INTRODUCTION

Banks have a vital function in the economy. They have easy access to
funds through collecting savers money, issuing debt securities, or
borrowing on the inter-bank markets. The funds collected are invested
in short-term and long-term risky assets, which consist mainly of credits
to various economic actors (individuals, companies, governments )
Through centralizing any money surplus and injecting it back into the
economy, large banks are the heart maintaining the blood supply of our
modern capitalist societies. So, it is no surprise that they are subject to
so much constraint and regulations.
But if banks often consider regulation only as a source of the costs that
they have to assume to maintain their licenses, their attitudes are
evolving under the pressure of two factors.
First, risk management discipline has seen significant development
since the 1970s, thanks to the use of sophisticated quantification
techniques. This revolution first occurred in the field of market risk
management, and more recently credit risk management has also
reached a high level of sophistication.
Risk management has evolved from a passive function of risk
monitoring, limit-setting, and risk valuation to a more proactive
function of performance measure, risk-based pricing, portfolio
management, and economic capital allocation. Modern approaches
desire not only to limit losses but to take an active part in the process of
shareholder value creation, which is (or, at least, should be) the main
goal of any companys top management.
The second factor is that banking regulation is currently under review.
The banking regulation frameworks in most developed countries are
currently based on a document issued by a G10 central bankers
working group.
This document, International convergence of capital measurement and
capital standards, was a brief set of simple rules that were intended to
ensure financial stability and a level playing field among international
banks. As it quickly appeared that the framework had many
weaknesses, and even sometimes perverse effects, and thanks to the
evolution that we mentioned above, a revised proposition saw the light
in 1999. After three rounds of consultation with the sector, the last
document, supposed to be the final one (often called the
Basel 2 Accord) was issued in June 2004 (Basel Committee on Banking
Supervision, 2004d, p. 239). The level of sophistication of the proposed
revision is a tremendous progress by comparison with the 1988 text,
which can be seen just by looking at the documents size (239 pages
against 28). The formulas used to determine the regulatory capital
requirements are based on credit risk portfolio models that have been
known in the literature for some years but that few banks, except the
largest, have actually implemented. Those two factors represent an
exceptional opportunity for banks that wish to improve their risk
management frameworks to make investments that will both match the
regulators new expectations and, by adding a few elements, be in line
with state-of-the-art techniques of shareholder value creation through
risk management.
The goal of this book is to give a broad outline of the challenges that
will have to be met to reach the new regulatory standards, and at the
same time to give a practical overview of the two main current
techniques used in the field of credit risk management: credit scoring
and credit value at risk. The book is intended to be both pedagogic and
practical, which is why we include concrete examples and furnish an
accompanying website (www.creditriskmodels.com) that will permit
readers to move from abstract equations to concrete practice. We
decided not to focus on cutting-edge research, because little of it ends
up becoming an actual market standard.
Rather, we preferred to discuss techniques that are more likely to
be tomorrows universal tools.
The Basel 2Accordis often criticized by leading banks because it is said
not to go far enough in integrating the latest risk management
techniques. But those techniques usually lack standardization, there is
no market consensus on which competing techniques are the best, and
the results are highly sensitive to model parameters that are hard to
observe. Our sincere belief is that todays main objective of the sector
should be the wide-spread integration of the main building blocks of
credit risk management techniques (as has been the case for market
risk management since the 1990s); to be efficient for everyone, these
techniques need wide and liquid secondary credit markets,
where each bank will be able to trade its originated credits efficiently
to construct a portfolio of risky assets that offers the best riskreturn
profile as a function of its defined risk tolerance. Many initiatives of
various banks, researchers, or risk associations have contributed to the
educational and standardization work involved in the development of
these markets, and this book should be seen as a small contribution to
this common effort.

Current Banking Regulation

Definition of BASEL Committee:

The Basel Committee on Banking Supervision (BCBS) is a committee of

banking supervisory authorities that was established by the central
bank governors of the Group of Ten countries in 1974. It provides a
forum for regular cooperation on banking supervisory matters. Its
objective is to enhance understanding of key supervisory issues and
improve the quality of banking supervision worldwide. The Committee
frames guidelines and standards in different areas - some of the better
known among them are the international standards on capital
adequacy, the Core Principles for Effective Banking Supervision and the
Concordat on cross-border banking supervision. The Committee's
Secretariat is located at the Bank for International Settlements
(BIS) in Basel, Switzerland. However, the BIS and the Basel Committee
remain two distinct entities.

