Basel and its impact on the global & Egyptian banking

sector

Paper' Agenda:

1) What is Basel Accords

2) What is Basel I
3) Basel II.
4) Basel III.
5) Stages of applying Basel and its impact on Egyptian
banking sector.

References used:

1) http://www.cbe.org.eg/Publications.htm
2) http://en.wikipedia.org/wiki/Basel_accord
3) http://www.investopedia.com/terms/b/basel_I.asp
4) http://www.bis.org/list/bcbs/index.htm
5) http://www.cbe.org.eg/public/annualreport2009_2010
E

Presented to:

Professor Dr. Ayman Metwaly.

Presented by:

Mohamed Saber Mohamed Hassan

MBA, fourth, finance.

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Basel Accords

The Basel Accords refer to the banking supervision Accords (recommendations on banking laws
and regulations) -- Basel I and Basel II issued and Basel III under development -- by the Basel
Committee on Banking Supervision (BCBS). They are called the Basel Accords as the BCBS
maintains its secretariat at the Bank for International Settlements in Basel, Switzerland and the
committee normally meets there.

A document was written in 1988 by the Basel Committee on Banking Supervision, which
recommends certain standards and regulations for banks. The main recommendation of this
document is that in order to lower credit risk, banks should hold enough capital to equal at least
8% of its risk-weighted assets. Most countries have implemented some version of this regulation.

Each country's banking regulator, however, has some discretion over how differing financial
instruments may count in a capital calculation. This is appropriate, as the legal framework varies
in different legal systems.

The theoretical reason for holding capital is that it should provide protection against unexpected
losses. Note that this is not the same as expected losses, which are covered by provisions,
reserves and current year profits. In Basel I agreement, Tier 1 capital is a minimum of 4%
ownership equity but investors generally require a ratio of 10%.

Basel I: is the round of deliberations by central bankers from around the world, and in 1988, the
Basel Committee (BCBS) in Basel, Switzerland, published a set of minimal capital requirements
for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of
Ten (G-10) countries in 1992. Basel I is now widely viewed as outmoded. Indeed, the world has
changed as financial conglomerates, financial innovation and risk management have developed.
Therefore, a more comprehensive set of guidelines, known as Basel II are in the process of
implementation by several countries and new updates in response to the financial crisis
commonly described as Basel III.

From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United States.
Bank failures were particularly prominent during the '80s, a time which is usually referred to as
the "savings and loan crisis." Banks throughout the world were lending extensively, while
countries' external indebtedness was growing at an unsustainable rate

As a result, the potential for the bankruptcy of the major international banks because grew as a
result of low security. In order to prevent this risk, the Basel Committee on Banking Supervision,
comprised of central banks and supervisory authorities of 10 countries, met in 1987 in Basel,
Switzerland.

The committee drafted a first document to set up an international 'minimum' amount of capital
that banks should hold. This minimum is a percentage of the total capital of a bank, which is also
called the minimum risk-based capital adequacy. In 1988, the Basel I Capital Accord (agreement)
was created.

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The Purpose of Basel I
In 1988, the Basel I Capital Accord was created. The general purpose was to:

1. Strengthen the stability of international banking system.

2. Set up a fair and a consistent international banking system in order to decrease competitive
inequality among international banks.

The basic achievement of Basel I has been to define bank capital and the so-called bank capital
ratio. In order to set up a minimum risk-based capital adequacy applying to all banks and
governments in the world, a general definition of capital was required. Indeed, before this
international agreement, there was no single definition of bank capital. The first step of the
agreement was thus to define it.

Two-Tiered Capital
Basil I defines capital based on two tiers:

1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or shareholders equity) and declared
reserves, such as loan loss reserves set aside to cushion future losses or for smoothing out income
variations.

2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as gains on
investment assets, long-term debt with maturity greater than five years and hidden reserves
(i.e. excess allowance for losses on loans and leases). However, short-term unsecured debts (or
debts without guarantees), are not included in the definition of capital.

Credit Risk is defined as the risk weighted asset (RWA) of the bank, which are banks assets
weighted in relation to their relative credit risk levels. According to Basel I, the total capital
should represent at least 8% of the bank's credit risk (RWA). In addition, the Basel agreement
identifies three types of credit risks:

• The on-balance sheet risk (see Figure 1 for example).

• The trading off-balance sheet risk. These are derivatives, namely interest rates, foreign
exchange, equity derivatives and commodities.
• The non-trading off-balance sheet risk. These include general guarantees, such as forward
purchase of assets or transaction-related debt assets.
Let's take a look at some calculations related to RWA and capital requirement. Figure 1 displays
predefined categories of on-balance sheet exposures, such as vulnerability to loss from an
unexpected event, weighted according to four relative risk categories.

