OVERVIEW OF RISK
MANAGEMENT
AND
BASEL II ACCORD
SUMMARY
BASEL I – Merits and Weaknesses
BASEL II - Objectives
Risk Management and Basel II
BASEL II – Structure of the New Accord
PILLAR 1
PILLAR 2
PILLAR 3
BASEL II – Impact on banks business
BASEL II – Implications
BASEL II – Next Steps
BASEL II – Timetable
BASEL I - MERITS:
First BASEL Accord in 1988 introduced capital requirements for Credit
Risk, followed by Amendment in 1996 for Market Risk.
The merits of the Old Accord:
Substantial increases in capital ratios of internationally active
banks;
Relatively simple structure;
Worldwide adoption;
Greater discipline in managing capital;
A benchmark for assessment by market participants.
BASEL I - WEAKNESSES :
Uniform, ignoring individual risk profiles, based on size of the business;
Only considered credit risk;
No explicit recognition of operational or other risks;
Does not assess capital adequacy in relation to a bank’s true risk profile;
The OECD/non-OECD distinction does not properly address country
risk;
Does not provide proper incentives for credit risk mitigation techniques;
Enables regulatory arbitrage through securitization etc.
BASEL II - OBJECTIVES :
To maintain at least the current level of capital in the system;
To enhance competitive equality;
To emphasize the responsibility of directors and senior management;
To focus on internationally active banks;
To contain approaches to capital adequacy that are appropriately
sensitive to the degree of risk involved in a bank’s positions and activities.
RISK MANAGEMENT AND BASEL II (1) :
Risk Management Function
Traditional View Modern View
Risk management was perceived
as:
Return, risk and capital are
linked
A cost centre – placing constraints
on revenue generators
You must achieve an adequate
return for the risks you are
taking
A reporting centre – with no
operational responsibilities Risk management is evolving
from the measurement of Risk
to the integral management of
risk
Staffed with relatively lowly-skilled
people
RISK MANAGEMENT AND BASEL II (2)
Risk Management Function
Risk management has become a strategic competitive weapon
allowing institutions to:
measure their risk on a consistent global basis;
calculate the risk-return performance of different business
units;
allocate scarce resources to their optimal use;
With the new BASEL Accord, Risk Management will become
increasingly important within banks.
BASEL II – Structure of the New Accord :
The considerably increased scope of the regulations in the New BASEL
Capital Accord is represented in a framework of three complementary
pillars that will help make the banking system SAFER, SOUNDER, and
MORE EFFICIENT.
Pillar 1: Minimum Capital Requirement:
Credit Risk, Market Risk, Operational Risk.
Pillar 2: Increased Supervisory Review
Segregation of duties and increased dialogue between banks
and supervisors.
Pillar 3: Market Discipline (Disclosure)
Enhance quality of disclosures;
Improved information and transparency.
PILLAR 1 – MINIMUM CAPITAL :
Basel II establish minimum standards for management of capital on a
more risk sensitive basis.
BASEL I Ratio: BASEL II Ratio:
Regulatory Capital
-------------------------= >8
Weighted assets
Regulatory Capital
---------------------------------------------- = >8%
(Credit Risk+Market Risk+Operational Risk)
It results that all types of risks must be
quantified
Pillar 1: Minimum Capital Requirements
Total capital (Tier-1 + Tier-2)
Credit Risk + Market Risk + Operational Risk
= The bank’s capital ratio ≥ 10%
Credit Risk – Banking BookThe credit risk element of the denominator
is the risk-weighted assets. The risk-
weighted assets are calculated through
either the Standardised, or the Internal
Ratings Based (IRB) approaches.
Market Risk – Trading BookThe market risk element of the
denominator is the market risk
requirement relating to
trading books.
These rules were introduced in
the 1996 Market Risk
amendment to Basel I and are
unchanged under Basel II.
Operational Risk
The operational risk element of
the denominator is the
operational risk requirement
which can be calculated using
either the Basic Indicator, the
Standardised of Advanced
Measurement Approaches
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Tier 1 Capital
Paid-up share capital
Irredeemable Preference Shares
Share premium
General Reserves (Retained
profit)
SMEEIS Reserves
Statutory Reserves
Other reserves as CBN
Tier-2Supplementary capital
Revaluation reserve
Undisclosed reserves
Hybrid instruments
Subordinated term debt
Pillar 1 Pillar 2 Pillar 3
Minimum Capital Requirements
Supervisory ReviewProcess
Market Discipline
Establishes minimum standards for management of capital on a more risk-sensitive basis and specifically addresses:
• Credit risk• Market Risk• Operational risk
Increases the responsibilities and
levels of discretion for supervisory
reviews and controls covering:
• Processes for capital and risk
profile management
• Capital adequacy
• Level of capital charge
• Proactive monitoring of
capital levels and ensuring
remedial action
Expands the content and improves the transparency of financial disclosures to the market, with disclosure of:
• Description of risk management approaches
• Levels of capital• Analysis of risk
exposures and capital by businesses / segments
Basel II Capital Accord consists of three mutually enforcing pillars. All three pillars need to be applied by
banks.
18/09/2020
1. ICAAP
2. Supervisory Review
Process
11
Structure of Basel II Capital Accord
PILLAR I – CAPITAL REQUIREMENTS FOR CREDIT RISK (1) :
The old Accord:
did not permit internal models;
was extremely credit insensitive with fixed risk percentages applied
to certain, pre-defined risk categories: 0%, 20%, 50%, 100%;
no perception of Economic Capital.
The new Accord:
EC is the true capital required to off-set Unexpected Losses.
