THE BANKER’S GUIDE TO THE BASEL II

FRAMEWORK

December 2005
FOREWORD

The Basel II document, formally The International Convergence of Capital

Measurement and Capital Standards, published by the Basel Committee on
Banking Supervision of the Bank for International Settlements (2004), had far
reaching implications for banking in South Africa. The aim of this paper is to
provide an introductory guide to this highly technical document and the vast
amount of accompanying popular and scientific literature available on the web
and in the press. This paper aims to provide a basic insight into the Basel II
document for persons, e.g. new financial market analysts and financial journalist
needing a basic understanding or introduction to the current bank supervision
and regulation.
The paper was compiled from the original documents and reference to the
paragraph numbers of the original documents is made in each section. The
reader can therefore easily find the specific section in the original documents and
read the detailed explanation not covered in this paper.
This paper is compiled from the Basel II documents by Prof. Paul Styger and Dr.
Pieter G. Vosloo of the Centre for Business Mathematics and Informatics at the
North-West University.
The Banking Association is the trade association for the banking industry in
South Africa and can be located at www.banking.org.za

ii
 TABLE OF CONTENTS

Page

FOREWORD ii

TABLE OF CONTENTS iii

LIST OF FIGURES vi

LIST OF TABLES vi

LIST OF ABBREVIATIONS vii

CHAPTERS

1. PART ONE: SCOPE OF APPLICATION 1

1.1 Introduction 1
1.2 Application Scope 3
1.2.1 Banking, securities and other financial subsidiaries 4
1.2.2 Significant minority investments in banking, securities and other 4
financial entities
1.2.3 Insurance entities 5
1.2.4 Significant investments in commercial entities 5

2. PART TWO: MINIMUM CAPITAL REQUIREMENTS 6

2.1 Calculation of minimum capital requirements 6
2.1.1 Definition 6
2.1.2 Regulatory capital 6
2.1.2.1 Capital elements 6
2.1.2.2 Definition of capital elements 7
2.1.2.2.1 Tier 1 7
2.1.2.2.2 Tier 2 7
2.1.2.2.3 Tier 3 8
2.1.3 Risk weighted assets 8
2.2 Credit risk 9
2.2.1 Introduction 9
2.2.2 Risk profile 9
2.2.3 Risk management and measurement 9
2.2.3.1 The standardised approach 10
2.2.3.1.1 Corporate, Bank and Sovereign exposures 10
2.2.3.1.2 Retail exposures 11
2.2.3.1.3 Higher risk categories 11
2.2.3.1.4 Other assets 11
2.2.3.1.5 Off-balance sheet items 11
2.2.3.1.6 External credit assessments 12
2.2.3.1.7 Credit risk mitigation 12
2.2.3.2 Internal ratings-based approach 13
2.2.3.2.1 Introduction 13

iii
2.2.3.2.2 Asset classes 14
2.2.3.2.3 Eligible purchased receivables 16
2.2.3.2.4 Unexpected and expected losses 16
2.2.3.2.5 Capital requirements under the IRB-approach 17
2.2.3.2.6 IRB-approach for specialised lending 18
2.2.3.2.7 IRB-approach for equity exposures 18
2.2.3.2.8 Implementation issues and requirements 19
2.2.3.3 Securitisation framework 20
2.2.3.3.1 Introduction 20
2.2.3.3.2 Standardised approach 21
2.2.3.3.3 Internal ratings-based approach 22
2.3 Operational risk 23
2.3.1 Definition 23
2.3.2 The measurement methodologies 24
2.3.2.1 Introduction 24
2.3.2.2 The basic indicator approach 25
2.3.2.3 The standardised approach 26
2.3.2.4 Advanced measurement approaches 27
2.3.2.5 Partial use – combinations 28
2.4 Trading book issues 28
2.4.1 Introduction 28
2.4.2 Basel II viewpoint 29
2.4.2.1 Definitions 29
2.4.2.2 Eligibility for trading book capital treatment 29
2.4.2.3 Valuation of the trading book 30
2.4.2.3.1 Marking to market 31
2.4.2.3.2 Marking to model 31
2.4.2.3.3 Independent price verification 31
2.4.3 Basel II applied to trading activities and the treatment of double 32
default effects
2.4.3.1 General 32
2.4.3.2 Measures of counterparty credit risk 33
2.4.3.3 The internal model method 33
2.4.3.4 Non-internal model methods 34
2.4.3.4.1 Current exposure method 34
2.4.3.4.2 Standardised method 35

3. PART THREE: THE SECOND PILLAR – THE SUPERVISORY 37

REVIEW PROCESS
3.1 Introduction 37
3.2 The importance of supervisory review 37
3.2.1 Introduction 37
3.2.2 Four key principles of supervisory review 38
3.2.2.1 Principle 1 38
3.2.2.1.1 Board and senior management oversight 38
3.2.2.1.2 Sound capital assessment 38
3.2.2.1.3 Comprehensive assessment of risks 39
3.2.2.1.4 Monitoring and reporting 40
3.2.2.1.5 Internal control review 41

iv
3.2.2.2 Principle 2 41
3.2.2.3 Principle 3 42
3.2.2.4 Principle 4 42
3.2.3 Specific issues to be addressed under the supervisory review 43
process
3.2.3.1 Introduction 43
3.2.3.2 Interest rate risk in the banking book 43
3.2.3.3 Credit risk 43
3.2.3.3.1 Stress tests under the IRB-approaches 43
3.2.3.3.2 Definition of default 43
3.2.3.3.3 Residual risk 44
3.2.3.3.4 Credit concentration risk 44
3.2.3.4 Operational risk 45
3.2.4 Other aspects of the supervisory review process 45
3.2.4.1 Supervisory transparency and accountability 45
3.2.4.2 Enhanced cross-border communication and cooperation 45
3.2.5 The supervisory review process for Securitisation 46
3.2.5.1 Introduction 46
3.2.5.2 Significance of risk transfer 46
3.2.5.3 Market innovation 46
3.2.5.4 Provision of implicit support 46
3.2.5.5 Residual risks 47
3.2.5.6 Call provisions 47
3.2.5.7 Early amortisation 47

4. PART FOUR: THE THIRD PILLAR – MARKET DISCIPLINE 49

4.1 Introduction 49
4.2 The disclosure requirements 50
4.2.1 General disclosure principle 50
4.2.2 Scope of application 50
4.2.3 Capital 50
4.2.4 Risk exposure and assessment 50

5. CONCLUSION 51

6. BIBLIOGRAPHY 52

v
 LIST OF FIGURES

Figure Page

1.1 Structure of The New Framework document 4

1.2 Illustration of the new scope and application of The New 5

Framework

2.1 Valuation framework of the trading book 30

LIST OF TABLES

Table Page

2.1 Credit conversion factors 12

2.2 Risk Components 17

vi
 LIST OF ABBREVIATIONS

ABCP Asset-backed commercial paper

ADC Acquisition, development and construction
AMA Advanced measurement approaches
ASA Alternative standardised approach
CCF Credit conversion factor
CDR Cumulative default rate
CF Commodities finance
CRM Credit risk mitigation
EAD Exposure at default
ECA Export credit agency
ECAI External credit assessment institution
EL Expected loss
FMI Future margin income
HVCRE High-volatility commercial real estate
IAA Internal assessment approach
IPRE Income-producing real estate
I/O Interest-only strips
IRB Internal ratings-based approach
LGD Loss given default
M Effective maturity
MDB Multilateral development bank
NIF Note issuance facility
OF Object finance
PD Probability of default
PF Project finance
PSE Public sector entity
QRRE Qualifying revolving retail exposures
RBA Ratings-based approach
RUF Revolving underwriting facility
SF Supervisory formula
SL Specialised lending
SME Small- and medium-sized entity
SPE Special purpose entity
UCITS Undertakings for collective investments in transferable securities
UL Unexpected loss

vii
1. Part One: Scope of application

1.1. Introduction
The Basel Committee (Committee on Banking Regulations and Supervisory
Practices) was established by the Central Bank Governors of the Group of Ten
countries at the end of 1974 in the aftermath of serious disturbances in
international currency and banking markets (notably the failure of Bankhaus
Herstatt in West Germany). After the initial meeting held in February 1975,
regular meetings were held three to four times a year ever since. The
Committee's members come from Belgium, Canada, France, Germany, Italy,
Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United
Kingdom and the United States. Countries are represented by their respective
central bank and/or the nominated authority with formal responsibility for the
prudential supervision of banking business. The present Chairman of the
Committee is Mr Jaime Caruana, Governor of the Bank of Spain.
The Committee provides a forum for regular cooperation on banking
supervisory matters, between its member countries. Initially, it discussed
modalities for international cooperation in order to close gaps in the supervisory
net, but its wider objective has been to improve supervisory understanding and
the quality of banking supervision worldwide. It seeks to do this in three
principle ways: by exchanging information on national supervisory
arrangements; by improving the effectiveness of techniques for supervising
international banking business; and by setting minimum supervisory standards
in areas where considered desirable.
The Committee does not possess any formal supranational supervisory
authority. Its conclusions do not have, and were never intended to have, legal
force. Rather, it formulates broad supervisory standards and guidelines and
recommends statements of best practice in the expectation that individual
authorities will take steps to implement them through detailed arrangements –
statutory or otherwise – which are best suited to their own national systems. In
this way, the Committee encourages convergence towards common approaches
and common standards without attempting detailed harmonisation between the
supervisory techniques of its members.
The topic to which most of the Committee's time has been devoted in recent
years is capital adequacy. In the early 1980s, the Committee became concerned
that the capital ratios of the main international banks were deteriorating just at
the time that international risks, notably those vis-à-vis heavily-indebted
countries, were growing. Backed by the Group of Ten Governors, the members
of the Committee resolved to halt the erosion of capital standards in their
banking systems and to work towards greater convergence in the measurement
of capital adequacy. This resulted in the emergence of a broad consensus on a
weighted approach to the measurement of risk, on and off the balance sheet.
There was a strong recognition within the Committee of the overriding need for
a multinational accord to strengthen the stability of the international banking

1
system and to remove a source of competitive inequality arising from
differences in national capital requirements. Following comments on a
consultative paper published in December 1987, a capital measurement system
commonly referred to as the Basel Capital Accord (or the 1988 Accord) was
approved by the G10 Governors and released to banks in July 1988. This system
provided for the implementation of the framework with a minimum capital
standard of 8 percent by end-1992. Since 1988, this framework has been
progressively introduced not only in member countries but also in virtually all
other countries with active international banks. In September 1993, a statement
was issued confirming that all the banks in the G10 countries with material
international banking business were meeting the minimum requirements laid
down in the 1988 Accord. Some countries, like South Africa, even adopted
higher capital adequacy requirements than specified.
The 1988 capital framework was not intended to be static but to evolve over
time. In June 1999, the Committee issued a proposal for a new capital adequacy
framework to replace the 1988 Accord, and this has been refined in the
intervening years, culminating in the release of the New Capital Framework on
26 June 2004. Subsequent refinements on the new framework, e.g. The
Application of Basel II to Trading Activities and the Treatment of Double
default Effects (July 2005) are being published. The new framework consists of
three pillars: minimum capital requirements, which seek to develop and expand
on the standardised rules, set forth in the 1988 Accord; supervisory review of an
institution's capital adequacy and internal assessment processes; and effective
use of market discipline as a lever to strengthen disclosure and encourage safe
and sound banking practices. The Committee believes that, collectively, these
three elements are the essential pillars of an effective capital framework.
The fundamental objective of the Committee’s revision of the 1988 Accord was
to develop a framework that would further strengthen the soundness and
stability of the international banking system while still maintaining sufficient
consistency in capital adequacy regulation that it will not be a significant source
of competitive inequality among internationally active banks. The Committee
believes that the revised Framework will promote the adoption of stronger risk
management practices by the banking industry, and views this as one of its
major benefits. The Committee notes, in their comments on the proposals that
banks and other interested parties have welcomed the concept and rationale of
the three pillars approach (minimum capital requirements, supervisory review,
and market discipline) on which the revised framework is based. More
generally, they have expressed support for improving capital regulation to take
into account changes in banking and risk management practices while at the
same time preserving the benefits of a framework that can be applied as
uniformly as possible at the national level.
The publication of the framework represents the culmination of nearly six years
of challenging work. During those years, the Basel Committee consulted
extensively with banks and industry groups in an attempt to develop
significantly more risk-sensitive capital requirements that are conceptually
sound. At the same time, the Committee considered the characteristics and
needs of markets and supervisory systems in numerous countries. To achieve its
aims, the Committee undertook a careful review of the existing rules and of the

