STATE BANK OF PAKISTAN

Banking Service Corporation (Bank)

Faisalabad

Internship Report
Basel II & Its Implementation in Pakistan Banking
Sector
Submitted To;

Chief Manager
SBP (BSC) Bank Faisalabad

Coordinator Officer;
Mr. Muhammad Rehan Submitted by;

Administration Department Aamir Raza

MBA-08-012
M.B.A (Finance)
University of Sargodha, Sargodha
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 I would like to thank our coordinator “Mr. Muhammad Rehan” who was
always there to help and guide us when we needed help. His perceptive criticism kept
us working to make this project more full proof. We are thankful to him for his
encouraging and valuable support. Working under him was an extremely
knowledgeable and enriching experience for us. We are very thankful to him for all
the value addition and enhancement done to us.

No words can adequately express my overriding debt of gratitude to my parents

whose support helps me in all the way. Above all I shall thank my friends who
constantly encouraged and blessed me so as to enable me to do this work successfully.

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 First of all I would like to thank that great entity that helped us to get through
this report safely, the one who was always there when no one was!

SHUKER- ALL- HUMDULILLAH!

Would that I have words to pay tribute to our loving parents and teachers whose
invaluable prays salutary admire and embodying attitude kept our spirit alive to
strive for knowledge and integrity which enable us to reach milestone.

I would also like to express enormous gratitude to our respectable teacher “Mr.
Muhammad Rehan” for providing the direction for this project and for helping us
in refining our effort and ideas.

I also acknowledge the help and pleasant gathering of all our class fellows. I am
also thankful to all of those people who helped us in accomplishing our project.

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Abstract………….………………………………………….….06

1.0 Introduction of Basel Capital Accord………………….…07

History of Basel I Accord…………………………………………07

Goals of Basel I Accord… … … … … … … … … ….…………08

Capital structure under Capital Accord… … …..……………08

Merits & Weakness of Basel I Accord………………………… 10

2.0 Introduction of Basel II Accord......................................11

History of Basel II Accord……………….………………………11

Objectives of Basel II Accord……………………………………12

Rationale of Basel II Accord… …………………………………13

Comparison of Basel I & Basel II Accord……….……………13

Risk Based Capital Standard………..………………………… 14

Purpose behind the New Accord ……...………………14
Scope of Application…………….………………………15

New Basel Capital Accord… … … … …………………………15

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3.0 Building Blocks of Basel II Accord……………………...16

Pillar 1: Minimum Capital Requirement…………………… 17

Regulatory Capital& Capital Elements………..…………… 18

Types of Risks…………………………………………………… 19
Credit Risk……………………………………………..... 20
Operational Risk …………………………………………25
Market Risk ………………………………………………30

Pillar 2: Supervisory Review Process……………………… 31

Supervisory Review Principles……………………………… 32

Pillar3: Market Discipline……………………………………34

Benefits of Basel II Accord……………………………………37

Issues & Challenges faced by Basel II Accord…………….38

4.0 Implementation of Basel II Accord in Pakistan...........39

Basel II in Pakistan…………………………… … … ….… … 38

Basel II Implementation Division……………… … … … … 43

Basel II Implementation Plan Status… … … ……………..…44

Issues & Challenges Pakistan Face in Implementing …… 46

5.0 Conclusion………………………………………….……47
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Basel II Capital Accord a revised Capital Framework used enhances the performance of the Banks. I
have to check out the implementation Issues, Challenge faced by the Pakistan and how effectively it
is being implemented in the foreign countries. I have to check out the role of State Bank of Pakistan
in the implementation of Basel II Accord. I have to check out the flaws and impediments in its
implementation process. Check out the role of Basel II in the performance appraisal of the
Commercial Banks.
Basel Capital Accord the 1st market Supervisory Framework implemented in 1988 covering only the
Market and Credit Risk. But in 1994 the Basel Committee on Banking Supervision stated to think
some more components in Credit Risk. Thus a need for a new Accord arises and in 2000 1 st
document on New Capital Accord was published and in its full form it published in 2004 comprises
of three pillars and revised credit and a new operational risk concept introduced in this New Accord.
From its introduction many countries started adopting to remain in the competitive market. Pakistan
also started adopting and make a complete plan to adopt it term by term due to its heavy cost of
implementation till 2009 the date extended later.

State Bank of Pakistan played a vital role in the implementation of this New Accord and a separate
department named Banking Surveillance Department was in action for its implementation and a
division name Basel II Implementation division and receive a greater response from the Banking
sector. All most Banks adopted Basel II term by term and some at initial stages of adoptions.

Main hurdle in its implementation is the cost of implementation. Developed countries like China has
not adopted Basel II at any instant, America also not adopted fully due to large operational cost.
Adoption of Basel II is the need of time to remain in the Market and avoid back warding from
foreign banks. In Pakistan it is implemented according to the time frame given by State Bank of
Pakistan.

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 Basel Capital Accord
Basel capital accord introduced a system for implementing a credit risk framework for determining
the minimum amount of capital that a bank must hold as a cushion against risk.
Basel capital accord was adopted b y not only member countries, but virtually in all countries
operating international banks.

History of Basel I Accord

In the mid-1980s, when the capital ratios of the world‟s largest banks fell to dangerously low levels.
The result was the Basel Capital Accord, which was applied to international banks in G-10 countries.
The accord first concentrated on credit risk and required a minimum capital ratio of 8% of a bank‟s
risk-weighted assets. In the 1990s it gained recognition as the worldwide standard for capital
adequacy in banking and is now applied in over 100 countries around the world. Basel Committee
on Banking Supervision is a committee of banking supervision authority that was established by the
central bank governors of the G-10 countries in 1975.

Evolution of Capital Standard

 Originated in July 1988 under the auspices of Bank for International Settlement (BIS) in Basle,
Switzerland – popularly termed as Basle Committee.
 Basel I defines a common measure of solvency, called the Cooke ratio which covers only
credit risk – one size fits all policy
 Specifies 8% (9% in India) capital charge on all exposures.
 Exposures being defined by respective risk weights
 1988 accord is termed as Basel – I.

Goals of Basel I Accord 1988

 Promote international convergence of capital adequacy standards and measurements
 Minimum excessive risk taking behaviour by banks on the asset side
 Extend capital requirements to off balance sheet position
 Reduce the incentive for banks to use capital as a source of competitiveness

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Basic Structure

 Targeted at internationally active banks in G-10 countries

 Establish minimum capital requirement to cover credit risk (Only)
 Broad risk-weighting structure; 0%, 20%, 50%, 100%

Minimum Ratio = Capital > 8%

Risk weighting Assets

Capital Structure under Basel Accord

A Closer Look into Basel-I

 Tier 1 (Core capital)

 Supplementary Capital
 Tier 2
 Tier 3

Capital in Regulatory Context

 Tier 1 Capital (Core Capital) also called Equity
 Share capital equity and disclosed reserves
 Capital deposited with SBP by foreign banks
 Premium on shares
 Reserve for bonus shares
 General reserve
 Un appropriated profit
Deductions

 Intangible assets like goodwill

 Investment in the equity of subsidiary which are not consolidated
 Shortfall in provisions

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 Supplementary Capital
 Tier 2 Capital (Supplementary Capital)

 Revaluation reserve
 Undisclosed reserve
 Subordinated debt
 General provision for loan losses
 Hybrid capital instrument
 Perpetual securities, unrealized gains on investment securities, hybrid capital instruments
and long term subordinated debt

 Tier 3 Capital (Supplementary Capital)

 Short term subordinated debt

 Only to meet capital charge for market risk

Maximum Limit

 Total of Tier 2 capitals is limited to a maximum of 100% of the total Tier 1 capital.
 The subordinated debt will be limited to a maximum of 50% of equity (Tier 1)
 Basel I requires Tier 1 and Tier 2 capitals to be at least 8% of the total risk weighted assets.

