Basel II Accord To Guard Against Financial Shocks

Basel Accords Determine Bank Equity Capital
The Basel Accords determine how much equity capital - known as regulatory capital - a bank must hold to buffer unexpected losses. Equity is assets minus liabilities. For a traditional bank, assets are loans and liabilities are customer deposits. But even a traditional bank is highly leveraged (i.e., the debt-to-equity or debt-to-capital ratio is much higher than for a corporation). If the assets decline in value, the equity can quickly evaporate. So, in simple terms, the Basel Accord requires banks to have an equity cushion in the event that assets decline, providing depositors with protection. The regulatory justification for this is about the system: If big banks fail, it spells systematic trouble. If not for this, we would let banks set their own levels of equity -known as economic capital - and let the market do the disciplining. So, Basel attempts to protect the system in much the same way that the Federal Deposit Insurance Corporation (FDIC) protects individual investors. (For more insight, read Are Your Bank Deposits Insured?)

Bank Loans - Then and NowThe traditional "loan and hold" bank may now only exist in a museum. Modern banks "originate and distribute" and they have astonishingly complex balance sheets. For example, many banks have been tilting away from long-term illiquid assets and toward tradable assets. In addition, many banks routinely securitize. That is, they sell loan assets off of their balance sheets, or achieve a similar risk transfer by purchasing credit protection from a third party, often a hedge fund indirectly. This is a called a synthetic securitization. (To learn more, read Behind The Scenes Of Your Mortgage and What is securitization?)

The Original Accord Is Broken
The Basel I Accord, issued in 1988, has succeeded in raising the total level of equity capital in the system. Like many regulations, it also pushed unintended consequences; because it does not differentiate risks very well, it perversely encouraged risk seeking. It also promoted the loan securitization that led to the unwinding in the subprime market. (For more on the subprime crisis, check out our Subprime Mortgage Feature page.)In short, Basel I has several shortcomings. And, although some people are mistakenly implicating all of Basel in some of the problems it has created, it is too early to tell whether Basel II will fail in regard to credit derivatives and securitizations. Basel II does try to address new innovations in risk but the cost is complexity.

Basel II Is Complicated
The new accord is called Basel II. Its goal is to better align the required regulatory capital with actual bank risk. This makes it vastly more complex than the original accord. Basel II has multiple approaches for different types of risk. It has multiple approaches for securitization and for credit risk mitigants (such as collateral). It also contains formulas that require a financial engineer.

Some countries have implemented basic versions of the new accord, but in the United States, Basel II is seeing a painful, controversial and prolonged deployment (even as large banks have been working for years to meet its terms). Many of the problems are inevitable: The agreement tries to coordinate bank capital requirements across countries and across bank sizes. International coherence is hard enough, but so is scaling the requirements - in other words, it is very hard to design a plan that does not give advantage to a banking giant over a smaller regional bank.

Basel II has three pillars: minimum capital, supervisor review and market discipline.



Minimum capital is the technical, quantitative heart of the accord. Banks must hold capital against 8% of their assets, after adjusting their assets for risk.

Supervisor review is the process whereby national regulators ensure their home country banks are following the rules. If minimum capital is the rulebook, the second pillar is the referee system.

Market discipline is based on enhanced disclosure of risk. This may be an important pillar due to the complexity of Basel. Under Basel II, banks may use their own internal models (and gain lower capital requirements) but the price of this is transparency.

Basel II Charges for Three Risks
The accord recognizes three big risk buckets: credit risk, market risk and operational risk. In other words, a bank must hold capital against all three types of risks. A charge for market risk was introduced in 1998. The charge for operational risk is new and controversial because it is hard to define, not to mention quantify, operational risk (The basic approach uses a bank's gross income as a proxy for operational risk. It is not hard to challenge this idea.)

The Basel II Transition
Not only is the implementation staggered globally, but the accord itself contains tiered approaches. For example, credit risk has three approaches: standardized, foundation internal ratings-based (IRB), and advanced IRB. Roughly, a more advanced approach relies more on a bank's internal assumptions. A more advanced approach will also generally require less capital, but most banks will need to transition to more advanced approaches over time.

Summary
The Basel II Accord attempts to fix the glaring problems with the original accord. It does this by more accurately defining risk, but at the cost of considerable rule complexity. The technical rules will be importantly supported by supervisor review (Pillar 2) and market discipline (Pillar 3). The goal remains: Maintain enough capital in the banking system to guard against the damage of financial shocks.

Minimum Capital Requirement

Capital Requirement
What Does Capital Requirement Mean?The standardized requirements in place for banks and other depository institutions, which determines how much liquidity is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit Insurance Corporation or Federal Reserve Board. These requirements are put into place to ensure that these institutions are not participating or holding investments that increase the risk of default and that they have enough capital to sustain operating losses while still honoring withdrawals. Also known as "regulatory capital".

Investopedia explains Capital Requirement
In the United States, the capital requirement for banks is based on several factors, but is mainly focused on the weighted risk associated with each type of asset held by the bank. The capital requirements guidelines are used to create capital ratios, which can then be used to evaluate and compare lending institutions based on their relative safety.

An adequately capitalized institution, based on the Federal Deposit Insurance Act, must have a Tier 1 capital-to-risk weighted assets ratio of at least 4%. Institutions with a ratio below 4% are considered undercapitalized and those below 3% are significantly undercapitalized.

http://www.investopedia.com/terms/c/capitalrequirement.asp

Basel II Explained

What is Basel II? Who is behind it? Who has developed it? Is it an international law? Do we have to comply? Who has to comply? May I have a Basel II Summary? These are very important questions, and it is good to start from their answers.

The Basel II Framework (the official name is "International Convergence of Capital Measurement and Capital Standards: a Revised Framework") is a new set of international standards and best practices that define the minimum capital requirements for internationally active banks. Banks have to maintain a minimum level of capital, to ensure that they can meet their obligations, they can cover unexpected losses, and can promote public confidence (which is of paramount importance for the international banking system).

