Introduction to

Basel ll Accord

February 2009

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 Introduction

- Do know anything about BASEL?

- Yes! Basel is:

1) a canton (i.e. political division) of NW Switzerland, divided into the
demi-cantons: Basle-Landschaft and Basle-Stadt.
Areas: 427 sq. km (165 sq. miles) and 36 sq. km (14 sq. miles)
respectively;
and
2) a city in NW Switzerland, capital of Basle canton, on the Rhine:
oldest university in Switzerland.

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 Introduction (cont.)
- In fact the Basel is not only the canton or city, but also is:
• the International Convergence of Capital Measurement and Capital Standards; or
• Revised Framework (the “Basel II Framework”) which offers a new set of standards for
establishing minimum capital requirements for banking organizations.

- But what was Basel I Framework?

- Basel I Framework was:

• The international accord to set minimum capital requirements or banks, building societies
and other deposit taking institutions. It was developed to create a level playing field for
lenders operating in different countries and to ensure that lenders had sufficient
capitalization in order to protect their depositors and the financial system.

• First Basel Framework (or Basel Capital Accord) was prepared by the Basel Committee
on Banking Supervision, a group of central banks and bank supervisory authorities in the
G10 countries*, that developed the first standard in 1988.

• Then it became acknowledged as a benchmark measure of a bank’s solvency and was

applied in many other countries.

• However, later relevant supervisors and sophisticated banking organizations have

detected that the static rules set out in the Basel Capital Accord, 1988 have not kept
pace with advances in risk management practices. This suggests that the implemented
capital regulations may not reflect banks’ actual business practices.
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* A Group of Ten Nations who met in Paris in 1961 to arrange the special drawing rights of the IMF ( Belgium, Canada, France,
Italy, Japan, Netherlands, Sweden, UK, US, and West Germany).
 Introduction (cont.)

- So, what is the solution? Basel II….?

- Yes, it is a Basel II.

• Basel II Framework is a voluntary agreement between the banking authorities of the
major developed countries. However, the provisions of Basel II have been included
in the EU Capital Requirements Directive (CRD). It makes the provisions a part of
the law applicable throughout the EU.

- What's new in Basel II?

• The new updated Basel II Framework is more reflective in terms of risk management
of underlying banking risks.
• It was created based on the Basel Accord 1988 structure for setting capital
requirements.
• It improves the sensitivity of capital framework to the actual risks faced by the banks.
• Capital requirements are more closely aligned to the risk of credit loss.

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 Basel I v/s Basel II

• Basel I required lenders to calculate a minimum level of capital based on a single risk
weight for each limited number of asset classes (e.g. mortgages, consumer lending,
corporate loans, exposures, etc).

• Basel II also permits some lenders to use their own risk measurement models to
calculate required regulatory capital, and seeking to ensure that lenders implement a
relevant risk management culture at the heart of the business up to the highest
managerial level.

- When the Basel II shall be implemented?

• In the EU all deposit takers had to implement Basel II before or by no later than 1
January 2008. The US delayed this date to January 2009.

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 The goals of Basel II
The major goal for the Basel II Framework is to promote the adequate capitalization of
banks and to encourage improvement in risk management strategies, and strengthen the
stability of respective financial systems.
The aforementioned goal will be accomplished through the introduction of “three pillars”:

Wealth economy and financial system stability

(Supervisory Review)

(Market Discipline)
Capital Adequacy
Minimum Capital
Requirements

Reporting
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 Three Pillars: Pillar 1

Pillar 1 – Minimum Capital Requirements:

• Pillar 1 aligns the minimum capital requirements more closely to actual risks of bank’s
economic loss (i.e. credit risk , market risk and operational risk).
• Revised Basel risks:

Credit risk (revised)

Operational risk (new provision)

Market risk (minor changes)
• First, Basel II improves the capital framework’s sensitivity to the risk of credit.
• Capital is calculated based on the standardized and internal approaches for further
reporting to responsible regulators and other stakeholders.
• 3-Approaches:

Standardized approach (RSA)

a-Foundation internal rating based approach (IRBA)

b-Advance internal rating base approach (IRBA)

Securitization framework

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 Three Pillars: Pillar 1 (cont.)

Credit risk
• In Risk Standardized Approach (RSA), Risk weight depends on external credit
rating.
• In foundation Independent Regulatory Board for Auditors (IRBA), banks use
internal credit rating and supply Probability of Default (PD).
• Advance IRBA, bank use internal rating and supply Probability of Default, Loss
Given Default, Exposure at Default.
• Securitization framework provides with various approaches to compute capital.

Operational risk
• Basic indicator approach, capital is fraction of gross income (15% of average 3
year gross income).
• Standardized approach capital is computed by business lines (fixed percentages).
• Advance measurement use statistical methods (Estimation, Standard Deviation,
Correlation) to calculate capital.
Market risk
• Market risk is calculated on the basis of internal rating of organization.
• Specific ratings (AA-BB) are charged specific level of risks percentage.

