Basel II - A

.
Basel Capital Accord
State Bank of Pakistan

Background 1. Bank for International Settlements
Based in Basel and created in 1930, the BIS is the worlds oldest international financial institution Its mission is to foster cooperation among central banks and other agencies in pursuit of monetary and financial stability Fosters regulatory and supervisory convergence across jurisdictions and financial sectors
2. Basel Committee on Banking Supervision

Voluntary Association No formal supra-national authority Output series of Broad supervisory guidelines and Statements of best practices
Desired outcome: Convergence in Standard
3. Most Significant guidelines of BCBS is Capital Adequacy Standards commonly known as Basel I & Basel II

A Standard for the Measurement of Risks in Banks, and for the Allocation of Capital to cover those risks Published by the Basel Committee on Banking Supervision
Why Capital requirement for banks

Expected Loss
Unexpected loss
Probability
Extreme Loss
Amount
Background Basel-I
Basel I or Capital Accord 1988
o The First ever internationally accepted standard for minimum capital requirement for Banks o Though meant for G-10 countries, accepted and adopted by most of the economies. o Prescribe a simple framework for the calculation of minimum capital requirement for banks.
Capital (Asset X Risk Weight) X 8%

Broadly defined risk weights on the basis of asset class : 0, 20, 50, 100% For instance
0% Balance with Banks 20% Mortgage Finance 50% Loans to private firms 100%
Cash
The Basic Formula
Capital > 8% Risk weighted assets
Background Basel-I
Bank Risk Weights Risk Weighted Assets A 0% 20% 0 13 B 0 9 C 0 4
Assets
Cash Balance with other Banks Investments Government Securities Private sector debentures, Bonds, PTCs etc. Other Investments Advances Federal Government Private Sector Secured against mortgage of residential or commercial property Consumer Financing Other Assets Total Assets Capital Requirements 10% of RWA
A B C 10 5 35 65 45 20
110 200 70 30 30 80 10 0 40
0% 100% 100%
0 30 10
0 30 0
0 80 40
80 10 50 200 170 100 20 80 40 80 100 200 45 10 15
0% 100% 50% 100% 100%
0 200 10 80 45 388 39
0 170 40 100 10 359 36
0 100 20 200 15 459 46
650 650 650
Basel II - Overview
Weaknesses of Basel I
Did not assess capital adequacy in relation to a banks true risk profile Broad-brushed risk weighting structure does not differentiate high risk or low risk transactions within an asset class
Firm X Weak Financial position
Rating BB
Both assigned 100% risk Weight

Firm Y Strong Financial position Rated AAA
Created an incentive to take some highest quality assets off the balance sheet Covered only credit risk across bank and market risks only in trading book
(Interest rate risk in banking book, credit concentration risk, etc were ignored and operational risk assumed to be covered in credit risk capital charge)
Despite these weaknesses remained global standard for almost a decade
Basel II - Overview
1988: Basel I
Focus on Single Measure (Capital) One Size Fits All Broad Brush
2005: Basel II
Three Pillars Menu of Approaches Greater Risk Sensitivity
Basel II Scope of Application

Diversified Financial Group
Holding Company
Internationally Active Bank Internationally Active Bank Domestic Bank Securities Firm Internationally Active Bank
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Basel II Overall framework

Three Mutually Reinforcing Pillars
Pillar 1: Minimum Capital Requirement Pillar 2: Supervisory Review Process
Pillar 3: Market Discipline

Core Capital
Risk Weighted Assets
Definition of Capital
Supplementary Capital
Credit Risk
Standardized Approach
Operational Risk
Basic Indicator Approach Standardized Approach
Market Risk
Standardized Approach Internal Model Based Approach
Internal Rating Based
AMA
Basel II Pillar 1 Capital Charge for Credit Risk

Each exposure is assigned a risk
Standardised Approach
of External Rating agency weight pursuant to the risk assessment
Least sophisticated capital calculations; generally highest capital burdens

Risk weights are calculated using a standard formula. Input parameters
to the formula known as risk components are
Foundation IRB Approach
More risk sensitive capital requirements

by the banks themselves
probability of default (PD) loss given default (LGD), exposure at default (EAD) and maturity (M).
Same as FIRB Approach except the risk components are to be calculated

Advanced IRB Approach
Most risk-sensitive (although not always lowest) capital requirements Transition to Advanced IRB status only with robust internal risk
management systems and data
Basel II Major changes

8% Minimum CAR Unchanged Definition Unchanged
Capital Ratio =
Total Capital
Credit Risk + Market Risk + Operational Risk.
RWA Calculation Revised
No Change
New Risk Capital Charge
Major change is the calculation of risk weighted assets for credit risk Besides Basel II prescribes a framework for risk management and allocation of capital against other risks
Basel II Pillar 1 Minimum Capital Requirement

Definition of Capital (unchanged) Tier 1 : Core Capital
Equity Disclosed reserves Instruments eligible under October 1998 press release
Tier 2 : Supplementary Capital (limited to 100% Tier 1)