Qualification for Basel I Accord

 To qualify for Tier-1 or supplementary capital, capital must be unsecured, free from terms,
restrictions etc

Calculation of Capital Charge

Sum of the directly calculated risk charge for each of the market risk subcategories

 Interest rate risk

 Equity price risk
 Foreign exchange risk
 Commodity price risk
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Merits of Basel I Accord

 Relatively simple structure

 Initiated substantial increase in capital ratios of international banks
 Strengthened the soundness and stability of the international banking system
 World wide adoption
 Enhanced the competitive equality among international banks
 Provide a benchmark for market assessment

Weakness of Basel Capital Accord

 It looks a one size fits for all approach
 Do not discuss capital adequacy in relation to a banks true risk profile
 Broad bushed risk weighting structure
 Created an incentive to take some highest quality assets off the balance sheet
 Cover only credit and market risk
 Does not distinguish among different credit exposures
 Both AAA and BBB assets attract the same capital charge
 Does not allow any capital charge for operational risk
 It was not adequate for modern risk situation

Basel II Capital Accord

Basel II is a framework, and the standards it contains have been endorsed by the Central Bank
Governors and Heads of Banking Supervision of the Group of Ten countries. It presents the outcome
of the Basel Committee on Banking Supervision‟s work over recent years to secure international
convergence on revisions to supervisory regulations governing the capital adequacy of
internationally active banks. Following the publication of the Committee‟s first round of proposals
for revising the capital adequacy framework in June 1999, an extensive consultative process was set
in train in all member countries and the proposals were also circulated to supervisory authorities
worldwide. The Committee subsequently released additional proposals for consultation in January
2001 and April 2003 and furthermore conducted three quantitative impact studies related to its

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 proposals. As a result of these efforts, many valuable improvements have been made to the original
proposals. The present paper is now a statement of the Committee agreed by all its members. It sets
out the details of the agreed Framework for measuring capital adequacy and the minimum standard
to be achieved which the national supervisory authorities represented on the Committee will propose
for adoption in their respective countries.

History of Basel II Capital Accord

Basel II is a round of deliberations by central bankers from around the world, under auspices of
Basel Communities on Banking supervision (BCBS) in Basel (Switzerland) aimed at producing
uniformity in the way banks and banking regulations approach risk management across boarders.

The Basel Committee on Banking Supervision formulated and issued a revised capital framework
referred to as Basel II in June 2004 which became available for implementation among its 13
member countries to G-10 countries from end-2006 and from end 2007 for the most advanced
approaches.

Basel II a new capital accord which aims to align banks with their basic risk profiles.

 It is very elaborate and far superior in terms of its coverage and detail
 Exploit effectively a new frontier of risk management
 It seeks to give impetus to the development of a sound risk management system which hopefully
will promote a more efficient, equitable and prudent allocation of resources

When the banking company recognizes that Basel I fail to properly align capital with actual risk
profiles of the bank. This has laid the foundation of very long drawn process of Basel II, which
recognizes the perceived shortcomings of Basel I and progressively address its inherent weakness,
while gearing the risk management framework for the emerging financial engineering and
innovation.

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Objectives of Basel II
The relevance and significance of Basel II steps from its ability to recognize effectively the different
types of risk facing industry and the new product as well as off balance sheet transactions. Some
salient characteristics of Basel II are note worthy;

 To promote safety and soundness in the financial system

 Aligns capital of banks with their basic risk profiles
 It is elaborate and far superior in terms of its coverage and detail
 To render capital adequacy more risk-sensitive
 To provide incentives for banks to enhance their risk measurement capabilities
 Introduce a capital charge for operational risk
 Treatment of equity risk in the banking book
 To allow banks to use in-house methods
 To continue to enhance completive equality
 To constitute a more comprehensive approach to addressing risks
 Reform credit risk weightings making them more risk sensitive in line with bank practices
 To cover all essential banking risks with theoretically grounded, flexible and operable
requirements which create incentives for advanced implementation

Rationale for Basel II

The original accord was based on "actual" banking risk (i.e. credit risk). The Basel Committee began
revising the original accord in 1999 named New Basel Capital accord (Basel II) with the following
objectives:
 Enhance the risk sensitivity of capital requirement
 Accord 1988: Four brad risk weighting categories
 Align regulatory capital requirements closer to the actual risk profile of banks
 Accord 1988: Credit risk assessed by supervisors only
 Comprehensive coverage of risks
 Accord 1988: Credit risk plus 1996 market risks
 More powers to supervisors and the market
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  Accord 1988: Only minimum capital requirement
 Relatively Complex Rules
 Accord 1988: Comparatively Simple
 Present a menu of options to chose from
 Accord 1988: One size fits all approach

Comparison of Basel I and Basel II

BASEL I BASEL II
 Focus on Single Risk Measure  More emphasis on Bank’s internal
methodologies, supervisory review &
 One Size fits all market discipline
 Flexibility, menu of approaches. Provides
 Operational Risk not considered incentives for better risk management
 Introduces approaches for Credit risk &
 Broad Brush Structure Operational risk in addition to Market risk
introduced earlier
 More Risk Sensitivity

Salient Features and Overview

The objectives of accord are;

 To maintain safety and soundness in the financial system and therefore to maintain at least the
current level of capital in the system
 To enhance competitive equality
 To introduce a more risk sensitive framework that closely aligns internal economic capital with
regulatory capital
 To focus on internationally active banks

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Risk Based Capital Standard
 Why do banks need to hold capital in order to do business?

 Provides a cushion against unexpected loss that may arise due to credit/market/operational risk.
 Capital that needs to be maintained as a proportion of risk based assets is termed as risk based
capital – otherwise termed as capital adequacy ratio (CAR).
 E.g. bank does not maintain any capital towards credit risk component of Go I bonds as it is non-
existent.

Purpose behind the New Accord

The fundamental objective of the committee`s work has been to develop a framework that would
further strengthen the soundness and stability of the international banking system while remaining
sufficient consistency that capital adequacy regulation will not be a significant source of competitive
inequality among international active banks.
Capital requirement should increase for banks that hold risky assets and decrease significantly for
banks that hold safer portfolios.

