Basel Accord II - Framework

Assigned by: Sir Tahir Saeed

Submitted By: Group 3 MBA 90 (5) SZABIST - Hyderabad

Rotaba Mahik, Jeventy Meena Kumari, Suneel Kumar, Mir Farzok Talpur & Danial Saleem

Project Report

Basel -II Framework

Contents

Executive Summary ............................................................................................................................2 Introduction of Basel - II.....................................................................................................................3 Why Basel Committee introduced Basel II ........................................................................................4 Objectives of Basel II..........................................................................................................................5 Basel II Capital Adequacy Framework ............................................................................................6 Pillar 1: Minimum Capital Requirements Addressing Risk .....................................................8 1. Credit Risk ..............................................................................................................................9 Methods of Credit Risk Management ...........................................................................................9 Standardized Approach .....................................................................................................9 Foundation IRB Approach ................................................................................................9 Advanced IRB Approach ...............................................................................................10

2. Operational Risk ...................................................................................................................10 Methods of Operational Risk Management ................................................................................10 Basic Indicator Approach ...............................................................................................10 Standardized Approach ...................................................................................................11 Advanced Measurement Approach ................................................................................12

3. Market Risk ...........................................................................................................................12 Methods of Market Risk Management .......................................................................................12 Standardized Approach ...................................................................................................12 Internal Models Approach ............................................................................................13 Pillar 2: Supervisory Review Process ................................................................................13 Pillar 3: Market Discipline (Disclosure) ............................................................................14 Achievements of Basel II ............................................................................................................15 Limitations of Basel II ................................................................................................................16 Implementation of Basel II in Pakistan .......................................................................................17 Conclusion ..................................................................................................................................19 Reference ....................................................................................................................................20

Lecturer: Sir Tahir Saeed

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Executive Summary
Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. Basel II is a highly complex set of guidelines and regulations related to measurement, management and monitoring of capital. Promotes more sophisticated capital framework intended to accommodate the banking industry's risk diversity. Basel ii is not intended simply to ensure compliance with a new set of capital rules. Rather, it is intended to enhance the quality of risk management supervision said Jaime Caruana Former Chairman of Basel Committee. Basel II Capital Adequacy framework for banks aims at building a solid foundation of practical capital regulation, supervision, market discipline, along with enhancing risk management and financial stability. Basel II consists of 3 'pillars' which enshrine the key principles of the new regime providing a flexible, risk-sensitive capital management framework. The Basel II capital framework comprises three mutually reinforcing pillars, i.e. (1) Minimum capital requirements, (2) Supervisory review and (3) Market discipline. Pillar 1 covers regulatory capital requirements for market, credit and operational risk. The capital requirement represents an attempt to capture the average probability that a loan to each category of borrower would default, and the proportion of the loan that would be lost if default occurred. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. According to the Basel committee, Market risk is the risk that the value of an investment will decrease due to moves in market factors. The 2nd Pillar of Basel II covers the following: Ensures that banks have adequate capital to support all the risks in their business and encourages banks to develop and use better risk management techniques. Pillar 3, Market Discipline reflects how bank management can be improved through transparency in public reporting. In a nutshell, implementation of Basel II benefits the banking sector in three areas; 1. Increase focus on risk management, i.e., credit, price and operational risk; 2. Banks would assess their capital adequacy in relation to their risk profile and Greater disclosure from banks to make discipline more efficient.

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Basel -II Framework

Basel II Introduction
Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. Basel II, initially published in June 2004, by the Basel Committee on Banking Supervision based in the Bank for International Settlements, Basel, Switzerland, is the international standard framework for assessing capital adequacy of banks. This new framework replaces Basel I as the international capital adequacy norm for banks It is a set of banking regulations put forth by the Basel Committee on Bank Supervision, which regulates finance and banking internationally. Advocates of Basel II believed that such an international standard could help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. It was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face. Unlike the first accord, Basel I, where focus was mainly on credit risk, the purpose of Basel II was to create standards and regulations on how much capital financial institutions must have put aside. Banks need to put aside capital to reduce the risks associated with its investing and lending practices. The primary changes in the Basel II framework, compared to the 1988 document, are in the approach to credit risk and in the inclusion of obvious capital requirements for operational risk. A range of risk-sensitive options for addressing both types of risk is elaborated upon. Basel II is a highly complex set of guidelines and regulations related to measurement, management and monitoring of capital. Promotes more sophisticated capital framework intended to accommodate the banking industry's risk diversity. Closely aligns regulatory capital requirements with the industrys risk measurement & management practices and more comprehensive view of banks risks through inclusion of operational risk. More flexible, risksensitive capital requirements, better and more integrated risk and capital management practices and more formalized risk management programs

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Basel -II Framework

Why Basel Committee Introduced Basel II

Basel I required lenders to calculate a minimum level of capital based on a single risk weight for each of a limited number of asset classes, e.g., mortgages, consumer lending, corporate loans, exposures to sovereigns. Basel II goes well beyond this, allowing some lenders to use their own risk measurement models to calculate required regulatory capital whilst seeking to ensure that lenders establish a culture with risk management at the heart of the organization up to the highest managerial level.

