Corporate & Capital Markets

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1 Basel II: Revised Framework For The International Convergence Of Capital Measurement And Capital Standards Finally Introduced Overview... 1 The 1998 Basel Accord, which formed the basis of capital maintenance for banks across the worlds, has been updated to take into account risk management concerns. This update highlights the key changes introduced. Background To Basel Requirements And Bank Compliance Basel II Objective Difference Between Basel II And The 1988 Basel Capital Accord Scope Of Basel II Framework... 3 How Will Basel II Framework Be Achieved Implementation Timelines... 5 Conclusion... 5 Please feel free also to contact the Knowledge & Risk Management Group at eoasis@rajahtann.com Overview On 26, the Central bank governors and the heads of bank supervisory authorities in the Group of Ten ( G10 ) countries endorsed the publication of the International Convergence of Capital Measurement and Capital Standards: A Revised Framework, The New Capital Adequacy Framework commonly known as Basel II ( Basel II Framework ). The Basel II framework is a consequence of the Basel Committee on Banking Supervision s ( the Committee ) work over the last few years to secure international convergence on revisions to supervisory regulations governing the capital adequacy of internationally active banks. The work started with the publication of the Committee s first round of proposals for revising the capital adequacy framework in June An extensive consultative process followed this in all member countries, as well as by supervisory authorities worldwide. The Committee subsequently released additional proposals for consultation in January 2001 and April 2003 and also conducted three quantitative impact studies related to its proposals. The efforts outlined saw a number of improvements being made to the original proposals. These include the changes in the approach to the treatment of expected losses ( EL ) and unexpected losses ( UL ) and to the treatment of securitisation exposures. In addition, changes in the treatments of credit risk mitigation and qualifying revolving retail exposures, among others, have also been incorporated. The Committee also has sought to clarify its expectations regarding the need for banks using the advanced internal ratings-based ( IRB ) approach to incorporate the effects arising from economic downturns into their loss-given-default ( LGD ) parameters. The Basel II Framework, as now issued, sets out the details of the agreed framework for measuring capital adequacy and the minimum standard to be achieved. Essentially, the Basel II Framework sets out the details for adopting more risk-sensitive minimum capital requirements for banking organisations. In doing so, it reinforces the risk-sensitive requirements by laying out principles for banks to assess the adequacy of their capital and for supervisors to review such assessments to ensure banks have adequate capital to support their risks. It also seeks to strengthen market discipline by enhancing transparency in banks financial reporting. The Basel II Framework Page 1

2 is intended to serve as the basis for national rule-making. It is intended that the Basel II Framework will be applied on a consolidated basis to all internationally active banks at every tier within the banking group. For countries where consolidation is not a current requirement, a three year transitional period for applying full sub-consolidation will be provided. This Update provides an overview of the Basel II Framework requirements. Background To Basel Requirements And Bank Compliance By the way of background, banks around the world have adopted a consistent approach to capital maintenance and risk management since the 1980s. Specifically, the 1988 Basel Capital Accord set out the first internationally accepted definition of, and a minimum measure for, bank capital. The Committee designed the 1988 Accord as a simple standard of capital maintenance so that it could be applied to many banks in various jurisdictions at varying levels of development. The minimum level of capital that banks maintain serve as a foundation for a bank s future growth and as a cushion against its unexpected losses. Adequately capitalised banks that are well managed are better able to withstand losses and to provide credit to consumers and businesses alike throughout the business cycle, including during downturns. Adequate levels of capital thereby help to promote public confidence in the banking system. The technical challenge for both banks and supervisors has been to determine how much capital is necessary to serve as a sufficient buffer against unexpected losses. If capital levels are too low, banks may be unable to absorb high levels of losses. Excessively low levels of capital increase the risk of bank failures which, in turn, may put depositors funds at risk. If capital levels are too high, banks may not be able to make the most efficient use of their resources, which may constrain their ability to make credit available. What the 1988 accord did was to require banks to divide their exposures up into broad classes reflecting similar types of borrowers. Exposures to the same kind of borrower such as all exposures to corporate borrowers were subject to the same capital requirement, regardless of potential differences in the creditworthiness and risk that each individual borrower might pose. Given the evident limitations, the Committee supplemented the 1988 Accord s original focus on credit risk with requirements for exposures to market risk in Overtime, however, further improvements in internal processes, the adoption of more advanced risk measurement techniques, and the increasing use of sophisticated risk management practices such as securitisation changed the methods used by banks in monitoring and management of exposures and activities. supervisors and sophisticated banking organisations have found that the static rules set out in the 1988 Accord have not kept pace with advances in sound risk management practices, with the consequence that the banks actual business and risk practices were not accurately reflected. This thus was the catalyst for the introduction of the Basel II Framework. Basel II Objective The fundamental objective of the Committee s work to revise the 1988 Accord has been to develop a framework that would further strengthen the soundness and stability of the international banking system, bearing in, mind varying risk management concerns, while maintaining sufficient consistency that capital adequacy regulation will not be a significant source of competitive inequality among internationally active banks. In developing the Basel II Framework, the Committee has sought to arrive at significantly more risk-sensitive capital requirements that are conceptually sound and at the same time pay due regard to particular features of the present supervisory and accounting systems in individual member countries. The Committee is also retaining key elements of the 1988 capital adequacy framework, including: the general requirement for banks to hold total capital equivalent to at least 8% of their risk-weighted assets; the basic structure of the 1996 Market Risk Amendment regarding the treatment of market risk; and the definition of eligible capital. Difference Between Basel II And The 1988 Basel Capital Accord The Basel II Framework is more reflective of the underlying risks in banking and provides stronger incentives for improved risk management. It builds on the 1988 Accord s basic structure for setting capital requirements and improves the capital framework s sensitivity to the risks that banks actually face. Page 2

