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The Rules of Basel I - Essay Example

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The paper "The Rules of Basel I" discusses that the rules of Basel I for calculating risk-weighted assets are said not to reflect the actual economic risk of a transaction in its entirety, but only to a limited extent. Under Basel 1, corporate exposure with a high rating…
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The Rules of Basel I
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Order No. 123032 on Banking. BASEL II: The New Capital Adequacy Framework: An Assessment. Thomas Mathew The rules of Basel I for calculating risk weighted assets are said not to reflect the true economic risk of a transaction in its entirety, but only to a limited extent. Under the Basel 1, a corporate exposure with a high rating and low risk attracts the same credit risk weighting as a corporate exposure with a low rating and a high risk1. It is said that the arbitrary nature of both risk classes and corresponding risk weights prompted the Basel Committee to seek to replace the Basel 1 risk-based capital regime by one with greater differentiation and risk sensitivity. For this reason, the Basel Committee has proposed in the new Basel II Accord to base credit risk weightings either on a simple approach based on the ratings of external rating agencies or one of two approaches based on banks' own internal ratings. Not only the internal rating, but also the governance and the quality of risk management will be a major factor in being able to use internal ratings as a basis for calculating regulatory capital requirements. National supervisors will authorise firms to use one of the internal-ratings based approaches on a case by case basis. Basel II also introduces capital requirements for operational risk, a risk category that was not explicitly addressed under the Basel I rules. To a large extent, the proposed Basel II was in response to widespread criticism of Basel I. But it also reflected additional thought and analysis of the role of bank capital regulation. In particular, Basel II added two new "pillars" - supervisory review (pillar 2) and market discipline (pillar 3) - to the single pillar of minimum capital requirement of Basel I. In response to public comments, the Committee revised its proposal twice and issued a third consultative paper (CP3) in early 2003. If approved, the proposed standards are scheduled for implementation in most countries at the beginning of 2007. In preparation, in August 2003, U.S. regulators circulated an Advance Notice of Proposed Rulemaking (ANPR) for the application of Basel II to U.S. banks for public comment by the end of the year, and the major features have been incorporated by the European Union in a proposed revision of its Capital Adequacy Directive (CAD) for financial institutions, for approval by the European Parliament and the member national parliaments before adoption A key feature of the New Accord, as noted above, is that it is structured on the basis of three pillars: (1) Pillar 1. Minimum capital requirements for market credit and operational risk (2) Pillar 2. Supervisory review process and (3) Pillar 3. Market discipline These pillars are interlocking and mutually reinforcing. For example, the use of the more sophisticated approaches to credit or operational risk will bring additional disclosure requirements under Pillar 3, and will affect the nature of the supervisory review conducted under Pillar 2. Pillar 1 - Minimum capital requirements Under Basel II, the definition of regulatory capital as well as the minimum required ratio of 8% of risk-weighted assets remains substantially unchanged from the Basel I Accord2. The treatment of position risk arising from trading activities as set out in the 1996 Amendment of Basel I Accord also remains substantially un-changed, although significant changes are proposed to the treatment of counterparty credit risk that have been discussed in a joint working group established by the Basel Committee and the International Organisation of Securities Commissions (IOSCO). The principal modifications relate to the methodology for calculating risk-weighted assets categories, credit and operational risk. The minimum capital requirements and methods used to measure the risks faced by banks, as defined under Pillar 1 of the Basel II Ac-cord, are given in the paragraphs below. Credit Risk: Pillar 1 Three methods for calculating credit risk capital are offered. In order of increasing sophistication and risk sensitivity these are: the Standardised Approach; the Internal Ratings Based (IRB) Foundation Approach (FIRB); and the IRB Advanced Approach (AIRB). 0 Standardised Approach The Standardised Approach is similar to the Basel I approach where exposures are assigned to risk weight categories based on their characteristics. The main supervisory categories in the Standardised Approach are claims on sovereigns, banks, corporates, retail loans, residential real estate and commercial real estate. Each category has a fixed risk weight related to external credit assessments to provide an element of risk sensitivity. The individual borrower's quality is reflected by its external rating. If there is no external rating, the loan's risk is generally weighted with 100%3 (as under Basel I). In order to calculate the credit risk capital requirement, the loan amount is multiplied with the risk weight and the solvency coefficient of 8% (or whatever figure the supervisor deems appropriate under Pillar 2). The Committee has also enhanced the risk sensitivity of the Standardised Approach by a substantial revision of the approach