Basel ii is not intended simply to ensure compliance with a new set of capital rules. Rather, it is intended to enhance the quality of risk management supervision.

Jaime Caruana Governor of the Bancode Espaa Former Chairman of Basel Committee

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Objectives of Basel II
The objective of Basel II is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks that banks face. Furthermore, Basel II aims at: 1. Ensuring that capital allocation is more risk sensitive. 2. Address financial innovations 3. Comprehensive framework for credit risk, operational risk and market risk. 4. To promote safety and soundness in the financial system 5. Strengthen the ability of International Banking System. 6. To create standards and regulations on how much capital financial institutions must have put aside. Banks need to put aside capital to reduce the risks associated with its investing and lending practices 7. Encourages market transparency and disclosures

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Basel II Capital Adequacy Framework

Capital adequacy is the key measure of the soundness and stability of banks. Basel II, introduced in June 2004 by the Basel Committee on Banking Supervision based in the Bank for International Settlements, Basel, Switzerland, is the current international standard framework for assessing capital adequacy of banks. This new framework replaces Basel I as the international capital adequacy norm for banks.

Basel II Capital Adequacy framework for banks aims at building a solid foundation of prudent capital regulation, supervision, market discipline, along with enhancing risk management and financial stability.

Basel II consists of 3 'pillars' which enshrine the key principles of the new system providing a capital management framework. The Basel II capital framework comprises three mutually reinforcing pillars, i.e.

(1) Minimum Capital Requirements (addressing risk), (2) Supervisory Review and (3) Market Discipline.

The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.

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Basel -II Framework

A complex international standard for capital adequacy for commercial banks that adapts a more comprehensive view of risks

Basel II

Aims to overcome Basel Is Failure to account for relative riskiness of asset by assigning higher risk weights to riskier assets a more sensitive framework

Pillar 1 Minimum Capital Requirements

Pillar 2 Supervisory Process

Pillar 3 Market Discipline (Disclosure)

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Basel -II Framework

Pillar 1: Minimum Capital Requirements Addressing Risk

Pillar 1 covers regulatory capital requirements for market, credit and operational risk. To improve risk sensitivity, the Committee is proposing a range of options for addressing both credit and operational risk. The first pillar deals with the calculation of minimum capital requirements on account of three major components of risk that a bank faces: Credit Risk, Operational Risk, and Market Risk.

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Basel -II Framework

1. Credit risk
Pillar 1, of Basel II, Credit risk has been traditionally defined as default risk, i.e. the risk of loss from a borrower/counterpartys failure to repay the amount owed (principal or interest) to the bank on a timely manner based on a previously agreed payment schedule. The capital requirement represents an attempt to capture the average probability that a loan to each category of borrower would default, and the proportion of the loan that would be lost if default occurred. The credit risk component can be calculated in three different ways, namely standardized approach, Foundation IRB, and Advanced IRB.IRB stands for "Internal Rating-Based Approach".

Methods of Credit Risk Management

(i) Standardized Approach: The term standardized approach refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Risk-weights now more sensitive as they are based on external credit assessments - In terms of Credit rating (AAA, AA,, BBB and so forth), involves introduction of additional risk weight categories more refined treatment of credit risk mitigation.

(ii) Internal ratings-based approach: Under the Basel II guidelines, banks are allowed to use their own estimated risk parameters for the purpose of calculating regulatory capital. This is known as the Internal Ratings-Based (IRB) Approach to capital requirements for credit risk. Basel II improves credit risk sensitivity by requiring higher capital levels for borrowers who are likely to present higher levels of credit risk. The capital for credit risk is then calculated as 8% of the total Risk Weighted Assets under Basel II.

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(iii)

Advanced

IRB

Approach:

The

term Advanced

IRB is

an

abbreviation

of advanced internal ratings-based approach and it refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. It is an approach that requests that all risk components be calculated internally within a financial institution. The advanced internal rating-based (AIRB) approach helps an institution reduce its capital requirements and credit risk.

2. Operational risk

A widely used definition of operational risk is the one contained in the Basel II regulations. This definition states that: Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. (Not working as desired) An operational risk is defined as a risk incurred by an organizations internal activities. Operational risk is the broad discipline focusing on the risks arising from the people, systems and processes through which a company operates. It can also include other classes of risk, such as fraud, legal risks, physical or environmental risks.

