Basel2 Jun05

The Basel II Capital Accord
June 2005
Table of Contents
Chapter 1 Basel basics
Executive Summary Basel I overview Basel II overview Timing Scope of application Capital components Types of Banks IRB Transition Period
7 8 9 10 13 14 16 18 21 24 27 30 33 34
Chapter 2 Basel II minimum capital charges First Pillar

Sovereign exposures Bank exposures Corporate exposures Retail exposures Real estate exposures Covered bonds Specialised lending
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Table of Contents (contd)

Chapter 2 Basel II capital charges (contd)
Off-balance sheet items Equity Non-performing loans Credit risk mitigation (CRM) Securitisation exposures Standardised banks
35 37 39 45
- Ratings based approach - Most senior exposures; second loss positions or better - Liquidity facilities - Overlapping exposures IRB banks - Ratings based approach - Internal assessments approach - Supervisory formula approach - Liquidity facilities - Top-down approach
51 52 53 55 57 58 61 63 64
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Chapter 2 Basel II capital charges (contd)
Early amortisation structures Trading book
66 71 84
Chapter 3 Basel II operational risk charges

Basic indicator approach Standardised approach Advanced measurement approach
Chapter 4 Supervisory Review Second Pillar

Four key principals of supervisory review Supervisory review process for securitisation
87 89
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Chapter 5 Market discipline Third Pillar
Qualitative disclosure Quantitative disclosure
92 93
Chapter 6 Some observations

Open issues Impact on financial markets Impact on banks Impact on securitisation markets Impact on ABCP conduits
95 96 97 98 99
Contact Details
100
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Chapter 1 Basel II Basics
Executive Summary
In effect since 1988; very
simple in application
Basel I
Easy to achieve significant
Basel II introduced to: combat regulatory arbitrage

exploit and improve bank risk
capital reduction with little or no risk transfer
management systems
Much more complex and risk
sensitive
Basel II
First Pillar Minimum capital Second Pillar Supervisory review Third Pillar Market discipline
Will profoundly alter bank behaviour
Treats exposures very unequally
depending on exposure characteristics

Treats banks very unequally
depending on sophistication of risk management systems

7
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Basel I Capital Charges

Risk weights
OECD sovereigns: 0% OECD banks: 20% Residential mortgages: 50% Synthetic: 20% super-senior, 0% cash-collateralised mezzanine, deduction or 100%
first loss (with national variations)

Unfunded commitments under one year: 0% Unfunded commitments over one year: 50% Everything else: 100%
Sample capital calculation

100 million corporate exposure 100% risk weight = 100 million risk weighted assets (RWA) Capital charge = Capital = 8% minimum
RWA
Capital charge: 8 million
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Basel II Timing
Basel II
Published June 2004 End 2006 for standardised and foundation
However
New rules will alter banks behaviour right away Some countries will adopt prior to expected
IRB banks ( 2)
End 2007 for advanced IRB banks ( 2) End 2009 (at earliest) before full IRB benefits
implementation dates, at least in part

Implementation may be delayed in some
countries
Reaction of US regulators to QIS 4 results
achievable due to transition period ( 45-49)

Basel/IOSCO review (not yet final) will
may cause delays

EU and member state adoption schedules
change CRM rules and rules for trading book exposures Capital Requirements Directive (CRD)
Will implement Basel II within EU Same adoption timing sought May vary from Basel II (and thus from rules in
not usually so quick

Implementation may not be uniform 140+ items subject to national discretion Supervisory discretion Lengthy adoption time permits lobbying
US and elsewhere) in important respects

Unless otherwise indicated, all references to paragraph numbers in these materials refer to paragraphs in June 2004 Basel II Accord
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Basel II Scope of Application

Applied on consolidated basis to internationally active banks ( 20)*
All banking and other financial activities
Insurance entities
Generally, deduct banks equity and other capital
investments in insurance subsidiaries ( 30)

However, some G10 countries will retain current risk
(whether or not regulated) captured through consolidation ( 24)

Financial activities do not include
weighting treatment (100% for standardised banks) for competitiveness reasons ( 31)
Supervisors may permit recognition by bank of excess
insurance ( 24, fn. 5)

Majority-owned subsidiaries not
consolidated: deduct equity and capital investments ( 27)

Significant minority investments without
capital invested in insurance subsidiary over required amount ( 33) Commercial entities
generally deducted significant investments in
control: deduct equity and capital investments ( 28)

Deduction of investments 50% from tier 1
commercial entities above materiality thresholds ( 35)

Significant investments in commercial entities below
and 50% from tier 2 capital ( 37)

* EU rules (CRD) will also apply to solo entities and to investment firms
materiality thresholds risk weighted 100% ( 36)
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Basel II Capital and Provisions

Definition of regulatory capital unchanged ( 41) (but some changes anticipated going forward) Treatment of provisions
Standardised approach: general provisions can be included in tier 2 capital up to limit of 1.25%
of risk-weighted assets ( 42)

IRB approach: Securitisation and certain equity exposures: expected loss (EL) amount must first be
deducted from capital ( 43)

Other exposures: bank must compare total eligible provisions against total EL amount and
deduct any excess EL amount over eligible provisions (excess of provisions over EL amount may be added to tier 2 capital up to maximum of 0.6% of risk-weighted assets ( 43, 374-386) Scaling Factor
Scaling factor of 1.06 (subject to recalibration following QIS 4 and QIS 5) introduced to ensure
same aggregate amount of capital remains in banking system following Basel II adoption ( 44, fn. 11)
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Basel II Three Pillars

Minimum Capital Charges: Minimum capital requirements based on market, credit and operational risk to (a) reduce risk of failure by cushioning against losses and (b) provide continuing access to financial markets to meet liquidity needs, and (c) provide incentives for prudent risk management ( 40-718)
First Pillar
Second Pillar
Supervisory Review: Qualitative supervision by regulators of internal bank risk control and capital assessment process ( 719-807), including supervisory power to require banks to hold more capital than required under the First Pillar
Third Pillar
Market Discipline: New public disclosure requirements to compel improved bank risk management ( 808-822)
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Basel II Capital Components

Credit risk charges ( 40-643)
Revised To ensure capital charges are more sensitive to risks of exposures in banking book Enhancements to counterparty risk charges also applicable to trading book exposures
Operational risk charges ( 644-683)

New To require capital for operating risks (fraud, legal, documentation, etc.)
Market risk charges ( 684-718)

Initially unchanged, but Basel/IOSCO review has proposed changes to specific risk
calculations and Second Pillar stress testing

To require capital for exposures in trading book Rules in Market Risk Amendment (1996)
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Basel II Types of Banks
Standardised
Measure credit risk pursuant to fixed risk weights based on external credit assessments (ratings) Least sophisticated capital calculations; generally highest capital burdens Most Japanese banks will start Basel II as standardised banks Most US banks will stay under Basel I (or, more likely, will move to Basel 1) Measure credit risk using sophisticated formulas using internally determined inputs of probability of default (PD) and inputs fixed by regulators of loss given default (LGD), exposure at default (EAD) and maturity (M). More risk sensitive capital requirements Most European banks will likely qualify for Foundation IRB status at start of Basel II Measure credit risk using sophisticated formulas and internally determined inputs of PD, LGD, EAD and M Most risk-sensitive (although not always lowest) capital requirements Transition to Advanced IRB status only with robust internal risk management systems and data Top 10 US banks expected to implement Advanced IRB at start of Basel II
Foundation IRB
Advanced IRB
Under Basel II, banks have strong incentive to move to IRB status and reduce capital charges by improving risk management systems
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External Ratings Criteria

Recognition External credit assessment institution (ECAI)(rating agency) recognised/ approved by national supervisor on basis of objectivity, independence, transparency, disclosure, resources and credibility ( 91) If two assessments, higher risk weight applied ( 97) If three or more assessments, two lowest risk weights referred to and higher of those two applied ( 98) Ratings assessment must take into account entire exposure (principal only ratings will not qualify) ( 100)
Multiple ratings
Assessment
CRM
Credit risk mitigation (CRM) not recognised if taken into account in rating ( 101)
Solicited
Subject to national discretion, unsolicited ratings recognised ( 108)
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Transition Period (IRB Banks only)

2007 Foundation IRB capital requirements for credit risk, operational risk and market risk may not fall below 95% of the current minimum required for credit and market risks ( 46) IRB capital requirements for credit risk, operational risk and market risk may not fall below 90% of the current minimum required for credit and market risks ( 46) IRB capital requirements for credit risk, operational risk and market risk may not fall below 80% of the current minimum required for credit and market risks ( 46) BIS Committee and/or national supervisors may extend floor if warranted ( 48)
2008
2009
2010 and after
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Chapter 2 Basel II First Pillar Minimum Capital Charges
Basel II Sovereign Capital Charges