Banks like to invest their money, not keep them for future risks. Regulatory capital (the minimum capital required) is an obligation. A low level of capital is a threat for the banking system itself: Banks may fail, depositors may lose their money, or they may not trust banks any more. This framework establishes an international minimum standard.

Basel II will be applied on a consolidated basis (combining the bank's activities in the home country and in the host countries).The framework has been developed by the Basel Committee on Banking Supervision (BCBS), which is a committee in the Bank for International Settlements (BIS), the world's oldest international financial organization (established on 17 May 1930).

The Basel Committee on Banking Supervision was established by the G10 (Group of Ten countries) in 1974. These 10 countries (have become 11) are the rich and developed countries: Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States.

The G10 were behind the development of the previous (Basel i) framework, and now they have endorsed the new Basel II set of papers (the main paper and the many explanatory papers). Only banks in the G10 countries have to implement the framework, but more than 100 countries have volunteered to adopt these principles, or to take these principles into account, and use them as the basis for their national rulemaking process.

Basel I was not risk sensitive. All loans given to corporate borrowers were subject to the same capital requirement, without taking into account the ability of the counterparties to repay. We ignored the credit rating, the credit history, the risk management and the corporate governance structure of all corporate borrowers. They were all the same: Private corporations.

Basel II is much more risk sensitive, as it is aligning capital requirements to the risks of loss. Better risk management in a bank means that the bank may be able to allocate less regulatory capital.

In Basel II we have three Pillars:

Pillar 1 has to do with the calculation of the minimum capital requirements. There are different approaches:

The standardized approach to credit risk

Banks rely on external measures of credit risk (like the credit rating agencies) to assess the credit quality of their borrowers.

The Internal Ratings-Based (IRB) approaches too credit risk

Banks rely partly or fully on their own measures of a counterparty's credit risk, and determine their capital requirements using internal models.

Banks have to allocate capital to cover the Operational Risk (risk of loss because of errors, fraud, disruption of IT systems, external events, litigation etc.). This can be a difficult exercise.

The Basic Indicator Approach links the capital charge to the gross income of the bank. In the Standardized Approach, we split the bank into 7 business lines, and we have 7 different capital allocations, one per business line. The Advanced Measurement Approaches are based on internal models and years of loss experience.

Pillar 2 covers the Supervisory Review Process. It describes the principles for effective supervision. Supervisors have the obligation to evaluate the activities, corporate governance, risk management and risk profiles of banks to determine whether they have to change or to allocate more capital for their risks (called Pillar 2 capital).

Pillar 3 covers transparency and the obligation of banks to disclose meaningful information to all stakeholders. Clients and shareholders should have a sufficient understanding of the activities of banks, and the way they manage their risks.

巴塞爾II落實在即銀行整併戰況空前

不管是當家的10家銀行，還是未來的6家主導銀行，業界認為，巴塞爾II的落實，將催化業者加速整合。 1991年，讓人震驚的違法活動導致國際商業與信用銀行（Bank of Commerce and Credit International, BCCI）被100億美元的損失壓垮。4年后，紐約Daiwa公司因未經授權交易，損失11億美元。1995年發生的霸菱（Barings）事件，使這家擁有233年歷史的英國金融機構，被一個交易員在衍生性商品中給搞垮。

2004年6月，著重在金融銀行業風險管理的“國際標準巴塞爾協定第2部”（Basel II Accord）最新指南出爐了，全球性金融銀行業的風險管理演化進程，也正式邁入了全新境界。 　不過，根據國際知名會計師事務所安永（Ernst & Young）研究報告，亞太區高達65%的金融機構，都僅處在落實符合巴塞爾協定風險管理的“初期階段”，或者是完全還沒開始。 　

OSK證券分析員陳建堯則意外的說，巴塞爾協定風險管理標準的最大投資會是“資訊科技”，而不是例如像提高資本適足率（Capital Adequacy Ration）等其它融資成本。眼看我國將全面落實巴塞爾協定的2008年很快就到來，陳建堯也呼籲業者，必須“加緊腳步”，否則就會被逐漸開放的市場力量。

面對即將落實的全新國際金融銀行業風險管理標準“國際標準巴塞爾協定第2部”（Basel II Accord，簡稱巴塞爾II），分析員認為，國內銀行積極提升資金管理層次，目的就是要作好準備。不過，國際知名會計師事務所安永（Ernst & Young）的調查研究報告成果卻顯示，亞太區約20%的金融機構，沒還在資金管理策略上作出決定。 　

同一個標準卻出現兩種很不一樣的觀察，陳建堯告訴《財經天地》：“這是因為市場決定了銀行業者的落實決心，我國銀行業目前還在整合，業界還在消化，觀望成了業者的普遍心態。” “距離我國的2008年落實期限，目前還有一段空檔時間，我想這就是為什么外界認為，我國業者還沒什么具體行動的主因。” 　

根據稍早前業界公佈的數據，銀行業者在落實巴塞爾II時，成本平均將上揚介于2000萬令吉至7000萬令吉之間。陳建堯認為，其中一大部份成本將流向以資料收集、儲存、管理、以及評估的資訊平台。就金融業信貸和營運風險而言，業界認為，我國銀行業者最擔心的，莫過于“內部評級估算法、內部評級用資料收集、以及如何符合管理單位在放款和內部評級上的要求。” 　

陳建堯說，由于銀行業競爭激烈和市場導向明顯，“不認為例如像國家銀行（Bank Negara）等這類主管單位需要很詳細的指南細節。 　“市場力量驅使下，主管單位只需描出大方向即可，太詳細可能會有干預市場的嫌疑。” 　

另一方面，由聯昌國際（CIMB）欲收購南方銀行（SBANK）而帶動的國內銀行業整併形動，看在業界的眼裡，某程度上也受巴塞爾II的帶動。 國際評級機構穆迪（Moody）稍早前一份針對我國銀行業展望的分報告中，就直截了當的說：“激烈競爭、強制性巴塞爾II的落實，以及存款保險（Deposit Insurance）成本，將進一步帶動大馬銀行業的整合。” 　