to credit risk mitigation. The 1988 Accord only recognised cash and government securities as collateral that was capable of reducing risk and therefore of reducing (or eliminating) the capital charge. There has been a considerable expansion of the range of collateral, guarantees and credit derivatives that are eligible for risk mitigation purposes and thus capable of reducing the capital charge. The tables below (Table 1 and Table 2) contain an overview of the proposed new risk weights under the Standardised Approach: Table 1: Risk weights for Sovereigns and Banks Claim AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated Sovereign 0% 20% 50% 100% 150% 100% Bank Option 14 20% 50% 100% 100% 150% 100% Option 25 20% 50% 50% 100% 150% 50% Option 2 short term6 20% 20% 20% 50% 150% 20% Table 2: Risk weights for Corporates and real estate exposures Claim AAA to AA- A+ to A- BBB+ to BB- Below BB- Unrated Corporate 20% 50% 100% 150% 100% Regulatory Retail Portfolios 75% Residential Mortgages 35% Commercial Real Estate 100%. A 50% risk weighting may be applied at national discretion subject to a number of conditions on loan-to-value ratios and historical loss rates. The IRB (Internal Ratings based) Approach The two main principles behind the Internal Ratings Based (IRB) Approach are the usage of banks' own information about the credit quality of their assets and the promotion of best practices in risk measurement and risk management. This is in contrast to the current approach and the Standardised Approach under Basel II, which is entirely dependent on supervisory inputs to determine the capital requirement. Under the IRB Approach, banks must categorise banking book exposures into six broad classes of assets with different underlying risk characteristics. The main asset classes are corporate, sovereign, bank, retail and equity, with additional classes for securitization exposures and eligible purchased receivables. Within the corporate and the retail segment, further sub-classes are separately identified. For each of the asset classes there are three key elements to the requirements of the new Accord: 1 Risk components - internal or supervisory estimates of risk factors such as the probability of default (PD), loss given default (LGD), exposure at default (EAD), maturity (M) and size of the company (S) as expressed in terms of the company's annual turnover. Everything else being equal, higher values for PD, LGD, EAD, M and S lead to higher capital requirements (and vice versa). At the most advanced level, banks will calculate all of these elements. 2. Risk weight functions - the means by which the risk components for specific exposures are transformed into risk weighted assets. These are determined by super-visors and set out in the Accord. 3. Minimum requirements - the minimum qualitative requirements covering issues such as governance, independent review and data quality must be met in order to be able to apply the IRB Approach for a given asset class. Under the IRB Foundation Approach, banks supply their own PDs into the formulae for calculating risk weights. The history requirements for PD data are 5 years. Banks rely on supervisory estimates of LGD and EAD. The LGD parameters (and therefore capital requirements) can be reduced by mitigation with financial collateral and several types of physical collateral. The maturity (M) is set at 2, 5 years IRB Advanced Approach (AIRB) Under the IRB Advanced Approach, banks estimate PD, LGD, EAD and M internally. Estimation of these parameters is based on the banks' own data and is subject to strict qualifying criteria. The actual value of these parameters depends on the specific banks' practices for using risk mitigation and handling bad loans. Also, the absence of limitations regarding the use of any physical collateral to mitigate credit risk (and therefore to reduce capital requirements) is a notable development and a considerable inducement for banks to seek to use the Advanced Approach. The history requirements for LGD and EAD data are a minimum of 7 years. Because the AIRB is so dependent on the data, experience and systems of the individual bank, it is not possible to give a sensible estimate of the risk weights that would apply for any given probability of default. 1 IRB Approach for equity exposures Where banks have material holdings of equities in the banking book, specific capital requirements apply. Holdings are material if the aggregate value of equities in the banking book exceeds 10% of regulatory capital. A lower threshold of 5% applies if the portfolio contains fewer than 10 individual holdings A number of methods can be used. The simplest and crudest one assigns risk weights of 300% to publicly traded equities and 400% to all other equities. Alternatively, banks may use - or national supervisors may require - a VAR-type model to derive capital requirements, subject to a floor risk weight of 200% for publicly traded equities and 300% for other equities. As a final option, banks may use or supervisors may require the use of the same PD/LGD approach used for calculating capital requirements for corporate exposures. However, an LGD of 90% would be assumed, compared with a supervisory estimate of 45% for LGD on ordinary corporate lending exposures. 