Basel II Framework

One of the important parameters to assess the financial

Capital Requirement In Banks

strength of any business is its Capital or Net Worth. Banking business is no exception to this rule. The issue of what should be the minimum capital requirement of a banking company had been engaging the attention of regulators in many countries . Till late 1970s, there were no set or standard guidelines in this regard. The Governors of the central banks of G-10 countries constituted a Committee of Banking Supervisory Authorities in 1975. This Committee usually meets at the Bank for International Settlements at Basel in Switzerland and hence has come to be known over the years as the Basel Committee on Banking Supervision (BCBS). The Basel Committee provided for the first time a framework for capital adequacy in 1988 which is known as Basel I Accord.

Basel I Accord
The norms for Capital Adequacy used to differ from bank

to bank and from country to country. Japanese banks used to consider capital to the extent of 1 to 2% of the assets as adequate. Banks in Europe used to require 8 to 10% of their assets as capital. The Basel Committee addressed the issue of standardization in this regard and provided the requisite framework. It defined the components of capital, allotted risk weights to the different classes of assets and prescribed what should be the minimum ratio of capital to sum total of all risk weighted assets.

Basel I Accord ( continued )

The Basel I norms for risk weights were more of a rudimentary

nature. For example, i) All exposures to sovereigns were assigned a risk weight of zero. ii) All bank exposures were assigned a risk weight of 20%, and iii) All corporate exposure were assigned a risk weight of 100%, etc. Such a rigid approach without any consideration for the strengths or weaknesses of individual entities was the main shortcoming of the Basel I Accord. The fact that an excellent corporate like L&T could have a lesser risk weight than even a weak bank was not recognized under Basel I. Basel I Accord continued to be operative for about 15 years with some periodic modifications , but came for a total overhaul and review towards the end of the 20th century.

Birth Of Basel II Accord

The first round of proposals for changes in Basel I accord

came up for deliberations and consultative process in June 99. An extensive consultative process was initiated and banking supervisors from across the world were roped into the exercise. After 5 years of deliberations, the revised framework for capital adequacy was finalised in June 2004 with the approval of all the 10 members of the G-10 Committee. The report of the Committee is titled as INTERNATIONAL CONVERGENCE OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS A REVISED FRAMEWORK. The Committee desired the revised framework be put in place by the end of 2006.In India, the parallel runs commenced in April 2006 and implementation has been completed by 31-32008 by foreign banks and Indian banks having international operations and by 31-3-2009 by other banks.

Main Features Of Basel II Accord

The fundamental objective of Basel II accord was to revise the

Basel I accord in order to strengthen the soundness and stability of the system. The intention of Basel II is to promote sound risk management practices by Banks. It demands allocation of capital for Operational Risk for the first time. The Basel II accord is expected to establish a minimum level of capital for internationally active banks. National regulators are free to set higher standards for minimum capital if they so desire. In India, the CRAR requirement is set at 10% for internationally active banks and 9% for other banks, of which Tier I Capital should be at least 6% and balance can be Tier II Capital.

What are Tier I Capital items?

Tier I Capital consists of the following

1) Equity and Preference Capital, 2) Reserves and Surplus ( including Statutory Reserves, Capital Reserves and Retained profits kept in the P & L Account). General Reserves and Share Premium also come under this category and all these items of reserves are collectively known as Disclosed Reserves. 3) Innovative Perpetual Debt Instruments (IPDI s) These are long term debt instruments of maturity more than 10 years issued by the Bank in domestic as well as international markets.

 Tier II Capital consists of the following items

What are Tier II Capital Items?

1) Revaluation Reserves, 2) Undisclosed reserves, 3) Exchange Equalization Reserves on Current Assets, 4) General Provision and reserves to the extent permitted by the Regulatory Authorities, presently 1.25% of risk weighted assets, 5) Hybrid Instruments having the debt and equity characteristics, 6) Subordinated Debts, which are debt instruments with a maturity of 5 to 15 years and should not exceed 50% of Tier I Capital, 7) Investment Fluctuation Reserves, and 8) General Provision for Standard Assets. Tier II Capital is restricted to 100% of Tier I Capital.