Sovereigns In a Nutshell
Basel I Type of Sovereign OECD nonOECD Risk Weight 0% External Rating 100% AA- or above A BBB BB+ to Bbelow Bunrated Standardised bank risk weights 0% 20% 50% 100% 150% 100% * Country Basel II Sample est. FIRB bank risk weights* Poland Russia Turkey Bulgaria Czech Republic Hungary 25% 68% 141% 100% 24% 24% Rating A2/BBB+ Baa3/BBBB1/BBBa1/BBBA1/AA1/A-
Winners non-OECD rated above BB+ Examples: Chile, China, Thailand
Losers OECD rated below AA Examples: Czech Republic, Greece, Hungary, Mexico, Turkey
Inputs: average rating agency values for PD, LGD of 45%, supervisory value for EAD and M of 2.5. (Moodys rating applied if different from S&P)
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Sovereigns Standardised Banks ( 53-59)
Risk weights for sovereign exposures:
Rating Risk Weight
AAA to AA0%
A+ to A- BBB+ to BB+ to B- Below B- Unrated BBB20% 50% 100% 150% 100%
Risk weights may also be based on ECA risk scores Claims on non-central government public sector entities based on corporate exposure risk
weights
Claims on multilateral development banks have 0% risk weight if conditions are met,
including: (i) majority of MDBs ratings are AAA, (ii) significant portion of shareholders are AA- or better rated sovereigns, (iii) funding is in form of paid-in equity with little or no leverage, and (iv) conservative lending criteria
At national discretion, lower risk weight for banks exposures to their sovereign (or central
bank) in domestic currency; if adopted, other regulators may permit same risk weight
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Sovereigns IRB Banks ( 270-272)
Formula for exposure not in default:
Correlation (R) = Maturity adjustment (b) = Capital requirement (K) = Risk-weighted assets (RWA) = 0.12 (1 EXP (-50 PD)) / (1 EXP (-50)) + 0.24 [1 - (1 - EXP(-50 PD))/(1 - EXP(-50))] (0.11852 0.05478 ln (PD))^2 [LGD N [(1 - R)^-0.5 G (PD) + (R / (1 - R))^0.5 G (0.999)] PD x LGD] x (1 - 1.5 x b)^ -1 (1 + (M - 2.5) b) K x 12.5 x EAD
Capital requirement for defaulted exposure equals greater of zero and difference between exposures
LGD and banks best estimate of loss Input characteristics (applicable to all types of exposures) ( 285-325): PD: internally determined one-year probability of default LGD: - FIRB: 45% (senior)/75% (subordinated); adjusted (LGD* = LGD x (E* / E) for CRM recognition - AIRB: own estimates; adjusted for CRM recognition EAD: not less than sum of (a) amount by which bank capital would reduce if exposure written-off fully and (b) specific provisions and partial write-offs M: 2.5 years for FIRB (6 months for repos); own est. for AIRB for each exposure; max. 5 years
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Basel II Bank Capital Charges

Banks In a Nutshell
Basel I Type of Bank OECD nonOECD Risk Weight 20% External Rating 100% AA- or above A+ to ABBB+ to BBBBB+ to Bbelow Bunrated Standardised Option 1 20% 50% 100% 100% 150% 100% Standardised Option 2 20% External Rating 50% 50% 100% 150% 50% AA- or above A+ to ABBB+ to BBBBB+ to Bbelow BUnrated*** * Basel II FIRB est. risk weights* 14% - 24% 24% - 28% 38% - 68% 100% - 197% 226% NA
Winners non-OECD rated above BB+ under Option 2 Examples: May Bank, Public Bank Berhad
Losers OECD rated A or below under either option Examples: Commerzbank, HVB, SEB, Mizuho, Bradesco
Using inputs of average rating agency values for PD, LGD of 45%, supervisory value for EAD and M of 2.5.
** Using inputs of rating agency values for PD, LGD of 10%, supervisory value for EAD and M of 2.5. *** Internal PD estimate to be applied.
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Banks Standardised Banks ( 60-65)
2 options, selected by national regulator to apply for all banks in jurisdiction:
Option 1: Banks risk weighted one category below risk weights of banks sovereigns:
Rating Risk Weight
AAA to AA20%
Option 2: At national discretion, banks risk weighted on basis of own external ratings (plus
more favourable risk weight if claim maturity < 3 months)
Rating Risk Weight
AAA to AA20%
Local currency reduction: National regulators may reduce by one notch risk weight of local
currency bank debt having maturity of less than 3 months, subject to floor of 20%
Exposures to securities firms treated as bank claims if regulatory arrangements
comparable
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Banks IRB Banks ( 270-272)
Formulas for bank exposures same as for sovereign exposures, but with floor for PD of 0.03% Effective floor of 16 to 48 basis points for highest quality credits (depending on maturity
assumption) under Advanced IRB Generally, PD for high-quality bank debt will be below 0.03% floor (so floor must be used)
More realistic 10% LGD for Advanced IRB bank (rather than 45% supervisor-imposed LGD
for Foundation IRB banks) results in significant capital reductions

Compare to 56 basis point floor for highest quality ABS
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Basel II Corporate Capital Charges

Corporates In a Nutshell
Basel I Risk Weight 100% AA- or above External Rating A BBB+ to BBbelow BBunrated Standardised Option 1 20% 50% 100% 150% 100% Standardised Option 2 100% External Rating 100% 100% 100% 100% AA- or above A BBB BB+ to Bbelow BUnrated** * Basel II FIRB est. risk weights* 14% - 24% 24% - 28% 38% - 68% 100% - 197% 226% NA
Winners Corporates rated above BBB+
Losers Corporates rated below BB-
Using inputs of rating agency values for PD, LGD of 45%, supervisory value for EAD and M of 2.5.
** Internal PD estimate to be applied.
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Corporates Standardised Banks ( 66-68)
2 options, selected by national regulator to apply for all banks in jurisdiction:
Option 1: Corporates risk weighted as set out in following chart (supervisory authority to
increase 100% risk weight for unrated corporates where warranted by higher default rates):
Rating Risk Weight
AAA to AA20%
A+ to A- BBB+ to BB50% 100%
Below BB150%
Unrated 100%
Option 2: At national discretion, all corporates risk weighted at 100% without regard to
external ratings
SME Adjustment: 75% risk weight for unrated SME if exposure under 1 million and either
treated by bank as retail or guaranteed by individual

Includes claims on insurance companies
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Corporates IRB Banks ( 270-274)
Formulas for corporate exposures same as for bank exposures, including floor for PD of 0.03% SME Adjustment for firms setting total annual sales (S) at 50 million or and 5 million or more:
Correlation (R) = 0.12 (1 EXP (-50 PD)) / (1 EXP (-50)) + 0.24 [1 - (1 - EXP(-50 PD))/(1 - EXP(-50))] 0.04 (1 (S-5)/45)
Subject to national discretion, supervisors may allow banks to substitute total assets for total
sales
SME adjustment generates approx. 20% reduction in risk weights (depending upon original
creditworthiness)
Effective floor of 14% risk weighting for foundation IRB banks due to minimum PD of 0.03%
representing a capital charge of 112 bps
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Basel II Retail Capital Charges

Retail In a Nutshell
Basel I Risk Weight 100% Standardised bank risk weights Generally Default 75% if conditions met From 150% to 50% depending on level of specific provisions against exposure Credit cards Other Retail Basel II FIRB est. risk weights* 70% - 110%** 60% - 90%***
Internally determined PDs and LGDs under Foundation IRB
PD and LGD inputs provided by bank ( 331); PD floor at 0.03%
** Using PD of 3% and LGD of 80% and PD of 5% and LGD of 90%, respectively *** Using PD of 5% and LGDs of 40% and 60%, respectively
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Retail Standardised Banks ( 69-71)
Generally 75% risk weight if:
Exposure to individual or small business Exposure takes form of revolving credit, line of credit, personal loan, lease, or small
business facility (mortgage loan excluded to extent otherwise covered (see below))
Portfolio diversified (granular); Basel II accord suggests no aggregate exposure to any one
counterparty should exceed 0.2% of overall portfolio

Maximum aggregate counterparty exposure 1 million or less Effective floor of 600 basis points
Past Due Unsecured portion of exposure past due for more than 90 days, net of specific provisions, risk weighted as follows: 150% when specific provisions less than 20% of outstanding amount of exposure
100% when specific provisions 20% or more of outstanding amount of exposure 100% when the specific provisions 50% or more of outstanding amount of exposure, with
supervisory discretion to reduce risk weight to 50% in such case
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Retail IRB Banks ( 326-338)
Formula for qualifying revolving retail exposure not in default:
Correlation (R) = Capital requirement (K) = Risk-weighted assets (RWA) = 0.04 LGD N[(1 - R)^-0.5 G(PD) + (R / (1 - R))^0.5 G (0.999)] PD LGD K x 12.5 x EAD
Formula for other retail exposure not in default:

Correlation (R) = Capital requirement (K) = Risk-weighted assets (RWA) = 0.03 (1 EXP (-35 PD)) / (1 EXP (-35)) + 0.16 [1 - (1 - EXP(-35 PD))/(1 - EXP(-35))] LGD N[(1 - R)^-0.5 G(PD) + (R / (1 - R))^0.5 G (0.999)] PD LGD K x 12.5 x EAD
When only drawn balances securitised, bank must hold required capital against unfunded
commitment
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Basel II Real Estate Capital Charges

Real Estate In a Nutshell
Basel I Type of Exposure Residential Commercial Risk Weight 50% 100% Standardised bank risk weights Residential Commercial * Subject to conditions 35%* 100%** Residential Commercial Basel II FIRB est. risk weights 10% - 50%*** 20% - 90%**** *** Using PD of 1% and LGD of 10% and PD of 2% and LGD of 25% **** Using PD range of 0.07% and 2.1% and LGD of 35%
** Reduced 50% risk weight possible, subject to conditions
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Real Estate Standardised Banks
Residential Real Estate ( 72-73) 35% risk weight for exposures fully secured by mortgages on residential property occupied by the borrower or rented Strict prudential criteria (including loan to value ratios) determined by national regulators
Supervisors may require increased risk weight if data warrant Effective floor of 280 basis points
Commercial Real Estate ( 74) Generally 100% risk weight, given experience in numerous countries with troubled credits over the past few decades However, 50% risk weight possible in certain markets if (among other conditions): (i) tranche not greater than lower of 50% of market value and 60% of mortgage lending value, (ii) losses on tranche do not exceed 0.3% in any year, and (iii) overall losses from commercial real estate in relevant market do not exceed 0.5% in any year
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Real Estate IRB Banks
Residential Mortgages Formula for exposure not in default ( 327-328):
Correlation (R) = Capital requirement (K) = Risk-weighted assets (RWA) = 0.15 LGD N[(1 - R)^-0.5 G(PD) + (R / (1 - R))^0.5 G (0.999)] PD LGD K x 12.5 x EAD
High volatility commercial real estate (HVCRE) ( 280-284):
Supervisory Rating Risk Weight
Strong 95%
Good 120%
Satisfactory 140%
Weak 250% 0%
Default
At national discretion, banks may assign preferential risk weights of 70% to strong and
95% to good where maturity is less than 2.5 years or supervisor determines banks underwriting criteria and other risk characteristics are substantially stronger
Treated differently under CRD
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Basel II Covered Bonds Capital Charges

Covered Bonds In a Nutshell
Basel I (CRD) Type of Exposure UCITS qualifying Exceptions* * EU Risk Weight 10% 20% Standardised bank risk weights Senior debt RW Covered bond RW * 20%* 10% 50%** 20% 100% 50% 150% 100% PD of 0.03% PD of 0.15% Basel II (CRD) FIRB est. risk weights*** 4% 10%
Italy, Portugal, Sweden, UK
Requires rating of AAA to AA-
** Requires rating of A+ to A- under Option 1 and rating of A+ to BBBunder Option 2
*** LGD of 12.5% required in CRD with PD floor of 0.03%. Using inputs PD as noted, LGD of 12.5%, supervisory value for EAD and M of 2.5.
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Basel II Specialised Lending Capital Charges

Specialised Lending In a Nutshell
Basel I Risk Weight All 100% Standardised bank risk weights ( 80) All 100% Basel II IRB bank risk weights ( 275-284) Five Classes of Specialised Lending:
Project finance Object finance Commodities finance Income-producing real estate High-volatility commercial real estate
Generally: For exposures other than HVCRE, banks that do not meet requirements for estimation of PD will map internal grades to five supervisory categories (70% for strong, 90% for good, 115% for satisfactory, 250% for weak and 0% for default) ( 275) At national discretion, supervisors may allow 50% for strong and 70% for good if remaining maturity less than 2.5 years or supervisor determines underwriting or other risk characteristics are substantially stronger ( 277)
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Basel II Off Balance Sheet Items

Off Balance Sheet Items Standardised Banks ( 82-89)
Off-balance sheet items converted into credit exposure equivalents using credit conversion factor (CCF) Commitments Original maturity of up to one year: 20% CCF Original maturity in excess of one year: 50% CCF Unconditionally cancelable: 0% CCF Securities lending Lending of bank securities or posting as collateral (including repo and reverse repo transactions): 100% CCF Letters of Credit Short-term self-liquidating trade letters of credit: 20% CCF Other commitments As specified in Basel I Failed transactions As specified by national regulators Effect of failed transactions on off-balance sheet items subject to Basel/IOSCO review
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Basel II Off Balance Sheet Items

Off Balance Sheet Items IRB Banks ( 310-316)
Off-balance sheet items converted into exposure at default (EAD) input using credit conversion factor (CCF) under either foundation approach to EAD or advanced approach to EAD: Foundation approach to EAD Types of instruments and CCFs same as for standardised approach ( 82-89) except for commitments, note issuance facilities (NIFs) and revolving underwriting facilities (RUFs) CCF of 75% applicable to commitments, NIFs and RUFs regardless of maturity CCF of 0% if commitment unconditionally cancelable Advanced approach to EAD Banks allowed to use own estimates of CCF if allowed to use internal estimates for EAD ( 474-478) But 100% CCF if required under foundation approach to EAD
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Basel II Equity Capital Charges

Equity In a Nutshell
Basel I Type of Exposure Non-consol equity Risk Weight 100% Standardised bank risk weights Corporates Banks Securities firms 100%* 100% Company 100% DaimlerChrysler Siemens Fresenius Med. Care GE Sony
Basel II Simple Model* 290% 290% 290% 290% 290% 290% 290% PD/LGD Model** 92%*** 81%*** 264% 32%*** 82%*** 195%*** 120%*** Rating A3/BBB Aa3/AABa1/BB+ Aaa/AAA A1/A Baa3/BBBBaa1/BBB+
For banking book exposures. National supervisors may exempt from IRB treatment for up to ten years particular equity exposures held at publication date of Basel II accord ( 267) CRD has preferential treatment vs. Basel II Accord; supervisors may increase to 150% for venture capital and private equity investments ( 80)
Vivendi Universal Bertlesmann ** Inputs: average rating agency PDs, LGD of 90%, supervisory value for EAD and M of 5. *** Under Basel II ( 353) a floor risk weight of 200% applies to listed equities
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Basel II Equity Capital Charges

IRB Banks Three Approaches
Simple risk method ( 344-345) CRD: 190% risk weight for diversified private equity exposures (not in Basel II) CRD: 290% risk weight for publicly traded exposures (300% in Basel II) CRD: 370% risk weight for all other holdings (400% in Basel II) Internal models method ( 346-349) Taken from VaR models as 12.5 times difference between 99% percentile one-tail quarterly return and Risk free rate over long-term sample period Floor: capital charge under simple risk model but using 200% (traded) and 300% (not traded) PD/LGD method under CRD ( 350-361) Generally, use normal corporate exposure formulas if possible (results in risk weights substantially below 200% and 300% floor in Basel II) If bank does not have sufficient information to use definition of default, then apply scaling factor of 1.5 to risk weights Unfunded credit protection on equity exposure recognised, subject to LGD of 90%, with reduced LGD of 65% for private equity exposures
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Basel II Non-Performing Loan Capital Charges

Non-Performing Loans (NPLs) In a Nutshell
Basel I No uniform rules:
In Europe combination
Basel II/CRD Standardised bank risk weights ( 75-78) Generally: Unsecured portion of exposure past due for more than 90 days, net of specific provisions, risk weighted as follows:
150% when specific provisions less than 20%
IRB bank risk weights Generally: capital requirement for defaulted exposure is equal to greater of zero and difference between LGD (described in para. 468) and banks best estimate of expected loss ( 272) Under IRB approach, for asset classes other than securitisation, bank must compare (i) total amount of eligible provisions with (ii) total expected losses and deduct excess (if any) of expected losses over provisions ( 43, 380-383) For securitisation exposures or the PD/LGD approach for equity exposures, bank must first deduct EL amounts under paras. 563 and 386, respectively ( 43)
of general and specific provisions

In
US five-tier ranking system derives capital
of outstanding amount of exposure

100% when specific provisions 20% or more of
outstanding amount of exposure

100% when specific provisions 50% or more of
outstanding amount of exposure, with supervisory discretion to reduce risk weight to 50% in such case Residential Mortgages: risk weighted at 100% net of specific provisions; at national discretion risk weight reduced to 50% of specific provisions 20% or greater Commercial Mortgages: weighted at 100% unexpected loss risk-
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Non-performing loans Generally
Essentials:
Non-performing loan under Basel II is any loan that is past due for more than 90 days, but
subject to national variation

For purposes of defining secured portion of non-performing loan, eligible collateral and
guarantees will be recognised as under CRM rules for performing loans

