Basel II overview and its implications for emerging markets
Luo Ping
China Banking Regulatory /Commission
[email protected]
At APEC seminar in Shanghia, Dec 8, 2008
1
Table of content
• Basel II overview
Agenda
• Implications for emerging markets
2
The Organization of the New Accord
Three Basic Pillars
Minimum capital
requirements
Supervisory
Review
Process
Market
Discipline
3
Outline of the New Accord - Basic Structure
Three
Basic Pillars
Minimum capital
requirements
Supervisory review
process
Definition of
capital
Risk weighted
assets
Standardised
Approach
Internal
Ratings-based
Approach
Basic
Indicator
Approach
Standardised
Approach
Core
Capital
Market
risks
Operational
risk
Credit risk
Market
discipline
Advanced
Measurement
Approaches
Standardised
Approach
Supplementary
Capital
Models
Approach
4
Operational Risk in the New Basel Capital Accord
Tier 1 + Tier 2 + Tier 3
CRWA + 12.5 (MR) + 12.5 (OR)
>
= 8%
5
Standardised Approach – Risk Weights
Claim
Assessment
AAA AA-
Sovereigns
(Export credit agencies)
Option 1
1
Banks
Option 2
2
Corporates
A+ - A-
BBB+ BBB-
BB+ - B-
Below B-
Unrated
100%
(4-6)
150%
(7)
100%
150%
100%
0%
(1)
20%
(2)
50%
(3)
20%
50%
100%
100%
20%
3
(20%)
50%
3
(20%)
50%
3
(20%)
100%
3
(50%)
20%
50%
100%
BB+ - BB100%
150%
3
(150%)
50%
3
(20%)
Below BB150%
100%
Mortgages
35%
Other retail
75%
Retail
1
Risk weighting based on risk weights of sovereign in which the bank is incorporated, but one
category less favourable.
2
Risk weighting based on the assessment of the individual bank.
3
Claims on banks of an original maturity of less than three months generally receive a weighting
that is one category more favourable than the usual risk weight on the bank’s claim.0
6
Risk sensitivity of various approaches
Comparison of Proposed Total Regulatory Capital Charges for Corporations
Source for VaR Data: Breitling Study
(%)
30
99.97% VaR for unexpected losses
25
Basel II’s standardised approach
20
1988 Basel Accord requirements for claims on corporations
15
10
5
0
AAA
AA+
AA
AA-
A+
A
A-
BBB+
BBB
BBB-
BB+
BB
BB-
B+
B
B-
CCC+
CCC
and
worse
7
Elements of IRB
Risk Components
Key components
• Obligor risk:
• Transaction risk:
• Size of exposure:
probability of default (PD)
loss given default (LGD)
exposure at default (EAD)
Other important elements
• Maturity
• Borrower size
8
Risk Components: Drivers of Credit Risk
Driver of
Standardised
IRB
Credit Risk
Approach
Approach
Obligor risk
Credit assessment
institutions
Probability of Default
(PD)
Transaction risk
Credit risk mitigation
techniques
Loss Given Default
(LGD)
Likely size of
exposure
Credit conversion
factors
Exposure at Default
(EAD)
Maturity
Limited recognition
Maturity (M)
9
Risk Weight Function

The risk weight function is calibrated to “unexpected losses” (UL) only.
Frequency of loss
provisions
Expected
loss
stress
loss
unexpected loss
99.9%
under
IRB
0
Capital
amount of loss
10
Definition of Operational Risk
Risk of loss resulting from:
inadequate or failed
• internal processes
• people
• systems
Includes, but not limited to,
exposure to fines, penalties,
or punitive damages
resulting from supervisory
actions, as well as private
settlements
or from external events
includes legal risk
excludes strategic and
reputational risk
11
Operational Risk Events
Risk Events
Examples
-Internal Fraud
Employee robbery, misreporting positions
-External Fraud
Hacking, branch robbery
-Employment Practices
& Workplace Safety
Costs and legal liabilities related to workers’ wrongful
dismissal, harassment, compensation, etc
-Clients, Products &
Business Practices
Costs and legal liabilities associated with suitability issues,
breach of fiduciary duties, sales practices, etc
-Damage to Physical
Assets
Natural disasters and human-instigated acts of damage
-Business Disruption
and System Failures
-Execution &
Processing Errors
Software, hardware and telecommunication problems
Front office / mid office / back office execution errors,
system failures
12
Basic Indicator Approach (BIA)
Capital charge is based on the average of a fixed percentage (alpha: ) of
positive annual gross income (GI) over the previous 3 years
Capital charge = [ (GI1…n x )] /n
GI: net interest income + net non-interest income as defined by national
supervisors and/or national accounting standards
• Figures for any year in which annual gross income is negative or zero
should be excluded
 = 15%
No qualifying criteria – encouraged to comply with sound practices paper
Not expected to be used by internationally active banks or banks with
significant operational risk exposures
13
Basic Indicator Approach (BIA)
Year 1 Year 2 Year 3
Gross Income 1825 1130 625
Alpha
15% 15% 15%
Capital Requirements 273.75 169.5 93.75 537/3
179
14
Standardised Approach (TSA)
Business Line
Corporate Finance
Trading and Sales
Retail Banking
Commercial Banking
Payment and Settlement
Agency Services
Asset Management
Retail Brokerage
Total gross income
Year 1 Year 2
Year 3
250
300 200
100
-70 -80
500
200 -300
400
300 400
300
350 300
75
50 45
50
-100 -20
150
100 80
1825
1130 625
x
x
x
x
x
x
x
x
Beta
18%
18%
12%
15%
18%
15%
12%
12%
15
Standardised Approach (TSA)
Business Line
Corporate Finance
Trading and Sales
Retail Banking
Commercial Banking
Payment and Settlement
Agency Services
Asset Management
Retail Brokerage
Aggregate capital requirement
Year 1 Year 2
54
45
-12.6
18
24
60
45
60
63
54
7.5
11.25
-12
6
12
18
272.25 180.9
Year 3
36
-14.4
-36
60
54
6.75
-2.4
9.6
113.55
Capital
requirement
45
-3
16
55
57
8.5
-2.8
13.2
189
566.7/3
16
AMA Qualifying Criteria
Frequency
of loss
Pricing, expenses,
reserves
Expected
loss
Capital
Unexpected
loss
Can not be absorbed
by a firm
Catastrophic
loss
Amount
17
of loss
Basel II - The four principles of Pillar 2
Principle 2
Principle 1