3 This will be achieved in part by aligning capital requirements more closely to the risk of credit loss and by introducing a new capital charge for exposures to the risk of loss caused by operational failures. The Basel Committee, however, intends to maintain broadly the aggregate level of minimum capital requirements, while providing incentives to adopt the more advanced risk-sensitive approaches of the revised Framework. Basel II combines these minimum capital requirements with supervisory review and market discipline to encourage improvements in risk management. Scope Of Basel II Framework The overarching goal for the Basel II Framework is to promote the adequate capitalisation of banks and to encourage improvements in risk management, thereby strengthening the stability of the financial system. This goal will be accomplished through the introduction of three pillars that reinforce each other and that create incentives for banks to enhance the quality of their control processes. The first pillar represents a significant strengthening of the minimum requirements set out in the 1988 Accord, while the second and third pillars represent innovative additions to capital supervision. Pillar 1 Pillar 1 of the new capital framework revises the 1988 Accord s guidelines by aligning the minimum capital requirements more closely to each bank s actual risk of economic loss. This is discussed further here. First, Basel II improves the capital framework s sensitivity to the risk of credit losses generally by requiring higher levels of capital for those borrowers thought to present higher levels of credit risk, and vice versa. Three options are available to allow banks and supervisors to choose an approach that seems most appropriate for the sophistication of a bank s activities and internal controls, as follows: Standardised approach to credit risk under this approach banks that engage in less complex forms of lending and credit underwriting and that have simpler control structures may use external measures of credit risk to assess the credit quality of their borrowers for regulatory capital purposes. Internal ratings-based ( IRB ) approaches to credit risk under an IRB approach, banks rely partly on their own measures of a borrowers credit risk to determine their capital requirements, subject to strict data, validation, and operational requirements. Such an approach is more apt for Banks that engage in more sophisticated risk-taking and that have developed advanced risk measurement systems may, with the approval of their supervisors. Second, the new Framework establishes an explicit capital charge for a bank s exposures to the risk of losses caused by failures in systems, processes, or staff or that are caused by external events, such as natural disasters. Similar to the range of options provided for assessing exposures to credit risk, banks will choose one of three approaches for measuring their exposures to operational risk that they and their supervisors agree reflects the quality and sophistication of their internal controls over this particular risk area. By aligning capital charges more closely to a bank s own measures of its exposures to credit and operational risk, the Basel II Framework encourages banks to refine those measures. It also provides explicit incentives in the form of lower capital requirements for banks to adopt more comprehensive and accurate measures of risk as well as more effective processes for controlling their exposures to risk. Pillar 2 Pillar 2 of the new capital framework recognises the necessity of exercising effective supervisory review of banks internal assessments of their overall risks to ensure that bank management is exercising sound judgement and has set aside adequate capital for these risks. To achieve this, national supervisors will have to evaluate the activities and risk profiles of individual banks to determine whether those organisations should hold higher levels of capital than the minimum requirements in Pillar 1 would specify and to see whether there is any need for remedial actions. Pillar 3 Pillar 3 leverages the ability of market discipline to motivate prudent management by enhancing the degree of transparency in banks public reporting. It sets out the public disclosures that banks must make that lend greater insight into the adequacy of their capitalisation. The Committee believes that, when marketplace participants have a sufficient understanding of a bank s activities and the controls it has in place to manage its exposures, they are Page 3