馬銀行證券（Mayban Securities）日前在評論聯昌欲收購南方銀行時也曾說：“南方銀行曾說，2010年前都無法符合巴塞爾II；這情況下，小業者跟大業者合併符合我國銀行業生態，因此我認為聯昌國際勝算頗大，問題只在議價空間。” 公平較量實力突圍 不過，陳建堯也說，目前而言，業者都還在準備階段，而且所涉及的資料極為機密，因此準備細節很難從公開場合中取得。

“要精確估算業者的準備進展，恐怕只能從有限的官方資料中查到。” 本質上而言，陳建堯說：“我們認為這種動態的風險管理是必要的，特別是銀行業競爭激烈的當前，業界更需要一種不但能自保，又能公平較量的標準和指針。” 　

“假設銀行業者的價格戰已全面開打，大部份銀行在產品定價時得靠自己的熟客，以及行銷策略來求突圍。” 　“如果說，這家銀行在房貸上的實力很強，那它就可以在房貸利率上讓步，雖然低風險回酬相對較低，但也因此有機會搶進對手的市場。” 業者積極改革風險自定勝券在握。 國內銀行業者積極改革之極，陳建堯認為，作為主管單位的國行也並沒有閒著，目前正在架設廣泛和中央化的銀行資料系統。“這會是業者和相關主管單位為符合巴塞爾協定風險管理的落實上的明確參考。” 　

陳建堯說，“巴塞爾協定第1部”（Basel I Accord，簡稱巴塞爾I）要求金融機構維持最低的資本額，以補足信貸風險，這也就是所謂的資本適足率（Capital Adequacy）。“業者在應用這標準來衡量風險時，也就有了一個明確的機制和標準。”

不過，隨著金融業不斷發展，技術和風險管理層級顯得有點落伍，所以才會有人倡導推出巴塞爾I。 　他說，巴塞爾II對決定資本適足率上的風險管理特別敏感，不再限制信貸風險差別，轉而讓銀行業者自行設定自己的風險權重。 　這樣一來，業者就能依自己的條件和環境，訂出更能反映自身風險的信貸風險級別，也更能控制業者自己的損失，進而穩定整個金融業。 　

陳建堯說，巴塞爾II不但可降低銀行業者的資本要求（Capiatal Requirements），還可以改善金融銀行業者的結構性風險評估和管理。“銀行的作業流程效率會因此提升，盈收會增加，股東價值也會被進一步強化。”

巴塞爾II 3大支柱
第1支柱：最低資本額 　最低資本額將由一套強化了的風險估算架構加以衡量，包括信貸、市場、以及營運風險。
第2支柱：管理審查 　提供金融機構內部自我監視和評估資本適足率。
第3支柱：市場紀律 　透過高效率資料公開原則，鼓勵落實良好的銀行業行為準則，目的是確保銀行公開資料，好讓投資者得以評估業者的資本適足率，以及風險管理系統的效率。

新聞辭典：
2006年正式實施 新版巴塞爾協定 國際清算銀行（Bank for International Settlement）旗下之巴塞爾銀行監理委員會（Basel Committee on Banking Supervision），是世界10大工業國中央銀行于1974年共同成立，每年定期聚會4次，初期重點在制訂銀行業務之監理原則。 　1973年及1979年2次石油危機引發通貨膨脹、利率大幅波動、傳統金融無商品投資報酬率不佳等影響，促使巴塞爾委員會轉而致力資本適足（capital adquacy）的研究，並加強風險控管。 　

為了強化國際銀行體系之穩定，並避免因各國銀行資本規定不同，造成不公平競爭情形，委員會對于跨國規範之需求日益增強，于1988年正式對會員之國內銀行公佈。直至1992年杪，銀行自有資本與風險性資產之比率至少需達到8%之標準，至1993年，會員國內所有國際銀行亦需符合8%的要求，此要求亦漸漸被世界各國普遍接受。 　
由于金融環境瞬息萬變，實施多年之巴塞爾協定內容已無法充分反應金融機構內部資本效益，及面臨風險的全貌。 巴塞爾委員會于1999年，公佈新資本適足率資本架構（A new capital adequacy framwork），並于2001年公佈新版巴塞爾協定草案，主要架構包括最低資本適足、監理審查、及市場制約等，預計2006年將正式實施新版巴塞爾協定。

不影響財務有助提升競爭力 雖然大部份金融機構不認為，落實巴塞爾II初期階段會影響財務現狀，但3分之2的受訪業者認為，中、長期而言，巴塞爾II有助提升競爭力。” 根據安永報告，就管理單位的因應而言，本地主管單位頒佈的指針“合理”或“差”的業者，佔了70%。 　除了巴塞爾II外，3分之2的亞太區金融機構認為，他們最重視的其它新國際標準包括國際會計標準（IAS），以及美國企業改革法案（Sarbanes-Oxley）。

安永亞太調查報告‧ 逾半希望2010年 全面符合標準 就落實巴塞爾II的決心而言，安永報告發現，希望到了2010年時，可以完全符合巴塞爾II規定的受訪金融業者，超過一半。 報告說，認為巴塞爾II會大幅度改變自有信貸風險管理的受訪業者，超過80%。 至于已完成的部份，40%受訪業者說，他們已完成了部份借貸者的信貸評級，而且正建立評級模式。 　

報告說，完全沒有或只跟主管單位商談支柱1，以及支柱2細節的受訪業者，佔了約60%；這顯示業者和主管單位，在落實巴塞爾II時缺乏溝通。至于“完全還沒”，或只有“部份落實”巴塞爾II第3支柱的受訪業者，超過80%。 　

安永報告也指出，業者面對科技時的態度，近3分之2的受訪業者，還沒完成落實巴塞爾II時所涉及的科技規劃。 新資金管理進度 20%未做好準備 國際會計師事務所安永（Ernst & Young）調查研究報告指出，就巴塞爾II整體事務而言，亞太區金融機構在準備上仍處于“初期階段”的高達65%。 報告說，有些甚至還沒開始。 就如何面對自己的新資金管理進度而言，安永說：“大約有20%的區域金融機構，還沒決定到底要怎么處理信貸和營運風險。” 　“3分之2的金融機構，還無法預估自己的整體巴塞爾II成本”。