2 . Operational Risk Operational risk is defined as "the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events". This definition includes legal risk, but excludes strategic and reputational risk. Three methods for calculating operational risk capital are defined with increasing sophistication and risk sensitivity: (a) Basic Indicator Approach: The operational risk capital under the Basic Indication Approach is equal to a fixed percentage alpha (15%) of the three-year average gross income of the bank. 1 (b) Standardized Approach: Under the Standardised Approach, the banks' activities are divided into eight business lines (e.g. corporate finance, retail banking) and the operational risk capital is calculated separately for each business line. The operational risk capital for each business line is given by a business line specific fixed percentage beta (ranging between 12-18%) of the three-year average gross income of the respective business line7. The total operational risk capital for the bank is the sum of the operational risk capital across each business line. In order to qualify for use of the Standardized Approach, internationally active banks must satisfy certain minimum qualitative criteria set by the Committee regarding their operational risk framework. (c) Advanced Measurement Approaches (AMA): Under the Advanced Measurement Approaches (AMA), operational risk capital will be calculated using the banks' internal operational risk measurement system, provided that the system conforms to specific quantitative and qualitative criteria set by the Committee. The qualifying criteria state for example that a bank's internal measurement system must "reasonably estimate unexpected losses based on the combined use of internal and relevant external loss data, scenario analysis and bank-specific business environment and internal control factors". The banks' measurement system must also be capable of supporting an allocation of economic capital for operational risk across business lines in a manner that creates incentives to improve business line operational risk management. Pillar 2 - Supervisory review process Pillar 2 is aimed at ensuring "that banks have adequate capital to support all the risks in their business"8 determined both by pillar 1 and by supervisory evaluation of risks not explicitly captured in pillar 1, e.g., interest rate risk and credit concentration. . "Supervisors are expected to evaluate how well banks are assessing their capital needs relative to their risks and to intervene, where appropriate. This interaction is intended to foster an active dialogue between banks and supervisors such that when deficiencies are identified, prompt and decisive action can be taken to reduce risk or restore capital"9 There are two key elements to Pillar 2: a bank specific internal assessment and management of capital adequacy; and the supervisory review of this internal capital assessment and of the robustness of risk management processes, systems and controls. This supervisory responsibility is spelled out further in three of four key principles developed for supervisory review. Principle 2 of pillar 2 states that "supervisors should take appropriate supervisory action if they are not satisfied with"10 their review and evaluation of the adequacy of the banks' internal models. Moreover, principle 3 states that "supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum"11. Principle 4 states that "supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels... and should require rapid remedial action if capital is not maintained or restored"12 . But nowhere in the Consultative Document are supervisors granted the tools and authority to perform these functions. This makes it less likely that countries not currently granting regulators such powers will introduce them when adopting Basel II. In contrast, in the U.S., the FDIC Improvement Act (FDICIA) enacted in 1991, the same year as Basel I was implemented in the U.S., not only explicitly granted supervisors the authority to impose such sanctions on banks that failed to maintain minimum capital requirements but required the regulators to impose such sanctions when the capital ratios of banks declined below given threshold levels or the banks displayed other indications of financial troubles. The system of first discretionary and then mandatory regulatory sanctions in FDICIA is referred to as prompt corrective action (PCA). FDICIA specifies that both RBC and simple capital leverage ratios need to be considered and the bank regulators defined RBC in accord with Basel I. Banks have to satisfy all three capital measures specified. The mandatory sanctions were included to supplement the discretionary sanctions because the U.S. experience with the banking and thrift crises of the 1980s suggested that for a number of reasons regulators may not always intervene in troubled institutions in a forceful and timely fashion and instead delay or forbear to act. The structure of discretionary and mandatory sanctions included in PCA is designed to become progressively harsher and the mandatory sanctions progressively more important as the financial condition of a bank deteriorates and its capital ratios decline below the thresholds of each of the five capital tranches or tripwires. The mandatory sanctions are to protect against undue delay and forbearance by regulators in imposing discretionary sanctions The sanctions mimic those that the market typically imposes on unregulated firms facing similar financial difficulties. Shortly after a bank becomes "critically undercapitalized," which is currently defined as a 2 percent equity to asset ratio, the regulators are required to place the institution in receivership or conservatorship (legal closure) and to resolve it at least cost to the FDIC. The purpose of the sanctions is not to punish the bank per se, but to provide incentives for owners and managers to turn the bank around and return it to greater profitability and a stronger capital position. Without similar PCA type authority, it is unlikely that bank regulators in other countries can