Methods of Operational Risk Management Continuum of Approaches

(i) Basic Indicator Approach (based on annual revenue of the Financial Institution): The basic approach or basic indicator approach is a set of operational risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Based on the original Basel Accord, banks using the basic indicator approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive annual gross income. Figures for any year in which annual gross income is negative

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Basel -II Framework or zero, should be excluded from both the numerator and denominator when calculating the average. The fixed percentage alpha is typically 15 percent of annual gross income.

(ii) Standardized Approach (based on annual revenue of each of the broad business lines of the Financial Institution): Based on the original Basel Accord, under the Standardized Approach, banks activities are divided into eight business lines: corporate finance, trading & sales, retail

banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. Risk weights range from 12% to 18%. Beta serves as a proxy for the industry-wide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line.

Business Line

Beta Factor 18% 18% 12% 15%

Corporate finance Trading and sales Retail banking Commercial banking Payment and settlement Agency services Asset Management Retail Brokerage

18%

15% 12% 12%

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Basel -II Framework (iii) Advanced Measurement Approaches: The most advanced and complex option under Basel ii is the Advanced Measurement Approach (AMA). This approach allows the bank to be able to approximate unexpected losses One of the most visible impacts of implementing an advanced approach for operational risk management certainly sends out the positive effects on the reputation and perception by stakeholders. More advanced risk management certainly sends out a clear message of solid and sound risk management to shareholders, clients, rating agencies and the market.

3. Market Risk

According to the Basel committee, Market risk is the risk that the value of an investment will decrease due to moves in market factors. Market risk refers to the risk to an institution resulting from movements in market prices, in particular, changes in interest rates, foreign exchange rates, and equity and commodity prices.

It is a risk that the value of an investment will decline as a result of market conditions. This type of risk is primarily associated with stocks. Risk that a major natural disaster will cause a decline in the market as a whole is an example of market risk. Other sources of market risk include recessions, political turmoil, changes in interest rates and terrorist attacks.

Methods of Market Risk Management

(i)

Standardized Measurement Method:

For Interest Rate, Equity positions and their derivatives, the minimum capital requirement is expressed in terms of two separately calculated charges: Specific risk of each security: The capital charge for specific risk is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer. General market risk on offset positions: The capital requirements for general market risk are designed to capture the risk of loss arising from changes in market.

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Basel -II Framework (ii) Internal Models Approach (IMA):

A risk management system developed by the bank to analyze the overall risk position, to quantify risks and to determine the capital required to meet those risks. Getting IMA brings significant benefits to the bank. It gives bank a better understanding and control of risk improved risk sensitivity and measures

Results in Better risk management and Better risk discipline driven by more precise risk weighting Better reputation for sound governance Enhanced management information -supports more optimal management decisions Improved market perception - enhanced reputation for risk management Identify the right IT architecture Set clear end-goals and expected benefits Can take 2-4 years

Pillar 2: Supervisory Review Process

The second Pillar of Basel II covers the following:

Ensures that banks have adequate capital to support all the risks in their business. Encourages banks to develop and use better risk management techniques.

This Pillar covers the 4 key Principles of Supervisory Review:

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. 2. Supervisors should review and evaluate banks internal capital adequacy assessment. Supervisors should take appropriate action if they are not satisfied with the results of this process.

3. Supervisors should expect banks to operate above the minimum regulatory ratios and should have the ability to require banks to hold capital in excess of the minimum.
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Basel -II Framework 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.

Pillar 3: Market Discipline (Disclosure)

The third major element of the Committees approach to capital adequacy is market discipline. Market Discipline reflects how bank management can be improved through transparency in public reporting. It points out the disclosures that banks must report for the public to have better insight into their capital adequacy. By understanding the banks activities and its ability to manage its exposures, consumers will be in a position to reward banks that prudently manage their risks and punish those that do not.

Pillar 3 requires that banks have a formal disclosure policy approved by the board of directors. Banks should also have a process for assessing the appropriateness, validation and frequency of disclosures.

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Basel -II Framework

Achievements of Basel II
The specific areas in which it adds on to Basel accord are:

a) Basel II substantially enhances the capital measurement of credit risk exposure and also requires banks to have sufficient capital to cover operational risk.

b) Basel II reinforces the principles of internal control and other corporate governance practices by defining supervision requirements and assigning the specific responsibilities to the Board and senior management.

c) Basel II requires far greater disclosures from banks to make market disciplines more effective. One of the challenges for the Banks management will be to balance the greater transparency with the requirements of International Financial Reporting Standards (IFRS) for consistency in reporting of financial information.

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Basel -II Framework

Limitations of Basel II
1. Lack of sufficient public knowledge: Knowledge about banks portfolios and their future risk-weight, since this will also depend on whether banks will use the standardized or IRB approaches.

