Asset management ? Non-bank equities ? Impact on corporate lending activities ? Return of high-quality corporates to banks as borrowers ? Credit less available to lower-quality borrowers ? Tiering of SME market – local banks for relationship lending, larger banks for credit-based lending
26
Basel II – Observations
Impact on securitisation markets
? Will motivate banks to securitise higher risk weighted assets and keep lower risk weighted assets ? Will cost more to securitise, due to higher capital for lower rated tranches and unfunded commitments (motivating banks to seek non-regulated investor base and lower cost liquidity alternatives) ? Higher costs may slow growth of securitisation generally, reducing banks’ ability to disperse credit risks throughout the financial system ? Securitisation volumes may rise in certain products to remove them from banks’ balance sheets: ? Credit cards – due to capital held against unfunded commitments ? Commercial mortgages – due to higher capital charges against lower quality exposures
? Loans – due to higher capital charges against lower quality exposures
? Covered bonds ? If cheaper to hold mortgages on balance sheet under Basel II, then covered bonds advantages over securitisation ? But will regulators limit quantity of covered bond issuances? (FSA’s 4% suggestion)
27
Basel II – Challenges
• The new norms might, in some cases, lead to an increase in the overall regulatory capital requirements for the banks • The Standardized Approach for credit risk leans heavily on the external credit ratings. • While the RBI has accredited four rating agencies operating in India, the rating penetration in India is rather low. • The risk weighting scheme under Standardized Approach also creates some incentive for some of the bank clients to remain unrated since such entities receive a lower risk weight of 100 per cent vis?à vis 150 per cent risk weight for a lowest rated client. This might specially be the case if the unrated client expects a poor rating. The banks will need to be watchful in this regard. • Implementing the ICAAP under the Pillar 2 of the framework would perhaps be the biggest challenge for the banks in India as it requires a comprehensive risk modeling infrastructure to capture all the risks that are not covered under the other two Pillars of the framework. The validation of the internal models of the banks by the supervisors would also be an arduous task. • An overarching requirement for efficient data management and for effective risk management structures would be a state?of?the?art technological infrastructure which might need significant investment. • The complexity of advanced approaches requires highly skilled staff and the human resource management in the banking industry, particularly for the public sector banks, could emerge to be a binding constraint, in adopting advanced approaches
28
Basel II – Criticisms
• Unfairly advantage the larger banks • Disadvantage the economically marginalized by restricting their access to credit or by making it more expensive • The operation of Basel II will lead to a more pronounced business cycle
29
Basel II – India Case
Basel II framework has been evolved to suit mainly the industrialised G?10 countries where the demand for primary credit has long been saturated. In fact, there has been a general concern that the Basel II norms may go against the interests of developing countries, small enterprises and infrastructure projects, which deserve a liberal approach to bank credit. In other words, critics fear that Basel II might accentuate the classic dilemma faced by the developing countries? Whether to have sound banking or good roads. Moreover, developing countries such as India and China enjoy a tradition of public trust in government banks, which continue to do business in good times and bad, irrespective of the level of capital they hold. Under the circumstances, the question arises why these countries should opt for elaborate and cumbersome regulations such as Basel II. Again, critics point out, minimum capital requirement is only good as far as it goes and wonder how good it will be when crisis hits the banks. Most banks which suffered in the Asian financial crisis were well capitalised with capital adequacy well above the required levels.
30
Basel II – India Case
The explanation why countries such as India are eager to adopt the new framework perhaps lies in the Basel II authors' contention that "by motivating banks to upgrade and improve their risk management systems, business models, capital strategies and disclosure standards, the Basel II framework should improve their overall efficiency and resilience." Even Basel I was originally meant for internationally active banks in the G?10 countries but it was soon accepted universally as a benchmark measure of a bank's solvency and was, subsequently, adopted in some form by more than 100 countries. Introduction of Basel I coincided with the initiation of financial reforms in India in the early 1990s. The prudential norms set out by Basel I came as a timely solution to the ills affecting the Indian banks, particularly the public sector banks (PSBs) after two decades of nationalisation. That these banks despite the differences in their strengths and weaknesses could switch over to the international standards without much hiccups has surprised many a critic.
