Professional Documents
Culture Documents
Abstract
Keywords: Basel I, Basel II, Risk Weighted Assets, capital requirements, pilot testing
model, developing economies
1.1. Background
Until the late 1970s, banks were highly regulated and protected entities with hardly any competition
among them. Collapse of the Bretton Woods agreement put them in a new environment of increased
competition, leading to gradual erosion of capital that started to alarm the regulators. Dealing with the
problem on international level seemed to be the only possible way of finding a proper solution without
increasing competitive differences between banks from individual countries. Hence, a special
committee was set up under the auspices of the Bank for International Settlements(BIS) in Basel. The
Committee2, initially known as the Cooke Committee and later renamed the Basel Committee on
1
Views expressed in this paper are author’s own
2
Committee on Banking Regulations and Supervisory Practices or shortly the Basel Committee was established in 1974 by the governors of central
banks of the Group of Ten (G10) countries (Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, United Kingdom and
International Research Journal of Finance and Economics - Issue 23 (2009) 47
Banking Supervision (BCBS), formed a proposal in which it suggested that a common framework for
calculating the capital adequacy of banks should be formed. This document, known as the 1988 Basel
Capital Accord, became a huge success after its adoption – it not only managed to level the playing
field, but it also brought national practices on capital adequacy of banks in line.
In 1988, the Basel Committee published a set of minimal capital requirements for banks, known
as the 1988 Basel Accord. These were enforced by law in the G-10 countries in 1992, with Japanese
banks permitted an extended transition period. The 1988 Basel Accord focused primarily on credit risk.
Bank assets were classified into five risk buckets i.e. grouped under five categories according to credit
risk carrying risk weights of zero, ten, twenty, fifty and one hundred per cent. Assets were to be
classified into one of these risk buckets based on the parameters of counter-party (sovereign, banks,
public sector enterprises or others), collateral (e.g. mortgages of residential property) and maturity.
Generally, government debt was categorized at zero per cent, bank debt at twenty per cent, and other
debt at one hundred per cent. Off-Balance Sheet(OBS) exposures such as performance guarantees and
letters of credit were brought into the calculation of risk weighted assets using the mechanism of
variable credit conversion factor. Banks were required to hold capital equal to 8% of the risk weighted
value of assets. Since 1988, this framework has been progressively introduced not only in member
countries but also in almost all other countries having active international banks.
Close on the heel of the 1996 amendment to the Basel I Accord, In June 1999 BCBS issued a
consultative paper on New Capital Adequacy Framework to replace the 1988 Accord. The new capital
framework consists of three pillars: minimum capital requirements, which seek to refine the
standardized rules set forth in the 1988 Accord; supervisory review of an institution's internal
assessment process and capital adequacy; and effective use of disclosure to strengthen market
discipline as a complement to supervisory efforts.
The 1988 Basel I Accord has very limited risk sensitivity and lacks risk differentiation (broad
brush structure) for measuring credit risk. For example, all corporations carry the same risk weight of
100 per cent. It also gave rise to a significant gap between the regulatory measurement of the risk of a
given transaction and its actual economic risk. The most troubling side effect of the gap between
regulatory and actual economic risk has been the distortion of financial decision-making, including
large amounts of regulatory arbitrage, or investments made on the basis of regulatory constraints rather
than genuine economic opportunities. The strict rule based approach of the 1988 accord has also been
criticized for its `one size fits all’ prescription. In addition, it lacked proper recognition of credit risk
mitigants such as credit derivatives, securitisation, and collaterals. The recent cases of frauds, acts of
terrorism, hacking, have brought into focus the operational risk that the banks and financial institutions
are exposed to. Basel II is claimed by BCBS to be an improved capital adequacy framework intended
to foster a strong emphasis on risk management and to encourage ongoing improvements in banks’ risk
assessment capabilities. It also seeks to provide a `level playing field’ for international competition and
attempts to ensure that its implementation maintains the aggregate regulatory capital requirements as
obtaining under the current accord. The new framework deliberately includes incentives for using more
advanced and sophisticated approaches for risk measurement and attempts to align the regulatory
capital with internal risk measurements of banks subject to supervisory review and market disclosure.
