IT Governance framework Basel

Table of contents:

Executive summary……………………………………………………………………1

Introduction…………………………………………………………………………...2

1 BASEL I ………………...…………………………………………………….……3

1.1 The Purpose of Basel I ……………………………………………………3

1.2 Two-Tiered Capital ……………………………………………………….3

1.3 Limitations of Basel I…………………………………………………..…4

2 BASEL II ……………………………………………………………….…………..5

2.1 Objectives of Basel II ………………………………..……………………5

2.2 Three pillars of Basel II…………………………………………………...5

2.2.1 The First Pillar ……………………………………………………..5

2.2.2 The Second Pillar …………………………………………………..6

• The Third Pillar……………………………………………………6

3 PILLAR III INFORMATION FOR ING BANK…………………………………….7

3.1 Risk Management at ING Bank…………………………………………….7

3.2 Regulatory Capital Requirements…………………………………………..7

3.3 Credit Risk at ING…………………………………………………………..8

3.3.1 Pillar 3 Credit Risk in Practice………………………………………..9

3.4 Risk Rating Methodology.............................................................................10

3.5 Market Risk at ING………………………………………………………...12

3.6 Operational Risk……………………………………………………………12

4 BASEL III…………………………………………………………………….13

4.1 Key points of Basel III accord………………………………………………13

Conclusion ……………………………………………………………………...15

Literature and sources …………………………………………………………..16

Index of tables:

Table 1: Regulatory capital requirements ………………………………………………7

Table 2: Exposures (EAD) by PD grade under the AIRB approach …………………...10

Table 3: Average LGD by PD grade under the AIRB approach ……………………….11

Table 4: VaR values for IMA portfolios ………………………………………………..12

Table of pictures

Picture 1: Pillar 3 Credit Risk in Practice ……………………………………………….9

EXECUTIVE SUMMERY

The Basel Accords, while extremely influential, are oftentimes too detailed and technical to

be easily accessible to the nontechnical policymaker or interested scholar. This paper looks to

fill that gap by detailing the origin, regulation, implementation, criticism, and results of Basel

I, Basel II and Basel III respectively. Also between explaining this three pillars there is an

example from ING bank on how Basel II framework is used in practice. Findings include in

the first part, the limited scope and general language of Basel wich gives banks excessive

margin in their interpretation of its rules, and in the end, allows financial institutions to take

improper risks and hold unreasonably low capital reserves. The second part gives more

detailed information aboyt Basel II, which seeks to extend the gasp and precision of Basel I,

bringing in factors such as market and operational risk, market-based discipline and

surveillance, and regulatory mandates, but is oftentimes excessively long and complex. The

third part shows how parts of the Basel II framework are used in practice trough example of

ING Bank. In the fourth and final part of this paper includes broader expiation of the

reformed measures in Basel III and their aims. It also notes and briefly explains the key

points of this accord.

INTRODUCTION

The Basel Committee was formed in response to the messy liquidation of a Cologne-based

bank in 1974. On 26 June 1974, a number of banks had released Deutschmark to the Bank

Herstatt in exchange for dollar payments deliverable in New York. On account of differences

in the time zones, there was a lag in the dollar payment to the counter-party banks, and during

this gap, and before the dollar payments could be effected in New York, the Bank Herstatt

was liquidated by German regulators.

This incident prompted the G-10 nations [The Group of Ten is made up of eleven industrial

countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden,

Switzerland, the United Kingdom and the United States] which consult and co-operate on

economic, monetary and financial matters to form towards the end of 1974, the Basel

Committee on Banking Supervision, under the auspices of the Bank of International

Settlements (BIS) located in Basel, Switzerland.

The major impetus for the 1988 Basel Capital Accord was the concern of the Governors of

the G10 central banks that the capital of the world's major banks had become dangerously

low after persistent erosion through competition. Capital is necessary for banks as a cushion

against losses and it provides an incentive for the owners of the business to manage it in a

prudent manner.