achieve the control over a bank's capital that pillar 2 envisions. Indeed, the early experience with PCA in the U.S. suggests that some regulators may not be using their authority as vigorously as intended in the legislation and that supervisory review needs to be supplemented by other forces including market discipline, which is pillar 3 in the Basel II proposal. Pillar 3. Market Discipline Market discipline may be defined as actions by stakeholders to both monitor and influence the behavior of entities to improve their performance. Pillar 3 is intended "to complement the minimum capital requirements (Pillar 1) and the supervisory process (Pillar 2) [and] to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess the capital adequacy of the institution"13. These disclosure requirements are aimed at providing the market with more and better information on banks' risk assessment capabilities, risk profile and capital adequacy. Banks will be required to disclose essential information regarding their capital allocation processes and the risks they take beyond the present financial reporting framework. However, the requirements for effective market discipline are not discussed in the section on market discipline in the Consultancy Paper. Rather, the section discusses in great detail what information on a bank's financial and risk positions need be disclosed to the public14 Disclosure and transparency is a necessary but not sufficient condition for effective market discipline. Stakeholders not at-risk would have little or no incentive to monitor and influence their banks and thus have little if any use for the information disclosed about the financial performance of the banks. While market discipline is likely to encourage disclosure, disclosure per se is less likely to encourage market discipline in the absence of a significant number of at-risk stakeholders. Because of the fear of substantial economic harm caused by the failure of large banks, governments and bank regulators in almost all countries have tended to avoid failing such institutions and, where they have, protected all depositors and other creditors in a de facto policy termed "too-big-to-fail" (TBTF).. Thus, few de facto at-risk stakeholders have existed in even privately owned banks, no less state owned banks. However, the U.S. has taken steps in recent years to enhance market discipline by reversing the policy of blanket protection of debt stakeholders and converting the largest stakeholders - depositors, creditors, and shareholders - to at-risk status. FDICIA prohibits the FDIC from protecting any uninsured stakeholder at failed banks in which doing so is not a least-cost resolution to it. But there is an exception Another way to increase the importance or at-risk claimants is to require banks to issue a minimum amount of subordinated debt (sub-debt). Such debt would be both de jure as well as credibly de facto unprotected and therefore at-risk. Thus, the interest yield spreads at which it is either sold initially in the primary market or traded later in the secondary market would reflect investors' perceptions of the financial strength of the issuing institution15. These market determined yield spreads are likely both to affect investors' attitudes toward the institution and management's actions, and to serve as a signal to regulators of market perceptions. Such signals would supplement the information regulators obtain from their own examinations and other sources and in some proposals would automatically feed into PCA and possibly trigger sanctions on the institution when the yield spreads become sufficiently large. Unfortunately, to date, regulators in neither the U.S. nor the other Basel countries have viewed these proposals favorably and implemented them. Conclusion With the coming of Basel II there has already been a notice of proposed rulemaking in the U.S. and a proposed revised CAD in the EU countries. But, particularly in the U.S. praise by the industry, regulators, and scholars have been much more muted and have become progressively even more muted through time as the details are examined more closely. Indeed, U.S. bank regulators seem to have effectively rejected Basel II as a requirement for all but the largest 10 or so internationally active banks, which would be required to use the advanced IRB approach. Since the Depositor Preference Act of 1993, in the U.S all bank debt is subordinated to depositt of domestic offices and the FDIC. Thus, for this proposal, the term "subdebt" is no longer necessary in the U.S., except at the bank holding company level. All other banks may compute their RBC on the basis of the current Basel I, although they can adopt the advanced IRB approach if they wish and their supervisors concur. The rejection in the U.S. centers primarily on the complexity of computations and doubts about the adequacy of the RBC requirement, the inadequacies of pillars 2 and 3 mentioned above, and the existence of PCA in the U.S. to which all banks are subject. For example, a Federal Reserve official has stated that "for the United States banking authorities, pillar II of Basel II requires nothing new... [and] considerable information is publicly disseminated - for example, through our Call Reports - and is available for counterparties"16 Similar views have been expressed by the Comptroller of the Currency17. That is, despite its well-recognized shortcomings, the U.S. already has a more effective system in place. Moreover, to the extent the advanced IRB approach may compute lower capital requirements for the largest banks that will use it, even after addition of operational risk, as it appears likely to do and appears to be its major