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 Figure 1: Basel's Classification of risk weights of on-balance sheet assets

As shown in Figure 2, there is an unsecured loan of $1,000 to a non-bank, which requires a risk
weight of 100%. The RWA is therefore calculated as RWA=$1,000 × 100%=$1,000. By using
Formula 2, a minimum 8% capital requirement gives 8% × RWA=8% ×$1,000=$80. In other
words, the total capital holding of the firm must be $80 related to the unsecured loan of $1,000.
Calculation under different risk weights for different types of assets are also presented in Table 2.

Figure 2: Calculation of RWA and capital requirement on-balance sheet assets

Market risk includes general market risk and specific risk. The general market risk refers to
changes in the market values due to large market movements. Specific risk refers to changes in
the value of an individual asset due to factors related to the issuer of the security. There are four
types of economic variables that generate market risk. These are interest rates, foreign exchanges,
equities and commodities. The market risk can be calculated in two different manners: either with
the standardized Basel model or with internal value at risk (VaR) models of the banks. These
internal models can only be used by the largest banks that satisfy qualitative and quantitative
standards imposed by the Basel agreement. Moreover, the 1996 revision also adds the possibility
of a third tier for the total capital, which includes short-term unsecured debts. This is at the
discretion of the central banks.

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Pitfalls of Basel I
Basel I Capital Accord has been criticized on several grounds. The main criticisms include the
following:

• Limited differentiation of credit risk

There are four broad risk weightings (0%, 20%, 50% and 100%), as shown in Figure1,
based on an 8% minimum capital ratio.

• Static measure of default risk

the assumption that a minimum 8% capital ratio is sufficient to protect banks from failure
does not take into account the changing nature of default risk.

• No recognition of term-structure of credit risk

the capital charges are set at the same level regardless of the maturity of a credit
exposure.

• Simplified calculation of potential future counterparty risk

the current capital requirements ignore the different level of risks associated with
different currencies and macroeconomic risk. In other words, it assumes a common
market to all actors, which is not true in reality.

• Lack of recognition of portfolio diversification effects

In reality, the sum of individual risk exposures is not the same as the risk reduction
through portfolio diversification. Therefore, summing all risks might provide incorrect
judgment of risk. A remedy would be to create an internal credit risk model - for
example, one similar to the model as developed by the bank to calculate market risk. This
remark is also valid for all other weaknesses.

These listed criticisms have led to the creation of a new Basel Capital Accord, known as Basel II,
which added operational risk and also defined new calculations of credit risk. Operational risk is
the risk of loss arising from human error or management failure. Basel II Capital Accord was
implemented in 2007.

Basel II: is the second of the Basel Committee on Bank Supervision's recommendations, and
unlike the first accord, Basel I, where focus was mainly on credit risk, the purpose of Basel II was
to create standards and regulations on how much capital financial institutions must have put
aside. Banks need to put aside capital to reduce the risks associated with its investing and lending
practices

By the late 1990s, banks had become much more sophisticated in their operations and risk
management and were increasingly able to find ways to reduce a bank's risk weighted assets in
ways that did not reflect lower real risk (what has become known as regulatory capital arbitrage).
It was therefore decided that a new capital standard was required and work began on Basel II.

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The aim of Basel II is to better align the minimum capital required by regulators (so-called
regulatory capital) with risk. This inevitably requires a more complex regime, given that some of
the greatest anomalies in the first Basel Accord stemmed from its simplicity – for example all
unsecured corporate exposures were weighted 100% whether the company was a highly
profitable global giant or a struggling small business. As a result Basel II is far more complex
than Basel I and goes far beyond Basel I is its scope.

Basel II came into effect in the European Union on 1 January 2007 under the Capital
Requirements Directive (CRD) and all lenders covered by the CRD have had to implement it
from the beginning of 2008.

Structure of Basel II

Basel II consists of 3 'pillars' which enshrine the key principles of the new regime. Collectively,
they go well beyond the mechanistic calculation of minimum capital levels set by Basel I,
allowing lenders to use their own models to calculate regulatory capital while seeking to ensure
that lenders establish a culture with risk management at the heart of the organisation up to the
highest managerial level.

Pillar 1 sets out the mechanism for calculating minimum regulatory capital. Under Basel I this
calculation related only to credit risk, with a calculation for market risk added in 1996. Basel II
adds a further charge to allow for operational risk.