Scope of Application
 Basel II has become an international competition for consultants, How to help banks allocate less
capital
 Basel II creates incentives for banks to more risky assets to unregulated parts of the holding
companies

The new capital accord will be applied on a consolidated basis to;

 Holding companies of banking groups on a consolidated basis

 All internationally active banks at every level in the banking group
 Individual banks must also be adequately; capitalized on a stand alone basis

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The New Basel Capital Accord

Total Capital Capital Adequacy Ratio (Min 8%) CAR

Credit Risk + Market Risk + Operational Risk

Revised Unchanged New

The new Accord focuses on revising only the denominator (Risk-weighted assets), the definition and
requirements for capital are unchanged from the original Accord. General requirement for banks to
hold total capital equivalent to at least 8% of their Risk weighted assets.
Ranges of options are available for determining capital requirement for;

 Credit risk
 Operational risk
 Market risk
 Framework also allows “Limited degree of National Discretion”

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3.0 Building Blocks of Basel II Accord

BUILDING BLOCKS OF BASEL II

Pillar 1 Pillar 2 Pillar 3

Minimum Supervisory Market
Capital Review Discipline
Requirement Process

Establishes Increase the Establishes

minimum responsibility and minimum
standards for levels of standards for
management of discretion for management of
capital on a more supervisory capital on a more
risk sensitive reviews and risk sensitive
basis and control covering; basis and
specifically specifically
addresses; addresses;
 Process of
 Credit Risk capital and Risk  Description of
 Operational profile risk
Risk management management
 Market Risk  Capital approaches
Adequacy  Levels of
 Level of capital capital
charge  Analysis of risk
 Proactive
monitoring of
capital levels
Ensuring
Remedial
action

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The three pillars together are intended to achieve a level of capital commensurate with a bank‟s
overall risk profile
• Correlation between required capital and effectiveness of bank‟s risk management
• Increased capital is not the only way to effectively addressing an increase in risks
• Strengthen risk management
• Apply internal limits
• Improve internal controls

Pillar1: Minimum Capital Requirement (MCR)

It provides approaches to the calculation of capital changes in the areas of credit, operational and
market risk. Increasingly complex methods of calculation are allowed and Basel committee expects
bank to move to the advanced approaches as the internal risk management techniques developed.

 Wide range of credit risk mitigants has also been developed for the 1st time
 Capital changes in relation to operational risk considered for the 1st time Due to;
 Number of areas
 New complex financial products & strategies
 Specialized processing operations
 Reliance on rapidly evolving technology
 Outsources and recent bank failures

For assessing the bank‟s specific risk situation and appropriate capital resources exist
Part 2 of Basel II (the New Capital Framework) describes the calculation of the total minimum
capital requirements for credit, market and operational risk.
The capital adequacy ratio (CAR) is defined by the following formula:

CAR > 8% = Qualifying Regulatory Capital / Risk Weighted Assets Basel II requires CAR
(CAR will be calculated using the definition of regulatory Capital and Risk-weighted asset)

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Regulatory Capital
The Basel I definition of eligible regulatory capital remains in place. The capital which is necessary
for the covering of probability of default of given risk is called regulatory capital.

Capital in Regulatory Context

Core Capital: Tier 1

 Paid-up share capital/common stock

 Disclosed reserves
 Premium on shares
 General reserve
 Capital deposited with SBP by foreign banks

Supplementary Capital: Tier 2

 Undisclosed reserves
 Asset revaluation reserves
 General provisions/general loan-loss reserves
 Hybrid (debt/equity) capital instruments
 Subordinated debt
 Revaluation reserve

Supplementary Capital: Tier 3 (Added in later Basel documents)

 Short-term subordinated Debt

 Currently the SARB applies a capital adequacy ratio of 10%

Tier 3 (Added in Later Basel Documents)

Tier 3 capital will be subject to the following conditions:

 It should have an original maturity of at least two years and will be limited to 250% of the bank's Tier
1 Capital that is allocated to support Market Risk.
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  It is only eligible to cover market risk, including foreign exchange risk and commodities risk.
 Insofar as the overall limits in the 1988 Accord are not breached, tier 2 elements may be substituted
for tier 3 up to the same limit of 250%.
 It is subject to a "lock-in" provision which stipulates that neither interest nor principal may be paid if
such payment means that the bank’s overall capital would then amount to less than its minimum
capital requirement.

The New Basel Capital Accord Risks Overview

 Credit Risk (Banking Book Risk)
Risk arising due to default or deterioration of the credit quality of the obligor/borrower

 Standardized approach
 Internal Rating Based (IRB) Approach
 Foundation vs. Advanced

 Operational Risk
Loss resulting due to errors instructing payments or setting transactions

 Basic indicator approach

 Standardized approach
 Advanced measurement approach

 Market risk (Trading Book)

Risk arising due to market movement of different benchmark rates

 Standardized
 Internal Model Based

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 1. Credit Risk

Credit risk refers to the risk that a counter party or borrower may default on contractual obligations
or agreements. Pillar 1 of Basel II sets out the quantitative and qualitative requirements and formulae
to calculate capital for credit risk. The overarching principle behind these requirements is that rating
and risk estimation systems and processes provide for a meaningful assessment of borrower and
transaction characteristics; a meaningful differentiation of risk; and reasonably accurate and
consistent quantitative estimates of risk. Furthermore, the systems and processes must be consistent
with internal use of these estimates. The Committee recognizes that differences in markets, rating
methodologies, banking products, and practices require banks and supervisors to customize their
operational procedures. It is not the Committee‟s intention to dictate the form or operational detail of
banks‟ risk management policies and practices. Each supervisor will develop detailed review
procedures to ensure those banks‟ systems and controls are adequate to serve as the basis for the
Interest Rating Based approach.

Credit Risk Component

Arises at two levels

 Transaction level
At the sanction level–Issues of appraisal, credit worthiness of the obligor etc
 Portfolio level
How to manage risk once the bank has built up its portfolio – does the individual obligor
default? – If so, what is the probability of default? In the event of default what is the
expected and unexpected loss? Any cushion required?

Approaches to Calculation

1. Standardized Approach
2. Foundation Internal Rating Based
3. Advanced IRB

1. The Standardized Approach

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 The Standardized Approach is similar to the current Basel I approach where exposures are assigned
to risk weight categories based on their characteristics. The Standardized Approach is supported by
external credit assessments. The main supervisory categories in the Standardized Approach are
claims on sovereigns, non-central Government public sector entities, multilateral development
banks, banks, corporate, retail loans, residential real estate and commercial real estate.
 Comprehensive

 Focuses on the cash value of the collateral taking into account price volatility
 In Comprehensive approach banks need to calculate their adjusted exposure (against a
counterparty) by taking into account of the effects of that collateral.
 Banks need to adjust the exposure amount and the price of the collateral by adjusting both
against the future fluctuation in the value of each.

