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Overview of Basel II- Why, What, How and When -

SAARCFINANCE Seminar on Basel II Implementation in South Asia

Islamabad, Pakistan26 June 2008

Jason GeorgeFinancial Staiblilty Institute / Bank for International Settlements

Representative Office for Asia and the PacificHong Kong SAR

2

Agenda

Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil

“Basel II introduces a far more comprehensive framework for regulatory capital and risk management than we have ever known”

Former Basel Committee Chairman Jaime Caruana11 May 2004

3

Capital Adequacy

Supervisors must set prudent and appropriate minimum capital adequacy requirements for banks that reflect the risks that the bank undertakes, and must define the components of capital, bearing in mind its ability to absorb losses. At least for internationally active banks, these requirements must not be less than those established in the applicable Basel requirement.

Core Principle 6, Core Principles for Effective Banking Supervision, October 2006

4

The Case for a Capital Framework

Financial instability is costly to the economy, such as…– Disruption in the distribution of funds – Breakdown in the payment systems– Possibility of international contagion

Therefore, the need for supervision and capital regulation– But the objective should not be to assure that banks

will never fail Capital regulation can have competitive implications

– The need to have internationally harmonised rules for internationally active banks competing with each other

– International versus domestic banks

5

Benefits of Basel I … and Some Issues

Created an internationally recognised standard

– Adopted world-wide

Contributed to financial stability

– Reversed a downward trend in international banks’ capital levels

– Promoted level playing field among internationally-active banks

Relatively simple

Capital requirements not always reflective of economic risk

Does not address innovation in risk measurement and management practices

– Arbitrage opportunities (eg through securitisation)

• Little recognition of credit risk mitigants

“OECD Club-Rule”

6

Objectives of Basel II

Greater use of the roles played by bank management (pillars 1 and 2) and the market (pillar 3)

Better align regulatory capital to underlying risk (economic capital)

Encourage banks to improve risk management capabilities

Comprehensive coverage of risks– Pillar 1: credit, market and operational risk– Pillar 2: all other risks, aspects of pillar 1 risks not

captured in pillar 1, and external factors Applicability to a wider range of banks and systems

(menu of options)

7

Basel II: The Three Pillars

Perfect rules are not feasible- no perfect measurement system- difficult balance between accuracy and simplicity

8

Basel II: The Three Pillars Plus…

Standard isedApproach

Interna lR atings-based

Approach

C redit risk

BasicInd icatorApproach

S tandard isedApproach

AdvancedM easurem entApproaches

O perationalrisk

S tandard isedApproach

M odelsApproach

M arketrisks

R isk w eightedassets

C oreC apita l

Supplem entaryC apita l

D efin ition ofcapita l

M in im um capita lrequirem ents

Supervisory revie wprocess

M arketd iscip line

ThreeBasic P illars

9

Relationship of the Three Pillars

Pillar 1: A quantitative approach to minimum capital requirements

Pillar 2: Banks should have a process for assessing their overall capital adequacy; supervisors will review this process and require additional capital if necessary

Pillar 3: Market participants should have better access to information regarding the credit standing of banks (ie enhanced disclosure)

All three pillars are mutually reinforcing

10

Potential Implications of Basel II

Major improvement in capital regulation– Intended to enhance safety and soundness of the banking

system– Implementation poses significant challenges

Capital requirements more aligned to underlying risks– Less incentives for regulatory arbitrage– Transactions likely to be motivated more by funding and

credit risk management needs– Better risk management and pricing by institutions– More efficient allocation of capital

11

Agenda

Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil

12

Main elements of Basel II

Based on three pillars Revised capital requirements for credit risk, new ones for

operational risk, and hardly changed ones for market risks (1996 amendment)

Menu of approaches for the measurement of risks More recognition of drivers of credit risk

13

Basel II: The three pillars

• Credit risk

• Operational risk

• Market risk

• Bank ICAAP

• Supervisory review

• Enhanced disclosure

14

Capital requirements for credit risk

Several approaches to choose from

– Standardised approach (SA)

– Foundation internal ratings-based approach (FIRB)

– Advanced internal ratings-based approach (AIRB)

15

Credit risk: Standardised approach

Main characteristics

– Closest to 1988 Capital Accord

– OECD/non-OECD distinction for claims on sovereigns replaced

– Riskiness determined by external credit assessments

– Lower risk weights for claims on retail and residential mortgages

– Significantly more recognition of credit risk mitigation techniques

16

1 Risk weighting based on risk weights of sovereign in which the bank is incorporated, but one category less favourable.

2 Risk weighting based on the assessment of the individual bank.3 Claims on banks of an original maturity of less than three months generally receive a weighting

that is one category more favourable than the usual risk weight on the bank’s claim.

