Transcript Slide 1

Presented by: Dr. Peter Larose
Key Components of Credit Risk under Basel II
Credit Risk Elements
Transaction Risk
2
Borrower’s Risk
Exposure Risk
1
3
1. The probability of default (PD) being assessed using both quantitative & qualitative
information about the borrower and the market.
2. Loss given default assessed on actual details such as: recovery time, collateral,
market value of debt, and also within the perceived risk of the borrower.
3. Exposure at default of the loan (EAD). This component takes into consideration
value of the outstanding debt at the time of default (t), and also any committed
by unused line of credit.
Note: Other factors such as: the amount outstanding, borrower’s position within the
Industry, degree of concentration risk involved, scope of diversification, and maturity
Option 1 – Advanced Internal Ratings-Based (Advanced IRB)
This approach is derived from banks’ own assessment of all risk factors
Option 2 – Simplified Standardized Approach ((Simplified SA)
This option is very close to the current Basel I, and the standardized (SA)
based on external assessments of risks.
Option 3 – Foundation Internal Ratings-Based
(Foundation IRB)
This option depends mostly on the banks’ own assessment of probability of
default.
* Either Option can be used to calculate the capital charge
Proposed Basic Structure of BASEL II
3 Basic Pillars
Minimum
Capital
Requirement
Supervisory
Review
Process
Market
Discipline
Risk
Weighted
Assets (RWAs)
Core
Capital
Models Approach
Standardized Approach
Market
Risk
Advanced Measurement
Approach
Basic Indicator Approach
Internal RatingsBased Approach
Standardized Approach
Standardized Approach
Operational
Risk
Credit Risk
Definition
of Capital
Supplementary
Capital
Why Basel II?
Basel I was not implemented to the maximum by all the banks.
Banks had different portfolio risk profiles in terms of client base
(e.g. blue chip companies vs small & medium enterprises)
Banks had different activities (e.g. inter-bank lending vs commercial)
Banks actual exposure varied over time with intensity of competition,
which
resulted into changes in the risk weighting approach.
New framework is more flexible for banks, which had reached different
levels
of complexity and sophistication in their operations.
It is more comprehensive in application as it recognizes and includes
operational risk in the capital adequacy calculations.
It also includes two new pillars within the framework (e.g. market &
supervisory discipline).
Measurement of Capital Charge Under Basel II - SA
Business
Line
Banks
Retail
Corporate
Sovereigns
AAA to
AA-
A+ to A-
BBB+ to
BBB-
BB+ to
B-
Below B-
Unrated
*Option 1
20%
50%
100%
100%
150%
100%
**Option
2
20%
50%
100%
100%
150%
50%
***Option
3
20%
20%
20%
50%
150%
20%
Mortgage
35%
Other
75%
20%
50%
100%
100%
150%
0%
20%
50%
100%
150%
100%
*Sovereign : Risk weighting based on risk weights of sovereign state where the bank
is originally incorporated to operate.
**
Risk weights based on the assessment of Individual Bank
***
Claims on banks of original maturity of 3 months receive a weight which
is less favourable.
Identified Weaknesses of Basel I
(i) Basel I does not provide good incentives for credit risk mitigation
techniques.
(e.g. hedging of forex risk, and interest rate risk)
(ii) Credit Risk in G10 countries were taken for granted that they were
less risky from a sovereign risk perspective.
(iii) Does a solid platform to assess capital adequacy in relation to a
bank’s true risk profile. (e.g. no recognition of operational &
other risks).
Objective of Basel II
In line with previous framework, Basel II is to
continue to promote safety and soundness
among internationally active banks.
The new framework is to encourage banks to
further improve their internal risk management
systems.
Bring the regulatory capital in line with the
identifiable risks of the commercial banks.
Internal Ratings-Based Approach
Risk Components
(1)
Probability of Default
(PD), Loss Given
Default,
Maturity,
Exposure at Default
Risk Weight Function
(2)
Various weights
Minimum Capital Requirements
(3)
IRB use Separate Approaches for EACH Portfolio of Assets
Component
Recognition
Probability of Default (PD)
Bank
Foundation
Advanced
Loss Given Default (LGD)
45%
Bank
Exposure at Default (EAD)
100%
Bank
2 1/2 Years
Bank
Maturity
Note: 3 Categories of Exposure in Banks’ Assets.
Retail
Corporate
•Residential Mortgages
•Qualifying Revolving Exposures
•Other Retail
SMEs
Specialized Lending
Sovereign
Commercial Real Estate
Equities
Treatment of Operational Risk in Pillar 1
Definition of Operational Risk in the context of Basel II
“ It is defined as being the risk of operating financial loss resulting from
inadequate or failed: systems, loss of key personnel, internal processes,
and external events”.
Possible Events, which can trigger an operational risk:
•Damage to physical assets of the bank
•Business interruptions and I.T/Accounting System failure
•Internal collusion of employees committing fraudulent transactions
•External collusion of employee-customer committing fraudulent transactions
•Sudden shift in clients’ business behaviour – switching to other parties
•Change in business practices by the bank
•Change in employment practice and work place safety.
•Business execution and delivery
Risks To Be Covered Under the 3 Pillars
Pillar 1
Operational Risk
X
Pillar 2
Pillar 3
X
X
Liquidity Risk
X
X
Interest Rate Risk
X
X
Strategic (Reputation Risk)
X
X
Basic Indicator Approach (BIA)
The level of requested capital charge is calculated by multiplying a single
Indicator by a fixed percentage (%). 