Undisclosed reserves Revaluation reserves General provisions/general loan loss reserves Hybrid instruments Subordinated debt ( lower tier 2)
Tier 3 : ( for market risk) short term subordinated debt
Claims on Sovereigns
Based upon ECAIs long-term domestic rating for domestic and foreign currency obligations.
Credit Assessment
AAA to AA-
A+ to A-
BBB+ to BBB -
BB+ to B-
Below Un -rated B-
Risk weighting
0% 20% 50% 100% 150%
100%
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At national discretion, supervisors may allow the use of ratings from Export Credit Agencies Available for a far greater number of sovereigns.
ECA Risk Score
4 to 6
Risk Weighting
0%
20% 50% 100% 150%
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National Discretion : Preferential treatment (e.g. 0% risk weight ) can apply to
Exposures in domestic currencies to a banks own sovereign (and central bank ) under the condition that exposures are also funded in national currency Preconditions for the own sovereign
i. Claim on the own sovereign ii. Exposure denominated in domestic currency iii. Exposure funded in domestic currency
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Preferential Treatment: Example

Bank in Pakistan, exposure to Government of Pakistan, denominated and funded in Pak Rupees
Pak. Rs.
Gov. 100 Other 600 US$ 200 Cap. 100 Liab. 200 US$ 600
Pak. Rs.
Gov. $ 100 Other 600 US$ 200 Cap. 100 Liab. 200 US$ 600
Pak.Rs.
Gov. $ 100 Other 600 US$ 200 Cap. 100 US$ 800
Preferential treatment for government claim Yes
Preferential treatment for government claim No
Preferential treatment for government claim No

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Preferential Treatment: Example

Other supervisors may also permit their banks to apply the same risk weighting (i.e. if Pakistan applies 0%, Hong Kong can follow) Bank in Hong Kong
Assets
Gov. of Pakistan Other assets 500 Pak.Rs. 1,200 HK$ Capital Liabilities Liabilities
Liabilities
300 HK $ 500 Pak.Rs. 900 HK $
Claims on central banks , BIS, ECB, IMF will receive the lowest risk weight applicable to sovereigns
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Claims on Banks
Two options supervisors must apply one option to all banks in their jurisdiction No unrated claim may receive a risk weight less than that of its sovereign.
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Claims on Banks including securities firms: Option 1

Banks are assigned a RW one category less favorable than that of its country of incorporation. RW cap at 100% except in countries rated below B-, in which case the RW is 150%.
Credit AAA A + BBB+ BB+ Assessment of to to to to BSovereign AA- A- BBB-
Below Unrated B-
Sovereign RW
Bank Risk Weight
0%
20%
50%
100%
150%
150%
100%
100%
20% 50% 100% 100%
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Claims on Banks including securities firms:
:Option 2
Based upon the credit assessment of the bank itself. At national discretion a preferential treatment exists for claims of 3 months or less (original maturity), subject to a floor of 20%. Not available to banks rated below B-.
Credit Assessment of banks Risk Weight Risk Weight ST claim
AAA to AA20% 20%
A + to A50% 20%
BBB+ to BBB50% 20%
BB+ to B100% 50%
Below B-
Unrated
150% 150%
50% 20%
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Claims on MDBs
Risk weighted similar to banks under option 2 0 % risk weight is possible ( as determined by the Basel Committee) for MDBs o Majority of the external assessments are AAA; o Shareholder structure is significantly comprised of sovereigns with long term issuer credit assessment of AA or better; o Strong shareholder support (i.e. amount of capital , amount of callable capital); o Adequate level of capital and liquidity
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Claims on PSEs
Generally treated as a claim on a bank (if using option 2 , the ST preferential treatment is not available to PSEs) At national discretion may be treated as a claim on the sovereign in the jurisdiction where established Example : categorization of PSEs by revenue raising power
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Claims on Corporate
Based upon comments received from the industry, a 50% RW was added and expansion of 150% RW.
No unrated claim can receive a RW less than the sovereign RW.
Credit Assessment Risk Weight
AAA to AA20%
A+ BBB + Below Un-rated to A- to BB- BB50% 100% 150% 100%

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Claims on Corporate
Risk weight for unrated corporates (100%) is a floor. Low rated ( below BB- ) corporates that give up their rating in order that the bank can have a 100 % capital charge will affect the quality of the un rated borrower pool;thus a higher RW (higher than 100%) may be necessary.
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Claims on Corporate
At national discretion supervisory authorities may permit banks to risk weight all corporate claims at 100 % without regard to external ratings. Where this discretion is exercised by supervisor,it must ensure that banks apply a single consistent approach i.e to use ratings wherever available or not at all.
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Rules for Retail

New lower risk weight for retail portfolio,e.g
35% for residential mortgages Past due mortgage loans are weighted at 100% 75 % for other retail ( 100 %) Aggregate exposure to one counterpart cannot exceed 0.2% of the overall regulatory retail portfolio The banks total exposure to the firm must be less than Euro 1 million Past Due claims do not qualify for this preferential treatment
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Past Due Exposures

The unsecured portion of any loan (other than qualifying residential mortgages loan ) that is past due for more than 90 days, net of specific provisions , will be risk weighted as follows:
Where specific provisions are less than 20 % of outstanding loan amount : risk weight 150 % Where specific provisions are no less than 20 % of outstanding loan amount : risk weight 100 % Where specific provisions are no less than 50 % of outstanding loan amount : risk weight 100 % ,however may be reduced to 50 % with supervisory discretion.
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Other Claims
All other assets will continue at 100 % National Supervisor may decide to apply a 150% or higher risk weight to high risk assets (venture capital , private equity)
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Other Risk weight issues