31
Financial Sector Reforms
Raghuram rajan report (RRR)
32
Flow
– Macroeconomic Framework – Broadening Access to Finance – Leveling the Playing Field – Creating More Efficient and Liquid Markets – A Growth Friendly Regulatory Framework – Creating a Robust Infrastructure for Credit – Drawbacks
Conception of the Committee
1. Financial Inclusion 2. Contribution of the Financial Sector to Growth 3. Improve Financial Stability
– Underlying Theme: Need to enhance inclusion, growth and stability by allowing players more freedom, and strengthening the financial and regulatory infrastructure
Macroeconomic Framework
• The Country has to adjust to a world of rapid capital flows • Real exchange rate determined by productivity growth and demand supply imbalances • Hobson’s choice: Inflation or as nominal exchange rate appreciation
• RBI’s freedom of action confuses markets – Markets charge a high premium, hurting growth
Macroeconomic Framework
– Proposal 1: RBI should have a single objective of controlling Inflation
• Single instrument (repo and reverse repo) • Capital controls/ Sterilized currency intervention ineffective in the long run • Should not stamp on foreign capital – infrastructural needs, future requirements
Macroeconomic Framework
– Proposal 2: Open up investment in the rupee corporate and government bond markets to foreign investors, after framework is in place
• Allow foreign investors in Corporate and Government bond market – liquidity • Considering the exchange rate appreciation it must be done opportunistically • we should accept the possible costs of appreciation as a down payment on the more robust markets and financing we will enjoy in thefuture. • Relieve pressure from inflows by becoming more liberal on outflows • Rides on Fiscal Discipline & Real Sector Reforms
Macroeconomic Framework
• Criticism:
– Academic and aloof from reality – India has done remarkably well with an “intermediate” exchange rate regime of managed flexibility and partial capital controls – Single objective of RBI means RBI should drop the other objectives namely, the level and growth of the country’s economic activity, the nation’s financial stability and the level and volatility of the exchange rate – Single objective of targeting Inflation will not work in India
Broadening Access to Finance
• Financial Inclusion:
– Not only expanding credit – Expanding access to financial services, like payment services, insurance products etc.
• National goal of access to deposit schemes to 90% of households in 3 years • Access to Poor whether in Urban or Rural areas
Broadening Access to Finance
– Proposal 3: Allow more entry to private wellgoverned deposit-taking small finance banks
• Offset concentration risk by requiring higher capital adequacy norms, strict prohibition on related party transactions, lower allowable concentration norms • Better monitoring and supervision of these banks and more selective • Small banks have not distinguished themselves in India in the past, often because of poor governance structures, excessive government and political support as well as interference, and an unwillingness/inability of the regulator to undertake prompt corrective action.
Broadening Access to Finance
– Large banks must be able to ‘Bridge the last mile’
• should be able to use existing networks like cellphone kiosks or kirana shops as business correspondents to deliver products.
Broadening Access to Finance
– Proposal 4: Liberalize the banking correspondent regulation so that a wide range of local agents can serve to extend financial services.
• Large banks must be able to ‘Bridge the last mile’ • should be able to use existing networks like cellphone kiosks or kirana shops as business correspondents to deliver products. • Use technology both to reduce costs and to limit fraud and misrepresentation
Broadening Access to Finance
– Governance reforms for Co-operative banks where:
• members have their funds at stake and exercise control • debtors do not have disproportionate power • Government refinance gives way to refinance by the market
Broadening Access to Finance
– Proposal 5: Priority Sector Loan Certificates (PSLC) to all entities that lend to eligible categories in the priority sector
• Similar to carbon credits, banks that undershoot their priority sector obligations to buy the PSLC and submit it towards fulfillment of their target • At the same time liberalize interest rates
– Proposal 6: Liberalizing Interest rates for poor
• Ensure Transparency & only loans that stay within a margin of local estimated costs of lending to the poor be eligible for PSLCs.
Broadening Access to Finance
• Criticism:
– The committee has underestimated the enormous regulatory challenges involved with governing local area private banks, especially in a multi-party federation with declining governance standards.