 The new capital accord will require banks to manage risks by

Main Features Of Basel II (cont)

not only allocating regulatory capital but also by disclosing greater risk information and setting standards for risk management processes. Basel II also provides incentives for banks to invest in and increase the sophistication in their internal risk management capabilities in order to gain reductions in capital. This will help them to increase their lending and to maximise profits / returns to shareholders. Generally, banks consider regulatory requirements as a burden to be complied with. However Basel II requirements are viewed as an opportunity for the banks to demonstrate their credentials and strength. The reputation of a bank is very important. Banks are trying hard to ensure compliance with Basel II to prove themselves as good practioners of sound risk management methodology.

Scope Of Application Of Basel II

The Basel II Accord aligns regulatory capital with the risk

profile of a bank. It rests on 3 Pillars, as under

First Pillar. MINIMUM CAPITAL REQUIREMENT.
Second PillarSUPERVISORY REVIEW PROCESS. Third PillarMARKET DISCIPLINE. The first pillar replaces the existing One Size Fits All

framework of Basel I accord for the assessment of capital with several options for the banks. The second pillar provides guidelines for supervisors to ensure that each bank has robust internal systems for risk management and the adequacy of capital is assessed properly.

Scope Of Application Of Basel II (cont)

The third pillar puts in place disclosure norms about risk

management practices and allocation of regulatory capital. This pillar helps to strengthen market discipline as a complement to supervisory efforts. Banks and supervisors are required to pay attention to the second and third pillars . The revised framework will be mainly applicable to internationally active banks. All banking and other relevant financial activities (other than insurance) conducted within a group containing an internationally active bank will be captured through a consolidation process. The revised accord also provides incentives to banks to improve their risk management practices .

Pillar I Minimum Capital Requirement

1)

2)

3)

Capital for Credit Risk a) Standardized Approach. b) Internal Rating Based Approach (IRB). i) Foundation Approach. ii) Advanced Approach. Capital for Market Risk a) Standardized Method. i) Maturity Method. ii) Duration Method. b) Internal Models Method. Capital for Operational risk a) Basic Indicator Approach. b) Standardized Approach. c) Advanced Measurement Approach.

Pillar II Supervisory Review Process

Evaluate Risk Management System. Ensure the integrity and soundness of the

banks internal processes to assess adequacy of capital. Ensure maintenance of minimum capital with prompt corrective action for shortfall. Prescribe differential capital, where necessary, i.e., where internal processes are slack / weak.

Pillar III Market Discipline

Enhanced disclosures. Core disclosures & Supplementary Disclosures. Timely - at least semiannual disclosures.

Thus Basel II framework of 1995 is more risk sensitive than Basel I framework of 1988.

 Since Basel I was a one size fits all framework, it affected

Pillar I Capital Charge For Credit Risks

proper capital allocation for credit risk. The capital allocation should vary with the risk rating of an asset. Higher the risk, higher should be the capital allocation.
This aspect is addressed in Basel II. Under the new accord,

rating methodology acquires importance. The accord suggests two options for rating - Rating by External Rating Agencies or Rating based on Internal Assessment .
The integrity and consistency of rating would be a critical

aspect under the new regime. The risk weights would , thereafter, be based on the credit rating. The class or category of the borrower is also taken into account while prescribing the risk weights.

Credit Risk
Credit Risk can be defined as the possibility of losses due to

failure of the borrower / counterparty to meet their commitments in relation to lending, trading settlements, or any other financial transaction. Alternatively, losses occur from reduction in portfolio value due to deterioration in credit quality. Under Basel I, assets were assigned uniform risk weights such as 0% for all sovereigns, 20% for all banks and 100% for all corporates etc. The credit rating or health of the counterparty was not taken into account. This aberration is proposed to be corrected in Basel II. Along with the class / category of the borrower, his credit rating is given due consideration under the revised accord.