The ultimate choice of what capital standard to adopt will be made by national authorities, and
it is likely several developing countries will seek to adopt Basel II as early as possible. The World
Bank and the IMF have publicly stated their desire to support countries preparing for the decision of
whether, when and how to implement Basel II. However, both institutions emphasize that Basel I
remains a viable option in the foreseeable future, and that Basel II must be built on a solid foundation
(as exemplified by compliance with key codes and standards) of sound accounting and governance
standards, realistic valuation rules and loan classification and provisioning practices, effective legal
and judicial systems, and adequate supervisory resources and powers.
USA) and Luxemburg. Its work focuses on (1) strengthening the soundness and stability of the international banking system, and (2) reducing the
distortion of competition between international banks. The Basel Committee’s meetings are usually held at the Bank for International Settlements.
48 International Research Journal of Finance and Economics - Issue 23 (2009)
In Bangladesh, Basel II Road Map has already been issued by Bangladesh Bank, the central
bank of the country. Basel II would be implemented from January 2009(Bangladesh Bank,2007). In
this regard a Quantitative Impact Study (QIS) to assess the preparedness for implementing Basel II as
well as the bank’s view on the optional approaches for calculating Minimum Capital Requirement
(MCR) as stated in Basel II was carried out in April-May 2007. Basel II would be implemented with
the following specific approaches as initial steps with the parallel calculations starting from January
2009:
• Standardized Approach for calculating Risk Weighted Assets (RWA) against Credit Risk
supported by External Credit Assessment Institutions (ECAIs)
• Standardized Rule Based Approach against Market Risk and
• Basic Indicator Approach for Operational Risk.
The questions to be addressed in this paper are as follows:
1. What are the implications of Basel II implementation in the developing economies?
2. What are the spill-over impact of Basel II Implementation in Developed economies on
Developing economies?
3. What are the changes in capital requirements in the developing markets, in particular
reference to Bangladesh due to Basel II implementation?
3
Deposit insurance creates moral hazard problems with respect to insured banks’ holding less capital after getting insurance. When deposits are insured,
managers of these banks’ start to believe that risk is lower and start investing in risky loans. Simultaneously, share-holders reduce monitoring of these
banks because risk of loosing deposits is offset by the insurance.
International Research Journal of Finance and Economics - Issue 23 (2009) 49
the weights used in the computations of the ratio are equal to the systematic risk of the assets. A further
theoretical ground argued that banks choose portfolios with maximal risk and minimum diversification.
The second strand of literature on the topic utilizes option models. Furlong and Keeley (1989)
and Keeley (1990) developed several models under this framework and showed that higher capital
requirements reduce the incentives for a value-maximizing bank to increase asset risk, which is
opposite to the conclusions of the first generation studies discussed above. They criticized the utility-
maximizing framework, which comes to opposite conclusions, as inappropriate because it
mischaracterizes the bank’s investment opportunity set by omitting the option value of deposit
insurance and the possibility of bank failure. However, this evidence of the option model was
weakened by the findings of Gennottee and Pyle (1991). They relaxed the assumption that banks invest
in zero net present value assets and found that there are now plausible situations in which an increase
in capital requirements results in an increase of asset risk.
Using a dynamic framework (multiple periods), as opposed to the static framework used in the
studies above, Blum (1999) found that capital regulation may increase banks’ riskiness due to an
intertemporal effect. Using a two-period model, he showed that banks find it too costly to raise
additional equity to meet new capital requirements tomorrow or are unable to do so, they will increase
risk today. He also pointed out that this second effect will reinforce the well-known risk-shifting
incentives due to the reduction in profits. Subsequently, Marshal and Prescott (2000) showed that
capital requirements directly reduce the probability of default and portfolio risk and suggested that
optimal bank capital regulations could be made by incorporating state-contingent penalties based on
banks’ performance. At the same time, Vlaar (2000) found that capital requirements acted as a burden
for inefficient banks when assets of banks are assumed to be fixed. However, such regulations
increased the profitability of efficient banks.In short, whether imposing harsher capital requirements
leads banks to increase or decrease the risk structure of their asset portfolio is still a debated question
and, at least for now, it seems, there is no simple answer to this question.