C l a i m As s e s s m e n t

A A A - A A-

A+ - A- B B B + -

B B B - B B + - B - B e l o w B - U n r a t ed

S o v e r e i g n s ( E x p o r t c re d i t a g en c i e s )

0 % ( 0 - 1 )

2 0 % ( 2 )

5 0 % ( 3 )

1 0 0 % ( 4 - 6 )

1 5 0 % ( 7 )

1 0 0 %

O p t i o n 1 1 2 0 % 5 0 % 1 0 0 % 1 0 0 % 1 5 0 % 1 0 0 %

B a n k s

O p t i o n 2 2 2 0 %

( 2 0 % ) 3 5 0 %

( 2 0 % ) 3 5 0 %

( 2 0 % ) 3 1 0 0 % ( 5 0 % ) 3

1 5 0 % ( 1 5 0% ) 3

5 0 % ( 2 0 % ) 3

C o rp o r a t e s 2 0 % 5 0 % 1 0 0 % B B + - B B -

1 0 0 % B e l o w B B -

1 5 0 % 1 0 0 %

M o r t g ag e s 3 5 % R e t a i l

O t h e r r e t a i l

7 5 %

Credit risk: Standardised approach

Area of national

discretion

17

Credit risk: IRB approach

Basic principles Relies on a bank‘s internal ratings system Based on three main elements

– Risk components (e.g. PD, LGD, EAD)– Risk weight functions– Minimum requirements

Separate approaches for each portfolio of assets Subject to supervisory validation and approval

18

Credit risk: IRB approach risk weights

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

Probability of defailt

Ris

k w

eig

ht

Corporates SME 5mn Retail

19

Operational risk: Definition

Risk of loss resulting from:

Inadequate or failed

– Internal processes– People– Systems

Or from external events

Includes legal risk

Excludes strategic and reputational risk

Includes, but not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements

20

Operational risk: It is not new …. however,

New complex financial products and strategies

Growing reliance on automated technology

Cost reduction strategies

Mergers

Migration to outsourcing

Banks are increasing their operational risk exposure

21

Operational risk: Pillar 1 approaches

Choice of three approaches…– Basic indicator (15% of average gross income over 3

years)– Standardised approach (based on separate scaling

factors for gross income from defined business lines between 12% and 18% gross income)

– Range of advanced methods based on loss experience, subject to additional risk control criteria

22

Pillar 2 – Supervisory review process

• The three pillars together are intended to achieve a level of capital commensurate with a bank‘s overall risk profile

• Pillar 2 is based on four key principles:– Banks‘ own assessment of capital adequacy– Supervisors‘ review of banks‘ capital adequacy

assessment– Capital above regulatory minimums– Supervisory intervention

Foundation = existing supervisory guidance, especially Core Principles for Effective Banking Supervision

23

Rationale for Pillar 2

Encourage banks to utilise better risk management techniques

Ensure banks have adequate capital to support all risks

Focus on internal, not regulatory, capital

Accommodate differences between banks

24

Capital above regulatory minimums

Pillar 1 requirements include a buffer for uncertainties that affect the banking population as a whole

All banks are expected to operate ABOVE the minimum requirement (i.e. not just at 8%!)

Supervisors will need to consider whether the particular features of their banks/markets are adequately covered

25

Pillar 3 – Market Discipline

Disclosure requirements allow market participants to assess key information relating to:

– Scope of application

– Capital

– Risk exposures

– Risk assessment process

Both quantitative and qualitative disclosures

Some disclosures are required in order to use the more advanced Pillar 1 approaches

26

Pillar 3 – Market Discipline

Particularly relevant because internal methodologies allow banks discretion in assessing capital requirements

Disclosures should be consistent with how management and the board assess and manage risks

Pillar 3 disclosures based upon Basel II framework inform the market about a bank’s exposure to risk in a consistent and understandable manner (ie enhanced comparability)

27

Pillar 3 - Achieving Appropriate Disclosures

Supervisors have different powers available to achieve disclosure requirements– Disclosure on safety and soundness grounds– Disclosure of regulatory reports

Mechanisms to enforce requirements– Moral suasion (to change behavior)– Enforcement actions– Financial penalties

Nature of exact measures will depend upon legal powers of the supervisor and nature of any deficiency

Refer to Basel Committee Disclosure Surveys

28

Agenda

Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil

“The implementation of the Basel II framework provides an opportunity for banks and supervisors to strengthen the resilience of the banking system…”

Basel Committee Chairman Nout Wellink4 March 2008

29

Building the Road to the Implementation of Basel II

30

Necessary Steps for Building a Road

1) Assessing the current environment

2) Making a plan:

a) Where should the road lead to?

b) What kind of road are we building?

3) Setting up a project:

a) What is the time schedule for building the road?

b) What is required to build the road to Basel II?