Leveling the Playing Field
• The public sector is constrained in some ways but enjoys some privileges in other ways • The domestic private sector enjoys some privileges relative to foreign players, but not everywhere • The public sector banks, accounting for 70 percent of the system • Much of the public sector is falling behind in its ability to attract skilled people, especially at senior levels, in its ability to take advantage of new technologies, in its ability to motivate employees at lower levels, and in its ability to innovate • Reducing the government’s ownership below 50 percent while retaining its control
Leveling the Playing Field
– Proposal 7: Sell small underperforming public sector banks, possibly to another bank or to a strategic investor, to gain experience with the process and gauge outcomes
• Ruling out the sale of large PSB’s to large Private sector banks, Industrial houses or to international Banks, Only a sale through public offering is left
– Proposal 8: Create stronger boards for large public sector banks, with more power to outside shareholders
Leveling the Playing Field
– Proposal 9: Delink the banks from additional government oversight, including by the Central Vigilance Commission and Parliament – Proposal 10: Be more liberal in allowing takeovers and mergers – Proposal 11: Free banks to set up branches and ATMs anywhere
• Anyone who has seen the transformation in the telecom and civil aviation sectors will testify to the benefits of greater competition.
– Proposal 12: Allow holding company structures, with a parent holding company owning regulated subsidiaries. The holding company should be supervised by the Financial Sector Oversight Agency (see later), with each regulated subsidiary supervised by the appropriate regulator. The holding company should be well diversified if it owns a bank.
Creating More Efficient and Liquid Markets
• Moribund markets – corporate bonds, exchange traded interest rate, forex derivatives • Equity markets – to be more inclusive • All trading under one regulator SEBI • Formation of Financial Sector Oversight Agency (FSOA)
Creating More Efficient and Liquid Markets - Drawbacks
• FSOA – Yet another regulating body ! • In the absence of risk free yield curve, reviving bond markets will be futile due to huge government borrowings • Corporate bonds are priced off the risk-free sovereign yield curve as per credit rating of firm • Change ‘If you can’t manage them, ban them’ mentality
Creating a Growth Friendly Regulatory Environment
• Key concerns :
– Slow pace of innovation – Excessive regulatory micro-management – Banks are not the only source of liquidity risk in the markets
– Suggestions – Deep markets with varied participants can absorb risk better – There is no perfect regulator – Northen Rock, Bear Sterns – Regulators can not stand in the way of progress
Creating a Robust Infrastructure for Credit
• Free flow of credit requires :
– Lenders having sufficient knowledge about the borrowers – Able to take borrower’s assets as collateral – Able to enforce penalties in case of default – Able to seize borrower’s pledged assets
Creating a Robust Infrastructure for Credit
• Key Characteristics:
– Unique national ID number with biometric identification – Information sharing among credit provider to be changed from ‘reciprocity’ to ‘need to know and authorization to use’ – Land registration and titling to be speeded up and land dispute backlogs to be cleared using special court laws and support from Center – Bankruptcy code – Encourage the entry of more well-capitalized ARCs, including ones with foreign backing
Closing Thoughts
• Bold but cautious • Committee composition • Many top notch suggestions
– Promoting small banks – Collateral registration – Creditor protection and new bankruptcy code
doc_935716837.pptx
This is a presentation about basel basics, four pillars of basel 2 i.e. basel 2 minimum capital capital requirements, basel 2 operational risk charges, supervisory review and market discipline.
