Basel guidelines.pdf

NEW CAPITAL ADEQUACY FRAMEWORK (NCAF) – BASEL II

BASEL II

• The Bank for International Settlements (BIS) created the first Basel Capital in 1988

• To develop standardised risk-based capital requirements for banks across countries

• The accord came under criticism within a few years of its issuance

• The Accord was replaced with a new capital adequacy framework (Basel II), published in June 2004.

Shortcomings of Basel I

Inadequate differentiation of Credit Risk

Limited recognition of Collateral

No recognition of on-balance sheet netting

Inadequate consideration of maturity aspects

No consideration of Operational risk and disclosure requirements

Basel II seeks to address these shortcomings

1.

• Differentiate borrowers creditworthiness & reflection in capital

2. • Recognise risk mitigation techniques

3. • Bring regulatory model closer to good industry practice

(and regulatory capital closer to Economic Capital)

4. • Maintain stability and security in banking industry

5. • Introduce incentives for good risk management

The three pillars

Basel II framework rests on the following three mutually- reinforcing pillars: Pillar 1: Minimum Capital Requirements ; prescribes a risk-

sensitive calculation of capital requirements that, for the first time, explicitly includes operational risk along with market and credit risk.

Pillar 2: Supervisory Review Process ; envisages the establishment of suitable risk management systems in banks to assess the adequacy of their capital relative to their risk and supervisors should review and take corrective action of problems occur.

Pillar 3: Market Discipline and Disclosures ; seeks to achieve increased transparency through expanded disclosure requirements for bank

Minimum Capital Requirement (Pillar I)

Credit Risk

a. Standardised Approach

b. Foundation Internal Rating Based Approach

c. Advanced Internal Rating Based Approach

Market Risk

a. Standardised Method

b. Internal Models Approach (IMA)

Operational Risk

a. Basic Indicator Approach

b. Standardised Approach

c. Advanced Measurement Approach.

Tier I capital

Paid-up equity capital, statutory reserves, and other disclosed free reserves, if any;

Capital reserves representing surplus arising out of

sale proceeds of assets;

Innovative perpetual debt instruments (IPDI) eligible for inclusion in Tier I capital,

Perpetual Non-Cumulative Preference Shares

(PNCPS)

Any other type of instrument


Tier II Capital

Revaluation Reserve

General Provisions and Loss Reserves; Hybrid debt capital instruments;

Subordinated debts;

IPDI in excess of 15% of Tier I capital and PNCPS in

excess of overall ceiling of 40% of Tier I capital; Any other type of instrument



Total CRAR = Eligible total capital funds Credit Risk RWA + Market Risk RWA + Operational Risk RWA

Credit Risk - Standardised Approach:

• External credit ratings by institutions recognized for the purpose by the central bank for determining the risk weight.

• Exposure on sovereigns and their central banks could vary from zero percent to 150 percent depending on credit assessment from ‘AAA’ to below B- .

• Exposure on public sector entities, multilateral development banks, other banks, securities firms and corporates also may have risk weights from 20 percent to 150 percent.

• Exposure on retail portfolio may carry risk weight of 75 percent (except certain Home loans).

• While Basel II stipulates minimum capital requirement of 8 percent on risk weighted assets, India has prescribed 9 percent.

Credit Risk - Standardised Approach- Example

• Under Basel II exposure on a corporate with ‘AAA’ rating will

have a risk weight of only 20 percent and BB- rating will have a

risk weight of 150 percent.

• This implies that for Rs. 100 crore exposure on a ‘AAA’ rated

corporate the capital adequacy will be only Rs.1.8 crore (100 x

20% x 9%) compared to the earlier requirement of Rs. 9 crore.

• However, claims on a corporate with below BB- rating will carry

a risk weight of 150 percent and the capital requirement will be

Rs.13.50 crore (100 x 150% x 9%).

Credit Risk - Internal Ratings Based (IRB) Approach

• The IRB approach use a bank’s own internal estimates of creditworthiness to determine the risk weightings in the capital calculation.

• Bank’s overall Credit Risk management practices must be consistent with the sound practice guidelines issued by the Basel committee and the National Supervisor

• Banks should have confidence in the robustness of PD estimates and the underlying statistical analysis

• The bank should have reliable data on Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and effective Maturity (M) to make use of IRB approach

• The Rating Structure adopted need to have minimum 7 grades of performing borrowers and a minimum 1 Grade of non-performing borrowers

• Validation of internal Rating systems/ Models by the Supervisor

Basel II Credit Parameters

Probability of Default (PD)

- How likely is it that the customer will default in a 12 month period?

Exposure at Default (EAD)

- What will our exposure to the customer be if he does default?

Loss given Default (LGD)

- How much will we lose if the customer defaults ?

