Basel II Implementation Update
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1 Basel II Implementation Update World Bank/IMF/Federal Reserve System Seminar for Senior Bank Supervisors from Emerging Economies October 2007 Elizabeth Roberts Director, Financial Stability Institute
2 Agenda Review of the Key Concepts of Basel I Basel II: A Brief Overview Basel II: Implementation Considerations
3 Why adequate capital is important Capital absorbs unexpected losses and provides time to address problems Expected losses covered by reserves Protects depositors, the insurance fund, and taxpayers Disciplines growth Fosters financial stability All other things being equal, higher capital levels reduce the likelihood that a bank will become insolvent.
4 What Factors Drive Capital Levels? Management strategy the level which management deems appropriate based on internal assessments Market views e.g. counterparties, rating agencies Shareholder expectations Return on capital Regulatory capital requirements Basel Accord
5 The 1988 Basel Capital Accord Established minimum capital requirements to cover credit risk only but with inherent buffer for other risks While the adoption of these standards was initially intended for large internationally active banks incorporated in Basel Committee countries, it is now applied in more than 100 jurisdictions around the world In many countries, it is applied to solely domestic banks as well as to the internationally active banks
6 Key Elements of the 1988 Capital Accord Common definition of capital Tier 1 Tier 2 Use of risk weights for categories of assets 0, 20, 50 and 100 percent Capital requirement for off-balance sheet items Minimum capital ratios 4% tier 1 capital to total risk-weighted assets 8% total capital to total risk-weighted assets
7 Definition of Capital Tier 1: Core capital Elements with the highest loss absorption capacity Tier 2: Supplementary capital A wide range of elements whose availability to cover losses is more limited Not all elements permitted in all countries More of a menu of elements Tier 3: Additional supplementary capital Can only be used to meet a proportion of a bank s capital requirements for market risk
8 From Basel I to Basel II Work since : Amendment to the Accord to incorporate market risks (implementation: end-1997) Many additional clarifications and refinements 1999: a new capital framework first discussion paper 2001: a revised draft 2003: the third draft of the proposed changes June 2004: publication of the final document
9 Merits of the 1988 Accord Substantial increases in capital ratios of internationally active banks Relatively simple structure Worldwide adoption Increased competitive equality among international banks Greater discipline in managing capital A benchmark for assessment by market participants
10 Weaknesses of the 1988 Accord Does not assess capital adequacy in relation to a bank s true risk profile Limited differentiation of credit risk No explicit recognition of operational and other risks Sovereign risk not appropriately addressed Does not provide proper incentives for credit risk mitigation techniques (e.g. hedging) Enables regulatory arbitrage through securitisation, etc.
11 Key Changes in Basel II Addition of two new pillars (supervisory review process and market discipline) More reliance on banks own assessments of risk Greater recognition of credit risk mitigation techniques Inclusion of a specific capital charge for operational risk But perfect rules are not possible no ideal measurement system for different risks difficult balance between accuracy and simplicity
12 Objectives of Basel II Continue to promote safety and soundness Better align regulatory capital to underlying risk Cover a more comprehensive range of risks Encourage banks to improve further their risk management systems Formally recognise the role of supervisors Leverage market discipline Provide options for banks (focus is on internationally active banks but suitable for banks of varying levels of complexity and sophistication)
13 Why Is Basel II So Complex? More risk sensitivity means more detail It is applicable to all banks, so in many cases there are more options Banks in different jurisdictions Banks of all sizes and levels of sophistication It is much more comprehensive: two new pillars plus operational risk