Credit risk

While Basel I offered a single approach to calculating regulatory capital for credit risk, one of the
greatest innovations of Basel II is that it offers lenders a choice between:

1. The standardized approach. This follows Basel I by grouping exposures into a series of risk
categories. However, while previously each risk category carried a fixed risk weighting, under
Basel II three of the categories (loans to sovereigns, corporates and banks) have risk weights
determined by the external credit ratings assigned to the borrower.

Amongst the other categories that continue to have fixed risk weights applied by Basel II, loans
secured on residential property carry a risk weight of 35% against 50% previously, as long as the
loan-to-value (LTV) ratio is up to 80%. This lower weighting is a recognition of the historically
low rate of losses typically incurred on residential mortgage loan portfolios across different
countries and over a range of economic environments.

2. Foundation internal ratings based (IRB) approach. Lenders are able to use their own
models to determine their regulatory capital requirement using the IRB approach. Under the
foundation IRB approach, lenders estimate a probability of default (PD) while the supervisor
provides set values for loss given default (LGD), exposure at default (EAD) and maturity of
exposure (M). These values are plugged into the lender's appropriate risk weight function to
provide a risk weighting for each exposure or type of exposure.

3. Advanced IRB approach. Lenders with the most advanced risk management and risk
modeling skills are able to move to the advanced IRB approach, under which the lender estimates
PD, LGD, EAD and M. In the case of retail portfolios only estimates of PD, LGD and EAD are
required and the approach is known as retail IRB.

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Given that a key objective of Basel II is to improve risk management culture, it is unsurprising
that the regime encourages lenders to move towards the IRB approach and ultimately, the
advanced or retail IRB approach. To this end, most banks can expect to see a modest release of
regulatory capital in moving from the standardized to foundation IRB approach and on to the
advanced or retail IRB approach.

Operational risk

The Accord defines operational risk as 'the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events'. In keeping with the approach to credit
risk, it provides three mechanisms for computing operational risk of rising complexity to suit
lenders' varying characteristics.

Pillar 2 is meant to identify risk factors not captured in Pillar 1, giving regulators discretion to
adjust the regulatory capital requirement against that calculated under Pillar 1. For most lenders,
the Pillar 2 process results in a higher regulatory capital requirement than calculated under Pillar
1 alone. Pillar 2 requires banks to think about the whole spectrum of risks they might face
including those not captured at all in Pillar 1 such as interest rate risk.

Pillar 3 is designed to increase the transparency of lenders' risk profile by requiring them to give
details of their risk management and risk distributions. Information is released through the normal
mandatory financial statements lenders are required to publish or through lenders' websites.

Timetable

All lenders covered by the CRD fully implemented Basel II from the beginning of 2008.
However, for the time being firms are still being required to conform to their Basel I capital
floors as well.

Implications of Basel II

There has been a considerable amount of debate concerning the potential impact of Basel II.
Perhaps the most obvious effect will be to alter the percentage return on regulatory capital by
altering the denominator (the amount of regulatory capital required). For residential mortgages,
the release of regulatory capital under both the standardised and retail IRB approaches should be
considerable. Many commentators see this as the basis for significant changes in industry pricing
once the Basel I capital floors are removed and lenders move entirely to Base II as the
determinant of regulatory capital, which they believe could alter the competitive landscape and
drive consolidation.

However, there are a number of reasons why the impact on market pricing might not be as
dramatic as some suppose:

• Many of the largest financial institutions already set their pricing on the basis of
economic rather than regulatory capital. For them Basel II should not lead directly to a
desire to reappraise their pricing.
• Non-deposit taking lenders face different regulatory capital requirements under which the
minimum levels of capital they are required to hold is much lower, so the introduction of
Basel II should have no direct impact on their pricing. The fact that non-deposit
taking lenders have not come to dominate the lending industry is testament to the

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 competitive importance of factors other than capital (like access to a stable retail deposit
base).
• Lenders routinely hold capital well above the regulatory minimum. Even where the
minimum level of regulatory capital alters significantly, a lender may choose not to alter
its actual capital profile in response. Lenders hold capital for a number of reasons, such
as to enhance their credit rating or allow for future possible acquisitions, and not just to
satisfy the regulator.
• Lenders face a risk/reward trade-off: The higher their capital ratio, the lower the
perceived risk, other things being equal. This provides lenders with an incentive to hold
more capital independent of the requirements of the regulator.

The conclusion from the above must be that the impact of Basel II on pricing after the removal of
the Basel I floors may not be particularly large, especially in the market for prime lower LTV
mortgages served by a heterogeneous group of lenders including non-deposit taking institutions.
However the pricing of higher risk and higher LTV mortgages may be affected by the greater
levels of capital IRB firms will be required to hold against these loans.

