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Overview of Basel II
   - Why, What, How and When -

SAARCFINANCE Seminar on Basel II
  Implementation in South Asia
                   Islamabad, Pakistan
                       26 June 2008


                            Jason George
Financial Staiblilty Institute / Bank for International Settlements
        Representative Office for Asia and the Pacific
                          Hong Kong SAR
Agenda

 Introduction and background (why?)
 Main elements of Basel II (what?)
 Building the road to Basel II implementation (how?)
 Basel II implementation in Asia…and elsewhere (when?)
 Basel II and the current market turmoil


“Basel II introduces a far more comprehensive framework for
regulatory capital and risk management than we have ever
known”
        Former Basel Committee Chairman Jaime Caruana
        11 May 2004

                                                              2
Capital Adequacy

Supervisors must set prudent and appropriate minimum
capital adequacy requirements for banks that reflect the risks
that the bank undertakes, and must define the components of
capital, bearing in mind its ability to absorb losses. At least for
internationally active banks, these requirements must not be
less than those established in the applicable Basel
requirement.


Core Principle 6, Core Principles for Effective Banking
Supervision, October 2006


                                                                      3
The Case for a Capital Framework
 Financial instability is costly to the economy, such as…
    – Disruption in the distribution of funds
    – Breakdown in the payment systems
    – Possibility of international contagion
 Therefore, the need for supervision and capital regulation
    – But the objective should not be to assure that banks
      will never fail
 Capital regulation can have competitive implications
    – The need to have internationally harmonised rules for
      internationally active banks competing with each other
    – International versus domestic banks
                                                               4
Benefits of Basel I … and Some Issues

 Created an internationally       Capital requirements not
   recognised standard              always reflective of economic
     – Adopted world-wide           risk
 Contributed to financial         Does not address innovation
   stability                        in risk measurement and
     – Reversed a downward
                                    management practices
       trend in international        – Arbitrage opportunities (eg
       banks‟ capital levels           through securitisation)
     – Promoted level playing   •   Little recognition of credit risk
       field among                  mitigants
       internationally-active
       banks                       “OECD Club-Rule”
 Relatively simple
                                                                        5
Objectives of Basel II

  Greater use of the roles played by bank management
   (pillars 1 and 2) and the market (pillar 3)
  Better align regulatory capital to underlying risk (economic
   capital)
  Encourage banks to improve risk management capabilities
  Comprehensive coverage of risks
    – Pillar 1: credit, market and operational risk
    – Pillar 2: all other risks, aspects of pillar 1 risks not
        captured in pillar 1, and external factors
  Applicability to a wider range of banks and systems
   (menu of options)
                                                              6
Basel II: The Three Pillars

                       Three
                       pillars
                      approach


  Minimum
                     Supervisory
   capital                             Market discipline
                   review process
requirements

   Perfect rules are not feasible
   - no perfect measurement system
   - difficult balance between accuracy and simplicity

                                                           7
Basel II: The Three Pillars Plus…
                                                                              Three
                                                                            Basic Pillars


                                                                          Minimum capital       Supervisory review           Market
                                                                           requirements             process                 discipline


                                            Risk weighted                                                        Definition of
                                               assets                                                              capital


         Credit risk                         Operational                               Market               Core        Supplementary
                                                risk                                    risks              Capital         Capital


Standardised       Internal       Basic     Standardised     Advanced      Standardised          Models
  Approach      Ratings-based   Indicator    Approach       Measurement      Approach           Approach
                  Approach      Approach                    Approaches


                                                                                                                                         8
Relationship of the Three Pillars
  Pillar 1: A quantitative approach to minimum capital
   requirements
  Pillar 2: Banks should have a process for assessing their
   overall capital adequacy; supervisors will review this
   process and require additional capital if necessary
  Pillar 3: Market participants should have better access to
   information regarding the credit standing of banks (ie
   enhanced disclosure)

  All three pillars are mutually reinforcing




                                                                9
Potential Implications of Basel II
 Major improvement in capital regulation
   – Intended to enhance safety and soundness of the banking
     system
   – Implementation poses significant challenges
 Capital requirements more aligned to underlying risks
   – Less incentives for regulatory arbitrage
   – Transactions likely to be motivated more by funding and
     credit risk management needs
   – Better risk management and pricing by institutions
   – More efficient allocation of capital


                                                               10
Agenda

 Introduction and background (why?)
 Main elements of Basel II (what?)
 Building the road to Basel II implementation (how?)
 Basel II implementation in Asia…and elsewhere (when?)
 Basel II and the current market turmoil




                                                          11
Main elements of Basel II

 Based on three pillars
 Revised capital requirements for credit risk, new ones for
   operational risk, and hardly changed ones for market risks
   (1996 amendment)
 Menu of approaches for the measurement of risks
 More recognition of drivers of credit risk




                                                                12
Basel II: The three pillars

                        Three
                        pillars
                       approach

    Minimum
                       Supervisory
     capital                          Market discipline
                     review process
  requirements

• Credit risk        • Bank ICAAP      • Enhanced
                                         disclosure
• Operational risk   • Supervisory
                       review
• Market risk
                                                          13
Capital requirements for credit risk

 Several approaches to choose from
   – Standardised approach (SA)
   – Foundation internal ratings-based approach (FIRB)
   – Advanced internal ratings-based approach (AIRB)