4) Testing (and, if need be, improving) the foundation

5) Constructing the road

31

Where Should the Road Lead To?

Adequately capitalised banks A sounder and safer banking (and financial) system as a

precondition for a stable economy and economic growth

32

Readiness on the Regulators’ Side

Preconditions– Sound macro-economic policies– Legal, accounting, auditing and payment systems– Systemic protection

Institutional setting of the supervisor– Independence, governance, accountability, transparency– Resources, legal power

Control over bank’s structure– Licensing– Ownership– Activities,

acquisitions

Risk management and capital– Provisioning– Large

exposure– Related party

exposure– Liquidity

Banks’ internal control and governance

Account-ing and disclosure

On-site, off- site monitoring

Remedial actions

Consolidated supervision

Home-host cooperation

Basel II framework

33

What Kind of Road are we Building?

34

What Kind of Road are we Building?

35

What Kind of Road are we Building?

The superhighway appears attractive, but traveling at high speeds brings great risks!!

36

What Kind of Road are we Building?

Approaches for credit risk– Simplified standardised approach– Standardised approach– Foundation internal ratings-based approach– Advanced internal ratings-based approach

Approach for operational risk– Basic Indicator approach– Standardised approach– Alternative standardised approach– Advanced measurement approaches

There is not one way to implement Basel II

37

Big banks urge emerging markets to move quickly…

IIF Steering Committee on Regulatory Capital (Nov 2005)

…member banks believe that, as soon as reasonably possible, they and their local jurisdictions should aim to take advantage of … the Internal Ratings Based (IRB) Approaches.

…but the IMF board cautions against moving too quickly…

IMF Executive Board (Nov 2005)

(The Directors) urged staff to be completely candid when asked to assess countries’ readiness to move to Basel II and to indicate clearly the risks of moving too quickly and too ambitiously.

38

Basel II Implementation…(when do we build the road?)

When should Basel II be implemented?– Only national authorities can answer this question– Basel II may be a lesser priority compared to other efforts

Depending on a bank‘s business, the 1988 Accord may remain an alternative

– But principles of Basel II are valuable for supervisors and banks in all markets

In their assessments of a country’s compliance with Core Principle 6 the IMF and the World Bank will not assess compliance based on whether or not a country has implemented Basel II. (IMF staff note, 23 April 2004)

39

What is Required to Build the Basel II Road?

Implementing Basel II is a major challenge for banks and supervisors

Assessing resource and training needs– Human resources– Financial resources– Information systems

Ongoing communication between supervisors and between supervisors and banks

40

Solid Foundation

A solid foundation is essential for building a road Basel II requires an appropriate infrastructure

– Otherwise there could be a false sense of financial stability

Preconditions for Core Principles are fundamental Compliance with Core Principles is crucial

– System of effective supervision must exist in a country– Sound accounting and provisioning standards

41

The Construction Process – Practical Steps for Implementation Transform the framework into enforceable rules Implementation

– Minimum capital ratio – is 8% enough (the speed limit)– Deciding on the use of national discretion– Accord Implementation Group– Determining the scope of application of Basel II

Paper on “practical considerations” published in July 2004– Intended as a “roadmap” for implementation

42

Areas of National Discretion

Recognises countries‘ different realities Essential part to ensure that the implementation is to be a

success Supervisors should develop policy decisions on the whole

range of issues (Annex of “practical considerations paper“)– Draw upon domestic market practice and experience– Be consistent with the Basel II principles

Share information with other supervisors

43

Think About the Intersections

44

Think About the Intersections

Cross-border implementation as a major issue Relationship between home and host supervisor Examples

– HSBC has offices over 80 countries and jurisdictions – Citigroup has offices in approximately 90 countries and

jurisdictions– Barclays has offices in over 60 countries

45

Agenda

Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil

“This document is being circulated to supervisory authorities worldwide with a view to encouraging them to consider adopting this revised Framework at such time as they believe is consistent with their broader supervisory priorities.”

Basel II Framework, para 3June 2006

46

Basel II Implementation in Asia

Implementation status

Credit Risk Operational Risk

Australia SA: 01.01.2008

FIRB: 01.01.2008

AIRB: 01.01.2008

BIA: 01.01.2008

SA: 01.01.2008

AMA: 01.01.2008

China SA: Not permitted

FIRB: 31.12.2010/2013*

AIRB: 31.12.2010/2013*

BIA: Undecided

SA: Undecided

AMA: Undecided

Hong Kong SA: 01.01.2007

FIRB: 01.01.2007

AIRB: 01.01.2008

BIA: 01.01.2007

SA: 01.01.2007

AMA: Not permitted

* Only for internationally active banks; banks can implement IRB as early as 31.12.2010 but must have implemented it by 31.12.2013. 