Capital charges depend on level of specific provisions held against loan
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Non-performing loans Standardised Approach
Unsecured non-performing loan:
Unsecured portion of non performing loan will be risk-weighted as follows: 150% when specific provisions less than 20% of outstanding amount of exposure 100% when specific provisions 20% or more of outstanding amount of exposure 100% when specific provisions 50% or more of outstanding amount of exposure, with
supervisory discretion to reduce risk weight to 50% in such case Secured non-performing loan:
Qualifying residential mortgage loans risk weighted at 100%, net of specific provisions. If
such loans are past due but specific provisions are no less than 20% of their outstanding amount, the risk weight applicable to the remainder of the loan can be reduced to 50% at national discretion
Commercial mortgages: unexpected loss risk weighted at 100% Non-performing loans fully secured by forms of collateral not recognized under Basel II (eligible
financial collateral) risk weighted at 100% when provisions reach 15% of outstanding amount of loan
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Non-performing loans IRB Approach
General Rules: Capital charges to cover unexpected losses
Bank must cover expected losses with specific provisions
Consequences: Fixed LGD at 45% for non-retail assets and senior exposures may result in risk weights as follows: 565% when no specific provisions of outstanding amount of exposures
400% when specific provisions 20% of outstanding amount of exposure 0% when the specific provisions 50% or more of outstanding amount of exposure
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Non-performing loans sample capital calculation (100 million NPL)
Specific Provisions Net exposure Capital Charges Basel I Standardised Approach IRB Approach Advanced IRB Approach Risk Weights Basel I Standardised Approach IRB Approach Advanced IRB Approach 100% 150% 565%
Assumptions:
0% 100 70
30% <50
>50% 20
80%
8.0 12.0 45.0 30.0
5.6 5.6 15.0 0.0
3.2 1.6 0.0 0.0
1.6 0.8 0.0 0.0
100% 100% 270% 0%
100% 50% 0% 0%
100% 50% 0% 0%
380%
Supervisory discretion allows use of 50% risk weight if exposure has specific provision of 50% or better LGD in Advanced IRB Approach is 30% IRB Approach and Advanced IRB Approach are approximated
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Non-performing loans Originators point of view and market outlook
Motivations to sell non-performing loan portfolios: Reduce capital supporting non-performing loans
Reduce negative carry by eliminating financing needs Shift capital and resources into more profitable businesses Optimize banks balance sheet Improve banks credit ratings Reduce operating costs due to smaller work-out departments
Market outlook Basel II will motivate banks to sell NPLs

German NPL market estimated between 160 billion and 300 billion (Boersenzeitung
18.2.2005)
German NPL market development to increase to estimated 20 billion this year and possible
average of 15 billion per year after 2007 (Boersenzeitung 18.2.2005)

No capital charges required if investors not banks
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Basel II Credit Risk Mitigation

Credit Risk Mitigation (CRM) In a Nutshell
Basel I Type of Exposure OECD sovereign OECD bank Non-OECD bank** * Risk Weight* 0% 20% 20% Standardised banks Simple approach: Risk weight of CRM is substituted for risk weight of unsupported exposure Comprehensive approach: Adjust value of both amount of exposure and value of CRM with either supervisory or own-estimate haircuts; adjust for maturity and currency mismatches Basel II IRB banks Generally: CRM reduces PD or LGD inputs
Same as simple approach under Basel II for standardised banks (i.e., substitution)
** Maturity of < one year
Subject to considerable change due to Basel/IOSCO review, including introduction of double default recognition for certain exposures rather than substitution approach
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Credit Risk Mitigation General Rules ( 109-210)
Determine capital as provided on following page, except determine capital pursuant to securitisation rules (following) if credit risk protection tranched (e.g., purchased derivatives)
Protection Buyer
Protection Seller
Treat as cash position in underlying

First to default and second to default protection
( 207-210) Specific Adjustments

Proportional cover ( 190(c), 198)) Maturity and currency mismatches:
size of haircut depends on type of instrument, type of transaction and frequency of mark-to-market and remargining ( 135)
46

Credit Risk Mitigation Capital Calculation Method
Simple Approach ( 129, 182-185) Risk weight of CRM substituted for risk weight of unsupported exposure ( 129) Subject to floor of 20%, with exceptions, e.g., core market participant floor is 0%, subject to certain conditions ( 183) Comprehensive Approach ( 130-138) Supervisory or own-estimate haircuts adjust both amount of exposure and value of collateral received ( 130) Further adjustments for maturity mismatches (square root of time formula) and currency mismatches ( 135) Guarantees and credit derivatives recognised; only limited double-default recognition proposed under Basel/IOSCO review ( 140-142, 189-193) VaR models permitted subject to supervisory approval ( 138, 178-181) On-balance sheet netting recognised ( 139, 188) Generally Collateral reduces PD or LGD input (reducing required capital) ( 289-307) Guarantees and credit derivatives recognised; only limited double-default recognition proposed under Basel/IOSCO review ( 301) VaR models permitted subject to supervisory approval ( 292) On-balance sheet netting recognised ( 292)
47
Standardised Banks
IRB Banks

Credit Risk Mitigation - Eligible Financial Collateral
Eligible Collateral ( 145-146)
Cash and gold Rated debt securities (sovereign BB- or higher; other BBB- or higher) Senior, unrated debt securities issued by bank if listed on recognised
exchange and all other bank issues are BBB- or higher Equities included in main index or listed on recognised exchange UCITS/mutual funds where price quoted daily and UCITS/fund only invests in above instruments For IRB banks only: receivables, real estate and other collateral meeting minimum requirements ( 289) All items recognised as collateral in banking book can also be recognised in trading book
No correlation
Collateral must not have material positive correlation with underlying exposure ( 124)
First-to-default:
First-to-Default Second-to-Default
recognised if bank obtains protection for entire basket, credit event triggers contract, and notional of underlying less than contract ( 207-208); regulatory capital relief for asset with lowest risk-weight in the basket Second-to-default: recognised if bank obtains first-to-default protection as above or if one asset already defaulted ( 209-210)
48

Credit Risk Mitigation - Other Criteria
Recognition of credit derivatives ( 191-194) Legally binding documentation; direct claim on provider; irrevocable and unconditional Mandatory credit events not determined solely by protection provider: (a) failure to pay, (b) insolvency and (c) Restructuring (recognition up to 60% of underlying if no restructuring) If asset mismatch, underlying/reference obligation must be pari passu and protection must contain cross-default/cross-acceleration Cash settlement permitted if robust valuation process If protection purchasers right to transfer underlying subject to obligor consent, may not be unreasonably withheld Eligible protection providers ( 195) Sovereigns, public sector entities, and banks and securities firms with lower risk weighting than underlying exposure (not SPEs) Counterparty risk charges for OTC derivatives ( 186-187) Counterparty credit risk charge = [(RC + add-on) CA] x r x 8% where: RC=replacement cost; add-on= as determined under Basel I; CA=volatility adjusted collateral amount; r=risk weight of counterparty Being changed to model-based approach under Basel/IOSCO review
Source:
Text
49
Basel II Securitisation Capital Charges

Securitisation In a Nutshell
Basel I Type of Exposure Generally First loss Unfunded < one year Risk Weight 100% Deduct 0% Standardised banks Risk weights based on rating of position. If exposure unrated, then deduct from capital except in case of:
Most senior exposure (look-through to average
Basel II IRB banks Hierarchy of approach:

If exposure rated must determine risk weight
based on ratings based approach (RBA)

If unrated exposure to ABCP conduit may use
risk weight of pool)

Second loss position or better (look-through to
higher of 100% and highest risk weight of pool)

Liquidity facilities (credit conversion factors
internal assessments approach (IAA) if conditions met

If unrated exposure may use supervisory
depending on type and length of liquidity commitment)
formula approach (SFA) if can determine inputs (including using top down methodology)
If unrated exposure and RBA, IAA and SFA
unavailable, may use exceptional look through approach with regulator consent on temporary basis for liquidity facilities
Otherwise, must deduct unrated exposure from
capital
Source:
Text
50

Securitisation Standardised Banks Ratings Based Approach
Short Term Ratings Standardised bank risk weights ( 567) A-1/P-1 External Rating A-2/P-2 A-3/P-3 All other ratings/ unrated 20% External Rating 50% 100% Deduct
Long Term Ratings Standardised bank risk weights ( 567) AA- or above A BBB BB+ to BBB+ or below unrated * 20% 50% 100% 350%* Deduct Deduct
Originating banks must deduct BB+ to BB- exposures ( 569)
Source:
Text
51

Securitisation Standardised Banks Except as provided below, unrated securitisation exposures must be deducted ( 567)
Most senior exposures ( 572-573) If the most senior tranche is unrated, the bank that holds or guarantees that position may look through to the underlying pool to determine the risk weight (and may assign a risk weight equal to average of risk weight assigned to exposures in underlying pool), provided that the composition of the pool is known at all times Second loss positions or better ( 574-575) Qualifying exposures provided by sponsor banks in ABCP programs that are in second loss position or better may apply a risk weight equal to the greater of (x) 100% and (y) the highest risk weight assigned to any exposure in underlying pool, but only if: The first loss position provides significant credit protection
The associated credit risk is investment grade or better The bank holding the exposure does not hold the first loss position
Eligible liquidity facilities ( 576) Banks may apply risk weight to eligible liquidity facilities equal to highest risk weight assigned to any exposure in underlying pool
52
Source:
Text