1 BASEL I

Basel I represents a set of international banking regulations put forth by the Basel Committee

on Bank Supervision in the year 1988, which set out the minimum capital requirements of

financial institutions with the goal of minimizing credit risk. Banks that operate

internationally are required to maintain a minimum amount (8%) of capital based on a

percent of risk-weighted assets. (http://www.ecb.europa.eu/pub/pdf/scpops/ecbocp42.pdf)

• The Purpose of Basel I

In 1988, the Basel I Capital Accord was created. The general purpose was to:

1. Strengthen the stability of international banking system.

2. Set up a fair and a consistent international banking system in order to decrease competitive

inequality among international banks.

The basic achievement of Basel I have been to define bank capital and the so-called bank

capital ratio. In order to set up a minimum risk-based capital adequacy applying to all banks

and governments in the world, a general definition of capital was required. Indeed, before this

international agreement, there was no single definition of bank capital. The first step of the

agreement was thus to define it. (http://www.ecb.europa.eu/pub/pdf/scpops/ecbocp42.pdf)

1.2 Two-Tiered Capital

Basel I defines capital based on two tiers:

1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or shareholders equity) and

declared reserves, such as loan loss reserves set aside to cushion future losses or for

smoothing out income variations.

2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as gains on

investment assets, long-term debt with maturity greater than five years and hidden reserves

(i.e. excess allowance for losses on loans and leases). However, short-term unsecured debts

(or debts without guarantees), are not included in the definition of capital.

Credit Risk is defined as the risk weighted asset (RWA) of the bank, which are banks assets

weighted in relation to their relative credit risk levels. According to Basel I, the total capital

should represent at least 8% of the bank's credit risk (RWA). In addition, the Basel agreement

identifies three types of credit risks:

1. The on-balance sheet risk.

2. The trading off-balance sheet risk. These are derivatives, namely interest rates, foreign

exchange, equity derivatives and commodities.

3. The non-trading off-balance sheet risk. These include general guarantees, such as forward

purchase of assets or transaction-related debt assets.

Market risk includes general market risk and specific risk. The general market risk refers to

changes in the market values due to large market movements.

Specific risk refers to changes in the value of an individual asset due to factors related to the

issuer of the security.

There are four types of economic variables that generate market risk. These are

• Interest Rates

• Foreign Exchanges

• Equities

• Commodities

(http://www.ecb.europa.eu/pub/pdf/scpops/ecbocp42.pdf)

• Limitations of Basel I

Basel I Capital Accord has been criticized on several grounds. The main criticisms include

the following:

• Limited differentiation of credit risk: There are four broad risk weightings (0%, 20%,

50% and 100%), as shown in Figure1, based on an 8% minimum capital ratio.

• Static measure of default risk: The assumption that a minimum 8% capital ratio is

sufficient to protect banks from failure does not take into account the changing nature of

default risk.

No recognition of term-structure of credit risk: The capital charges are set at the same

level regardless of the maturity of a credit exposure.

Simplified calculation of potential future counterparty risk: The current capital

requirements ignore the different level of risks associated with different currencies and

macroeconomic risk. In other words, it assumes a common market to all actors, which is not

true in reality.

Lack of recognition of portfolio diversification effects: In reality, the sum of individual

risk exposures is not the same as the risk reduction through portfolio diversification.

Therefore, summing all risks might provide incorrect judgment of risk. A remedy would be to

create an internal credit risk model – for example, one similar to the model as developed by

the bank to calculate market risk. This remark is also valid for all other weaknesses. These

listed criticisms have led to the creation of a new Basel Capital Accord, known as Basel II,

which added operational risk and also defined new calculations of credit risk. Operational

risk is the risk of loss arising from human error or management failure.

The Basel I Capital Accord aimed to assess capital in relation to credit risk, or the risk that a

loss will occur if a party does not fulfil its obligations. It launched the trend toward increasing

risk modelling research; however, its over-simplified calculations, and classifications have

simultaneously called for its disappearance, paving the way for the Basel II Capital Accord

and further agreements as the symbol of the continuous refinement of risk and capital.