14 The Organisation of the New Accord Three Basic Pillars Minimum capital requirements Supervisory Review Process Market Discipline
15 Outline of the New Accord - Basic Structure Three Basic Pillars Minimum capital requirements Supervisory review process Market discipline Risk weighted assets Definition of capital Credit risk Operational risk Market risks Core Capital Supplementary Capital Standardised Approach Internal Ratings-based Approach Basic Indicator Approach Standardised Approach Advanced Measurement Approaches Standardised Approach Models Approach
16 Menu of Options for Credit Risk Standardised approach based on external assessments of risks Foundation internal ratings-based approach based on banks own assessments of probability of default Advanced internal ratings-based approach based on banks own assessments of all risk factors
17 Drivers of Credit Risk Type of risk Riskiness of borrower Riskiness of transaction Likely amount of exposure Time dimension risk Concentration Driver Probability of default Loss given default Exposure at default Maturity Correlations
18 Recognition of Drivers of Credit Risk Example: Loan to General Motors of 500,000, of which 300,000 is undrawn commitment, 100,000 is collateralised by US Treasury Bonds, maturity 3 years Type of risk Riskiness of borrower Riskiness of transaction Likely amount of exposure Time dimension risk Diversification/Concentration
19 Recognition of Drivers of Credit Risk 1988 Accord Standardised approach FIRB AIRB Probability of default Basel Committee External Credit assessment Inst. Banks own assessments Banks own assessments Loss given default Few CRMs recognised Expanded list of CRMs Fixed LGDs Banks own assessments Exposure at default Credit conversion factors Credit conversion factors Credit conversion factors, fixed EADs Banks own assessments Maturity Hardly recognised Hardly recognised 2.5 years or banks own assessments Banks own assessments or 2.5 years Correlations Not explicitly recognised Not explicitly recognised Preset correlations Preset correlations
20 The Standardised Approach Objective is to align regulatory capital with economic capital and key elements of risk by introducing a wider differentiation of risk weights and credit risk mitigation techniques Balance between simplicity and accuracy Simplest of the three approaches to credit risk Will be used by most banks in the foreseeable future
21 The Standardised Approach Main Features: Continue to slot exposures into risk-weighted buckets based on broad distinctions of risk determined by supervisors Risk-weights now more sensitive to inherent risks based on external credit assessments introduction of additional risk weight categories more refined treatment of credit risk mitigation
22 Risk Weights - Standardised Approach Continue to be set by supervisors Risk weights determined by category of borrower: sovereign bank corporate retail Risk weights dependent upon external credit assessments
23 Claims on Retail New lower risk weight for retail portfolio, e.g. 35% for residential mortgages (currently 50%) Past due mortgage loans are weighted at 100% 75% for other retail (currently 100%) The bank s total exposure to the firm must be less than the equivalent of 1 million Past due claims do not qualify for this preferential treatment
24 Other Risk Weighting Issues The unsecured portion of past due assets (90 days or more), net of specific provisions, will be risk weighted at 150% Other assets will continue to be weighted at 100% Maturity is a factor relevant to the assessment of credit risk, but would make the standardized approach more complex
25 Standardised Approach Risk Weights Claim Assessment AAA - AA- A+ - A- BBB+ - BBB- BB+ - B- Below B- Unrated Sovereigns (Export credit agencies) 0% (1) 20% (2) 50% (3) 100% (4-6) 150% (7) 100% Banks Option % 50% 100% 100% 150% 100% Option % (20%) 3 50% (20%) 3 50% (20%) 3 100% (50%) 3 150% (150%) 3 50% (20%) 3 Corporates 20% 50% 100% Retail BB+ - BB- 100% Below BB- 150% 100% Mortgages 35% Other retail 75% 1 Risk weighting based on risk weights of sovereign in which the bank is incorporated, but one 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.
26 Internal Ratings-based Approach The fundamental question: Who is the best judge of a bank s exposure to credit risk? The supervisor? A rating agency? The bank itself?