Credit Risk (continued)

Banks have a choice between two broad methodologies for calculating their capital

requirements for credit risk. One method is to measure credit risk in a standardized manner based on external credit rating assessment. Other method is to use the internal rating system for credit risk. This would be subject to the explicit approval of the supervising authority. This second method, known as IRB approach has two further options Foundation Approach and Advanced Approach.

Standardized Approach (Option I)

This option allows banks to measure credit risk in a

standardized manner based on external credit rating from a recognized agency. RBI have accredited certain rating agencies ( presently, CRISIL ,CARE, ICRA and FITCH). The risk weights are inversely related to the credit rating of the counterparty, i.e., higher the credit rating, lower will be the risk weight etc. The rating agencies are given recognition based on certain criteria like i) Objectivity, ii) Independence, iii) Transparency, iv) Disclosure, v) Credibility.

 For the purpose of credit rating of sovereigns, the country

Standardized Approach (continued)

scores of Export Credit Agency (ECA) may be recognized. In the case of commercial banks, two options are available. Under the first option, all banks in a given country are assigned a risk weight one notch below the risk weight assigned to that country. In respect of exposures on banks, the following methodology is used For rupee exposures on domestic scheduled banks, the risk weight will be 20% and it will be 100% in respect of non scheduled banks having minimum CRAR. For others, it will be on a graded scale, depending on their CRAR and ranges from 50% to 125%. In case of foreign currency exposures, the risk weights will depend upon the ratings assigned to the counterparty by recognized international rating agencies such as Moodys and Standard & Poors.

 Claims on corporates have risk weights based on credit

Standardized Approach (continued)

ratings. The risk weights for unrated claims would be 100%.Unrated corporates can not have a rating better than their sovereigns of incorporation. The supervisor may increase the standard risk weight of unrated claims based on default experience. The standardized approach gives a special treatment to certain classes of exposures. Retail and SME exposures attract a uniform risk weight of 75%.To become eligible for inclusion in retail category, the criteria stipulated are as under i) Exposure is to an individual person or persons or to a small business, ii) Exposure is in the form of a revolving credit, personal term loans, small business facilities. Securities, bonds and equities are specifically excluded. iii) Portfolio must be well diversified (granularity concept).

Standardized Approach (continued)

iv) Low value of individual exposures. The single borrower exposure limit to be Euro 1 million.( In our country RBI has proposed to fix a ceiling of RS.50 Million for this purpose). Lending fully secured by mortgage on residential property to have a risk weight of 50% for loans up to RS.2 million and 75% for others, provided LTV is not more than 75%. Loans secured by commercial real estate will have a risk weight of 150%. Past due loans would attract 150% risk weight when specific provisions are less than 20%. The risk weight would go down if higher provisioning is available. In case of off balance sheet items, credit conversion factors are used like the ones in Basel I accord. Cash or liquid securities available are allowed to be netted if the bank has a right to appropriate the same. Where certain guarantees are available, like ECGC or CGTMSE, the risk weight would go down accordingly.

Internal Rating Based Approaches

One of the most innovative aspects of Basel II is the Internal

Rating Based approach for measurement of capital requirement for credit risk. This approach involves assigning risk weights based upon the internal ratings of the borrowers. The rating exercise must fulfill certain criteria to the satisfaction of the regulator. There are two options available Foundation Approach and Advanced Approach. In the IRB approaches, the banks internal assessment of key risk parameters serves as a primary input to capital computation. The main features of IRB approach are i) capital charge computation is dependent upon the following parameters PD (probability of default), LGD (loss given default), ED (exposure at default) and M ( effective maturity)

Internal Rating Based Approach ( cont )

IRB approach computes the capital requirement of each

exposure directly. Banks need to categorize banking book exposures into broad classes of assets with different underlying risk characteristics such as (a) corporate (b) sovereign (c) banks (d) retail and (e) equity or capital market. Within corporates and retail, there are subclasses which are separately identified. Risk weighted assets are derived from the capital charge computation. Banks must use the risk weights provided by Basel II. IRB approach does not allow banks to determine all the above elements.