The proposed indicator is the Gross Income, where:
Capital Charge =
 X indicator
Please note that Basel II calibrates this ration to 12% not 8% of MRC with an
 set at 15%. The indicator used should be the 3-year average gross
revenue.
Standardized Approach
The standardized approach is more detailed that the basic one.
It divides the banking activities into 8 business portfolios. The indicator used
Is also the Gross Income (GI), but the capital charge is calculated using
A specific Beta factor for each portfolio. The total capital charge to be
Provisioned for by each bank is the total of all the portfolios together such as:
Capital Charge = sum(GI(t-8) x B(t-8)
8 Portfolio Assets
Details
1.
2.
3.
4.
5.
6.
7.
8.
Trading & Sales
Retail Banking
Corporate Finance
Commercial Banking
Payment & Settlement
Agency Services
Retail Brokerage
Asset Management
Beta Value
18%
12%
18%
15%
18%
15%
12%
12%
Pillar 2 – Supervisory Review Process
This new pillar is to support the capital requirement quantitative
Techniques and cover those dimensions of capital adequacy
Requirements not considered under Pillar 1 (e.g. large exposures,
concentration risk etc) and other risks not taken into account
(e.g. liquidity risk, interest rate risk) as well as all external factors
that may affect the bank.
Under Pillar 2, the role of the bank supervisors is absolutely very
crucial
Pillar 3 – Market Discipline
Market discipline is as important as the other two pillars as it should
Result into a greater level of confidence with the customers and
Members of the public that the banking system is much safer.
Timely disclosure of reliable information as required under Pillar 3
Allows for well founded counterparty risk assessment.
Disclosure requirement will involve:
a. Capital adequacy
b. Risk exposures (e.g. credit, market and others)
c. Composition of capital structure.
Reasons to Defer the Implementation of Basel II
Basel I has not been fully implemented by all banks
Each bank depending on their level of sophistication will choose the
most advantageous model to minimize capital charge
It is a rather complex model to implement fully
It will be difficult for international comparison of bank performance, if
there is a lack of standard model applied
Not all regulatory agencies will be equipped to handle the model
It will be very difficult for banks to quantify “operational risk” and
make provisions for natural disaster.
There has been no concrete evidence using real data, which justify
its implementation – “trial & error”
Reasons to Adopt Basel II
The Accord should improve cross-borders supervisory co-operation
Unless the model is tried and tested, some banks may be marginalized
from the rest of the international community
It is an impetus for banks to modernize their risk management
infrastructure
Challenges Ahead in the Implementation of Basel II
Data availability, accuracy, and reliability
Legal framework improvement needed
Feasibility of cross-border co-operation and its lasting effect
Human resources requirement with adequate knowledge of the model
Operational assistance from developed countries needed
Change in customer expectations and behaviour
Political support to bring change to the banking system
Data Availability, Accuracy, and Reliability
In some countries, it may be difficult to collect accurate and reliable data from the
financial sector.
This is especially the case with the developing countries, which may not have a
developed financial system.
Regular up date of information would be needed (both quantitative & qualitative)
in order to implement Pillar 1
If information is not forthcoming with a stated time frame, it would become more
difficult to follow through the full implementation with more delays.
New Legal Framework Needed
In some developing countries, bank supervisors do not have sufficient
legal and regulatory power to intervene when the management of a
commercial bank has not fulfilled the required data submission.
This poses a problem, unless, otherwise, the Government is prepared to
bring about new changes in the existing legislations.
There can be major time-lag from the consultative period to the full enactment
of the legal requirement.
International banks having representative operations or branches located in
those jurisdictions may be severely handicapped, when due consideration
is taken to evaluate Basel II implementation at the group level.
Feasibility of Cross-Border Co-operation & Its Lasting Effect
While many neighbouring countries are co-operating with one another
in the implementation of Basel I, it may not always be the case with
Basel II.
This is due to its level of sophistication and the demand for resources.
The more advanced institutions will have to assist those international
banks having difficulty to implement it.
There will be a huge cost involved for the bank to take into consideration
as part of their operating expenditure.
Human Resources Requirement to Implement the Model
The existing employees of the banks including supervisors must be
adequately trained to understand the new Accord.
Regular training will be an issue for the banks to consider in their
forward planning for them to update their knowledge about the
dynamics of their portfolios and the impact on capital structure.
Operational Assistance from Developed Countries
The local supervisors at the respective regulatory authorities will
require a fair amount of assistance ( in terms of technical assistance)
from developed countries.
Exchange programs will have to be established for regional sessions
to allow the supervisors to learn from each other and to strengthen
their collaboration.
Changes in Customer Expectations & Behaviour
The customers would more curious and demanding in the level of
Information, which is presently available in the public domain.
This is due that as they request for additional services from their
respective bank, the risk premium, which they have to pay for the
varied services will change.
Consequently, we will apply pressure on the banks to package the
interest paid collectively rather than paying for the individual risk.
As a result, the customers may consider the banker-customer
relationship, which they could have negotiated for the interest rates
in a different manner.
Political Support to Bring Change to the Banking System
With every new regulation, there will always a fair amount of “critique”
coming from the opponents.
Bank supervisors must ensure that all stakeholders are adequately
informed of the implications and results of the Basel II.
Otherwise, the Government may be subject to unnecessary pressure
to maintain the “status quo”.
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Participation
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