Securitisation Standardised Banks Liquidity facilities ( 579-580)
Generally 20% credit conversion factor (CCF) for eligible liquidity commitments with an original maturity of one year or less 50% CCF for eligible liquidity commitments of more than one year
100% CCF for all other liquidity commitments, including rated commitments
Increase from 0% under Basel I Regulators believe liquidity absorbs more than just liquidity risks Credit conversion factor of 0% theoretically possible if: Commitment qualifies as eligible liquidity
Commitment can only be drawn if general market disruption (i.e., where more than
one SPE across different transactions is unable to roll over maturing commercial paper i.e., not as result of impairment in credit quality of specific SPE or its pool)
Commitment must be secured by underlying assets and rank pari passu with conduits
securities
Source:
Text
53

Securitisation Standardised Banks Eligible Liquidity ( 578)
Documentation must identify and limit circumstances of draw, and amounts drawn
must be limited to amount likely to be repaid from underlying assets and sellerprovided credit enhancement
No incurred losses should be covered and draw should not be automatic Asset quality test should not cover defaulted assets as defined in paragraphs 452-459
(including receivables more than 90 days past due unless extended up to 180 days by national regulators); if funding based on rating of underlying asset, it must be rated at least investment grade at time of draw
Facility cannot be drawn after all applicable credit enhancement to which liquidity
facility has access has been exhausted

Repayment of draws must not be subordinated to interests of any conduit security
holder
Source:
Text
54

Securitisation Standardised Banks Overlapping Exposures ( 581)
For example, if conduit sponsor provides programme-wide liquidity and credit enhancement to ABCP conduit: If funding one exposure precludes funding the other exposure, sponsor need not hold capital against both exposures Instead, for overlapping portion sponsor should hold capital against exposure with highest credit conversion factor Query How to allocate partial credit enhancement
How to allocate programme-wide credit enhancement
Eligible servicer advances ( 582)

Servicers may contractually agree to advance cash to insure uninterrupted payments
to investors if full reimbursement right is senior to other claims

At national discretion, CCF of 0% for facility cancellable without prior notice
Source:
Text
55

Securitisation IRB Banks
Options IRB bank must calculate capital on basis of:
external ratings pursuant to ratings based approach (RBA) inputs into supervisory formula (SF) approach internal assessments approach (IAA) Cap: If IRB would require more capital for securitisation exposure than had the position not
been securitised, bank may use IRB capital requirement for underlying exposures ( 610) Hierarchy ( 609) IRB bank must use ratings based approach (RBA) to calculate capital if external rating or inferred rating available Where RBA not available, bank may use SF or IAA if available
Where neither RBA nor SF or IAA are available, bank may use look-through approach (see
below) in paragraph 639

Otherwise, position must be deducted
Source:
Text
56

Securitisation IRB Banks Ratings Based Approach
Short Term Ratings IRB bank ratings-based risk weights ( 616) Most senior External Rating A-1/P-1 A-2/P-2 A-3/P-3 All other ratings/ unrated 7% 12% 60% Deduct Base case 12% 20% 75% Deduct Non-granular 20% 35% 75% Deduct AAA AA A+ A External Rating ABBB+ BBB BBBBB+ BB BB<BB- or unrated
Source: Text
Long Term Ratings IRB bank ratings-based risk weights ( 615) Most senior 7% 8% 10% 12% 20% 35% 60% 100% 250% 425% 650% Deduct Base case 12% 15% 18% 20% 35% 50% 75% 100% 250% 425% 650% Deduct Non-granular 20% 25% 35% 35% 35% 50% 75% 100% 250% 425% 650% Deduct
57

Securitisation IRB Banks Internal Assessments Approach ( 619-622)
IRB bank may use IAA if conditions satisfied Only available for exposures to ABCP programmes
Internal assessments mapped to equivalent external ratings and exposures assigned
resulting risk weights

Supervisor may suspend banks use of IAA until deficiencies (if any) are corrected
Conditions ABCP issued by conduit must be externally rated

Internal assessment must be based on ratings criteria for each asset type and be
equivalent of investment grade when exposure is funded

Banks supervisors must be satisfied that internal ratings meet required criteria in
paragraphs 90-108 and with relevant external ratings criteria

Bank must show that internal criteria matches external criteria
Source:
Text
58

Conditions (contd) Supervisor may, if warranted, disallow any seller provided recourse, guarantees or excess spread or any other first loss enhancement Internal assessment must identify gradations of risk that can be mapped to external ratings gradations Internal assessment process, and particularly stress factors, must be at least as conservative as publicly available ratings criteria from rating agencies rating ABCP programme: Bank must choose most conservative of two or more external criteria if two or more criteria apply Bank must not choose only ratings agencies with less restrictive methodologies to rate ABCP programme and must keep up with methodology changes Bank cannot use a non-public ratings methodology but may consider more conservative non-publicly available methodology For new or unique transactions, bank may discuss applying IAA with supervisor
Source:
Text
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Conditions (contd) Internal and external auditors, a rating agency, or banks internal credit review or risk management function must perform regular reviews of internal assessment process; if internal reviews are used, they must be independent of ABCP business line Bank must track and adjust internal processes over time
ABCP programme must have credit and investment guidelines (which should cover issues
specified by supervisor)
Credit analysis of sellers risk profile must be performed ABCP programme must have minimum asset eligibility criteria that exclude defaulted assets,
limit concentrations, limit asset tenor, etc.

ABCP programme should have collections processes established that consider operational
capability and credit quality of servicer, lockbox arrangements, etc.

All sources of risk must be considered (including credit and dilution) Structural features must be included such as wind down events
Source:
Text
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Securitisation IRB Banks Supervisory formula approach ( 623-636)
Capital charge determined under supervisory formula (see following page) on basis of five inputs (with 56 basis point floor): Regulatory capital of exposure if held on balance sheet (KIRB) Degree of credit enhancement supporting exposure (L) Exposures thickness (T) Effective number of exposures in the securitised pool (N) Pools exposure-weighted average loss given default (LGD) Definition of KIRB KIRB is ratio (expressed as a decimal) of the IRB capital requirement for the underlying exposures in the pool to the notional amount of such exposures For structures involving SPE, all SPE assets must be included in pool, including residual interests (such as a cash collateral account) Reserves against assets in pool do not reduce notional amount of the pool in determining KIRB, but can count as credit enhancement
Source:
Text
61

Supervisory Formula ( 624-626):
IRB Capital charge = greater of (a) 0.0056 and (b) (S [L+T] S [L]) S[L] = L if L<= KIRB, else, S[L]= KIRB +K[L] K[KIRB] +(d. KIRB / )(1- exp( *(KIRB L)/ KIRB)) Where h=(1- KIRB /LGD)N c= KIRB /(1-h) v =((LGD- KIRB) KIRB +0.25(1-LGD) KIRB )/N f=((v + KIRB 2 )/(1-h) c 2 ) + (((1- KIRB) KIRB v )/(1-h) ) g=((1-c)c)/f -1 a=gc b=g(1-c) d=1-(1-h)(1-Beta[KIRB, a,b]) K[L]=(1-h)((1-Beta[L,a,b]L+ Beta[L,a+1,b]c) Beta [L,a,b] refers to the cumulative beta distribution with parameters a and b evaluated at L, =1000 and = 20
Source:
Text
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Securitisation IRB Banks Liquidity facilities ( 637-639)
Generally Eligible liquidity facilities only drawn in event of general market disruption (as defined in 580) have a 20% CCF Otherwise, all liquidity facilities have 100% CCF; 100% CCF permits IRB banks to provide multi-year liquidity or structured liquidity without additional capital requirements Determination of capital If facility is externally rated, bank may rely on rating provided it uses 100% CCF If facility is unrated, bank may use IAA if qualifying If facility is unrated and IAA unavailable, bank must determine KIRB either using bottom-up approach or top-down approach and apply SF Look-through procedure If not practical to use bottom-up or top-down, bank may, on an exceptional basis and subject to supervisory approval, temporarily apply highest risk weight of pool under standardised approach to individual exposures covered by eligible liquidity facility In such a case, the bank must use 50% CCF for commitments of one year or less and 100% for commitments in excess of a year, or 20% CCF for market disruption liquidity
63
Source:
Text

Securitisation IRB Banks Top-Down Approach ( 362-373)
For use in determining KIRB in SF Generally Top-down approach available provided banks programme complies with criteria for
eligible receivables and minimum operational requirements Intended mainly for asset-backed securitisation exposures, but may also be used for appropriate on-balance sheet exposures
Eligible Corporate Receivables ( 241-243)