Nevertheless, Basel I, as the first international instrument assessing the importance of risk in

relation to capital, will remain a milestone in the finance and banking history.

(A Guide to Capital Adequacy Standards for Lenders. The United Kingdom

Council of Mortgage Lenders, February 2008.)

2 BASEL II

Measurement and Capital Standards, helps international banks and financial institutions

safeguard themselves against operational and financial risks. It does this by setting up

rigorous risk and capital management requirements designed to ensure that a bank holds

enough capital reserves on hand to offset its risks.

While risk management has always been a core banking function, banks were earlier

permitted to develop their own risk methodologies. For this reason it was very tough to

compare risk position of two different banks. With Basel II, each bank has to follow

minimum risk methodology standards, develop their own risk management framework and

ensure regulatory supervision. This brings the banks under one umbrella to understand risk

position. (http://www.bis.org/publ/bcbs118.htm)

2.1 Objectives of Basel II:

There were four key objectives of the new framework, namely:

1. The Accord should continue to promote safety and soundness of the financial system

2. The Accord should continue to enhance competitive equality

3. The Accord should constitute a more comprehensive approach to addressing risks

4. The Accord should focus on internally active banks, although its underlying principles

should be suitable for application to banks of varying levels of complexity and sophistication.

(http://www.bis.org/publ/bcbs118.htm)

2.2 Three pillars of Basel II:

The Basel II approach to risk is designed to encompass the complexity of information technology and

information management. The enhanced framework, is built on three pillars:

● Risk based capital (Pillar 1)

● Risk based supervision (Pillar 2)

● Risk disclosure to enforce market discipline (Pillar 3)

2.2.1 The First Pillar – Minimum Capital Requirements

The first pillar sets out minimum capital requirement. The new framework maintains

minimum capital requirement of 8% of risk assets. Basel II focuses on improvement in

measurement of risks. The revised credit risk measurement methods are more elaborate than

the current accord. It proposes, for the first time, a measure for operational risk, while the

market risk measure remains unchanged.

The first pillar deals with maintenance of regulatory capital calculated for three major

components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks

are not considered fully quantifiable at this stage.

The credit risk component can be calculated in three different ways of varying degree of

sophistication, namely standardized approach, Foundation IRB, Advanced IRB and General

IB2 Restriction. IRB stands for "Internal Rating-Based Approach".

For operational risk, there are three different approaches – basic indicator approach or

BIA, standardized approach or STA, and the internal measurement approach (an advanced

form of which is the advanced measurement approach or AMA).

For market risk the preferred approach is VaR (value at risk).

As the Basel II recommendations are phased in by the banking industry it will move from

standardised requirements to more refined and specific requirements that have been

developed for each risk category by each individual bank. The upside for banks that do

develop their own bespoke risk measurement systems is that they will be rewarded with

potentially lower risk capital requirements. In the future there will be closer links between the

concepts of economic and regulatory capital. (http://www.bis.org/publ/bcbs107b.pdf)

2.2.2 The Second Pillar - Supervisory Review Process

Supervisory review process has been introduced to ensure not only that banks have adequate

capital to support all the risks, but also to encourage them to develop and use better risk

management techniques in monitoring and managing their risks.

The process has four key principles

a) Banks should have a process for assessing their overall capital adequacy in relation to their

risk profile and a strategy for monitoring their capital levels.

b) Supervisors should review and evaluate bank’s internal capital adequacy assessment and

strategies, as well as their ability to monitor and ensure their compliance with regulatory

capital ratios.

c) Supervisors should expect banks to operate above the minimum regulatory capital ratios

and should have the ability to require banks to hold capital in excess of the minimum.

d) Supervisors should seek to intervene at an early stage to prevent capital from falling below

minimum level and should require rapid remedial action if capital is not mentioned or

restored. (http://www.bis.org/publ/bcbs107c.pdf)

2.2.3 The Third Pillar - Risk Disclosure to Enforce Market Discipline

This pillar aims to complement the minimum capital requirements and supervisory review

process by developing a set of disclosure requirements which will allow the market

participants to gauge the capital adequacy of an institution.

