1.

Future Banking Supervision under the New Basel Capital

Accord (Basel II)

1.1 The Basel Capital Accord of 1988

1.1.1 Historical Development

The period between the end of Bretton Woods and the mid eighties saw a general
reduction of protection and regulatory restrictions. Many banks were not ready for the
increasing international competition and reacted by an enlargement of their credit
volumes and more aggressive credit pricing. Credit granting also increased outside the
OECD countries where especially developing countries profited from new sources for
debt rising. However, the debt situation worsened rapidly and reached a high with the
1982 Mexico crisis. During the subsequent crisis of the US savings & loans in the mid
eighties the number of banking failures increased rapidly and reached a record level. As a
reaction the US Congress created the FDIC Improvement Act (FDICIA), a framework
enabling the supervisory bodies to intervene or even close a financial institution at an
early stage.1 This measure should help to guarantee a minimum capital, reduce the
number of bank failures and the economic cost of such events. Outside the USA similar
measures had to be taken. In 1975 the Bank of England had to prevent over 20
institutions from defaulting.

The general reduction of banks equity ratios and the threatened existence of large banks
needed corrective measures by the international supervisory bodies. As a consequence
the 1988 Basel Capital Accord2 was issued forming an universal ground for the capital
adequacy of credit risk. Since then minimum capital requirements became one of the
primary instruments of the bank supervision even if high equity rations cannot prevent
banks from failing.3

1.1.2 Subject of the 1988 Basel Capital Accord

After the consultative period within the G10 countries the Basel Committee on Banking
Supervision published the framework International Convergence of Capital
Measurement and Capital Standards that formed the basis for capital requirements. The
standard had to be adopted by the central banks of the G10 countries into national law by
the end of 1992. Even though there was no legal enforcement the adoption was morally
binding.

The Basel Capital Accord of 1988 was thought to guarantee the stability of the
international banking system on a harmonized equity basis and to reduce the global
systematic risk (same risk, same rules). Despite all critics the Accord marked the
beginning of the risk sensitive treatment of risk and differentiated between the major
balance and off-balance sheet positions. The risk weighting was and is transaction based
depending of the nature of the counterparty:4

1
Board of Governors of the Federal Reserve System [1991]
2
Basel Committee on Banking Supervision [1988]
3
SEE Estrella/Park/Peristiani [2000] 37. THE AUTHORS ARGUE THAT DEFAULTED BANKS IN THE USA
BETWEEN 1988 AND 1992 GENERALLY OPERATED FAR ABOVE THE MINIMUM CAPITAL REQUIREMENTS.

Panorama Trading and Risk Systems

The Accord states that banks hold at least 8% as capital in terms of their risk-weighted
assets. Four risk weights (risk buckets) were defined. The first bucket consists of claims
on OECD governments and has a zero weight. The second bucket, consisting of claims
on banks incorporated in OECD countries, receives a 20% weight. The third bucket,
consisting of asset-backed claims, is weighted 50%, and the fourth bucket, consisting of
claims on consumers and corporations, has a 100% weight. 5

Several amendments were added to the Accord in relation to capital adequacy. Most
importantly, in the 1996 Market Risk Amendment 6 minimum capital requirements were
defined for market risk of banks' trading positions (accounts that contain assets held for
short-term trading purposes). 7 However, the treatment of credit risk has remained the
same since 1988.

1.1.3 Limitations of the Capital Accord of 1988

Following the adoption of the Accord, the amount of capital held by banks increased
substantially. However, over time several important limitations of the current framework
have become apparent, particularly that the regulatory measure of bank risk (risk-
weighted assets) can differ substantially from actual bank risk. One example of such a
difference stems from the growth in loan securitisation. By selling loans to a third party
while retaining some exposure via credit enhancements, a bank can effectively remove
loans from its portfolio and decrease its required capital without a commensurate
reduction in its overall credit risk.8

The existing risk weights also generate incentives to shift banks portfolio compositions
towards lower quality claims within a risk bucket. 9 For example, claims on corporations
receive a 100% risk weight, regardless of their rating and riskiness. A bank would
generally prefer the riskier claims to generate greater returns on investment. Clearly,
shifting to riskier assets could keep a bank's required regulatory capital constant, even
though its overall riskiness has increased. Since the current framework provides only a
crude measure of bank risk, minimum capital requirements do not necessarily reflect a
bank's true economic risks and thus are inappropriate for regulatory purposes.

4
THE IMPLEMENTATION OF THE 1988 RISK WEIGHTING SCHEME IN SWITZERLAND DIFFERS SLIGHTLY:
0% IS CHARGED FOR CLAIMS AGAINST CENTRAL GOVERNMENTS, 25% FOR BANKS IN OECD
COUNTRIES WITH MATURITIES UP TO 1 YEAR, 50% FOR BANKS IN OECD COUNTRIES WITH
MATURITIES UP TO 3 YEARS, 75% FOR BANKS IN OECD COUNTRIES OVER 3 YEARS MATURITY AND
100% FOR PRIVATE NON-BANKS. SEE ART. 12 SEC. 1 AND 2 BANK ORDINANCE.
5
A OECD COUNTRY IS A SOVEREIGN THAT MEETS THE CRITERIA OF ARTICLE 14 SECTION A
BANKING ORDINANCE.
6
SEE Basel Committee on Banking Supervision [1996]
7
A DEFINITION OF THE TRADING BOOK IN SWITZERLAND IS GIVEN IN ARTICLE 14 SECTION E
BANKING ORDINANCE. A TRADING BOOK POSITION MUST MEET THE FOLLOWING CRITERIA: (1) SHORT
TERM HOLDING, (2) ACTIVE MANAGEMENT (I.E. HIGH TURNOVER), (3) LISTING ON A RECOGNIZED
EXCHANGE OR ON A SOCALLED REPRESENTATIVE MARKET AND (4) MARK-TO-MARKET ON A DAILY
BASIS.
8
see JONES [2000] 35-58.
9
SEE FOR EXAMPLE Wall/Peterson [1996] 1-17