Advanced Approach
Foundation and advanced approaches differ primarily in

terms of the inputs that are provided by the Bank on its own estimates and those that are specified by the supervisor. Under the Foundation Approach, Banks provide their own estimates of PD and rely upon supervisory estimates for other risk components. Under the advanced approach, banks provide their own estimates of PD, LGD, ED and M. Banks adopting to use IRB approach are expected to continue the same. A voluntary return to the earlier or lower approach is permitted only in very exceptional circumstances with the Regulators approval.

Capital Charge For Market & Operational Risks

Changes in market prices of

assets affects financial conditions. Assets may appreciate or depreciate in value. This risk is called Market Risk. Banks face risks other than credit risk and market risk and these can be substantial. These are called Operational risks. Basel I accord did not address the issue of allocation of capital for operational risks. There is a general perception that operational risks are on the rise. Many bank failures like the Daiva Bank have been attributed to the operational risks (failure of internal controls ). Basel II accord has dealt with the issue of allocation of capital for operational risks and has suggested three methodologies for the same.

Capital Charge For Market Risk

Market risk is the risk of losses in on-balance sheet and off balance-sheet positions arising from the movement in market prices. The market risk positions requiring capital charge are i) Interest rate related instruments in the trading book, ii) Equities in the trading book, and iii) Open FX positions (including positions in precious metals and commodities) throughout the bank, i.e., both the banking book and the trading book. A trading book consists of financial instruments and commodities held with either trading intent or in order to hedge other elements in the trading book.

Capital Charge For Operational Risk

Basel II accord stipulates that the positions should be

frequently and accurately valued. The regulator may provide guidance on prudent valuation for positions. In the Indian context, the trading book comprises of i) Securities under Held for Trading category (HFT), ii) Securities under Available For Sale category (AFS), iii) Open Foreign Exchange positions, iv) Open Gold Positions, v) Trading Positions in Derivatives, and vi) Derivatives for hedging trading positions. Banks will be required to calculate counterparty credit risk charge for OTC derivatives.

Capital Charge For Interest Rate Related Instruments And Equities

The

capital charge for interest rate related instruments and equities would apply to the current market value of these items. The minimum capital requirement comprises of two components as under Specific risk charge for each security, which is similar to the conventional capital charge for credit risk both for short and long positions, and General market risk charge towards interest rate risk in the portfolio.

Capital Charge For Operational Risk

In the Basel I accord, risk capital for operational risk was not

envisaged. Basel II accord deals with this important aspect of risk management and prescribes minimum capital for operational risk. Operational risk varies with the volume and nature of business. It may be measured as a proportion of gross income, which is a direct measure of operational volumes. Operational risk is defined as a risk of loss resulting from inadequate or failed internal processes, people, systems or from external processes / events. This definition includes legal and compliance risk, but excludes strategic and reputational risk.

Capital Charge For Operational Risk (continued)

Basel II accord provides three methods for calculating

capital charge for operational risks 1) The Basic Indicator Approach (BIA), 2) The Standardized Approach (SA), and 3) The Advanced Management Approach (AMA). The banks are expected to move from the Basic Indicator Approach to Advanced Management Approach over a period of time. A bank will not normally be allowed to revert to a simpler approach once it is approved for more advanced approach.

Basic Indicator Approach

Under the BIA regime, a bank must hold capital for operational risk equal to the average over the

previous three years of a fixed percentage (denoted by alpha) of positive annual gross income. If annual income is negative or zero, it should be excluded. The capital charge may be expressed as follows K = ( GI 1..3 X alpha ) / 3, where , K = Capital charge required under BIA, GI = Gross Annual Income over the previous three years, wherever positive, and alpha = 15% which is set by Basel II accord.

Basic Indicator Approach (continued)

Annual Gross Income is defined as NII + NNII.

This amount should be i) gross of any provisions, ii) gross of operating expenses, iii) exclude realized profits / losses from sale of investments in the banking book (AFS & HTM), and iv) exclude extraordinary or irregular items and income derived from insurance business. Thus, GI = Operating profit + operating expenses extraordinary items realized profits from sale of investments in the banking book. Banks using this approach are expected to comply with Basel Committees guidance on sound practices for the management and supervision of operational risks.