Market discipline supplements regulation as sharing of information facilitates assessment of

the bank by others, including investors, analysts, customers, other banks, and rating agencies,

which leads to good corporate governance. The aim of Pillar 3 is to allow market discipline to

operate by requiring institutions to disclose details on the scope of application, capital, risk

exposures, risk assessment processes, and the capital adequacy of the institution. It must be

consistent with how the senior management, including the board, assess and manage the risks

of the institution.

When market participants have a sufficient understanding of a bank's activities and the

controls it has in place to manage its exposures, they are better able to distinguish between

banking organizations so that they can reward those that manage their risks prudently and

penalize those that do not.

These disclosures are required to be made at least twice a year, except qualitative disclosures

providing a summary of the general risk management objectives and policies which can be

made annually. Institutions are also required to create a formal policy on what will be

disclosed and controls around them along with the validation and frequency of these

disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of

the banking group to which the Basel II framework applies.

Each of the three pillars are complimentary to each other and are required for supervising

both the overall financial health of the banking industry and that of the individual institution

as well, though it must be highlighted that none can substitute for effective bank

management. The rationale behind adopting the new Accord is that it is believed by the

committee that the new framework has the potential to meet challenges of innovations in

increasingly complex financial markets. (http://www.bis.org/publ/bcbsca10.pdf)

• PILLAR III INFORMATION FOR ING BANK

3.1 Risk Management at ING Bank

ING has a group risk management function that is embedded at all levels of the organisation

and operates through a comprehensive risk governance framework.

The primary responsibility of the Bank risk management function lies with the Chief Risk

Officer (CRO), who is a member of the Executive Board. The CRO is responsible for the

management and control of risk on a consolidated level to ensure that ING’s bank risk profile

is consistent with its financial resources and the risk appetite defined by the Executive Board.

The CRO has several direct reports who are all responsible for a specific risk management

function within ING Bank.

(http://annualreports.ing.com/2008/additional_information/additional_information_sub/pillar

_info/rm_ing_bank/index.html)

• Regulatory Capital Requirements

Table 1: Regulatory capital requirements

Credit risk

Portfolios subject to standardised approach 3,083

Portfolios subject to advanced IRB approach

– Central governments and central banks 309

– Institutions 1,680

– Corporate 9,366

– Residential mortgages 3,062

– Other retail 885

Total portfolios subject to advanced IRB approach 15,302

Securitisation exposures 2,321

Equity portfolios in the banking book under the simple risk weight approach 194

Other Non-Credit Obligation Assets (ONCOA) 2,166

Total credit risk 23,066

Market risk

Standardised approach 449

Internal models approach – trading book 587

Total market risk 1,036

Operational risk

Advanced measurement approach 3,368

Total Basel II required Regulatory Capital 27,470

Basel II floor* 34,369

Additional capital requirement 6,899

Source:http://annualreports.ing.com/2008/additional_information/additional_information_su

b/pillar_info/rm_ing_bank/index.html

Regulatory capital requirements

90% of Basel I required Regulatory Capital. In order to prevent large short term effects on

capital requirements, the regulators introduced transition rules (the ‘capital floor’) for

institutions implementing the new capital adequacy reporting. For 2008 and 2009 the capital

requirements should be no less than 90% and 80% respectively of the capital requirements

calculated under Basel I regulations. The additional capital requirements according to the

transition rules are EUR 6,899 million. The required regulatory capital shown in this section

should be compared to the available regulatory capital.

(http://annualreports.ing.com/2008/additional_information/additional_information_sub/pillar

_info/rm_ing_bank/index.html)

.

3.3 Credit Risk at ING

ING Bank’s credit policy is to maintain an internationally diversified loan and bond portfolio,

while avoiding large risk concentrations. The emphasis is on managing business

developments within the business lines by means of top-down concentration limits for

countries, individual obligors and obligor groups. The aim is to expand relationship-banking

activities, while maintaining stringent internal risk/return guidelines and controls.

