Introduction to Basel II

8/7/2019 Introduction to Basel II

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Introduction

- Do know anything about BASEL?

- Yes! Basel is:1) a canton (i.e. political division) of NW Switzerland, divided into thedemi-cantons: Basle-Landschaft and Basle-Stadt.Areas: 427 sq. km (165 sq. miles) and 36 sq. km (14 sq. miles)respectively;

and

2) a city in NW Switzerland, capital of Basle canton, on the Rhine:oldest university in Switzerland.

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Introduction (cont.)

- In fact the Basel is not only the canton or city, but also is:• the International Convergence of Capital Measurement and Capital Standards; or • Revised Framework (the “Basel II Framework”) which offers a new set of standards for

establishing minimum capital requirements for banking organizations.

- But what was Basel I Framework?

- Basel I Framework was:• The international accord to set minimum capital requirements or banks, building societies

and other deposit taking institutions. It was developed to create a level playing field forlenders operating in different countries and to ensure that lenders had sufficient

capitalization in order to protect their depositors and the financial system.

• First Basel Framework (or Basel Capital Accord) was prepared by the Basel Committeeon Banking Supervision, a group of central banks and bank supervisory authorities in theG10 countries*, that developed the first standard in 1988.

• Then it became acknowledged as a benchmark measure of a bank’s solvency and wasapplied in many other countries.

• However, later relevant supervisors and sophisticated banking organizations havedetected that the static rules set out in the Basel Capital Accord, 1988 have not kept pace with advances in risk management practices. This suggests that the implementedcapital regulations may not reflect banks’ actual business practices.

* A Group of Ten Nations who met in Paris in 1961 to arrange the special drawing rights of the IMF ( Belgium, Canada, France,Italy, Japan, Netherlands, Sweden, UK, US, and West Germany).

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Introduction (cont.)

- So, what is the solution? Basel II….?

- Yes, it is a Basel II.• Basel II Framework is a voluntary agreement between the banking authorities of the

major developed countries. However, the provisions of Basel II have been includedin the EU Capital Requirements Directive (CRD). It makes the provisions a part ofthe law applicable throughout the EU.

- What's new in Basel II?• The new updated Basel II Framework is more reflective in terms of risk management

of underlying banking risks.• It was created based on the Basel Accord 1988 structure for setting capital

requirements.• It improves the sensitivity of capital framework to the actual risks faced by the banks.• Capital requirements are more closely aligned to the risk of credit loss.

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Basel I v/s Basel II

• Basel I required lenders to calculate a minimum level of capital based on a single riskweight for each limited number of asset classes (e.g. mortgages, consumer lending,corporate loans, exposures, etc).

• Basel II also permits some lenders to use their own risk measurement models tocalculate required regulatory capital, and seeking to ensure that lenders implement arelevant risk management culture at the heart of the business up to the highestmanagerial level.

- When the Basel II shall be implemented?• In the EU all deposit takers had to implement Basel II before or by no later than 1

January 2008. The US delayed this date to January 2009.

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The goals of Basel II

The major goal for the Basel II Framework is to promote the adequate capitalization of

banks and to encourage improvement in risk management strategies, and strengthen thestability of respective financial systems.

The aforementioned goal will be accomplished through the introduction of “three pillars”:

Mi ni mu

m C api t al

R equ

i r ement s

Wealth economy and financial system stability

C api t al

A d equac y

( S uper v i s

or y R ev i ew)

R epor t i ng

( Mar k et

D i s c i pl i ne)

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Three Pillars: Pillar 1

Pillar 1 – Minimum Capital Requirements:

• Pillar 1 aligns the minimum capital requirements more closely to actual risks of bank’s

economic loss (i.e. credit risk , market risk and operational risk).• Revised Basel risks:

Credit risk (revised)

Operational risk (new provision)

Market risk (minor changes)

• First, Basel II improves the capital framework’s sensitivity to the risk of credit.• Capital is calculated based on the standardized and internal approaches for further

reporting to responsible regulators and other stakeholders.

• 3-Approaches: Standardized approach (RSA)

a-Foundation internal rating based approach (IRBA)

b-Advance internal rating base approach (IRBA)

Securitization framework

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Three Pillars: Pillar 1 (cont.)

Credit risk

• In Risk Standardized Approach (RSA), Risk weight depends on external creditrating.

• In foundation Independent Regulatory Board for Auditors (IRBA), banks useinternal credit rating and supply Probability of Default (PD).

• Advance IRBA, bank use internal rating and supply Probability of Default, LossGiven Default, Exposure at Default.

• Securitization framework provides with various approaches to compute capital.

Operational risk

• Basic indicator approach, capital is fraction of gross income (15% of average 3year gross income).

• Standardized approach capital is computed by business lines (fixed percentages).• Advance measurement use statistical methods (Estimation, Standard Deviation,

Correlation) to calculate capital.Market risk

• Market risk is calculated on the basis of internal rating of organization.