History of BASEL:
Founded in 1974
At a glance
The Basel Committee - initially named the Committee of 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).
The Committee, headquartered at the Bank for International
Settlements in Basel, was established to enhance financial stability by
improving the quality of banking supervision worldwide, and to serve as
a forum for regular cooperation between its member countries on
banking supervisory matters. The Committee's first meeting took place
in February 1975, and meetings have been held regularly three or four
times a year since.
Since its inception, the Basel Committee has expanded its membership
from the G10 to 45 institutions from 28 jurisdictions. Starting with the
Basel Concordat, first issued in 1975 and revised several times since, the
Committee has established a series of international standards for bank
regulation, most notably its landmark publications of the accords on
capital adequacy which are commonly known as Basel I, Basel II and,
most recently, Basel III.
Laying the foundation: international cooperation between banking
supervisors
At the outset, one important aim of the Committee's work was to close
gaps in international supervisory coverage so that (i) no banking
establishment would escape supervision; and (ii) supervision would be
adequate and consistent across member jurisdictions. A first step in this
direction was the paper issued in 1975 that came to be known as the
"Concordat". The Concordat set out principles for sharing supervisory
responsibility for banks' foreign branches, subsidiaries and joint
ventures between host and parent (or home) supervisory authorities. In
May 1983, the Concordat was revised and re-issued as Principles for the
supervision of banks' foreign establishments.
In April 1990, a supplement to the 1983 Concordat was issued. This
supplement, Exchanges of information between supervisors of
participants in the financial markets, aimed to improve the cross-border
flow of prudential information between banking supervisors. In July
1992, certain principles of the Concordat were reformulated and
published as the Minimum standards for the supervision of
international banking groups and their cross-border establishments.
These standards were communicated to other banking supervisory
authorities, which were invited to endorse them.
In October 1996, the Committee released a report on The supervision
of cross-border banking, drawn up by a joint working group that
included supervisors from non-G10 jurisdictions and offshore centres.
The document presented proposals for overcoming the impediments to
effective consolidated supervision of the cross-border operations of
international banks. Subsequently endorsed by supervisors from 140
countries, the report helped to forge relationships between supervisors
in home and host countries.
The involvement of non-G10 supervisors also played a vital part in the
formulation of the Committee's Core principles for effective banking
supervision in the following year. The impetus for this document came
from a 1996 report by the G7 finance ministers that called for effective
supervision in all important financial marketplaces, including those of
emerging market economies. When first published in September 1997,
the paper set out 25 basic principles that the Basel Committee believed
should be in place for a supervisory system to be effective. After several
revisions, most recently in September 2012, the document now
includes 29 principles, covering supervisory powers, the need for early
intervention and timely supervisory actions, supervisory expectations of
banks, and compliance with supervisory standards.

Basel I: the Basel Capital Accord

With the foundations for supervision of internationally active banks
laid, capital adequacy soon became the main focus of the Committee's
activities. In the early 1980s, the onset of the Latin American debt crisis
heightened the Committee's concerns that the capital ratios of the main
international banks were deteriorating at a time of growing
international risks. Backed by the G10 Governors, Committee members
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 a broad consensus on a weighted
approach to the measurement of risk, both on and off banks' balance
sheets.
There was strong recognition within the Committee of the overriding
need for a multinational accord to strengthen the stability of the
international banking 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 was approved by the G10 Governors and released to
banks in July 1988.
The 1988 Accord called for a minimum ratio of capital to risk-weighted
assets of 8% to be implemented by the end of 1992. Ultimately, this
framework was introduced not only in member countries but also in
virtually all countries with active international banks. In September
1993, the Committee issued a statement confirming that G10 countries'
banks with material international banking business were meeting the
minimum requirements set out in the Accord.
The Accord was always intended to evolve over time. It was amended
in November 1991 to more precisely define the general provisions or
general loan loss reserves that could be included in the capital
adequacy calculation. In April 1995, the Committee issued another
amendment, to take effect at the end of that year, to recognise the
effects of bilateral netting of banks' credit exposures in derivative
products and to expand the matrix of add-on factors. In April
1996, another document was issued explaining how Committee
members intended to recognise the effects of multilateral netting.
The Committee also refined the framework to address risks other than
credit risk, which was the focus of the 1988 Accord. In January 1996,
following two consultative processes, the Committee issued
the Amendment to the Capital Accord to incorporate market risks (or
Market Risk Amendment), to take effect at the end of 1997. This was
designed to incorporate within the Accord a capital requirement for the
market risks arising from banks' exposures to foreign exchange, traded
debt securities, equities, commodities and options. An important aspect
of the Market Risk Amendment was that banks were, for the first time,
allowed to use internal models (value-at-risk models) as a basis for
measuring their market risk capital requirements, subject to strict
quantitative and qualitative standards. Much of the preparatory work
for the market risk package was undertaken jointly with securities
regulators.

Basel II: the New Capital Framework

In June 1999, the Committee issued a proposal for a new capital

adequacy framework to replace the 1988 Accord. This led to the release
of a revised capital framework in June 2004. Generally known as "Basel
II", the revised framework comprised three pillars:
1. minimum capital requirements, which sought to develop and expand
the standardised rules set out in the 1988 Accord
2. supervisory review of an institution's capital adequacy and internal
assessment process
3. effective use of disclosure as a lever to strengthen market discipline and
encourage sound banking practices
The new framework was designed to improve the way regulatory capital
requirements reflect underlying risks and to better address the financial
innovation that had occurred in recent years. The changes aimed at
rewarding and encouraging continued improvements in risk
measurement and control.
The framework's publication in June 2004 followed almost six years of
intensive preparation. During this period, the Basel Committee
consulted extensively with banking sector representatives, supervisory
agencies, central banks and outside observers in order to develop
significantly more risk-sensitive capital requirements.
Following the June 2004 release, which focused primarily on the
banking book, the Committee turned its attention to the trading book.
In close cooperation with the International Organization of Securities
Commissions (IOSCO), the international body of securities regulators,
the Committee published in July 2005 a consensus document governing
the treatment of banks' trading books under the new framework. For
ease of reference, this new text was integrated with the June 2004 text
in a comprehensive document released in June 2006: Basel II:
International convergence of capital measurement and capital
standards: A revised framework - Comprehensive version.
Committee members and several non-members agreed to adopt the
new rules, albeit on varying timescales. One challenge that supervisors
worldwide faced under Basel II was the need to approve the use of
certain approaches to risk measurement in multiple jurisdictions. While
this was not a new concept for the supervisory community - the Market
Risk Amendment of 1996 involved a similar requirement - Basel II
extended the scope of such approvals and demanded an even greater
degree of cooperation between home and host supervisors. To help
address this issue, the Committee issued guidance on information-
sharing in 2006, followed by advice on supervisory cooperation and
allocation mechanisms in the context of the advanced measurement
approaches for operational risk.