Credit Risk is the risk of loss from the default by debtors or counterparties. Credit risks arise

in ING Bank’s lending, money market, pre-settlement and investment activities, as well as in

its trading activities. Credit risk management is supported by dedicated credit risk

information systems and internal rating methodologies for debtors and counterparties.

ING Bank’s credit exposure is mainly related to traditional lending to individuals and

businesses, bonds held in the investment portfolios and financial markets trading activities.

Loans to individuals are mainly mortgage loans secured by residential property. Loans to

businesses are often collateralised, but can be unsecured based on internal analysis of the

obligors’ creditworthiness. Financial Markets activities include derivatives trading, securities

financing, and Foreign Exchange (FX) transactions, which we collectively refer to as Pre-

Settlement risks. ING uses various market pricing and measurement techniques to determine

the amount of credit risk on pre-settlement activities. These techniques estimate ING’s

potential future exposure on individual and portfolios of trades. Master agreements and

collateral agreements are frequently entered into to reduce these credit risks.

(http://annualreports.ing.com/2008/additional_information/additional_information_sub/pillar_info/cre

dit_risk/index.html)

3.3.1 Pillar 3 Credit Risk in Practice

The Basel II Accord not only changes the way ING reports its credit risk for regulatory

purposes; it also affects the daily operations and practices of all types of risk management at

all levels within ING Bank. It has no effect on ING Insurance or Asset Management

operations.

One of the key elements of the Basel II Accord is the ‘Use Test’, which requires ING to use

Basel concepts in its day-to-day activities. The diagram below illustrates where ING has

incorporated the Basel II concepts into its daily activities, both globally and locally: (http://annualreports.ing.com/2008/additional_information/additional_information_sub/pillar_info/cre

dit_risk/pillar3_credit_risk.html)

Picture 1: Pillar 3 Credit Risk in Practice

Source:http://annualreports.ing.com/2008/additional_information/additional_information_sub/pillar_info/credi

t_risk/pillar3_credit_risk.html

3.4 Risk Rating Methodology

In principle all Risk Ratings are based on a Risk Rating (PD) Model that complies with the

minimum requirements detailed the CRD, the DNB Supervisory Rules and CEBS guidelines.

This concerns all Obligor Types and Segments, including Countries.

ING’s Probability of Default (PD) rating models are based on a 1-22 scale, which roughly

corresponds to the same rating grades that are assigned by external rating agencies, such as

Standard & Poor’s and Fitch. For example, an ING rating of 1 would correspond to an

S&P/Fitch rating of AAA; an ING rating of 2 would correspond to an S&P/Fitch rating of

AA+, and so on.

Table 2: Exposures (EAD) by PD grade under the AIRB approach

Central

governments

and central

banks

Institutions Corporate Residential

mortgages

Other

retail

Total

1 (AAA) 28,745 1,857 7,698 181 38,481

2 (AA+) 26,271 2,185 1,553 1,859 146 32,014

3 (AA) 3,321 19,158 5,142 1,990 100 29,711

4 (AA-) 11,463 43,761 6,352 1,046 84 62,706

5 (A+) 618 23,075 9,156 4,761 2,638 40,248

6 (A) 314 10,589 12,181 1,571 311 24,966

7 (A-) 865 9,357 14,793 18,839 1,086 44,940

8 (BBB+) 948 5,441 24,173 19,238 2,481 52,281

9 (BBB) 129 1,950 30,589 40,149 4,067 76,884

10 (BBB-) 848 3,792 39,143 45,809 3,523 93,115

11 (BB+) 116 1,636 35,671 66,961 6,085 110,469

12 (BB) 1,969 1,329 30,210 30,016 2,558 66,082

13 (BB-) 42 1,121 23,890 6,088 2,036 33,177

14 (B+) 151 432 14,343 1,501 1,139 17,566

15 (B) 53 415 4,993 7,396 1,089 13,946

16 (B-) 403 2,289 855 347 3,894

17 (CCC-C) 9 1,011 3,771 2,776 481 8,048

18 (Special

Mention) 52 2,183 311 488 3,034

19

(Substandard) 3 43 567 1,566 271 2,450

20 (Doubtful) 4 181 3,359 1,466 679 5,689

21

(Liquidation –

no loss)

182 1,346 79 1,607

22

(Liquidation –

with loss)

9 407 23 110 549

Total 75,869 127,797 272,645 255,567 29,979 761,857

Source:http://annualreports.ing.com/2008/additional_information/additional_information_su

b/pillar_info/credit_risk/credit_risk_exposures.html

The figures presented above are based on EAD and as such differ from those presented in the

annual accounts due to different measurement methodology.

