Sunday, September 25, 2011

Basel Accords for Banks- Basel II--

Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.

 With the experience gained, the Basel committee wanted to create a new framework which takes into account not only the credit risk but also the operational risk.  The committee wanted to create a set of new guidelines which provide a spectrum of approaches from simple to advanced methodologies for the measurement of these risks.   The new framework is expected to provide a flexible structure in which banks, subject to supervisory review, will adopt approaches which best fit their level of sophistication and their risk profile, and suitable rewards are to be built in for stronger and more accurate risk measurement.  With the above objectives Basel committee released their first consultative package on the new accord in June, 1999 and Second consultative package in January, 2001.  

Structure of the new Accord:  The new accord consists of the following three pillars.
1.    Minimum Capital Requirements
2.    Supervisory review process
3.    Market discipline.
The above pillars are mutually reinforcing and complementary to each other. The committee stresses the need for rigorous application of all the three pillars not any one or two of them.

Minimum Capital requirements:  The current definition of capital (viz., Tier 1 and Tier 2 and Tier 1 to be minimum of 50% of total capital etc.,)  and the minimum requirements of 8% of risk weighted assets are continued in the new accord also(not 9%).  However the 8% is calculated by dividing the total capital by the added figure of credit risk, operational risk and market risk.  The credit risk measurement methods are more elaborate than the 1988 accord.  Market risk calculation measure remains unchanged.  New methods are proposed to measure operational risk.  

There are three approaches proposed for measurement of credit risk, 2 for measurement of market risk and 3 for measurement of operational risk.

 Supervisory review process:  The supervisory review process requires supervisors to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on a thorough evaluation of risks. The internal processes being followed by the Banks will be subject to evaluation and intervention by the supervisors wherever required.

 Market discipline: The third pillar aims to improve market discipline through enhanced disclosure by banks.  The new accord sets out disclosure requirements and recommendations in several areas including the way the bank calculates its capital adequacy and risk assessment methods.

 Credit Risk:  Basel accord provides three different approaches to the measurement of credit risk.  They are Standardised approach; Foundation Internal Ratings based approach and Advanced Internal Ratings Based approach.  Various eligibility norms have been prescribed for Banks for calculating their credit risk in different approaches.  While the standardized approach for credit risk measurement is only an extension of the existing risk weighted assets balance calculation, both the foundation and Advanced Internal Ratings based approaches give credence to the respective Banks’ own systems and Internal Control procedures.  The foundation and Advanced Internal Ratings Based approach requires the explicit approval of the National supervisor.

Standardised approach:  To improve risk sensitivity without making the standardized approach very complex, the new accord has prescribed to base risk weights on external credit assessments. Such Ratings of the External Credit Assessment Institutions are mapped to the standardized risk buckets through a method developed by the committee. The committee anticipates that the standardized approach will be used by large number of Banks for calculating the minimum capital requirements and want Banks to migrate later to the Foundation IRB approach and then to Advanced IRB approach.    The following are certain principal features proposed in the Standardised approach to Credit risk measurement.
1.    Banks exposure to Sovereigns ( the term ‘sovereigns’ include Governments, Central Banks and Public Sector Enterprises treated as Sovereigns by the national supervisor) which was classified under 0% bucket in 1988 accord has to be put into the appropriate buckets based on the ratings of External Credit assessment Institutions.
2.    While the Risk weight was exclusively decided by the nature and type of the counter party in the 1988 accord, the new accord proposes to apply preferential risk weight to Bank’s short term exposures (having an original maturity of 3 months or less) to other Banks, if they are denominated and funded in local currency.
3.    Highly rated banks and corporate which have better ratings than their sovereign of incorporation can now continue to have their personalized ratings, but the minimum risk weight is prescribed at 20%.  Earlier these Banks and corporate have been placed at the floor ratings of their sovereign of incorporation. 
4.    Banks exposure to unrated corporate is prescribed at 100% risk weight, but it is only a floor rate.  Necessary increase in the risk weight can be prescribed by the supervisors wherever required.
5.    A new risk weight category of 150% is added which includes  the bank’s exposure to lowest rated sovereigns, banks and corporate, unsecured portion of assets(loans) that are past due for more than 90 days (all these categories are classified in 100% bucket in the 1988 accord).  National supervisors have been given the power to apply a risk weight of 150% or higher to assets that warrant such treatment.