Towards Basel III

Even before Lehman Brothers collapsed in September 2008, the need

for a fundamental strengthening of the Basel II framework had become
apparent. The banking sector entered the financial crisis with too much
leverage and inadequate liquidity buffers. These weaknesses were
accompanied by poor governance and risk management, as well as
inappropriate incentive structures. The dangerous combination of these
factors was demonstrated by the mispricing of credit and liquidity risks,
and excess credit growth.
Responding to these risk factors, the Basel Committee issued Principles
for sound liquidity risk management and supervision in the same month
that Lehman Brothers failed. In July 2009, the Committee issued a
further package of documents to strengthen the Basel II capital
framework, notably with regard to the treatment of certain complex
securitisation positions, off-balance sheet vehicles and trading book
exposures. These enhancements were part of a broader effort to
strengthen the regulation and supervision of internationally active
banks, in the light of weaknesses revealed by the financial market crisis.
In September 2010, the Group of Governors and Heads of Supervision
(GHOS) announced higher global minimum capital standards for
commercial banks. This followed an agreement reached in July
regarding the overall design of the capital and liquidity reform package,
now referred to as "Basel III". In November 2010, the new capital and
 liquidity standards were endorsed at the G20 Leaders' Summit in Seoul
and subsequently agreed at the December 2010 Basel Committee
meeting.
The proposed standards were issued by the Committee in mid-
December 2010 (and have been subsequently revised). The December
2010 versions were set out in Basel III: International framework for
liquidity risk measurement, standards and monitoring and Basel III: A
global regulatory framework for more resilient banks and banking
systems. The enhanced Basel framework revised and strengthen the
three pillars established by Basel II. It also extended the framework with
several innovations:
an additional layer of common equity - the capital conservation
buffer - that, when breached, restricts pay-outs to help meet the
minimum common equity requirement
a countercyclical capital buffer, which places restrictions on
participation by banks in system-wide credit booms with the aim of
reducing their losses in credit busts
a leverage ratio - a minimum amount of loss-absorbing capital
relative to all of a bank's assets and off-balance sheet exposures
regardless of risk weighting
liquidity requirements - a minimum liquidity ratio, the Liquidity
Coverage Ratio (LCR), intended to provide enough cash to cover funding
needs over a 30-day period of stress; and a longer-term ratio, the Net
Stable Funding Ratio (NSFR), intended to address maturity mismatches
over the entire balance sheet
additional proposals for systemically important banks, including
requirements for supplementary capital, augmented contingent capital
and strengthened arrangements for cross-border supervision and
resolution
In January 2012, the GHOS endorsed a comprehensive process
proposed by the Committee to monitor members' implementation of
Basel III. The Regulatory Consistency Assessment Programme
 (RCAP) consists of two distinct but complementary workstreams
to monitor the timely adoption of Basel III standards, and to assess the
consistency and completeness of the adopted standards including the
significance of any deviations from the regulatory framework.
These tightened definitions of capital, significantly higher minimum
ratios and the introduction of a macroprudential overlay represent a
fundamental overhaul for banking regulation. At the same time, the
Basel Committee, its governing body and the G20 Leaders have
emphasised that the reforms will be introduced in a way that does not
impede the recovery of the real economy.
In addition, time is needed to translate the new internationally agreed
standards into national legislation. To reflect these concerns, a set of
transitional arrangements for the new standards was announced in
September 2010, although national authorities are free to impose
higher standards and shorten transition periods where appropriate.
The strengthened definition of capital will be phased in over five years:
the requirements were introduced in 2013 and should be fully
implemented by the end of 2017. Capital instruments that no longer
qualify as Common Equity Tier 1 capital or Tier 2 capital will be phased
out over a 10-year period, beginning 1 January 2013.
Turning to the minimum capital requirements, the higher minimums for
Common Equity and Tier 1 capital were phased in from 2013, and
became effective at the beginning of 2015. The schedule is as follows:
The minimum common equity and Tier 1 requirements increased
from 2% and 4% to 3.5% and 4.5%, respectively, at the beginning of 2013.
The minimum common equity and Tier 1 requirements rose to 4%
and 5.5%, respectively, at the beginning of 2014.
The final requirements for common equity and Tier 1 capital were
set at 4.5% and 6%, respectively, at the beginning of 2015.
The 2.5% capital conservation buffer, which will comprise common
equity and is in addition to the 4.5% minimum requirement, will be
phased in progressively starting on 1 January 2016, and will become
fully effective by 1 January 2019.
The leverage ratio will also be phased in gradually. The test (the so-
called "parallel run period") began in 2013 and will run until 2017, with
a view to migrating to a Pillar 1 treatment on 1 January 2018 based on
review and appropriate calibration. The exposure measure of the
leverage ratio was finalised in January 2014.
The liquidity coverage ratio (LCR) will be phased in from 1 January 2015
and will require banks to hold a buffer of high-quality liquid assets
sufficient to deal with the cash outflows encountered in an acute short-
term stress scenario as specified by supervisors. To ensure that banks
can implement the LCR without disruption to their financing activities,
the minimum LCR requirement began at 60% in 2015, rising in equal
annual steps of 10 percentage points to reach 100% on 1 January 2019.
The other minimum liquidity standard introduced by Basel III is the Net
Stable Funding Ratio. This requirement, which takes effect as a
minimum standard by 1 January 2018, will promote longer-term
funding mismatches and provide incentives for banks to use stable
funding sources.

