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BASEL I and BASEL II: HISTORY OF

AN EVOLUTION
Hasan Ersel
HSE
May 23, 2011

SEARCHING WAYS TO REGULATE


BANKS: THE U.S. PRACTICE

Capital Adequacy Requirements (1900s)


Regulation Q of the Federal Reserve (1933-1986):
limited interest rate paid banks, restrained price
competition.
Prohibition of interstate branching (1956-1994) (Bank
Holding Company Act of 1956; Repealed by RiggleNeal Interstate Banking and Branching Efficiency Act
of 1994)
Glass-Steagal Act (1933-1999) forbade investment
banks from engaging in banking activities

HISTORY OF CAPITAL ADEQUACY


RULES IN THE U.S.
1900-late 1930s: Capital to Deposit Ratio (The Office of
Comptroller of the Currency [OCC] adopted the 10%
minimum)
Late 1930s: Capital to Total Assets (FDIC)
II WW: No capital ratios (Banks were buying US
Government bonds)
1945-late 1970s: Capital to Risk Assets Ratio (FED and
FDIC), Capital to Total Assets Ratio (FDIC)

BANK SAFETY AND SOUNDNESS

Capital adequacy requirements


i) provide a buffer against bank losses
ii) protects creditors in the event of bank fails
iii) creates disincentive for excessive risk taking

INTERNATIONAL REGULATION

1988 Basel Accord (Basel-I)


1993 Proposal: Standard Model
1996 Modification: Internal Model
New Basel Accord (Basel-II)

THE FIRST BASEL ACCORD


The first Basel Accord (Basel-I) was completed
in 1988

WHY BASEL-I WAS NEEDED?


The reason was to create a level playing field for
internationally active banks
Banks from different countries competing for the
same loans would have to set aside roughly the same
amount of capital on the loans

1988 BASEL ACCORD (BASEL-I)

1)The purpose was to prevent international banks from


building business volume without adequate capital
backing
2) The focus was on credit risk
3) Set minimum capital standards for banks
4) Became effective at the end of 1992

A NEW CONCEPT: RISK BASED CAPITAL


Basel-I was hailed for incorporating risk into the
calculation of capital requirements

COOKE RATIO
Named after Peter Cooke (Bank of England), the
chairman of the Basel committee)
Cooke Ratio=Capital/ Risk Weighted Assets8%
Definition of Capital
Capital= Core Capital
+ Supplementary Capital
- Deductions

BASEL-I CAPITAL REQIREMENTS


Capital was set at 8% and was adjusted by a
loans credit risk weight
Credit risk was divided into 5 categories: 0%,
10%, 20%, 50%, and 100%
Commercial loans, for example, were
assigned to the 100% risk weight category

CALCULATION OF REQUIRED CAPITAL


To calculate required capital, a bank would
multiply the assets in each risk category by the
categorys risk weight and then multiply the
result by 8%
Thus a $100 commercial loan would be
multiplied by 100% and then by 8%, resulting
in a capital requirement of $8

CORE & SUPPLEMENTARY CAPITAL


1)

Core Capital (Tier I Capital)


i) Paid Up Capital
ii) Disclosed Reserves (General and Legal Reserves)

2)

Supplementary Capital (Tier II Capital)


i) General Loan-loss Provisions
ii) Undisclosed Reserves (other provisions against
probable losses)
iii) Asset Revaluation Reserves
iv) Subordinated Term Debt (5+ years maturity)
v) Hybrid (debt/equity) instruments

DEDUCTIONS FROM THE CAPITAL


Investments in unconsolidated banking and
financial subsidiary companies and investments
in the capital of other banks & financial
institutions
Goodwill

DEFINITION OF CAPITAL IN BASEL-I


(1)
TIER 1
Paid-up share capital/common stock
Disclosed reserves (legal reserves, surplus and/or
retained profits)

DEFINITION OF CAPITAL IN BASEL-I


(2)

TIER 2
Undisclosed reserves (bank has made a profit but this
has not appeared in normal retained profits or in general
reserves of the bank.)
Asset revaluation reserves (when a company has an
asset revalued and an increase in value is brought to
account)
General Provisions (created when a company is aware
that a loss may have occurred but is not sure of the
exact nature of that loss) /General loan-loss reserves
Hybrid debt/equity instruments (such as preferred stock)
Subordinated debt

RISK WEIGHT CATEGORIES IN BASEL-I


(1)
0% Risk Weight:

Cash,
Claims on central governments and central
banks denominated in national currency and
funded in that currency
Other claims on OECD countries, central
governments and central banks
Claims collateralized by cash of OECD
government securities or guaranteed by OECD
Governments