2
 recent advances attained in the industry. It consulted widely and publicly with
industry representatives, supervisory agencies, central banks, and outside
observers. Through the medium of international conferences and the
supervisory groupings referred to, the principles agreed by the Basel Committee
have been widely disseminated. A large number of countries outside the Group
of Ten have given their support to the fundamental objective of ensuring that no
international banking activity should escape supervision.
The Committee has also recognised that home country supervisors have an
important role in leading the enhanced cooperation between home and host
country supervisors that will be required for effective implementation.
The Committee believes that the complexity of the new framework is a natural
reflection of the advancements in the banking industry. Its underlying principles
are intended to be suitable for application to banks of varying levels of
complexity and sophistication. The goal of this effort has been to ensure that the
principles embodied in the three pillars of the new framework are generally
suitable to all types of banks around the globe. The Committee therefore
expects the New Accord to be adhered to by all significant banks after a certain
period of time.
The primary changes in the Basel II framework, compared to the 1988
document, are in the approach to credit risk and in the inclusion of explicit
capital requirements for operational risk. A range of risk-sensitive options for
addressing both types of risk is elaborated upon. While the new proposals
provide capital reductions for various forms of transactions that reduce risk,
they impose minimum operational standards in recognition that poor
management of operational risks (including legal risks) could render such
mitigants of effectively little or no value.
The Basel II document (The New Capital Framework) and this educational
framework is divided into four parts. The first part, being the scope of
application and details on how the capital requirements are to be applied within
a banking group. In part two the calculation of the minimum capital
requirements for credit risk and operational risk, as well as certain trading book
issues is provided. The third and fourth parts outline expectations concerning
supervisory review and market discipline, respectively. This structure of the
document is presented in Figure 1.1 below.

1.2. Application scope

To ensure that risks within the entire banking group (i.e. holding company and
its subsidiaries) are considered, the revised Accord will be extended and applied
on a consolidated basis to internationally active banks, any holding company
that is the parent entity within a banking group and to holding companies of
banking groups excluding insurance subsidiaries.
Par 1 – 23 1

1 These numbers refer to the paragraph numbers in the Basel II document.

3
 The illustrative chart at the end of Part 1 provides the layout and scope of the
New Capital Accord. The scope in terms of the application to subsidiaries,
minority investments, insurance and investments in commercial entities, are
summarised in the paragraphs to follow.

Figure 1.1 Structure of the New Capital Framework document

1.2.1. Banking, securities and other financial subsidiaries

All banking, majority-owned or -controlled banking entities, securities
entities and other financial entities and other relevant financial activities
(both regulated and unregulated) conducted within a group containing an
internationally active bank will be captured through consolidation.
Par 24 – 27

1.2.2. Significant minority investments in banking, securities and

other financial entities
Significant minority investments in banking, securities and other financial
entities, where control does not exist, will be excluded from the banking
group’s capital by deduction of the equity and other regulatory investments.
It should however be noted that certain exceptions exist, for example, JV’s

4
 (Joint Ventures) or where parent companies are legally obliged to support
another company, it should form part of the capital calculation.
Par 28 – 29

1.2.3. Insurance entities

A bank that owns an insurance subsidiary bears the full entrepreneurial risks
of the subsidiary and should recognise on a group-wide basis the risks
included in the whole group. When measuring regulatory capital for banks,
the Committee believes that at this stage it is, in principle, appropriate to
deduct banks’ equity and other regulatory capital investments in insurance
subsidiaries and also significant minority investments in insurance entities
(The deduction approach will be 50% from Tier 1 and 50% from Tier 2
capital)Supervisors will ensure that majority-owned or controlled insurance
subsidiaries, which are not consolidated and for which capital investments
are deducted or subject to an alternative group-wide approach, are
themselves adequately capitalised to reduce the possibility of future
potential losses to the bank.
Par 30 -34

1.2.4. Significant investments in commercial entities

Investments in significant minority- and majority-owned and -controlled
commercial entities below the materiality levels, determined by national
accounting and/or regulatory practices, will be risk-weighted at no lower
than 100% for banks using the standardised approach. For banks using the
IRB approach, the investment would be risk weighted in accordance with
the methodology the Committee is developing for equities and would not be
less than 100%.
Par 35 – 36
Figure 1.2 Illustration of the new scope and application of the New Framework

5
2. Part 2: The First Pillar – Minimum Capital Requirements

2.1. Calculation of minimum Capital Requirements

2.1.1. Definition
Part 2 of Basel II (the New Capital Framework) describes the calculation of the
total minimum capital requirements for credit, market and operational risk.
The capital adequacy ratio (CAR) is defined by the following formula:
CAR = Qualifying (Eligible) Regulatory Capital / Risk Weighted Assets
Basel II requires CAR > 8% 2
CAR will be calculated using the definition of regulatory capital and risk-
weighted assets.

2.1.2. Regulatory capital

The Basel I definition of eligible regulatory capital remains in place.

2.1.2.1. Capital elements

Tier 1
(a) Paid-up share capital/common stock
(b) Disclosed reserves
Tier 2
(a) Undisclosed reserves
(b) Asset revaluation reserves
(c) General provisions/general loan-loss reserves
(d) Hybrid (debt/equity) capital instruments
(e) Subordinated debt
Tier 3 (added in later Basel documents)
(a) Short-term subordinated debt.

2 Currently the SARB applies a capital adequacy ratio of 10%

6
2.1.2.2. Definition of Capital elements
2.1.2.2.1. Tier 1
Includes only permanent shareholders' equity (issued and fully paid
ordinary shares/common stock and perpetual non-cumulative
preference shares) and disclosed reserves (created or increased by
appropriations of retained earnings or other surplus, e.g. share
premiums, retained profit, general reserves and legal reserves). In the
case of consolidated accounts, this also includes minority interests in
the equity of subsidiaries that are less than wholly owned. This basic
definition of capital excludes revaluation reserves and cumulative
preference shares.
2.1.2.2.2. Tier 2
(a) Undisclosed reserves are eligible for inclusion within
supplementary elements provided these reserves are accepted by the
supervisor. Such reserves consist of that part of the accumulated
after-tax surplus of retained profits which banks in some countries
may be permitted to maintain as an undisclosed reserve. This
definition of undisclosed reserves excludes values arising from
holdings of securities in the balance sheet at below current market
prices.
(b) Revaluation reserves arise in two ways. Firstly, in some
countries, banks (and other commercial companies) are permitted to
revalue fixed assets, normally their own premises, from time to time
in line with the change in market values. Revaluations of this kind
are reflected on the face of the balance sheet as a revaluation reserve,
including, at national discretion, allocations to or from reserve during
the course of the year from current year's retained profit. Secondly,
hidden values of "latent" revaluation reserves may be present as a
result of long-term holdings of equity securities valued in the balance
sheet at the historic cost of acquisition. Both types of revaluation
reserve may be included in tier 2 provided that the assets are
prudently valued, fully reflecting the possibility of price fluctuation
and forced sale
(c) Hybrid (debt/equity) capital instruments. This heading
includes a range of instruments that combine characteristics of equity
capital and of debt. Their precise specifications differ from country
to country, but they should meet the following requirements:
- they are unsecured, subordinated and fully paid-up;
- they are not redeemable at the initiative of the holder or without the
prior consent of the supervisory authority;
- they are available to participate in losses without the bank being
obliged to cease trading (unlike conventional subordinated debt);

7
 - although the capital instrument may carry an obligation to pay
interest that cannot permanently be reduced or waived (unlike
dividends on ordinary shareholders' equity), it should allow service
obligations to be deferred (as with cumulative preference shares)
where the profitability of the bank would not support payment.
(d) Subordinated term debt: includes conventional unsecured
subordinated debt capital instruments with a minimum original fixed
term to maturity of over five years and limited life redeemable
preference shares. These instruments will be limited to a maximum
of 50% of Tier 1.
2.1.2.2.3. Tier 3 (added in later Basel documents)
Tier 3 capital will be subject to the following conditions:
a) It should have an original maturity of at least two years and will be
limited to 250% of the bank's tier 1 capital that is allocated to support
market risk.
b) It is only eligible to cover market risk, including foreign exchange
risk and commodities risk.
c) Insofar as the overall limits in the 1988 Accord are not breached,
tier 2 elements may be substituted for tier 3 up to the same limit of
250%.
d) It is subject to a "lock-in" provision which stipulates that neither
interest nor principal may be paid if such payment means that the
bank's overall capital would then amount to less than its minimum
capital requirement.

2.1.3. Risk weighted assets

The Committee considered in Basel I that a weighted risk ratio (where capital is
related to different categories of asset or off-balance-sheet exposure, weighted
according to broad categories of relative riskiness), is the preferred method for
assessing the capital adequacy of banks.
In Basel II this approach is expanded. This is not to say that other methods of
capital measurement are not also useful, but they are considered by the
Committee to be supplementary to the risk-weight approach. The Committee
believes that a risk ratio has the following advantages over the simpler gearing
ratio approach:
o it provides a fairer basis for making international comparisons between
banking systems whose structures may differ;
o it allows off-balance-sheet exposures to be incorporated more easily into
the measure;

8
 o it does not deter banks from holding liquid or other assets which carry
low risk.
The total risk-weighted assets are determined by multiplying the capital
requirements for market risk and operational risk by 12.5 (i.e. the reciprocal of
the minimum capital ratio of 8%) and adding the resulting figures to the sum of
risk-weighted assets for credit risk.
Par 40 – 44
The remainder of Part 2 is dedicated to the calculation of credit risk and
operational risk and their associated capital charges, as well as a short discussion
on trading issues that need to be addressed.