Operation:  The committee has outlined certain eligibility criteria for recognizing the External Credit assessment Institutions(ECAI).  The supervisors are expected to use the eligibility criteria to recognize the ECAIs.  However not only the supervisors but also the Banks are responsible for evaluating the methodology of the ECAI and the quality of the ratings prescribed.  The nomenclature for various classifications given by the ECAI may vary.  To provide a common standard the accord prescribes the OECD 1999 methodology as a common standard.  The OECD 1999 methodology establishes seven risk score categories from 1 to 7 (for the purpose of calculating export insurance premiums).  One of the conditions for the ECAI to qualify is to publish its risk scores explicitly and undertake to subscribe to OECD 1999 methodology.  Each ECAI may follow their own notation but it should correspond to OECD notations, and the accord has prescribed different risk weights for different OECD notations.  The ECAI notation should then be mapped with OECD notations. 
For example the notations used by “Standards & Poor” and their corresponding mappings are given below:

OECD 1999 ratings
Standard & Poor
AAA to AA-
A+ to A-
BB+ to B-
Below B-

Basel committee has prescribed different risk weights based on the ratings of the External credit assessment institutions.  Basel committee has used the ratings of “Standard & Poor” one of the External credit rating assessment institutions and has given risk weight based on different ratings. 

 Other categories: 
1.    Securitisation rated between BB+ and BB- are to be risk weighted at 150%. Similarly unsecured portion of asset that is past due for more than 90 days are to be risk weighted at 150% net of provisions.
2.    National supervisors have to prescribe risk weight at 150% or higher for other assets and also the unrated assets given in the above table.
3.    The off balance sheet items are to be converted through a process of credit conversion factor. The factor for commitments which are unconditionally cancelable at any time by the Bank without prior notice is 0%.  For other business commitments with an original maturity up to 1 year will be 20% .  The factor will be 100% for repo-style transactions.
4.    The committee proposes “hair-cuts” on the value of collaterals representing the difference between the collaterals currently marked value and expected realization on encashment.   Detailed guidelines have been given and different approaches are proposed for determining the value of such hair cuts. 
5.    Similar hair cuts are prescribed for currency mismatches also where the exposure is in one currency and collateral(s) in another currency.

Internal Ratings based approach:  The following are certain important features of the Internal Ratings based approach for credit risk measurement.
1.    Banks which meet minimum requirements may use IRB approach.  However if they chose to use IRB approach should use them across all classes of borrowers and across all significant business units (like subsidiaries, groups, branches etc.,).  Selective implementation of IRB and standardized approaches for certain classes of borrowers or certain business units is not allowed.
2.    Banks have to classify their exposures into six broad classes of assets with different underlying credit risk characteristics subject to certain definitions outlined in the accord.  
      The classes of assets are corporate, banks, sovereigns, retail, project finance and equity.  
    Except for project finance and equity the other classes have a specified set of risk inputs, risk weights and minimum requirements for eligibility.  Wherever the banks internal system have a different classification standards, they may continue to do so, but for tabulating and reporting appropriate treatment to each exposure to be maintained.  The methodology adopted by the banks has to be consistent and the banks have to demonstrate such consistency to the supervisors.  An exposure which does not fall into any of the above six categories should be grouped under corporate exposure.
3.    Corporate for the purpose of the classification include partnership, proprietorship etc., where the ongoing operations of the borrower is the source of repayment.  Project finance, Property mortgage lending etc., will not come under corporate classification.  Retail lending exposure is defined as one given to an individual person or persons.  Credit card exposures, installment loans, revolving credits, residential mortgages, low value of individual exposures (the bench mark value to be prescribed by the supervisor) and high volume loans which are managed by the Bank in comparable fashions (supervisors again have to set minimum number of exposures) are all examples of retail lending exposures. 
4.    The IRB approach is again divided into Foundation IRB and Advanced IRB.  Under Foundation IRB, Banks have to internally estimate Probability of default(PD) associated with the borrower grade while relying on supervisory rules for estimation of other components like Loss Given default(LGD), Exposure at default(EAD) and the treatment of guarantees/credit derivatives.  However under the Advanced IRB approach, the PD, LGD, and EAD can be estimated by the Banks themselves, based on certain clearly spelt formulas.  The Banks are allowed to migrate from Foundation IRB to Advanced IRB based on compliance of certain standards prescribed by Basel.   
The Banks have to initially use a minimum of 2 years data for estimating requirements in the year 2004 and increase the data usage by one year for every subsequent years up to a maximum of 5 years.