Eligible corporate receivables must satisfy following conditions for application of top-down
approach: Bank has not directly or indirectly originated receivables (and has purchased them from unrelated third parties) Receivables generated on arms length basis (and not subject to inter-company contra accounts) Purchasing bank must have claim on all proceeds from pool or a ratable interest National supervisors to develop concentration limits Recourse to seller does not automatically disqualify transaction as long as cash flows from assets are primary source of repayment (plus certain other requirements)
Source: Text
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Securitisation IRB Banks Inferred Ratings ( 617-618)
When following conditions are met, bank must attribute inferred rating to unrated
exposure:
Reference rated exposure must be subordinate in all respects to unrated exposure Credit enhancements must be taken into account in determining subordination (for
example, if reference position benefits from third party guarantee but unrated position does not, then latter may not be assigned inferred rating)
Maturity of reference position must be equal to or longer than that of unrated
position
Inferred rating must be updated continuously to reflect changes in external rating of
reference position
External rating must satisfy general requirements for recognition of external ratings
in securitisation transactions
Source:
Text
65
Basel II Early Amortisation Structures

Securitisation Early Amortisation Provisions
Originating banks are required to hold capital against investors interests in a securitisation when It sells assets into a structure containing an early amortisation feature and The exposures sold are of a revolving nature Banks are not required to apply the early amortisation rules to: Replenishment structures where the underlying exposures do not revolve and the early amortisation ends the banks ability to add new exposures Transactions of revolving assets containing early amortisation features that mimic term structures (i.e., where the risk does not return to the originating bank) Structures securitising credit lines where the investors remain liable to fund future draws by borrowers after amortisation events The early amortisation clause is triggered solely by events unrelated to the performance of the pool or the originator
66

Applicable capital charge equals (1) the notional amount of the investors interest times (2) the applicable credit conversion factor times (3) the risk weight for the underlying credits but capitalised assets (such as future margin income) are treated separately and will typically be deducted from capital Capped at the greater of: the capital required for retained securitisation exposures the capital required had the exposures not been securitised Applicable credit conversion factor based on whether the amortisation is controlled or non-controlled the securitised exposures are (i) uncommitted retail credit lines that are unconditionally cancellable or (ii) any other type of exposure
67

A controlled amortisation must meet the following conditions: The originator has in place a capital/liquidity plan to ensure it has sufficient capital and liquidity if early amortisation occurs Throughout the transaction, including the amortisation period, there is a pro rata sharing of interest, principal, expenses, losses and recoveries based on the balances of receivables outstanding at the beginning of each month The amortisation period fixed by the bank is sufficient for 90% of the total debt outstanding at the beginning of the period to have been repaid or to have been recognised as in default The pace of repayment is not any more rapid than would be allowed under straight-line amortisation over the period fixed as described above
68

Credit conversion factors (CCF) For structures with controlled amortisation 0% to 40% for uncommitted retail lines (see next page) 90% for committed retail lines 90% for all non-retail lines (whether committed or uncommitted) For structures with non-controlled early amortisation 0% to 100% for uncommitted retail lines (see next page) 100% for committed retail lines 100% for all non-retail lines (whether committed or uncommitted) For uncommitted retail credits Calculate two points: The point at which the bank is required to trap excess spread (or 4.5% above the early amortisation trigger if no trapping) The three month average excess spread for the transactions Divide the excess spread level by the trapping point and look up the CCF for the transaction on the following page
69

3 month average excess spread CCF for Uncommitted Retail CCF for Uncommitted Retail as % of trapping point Exposures in Controlled Exposures in Non-Controlled Structures Structures 133.33% or more Less than 133.33% to 100% Less than 100% to 75% Less than 75% to 50% Less than 50% to 25% Less than 25% 0% 1% 2% 10% 20% 40% 0% 5% 15% 50% 100% 100%
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Basel II Trading Book Capital Charges

Trading Book In a Nutshell*
Basel I (1996 Market Risk Amendment) Minimum capital requirement:
Credit risk requirements under regulatory capital rules,
Basel II (MRA; Accord 864-718) Essentially unchanged, except for revisions to:
Definition of trading book:
excluding debt and equity securities in trading book and all positions in commodities, but including credit counterparty risk in trading book or banking book, plus
Capital charges for specific risk and general market risk
positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book documented trading strategy; positions actively monitored and managed on trading desk; position limits set and monitored; positions marked to market at least daily; positions reported to senior management
Basic requirements for trading book treatment: clearly
under either standardised measurement method or internal models method (or combination thereof)
Capital charges for specific risks in connection with
Paragraph references in materials below on trading book are to 1996 Market Risk Amendment (MRA) unless otherwise noted
interest rate risk (see below)

Specific risk capital charge offsets for positions hedged
by credit derivatives (see below)

New
counterparty credit risk charges for OTC derivatives, repo-style and other transactions booked in trading book, and adjusted add-on factors for single name credit derivatives (see below)
Basel/IOSCO review will change trading book treatment significantly

71
Source:
Text

Capital Requirement
Definition of Capital (MRA Intro., II.1 I.2) At discretion of national regulators banks may employ third tier of capital for sole purpose of meeting proportion of capital requirements for market risks Tier 3 capital limited to 250% of banks tier 1 capital required to support market risks; tier 2 capital may be substituted for tier 3 capital up to same 250% limit subject to overall limits for tier 2 capital in Basel II Accord For subordinated debt to be eligible as tier 3 capital it must be available to absorb losses in event if insolvency and must at minimum: Be unsecured, subordinated and fully paid up
Have original maturity of at least two years Not be repayable prior to maturity date unless banks supervisor agrees Be subject to lock-in clause stipulating that neither interest nor principal may be paid at maturity
if payment would cause bank to fall below minimum capital requirements Calculation of Capital (MRA Intro., II.3 I.4) Bank must first calculate capital for credit risk, and only afterwards calculate market risk requirement Capital requirement to be met on continuous basis at close each business day (MRA Intro., I.14)
Source:
Text
72

Standardised Measurement Method Interest rate risk
Specific risk (MRA Part A.1.I; Accord 710) Specific risk charge:
Government:
AAA to AAA+ to BBB-
0.00% 0.25% (residual term to final maturity 6 months or less) 1.00% (residual term to final maturity between 6 and 24 months) 1.60% (residual term to final maturity exceeding 6 months) 0.25% (residual term to final maturity 6 months or less) 1.00% (residual term to final maturity between 6 and 24 months) 1.60% (residual term to final maturity exceeding 6 months) 8.00%
Other rating: 8.00% Qualifying:
Other:
Offsetting restricted to matched positions in identical issue (including positions in derivatives); no
offsetting if issuer same but not same issue Government category includes all forms of government paper Qualifying category includes securities rated investment grade by at least two recognised rating agencies or (subject to supervisory approval) unrated but either of comparable investment quality (standardised banks) or rated equivalent by banks internal systems and exchange listed (IRB banks) (Accord 712) National regulatory may impose higher specific risk charge on other category and/or disallow offsetting
Source:
Text
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Standardised Measurement Method Interest rate risk (contd)
General market risk (MRA Part A.1.II) Generally Two methods: maturity method and duration method Capital charge is sum of four components: net short or long position; small proportion of matched positions in each time band (vertical disallowance); larger proportion of matched positions across different time bands (horizontal disallowance); net charge for positions in options Maturity method Opposite positions of same amount in same issue may be omitted from framework Positions weighted by prescribed price sensitivity factor Partial offset (10% capital charge) for weighted longs and shorts in each time band Two rounds of horizontal partial offsetting between time bands pursuant to prescribed scale Duration method Calculate price sensitivity on basis of prescribed interest rate change depending on maturity Slot resulting sensitivity measures into duration-based ladder within time bands Subject long and short positions to 5% vertical disallowance Carry forward net positions for horizontal offsetting as above
Source:
Text
74

Interest rate derivatives (MRA Part A.1.III) Convert derivatives into positions in relevant underlying subject to specific and general market risk charges as above Futures: treated as combination of long and short position in notional government security Swaps: treated as two notional positions in government securities with relevant maturities No specific risk charge for most interest rate derivatives General market risk charge generally same as for cash positions, subject to exemption for very closely matched positions in identical instruments Counterparty credit risk charge add-on factors for single name credit derivative (Accord 707) If reference asset is qualifying: 5% for protection buyer and 5% for protection seller If reference asset is not qualifying: 10% for protection buyer and 10% for protection seller
Source:
Text
75