BASEL I
What is 'Basel I'
Basel I is a set of international banking regulations put forth by
the Basel Committee on Bank Supervision (BCBS) that sets out the
minimum capital requirements of financial institutions with the goal of
minimizing credit risk. Banks that operate internationally are required
to maintain a minimum amount (8%) of capital based on a per cent of
risk-weighted assets. Basel I is the first of three sets of regulations
known individually as Basel I, II and III and together as the Basel
Accords.
Main Framework:
Basel I, that is, the 1988 Basel Accord, is primarily focused on credit
risk and appropriate risk-weighting of assets. Assets of banks were
classified and grouped in five categories according to credit risk,
carrying risk weights of 0% (for example cash, bullion, home country
debt like Treasuries), 20% (securitisations such as mortgage-backed
securities (MBS) with the highest AAA rating), 50% (municipal revenue
bonds, residential mortgages), 100% (for example, most corporate
debt), and some assets given No rating. Banks with an international
presence are required to hold capital equal to 8% of their risk-weighted
assets (RWA).
The tier 1 capital ratio = tier 1 capital / all RWA
The total capital ratio = (tier 1 + tier 2 + tier 3 capital) / all RWA
Leverage ratio = total capital/average total assets
Banks are also required to report off-balance-sheet items such as letters
of credit, unused commitments, and derivatives. These all factor into
the risk weighted assets. The report is typically submitted to the Federal
Reserve Bank as HC-R for the bank-holding company and submitted to
the Office of the Comptroller of the Currency (OCC) as RC-R for just the
bank.
From 1988 this framework was progressively introduced in member
countries of G-10, comprising 13 countries as of 2013
Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlan
ds, Spain, Sweden, Switzerland, United Kingdom and the United States
of America.
Implementation of Basel I
The BCBS regulations do not have legal force. Members are responsible
for their implementation in their home countries. Basel I originally
called for the minimum capital ratio of capital to risk-weighted assets of
8% to be implemented by the end of 1992. In September 1993, the
BCBS issued a statement confirming that G10 countries' banks with
material international banking business were meeting the minimum
requirements set out in Basel I.
According to the BCBS, the minimum capital ratio framework was
introduced in member countries and in virtually all other countries with
active international banks.
BASEL ACCORD:

The Basel Accords are three sets of banking regulations (Basel I, II and
III) set by the Basel Committee on Bank Supervision (BCBS), which
provides recommendations on banking regulations in regards to capital
risk, market risk and operational risk. The purpose of the accords is to
ensure that financial institutions have enough capital on account to
meet obligations and absorb unexpected losses.

Basel I

The first Basel Accord, known as Basel I, was issued in 1988 and focuses
on the capital adequacy of financial institutions. The capital adequacy
risk (the risk that a financial institution will be hurt by an unexpected
loss), categorizes the assets of financial institutions into five risk
categories (0%, 10%, 20%, 50% and 100%). Under Basel I, banks that
operate internationally are required to have a risk weight of 8% or less
POSITIVE IMPACTS
Despite a lot of criticism, the Basel 1 Accord was successful in many
ways. The first and incontestable achievement of the initiative was that
it created a worldwide benchmark for banking regulations. Designed
originally for internationally active banks of the G10 countries, it is now
the basis of the inspiration for banking regulations in more than 100
countries and is often imposed on national banks as well. Detractors will
say that it does not automatically produce a level playing field for banks,
which was one of the Accord targets, because banks with different risk
profiles can end up with the same capital requirement. But, at least,
international banks are now facing a uniform set of rules, which avoids
them having to discuss with each national regulator what the correct
capital level should be for conducting the same business in many
different countries. Additionally, banks of different countries competing
on the same markets have equivalent regulatory capital requirements.
That is clearly an improvement in comparison with the situation before
1988.
The introduction of different risk-weights for different assets classes,
although not reflecting completely the true risks of banks credit
portfolios, is a clear improvement on the previous regulatory ratios that
were used in some countries such as equity: assets or equity: deposits
ratios.
Has the Basel 1 Accord succeeded in making the banking sector a safer
place? Lot of research has been carried out on the subject but the
answer is still unclear. The capital ratios of most banks indeed increased
at the beginning of the 1990s (the capital ratios of the large G10 banks
went from an average of 9.3 percent in 1988 to 11.2 percent in 1996),
and bank failures diminished (for instance, yearly failures of FDIC-
insured banks in the US went from 280 in 1988 to fewer than 10 a year
between 1995 and 2000). But to what extent this amelioration of the
situation is attributable to Basel 1 or to other factors (such as better
economic conditions) is still an open question. But even without
empirical evidence, one can reasonably think that the capital ratio has
forced banks under the 8 percent value to get some fresh capital (or to
decrease their risk exposures) and that the G10 initiative has
contributed to a greater focus and a better understanding of the risks
associated with banking activities.