 Simple Approach

 Developed for banks that only engage to a limited extent in collateralized transactions
 Maintains the substitution approach in the current accord
 Will generate higher capital requirements than the comprehensive approach

 Risk Weighted Assets

 Unlike Basel I each asset or portfolio of similar assets is assigned risk weight.
 Risk weights determined by category of borrower: sovereign (no distinction based
upon OECD membership), bank, and corporate
 Risk weights dependent upon external credit assessments

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The Causes of Credit Risk
1. The underlying causes of the credit risk include the performance health of
counterparties or borrowers
2. Unanticipated changes in economic fundamentals
3. Changes in regulatory measures
4. Changes in fiscal and monetary policies and in political conditions

Credit Risk Mitigation (CRM) Basel II

Basel II allows for more recognition of credit risk mitigation instruments, in line with the philosophy
of a more risk sensitive capital regime. The following is a brief overview of the different credit risk
mitigation techniques

 Eligible collateral: Very Little

 Cash in deposit at the lending bank
 OECD sovereign and PSE: Securities
 Some MDB securities
 Eligible guarantors: Very Few
 OECD sovereigns: PSEs, banks and securities firms
 Some Multilateral development banks
 Non-OECD sovereigns if local currency and Non-OECD banks for short-term guarantees
 Approaches
 Simple
 Comprehensive
 Own estimate of LGD

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 2. Internal Ratings Based Approach

The two main principles behind the Internal Ratings Based (IRB) Approaches (Foundation and Advanced) are
the usage of banks’ own information about the credit quality of their assets and the promotion of best
practices in risk measurement and risk management. This is in contrast to the current approach and the
Standardized Approach under Basel II, which is mainly dependent on supervisory inputs to determine the
capital requirement.

The IRB Approach is based on measures of Unexpected Loss and Expected Loss. The risk weight
functions produce capital requirements for the Unexpected Loss portion. Under the IRB Approach,
banks must categories banking book exposures into broad classes of assets with different underlying
risk characteristics, being corporate, sovereign, bank, retail and equity. These are discussed in
greater detail later in this document. For each of the asset classes covered under the IRB framework,
there are three key elements:

 Risk components estimate of risk parameters provided by banks some of which are supervisory
estimates. These are Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD)
and Maturity (M) that are discussed in more detail below
 Risk-weight functions the means by which risk components are transformed into risk-weighted
assets and therefore capital requirements
 Minimum requirements the minimum standards that must be met in order for a bank to use the IRB
approach for a given asset class

For many of the asset classes, the Basel Committee has made available two broad approaches: a
foundation and an advanced. Under the foundation approach, as a general rule, banks provide their
own estimates of PD and rely on supervisory estimates for other risk components. Under the
advanced approach, banks provide their own estimates of PD, LGD and EAD, and their own
calculation of Maturity, subject to meeting minimum standards. For both the foundation and
advanced approaches, banks must always use the risk-weight functions provided in this Framework
for the purpose of deriving capital requirements.

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Basic Principles of Interest Rating Based (IRB)

 Relies on banks internal assessment of its counterparties and exposures

 Based on three main elements
 Risk components (PD, LGD, EAD)
 Risk weight function (RWA=EAD* f (PD, LGD, EAD)
 Minimum Requirements
 Separate approaches for each portfolio
 Subject to supervisory validation and approval

Probability of default (PD)

One year of probability that a borrower will default on its debt obligations.

Loss given default (LGD)

The loss in the event of default, i.e. Expected average loss per unit of exposure. This will depend on the
collateral, both financial and physical. For the FIRB, prescribed LGD’s are given by Basel II. For the AIRB, the
bank will use its own estimates of loss.

Exposure at default (EAD)

For on balance sheet transactions, the exposure at default will be the amount of the exposure. For off
balance sheet items, credit conversion factors are used to obtain credit equivalent amounts. For the FIRB,
the EAD measures are provided, and for AIRB the bank will use its own estimates.

Maturity (M)
Maturity is based on contractual cash flows. All other things being equal, the longer the maturity of an
exposure, the higher the risk. Maturity is capped at 5 years.

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 2. Operational risk

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and
systems or from external events.
Peoples

The risk of loss resulting from:

 Inadequate or Failed Operational

Systems Internal
 Internal processes Risk Processes
 Peoples
 Systems
External
 From external events
Events

 Inadequate or failed internal processes

Financial institutions operate a myriad of processes to deliver their products to customers. Process
risk can arise at any stage of an end to end process in the value chain. For example, marketing
material can be mailed to the wrong customers, account opening documentation can turn out not to
be robust, transactions can be processed incorrectly, etc.

 People

Operational risk losses can occur due to worker compensation claims, violation of employee health
and safety rules, organized labour activities and discrimination claims. People risks can also include
inadequate training and management, human error, lack of segregation, reliance on key individuals,
lack of integrity, honesty, etc.

 Systems

The growing dependence of financial institutions on IT systems is a key source of operational risk.
Data corruption problems, whether accidental or deliberate, are regular sources of embarrassing and
costly operational mistakes.

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  External Events

This source of operational risk has at least two discernible dimensions to it, firstly the extent to
which a chosen business strategy pursued by a bank may expose it to adverse external events, and
secondly external events that impact it independently, emanating from the business environment in
which it operates.

Operational Risk Component

 Internal fraud
 External fraud
 Employment practices & workplace safety
 Clients, products & business practices
 Damage to physical assets
 Business disruption & system failures
 Execution and delivery

Basel 2 Operational risk

Risk of loss resulting from inadequate or failed internal processes, people and systems or from
external events. This includes legal risk, but not strategic, reputational or systemic risk.
Main objective of including Operational Risk in Basel II is to incentivize banks to improve
internal risk management by integrating control areas like audit & compliance into the capital
charge and therefore pricing. EG if a BU gets adverse audit rating then RWA goes up, capital
ratios down and ROE falls if more capital raised. Typically, the objective is a fully integrated
enterprise-wide risk management system.
Given the varying abilities of different banks to undertake this sort of thing, 3 options were
proposed: a simple „basic indicator‟ approach, a „standard‟ approach, and an Advanced
Measurement Approach (AMA) Most banks tried to opt for the basic indicator approach and
larger banks had to be forced to use AMA.

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 Operational Risk and the New Capital Accord

 Operational risk is now to be considered as a fully recognized risk category on the same footing as
credit and market risk.
 It is dealt with in every pillar of Accord, i.e., Minimum Capital Requirements, Supervisors Review and
Disclosure Requirements

The Approaches to Measurement

Depending on the level of sophistication of individual banks, the Basel Accord permits three
methods for calculating operational risk capital charges in a continuum of increasing sophistication
and risk sensitivity:

 The Basic Indicator Approach,

 The Standardized and Alternative Standardized Approach
 Advanced Measurement Approach (AMA)

1. The Basic Indicator Approach (BIA)

Essentially, this approach uses gross income as a proxy for operational risk, with the capital charge
equal to 15% of the average of gross income for the last three years. Basic Indicator Approach
(BIA) is very straightforward and does not require any change to the business.
No specific qualifying criteria are specified, but banks are encouraged to comply with the Basel
Committee‟s proposed practices as documented in the Sound Practices for the Management and
Supervision of Operational Risk, published in February 2003. These principles in fact form the
underlying foundation for all three the methodologies, as well as the qualifying criteria that
participating banks should adhere to when adopting a particular approach.

The Accord specifies the calculation of the charge as follows:

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 (denoted alpha) of positive annual gross income.