Panorama Trading and Risk Systems 2

1.2 Revision of the 1988 Basel Capital Accord (Basel II)

Although some modifications have been realized over the years, especially the 1996
amendment to add the market-risk aspect 10, the Basel Accord has been criticized by the
banking industry as well as by academics. They primarily complain about the one-size-
fits-all approach to capital adequacy. It is argued that as an unintended consequence of
this approach banks have been given an incentive to shift up their risk exposures without
being required to hold an adequate amount of capital against these risks.

Largely in reaction to these concerns, in June 1999 the Basel Committee released for
comment a consultative paper that introduced the Committee's proposal for a new capital
adequacy framework.11 In its 1999 release, the Basel Committee said that the new
framework should improve capital requirements reflecting the underlying risks. In
addition, a particular focus was given to the financial innovations that have developed
since the introduction of the original Basel Accord. The Basel Committee mentioned that,
as a result of these innovations, the Accord has become less effective to reflect a bank's
true risk profile. During the formal comment period on the 1999 proposal, which ended
on March 31, 2000, the Basel Committee received more than 200 comments from
industry members and supervisors around the world. The result is a comprehensive
proposal that goes beyond simply setting rules for credit risk in the banking book.

On January 16, 2001, the Basel Committee on Banking Supervision released the second
version for a new Basel Capital Accord. 12 The proposal modifies and substantially
expands the earlier proposal of June 1999. Comments on the proposal were due by May
31, 2001, and the Committee expects to issue the definitive version of the new accord by
year-end 2001. Implementation by participating supervisory jurisdictions is targeted for
2005.13

The full release of the Basel Committees proposal of January 16, 2001 includes over 500
pages and consists of the following parts:

(1) an overview paper that summarizes the proposal and describes the key components
of the new framework;
(2) the new Basel Capital Accord itself, which explains the proposal in detail and forms
the basis for the final rule expected to be adopted at the end of the comment period;
(3) a set of seven technical papers that serve as the supporting documentation for the
proposal and contain the background information and technical details regarding the
underlying analysis for the proposal.

The proposed framework builds on the three pillars to assess a financial institution's
capital adequacy:

(1) minimum regulatory capital standards that are more risk sensitive;
(2) an effective supervisory review process;
(3) and more effective use of market discipline through enhanced public disclosures.

10
see BASEL COMMITTEE ON BANKING SUPERVISION [1996]
11
see BASEL COMMITTEE ON BANKING SUPERVISION [1999B]
12
see BASEL COMMITTEE ON BANKING SUPERVISION [2000C]
13
By the end of June 2001 the Basel Committee on Banking Supervision decided to shoot for 2005
as implementation date. This is a year later than originally envisioned. Given the number and quality
of comments received, the Committee has pushed back the schedule for introducing the rules while it
discusses them with the industry.

Panorama Trading and Risk Systems 3

In addition, the Basel Committee will extend the new Basel Accord on a consolidated
basis to holding companies of banking groups, with the avowed purpose of ensuring that
the risks of the entire banking group are considered.

1.3 Pillar I: Minimum Capital Requirement

1.3.1 Overview

The new framework leaves unchanged the existing definition of capital and the minimum
requirement of 8% of capital to risk-weighted assets. 14 The major changes concern the
measurement of the underlying risk itself. Under the 1988 accord, uniform risk-weights
are assigned according to the institution type and country of the borrower. This includes a
distinction between corporates, sovereigns and banks. Within these categories risk-
weights vary according to membership or not of the OECD and the definition of the
claim's maturity. Under the new framework, the treatment of credit risk is more
sophisticated. While the measurement of market risk remains unchanged the New Accord
will require capital for operational risk.

1.3.2 Measurement of credit risk in the New Accord

The new framework includes three different approaches to the measurement of credit
risk:

The Standardised Approach (as a modified version of the existing approach)

The Foundation Internal Ratings Based Approach and
The Advanced Internal Ratings Based Approach.

The Basel Committee expects that in the beginning a majority of banks will operate
under the standardised approach while only the most sophisticated of international banks
will qualify the internal ratings based approach (IRB). Over time it is assumed that an
increasing number of financial institutions will change to the IRB approach. In order to
bring this process forward, the Committee has created explicit and implicit incentives in
the more sophisticated approaches, especially a potential reduction of required capital.
Indeed, following recent consultations, the Basel Committee has concluded that a greater
number of major banks will be in a position to adopt the IRB approach when the Accord
is implemented.

14
see BASEL COMMITTEE ON BANKING SUPERVISION [1988] 3

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1.3.2.1 The Standard Approach for Credit Risk

As in the current framework, the credit equivalent and the proposed risk weights are
multiplied to obtain the risk-weighted assets. Weights will still be depending upon the
category of borrower (sovereign, bank or corporate). However, to create the new standard
approach more risk sensitive there are some major changes from the 1988 Accord:

The distinction between OECD/non-OECD countries is to be abandoned.

The Creditworthiness of the debtor is given by external credit assessment institutions
(ECAIs).
The sovereign rating for claims in the specific country is abandoned. In this way,
banks and corporates may be assigned a higher rating than their sovereign.
The number of risk-buckets is increased to obtain a better differentiation of risk in
corporate claims. Especially, a 50% weight is added for single A rated assets and
single B rated assets now require a 150% weight.