安永認為，亞太區金融機構在為巴塞爾II作好準備上，整體而言進度不一。“顯然的，相較大型西歐和北美銀行，部份亞太區銀行的準備功夫落差很大。” 　不過，安永研究也發現，亞太地區銀行業者的巴塞爾II準備意識，過去2年來提升不少。 　一般而言，規模較小的銀行在準備上不如大型銀行。報告說，所謂準備指的是完成評估，以及落實信貸評級模式、強力推行營運風險品管、以及提早將巴塞爾II的商業效益，轉移至實質上的業務。 　“其中還包括建置信貸風險基礎建設上，取得大幅度進展，就某些案例而言，已經自行開發出風險權重資產的整合機制。” 　因此，安永報告認為，亞太區大部份金融機構仍把重點擺在巴塞爾II第1支柱（Pillar 1，請參考“巴塞爾II小辭典”）上。”也就是說，業者比較重視如何去決定資本收費，不過，某些業者已經開始注意到第2支柱，以及第3支柱的重要性。

3分2受訪者未完成科技規劃 許多亞太地區金融機構表示，將選擇採用“簡易法”（ Simpler Approaches ），落實巴塞爾II規定的。 　國際會計師事務所安永的調查研究報告說，受訪的金融機構中，規劃在2010年採用“進階法”（Avanced Measurement Approach）來落實巴塞爾II規定的金融機構，佔了“一半以上”。 　面對以風險管理為核心的巴塞爾II，3分之2的亞太區金融機構回應安永調查時說，營運風險管理對他們來說“重要”以及“很重要”。 　不過，已經完成某程度風險和控管評估的受訪業者，僅佔“約40%”。 “超過一半的受訪業者表示，他們將在2005年內完成巴塞爾II的其它規定，特別是風險指標的製定、情景分析、以及資料遺失搶救。”安永報告認為，從研究分析成果中得知，亞太區金融機構忽略了第2支柱的重要性。 　報告說，巴塞爾II第2支柱的規定包括“建置管理機制”、“持續性調整評級模式”、“評級模式品管”、以及“風險資訊必須用來衡量所有關鍵信貸相關作業流程。” 　了解到科技在風險管理上的重要性後，報告說，規劃透過科技來提升風險管理層次的受訪業者，佔了75%。

The Structure of Basel II

The Structure of Basel II
The original Basel Accord’s simplicity probably helped its introduction by national prudential regulators. But the insensitivity to variations in risk (both between and within risk categories) had the potential to increase the incentive for risk-taking behaviour. Hogan & Sharpe (1997a and 1997b) and Gup (2003: 74), for example, argue that attaching a risk weight of 100% to all commercial loans irrespective of counterparty allowed banks to pursue higher-risk (to achieve higher return) lending since this requires no more capital than less-risky lending but has greater upside income potential. Basel II addressed this shortcoming by enabling the use of a much wider range of credit-risk weights, by providing for the use of different approaches to determining risk weights and by extending the capital requirement to cover all risks banks face.

Basel II has three pillars.
The first deals with a bank’s core capital requirement (Pillar 1); the second allows for supervisor discretion to adjust this requirement to allow for additional risk and particular circumstances (Pillar 2); and the third fosters market discipline (Pillar 3).

Pillar 1: Capital requirements for core risks

Pillar 1 refines the calculation of regulatory capital in three important ways. First, it uses a more granular approach to credit-risk weights; second, it provides banks (subject to the regulator’s approval) with a choice of methods for calculating risk weights for certain types of risk; and third, it incorporates operating risk into the capital requirement.

The anatomy of Pillar 1 is represented in Figure 1, which shows the Basel II innovations in bold type to distinguish them from those of Basel I. Note the introduction of three possible approaches to the calculation of the capital requirement for credit risk under Basel II; the standardised (externally set) risk weights and two approaches that rely on internal ratings (the foundation internal ratings basis, FIRB, and the advanced internal ratings basis, AIRB). Observe the introduction of a capital requirement for operating risk also provides for three approaches to the calculation of the capital requirement. An introduction to each innovation follows.

The calculation of the capital requirement for credit risk starts by dividing a bank’s assets into five categories (corporate, sovereign, bank, retail and equity) within which there are sub-groups reflecting the different risk parameters for each asset type. The capital requirement for each represents an attempt to capture the average probability that a loan to each category of borrower would default, and the proportion of the loan that would be lost if default occurred.

Under the standardised approach, risk-weights are prescribed for each risk category, where the risk of each is rated by the borrower’s externally-determined credit-rating agency such as Standard and Poor’s (S&P). The value of the loans in each category is multiplied by the prescribed risk weight and the product is multiplied by 8 per cent to determine the minimum capital requirement. To illustrate, there are six credit-rating grades for corporate loans, where grade 1 covers loans rated AAA to AA– (on Standard and Poor’s long-term scale), grade 2 covers A+ to A– and so on. The standard risk weights vary from 20 per cent to 150 per cent for these grades (APRA, APS 112 and APG 112). While this is the ‘default’ approach, which can be viewed as an extension of Basel I, it represents a substantial advance. Basel I used just four risk weights, two of which (in Australia) covered the bulk of bank balance sheet assets. The standardised approach requires an improvement in risk-management systems to generate the data to satisfy Basel II’s more granular risk categories. Most ADIs are using this approach, which is expected to generate, on average, a modest reduction in regulatory capital (Egan 2007).



The more radical innovation is the provision for banks to use either of two internal rating approaches subject to the regulator’s (that is, APRA) approval. The foundation internal ratings-based approach (FIRB) uses internal estimates of the probability of loan defaults (PD) and feeds this into a more complex probability-based formula (that relies on the supervisor’s estimates of the other risk components) to determine the risk weight to be used to calculate the amount of capital to be held against the loan. The advanced internal ratings-based approach (AIRB) uses internal estimates of loss given default (LGD) and the other risk components (effective maturity and the exposure at default) in a prescribed formula to determine the risk weight and hence the capital charge against a loan. These approaches derive from the internal risk assessments banks (including Australia’s big banks) began undertaking in the 1990s and thus Basel II can be viewed as following industry practice.