                                                         14
Credit risk: Standardised approach

 Main characteristics
   – Closest to 1988 Capital Accord
   – OECD/non-OECD distinction for claims on sovereigns
     replaced
   – Riskiness determined by external credit assessments
   – Lower risk weights for claims on retail and residential
     mortgages
   – Significantly more recognition of credit risk mitigation
     techniques


                                                                15
Credit risk: Standardised approach
                 Claim                                               Assessment
                                                AAA -                BBB+ -
                                                          A + - A-               BB+ - B-      Below B-      Unrated
                                                 AA-                  BBB-

             Sovereigns                          0%         20%       50%        100%          150%
                                                                                                             100%
             (Export credit agencies)           (0-1)       (2)       (3)         (4-6)         (7)

                                         1
                              Option 1          20%         50%      100%        100%          150%          100%
             Banks
                                         2      20%          50%      50%        100%          150%           50%
                              Option 2               3           3         3           3             3             3
                                               (20%)       (20%)     (20%)       (50%)        (150%)         (20%)
                                                                               BB+ - BB-      Below BB-
             Corporates                         20%         50%      100%                                    100%
                                                                                100%           150%
                              Mortgages                                                                       35%
             Retail
                              Other retail                                                                    75%
 Area of
 national    1        Risk weighting based on risk weights of sovereign in which the bank is incorporated, but one
discretion            category less favourable.
             2        Risk weighting based on the assessment of the individual bank.
             3        Claims on banks of an original maturity of less than three months generally receive a weighting
                      that is one category more favourable than the usual risk weight on the bank‟s claim.

                                                                                                                        16
Credit risk: IRB approach

Basic principles
 Relies on a bank„s internal ratings system
 Based on three main elements
    – Risk components (e.g. PD, LGD, EAD)
    – Risk weight functions
    – Minimum requirements
 Separate approaches for each portfolio of assets
 Subject to supervisory validation and approval




                                                     17
Credit risk: IRB approach risk weights
              200%

              180%

              160%

              140%

              120%
Risk weight




              100%

              80%

              60%

              40%

              20%

               0%
                     0%   1%      2%    3%   4%        5%         6%   7%   8%        9%   10%
                                              Probability of defailt


                           Corporates               SME 5mn                  Retail


                                                                                                 18
Operational risk: Definition

 Risk of loss resulting from:
  Inadequate or failed

     – Internal processes
     – People
     – Systems
  Or from external events      Includes, but not limited to,
                                exposure to fines,
  Includes legal risk          penalties, or punitive
                                damages resulting from
  Excludes strategic and       supervisory actions, as
    reputational risk           well as private settlements



                                                         19
Operational risk: It is not new …. however,
 New complex financial products and strategies

 Growing reliance on automated technology

 Cost reduction strategies

 Mergers

 Migration to outsourcing


          Banks are increasing their
          operational risk exposure

                                                  20
Operational risk: Pillar 1 approaches

 Choice of three approaches…
   – Basic indicator (15% of average gross income over 3
     years)
   – Standardised approach (based on separate scaling
     factors for gross income from defined business lines
     between 12% and 18% gross income)
   – Range of advanced methods based on loss
     experience, subject to additional risk control criteria




                                                               21
Pillar 2 – Supervisory review process

• The three pillars together are intended to achieve a level
  of capital commensurate with a bank„s overall risk profile
• Pillar 2 is based on four key principles:
    – Banks„ own assessment of capital adequacy
    – Supervisors„ review of banks„ capital adequacy
      assessment
    – Capital above regulatory minimums
    – Supervisory intervention


 Foundation = existing supervisory guidance, especially
   Core Principles for Effective Banking Supervision
                                                               22
Rationale for Pillar 2

 Encourage banks to utilise better risk management
   techniques


 Ensure banks have adequate capital to support all risks


 Focus on internal, not regulatory, capital


 Accommodate differences between banks




                                                            23
Capital above regulatory minimums

 Pillar 1 requirements include a buffer for uncertainties that
   affect the banking population as a whole


 All banks are expected to operate ABOVE the minimum
   requirement (i.e. not just at 8%!)


 Supervisors will need to consider whether the particular
   features of their banks/markets are adequately covered




                                                                  24
Pillar 3 – Market Discipline

 Disclosure requirements allow market participants to
   assess key information relating to:
    – Scope of application
    – Capital
    – Risk exposures
    – Risk assessment process
 Both quantitative and qualitative disclosures

 Some disclosures are required in order to use the more
   advanced Pillar 1 approaches


                                                           25
Pillar 3 – Market Discipline

 Particularly relevant because internal methodologies allow
  banks discretion in assessing capital requirements
 Disclosures should be consistent with how management
  and the board assess and manage risks
 Pillar 3 disclosures based upon Basel II framework inform
  the market about a bank‟s exposure to risk in a consistent
  and understandable manner (ie enhanced comparability)




                                                               26
Pillar 3 - Achieving Appropriate Disclosures

 Supervisors have different powers available to achieve
  disclosure requirements
   – Disclosure on safety and soundness grounds
   – Disclosure of regulatory reports
 Mechanisms to enforce requirements
   – Moral suasion (to change behavior)
   – Enforcement actions
   – Financial penalties
 Nature of exact measures will depend upon legal powers
  of the supervisor and nature of any deficiency
 Refer to Basel Committee Disclosure Surveys