Over 95% of ING’s credit risks have been rated using one of the in-house developed PD

rating models. Within the AIRB Portfolio, the level of Basel II ratings exceeds 99% coverage

by exposure. Bank wide, ING has implemented approximately 90 PD models, including

various sub models that may be applicable. Some of these models are universal in nature,

such as models for Large Corporate, Commercial Banks, Insurance Companies, Central

Governments, Local Governments, Funds, Fund Managers, Project Finance, and Leveraged

Companies.

Under Basel II rules, the nominal exposures are weighted to determine the RWA (and

regulatory capital) of a portfolio, under a ‘risk-based approach’. This approach dictates that

less capital is required for credit risks which are well-rated, while progressively more capital

is required as an obligor’s risk (rating) deteriorates. This effect can cause RWA assets to

increase or decrease together with risk rating migration without a significant change in the

size of the underlying financial assets, in terms of financial accounting. As such, rating

migrations are closely monitored within ING.

(http://annualreports.ing.com/2008/additional_information/additional_information_sub/pillar

_info/credit_risk/credit_risk_exposures.html)

Table 3: Average LGD by PD grade under the AIRB approach IRB approach

Central

governments

and central

banks

Institutions Corporate Residential

mortgages Other

retail Total

1 (AAA) 20% 16% 34% 10% 53% 23%

2 (AA+) 20% 22% 34% 10% 46% 20%

3 (AA) 20% 21% 37% 10% 42% 23%

4 (AA-) 20% 22% 41% 10% 37% 23%

5 (A+) 20% 24% 35% 12% 55% 27%

6 (A) 21% 24% 28% 10% 52% 25%

7 (A-) 24% 27% 31% 21% 40% 26%

8 (BBB+) 55% 27% 34% 18% 22% 27%

9 (BBB) 18% 37% 29% 16% 33% 23%

10 (BBB-) 41% 29% 25% 14% 26% 19%

11 (BB+) 22% 38% 20% 13% 37% 17%

12 (BB) 37% 42% 22% 16% 38% 20%

13 (BB-) 49% 43% 18% 16% 40% 20%

14 (B+) 8% 36% 23% 15% 39% 23%

15 (B) 8% 43% 26% 13% 45% 21%

16 (B-) 52% 74% 20% 14% 33% 25%

17 (CCC-C) 17% 33% 30% 12% 37% 24%

18 (Special

Mention) 20% 24% 16% 19% 19% 17%

19

(Substandard) 33% 48% 18% 14% 35% 18%

20 (Doubtful) 28% 30% 25% 24% 44% 27%

21

(Liquidation –

no loss)

1% 15% 14% 57% 16%

22

(Liquidation –

with loss)

15% 27% 14% 73% 36%

Total 21% 24% 26% 15% 36% 22%

Sorce:http://annualreports.ing.com/2008/additional_information/additional_information_sub/

pillar_info/credit_risk/credit_risk_exposures.html

The table above represents the weighted average LGD for each of the represented

combination of PD Grade and Exposure Class. For example, the weighted average LGD for

an AAA rated corporate is 34%, while the weighted average LGD for a BBB rated corporate

is 29%. LGD percentages are influenced by the transactional structure of the financial

obligation, the related collateral or covers provided, and the country in which the collateral (if

any) would have to be recovered.

In certain cases, the portfolio size is relatively small, which can also have an effect on the

weighted average LGD in a given PD Grade and Exposure Class. Therefore, this table should

be read in conjunction with the previous table (Exposures (EAD) by PD grade).

