Basel II & Risk Management

The Basel Committee on Banking Supervision [BCBS], is a committee of central banks and bank supervisors / regulators from major industrialized countries, that meets every three months at the Bank for International Settlement [BIS] in Basel, to provide broad policy guidelines that each country’s supervisors can use to determine their own supervisory policies. The Basel Committee was set up in 1975 by G-10 countries. Committee’s conclusions do not have any legal force / binding on countries other than member countries. The iMF and World Bank uses the Basel’s standards as a benchmark for conducting their assessment of the banking-system.

New accord of Basel Committee:

The current approach on Credit Risk published in July 1988 was implemented by internationally active banks by end 1992. [Supervisors over 140 countries including India adopted it uniformly though it was to be adopted by internationally active banks]. First accord was partially amended in 1996 to address the issues of Market Risk. Financial innovations and growing complexity of financial transactions have necessitated review of the existing capital framework.

First Consultative Package on the New Accord [A new capital framework] – June 1999 for comments by Central Banks, Market Players and other interested parties. Second Consultative Package started in January 2001. Recommendations started in July 2004. It creates quantitative Impact Survey studies. India is also participating in QIS. 7 Banks Group-3 PSBs, 2 New PrSB and 2 Old PrSB selected by RBI. Implementation started at the end 2006 for G-10 member Banks, but other countries may need more time.

A brief comparison between old and new accord:

The old Accord focuses on a single risk measure. One size fits all. It is based on broad brush structure. The new Accord is a more risk sensitive Accord. It is a more comprehensive framework for addressing risk: credit risk, operational risk, interest rate risk in the banking book, and market risk. It has several options to fit banks (and banking systems) with different sizes and different levels of sophistication.

It gives more emphasis on Bank’s own internal methodology, supervisory review and market discipline. It provides more flexibility in functions such as Menu of Approaches, Incentives for better risk management. New framework intends to improve safety, soundness in the financial system and enhancing competitive equality.

Scope of Application of new Basel Accord:

Focus on international banks [cross border business exceeding 15%] on a consolidated basis. New Basel accord provisions can be adhered to by all significant banks [market share in the total assets of the domestic banking system exceeds 1%] after a certain period of time. National supervisors may implement the new Accord in a phased manner for banks predominantly engaged in traditional banking.

The structure / three pillars of New Accord:

First Pillar -Minimum Capital Requirements: It is to refine the measurement framework set out in the 1988 Accord. It includes Operational Risk in addition to Credit and Market Risks.

Second Pillar – Supervisory Review Process: It is based on capital adequacy and internal assessment process.Third Pillar – Market Discipline: It is through effective disclosure to encourage safe and sound banking practices.

Basel II glossary:

Regulatory Capitall- It is derived from a set of rules, such as Bank of International Settlement Capital Accord and BIS 1996. Regulatory Capital focuses on a single uniform prescription for exposure on all risk categories.

Economic Capital- It is the capital required to insulate a bank from unexpected losses in its activities up to a certain level of confidence. This is also the new theme for banks to estimate actual capital requirements.

Tier I Capital- It is also known as Core/ Permanent Capital provides first cushion against unexpected losses. Tier II

Capital- It is also known as less permanent capital consists of Undisclosed Reserves, Revaluation Reserves, Investment Fluctuation Reserves, and Subordinated Debt.

Default- When an Obligor is unlikely to pay its debt obligations in full/ payment is past due for more than 90 days/ obligor has filed for bankruptcy.

Probability of Default- The expected number of accounts in the portfolio or a particular rating grade that will fill in default within a specified time horizon.

Loss Given Default- The portion of an exposure to default which cannot be recovered, usually expressed as 1- Rate of Recovery.

Risk Adjusted Return on Capital- RAROC refers to return on Capital allocated to any line of business after accounting for the expected losses in that line of business.

RAROC is thus;
Risk adjusted Return = Revenue-Exp- E.L. Economic Capital for unexpected Loss
A menu of approaches to calculate minimum capital requirements under Pillar I:

Bank’s own assessment of Capital Adequacy ensures regulatory minimum capital. Supervisory review process within internal circle of banks is to ensure the process of assessing capital in relation to risk profile by each bank and periodic review and evaluation of such process, compliance, strategy, etc. by onsite inspection and off site surveillance. Supervisory intervention within executive level of banks is to prevent capital falling from prudent level.

Basel Accord Pillar III: 

Basel Accord Pillar III promotes market discipline through greater transparency and improved public disclosure. Disclosure recommendations and requirements are important in view of the fact that they will be based on internal assessments. IRB disclosure requirements include – PDs. LGDs, and EADs within portfolios, composition and assessment of risk and performance of internal assessments.

Disclosure requirements to focus on – scope of application of the new requirements to the disclosing bank, components of regulatory capital, risk exposures and assessments [CR, MR and OR] and capital adequacy disclosures. Focus on ‘core disclosures’ relevant for market discipline; transparency and adequate ‘supplementary disclosures’ as stipulated. Basel Accord Pillar III checks for quarterly disclosure for internationally active banks and on a semi-annual basis for others to indicate their strength to the market-participants.

Basel Accord Credit Risk – Standardized approach:

Basel Accord Credit Risk is a modified version of the existing approach. Risk weights are calculated in accordance with the category of borrowers. Calculation of risks is done through weight for each balance sheet & off balance sheet item. Risk weights are not broad brush – based on External Credit Ratings / Export Credit Agencies. Authorization of credit risks is done by the regulator on the basis of a close look at assessment methodology of external agency.

Credit rating agencies or Export Credit Agencies (sovereign), recognized by national supervisors. It is concluded that credit risks deals with more than one risk bucket under each category of exposure (20%, 50%, 100% and 150%) for arriving at risk weight assets.0% risk weight for certain multilateral development banks.

External Credit Assessment Institutions [ECAIs]:

External Credit Assessment Institutions to be recognized by the national supervisor based on eligibility criteria fixed by the Basel Committee. Methodology of ECAIs should be rigorous, systematic and validated. ECAIs is not to be subject to political or economic pressures.

ECAIs is not to be available to both domestic and foreign institutions at equivalent terms. Sufficient resources to carry out high quality credit assessments. Existence of external credit assessment institutions deals with internal procedures to prevent misuse of confidential information.

Credit Risk – IRB-Approach:

Credit Risk – IRB-Approach is risk sensitive and incentive compatible. Credit Risk – IRB-Approach is a set of inputs translated into minimum capital requirements. It is a banking group that uses the IRB approach for some of its exposures must use it for all its exposures and significant business units.

Bank’s rating systems should provide for a meaningful differentiation of risk. Data sources used by banks should be suitably rich and robust. Ratings should be subject to some independent review. Rating should be an integral part of the culture and management of the banks.

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