Empirical work in the area concentrates on two aspects of capital regulations. First, to
investigate whether banks fulfill the capital requirements by increasing capital or by altering the risk-
weighted assets; and second, to test if the enforcement of capital requirements can result in a
contraction in banks’ supply of loans, a situation best described as a credit crunch. Many of these
works use a simultaneous equations approach, which allows comparing the behavior of
undercapitalized and adequately capitalized banks with respect to changes in risk and capital ratios.
Shrieves and Dahl (1992) use several periods of cross-section data on commercial banks in the U.S.
under the simultaneous equations framework. They find that the effectiveness of risk-based capital
regulations depend on how well the regulations reflected the true risk exposure of banks. U.S. studies
are not easy to interpret since the implementation of the second stage of the Basel Accord, between
end-1990 and end-1992, overlapped with the passage of the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) in December 1991. Section 131 of FDICIA, Prompt Corrective Action
(PCA), went a step further than the Basel Accord by including five categories in which banks are
classified according to their compliance with the capital ratios. Thus, it is hard to ascribe the findings
of the two papers by Aggarwal and Jacques (1998, 2001) to the Basel Accord as opposed to FDICIA,
as U.S. banks’ behavior is likely to have been affected by both regulations over the period that they
consider. They found that banks in the undercapitalized categories increased their capital target ratios
more quickly than other banks with higher initial capital. But, if one is interested in the impact of
capital regulations in a broad sense, then this is not a big problem.
The study by Jacques and Negro (1997) deals exclusively with the consequences of the Basel
Accord, as it concentrates on the years 1990-91, which is the period before FDICIA was passed. They
find that capital regulation has a significant impact on risk and vice versa. But the problem of this
study is the very low number of undercapitalized institutions in Jacques and Negro’s sample – less than
2 percent of the total number of banks, which may have reduced the reliability of some of their
estimates.
50 International Research Journal of Finance and Economics - Issue 23 (2009)
Ediz, Michael, and Perraudin (1998) and Rime (2001) present some non-U.S. evidence
regarding the relationship between capital ratios and credit risk. Ediz, Michael, and Perraudin (1998)
employ confidential U.K. data including detailed information about the balance sheet and profit and
loss account of all British banks during the 1989-1995 periods whereas Rime (2001) uses Swiss data
for the period 1989-1996. Ediz, Michael, and Perraudin (1998) used a limited information technique
different from the simultaneous equations framework. Their study used a period 1989-1995 sample and
applied a random effects model. They found that capital regulations were effective in increasing the
capital to meet the minimum standard. Unfortunately, Ediz et al.’s model leads to the puzzling result
that banks are adjusting their capital levels each year by more than the difference between the current
level and the target they have in mind, which means that banks are overshooting the target (and by
more and more each year).
The study by Rime (2001) is interesting because it provides the application of the simultaneous-
equations model. His results indicate that Swiss banks react to capital regulations by increasing their
capital, but this did not change banks’ risk-taking. One of the problems with this study might be the
fact that Rime adopted the PCA regulatory classification to measure regulatory pressure on Swiss
banks, which might be inappropriate given that the additional requirements set by PCA have not been
adopted formally by any country other than the U.S. Sheldon (1996) used an option-pricing framework
to analyze the risk effects of capital adequacy on eleven G-10 countries. He found that the Basel
Accord did not have a risk-increasing impact on banks’ portfolio. But this result is not easy to interpret
as he did not control for regulatory and non-regulatory influences. Moreover, sample coverage of this
study is not representative for the countries they represent.
Van Roy (2003) studied the impact of capital requirements on risk taking by commercial banks
of seven OECD countries within the framework of the simultaneous equations framework. He found
that changes in capital and credit risk were negatively related over the period studied, which supported
the argument that stringent capital requirements went hand in hand with greater financial stability in
addition to imposing a higher capital buffer against unexpected credit risk losses. However, they also
found evidence indicating that the regulation was ineffective in raising the capital ratio of
undercapitalized banking institutions in France and in Italy, which leaves room for the validity of the
argument presented above.