REGULATORY WEAKNESSES AND CAPITAL ARBITRAGE

Aside from the merits that we have emphasized above, we have to
recognize that the Basel 1988 Accord has a lot of deficiencies, which are
only increasing as time passes, bringing a constant flow of innovations
in financial markets. Since the 1990s, research on credit risk
management-related topics has brought tremendous innovations in the
way that banks handle their risk. Quantification techniques have
allowed sophisticated banks to make continuously more reliable and
precise estimates of their internal economic capital needs. Economic
capital (EC), as opposed to the regulatory capital that is required by the
regulating bodies, is the capital needed to support the banks risk-taking
activities as estimated by the bank itself. It is based on the banks
internal models and risk parameters. The result is that when a bank
estimates that its economic capital is above the regulatory capital level,
there is no problem. But if the regulatory capital level is higher than
economic capital, it means that the bank has to maintain a capital level
in excess of what it estimates as an adequate level, thereby destroying
shareholder value. The response of sophisticated banks is what is called
capital arbitrage. This means making an arbitrage between regulatory
and economic capital to align them more closely it can be done by
engaging in new operations that consume more economic than
regulatory capital. As long as these new operations are correctly priced,
they will increase the returns to the shareholders. Capital arbitrage in
itself is not a bad thing, as it allows banks to correct the regulatory
constraints weaknesses that are recognized even by the regulators
themselves. However, the more this practice spreads and the more it is
facilitated by financial innovations, the less the 1988 Basel Capital
Accord remains efficient.
Banks use various capital arbitrage techniques. The simpler one consists
of investing, inside a risk-weight band, in riskier assets. For instance, if
the bank wants to buy bonds on the capital markets, it can buy
speculative-grade bonds that provide high interest rates while requiring
the same regulatory capital as investment-grade bonds (that they could
sell to finance the operation).
The economic capital consumed by the deal should be higher than the
regulatory capital, allowing the bank to use the excess economic capital
it has to hold because of regulatory constraints. The more sophisticated
techniques that are now used are recourse to securitization and to
credit derivatives. The banks show an innovative spirit in creating new
financial instruments that allow them to lower their capital
requirements even if they dont really lower their risk. The regulators
then adapt the 1988 rules to cover these new instruments, but always
with some delay.

Securitization
Securitization consists generally of transferring some illiquid assets,
such as loans, to an independent company called a Special Purpose
Vehicle (SPV).
The SPV buys the loans to the bank and funds itself by issuing securities
that are backed by them (Asset Backed Securities, ABS). Usually, the
bank provides some form of credit enhancement to the structure by,
for instance, granting a subordinated loan to the SPV. Or, simply, the
SPV-issued debts are structured in various degrees of seniority, and the
bank buys the lowest one. The result is that the repayment of the SPVs
debts is made with the cash flows generated by the securitized loans.
The more senior loans are paid first, and so on, until the so-called
equity tranche (the more junior loans) that is often kept by the bank.
The securities bought by investors have a better quality than the
underlying loans because the first losses of the pool are absorbed by
the equity tranche. This creates attractive investment opportunities for
investors but it means that the main part of the risk is still in the banks
balance sheet.

Other main weaknesses of the Accord, besides the possibility to lower

Capital requirements while keeping the risk level almost unchanged are:

The lack of risk sensitivity. For instance, a corporate loan to a small

company with high leverage consumes the same regulatory capital
as a loan to a AAA-rated large corporate company (8 per cent,
because they are both risk-weighted at 100 per cent).
A limited recognition of collateral. As we saw in Chapter 1, the list
of eligible collateral and guarantors is rather limited in comparison
to those effectively used by the banks to mitigate their risks.
An incomplete coverage of risk sources. Basel 1 focused only on
credit risk.

The 1996 Market Risk Amendment filled an important gap, but there
are still other risk types not covered by the regulatory requirements:
operational risk, reputation risk, strategic risk. A one-size-fits all
approach. The requirements are virtually the same, whatever the risk
level, sophistication, and activity type, of the bank.

An arbitrary measure. The 8 per cent ratio is arbitrary and not based on
explicit solvency targets.

No recognition of diversification. The credit-risk requirements are only

additive and diversification through granting loans to various sectors
and regions is not recognized.

In conclusion, although Basel 1 was beneficial to the industry, the time

has come to move to a more sophisticated regulatory framework. The
Basel 2 proposal, despite having already received its share of criticism,
is a major step in the right direction. It addresses a lot of Basel 1s
criticisms and, in addition to ameliorating the way the 8 per cent capital
ratio is calculated, emphasizes the role of regulators and of banks
internal risk management systems. It creates a positive ascending spiral
that is forcing many actors in the sector to increase their knowledge
level, or at least for those that already use sophisticated approaches
to discuss openly the various existing techniques that are far from
receiving a consensus among either industry or researchers.