Off balance-sheet items current framework will remain in place with a few exceptions
Credit conversion for ST commitments (upto one year) will be 20 %: over one year 50% . A 0 % RW can be applied if the commitment is unconditionally cancelable. 100% conversion factor applied to repo-style transactions. For short term self liquidating trade letters of credit , a 20% CCF will be applied to both issuing and confirming banks.
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External Credit Assessment Inst. (ECAI)

ECAI must be recognized by the supervisor. ECAIs may be recognized on a limited basis (i.e. type of claim or jurisdiction). Process for recognizing ECAIs must be disclosed. Eligibility critieria - Objectivity Independence - International access disclosure (transparency) - resources credibility
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Implementation considerations
Mapping Process: responsibility of the supervisor to map ratings to RW in an objective manner; process for mapping must be disclosed by supervisor; disclosure by banks of ECAI used by type of claim and % of RWA that are based on the assessment of each ECAI. Multiple assessments: 2 ratings use the one resulting in a higher RW; Multiple ratings use the two that correspond to the lowest RW and choose the higher RW of the two.
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Issuer versus issue assessment if there is no issue rating available for the banks particular investment:
if a high-quality (maps to a better than unrated RW) issue rating is available from another issue of the same issuer, it may be used provided that the banks claim ranks pari pasu or is more senior; otherwise the claim should be treated as unrated; If there is an issuer rating, it will typically apply to senior claims; consequently, only senior claims can use the issuer assessment; otherwise, the claim should be treated as unrated. Issue or issuer low quality assessment use this rating.
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Issuer versus issue assessment if there is no issue rating available for the banks particular investment:
if a high-quality (maps to a better than unrated RW) issue rating is available from another issue of the same issuer, it may be used provided that the banks claim ranks pari pasu or is more senior; otherwise the claim should be treated as unrated; If there is an issuer rating, it will typically apply to senior claims; consequently, only senior claims can use the issuer assessment; otherwise, the claim should be treated as unrated. Issue or issuer low quality assessment use this rating.
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External assessments from one entity in the corporate group cannot be used to RW other entities in the same group. Unsolicited ratings - Generally should not be used - At national discretion, they may be used - Supervisor should be aware of pressure by the ECAI applied to the corporate to obtain a rating - Benefits could widen ratings coverage
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Disclosure for supervsiors

Aim: transparent process for recognizing ECAIs
Supervisors should disclose process for recognizing ECAIs Supervisors may choose to disclose list of recognized ECAIs
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Disclosure for Banks

Banks must disclose
Credit assessment institution(s) they use Mapping process Percentage of risk weighted assets mapped into single grades
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Example
Grade
Rating
1
AA A 20
2
AA
3
A
6
BB-
7
B
BBB BB+
RW% % assets
20 10
50 20
100 25
100 15
100 150 10 5
15
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Rules for Equity Exposure

Equity Exposure
Basel I Type of Exposure Non-consol equity Risk Weight 100% Standardised bank risk weights Corporates Banks Securities firms 100%* 100% Company 100% DaimlerChrysler Siemens Fresenius Med. Care GE Sony
Basel II Simple Model* PD/LGD Model** Rating A3/BBB Aa3/AABa1/BB+ Aaa/AAA A1/A
290%
290% 290% 290% 290% 290% 290%
92%***
81%*** 264% 32%*** 82%*** 195%*** 120%***
For banking book exposures. National supervisors may exempt from IRB treatment for up to ten years particular equity exposures held at publication date of Basel II accord ( 267) CRD has preferential treatment vs. Basel II Accord; supervisors may increase to 150% for venture capital and private equity investments ( 80)
Vivendi Universal Bertlesmann
Baa3/BBBBaa1/BBB+
** Inputs: average rating agency PDs, LGD of 90%, supervisory value for EAD and M of 5. *** Under Basel II ( 353) a floor risk weight of 200% applies to listed equities
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Source:
Text
Basel II Pillar 1 Capital Charge for Credit Risk

Standardized Approach - Risk Weighting Scheme (Past Due)
Provision less than 20% of Outstanding amount Provision more than Provision no less 20% but less than than 50% of 50% of Outstanding Outstanding amount amount
All except retail

Retail
150%
100%
150%
50%
Collateralized Transaction A transaction where: the bank has a credit exposure or potential credit exposure
to a counter party; AND
the exposure is hedged in whole or in part by collateral

posted by a counter party or by a third party on behalf of the counter party.
As a general rule, no transaction should receive a RW higher than an unsecured claim.