47

Basel II Implementation in Asia

Implementation status

Credit Risk Operational Risk

India SA: 31.03.2008/2009*

FIRB: Undecided

AIRB: Undecided

BIA: 31.03.2008/2009*

SA: Undecided

AMA: Undecided

Japan SA: 01.04.2007

FIRB: 01.04.2007

AIRB: 01.04.2008

BIA: 01.04.2007

SA: 01.04.2007

AMA: 01.04.2008

Korea SA: 01.01.2008

FIRB: 01.01.2008

AIRB: 01.01.2009

BIA: 01.01.2008

SA: 01.01.2008

AMA: 01.01.2009

* 31.03.2008 for Indian banks having foreign presence and foreign banks operating in India; 31.03.2009 for all other domestic banks. 

48

Basel II Implementation in Asia

Implementation status

Credit Risk Operational Risk

Malaysia SA: 01.01.2008

FIRB: 01.01.2010

AIRB: 01.01.2010

BIA: 01.01.2008/2010*

SA: 01.01.2008/2010*

AMA: Undecided

Singapore SA: 01.01.2008

FIRB: 01.01.2008

AIRB: 01.01.2008

BIA: 01.01.2008

SA: 01.01.2008

AMA: 01.01.2008

Thailand SA: 31.12.2008

FIRB: 31.12.2008

AIRB: 31.12.2009

BIA: 31.12.2008

SA: 31.12.2008

AMA: Not permitted

* 01.01.2008 for Malaysian banks that are adopting the SA for credit risk; 01.01.2010 for banks that are adopting an IRB approach for credit risk. 

49

Basel II Implementation - Other Regions

Implementation status

Credit Risk Operational Risk

Basel Committee (ex US and Japan)

SA: 01.01.2007

FIRB: 01.01.2007

AIRB: 01.01.2008

BIA: 01.01.2007

SA: 01.01.2007

AMA: 01.01.2008

United States Currently only applies to the 10-15 largest banks (core banks)*

Only advanced approaches permitted Parallel run to begin 2009(?); minimum four

quarters of testing, followed by a … Three year transitional period (capital floors) 01.10.2008 implementation plan adoption

* US regulators will publish rules permitting the use of standardised approach for non-core banks

50

Basel II Implementation in Asia

Implementation challenges Supervisory infrastructure (laws, regulations, accounting

standards, supervisory guidance, Core Principles, etc) Pillar 2

– Banks: developing a robust ICAAP– Supervisors: understanding how to assess an ICAAP

and developing appropriate & proportionate responses Common reporting framework (eg Pillar 3) Data Resources and training

51

Agenda

Introduction and background (why?) Main elements of Basel II (what?) Building the road to Basel II implementation (how?) Basel II implementation in Asia…and elsewhere (when?) Basel II and the current market turmoil

“The new framework is designed to evolve over time and adapt to innovations in banking and financial markets…”

Federal Reserve Board Chairman Ben Bernanke2 November 2007

52

Basel II and the Current Market Turmoil

The build-up to, and unfolding of the financial turmoil took place in a Basel I environment– Lack of risk sensitivity– Inflexibility to rapid innovation– Perverse incentives to move exposures off the balance

sheet– Failure to fully capture important elements of a bank’s

risk exposures Basel II needs timely implementation

– The starting point for improving capital adequacy in banks is the timely implementation of Basel II

53

Basel II and the Current Market Turmoil

Pillar 1 (minimum capital requirements) The Basel Committee will revise Basel II to…

– Establish higher capital requirements for complex structured products• These have produced a majority of the losses

– Strengthen the capital treatment of liquidity facilities extended to support off-balance sheet vehicles (2008)

– Strengthen the capital requirements in the trading book• Trading assets, especially complex, less liquid

products, have increased significantly

54

Basel II and the Current Market Turmoil

Pillar 2 (risk management practices) The market turmoil has revealed significant risk

management weaknesses in financial institutions Pillar 2 provides supervisors with tools to assess risk

management and internal capital management processes The Basel Committee will issue Pillar 2 guidance to help

strengthen risk management and supervisory processes– Management of firm-wide risks– Stress testing practices and capital planning processes– Management of off-balance sheet exposures– Supervisory assessment of valuation practices

55

Basel II and the Current Market Turmoil

Pillar 3 (disclosure practices) Weaknesses in bank transparency for complex products

contributed to the build-up of concentrations in illiquid structured credit products

Enhanced disclosures relating to (2009)…– Complex securitisation exposures– ABCP conduits– Sponsorship of off-balance sheet vehicles (eg SIVs)

Other The Basel Committee will assess the level and cyclicality

of capital requirements over time (2008)

Overview of Basel II- Why, What, How and When -

Jason George

Financial Stability Institute

Bank for International Settlements

Representative Office for Asia and the Pacific

Hong Kong SAR

jason.george@bis.org

(852) 2878 7109