(http://annualreports.ing.com/2008/additional_information/additional_information_sub/pillar

_info/credit_risk/credit_risk_exposures.html)

3.5 Market Risk at ING

According to the Dutch regulation, regulatory capital for trading portfolios can be calculated

using the standardised approach (CAD1) or an internal model approach (CAD2). In 1998,

ING received approval from the Dutch Central Bank (DNB) to use an internal Value-at-Risk

(VAR) model to determine the regulatory capital for the market risk in the trading book of

ING Bank. Market risk capital of CAD2 trading books is calculated according to the internal

VaR model, where correlations and volatilities are taken into account. On the other hand,

market risk capital of CAD1 books is calculated using standardised fixed risk weights.

Table 4: VaR values for IMA portfolios

High Mean Low Period-end

Interest rate risk 50 37 22 40

Equity position risk 11 7 4 7

Foreign exchange risk 8 5 2 6

Diversification effect 5 3

Total 44 50

For a summary of the Value-at-Risk measurement applicable to the internal model approach

please refer to the Market Risk segment in the Risk Management section. It should be noted

that the VaR figures in the above table only relate to the CAD2 trading books for which the

internal model approach is applied. The VaR figures reported in the Risk management section

relate to all books under trading governance.

(http://annualreports.ing.com/2008/additional_information/financial_information/pillar_info/

msarket_risk/index.html)

3.6 Operational Risk

The Operational Risk Capital model of ING is based on a Loss Distribution Approach

(LDA). The Loss Distribution is based on both external and internal loss data exceeding EUR

1 million. The model is adjusted for the scorecard results, taking into account the specific

quality of control in a business line and the occurrence of large incidents (‘bonus/malus’).

This provides an incentive to local (operational risk) management to better manage

operational risk. Originally, the model was designed for Economic Capital (99.95%

confidence level) and the Financial Risk Dashboard (90% confidence level). From 2008

onwards, the model is used for regulatory capital reporting purposes as well (AMA

approach). Insurance reduction because of risk mitigation by insurance has not been applied

to the AMA capital of 2008.

The Operational Risk Capital using AMA significantly increased to EUR 3,368 million in

(as stated in the operational risk part of the risk management section) due the periodic update

of the external loss data, which reflected the increased uncertainty/turmoil in the financial

market. Two acquisitions took place that impacted capital and the related diversification

benefit as well: ING Turkey and ING Direct Interhyp.

(http://annualreports.ing.com/2008/additional_information/additional_information_sub/pillar

_info/operational_risk.html)

4 BASEL III

After the current global financial crisis the Basel committee feels the importance to improve

the current Basel II accord and start to work for developing a new capital framework known

as the Basel III.

Basel III is a comprehensive set of reform measures, developed by the Basel Committee on

Banking Supervision, to strengthen the regulation, supervision and risk management of the

banking sector. These 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.

(http://www.bis.org/bcbs/basel3.htm)

4.1 Key points of Basel III accord:

Banks will have to increase their core tier-one capital ratio to 4.5% by 2015. In addition, they

will have to carry a further "counter-cyclical" capital conservation buffer of 2.5% by 2019.

Any bank that fails to meet the new requirements is expected to be banned from paying

dividends to shareholders until it has improved its balance sheet.

Financial supervision: The G20 wants closer supervision of systemic risk at local and

international levels.

Derivatives: The G20 has called for greater standardization and central clearing of privately

arranged, over-the-counter contracts by the end of 2012.

Hedge funds: US reforms are in line with the G20 pledge that funds above a certain size

should be authorized and obliged to report data to supervisors. A draft EU law includes

private equity groups and restrictions on non-EU fund managers seeking European investors.

Accounting: The G20 wants common global accounting rules by mid-2011.

Credit rating agencies: The G20 wants them registered and supervised by the end of 2009.

The EU has adopted a law mandating registration and direct supervision that takes effect this

year. US legislation passed this year includes similar provisions.

Pay: The G20 has endorsed principles designed to stop bonus schemes in banks from

encouraging too much short-term risk-taking.