RISK WEIGHT CATEGORIES IN BASEL-I


(2)
20% Risk Weight
Claims on multilateral development banks and claims
guaranteed or collateralized by securities issued by such
banks
Claims on, or guaranteed by, banks incorporated in the
OECD
Claims on, or guaranteed by, banks incorporated in
countries outside the OECD with residual maturity of up
to one year
Claims on non-domestic OECD public-sector entities,
excluding central government, and claims on guaranteed
securities issued by such entities
Cash items in the process of collection

RISK WEIGHT CATEGORIES IN BASEL-I


(3)
50 % Risk Weight
Loans fully securitized by mortgage on residential
property that is or will be occupied by the borrower or
that is rented.

RISK WEIGHT CATEGORIES IN BASEL-I


(4)

100% Risk Weight


Claims on the private sector
Claims on banks incorporated outside the OECD with
residual maturity of over one year
Claims on central governments outside the OECD
(unless denominated and funded in national currency)
Claims on commercial companies owned by the public
sector
Premises, plant and equipment, and other fixed assets
Real estate and other investments
Capital instruments issued by other banks (unless
deducted from capital)
All other assets

RISK WEIGHT CATEGORIES IN BASEL-I


(5)
At National Discretion (0,10,20 or 50%)
Claims on domestic public sector entities, excluding
central governments, and loans guaranteed by securities
issued by such entities

CRITIQUE OF BASEL-I
Basel-I accord was criticized
i) for taking a too simplistic approach to setting
credit risk weights
and
ii) for ignoring other types of risk

THE PROBLEM WITH THE RISK


WEIGHTS
Risk weights were based on what the parties to the
Accord negotiated rather than on the actual risk of each
asset
Risk weights did not flow from any particular
insolvency probability standard, and were for the most
part, arbitrary.

OPERATIONAL AND OTHER RISKS


The requirements did not explicitly account for
operating and other forms of risk that may also
be important
Except for trading account activities, the capital
standards did not account for hedging, diversification,
and differences in risk management techniques

1993 PROPOSAL: STANDARD MODEL


Total Risk= Credit Risk+ Market Risk
Market Risk= General Market Risk+ Specific
Risk
General Market Risk= Interest Rate Risk+
Currency Risk+ Equity Price Risk + Commodity
Price Risk
Specific Risk= Instruments Exposed to Interest
Rate Risk and Equity Price Risk

1996 MODIFICATION: INTERNAL MODEL


Internal Model Value at Risk Methodology
Tier III Capital (Only for Market Risk)
i) Long Term subordinated debt
ii) Option not to pay if minimum required capital
is <8%

BANKS OWN CAPITAL ALLOCATION


MODELS
Advances in technology and finance allowed
banks to develop their own capital allocation
(internal) models in the 1990s
This resulted in more accurate calculations of
bank capital than possible under Basel-I
These models allowed banks to align the
amount of risk they undertook on a loan with the
overall goals of the bank

INTERNAL MODELS AND BASEL I


Internal models allow banks to more finely
differentiate risks of individual loans than is
possible under Basel-I
Risk can be differentiated within loan categories and
between loan categories
Allows the application of a capital charge to each
loan, rather than each category of loan

VARIATION IN RISK QUALITY


Banks discovered a wide variation in credit quality within
risk-weight categories
Basel-I lumps all commercial loans into the 8% capital
category
Internal models calculations can lead to capital
allocations on commercial loans that vary from 1% to
30%, depending on the loans estimated risk

CAPITAL ARBITRAGE
If a loan is calculated to have an internal capital
charge that is low compared to the 8% standard,
the bank has a strong incentive to undertake
regulatory capital arbitrage
Securitization is the main means used especially
by U.S. banks to engage in regulatory capital
arbitrage

EXAMPLES OF CAPITAL ARBITRAGE


Assume a bank has a portfolio of commercial loans with the
following ratings and internally generated capital requirements
AA-A: 3%-4% capital needed
B+-B: 8% capital needed
B- and below: 12%-16% capital needed
Under Basel-I, the bank has to hold 8% risk-based capital
against all of these loans
To ensure the profitability of the better quality loans, the bank
engages in capital arbitrage--it securitizes the loans so that
they are reclassified into a lower regulatory risk category with a
lower capital charge
Lower quality loans with higher internal capital charges are
kept on the banks books because they require less risk-based
capital than the banks internal model indicates

NEW APPRACH TO RISK-BASED


CAPITAL
By the late 1990s, growth in the use of regulatory capital
arbitrage led the Basel Committee to begin work on a
new capital regime (Basel-II)
Effort focused on using banks internal rating models and
internal risk models
June 1999: Committee issued a proposal for a new
capital adequacy framework to replace the 1998 Accord