                                                           27
Agenda

 Introduction and background (why?)
 Main elements of Basel II (what?)
 Building the road to Basel II implementation (how?)
 Basel II implementation in Asia…and elsewhere (when?)
 Basel II and the current market turmoil


“The implementation of the Basel II framework provides an
opportunity for banks and supervisors to strengthen the
resilience of the banking system…”
        Basel Committee Chairman Nout Wellink
        4 March 2008

                                                            28
Building the Road to the Implementation of Basel II




                                                  29
Necessary Steps for Building a Road

1)   Assessing the current environment
2)   Making a plan:
      a) Where should the road lead to?
      b) What kind of road are we building?
3)   Setting up a project:
      a) What is the time schedule for building the road?
      b) What is required to build the road to Basel II?
4)   Testing (and, if need be, improving) the foundation
5)   Constructing the road


                                                            30
Where Should the Road Lead To?

   Adequately capitalised banks
   A sounder and safer banking (and financial) system as a
    precondition for a stable economy and economic growth




                                                              31
Readiness on the Regulators’ Side
                                                 Basel II framework
   Control over        Risk                  Banks‟           Account-        On-site, off-
    bank‟s structure     management             internal          ing and          site
     –  Licensing        and capital            control and       disclosure       monitoring
     –  Ownership         – Provisioning        governance                        Remedial
     –  Activities,       – Large                                                  actions
        acquisitions         exposure                                             Consolidated
                          – Related party                                          supervision
                             exposure                                             Home-host
                          – Liquidity                                              cooperation

       Institutional setting of the supervisor
         –    Independence, governance, accountability, transparency
         –    Resources, legal power
       Preconditions
         –  Sound macro-economic policies
         –  Legal, accounting, auditing and payment systems
         –  Systemic protection
                                                                                          32
What Kind of Road are we Building?




                                     33
What Kind of Road are we Building?




                                     34
What Kind of Road are we Building?




The superhighway appears attractive, but traveling at
          high speeds brings great risks!!

                                                        35
What Kind of Road are we Building?

   Approaches for credit risk
     –   Simplified standardised approach
     –   Standardised approach
     –   Foundation internal ratings-based approach
     –   Advanced internal ratings-based approach
   Approach for operational risk
     –   Basic Indicator approach
     –   Standardised approach
     –   Alternative standardised approach
     –   Advanced measurement approaches
   There is not one way to implement Basel II



                                                      36
Big banks urge emerging              …but the IMF board
markets to move                      cautions against moving
quickly…                             too quickly…
 IIF Steering Committee on           IMF Executive Board (Nov
  Regulatory Capital (Nov              2005)
  2005)
  …member banks believe that,          (The Directors) urged staff to be
  as soon as reasonably                completely candid when asked to
  possible, they and their local       assess countries‟ readiness to
  jurisdictions should aim to take     move to Basel II and to indicate
  advantage of … the Internal          clearly the risks of moving too
                                       quickly and too ambitiously.
  Ratings Based (IRB)
  Approaches.


                                                                   37
Basel II Implementation…(when do we build the road?)

    When should Basel II be implemented?
       – Only national authorities can answer this question
       – Basel II may be a lesser priority compared to other efforts
    Depending on a bank„s business, the 1988 Accord may remain an
     alternative
       – But principles of Basel II are valuable for supervisors and
           banks in all markets
    In their assessments of a country‟s compliance with Core Principle
     6 the IMF and the World Bank will not assess compliance based on
     whether or not a country has implemented Basel II. (IMF staff note,
     23 April 2004)




                                                                  38
What is Required to Build the Basel II Road?

 Implementing Basel II is a major challenge for banks and
  supervisors
 Assessing resource and training needs
   – Human resources
   – Financial resources
   – Information systems
 Ongoing communication between supervisors and
  between supervisors and banks




                                                             39
Solid Foundation

 A solid foundation is essential for building a road
 Basel II requires an appropriate infrastructure
    – Otherwise there could be a false sense of financial
      stability
 Preconditions for Core Principles are fundamental
 Compliance with Core Principles is crucial
    – System of effective supervision must exist in a country
    – Sound accounting and provisioning standards




                                                                40
The Construction Process – Practical
Steps for Implementation
 Transform the framework into enforceable rules
 Implementation
    – Minimum capital ratio – is 8% enough (the speed limit)
    – Deciding on the use of national discretion
    – Accord Implementation Group
    – Determining the scope of application of Basel II
 Paper on “practical considerations” published in July 2004
    – Intended as a “roadmap” for implementation




                                                               41
Areas of National Discretion

 Recognises countries„ different realities
 Essential part to ensure that the implementation is to be a
   success
 Supervisors should develop policy decisions on the whole
   range of issues (Annex of “practical considerations paper“)
    – Draw upon domestic market practice and experience
    – Be consistent with the Basel II principles
 Share information with other supervisors




                                                                 42
Think About the Intersections




                                43
Think About the Intersections

 Cross-border implementation as a major issue
 Relationship between home and host supervisor
 Examples
   – HSBC has offices over 80 countries and jurisdictions
   – Citigroup has offices in approximately 90 countries and
     jurisdictions
   – Barclays has offices in over 60 countries




                                                               44
Agenda

 Introduction and background (why?)
 Main elements of Basel II (what?)
 Building the road to Basel II implementation (how?)
 Basel II implementation in Asia…and elsewhere (when?)
 Basel II and the current market turmoil


“This document is being circulated to supervisory authorities
worldwide with a view to encouraging them to consider
adopting this revised Framework at such time as they believe
is consistent with their broader supervisory priorities.”

