3. Basel 2
Pillar 1 Pillar 2 Pillar 3
Minimum Capital Supervisory Review Market Discipline
Requirement
Capital for Capital for Capital for
Credit Risk Market Risk Operational Risk
4. Definition of credit risk
• Credit risk is defined as the possibility of losses
associated with diminution in the credit quality of
borrowers or counterparties.
In a bank’s portfolio, losses stem from outright
default due to inability or unwillingness of a
customer or counterparty to meet commitments in
relation to lending, trading, settlement and other
financial transactions.
Alternatively, losses result from reduction in
portfolio value arising from actual or perceived
deterioration in credit quality.
5. Manifestation of credit risk
• Direct lending: principal/and or interest amount may not be
repaid;
• Guarantees or Letters of credit: funds may not be
forthcoming from the constituents upon crystallization of the
liability;
• Treasury operations: the payment or series of payments due
from the counter parties under the respective contracts may
not be forthcoming or ceases;
• Securities trading businesses: funds/ securities settlement
may not be effected;
• Cross-border exposure: the availability and free transfer of
foreign currency funds may either cease or restrictions may be
imposed by the sovereign.
6. Need for Basel 2
Basel 1
• Not risk sensitive
• Broad Brush Approach
• Lack of flexibility & incentives for better risk
management
• No incentives for credit risk mitigation techniques
Thus Basel I uses arbitrary risk categories and arbitrary risk weights
having no relation to default rates. All assets are considered within
one category as equally risky
Basel 2
• More risk sensitive
• Provides a range of options for estimating regulatory
capital for credit risk
• Provides incentives to improved credit risk management
7. Approaches for computing
Capital charge for
Credit Risk
Standardised Approach Internal Ratings Based
(Option 1) Approach
Foundation IRB Advanced IRB
Approach Approach
(Option 2) (Option 3)
8. Transition
• Standardised Approach – by end December 2006
Year end Dec 05 Dec 06 Dec 07 Dec 08
FIRB Parallel 95% 90% 80%
AIRB Parallel/ Parallel 90% 80%
impact
• Capital floor, as above, will apply to banks adopting
IRB Approaches up to year ending December 2008
9. Standardised Approach
• Based on the risk weighted assets method followed
under Basel 1 where risk weights are linked to external
ratings of counter-party
• Sovereign, banks, PSUs, corporate
Risk weight linked to external rating of the counter-party (0 to
150% RW)
Better the credit rating, lesser the risk weight
Unrated exposures attract 100% RW
Ratings below threshold levels attract 150% RW
• Portfolio approach adopted for following exposures
Regulatory retail (75% RW)
Residential mortgage (35% RW)
Commercial real estate (100% RW)
NPAs (100 or 150% RW)
• Maximum risk weight is 350%
10. Standardised Approach (2)
• Sovereigns
Range - 0, 20, 50, 100, 150 (UR – 100)
National discretion for exposure to sovereign of incorporation
National discretion to keep claims on certain domestic PSUs on
par with claims on sovereign
• Banks & PSUs
Two options
Linked to rating of the sovereign
(Range – 20, 50, 100, 150 (UR – 100)
Rating of the bank; with lower RW for exposures of 3 months
or less (Range – 20, 50, 100, 150 (UR – 50)
• Corporates
Range - 20, 50, 100, 150 (UR – 100)
National discretion to increase RW for unrated claims > 100 in
countries where corp. NPA level is high
NPAs (> 90 days) – 150 %
11. Standardised Approach (3)
• Retail (75%) – qualification
Orientation – exposures to individuals or small
business
Product criterion – specified types of financial
assistance (including non fund based)
Granularity criterion – Aggregate exposure to one
counter-party to be within 0.2% of overall retail
portfolio
Absolute threshold – Not to exceed Euro 1 million
• Residential Property (35%)
Residential property – self occupied or rented
Existence of substantial margin based on strict
valuation norms
• Commercial real estate (100%)
Mortgage of office or multi purpose commercial
premises
12. Standardised Approach (4)
• Unsecured portion of NPAs net of specific provisions
150% RW if specific provisions are less than 20% of the
outstanding loan amount
100% RW if specific provisions are no less than 20% of the
outstanding loan amount
100% RW if specific provisions are no less than 50% of the
outstanding loan amount, but can be reduced to 50% RW
at the discretion of the supervisor
• Higher risk categories – 150 % or more RW
13. Standardised Approach – Sources
of impact
• Higher RW on sovereigns as per ratings other than country of
incorporation (<=20% at present)
• Higher RW on banks as per ratings (20% at present)
• Benefit of lower RW for corporates limited – since majority
are unrated
• Benefits of lower risk weights for residential mortgages &
retail sector
• Higher RW on unsecured, unprovided NPA of > 90 days
• Higher RW for high risk ventures (150)
• Operational risk
14. Credit Risk Mitigation
• Simple Approach
As in 1988 Accord substitutes the risk weight of
the collateral for the risk weight of the counter
party
Eligible collaterals
Cash, Deposit with lending banks, CDs
issued by lending banks
Gold
Debt securities meeting criteria
Equities included in a main index
Units meeting criteria
15. Credit Risk Mitigation (2)
• Comprehensive Approach
Allows a fuller offset of collateral against exposures
Eligible collaterals
All included under simple approach
Other listed equities
Other Units which include above equities
• Collateral valuation as prescribed
• Eligibility as per qualifying standards
Legal certainty