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No capital relief if the following conditions are not met.
Legal certainty:
All documentation used in the collateralized transactions must be binding on all parties and legally enforceable in all relevant jurisdictions. Legal opinion on enforceability should be obtained and updated. Legal mechanism must ensure that the bank has clear rights over the collateral and may liquidate or take legal possessions of it in the event of default, insolvency, or bankruptcy of the counter party. Banks must take all steps necessary to fulfill local requirements for obtaining and maintaining an enforceable security interest.
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Basel II - Pillar 1 Capital Charge for Credit Risk

Standardized Approach - Risk Mitigation
Eligible Collaterals
1. Cash/ Cash Equivalent 2. Debt Securities (Rated) 3. Debt securities (Unrated) subject to following conditions:
Issued by a bank; and Listed on a recognized exchange; and Qualify as senior debt; and All other rated issues by the issuing bank are rated at least BBB- or A3/ P3; and The lending bank has no information to suggest that the issue justifies a rating below BBB- or A3/ P3; and
4. Equities included in a main index 5. Listed Undertakings in Collective Investments in Transferable Securities (UCITS)/Mutual funds Additionally in Comprehensive approach followings are also recognized Equity not included in a main index, but listed on a recognized exchange UCITS/ mutual funds which include such equities

1. Simple approach:
Same as in Basel I, However allows only liquid collaterals eligible. It follows a substitution mechanism whereby the value of eligible collateral is deducted from exposure amount and risk weight is to be calculated on residual amount developed for banks that only engage to a limited extent in collateralized transactions
Example loan: 100, collateral: 80 bonds, risk weight of borrower: 100% risk weight of bond: 50% (A rated) risk weighted assets of covered portion: 80 x 50% = 40 risk weighted assets of uncovered portion: 20 x 100% = 20 total risk weighted assets: 40 + 20= 60

Standardized Approach - Risk Mitigation 2. Comprehensive Approach: focuses on the cash value of the collateral taking into account price volatility
The exposure amount after risk mitigation is calculated as follows,
Using standard supervisory or own estimates haircuts E* = max {0, [E x (1 + He) C x (1 Hc Hfx)]} where: E* = the exposure value after risk mitigation E = current value of the exposure He = haircut appropriate to the exposure C = the current value of the collateral received Hc = haircut appropriate to the collateral Hfx = haircut for currency mismatch
Comprehensive Approach
Haircuts
Will depend on type of exposure/ collateral,rating, remaining maturity, and frequency of mark- to- market and re-margining 1. Standard supervisory haircuts Fixed by Basel Committee
2. Own- estimate haircuts

Based on banks internal estimates of market price and FX
volatilities Permission will be conditional on the satisfaction of minimum qualitative and quantitative standards.
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Type Minimum Holding Period Condition
Repo Style Transactions

Other Capital Market Transactions Secured Lending
5 days
10 days 20 days
NR + (TM-1) TM
Daily remargining
Daily remargining Daily Revaluation
H = HM
Hm = haircut for the min holding period Nr = no of days between remargining Tm = min holding period for the type of transaction 49
Maturity Mismatch
Collateral only recognized if original maturity more than a year and residual maturity of more than 3 months. Maturity mismatch not allowed in simple approach When there is a maturity mismatch following adjustment is required in collateral value:
Pa = P x (t-0.25)/(T-0.25)
Where Pa = value of collateral after maturity mismatch adjustment P = value of collateral t= min( T, residual maturity of collateral in years) T = min (5, residual maturity of exposures in years)
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Currency Mismatch
Where the credit protection is denominated in a currency different from that in which the exposure is denominated i.e. there is a currency mismatch the amount of the exposure deemed to be protected will be reduced by the application of a haircut HFX, i.e.
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2. Own- estimate haircuts (Continued)
Quantitative Criteria 99 th percentile one- tailed confidence interval is to be used The minimum holding period will depend on the type of transaction and the frequency of remargining or MTM Banks must take into account the illiquidity of lower- quality assets by adjusting holding period upwards and should identify where historical data may understate potential volatility. The choice of historical observation period for calculating haircuts shall be a minimum of one year. Banks should update their data sets at least once every 3 months and reassess them whenever market prices are subject to material changes.
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2. Own- estimate haircuts (Continued)
Qualitative Criteria The estimated volatility data (and holding period) must be used on the day- to- day risk management process of the bank. Banks should have robust processes in place for ensuring compliance with internal policies, controls and procedures concerning the operation of risk measurement system. The risk management system should be used in conjunction with internal exposure limits. An independent review of the risk management system should be carried out regularly at the banks own internal auditing process (ideally at least once a year).
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Core Capital
Credit Risk
Operational Risk
Market Risk
AMA
Internal Standardized Approach Rating Based Approach
(IRB)
Internal Rating Based Approach Basic Concept

Credit rating is a symbolic representation of the risk profile of an obligor or an exposure
Probability of Default (PD)
Moodys Aaa Aa A Baa Ba Caa Ca-c 0% .01% .02% .11% .6% 2.73% 10.50% DR S&P AAA AA A BBB BB B CCC 0% .01% .06% .23% 1% 4.57% 25.59% DR
Loss Given Default (LGD)
Exposure at Default (EAD)
EL = PD x LGD x EAD
Probability
Expected Loss (EL) Unexpected Loss at 99% (UL) Unexpected loss beyond 99%
Amount
Borrower default if the value of its assets falls below its obligation or a default threshold There relationship between distance to default and PD can be described by normal distribution function.
Value
Distribution of asset value at horizon
Asset Value Distance-to-Default = 3 Standard deviations
Asset Volatility (1 Std Dev)
Default Point
EDF Today
1 Yr
Time