Global Economy
BASEL II & Raghuram Rajan committee executive summary
10th September 2008
Presented by:
•30166 Kaashika Bhalla •30161 Aanchal Agarwal •30168 Darshil Bhatt •30175 Jude D’souza
The Basel II Capital Accord
June 2005
Flow of Presentation
Basel basics Basel II minimum capital charges – First Pillar Basel II operational risk charges Supervisory Review – Second Pillar Market discipline – Third Pillar Some observations
Executive Summary
? In effect since 1988; very simple in application
Basel I
? Easy to achieve significant capital reduction with little or no risk transfer ? Much more complex and risk sensitive
Basel II
?First Pillar – Minimum capital
Basel II introduced to:
? combat regulatory arbitrage ? exploit and improve bank risk management systems
?Second Pillar – Supervisory review
?Third Pillar – Market discipline ? Treats exposures very unequally depending on exposure characteristics ? Treats banks very unequally depending on sophistication of risk management systems
? Will profoundly alter bank behaviour
4
Basel II – Timing
• Basel II – Published June 2004 – End 2006 for standardized and foundation IRB banks – End 2007 for advanced IRB banks – End 2009 (at earliest) before full IRB benefits achievable due to transition period – Basel/IOSCO review (not yet final) will change CRM rules and rules for trading book exposures • – – – – However New rules will alter banks’ behaviour right away Some countries will adopt prior to expected implementation dates, at least in part Implementation may be delayed in some countries Implementation may not be uniform • 140+ items subject to national discretion • Supervisory discretion • Lengthy adoption time permits lobbying
*Unless otherwise indicated, all references to paragraph numbers in these materials refer to paragraphs in June 2004 Basel II Accord 5
Basel II – Scope of Application
• Applied on consolidated basis to internationally active banks • Insurance entities – Generally, deduct bank’s equity and other capital investments in insurance subsidiaries – However, some G10 countries will retain current risk weighting treatment (100% for standardised banks) for competitiveness reasons – Supervisors may permit recognition by bank of excess capital invested in insurance subsidiary over required amount • Commercial entities – generally deducted significant investments in commercial entities above materiality thresholds – Significant investments in commercial entities below materiality thresholds risk weighted 100%
– All banking and other financial activities (whether or not regulated) captured through consolidation
– Financial activities do not include insurance
– Majority-owned subsidiaries not consolidated: deduct equity and capital investments
– Significant minority investments without control: deduct equity and capital investments – Deduction of investments 50% from tier 1 and 50% from tier 2 capital
6
Basel II – Three Pillars
Minimum Capital Charges: Minimum capital requirements based on market, credit and operational risk to (a) reduce risk of failure by cushioning against losses and (b) provide continuing access to financial markets to meet liquidity needs, and (c) provide incentives for prudent risk management
First Pillar
Second Pillar
Supervisory Review: Qualitative supervision by regulators of internal bank risk control and capital assessment process , including supervisory power to require banks to hold more capital than required under the First Pillar
Third Pillar
Market Discipline: New public disclosure requirements to compel improved bank risk management
8
Basel II – Capital Components
• Credit risk charges – Revised
– To ensure capital charges are more sensitive to risks of exposures in banking book
– Enhancements to counterparty risk charges also applicable to trading book exposures • Operational risk charges
– New
– To require capital for operating risks (fraud, legal, documentation, etc.) • Market risk charges
– Initially unchanged, but Basel/IOSCO review has proposed changes to specific risk calculations and Second Pillar stress testing
– To require capital for exposures in trading book – Rules in Market Risk Amendment (1996)
9
Basel II – Risks in Banking
– Credit Risk
• Default risk • Country Risk • Settlement risk
– Market Risk
– Liquidity Risk
– Interest Rate Risk – Operational risk – Reputational Risk
10
Basel II – Credit Risk
RBI definition
: Credit risk is defined as the possibility of losses associated with diminution in the
credit quality of borrowers or counterparties.
In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality.
External factors changes in government policies - trade policy - fiscal policy - import-export policy slow down in economy changes in market variables Internal factors -Business failure risk -Business management risk -Financial management risk -Settlement/pre-settlement risk on derivative products Portfolio risk -Adverse distribution -Adverse concentration -Large exposure -Correlation between industry sectors
11
Willful default
Basel II – Credit Risk
Size of Expected Loss “Expected Loss“ = EL = 1. What is the probability of a counterparty going into default?
“Probability of Default”
=
PD X
2. How much will that customer owe the bank in the case of default? (Expected Exposure)
“Loan Equivalency” (Exposure at Default)
=
EaD X
3. How much of that exposure is the bank going to lose?
“Severity” (Loss Given Default)
=
LGD
12
Basel II – Operational Risk Charges
Defined as risk of loss from inadequate or failed internal processes, people and systems, or from external events Examples of risks covered
? Internal and external fraud ? Legal risks ? Damages to customers ? Losses arising out of labour, health and safety, diversity, personal injury, etc.