Offsetting for interest rate derivatives (MRA Part A.1.III) Banks may exclude long and short positions (both actual and notional) in identical instruments with exactly the same issuer, coupon, currency and maturity, and may fully offset a matched position in a future or forward and its underlying If choice of underlying deliverable instruments (e.g., cheapest-to-deliver), offset only permitted if future or forward move in close alignment Offset may be allowed for opposite positions in same category of instruments if same underlying, same nominal value and same currency e.g., futures (identical products maturing within 7 days of each other); swaps and forward rate agreements (identical reference rate and coupon within 15 basis points); limits on next interest fixing date No offsetting for positions in different currencies But modified by Accord (see next page)
Source:
Text
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Specific risk capital charges for positions hedged by credit derivatives (Accord 713-718)
No specific risk capital charge for either side of the position if values of full legs always move in the
opposite direction and generally to the same extent (e.g., identical instruments; long cash position hedged by total rate of return swap with exact match between reference obligation and underlying)
80% specific offset recognised when value of two legs always moves in opposite direction but not
broadly to same extent (e.g., long cash position hedged by credit default swap or credit-linked note with exact match between reference obligation and underlying); to extent that transaction transfers risk, 80% risk offset for side with higher capital charge and zero specific risk requirement on other side
Partial allowance where value of two legs usually moves in opposite direction (e.g., asset mismatch
between reference and underlying)

Otherwise, specific risk capital charge for both sides of transaction
Source:
Text
77

Standardised Measurement Method Equity position risk
Specific risk and general market risk (MRA Part A.2.I) Specific risk charge
Defined as banks gross equity position, calculated on national market-by-market basis 8% unless portfolio both liquidity and well-diversified, in which case 4% General market risk charge Defined as difference between sum of longs and sum of shorts, also calculated on national
market-by-market basis
8%
Equity derivatives (MRA Part A.2.II) Convert derivatives into positions in relevant underlying
Matched positions may be fully offset Index risk: Further capital charge of 2% against net long or short position in index contract
comprising diversified portfolio of equities to cover factors such as execution risk

Arbitrage: Additional 2% capital charge in qualifying futures-related arbitrage strategies may be
applied only to one index with opposite position exempt from capital charge
Source:
Text
78

Standardised Measurement Method Foreign exchange risk
Two processes (MRA Part A.3) Measure exposure in single currency position
Measure risks inherent in mix of long and short positions in different currencies
Measuring positions in single currency (MRA Part A.3.I) Measured by summing: net spot position (including interest earned but not received, expenses accrued, and expenses not yet accrued but certain); net forward position; guaranties certain to be called and likely to be irrevocable; net future income/expenses not yet accrued but already fully hedged (at bank discretion); net delta-based equivalent of total book of foreign currency options Positions taken to hedge capital ratio may be excluded if structural (non-dealing) nature, applied consistency, does no more than protect bank capital ratio Measuring foreign exchange risk (MRA Part A.3.II) Two alternatives:
shorthand method treating all currencies equally capital charge is 8% times overall net
open position determined by converting nominal amount (or net present value) of net position in each currency into reporting currency
internal models approach (see below)
Source:
Text
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Standardised Measurement Method Commodities risk
Generally (MRA Part A.4) Defined as physical product which is or can be traded on a secondary market More complex and volatile, and less liquid Variety of additional risks, including basis risk (risk that relationship between prices of similar commodities varies over time); interest rate risk (risk of cost of carry); forward gap risk (risk that forward price may change other than due to interest rate changes) Three options: models (see below); measurement system; simplified approach Measurement system (maturity ladder) approach (MRA Part A.4.II) Express commodity position in standard unit of measurement (barrel, etc.) Convert net position at current spot rates into national currency Assess capital charge against matched long and short positions in specified time bands and specified spread rates Residual net positions in nearer time banks may be carried forward to offset exposures in later time bands, subject to surcharge equal to 0.6% of net position carried forward 15% capital charge against resulting long or short position Simplified approach (MRA Part A.4.III) Same capital charge for directional risk as under measurement approach Additional capital charge of 3% of gross positions in each commodity for basis risk, interest rate risk and forward gap risk
Source:
Text
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Standardised Measurement Method Options
Generally (MRA Part A.5) Banks with purchased options only permitted to use simplified approach Otherwise, use either one of the intermediate approaches (see below) or internal model (see below) Simplified approach (MRA Part A.5.I) Long cash and long put, or short cash and long call: Capital charge is market value of underlying multiplied by sum of specific and general market risk charges for underlying less amount option is in money (if any) bounded by zero Long call or long put: Capital charge is lesser of (a) market value of underlying multiplied by sum of specific and general market risk charges for underlying and (b) market value of option Delta-plus (intermediate) approach (MRA Part A.5.II) Options reported as position equal to market value of underlying multiplied by delta Delta-weighted capital charge: Determined pursuant to Parts A.1 through A.4 depending on whether option underlying is debt security or interest rate instrument (Part A.1), equity (Part A.2), foreign exchange and gold (Part A.3) or commodities (Part A.4) Additional capital charges for gamma (measuring rate of change of delta) and vega (measuring sensitivity of value of option to change in volatility) Scenario (intermediate) approach (MRA Part A.5.II) (for more sophisticated banks) Capital charge determined by calculating changes in option value at various points along grid of ranges of changes in option portfolios risk factors
Source: Text
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Internal models method (MRA Part B)
Generally (MRA Part B.1) Conditional upon explicit approval of supervisor Conditions to use of internal model (MRA Parts B.2 B.7) Qualitative standards: independent risk control unit; integration with day-to-day risk management of bank; trading limits; compliance function; stress-testing; back-testing; external validation; independent review Quantitative standards: value-at-risk calculated daily (to 99th percentile, one-tailed confidence interval; with instantaneous price shock equivalent to 10 day movement in prices); update data sets no less frequently than every three months; no particular type of model prescribed (but must accurately capture option risks); discretion to recognise empirical correlations within broad risk categories; daily calculation of capital requirement; multiplication factor based on supervisor judgment of quality of banks risk management system Market risk factors: risk measurement system that models yield curve (interest rate risk), foreign exchange exposures (foreign exchange risk), market movements in equities (equity risk), convenience yield (commodities risk)
Source:
Text
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Chapter 3 Basel II First Pillar Operational Risk Capital Charges
Basel II Operational Risk Charges

Defined as risk of loss from inadequate or failed internal processes, people and systems, or from external events ( 644) Examples of risks covered Internal and external fraud
Legal risks Damages to customers Losses arising out of labour, health and safety, diversity, personal injury, etc. Damage to physical assets Business interruption
Examples of risks not covered Reputational risk

Strategic errors
Source:
Text
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Basel II Operational Risk Charges

Basic Indicator Approach ( 649-651) 15% of banks average annual gross income over previous three years Standardised Approach ( 652-654, 660-663) Capital charge for each of 8 business lines calculated against average annual gross income for business line times: 18% for corporate finance (15% transitional charge within EU if major activity)
18% for trading and sales (15% transitional charge within EU if major activity) 12% for retail banking 15% for commercial banking 18% for payment and settlement 15% for agency services 12% for asset management 12% for retail brokerage
Advanced Measurement Approach ( 655-659, 664-679) Calculated on basis of internal operational risk management system approved by national regulator
Source:
Text
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Chapter 4 Basel II Second Pillar Supervisory Review
Basel II Supervisory review

Four key principles of supervisory review ( 725-760)
Principle 1: Banks should have process for assessing overall capital adequacy in relation
to risk profile and strategy for maintaining capital levels. Five main features of rigorous process: Board and senior management oversight
Sound capital assessment Comprehensive risk analysis (credit risk, operational risk, market risk, interest rate
risk in banking book, liquidity risk, other risk)

Monitoring and reporting Internal control review Principle 2:
Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as ability to monitor and ensure compliance with ratios. Supervisors should take appropriate action if not satisfied. Supervisors should expect banks to operate above minimum ratios and should have ability to require banks to hold capital in excess of minimum Supervisors should seek to intervene at early stage and require rapid remedial action
Principle 3:
Principle 4:
Source:
Text
87

Specific issues ( 761-778)
Interest rate risk in banking book: Basel II treats interest rate risk under Second Pillar
of supervisory review (rather than First Pillar of regulatory capital) due to differences in methods banks use to handle risk
Credit risk:
Supervisory review is appropriate to regulate stress tests under IRB approach, definition of default used to determine PD and/or LGD and EAD, residual risk, credit concentration risk and operational risk
Other issues ( 779-783)

Supervisory transparency and accountability:
Supervisors should make publicly available criteria used in review of banks internal capital assessments pragmatic provision of close and continuous dialogue between industry participants and supervisors, as well as between supervisors (without changing legal responsibilities of national regulators).
Enhanced cross-border communication and cooperation: Basel Committee supports
Source:
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Supervisory review process for securitisation ( 784-807)
Economic substance: Supervisory capital requirements may vary from those specified in
First Pillar if would not adequately and sufficiently reflect risks of exposure
Maturity: Supervisors will review documentation to ensure that maturity mismatches not
artificially created to reduce capital requirements

Correlation: Supervisors may review banks assessment of actual correlations between
assets in pools and how that is reflected in capital calculation; with ability to increase capital if correlation not appropriately reflected
Significant risk transfer: Although securitisation may occur for reasons other than risk
transfer (i.e., funding), where risk transfer is insufficient or non-existent supervisors can deny capital relief
Market innovations: Supervisors can take account of new features either through First
Pillar changes in minimum capital requirements or Second Pillar supervisory action