2.2. Credit risk

2.2.1. Introduction
Pillar 1 of Basel II sets out the quantitative and qualitative requirements and
formulae to calculate capital for credit risk. The overarching principle behind
these requirements is that rating and risk estimation systems and processes
provide for a meaningful assessment of borrower and transaction characteristics;
a meaningful differentiation of risk; and reasonably accurate and consistent
quantitative estimates of risk. Furthermore, the systems and processes must be
consistent with internal use of these estimates. The Committee recognises that
differences in markets, rating methodologies, banking products, and practices
require banks and supervisors to customise their operational procedures. It is not
the Committee’s intention to dictate the form or operational detail of banks’ risk
management policies and practices. Each supervisor will develop detailed review
procedures to ensure that banks’ systems and controls are adequate to serve as the
basis for the IRB approach.
Par 389

2.2.2. Risk profile

Basel II improves the capital framework's sensitivity to the risk of credit losses
generally by requiring higher levels of capital for those borrowers thought to
present higher levels of credit risk, and vice versa. The formulae consider not
only an estimate of the creditworthiness of borrowers, but also transaction
characteristics such as collateral and maturity in order to arrive at the capital
requirement.

2.2.3. Risk management and measurement

Three options are available to allow banks and supervisors to choose an approach
that seems most appropriate for the sophistication of a bank's activities and

9
 internal controls. In order of increasing sophistication and risk sensitivity these
options are:
• the Standardised Approach;
• the Internal Ratings Based (IRB) Foundation Approach (FIRB); and.
• the IRB Advanced Approach (AIRB).
Banks that engage in more sophisticated risk-taking and that have developed
advanced risk measurement systems may, with the approval of their supervisors,
select from one of two "internal ratings-based" ("IRB") approaches to credit risk.
Under an IRB approach, banks rely partly on their own measures of a borrower’s
credit risk to determine their capital requirements, subject to strict data,
validation, and operational requirements.
The new regulations link the quality of a bank’s advances (credit) portfolio
directly to a risk-based capital adequacy requirement. Importantly, the new
regulations recognise sound collateral-taking (security) and recovery rates on
defaulted debts.

2.2.3.1. The Standardised Approach

The Standardised Approach is similar to the current Basel I approach
where exposures are assigned to risk weight categories based on their
characteristics. The Standardised Approach is supported by external credit
assessments. The main supervisory categories in the Standardised
Approach are claims on sovereigns, non-central government public sector
entities, multilateral development banks, banks, corporates, retail loans,
residential real estate and commercial real estate.
Par 50 - 52
2.2.3.1.1. Corporate, bank and sovereign exposures
The individual borrower's quality is reflected by its external rating, as
assigned by external rating agencies. If there is no external rating, the
loan's risk is generally weighted with 100% (as under Basel I).
In order to calculate the credit risk capital requirement ratio, the loan
amount is multiplied with the risk weight and the capital requirement
of 8% (or currently 10% in South Africa).
Basel II has also enhanced the risk sensitivity of the Standardised
Approach, from Basel l, by a substantial revision of the approach to
credit risk mitigation. The 1988 Accord only recognised cash and
government securities as collateral that was capable of reducing risk
and therefore of reducing (or eliminating) the capital charge. There
has been a considerable expansion of the range of collateral,
guarantees, netting and credit derivatives that are eligible for risk
mitigation purposes and the resulting reduction in the capital charge.

10
 Few corporates in South Africa are externally rated. Therefore, the
simplified standardised approach can be applied, where a risk weight
of 100% is assigned to all of these exposures.
Par 53 - 68
2.2.3.1.2. Retail exposures
Retail exposures are generally weighted at 75% under the
standardised approach. (The exception being past due loans, where
risk weight percentage will depend on the level of specific
provisions.) However, lending fully secured by mortgages on
residential property, that is or will be occupied by the borrower, or
that is rented, can be risk weighted at 35% once the supervisory
authorities have satisfied themselves that the concession is applied
for residential purposes only. Due to the impact of this concession,
the difference in the capital charge between the Standardised
Approach and the IRB Approach should be noted.
The criteria for an exposure to be recognized as part of the retail
portfolio are based on the counterparty, the product type, the number
of exposures in the portfolio, the value of the exposures and the
collateral type (e.g. residential mortgages). For purposes of risk
weighting, past due loans are to be excluded from the overall
regulatory retail portfolio (granularity criterion).
Par 70 - 78
2.2.3.1.3. Higher risk categories
Basel II also identifies certain higher risk assets which are weighted
at 150%. These include, (inter alia), sovereigns and banks rated
below B- and corporates rated below BB-.
Par 79 - 80
2.2.3.1.4. Other assets
All other assets (except securitisation assets) are risk weighted at
100%, as in Basel l.
2.2.3.1.5. Off-balance sheet items
Off-balance-sheet items under the standardised approach are
converted into credit exposure equivalents through the use of credit
conversion factors (CCF).

11
 Table 2.1 Credit conversion factors

Credit conversion factors

Commitments -original maturity 20%
up to one year*
Commitments -original maturity 50%
over one year*
Securities lending (including 100%
where these arise out of repo-
style transactions)
Short-term self-liquidating letters 20%
of credit

* Except any commitments that are unconditionally cancellable at

any time by the bank without prior notice, or that effectively provide
for automatic cancellation due to deterioration in a borrower's
creditworthiness (which will receive a 0% CCF). CCFs not specified
remain as defined in the 1988 Accord (e.g. performance guarantees at
50%).
Par 82 - 89
2.2.3.1.6. External credit assessments
As mentioned above, external credit assessments (credit ratings) are
used to determine the risk weightings of corporate, bank and
sovereign exposures under the standardised approach. The regulator
will have to determine whether an external credit assessment
institution (rating agency) meets the criteria of Basel II which include
objectivity, independency, transparency and credibility.
Par 90 -108
2.2.3.1.7. Credit risk mitigation
Basel II allows for more recognition of credit risk mitigation
instruments, in line with the philosophy of a more risk sensitive
capital regime. The following is a brief overview of the different
credit risk mitigation techniques:
Collateralised transactions
A collateralised transaction is one in which banks have a credit
exposure or potential credit exposure; and that credit exposure or
potential credit exposure is hedged in whole or in part by collateral
posted by a counterparty or by a third party on behalf of the
counterparty. Banks must have clear and robust procedures for the
timely liquidation of collateral to ensure that any legal conditions

12
 required for declaring the default of the counterparty and liquidating
the collateral are observed, and that collateral can be liquidated
promptly. A capital requirement will be applied to a bank on either
side of the collateralized transaction: for example, both repos and
reverse repos will be subject to capital requirements. Likewise, both
sides of securities lending and borrowing transactions will be subject
to explicit capital charges, as will the posting of securities in
connection with a derivative exposure or other borrowing.
On-balance sheet netting
Where banks have legally enforceable netting arrangements for loans
and deposits they may calculate capital requirements on the basis of
net credit exposures.
Guarantees and credit derivatives
Where guarantees or credit derivatives are direct, explicit,
irrevocable and unconditional, and supervisors are satisfied that
banks fulfil certain minimum operational conditions relating to risk
management processes they may allow banks to take account of such
credit protection in calculating capital requirements.
Maturity mismatch
Where the residual maturity of the CRM (Credit Risk Mitigation) is
less than that of the underlying credit exposure a maturity mismatch
occurs. Where there is a maturity mismatch and the CRM has an
original maturity of less than one year, the CRM is not recognised for
capital purposes. In other cases where there is a maturity mismatch,
partial recognition is given to the CRM for regulatory capital
purposes. Under the simple approach for collateral maturity
mismatches will not be allowed. For purposes of calculating risk
weighted assets in the Standardised Approach, a maturity mismatch
occurs when the residual maturity of a hedge is less than that of the
underlying exposure.
Miscellaneous
Treatments for pools of credit risk mitigants and first- and second-to-
default credit derivatives are explained.
Par 109- 210

2.2.3.2. The Internal Ratings-Based Approach

2.2.3.2.1. Introduction
The two main principles behind the Internal Ratings Based (IRB)
Approaches (Foundation and Advanced) are the usage of banks’ own
information about the credit quality of their assets and the promotion

13
 of best practices in risk measurement and risk management. This is
in contrast to the current approach and the Standardised Approach
under Basel II, which is mainly dependent on supervisory inputs to
determine the capital requirement.
The IRB Approach is based on measures of Unexpected Loss and
Expected Loss. The risk weight functions produce capital
requirements for the Unexpected Loss portion. Under the IRB
Approach, banks must categorise banking book exposures into broad
classes of assets with different underlying risk characteristics, being
corporate, sovereign, bank, retail and equity. These are discussed in
greater detail later in this document.
Par 211 - 217
For each of the asset classes covered under the IRB framework, there
are three key elements:
• Risk components ─ estimates of risk parameters provided by
banks some of which are supervisory estimates. These are
Probability of Default (PD), Loss Given Default (LGD),
Exposure at Default (EAD) and Maturity (M) that are
discussed in more detail below.
• Risk-weight functions ─ the means by which risk components
are transformed into risk-weighted assets and therefore
capital requirements.
• Minimum requirements ─ the minimum standards that must
be met in order for a bank to use the IRB approach for a
given asset class.
For many of the asset classes, the Basel Committee has made
available two broad approaches: a foundation and an advanced.
Under the foundation approach, as a general rule, banks provide their
own estimates of PD and rely on supervisory estimates for other risk
components. Under the advanced approach, banks provide their own
estimates of PD, LGD and EAD, and their own calculation of M,
subject to meeting minimum standards. For both the foundation and
advanced approaches, banks must always use the risk-weight
functions provided in this Framework for the purpose of deriving
capital requirements.
Par 244 - 262
2.2.3.2.2. Asset classes
The main asset classes are:
Corporate (with further sub-classes for specialised lending)
In general, a corporate exposure is defined as a debt obligation of a
corporation, partnership, or proprietorship. Banks are permitted to

14
distinguish separately exposures to small- and medium-sized entities
(SME). Five sub-classes of specialised lending are identified,
namely, project finance, object finance, commodity finance, income-
producing commercial real estate and high-volatility commercial
estate.
Sovereign
This asset class covers all exposures to counterparties treated as
sovereigns under the standardised approach.
Bank
This asset class covers exposures to banks and securities firms,
where the latter are subject to supervisory and regulatory
arrangements that are compatible to the arrangements as advocated
by the new framework.
Retail (with further sub-classes i.t.o. products) needs to meet the
following criteria:
• Exposures to individuals – such as revolving credits and lines
of credit (e.g. credit cards, overdrafts, and retail facilities
secured by financial instruments) as well as personal term
loans and leases (e.g. instalment loans, auto loans and leases,
student and educational loans, personal finance, and other
exposures with similar characteristics).
• Residential mortgage loans (including first and subsequent
liens, term loans and revolving home equity lines of credit)
are eligible for retail treatment regardless of exposure size so
long as the credit is extended to an individual that is an
owner-occupier of the property (with the understanding that
supervisors exercise reasonable flexibility regarding buildings
containing only a few rental units ─ otherwise they are
treated as corporate).
• Loans extended to small businesses and managed as retail
exposures are eligible for retail treatment.
• The exposure must be one of a large pool of exposures, which
are managed by the bank on a pooled basis.
Equity
In general, equity exposures are defined on the basis of the economic
substance of the instrument. They include both direct and indirect
ownership interests, whether voting or non-voting, in the assets and
income of a commercial enterprise or of a financial institution that is
not consolidated or deducted pursuant to Part 1 of the Framework.

15
 Debt obligations and other securities, partnerships, derivatives or
other vehicles structured with the intent of conveying the economic
substance of equity ownership are considered an equity holding.