        Basel II Framework, para 3
        June 2006                                               45
Basel II Implementation in Asia

Implementation status
                                    Credit Risk               Operational Risk

Australia                     SA: 01.01.2008                  BIA: 01.01.2008
                              FIRB: 01.01.2008                SA: 01.01.2008
                              AIRB: 01.01.2008                AMA: 01.01.2008
China                         SA: Not permitted               BIA: Undecided
                              FIRB: 31.12.2010/2013*          SA: Undecided
                              AIRB: 31.12.2010/2013*          AMA: Undecided
Hong Kong                     SA: 01.01.2007                  BIA: 01.01.2007
                              FIRB: 01.01.2007                SA: 01.01.2007
                              AIRB: 01.01.2008                AMA: Not permitted
* Only for internationally active banks; banks can implement IRB as early as 31.12.2010
  but must have implemented it by 31.12.2013.                                             46
Basel II Implementation in Asia

Implementation status
                                   Credit Risk               Operational Risk

India                        SA: 31.03.2008/2009*          BIA: 31.03.2008/2009*
                             FIRB: Undecided               SA: Undecided
                             AIRB: Undecided               AMA: Undecided
Japan                        SA: 01.04.2007                BIA: 01.04.2007
                             FIRB: 01.04.2007              SA: 01.04.2007
                             AIRB: 01.04.2008              AMA: 01.04.2008
Korea                        SA: 01.01.2008                BIA: 01.01.2008
                             FIRB: 01.01.2008              SA: 01.01.2008
                             AIRB: 01.01.2009              AMA: 01.01.2009
* 31.03.2008 for Indian banks having foreign presence and foreign banks operating in
  India; 31.03.2009 for all other domestic banks.                                      47
Basel II Implementation in Asia

Implementation status
                                    Credit Risk               Operational Risk

Malaysia                      SA: 01.01.2008                 BIA: 01.01.2008/2010*
                              FIRB: 01.01.2010               SA: 01.01.2008/2010*
                              AIRB: 01.01.2010               AMA: Undecided
Singapore                     SA: 01.01.2008                 BIA: 01.01.2008
                              FIRB: 01.01.2008               SA: 01.01.2008
                              AIRB: 01.01.2008               AMA: 01.01.2008
Thailand                      SA: 31.12.2008                 BIA: 31.12.2008
                              FIRB: 31.12.2008               SA: 31.12.2008
                              AIRB: 31.12.2009               AMA: Not permitted
* 01.01.2008 for Malaysian banks that are adopting the SA for credit risk; 01.01.2010 for
  banks that are adopting an IRB approach for credit risk.                                  48
Basel II Implementation - Other Regions

Implementation status
                                     Credit Risk                Operational Risk

 Basel Committee               SA: 01.01.2007                 BIA: 01.01.2007
 (ex US and Japan)             FIRB: 01.01.2007               SA: 01.01.2007
                               AIRB: 01.01.2008               AMA: 01.01.2008
 United States                  Currently only applies to the 10-15 largest
                                   banks (core banks)*
                                Only advanced approaches permitted
                                Parallel run to begin 2009(?); minimum four
                                   quarters of testing, followed by a …
                                Three year transitional period (capital floors)
                                01.10.2008 implementation plan adoption
* US regulators will publish rules permitting the use of standardised approach for non-core banks
                                                                                                    49
Basel II Implementation in Asia

Implementation challenges
 Supervisory infrastructure (laws, regulations, accounting
   standards, supervisory guidance, Core Principles, etc)
 Pillar 2
    – Banks: developing a robust ICAAP
    – Supervisors: understanding how to assess an ICAAP
      and developing appropriate & proportionate responses
 Common reporting framework (eg Pillar 3)
 Data
 Resources and training


                                                              50
Agenda

 Introduction and background (why?)
 Main elements of Basel II (what?)
 Building the road to Basel II implementation (how?)
 Basel II implementation in Asia…and elsewhere (when?)
 Basel II and the current market turmoil


“The new framework is designed to evolve over time and
adapt to innovations in banking and financial markets…”
        Federal Reserve Board Chairman Ben Bernanke
        2 November 2007


                                                          51
Basel II and the Current Market Turmoil

 The build-up to, and unfolding of the financial turmoil took
  place in a Basel I environment
   – Lack of risk sensitivity
   – Inflexibility to rapid innovation
   – Perverse incentives to move exposures off the balance
     sheet
   – Failure to fully capture important elements of a bank‟s
     risk exposures
 Basel II needs timely implementation
   – The starting point for improving capital adequacy in
     banks is the timely implementation of Basel II

                                                                 52
Basel II and the Current Market Turmoil

Pillar 1 (minimum capital requirements)
 The Basel Committee will revise Basel II to…
    – Establish higher capital requirements for complex
      structured products
       • These have produced a majority of the losses
    – Strengthen the capital treatment of liquidity facilities
      extended to support off-balance sheet vehicles (2008)
    – Strengthen the capital requirements in the trading book
        • Trading assets, especially complex, less liquid
          products, have increased significantly