BREAKING DOWN 'Basel Accord'

The BCBS was founded in 1974 as a forum for regular cooperation
between its member countries on banking supervisory matters. The
BCBS describes its original aim as the enhancement of "financial
stability by improving supervisory knowhow and the quality of banking
supervision worldwide." Later on, it turned its attention to monitoring
and ensuring the capital adequacy of banks and the banking system.

BREAKING DOWN 'Basel I'

The BCBS was founded in 1974 as an international forum where
members could cooperate on banking supervision matters. The BCBS
aims to enhance "financial stability by improving supervisory know-how
and the quality of banking supervision worldwide." This is done through
regulations known as accords. Basel I was the first accord. It was issued
in 1988 and focused mainly on credit risk by creating a bank asset
classification system.
Bank Asset Classification System
The Basel I classification system groups a bank's assets into five risk
categories, classified as percentages: 0%, 10%, 20%, 50% and 100%. A
bank's assets are placed into a category based on the nature of the
debtor.
The 0% risk category is comprised of cash, central bank and
government debt, and any Organization for Economic Cooperation and
Development (OECD) government debt. Public sector debt can be
placed in the 0%, 10%, 20% or 50% category, depending on the debtor.
Development bank debt, OECD bank debt, OECD securities firm debt,
non-OECD bank debt (under one year of maturity), non-OECD public
sector debt and cash in collection comprises the 20% category. The 50%
category is residential mortgages, and the 100% category is represented
by private sector debt, non-OECD bank debt (maturity over a year), real
estate, plant and equipment, and capital instruments issued at other
banks.
The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8%
of its risk-weighted assets. For example, if a bank has risk-weighted
assets of $100 million, it is required to maintain capital of at least $8
million.

BASEL II:

Basel II is a set of international banking regulations put forth by

the Basel Committee on Bank Supervision, which levelled the
international regulation field with uniform rules and guidelines. Basel II
expanded rules for minimum capital requirements established under
Basel I, the first international regulatory accord, and provided
framework for regulatory review, as well as set disclosure requirements
for assessment of capital adequacy of banks. The main difference
between Basel II and Basel I is that Basel II incorporates credit risk of
assets held by financial institutions to determine regulatory capital
ratios.
Basel II is an international business standard that requires financial
institutions to maintain enough cash reserves to cover risks incurred by
operations. The Basel accords are a series of recommendations on
banking laws and regulations issued by the Basel Committee on Banking
Supervision (BSBS). The name for the accords is derived from Basel,
Switzerland, where the committee that maintains the accords meets.

Basel II improved on Basel I, first enacted in the 1980s, by offering more

complex models for calculating regulatory capital. Essentially, the
accord mandates that banks holding riskier assets should be required to
have more capital on hand than those maintaining safer portfolios.
Basel II also requires companies to publish both the details of risky
investments and risk management practices. The full title of the accord
is Basel II: The International Convergence of Capital Measurement and
Capital Standards - A Revised Framework.

The three essential requirements of Basel II are:

1. Mandating that capital allocations by institutional managers are

more risk sensitive.
2. Separating credit risks from operational risks and quantifying both.
3. Reducing the scope or possibility of regulatory arbitrage by
attempting to align the real or economic risk precisely with
regulatory assessment.
Basel II has resulted in the evolution of a number of strategies to allow
banks to make risky investments, such as the subprime mortgage
market. Higher risks assets are moved to unregulated parts of holding
companies. Alternatively, the risk can be transferred directly to
investors by securitization, the process of taking a non-liquid asset or
groups of assets and transforming them into a security that can be
traded on open markets.

The Basel II Accord:

The Basel ii Accord (or, the International Convergence of Capital
Measurement and Capital Standards: A Revised Framework) presents
the outcome of the Basel Committee on Banking Supervision's ("the
Committee") work over recent years to secure international
convergence on revisions to supervisory regulations governing the
capital adequacy of internationally active banks.

Following the publication of the Committee's first round of proposals

for revising the capital adequacy framework in June 1999, an extensive
consultative process was set in train in all member countries and the
proposals were also circulated to supervisory authorities worldwide.
The Committee subsequently released additional proposals for
consultation in January 2001 and April 2003 and furthermore
conducted three quantitative impact studies related to its proposals. As
a result of these efforts, many valuable improvements have been made
to the original proposals.

The Basel II Accord sets out the details of the agreed Framework
for measuring capital adequacy and the minimum standard to be
achieved. This Framework and the standard it contains have
been endorsed by the Central Bank Governors and Heads of Banking
Supervision of the Group of Ten countries.

The fundamental objective of the Committee's work to revise the 1988

Accord has been to develop a framework that would further
strengthen the soundness and stability of the international banking
system while maintaining sufficient consistency that capital adequacy
regulation 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 that, in their comments on the
proposals, banks and other interested parties have welcomed the
concept and rationale of the three pillars (minimum capital
requirements, supervisory review, and market discipline) approach 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.

In developing the revised Framework, the Committee has sought to

arrive at significantly more risk-sensitive capital requirements that are
conceptually sound and at the same time pay due regard to particular
features of the present supervisory and accounting systems in individual
member countries. It believes that this objective has been achieved.