Internal Rating Based Approach
The capital requirement is calculated on the basis of risk assessed by the bank itself The risk Assessment is based on internal risk rating of exposures which are used to calculate following inputs parameters called risk components
Borrower risk: Transaction risk:
Probability of default (PD) Loss given default (LGD)
Exposure:
Exposure at default (EAD)
The appropriate default threshold for average conditions is determined by applying the inverse normal distribution function to the average PD Further , the required appropriately conservative value of the systematic risk factor can be derived by applying the inverse of the normal distribution function to the predetermined supervisory confidence level. A correlation-weighted sum of the default threshold and the conservative value of the systematic factor yields a conditional (or downturn) default threshold. In a second step, the conditional default threshold is used as an input into the original Merton model and is put forward in order to derive a conditional PD.
Mechanics of the IRB approach

Calculation of Provisions
maximum of 1.25% of total Risk Weighted Assets.
Total Provisions = specific + general provision provision (equity)
Expected loss to be calculated for
1. 2. 3. 4. assets subject to IRB Approach Equity Exposure subject to PD LGD Approach Expected Loss = PD x LGD x EAD Equities subject to PD/LGD Approach Specialized lending using supervisory slotting criteria for IRB
5. HVCRE

Expected loss all provisions
If there is surplus, it can be part of tier 2 subject to a max of 0.6% of RWA

If there is a deficit it will deducted 50% from tier 1 and 50% from tier 2 EL for equity exposures to be deducted 50% from tier 1 and 50% from tier 2 Partial Adoption of IRB: provisions should be calculated on pro rata basis

Categorization of exposures
Corporate
Sovereign Bank
1. 2. 3. 4. 5.
Project Finance Object Finance Commodities Finance Income Producing Real Estate High Volatile Commercial Real Estate
Retail
Equity.
1. Residential Mortgage 2. Qualifying Retail Exposure 3. Other Retails
Mechanics of the IRB approach- Types
1. Foundation IRB
banks provide their own estimates of PD and rely on supervisory estimates for other risk components.
2. Advanced IRB
banks provide more of their own estimates of PD, LGD and EAD, and their own calculation of M, subject to meeting minimum standards.
For both the foundation and advanced approaches, banks must always use the risk-weight functions
Adoption of the IRB approach across asset classes

1. Once a bank adopts an IRB approach for part of its holdings 2. supervisors may allow banks to adopt a phased rollout of the IRB approach across the banking group. The phased rollout includes a. adoption of IRB across asset classes within the same business unit (or in the case of retail exposures across individual sub-classes) b. adoption of IRB across business units in the same banking group and move from the foundation approach to the advanced approach for certain risk components.
c.
Rules for corporate, sovereign, and bank exposures Formula for derivation of risk-weighted assets
Firm-size adjustment for small- and medium-sized entities (SME)
Rules for Assets subject to double Default Formula for derivation of risk-weighted assets
Specialized Lending
50%
70%
Mapping of Supervisory categories with ECAIs
70%
95%
Rules for Equity Exposures

1. Market-based approach
Simple risk weight method Internal models method
300% 200% 400% 300%
2. PD/LGD approach Similar to risk weight calculation for corporate subject following conditions LGD floor is kept at 90% For long term equity holdings the risk weight floor will be 100% For short term holding the same floor is 200% for publically traded and 300% for non traded equity holdings.
Rules for Retail Exposures

Residential mortgage exposures
Qualifying revolving retail exposures
Other retail exposures
IRB approach- Risk Components Revisited
1. Probability of Default (PD)

Measured in percentage over a time horizon of 1 year
a. Actual Default Observed
b. Mapping with the ECAIs

c. Statistical Model
2. Loss Given Default

The percentage of exposure that bank will loose in case of default. Sub-ordinate 75% Unsecured = 45% In addition to comprehensive approach following collaterals are also eligible
3. Exposure at Default

Loan in cash of 1000, with a remaining maturity of 5 years, to a corporate with an internal grade of 3 (pd .05). The loan is secured by debt securities issued by a bank with an external rating of AA. The debt securities have a remaining maturity of 7 years and a market value of USD 500. Additional collateral, in the form of commercial real estate, with a market value of 500 and a mortgage lending value of 300 secures the loan.
IRB Approach Minimum Requirement

Rating system design
The term rating system comprises all of the methods, processes, controls, and data collection and IT systems that support the assessment of credit risk, the assignment of internal risk ratings, and the quantification of default and loss estimates Perceived and measured risk must increase as credit quality declines from one grade to the next
A bank must define risk of each grade and the criteria used to distinguish that level of credit risk

Rating dimensions-corporate, sovereign and bank exposures
A qualifying IRB rating system must have two separate and distinct dimensions:
the risk of borrower default transaction-specific factors. foundation IRB banks, this requirement can be fulfilled by the existence of a facility dimension, which reflects both borrower and transaction-specific factors. Where a rating dimension reflects EL and does not separately quantify LGD, the supervisory estimates of LGD must be used.

Rating dimensions-Retail exposures
1. 2. 3. 4. 5. must be oriented to both borrower and transaction risk Banks must assign each retail exposure for IRB purposes into a particular pool. Each pool gives a meaningful differentiation of risk For each pool, banks must estimate PD, LGD, and EAD. Multiple pools may share identical PD, LGD and EAD estimates. At a minimum, banks should consider the following risk drivers when assigning exposures to a pool: Borrower risk characteristics (e.g. borrower type, demographics such as age/occupation); Transaction risk characteristics, including product and/or collateral types (e.g. Loan to value measures, seasoning, guarantees; and seniority (first vs. second lien)). Delinquency of exposure: Banks are expected to separately identify exposures that are delinquent and those that are not.