 Operational Risk:  The operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.  The committee has outlined three different methods at present for calculating operational risk viz., 1.  Basic indicator approach   2. The standardized approach 3.  The Internal measurement approach.  Minimum standards for the use of each approach are given by the accord and the banks which fulfilled the criteria for a given approach are allowed to use that approach. 
Under the basic indicator approach, the Banks have to hold capital for operational risk equal to a fixed percentage of Gross Income, which is income before the operational loss if any.  The basic indicator approach which is the most simple of all the three approaches can be followed by the Banks which comply meticulously the Basel committee’s guidance on “Operational Risk Sound Practices”.  The same document is to serve as guidance to the national supervisors also.
            Under the standardized approach the activities of the bank is divided into business units and business lines within each business units.  Indicators have been specified for each business units and capital requirements will be calculated based on the product of the capital factor for each business indicator.  The following is the broad classification of the units, lines and indicators.
Business units
Business Lines
Investment banking
Corporate finance
Trading and Sales
Gross Income
Gross Income or Value at Risk
Retail Banking
Commercial Banking
Payment and settlement
Annual average assets Average annual assets
Annual settlement value
Retail brokerage
Asset management
Gross Income
Total funds under management

The numerical value of the above indicator is to be taken and a capital factor(known as beta factor which the committee is to calibrate and announce) will be multiplied.  The resulting figure is called as capital charge on operational risk under the Standardised approach.  To be eligible under the Standardised approach, the Banks apart from complying with the Basel committee’s guidance on “Operational Risk Sound Practices”, must satisfy the national superiors that there exists an independent risk control and audit function, effective use of risk reporting systems, active involvement of board and top management in risk management and a clear documentation of risk management systems.  The banks also should satisfy the existence of the regular review of the process and procedures to track relevant operational risk data by business line and documented criteria to map current business lines and activities into the standardized framework.

            Under the internal measurement approach, the banks activities are categorized as per the standardized approach.  For each business line, the supervisor specifies the Exposure indicator which is the proxy for the size of each business line’s operational risk exposure(denoted by EI).  The banks based on their own data prepares a factor for probability of loss (denoted by PE) and a parameter representing the loss given event (denoted as LGE).  The product of EI,PE and LGE is the expected loss.  The supervisor then gives a factor ( called gamma factor) which translates the expected loss as capital charge.  The EI determines the mix of various business  lines.  The PE and LGE is determined by the Bank based on past data.  Therefore this approach is more close to the probable exposure on the operational risk.  However Basel insists that apart from complying with the conditions for the standardized approach, the Bank should have satisfactory and sound internal loss reporting practices, loss database systems in place. 

Market risk:  Market risk or so often mentioned as Trading book in the Basel accord is defined as ‘positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book’.  They must be free of any restrictive clauses on tradability.  The type of assets for which market risk measurement need to be done are those where expected short term price movements are sought to be exploited by the bank.  The following guidelines, which almost reflect the provisions of the current accord is given for the measurement of market risk. 
1.    The Banks should mark to market the daily positions at readily available close out prices that are sourced independently. 
2.    Banks must mark to market as much as possible.  The more prudent side of bid/offer must be used for this purpose.
3.    Where marking to market is not possible, the Banks should resort to marking to model.  Marking to model is defined as a valuation, which has to be bench marked, extrapolated or otherwise calculated from a market input. 
4.    Supervisory authorities to impose at the minimum the adjustments/reserves such as unearned credit spreads, early termination, investing and funding costs,
5.    Supervisory authorities may require the banks to establish reserves for less liquid positions, stale positions etc..
While the above measures rely more on supervisory control mechanism, the Basel accord provides specific capital charges based on external credit assessment and the residual maturity of the commercial paper.

External credit assessment
Capital charge
AAA to AA-
A+ to BBB-
0.25% if the residual maturity is 6 months or less
1.00% if the residual maturity is greater than 6 months and up to 24 months
1.60% if it is greater than 24 months
All others

Second Pillar – Supervisory review process:  The following areas are covered under the  supervisory review process.
1.    Risks considered under Pillar 1 that are not fully captured by the Pillar 1 process e.g.  operational risks charge in pillar 1 might not include risks specific to an instituition.
2.    Specific risks not taken into account under pillar 1 – Interest rate risk is left to the supervisory review process. 
3.    Risk factors external to the Bank – e.g. business cycle effects and consequent risks.
Basel committee has published two papers  viz., “Supervisory review process – supporting document” and  “core principles for effective banking supervision and the core principles methodology”  which act as guidance to the National supervisors in the Supervisory review process. 