4 Soon Choo Hock Partner Contact Details Direct: (65) Facsimile: (65) better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not. How Will Basel II Framework Be Achieved. A significant innovation of the Basel II Framework, as noted, is the greater use of assessments of risk provided by banks internal systems as inputs to capital calculations. In taking this step, the Committee is also putting forward a detailed set of minimum requirements designed to ensure the integrity of these internal risk assessments. The Committee, however, does not propose dictating the form or operational detail of banks risk management policies and practices. This will be left to each national supervisor, who will develop a set of review procedures for ensuring that banks systems and controls are adequate to serve as the basis for the capital calculations. Supervisors will need to exercise sound judgements when determining a bank s state of readiness, particularly during the implementation process. The Committee expects national supervisors will focus on compliance with the minimum requirements as a means of ensuring the overall integrity of a bank s ability to provide prudential inputs to the capital calculations and not as an end in itself. The Basel II Framework provides a range of options for determining the capital requirements for credit risk and operational risk to allow banks and supervisors to select approaches that are most appropriate for their operations and their financial market infrastructure. In addition, the Framework also allows for a limited degree of national discretion in the way in which each of these options may be applied, to adapt the standards to different conditions of national markets. These features, however, will necessitate substantial efforts by national authorities to ensure consistency in application. To this end the Committee intends to monitor and review the application of the Framework in the period ahead with a view to achieving even greater consistency. In particular, its Accord Implementation Group ( AIG ) was established to promote consistency in the Framework s application by encouraging supervisors to exchange information on implementation approaches. The Committee has also recognised that national supervisors have an important role in leading the enhanced cooperation between home and host national supervisors that will be required for effective implementation. The AIG is developing practical arrangements for cooperation and coordination that reduce implementation burden on banks and conserve supervisory resources. Based on the work of the AIG, and based on its interactions with supervisors and the industry, the Committee has issued general principles for the cross-border implementation of the revised Framework and more focused principles for the recognition of operational risk capital charges under advanced measurement approaches for home and host supervisors. Finally, it is to be noted that the revised Framework is more risk sensitive than the 1988 Accord, but countries where risks in the local banking market are relatively high nonetheless need to consider if banks should be required to hold additional capital over and above Page 4

5 the Basel minimum. This is particularly the case with the more broad brush standardised approach, but, even in the case of the IRB approach, the risk of major loss events may be higher than allowed for in this Framework. Implementation Timelines The Committee intends the Basel II Framework to be available for implementation as of year-end However, the Committee feels that one further year of impact studies or parallel calculations will be needed for the most advanced approaches, and these therefore will be available for implementation as of year-end In Singapore, the MAS has already taken several steps to raise local standards, which is already above the 1998 Accord requirements, further. One instance of this are the various risk management guidelines the MAS has introduced. Client updates on two risk managements guidelines the MAS has introduced are available on eoasis at /default.asp under legal update: Conclusion The objectives of the Basel II Framework are to broadly maintain the aggregate level of such requirements, while also providing incentives to adopt the more advanced risk-sensitive approaches. The Committee will review the calibration of the Basel II Framework prior to its implementation. Should the information available at the time of such review reveal that the Committee s objectives on overall capital would not be achieved, the Committee is prepared to take actions necessary to address the situation. In particular, and consistent with the principle that such actions should be separated from the design of the Framework itself, this would entail the application of a single scaling factor which could be either greater than or less than one to the IRB capital requirement resulting from the revised Framework. The current best estimate of the scaling factor using Quantitative Impact Study 3 data adjusted for the EL-UL decisions is The final determination of any scaling factor will be based on the parallel running results, which will reflect all of the elements of the Framework to be implemented. It is evident that the Committee has designed the Basel II Framework to be a more forward-looking approach to capital adequacy supervision, one that has the capacity to evolve with time. This evolution is necessary to ensure that the Framework keeps pace with market developments and advances in risk management practices. Rajah & Tann is one of the largest law firms in Singapore, with a representative office in Shanghai. It is a full service firm and given its alliances, is able to tap into resources in a number of countries. Rajah & Tann is firmly committed to the provision of high quality legal services. It places strong emphasis on promptness, accessibility and reliability in dealings with clients. At the same time, the firm strives towards a practical yet creative approach in dealing with business and commercial problems. The information contained in this Update is correct to the best of our knowledge and belief at the time of writing. The contents of the above are intended to provide a general guide to the subject matter and should not be treated as a substitute for specific professional advice for any particular course of action as the information above may not necessarily suit your specific business and operational requirements. It is to your advantage to seek legal advice for your specific situation. In this regard, you may call the lawyer you normally deal with in Rajah & Tann or the Knowledge & Risk Management Group at eoasis@rajahtann.com. Page 5