Table Future Banking Supervision under the New Basel Capital Accord (Basel II)-1
shows the weights for claims against sovereigns. As a major changes the distinction
between OECD members and other countries is replaced by an external credit assessment
of the sovereign. It was widely argued that the membership criterion is insufficient since
the creditworthiness within the OECD is not homogenous.15

Table Future Banking Supervision under the New Basel Capital Accord (Basel II)-1:
Sovereign Weights

Sovereign AAA to A+ to A- BBB+ to BB+ to Below B- Unrated

credit- AA- BBB- B-
worthiness

Risk-Weights 0% 20% 50% 100% 150% 100%

Source: BASEL COMMITTEE ON BANKING SUPERVISION [2000D] 3.

As far as risk weights for banks are concerned supervisors will have to choose between
two options. The first option assigns a weight that is one category lower than the
sovereigns weight. There is a cap at 100%, except for banks in countries with a rating
below B- where a 150% weight is applied. The second option considers the banks rating
of ECAIs. In addition to the higher differentiated risk buckets, there is a special treatment
for short-term debt. In the current regulation a risk weight of 20% is assigned for banks
outside the OECD if the maturity of the claim is less than one year. A 100% weighting is
applied for claims of greater duration. This distinction has created an incentive for
financial institutions to prefer short-term debt. In opposite to the 1999 proposal, the
Committee decided to lower the maturity bound to three months. However, negative
incentives are not totally removed for banks with an external rating between A1 and B-.
Table Future Banking Supervision under the New Basel Capital Accord (Basel II)-2
shows the proposed weights for banks under the two options.

15
The external rating of OECD countries varies substantially. Negative Examples are Mexico or
Turkey. On the other hand a number of highly rated countries are not OECD members, such as
Singapore or Taiwan. See www.oecd.org.

Panorama Trading and Risk Systems 5

 Table Future Banking Supervision under the New Basel Capital Accord (Basel II)-2:
Bank Weights

External credit AAA to A+ to A- BBB+ to BB+ to B- Below B- Unrated

assessment of AA- BBB-
banks

Risk Weights 20% 50% 50% 100% 150% 50%

Risk Weights 20% 20% 20% 50% 150% 20%

for Short-term
claims

Source: BASEL COMMITTEE ON BANKING SUPERVISION [2000D] 6.

In the corporate sector risk weights are applied in a similar way. In opposition to the
banks scheme there is broader distinction between rating classes. Despite the fact that an
unrated debtor of low credit quality receives a 100% weight, the Committee believes that
negative incentives and adverse selection will be limited. Table Future Banking
Supervision under the New Basel Capital Accord (Basel II)-3 describes the weighting
scheme for corporates and the private sector.

Table Future Banking Supervision under the New Basel Capital Accord (Basel II)-3:
Corporates Weights

Credit AAA to AA- A+ to A- BBB+ to Below BB- Unrated

Assessment BB-

Risk Weights 20% 50% 100% 150% 100%

Source: BASEL COMMITTEE ON BANKING SUPERVISION [2000D] 7.

The decision to remove the OECD criterion is seen as one of the major improvements in
the proposed Standard Approach. However, this will have negative effects on low rated
OECD countries. In addition, by the removal of the sovereign floor highly rated debtors
in less highly rated countries will benefit. It is expected that the new Capital Accord will
in sum create more risk sensitivity. One crucial aspect, however, could be the
introduction of external credit assessment by private sector agencies. 16 Many comments
received by the Committee have highlighted that the historical performance of such
external ratings has proved to be poor in stressed market situations. In this context
external ratings are said to be inherently pro-cyclical. 17 Therefore, the Basel Committee
proposes that the external ratings be supplemented by national export credit agencies
(ECAs). The ECAs need to be recognized by national supervisors and therefore fulfill
certain criteria.18 The seven categories used by ECAs are mapped to the risk weights as

16
for a discussion of external ratings see GRNBICHLER [1999] 692
17
for a more extended discussion on external ratings see TREACY /CAREY [1998] 897-921
18
The criteria are: (1) objectivity for the assigning of credit assessment, (2) economic and political
independence, (3) international access and transperancy, (4) disclosure of qualitative and quantitative
information regarding rating assessment, (5) sufficient ressources and (6) credibility. See BASEL
COMMITTEE ON BANKING SUPERVISION [2001D] 11.

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described in Table Future Banking Supervision under the New Basel Capital Accord
(Basel II)-4.

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 Table Future Banking Supervision under the New Basel Capital Accord (Basel II)-4:
Weights According to ECA Risk Scores
ECA Risk 1 2 3 4 to 6 7
Scores

Risk Weights 0% 20% 50% 100% 150%

Source: BASEL COMMITTEE ON BANKING SUPERVISION [2000D] 4.

1.3.2.2 The Internal-Ratings-Based (IRB) Approach for Credit Risk

The second and more sophisticated approach for the treatment of credit risk is the
internal-ratings-based (IRB) approach.19 It represents a "fundamental shift in the
Committee's thinking on regulatory capital."20 In order to use the IRB approach, there is a
comprehensive set of minimum requirements that need to be met. Depending on its
methods used to evaluate credit quality, banks may choose between two proposed IRB
approaches. The first one, the foundation approach, gives more weight to supervisory
parameters that are taken over from the standardized approach and less weight to the
banks own parameters. While the probability of default (PD) is estimated by the banks
rating unit, other inputs will be provided by the national supervisor. If a bank chooses the
second approach, called advanced IRB, it needs to determine the input data. In addition,
the required standards regarding assessment competency and process control are more
strict. In both cases the following input figures are needed for risk assessment and capital
determination:

(1) probability of default;

(2) estimate of loss severity, known as the loss given default;
(3) amount at risk in the event of default or exposure at default;
(4) remaining maturity on the credit facility.