Basel II does not change the two methods that can be used for assessing the capital requirement for market risk introduced in 1996. However, it introduced a capital requirement for operational risk exposures. Operational risk refers to the risk that losses may result from a lack of verification and control processes (such as the loss of Є4.9 billion at Société Généralé due to a trader’s ability to circumvent operating systems that was revealed in January 2008). Three approaches for assessing operating risk are available; two that are relatively simple (the basic indicator and several standardised approaches) and the third advanced measurement approach (AMA) could be used by banks ‘with advanced operational risk measuring and modelling capabilities’. Under the standardised approach, an ADI divides its activities into three categories — retail banking, commercial banking and all other activities, which have different capital requirements — and the sum of these requirements sets the ADI’s operational risk-capital requirement. The capital requirement for retail and commercial banking is based on an ADI’s gross outstanding loans and advances (as an indicator of its operating risk exposure) whereas for the third category the capital requirement is based on the ADI’s gross income from these activities (APRA, APS114). To be accredited to use the advanced approach banks must have ‘an operational risk management framework that is sufficiently robust to facilitate quantitative estimates of the ADI’s ORRC (operational risk regulatory capital) that are sound, relevant and verifiable’ in relation to the ‘complexity of the ADI’s business’ (APRA, APS115: para. 21).

Three banks were accredited to use the advanced methods from January 2008 and a fourth (NAB) was given approval to use the foundation IRB approach. Three other banks have applied to move to an IRB approach during 2008 and are operating under Basel I in the meantime (RBA 2008a: 67). The advanced approaches are expected to reward banks with modest reductions in regulatory capital (for lower credit-risk exposures); although 10 per cent will be the maximum reduction in 2008 and 2009 (under Pillar 2 provisions) while the banks are demonstrating the performance of their risk-management models (Egan 2007).

Pillar 2: The Supervisory Review Process
Pillar 2 has two aspects. The first requires banks to assess their overall risk profile (in addition to the risks specified under Pillar 1) and to calculate any further capital that should be held against this additional risk. The additional risks potentially identified under Pillar 2 include credit concentration risk, liquidity risk, reputation and model risk. Consequently, Pillar 2 could be expected to add to the amount of capital held by banks (and offset the lower credit-risk capital requirement).

The second aspect of Pillar 2 is its inclusion of a ‘supervisory review process’. This allows supervisors to evaluate each bank’s overall risk profile and to mandate a higher prudential capital ratio where this is judged to be prudent (APRA, APS 110). APRA’s decision to increase NAB’s capital requirement following its foreign exchange losses (in January 2004) illustrates this process.

Pillar 3: Market Discipline

Pillar 3 requires disclosure of information regarding the calculation of bank capital positions and risk-management processes designed to strengthen the capacity of security markets to respond to changes in bank risk profiles. The idea is that banks which the market judges to have increased their risk profiles without adequate capital will have their securities sold down in debt and equity markets. The additional costs that this will impose on financing bank operations will provide an incentive for management to modify either the bank’s risk profile or its capital base. This dimension of Basel II is thus designed to complement Pillars 1 and 2 by providing additional discipline on bank risk-taking behaviour.

APRA’s prudential information disclosure requirements are most detailed for the Australian-owned ADIs that use the advanced risk-management approaches because of their use of internally-generated risk ratings. They are required to report quantitative risk-management information on a semi-annual basis and qualitative risk-management information on an annual basis, as well as reporting basic capital-adequacy information on a quarterly basis. The reporting requirements are less detailed for the ADIs that use the standard risk weights and for overseas-owned ADIs, assuming their home regulator’s prudential information disclosure requirements are equivalent to APRA’s (APRA June 2007 and APS330).

Securitisation
In this and the next sub-section Basel II’s approach to securitisation (BCBS 2004b: 120–43) and credit risk mitigation (BCBS 2004b: 31–51) within Pillar 1 are introduced because of the role these processes played in the crisis triggered by the US sub-prime loan debacle (which is discussed in section 5). The process of moving assets (these principally have been housing loans) off the balance sheet via securitisation (a variation of the ‘originate-to-distribute’ model used by Australia’s loan originators) has been an important feature of bank asset-liability management. In Australia it has been used especially by the regional banks.

The assets are securitised through the services of a special-purpose vehicle (SPV) established by a bank. The SPV arranges the issue of asset-backed securities (mortgage-backed securities, MBSs, where housing loans are involved) to investors and pays the bank for the loans with the proceeds. The bank avoids a capital requirement for the securitised assets provided the arrangement ensures it is no longer exposed to any risks associated with the assets, such as the risks that would arise if the originating bank agreed to any explicit credit enhancement of the securities or from implicit liquidity or solvency support for the SPV which could result in the securitised assets being brought back onto the originator’s balance sheet.

Credit-risk mitigation
An important dimension of Basel II is its treatment of credit-risk mitigation techniques such as the use of collateral, guarantees (by a third party) and other credit-risk reduction measures such as credit derivatives, which reduce the amount of loss in cases of default. Credit-default swaps (CDS) are the most extensively used credit derivative. They provide banks with the opportunity to buy protection against default events on one or more of its assets, which would reduce its credit risk. For example, a bank could purchase credit-risk protection on a specified set of loans or corporate securities held by the bank by issuing a CDS and paying a premium (this would be paid six monthly at the agreed rate) to the party that decides to accept the credit risk (such as a bond investment manager or another bank that wants to diversify its credit risks). The protection seller faces the obligation to compensate the protection buyer should pre-defined default events occur on the specified parcel of loans or securities. Should a default event occur the bank would receive a compensation payment and this lowers its loss given default, whereas should no default event occur the seller would receive the premium payments without having to compensate the bank.

Basel II explicitly recognises the role of banks’ increasing use of instruments such as credit derivatives. Since these instruments reduce the risk of loss they reduce a bank’s capital requirement. The reduction depends on the credit standing of the provider of the credit-risk mitigation instrument, such as the protection seller in the case of CDS. Thus the risk-weighted assets are adjusted using a risk weight appropriate to the risk class of the protection seller. For protection sold under the CDS, the same process is followed but the risk weight applied is that appropriate to the reference credit being protected.

