BASEL

I, II, III
BASEL
A set of international banking regulations put
forth by the Basel Committee on Bank
Supervision, which set out the minimum
capital requirements of financial institutions
with the goal of minimizing credit risk.
Basle concordat
Basle agreement was originated by a committee
of central bank members of the bank for
international settlement (BIS) in 1975 and since
then amended.
The major amendments were done in 1983; the
agreement stipulates standards and guidelines
for international banking supervision.
The amendments also provide guidelines for
supervision for both domestic and cross-border
banking; a system of loan classification and a
system of provisions of bad loans.
Basle Capital Accord
Basle capital accord of 1988 and its amendments
provide internationally acceptable standards for
capital adequacy of banking institutions and
stipulates constituent elements of banks core
and supplementary capital, providing a uniform
standard for banks concerning their financial
evaluation, performance and reporting.

These capital adequacy standards are being
widely adopted by many countries, including
Pakistan. (see capital adequacy; capital, core,
supplementary)
Calculation of Capital
Tier One Capital
the ordinary share capital (or equity) of the
bank; and
audited revenue reserves e.g.. retained
earnings; less
current year's losses;
future tax benefits; and
intangible assets, e.g. goodwill.

Calculation of Capital
Upper Tier Two Capital
Un-audited retained earnings;
revaluation reserves;
general provisions for bad debts;
perpetual cumulative preference shares (i.e.
preference shares with no maturity date whose
dividends accrue for future payment even if the
bank's financial condition does not support
immediate payment);
perpetual subordinated debt (i.e. debt with no
maturity date which ranks in priority behind all
creditors except shareholders).
Calculation of Capital
Lower Tier Two Capital
Subordinated debt with a term of at least 5
years;
Sedeemable preference shares which may not
be redeemed for at least 5 years.
Capital Adequacy
Capital Adequacy: for a bank, adequacy is the
sufficiency of capital of a bank to sustain its
lending operations and other activities; in
particular, sufficiency of capital of a bank as
determined by central bank or supervisory
authority to meet its obligation as they fall
due, and to meet its loan losses as they arise,
or to absorb unexpected trading losses from a
banks asset portfolio and its off-balance sheet
commitments.
Capital adequacy for banks is measured in
terms of the ratio of banks capital.
Capital Adequacy Ratio
CAR is calculated as the sum of tier 1 and tier
2 capital divided by the sum of risk weighted
assets in the balance sheet and credit
equivalents of off- balance sheet assets.
BASEL I
The first accord was the Basel I. It was issued in 1988 and focused
mainly on credit risk by creating a bank asset classification system. This
classification system grouped a bank's assets into five risk categories:

0% - cash, central bank and government debt and any OECD
government debt
20% - development bank debt, OECD bank debt, non-OECD bank debt
(under one year maturity) and non-OECD public sector debt
50% - residential mortgages
100% - private sector/corporate debt (maturity over a year), real
estate, plant and equipment, capital instruments issued at other banks

Banks with international presence are required to hold capital equal to 8
% of the risk-weighted assets.

Member Countries
Since 1988, this framework has been
progressively introduced in member countries
of G10, currently comprising 13 countries, na
mely;

Belgium, Canada, France,Germany, Italy, Japan
, Luxembourg, Netherlands, Spain, Sweden, S
witzerland, UK and USA.
Basel II
The purpose of Basel II, which was initially
published in June 2004, is to create an
international standard that banking regulators
can use when creating regulations about how
much capital banks need to put aside to guard
against the types of financial and operational
risks banks face.
Basel II
In practice, Basel II attempts to set up rigorous
risk and capital management requirements
designed to ensure that a bank holds capital
reserves appropriate to the risk the bank
exposes itself to through its lending and
investment practices.

Generally speaking, these rules mean that
the greater risk to which the bank is exposed,
the greater the amount of capital the bank needs
to hold to safeguard its solvency and overall
economic stability.
Basel I to Basel II

New credit risk approaches
o Market risk - unchanged
o Add operational risk portion


3 Pillars
1) Minimum capital requirements
2) Supervisory review
3) Market discipline
The Basel II Framework
Pillar 1:
Minimum capital
requirements
Pillar 2:
Supervisory
review
Pillar 3:
Market
discipline
A guiding
principle
for banking
supervision
Credit Risk
Market Risk
Operational Risk
Disclosure
requirements
Pillar 1: Minimum Capital
Requirements

The calculation of regulatory minimum capital
requirements:
% 8
assets weighted - risk Total
capital of amount the
>
The Capital and Assets
Definition of capital:
Tier 1 capital + Tier 2 capital (with some
adjustments)

Total risk-weighted assets are determined by:
Risk weighted assets of credit risk
plus
12.5* capital requirement for market risk
plus
12.5* capital requirement for operational risk