2.2.3.2.3. Eligible purchased receivables

Eligible purchased receivables are divided into retail and corporate
receivables as defined below.
Retail receivables
Purchased retail receivables, provided the purchasing bank complies
with the IRB rules for retail exposures, are eligible for the top-down
approach as permitted within the existing standards for retail
exposures. The bank must also apply the minimum operational
requirements.
Corporate receivables
In general, for purchased corporate receivables, banks are expected
to assess the default risk of individual obligors consistent with the
treatment of other corporate exposures. However, the top-down
approach may be used, provided that the purchasing bank’s
programme for corporate receivables complies with both the criteria
for eligible receivables and the minimum operational requirements of
this approach.
The IRB approach provides formulae to calculate the risk weights of
the assets. In principle, higher risk (as determined by the risk
components discussed below) will result in a higher capital
requirement.
The IRB approach also sets minimum qualitative requirements
covering issues such as governance, independent review and data
quality and must be met in order to be able to apply the IRB
Approach for a given asset class.
Par 218 – 243
2.2.3.2.4. Unexpected losses and expected losses
The IRB risk weight functions produce capital requirements that
should cover the unexpected losses of the bank. The expected losses
are calculated separately and are compared to the total allowable
provisions (specific and general credit provisions). Any shortfalls or
excesses of provisions over expected losses could be adjusted to or
recognized as capital under Basel II, subject to certain limits.

16
2.2.3.2.5. Capital requirements under the Internal Ratings Based
Approach
For both the Internal Rating Based Approaches, the following
diagram depicts the interaction of the risk components and the capital
requirement:

Table 2.2 Risk components

Risk components

Foundation Advanced
PD Bank calculates Bank calculates
LGD Prescribed Bank calculates
EAD Prescribed Bank calculates
M Prescribed/calculated Bank calculates

⇓
Risk weight functions
Risk weight = PD (x capital factor) x LGD

⇓
Capital requirements
Capital requirement = Risk weight x exposure (EAD) x 8%
(currently 10% in South Africa)

Below are descriptions of the risk components mentioned above:

• Probability of default (PD): one-year probability that a borrower
will default on its debt obligations.
• Loss given default (LGD): the loss in the event of default, i.e.
expected average loss per unit of exposure. This will depend on
the collateral, both financial and physical. For the FIRB,
prescribed LGD’s are given by Basel II. For the AIRB, the bank
will use its own estimates of loss.
• Exposure at default (EAD): for on balance sheet transactions, the
exposure at default will be the amount of the exposure. For off
balance sheet items, credit conversion factors are used to obtain
credit equivalent amounts. For the FIRB, the EAD measures are
provided, and for AIRB the bank will use its own estimates.

17
 • Maturity (M): Maturity is based on contractual cash flows. All
other things being equal, the longer the maturity of an exposure,
the higher the risk. Maturity is capped at 5 years.
For retail exposures, banks must provide their own estimates for PD,
LGD and EAD, and thus there is no distinction between the
Foundation and Advanced Approaches.
Banks must use information and techniques that take appropriate
account of the long-run experience when estimating the average PD
for each rating grade. Basel II sets out three specific techniques for
PD estimation, namely internal default experience, mapping to
external data and statistical default models. For retail exposures,
banks must regard internal data as the primary source of information
for estimating loss characteristics. At least five years of data are
required to estimate PD’s. The history requirements for LGD and
EAD data are a minimum of seven years (LGD data = 5 years for
retail and 7 years for corporate).
Par270 - 338
2.2.3.2.6. IRB Approach for specialised lending
The Specialised Lending Approach will be applicable to project
finance, object finance, commodities finance, income-producing
commercial real estate and high-volatility commercial real estate.
Banks that do not meet the requirements for the estimation of PD
under the corporate foundation approach for their specialised lending
(SL) assets are required to map their internal risk grades to five
supervisory categories, each of which is associated with a specific
risk weight. (This is referred to as the Supervisory Slotting Criteria
Approach).
Should the bank be able to meet the requirements for the estimation
of PD on the SL portfolio, the Foundation Approach can be used
where the corporate risk weights are used for these assets (with the
exception of high volatility commercial real estate).
If the bank meets the requirements for the estimation of PD, LGD
and EAD, it can use the Advanced Approach with the corporate risk
weights for all classes of SL (with the exception of high volatility
commercial real estate).
Par 275 - 284
2.2.3.2.7. IRB Approach for equity exposures
Two approaches are available, namely, a market-based approach and
a PD/ LGD approach. Under market-based approach two methods
are available, namely, a simple risk weight method and an internal
models method. Under the simple weight method, a risk weight of

18
 300% is to be applied to publicly traded equities and 400% to all
other equities.
With regards to the internal models method, banks may use – or
national supervisors may require – a VAR-type model to derive
capital and requirements, subject to a floor risk weight of 200% for
publicly traded equities and 300% for other equities.
As a final option, banks may use, or supervisors may require the use
of the same PD/LGD approach used for calculating capital
requirements for corporate exposures. However, an LGD of 90%
would be assumed, compared with a supervisory estimate of 45% for
LGD on ordinary corporate lending exposures.
Par 339 - 358
2.2.3.2.8. Implementation issues and minimum requirements
Once a bank adopts an IRB Approach for part of its assets, it is
expected to extend this across the entire banking group, although this
does not have to be done simultaneously. The bank will have to
produce an implementation plan, detailing when it intends to roll out
the selected approach across material asset classes. Immaterial asset
classes can be exempt subject to supervisory approval.
By relying on internally generated inputs to the Basel II risk weight
functions, there is bound to be some variation in the way in which
the IRB Approach is carried out. To ensure significant comparability
across banks, Basel II has established minimum qualifying criteria
for use of the IRB Approaches that cover the comprehensiveness and
integrity of banks’ internal credit risk assessment capabilities. While
banks using the Advanced IRB Approach will have greater flexibility
relative to those relying on the Foundation IRB Approach, at the
same time they must also satisfy a more stringent set of minimum
standards.
To be eligible for the IRB Approach the bank must demonstrate to
the supervisor that it meets certain minimum requirements at the
outset and on an ongoing basis. Many of these requirements are in
the form of objectives that a qualifying bank’s risk rating system
must fulfil. The focus on bank’s abilities to rank order and quantify
risk in a consistent, reliable and valid fashion. The overarching
principle behind these requirements is that rating and risk estimation
systems and processes provide for a meaningful differentiation of
risk; and reasonably accurate and consistent quantitative estimates of
the risk. Furthermore, the systems and the processes must be
consistent with internal use of these estimates.
Specific requirements have been set out by the Basel II framework
on the design of the rating system incorporating the rating structure,
criteria and documentation standards. Data maintenance will have to

19
 ensure effective support to the internal credit risk measurement and
management processes. The bank will have to implement adequate
corporate governance and oversight processes around the rating
system used under the IRB Approaches to qualify to use these
approaches.
Par 387 – 537.

2.2.3.3. Securitisation Framework

2.2.3.3.1. Introduction
Securitisation is defined in Basel II as:
• Traditional Securitisation:
is a structure where the cash flow from an underlying pool of
exposures is used to service at least two different stratified risk
positions or tranches reflecting different degrees of credit risk.
Payments to the investors depend upon the performance of the
specified underlying exposures, as opposed to being derived from an
obligation of the entity originating those exposures.
• Synthetic Securitisation:
is a structure with at least two different stratified risk positions or
tranches that reflect different degrees of credit risk where credit risk
of an underlying pool of exposures is transferred, in whole or in part,
through the use of funded (e.g. credit-linked notes) or unfunded (e.g.
credit default swaps) credit derivatives or guarantees that serve to
hedge the credit risk of the portfolio. Accordingly, the investors’
potential risk is dependent upon the performance of the underlying
pool.
Banks’ securitisation exposures can include:
o Asset-backed securities,
o Mortgage-backed securities,
o Credit enhancements,
o Liquidity facilities,
o Interest rate and currency swaps,
o Credit derivatives, and
o Tranched cover.
The capital treatment of a securitisation exposure must be determined
on the basis of its economic substance rather than its legal form
because securitisations may be structured in many different ways.

20
 The underlying instruments in the pool that is being securitised may
include:
o Loans
o Commitments
o Asset-backed and mortgage-backed securities,
o Corporate bonds,
o Equity securities, and
o Private equity investments
Par 538 – 542
2.2.3.3.2. The Standardised Approach
Banks applying the Standardised Approach to measure the credit risk
for the same type of products as those used in the securitisation, must
also use the Standardised Approach under the securitisation
framework.
• Basel prescribes a set of risk weights. The risk-weighted asset
amount of the securitisation exposure is computed by multiplying the
amount of the position by the appropriate risk weight. Unrated
securitisation exposures must be deducted except when it is the most
senior exposure or an eligible liquidity facility. When the most senior
exposure in a traditional or synthetic securitisation is unrated the
bank that holds or guarantees the exposure may use the look-through
method to determine the risk-weight. This implies that the unrated
most senior exposure receives the average risk weight of the
underlying exposures, subject to supervisory review. All off-balance
sheet exposures receive a CCF of 100% except those that qualify as
‘eligible liquidity facility’ or as ‘eligible servicer cash advance
facility’ in which case a lower CCF will be applied.
• When a bank other than the originator provides credit risk
mitigants on a securitisation, such as guarantees, credit derivatives,
collateral and on-balance sheet netting, it must calculate the capital
requirement on the covered exposure as if it were an investor in that
securitisation.
• Early amortisation provisions in securitisation allow investors to be
paid out prior to the originally stated maturity of the securities
issued. For a bank subjected to the early amortisation treatment, the
total capital charge for all its positions will be subjected to a cap
equal to the greater of that required for retained securitisation
purposes, or the capital requirement that would apply had the
exposures not been securitised.
Par 566 – 605

21
2.2.3.3.3. The Internal Ratings-based Approach (IRB)
The securitisation IRB Approach to securitisation of the Ratings
Based Approach (RBA), Internal Assessment Approach (IAA) and
the Supervisory Formula (SF). Banks must use the IRB Approach for
securitisations when they have received approval to used the IRB
Approach for the type of underlying exposures securitised (e.g. their
retail portfolio). If the bank uses the IRB and Standardised
Approaches for different exposures in the underlying pool, it should
use the approach used for the largest part of the exposure. When
there is no specific IRB method for a specific underlying asset type,
the originating bank must use the Standardised Approach and
investing banks must use the RBA.
The capital charge for securitisation exposures that are rated must be
calculated using the RBA. Where an external or internal rating is not
available, the SF or IAA must be used in the calculation. The
maximum capital requirement when using the IRB approach for
securitisation will be equal to the IRB capital requirement for the
same exposures when they are not securitised.
Par 606 - 610
The RBA
o Specific risk weights are provided for this method
o The risk weights depend on
ƒ The external rating grade or available inferred rating;
ƒ Whether the credit rating (external or inferred) represents a
short- or long-term credit rating;
ƒ The granularity of the underlying pool; and
ƒ The seniority of the position.
Par 611 - 618
The IAA
o A bank may use its internal assessments of the credit quality of
the securitisation exposures it extends if the internal assessment
meets the requirements.
o Internal assessments of exposures provided to ABCP (Asset-
backed commercial paper) programmes must be mapped to
equivalent external ratings of an ECAI (External credit
assessment institution).
o The risk weight appropriate to the credit rating equivalent must
be used with the notional amount of the securitisation exposure
to the ABCP programme.