BASEL-II

BASEL-II
Basel-II consists of three pillars:
Minimum capital requirements for credit risk, market
risk and operational riskexpanding the 1988 Accord
(Pillar I)
Supervisory review of an institutions capital adequacy
and internal assessment process (Pillar II)
Effective use of market discipline as a lever to
strengthen disclosure and encourage safe and sound
banking practices (Pillar III)

IMPLEMENTATION OF THE BASEL II


ACCORD
Implementation of the Basel II Framework continues to
move forward around the globe. A significant number of
countries and banks already implemented the
standardized and foundation approaches as of the
beginning of 2007.
In many other jurisdictions, the necessary infrastructure
(legislation, regulation, supervisory guidance, etc) to
implement the Framework is either in place or in process,
which will allow a growing number of countries to proceed
with implementation of Basel IIs advanced approaches in
2008 and 2009.
This progress is taking place in both Basel Committee
member and non-member countries.

BASEL-II (1)
Minimum Capital Requirement (MCR)
Capital
MCR
8%
Credit Risk Market Risk Operational Risk

BASEL-II (2)
PILLAR I: Minimum Capital Requirement
1) Capital Measurement: New Methods
2) Market Risk: In Line with 1993 & 1996
3) Operational Risk: Working on new methods

BASEL-II (3)
Pillar I is trying to achieve
If the banks own internal calculations show that they
have extremely risky, loss-prone loans that generate
high internal capital charges, their formal risk-based
capital charges should also be high
Likewise, lower risk loans should carry lower riskbased capital charges

BASEL-II (4)
Credit Risk Measurement
1) Standard Method: Using external rating for
determining risk weights
2) Internal Ratings Method (IRB)
a) Basic IRB: Bank computes only the probability of
default
b) Advanced IRB: Bank computes all risk components
(except effective maturity)

BASEL-II (5)
Operational Risk Measurement
1) Basic Indicator Approach
2) Standard Approach
3) Internal Measurement Approach

BASEL-II (6)
Pillar I also adds a new capital component for
operational risk
Operational risk covers the risk of loss due to system
breakdowns, employee fraud or misconduct, errors in
models or natural or man-made catastrophes, among
others

BASEL-II (7)
PILLAR 2: Supervisory Review Process
1)

2)

Banks are advised to develop an internal capital


assessment process and set targets for capital to
commensurate with the banks risk profile
Supervisory authority is responsible for evaluating how
well banks are assessing their capital adequacy

BASEL-II (8)
PILLAR 3: Market Discipline
Aims to reinforce market discipline through enhanced
disclosure by banks. It is an indirect approach, that
assumes sufficient competition within the banking sector.

ASSESSING BASEL-II
To determine if the proposed rules are likely to
yield reasonable risk-based capital requirements
within and between countries for banks with
similar portfolios, four quantitative impact studies
(QIS) have been undertaken

RESULTS OF QUANTITATIVE IMPACT


STUDIES (QIS)
Results of the QIS studies have been troubling
Wide swings in risk-based capital
requirements
Some individual banks show unreasonably
large declines in required capital
As a result, parts of the Basel II Accord have
been revised

IMPLICATIONS OF BASEL-II (1)


The practices in Basel II represent several important
departures from the traditional calculation of bank capital
The very largest banks will operate under a system
that is different than that used by other banks
The implications of this for long-term competition
between these banks is uncertain, but merits further
attention

IMPLICATIONS OF BASEL-II (2)


Basel IIs proposals rely on banks own internal risk
estimates to set capital requirements
This represents a conceptual leap in determining
adequate regulatory capital
For regulators, evaluating the integrity of bank models is
a significant step beyond the traditional supervisory
process

IMPLICATIONS OF BASEL-II (3)

Despite Basel IIs quantitative basis, much will


still depend on the judgment
1) of banks in formulating their estimates
and
2) of supervisors in validating the
assumptions used by banks in their models

PRO-CYCLICALITY OF THE CAPITAL


ADEQUACY REQUIREMENT
In a downturn, when a banks capital base is likely
being eroded by loan losses, its existing (nondefaulted) borrowers will be downgraded by the
relevant credit-risk models, forcing the bank to hold
more capital against its current loan portfolio. To the
extent that it is difficult or costly for the bank to raise
fresh external capital in bad times, it will be forced to
cut back on its lending activity, thereby contributing
to a worsening of the initial downturn.
Kashyap & Stein (2004, p. 18)

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