Governor's Keynote Address at the Risk Management Seminar on the New Capital Accord (Basel II)

Speaker : Governor Dr. Zeti Akhtar Aziz
Venue : Nikko Hotel, Kuala Lumpur
Date : 15 April 2004
Language : English


"Enhancing the Soundness of the Banking Sector - The New Capital Accord"

It is my pleasure to welcome you to the Risk Management seminar on Basel II organized for the directors and senior management of banking institutions. The objective of this seminar is to promote greater understanding of the impending changes to the international capital adequacy regulation. Given the importance of the subject and its implications on the banking industry, it is important for the industry to understand the intentions and the challenges arising from these changes so that the necessary action may be taken in a manner in which the benefits to be derived from it can be maximised. While there has been global acceptance of the broad principles of the new accord, differing implementation approaches are being adopted by different countries. I will take the opportunity to discuss the new Accord from our perspective and the approach that will be adopted for Malaysia. This seminar will provide you with the opportunity to engage in discussions on the issues concerning the new Accord.

Philosophy and objective of capital regulation

A well functioning and efficient banking sector is vital to the economic growth process. The banking institutions perform the important intermediation function of mobilizing funds to finance productive activities. This intermediation process needs to be performed in an environment of financial stability. Therein lies the importance of confidence and soundness of the financial system. Banking business inherently involves risks and these risks need to be rigorously managed. In an environment of heightened uncertainty and increased volatility, this needs to be reinforced with the development of a more robust and resilient banking system. Hence the importance of prudential regulations to ensure the soundness and stability of the financial system.

An important component of prudential regulation is having a sound capital framework that measures risks accurately and allocates adequate capital to the risks. The current capital accord issued in 1988 has served as the international benchmark for capital adequacy assessment for banking institutions. While it has achieved the desired results in terms of developing more well-capitalized banking institutions globally, the rapid developments in the financial markets over the years, including the growth of off-balance sheet financing such as asset securitisation have rendered the broad-brush measurement of the existing accord to be less effective.

Risk and Risk Management - the need for new accord

New institutional structures and evolving market practices have reduced the effectiveness of the existing accord. While the basic categorization of risks have not changed significantly, the ways in which risks present themselves have changed quite substantially. With the introduction of new products and more complex financial transactions enabled by technological innovations, risks can be disaggregated and rebundled in new ways. Similarly, the advances in financial engineering and improved expertise have allowed the introduction of new hedging instruments to facilitate risk management. Significant enhancements have been achieved in the measurement of market risk where the use of internal value-at-risk models is fast becoming the industry standard.

The advances in the quantitative approach to the management of market risks have also expanded to the areas of credit as well as operational risks. Despite the significant data constraints, new research has strengthened the theoretical foundation for internal credit and operational risk modeling. The development of new hedging instruments such as credit derivatives has also increased the use of credit risk transfer mechanisms within the financial system, thus promoting more active credit portfolio risk management. Key developments have also taken place in the area of operational risk. The experience of large corporate failures due to fraud and lapses in internal controls has focused greater attention on improving operational risk management in banking institutions. This has prompted the need for banking institutions to provide capital for operational risk and to put in place a more integrated risk management framework on an enterprise-wide basis.

The essence of the new accord

The efforts of the BIS to introduce an enhanced framework for capital adequacy regulation through Basel II is in the context of these developments. The accord seeks to bring into greater alignment the more advanced concept of capital management into the regulatory equation. The assessment of capital adequacy needs to look beyond the computed capital ratio. The new Basel Accord therefore comprises three pillars. The first pillar provides a minimum capital measurement framework for credit and operational risks. In essence, the regulatory capital requirement is aligned more closely with the actual degree of underlying risk that the banking institution faces. It provides the capital measurement that has three options with different levels of complexities for both credit and operational risks to better reflect actual risk. The second pillar focuses on strengthening the supervisory process, particularly in assessing the quality of risk management in the banking institutions. The supervisory process aims to provide the mechanism to ensure that other risks such as concentration risks and market risks in the banking books being managed. Under such an environment, prudent lending such as that characterized by a high degree of portfolio diversification, could justify lower capital requirements. The third pillar specifies minimum disclosure requirements on capital adequacy to enhance market discipline.

Despite its relatively more complex architecture, the implementation of the new framework provides a number of options and flexibility to banking institutions. This is to ensure that the approach adopted reflects and is commensurate with the nature of risk-taking activities and the level of sophistication of individual institutions. In adopting the standardized approach for credit risks, the credit exposures are weighted based on recognized external credit ratings. However, for large banking institutions with businesses which are highly complex, the more advanced approaches, that is, the foundation or advanced internal rating based (IRB) approach may be more appropriate to reflect their actual risk profile. Similarly, there are three alternative approaches that may be adopted in allocating capital for operational risks, that is the basic indicator approach, the standardised approach and the advanced measurement approach.

The objective of the new framework is to emphasise on the need for refined measurement of risks, more efficient capital management and the adoption of sound risk management practices that will ultimately contribute to greater financial stability. This will be complemented with efforts to enhance the corporate governance framework, the robustness of the internal control systems, and to introduce greater transparency and market discipline. Within the context of these developments is the importance of the ability of the board members and top management of banking institutions to assess risk from a broader perspective and its strategic impact on the institution.

In view of the significant implications of this new capital framework, Bank Negara Malaysia has been directly involved in the consultative process through regional forums to ensure that issues and concerns of the emerging markets are considered by the BIS in designing the new accord. We are pleased to note that many of these issues have been taken into consideration.

Motivation for migration to the new accord

The adoption of the new accord is consistent with building strong risk management capability. The enhanced risk management practices required by the new accord not only can result in greater capital savings but becomes vital as the domestic banking system becomes increasingly competitive and integrated with the global marketplace. Effective and efficient decision making is enhanced with relevant and timely information supported by more quantitative analysis. This can be achieved through having a more robust data architecture and information system, integrated processes and enhanced information flow and reporting. Having a robust risk management framework would also allow banking institutions to better assess the marginal contribution of existing as well as new business lines to the institution’s overall financial performance. This would allow for more-informed decision-making, thus contributing towards greater competitive advantage.