22
 Par 619 – 622

The SF
o As in the IRB Approaches, risk-weighted assets generated
through the use of the SF are calculated by multiplying the
capital charge by 12.5. Under the SF, the capital charge for a
securitisation tranche depends on five bank-supplied inputs: the
IRB capital charge had the underlying exposures not been
securitised (KIRB); the tranche’s credit enhancement level (L)
and thickness (T); the pool’s effective number of exposures
(N); and the pool’s exposure-weighted average loss-given-
default (LGD). The capital charge is calculated as follows:
Tranche’s IRB capital charge = the amount of exposures that
have been securitised times the greater of (a) 0.0056*T, or (b)
(S [L+T] – S [L])
o If there is credit risk mitigation for the securitisation exposures,
the banks are required to apply the CRM techniques of the
foundation IRB Approach, when applying the SF.
o The capital charge attributed to investors’ interest, for early
amortisation provisions, is determined by the product of the
investors’ interest; the appropriate CCF and the ratio of (a) the
IRB capital requirement including the EL portion for the
underlying exposures in the pool to (b) the exposure amount of
the pool (e.g. the sum of drawn amounts related to securitised
exposures plus the EAD associated with undrawn
commitments related to securitised exposures.
Par 623 – 643

2.3. Operational risk

2.3.1. Definition
The Basel II definition of operational risk is “the risk of loss resulting from
inadequate or failed internal processes, people and systems or from external
events. This definition includes legal risk, but excludes strategic and reputation
risk for capital charge purposes”. Legal risk in turn includes (but is not limited
to), exposure to fines, penalties, or punitive damages resulting from supervisory
actions, as well as private settlements.
In arriving at the definition, it is acknowledged that the exact approach for
operational risk management that a bank chooses “will depend on a range of
factors, including its size and sophistication and the nature and complexity of its
activities.” Notwithstanding individual differences, the new regime demands
clearly documented strategies and oversight by the board and senior

23
 management, a strong operational risk culture and internal control culture
(including, among other things, clear lines of responsibility and segregation of
duties), effective internal escalation and reporting and contingency planning.
The definition refers to loss resulting from the following four sources, which are
now explained in more detail in order to aid understanding of the definition:
• Inadequate or failed internal processes.
Financial institutions operate a myriad of processes to deliver their products to
customers. Process risk can arise at any stage of an end to end process in the
value chain. For example, marketing material can be mailed to the wrong
customers, account opening documentation can turn out not to be robust,
transactions can be processed incorrectly, etc.
• People
Operational risk losses can occur due to worker compensation claims, violation
of employee health and safety rules, organized labour activities and
discrimination claims. People risks can also include inadequate training and
management, human error, lack of segregation, reliance on key individuals, lack
of integrity, honesty, etc.
• Systems
The growing dependence of financial institutions on IT systems is a key source of
operational risk. Data corruption problems, whether accidental or deliberate, are
regular sources of embarrassing and costly operational mistakes.
• External events
This source of operational risk has at least two discernible dimensions to it,
firstly the extent to which a chosen business strategy pursued by a bank may
expose it to adverse external events, and secondly external events that impact it
independently, emanating from the business environment in which it operates.
Par 644

2.3.2. The measurement methodologies

2.3.2.1. Introduction
Depending on the level of sophistication of individual banks, the Basel
Accord permits three methods for calculating operational risk capital
charges in a continuum of increasing sophistication and risk sensitivity:
• the Basic Indicator Approach, resulting in a capital charge indicated by
KBIA;
• the Standardised and Alternative Standardised Approach, resulting in a
capital charge indicated by KTSA/TASA; and
• Advanced Measurement Approach (AMA).

24
 Banks are encouraged to move along the spectrum of approaches and will
be allowed to use a combination of approaches for different business lines
(partial use). Once an approach is chosen, a bank will not be permitted to
revert to a less sophisticated approach. More sophisticated approaches
should permit greater benefits, both in terms of the capital charge as well as
in terms of more effective and efficient business practices.
As a general point to note, the Accord provides for supervisors to review
the capital requirement produced by the operational risk approach used by
a bank (whether Basic Indicator Approach, Standardised Approach or
AMA) for general credibility, especially in relation to a firm’s peers. In the
event that credibility is lacking, appropriate supervisory action under Pillar
2 will be considered.
Par 645-648

2.3.2.2. The Basic Indicator Approach

Essentially, this approach uses gross income as a proxy for operational risk,
with the capital charge equal to 15% of the average of gross income for the
last three years.
No specific qualifying criteria are specified, but banks are encouraged to
comply with the Basel Committee’s proposed practices as documented in
the Sound Practices for the Management and Supervision of Operational
Risk, published in February 2003. These principles in fact form the
underlying foundation for all three the methodologies, as well as the
qualifying criteria that participating banks should adhere to when adopting
a particular approach.
The Accord specifies the calculation of the charge as follows:
Banks using the Basic Indicator Approach must hold capital for operational
risk equal to the average over the previous three years of a fixed percentage
(denoted alpha) of positive annual gross income. Figures for any year in
which annual gross income is negative or zero should be excluded from
both the numerator and denominator when calculating the average.
The Accord is specific about what constitutes gross income, defining it as
net interest income plus net non-interest income, with the intention that it
should:
• be gross of any provisions (e.g. for unpaid interest);
• be gross of operating expenses, including fees paid to outsourcing
service providers;
• exclude realised profits/losses from the sale of securities in the banking
book; and

25
 • exclude extraordinary or irregular items as well as income derived
from insurance.
Par 649 - 651

2.3.2.3. The Standardised Approach

In the Standardised Approach, gross income is again a proxy measure for
operational risk, but in this case it is broken out by eight standard business
lines, each with a different beta factor to calculate capital. The business
lines, which are defined in detail in Annexure 6 of the Accord, are:
• corporate finance,
• trading & sales,
• retail banking,
• commercial banking,
• payment & settlement,
• agency services,
• asset management, and
• retail brokerage.
The total capital charge under this approach is the sum of the product of the
relevant business line gross income and the beta factor, with the beta factor
being a proxy for the assumed industry-wide relationship between the
operational risk loss experience for a given business line and the aggregate
level of gross income for that business line. It should be noted that in the
Standardised Approach gross income is measured for each business line,
not the whole institution, for example, in corporate finance, the indicator is
the gross income generated in the corporate finance business line.
For retail and commercial banking there is also an Alternative Standardised
Approach (ASA) available, introduced to eliminate double counting of
risks. Banks, at the national supervisor’s discretion, may be permitted to
substitute an alternative measure in the case of retail and commercial
banking. In this case, the volume of outstanding loans will be multiplied by
the beta factor and the result multiplied by 3.5%.
The Accord specifies the calculation of the charge as follows:
Banks using the Standardised Approach must hold capital for operational
risk equal to the three-year average of the simple summation of the
regulatory capital charges across each of the business lines in each year. In
any given year, negative capital charges (resulting from negative gross
income) in any business line may offset positive capital charges in other
business lines without limit. However, where the aggregate capital charge
across all business lines within a given year is negative, then the input to

26
 the numerator for that year will be zero. In order to qualify for the
standardised approach, banks need to comply with a set of minimum entry
standards, the most important one being undoubtedly the active
involvement of the board of directors and senior management.
Par 652 – 654

2.3.2.4. Advanced Measurement Approaches (AMA)

More exacting quantitative and qualitative entry standards are required
before a bank is permitted to qualify as an advanced measurement
approach bank. Under the AMA approach the regulatory capital
requirement will equal the risk measure generated by the bank’s internal
operational risk measurement system, which should be based on:
• Internal loss data
• External loss data
• Scenario analysis, and
• Business environment and internal control factors
As a general principle, the Accord does not prescribe an exact capital
required methodology under the advanced measurement approach. Banks
are encouraged to develop their own methods provided the measure
calculates capital that covers both expected loss and unexpected loss – it
must however be able to demonstrate that its approach captures potentially
severe ‘tail’ loss events. Whatever approach is used, a bank must
demonstrate that its operational risk measure meets a soundness standard
comparable to that of the internal ratings-based approach for credit risk,
(i.e. comparable to a one year holding period and a 99.9% confidence
interval).
One of the methods being used is the loss distribution approach, which
embodies some of the following aspects:
• Banks will calculate two distributions: one for frequency and one for
severity
• Frequency distributions are usually binomial, negative binomial or
Poisson
• Event severity distributions are wider in choice: log normal, Pareto,
Weibull or Inverse Gaussian
• A compound distribution is calculated using Monte Carlo simulation
(in Statistical terms, the convolution of the frequency and severity
distributions).
• Estimate the mean and the 99.9 percentile from the resulting
distribution, the latter being equal to the 1 year Value at Risk)

27
 • The calculated risk measure will have to comply with various sets of
criteria for the AMA in addition to those for the standardised
approach. The different types of criteria are:
• General (minimum) criteria
• Qualitative criteria
• Quantitative criteria
• Risk mitigation
• The Accord addresses some other specific issues, such as how to
determine capital requirements for international subsidiaries and the
incorporation of diversification benefits.
Par 655 – 679

2.3.2.5. Partial use - combinations

A bank will be permitted to use an AMA for some parts of its operations
and the Basic Indicator Approach or Standardised Approach for the
balance (partial use), provided that the following conditions are met:
• All operational risks of the bank’s global, consolidated operations are
captured;
• All of the bank’s operations that are covered by the AMA meet the
qualitative criteria for using an AMA, while those parts of its
operations that are using one of the simpler approaches meet the
qualifying criteria for that approach;
• On the date of implementation of an AMA, a significant part of the
bank’s operational risks are captured by the AMA; and
• The bank provides its supervisor with a plan specifying the timetable
to which it intends to roll out the AMA across all but an immaterial
part of its operations. The plan should be driven by the practicality and
feasibility of moving to the AMA over time, and not for other reasons.
Par 680

2.4. Trading book issues

2.4.1. Introduction
Since 1998 banks have been required to measure and apply capital charges in
respect of their market risks.
Market risk is the risk of financial loss relating to a bank’s trading activities,
where the bank may act on its own account or on behalf of its clients in the
commodity, foreign exchange, equity, capital and money markets. Market risk

28
 arises where there are adverse movements in market prices e.g. interest and
foreign exchange rates, equity, bond and commodity prices.
In essence, capital charges, with respect to market risks, have been applied as
follows:
• In the case of interest rate related instruments and equities to the current
market value of banks’ trading books.
• In the case of foreign exchange and commodities risk to banks’ total currency
and commodity positions.

2.4.2. Basel II (The New Framework)

Banks will be seeking approval from their supervisory authority for use of their
internal risk models to calculate the capital charge to be held for market risks. A
bank however, has to fulfil a number of requirements before it may be eligible to
use its internal risk models in applying this capital treatment.

2.4.2.1. Definitions
In terms of Basel II the definition of trading book has been redefined.
A trading book consists of:
• positions in financial instruments and commodities
• held either with trading intent or
• in order to hedge other elements of the trading book.
• Positions held with trading intent are those:
• held intentionally for short-term resale and/or
• with the intent of benefiting from actual or expected short-term price
movements
• and may include for example proprietary positions, positions arising
from client servicing and market making.
• A hedge is a position that:
• materially or entirely offsets the component risk elements of another
trading book position or portfolio.
Par 684 -687, 689

2.4.2.2. Eligibility for trading book capital treatment

To be eligible for trading book capital treatment financial instruments
must either be freely tradable or able to be hedged completely.