3.1. Methodology
To measure the potential impact on the capital of banks in developing markets, the pilot testing model
are being constructed in line with the recommendations of BCBS 128 publication entitled
‘International Convergence of Capital Measurement and Capital Standards’, A Revised Framework
Comprehensive Version, June 2006. The pilot testing model with relevant data is annexed in Appendix
A. With the help of the tools given in Appendix A, the parallel calculations for the capital requirement
of bank under Basel II are being carried out. Capital requirements for Credit Risk, Market Risk and
Operational Risk are being calculated as per Standardized/Basic Approaches of Basel II. The data from
the public domain,i.e. the Annual Report of Mercantile Bank Limited, a commercial Bank in
Bangladesh are compiled and are put in the model. Data are collected for the year 2007.
4.2.1 Problems
4.2.1.1 Standardized Approach and External Credit Rating Problems
One of the two approaches prescribed for Credit Risk in Basel II is the standardized approach, which
makes use of external credit ratings for attaching risk weights. Being the easier of the two approaches
and also because of the continuity from the Basel I norms it is most likely to be implemented in
developing countries. One of the major problems is the availability of credit ratings in developing
countries. While Bangladesh has been fortunate in this respect with two Credit Rating agencies(Credit
Rating Information and Services Limited and Credit Rating Agency of Bangladesh Ltd.),many
developing countries are not so equipped in this field. Even in Bangladesh the penetration of credit
ratings is not deep. The supply-demand imbalance would make it even more difficult for smaller
players to get ratings. High prices are making credit more costly for them.
5.1. Findings
After pilot testing of the model for Basel II parallel calculations for Mercantile Bank Limited, it has
been found that the capital requirements to comply with Basel II Standardized/Basic approaches would
go up significantly. Under Basel I the minimum capital requirements for the Bank is BDT 2,903.66
million. Basel I Capital Accord only requires capital only for credit risk in Bangladesh. Market Risk
component of Basel I Accord has not yet been implemented even though it has been implemented since
1996 across the globe. As per the Basel I Capital Accord, the Bank is well-capitalized. After running
the pilot testing of the model for Basel II, it has been found that the capital requirement to comply with
Basel II has been increased by 41.94% as compared to Basel I capital requirements. The capital
requirement under Basel II regime increased due to additional burden of capital from Market Risk and
Operational Risk.
International Research Journal of Finance and Economics - Issue 23 (2009) 55
Table 2: Change in Capital
BDT in Million
Risk Weighted Assets(RWA) Basel I Basel II
A1. Credit Risk 29,036.56 37,749.64
A2.Market Risk - 537.10
A3.Operational Risk - 2,927.92
B. Total RWA(A1+A2+A3) 29,036.56 41,214.66
C. Tier I Capital 2,871.63 2,871.63
D. Tier II Capital 457.87 457.87
E. Total Capital(C+D) 3,329.50 3,329.50
F. Capital Adequacy Ratio-CAR(E/B) 11.47% 8.08%
Required Capital(10% against RWA) 2,903.66 4,121.47
Increase(Decrease) in Capital Requirement - 41.94%
6.1. Conclusion
There are many possible negative impacts of an unchecked implementation of Basel II. However,
Basel II is here to stay and the competitive forces will compel banks to follow the example. The option
here is to decide what form of the Basel II norms should be applied and to what extent to ensure the
survival and growth for the developing economies. Ultimately, the norms are for strengthening the
banking systems globally and this objective should not be lost. Developing Economies need to be
prepared and to adapt to the changing global conditions and to adapt the norms to their own advantage.
56 International Research Journal of Finance and Economics - Issue 23 (2009)
References
[1] Aggarwal, R. and K. Jacques,1998. "Assessing the impact of prompt corrective action on bank
capital and risk," Economic Policy Review, Federal Reserve Bank of New York, issue October,
23-32.
[2] Aggarwal, R. and K. Jacques, 2001, “The impact of FDICIA and Prompt Corrective Action on
bank capital and risk: estimates using a simultaneous equations model.” Journal of Banking and
Finance, 25, 1139-1160.
[3] Blum, J.,1999, “Do Capital Adequacy Requirements Reduce Risks in Baking?”, Journal of
Banking and Finance, 23, 755-71.
[4] Bangladesh Bank,2007. “Basel II Road Map”, December 30,2007.