For the foundation approach the loss severity (loss given default), the exposure at risk in
the event of default (exposure or credit equivalent at default) and remaining maturity are
provided by the national supervisory agency. The probability of default needs to be
assessed by the financial institution. In the case of the advanced IRB approach, banks
will need to calculate the four input figures. The process and the methods used to
determine the parameters would be subject to supervisory review and validation.

The risk weight for a specific claim under the IRB approach will be a function of the
probability of default, the loss given default and the duration of the credit facility.
However, so far there is no predefined formula for the calculation of the required capital.
It can be assumed that minimum capital requirements will be tied to the expected loss
concept:

Expected Loss = Probability of Default x (Credit Equivalent ./. Collaterals) x Loss Given Default

The expected loss function is supposed to replace the multiplication formula in the
standard approach at a later stage. To take into account losses arising from unexpected
credit events (i.e. losses exceeding the aggregated expected losses) banks will have to

19
see BASEL COMMITTEE ON BANKING SUPERVISION [2001E] or BASEL COMMITTEE ON BANKING
SUPERVISION [2001A]
20
see SPILLENKOTHEN [2001] 3

Panorama Trading and Risk Systems 8

implement credit portfolio models. Because of the inherent complexity of such models
and due to lack of data, the Basel Committee argues that internal credit portfolio models
cannot be used for regulatory capital purposes at this early stage. 21

Compared to the revised Standard Approach the differentiation between the debtors is
more far-reaching and allows more diverse risk weights in both IRB approaches. This is
supposed to substantially increase risk sensitivity. On the other hand, banks and
supervisors will have to use sophisticated systems and methods for this more flexible
approach. Banks implementing an IRB approach will be subject to periodic evaluation
and validation by their supervisors of their methods and internal controls. Supervisors
will continue to make a separate assessment of whether the capital charge generated by
the IRB approach is commensurate with the bank's risk profile as called for by pillar 2, as
discussed below.

In order to comply with financial markets innovations, the Basel Committee also
proposed methods for asset securitizations, credit risk mitigation (i.e. the risk reduction
through collateralization, guarantees, credit derivatives and netting arrangements).

1.3.3 Measurement of Operational Risk in the New Accord

1.3.3.1 The Basic Indicator Approach for Operational Risk

Apart from credit risk as the most important component within pillar 1, operational risk
is also addressed by the Basel Committee. 22 Operational risk is expected to represent on
average 20% of the minimum regulatory capital charge. In contrast to market risk and, to
a smaller extend, credit risk, the measurement and management of operational risk is not
yet a mature discipline. The Basel Committee as well as the banking industry itself is still
developing an adequate approach to this risk category. So far, three regulatory
approaches of increasing sophistication and risk sensitivity have been proposed for
further comment. The simplest version is the basic indicator, using a single indicator for
the approximation of an institution's overall operational risk exposure. The institution
would then be obliged to hold capital against the exposure equal to a fixed percentage of
gross income.

1.3.3.2 The Standard Approach for Operational Risk

Under the second method, called the Standard Approach, banking supervisors will define
a set of standardized business lines, as well as broad indicators and loss factors for each
business line. For example, business lines could be retail banking; private banking, asset
management and the broad indicators could be gross revenue, average balance sheet size
or total funds under management. For each business line, the capital charge will be
determined by multiplying the indicator by the relevant loss factor; thus, in the case of
the asset-management business line, total funds under management would be multiplied
by the standard loss factor determined by the supervisor to reach a business line capital
charge. The total operational-risk capital charge would be the sum of the various
business-line charges

21
See BASEL COMMITTEE ON BANKING SUPERIVISION [1999B]. For a survey of credit risk models see
BASEL COMMITTEE ON BANKING SUPERIVISION [1999A]. For the principles of credit risk
management see BASEL COMMITTEE ON BANKING SUPERIVISION [1999C].
22
see BASEL COMMITTEE ON BANKING SUPERVISION [2001G]

Panorama Trading and Risk Systems 9

1.3.3.3 The Internal Model Approach for Operational Risk

The third and most sophisticated approach is the internal model. Under this approach,
input (i.e. internal loss data) for calculating operational risk capital charge is provided by
the financial institution. Required capital under the model approach is defined as a
function of several factors:

(1) For each business line and across business lines, an operational loss type is defined.
For each combination of business line and loss type, the supervisor specifies an
exposure indicator (EI), which is used as an approximation for inherent operational
risk exposure.
(2) Apart from the exposure calculation and similar to the expected loss concept in credit
risk management, banks provide the probability of loss event as well as the loss
given that event based on their internal loss data.
(3) To translate expected losses from operational risk into capital requirements, a so-
called gamma factor for each combination of business lines and loss types is
provided by the supervisor.

The Basel Committee acknowledges in its proposal that there is currently only limited
data to support the various operational risk charges and that this risk area still has many
open questions and needs much additional work before it becomes final.

1.4 Pillar 2 The New Supervisory Review Process

1.4.1 Objective of Pillar 2

The Pillar 2 is considered to be an integral part of the new capital framework. 23 It should
act in a complementary way between the already discussed Pillar 1 (minimum
requirement) and the Pillar 3 (market discipline).

The supervisory process holds the bank management responsible for an internal capital
assessment process that fits the banks overall activities in terms of scope and volume.
Supervisors, on the other hand, are expected to evaluate a banks internal risk assessment
and to intervene at an early stage. The assessment of the compliance of the minimum
standards and the application of the advanced models for credit risk are also essential
tasks for the supervisor.

