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Donald Inscoe
Deputy Director Division of Insurance and Research U.S. Federal Deposit Insurance Corporation
Set minimum capital standards for banks Standards focused on credit risk, the main risk incurred by banks Became effective end-year 1992
Banks from different countries competing for the same loans would have to set aside roughly the same amount of capital on the loans
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
Risk-Based Capital
The Accord was hailed for incorporating risk into the calculation of capital requirements
Capital Calculation
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
The Accord, however, was criticized for taking too simplistic an approach to setting credit risk weights and for ignoring other types of risk
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
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
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 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
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 by U.S. banks to engage in regulatory 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
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
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)
Pillar I
In the United States, all banks that will be required to conform to the new capital standard will use the Advanced Internal Ratings Based approach (AIRB)
Collect sufficient data on loans to develop a method for rating loans within various portfolios Develop a Probability of Default (PD) for each rated loan Develop a Loss Given Default (LGD) for each loan
Safe loans: Over a 1-year period, only 0.25% of these loans default If a loan defaults, the bank only loses 1% on the outstanding amount Risky loans: Over a 1-year period, 1% of loans default every year If a loan defaults, the bank loses 10% of the outstanding amount
For a $100 million portfolio of the safe loans, the bank would expect to see $250,000 in defaults in a year and a loss on the defaults of $2500
For a $100 million in a risky portfolio the bank would expect to see $1 million in defaults in a year and a loss on the defaults of $100,000
Goal of Pillar I
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
Complexity of Pillar I
Banks have many different asset classes each of which may require different treatment
Each asset class needs to be defined and the approach to each exposure determined
Minimum standards must be established for rating system design, including testing and documentation requirements
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
Wide swings in risk-based capital requirements Some individual banks show unreasonably large declines in required capital
Operational Risk
Operational risk covers the risk of loss due to system breakdowns, employee fraud or misconduct, errors in models or natural or manmade catastrophes, among others
Pillar II focuses on supervisory oversight Pillar III looks at market discipline and public disclosure
Pillar II
Supervisory Oversight
Requires supervisors to review a banks capital adequacy assessment process, which may indicate a higher capital requirement than Pillar I minimums
Pillar III
SEC disclosure requirements for publicly traded banks Bank regulators require quarterly filing of call reports for all banks
U.S. authorities are currently considering what banks should publicly disclose about their Basel II calculations
Based on results for QIS4, which show the potential for substantial declines in capital, the U.S. banking regulators have proposed a revised implementation timeline
Transistional Arrangements Parallel Run 95% floor 90% floor 85% floor
After 2011, an institutions primary federal supervisor will assess the institutions readiness to operate under Basel II
Institutions will be assessed on a case-by-case basis Further revisions to the floors are anticipated Both Prompt Corrective Action and leverage capital requirements will remain
In the U.S., concerns that Basel II could give those banks operating under it a competitive advantage over other banks has resulted in a proposal called Basel 1-A Basel 1-A is designed to modernize the way all U.S. banks and thrifts calculate their minimum capital requirements
Implications
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
Basel IIs proposals rely on banks own internal risk estimates to set capital requirements
For regulators, evaluating the integrity of bank models will be a significant step beyond the traditional supervisory process
Implications
The proposed Accord will elevate the importance of human judgment in the process of capital regulation
Despite its quantitative basis, much will depend on the judgment of banks in formulating their estimates and of supervisors in validating the assumptions used by banks in their models
Work Continues
During the past 3 years the FDIC has expressed its concern that the proposed Accord will result in banks having too little risk-based capital Work continues on recalibrating the proposals and a workable solution is expected
Implications
Additional Data Needed to Counterbalance to Changes in Environment Changes in environment necessitate changes in risk Higher analysis for banks and Leverage supervisors/insurers
Unproven Rating Systems
Additional information will be needed to: Inform policy development. Supplement other sources of risk information used in supervisory resource planning and overall risk assessments Serve as an input into deposit insurance pricing and overall insurance funds adequacy analyses
Why XBRL ?
Internal ratings based and standard approach measures require complex data model
Common data requirements flow from Accord and Quantitative Impact Studies (QIS I IV) Domestic and international comparisons needed to ensure consistent application Taxonomy needed to compare banks internal ratings of similar and diverse risks
Common Data Elements Flow from Accord: Standardized Internal Risk Estimates
Data Types Internal Risk Estimate Reporting Granularity Summary Data
Exposure
Wholesale Retail Securitization Equity Market Risk Operational Risk
Why XBRL ?
Internal ratings based measures and standard approach require complex data model
Supervisors need detailed information to qualify banks for advanced approaches (IRB, AMA, and Market Risk) Data can be shared across different supervisory regimes
Consistent data needed to help identify risk estimates that may be inconsistent with peer estimates.
% of Wholesale Exposures 40 Banks PD Distribution Mapped to S&P Rating Scale 35 30 25 20 15 10 5 0 AA or better A to AA BBB to A BB to BBB B to BB >B Peer Banks PD Distribution Mapped to S&P Rating Scale
Follow-up: Can differences between Banks PD and benchmark be adequately explained by differences in risk?
Why XBRL ?
Open standard facilitates reuse and innovation Analysts can spend more time analyzing data Reduced reporting burden, especially for organizations operating in multiple jurisdictions
Why XBRL ?
Why XBRL ?
FINIS