The Evolution to Basel II

An overview of Basel I and II

First Basel Accord

The first Basel Accord (Basel I) was completed in 1988

Set minimum capital standards for banks Standards focused on credit risk, the main risk incurred by banks Became effective end-year 1992

Reason for the Accord

To create a level playing field for internationally active banks

Banks from different countries competing for the same loans would have to set aside roughly the same amount of capital on the loans

1988 Accord Capital Requirements

Capital was set at 8% and was adjusted by a loans credit risk weight Credit risk was divided into 5 categories: 0%, 10%, 20%, 50%, and 100%

Commercial loans, for example, were assigned to the 100% risk weight category

Risk-Based Capital

The Accord was hailed for incorporating risk into the calculation of capital requirements

Enforcement of Capital Adequacy

Two Capital Requirements

-Leverage Ratio -Risk-Based Capital Ratio

Leverage Ratio = Core Capital / Assets Risk-Based Approach implemented by Bank of International Settlements (BIS)
-Basel Agreement

Credit Risk - Basel I

Total Capital Risk Based Capital Ratio Credit Risk Adjusted Assets

Core (Tier I) and Supplementary (Tier II) Capital On Balance Sheet and Off Balance Sheet Assets Assigns risk weighting to different asset classes to obtain a Credit Risk Adjusted Asset Value

Credit Risk - Capital

Credit Risk On Balance Sheet

Credit Risk Adjusted On Balance Sheet Assets

wi ai
i 1

wi = Risk Weight of Asset

ai = Book Value of Asset on Balance Sheet

On BS Weightings Basel I

Capital Calculation

To calculate required capital, a bank would multiply the assets in each risk category by the categorys risk weight and then multiply the result by 8%

Thus a $100 commercial loan would be multiplied by 100% and then by 8%, resulting in a capital requirement of $8

Criticisms of the Accord

The Accord, however, was criticized for taking too simplistic an approach to setting credit risk weights and for ignoring other types of risk

Risk Weights

Risk weights were based on what the parties to the Accord negotiated rather than on the actual risk of each asset

Risk weights did not flow from any particular insolvency probability standard, and were for the most part, arbitrary

Operational and Other Risks

The requirements did not explicitly account for operating and other forms of risk that may also be important

Except for trading account activities, the capital standards did not account for hedging, diversification, and differences in risk management techniques

Banks Develop Own Capital Allocation Models

Advances in technology and finance allowed banks to develop their own capital allocation (internal) models in the 1990s This resulted in more accurate calculations of bank capital than possible under Basel I These models allowed banks to align the amount of risk they undertook on a loan with the overall goals of the bank

Internal Models and Basel I

Internal models allow banks to more finely differentiate risks of individual loans than is possible under Basel I

Risk can be differentiated within loan categories and between loan categories Allows the application of a capital charge to each loan, rather than each category of loan

Variation in Credit Quality

Banks discovered a wide variation in credit quality within risk-weight categories

Basel I lumps all commercial loans into the 8% capital category Internal models calculations can lead to capital allocations on commercial loans that vary from 1% to 30%, depending on the loans estimated risk

Capital Arbitrage

If a loan is calculated to have an internal capital charge that is low compared to the 8% standard, the bank has a strong incentive to undertake regulatory capital arbitrage Securitization is the main means used by U.S. banks to engage in regulatory capital arbitrage

Example of Capital Arbitrage

Assume a bank has a portfolio of commercial loans with the following ratings and internally generated capital requirements

AA-A: 3%-4% capital needed B+-B: 8% capital needed B- and below: 12%-16% capital needed

Under Basel I, the bank has to hold 8% risk-based capital against all of these loans To ensure the profitability of the better quality loans, the bank engages in capital arbitrage--it securitizes the loans so that they are reclassified into a lower regulatory risk category with a lower capital charge Lower quality loans with higher internal capital charges are kept on the banks books because they require less risk-based capital than the banks internal model indicates

New Approach to Risk-Based Capital

By the late 1990s, growth in the use of regulatory capital arbitrage led the Basel Committee to begin work on a new capital regime (Basel II) Effort focused on using banks internal rating models and internal risk models June 1999: Committee issued a proposal for a new capital adequacy framework to replace the 1998 Accord

Basel II

Basel II consists of three pillars:

Minimum capital requirements for credit risk, market risk and operational riskexpanding the 1988 Accord (Pillar I) Supervisory review of an institutions capital adequacy and internal assessment process (Pillar II) Effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices (Pillar III)

Pillar I

In the United States, all banks that will be required to conform to the new capital standard will use the Advanced Internal Ratings Based approach (AIRB)

AIRB Approach Requirements

Collect sufficient data on loans to develop a method for rating loans within various portfolios Develop a Probability of Default (PD) for each rated loan Develop a Loss Given Default (LGD) for each loan

Example: Safe v. Risky Loans

Safe loans: Over a 1-year period, only 0.25% of these loans default If a loan defaults, the bank only loses 1% on the outstanding amount Risky loans: Over a 1-year period, 1% of loans default every year If a loan defaults, the bank loses 10% of the outstanding amount

Example: Safe v. Risky Loans (continued)

For a $100 million portfolio of the safe loans, the bank would expect to see $250,000 in defaults in a year and a loss on the defaults of $2500

($100 million X .25% = $250,000) ($250,000 X 1% loss rate = $2500)

Example: Safe v. Risky Loans (continued)

For a $100 million in a risky portfolio the bank would expect to see $1 million in defaults in a year and a loss on the defaults of $100,000

($100 million X 1% = $1 million) ($1 million X 10% = $100,000)

Goal of Pillar I

Although simplistic, this example demonstrates what Pillar I is trying to achieve

If the banks own internal calculations show that they have extremely risky, loss-prone loans that generate high internal capital charges, their formal risk-based capital charges should also be high Likewise, lower risk loans should carry lower riskbased capital charges

Complexity of Pillar I

Banks have many different asset classes each of which may require different treatment

Each asset class needs to be defined and the approach to each exposure determined

Minimum standards must be established for rating system design, including testing and documentation requirements

The proposals must be tested in the real world

Assessing Basel II

To determine if the proposed rules are likely to yield reasonable risk-based capital requirements within and between countries for banks with similar portfolios, four quantitative impact studies (QIS) have been undertaken

Results of Quantitative Impact Studies

Results of the QIS studies have been troubling

Wide swings in risk-based capital requirements Some individual banks show unreasonably large declines in required capital

As a result, parts of the Accord have been revised

Operational Risk

Pillar I also adds a new capital component for operational risk

Operational risk covers the risk of loss due to system breakdowns, employee fraud or misconduct, errors in models or natural or manmade catastrophes, among others

Pillars II and III

Progress has also been made on Pillars II and III

Pillar II focuses on supervisory oversight Pillar III looks at market discipline and public disclosure

Pillar II

Supervisory Oversight

Requires supervisors to review a banks capital adequacy assessment process, which may indicate a higher capital requirement than Pillar I minimums

Pillar III

Market discipline and public disclosure

The United States is currently in the forefront of disclosure of financial data

SEC disclosure requirements for publicly traded banks Bank regulators require quarterly filing of call reports for all banks

U.S. authorities are currently considering what banks should publicly disclose about their Basel II calculations