                                                                 53
Basel II and the Current Market Turmoil

Pillar 2 (risk management practices)
 The market turmoil has revealed significant risk
   management weaknesses in financial institutions
 Pillar 2 provides supervisors with tools to assess risk
   management and internal capital management processes
 The Basel Committee will issue Pillar 2 guidance to help
   strengthen risk management and supervisory processes
    – Management of firm-wide risks
    – Stress testing practices and capital planning processes
    – Management of off-balance sheet exposures
    – Supervisory assessment of valuation practices
                                                                54
Basel II and the Current Market Turmoil

Pillar 3 (disclosure practices)
 Weaknesses in bank transparency for complex products
   contributed to the build-up of concentrations in illiquid
   structured credit products
 Enhanced disclosures relating to (2009)…
    – Complex securitisation exposures
    – ABCP conduits
    – Sponsorship of off-balance sheet vehicles (eg SIVs)
Other
 The Basel Committee will assess the level and cyclicality
   of capital requirements over time (2008)
                                                               55
Overview of Basel II
- Why, What, How and When -


               Jason George
        Financial Stability Institute
     Bank for International Settlements
Representative Office for Asia and the Pacific
              Hong Kong SAR

           jason.george@bis.org
              (852) 2878 7109

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1 basel ii overview - islamabad