The Standardized Approach

Under this approach, the banks activities are divided into

eight business lines as under 1) Corporate Finance 2) Trading & Sales 3) Retail Banking 4) Commercial Banking 5) Payments & Settlements 6) Agency Services 7) Asset Management 8) Retail Brokerage. Within each business line, gross income is a broad indicator for the operational risk exposure. The capital charge for each business line is calculated by multiplying the gross income by a factor ( beta) assigned to that business line. The total charge is the three years average of the simple summation of the regulatory capital charges for each of the business lines. The total charge is expressed as -

The Standardized Approach (continued)

K = Years 13 max ( GI 1.8 * Beta 1.8 ) / 3., where K = Capital charge required, GI 18 = Annual gross income for each of the eight business lines in a year, and beta 1.8 = a fixed percentage set by Basel II accord. The values of beta for different lines of business are as under Corporate Finance 18% Trading & Sales 18% , Retail banking 12% Commercial Banking 15%, Payments &Settlements 18%, Agency services 15%, Asset management 12% Retail Brokerage 12%.

Advanced Management Approach

Under the Advanced Management Approach,

banks internal operational risk measurement system is used. Internal Measurement System is required to be vetted by the Supervisor.
The regulatory capital requirement for operational risks will be equal to the risk measure generated by the banks internal operational risk measurement system, using certain qualitative and quantitative criteria as listed below:

Qualitative Standards
A bank must have an independent operational risk

management function. Operational Risk Management System must be closely integrated into day to day risk management processes. There must be a regular reporting system of operational risk exposures and loss experiences to the Board. Operational risk Management System must be well documented. Internal / external auditors must perform regular reviews of operational risk management processes and measurement systems. The validation of operational risk management system should be done by external auditors or the Supervisor.

Quantitative Standards
In view of the continuing evolution of analytical approaches

to operational risk, the Basel Committee has chosen not to prescribe a specific approach. However, a bank must demonstrate that their operational risk measures fulfil soundness standards comparable to that of internal rating based approach. The quantitative standards prescribed by the Committee are as under 1) The internal operational risk measurement system must be consistent. 2) The bank should calculate the regulatory capital and the expected as well as unexpected losses - EL and UL. 3) The measurement system must be sufficiently granular to capture major events of operational risks.

Qualitative Standards (continued)

4) The systems for determining correlations must be sound and the bank must validate the correlation assumptions. 5) The system must have key elements that meet supervisory standards. 6) A bank needs to have a credible, transparent , well documented and verifiable approach for weighing the fundamental elements in the risk measurement system. 7) Internally generated measures must be based on a minimum 5 years observation period in internal loss data. 8) A banks risk measurement system must use relevant external data. 9) A bank must use scenario analysis of expert opinion in conjunction with external data to evaluate its exposure to high severity events.

 The measures to prevent and control operational risks involve

Prevention Of Operational Risks

various tasks such as Personnel Selection Effective selection, training, induction , placement and promotions are critical factors. Integrity , domain knowledge and efficiency are important requisites. Work Culture Working environment, values and ethics play an important role. Organizational Structure A formal chain of command, compliances, grievance redressal mechanism are key factors. Audit & Internal Control - Effective audits, mix of continuity and surprise checks are essential to control operational risks. System of Reviews & Revision Periodical reviews of existing business processes in the light of changing environment, legal framework is essential.

Pillars II & III Supervisory Review & Market Discipline

Pillar I deals with calculation of capital charge for credit,

market and operational risks. The process of ascertaining capital adequacy needs to be reviewed and monitored by the Supervisor. Principles for such a review are laid down by the Basel committee. Transparency and objectivity are considered by the committee as important parameters of review process. The third pillar of Market Discipline is critical. Basel Committee prescribes the disclosure norms so as to enable the market to assess a banks position. The market needs a consistent and large scale information for making a meaningful assessment. Pillar III prescribes several qualitative and quantitative disclosures for this purpose. The three pillars thus play a mutually complementary role.