No material positive correlation
Clear & robust procedures for liquidation of collateral
• On balance sheet netting (margin money, deposits)
• Guarantees and credit derivatives
16. IRB Approaches
Foundation Approach
PD * LGD * EAD
PD by the bank (minimum requirements)
LGD & EAD by the Regulator (rules)
Advanced Approach
PD * LGD * EAD
All three by the bank
To be validated by the regulator
General provisions/ general loan loss reserves not eligible
for capital status
If EL is more than provisions held, difference should be
deducted from capital funds
Maximum risk weight 1250%
17. IRB Approaches – Minimum
requirements
• Banks need supervisory approval to use IRB approaches
• To be met at the outset and on an on-going basis
• Separate treatment for different Asset classes
• Credit risk management practices must be consistent with the
evolving sound practice guidelines issued by the BCBS and
supervisors
• Internal rating system should meet minimum requirements
• Objectives which the qualifying bank’s risk rating systems must
satisfy
Focus will be on the bank’s abilities to rank order and quantify
risk in a consistent, reliable and valid fashion
Systems and processes must be consistent with internal use
of the risk estimates
• Have in place sound back testing/ stress testing processes
• Disclosure requirements under Pillar 3
18. IRB Approaches – phased roll-out
• Phasing out permitted as under:
Adoption across asset classes within the business unit
Adoption across business units in the same banking group
Move from FIRB to AIRB for some risk components
• Realistic implementation plan to be settled with the
supervisor
• Once IRB approach is adopted, it should be continued to
be employed and no reversal without the approval of the
supervisor
19. IRB Approaches – phased roll-out (2)
Year end Dec 05 Dec 06 Dec 07 Dec 08
FIRB Parallel 95% 90% 80%
AIRB Parallel/ Parallel 90% 80%
• Parallel calculation AIRB Parallel/
impact
Parallel 90%
• Corporate, sovereign, bank & retail exposures
Banks must have used a rating system broadly in line with the
minimum requirements for at least three years prior to qualification
Data to estimate PD for five years for C,S & B
Data to estimate PD & LGD for five years for RE
LGD for RE not less than 10%
Mapping of internal ratings to supervisory risk category for SL
• Similar transition allowed for PD/ LGD for equity exposures
• Must have at least two years of data at the time of
implementation and will increase by one year with each of
the three years of transition
20. Basel 2 – Likely impact
QIS 3 results of Non-G 10 Countries
• The Sample for QIS of the above countries was
- 111 banks from 18 countries on Standardized Approach
- 25 banks from 6 countries on FIRB, and
- 9 banks from 3 countries on AIRB
• SA: An average increase in RWA at 13%. This reflects impact of
the new operational risk charge (+11%) plus a credit risk
contribution (+2%)
• FIRB : An average increase in RWA under the FIRB at 4%. This
reflects impact of the new operational risk charge of (+) 7% and a
credit risk contribution (-) 3%
• AIRB (For G-10 countries): An average decrease in RWA under the
AIRB at (-) 2%. This reflects impact of the new operational risk
charge (+) 11% and a credit risk contribution (-) 13%
21. Pillar 1 – Implementation Strategies –
Advanced approaches
• Many banks have recently adopted internal rating systems.
They are in the process of building up data banks and in due
course will have data on default probabilities, rating migration,
LGD etc.
• Acceptable PD history on rating scales
• Asset classes & Business line definition & reporting within
banks
• Validation of internal rating systems/ models
• Cost of implementation – a relevant factor
• Desirability of having some banks on SA and others on IRB
• Home and Host supervisor issues
• Pro-cyclicality – how to address
• Evolution of LGD by RBI
• Upgradation of supervisory skills
23. External Ratings
• Ratings of recognised rating agencies
• Disclose the chosen rating agencies
• Consistent use of ratings by chosen agencies
• Cherry picking of ratings not permitted
If two ratings: higher of the two
If more than two ratings: higher of the lowest two
• Issue rating Vs issuer rating – general principles
• Domestic currency rating Vs foreign currency rating
24. Asset Classes
• Corporate (5) • Sovereign
Project finance • Bank
Object finance • Retail (3) – managed as a
pool; Exposures to
Commodities finance
individuals
Income producing real Exposures secured
estate by residential
High-volatility properties
commercial real estate Qualifying revolving
retail exposures
All other retail
• Equity
Key elements for each asset class
• Risk components – estimates of risk parameters
• Risk weight functions – means by which risk components are transformed
to RWAs
• Minimum requirements – the minimum standards that must be met by the
bank for using IRB Approach for a given asset class
25. IRB Approaches – Rating system design
• Two separate and distinct dimensions –
Risk of borrower default
Transaction specific factors
• At least Seven grades for non-default borrowers and one for default
category
• Significant concentration in one grade/ grades must be supported by
convincing empirical evidence
• Separate PDs for each grade
• Banks using AIRB approach should have sufficient number of facility
grades to avoid grouping facilities with widely varying LGDs into a
single grade.
• These banks should have facility-wise LGD
• The minimum requirements are broadly classified in the following sub
systems:
Rating dimensions
Rating structure
Rating criteria
Rating assignment horizon
Use of models
Documentation of rating system design