Moving forward, there will be increased expectation for more efficient use of internal resources. A more enhanced and integrated risk management framework, and the adoption of a risk adjusted performance management model would serve to further facilitate shareholders’ activism and drive greater efficiency among banks.

Risk management however does not operate in a vacuum or in isolation and it should not be viewed merely for the purpose of regulatory compliance. Priority should be given to ensure that the risk management framework is well-aligned and well-integrated with the strategic business directions of the banking institution. The benefits of refined risk quantification and more robust risk management should be translated into improvements in business operations and more effective functioning of the institutions. This will in turn ultimately bring benefits to the consumers and the economy at large.

Implementation challenges and considerations

Given the complexity of Basel II, the ability to comply appears to be the main concern within the banking community. This is truly a major undertaking with respect to the IRB approaches or the internal rating based systems. The resources involved and data constraints are often cited as the two main challenges in implementing the IRB approach, particularly for banks in the emerging markets. At this stage, data on default and credit migration for certain market segments is too limited to facilitate any meaningful analysis. It is therefore recognized that some lead time would be needed for banking institutions to produce a robust and meaningful validation of internal estimates of probabilities of default and loss given default. However, this does not mean that banks should wait until all the requisite data is in place. Banks can initiate work to establish the framework for analytical functions.

While the industry survey conducted by Bank Negara Malaysia revealed a strong preference among Malaysian banking institutions to adopt the IRB approach, many had indicated the need to further strengthen their business case and undertake more comprehensive gap and impact analysis. This is indeed a critical process. Of importance is to be able to extract the benefits out of the new accord. This would however, take time even for large and internationally active banking institutions that have made substantial enhancements over the years.

Standardised approach offers benefits with much less complexity

While capital savings from the adoption of the standardized approach may be relatively lower than the IRB approach, the benefits to be gained under the standardized approach are still considerable compared to the current accord. It includes the lower risk weights to be assigned to the mortgage portfolio, which would be reduced from 50% currently to 35% under the standardized approach. Similarly, substantial capital savings could be generated from lending to small and medium enterprises (SME) that would qualify as retail exposures where the risk weights would be lowered from 100% to 75%. The potential impact of lower risk weight for this sector under the standardized approach could result in greater participation by banking institutions in this market segment.

Bank Negara Malaysia’s initial estimates on the impact of the standardized approach indicated that benefits would be derived by individual institutions in terms of capital savings. However, improvements in a number of areas such as loan identification systems as well as collateral management systems would result in higher capital savings for credit risks under the standardized approach. Continuous calibration would be required to ensure that banks under the standardized approach would continue to maximize capital savings for credit risks in view of the requirement for an explicit capital charge for operational risk under the new accord.

While the IRB approaches promise greater capital savings in the longer term, the adoption of the standardized approach in the transition is considered a more pragmatic option even for some internationally active banking groups. Under the IRB approaches, banks would need to reach an agreement with the regulator in the countries they operate on the robustness of group internal estimates and validation. The standardized approach is therefore seen to provide the breathing space for a smooth transition to IRB approaches while at the same time allowing banking institutions to avail themselves of the benefits of capital savings.

Different approaches are adopted by regulators

While there has been global acceptance of the broad principles of the new accord, differing implementation approaches are being adopted by different countries. In some countries, regulators have opted for the accord to be applied to all institutions while in others selected banks are being mandated specific approaches. Some other regulators have given greater flexibility for banks or have extended the timeline for the implementation of the new accord. These reflect the different considerations and priorities accorded by the various regulators in their policy agenda. In essence, the decision by national regulators are based on a number of common factors, namely, the stage of industry development and market infrastructure, the size and types of institutions involved, the regulatory philosophy and priorities, as well as the economic environment. Of importance is to ensure that the implementation of the new accord is consistent with the overall agenda and objectives for the financial sector to facilitate growth and economic expansion.

Implementation principles for Malaysia

In Malaysia the appropriateness of the new accord is being assessed in the context of our own objective to develop a more effective and resilient banking system that is best able to serve the nation. In view of the significant and special role of the banking sector in the economy, a well-capitalised banking system has always been a priority in the regulatory framework. In this context, the principles advocated by the new accord are consistent with our regulatory philosophy that encourages capacity building and enhancing risk management.
Effective Basel II implementation strategies would be premised on the industry having the correct understanding of the new framework. To implement the required changes, it is therefore vital that the management of banking institutions understands the principles of the new accord. One common misperception is that the recognition of financial collateral under the new framework will encourage more collateral-based lending within the banking sector. This is a simplistic conclusion given the stringent minimum standards for the recognition of such financial collaterals before banks can qualify for the capital savings. Moreover, the potential capital savings under the new framework is not from the recognition of financial collateral, but rather from the much lower risk weights attached to higher rated loans.

Indeed, the real benefit to be gained under Basel II environment comes from improved standards of loan underwriting and more accurate quantification of risks that can subsequently translate into enhanced performance. Acceptance of collateral is only to mitigate loss severity should a default take place. In an increasingly more competitive marketplace, the emphasis is on maximizing risk-adjusted returns on capital and maintaining an optimal asset portfolio that reflects the risk tolerance level of the institution. In such an environment, overemphasis on collateral is certainly not viable.

Bank Negara Malaysia will adopt four key principles in the implementation of Basel II in Malaysia:

Firstly, the need to accommodate capacity building efforts, with strong emphasis on gradual enhancement to risk management framework for all banking institutions;

Secondly, a more flexible timeframe that allows capacity building measures to be implemented;

Thirdly, an emphasis on strong business justification instead of regulatory mandate for the adoption of IRB approaches; and

Finally, an enhanced supervisory methodology to assess internal models and advanced risk management systems.

Malaysia will adopt a two-phased approach for Basel II
These principles would be implemented in a two-phased approach. The first phase will begin in January 2008 where all banks will adopt the standardized approach for credit risks and basic indicator approach for operational risks. Banking institutions would be required to submit to Bank Negara Malaysia parallel calculation of capital adequacy on a monthly basis for one year prior to the implementation of the standardized approach.