“Banks should have a process for
assessing their overall capital
adequacy in relation to their risk profile
and a strategy for maintaining their
capital levels” [ICAAP]

Principle 4
Principle 3

“Supervisors should expect banks to
operate above the minimum regulatory
capital ratios and should have the ability
to require banks to hold capital in excess
of the minimum”
“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. [SREP] Supervisors should take
supervisory action if they are not satisfied with
the result of this process”

“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”
18
2 views on Pillar 2
Pillar 2
Pillar 2 as an “add-on” to Pillar 1?
Pillar 1
Pillar 2 as a holistic view of
capital, with Pillar 1 as a subset?
Pillar 2
Pillar 1
19
SREP and ICAAP components
Basic risk
Other risks
Settlement risk
Other considerations
Fairness
Supervisory action
Correlation and
diversification
Credit risk
Supervisory outcomes
Residual risk
Prudential measures
Securitisation risk
Market risk
IRR in non-trading
activities
Legal and compliance
risk
Operational
risk
Liquidity risk
Economic & regulatory
Environment
Supervisory
review process
Forward capital
planning
• Business risks
(earnings and costs
• Strategy
• Stress test
Peer
group
•
•
•
•
Capital adjustment
Provisioning
Systems and controls
Restriction on
business
• Reduction of inherent
risk
Source: FSA
20
Table of content
• Basel II overview
Agenda
• Implications for emerging markets
21
Financial Stability Institute survey 2006
Adoption of Basel II seems to be on a very fast track
• Among 115 countries, 82 non-Basel Committee member
countries intend to implement Basel II, in most cases as of
2008 or 2009.
22
The FSI survey too optimistic?
• Moving toward Basel II adoption in the near future may not be the first priority
for all non-G10 supervisory authorities.
• The IMF also cautions that premature adoption of Basel II in countries with
limited capacity could inappropriately divert resources away from more urgent
priorities, ultimately weakening rather than strengthening supervision.
• As Basel II is designed and calibrated accordingly to G10 countries, adoption
of Basel II in many emerging markets will not be able to achieve the same set of
objectives for G10 countries
23
China’s approach
A dual-track or a
bifurcated
approach to
Basel II
• Large banks to adopt Basel II in 2010 with
a phase-in period of three years, while the
rest of the banking industry will follow the
current capital regulation.
• Small and medium-sized banks, particularly
foreign bank subsidiaries, have the
flexibility to opt in.
24
De facto international standard for capital regulation
Our strategy for adopting Basel II is driven by
• To introduce better corporate governance practices and to enhance risk
management and internal controls.
• Market and official pressure for large banks to move toward Basel II
for either compliance and/or competitive purposes
25
Basel II implementation challenges
• Pro-cyclicality
Challenges
• Alignment of Basel II and IFRS for
provisioning
• Further enhancement of capital regulation
in light of the sub-prime crisis
26
In search for customerization of Basel II
On the technical level, changes made in light
of our market conditions
• Lower threshold for SMEs
• More conservative PD estimation
• A higher Beta factor to reflect the high incidence of
internal fraud and the inadequacies of internal controls
27
Application of pillar I and pillar II
Pillar I
• IRB approach for credit risk
• Internal model approach for market risk
• Standardized approach and AMA for op risk
28
And pillar II
Pillar II:
• All large banks to have an adequate assessment process
• key elements of capital planning and management
• adequate amount of capital to provide a cushion to cover various risks.
• Other prudential measures that would require banks to improve their
systems and controls rather than hard and fast rules that would translate
the supervisory assessment process into an automatic capital add-on.
29
Basel II: flexible and adaptable
Basle
Committee’s
comprehensiv
e strategy
Nov 20, 2008
• Strengthening the risk capture of the Basel II
framework (in particular for trading book and offbalance sheet exposures)
• Enhancing the quality of Tier 1 capital
•
Building additional shock absorbers into the
capital framework that can be drawn upon during
periods of stress and dampen pro-cyclicality
30
Continued search for a better capital regulatory framework
• Building additional shock absorbers
into the capital framework that can be
drawn upon during periods of stress
and dampen procyclicality
• Evaluating the need to supplement
risk-based measures with simple gross
measures of exposure in both
prudential and risk management
frameworks to help contain leverage
in the banking system
• Leveraging Basel II to strengthen
risk management and governance
practices at banks
• Strengthening counterparty credit
risk capital, risk management and
disclosure at banks
• Promoting globally coordinated
supervisory follow-up exercises to
ensure implementation of supervisory
and industry sound principles
• Strengthening supervisory
frameworks to assess funding liquidity
at cross-border banks
31