The Committee is also retaining key elements of the 1988 capital

adequacy framework, including the general requirement for banks to
hold total capital equivalent to at least 8% of their risk-weighted assets;
the basic structure of the 1996 Market Risk Amendment regarding the
treatment of market risk; and the definition of eligible capital.

A significant innovation of the revised Framework is the greater use of

assessments of risk provided by banks' internal systems as inputs to
capital calculations. In taking this step, the Committee is also putting
forward a detailed set of minimum requirements designed to ensure
the integrity of these internal risk assessments. 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 a set of review procedures for ensuring

that banks' systems and controls are adequate to serve as the basis for
the capital calculations. Supervisors will need to exercise sound
judgements when determining a bank's state of readiness, particularly
during the implementation process. The Committee expects national
supervisors will focus on compliance with the minimum requirements
as a means of ensuring the overall integrity of a bank's ability to provide
prudential inputs to the capital calculations and not as an end in itself.

The revised Framework provides a range of options for determining the

capital requirements for credit risk and operational risk to allow banks
and supervisors to select approaches that are most appropriate for their
operations and their financial market infrastructure.

In addition, the Framework also allows for a limited degree of national

discretion in the way in which each of these options may be applied, to
adapt the standards to different conditions of national markets. These
features, however, will necessitate substantial efforts by national
authorities to ensure sufficient consistency in application.

The Committee intends to monitor and review the application of the

Framework in the period ahead with a view to achieving even greater
consistency. In particular, its Accord Implementation Group (AIG) was
established to promote consistency in the Framework's application by
encouraging supervisors to exchange information on implementation
approaches.
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 AIG is developing practical arrangements for cooperation and

coordination that reduce implementation burden on banks and
conserve supervisory resources.Based on the work of the AIG, and
based on its interactions with supervisors and the industry, the
Committee has issued general principles for the cross-border
implementation of the revised Framework and more focused principles
for the recognition of operational risk capital charges under advanced
measurement approaches for home and host supervisors.

It should be stressed that the revised Framework is designed to

establish minimum levels of capital for internationally active banks. As
under the 1988 Accord, national authorities will be free to adopt
arrangements that set higher levels of minimum capital.

Moreover, they are free to put in place supplementary measures of

capital adequacy for the banking organisations they charter. National
authorities may use a supplementary capital measure as a way to
address, for example, the potential uncertainties in the accuracy of the
measure of risk exposures inherent in any capital rule or to constrain
the extent to which an organisation may fund itself with debt.

Where a jurisdiction employs a supplementary capital measure (such as

a leverage ratio or a large exposure limit) in conjunction with the
measure set forth in this Framework, in some instances the capital
required under the supplementary measure may be more binding.
More generally, under the second pillar, supervisors should expect
banks to operate above minimum regulatory capital levels.
The revised Framework is more risk sensitive than the 1988 Accord, but
countries where risks in the local banking market are relatively high
nonetheless need to consider if banks should be required to hold
additional capital over and above the Basel minimum. This is
particularly the case with the more broad brush standardised approach,
but, even in the case of the internal ratings-based (IRB) approach, the
risk of major loss events may be higher than allowed for in this
Framework.

The Committee also wishes to highlight the need for banks and
supervisors to give appropriate attention to the second (supervisory
review) and third (market discipline) pillars of the revised Framework.It
is critical that the minimum capital requirements of the first pillar be
accompanied by a robust implementation of the second, including
efforts by banks to assess their capital adequacy and by supervisors to
review such assessments. In addition, the disclosures provided under
the third pillar of this Framework will be essential in ensuring that
market discipline is an effective complement to the other two pillars.

GOALS OF THE ACCORD

It is instructive to look at the three stated Committee objectives:

To increase the quality and the stability of the international
banking system.
To create and maintain a level playing field for internationally
active banks.
To promote the adoption of more stringent practices in the risk
management field.
The first two goals are those that were at the heart of the 1988Accord.
The last is new, and is said by the Committee itself to be the most
important. This is the sign of the beginning of a shift from ratio-based
regulation, which is only a part of the new framework, towards a
regulation that will rely more and more on internal data, practices, and
models. This evolution is similar to what happened in market-risk
regulation, where internal models became allowed as the basis for
capital requirements. That is why, backstage, people are already
speaking of a Basel 3 Accord that would fully recognize internal credit
risk models. Numerous contacts had to be created between regulators
and the sector through joint forums and consultations to set up Basel 2;
this built precious communications structures that are expected to be
maintained even after Basel 2s implementation date to keep working
on what will be the regulation for the 2010s. This evolution is even
highlighted in the final text itself:
The Committee understands that the IRB [Internal Rating-Based]
approach represents a point on the continuum between purely
regulatory measures of credit risk and an approach that builds more
fully on internal credit risk models. In principle, further movements
along that continuum are foreseeable, subject to an ability to address
adequately concerns about reliability, comparability, validation
and competitive equity. (Basel Committee on Banking Supervision,
2004d)