29
 A bank must have:
• A clearly documented trading strategy for the position/instrument or
portfolios, approved by senior management.
• Clearly defined policies and procedures for the active management
of the position, which must include:
o positions are managed on a trading desk;
o position limits are set and monitored for appropriateness;
o dealers have the autonomy to enter into/manage the position within
agreed limits and according to the agreed strategy;
o positions are marked to market at least daily;
o positions are reported to senior management as an integral part of
the institution’s risk management process; and
o positions are actively monitored with reference to market
information sources.
• Clearly defined policy and procedures to monitor the positions
against the bank’s trading strategy
• Furthermore, positions should be frequently and accurately valued, and
the portfolio should be actively managed.
Par 688

2.4.2.3. Valuation of the trading book

A framework for prudent valuation practices has been laid out and should
at a minimum include the following:

Figure 2.1 Valuation framework of the trading book

Valuation framework

Systems and Methodologies Valuation

controls • Marking to market adjustment or
• Adequate reserves
• Marking to model
• Reliable
• Independent price

The valuation framework must provide confidence that the valuation

estimates are prudent and reliable. The valuation framework must be

30
 integrated with other risk management systems within the organisation
(such as credit analysis). It must include documented policies and
procedures for the process of valuation, as well as clear and independent
(i.e. independent of front office) reporting lines for the department
accountable for the valuation process.
Par 690 - 692
There are a number of valuation methodologies that a bank may apply.
These include: Marking to market, Marking to model and Independent
price verification.
2.4.2.3.1. Marking to market
o The daily valuation of positions at readily available close out
prices (that are sourced independently).
o Examples of readily available close out prices include exchange
prices, screen prices, or quotes from several independent
reputable brokers.
2.4.2.3.2. Marking to model
o Where marking-to-market is not possible, banks may mark-to-
model e.g. where the instrument is not readily tradable such as an
option on X written by Y for 2020.
o Marking-to-model is defined as any valuation, which has to be
benchmarked, extrapolated or otherwise calculated from a market
input e.g. the use of a Black and Scholes model to calculate the
value of the option written.
o Marking to model must be demonstrated to be prudent as there is
naturally a degree of assumption involved.
o The model should be subject to periodic review to determine the
accuracy of its performance e.g. assessing continued
appropriateness of the assumptions
2.4.2.3.3. Independent price verification
o Independent price verification is distinct from daily mark-to-
market.
o It is the process by which market prices or model inputs are
regularly verified for accuracy.
o While daily marking-to-market may be performed by dealers,
verification of market prices or model inputs should be
performed by a unit independent of the dealing room, at least
monthly.
Par 693 - 697

31
 Procedures for considering adjustments or reserves must be
established and maintained to mitigate against the risks arising from
(for example):
o Inaccuracies in valuation methods and models.
o Operational risk.
o Reduced liquidity in a position arising from market event.
The valuation adjustments must impact the regulatory capital.
Par 698 – 705

2.4.3. Basel II applied to the Trading Activities and the Treatment of

Double Default Effects
2.4.3.1. General
The document: The Application of Basel II to Trading Activities and
the Treatment of Double Default Effects, to update the prescriptions for
the trading book, was published by the Basel Committee in July 2005.
Only the main focus of the document will be highlighted here and
reference here is to the new document’s relevant paragraph numbers.
Two areas that the Basel Committee identified where immediate work
should be done are: (1) finding a prudentially sound treatment under the
Revised Framework for exposures to double default,” where the risk of
both a borrower and a guarantor defaulting on the same obligation may be
substantially lower than the risk of only one of the parties defaulting; and
(2) applying the Revised Framework to certain exposures arising from
trading activities.
This document describes a proposal to address five specific issues related
to double default and trading activities prior to the implementation of the
Revised Framework. These issues consist of the following:
• the treatment of counterparty credit risk for over-the-counter
derivatives, repo-style and securities financing transactions; and the
treatment of cross-product netting arrangements;
• the treatment of double-default effects for covered transactions;
• the short-term maturity adjustment in the internal ratings-based
approach;
• improvements to the current trading book regime, especially with
respect to the
• treatment of specific risk; and

32
 • the design of a specific capital treatment for failed transactions and
transactions that are not settled through a delivery-versus-payment
framework.

2.4.3.2. Measures of Counterparty Credit Risk (CCR)

Positions that give rise to CCR exposures share certain generic
characteristics. They generate a credit exposure, which is defined as the
cost of replacing the transaction if the counterparty defaults assuming there
is no recovery of value. In addition, credit exposure depends on one or
more underlying market factors.
Banks use several measures to manage their exposure to CCR including
potential future exposure (PFE), expected exposure (EE), and expected
positive exposure (EPE). PFE is the maximum exposure estimated to occur
on a future date at a high level of statistical confidence. Banks often use
PFE when measuring CCR exposure against counterparty credit limits. EE
is the probability-weighted average exposure estimated to exist on a future
date. EPE is the time-weighted average of individual expected exposures
estimated for given forecasting horizons (e.g. one year). Banks typically
compute EPE, EE, and PFE using a common stochastic model.

Consistent with the industry’s general practice for computing exposures to

CCR, banks are required to estimate the exposure amount or EAD, and
calculate the associated capital charge, on the basis of one or more defined
bilateral “netting sets.” A “netting set” is a group of transactions with a
single counterparty that are subject to a legally enforceable bilateral netting
arrangement and permitted to be netted under the provisions of the 1988
Accord, as amended.
Par 1 – 25

2.4.3.3. The internal model method (IM)

The Basel Committee has articulated the principle that banks should be
allowed to use the output of their “own estimates” developed through
internal models in an advanced EAD approach. To achieve that principle,
qualifying institutions are permitted to employ internal estimates of the
EPE of defined netting sets of their counterparty exposures in computing
the exposure amount or EAD for capital purposes under the Revised
Framework. In general, internal models commonly used for CCR estimate
a time profile of EE over each point in the future, which equals the average
exposure, over possible future values of relevant market risk factors, such
as interest rates, foreign exchange rates, etc.

33
 Consistent with the Revised Framework’s requirement for the use of a one-
year probability of default (PD) time horizon, Effective EPE is to be
measured as the average of Effective EE over one year. If all contracts in
the netting set mature before one year, Effective EPE is the average of
Effective EE until all contracts in the netting set mature, for example, if the
longest-maturity contract in the netting set matures in six months, Effective
EPE would be the average of Effective EE over six months.

The alpha multiplier provides a means of conditioning internal estimates of

EPE on a “bad state” of the economy consistent with the determination of
credit risk under the Revised Framework. In addition, it acts to adjust
internal EPE estimates for both (1) correlations of exposures across
counterparties exposed to common risk factors and (2) the potential lack of
granularity across a firm’s counterparty exposures. The alpha multiplier is
also viewed as a method to offset model error or estimation error.

EEs can be calculated based on either the risk-neutral distribution of a risk

factor or the actual distribution of a risk factor. To the extent that a bank
recognises collateral in EAD via current exposure, a bank would not be
permitted to recognise the benefits in its estimates of loss given default
(LGD). As a result, the bank would be required to use an LGD of an
uncollateralized facility.

Par 26 - 48

2.4.3.4. Non-internal model methods

2.4.3.4.1. The Current Exposure Method (CEM)
Supervisors have also explored alternative methods for computing
capital requirements for CCR that would apply to those banks that do
not qualify for the use of internal models. Given the multiple capital
treatments available for SFTs in the Revised Framework, supervisors
have focused only on the treatment of OTC derivatives.
The existing CEM incorporated in the 1988 Accord and the Revised
Framework remains an alternative method for computing capital
requirements for CCR for banks that do not qualify for the IMM.
The existing CEM takes the form of the following equation:
Counterparty Capital Charge = [(RC + add-on) – volatility adjusted
collateral] * Risk Weight * 8%
Where:
RC is the Current Replacement Cost
Add-on is the estimated amount of potential future
exposure calculated under the 1988 Accord as amended.

34
 Volatility adjusted collateral is the value of collateral.
Risk Weight is the risk weight of the counterparty.
Under the CEM, exposure amount or EAD is equal to [(RC
+ add-on) – volatility adjusted collateral].
2.4.3.4.2. The Standardised Method (SM)
The SM is also available for banks that do not qualify to estimate the
EPE associated with OTC derivatives but that would like to adopt a
more risk-sensitive method than the CEM set out in the 1988 Basel
Accord, as amended. The SM is designed to capture certain key
features of the IMM for CCR. At the same time, it seeks to provide a
method that is simple to implement compared to the IMM.
The SM entails a number of simplifying assumptions. For example,
CCR exposures are expressed in risk positions that reference short-
term changes in valuation parameters (e.g. modified duration for debt
instruments, delta concept for options). It also assumes that the
positions that are open under a short-term forecasting horizon of, for
example, one day remain open and unchanged throughout the
forecasting horizon. There is no recognition of diversification effects.
Under the SM, the exposure amount represents the product of (i) the
larger of the net current market value or a “supervisory EPE,” times
(ii) a scaling factor, termed beta. The first factor captures two key
features of the IMM: (1) for netting sets that are deep in the money,
the EPE is primarily determined by the current market value of the
netting set; and (2) for netting sets that are at the money, the current
market value is not relevant, and CCR is driven only by the potential
change in the value of the transactions. Neither of these features is
applicable in the CEM. By summing the current exposure with the
computed add-ons, the CEM essentially assumes that the netting set
is at the money and deep in the money at the same time.
The second factor, beta, serves the same purpose as the alpha scaling
factor used in the IMM. As such, it implicitly conditions the
exposure amount or EAD on a “bad” state of the economy, addresses
stochastic dependency of market values of exposures across
counterparties, and addresses estimation and modelling error. Beta
also helps to ensure an appropriate incentive for banks to choose the
IMM over the standardised method, particularly when a bank’s
derivative transactions are diversified and not narrowly focused on
certain risk areas (e.g. domestic interest rates, certain commodities).
As a result beta facilitates the recognition of a risk-sensitive
treatment for banks that are actively using OTC derivative
transactions.
The exposure amount or EAD for a counterparty is the sum of the
exposure amounts or EADs across netting sets with that

35
counterparty. The calibration of the CCFs has been made assuming
at-the-money forwards or swaps and given a forecasting horizon of
one year. The forecasting horizon of one year is chosen to conform to
the IRB approach to credit risk under the Revised Framework, which
requires the use of a one-year probability of default (PD) time
horizon.
Par 49 – 74

36
3. Part 3: The Second Pillar – The Supervisory Review Process

3.1. Introduction
The Supervisory Review Process is defined as the “Second Pillar” of Basel II and
as such represents an important key element of the Basel II document and the
approach to ensure safer and sound banking. The focus on supervision is,
however, not new to the Basel Committee. This part of the Report is the
culmination of 20 documents on supervision published by the Basel Committee,
the first being Part B of the Amendment to the Capital Accord to incorporate
market risks, published in January 1996 and the twentieth being the Sound
practices for the management and supervision of operational risk, published in
February 2003.
The aim of this part of the Basel II document is to discuss and describe the key
principles of supervisory review; risk management guidance; and supervisory
transparency and accountability.