Another possible effect of Basel II that has been discussed is that it might drive consolidation
because of the cost of compliance and the lower capital requirement of the IRB as opposed to the
standardized approach. Here again there is a risk of overstating the impact.

The reason for a three tier approach to credit and operational risk is to allow for the fact that
smaller lenders are not going to be able to devote the same resources to Basel as the larger ones.
And although a move from standardized to retail IRB should see a reduction in regulatory capital
for mortgage lenders, the move to Basel II will have brought much larger changes driven by
relative portfolio mix. As a result, the pressure that Basel II will create for further consolidation
may not be as great as some commentators have claimed.

The other area where Basel II will be felt is in firms' 'risk culture'. A key objective of the Accord
is to promote a more rigorous approach to risk management. It will require increasingly
sophisticated risk management and greater senior management engagement in issues relating to
risk. The requirement for public disclosure outlined in Pillar 3 and the expected regulatory capital
relief for IRB banks against those on the standardized approach support this objective.

Basel III is a set of international banking regulations developed by the Bank for International
Settlements in order to promote stability in the international financial system. The purpose of
Basel III is to reduce the ability of banks to damage the economy by taking on excess risk.
(Problems with the original accord became evident during the subprime crisis in 2007.

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Basel III and the Banks
With that in mind, banks must hold more capital against their assets, thereby decreasing the size
of their balance sheets and their ability to leverage themselves. While these regulations were
under discussion prior to the financial crisis, their necessity is magnified as more recent events
occur.

The Basel III regulations contain several important changes for banks' capital structures. First of
all, the minimum amount of equity, as a percentage of assets, will increase from 2% to 4.5%.
There is also an additional 2.5% "buffer" required, bringing the total equity requirement to 7%.
This buffer can be used during times of financial stress, but banks doing so will face constraints
on their ability to pay dividends and otherwise deploy capital. Banks will have until 2019 to
implement these changes, giving them plenty of time to do so and preventing a sudden "lending
freeze" as banks scramble to improve their balance sheets.

It is possible that banks will be less profitable in the future due in part to these regulations. The
7% equity requirement is a minimum and it is likely that many banks will strive to maintain a
somewhat higher figure in order to give themselves a cushion. If financial institutions are
perceived as being safer, the cost of capital to banks would actually decrease. Banks that are more
stable will be able to issue debt at a lower cost. At the same time, the stock market might assign a
higher P/E multiple to banks that have a less risky capital structure

Basel III and Financial Stability

Basel III is not a panacea, and will not single-handedly restore stability to the financial system
and prevent future financial crisis. However, in combination with other measures, these
regulations are likely to help produce a more stable financial system. In turn, greater financial
stability will help produce steady economic growth, with less risk for crisis fueled recessions such
as that experienced following the global financial crisis of 2008-2009.

While banking regulations may help reduce the possibility of future financial crises, it may also
restrain future economic growth. This is because bank lending and the provision of credit are
among the primary drivers of economic activity in the modern economy. Therefore, any
regulations designed to restrain the provision of credit are likely to hinder economic growth, at
least to some degree. Nevertheless, following the events of the financial crisis, many regulators,
financial market participants and ordinary individuals are willing to accept slightly slower
economic growth for the possibility of greater stability and a decreased likelihood of a repeat of
the events of 2008 and 2009.

Basel III and Investors

As with any regulations, the ultimate impact of Basel III will depend upon how it is implemented
in the future. Furthermore, the movements of international financial markets are dependent upon
a wide variety of factors, with financial regulation being a large component. Nevertheless, it is
possible to generalize about some of the possible impacts of Basel III for investors.

It is likely that increased bank regulation will ultimately be a positive for bond market investors.
That is because higher capital requirements will ultimately make bonds issued by banks safer

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investments. At the same time, greater financial system stability will provide a safer backdrop for
bond investors, even if the economy grows at a slightly weaker pace as a result. The impact on
currency markets is less clear; but increased international financial stability will allow
participants in these markets to focus upon other factors while perhaps eventually giving less
focus to the relative stability of each country's banking system.

Finally, the effect of Basel III on stock markets is uncertain. If investors value enhanced financial
stability more than the possibility of slightly higher growth fueled by credit, stock prices are
likely to benefit from Basel III (all else being equal). Furthermore, greater macroeconomic
stability will allow investors to focus more on individual company or industry research while
having to worry less about the economic backdrop or the possibility of broad-based financial
collapse.

