Basel Committee Norms

Basel Framework

• Basel Committee set up in 1974

• Objectives

– Supervision must be adequate

– No foreign bank should escape supervision

BASEL I

• Risk management

• Capital adequacy, sound supervision and regulation

• Transparency of operations

• Unquestionably accepted by developed and developing

countries

– Capital requirement 8% of assets

– Tier 1 capital at 4%

– Tier 2 capital at 4%

BASEL I

• Focused on credit risk

• In 1996, the accord was amended to include market risk

• Did not recognize risk exposure according to credibility

of borrowers

• No recognition of operational risk

BASEL II

• Following the South East Asian currency crisis, the Basel

Committee met in June 1999 and came up with Basel II.

• Short term funds played a major role in Asian currency

crisis.

• Risk weights accordingly adjusted under Basel II.

BASEL II

• Brings order, discipline and safety to banking institutions.• Involves complex calculations based on huge data.• Provides a number of approaches for risk measurement.• Flexibility for banks to choose an approach in line with

their risk profile.• Incentives for stronger and more accurate risk

measurement.

The Three Pillars

• Supervisory review process

• Minimum capital

• Market discipline

Capital Adequacy

• Supervisors can impose additional capital

• Early intervention by regulators in case of problem

Market Discipline

• Disclosure of information

– Capital structure

– Capital adequacy

– Different types of risk

Minimum Capital RequirementBASEL II

• Banks can choose from different methods

• Credit risk

– Standardized approach

– Internal ratings based approach

• Market risk

– Standardized approach

– Internal models approach

Minimum Capital RequirementBASEL II

• Operational risk

– Basic indicator approach

– Standardized approach

– Advanced measurement approach

Measurement of Credit Risk

• Standardized approach

• Internal ratings based approach

– Foundation

– Advanced

Standardised Approach

• Useful for less sophisticated banks

• Concept of capital ratio

• Numerator is amount available

• Denominator is the measure of risk faced by the bank

• Risk weights – 0, 20%, 50%, 100%, 150%

Internal Ratings Based Approach

• Prime objectives of IRB approach

– Allocation of capital based on internal ratings

– More sensitivity to drivers of credit risk

• Encouraging banks to continue to improve their internal

risk management process

• Foundation and advanced IRB approach

• Segments portfolios according to bank’s own criteria

Internal Ratings Based Approach

• Apply formula to determine capital ratio for each segment

• Foundation IRB approach

– Banks indicate only Probability of Default (PD) and loss in

each segment

– Supervisory estimates other components of loss

• Advanced IRB approach

– Banks provide estimates of Loss Given Default (LGD) and

Exposure at Default (EAD) and maturity

– Requirement of reliable database

Internal Ratings Based Approach

• Probability of default – Likelihood that customers will

default in the next 12 months.

• Exposure at default – Expected amount of exposure at

the point of default.

• Loss given default – Likely financial loss associated with

the default.

Internal Ratings Based Approach

• Banks can use their internal estimates of borrower credit

worthiness to assess credit risk

• Credit risk = Exposure x Probability of Default x Loss

given Default

Measurement of Market Risk

• Standardized approach

• Internal model approach

Market Risk

• Interest rate sensitive position

– General market risk, Duration or Maturity method

– Specific market risk, Net position x weight factor

• Equity instruments

– General market risk – 8% of net position per market

– Specific market risk – 8% of net position per issue

• Precious metals: 10% of net position

Market Risk

• Currencies

– 10% of all net long or short positions whichever is

greater

• Commodities

– 20% of net position per commodity group + 3% of net

position of all commodity groups

Measurement of Operational Risk

Any risk not characterized as market or credit risk

• Risk arising out of human or technical error

• Settlement or payment risk

• Business interruption risk

• Inadequate systems, controls, processes

• Fraud

Measurement of Operational Risk

Exists almost anywhere in the organization

– Can be high occurrence low value or low occurrence

high value

• Basic indicator approach

• Standardized approach

• Advanced measurement approach

Types of Operational Risk

Based on causes

– People oriented

– Process oriented

– Technology oriented

– External

Types of Operational Risk

Based on effect

– Legal liability

– Regulatory compliance and taxation penalties

– Loss or damage to assets

Types of Operational Risk

• Based on event

– Internal fraud

– External fraud

– Employment practices and workplace safety

– Clients, products and business practices

– Business disruption and systems failures

– Execution, delivery and process management

Basic Indicator Approach

• Capital allocation is based on a single indicator

– Gross income as a proxy for operational risk

– Regulatory norm (%) X Gross income

• Easy to implement

• Limited responsiveness to firm specific needs and

characteristics

• Applicable for smaller size domestic banks

Standardised Approach

• More complex than basic indicator approach• Better able to reflect the differing risk profiles across

banks• Within each business line, a broad indicator can be

chosen• Bank activities segregated into eight business lines

Standardised Approach (Example)Business Line Percentage

Corporate finance 18%

Trading and sales 18%

Retail banking 12%

Commercial banking 15%

Payment and settlement 18%

Agency services 15%

Asset management 12%

Retail brokerage 12%

Standardised Approach

• Split gross income into business lines

• Multiply average gross income for three years by the

regulator stated beta

• In a simplified approach, split gross income across

traditional banking (commercial and retail) and other

activities.

Advanced Measurement Approach

• Bank uses internal measurement using both quantitative and

qualitative criteria

• Internal loss data is used in determining required capital

• Qualitative criteria

– Independent function

– Involvement of Board

– Reporting of exposure and loss experience

Advanced Measurement Approach

• Documentation of risk management system• Quantitative criteria• Stress testing• Approximate risk measurement• Expected loss and unexpected loss• Minimum 5 years of observation period of internal loss

data