Rating structure
1. Standards for corporate, sovereign, and bank exposures
A bank must have a meaningful distribution of exposures across grades with no excessive concentrations, on both its borrower-rating and its facility-rating scales. must have a minimum of seven borrower grades for non-defaulted borrowers and one for those that have defaulted. Banks using the supervisory slotting criteria for the SL asset classes must have at least four grades for non-defaulted borrowers, and one for defaulted borrowers.
There is no specific minimum number of facility grades
2. Standards for Retail exposures

For each pool identified, the bank must be able to provide quantitative measures of loss characteristics (PD, LGD, and EAD) for that pool.

Although the time horizon used in PD estimation is one year, banks are expected to use a longer time horizon in assigning ratings. rating must represent the borrowers ability and willingness to contractually perform despite adverse economic conditions or the occurrence of unexpected events. Use of models
The burden is on the bank to satisfy that a model or procedure has good predictive power The bank must have in place a process for vetting data the judgment must take into account all relevant and material information not considered by the mode The bank must have procedures for human review of model-based rating assignments. The bank must have a regular cycle of model validation
Rating assignment horizon

Documentation of rating system design
Banks must document in writing their rating systems design and operational details If statistical models are used, the bank must document their methodologies outline of the theory, assumptions and/or mathematical and empirical basis of the assignment of estimates of Establish a rigorous statistical process Indicate any circumstances under which the model does not work Use of a model obtained from a third-party vendor that claims proprietary technology is not a justification for exemption from documentation

Risk rating system operations
Coverage of ratings Integrity of rating process Overrides Data maintenance
Stress tests used in assessment of capital adequacy Corporate governance and oversight
Use of internal ratings

Risk quantification

Internal Rating Based Approach Basel II prescribes a risk weight function which gives capital requirement & RWA using the risk components Example: Risk Weight Function & other formulas for Corporate Sovereign and Bank
Exposures
Correlation (R) =
0.12 x (1-exp(-50xPD))/(1-exp(-50))+0.24 x [1-(1-exp(50xPD)/(1-exp(-50))]
Capital Requirement (K) =
LGD x N[(1-R)^-0.05 x G(PD) + (R/(1-R)^0.5 x G(0.999)] PD x LGD] x(1-1.5 x b)^-1 x (1+(M-2.5) x b)
Risk-weighted assets (RWA) = K x 12.5 x EAD Similar formulas with slight modifications are for other exposure types (Retail, SMEs etc) The difference between FIRB & AIRB is the calculation of Risk Components PD, LGD Foundation IRB Advanced IRB
Only PD to be calculated by bank Risk components LGD & EAD All Risk components to be calculated by bank itself
Capital Charge For Market Risk


Core Capital
Credit Risk
Operational Risk
Market Risk
AMA
Internal Standardized Approach Rating Based Approach
(IRB)
Capital Charge For Market Risk

Definition: Market risk is the risk of loss in on and off-balance sheet positions due to adverse movement of market factors. Consequently it encompass;
Interest rate risk Equity Price Risk Foreign Exchange risk & Commodity price risk.
Capital Required = Sum of Capital Charge for all these 4 Risk sub categories
Tier 3 Capital
Short term subordinated debt with a minimum maturity of 2 years is allowed to be tier 3 capital. It shall be exclusively for market risk
Shall be limited to 250% of tier 1 that is available to support market risk i.e. at least 28.5% of capital requirement against Market Risk has to be met from tier 1.
Tier 2 elements may be substituted for tier 3 provided tier 3 capital will be limited to 250% of tier 1 that is required to support market risk.
Calculation of CAR (Cont..)

The first step is to calculate risk weighted assets (for credit risk) Then,
The second step is to calculate risk weighted assets subject to market risk capital charge. The methodology provides calculation of market risk capital charge directly. So in order to ensure consistency assuming this capital charge is 8% of risk weighted assets, it is multiplied by 12.5 to obtain risk weighted assets for market risk. Then overall CAR is,
Tier 1 + Tier 2
CAR ( credit risk) = Risk weighted assets

>250% of tier 1 i.e. 72% of Capital charge For market risk Charge.
Min 28.5% of Capital charge For market risk To be covered By tier 2
Tier 1 + Tier 2 + Tier 3 CAR ( overall ) = RWA( credit) + RWA( Market)
two broad methodologies for calculation of risk charge
1. 2.
Standardized Approach. Internal Model Based Approach
Banks are allowed to adopt any of the two methodologies subject to approval of national supervisory authority. However the later require certain preconditions such as bank have proper risk management framework, models being used to measure risk have proven track record and bank regularly conducts stress tests etc.
The capital requirement against interest rate risk apply only on trading book positions The minimum capital for IRR is sum of two separately calculated charges i.e. Specific Risk. Apply to each security position whether it is short or long (basically to cover credit risk) General Market risk. It is the capital requirement on portfolio basis, where long and short positions can be offset subject to certain conditions
Capital charge for IRR - Specific Risk