? Damage to physical assets
? Business interruption
Examples of risks not covered
? Reputational risk ? Strategic errors
13
Basel II – Operational Risk Charges
Basic Indicator Approach
? 15% of bank’s average annual gross income over previous three years
Standardised Approach
? Capital charge for each of 8 business lines calculated against average annual gross income for business line times: ? 18% for corporate finance (15% transitional charge within EU if major activity) ? 18% for trading and sales (15% transitional charge within EU if major activity)
? 12% for retail banking
? 15% for commercial banking ? 18% for payment and settlement ? 15% for agency services ? 12% for asset management ? 12% for retail brokerage
Advanced Measurement Approach
? Calculated on basis of internal operational risk management system approved by national regulator
14
Basel II – Rating Charges
15
Basel II –Risk Charges
16
Basel II – Indian Banks: Preparedness
17
Basel II – Second Pillar Supervisory Review
Four key principles of supervisory review ? Principle 1: Banks should have process for assessing overall capital adequacy in relation to risk profile and strategy for maintaining capital levels. Five main features of rigorous process:
? Board and senior management oversight ? Sound capital assessment ? Comprehensive risk analysis (credit risk, operational risk, market risk, interest rate risk in banking book, liquidity risk, other risk) ? Monitoring and reporting
? Internal control review ? Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as ability to monitor and ensure compliance with ratios. Supervisors should take appropriate action if not satisfied. ? Principle 3: Supervisors should expect banks to operate above minimum ratios and should have ability to require banks to hold capital in excess of minimum ? Principle 4: Supervisors should seek to intervene at early stage and require rapid remedial action
18
Basel II – Supervisory review
Specific issues ? Interest rate risk in banking book: Basel II treats interest rate risk under Second Pillar of supervisory review (rather than First Pillar of regulatory capital) due to differences in methods banks use to handle risk ? Credit risk: Supervisory review is appropriate to regulate stress tests under IRB approach, definition of default used to determine PD and/or LGD and EAD, residual risk, credit concentration risk and operational risk Other issues ? Supervisory transparency and accountability: Supervisors should make publicly available criteria used in review of banks’ internal capital assessments ? Enhanced cross-border communication and cooperation: Basel Committee supports pragmatic provision of close and continuous dialogue between industry participants and supervisors, as well as between supervisors (without changing legal responsibilities of national regulators).
Source:
Text
19
Basel II – Supervisory review
Supervisory review process for securitisation) ? Economic substance: Supervisory capital requirements may vary from those specified in First Pillar if would not adequately and sufficiently reflect risks of exposure ? Maturity: Supervisors will review documentation to ensure that maturity mismatches not artificially created to reduce capital requirements ? Correlation: Supervisors may review banks’ assessment of actual correlations between assets in pools and how that is reflected in capital calculation; with ability to increase capital if correlation not appropriately reflected ? Significant risk transfer: Although securitisation may occur for reasons other than risk transfer (i.e., funding), where risk transfer is insufficient or non-existent supervisors can deny capital relief ? Market innovations: Supervisors can take account of new features either through First Pillar changes in minimum capital requirements or Second Pillar supervisory action ? Implicit Support: If banks engage in implicit support more than once, supervisors must require disclosure and may apply one or more of (a) refusing further capital relief for securitised assets, for period of time or permanently, (b) applying conversion factor to all securitised assets so as to hold capital against them, or (c) requiring banks to hold capital in excess of minimum requirements
20
Basel II – Third Pillar Market Discipline
Objective ? Impose market discipline on banks by requiring disclosure of key information relevant to banks’ risks and capital Qualitative Disclosures for Securitisation ? Bank’s objectives for, and roles played by it in, securitisation process ? Bank’s accounting objectives for securitisation ? Whether treated as sales or financings ? Whether bank recognises gain on sale ? Key assumptions used by bank for valuing retained interests ? Bank’s treatment of synthetic securitisations ? Names of rating agencies used by bank and types of exposures rated by each agency
21
Basel II – Disclosure
Quantitative Disclosures for Securitisation ? Total outstanding exposures securitised by bank subject to securitisation framework ? For exposures securitised by bank subject to framework (in each case broken down by exposure type): ? Amount of impaired/past due assets ? Losses recognised by bank during current period ? Aggregate amount of securitisation exposures retained or purchased by bank, broken down by exposure type ? Aggregate amount of securitisation exposures retained or purchased by bank, broken down by “reasonable number” of risk bands (deducted exposures disclosed separately) ? Aggregate amount of securitised revolving exposures segregated by originator’s interest and investors’ interest ? Summary of current year’s securitisation activity, including aggregate amount of exposures securitised and gain or loss on sale, by asset type
22
Some Observations
Basel II – Observations
Open Issues
? Will banks cope (implementing systems)? ? Will regulators cope (monitoring systems and data)? ? Will inconsistencies be minimised? ? Inconsistent rules in Basel II itself (e.g. corporate risk weights vs. securitisation risk weights) ? Inconsistent national rules finally adopted by regulators ? Inconsistent application by supervisors (including different supervision of banks, vs. securities firms, vs. insurance companies, vs. non-regulated financial companies)
? Will regulators provide recognition of double-default effects for pools of exposures or stick with substitution?
