Vade Mecum - New Basel Capital Accord

International Convergence of Capital Measurement and Capital Standards Basel Committee on Banking Supervision •

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The Changes in Basel II vs Basel I o

More sophisticated approaches for calculating credit risk capital requirements

o

Reduces scope for Capital Arbitrage1

o

A Capital Charge for Operational Risk2

o

Comprehensive requirements for Market Disclosure

o

Scope for supervisory action is extended

The Structure o

Pillar I – Minimum Capital Requirements


Improvements to the Capital Ratio •

Numerator – Regulatory Capital – No Change

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Denominator – Risk Weighted Assets – Calculation changed

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Capital Ratio – no less than 8% - Tier 2 Cap limited to 100% of Tier 1




Inclusion of Operational Risk in the definition of risk-weighted assets




Different Options for calculating •

Credit Risk o

Standardised Approach


Greater risk sensitivity




Risk weights acc to both •

category of borrower (sovereign, banks corporate)

• o

credit rating given by an ECAI

Internal Ratings Based Approach


Banks can quantify elements needed to calculate Cap requirements




Based on a model where likelihood of a company not repaying debt is the difference between the value of its assests and the nominal value of its debt




Calculation of capital requirements for a loan’s default risk includes •

PD – Probability of Default

1

Strategies that reduce the bank’s regulatory capital requirements without a corresponding reduction in its risk exposure 2 Risk of a loss from inadequacies or failures on part of internal processes, people or systems/ external events

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International Convergence of Capital Measurement and Capital Standards Basel Committee on Banking Supervision •

LGD – Loss Given Default (% of nom debt)

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EAD – Exposure at Default (nom debt value)

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Maturity of Loan

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Correlation to Systematic Risk3

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Risk Weight Functions – relating loss forecast to minimum Cap Requirements

a. Foundation Internal Ratings-Based approach i. Relies on bank’s PD estimates b. Advanced Internal Ratings-Based approach i. Also accounts for estimates of LGD and Maturity

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Operational Risk (OR) o

Basic Indicator Approach


Bank’s Cap Requirement (CR) to cover OR = 15% of average annual gross income over past 3 years

o

Standardised Approach


Cap Charge for each of 8 different business lines calculated by – multiplying gross income for each line with a factor determined by BCBS


o

The Total CR = sum of all 8 individual ones.

Advanced Measurement Approach


CP calculated acc to bank’s internal OR measurement systems

o

Pillar II – Supervisory Review Process


Banks to assess Cap Adequacy acc to their own internal risk mgmt system




Supervisors should determine if the bank should hld an additional Cap for risks not covered under in Pillar I

o

Pillar III – Market Discipline


Improving disclosure of information to improve access to information

3

Estimate the link between joint default of two separate borrowers using a single systematic risk factor which is a variable representing the state of the economic cycle. The IRB correlation this factor is based on the firm’s credit Q

2 Epili Sagar ©

International Convergence of Capital Measurement and Capital Standards Basel Committee on Banking Supervision


Banks need to publish detailed qualitative and quantitative information about risk, capital and risk mgmt.




Requirements on how bank calculates its capital adequacy + techniques it uses in risk assessment.




Provisions on supervisory recognition of internal methodologies for credit risk, credit risk mitigation techniques and asset securitisation

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The Impact o

On Banks


Redistribution of capital according to actual risk profiles




Large International Banks – Little change in Cap Requirements




Smaller Domestic Banks – lower CR assuming IRB approach used •

o

But might vary widely depending on their individual portfolios

On Firms


Fears of disadvantage to SMEs & startups because of a approach based on •

Credit ratings

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More of quantitative measures rather than qualitative factors like entrepreuerial abilites and business plans

o

Pro-cyclicality


Pro-cyclicality refers to bank’s loan business following the same cyclical pattern as that of the real economy.




Concerns were raised that there would be increased Pro-cyclicality since 3 of the components under IRB can be influenced to a large extent by the real economy •




Probability of Default, Loss Given Default and Exposure At Default

Higher risk-sensitive system will lead to an increased Cap Requirement -> will lead to lower lending -> too low might exacerbate downturn




BCBS recommendations to counter these concerns •

Flatten the risk weight function in Pillar I – reduce risk sensitivity

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Under Pillar II, banks asked to review their risk bearing capacities according to scenarios o

Implement a credit risk “stress test” to judge how certain events will affect Cap Requirements

3 Epili Sagar ©

International Convergence of Capital Measurement and Capital Standards Basel Committee on Banking Supervision •

Maintain Buffer over and above the minimum cap requirments to tackle macroeconomic downturns

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Dynamic Provisioning – possible loss over whole life of loan is accounted for; full risk profile over biz cycle is given consideration

THE END

4 Epili Sagar ©