3.2. The importance of supervisory review

3.2.1. Introduction
The focus here is, firstly, on the responsibility of bank management in
developing an internal capital assessment process and setting appropriate capital
targets for the bank’s risk profile and control environment. Secondly, supervisors
should evaluate how well the banks are assessing their capital needs, relative to
their risks, and to intervene where appropriate.
Pillar 2 also addresses the treatment of risks considered under Pillar 1, but not
fully captured by the Pillar 1 process (e.g. credit concentration risk); factors not
taken into account in Pillar 1 (e.g. interest rate risk in the banking book); and
factors external to the bank (e.g. business cycle effects).
Lastly, Pillar 2 addresses the assessment of the banks’ compliance with the
minimum standards and disclosure requirements of the more advanced methods
of Pillar 1.
Par 720 - 724

37
3.2.2. Four key principles of supervisory review
The Basel Committee has identified four key principles of supervisory review

3.2.2.1. 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.
Banks must be able to demonstrate that the chosen internal capital targets
are well founded and consistent with their overall risk profile and operating
environment. Bank management bears the primary responsibility for
ensuring that the bank has adequate capital to support its risks. The Basel
Committee outlines five main features of the rigorous process that banks
should follow, namely, board and senior management oversight, sound
capital assessment, comprehensive assessment of risks, monitoring and
reporting and internal control review. These five features will briefly be
discussed below.
3.2.2.1.1. Board and senior management oversight
A sound risk management process is the foundation for an effective
assessment of the adequacy of a bank’s capital position. The analysis
of a bank’s current and future capital requirements in relation to its
strategic objectives is a vital element of the strategic planning
process. The strategic plan should clearly outline the bank’s capital
needs, anticipated capital expenditures, desirable capital level, and
external capital sources. Senior management and the board should
view capital planning as a crucial element in being able to achieve its
desired strategic objectives.
The bank’s board of directors has responsibility for setting the bank’s
tolerance for risks. It should also ensure that management establishes
a framework for assessing the various risks, develops a system to
relate risk to the bank’s capital level, and establishes a method for
monitoring compliance with internal policies. It is likewise important
that the board of directors adopts and supports strong internal
controls and written policies and procedures and ensures that
management effectively communicates these throughout the
organisation.
Par 728 – 730
3.2.2.1.2. Sound capital assessment
The fundamental elements of sound capital assessment include:
• Policies and procedures designed to ensure that the bank
identifies, measures, and reports all material risks;

38
 • A process that relates capital to the level of risk;
• A process that states capital adequacy goals with respect to risk,
taking account of the bank’s strategic focus and business plan;
and
• A process of internal controls reviews and audits to ensure the
integrity of the overall management process.
Par 731
3.2.2.1.3. Comprehensive assessment of risks
All material risks faced by the bank should be addressed in the
capital assessment process. The following exposures, by no means a
complete list, should be considered:
• Credit risk
Banks should have methodologies that enable them to assess the
credit risk involved in exposures to individual borrowers or
counterparties as well as at the portfolio level. For more sophisticated
banks, the credit review assessment of capital adequacy, at a
minimum, should cover four areas: risk rating systems, portfolio
analysis/aggregation, securitisation/complex credit derivatives, and
large exposures and risk concentrations.
Internal risk ratings should support the identification and
measurement of risk from all credit exposures, and should be
integrated into an institution’s overall analysis of credit risk and
capital adequacy. The analysis of credit risk should adequately
identify any weaknesses at the portfolio level, including any
concentrations of risk.
• Operational risk
A bank should develop a framework for managing operational risk
and evaluate the adequacy of capital given this framework. The
framework should cover the bank’s appetite and tolerance for
operational risk, as specified through the policies for managing this
risk, including the extent and manner in which operational risk is
transferred outside the bank. It should also include policies outlining
the bank’s approach to identifying, assessing, monitoring and
controlling/mitigating the risk.
• Market risk
This assessment is based largely on the bank’s own measure of
value-at-risk or the standardised approach for market risk. Emphasis
should also be placed on the institution performing stress testing in
evaluating the adequacy of capital to support the trading function.

39
 • Interest rate risk in the banking book
The measurement process should include all material interest rate
positions of the bank and consider all relevant repricing and maturity
data. Such information will generally include current balance and
contractual rate of interest associated with the instruments and
portfolios, principal payments, interest reset dates, maturities, the
rate index used for repricing, and contractual interest rate ceilings or
floors for adjustable-rate items. The system should also have well-
documented assumptions and techniques. Regardless of the type and
level of complexity of the measurement system used, bank
management should ensure the adequacy and completeness of the
system.
• Liquidity risk
Liquidity is crucial to the ongoing viability of any banking
organisation. Banks’ capital positions can have an effect on their
ability to obtain liquidity, especially in a crisis. Each bank must have
adequate systems for measuring, monitoring and controlling liquidity
risk.
• Other risks
Although the Basel Committee recognises that ‘other’ risks, such as
reputational and strategic risk, are not easily measurable, it expects
industry to further develop techniques for managing all aspects of
these risks.
Par 732 – 742
3.2.2.1.4. Monitoring and reporting
The bank’s senior management or board of directors should, on a
regular basis, receive reports on the bank’s risk profile and capital
needs. These reports should allow senior management to:
• Evaluate the level and trend of material risks and their effect on
capital levels
• Evaluate the sensitivity and reasonableness of key assumptions
used in the capital assessment measurement system;
• Determine that the bank holds sufficient capital against the
various risks and is in compliance with established capital
adequacy goals, and
• Assess its future capital requirements based on the bank’s
reported risk profile and make necessary adjustments to the
bank’s strategic plan accordingly
Par 743

40
 3.2.2.1.5. Internal control review
The bank’s board of directors has a responsibility to ensure that
management establishes a system for assessing the various risks,
develops a system to relate risk to the bank’s capital level, and
establishes a method for monitoring compliance with internal
policies. The board should regularly verify whether its system of
internal controls is adequate to ensure well-ordered and prudent
conduct of business. The bank should conduct periodic reviews of its
risk management process to ensure its integrity, accuracy, and
reasonableness. Areas that should be reviewed include:
• Appropriateness of the bank’s capital assessment process given
the nature, scope and complexity of its activities;
• Identification of large exposures and risk concentrations;
• Accuracy and completeness of data inputs into the bank’s
assessment process;
• Reasonableness and validity of scenarios used in the assessment
process; and
• Stress testing and analysis of assumptions and inputs.
Par 744 – 745

3.2.2.2. Principle 2
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. Supervisors should take
appropriate supervisory action if they are not satisfied with the result of
this process.
The supervisory authorities should regularly review the process by which a
bank assesses its capital adequacy, risk position, resulting capital levels,
and quality of capital held. Supervisors should also evaluate the degree to
which a bank has in place a sound internal process to assess capital
adequacy. The emphasis of the review should be on the quality of the
bank’s risk management and controls and should not result in supervisors
functioning as bank management. The periodic review can involve some
combination of:
• On-site examinations or inspections;
• Off-site review;
• Discussions with bank management;
• Review of work done by external auditors (provided it is adequately
focused on the necessary capital issues); and

41
 • Periodic reporting.
The supervisors’ detailed analysis of each bank’s internal risk analysis
should include:
• A review of adequate risk assessment;
• An assessment of capital adequacy;
• Assessment of the control environment;
• A supervisory review of compliance with minimum standards; and
• A supervisory response.
Par 746 - 756

3.2.2.3. 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.
Pillar 1 capital requirements will include a buffer for uncertainties
surrounding the Pillar 1 regime that affect the banking population as a
whole. Bank-specific uncertainties will be treated under Pillar 2. There are
several means available to supervisors for ensuring that individual banks
are operating with adequate levels of capital. Among other methods, the
supervisor may set trigger and target capital ratios or define categories
above minimum ratios (e.g. well capitalised and adequately capitalised) for
identifying the capitalisation level of the bank.
Par 757

3.2.2.4. Principle 4
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.
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.
The permanent solution to banks’ difficulties is not always increased
capital. However, some of the required measures (such as improving
systems and controls) may take a period of time to implement. Therefore,
increased capital might be used as an interim measure while permanent
measures to improve the bank’s position are being put in place.

42
 Par 759 – 760

3.2.3. Specific issues to be addressed under the supervisory review

process
3.2.3.1. Introduction
The Basel Committee has identified a number of important issues that
banks and supervisors should particularly focus on when carrying out the
supervisory review process.

3.2.3.2. Interest rate risk in the banking book

The Basel Committee remains convinced that interest rate risk in the
banking book is a potentially significant risk which merits support from
capital. The Basel Committee has concluded that it is at this time most
appropriate to treat interest rate risk in the banking book under Pillar 2 of
the Framework.
The revised guidance on interest rate risk recognises banks’ internal
systems as the principal tool for the measurement of interest rate risk in the
banking book and the supervisory response. To facilitate supervisors’
monitoring of interest rate risk exposures across institutions, banks would
have to provide the results of their internal measurement systems,
expressed in terms of economic value relative to capital, using a
standardised interest rate shock.
Supervisors should be particularly attentive to the sufficiency of capital of
‘outlier banks’ where economic value declines by more than 20% of the
sum of Tier 1 and Tier 2 capital as a result of a standardised interest rate
shock (200 basis points) or its equivalent.
Par 762 – 764

3.2.3.3. Credit risk

3.2.3.3.1. Stress tests under the IRB-approaches
A bank should ensure that it has sufficient capital to meet the Pillar 1
requirements. The results of the stress test will thus contribute
directly to the expectation that a bank will operate above the Pillar 1
minimum regulatory capital ratios. The supervisors may therefore
wish to review how the stress test has been carried out.
3.2.3.3.2. Definition of default
A bank must use the reference definition of default (90 days past
due) for its internal estimations of PD and/or LGD and EAD. The

43
 national supervisors will issue guidance on how the reference
definition of default is to be interpreted in their jurisdictions.
Supervisors will assess individual banks’ application of the reference
definition of default and its impact on capital requirements.
3.2.3.3.3. Residual risk
The Framework allows banks to offset credit or counterparty risk
with collateral, guarantees or credit derivatives, leading to reduced
capital charges. While banks use credit risk mitigation (CRM)
techniques to reduce their credit risk, these techniques give rise to
risks that may render the overall risk reduction less effective.
Accordingly these risks (e.g. legal risk, documentation risk, or
liquidity risk) to which banks are exposed are of supervisory
concern. Where such risks arise, and irrespective of fulfilling the
minimum requirements set out in Pillar 1, a bank could find itself
with greater credit risk exposure to the underlying counterparty than
it had expected. Therefore, supervisors will require banks to have in
place appropriate written CRM policies and procedures in order to
control these residual risks.
3.2.3.3.4. Credit concentration risk
A risk concentration is any single exposure or group of exposures
with the potential to produce losses large enough (relative to a bank’s
capital, total assets, or overall risk level) to threaten a bank’s health
or ability to maintain its core operations. Risk concentrations can
arise in a bank’s assets, liabilities, or off-balance sheet items, through
the execution or processing of transactions (either product or
service), or through a combination of exposures across these broad
categories.
Credit risk concentrations, by their nature, are based on common or
correlated risk factors, which, in times of stress, have an adverse
effect on the creditworthiness of each of the individual counterparties
making up the concentration. Such concentrations are not addressed
in the Pillar 1 capital charge for credit risk. Banks should have in
place effective internal policies, systems and controls to identify,
measure, monitor, and control their credit risk concentrations. Banks
should explicitly consider the extent of their credit risk
concentrations in their assessment of capital adequacy under Pillar 2.
In the course of their activities, supervisors should assess the extent
of a bank’s credit risk concentrations, how they are managed, and the
extent to which the bank considers them in its internal assessment of
capital adequacy under Pillar 2.
Par 765 – 777