Within the new Capital Accord, Pillar 2 addresses the following issues:

The Operational Risk Charge might not completely covered in all possible aspects by
Pillar 1. Some additional risks could be specifically charged in Pillar 2.
The Interest Rate Risk in the banking book is not considered at all in Pillar 1.
Exogenous factors such as the impact of the business cycle on the capital of a bank.

For some of these issues guidance is provided by the Basel Committee for either interest
rate risk in consultative form 24 or operational risk for which a paper is in progress 25.

23
BASEL COMMITTEE ON BANKING SUPERVISION [2001H]
24
see BASEL COMMITTEE ON BANKING SUPERVISION [2001I]
25
see BASEL COMMITTEE ON BANKING SUPERVISION [2001G]

Panorama Trading and Risk Systems 10

There are four principles on which the new supervisory review process is based upon.
They are discussed in the following paragraphs.

1.4.2 Principle 1: Banks processes for assessing the overall capital adequacy

As outlined in Figure Future Banking Supervision under the New Basel Capital Accord
(Basel II)-1 the risk management process starts at the strategic planning process and must
be in line with the banks overall strategy and business plan. It is the board of directors
responsibility to set the banks level of risk tolerance and that an adequate amount of
capital is provided to support the desired risk. Appropriate systems, procedures and
written policies (e.g. an internal capital allocation methodology) must be in place to
communicate these chosen levels of risk throughout the organisation.

Each risk category is to be assessed with a fitting risk methodology:

Credit Risk: A bank must be capable of assessing its credit risk on the individual as
well as the portfolio level. A more sophisticated approach to measure the capital
adequacy should cover the following areas: risk rating system, portfolio
analysis/aggregation, securitisation/complex credit derivatives, and large exposures
and risk concentrations.
Interest Rate Risk in the Banking Book: The assessment process should include all
material interest rate positions on the asset and liability side. It must be include all
the important parameters that are crucial for the measurement of the risk category
such as: interest rate of the positions, maturity, reset date etc. The system that is used
for the assessment has to be well founded and based on recognized techniques.
Market Risk: The value-at-risk of the banks trading book (interest rate and equity
risk) should be calculated on the basis of its own measurement system.
Liquidity Risk: Maintaining adequate levels of liquidity is crucial for every banking
organisation. An inappropriate level of capital can effect a banks capability of
receiving the sought for liquidity. The market in which a bank is operating is also
crucial when assessing the liquidity risks.
Other Risk (Operational Risks): The main focus in this category is the operational
risk since it can be measured more adequately than others such as image or strategic.
Currently there are no well-developed methodologies that cover this operational risk.
First of all, data has to be collected that help to make operational risk measurable in
an appropriate way.

Panorama Trading and Risk Systems 11

 Figure Future Banking Supervision under the New Basel Capital Accord (Basel II)-1
Overview of Pillar 2

Principle 1: Banks process for assessing the overall capital adequacy

Strategy/
Assessment of Credit Risk
Business
Plan
Assessment of Interest Rate Risk in the Banking Book
Board of Level of
Directors Risk Tol- Assessment of Market Risk
erance/
Adequate Assessment of Liquidity Risk
Capital to
Support
Assessment of other Risks: especially Operational Risks
Risk
Stress- Monitoring/ Internal External
Testing Reporting Control Audit

Transparency and Accountability

Principle 2: Supervisors Principle 3: Supervisors Principle 4: Supervisors
review of capital adequacy should urge banks to oper- intervention at an early
assessments and strategies ate above the minimum stage

All risk categories discussed above must be based on methodologies, technical systems
and organizational procedures that allow a stress testing and efficient monitoring and
reporting. The result should be a transparent information that informs the board of
directors senior staff on the banks risk profile and the resulting capital needs.

Monitoring of the progress of the implemented strategies as well as the foundation for a
future strategic planning should be derived from stress testing and the monitoring and
Reporting of each category.

The internal control review process is an independent view of the different assessment
methodologies for each risk category discussed above. 26 The review process must ensure
that the different risk management processes are at an accurate level in terms of
reasonableness and integrity. Identification of large exposures and risk concentrations,
validity of scenarios used to identify risk, data inputs as well as the stress testing are the
main areas that are covered. Additionally, the external audit should have a clearly
structured overall risk assessment as a basis for its legally imposed examinations.

1.4.3 Principle 2: Supervisors review of capital adequacy assessments and strategies

The supervisory review process should concentrate on five sections. The assessment of
the banks risk management processes (I), its capital adequacy (II) and control
environment (III) as well as its compliance with minimum standards (IV). In case I to IV
are not followed adequately by the supervised bank, the supervisors has to impose the
necessary actions which are discussed in principle 3 and 4 response (V). 27

26
see BASEL COMMITTEE ON BANKING SUPERVISION [1998B] for the internal control process

Panorama Trading and Risk Systems 12

Supervisors can adopt a number of techniques to review a banks risk management
procedures such as the examination of annual financial statements or the conduct of
meetings with the banks management. These reviews can be conducted on-site as well as
off-site. The examination of external auditors is an additional assistance for the
supervisory review process.

1.4.3.1 Adequacy of the risk management (I)

Supervisors must assess how far the existing risk management procedures cover all
material risks that the bank is facing based on the complexity of its activities. An
important factor is the extent to which the risk measure are followed in the daily
operations of a bank or whether they are used to measure the performance of business
lines. Sensitivity analysis and other stress testing conducted by the supervised bank are
also important for the assessment of the risk managements adequacy.

1.4.3.2 Assessment of capital adequacy (II)

The capital structure and targets of a bank must be in line with the composition of its
overall business activities. All business activities must be monitored by the senior
management of the bank.