In Phase I, Bank Negara Malaysia may also allow banking institutions to remain on the current accord if they intend to adopt the Foundation Internal Rating Based (FIRB) approach, instead of the standardized approach. However, Bank Negara Malaysia would require a submission of business case justification as well as a blueprint for implementation that has been approved by the Board of Directors of the banking institutions concerned. These banking institutions would be expected to have undertaken a comprehensive gap and business impact studies to justify their roll-out plans. In this regard, a broad guideline on the required processes and expectations will be issued to facilitate the process.

Banking institutions intending to adopt the FIRB approach are expected to do so by January 2010. This is when the second phase of implementation will commence. These institutions will be required to submit to Bank Negara Malaysia parallel calculation of capital adequacy on a monthly basis for one year prior to implementation. However, during the second phase, banks on the standardized approach will not be mandated to migrate to the FIRB approach. For purposes of regulatory validation and approval, Bank Negara Malaysia would expect that all parameters and assumptions used for the FIRB approach will be based on local data inputs.

Conclusion – capital is key, but not the sole factor to ensure soundness

Despite the increased sophistication of the regulatory capital framework and internal economic capital model in banks, capital remains the last line of defence. Capital regulations will have to be complemented with prudent banking that includes enhanced underwriting standards, effective internal controls and risk management, as well as strong corporate governance. In achieving your future goals and aspirations, significant benefits can be derived from Basel II provided that your institutions undertake the necessary efforts to align your strategy and business orientation with the new standards. Your interest, participation and decisive actions on the new accord are therefore important in positioning your institution in this increasingly competitive and more dynamic environment.


Source :© Bank Negara Malaysia, 2010. All rights reserved.

Basel II - Introduction

International Convergence of Capital Measurement and Capital Standards: A Revised Framework Introduction

1. This report presents the outcome of the Basel Committee on Banking Supervision’s (“the Committee”)1 work over recent years to secure international convergence on revisions to supervisory regulations governing the capital adequacy of internationally active banks. Following the publication of the Committee’s first round of proposals for revising the capital adequacy framework in June 1999, an extensive consultative process was set in train in all member countries and the proposals were also circulated to supervisory authorities worldwide. The Committee subsequently released additional proposals for consultation in January 2001 and April 2003 and furthermore conducted three quantitative impact studies related to its proposals. As a result of these efforts, many valuable improvements have been made to the original proposals. The present paper is now a statement of the Committee agreed by all its members. It sets out the details of the agreed Framework for measuring capital adequacy and the minimum standard to be achieved which the national supervisory authorities represented on the Committee will propose for adoption in their respective countries. This Framework and the standard it contains have been endorsed by the Central Bank Governors and Heads of Banking Supervision of the Group of Ten countries.

2. The Committee expects its members to move forward with the appropriate adoption procedures in their respective countries. In a number of instances, these procedures will include additional impact assessments of the Committee’s Framework as well as further opportunities for comments by interested parties to be provided to national authorities. The Committee intends the Framework set out here to be available for implementation as of year-end 2006. However, the Committee feels that one further year of impact studies or parallel calculations will be needed for the most advanced approaches, and these therefore will be available for implementation as of year-end 2007. More details on the transition to the revised Framework and its relevance to particular approaches are set out in paragraphs 45 to 49.

3. This document is being circulated to supervisory authorities worldwide with a view to encouraging them to consider adopting this revised Framework at such time as they believe is consistent with their broader supervisory priorities. While the revised Framework has been designed to provide options for banks and banking systems worldwide, the Committee acknowledges that moving toward its adoption in the near future may not be a first priority for all non-G10 supervisory authorities in terms of what is needed to strengthen their supervision. Where this is the case, each national supervisor should consider carefully the benefits of the revised Framework in the context of its domestic banking system when developing a timetable and approach to implementation.


1 The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States. It usually meets at the Bank for International Settlements in Basel, where its permanent Secretariat is located.
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Part 1: Scope of Application I. Introduction 20. This Framework will be applied on a consolidated basis to internationally active banks. This is the best means to preserve the integrity of capital in banks with subsidiaries by eliminating double gearing. 21. The scope of application of the Framework will include, on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group.3 Banking groups are groups that engage predominantly in banking activities and, in some countries, a banking group may be registered as a bank. 22. The Framework will also apply to all internationally active banks at every tier within a banking group, also on a fully consolidated basis (see illustrative chart at the end of this section).4 A three-year transitional period for applying full sub-consolidation will be provided for those countries where this is not currently a requirement. 23. Further, as one of the principal objectives of supervision is the protection of depositors, it is essential to ensure that capital recognised in capital adequacy measures is readily available for those depositors. Accordingly, supervisors should test that individual banks are adequately capitalised on a stand-alone basis. II. Banking, securities and other financial subsidiaries 24. To the greatest extent possible, all banking and other relevant financial activities5 (both regulated and unregulated) conducted within a group containing an internationally active bank will be captured through consolidation. Thus, majority-owned or -controlled banking entities, securities entities (where subject to broadly similar regulation or where securities activities are deemed banking activities) and other financial entities6 should generally be fully consolidated. 25. Supervisors will assess the appropriateness of recognising in consolidated capital the minority interests that arise from the consolidation of less than wholly owned banking, 3 A holding company that is a parent of a banking group may itself have a parent holding company. In some structures, this parent holding company may not be subject to this Framework because it is not considered a parent of a banking group. 4 As an alternative to full sub-consolidation, the application of this Framework to the stand-alone bank (i.e. on a basis that does not consolidate assets and liabilities of subsidiaries) would achieve the same objective, providing the full book value of any investments in subsidiaries and significant minority-owned stakes is deducted from the bank's capital. 5 “Financial activities” do not include insurance activities and “financial entities” do not include insurance entities. 6 Examples of the types of activities that financial entities might be involved in include financial leasing, issuing credit cards, portfolio management, investment advisory, custodial and safekeeping services and other similar activities that are ancillary to the business of banking.
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