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Figures for any year in which annual gross income is negative or zero should be excluded from both
the numerator and denominator when calculating the average.
The Accord is specific about what constitutes gross income, defining it as net interest income plus
net non-interest income, with the intention that it should:

 Be gross of any provisions (e.g. for unpaid interest)

 Be gross of operating expenses, including fees paid to outsourcing service providers
 Exclude realized profits/losses from the sale of securities in the banking book; and exclude
extraordinary or irregular items as well as income derived from insurance

2. The Standardized Approach

In the Standardized Approach, gross income is again a proxy measure for operational risk, but in this
case it is broken out by eight standard business lines, each with a different beta factor to calculate
capital. The business lines, which are defined in detail in Annexure 6 of the Accord, are:

 Corporate finance
 Trading & sales
 Retail banking
 Commercial banking
 Payment & settlement
 Agency services
 Asset management
 Retail brokerage

The total capital charge under this approach is the sum of the product of the relevant business line
gross income and the beta factor, with the beta factor being a proxy for the assumed 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. It should be noted that in the Standardized Approach
gross income is measured for each business line, not the whole institution, for example, in corporate
finance, the indicator is the gross income generated in the corporate finance business line.
For retail and commercial banking there is also an Alternative Standardized Approach (ASA)
available, introduced to eliminate double counting of risks. Banks, at the national supervisor‟s
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 discretion, may be permitted to substitute an alternative measure in the case of retail and commercial
banking. In this case, the volume of outstanding loans will be multiplied by the beta factor and the
result multiplied by 3.5%.

3. Advanced Measurement Approaches (AMA)

AMA approach is a step-change for many banks not only in terms of how they calculate capital
charges, but also how they manage operational risk on a day-to-day basis.
More exacting quantitative and qualitative entry standards are required before a bank is permitted to
qualify as an advanced measurement approach bank. Under the AMA approach the regulatory
capital requirement will equal the risk measure generated by the bank‟s internal operational risk
measurement system, which should be based on:

 Internal loss data

 External loss data
 Scenario analysis, and
 Business environment and internal control factors

As a general principle, the Accord does not prescribe an exact capital required methodology under
the advanced measurement approach. Banks are encouraged to develop their own methods provided
the measure calculates capital that covers both expected loss and unexpected loss – it must however
be able to demonstrate that its approach captures potentially severe „tail‟ loss events. Whatever
approach is used, a bank must demonstrate that its operational risk measure meets a soundness
standard comparable to that of the internal ratings-based approach for credit risk, (i.e. comparable to
a one year holding period and a 99.9% confidence interval)
One of the methods being used is the loss distribution approach, which embodies some of the
following aspects:

 Banks will calculate two distributions: one for frequency and one for severity
 Frequency distributions are usually binomial, negative binomial or Poisson
 Event severity distributions are wider in choice: log normal, Pareto, Weibull or Inverse Gaussian

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  A compound distribution is calculated using Monte Carlo simulation (In Statistical terms, the
convolution of the frequency and severity distributions)
 Estimate the mean and the 99.9 percentile from the resulting distribution, the latter being equal to
the 1 year Value at Risk)

Market Risk Management

 Convergence of Economies
 Easy and faster flow of information
 Skill Enhancement
 Increasing Market activity

 Increased Volatility
 Need for measuring and managing Market Risks
 Regulatory focus
 Profiting from Risk

Market Risk Component

 Can arise due to movement of rates (e.g. Interest rate, Stock prices, exchange rate etc.) in different
markets.
 Bank may have exposure to different markets such as equity, foreign exchange, commodity etc.
 By far, interest rate risk is the most prominent component because
 Most of the banks’ assets are benchmarked to interest rates which are deregulated.
 Investment portfolio of banks consists of a substantial investment on treasury bonds (G-Secs) which
are interest rate sensitive.
 Reasonable exposure to international benchmark interest rate such as LIBOR (London Interbank
Offer Rate)

The 2nd Pillar Supervisory Review Process

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 Pillar 2 is based on four key principles
1 Banks‟ own assessment of capital adequacy
2 Supervisory review process
3 Capital above regulatory minima
4 Supervisory intervention

Under this pillar, banks are required to set aside adequate capital to cover all the business risks they
face including those outside credit, market and operational risks. Supervisors on the other hand are
required to assess the internal capital adequacy process that banking institutions have put in place.
The Supervisory Review Process is defined as the “Second Pillar” of Basel II and as such represents
an important key element of the Basel II document and the approach to ensure safer and sound
banking. The focus on supervision is, however, not new to the Basel Committee. This part of the
Report is the culmination of 20 documents on supervision published by the Basel Committee, the
first being Part B of the Amendment to the Capital Accord to incorporate market risks, published in
January 1996 and the twentieth being the Sound practices for the management and supervision of
operational risk, published in February 2003.
The aim of this part of the Basel II document is to discuss and describe the key principles of
supervisory review; risk management guidance; and supervisory transparency and accountability.
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”

Main Features of Assessing Capital

 Board and senior management oversight
 Policies and procedures designed to ensure that the bank identifies , measures and reports all
material risks
 A systematic process
 That relates capital to the level of risk of internal controls, reviews, and audit to ensure the
integrity of the overall management process.
 What factors should management consider?

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  Regulatory ratios and requirements
 Peer comparisons
 Concentrations of credit and other risks

 Strategic planning

 Helps bank anticipate and adapt to change

 Allows it to be proactive rather than reactive

Supervisory Review 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 results
of this process.”
Supervisory Review: 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”
 Supervisor may also choose to set higher minimum requirements for all banks
 Means to ensure that banks have adequate capital:
 Reliance on a bank’s internal capital assessment
 Establishment of trigger and target ratios
 Establishment of defined capital categories above minimum ratios
 Well capitalized banks
 Adequately capitalized banks
 Means to ensure banks are operating with adequate capital levels:
 Reliance on a bank’s internal capital assessment
 Establishment of trigger and target ratios (e.g. the UK model)
 Establishment of defined capital categories above minimum ratios

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  Supervisory Review 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.”
 Intervening actions:

 Determined by law, national policies, case-by-case analysis

 Moral suasion to encourage banks to improve capital position
 Capital ratios may represent triggers for supervisory action

 Potential supervisory actions

 Increased monitoring of the bank
 Requiring the bank to submit a capital restoration plan
 Placing restrictions on bank activities, acquisitions, investments
 Restricting the payment of dividends
 Requiring replacement of senior management

Interest Rate Risk in Banking Book

 Interest rate risk in trading book covered by Market Risk Amendment
 Potentially significant risk, which merits support from capital
 Heterogeneity of processes for monitoring and managing
 Dealt with under Pillar 2
 Suggested treatment for outlier banks
 Definition of outlier bank
 Economic value declines by more than 20% of total capital
 As a result of a 200 basis point interest rate shock
 Supervisors are encouraged to require banks to hold higher amount of capital

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What Risks Does Pillar 2 Encompass?
Quality of systems & controls, including:

 Management quality
 Policies procedures & controls
 Risk management
 IT
 Outsourcing
 Business continuity
 Corporate governance

The Importance of Supervisory Review

The focus here is, firstly, on the responsibility of bank management in developing an internal capital
assessment process and setting appropriate capital targets for the bank‟s risk profile and control
environment. Secondly, supervisors should evaluate how well the banks are assessing their capital
needs, relative to their risks, and to intervene where appropriate.
Pillar 2 also addresses the treatment of risks considered under Pillar 1, but not fully captured by the
Pillar 1 process (e.g. credit concentration risk); factors not taken into account in Pillar 1 (e.g.
interest rate risk in the banking book); and factors external to the bank (e.g. business cycle effects)

The 3rd Pillar Market Discipline

Under this pillar, banks are required to disclose to the public, their risk management frameworks i.e.
how they identify, measure and mitigate the risks they face. Market discipline can contribute to a
safe and sound banking environment, and supervisors require firms to operate in a safe and sound
manner. Under safety and soundness grounds, supervisors could require banks to disclose
information. Alternatively, supervisors have the authority to require banks to provide information in
regulatory reports.