? Will impractical operational requirements for IAA be addressed? ? Will the definition of defaulted assets be extended beyond 90 days?
24
Basel II – Observations
Impact on financial markets
? Spread tightening as capital costs of holding “winners” drops: ? ABS tranches rated BBB and higher ? Corporates rated BBB or higher ? Non-OECD sovereigns rated above BB+
? Spread widening/credit tightening as capital costs of holding “losers” increases: ? Lower rated banks, corporates and ABS ? OECD sovereigns rated below AA- (but banks may hold for liquidity purposes anyway) ? Non-bank equities; non-core high operating cost activities (asset management)
25
Basel II – Observations
Impact on banks
? Banks with more Basel II winners in portfolio benefit ? Banks with more Basel II losers in portfolio suffer ? Possible divestitures of capital-heavy businesses ? Insurance ? Asset management ? Non-bank equities ? Impact on corporate lending activities ? Return of high-quality corporates to banks as borrowers ? Credit less available to lower-quality borrowers ? Tiering of SME market – local banks for relationship lending, larger banks for credit-based lending
26
Basel II – Observations
Impact on securitisation markets
? Will motivate banks to securitise higher risk weighted assets and keep lower risk weighted assets ? Will cost more to securitise, due to higher capital for lower rated tranches and unfunded commitments (motivating banks to seek non-regulated investor base and lower cost liquidity alternatives) ? Higher costs may slow growth of securitisation generally, reducing banks’ ability to disperse credit risks throughout the financial system ? Securitisation volumes may rise in certain products to remove them from banks’ balance sheets: ? Credit cards – due to capital held against unfunded commitments ? Commercial mortgages – due to higher capital charges against lower quality exposures
? Loans – due to higher capital charges against lower quality exposures
? Covered bonds ? If cheaper to hold mortgages on balance sheet under Basel II, then covered bonds advantages over securitisation ? But will regulators limit quantity of covered bond issuances? (FSA’s 4% suggestion)
27
Basel II – Challenges
• The new norms might, in some cases, lead to an increase in the overall regulatory capital requirements for the banks • The Standardized Approach for credit risk leans heavily on the external credit ratings. • While the RBI has accredited four rating agencies operating in India, the rating penetration in India is rather low. • The risk weighting scheme under Standardized Approach also creates some incentive for some of the bank clients to remain unrated since such entities receive a lower risk weight of 100 per cent vis?à vis 150 per cent risk weight for a lowest rated client. This might specially be the case if the unrated client expects a poor rating. The banks will need to be watchful in this regard. • Implementing the ICAAP under the Pillar 2 of the framework would perhaps be the biggest challenge for the banks in India as it requires a comprehensive risk modeling infrastructure to capture all the risks that are not covered under the other two Pillars of the framework. The validation of the internal models of the banks by the supervisors would also be an arduous task. • An overarching requirement for efficient data management and for effective risk management structures would be a state?of?the?art technological infrastructure which might need significant investment. • The complexity of advanced approaches requires highly skilled staff and the human resource management in the banking industry, particularly for the public sector banks, could emerge to be a binding constraint, in adopting advanced approaches
28
Basel II – Criticisms
• Unfairly advantage the larger banks • Disadvantage the economically marginalized by restricting their access to credit or by making it more expensive • The operation of Basel II will lead to a more pronounced business cycle
29
Basel II – India Case
Basel II framework has been evolved to suit mainly the industrialised G?10 countries where the demand for primary credit has long been saturated. In fact, there has been a general concern that the Basel II norms may go against the interests of developing countries, small enterprises and infrastructure projects, which deserve a liberal approach to bank credit. In other words, critics fear that Basel II might accentuate the classic dilemma faced by the developing countries? Whether to have sound banking or good roads. Moreover, developing countries such as India and China enjoy a tradition of public trust in government banks, which continue to do business in good times and bad, irrespective of the level of capital they hold. Under the circumstances, the question arises why these countries should opt for elaborate and cumbersome regulations such as Basel II. Again, critics point out, minimum capital requirement is only good as far as it goes and wonder how good it will be when crisis hits the banks. Most banks which suffered in the Asian financial crisis were well capitalised with capital adequacy well above the required levels.