27 Basic Elements of the IRB Approach Relies on a bank s assessment of risk factors Based on three main elements Risk components (probability of default, loss-given default, exposure at default, maturity) Risk weight function Minimum requirements Separate approaches for each portfolio of assets Subject to supervisory validation and approval
28 IRB Methodology IRB replaces the set risk weights (0, 20, 50, & 100 percent) with continuous risk functions (smooth upward sloping curves), which are calibrated by supervisors For each wholesale exposure and segment of retail exposures, a bank will estimate four risk parameters PD, LGD, EAD and Maturity (for each wholesale exposure) The function maps these variables to capital requirement and risk-weighted asset amounts Mapping based on the type of exposure (e.g., corporate, retail) and (potentially) other characteristics (e.g. firm size) Separate risk weight function for different portfolios
29 IRB Approach Risk Components Component Probability of default Recognition Bank Foundation Advanced Loss-given-default (LGD) Exposure-at-default (EAD) Maturity Correlations 45% Bank 100% Bank 2 ½ years Bank Built into risk weight function (Fixed numbers)
30 Risk Components (PD) Assessment of Borrower Risk Quantitative information e.g. balance sheet, income statement, cash flow Qualitative information e.g. quality of management, ownership structure Measures Probability of default (PD)
31 Risk Components (LGD) Assessment of Transaction Risk Factors: collateral, seniority, recovery time, etc. Two-dimensional rating systems (matrix) Borrower risk and transaction risk Measures Loss-given-default (LGD)
32 Risk Components (EAD) Amount of Exposure at the Time of Default Nominal amount for simple structures For lines of credit: Amount outstanding + a portion of committed but undrawn lines Measures Exposure at default (EAD)
33 IRB - Categories of Exposures Corporates Traditional (sovereigns and banks in principle subject to same risk weight curve) SMEs Specialised lending High-volatility commercial real estate Retail Residential mortgages Qualifying revolving exposures Other retail Equities
34 Risk Weight Function 25% Charge 20% 15% 10% C & I Small and medium-sized enterprises (SMEs) Charge Charge 5% 8% (= current Accord 0% 0% 2% 4% 6% 8% 10% PD IRB does not always mean lower capital requirements
35 Risk Weight Function 20% Other retail (LGD 85%) 15% Charge 10% 5% Mortgages (LGD 25%) Revolving (LGD 85%) 8% (= current Accord 0% 0% 2% 4% 6% 8% 10% PD Different kinds of assets rely on different risk weight functions (curves)
36 Concluding Thoughts on Credit Risk Basel II s main goal: more risk sensitivity Basel II offers a range of options for the treatment of credit risk The Committee is moving away from a one-size-fits-all approach to capital regulation The IRB approach is primarily aimed at sophisticated banks, with well developed risk management systems in place The Standardised Approach is fully valid and beneficial for smaller and less complex banks
37 Menu of Options for Operational Risk Basic Indicator Approach 15% of average gross income over 3 years Standardised Approach based on gross income across 8 business lines with separate scaling factors between 12% and 18% Advanced Measurement Approaches a variety of approaches based on loss experience; subject to strict qualitative and quantitative criteria
38 Pillar 2: Supervisory Review Process Supporting Pillar 1 Dimensions of risks not considered, e.g. large exposures and concentrations Risks not taken into account (liquidity risk, interest rate risk) External factors to the bank Fostering improvements in risk management and in supervision Ensuring compliance with Pillar 1 requirements both quantitative and qualitative
39 Pillar 2: Supervisory Review Process Pillar 2 is based on four key principles: 1. Bank s own assessment of capital adequacy 2. Supervisory review process 3. Capital above regulatory minima 4. Supervisory intervention
40 Pillar 3: Market Discipline The role of market discipline A lever to strengthen the safety and soundness of the system Reliable and timely information allowing well founded counterparty risk assessments Specific requirements for disclosure of certain information composition of capital risk exposures (credit, market, others) capital adequacy
41 Implementation of Basel II Focus has shifted from drafting the rules to implementation Implementation will be a major undertaking Several issues to deal with, including Implementing the rules National discretion areas Cross-border implementation Basel Committee issued a paper on practical considerations in July 2004 intended as a roadmap for implementation Accord Implementation Group also seeks to provide guidance
42 Accord Implementation Group Mandate: to share information and thereby promote consistency in implementation of the new framework It is: a forum for discussion and sharing of experiences; collector of information; occasional creator of elaboration and guidance It is not: a creator of vast amounts of new rules; central control; guarantor of uniformity in application of the new framework Close contact with non-member countries mainly through regional sessions
43 What is the time schedule for implementation? 26 June 2004 Release of Basel II Framework End 2006 End ? National processes Impact studies (QIS 5 at end 2005) Legislation and national rule making Committee member implementation of simpler approaches Committee member implementation of advanced approaches Extended transition period for other countries
44 FSI 2006 Survey Implementation of Basel II Based on a questionnaire sent to 115 jurisdictions More than 90 countries intend to adopt Basel II The vast majority of countries will be offering the simpler approaches in the near to medium term A significant number of countries stated that they intend to adopt the more advanced approaches in the medium to long term Some countries showed a small delay in selected aspects of implementation from the 2004 survey One of the major drivers cited: implementation by foreign banks
45 When should it be implemented? Only national authorities can answer this question Timing should be determined by a country s own circumstances Basel II may be a lesser priority compared to other efforts Basel II Framework (June 2004) 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. (Paragraph 3)
46 Some Implementation Issues Implementation is a domestic/national issue National discretion areas provide room for adaptation to national circumstances The Basel Committee will not judge implementation in individual jurisdictions IMF and World Bank (through FSAPs) will judge against the text of Core Principle 6 (capital adequacy) they will only judge Basel II implementation if you have formally adopted it There is no single way to implement Basel II
47 What are supervisors around the world doing? 1. Learning about Basel II 2. Reviewing options 3. Assessing staffing needs/skills 4. Forming Basel II teams 5. Talking to banks 6. Talking to other supervisors 7. Making announcements 8. Pursuing legislation, if necessary 9. Doing nothing (is this still an option?)