1.4.3.3 Assessment of control environment (III)

The quality of the internal control review process especially the banks management
information system must be examined by the supervisor. An important part for this
section is also the responsiveness of the banks senior management to the changing
internal and external conditions that have an influence on the risk exposure in a
significant way.

27
see BASEL COMMITTEE ON BANKING SUPERVISION [2001H] 8

Panorama Trading and Risk Systems 13

1.4.3.4 Compliance with minimum standards (IV)

As banks use their own internal standards or approaches to calculate the capital
requirements, the disclosure of these methodologies to the supervisor is a necessary
precondition. Supervisors must ensure that the disclosure takes place on an ongoing basis
and that the documentation of the standards is guaranteed. This part of the principle 2 is a
crucial to support the supervisors with the necessary information to establish a
benchmark.

1.4.3.5 Response (V)

After having examined the capital adequacy assessments and strategies according to I to
IV the supervisor has to take the necessary actions to establish an adequate capital
allocation and a satisfactory level of capital. The range of sanctions that can imposed are
discussed in Principle 3 and 4.

1.4.4 Principle 3: Supervisors should urge banks to operate above the minimum 28

Capital requirements under Pillar 1 are to be followed by the entire banking population
and set the minimum standard and should assure that banks following these requirements
are considered to standing on a sound basis.

Under pillar 2 a variety of other factors should be considered to set the adequate level of
capital for a certain bank. Additional factors that can play a role in setting the capital
requirement for a specific bank are e.g. the experience and quality of management, risk
appetite and track record, relevant markets, the liquidity profile or the banks importance
on national or international markets and the overall economic condition of a country.
Therefore banks will be urged by the supervisors to operate above the minimum capital
requirements that are standardized under Pillar I.

This buffer can be measured and enforced for example by capital ratios that may apply to
the supervised banks. It is up to the supervisor to categorize banks according to their
actual capital ratios and derive the necessary actions for improvement.

Holding capital over the required minimum can also have considerable advantages for
the banks. A changing scope or volume of the business activity may impose an adequate
increase in capital which can be costly whilst certain market conditions prevail. Failing
to meet certain capital ratios may trigger immediate corrective actions by the supervisor
which can harm the long-term perspectives of a bank.

1.4.5 Principle 4: Supervisors intervention at an early stage

In addition to the minimum capital ratios outlined in principle 4 supervisors have several
methods to maintain or restore the compliance with the capital requirements originally
set. Possible corrective actions could be to intensify the monitoring of a non-complying
bank. The restrictions of its dividend payments or the immediate rise of additional
capital. These interim measures must be accompanied by actions that improve the long-

28
BASEL COMMITTEE ON BANKING SUPERVISION [2001H] 10

Panorama Trading and Risk Systems 14

term perspective of the bank. An adequate improvement of systems and controls are
highly recommended.

1.4.6 Other Aspects of Pillar 2

1.4.6.1 Supervisory Transparency and Accountability

While exercising the supervisory review process function as shown in principle 1, 2, and
3 the supervisory is obliged to apply the highest degree of transparency and
accountability. There will always be a certain amount of discretion in the review function
but supervisors especially when asking for additional capital requirements for risks not
covered in Pillar 2. Whenever the supervisor sets e.g. new capital ratios or imposes other
mitigation actions the criteria should be made available to the public. Especially auditing
firms places a high degree of attention to this aspect. 29

1.4.7 Interest Rate Risk in the Banking Book

As outlined in principle 1 the market risk for traded interest rate instruments is covered
under market risk in the trading book of a bank. Pillar 1 provides here for the necessary
capital requirements.

The interest rate risk in a banking book are more heterogeneous and depend substantially
on the scope and the nature of an international banks activities. In case a supervisor can
recognize a certain homogeneity it can set up a capital requirement for the specific risk of
a supervised bank. A possible internal measurement system should provide data of the
banks interest rate risk exposure in terms of economic value relative to capital in case
of standardized interest rate shock. The supporting document Document Principles for
the Management and Supervision of Interest Rate Risk 30 gives concrete suggestion of
how an outlier bank can be identified.31

1.4.7.1 Summary/Conclusion

Under principle 1 (core process) the Board of Directors sets in its Strategy/Business
Plan the level of risk is supported with an adequate capital. Based on the initial strategy
a separate risk assessment process must be in place for each of the risk categories (sub
processes). A more detailed description of the process steps can be derived from Pillar 1
and 2 as well as from the principles issued by the Basel Committee. All the risk
assessment processes must be accompanied by the core tasks adequate stress testing,
monitoring/reporting, internal control, and external audit.

The supervising core processes (principle 2 to 4) are in place to monitor the different
processes and tasks that derive from principle 1. The supervisor who manages its 3 core
processes must base his actions on transparency and accountability.
29
see for example KPMG [2001B]
30
BASEL COMMITTEE ON BANKING SUPERVISION [2001I]
31
In Switzerland, the Federal Banking Commission has created the circular 99/1 where interest rate
risk is adressed. In addition to this qualitative requirements financial institutions holding as Swiss
banking licence are subject to a regulary legal reporting. During the second half of 2001 the Federal
Banking Commissions will identify outliers and prompt for a reduction of interest rate risk or
increase equity requirements above the regulatory minimum. See EBK-RS 99/1 (www.ebk.admin.
ch).