Applying Basel and its Impact on Egyptian banking sector:

Apply Basel II standards in Egyptian banks to enhance their risk management practices. In this
context, a protocol had been signed with the European Central Bank and seven European central
banks to provide a three-year technical assistance program launched on 1 January 2009, to
implement Basel II requirements in the Egyptian banking sector.
It is worthy to note that the strategy of the CBE in implementing Basel II framework, which was
announced for Egyptian banks and the relevant parties in an extensive meeting held on Oct. 2009,
is based on two main principles; simplicity and consultation with banks, to ensure banks
'compliance with these standards. According to the above-said strategy Basel II standards should
be phased in over the following stages:

The first stage (January 2009 - June 2009) focused on the capacity building of the CBE’s core
team and elaboration on the Egyptian strategy for Basel II implementation. That stage was
successfully completed.

• The second stage (July 2009 - June 2011) - the pivotal stage of the reform plan - covers
extensive coordination with the banking sector, through discussion papers related to the most
important topics and selection of the most appropriate methods for application in Egypt, taking
into consideration similar experiences in other countries that have implemented Basel II.
Moreover, the quantitative impact of the possible consequences of Basel II standards will be
measured before the mandatory application.
• The third stage (July 2011 - December 2011) will focus on the fine-tuning of future
supervisory regulations related to Basel II, taking into account the legal aspects and development
of corrective action plans commensurate with the different types of banks, according to the
simulation results for each bank on a case by case basis. Also, a parallel run of existing
regulations and Basel II will be applied upon issuance, and a new data warehousing framework
will be implemented
to support the future updated supervisory regime.
• The fourth stage (continuing implementation) - a parallel run of Basel
II and existing regulations concerning capital adequacy will be applied upon issuance. Moreover,
the data warehousing framework will be completed.

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The CBE continued to move ahead with the banking reform plan, as the second stage (2009 -
2011) has been in progress. The second stage aims at enhancing the efficiency and soundness of
the Egyptian banking sector and upgrading its competitiveness and risk management ability, so
that it can perform its role in financial intermediation for the interest of the national economy, and
achieve the targeted development. The main pillars of this stage are as follows: (1) prepare and
implement a comprehensive program for the financial and administrative restructuring of
specialized state-owned banks; and (2) follow up the results of the first stage of the restructuring
program of the National Bank of Egypt (NBE), Banque
Misr (BM) and Banque du Caire (BdC), which revealed that the first stage of the reform plan had
positively affected their performance levels; besides finalizing the requirements for improving the
efficiency of these banks in financial intermediation and risk management.

The second stage aims also at applying Basel II standards in Egyptian banks to enhance their risk
management practices, as well as reviewing and strictly applying the international banking
governance rules. In this context, a protocol had been signed with the European Central Bank and
seven European central banks to provide a three-year technical assistance program launched on 1
January 2009, to implement Basel II requirements in the Egyptian banking sector. It is worthy to
note that the strategy of the CBE for the implementation of Basel II framework is based on the
two main principles of simplicity and consultation with banks, to ensure banks’ compliance with
these standards. This strategy will be phased in over four stages, the first of which has already
been completed.
The second stage of the banking reform plan has been launched, after the successful completion
of the preceding stage. The first stage was centered on four pillars: as for the first pillar, some
voluntary and state-forced mergers took place, leading to a decrease in the number of banks
operating in Egypt from 57 at end of December 2004 to 39 banks at end of June 2010. Under this
plan, 80 percent of the stake of the Bank of Alexandria was sold to Italy’s Sanpaolo Bank,
besides the divestiture of the shareholdings of state-owned banks in a number of joint venture
banks. According to the second pillar, state-owned banks were restructured under a
comprehensive and time-lined plan, designed by the Banking Reform Unit at the CBE.
Concerning the third pillar, addressing the problem of non-performing loans, the CBE's NPL
Management Unit worked out a variety of approaches and programs that helped settle more than
90 percent of NPLs (excluding debts of the public business sector). With regard to the irregular
debts of the public business sector enterprises to public banks, 62% was repaid in cash to the
public commercial banks.
As for the remaining debts (38%), an agreement was signed on 14/9/2010 whereby in-kind
repayments of outstanding debt were made at end of June 2010. With respect to the fourth pillar,
which addresses the reform of the Supervision Sector, a program was developed to achieve the
following targets: enhance the efficiency of the supervision sector by benefiting from the
international best practices, and apply the concept of risk-based supervision to ensure the sector’s
robustness and soundness.
Furthermore, efforts were exerted to recruit highly qualified staff versed in advanced technology,
while enhancing the efficiency of the existing personnel.

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