In The Name of ALLAH, The Most Merciful, The Most Beneficial.

STATE BANK OF PAKISTANBanking Service Corporation (Bank)

Faisalabad

Aamir Raza MBA-08-012

MBA (Finance)

University of Sargodha, Sargodha

REPORT ON

Basel II & Its Implementation in Pakistan

Banking Sector

Presenting To;

Chief ManagerSBP (BSC) Bank Faisalabad

INTRODUCTION

HISTORY

Basel Capital Accord

EVOLUTION OF CAPITAL STANDARD

1988

1988 Basel

Accord

Capital Charge

for Credit Risk

Discussion Paper:

Operational Risk

1998 199

9

1st Consultative Document:

A New Capital Adequacy

Framework

Proposed new framework to

replace existing Accord and

introduced capital charge for

operational risk.

2001

2nd Consultative Package:

The New Basel Capital Accord

including capital charge for

Operational

Risks

1992

Implementation

of 1988 Accord

1996

Introduction of

capital charge

for Market Risk

Working Paper on

Operational Risk

2001

BASEL II CAPITAL ACCORD

Introduction

WEAKNESS OF BASEL CAPITAL ACCORD

Basel I flaws are as under;

It looks a one size fits for all approach

Do not discuss capital adequacy in relation to a banks true risk profile

Broad bushed risk weighting structure

Created an incentive to take some highest quality assets off the balance sheet

Cover only credit and market risk

Does not distinguish among different credit exposures

Both AAA and BBB assets attract the same capital charge

Does not allow any capital charge for operational risk

It was not adequate for modern risk situation

THE OBJECTIVE OF THE NEW BASEL

CAPITAL ACCORD (“BASEL II) IS:

1. To promote safety and soundness in the financial system

2. To continue to enhance completive equality

3. To constitute a more comprehensive approach to addressing risks

4. To render capital adequacy more risk-sensitive

5. To provide incentives for banks to enhance their risk measurement capabilities

OBJECTIVES OF BASEL II

Are as under;

To promote safety and soundness in the financial system

Aligns capital of banks with their basic Risk profiles

It is elaborate and far superior in terms of its coverage and detail

To Render Capital Adequacy more risk-sensitive

To provide incentives for Banks to enhance their Risk measurement capabilities

Introduce a Capital charge for Operational risk

To continue to enhance completive equality

To constitute a more comprehensive approach to addressing risks

Reform credit risk weightings, making them more risk sensitive and in line with bank

practices

To cover all essential banking risks with theoretically grounded, flexible and operable

requirements which create incentives for advanced implementation

COMPARISON OF BASEL I AND BASEL II

Basel I Accord Basel II Accord

Focus on Single Risk Measure

One Size fits all

Operational Risk not considered

Broad Brush Structure

More emphasis on Bank’s internal

methodologies, supervisory review

& market discipline

Flexibility, menu of approaches.

Provides incentives for better risk

management

Introduces approaches for Credit

risk & Operational risk in addition to

Market risk introduced earlier

More Risk Sensitivity

RISK BASED CAPITAL STANDARD

Why do banks need to hold capital in order to do

business?

Provides a cushion against unexpected loss that may arise due to

credit/market/operational risk.

Capital that needs to be maintained as a proportion of risk based

assets is termed as risk based capital – otherwise termed as

capital adequacy ratio (CAR).

e.g., bank does not maintain any capital towards credit risk

component of GoI bonds as it is non-existent.

DEVELOPMENT OF A REVISED CAPITAL ADEQUACY

FRAMEWORK COMPONENTS OF BASEL II

Pillar 1 Pillar 2 Pillar 3

Basel II

Supervisory Review

Process

• How will supervisory

bodies assess, monitor

and ensure capital

adequacy?

• Internal process for

assessing capital in relation

to risk profile

• Supervisors to review and

evaluate banks’ internal

processes

• Supervisors to require

banks to hold capital in

excess of minimum to cover

other risks, e.g. strategic

risk

• Supervisors seek to

intervene and ensure

compliance

Market Disclosure

• What and how should banks

disclose to external parties?

• Effective disclosure of:

- Banks’ risk profiles

- Adequacy of capital

positions

• Specific qualitative and

quantitative disclosures

- Scope of application

- Composition of capital

- Risk exposure

assessment

- Capital adequacy

Minimum Capital

Requirements

• How is capital adequacy

measured particularly for

Advanced approaches?