The specific risk charge is graduated in five broad categories as follows:
Government
0.00%
qualifying
other
0.25% (residual term to final maturity 6 months or less) 1.00% (residual term to final maturity between 6 and 24 months) 1.60% (residual term to final maturity exceeding 24 months) 8.00%.
Capital charge for IRR general Market Risk

All debt securities and other sources of interest rate exposures including derivatives are slotted into a maturity ladder comprising of thirteen time bands
The general market risk is the sum of

a. A small portion of matched position in each time band (vertical disallowance) b. A larger portion of the matched position across different time bands (horizontal disallowance) c. The net short or long position in the whole trading book
Capital charge for IRR general Market Risk Before calculating net positions within time bands or across time bands all long and short positions are multiplied with certain sensitivity weights. There are two methodologies to do so
1.Maturity method, wherein these sensitivity numbers are predefined

2.Duration method wherein these sensitivity weights are duration of the asset calculated on the bases of assumed change in yield prescribed by Basel I.
Maturity method
Coupon 3% or more 1 month or less Coupon less than 3% 1 month or less Weights % 0
1 to 3 months
3 to 6 months 6 to 12 months 1 to 2 years 2 to 3 years 3 to 4 years 4 to 5 years 5 to 7 years 7 to 10 years
1 to 3 months
3 to 6 months 6 to 12 months 1 to 2 years 2 years2 to 3 years 3 to 4 years 4 to 5 years 4 to 5 years 5 to 7 years
0.2
0.4 0.7 1.25 1.75 2.25 2.75 3.25
3.75
Duration Method
Example IRR-General market Risk

Suppose a bank has following positions in its trading portfolio;
A 4% government bond having market value 15 million and residual maturity of 6 months.
A 3% qualifying bond having market value 12 million, residual maturity 2 months. An interest rate swap, Rs 150 million, bank receives floating rate interest and pays fixed next fixing after 9 months, residual life of swap 8 years. An interest rate swap with face value Rs 30 million and residual maturity 2.5 years. Bank receives fixed at 7% and pays floating rate of 5.5%. Next repricing after 4 months. A nine versus fifteen, Forward Rate Agreement sold on 6 months KIBOR with nominal amount Rs 20 million and settlement date after nine months.
Example (Cont..)
Zone 1
Time Band Position
Zone 2 6-12 1-2 2-3 3-4 4-5 5-7 7-10
Zone 3 10-15 15-20 Over 20
0-1
1-3
3-6
+12
-30
+150 -20
+20
+30
+15
-150
Weights %
Weighted positions Vertical Disallow ance Position AfterV D H.D 1 position HD2 HD3
0.2
0.024
0.4
-0.12
0.7
1.05 -0.14 0.14 x 10%= 0.014
1.25
0.25
1.75
0.525
2.25
2.75
3.25
0.488
3.75
-5.625
4.5
5.25
0.024
-0.12
0.91
0.25
0.525
0.488
-5.625 0.488 X 40% = 0.195
= 0.12 x 40% = 0.048 0.814 0.814 0.775
-5.137
= 0.775 x 40% = 0.31 Remaining Position = - 4.362
0.814 X 100% = 0.814 Remaining position = - 3.548
Capital Required = V. D +H. D + overall open position
Capital Charge for Equity Price risk

The instruments covered include common stocks, convertible securities that behave like equities, and commitments to buy or sell equity securities. The Capital requirement is sum of
1.specific risk capital charge that is against individual stock/security (netting not allowed) which will be 4% 2.General market risk is calculated on portfolio basis i.e. net position in a market which shall be 8%
Both calculated on market value of positions. Further the Asset subject to this capital requirement shall be given 0% Risk weight while calculating credit risk capital charge.
Capital charge for Foreign Exchange Risk.

The capital charge for foreign exchange risk apply to FCY exposures throughout banks balance sheet. It is simply 8% of the overall net open position of the bank The calculation of open position is the same as prescribed in F.E manual. However
a.Banks that have foreign currency business, defined as the greater of the sum of its gross long positions and the sum of its gross short positions in all foreign currencies, does not exceed 100% of eligible capital and b. their overall net open position does not exceed 2% of eligible capital
are exempted from holding capital against F.E risk.

Internal Model Based Approach.

Suppose portfolio of a single asset. The price volatility of asset over past hundred days is as plotted below.
2 1 -1 -2
Time (days)
Internal Model Based Approach

5% of area
No of Occurrences -4 -3 -2 -1 0 1 2 Daily Return 3 4
If Assets Value is 60 million and 5% of times the return are below 3% Than One day VaR at 95% confidence level = 60 x 3% = 1.8 m

Banks that are allowed by their supervisory agency to use internal models to calculate capital requirement should hold capital Equivalent to previous day var amount or Average of past 60 days var multiplied by a constant factor (minimum 3) whichever is higher. VaR is required to be calculate at 99% confidence level at 10 day time horizon.