  • 1. Overview of Basel II - Why, What, How and When - SAARCFINANCE Seminar on Basel II Implementation in South Asia Islamabad, Pakistan 26 June 2008 Jason George Financial Staiblilty Institute / Bank for International Settlements Representative Office for Asia and the Pacific Hong Kong SAR
  • 2. Agenda  Introduction and background (why?)  Main elements of Basel II (what?)  Building the road to Basel II implementation (how?)  Basel II implementation in Asia…and elsewhere (when?)  Basel II and the current market turmoil “Basel II introduces a far more comprehensive framework for regulatory capital and risk management than we have ever known” Former Basel Committee Chairman Jaime Caruana 11 May 2004 2
  • 3. Capital Adequacy Supervisors must set prudent and appropriate minimum capital adequacy requirements for banks that reflect the risks that the bank undertakes, and must define the components of capital, bearing in mind its ability to absorb losses. At least for internationally active banks, these requirements must not be less than those established in the applicable Basel requirement. Core Principle 6, Core Principles for Effective Banking Supervision, October 2006 3
  • 4. The Case for a Capital Framework  Financial instability is costly to the economy, such as… – Disruption in the distribution of funds – Breakdown in the payment systems – Possibility of international contagion  Therefore, the need for supervision and capital regulation – But the objective should not be to assure that banks will never fail  Capital regulation can have competitive implications – The need to have internationally harmonised rules for internationally active banks competing with each other – International versus domestic banks 4
  • 5. Benefits of Basel I … and Some Issues  Created an internationally  Capital requirements not recognised standard always reflective of economic – Adopted world-wide risk  Contributed to financial  Does not address innovation stability in risk measurement and – Reversed a downward management practices trend in international – Arbitrage opportunities (eg banks‟ capital levels through securitisation) – Promoted level playing • Little recognition of credit risk field among mitigants internationally-active banks  “OECD Club-Rule”  Relatively simple 5
  • 6. Objectives of Basel II  Greater use of the roles played by bank management (pillars 1 and 2) and the market (pillar 3)  Better align regulatory capital to underlying risk (economic capital)  Encourage banks to improve risk management capabilities  Comprehensive coverage of risks – Pillar 1: credit, market and operational risk – Pillar 2: all other risks, aspects of pillar 1 risks not captured in pillar 1, and external factors  Applicability to a wider range of banks and systems (menu of options) 6
  • 7. Basel II: The Three Pillars Three pillars approach Minimum Supervisory capital Market discipline review process requirements Perfect rules are not feasible - no perfect measurement system - difficult balance between accuracy and simplicity 7
  • 8. Basel II: The Three Pillars Plus… Three Basic Pillars Minimum capital Supervisory review Market requirements process discipline Risk weighted Definition of assets capital Credit risk Operational Market Core Supplementary risk risks Capital Capital Standardised Internal Basic Standardised Advanced Standardised Models Approach Ratings-based Indicator Approach Measurement Approach Approach Approach Approach Approaches 8
  • 9. Relationship of the Three Pillars  Pillar 1: A quantitative approach to minimum capital requirements  Pillar 2: Banks should have a process for assessing their overall capital adequacy; supervisors will review this process and require additional capital if necessary  Pillar 3: Market participants should have better access to information regarding the credit standing of banks (ie enhanced disclosure)  All three pillars are mutually reinforcing 9
  • 10. Potential Implications of Basel II  Major improvement in capital regulation – Intended to enhance safety and soundness of the banking system – Implementation poses significant challenges  Capital requirements more aligned to underlying risks – Less incentives for regulatory arbitrage – Transactions likely to be motivated more by funding and credit risk management needs – Better risk management and pricing by institutions – More efficient allocation of capital 10
  • 11. Agenda  Introduction and background (why?)  Main elements of Basel II (what?)  Building the road to Basel II implementation (how?)  Basel II implementation in Asia…and elsewhere (when?)  Basel II and the current market turmoil 11
  • 12. Main elements of Basel II  Based on three pillars  Revised capital requirements for credit risk, new ones for operational risk, and hardly changed ones for market risks (1996 amendment)  Menu of approaches for the measurement of risks  More recognition of drivers of credit risk 12
  • 13. Basel II: The three pillars Three pillars approach Minimum Supervisory capital Market discipline review process requirements • Credit risk • Bank ICAAP • Enhanced disclosure • Operational risk • Supervisory review • Market risk 13
  • 14. Capital requirements for credit risk  Several approaches to choose from – Standardised approach (SA) – Foundation internal ratings-based approach (FIRB) – Advanced internal ratings-based approach (AIRB) 14
  • 15. Credit risk: Standardised approach  Main characteristics – Closest to 1988 Capital Accord – OECD/non-OECD distinction for claims on sovereigns replaced – Riskiness determined by external credit assessments – Lower risk weights for claims on retail and residential mortgages – Significantly more recognition of credit risk mitigation techniques 15
  • 16. Credit risk: Standardised approach Claim Assessment AAA - BBB+ - A + - A- BB+ - B- Below B- Unrated AA- BBB- Sovereigns 0% 20% 50% 100% 150% 100% (Export credit agencies) (0-1) (2) (3) (4-6) (7) 1 Option 1 20% 50% 100% 100% 150% 100% Banks 2 20% 50% 50% 100% 150% 50% Option 2 3 3 3 3 3 3 (20%) (20%) (20%) (50%) (150%) (20%) BB+ - BB- Below BB- Corporates 20% 50% 100% 100% 100% 150% Mortgages 35% Retail Other retail 75% Area of national 1 Risk weighting based on risk weights of sovereign in which the bank is incorporated, but one discretion category less favourable. 2 Risk weighting based on the assessment of the individual bank. 3 Claims on banks of an original maturity of less than three months generally receive a weighting that is one category more favourable than the usual risk weight on the bank‟s claim. 16
  • 17. Credit risk: IRB approach Basic principles  Relies on a bank„s internal ratings system  Based on three main elements – Risk components (e.g. PD, LGD, EAD) – Risk weight functions – Minimum requirements  Separate approaches for each portfolio of assets  Subject to supervisory validation and approval 17
  • 18. Credit risk: IRB approach risk weights 200% 180% 160% 140% 120% Risk weight 100% 80% 60% 40% 20% 0% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Probability of defailt Corporates SME 5mn Retail 18