• Better align regulatory capital

with economic risk

• Evolutionary approach to

assessing credit risk

- Standardised (external

factors)

- Foundation Internal Ratings

Based (IRB)

- Advanced IRB

• Evolutionary approach to

operational risk

- Basic indicator

- Standardised

- Adv. Measurement

Issu

eP

rin

cip

le

• Continue to promote safety

and soundness in the

banking system

• Ensure capital adequacy is

sensitive to the level of

risks borne by banks

• Constitute a more

comprehensive approach to

addressing risks

• Continue to enhance

competitive equality

OBJECTIVES

THE NEW BASEL CAPITAL ACCORD

Total Capital

Credit + Market + Operational

Risk Risk Risk

= Capital Ratio (minimum 8%)

The new Accord focuses on revising only the denominator (risk-

weighted assets), the definition and requirements for capital are

unchanged from the original Accord.

NewUnchangedRevised

BASEL I V/S BASEL II

Basel: No Risk Differentiation

Capital Adequacy Ratio = Regulatory Capital / RWAs (Credit + Market)

8 % = Regulatory Capital / RWAs

RWAs (Credit Risk) = Risk Weight * Total Credit Outstanding AmountRWAs = 100 % * 100 M = 100 M

8 % = Regulatory Capital / 100 M

Basel II: Risk Sensitive Framework

RWA (PSO) = Risk Weight * Total Outstanding Amount= 20 % * 10 M = 2 M

RWA (ABC Textile) = 100 % * 10 M = 10 M

Total RWAs = 2 M + 10 M =12 M

OVERVIEW OF BASEL II APPROACHES (PILLAR I)

Total Regulatory

Capital

Operational Risk

Capital

CreditRisk

Capital

MarketRisk

Capital

Basic IndicatorApproach

Standardized Approach

Advanced Measurement

Approach (AMA)

Standardized Approach

Internal Ratings Based (IRB)

Foundation

Advanced

StandardModel

InternalModel

Score Card

Loss Distribution

Internal Modeling

16

CREDIT RISK – LINKAGES TO CREDIT PROCESS

Transaction Credit Risk Attributes

Exposure at Default

Loss Given Default

Probability of Default

Exposure Term

Economic loss or severity of loss in the event of default

Likelihood of borrower defaultover the time horizon

Expected amount of loan when default occurs

Expected tenor based on pre-payment, amortization, etc.

RISK RATING /

UNDERWRITING

COLLATERAL /

WORKOUT

LIMIT POLICY /

MANAGEMENT

MATURITY GUIDELINES

INDUSTRY / REGION

LIMITS

BORROWER LENDING

LIMITS

PortfolioCredit Risk Attributes

Relationship to other assets within the portfolio

Exposure size relative to the portfolio

Default Correlation

Relative

Concentration

OPERATIONAL RISK COMPONENT

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

Internal fraud

External fraud

Employment practices & workplace safety

Clients, products & business practices

Damage to physical assets

Business disruption & system failures

Execution and delivery

PILLAR 2ND SUPERVISORY REVIEW PROCESS

Increase the responsibility and levels of

discretion for supervisory reviews and control

covering;

Process of capital and Risk profile management

Capital Adequacy Ratio

Level of capital charge

Proactive monitoring of capital levels Ensuring Remedial action

PILLAR 3 MARKET DISCIPLINE

Comprehensive disclosure is essential for market participants

to understand the relationship between risk profile and capital

of an institution.

Includes the disclosure of capital structure, capital adequacy,

risk exposure such as market, credit and operational etc.

BASEL II NORMS IN INDIA: AN OVERVIEW

Credit risk

Adopts standardized approach

Operational risk

Adopts the basic indicator approach

Market risk

Banks are allowed to use their internal models to assess the

market risk (i.e., status quo has been maintained in this respect).

However, RBI’s guideline on Basel II remains silent on the issue of

Tier III capital in Indian context.

BASEL II NORMS IN PAKISTAN

Credit Risk

Adopts Standardized Approach for Credit Risk from January 1,

2008

Operational Risk

Adopts Standardized Approach for Operational Risk from January

1, 2008

Internal Rating Based (IRB) from Jan 1, 2010

(If commercial Banks have appropriate models of Risk Management)

STATE BANK OF PAKISTAN ROLE

Ensure establishment of Basel II unit in each

bank

Communication of plans to Banks

Drafting circulars laying down parameters

Defining the transition period of banks toward

Basel II

BENEFITS ON PAKISTAN BANKING SECTOR

Paved the way to institutionalize better risk management practices

Make them more competitive

Provide level playing field to robust system which eventually resulted in improved service standards

Attract Foreign Bank

As Supervisor, Its helped us in comparing our Banking sector with that of other economies of the world

Facilitated cross border sharing

ACKNOWLEDGMENT

At the end, I would like to thank my coordinator “Mr. Muhammad Rehan” who was always there to help and guide us when we needed help… I am thankful to him for his encouraging and valuable support. Working under him was an extremely knowledgeable and enriching experience for me.

I am very thankful to him for all the value addition and enhancement done to us.