Panorama Trading and Risk Systems 15

1.5 Pillar 3: Market Discipline

The third pillar may be the most controversial and complex of the three; 32 It is intended
to improve banks disclosed information in order to enhance the role of financial market
participants in monitoring banks: The Committee expects that market discipline imposes
strong incentives on banks to conduct their business in a safe, sound and efficient
manner. It can also provide a bank with an incentive to maintain a strong capital base as a
cushion against potential future losses arising from its risk exposures." 33

In 1998, the Committee published Enhancing Bank Transparency 34, in which it discussed
the subject of market discipline through disclosure. In the June 1999 consultative paper,
it outlined the intention to incorporate market discipline as a fundamental element of the
new Basel Accord. In the January 2001 consultative paper, the Basel Committee
formulated six specific recommendations about the type of public disclosures in three
broad areas: capital structure, risk exposures, and capital adequacy In the proposed new
Basel Accord, the areas of disclosure have been expanded to include the following broad
areas:

Capital includes disclosure information about the amount and the composition of
Tier 1 capital and the totals of Tier 2 and Tier 3 capital. Innovative, complex, and
hybrid equity instruments should also be disclosed. Qualitative information on
accounting policies is needed for asset and liability valuation, provisioning, and
income recognition.
Risk exposure includes disclosure information regarding credit, market, operational,
and interest-rate risk in the banking book. Disclosed information should vary
depending on internal risk-assessment.
Capital adequacy includes disclosure information of regulatory capital adequacy on
a consolidated basis, including actual capital ratios and other relevant information.
Disclosures should also account for an analysis of factors affecting capital adequacy
(for example changes in capital structure and the impact on key ratios and overall
capital position, contingency planning, and capital management strategy).

The treatment of these requirements is highly controversial. 35 It is unquestioned if the

complexity and regulatory burden of the new Basel Accord may outweigh the benefits of
their increased risk sensitivity. It is argued that subjecting a bank's condition to the public
could trigger a bank run by investors and depositors, lacking the sophistication necessary
to understand that information. However, the banking supervisors in the major industrial
nations believe that they need oversight and discipline of counterparties. This is
especially the case when banks expand into new areas and take on new risks.

32
BASEL COMMITTEE ON BANKING SUPERVISION [2001J]. See also BASEL COMMITTEE ON BANKING
SUPERVISION [1999D] and BASEL COMMITTEE ON BANKING SUPERVISION [1999B].
33
BASEL COMMITTEE ON BANKING SUPERVISION [2001J] 1
34
BASEL COMMITTEE ON BANKING SUPERVISION [1998A]
35
see for an example EUROPEAN COMMISSION [1999] 76

Panorama Trading and Risk Systems 16

1.6 Concluding Remarks

In this chapter the most relevant aspects of the new Basel Capital Accord has been
discussed. In sum, the following issues have shown to be essential:

Within pillar 1 (minimum capital requirements) the standardised approach to credit risk
offers a number of proposals for less sophisticated banks. Despite its simple nature, the
proposed changes should reduce some, but not all, of the negative incentives (for
example short-term lending, risk shifting etc.). The removal of the broad OECD/non-
OECD criterion is in favor of external rating agencies. The external assessment of credit
risk will potentially introduce a pro-cyclical element into the ratings (for instance in the
case of private ratings agencies).

The internal ratings based approach is designed for more sophisticated financial
institutions. To make use of this approach banks will have to meet a comprehensive set of
minimum requirements. The introduction of the foundation approach is welcomed by
most in the banking industry as it allows a larger number to further develop and make use
of internal rating systems. For the most sophisticated banks, the advanced approach will
potentially permit banks to reduce capital requirements for certain credit portfolios.

Apart from credit risk within pillar 1, operational risk is also covered by the new Basel
Accord although there is not a single framework for the measurement of these risks.
Three different approaches of increasing sophistication and risk sensitivity are proposed:
the basic indicator, using one single indicator, the standardized, based on a set of
business lines, broad indicators and loss factors, and the internal measurement approach,
using internal measurements of exposure, probability of loss and loss given event.
However, at this stage banks need to further develop their operational risk methodologies
before a solid regulatory framework can be released.

The pillar 2 (supervisory review process) is intended to ensure consistency between a

bank's capital and its overall risk profile. Apart from capital, banks should also
demonstrate adequate internal processes of risk measurement and capital allocation. The
second pillar underlines the role of the supervisory agency in the oversight of capital
adequacy. However, the Basel Committee states that despite of the role of the supervisor
judgment and expertise of bank management cannot be replaced nor the responsibility
for maintaining capital adequacy will be delegated to the supervisors.

Pillar 3 intends to improve the quality of disclosure information in order to enable

market participants to assess the exposure and the risk capacity of single institutions and
to respond accordingly. Among the three pillars, this may be the most complex and
controversial one. It must be ensured that banks are not forced to publish confidential and
market sensitive information.

The proposals contained in the new Basel Accord are voluminous and complex. The
future use of bank internal credit ratings as well as credit risk modelling are widely
welcomed although it remains uncertain how fast any specific proposal may be adopted.
Better recognition of capital deductions or allowances to reflect mitigation techniques
(such as credit derivatives) are expected to more accurately reflect banks practice. Some
concerns, however, arise with the possible introduction of gross capital charges for other
risks such as operational risks. The general attempt by the Committee to more closely
align capital regulation with internal credit and other risk management practices is
strongly welcomed by the industry practice.

Panorama Trading and Risk Systems 17

2. References

BASEL COMMITTEE ON BANKING SUPERVISION [1988]:

International Convergence on Capital Measurement and Capital Standards, Basel 1988.

BASEL COMMITTEE ON BANKING SUPERVISION [1993]:

Measurement of Banks Exposure to Interest Rate Risk, Basel 1993.

BASEL COMMITTEE ON BANKING SUPERVISION [1996]:

Amendment to the Capital Accord to Incorporate Market Risk, Basel 1996.