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 The Purpose of Pillar 3
Market discipline is to complement the minimum capital requirements (Pillar 1) and the supervisory
review process (Pillar 2). The Basel 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, risk assessment processes, and
hence the capital adequacy of the institution. The banks‟ disclosures should be consistent with how
senior management and the board of directors assess and manage the risks of the bank. These
disclosures are also a qualifying criterion under Pillar 1 to obtain lower risk weightings and/or to
apply specific methodologies.
The Basel Committee recognizes the need for a Pillar 3 disclosure framework that does not conflict
with requirements under accounting standards, which are broader in scope. The Basel Committee
has made a considerable effort to see that the narrower focus of Pillar 3, which is aimed at disclosure
of bank capital adequacy, does not conflict with the broader accounting requirements. Pillar 3
disclosures will not be required to be audited by an external auditor, unless otherwise required by
accounting standards setters, securities regulators or other authorities.
For those disclosures that are not mandatory under accounting or other requirements, management
may choose to provide the Pillar 3 information through other means such as on a publicly accessible
internet website or in public regulatory reports filed with bank supervisors. However, institutions
are encouraged to provide all related information in one location. A bank should decide which
disclosures are relevant for it based on the materiality concept. Information would be regarded as
material if its omission or misstatement could change or influence the assessment or decision of a
user relying on that information for the purpose of making economic decisions.
General Disclosure Principle
“Banks should have a formal disclosure policy approved by the board of directors . In addition ,
banks should implement a process for assessing the appropriateness of their disclosures , including
validation and frequency of them.”
Disclosure Requirements
 Attached to the use of a particular methodology or instrument
 Pre-condition for the use of some methodologies

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  Internal ratings-based approach
 Asset securitization
 Recognition of external credit assessment institutions

Types of Disclosures
 Qualitative
 Quantitative

1. Qualitative Disclosures

 General information on methodology and key inputs

 Explanation of structure of internal rating system and relation between internal and external ratings
 Process for managing and recognizing credit risk mitigation

2. Quantitative Disclosures

 Information for risk assessment

 PD, LGD assumptions
 Ex post performance as an indication of quality and reliability
 Actual defaults ,losses

Structure of Capital

 Disclosure about the nature, components and features of capital

 Amount of Tier 1 capital
 Innovative Tier 1 instruments separately
 Amount of Tier 2 and 3
 Terms and conditions of the main features of capital instruments

Risk Exposure and Assessment

Disclosure requirements and recommendations for four key banking risks:
 Credit risk
 Standardized approach
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  IRB banks Credit risk mitigation techniques
 Operational risk
 Interest rate risk in the banking book
 Market risk
Capital Adequacy
A bank should:

 Publicly disclose its capital ratio and other relevant capital adequacy information on a
consolidated basis
 Disclose measures of risk exposures calculated in accordance with the methodology set out in
the New Basel Capital Accord

Winners under New Accord

 Prudent banks with good quality credit counterparties
 Banks with first class control systems
 Highly rated private sector borrowers
 Highly rated sovereigns outside the OECD
 Public and tax payer, through a sounder framework

Benefits of Basel II Accord

1. Enhance risk sensitivity of Capital Requirement

Banks have to hold less capital against assets that are inherent low risk & higher capital against those
contain high level of risk

2. Good RM as a competitive advantage

RM is a prerequisite for the implementation of Basel II. Since good RM will result in less capital
requirement. (A driving force for improvement of RM framework of banks)

3. Greater emphasis on banks own RM

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Better RM practices are instituted in banks, it would comfort to the supervisors.

4. Facilitate better financial system

Better RM will allow banks with more sophisticated products

5. Cover operational and other risks

It covers all types of risks as well as liquidity, IRB, in banking book concentration risks etc

6. Flexibility

Offer number of options for the calculation of MCR

7. More powers to supervisors

Maintaining adequate capital is not just the purpose of Basel II, rather it requires banks to establish
better system to quantify risk.

8. Greater public disclosure

Basel II requires greater public disclosure. Thus market discipline has a key role to play in
reinforcing appropriate behavior by market participants.

9. Compliance with the international regulatory benchmarks

Basel II creates a benchmark standard for all the creating a single transaction level.

Issues and challenges of Basel II

 Goods and reliable data & information
 Development of sound risk management system
 Asymmetry in supervision
 Imperfect market
 Pro-cyclicality
 Access to finance for disadvantage
 Operational cost

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  Cross border challenges & Problems of adverse selection
 Cost and volume of capital
 Relevance of Basel II assumptions in the Asian context

4.0 Implementation of Basel II in Pakistan

Implementation of Basel II gripped a lot of interest internationally and with in Pakistan. Different
efforts are underway within the country and across the globe to ensure an effective adoption of this
new international regulatory and supervisory architecture.
Pakistan intends to be fully compliant to his important institutional development. This represents an
important subject for our sustained economic growth and compliance to international best practices.
State Bank of Pakistan vide its Circular No.3 of 2005 dated March 31, 2005 has decided to adopt
Basel II in Pakistan. This timeframe for adoption under Basel II is as under.

 Pakistan adopted standardized approach for credit risk from January 1, 2008
 Basic indicator approach for operations risk from January 1, 2008

Banks/DFI`s will be required to adopt a parallel run of one and a half year for standardized
approach and two years for IRB approach starting from July 1, 2006 and January 1, 2008.
State Bank of Pakistan has also issued a roadmap for implementation of Basel II requiring all
Banks/DFI`s to ensure completion of the action s on their part within specified timeframe.

Pakistan and Basel II

Pakistan has a progressive and dynamic financial sector which has grown rapidly particularly in the
last few years. Financial sector is predominantly bank, both conventional and Islamic, based in
performing its basic function of financial intermediation; however it also includes a wide range of
financial institutions operating as non-bank financial companies, insurance companies, micro finance
banks, and the Central Directorate of National Savings. Three stock exchanges at Karachi, Lahore
and Islamabad are also part of Pakistan‟s financial system. Financial assets have grown to $180
billion and are equivalent to 125 percent of GDP (compared to 95 percent of GDP at end-1997)
reflecting strong growth in banking sector assets and stock market capitalization.

