The Regulation of Banking Industry (Basel

Accord)AMRITA DEBNATH

ID# 708MBA

DEPT. OF BANKING AND INSURANCEUNIVERSITY OF DHAKA

BaselThe Basel Agreemento An international agreement on new capital standardso Designed to keep their capital positions strongo Reduce inequalities in capital requirements among different countrieso Promote fair competitiono Catch up with recent changes in financial services and financial innovation o In particular, the expansion of off-balance-sheet commitmentso Formally approved in July 1988o Included countries such as:

The United States, Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and Luxembourg

Objectives of Basel IObjectives• Strengthening the soundness and stability of the international

banking system• Providing an internationally consistent level playing field with a

view to diminishing an existing source of competitive inequality among international banks.

Components of Basel I

• Definition of capital• Deduction regime• A risk weighting approach • A solvency ratio capital to weighted risk asset

Definition of CapitalTier 1 (core) capitalo Common stock and surplus, undivided profits (retained

earnings), qualifying noncumulative perpetual preferred stock, minority interest in the equity accounts of consolidated subsidiaries, and selected identifiable intangible assets less goodwill and other intangible assets

Tier 2 (supplemental) capitalo Allowance (reserves) for loan and lease losses, subordinated

debt capital instruments, mandatory convertible debt, intermediate-term preferred stock, cumulative perpetual preferred stock with unpaid dividends, and equity notes and other long-term capital instruments that combine both debt and equity features

Definition of CapitalFor a bank to qualify as adequately capitalized, it must have:

A ratio of core capital (Tier 1) to total risk-weighted assets of at least 4 percent

A ratio of total capital (the sum of Tier 1 and Tier 2 capital) to total risk-weighted assets of at least 8 percent, with the amount of Tier 2 capital limited to 100 percent of Tier 1 capital

Deduction Regime• Deduction of accounting goodwill• Investments in other regulated financial institutions• Certain accounting items were deducted but then treated as tier 2

capita• Revaluation of reserve of holding of equity instrument as tier 2

Risk Weighting Approach• Risk weighting summary

Risk Weight Loans and Investment

0% Cash and OECD

10% Some public sector entities

20% Banks in the OECD and short term loans to non OECD banks

50% Residential mortgagesLong term unfunded commitments

100% Most other assets, including corporate and retailing; non OECD governments and long term loans to non-OECD banks; real estate and equity exposure

Calculating Risk Weight Asset

Each asset item on a bank’s balance sheet and each off-balance-sheet commitment it has made are multiplied by a risk-weighting factoro Designed to reflect its credit risk exposure

The most closely watched off-balance-sheet items are standby letters of credit and long-term, legally binding credit commitments

To compute this bank’s risk-weighted assets:o Compute the credit-equivalent amount of each off-balance-sheet (OBS)

itemo Multiply each balance sheet item and the credit-equivalent amount of

each OBS item by its risk weight

Ratio capital to weighted risk asset• Minimum Capital requirement is 8%

Modification • In 1996, Basel I include the capital charges for market risk• Value at Risk (VaR) Models Responding to Market Risk

Objectives of Basel 2 To improve the risk management Resilience banking industry Make capital requirements more risk sensitive and therefore relevant Utilize the information, resources and judgments of the banks

themselves

The Three-pillar Approach• 1. Minimum capital requirements• 2. Supervisory review• 3. Market discipline

Minimum Capital Requirement• Pillar 1 is sum of three componentsa. Credit Riskb. Market Riskc. Operational risk

Credit risks• Elements of expected loss calculation Default probability Exposure of default Loss given default Maturity of the exposure Type of lending

Risk-weighting of Corporate LoansCredit Rating of Corporate Risk-weight of Exposure (Under Basel II)

AAA to AA- 20%

A+ to A- 50%

BBB+ to BB- 100%

Below BB- 150%

Unrated 100%

Market Risk• General market risk VaR model is used. • Risk on a day to day basis VaR is useful but it is used in extreme

situations.

Operational Risk• Operational risks that are operation in nature

Fraud System failure Fire

• It includes legal risk but excludes strategic and reputational risk.

Pillar 2: Supervisory ReviewPillar 2 risk types interest risk Residual risk Liquidity risk Business risk Pension risk

Pillar 3: Market Discipline• The committee aims to encourage market discipline by developing a

set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures.

Critiques of Basel 2 1. Complexity2. Liquidity3. Incomplete implementation4. Over reliance on credit rating agencies5. Market risk module not fit for purpose

Basel III• The third installment of the Basel Accords was developed in response

to the deficiencies in financial regulation revealed by the financial crisis of 2007–08• Unlike Basel I and Basel II, which focus primarily on the level of bank

loss reserves that banks are required to hold, Basel III focuses primarily on the risk of a run on the bank, requiring differing levels of reserves for different forms of bank deposits and other borrowings• On 17 Dec. 2009, the Basel Committee published its ‘Consultative

Proposals to Strengthen the Resilience of the Banking Sector’

Capital RequirementsBasel II Basel III

Deductions Largely from Tier I and total capital All deductions from CET1

Denominator Basel II RWAs Basel III RWAs

CET1 2% 4.5%

Tier 1 4% 6%

Total Capital 8% 8%

Capital Requirements (Contd.) A mandatory “Capital Conservation Buffer", equivalent to 2.5% of

risk-weighted assets. Considering the 4.5% CET1 capital ratio required, banks have to hold a total of 7% CET1 capital, from 2019 onwards.

A “Discretionary Counter-cyclical Buffer", allowing national regulators to require up to an additional 2.5% of capital during periods of high credit growth. The level of this buffer ranges between 0% and 2.5% of RWA and must be met by CET1 capital.

Leverage Ratio• This is a non-risk-based leverage

ratio and is calculated by dividing Tier 1 capital by the bank's average total consolidated assets (sum of the exposures of all assets and non-balance sheet items)• The banks are expected to

maintain a leverage ratio in excess of 3% under Basel III.

Liquidity Requirements • The "Liquidity Coverage Ratio"

was supposed to require a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days. • The Net Stable Funding Ratio was

to require the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

Major Issues with Basel III Incremental and an Excessive Focus on Capital and Liquidity

Regulation Excessive Complexity New Risks: Sovereign Debt, CCPs and Shadow Banking Timing: Risk of a Credit Crunch Continued Reliance on the Credit Assessment of Either Internal

Models or External Ratings Agencies

Thank You.