Implicit Support: If banks engage in implicit support more than once, supervisors must
require disclosure and may apply one or more of (a) refusing further capital relief for securitised assets, for period of time or permanently, (b) applying conversion factor to all securitised assets so as to hold capital against them, or (c) requiring banks to hold capital in excess of minimum requirements
89
Source:
Text

Supervisory review process for securitisation ( 784-807) (contd)
Residual risks: Supervisors will expect banks to consider expected losses in economic
capital, as those losses not usually transferred in securitisation

Call provisions: May not be used to absorb losses or asset deterioration; supervisors
may require review of banks decision to call prior to exercise

Early amortisation: Supervisors should review how banks internally measure, monitor
and manage risks associated with securitisations of revolving facilities; following factors should be considered when analysing excess spread triggers:
interest payments by borrowers on underlying receivables other fees and charges to be paid gross charge-offs principal payments recoveries on charged-off loans interchange income interest paid on investors certificates relevant macro-economic factors
Source: Text
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Chapter 5 Basel II Third Pillar Market Discipline
Basel II Disclosure (Securitisation)

Objective ( 809-810)
Impose market discipline on banks by requiring disclosure of key information relevant to
banks risks and capital
Qualitative Disclosures for Securitisation ( 820, Table 8)

Banks objectives for, and roles played by it in, securitisation process Banks accounting objectives for securitisation Whether treated as sales or financings Whether bank recognises gain on sale Key assumptions used by bank for valuing retained interests Banks treatment of synthetic securitisations Names of rating agencies used by bank and types of exposures rated by each agency
Source:
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Basel II Disclosure (Securitisation)

Quantitative Disclosures for Securitisation ( 820, Table 8)
Total outstanding exposures securitised by bank subject to securitisation framework For exposures securitised by bank subject to framework (in each case broken down by
exposure type):
Amount of impaired/past due assets Losses recognised by bank during current period Aggregate amount of securitisation exposures retained or purchased by bank, broken
down by exposure type

Aggregate amount of securitisation exposures retained or purchased by bank, broken
down by reasonable number of risk bands (deducted exposures disclosed separately)

Aggregate amount of securitised revolving exposures segregated by originators interest
and investors interest

Summary of current years securitisation activity, including aggregate amount of exposures
securitised and gain or loss on sale, by asset type
Source:
Text
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Chapter 6 Some Observations
Basel II Observations
Open Issues
Will banks cope (implementing systems)? Will regulators cope (monitoring systems and data)? Will inconsistencies be minimised? Inconsistent rules in Basel II itself (e.g. corporate risk weights vs. securitisation risk
weights)
Inconsistent national rules finally adopted by regulators Inconsistent application by supervisors (including different supervision of banks, vs.
securities firms, vs. insurance companies, vs. non-regulated financial companies)

Will regulators provide recognition of double-default effects for pools of exposures or stick
with substitution?
Will impractical operational requirements for IAA be addressed? Will the definition of defaulted assets be extended beyond 90 days?
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Impact on financial markets
Spread tightening as capital costs of holding winners drops: ABS tranches rated BBB and higher Corporates rated BBB or higher Non-OECD sovereigns rated above BB+ Spread widening/credit tightening as capital costs of holding losers increases: Lower rated banks, corporates and ABS OECD sovereigns rated below AA- (but banks may hold for liquidity purposes anyway) Non-bank equities; non-core high operating cost activities (asset management)
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Impact on banks
Banks with more Basel II winners in portfolio benefit Banks with more Basel II losers in portfolio suffer Possible divestitures of capital-heavy businesses Insurance Asset management Non-bank equities Impact on corporate lending activities Return of high-quality corporates to banks as borrowers Credit less available to lower-quality borrowers Tiering of SME market local banks for relationship lending, larger banks for credit-
based lending
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Impact on securitisation markets Will motivate banks to securitise higher risk weighted assets and keep lower risk weighted assets Will cost more to securitise, due to higher capital for lower rated tranches and unfunded commitments (motivating banks to seek non-regulated investor base and lower cost liquidity alternatives) Higher costs may slow growth of securitisation generally, reducing banks ability to disperse credit risks throughout the financial system Securitisation volumes may rise in certain products to remove them from banks balance sheets: Credit cards due to capital held against unfunded commitments Commercial mortgages due to higher capital charges against lower quality exposures Loans due to higher capital charges against lower quality exposures Covered bonds If cheaper to hold mortgages on balance sheet under Basel II, then covered bonds advantages over securitisation But will regulators limit quantity of covered bond issuances? (FSAs 4% suggestion)
Source:
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Impact on ABCP conduits
Motivation to hold assets in ABCP conduit (rather than on-balance sheet for risk-based
capital purposes) not as strong under Basel II

IRB banks have much lower capital for many exposures on balance sheet Use of ABCP conduits may still help banks meet accounting objectives and
generates non-lending income for sponsor bank

New capital costs for liquidity may motivate move away from traditional 0% liquidity
commitments
Less liquidity Liquidity provided in new forms: e.g., market value swaps, trading book positions Funding provided in new forms: e.g., repos
Source:
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How to contact us:

Goldman Sachs
Christoph Gugelmann Goldman Sachs Peterborough Court 133 Fleet Street London EC4A 2BB England Tel: +44 20 7552 3185 E-mail: christoph.gugelmann@gs.com Peter Biendarra Goldman Sachs Peterborough Court 133 Fleet Street London EC4A 2BB England Tel: +44 20 7552 0546 E-mail: peter.biendarra@gs.com Alexei Zabudkin Goldman Sachs Friedrich-Ebert-Anlage 49 D-60308 Frankfurt am Main Germany Tel: +49 69 7532 1304 E-mail: alexei.zabudkin@gs.com
Mayer, Brown, Rowe & Maw

Jason Kravitt Mayer, Brown, Rowe & Maw 1675 Broadway New York, New York 10019-5820 U.S.A. Tel: +1 212 506 2622 E-mail: jkravitt@mayerbrownrowe.com Rob Hugi 71 South Wacker Drive 39th Floor Chicago, Illinois 60606 U.S.A. Tel: +1 312 7017121 E-mail: rhugi@mayerbrownrowe.com Mark Nicolaides Mayer, Brown, Rowe & Maw 11 Pilgrim Street London EC4V 6RW England Tel: +44 20 7246 6232 E-mail: mnicolaides@mayerbrownrowe.com
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The Basel II Capital Accord

Chapter 2 Basel II minimum capital charges First Pillar

Table of Contents (contd)

Table of Contents (contd)

Chapter 3 Basel II operational risk charges

Chapter 4 Supervisory Review Second Pillar

Table of Contents (contd)

Chapter 6 Some observations

Chapter 1 Basel II Basics

Easy to achieve significant

Basel II introduced to: combat regulatory arbitrage

capital reduction with little or no risk transfer

Much more complex and risk

Will profoundly alter bank behaviour

Treats exposures very unequally

depending on exposure characteristics

depending on sophistication of risk management systems

Basel I Capital Charges

first loss (with national variations)

Sample capital calculation

implementation dates, at least in part

achievable due to transition period ( 45-49)

may cause delays

not usually so quick

US and elsewhere) in important respects

Basel II Scope of Application

investments in insurance subsidiaries ( 30)

(whether or not regulated) captured through consolidation ( 24)

insurance ( 24, fn. 5)

consolidated: deduct equity and capital investments ( 27)

control: deduct equity and capital investments ( 28)

commercial entities above materiality thresholds ( 35)

and 50% from tier 2 capital ( 37)

materiality thresholds risk weighted 100% ( 36)

Basel II Capital and Provisions

of risk-weighted assets ( 42)

deducted from capital ( 43)

Basel II Three Pillars

Basel II Capital Components

Operational risk charges ( 644-683)

Market risk charges ( 684-718)

calculations and Second Pillar stress testing

Basel II Types of Banks

External Ratings Criteria

Subject to national discretion, unsolicited ratings recognised ( 108)

Transition Period (IRB Banks only)

2010 and after

Chapter 2 Basel II First Pillar Minimum Capital Charges

Basel II Sovereign Capital Charges

Winners non-OECD rated above BB+ Examples: Chile, China, Thailand

Basel II Sovereign Capital Charges

Rating Risk Weight

A+ to A- BBB+ to BB+ to B- Below B- Unrated BBB20% 50% 100% 150% 100%

Basel II Sovereign Capital Charges

Basel II Bank Capital Charges

Basel II Bank Capital Charges

Rating Risk Weight

A+ to A- BBB+ to BB+ to B- Below B- Unrated BBB50% 100% 100% 150% 100%

more favourable risk weight if claim maturity < 3 months)

Rating Risk Weight

A+ to A- BBB+ to BB+ to B- Below B- Unrated BBB50% 50% 100% 150% 50%

Basel II Bank Capital Charges

for Foundation IRB banks) results in significant capital reductions