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Supervision Financial institutions in Pakistan are regulated and supervised by State Bank of Pakistan
(SBP) and the Securities and Exchange Commission of Pakistan (SECP). SBP is primarily
responsible for regulating and supervising the scheduled banks (both conventional & Islamic), Micro
Finance Banks, Development Financial Institutions (DFIs) and Exchange Companies. The rest of
Financial Institutions including investment banks, leasing companies, Modarabas, discount douses,
venture capitals, asset management companies, mutual funds, housing finance companies, insurance
companies, and stock exchanges are regulated and supervised by Securities and Exchange
commission of Pakistan.
The National Saving Schemes are managed by the Central Directorate of National Savings, a
department of the Ministry of Finance.

Financial Reforms
The structure of banking sector has substantially changed since early 1990s particularly by
privatization of state owned banks. In 1990, Pakistan‟s banking sector was dominated by five
commercial banks which were all state owned but with the amendments of Banking Companies
Ordinance financial sector reforms were launched with privatization of two state owned banks MCB
(1991) & ABL (1993). These reforms were subsequently delayed for several years and resumed in
yearly 2000 with privatization of third large bank UBL in 2002. Privatization of the second largest
bank HBL commenced in 2004 and with that the banking system assets held by the public sector
commercial banks decreased to less than 25 percent. The largest bank of
country NBP remains state owned while government divested approximately 25 percent of its
shareholding. The privatization of state owned banks was accompanied by liberalization in the
financial system and openness to domestic and foreign competition. The number of banks and
NBFIs grew rapidly from 1990 to 1995. The moratorium was imposed in 1995 on establishment of
new banks as worries on health and soundness of small banks increased.

Consolidation
Within the banking sector, the ownership structure which had gradually moved from public to
private. The share of private and foreign ownership has substantially increased due to lucrative
return on investment in the banking sector. The private sector now controls nearly 80 percent of the
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system assets, as opposed to the early 1990s when 90 percent of the system assets were controlled by
the government. At the same time process of consolidation has been more pronounced in this sector.
Banking sector stability and robustness is of critical importance to financial sector stability. In
essence, the process of consolidation was driven by the need to bring to surface economies of scale
and scope, and efficiencies driven by competition and innovation. The consolidation process was
focused on three primary factors i.e. i) proactive Merger & Acquisitions (both domestic and
foreigner), ii) moratorium on licensing of conventional banks, and iii) minimum capital requirements
for banks and DFIs which have been stringently implemented by the SBP. All three factors have
helped, however the impact of the consolidation process has been diluted somewhat by the liberal
licensing of Islamic banks and Microfinance institutions, which are being promoted as an active
policy of the SBP with its focus on financial inclusion.
The ongoing mergers and acquisitions have exerted a profound impact on the ownership structure of
the financial sector. The financial sector is now led by private sector. Foreign Direct Investment in
the banking sector is on the rise and contributing factor in this trend is the growing interest of foreign
banks in the Islamic banking industry. As a result of these developments, foreign stake in the
banking sector increased to an all time high. The liberalized environment of the past few years drove
Merger & Acquisition activity in the banking sector, resulting in 36 transactions from 2001 to 2007.

Basel-II in Pakistan
Keeping in view the global response towards Basel-II, SBP decided to adopt Basel-II in Pakistan and
issued proposed Roadmap for the implementation of Basel II in Pakistan in March 2005. While
preparing this Roadmap, SBP conducted a survey to assess the existing capacity of the banks and
their financial position to meet additional capital requirement. The plans of other countries for
adoption of Basel II were reviewed. Efforts were made to draw a realistic timeline so as to give
banks sufficient time to prepare themselves for meeting the requirement of Basel-II.
In addition to above survey, SBP also conducted a quantitative impact study (QIS) of Basel-II
(Standardized Approach) based on data as of 31-12-2003. The study was based on the assumption
that there would not be any major variation in the capital requirement of banks against their credit
risk as in absence of external ratings most of the loans will fall under the category of unrated claims
and attract 100% risk weight. The capital requirement under Basel II of individual banks was
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therefore calculated by adding capital charge for market risk and operational risk. The result of the
study revealed that there would not be any significant increase in required capital and most of the
banks will be able to meet capital requirement under Basel II rules.

1. Credit Risk & Internal Ratings

Historically, credit risk has been the major risk causing heavy losses to banks operating in Pakistan.
Credit risk arises from the potential that an obligor is either unwilling to perform on an obligation or
its ability to perform such obligation is impaired resulting in economic loss to the bank. Bank‟s
failure to assess and manage credit risk proactively may be detrimental to the financial health of a
bank and may lead to severe losses to the bank. SBP has also issued guidelines to establish two tier
internal credit risk rating system.

2. Operational Risk & Reporting of Frauds/ Forgeries/ Dacoities

Keeping in view the size, sophistication, nature and complexity of operations of each bank/DFI,
adoption of clear-cut strategies and introduction of strong internal controls and effective reporting
will remain critical factors in preventing this and other types of operational risk events and resultant
losses. In view of the importance of frauds prevention/mitigation strategy in overall operational risk
framework and to improve the mechanism for active supervisory response, SBP has formulated the
revised reporting requirement for banks/DFIs on frauds/forgeries/dacoities cases. Submission of
complete and timely information on revised formats enables the State Bank to remain apprised of
developments at banks/DFIs and monitor follow-up action taken by them for all medium and high
severity frauds/forgeries including the emergency reported cases.
The information so collected is used to develop a database of frauds, forgeries, and dacoities events,
which will be used for measuring operational risk and determining capital requirements there
against. All banks/DFIs submit a quarterly statement of frauds/forgeries/dacoities which includes all
actual as well as attempted fraud cases even if the bank may not have sustained any monetary loss.
Therefore, the cases where bank recovers the entire amount involved and does not suffer any loss are
also reported to SBP.

3. Financial Derivatives
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 In Pakistan, though derivatives have been a relatively new concept until recently, the derivative
volume has increased manifold amidst the changing market and regulatory environment. In response
to the evolving market dynamics and in order to develop an Over the Counter financial derivatives
market in the country, SBP issued Financial Derivatives Business Regulations in November 2004.
Prior to this, banks were allowed to undertake the business of financial derivatives after getting
specific approvals from SBP. Now banks/ DFIs obtain Authorized Derivatives Dealer or Non Market
Maker Institution status from SBP after meeting the eligibility criteria and they have been allowed to
undertake derivatives business. The grant of such status is based on the capacity of the applicant to
undertake derivatives transactions based on both onsite and offsite analysis. The regulations allow
three types of transactions viz. Interest Rate Swaps, Forward Rate Agreements and FX options.