Losses on transactions are broken up into:
Expected (in a statistical sense) losses
Unexpected losses - Losses with a low degree of profitability
Economic Capital = Unexpected loss - Expected Loss.
PILLAR I – CAPITAL REQUIREMENTS FOR CREDIT RISK (2)
With the new Accord, Banks are allowed to choose one of the
following three measurement approaches:
A. The Standardized Approach:
Risk weightings given for certain classes of
instruments.
B. The Internal Ratings Based (IRB) Approach:
Risk weightings based on internal risk assessments;
Can differentiate more finely between classes of risk;
Takes additional risk factors into account.
C. Advanced IRB.
PILLAR I – CAPITAL REQUIREMENTS FOR MARKET RISK (1) :
The Old Accord:
1. Concentrated purely on Interest Rate Risk;
2. Based upon either maturity or duration bands;
3. Amended to include FX and Equity Risks.
Value-at-Risk (VaR) is the most popular internal model.
PILLAR 1 – CAPITAL REQUIREMENTS FOR OPERATIONAL RISK (1)
Required for the first time. Rolled opaquely into credit charge
under the old Accord.
Definition – Operational risk:
The risk of direct or indirect loss resulting from inadequate orfailed internal processes, people and systems or from externalevents.
This includes legal risk, but not strategic and reputational risk
as regulators recognise the difficulties of measuring indirect
losses.
PILLAR 1 – CAPITAL REQUIREMENTS FOR OPERATIONAL RISK (2):
BASEL II pointed out the following operational risks:
Business disruption and system failures;
External fraud;
Integration problems;
Lack of training and controls;
As well as the necessity of Business Continuity Plan and
Disaster Recovey Plan.
The New Basel Capital Accord requires a capital charge of 15% of
economic capital for the operational risk.(there are discussions to
reduce this percentage)
Banks are allowed to choose one of the following three
measurement approach:
The main challenge in the area of operational risk consist in
setting up an efficient IT infrastructure to monitor and measure
the operational risk.
PILLAR 1 – CAPITAL REQUIREMENTS FOR OPERATIONAL RISK (3)
Basic Indicator Approach
Standardised Approach
Advanced Measurement Approach
Key premise: Supervisors should be able to require (penalize)
banks to hold capital above the minimum.
Pillar 2 stresses:
Banks must develop their own internal models, based on
evolving best practice;
Supervisory must conduct regular review to ensure
adequate capital if review fails, supervisor should increase
capital charge.
Hence, responsibility for adequate capital rests with the bank’s
management.
Pillar 2 intended to encourage development and use of better
risk management practices.
BASLE II – PILLAR 2 - INCREASED SUPERVISORY REVIEW
Two types of disclosures:
Mandatory disclosures: group approach of BASEL II, amount
and quality of group capital, extensive information
regarding the measurement methods of risks, etc.
Supplementary disclosures, at request of regulator.
Concerns:
Disclosure overload – too much information;
Enforceability in some jurisdictions;
Timeliness;
Auditability and its link with IFRS 9 and IAS 39;
Cost;
Market response to disclosure of perceived bad news.
BASLE II – PILLAR 3 – MARKET DISCIPLINE (1)
Credit and Operational Risk Data becomes a valuable asset.
Need of sophisticated measurement tools (credit, market andoperational risk).
High investments in Risk Management methodologies, systemsand people
BASEL II – IMPACT ON BUSINESS (1)
Capital will be increasingly a scarce resource:
As capital providers demand fair returns;
Businesses will be charged on their contribution to total risk capital;
Assets will be allocated on that basis;
Hence risk measures will be on the same level as profit measures,especially as more complex risks are being captured.
Banks need to check BASEL II impact on:
Future Business, Strategy and Objectives;
Competitors;
Capital Charge.
Risk Management become an important senior management issue.
BASEL II – IMPACT ON BUSINESS (2)
The new capital requirements specified in the New Basel Capital
Accord have important implications for the bank.
BASEL II represents a major improvement compared to BASEL I but
the most difficult part is to implement it. Its implementation
requires a considerable human and financial effort i.e.
methodological changes, new software, new hardware capacities,
training, etc.
The new regulations requires changes in the general structure and
process organization within banks.
BASEL II - IMPLICATIONS
Banks are required to commence a parallel run of both
Basel I and II minimum capital adequacy computation
based on the requirements of these guidelines effective
from January, 2014.
The minimum capital adequacy computation under
Basel II rules commenced in June 2014.
Furthermore, Nigerian banks are required to comply
with the Basel II Pillar 3 disclosure requirements on a bi-
annual basis.
BASEL II - TIMETABLE
This the Basel II Pillar 3 disclosure requirements is to
provide an overview of the risk profile and risk
management practices of Nigerian banks.
It is also expected to contain detailed information on
the underlying drivers of (i) Risk weighted assets, (ii)
Banks capital structure, and (iii) the capital adequacy
ratio.
The objective of this disclosure is to encourage market
discipline and allow stakeholders to assess accurate
information on banks risk exposures and risk
assessment processes.
Banks are required to report in accordance with Pillar III
Disclosure requirements under the following regulatory
guidelines:
DISCLOSURE REPORT REQUIRED BY THE CBN (1/2)
I. The Central Bank of Nigeria’s (CBN) framework on
Regulatory Capital Measurement and Management for
the Nigerian Banking System for the implementation of
Basel II in Nigeria;
II. The Basel Committee on Banking Supervision’s
(BCBS) Revised Pillar 3 Disclosure Requirements;
III. The Central Bank of Nigeria’s (CBN) Revised
guidance on Pillar 3 Disclosure Requirement.
DISCLOSURE REPORT REQUIRED BY THE CBN (2/2)
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