2. Lack of precise knowledge: As to how operational risk costs will be charged. The banks are expected to benefit sharpening up some aspects of their risk management practices preparation and for the introduction of the operational risk charge.

3. Lack of consistency: At least at this stage, as to how insurance activities will be accounted for. One treatment outlined in the Capital Accord is that banks deduct equity and other regulatory capital investments in insurance subsidiaries and significant minority investments in insurance entities. An alternative to this treatment is to apply a risk weight age to insurance investments.

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Basel -II Framework

Implementation of Basel II in Pakistan

The State Bank of Pakistan (SBP) has a vital role in the implementation of Basel II initially as a regulator in terms of dissemination of information and providing guidelines to all the banks and once it is adopted it will act as a monitor. The implementation of Basel II in the local banking system has been initiated by SBP and hence it becomes mandatory for all banks to follow it. SBPs approach to implementing Basel II has been very appropriate, as it has provided the local banks with sufficient time to understand and implement it. In order to effectively implement Basel II SBP has embedded the following business processes in its Supervision

1. Capacity Building Initiative: Workshops and Seminars for Banking industry and SBPs officers Consultative sessions with individual banks as well through Pakistan Banks'
Association (PBA)

2. Information collection on Basel II implementation status across the banking sector:

Through its Offsite Supervision it has administered questionnaires with aims to assess banks Equivalent path of the standardized approach helped assess bank readiness to implement the basic approach of Basel II Holding of meeting with banks and their Basel II implementation teams to assess status of implementation

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Basel -II Framework 3. Quarterly Submission of Capital Adequacy Ratio to better monitor bank solvency:

This has helped verify problem areas that need to be addressed. Problems such as the need for strengthening the ratings culture, data collection and storage to facilitate moving on to advance approaches

4. Assessment & licensing of External Credit Rating Agencies namely JCRVIS and PACRA:

To facilitate the implementation of Basel II JCR-VIS and PACRA This has contributed to bringing about a ratings culture in Pakistan As such these agencies provide services across the financial arena and help better calculate risk weighted assets

In a nutshell, implementation of Basel II benefits the banking sector in three areas.

1. Increase focus on risk management, i.e., credit, price and operational risk; 2. Banks would assess their capital adequacy in relation to their risk profile; 3. Greater disclosure from banks to make discipline more efficient.

Lecturer: Sir Tahir Saeed

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Basel -II Framework

Conclusion
Basel II is a continuation of Basel accord. Basel II is the second of the Basel Committee on Bank Supervision's recommendations, and unlike the first accord, Basel I, where focus was mainly on credit risk, the purpose of Basel II was to create standards and regulations on how much capital financial institutions must have put aside. Banks need to put aside capital to reduce the risks associated with its investing and lending practices Basel II also sets up clear and strong connections between calculation rules for capital, adequacy standards, market supervision and market discipline.

The rules are more risk sensitive than those outlined in Basel I, however not sufficiently adequate in order to strengthen the banking system enough to be able to respond to the challenges of the financial crisis.

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Basel -II Framework

References:

Moodys Analytics. 2011. Basel II Pillar 1: an introduction. [ONLINE] Available at:http://www.moodysanalytics.com/~/media/Insight/Regulatory/Basel-II/ThoughtLeadership/2011/11-11-03-Basel-II-Regulations-an-introduction.ashx. [Accessed 15 November 13]

Wikipedia: 2013. Basel II. [ONLINE] Available at: http://en.wikipedia.org/wiki/Basel_II. [Accessed 18 November 13]

Investopedia: 2013. Basel II. [ONLINE] Available at: http://www.investopedia.com/terms/b/baselii/asp [Accessed 04 November 13]

Scribd: 2013. Basel II and Banks in Pakistan. [ONLINE] Available at: http://www.scribd.com/doc/24345041/Basel-II-and-Banks-in-Pakistan. [Accessed 07 November 13]

Global Association of Risk Professionals: 2013. Basel II Implementation in Pakistan. [ONLINE] Available at: http://www.garp.org/media/417060/basel%20ii%20implementation%20in%20pakistan_karac hi040808.pdf. [Accessed 04 November 13]

Bank for International Settlements: 2011. Basel II: A global regulatory framework for more resilient banks and banking systems. [ONLINE] Available at: http://www.bis.org/publ/bcbs189.pdf. [Accessed 03 November 13].

Hasan Ersel. 2011. BASEL I and BASEL II HISTORY OF AN EVOLUTION. [ONLINE] Available at:http://www.docstoc.com/docs/112586027/BASEL-I-and-BASEL-II-HISTORYOF-AN-EVOLUTION. [Accessed 03 November 13].

Lecturer: Sir Tahir Saeed

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