Third Pillar – Market discipline:  The committee for the first time has introduced the disclosure requirements.  Every bank should be bound by the following principles:
1.    Every Bank should have a formal disclosure policy approved by the board of directors containing the bank’s objective and strategy for the public disclosure of information on its financial condition and performance. 
2.    Banks should implement a process for assessing the appropriateness of their disclosure on continuous basis and decide on the frequency of disclosure.
The suggested form of disclosure is given by Basel in the form of a template and the banks are encouraged to disclose material information according to the template.  The template includes (illustrative not exhaustive)
1.    Paid up share capital
2.    disclosed reserves
3.    Minority interests in equity of subsidiaries
4.    Tier 1 capital instruments and capital
5.    Goodwill and other amounts deducted from tier 1
6.    total amount of tier 2 capital and deductions therefrom
7.    overall eligible capital
8.    Accounting policies for valuation of assets and liabilities, provisioning and income recognition
9.    information on consistency of accounting principles between year
10.  details of unrealized gains, unrealized losses, deferred taxes included in or deducted in capital
11.  Summary information in respect of maturity, call features, step up provisions, details of deferred interest/dividend, key trigger events etc..

In addition to the above the Basel accord prescribes detailed disclosure requirements in respect of Credit risk, operational risk, market risk and interest rate risk.

 Recent Chronological Updates

September 2005 update

On September 30, 2005, the four US Federal banking agencies (the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision) announced their revised plans for the U.S. implementation of the Basel II accord. This delays implementation of the accord for US banks by 12 months.

November 2005 update

On November 15, 2005, the committee released a revised version of the Accord, incorporating changes to the calculations for market risk and the treatment of double default effects. These changes had been flagged well in advance, as part of a paper released in July 2005.

July 2006 update

On July 4, 2006, the committee released a comprehensive version of the Accord, incorporating the June 2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the November 2005 paper on Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework. No new elements have been introduced in this compilation. This version is now the current version.

November 2007 update

On November 1, 2007, the Office of the Comptroller of the Currency (U.S. Department of the Treasury) approved a final rule implementing the advanced approaches of the Basel II Capital Accord. This rule establishes regulatory and supervisory expectations for credit risk, through the Internal Ratings Based Approach (IRB), and operational risk, through the Advanced Measurement Approach (AMA), and articulates enhanced standards for the supervisory review of capital adequacy and public disclosures for the largest U.S. banks.

July 16, 2008 update

On July 16, 2008 the federal banking and thrift agencies (the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision) issued a final guidance outlining the supervisory review process for the banking institutions that are implementing the new advanced capital adequacy framework (known as Basel II). The final guidance, relating to the supervisory review, is aimed at helping banking institutions meet certain qualification requirements in the advanced approaches rule, which took effect on April 1, 2008. 

January 16, 2009 update

For public consultation, a series of proposals to enhance the Basel II framework was announced by the Basel Committee. It releases a consultative package that includes: the revisions to the Basel II market risk framework; the guidelines for computing capital for incremental risk in the trading book; and the proposed enhancements to the Basel II framework.

July 8–9, 2009 update

A final package of measures to enhance the three pillars of the Basel II framework and to strengthen the 1996 rules governing trading book capital was issued by the newly expanded Basel Committee. These measures include the enhancements to the Basel II framework, the revisions to the Basel II market-risk framework and the guidelines for computing capital for incremental risk in the trading book.

Implementation progress

Regulators in most jurisdictions around the world plan to implement the new accord, but with widely varying timelines and use of the varying methodologies being restricted. The United States' various regulators have agreed on a final approach. They have required the Internal Ratings-Based approach for the largest banks, and the standardized approach will be available for smaller banks.
In India, Reserve Bank of India has implemented the Basel II standardized norms on 31 March 2009 and is moving to internal ratings in credit and AMA norms for operational risks in banks.
Existing RBI norms for banks in India (as of September 2010): Common equity (incl of buffer): 3.6%(Buffer Basel 2 requirement requirements are zero.); Tier 1 requirement: 6%. Total Capital : 9 % of risk weighted assets.
Basel III asks for those ratios as 7-8.5%(4.5% +2.5%(conservation buffer) + 0-2.5%(seasonal buffer)) and 8.5-11% for tier 1 cap and 10.5 to 13.5 for total capital (Proposed Basel III Guidelines: A Credit Positive for Indian Banks)
In response to a questionnaire released by the Financial Stability Institute (FSI), 95 national regulators indicated they were to implement Basel II, in some form or another, by 2015.
The European Union has already implemented the Accord via the EU Capital Requirements Directives and many European banks already report their capital adequacy ratios according to the new system. All the credit institutions adopted it by 2008.
Australia, through its Australian Prudential Regulation Authority, implemented the Basel II Framework on 1 January 2008.

Link to Master Circular By RBI on Prudential Guidelines on Capital Adequacy                                            
and Market Discipline – New Capital Adequacy Framework (NCAF):

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