appeal, these banks are still subject to the minimum leverage ratio constraint, which is unaffected by Basel II. Indeed, the ANPR specifically states that "the Agencies are not proposing to introduce specific requirements or guidelines to implement Pillar 2. Instead, existing guidance, rules, and regulations would continue to be enforced"18. There has been of criticism of proposed Basel II, particularly with respect to pillar 1. However, regardless of the complexity or desirability of RBC computed according to pillar 1, the provisions of pillars 2 and 3 are inadequate to enforce them. Although pillar 2 discusses the need for supervisors to intervene promptly if either a bank's capital or the model used to compute capital are perceived inadequate and impose remedial action, no powers are explicitly recommended for supervisors to effectively enforce this mandate. What appears necessary in countries that do not currently provide for such powers is the introduction of a system of PCA similar to that required in the U.S. since the enactment of FDICIA in 1991. Pillar 3 proposes to enhance market discipline by increasing financial disclosure requirements for banks. But disclosure is most effective if there are substantial bank stakeholders. But disclosure is most effective if there are substantial bank stakeholders at-risk. Presently, few stakeholders, particularly de-jure uninsured depositors, view themselves at risk as regulators have tended to protect them in nearly all large bank failures in almost all countries. What is necessary to enhance market discipline further is to increase the number and importance of stakeholders who perceive themselves at-risk de-facto as well as de-jure. This requires scaling back TBTF, as has been attempted in the U.S. with the introduction of SRE. Adoption of a subdebt requirement would expedite this process. .Thus, on the other hand, until the Committee proposes more substantial pillars for enhancing supervisory review and market disciple, Basel II will encounter difficulties in fulfilling many of the promises made at its introduction, particularly outside the United States. On the other hand, however, regardless of its shortcomings, Basel II has both increased our knowledge of the nature and measurement of risk in banking and increased the sensitivity of bankers, regulators, analysts, and the public to risk management. This is no small feat in itself and may represent Basel II's major lasing contribution. Indeed, the Basel proposals may make their greatest lasting contribution by continuing to be an ongoing process that is never implemented. ------------------------------------------------------------------------------------------------------------ Bibliography Barth, J R, Caprio, G. and Levine, R., "Banking Systems Around the Globe: Do Regulation and Ownership Affect Performance and Stability", Conference on Prudential Supervision: What Works and What Doesn't, National Bureau of Economic Research Inc., January 2000 Basel Committee on Banking Supervision, Working Paper on Risk Sensitive Approaches for Equity Exposures in the Banking Book for IRB Banks, August 2001 Basel Committee on Banking Supervision, The New Basel Capital Accord - Consultative Document, April 2003 Basel Committee on Banking Supervision, Quantitative Impact Study 3 - Overview of Global Results, May 2003 Basel Committee on Banking Supervision, Continued Progress towards Basel II, Press Release, 15 January 2004 Basel Committee on Banking Supervision, Modifications to the capital treatment for expected and unexpected credit losses in the New Basel Accord, January 2004 Basel Committee on Banking Supervision, The New Basel Capital Accord (Consultative Document), Basel,: Bank for International Settlements, April2003a. Basel Committee on Banking Supervision, Markets for Bank Subordinated Debt and Equity in Basel Committee Member Countries (Working Paper No. 12), Basel, Bank for International Settlements, August 2003b Benston, George J., Robert A. Eisenbeis, Paul M. Horvitz, Edward J. Kane, and George G. Kaufman, Perspectives on Safe and Sound Banking, Cambridge, MA, MIT Press, 1986. Benston, George J. and George G. Kaufman, "The Intellectual History of the Federal Deposit Insurance Corporation Improvement Act of 1991," in George Kaufman, ed., Reforming Financial Institutions and Markets in the United States, Boston: Kluwer Academic, 1994, pp. 1-18. Bliss, Robert R. and Mark J. Flannery, "Market Discipline in the Governance of U.S. Bank Holding Companies: Monitoring vs. Influence," European Finance Review, Vol. 6, No. 3, 2002, pp. 361-395. 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Kashyap, Anil K, and Stein, Jeremy C., Cyclical implications of the Basel II capital standards, Economic Perspectives, Federal Reserve Bank of Chicago, 1Q/2004 Merton, R.C., (1998), "Applications of Option-Pricing Theory: Twenty-Five Years Later", The American Economic Review, June 1998; Nakaso, H., "The Financial Crisis in Japan During the 1990s: How the Bank of Japan Responded and Lessons Learnt", BIS Papers no. 6, 2001 Scholes, M.S., (1998), "Derivatives in a Dynamic Environment", The American Economic Review, June 1998 Securities and Exchange Commission, Supervised Investment Bank Holding Companies, Proposed Rules, 17 CFR Part 240, Federal Register, Vol. 68, No 215, Thursday November 6, 2003, available at http://www.sec.gov/rules/proposed/34-48694.pdf Sharpe, W., (1995), "Nuclear Financial Economics", in: Risk Management: Problems & Solutions, McGraw-Hill ---------------------------------------------------------------------------------------------------------- . . 1 2 3 4 5 6 7 . 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