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 Three Pillars: Pillar 2

• Pillar 2 (Internal Capital Adequacy Assessment Process - ICAAP) recognizes the

necessity of exercising effective supervisory review of internal assessments of the overall
risks of the banks to ensure that the management is exercising relevant judgment and
has set aside adequate capital for these risks.
• Supervisory Review:

Bank should implement a process of assessment of capital adequacy in relation to risk and
strategy for maintaining capital level.

Supervisors shall review bank’s internal capital adequacy and compliance with regulatory capital
requirements, and if necessary, to take actions.
• Coverage in Pillar-II:

risks that are not fully covered by Pillar 1

Credit concentration risk

Counterparty credit risk

Risks that are not covered by Pillar 1

Interest rate risk in the banking book

Liquidity risk

Business risk

Stress testing 9
 Three Pillars: Pillar 3

• Pillar 3 (Reporting) leverages the ability of market discipline to motivate prudent

management by enhancing the degree of transparency in banks’ public reporting. It
sets out the public disclosures that banks must make that lend greater insight into the
adequacy of their capitalization.
• In other words, it proposes bank’s disclosure requirement and enhance degree of
transparency by recognizing disciplinary market mechanisms and reward that
manage risk and penalization if not.

• Qualitative & quantitative disclosure wherever relevant on:

Capital & capital structure

Capital adequacy

Credit risk

Credit risk mitigation

Counterparty credit risk

Securitization

Market risk

Operational risk

Equities in the banking book

Interest rate risk in the banking book

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 Basel 2 and CAMELS Approach

Basel 2 is similar to CAMELS rating and encourages growth by increasing assets quality
(Pillar 1),operational competency, earning ability, and manages risks to keep up
sustainability (Pillar 2 & 3) in long run.

BASEL 2 CAMELS Approach:

Pillar 1--- Risk-Capital matching
(increases) • C Capital Adequacy
Asset quality & utilization • A Asset Quality
• M Management Competence
Pillar 2--- Risk in bank books is • E Earnings Ability
removed by market
efficiency • L Liquidity Risk
• S Sensitivity to Market Risk
Pillar 3--- Corporate governance
Increases Market
mechanisms, Income and
Credibility

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 Retail v/s Wholesale
Basel II differentiates Retail and Wholesale, broadly:

Retail
Generally Exposures to Individuals (managed on a pool basis), including residential
mortgages, qualifying revolver exposure and other retail exposure

Wholesale
Wholesale generally comprise Exposures to Individually Managed (e.g. Classifiable)
obligors, including private sector corporate, sovereign (central governments and
banks, etc) and financial institutions.

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 DIFC Jurisdiction

• As Dubai Financial Centre is a financial hub in the Middle East region it is also has
adopted the Basel principles.
• Regardless the fact that DIFC is located in the Dubai, it adopted its own legislation.
• All DIFC registrants engaged in the financial services are monitored by the Dubai
Financial Services Authority (DFSA)*.

• The legislation of the DIFC is based on the “common law” principles and has been
designed in accordance with the international standards (including Basel) applied in
certain jurisdictions.
• The Basel principles are expressed in the following DIFC/DFSA rules:

Prudential - Investment, Insurance, Intermediation and Banking Module (PIB)

Prudential - Insurance Business Module (PIN) – applicable to all insurance/reinsurance
businesses

Prudential Returns Module (PRU)

DFSA is a separate integrated legal entity responsible for the regulation of the financial services and related activities through the
DIFC (including authorization, licensing, recognition and registration of the businesses engaged in financial or ancillary services as 13
well as the authorization of their members – individuals).
 PIB Module

• General chapters:

General Requirements

Capital requirements

• Specific chapters:

Islamic Financial Business (including Displaced Commercial Risk Capital Requirement)

Credit Risk

Market Risk

Liquidity Risk

Group Risk

Operational Risk

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 Conclusion: “Pros and Cons”

• Some analysts and researches believe that current minimum capital adequacy tool
(i.e. 8-10% of equity) presented in Basel Framework and other alternative local
standards adopted by almost all countries is ideal way of using available financial
resources.
• Others claim that this tool of capitalization is more unsecure strategy rather than
conservative approaches applied in XIX century and first part of XX century, such as
gold bullion securitization and product backing currency.
• Recent cases, namely, “soap bubbles”; “shrinking pies - banks” ideally exemplify the
level practical reliability of Basel and other alternative standards.
• Has the current recession developed the need for a new accord?
• Ongoing financial crisis has made regulators rethink on the principles on which Basel
2 Accord was framed.

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 Contact details

• Saad Maniar – Managing Partner (saad@horwathmak.com)

• Gillian McMeekin – Director - Risk Consulting (gillian@horwathmak.com)
• Firdaus Maniar – Senior Risk Consultant (firdaus@horwathmak.com)
• Muhammad Raashid – Senior Risk Analyst (raashid@horwathmak.com)
• Vladimir Abanin – Senior Consultant (vladimir@horwathmak.com)

DIFC, Dubai, UAE

PO Box 506705
Telephone: +971 4 438 0288
Fax: 971 4 367 2820

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