Minimum Capital Adequacy Ratios
Tier one capital to total risk weighted credit
exposures to be not less than 4 %;

Total capital (i.e. tier one plus tier two less
certain deductions) to total risk weighted
credit exposures to be not less than 8%

Credit Risk
Standardized Approach
IRB Approach
Credit Risk -
Standardized Approach
In determining the risk weights in the
standardized approach, banks may use
assessments by external credit assessment
institutions.
( )

Assets of Valus Book Assets for t Risk Weigh

Risk Weight for Assets
Credit
Assessment


Claims on sovereigns


Claims on banks and securities firms

Claims on
corporates

ECA risk
scores

Risk
Weight

Credit
assessment of
Sovereign


Credit assessment of Banks

Risk weight


Risk weight
for short-
term

AAA to AA-

1

0%

20%

20%

20%

20%

A+ to A-

2

20%

50%

50%

20%

50%
BBB+ to BBB-

3

50%

100%

50%

20%

100%

BB+ to BB-

4~6

100%

100%

100%

50%

100%

B+ to B-

4~6

100%

100%

100%

50%

150%
Below B-

7

150%

150%

150%

150%

150%
Unrated

-

100%

100%

50%

20%

100%

Credit Risk - IRB Approach
In the internal ratings-based (IRB) approach,
its based on banks internal assessment.

The approach combines the quantitative
inputs provides by banks and formula
specified by the Committee.
Credit Risk - IRB Approach
Four quantitative inputs (risk components):
Probability of default (PD)
Loss given default (LGD)
Exposure at default (EAD)
Maturity (M)
Use formula of the Committee to calculate the
minimum requirements.
Credit Risk - IRB Approach
Data Input

Foundation IRB

Advanced IRB


Probability of default
(PD)

From banks

From banks


Loss given default
(LGD)


Set by the Committee

From banks


Exposure at default
(EAD)


Set by the Committee

From banks

Maturity (M)


Set by the Committee or
from banks

From banks



Market Risk
Standardised method
- the standards of the Committee

Internal models
- use banks internal assessments

Operational Risk
The risk of losses results from inadequate or
failed internal processes, people and system,
or external events.

Basic Indicator Approach
Standardised Approach
Advanced Measurement Approaches(AMA)
Operational Risk -
Basic Indicator Approach
GI = average annual gross income(three years,
excepted the negative amounts)
= 15%
o =GI KBIA
Operational Risk -
Standardised Approach
GI
1-8
= average annual gross income from
business line from one to eight (three years,
excepted the negative amounts)
= A fixed percentage set by the Committee
( )

8 1 = | 8 1 GI KTSA
Beta of Business Lines
Business Lines

Beta Factors

Corporate finance (1)

18%

Trading and sales (2)

18%

Retail banking (3)

12%

Commercial banking (4)

15%

Payment and settlement (5)

18%

Agency services (6)

15%

Asset management (7)

12%

Retail brokerage (8)

12%

Operational Risk - Advanced
Measurement Approaches
Under the AMA, the regulatory capital
requirement will equal the risk measure
generated by the banks internal operational
risk measurement system using the
quantitative and qualitative criteria for the
AMA.
Use of the AMA is subject to supervisory
approval.
Pillar 2: Supervisory Review
Principle 1: Banks should have a process for
assessing and maintaining their overall capital
adequacy.
Principle 2: Supervisors should review and
evaluate banks internal capital adequacy
assessments and strategies.
Supervisory Review
Principle 3: Supervisors should expect banks
to operate above the minimum regulatory
capital ratios.
Principle 4: Supervisors should intervene at an
early stage to prevent capital from falling
below the minimum levels.
Pillar 3: Market Discipline
The purpose of pillar three is to complement
the pillar one and pillar two.
Develop a set of disclosure requirements to
allow market participants to assess
information about a banks risk profile and
level of capitalization.
Basel III
BIS began referring to this new international regulatory framework
for banks as "Basel III in September 2010. The draft Basel III
regulations include:

"tighter definitions of Tier 1 capital; banks must hold 4.5%
by January 2015, then a further 2.5%, totalling 7%.

the introduction of a leverage ratio,- (Put a floor under the build-up
of leverage in the banking sector)

Promote more forward looking provisions;


a framework for counter-cyclical capital buffers,

and short and medium-term quantitative liquidity ratios.(is
introducing a global minimum liquidity standard for internationally active banks )

What is procyclicality?
In particular, the financial regulations of
the Basel II Accord have been criticized for
their possible procyclicality.

The accord requires banks to increase
their capital ratios when they face greater
risks. Unfortunately, this may require them to
lend less during a recession or a credit crunch,
which could aggravate the downturn.