30
Basel II – India Case
The explanation why countries such as India are eager to adopt the new framework perhaps lies in the Basel II authors' contention that "by motivating banks to upgrade and improve their risk management systems, business models, capital strategies and disclosure standards, the Basel II framework should improve their overall efficiency and resilience." Even Basel I was originally meant for internationally active banks in the G?10 countries but it was soon accepted universally as a benchmark measure of a bank's solvency and was, subsequently, adopted in some form by more than 100 countries. Introduction of Basel I coincided with the initiation of financial reforms in India in the early 1990s. The prudential norms set out by Basel I came as a timely solution to the ills affecting the Indian banks, particularly the public sector banks (PSBs) after two decades of nationalisation. That these banks despite the differences in their strengths and weaknesses could switch over to the international standards without much hiccups has surprised many a critic.
31
Financial Sector Reforms
Raghuram rajan report (RRR)
32
Flow
– Macroeconomic Framework – Broadening Access to Finance – Leveling the Playing Field – Creating More Efficient and Liquid Markets – A Growth Friendly Regulatory Framework – Creating a Robust Infrastructure for Credit – Drawbacks
Conception of the Committee
1. Financial Inclusion 2. Contribution of the Financial Sector to Growth 3. Improve Financial Stability
– Underlying Theme: Need to enhance inclusion, growth and stability by allowing players more freedom, and strengthening the financial and regulatory infrastructure
Macroeconomic Framework
• The Country has to adjust to a world of rapid capital flows • Real exchange rate determined by productivity growth and demand supply imbalances • Hobson’s choice: Inflation or as nominal exchange rate appreciation
• RBI’s freedom of action confuses markets – Markets charge a high premium, hurting growth
Macroeconomic Framework
– Proposal 1: RBI should have a single objective of controlling Inflation
• Single instrument (repo and reverse repo) • Capital controls/ Sterilized currency intervention ineffective in the long run • Should not stamp on foreign capital – infrastructural needs, future requirements
Macroeconomic Framework
– Proposal 2: Open up investment in the rupee corporate and government bond markets to foreign investors, after framework is in place
• Allow foreign investors in Corporate and Government bond market – liquidity • Considering the exchange rate appreciation it must be done opportunistically • we should accept the possible costs of appreciation as a down payment on the more robust markets and financing we will enjoy in thefuture. • Relieve pressure from inflows by becoming more liberal on outflows • Rides on Fiscal Discipline & Real Sector Reforms
Macroeconomic Framework
• Criticism:
– Academic and aloof from reality – India has done remarkably well with an “intermediate” exchange rate regime of managed flexibility and partial capital controls – Single objective of RBI means RBI should drop the other objectives namely, the level and growth of the country’s economic activity, the nation’s financial stability and the level and volatility of the exchange rate – Single objective of targeting Inflation will not work in India
Broadening Access to Finance
• Financial Inclusion:
– Not only expanding credit – Expanding access to financial services, like payment services, insurance products etc.
• National goal of access to deposit schemes to 90% of households in 3 years • Access to Poor whether in Urban or Rural areas
Broadening Access to Finance
– Proposal 3: Allow more entry to private wellgoverned deposit-taking small finance banks
• Offset concentration risk by requiring higher capital adequacy norms, strict prohibition on related party transactions, lower allowable concentration norms • Better monitoring and supervision of these banks and more selective • Small banks have not distinguished themselves in India in the past, often because of poor governance structures, excessive government and political support as well as interference, and an unwillingness/inability of the regulator to undertake prompt corrective action.
Broadening Access to Finance
– Large banks must be able to ‘Bridge the last mile’
• should be able to use existing networks like cellphone kiosks or kirana shops as business correspondents to deliver products.
Broadening Access to Finance
– Proposal 4: Liberalize the banking correspondent regulation so that a wide range of local agents can serve to extend financial services.