Quantitative Standards
VaR is computed on daily basis Confidence interval 99%, Bank can use any model Stress testing
External validation

1. Qualitative standards e.g Board and senior management oversight Independent risk control unit Routine and rigorous stress testing Independent review of the risk measurement system
Basel II - Pillar 1 Capital Charge for Operational Risk

Defined as risk of loss from inadequate or failed internal processes, people and systems, or from external events
Examples of risks covered
Internal and external fraud Legal risks Damages to customers Losses arising out of labour, health and safety, diversity, personal injury, etc. Damage to physical assets Business interruption
Examples of risks not covered

Reputational risk Strategic errors
Basel II - Pillar 1 Capital Charge for Operational Risk

Basic Indicator Approach
15% of banks average annual gross income over previous three years
Standardised Approach
Capital charge for each of 8 business lines calculated against average annual gross income for business line times:
18% for corporate finance 18% for trading and sales 12% for retail banking 15% for commercial banking
18% for payment and settlement

15% for agency services 12% for asset management 12% for retail brokerage
Advanced Measurement Approach

Calculated on basis of internal operational risk management system approved by national regulator
Basel II Pillar II Supervisory Review Process

Four key principles of supervisory review
Principle 1: Banks should have process for assessing overall capital adequacy in relation to risk profile and strategy for maintaining capital levels. Five main features of rigorous process: Board and senior management oversight Sound capital assessment Comprehensive risk analysis (credit risk, operational risk, market risk, interest rate risk in banking book, liquidity risk, other risk) Monitoring and reporting Internal control review Principle 2: Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as ability to monitor and ensure compliance with ratios. Supervisors should take appropriate action if not satisfied. Principle 3: Supervisors should expect banks to operate above minimum ratios and should have ability to require banks to hold capital in excess of minimum Principle 4: Supervisors should seek to intervene at early stage and require rapid remedial action
Basel II Pillar II Supervisory Review Process

Specific issues
Interest rate risk in banking book: Basel II treats interest rate risk under Second Pillar of supervisory review (rather than First Pillar of regulatory capital) due to differences in methods banks use to handle risk Credit risk: Supervisory review is appropriate to regulate stress tests under IRB approach, definition of default used to determine PD and/or LGD and EAD, residual risk, credit concentration risk and operational risk
Other issues
Supervisory transparency and accountability: Supervisors should make publicly available criteria used in review of banks internal capital assessments Enhanced cross-border communication and cooperation: Basel Committee supports pragmatic provision of close and continuous dialogue between industry participants and supervisors, as well as between supervisors (without changing legal responsibilities of national regulators).
Basel II Pillar III Market Discipline

Impose market discipline on banks by requiring disclosure of key information relevant to banks risks and capital
Why Enhanced Disclosure?

Complements regulatory capital requirements and the supervisory review process Reliable and timely information allowing well founded counterparty risk assessments Provides banks with an incentives to maintain a strong capital base Enhance role of market participants in encouraging banks to hold adequate levels of capital
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.
Basel II - Overview
Types of Disclosures
Qualitative Quantitative
Disclosure Requirements
Attached to the use of a particular methodology or instrument Pre-condition for the use of some methodologies Internal ratings-based approach Asset securitization Recognition of external credit assessment institutions

Basel II - A

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Basel II - A

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Basel Capital Accord

State Bank of Pakistan

Basel Capital Accord

2. Basel Committee on Banking Supervision

Desired outcome: Convergence in Standard

Basel Capital Accord

Why Capital requirement for banks

Capital (Asset X Risk Weight) X 8%

State Bank of Pakistan

The Basic Formula

Capital > 8% Risk weighted assets

80 10 50 200 170 100 20 80 40 80 100 200 45 10 15

0% 100% 50% 100% 100%

0 170 40 100 10 359 36

0 100 20 200 15 459 46

650 650 650

Both assigned 100% risk Weight

Despite these weaknesses remained global standard for almost a decade

Basel II Scope of Application

State Bank of Pakistan

Basel II Overall framework

Pillar 3: Market Discipline

Risk Weighted Assets

Internal Rating Based

State Bank of Pakistan

Basel II Pillar 1 Capital Charge for Credit Risk

Least sophisticated capital calculations; generally highest capital burdens

Foundation IRB Approach

More risk sensitive capital requirements

Same as FIRB Approach except the risk components are to be calculated

Basel II Major changes

RWA Calculation Revised

New Risk Capital Charge

Basel II Pillar 1 Minimum Capital Requirement

Tier 2 : Supplementary Capital (limited to 100% Tier 1)

Tier 3 : ( for market risk) short term subordinated debt

0% 20% 50% 100% 150%

ECA Risk Score

20% 50% 100% 150%

Preferential Treatment: Example

Preferential treatment for government claim Yes

Preferential treatment for government claim No

Preferential treatment for government claim No

Preferential Treatment: Example

Claims on Banks including securities firms: Option 1

Credit AAA A + BBB+ BB+ Assessment of to to to to BSovereign AA- A- BBB-

20% 50% 100% 100%

Claims on Banks including securities firms:

Credit Assessment of banks Risk Weight Risk Weight ST claim

AAA to AA20% 20%

BBB+ to BBB50% 20%

BB+ to B100% 50%

Credit Assessment Risk Weight

A+ BBB + Below Un-rated to A- to BB- BB50% 100% 150% 100%

Rules for Retail

Past Due Exposures

Other Risk weight issues

External Credit Assessment Inst. (ECAI)

Disclosure for supervsiors

Disclosure for Banks

Rules for Equity Exposure