Pillar II Supervisory Review Process

The Supervisory Review Process addresses two issues-

1) To ensure that the banks have adequate capital to support all the risks in their business , and 2) To encourage banks to develop and use better risk management techniques in identifying, measuring, monitoring and mitigating their risks. Supervisors are expected to intervene, where necessary. They have to identify the deficiencies, if any, and prompt and decisive action should be taken to reduce risk or increase capital. The supervisors need to focus more on weaker banks. The supervisors need to concentrate on three major areas-

Supervisory Review Process (continued)

1) Risks considered under Pillar I, but not fully captured, such as credit concentration risk, 2) Factors that are not addressed in Pillar I process such as strategic risk, or interest rate risk in the banking book, 3)Factors external to the bank such as business cycle effects. The Supervisor must ensure compliance of minimum standards and disclosure requirements of more advanced methods on a continuing basis. Basel II Committee has identified 4 key principles of Supervisory Review Process, as under -

Principle I
Banks should have a process of assessing their capital adequacy in relation to their risk profile and

a strategy for maintaining their capital levels. Bank managements must have a rigorous process for ensuring that the bank has adequate capital to support its risks. The five main features of such a process are 1) Board & Senior Management Overview, 2) Comprehensive assessment of risks, 3) Sound Capital Assessment, 4) Monitoring & Reporting, and 5) Internal Control Review.

Principle II
Supervisors should review and evaluate banks internal

capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. The Supervisors should take appropriate supervisory action if they are not satisfied with the results of this process. The emphasis of the supervisory review should be on the quality of the Banks Risk Management Systems and controls. The periodic review should cover the following aspects 1) On site examinations or inspections, 2) Off - site review, 3) Discussions with Bank managements, 4) Review of work done by Auditors, and 5) Periodic Reporting.

Principle III
Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require the banks to hold capital in excess of the minimum needed. Supervisors should require banks to operate with a buffer over and above the Pillar I standard. Buffer is meant to cover uncertainties related to the

system. Similarly, bank specific uncertainties are addressed by bank specific buffer prescriptions.

Principle IV
Supervisors should seek to intervene at an early stage to

prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored. If bank is not meeting the requirements in the above four principles, the supervisor should consider a range of options. These may include extensive monitoring, restricting dividend pay outs, requiring the bank to raise additional capital etc. The Basel II Committee has identified a number of important issues that require focused attention of Supervisory Review Process. Some of these issues, which are not directly addressed under Pillar I are as follows -

Supervisory Review Process (continued)

1) Interest Rate Risk in the Banking Book, 2) Credit Risk (a) Stress Test Under IRB Approach (b) Definition of Default (c) Residual Risk (d) Credit Concentration Risk 3) Operational Risk. The Supervisory Review Process would always involve some amount of discretionary elements. Hence, supervisors must take care to carry out their obligations in a transparent and accountable way. The framework requires enhanced cooperation among supervisors for cross border supervision.

Pillar III Market Discipline

The purpose of Pillar III Market Discipline is to

complement the minimum capital requirements ( Pillar I) and Supervisory Review Process (Pillar II). Pillar III provides disclosure requirements for banks using Basel II framework. These disclosures will allow market participants to assess key information and thereby make informed decisions about a bank. Basel Committee has made considerable efforts to see that Pillar III disclosures framework does not conflict with the requirements under the accounting standards. Accounting and other mandatory disclosures are generally audited. Additional disclosures provided under Pillar III framework must be consistent with the audited statements. Banks are encouraged to provide all the information at one place.

YOU

What are Tier III Capital Items?

A Tier III Capital is raised to meet part of the Market Risk, viz., changes in interest rates, exchange rates,

equity prices, commodity prices etc. Issuance of short term subordinated debt subject to lock in period clause of two years and further limited to the extent of 250% of Tier I Capital would form part of Tier III Capital. Thus, the capital of a Bank consists of Tier I, Tier II and Tier III Capital, which are owned and borrowed funds which are available to the business on long term basis.