• Large banks must be able to ‘Bridge the last mile’ • should be able to use existing networks like cellphone kiosks or kirana shops as business correspondents to deliver products. • Use technology both to reduce costs and to limit fraud and misrepresentation
Broadening Access to Finance
– Governance reforms for Co-operative banks where:
• members have their funds at stake and exercise control • debtors do not have disproportionate power • Government refinance gives way to refinance by the market
Broadening Access to Finance
– Proposal 5: Priority Sector Loan Certificates (PSLC) to all entities that lend to eligible categories in the priority sector
• Similar to carbon credits, banks that undershoot their priority sector obligations to buy the PSLC and submit it towards fulfillment of their target • At the same time liberalize interest rates
– Proposal 6: Liberalizing Interest rates for poor
• Ensure Transparency & only loans that stay within a margin of local estimated costs of lending to the poor be eligible for PSLCs.
Broadening Access to Finance
• Criticism:
– The committee has underestimated the enormous regulatory challenges involved with governing local area private banks, especially in a multi-party federation with declining governance standards.
Leveling the Playing Field
• The public sector is constrained in some ways but enjoys some privileges in other ways • The domestic private sector enjoys some privileges relative to foreign players, but not everywhere • The public sector banks, accounting for 70 percent of the system • Much of the public sector is falling behind in its ability to attract skilled people, especially at senior levels, in its ability to take advantage of new technologies, in its ability to motivate employees at lower levels, and in its ability to innovate • Reducing the government’s ownership below 50 percent while retaining its control
Leveling the Playing Field
– Proposal 7: Sell small underperforming public sector banks, possibly to another bank or to a strategic investor, to gain experience with the process and gauge outcomes
• Ruling out the sale of large PSB’s to large Private sector banks, Industrial houses or to international Banks, Only a sale through public offering is left
– Proposal 8: Create stronger boards for large public sector banks, with more power to outside shareholders
Leveling the Playing Field
– Proposal 9: Delink the banks from additional government oversight, including by the Central Vigilance Commission and Parliament – Proposal 10: Be more liberal in allowing takeovers and mergers – Proposal 11: Free banks to set up branches and ATMs anywhere
• Anyone who has seen the transformation in the telecom and civil aviation sectors will testify to the benefits of greater competition.
– Proposal 12: Allow holding company structures, with a parent holding company owning regulated subsidiaries. The holding company should be supervised by the Financial Sector Oversight Agency (see later), with each regulated subsidiary supervised by the appropriate regulator. The holding company should be well diversified if it owns a bank.
Creating More Efficient and Liquid Markets
• Moribund markets – corporate bonds, exchange traded interest rate, forex derivatives • Equity markets – to be more inclusive • All trading under one regulator SEBI • Formation of Financial Sector Oversight Agency (FSOA)
Creating More Efficient and Liquid Markets - Drawbacks
• FSOA – Yet another regulating body ! • In the absence of risk free yield curve, reviving bond markets will be futile due to huge government borrowings • Corporate bonds are priced off the risk-free sovereign yield curve as per credit rating of firm • Change ‘If you can’t manage them, ban them’ mentality
Creating a Growth Friendly Regulatory Environment
• Key concerns :
– Slow pace of innovation – Excessive regulatory micro-management – Banks are not the only source of liquidity risk in the markets
– Suggestions – Deep markets with varied participants can absorb risk better – There is no perfect regulator – Northen Rock, Bear Sterns – Regulators can not stand in the way of progress
Creating a Robust Infrastructure for Credit
• Free flow of credit requires :
– Lenders having sufficient knowledge about the borrowers – Able to take borrower’s assets as collateral – Able to enforce penalties in case of default – Able to seize borrower’s pledged assets
Creating a Robust Infrastructure for Credit
• Key Characteristics:
– Unique national ID number with biometric identification – Information sharing among credit provider to be changed from ‘reciprocity’ to ‘need to know and authorization to use’ – Land registration and titling to be speeded up and land dispute backlogs to be cleared using special court laws and support from Center – Bankruptcy code – Encourage the entry of more well-capitalized ARCs, including ones with foreign backing
Closing Thoughts
• Bold but cautious • Committee composition • Many top notch suggestions
– Promoting small banks – Collateral registration – Creditor protection and new bankruptcy code
doc_935716837.pptx