  • 19. Operational risk: Definition Risk of loss resulting from:  Inadequate or failed – Internal processes – People – Systems  Or from external events Includes, but not limited to, exposure to fines,  Includes legal risk penalties, or punitive damages resulting from  Excludes strategic and supervisory actions, as reputational risk well as private settlements 19
  • 20. Operational risk: It is not new …. however,  New complex financial products and strategies  Growing reliance on automated technology  Cost reduction strategies  Mergers  Migration to outsourcing Banks are increasing their operational risk exposure 20
  • 21. Operational risk: Pillar 1 approaches  Choice of three approaches… – Basic indicator (15% of average gross income over 3 years) – Standardised approach (based on separate scaling factors for gross income from defined business lines between 12% and 18% gross income) – Range of advanced methods based on loss experience, subject to additional risk control criteria 21
  • 22. Pillar 2 – Supervisory review process • The three pillars together are intended to achieve a level of capital commensurate with a bank„s overall risk profile • Pillar 2 is based on four key principles: – Banks„ own assessment of capital adequacy – Supervisors„ review of banks„ capital adequacy assessment – Capital above regulatory minimums – Supervisory intervention Foundation = existing supervisory guidance, especially Core Principles for Effective Banking Supervision 22
  • 23. Rationale for Pillar 2  Encourage banks to utilise better risk management techniques  Ensure banks have adequate capital to support all risks  Focus on internal, not regulatory, capital  Accommodate differences between banks 23
  • 24. Capital above regulatory minimums  Pillar 1 requirements include a buffer for uncertainties that affect the banking population as a whole  All banks are expected to operate ABOVE the minimum requirement (i.e. not just at 8%!)  Supervisors will need to consider whether the particular features of their banks/markets are adequately covered 24
  • 25. Pillar 3 – Market Discipline  Disclosure requirements allow market participants to assess key information relating to: – Scope of application – Capital – Risk exposures – Risk assessment process  Both quantitative and qualitative disclosures  Some disclosures are required in order to use the more advanced Pillar 1 approaches 25
  • 26. Pillar 3 – Market Discipline  Particularly relevant because internal methodologies allow banks discretion in assessing capital requirements  Disclosures should be consistent with how management and the board assess and manage risks  Pillar 3 disclosures based upon Basel II framework inform the market about a bank‟s exposure to risk in a consistent and understandable manner (ie enhanced comparability) 26
  • 27. Pillar 3 - Achieving Appropriate Disclosures  Supervisors have different powers available to achieve disclosure requirements – Disclosure on safety and soundness grounds – Disclosure of regulatory reports  Mechanisms to enforce requirements – Moral suasion (to change behavior) – Enforcement actions – Financial penalties  Nature of exact measures will depend upon legal powers of the supervisor and nature of any deficiency  Refer to Basel Committee Disclosure Surveys 27
  • 28. Agenda  Introduction and background (why?)  Main elements of Basel II (what?)  Building the road to Basel II implementation (how?)  Basel II implementation in Asia…and elsewhere (when?)  Basel II and the current market turmoil “The implementation of the Basel II framework provides an opportunity for banks and supervisors to strengthen the resilience of the banking system…” Basel Committee Chairman Nout Wellink 4 March 2008 28
  • 29. Building the Road to the Implementation of Basel II 29
  • 30. Necessary Steps for Building a Road 1) Assessing the current environment 2) Making a plan: a) Where should the road lead to? b) What kind of road are we building? 3) Setting up a project: a) What is the time schedule for building the road? b) What is required to build the road to Basel II? 4) Testing (and, if need be, improving) the foundation 5) Constructing the road 30
  • 31. Where Should the Road Lead To?  Adequately capitalised banks  A sounder and safer banking (and financial) system as a precondition for a stable economy and economic growth 31
  • 32. Readiness on the Regulators’ Side Basel II framework  Control over  Risk  Banks‟  Account-  On-site, off- bank‟s structure management internal ing and site – Licensing and capital control and disclosure monitoring – Ownership – Provisioning governance  Remedial – Activities, – Large actions acquisitions exposure  Consolidated – Related party supervision exposure  Home-host – Liquidity cooperation  Institutional setting of the supervisor – Independence, governance, accountability, transparency – Resources, legal power  Preconditions – Sound macro-economic policies – Legal, accounting, auditing and payment systems – Systemic protection 32
  • 33. What Kind of Road are we Building? 33
  • 34. What Kind of Road are we Building? 34
  • 35. What Kind of Road are we Building? The superhighway appears attractive, but traveling at high speeds brings great risks!! 35
  • 36. What Kind of Road are we Building?  Approaches for credit risk – Simplified standardised approach – Standardised approach – Foundation internal ratings-based approach – Advanced internal ratings-based approach  Approach for operational risk – Basic Indicator approach – Standardised approach – Alternative standardised approach – Advanced measurement approaches  There is not one way to implement Basel II 36
  • 37. Big banks urge emerging …but the IMF board markets to move cautions against moving quickly… too quickly…  IIF Steering Committee on  IMF Executive Board (Nov Regulatory Capital (Nov 2005) 2005) …member banks believe that, (The Directors) urged staff to be as soon as reasonably completely candid when asked to possible, they and their local assess countries‟ readiness to jurisdictions should aim to take move to Basel II and to indicate advantage of … the Internal clearly the risks of moving too quickly and too ambitiously. Ratings Based (IRB) Approaches. 37
  • 38. Basel II Implementation…(when do we build the road?)  When should Basel II be implemented? – Only national authorities can answer this question – Basel II may be a lesser priority compared to other efforts  Depending on a bank„s business, the 1988 Accord may remain an alternative – But principles of Basel II are valuable for supervisors and banks in all markets  In their assessments of a country‟s compliance with Core Principle 6 the IMF and the World Bank will not assess compliance based on whether or not a country has implemented Basel II. (IMF staff note, 23 April 2004) 38
  • 39. What is Required to Build the Basel II Road?  Implementing Basel II is a major challenge for banks and supervisors  Assessing resource and training needs – Human resources – Financial resources – Information systems  Ongoing communication between supervisors and between supervisors and banks 39
  • 40. Solid Foundation  A solid foundation is essential for building a road  Basel II requires an appropriate infrastructure – Otherwise there could be a false sense of financial stability  Preconditions for Core Principles are fundamental  Compliance with Core Principles is crucial – System of effective supervision must exist in a country – Sound accounting and provisioning standards 40