48 1. Learning about Basel II Very complex document Wide range of options under national discretion Trying to digest all of the details Reading and discussing the June 2004 document Attending seminars, conferences, etc. Perhaps taking FSI Connect tutorials on Basel II
49 2. Reviewing options Stay with Basel I Implement parts of Basel II and if so, Which parts? Under what time frame? Implement all options under Basel II and if so, Under what time frame? What to do about the numerous areas of national discretion?
50 3. Assessing staffing needs/skills Are more staff required? In particular, Pillar 2 has staffing implications Do current staff have the necessary skills? If not, can their skills be enhanced? Demand for vs. supply of individuals with the skills for the more advanced aspects of Basel II
51 4. Forming Basel II teams Complexity of Basel II makes it very difficult for one person to be an expert on every aspect Consequently, many supervisory authorities are forming Basel II teams Everyone has a general awareness of the various components Individuals or groups of individuals specialising in specific aspects of Basel II Divide and Conquer!
52 5. Talking to banks Understanding bank practices and implementation challenges is critical What are banks in your jurisdiction able to do? Current range of practice in risk management Readiness of banks (data, staffing, etc) Industry consultations Domestic banks Local subs of foreign banks what they will do globally may differ from what they will do locally Impact on local branches of foreign banks
53 6. Talking to other supervisors Home-host supervisory relationship will be critical under Basel II so bilateral discussions should be taking place now Consultations (and competition!) among supervisors Regional groups playing a key role in this regard On the agendas of many regional group meetings Some regions are even coming up with a plan for implementation on a regional basis
54 Cross-border Implementation Key Challenges Initial and on-going validation of advanced Pillar 1 approaches Recognition of external ratings in different jurisdictions Supervisory review process under Pillar 2 Banks to focus on managing their risks rather than managing the demands of different supervisors Need to develop enhanced cooperation agreements Some countries are essentially host supervisors only
55 Cross-border Implementation - Guidance Committee has provided guidance High-level principles for cross-border implementation (August 2003) Principles for the home-host recognition of AMA operational risk capital (January 2004) Enhanced cross-border cooperation (May 2004 press release)
56 7. Making announcements Letting the rest of the world know of their intentions regarding implementation of Basel II For example: United States European Union China Be careful about what you believe in the press! Check supervisory authority websites
57 8. Pursuing legislation In many jurisdictions, capital requirements are built into banking legislation In some jurisdictions, supervisors do not have the necessary legal authority to implement certain aspects of Basel II, especially as it relates to Pillar II Getting legislation passed can be a lengthy process
58 9. Doing nothing It used to be a valid option but: It is becoming harder to do now that the framework has been finalised Will delay important activities such as data collection In the long run, domestic banks operating internationally will be penalised Foreign banks operating locally will not know what is expected of them by the national supervisor
59 Conclusion Publication of June 2004 Framework was only the beginning of a new phase: implementation Supervisors should have a strategy for implementing Basel II It is their decision whether and how to implement Basel II Cross-border implementation requires a high degree of cooperation and coordination between home and host country supervisors
60 Keeping Basel II in Context Capital requirements must be viewed in conjunction with other important standards The Core Principles Accounting standards Risk management Capital adequacy is only one part of the puzzle Not every country should be moving to Basel II and not all should be moving to Basel II immediately
61 Questions? Elizabeth Roberts Director Financial Stability Institute Bank for International Settlements
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