BASEL COMMITTEE ON BANKING SUPERVISION [1997]:

Principles for the Management of Interest Rate Risk, Basel 1997.

BASEL COMMITTEE ON BANKING SUPERVISION [1998A]:

Enhancing Bank Transparency Public Disclosure and Supervisory Information that
Promote Safety and Soundness in Banking Systems, Basel 1998.

BASEL COMMITTEE ON BANKING SUPERVISION [1998B]:

Framework for Internal Control Systems in Banking Organisations, Basel 1998.

BASEL COMMITTEE ON BANKING SUPERVISION [1999a]:

Credit Risk Modelling: Current Practices and Applications, Basel 1999.

BASEL COMMITTEE ON BANKING SUPERVISION [1999b]:

A New Capital Adequacy Framework, Consultative Paper, Basel 1999.

BASEL COMMITTEE ON BANKING SUPERVISION [1999c]:

Principles for the Management of Credit Risk, Basel 1999.

BASEL COMMITTEE ON BANKING SUPERVISION [1999d]:

Best Practices for Credit Risk Disclosure, Consultative Paper, Basel 1999.

BASEL COMMITTEE ON BANKING SUPERVISION [2000a]:

Range of Practice in Banks Internal Rating Systems, Discussion Paper, Basel 2000.

BASEL COMMITTEE ON BANKING SUPERVISION [2000b]:

A New Capital Adequacy Framework, Pillar 3: Market Discipline, Consultative Paper,
Basel 2000.

BASEL COMMITTEE ON BANKING SUPERVISION [2001A]:

The New Basel Capital Accord: An Explanatory Note, Basel 2001.

BASEL COMMITTEE ON BANKING SUPERVISION [2001B]:

Overview of The New Basel Capital Accord, Consultative Document, Basel 2001.

BASEL COMMITTEE ON BANKING SUPERVISION [2001C]:

The New Basel Capital Accord, Consultative Document, Basel 2001.

BASEL COMMITTEE ON BANKING SUPERVISION [2001D]:

The Standardised Approach to Credit Risk, Consultative Document, Basel 2001.

Panorama Trading and Risk Systems 18

BASEL COMMITTEE ON BANKING SUPERVISION [2001E]:
The Internal Ratings-Based Approach, Consultative Document, Basel 2001.

BASEL COMMITTEE ON BANKING SUPERVISION [2001F]:

Asset Securitisation, Consultative Document, Basel 2001.

BASEL COMMITTEE ON BANKING SUPERVISION [2001G]:

Operational Risk, Consultative Document, Basel 2001.

BASEL COMMITTEE ON BANKING SUPERVISION [2001H]:

Pillar 2 (Supervisory Review Process), Consultative Document, Basel 2001.

BASEL COMMITTEE ON BANKING SUPERVISION [2001I]:

Principles for the Management and Supervision of Interest Rate Risk, Consultative
Document, Basel 2001.

BASEL COMMITTEE ON BANKING SUPERVISION [2001J]:

Pillar 3 (Market Discipline), Consultative Document, Basel 2001.

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM [1991]:

Federal Deposit Insurance Corporation Improvement Act, Washington 1991.

ESTRELLA, A, PARK, S., PERISTIANI, S. [2000]:

Capital Ratios as Predictors of Bank Failure, Federal Reserve Bank of New York,
Economic Policy Review, July, 33-52.

EUROPEAN COMMISSION [1999]:

A Review of Regulatory Capital Requirements for EU Credit Institutions and Investment
Firms, Consultation Document, Brussels 1999.

FEDERAL BANKING COMMISSION [1999]:

Measurement, Management and Monitoring of Interest Rate Risk, Berne 1999.

FEDERAL RESERVE BANK OF NEW YORK [2001]:

A Payment Gone Awry: The Example of Bankhaus Herstatt, General Information, New
York, 2001 (www.ny.frb.org/bankinfo/payments/gi_part5.html).

GEIGER, H. [2000]:
Kreditkarten im Konsumkreditgesetz regeln?, NZZ No. 179, August 4, 2001.

GRNBICHLER, A. [1999]:
Rating und Europas Kapitalmarkt, sterreichisches Bankenarchiv, 9/99, 692-696.

JONES, D. [2000]:
Emerging Problems with the Basel Capital Accord: Regulatory Capital Arbitrage and
Related Issues, Journal of Banking and Finance, No. 1/2, 35-58.

KPMG [1999]:
Banking and Finance in Switzerland, Zurich, March 1999.

KPMG [2001A]:
New Basel Capital Accord, Sule 1: Operationelles Risiko, Conference in Zurich
organized by KPMG, March 22, 2001.

Panorama Trading and Risk Systems 19

KPMG [2001B]:
The Basel Committee on Banking Supervision, Proposals for a New Capital Adequacy
Framework, Zurich, March 2001.

SPILLENKOTHEN, R. [2001]:
Summary of the Basel Committee's The New Basel Capital Accord, attachment to letter
of Richard Spillenkothen, Board of Governors of the Federal Reserve System, January
23, 2001.

TREACY, W.F., CAREY, M. S. [1998]:

Credit Risk Ratings at large U.S. Banks, Federal Reserve Bulletin, Federal Reserve
Board, November, 897-921.

WALL, L.D., PETERSON, P.P. [1996]:

Banks Responses to Binding Capital Regulatory Requirements, Federal Reserve Bank of
Atlanta, Economic Review, March/April, 1-17.

ZIMMERMANN, H., JOVIC, D., MEYER, A. [2001]:

The new Basel II rules will challenge the way banks practice Asset- & Liability
Management, in: Financial Solutions International, Spring 2001, 74-76

Panorama Trading and Risk Systems 20