44
 3.2.3.4. Operational risk
Gross income, used in the Basic Indicator and Standardised Approaches for
operational risk, is only a proxy for the scale of operational risk exposure
of a bank and can in some cases (e.g. for banks with low margins or
profitability) underestimate the need for capital for operational risk. The
supervisor should, therefore, consider whether the capital requirement
generated by the Pillar 1 calculation gives a consistent picture of the
individual bank’s operational risk exposure, for example in comparison
with other banks of similar size and with similar operations.
Par 778

3.2.4. Other aspects of the supervisory review process

3.2.4.1. Supervisory transparency and accountability
The supervision of banks is not an exact science, and therefore,
discretionary elements within the supervisory review process are
inevitable. Supervisors must take care to carry out their obligations in a
transparent and accountable manner. Supervisors should make publicly
available the criteria to be used in the review of banks’ internal capital
assessments.
Par 779

3.2.4.2. Enhanced cross-border communication and cooperation

The Framework will not change the legal responsibilities of national
supervisors for the regulation of their domestic institutions or the
arrangements for consolidated supervision as set out in the existing Basel
Committee standards. The home country supervisor is responsible for the
oversight of the implementation of the Framework for a banking group on
a consolidated basis. Host country supervisors are responsible for the
supervision of those entities operating in their countries. In implementing
the Framework, supervisors should communicate the respective roles of
home country and host country supervisors as clearly as possible to
banking groups with significant cross-border operations in multiple
jurisdictions. The Basel Committee supports a pragmatic approach of
mutual recognition for internationally active banks as a key basis for
international supervisory co-operation.
Par 780 – 783

45
3.2.5. The supervisory review process for securitisation
3.2.5.1. Introduction
Pillar 1 requires that banks should take account of the economic substance
of transactions in their determination of capital adequacy. The supervisory
authorities will monitor, as appropriate, whether banks have done so
adequately. As a result, regulatory capital treatments for specific
securitisation exposures might differ from those specified in Pillar 1 of the
Framework, and these issues are addressed in Pillar 2.
Par 784 – 785

3.2.5.2. Significance of risk transfer

Securitisation transactions may be carried out for purposes other than credit
risk transfer (e.g. funding). Where this is the case, there might still be a
limited transfer of credit risk. However, for an originating bank to achieve
reductions in capital requirements, the risk transfer arising from a
securitisation has to be deemed significant by the national supervisory
authority. Therefore, the capital relief that can be achieved will correspond
to the amount of credit risk that is effectively transferred.
Par 786 – 788

3.2.5.3. Market innovations

As the minimum capital requirements for securitisation may not be able to
address all potential issues, supervisory authorities are expected to consider
new features of securitisation transactions as they arise.
Par 789

3.2.5.4. Provision of implicit support

Support to a transaction, whether contractual (i.e. credit enhancements
provided at the inception of a securitised transaction) or non-contractual
(implicit support) can take numerous forms. For instance, contractual
support can include over collateralisation, credit derivatives, spread
accounts, etc. Examples of implicit support include the purchase of
deteriorating credit risk exposures from the underlying pool, the sale of
discounted credit risk exposures into the pool of securitised credit risk
exposures, etc.
The provision of implicit (or non-contractual) support, as opposed to
contractual credit support (i.e. credit enhancements), raises significant
supervisory concerns. For traditional securitisation structures the provision
of implicit support undermines the clean break criteria, which when

46
 satisfied would allow banks to exclude the securitised assets from
regulatory capital calculations. For synthetic securitisation structures, it
negates the significance of risk transference.
When a bank has been found to provide implicit support to a securitisation,
it will be required to hold capital against all of the underlying exposures
associated with the structure as if they had not been securitised.
Supervisors will be vigilant in determining implicit support and will take
appropriate supervisory action to mitigate the effects.
Par 790 – 794

3.2.5.5. Residual risks

As with credit risk mitigation techniques more generally, supervisors will
review the appropriateness of banks’ approaches to the recognition of
credit protection. In particular, with regard to securitisations, supervisors
will review the appropriateness of protection recognised against first loss
credit enhancements. On these positions, expected loss is less likely to be a
significant element of the risk and is likely to be retained by the protection
buyer through the pricing. Therefore, supervisors will expect banks’
policies to take account of this in determining their economic capital.
Where supervisors do not consider the approach to protection recognised is
adequate, they will take appropriate action.
Par 795

3.2.5.6. Call provisions

Supervisors expect a bank not to make use of clauses that entitles it to call
the securitisation transaction or the coverage of credit protection
prematurely if this would increase the bank’s exposure to losses or
deterioration in the credit quality of the underlying exposures. Besides the
general principle stated above, supervisors expect banks to only execute
clean-up calls for economic business purposes, such as when the cost of
servicing the outstanding credit exposures exceeds the benefits of servicing
the underlying credit exposures.
Par 796 – 800

3.2.5.7. Early amortisation

Supervisors should review how banks internally measure, monitor, and
manage risks associated with securitisations of revolving credit facilities,
including an assessment of the risk and likelihood of early amortisation of
such transactions. At a minimum, supervisors should ensure that banks
have implemented reasonable methods for allocating economic capital

47
against the economic substance of the credit risk arising from revolving
securitisations. The supervisors should expect banks to have adequate
capital and liquidity contingency plans that evaluate the probability of an
early amortisation occurring and address the implications of both scheduled
and early amortisation.
Banks should consider the effects that changes in portfolio management or
business strategies may have on the levels of excess spread and on the
likelihood of an early amortisation event. Supervisors expect that the
sophistication of a bank’s system in monitoring the likelihood and risks of
an early amortisation event will be commensurate with the size and
complexity of the bank’s securitisation activities that involve early
amortisation provisions.
For controlled amortisations specifically, supervisors may also review the
process by which a bank determines the minimum amortisation period
required to pay down 90% of the outstanding balance at the point of early
amortisation. Where a supervisor does not consider this adequate it will
take appropriate action.
Par 801 - 807

48
4. Part 4: The Third Pillar – Market Discipline

4.1. Introduction
Market discipline can contribute to a safe and sound banking environment, and
supervisors require firms to operate in a safe and sound manner. Under safety and
soundness grounds, supervisors could require banks to disclose information.
Alternatively, supervisors have the authority to require banks to provide
information in regulatory reports.
The purpose of Pillar 3 ─ market discipline is to complement the minimum
capital requirements (Pillar 1) and the supervisory review process (Pillar 2). The
Basel Committee aims to encourage market discipline by developing a set of
disclosure requirements which will allow market participants to assess key pieces
of information on the scope of application, capital, risk exposures, risk
assessment processes, and hence the capital adequacy of the institution. The
banks’ disclosures should be consistent with how senior management and the
board of directors assess and manage the risks of the bank. These disclosures are
also a qualifying criterion under Pillar 1 to obtain lower risk weightings and/or to
apply specific methodologies.
The Basel Committee recognises the need for a Pillar 3 disclosure framework
that does not conflict with requirements under accounting standards, which are
broader in scope. The Basel Committee has made a considerable effort to see that
the narrower focus of Pillar 3, which is aimed at disclosure of bank capital
adequacy, does not conflict with the broader accounting requirements. Pillar 3
disclosures will not be required to be audited by an external auditor, unless
otherwise required by accounting standards setters, securities regulators or other
authorities.
For those disclosures that are not mandatory under accounting or other
requirements, management may choose to provide the Pillar 3 information
through other means such as on a publicly accessible internet website or in public
regulatory reports filed with bank supervisors. However, institutions are
encouraged to provide all related information in one location. A bank should
decide which disclosures are relevant for it based on the materiality concept.
Information would be regarded as material if its omission or misstatement could
change or influence the assessment or decision of a user relying on that
information for the purpose of making economic decisions.
The disclosures set out in Pillar 3 should be made on a semi-annual basis.
Qualitative disclosures that provide a general summary of a bank’s risk
management objectives and policies, reporting system and definitions may be
published on an annual basis.
The Basel Committee believes that the requirements set out in Pillar 3, strike an
appropriate balance between the need for meaningful disclosure and the
protection of proprietary and confidential information.
Par 808 – 819

49
4.2. The disclosure requirements
4.2.1. General disclosure principle
Banks should have a formal disclosure policy approved by the board of directors
that addresses the bank’s approach for determining what disclosures it will make
and the internal controls over the disclosure process.
Par 820 – 821

4.2.2. Scope of application

Pillar 3 applies at the top consolidated level of the banking group to which the
Framework applies. Disclosures related to individual banks within the groups
would not generally be required to fulfil the disclosure requirements. An
exception to this arises in the disclosure of Total and Tier 1 Capital Ratios by the
top consolidated entity where an analysis of significant bank subsidiaries within
the group is appropriate.
Par 822

4.2.3. Capital
A both qualitative and qualitative disclosure on Total, Tier 1 and Tier 2 capital,
as well as capital adequacy is required.
Par 822

4.2.4. Risk exposure and assessment

The risks to which banks are exposed and the techniques that banks use to
identify, measure, monitor and control those risks are important factors market
participants consider in their assessment of an institution. In Pillar 3, several key
banking risks are considered: credit risk, market risk, interest rate risk and equity
risk in the banking book and operational risk. Also included are disclosures
relating to credit risk mitigation and asset securitisation, both of which alter the
risk profile of the institution. Where applicable, separate disclosures are set out
for banks using different approaches to the assessment of regulatory capital.
Par 823 – 826

50
5. Conclusion

Never in the past did a document have the impact on financial institutions and regulators
alike, which the Basel II proposals had. Not only does it constitute best practice in terms
of risk management, but in order to be globally competitive, banks need to adopt these
requirements to ensure survival.
The aim of this paper was to provide an introductory guide to this highly technical
document and the vast amount of accompanying popular and scientific literature
available on the web and in the press. This paper provided a basic insight into the Basel II
document for persons, e.g. new financial market analysts and financial journalist needing
a basic understanding or introduction to the current bank supervision and regulation.
This paper was compiled from the original documents and reference to the paragraph
numbers of the original documents was made in each section.

51
6. Bibliography

Title Publisher / Author

The Basel Handbook: A Guide for Financial Michael K. Ong
Practitioners
International Convergence of Capital Measurement Basel Committee on Banking Supervision
and Capital Standards – June 2004
Managing Bank Capital (Second Edition) - Capital Chris Patten
Allocation & Performance Measurement John Wiley & Sons - 2000
A Practitioner’s Guide to The Basel Accord PricewaterhouseCoopers LLP
John Tattersall and Richard Smith
Credit Risk Models & the Basel Accords Donald R. Van Deventer
Kenji Imai
An Explanatory Note on the Basel II IRB Risk Basel Committee on Banking Supervision
Weight Functions – October 2004

Studies on the Validation of Internal Basel Committee on Banking Supervision

Rating Systems - Working Paper No. 14

Economic Capital: A Practitioner Guide Ashish Dev

Risk Books
Websites

www.baselalert.com
www.riskwaters.com
www.bis.org

www.federalreserve.gov <http://www.federalreserve.gov>
www.apra.gov.au <http://www.apra.gov.au>
www.info.gov.hk/hkma <http://www.info.gov.hk/hkma>
Committee of European Banking Supervisors - http://www.c-ebs.org/
www.erisk.com <http://www.erisk.com>
www.kamakuraco.com

Some additional general B2 references include:

Global Risk Regulator (website) www.globalriskregulator.com
Managing Bank Capital - Chris Matten

52