(http://www.theguardian.com/business/2010/sep/13/basel-iii-the-main-points)

CONCLUSION

One very important fact to assess is the achievements and limitations of each Basel Accord.

The first Basel Accord, Basel I, was a groundbreaking accord in its time, and did much to

promote regulatory harmony and the growth of international banking across the borders of

the G-10 and the world alike. On the other hand, its limited scope and rather general language

gives banks 16 excessive leeway in their interpretation of its rules, and in the end, allows

financial institutions to take improper risks and hold unduly low capital reserves. Basel II, on

the other hand, seeks to extend the breath and precision of Basel I, bringing in factors such as

market and operational risk, market based discipline and surveillance, and regulatory

mandates. The drawbacks of both accords, interestingly enough, are remarkably similar. Put

simply, both effectively ignore the implications of their rules on emerging market banks.

Although each states that its positions are not recommended for application in emerging

market economies, the use of Basel I and II by most private and public organizations as truly

international banking standards predicates the inclusion of emerging markets in each accord.

As a result of this drawbacks and the current global financial crisis the Basel committee

decides to improve the current Basel II accord and start to work for developing a new capital

framework known as the Basel III. The key points of this new accord will include financial

supervision, derivatives, hedge funds and accounting and are expected to overcome the

limitations and week points of the previous two pillars.

LITERATURE AND SOURCES

• Bank of International Settlements. Monetary and financial stability: Basel Committee on

Banking Supervision. Found on 28.12.2013 at http://www.bis.org/publ/bcbs118.htm

• Bank of International Settlements. Monetary and financial stability: Basel Committee on

Banking Supervision. Found on 28.12.2013 at http://www.bis.org/publ/bcbs107b.pdf

• Bank of International Settlements. Monetary and financial stability: Basel Committee on

Banking Supervision. Found on 28.12.2013 at http://www.bis.org/publ/bcbsca10.pdf

• Bank of International Settlements. Monetary and financial stability: Basel Committee on

Banking Supervision. Found on 29.12.2013 at http://www.bis.org/bcbs/basel3.htm

• Council of Mortgage Lenders, February 2008.

• European Central Bank. Found on 27.12.2013 at

• Guide to Capital Adequacy Standards for Lenders. The United Kingdom

• http://annualreports.ing.com/2008/additional_information/additional_information_sub/pill

ar_info/rm_ing_bank/index.html

• http://annualreports.ing.com/2008/additional_information/additional_information_sub/pill

ar_info/credit_risk/index.html

• http://annualreports.ing.com/2008/additional_information/additional_information_sub/pill

ar_info/credit_risk/credit_risk_exposures.html

• http://annualreports.ing.com/2008/additional_information/additional_information_sub/pill

ar_info/operational_risk.html

• http://annualreports.ing.com/2008/additional_information/financial_information/pillar_inf

o/msarket_risk/index.html

• http://www.ecb.europa.eu/pub/pdf/scpops/ecbocp42.pdf

• http://www.theguardian.com/business/2010/sep/13/basel-iii-the-main-points

• ING. Additional information: Credit Risk at ING. Found on 06.01.2014 at

• ING. Additional information: Market Risk at ING. Found 06.01.2014 at

• ING. Additional information: Operational Risk. Found on 06.01.2014 at

• ING. Additional information: Pillar 3 Credit Risk in Practice at ING. Found on

06.01.2014 at

http://annualreports.ing.com/2008/additional_information/additional_information_sub/pill

ar_info/credit_risk/pillar3_credit_risk.html

• ING. Additional information: Regulatory Capital Requirements. Found on 06.01.2014 at

• ING. Additional information: Risk Management at ING Bank. Found on 06.01.2014 at

http://annualreports.ing.com/2008/additional_information/additional_information_sub/pill

ar_info/rm_ing_bank/index.html

• ING. Additional information: Risk Rating Methodology. Found on 06.01.2014 at

• The Guardian. Business. Found on 29.12.2013 at

http://www.theguardian.com/business/2010/sep/13/basel-iii-the-main-points