[5] Basel Committee on Banking Supervision,2006.“International Convergence of Capital
Measurement and Capital Standards’, A Revised Framework Comprehensive Version”, Bank
for International Settlements.
[6] Ediz, T. Michael, I M and Perraudin, W R M, 1998, “Bank Capital Dynamics and Regulatory
Policy, “Bank of England mimeo.
[7] Ferri, G. and T.S. Kang, 1999, “The Credit Channel at Work: Lessons from the Financial Crisis
in Korea,” Economic Notes, 28, No. 2, 195-221.
[8] Furlong, Frederick. T. and Michael C. Keely, 1989, “Capital regulation and bank risk-taking: A
note”, Journal of Banking and Finance, 13, 883-891
[9] Gennote, G. and D. Pyle, 1991, “Capital Controls and Bank Risk,” Journal of Banking and
Finance, 15, 805-41.
[10] Hart, O.D. and D.M. Jaffe, 1974, “On the application of portfolio theory to depository financial
intermediaries,” Review of Economic Studies, 41, 129-147.
[11] Jacques, K.T.and P. Nigro,1997, “Risk-Based Capital, Portfolio Risk, and Bank Capital: A
Simultaneous Equations Approach,” Journal of Economic and Business, 533-47.
[12] Keeley, Michael, C., 1990, Deposit insurance, risk, and market power in banking, The
American Economic Review, 80, No. 5,1183-1200.
[13] Kim, D., and A.M. Santomero, 1988, “Risk in Banking and Capital Regulation,” Journal of
Finance, 43, 1219-33.
[14] Koehn, M. and A.M. Santomero, 1980, “Regulation of Bank Capital and Portfolio
Risk,”Journal of Finance, 35, 1235-44.
[15] Marshall, D.A., and E.S. Prescott, 2000, “Bank Capital Regulation with and Without State-
Contingent Penalties,” Federal Reserve Bank of Chicago Working Paper,10.
[16] Pyle, H.D., 1971, “On the theory of Financial Intermediation,” Journal of Finance, 26, 737-747.
[17] Furlong, Frederick. T. and Michael C. Keely, 1989, “Capital regulation and bank risk-taking: A
note”, Journal of Banking and Finance, 13, 883-891.
[18] Rime, B., 2001, “Capital Requirements and Bank Behavior: Empirical Evidence for
Switzerland,” Journal of Banking and Finance, 25, 798-805.
[19] Rochet, J.C., 1992, “Capital Requirements and the Behavior of Commercial Banks”, European
Economic Review, 36, 1137-78.
[20] Sheldon, G., 1996, “Capital Adequacy Rules and the Risk-Seeking Behavior of Banks: A Firm-
Level Analysis”, Swiss Journal of Economics and Statistics, 132,709-734.
[21] Shrieves, R. E. and D. Dhal, 1992,”The Relationship between Risk and Capital in Commercial
Banks,” Journal of Banking and Finance, 16, 439-57
[22] Van Roy, Patric.,2003, “Impact of the 1988 Basel Accord on banks’ capital ratios and credit
risk taking: an international study”, European Center for Advanced Research in Economics and
Statistics, Universite Libre de Bruxelles, Working Paper.
[23] Vlaar, P. J.,2000, “Capital Requirements and Competition in the Banking Industry,” Federal
Reserve Bank of Chicago, Working Paper, 18.
[24] Ward,J.,2002“The New Basel Accord and Developing Countries: Problems and Alternatives”
Cambridge Endowment of Research Finance, Working Paper No. 4, 14.
International Research Journal of Finance and Economics - Issue 23 (2009) 57
Appendix A
Experimental Calculation under Basel II
SUMMARY / OVERALL CAPITAL ADEQUACY RATIO
(BDT in Million)
Tier 1 Capital
1.1 Paid-up Capital 1,498.90
1.2 Non-repayable Share Premium Account
1.3 Statutory Reserve 966.50
1.4 Other Reserve 103.36
1.5 Retained Earnings 302.87
1.6 Minority Interest in Subsidiaries
1.7 Non-cumulative irredeemable Preference Shares
1.8 Dividend Equalisation Account
1.9 Sub-Total (1.1 to 1.8) 2,871.63
Deductions:
1.10 Book value of Goodwill
1.11 Shortfall in provisions required against classified assets irrespective of any
relaxation allowed.
