BASEL ACCORD on BANKING SUPERVISIONPresented By :Sanjeev Kaushik – 53

Retail Banking & Wealth Management

Basel Overview

☺ First Basel Accord came in existence in June, 1988 due to concerns of the governors of central banks of G10 countries.

☺ The Basel Committee for Banking Supervision (BCBS) consists of senior supervisory representatives from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom and the United States.

☺ The two principal purposes of the Accord were to ensure an “adequate level of capital” in the international banking system and to create a “more level playing field” in competitive terms.

☺ The 1988 Accord focussed on the total amount of bank capital, which is vital in reducing the risk of bank insolvency and the potential cost of a bank’s failure for depositors.

☺It usually meets at the Bank for International Settlements (BIS) in Basel, where its permanent Secretariat is located.

The major changes include:

☺For the standardised approach to credit risk measurement, the risk buckets for corporate exposures have been more closely aligned to the underlying risk, and banks and corporate can now receive a more favourable risk weight than their sovereign.

☺For the IRB approach to credit risk measurement, two options (foundation and advanced) are provided so that the IRB approach is now capable of being used by many more banks.

☺For the measurement of other risks, Pillar 1 now focuses on operational risk.

☺Far more specific criteria have been provided for Pillars 2 and 3.

How does Basel II differ from Basel I ?

3 Pillars of Basel Accord

Credit Risk☺Standardised Approach☺Foundation Internal Rating Based Approach☺Advanced Internal Rating Based ApproachMarket Risk☺Standardised Approach☺Internal Models ApproachOperational Risk☺Basic Indicator Approach☺Standardised Approach☺Advanced Measurement Approach

Various Approaches

Credit RiskStandardized Approach

☺ Classify assets into risk categories and assign risk weights.

☺Convert off-balance sheet commitments and guarantees to a notional ‘on-balance sheet’ credit equivalent, and classify these in the appropriate risk categories.

☺ Multiply the rupee amount of assets in each risk category by the appropriate risk-weight.

☺ Multiply the risk weighted assets by the minimum capital percentages required.

Internal Ratings Based Approach

Banks can use their internal estimates of borrower creditworthiness to assess the credit risk in their portfolio.

The risk components include measurement of the following:

☺ Probability of Default(PD)

☺ Loss Given Default(LGD)

☺ Exposure at Default(EAD)

☺ Effective Maturity(EM)

Expected Loss(EL) = PD * LGD * EAD

The risk weight functions account for Unexpected Loss(UL).

Advanced Internal Ratings Based Approach

Under the IRB approach,

Banks generally provide their own estimates of PD and rely on supervisory estimates for other risk components.

Whereas in Advanced IRB Approach,

Banks provide more of their own estimates of PD, LGD and EAD, subject to meeting minimum standards.

Market (Interest Rate) Risk

☺Risk faced by Banks due to treasury operations i.e. positions held by banks in financial instruments and commodities with intent of Trading or Hedging.☺ Banks may trade in: - Capital Markets

- Money Markets- Forex Market- Commodity Market- Bullion Market

Hence Market risk is the risk of loss to the bank from fluctuations in interest rates, equity prices, currency rates, commodity prices etc.

2 Categories of Market Risk:General Market Risk-Includes risks common to all securities such as changes in the general level of interest rates, exchange rates, commodity prices or stock prices.

Specific Market Risk- Arise from inherent risk of a particular security, such as the credit risk of the institution, which issued the security

Valuation of Trading Book Instruments

2 Methods:

Marking to Market: Daily Valuations of Positions at close out prices such as, exchange prices, screen prices or quote prices.

Marking to Model: Used where Marking to Market is not possible. It is any valuation which is bench marked, extrapolated or otherwise

calculated from a market input.

Standardised Approach

Specific and general risk charges as prescribed in Basel accordEg.

Internal Models ApproachBanks build their own models to assign specific and general risk charge to arrive at

Value at Risk (VaR)

Operational RiskRisk of loss resulting from inadequate or failed internal process, people and systems or from external events.

The Basel committee definition includes legal risk, but excludes strategic and reputational risk.

3 Methods to calculate Operational Risk Capital Charges

☺ Basic Indicator Approach

Banks have to hold capital for operational risk equal to a fixed percentage (denoted by α ‘Alpha’ = 15 percent) of gross income whereGross Income = Net Interest Income + Net Non-Interest Income (comprising (i) fees and commissions receivable less fees

☺ Advanced Measurement Approach

Under this, the capital required will be equal to the risk measure generated by the bank’s internal operational risk measurement system using the quantitative and qualitative criteria for the AMA.

Use of the is subject to supervisory approvaland commissions payable, (ii) the net result on financial operations and (iii) other income.

☺ Standardised Approach

Banks’ activities are divided into various business lines:

The capital charge for each business line is calculated by multiplying gross income by a factor Beta assigned to that business line and the sum of individual business line is the capital required

The Second Pillar –Supervisory Review Process

☺Requires supervisors to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on a thorough evaluation of its risks.

☺Stresses the importance of bank management developing an internal capital assessment process and setting targets for capital that are commensurate with the bank’s particular risk profile and control environment.

☺Supervisors would be responsible for evaluating how well banks are assessing their capital adequacy needs relative to their risks.

☺This internal process would then be subject to supervisory review and intervention, where appropriate.

Four Key Principals of Supervisory Review

Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.

Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.

Principle 3: 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.

Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

Banks should have a formal disclosure policy approved by the board of directors. This policy should describe the bank’s objective and strategy for the public disclosure of information on its financial condition and performance.

Banks should implement a process for assessing the appropriateness of their disclosure, including the frequency of disclosure.

The Third Pillar – Market Discipline

The Areas to be disclosed by Banks are:

THANX FOR LISTENING…

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