• Specific ratings (AA-BB) are charged specific level of risks percentage.

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• Pillar 2 (Internal Capital Adequacy Assessment Process - ICAAP) recognizes thenecessity of exercising effective supervisory review of internal assessments of the overall

risks of the banks to ensure that the management is exercising relevant judgment andhas set aside adequate capital for these risks.

• Supervisory Review: Bank should implement a process of assessment of capital adequacy in relation to risk and

strategy for maintaining capital level.

Supervisors shall review bank’s internal capital adequacy and compliance with regulatory capital

requirements, and if necessary, to take actions.

• Coverage in Pillar-II:

risks that are not fully covered by Pillar 1

Credit concentration risk

Counterparty credit risk

Risks that are not covered by Pillar 1

Interest rate risk in the banking book

Liquidity risk

Business risk

Stress testing 9




• Pillar 3 (Reporting) leverages the ability of market discipline to motivate prudentmanagement by enhancing the degree of transparency in banks’ public reporting. Itsets out the public disclosures that banks must make that lend greater insight into theadequacy of their capitalization.

• In other words, it proposes bank’s disclosure requirement and enhance degree oftransparency by recognizing disciplinary market mechanisms and reward thatmanage risk and penalization if not.

• Qualitative & quantitative disclosure wherever relevant on: Capital & capital structure Capital adequacy Credit risk Credit risk mitigation Counterparty credit risk

Securitization Market risk Operational risk Equities in the banking book Interest rate risk in the banking book

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Basel 2 and CAMELS Approach

BASEL 2

Pillar 1--- Risk-Capital matching(increases)

Asset quality & utilization

Pillar 2--- Risk in bank books isremoved by marketefficiency

Pillar 3--- Corporate governanceIncreases Marketmechanisms, Income andCredibility

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CAMELS Approach:

• C Capital Adequacy

• A Asset Quality• M Management Competence• E Earnings Ability• L Liquidity Risk• S Sensitivity to Market Risk

Basel 2 is similar to CAMELS rating and encourages growth by increasing assets quality(Pillar 1),operational competency, earning ability, and manages risks to keep upsustainability (Pillar 2 & 3) in long run.



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Basel II differentiates Retail and Wholesale, broadly:

RetailGenerally Exposures to Individuals (managed on a pool basis), including residential

mortgages, qualifying revolver exposure and other retail exposure

WholesaleWholesale generally comprise Exposures to Individually Managed (e.g. Classifiable)

obligors, including private sector corporate, sovereign (central governments andbanks, etc) and financial institutions.

Retail v/s Wholesale



DIFC Jurisdiction

• As Dubai Financial Centre is a financial hub in the Middle East region it is also hasadopted the Basel principles.

• Regardless the fact that DIFC is located in the Dubai, it adopted its own legislation.

• All DIFC registrants engaged in the financial services are monitored by the DubaiFinancial Services Authority (DFSA)*.

• The legislation of the DIFC is based on the “common law” principles and has been

designed in accordance with the international standards (including Basel) applied in

certain jurisdictions.• The Basel principles are expressed in the following DIFC/DFSA rules:

Prudential - Investment, Insurance, Intermediation and Banking Module (PIB)

Prudential - Insurance Business Module (PIN) – applicable to all insurance/reinsurance businesses

Prudential Returns Module (PRU)

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DFSA is a separate integrated legal entity responsible for the regulation of the financial services and related activities through the

DIFC (including authorization, licensing, recognition and registration of the businesses engaged in financial or ancillary services aswell as the authorization of their members – individuals).



PIB Module

• General chapters:

General Requirements

Capital requirements

• Specific chapters:

Islamic Financial Business (including Displaced Commercial Risk Capital Requirement )

Credit Risk

Market Risk Liquidity Risk

Group Risk

Operational Risk

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Conclusion: “Pros and Cons”

• Some analysts and researches believe that current minimum capital adequacy tool(i.e. 8-10% of equity) presented in Basel Framework and other alternative local

standards adopted by almost all countries is ideal way of using available financialresources.

• Others claim that this tool of capitalization is more unsecure strategy rather thanconservative approaches applied in XIX century and first part of XX century, such asgold bullion securitization and product backing currency.

• Recent cases, namely, “soap bubbles”; “shrinking pies - banks” ideally exemplify thelevel practical reliability of Basel and other alternative standards.

• Has the current recession developed the need for a new accord?

• Ongoing financial crisis has made regulators rethink on the principles on which Basel2 Accord was framed.

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Contact details

• Saad Maniar – Managing Partner ([email protected])

• Gillian McMeekin – Director - Risk Consulting ([email protected])

• Firdaus Maniar – Senior Risk Consultant ([email protected])

• Muhammad Raashid – Senior Risk Analyst ([email protected])

• Vladimir Abanin – Senior Consultant ([email protected])

DIFC, Dubai, UAE

PO Box 506705

Telephone: +971 4 438 0288

Fax: 971 4 367 2820

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Documents

Introduction to Basel II