1.12 Deficit on account of revaluation of investments held in AFS category
1.13 Any increase in equity capital resulting from a securitization transaction
1.15 Other deductions (50% of the amount as calculated on CAP 2)
1.16 Sub-Total (1.10 to 1.15)
1.17 Total eligible Tier 1 capital (1.9-1.16) 2,871.63
Tier 2 Capital
2.1 General Provisions or general reserves for loan losses-up to maximum
of 1.25% of Risk Weighted Assets 361.03
2.2 Asset Revaluation Reserves
2.3 Exchange Equalisation Account 2.32
2.4 Revaluation Resreves of HTM (upto 50%)
2.5 Provision for Off-Balance Sheet Items 94.52
2.6 Subordinated debt -upto maximum of 50% of Total eligible Tier 1
2.7 Total Tier 2 Capital (2.1 to 2.6) 457.87
Deductions:
2.8 Deductions (50% of the amount as calculated on CAP 2)
2.9 Total eligible Tier 2 Capital (2.7-2.8) 457.87
Tier 3 Capital (eligible for market risk only)
3.1 Actual Tier 3 Capital
3.2 Eligible Tier 3 Capital
58 International Research Journal of Finance and Economics - Issue 23 (2009)
Appendix A
4 Total Supplementary Capital eligible for capital adequacy ratio (2.9+3.2) 457.87
(Maximum upto 100% of Total eligible Tier 1 capital)
Appendix A
Credit Risk: Standardized Approach
1.Calculations of Risk Weighted Assets for Credit Portfolio
A. Corporate Portfolio BDT in Million
% of Total Exposure Credit Risk Adjusted Credit Rating Risk Weight Risk
Portfolio Mitigation Exposure Weighted
(CRM)** Assets
100% 27,903 3,069 24,834 Unrated 100% 24,834
Adjusted Exposure=
Exposure(1-CRM) Corporate Portfolio= Total Loans and Advances-Retail Portfolio-Commercial Real Estate-Past Due Loans
B. Retail Portfolio
B1. Residential Mortgage
Amount Risk Weight Risk Weighted Assets
1,278 35% 447
Appendix A
2.Calculations of Risk Weighted Assets for Balances with Banks and FIs &
Money at Call and Short Notice
% of Total Portfolio Exposure Risk Weight* Risk Weighted Assets
100% 729 20% 146
*Maturity <=3 Months
Appendix A
4.Calculations of Risk Weighted Assets for Fixed Assets and Other Assets
Exposure Risk Weight Risk Weighted Assets
1,516 100% 1,516
Appendix A
RISK WEIGHTED ASSETS FOR MARKET RISK
SUMMARY
(BDT in Million)
A Capital Charge for Interest Rate Risk
i. Total market risk capital charge for Specific Risk -
ii.Total market risk capital charge for General Market Risk -
Total -
B Capital Charge For Equity Exposure
i. Specific Risk 22.80
ii. General Market Risk 22.80
Total 45.60
C Capital Charge for Foreign Exchange Risk 8.11
D Total Capital Charge for Market Risk (A+B+C) 53.71
E Risk Weighted Assets for Market Risk (D x 10) 537.10
Appendix A
Appendix A
CAPITAL CHARGE FOR FOREIGN EXCHANGE RISK
Multiple Currency-Shorthand Method
(BDT in Million)
Position in Currency
Currency Net Spot Net Guarantees Net Others Net delta-based Total net BDT Position
Position Forward future equivalent of long Rate in BDT
Position income/ foreign (short)
expenses currency Positions
options
1 2 3 4 5 6 7 8 9 10
USD 0.67 0.67 68.57 45.94
EUR 0.07 0.07 100.91 6.76
GBP 0.11 0.11 136.72 14.36
JPY 4.80 4.80 0.61 2.93
CAD 0.05 0.05 69.91 3.50
AUD 0.12 0.12 59.98 7.20
CHF 0.007 0.007 60.81 0.43
Overall Long/Short Position 81.10
Capital Charge Rate 10%
Total Capital Charge 8.11
Appendix A