  • 41. The Construction Process – Practical Steps for Implementation  Transform the framework into enforceable rules  Implementation – Minimum capital ratio – is 8% enough (the speed limit) – Deciding on the use of national discretion – Accord Implementation Group – Determining the scope of application of Basel II  Paper on “practical considerations” published in July 2004 – Intended as a “roadmap” for implementation 41
  • 42. Areas of National Discretion  Recognises countries„ different realities  Essential part to ensure that the implementation is to be a success  Supervisors should develop policy decisions on the whole range of issues (Annex of “practical considerations paper“) – Draw upon domestic market practice and experience – Be consistent with the Basel II principles  Share information with other supervisors 42
  • 43. Think About the Intersections 43
  • 44. Think About the Intersections  Cross-border implementation as a major issue  Relationship between home and host supervisor  Examples – HSBC has offices over 80 countries and jurisdictions – Citigroup has offices in approximately 90 countries and jurisdictions – Barclays has offices in over 60 countries 44
  • 45. Agenda  Introduction and background (why?)  Main elements of Basel II (what?)  Building the road to Basel II implementation (how?)  Basel II implementation in Asia…and elsewhere (when?)  Basel II and the current market turmoil “This document is being circulated to supervisory authorities worldwide with a view to encouraging them to consider adopting this revised Framework at such time as they believe is consistent with their broader supervisory priorities.” Basel II Framework, para 3 June 2006 45
  • 46. Basel II Implementation in Asia Implementation status Credit Risk Operational Risk Australia SA: 01.01.2008 BIA: 01.01.2008 FIRB: 01.01.2008 SA: 01.01.2008 AIRB: 01.01.2008 AMA: 01.01.2008 China SA: Not permitted BIA: Undecided FIRB: 31.12.2010/2013* SA: Undecided AIRB: 31.12.2010/2013* AMA: Undecided Hong Kong SA: 01.01.2007 BIA: 01.01.2007 FIRB: 01.01.2007 SA: 01.01.2007 AIRB: 01.01.2008 AMA: Not permitted * Only for internationally active banks; banks can implement IRB as early as 31.12.2010 but must have implemented it by 31.12.2013. 46
  • 47. Basel II Implementation in Asia Implementation status Credit Risk Operational Risk India SA: 31.03.2008/2009* BIA: 31.03.2008/2009* FIRB: Undecided SA: Undecided AIRB: Undecided AMA: Undecided Japan SA: 01.04.2007 BIA: 01.04.2007 FIRB: 01.04.2007 SA: 01.04.2007 AIRB: 01.04.2008 AMA: 01.04.2008 Korea SA: 01.01.2008 BIA: 01.01.2008 FIRB: 01.01.2008 SA: 01.01.2008 AIRB: 01.01.2009 AMA: 01.01.2009 * 31.03.2008 for Indian banks having foreign presence and foreign banks operating in India; 31.03.2009 for all other domestic banks. 47
  • 48. Basel II Implementation in Asia Implementation status Credit Risk Operational Risk Malaysia SA: 01.01.2008 BIA: 01.01.2008/2010* FIRB: 01.01.2010 SA: 01.01.2008/2010* AIRB: 01.01.2010 AMA: Undecided Singapore SA: 01.01.2008 BIA: 01.01.2008 FIRB: 01.01.2008 SA: 01.01.2008 AIRB: 01.01.2008 AMA: 01.01.2008 Thailand SA: 31.12.2008 BIA: 31.12.2008 FIRB: 31.12.2008 SA: 31.12.2008 AIRB: 31.12.2009 AMA: Not permitted * 01.01.2008 for Malaysian banks that are adopting the SA for credit risk; 01.01.2010 for banks that are adopting an IRB approach for credit risk. 48
  • 49. Basel II Implementation - Other Regions Implementation status Credit Risk Operational Risk Basel Committee SA: 01.01.2007 BIA: 01.01.2007 (ex US and Japan) FIRB: 01.01.2007 SA: 01.01.2007 AIRB: 01.01.2008 AMA: 01.01.2008 United States  Currently only applies to the 10-15 largest banks (core banks)*  Only advanced approaches permitted  Parallel run to begin 2009(?); minimum four quarters of testing, followed by a …  Three year transitional period (capital floors)  01.10.2008 implementation plan adoption * US regulators will publish rules permitting the use of standardised approach for non-core banks 49
  • 50. Basel II Implementation in Asia Implementation challenges  Supervisory infrastructure (laws, regulations, accounting standards, supervisory guidance, Core Principles, etc)  Pillar 2 – Banks: developing a robust ICAAP – Supervisors: understanding how to assess an ICAAP and developing appropriate & proportionate responses  Common reporting framework (eg Pillar 3)  Data  Resources and training 50
  • 51. Agenda  Introduction and background (why?)  Main elements of Basel II (what?)  Building the road to Basel II implementation (how?)  Basel II implementation in Asia…and elsewhere (when?)  Basel II and the current market turmoil “The new framework is designed to evolve over time and adapt to innovations in banking and financial markets…” Federal Reserve Board Chairman Ben Bernanke 2 November 2007 51
  • 52. Basel II and the Current Market Turmoil  The build-up to, and unfolding of the financial turmoil took place in a Basel I environment – Lack of risk sensitivity – Inflexibility to rapid innovation – Perverse incentives to move exposures off the balance sheet – Failure to fully capture important elements of a bank‟s risk exposures  Basel II needs timely implementation – The starting point for improving capital adequacy in banks is the timely implementation of Basel II 52
  • 53. Basel II and the Current Market Turmoil Pillar 1 (minimum capital requirements)  The Basel Committee will revise Basel II to… – Establish higher capital requirements for complex structured products • These have produced a majority of the losses – Strengthen the capital treatment of liquidity facilities extended to support off-balance sheet vehicles (2008) – Strengthen the capital requirements in the trading book • Trading assets, especially complex, less liquid products, have increased significantly 53
  • 54. Basel II and the Current Market Turmoil Pillar 2 (risk management practices)  The market turmoil has revealed significant risk management weaknesses in financial institutions  Pillar 2 provides supervisors with tools to assess risk management and internal capital management processes  The Basel Committee will issue Pillar 2 guidance to help strengthen risk management and supervisory processes – Management of firm-wide risks – Stress testing practices and capital planning processes – Management of off-balance sheet exposures – Supervisory assessment of valuation practices 54
  • 55. Basel II and the Current Market Turmoil Pillar 3 (disclosure practices)  Weaknesses in bank transparency for complex products contributed to the build-up of concentrations in illiquid structured credit products  Enhanced disclosures relating to (2009)… – Complex securitisation exposures – ABCP conduits – Sponsorship of off-balance sheet vehicles (eg SIVs) Other  The Basel Committee will assess the level and cyclicality of capital requirements over time (2008) 55
  • 56. Overview of Basel II - Why, What, How and When - Jason George Financial Stability Institute Bank for International Settlements Representative Office for Asia and the Pacific Hong Kong SAR jason.george@bis.org (852) 2878 7109