Credit Risk - Internal Ratings Based (IRB) Approach

Foundation IRB

Advanced IRB

PD – Bank’s own estimates

Bank’s own estimates

LGD – Supervisory values set by Regulators


EAD – Supervisory values set by Regulators


M – Supervisory values set by Regulators

Remaining Maturity (max 5 years)

Benefits of IRB

• Improved Risk Management and Pricing Tools

• Optimal use of Capital

• Avoidance of Competitive Disadvantage and Reputation Risk

• Better shareholder returns

Credit Risk Mitigation Techniques

• Collateralized transactions - Two approaches

• Simple Approach - substitutes the risk weighting of the collateral for the risk weighting of the counterparty for the collateralized portion of the exposure

• Comprehensive Approach. – where the value of the collateral is deducted from the exposure. Comprehensive approach is being adopted by banks in India. Cash, Gold, securities, KVP, NSC (no lock in period), LIC policies, Debt securities, Mutual Funds units, etc. are eligible financial instruments

• On Balance Sheet Netting

• Guarantees

Capital charge for Market Risk

• Market Risk relates to risk of losses arising on account of movement in market prices.

• The market risk positions subject to capital charge requirement are risks pertaining to interest rate related instruments , equities and Foreign Exchange risk.

• Capital for Market risk is to be maintained for the following exposures

a. Securities held for trading

b. Derivatives – trading and hedging positions

c. Open position

Market Risk – Minimum Capital Required

Capital charge for Specific Risk charge

• To protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer

• Varies from 0% to 100 %

Capital charge for General Market Risk • The capital requirements for general market risk are designed

to capture the risk of loss arising from changes in market interest rates.

• Capital Charge for General Market Risk = Modified Duration of the Security X

Market value of the Security X Assumed change in yield

Market Risk – Minimum Capital Required

Measurement for capital charge for Equity Risk Capital charge for Specific Risk and General Market Risk, calculated on bank’s gross equity position Measurement of capital charge for Foreign Exchange Risk The bank’s net open position in each currency shall be calculated by summing: a)The net spot position b)The net forward position c)Guarantees (and similar instruments) that are certain to be called and are likely to be irrecoverable; d)Net future income/expenses not yet accrued but already fully hedged e)The net delta-based equivalent of the total book of foreign currency options

Capital charge for Operational Risk

• Basic Indicator Approach Op Risk Charge (Under BIA) = Alpha factor X Average Gross Income over the prior three years • Standardized Approach Op Risk Charge (Under SA) = Sum( Beta factor for business line X Average Gross Income for business line) • Advanced Measurement Approach Bank’s Operational Value at risk with a one year horizon and a 99.9% confidence level

Supervisory Review and Evaluation Process (SREP)

(Pillar 2) Key principles envisaged under the SRP are:-

a)Banks are required to have a process for assessing their overall

capital adequacy in relation to their risk profile and a strategy for

maintaining their capital levels.

b)Evaluation of banks’ internal capital adequacy assessments and

strategies as well as their ability to monitor and ensure their

compliance with the regulatory capital ratios by Supervisors.

c)Supervisors should expect banks to operate above the minimum

regulatory capital

d)Supervisors should intervene at an early stage to prevent capital

from falling below the minimum levels and should require rapid

remedial action if capital is not maintained or restored.

Supervisory Review and Evaluation Process (SREP)

(Pillar 2) Internal Capital Adequacy Assessment Process (ICAAP) • For assessing their capital adequacy based on the risk

profiles as well as strategies for maintaining their capital levels

• Responsibility of designing and implementation of the ICAAP rests with the Board

• Integral part of the management and decision-making culture of a bank

• RBI expects degree of sophistication in the ICAAP in regard to risk measurement which should commensurate with the nature, scope, scale and the degree of complexity in the bank’s business operations

• Stress Testing practices

Supervisory Review and Evaluation Process (SREP) (Pillar 2)

1. Check Compliance with Pillars 1 and 3 2. Assess risks not fully covered in Pillar 1 eg legal

risk, documentation risk, liquidity risk and credit concentration risk

3. Assess the internal capital management methods employed by the bank and their adequacy

4. Review internal control systems

Market Discipline- (Pillar – 3)

• Market Discipline is termed as development of a set of disclosure requirements so that the market participants would be able to access key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and in turn the capital adequacy of the institution.

• Both quantitative and qualitative • The disclosure on the websites should be made in

a web page titled “Basel II Disclosures” and the link to this page should be prominently provided on the home page of the bank’s website

Basel III measures aim to:

• improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source

• improve risk management and governance

• strengthen banks' transparency and disclosures.

Basel III

Major Features of Basel III

• Better Capital Quality

• Capital Conservation Buffer

• Countercyclical Buffer

• Minimum Common Equity and Tier 1 Capital Requirements

• Leverage Ratio

• Liquidity Ratios - Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)

• Systemically Important Financial Institutions

Comparison of Capital Requirements under Basel II and Basel III (BIS norms)

Requirements Under Basel II Under Basel

III

Minimum Ratio of Total

Capital To RWAs 8% 10.50%

Minimum Ratio of

Common Equity to RWAs 2%

4.50% to

7.00%

Tier I capital to RWAs 4% 6.00%

Capital Conservation

Buffers to RWAs None 2.50%

Leverage Ratio None 3.00%

Countercyclical Buffer None 0% to 2.50%

Minimum Liquidity

Coverage Ratio None TBD (2015)

Minimum Net Stable

Funding Ratio None TBD (2018)

Systemically important

Financial Institutions

Charge

None TBD

Documents

Basel guidelines.pdf