Basel II Implementation Division

A key function of SBP is to ensure the soundness of the financial system. The prime indicator of
financial health of the banking system is the adequacy of capital. A major international
developments in measurement and assessing the capital adequacy of banks is the issuance of
International Convergence of Capital Measurement and Capital Standards by Basel Committee on
Banking Supervision initially in 1988 and the revised version in June 2004. The revised form is
generally known as Basel II. Following is a summary of some of the assignments in the division:

 Provide input/clarification on regulatory/policy issues relating to capital requirement for banks and
other financial institutions under Basel II
 Participating and arranging in capacity building of Banking Industry to adapt and implement Basel II
Accord.
 Ensure compliance with Basel Core Principles of Banking Supervision.
 Coordinate with banking industry for implementation of Basel-II and core principles and also give
impetus for adoption of new best international practices relating to capital standard and risk
management

Function of Basel II Accord Implementation Division

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The Basel II Accord Division oversees the Basel II Implementation in Pakistan. The main
deliverables for the division are guidelines/ clarifications to banks, recognition of External Credit
Assessment Institutions, coordination with SECP, monitoring progress towards Advanced
Approaches, validations of models to be used in Advanced Approaches, monitor Minimum Capital
Requirements both in terms of absolute amount and the Capital Adequacy Ratio, give clearance to
banks with respect to raising subordinated debt through TFCs; capacity building within SBP as well
as in banking industry. Currently the division comprises of five units.

Basel II Standardized Approach Unit (BAI-1)

This unit is accountable for ensuring compliance with and monitoring the implementation
of the Standardized Approaches of Basel II Accord. The unit is the pivot for Implementation of
Standardized Approach as well as for the issuance of any guidelines related to Basel II
Implementation. The duties focus on supervision of the Banks/DFIs to ensure compliance of the
Basel II Guidelines and addressing queries raised by them. Furthermore, the position also requires
carrying out certain matters that may support the implementation of Basel II.
Key Result Areas

• Monitoring implementation of Basel II Standardized Approaches.

• Dispose off queries related to Basel II Standardized Approaches.
• Obtaining status/ follow up of commitments by banks regarding Basel II Implementation.
• Maintain the FAQs on Basel II Implementation.

Basel II Implementation Plan Status

The roadmap for implementation of Basel-II was developed in consultation with banking industry
and laid the foundation of Basel-II implementation in Pakistan. In pursuance of the roadmap, banks
submitted their individual plans mentioning specific approach (Standardized or IRB) they intend to
adopt and their internal arrangements for implementation. Majority of the banks expressed the
intension to start with simpler approach and move to the advanced approach after improving their
systems. The timeframe for adoption of different approaches under Basel II in Pakistan is as under;

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 Standardized Approach for credit risk and Basic indicator / Standardized Approach for operational
risk from 1st January 2008.
 Banks interested in adopting Internal Ratings Based Approach may approach SBP for the purpose. Their
request will be considered on case-to-case basis.

For the smooth, realistic and undisrupted transition from Basel-I capital adequacy framework
towards more risk sensitive new capital adequacy framework – the Basel II, all banks/DFIs were
required to designate one senior officer from their institution who would supervise all activities
relating to Basel II within the bank and will serve as a focal point between SBP and that particular
bank. It is anticipated that in coming years commercial banks would continue to develop their
infrastructure, technology and human resource capacities to adopt and implement Basel-II in a
phased manner.

Guidelines on Basel II Implementation in Pakistan

Initially draft guidelines on Basel-II accord were prepared and circulated to the banks for
comments/views through an industry forum of Pakistan Banks Association. Finalized instructions
were rolled out on June 26, 2006 giving detail and definitions of capital, measurement of capital
adequacy, risk management framework, different approaches and reporting requirements. There
were not any major departures from BIS guidelines. SBP has also issued guidelines for Internal
Capital Adequacy Assessment Process (ICAAP) after consulting Pakistan Banks Association and
other stakeholders. Regarding Pillar III (Market Discipline), SBP has revised the format of annual
accounts to improve disclosure requirements.

Summary of Work Done & Progress

The Standardized Approach makes use of credit risk assessment by recognized External Credit
Assessment Institutions (ECAIs) on the basis of risk profile / credit ratings of counterparty. SBP has
developed eligibility criteria of ECAIs and recognized two domestic ECAIs namely JCR-VIS and
PACRA. Moreover, Fitch, Moody‟s and S&P are also recognized for banks‟ exposure outside
Pakistan. For future implementation of Advance Approaches of Basel-II, guidelines of Internal
Credit Risk Rating System have been issued. Initially banks are required to develop the policy of
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Obligor Ratings and to rate all the exposures by September 30, 2008. Going forward banks are
encouraged to establish their systems for carrying out Facility Ratings.
SBP is closely interacting with Banks/DFIs and series of meetings have held in the past and the
process is going on. A working group of SBP and Pakistan Banks Association has been formed to
deliberate upon any impediments faced by banks and issue recommendations for resolution. Further
SBP is coordinating closely with SECP which is apex regulator for External Credit Assessment
Institutions and corporate sector. A number of training sessions and seminars have been organized in
order to impart knowledge to the industry as well as to the SBP officials. Officials from foreign
supervisory authorities and foreign banks operating in Pakistan are invited to share their knowledge
and internal practices.

Issues and Challenges

 Lack of good quality reliable historical data / information

 Initial phase of development of Risk Management systems at banks / DFIs
 Implementation costs and Human Resources constraints
 Lack of rating culture and low penetration of External Credit Assessment Institutions
 Asymmetry in supervision
 Pro-cyclicality and Relevance of Basel-II assumptions in South Asian Countries.
 Access to finance for disadvantaged sector will be more restricted as a result financial
 Inclusion goals may not be achieved
 Permissible collateral is limited and banks cannot take benefit of traditional collaterals i.e.
residential mortgages for business purpose loans.

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 After all my work and research on Basel II in Pakistan and international sector I found that
the need to implement Basel II in the banking sector is much needed due to the relevance and
significance of Basel II steps from its ability to recognize effectively the different types of risk
facing industry and the new product as well as off balance sheet transactions.

The fallowing characteristics made the need to implement Basel II as its draft prepared;

 To promote safety and soundness in the financial system

 Aligning capital of banks with their basic risk profiles
 It is elaborate and far superior in terms of its coverage and detail
 To render capital adequacy more risk-sensitive
 To provide incentives for banks to enhance their risk measurement capabilities
 Introduce a capital charge for operational risk
 Treatment of equity risk in the banking book
 To allow banks to use in-house methods
 To continue to enhance completive equality
 To constitute a more comprehensive approach to addressing risks
 Reform credit risk weightings making them more risk sensitive in line with bank practices

These objectives create the need to implement Basel II in the Pakistani Banking sector and it
enhances the risk sensitivity of Banks due to which Probability of loses are avoided.

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http://www.bis.org/bcbs/index.htm

http://www.bis.org/publ/bcbs24.pdf?noframes=1,

http://www.banque-france.fr/gb/publications/telechar/rsf/2006/etud1_0506.pdf

http://www.bundesbank.de/download/bankenaufsicht/dkp/200814dkp_b_.pdf

http://finance.wharton.upenn.edu/~benninga/mma/MiER74.pdf,

http://www.bionicturtle.com/learn/article/basel_ii_market_risk/

http://www.bionicturtle.com/learn/article/basel_ii_backtesting_the_var_model_with_t
he_traffic_light

http://www.riskprofessional-digital.com/riskprofessional/200904/?pg=39

http://www.bis.org/publ/bcbs107.pdf?noframes=1

http://www.bis.org/bcbs/qis/qis5results.pdf,

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