OPEN ISSUES

At the time of writing, there are still some open issues that the
Committee plans to fix before the implementation date. The five most
important ones are:
The recognition of double default. In a nutshell, the current
proposal treats exposures that benefit from a guarantee or that
are covered by a credit derivative (which means that to lose
money the bank would have to incur a double default, that of its
counterparty and that of its protection provider) as if the exposure
was directly held against the guarantor. Of course, this treatment
 understates the true protection level as it supposes a perfect
correlation between the risk of the counterparty and the risk of
the hedge. This could lead to a weak incentive for banks to
effectively hedge their risk from a regulatory capital consumption
perspective.
The definition of Potential Future Exposures (PFEs). This point has
been actively debated with IOSCO as it is especially important for
banks with large trading books of derivative exposures (securities
firms). Since the new Accord introduces a credit risk capital
requirement for some trading book positions, the way PFE are
evaluated will have a material impact on this sector.
The definition of eligible capital. The definition currently
applicable is the one of 1988 updated by a 1998 press release:
Instruments eligible for inclusions in Tier 1 capital (Basel
Committee on Banking Supervision, 1998) but further work is
expected on this issue.
The scaling factor. As mentioned above, the regulators target is
to maintain the global level of capital in the banking sector. As the
last tests made on QIS 3 data seem to show a small decrease
under the IRB approach (following the Madrid Compromise that
accepted that capital requirements could be based only on the
unexpected loss part of a credit portfolio, excluding the expected
loss: we shall discuss this in detail later the regulators should
require a scaling factor currently estimated at 1.06. This means
that IRB capital requirements would be scaled up by 6 percent.
The exact value of this adjustment will be fixed after the parallel
run period.
Accounting issues. The Committee is aware of possible distortions
arising from the application of the same rules under different
accounting regimes, and will keep on monitoring these issues. The
trend is toward international standardization, mainly with the new
International Accounting Standards (IAS) that will be implemented
in banks in the same time frame as the new Accord. But if this
 helps to limit the problems associated with different accounting
practices, it raises new questions, one of the most important
being the definition of capital, that could become a much more
volatile element if all gains and losses on assets and liabilities are
valued MTM and passed through the profit and loss (P&L)
accounts, as required by the controversial IAS 39 rule.

SCOPE OF APPLICATION

As with the 1988 Accord, Basel 2 is only a set of recommendations for

the G10 countries. But as with the 1988Accord also, it is expected to be
translated into laws in Europe, North America, and Japan, and should
reach finally the same coverage, which means that it will be the basis of
regulation in more than 100 countries. The Accord is supposed to be
applied on a consolidated basis for internationally active banks,
including at the levels of the holdings.
National banks that are not within the scope of the Accord are,
however, supposed to be under the supervision of their national
authorities that should ensure that they have a sufficient capital level.
That is the theory. In practice, the Accord will be mandatory for all
banks and securities firms, even at the national level, in many countries.
This will certainly be the case in Europe. On the other hand, in the US,
the most advanced options of Basel 2 will be imposed only on a small
group of very large banks (it is the position of US regulating bodies at
the time of writing) while all the others will remain subject to the
current approach (the 1988 Accord).

TREATMENT OF PARTICIPATIONS

The risk of double gearing has always been an issue for the regulators.
Important participations that are not consolidated are treated as a
function of their nature in the way.
Majority-owned financial companies that are not consolidated have to
be deducted from equity. If the subsidiary has any capital shortfall, it
will also be deducted from the parent companys capital base. Minority
investments that are significant (to be defined by the national
regulators, in Europe the criterion is between 20 percent and 50
percent) have to be deducted or can be consolidated on a pro rata basis
when the regulators are convinced that the parent company is prepared
to support the entity on a proportionate basis.
Significant participations in insurance companies have in principle to be
deducted from equity. However, some G10 countries will apply other
methods because of competitive equality issues. In any case, the
Committee requires that the method include a group-wide perspective
and avoid double counting of capital.
Participations in commercial companies receive a normal risk-weight
(With a minimum of 100 percent) up to an individual (15 percent of
capital) and an aggregated (60 percent of capital) threshold. Amounts
above those reference values (or a stricter level at national discretion)
will have to be deducted from the capital base.

STRUCTURE OF THE ACCORD

The Basel 2 Accord is structured in three main pillars (pillars 13) the
three complementary axes designed to support the global objectives of
financial stability and better risk management practices (see Figure 4.5
opposite).

Pillar 1

This is the update of the 1988 solvency ratio. Capital: RWA is still viewed
as the most relevant control ratio, as capital is the main buffer against
losses when profits become negative. The 8 percent requirement is still
the reference value, but the way assets are weighted has been
significantly refined.
The 1988 values were rough estimates while the Basel 2 values are
directly and explicitly derived from a standard simplified credit risk
model. Capital requirements should now be more closely aligned to
internal economic capital estimates (the adequate capital level
estimated by the bank itself, through its internal models). There are
three approaches, of increasing complexity, to compute the risk-
weighted assets (RWA) for credit risk. The more advanced are designed
to consume less capital while they impose heavier qualitative and
quantitative requirements on internal systems and processes. This is an
incentive for banks to increase their internal risk management
practices. As well as more explicit capital requirements by function of
risk levels, an important extension of the types of collateral that are
recognized to offset the risks is another incentive to produce a more
systematic collateral management practice. This is also significant
improvement on the current Accord, where the scope of eligible
collateral is rather limited.
Another important innovation in pillar 1 is a new requirement for
operational risk. In the new Accord there is an explicit capital
requirement for risks related to possible losses arising from errors in
processes, internal frauds, information technology (IT) problems . . .
Again, there are three approaches, of increasing complexity, that are
available. The eligible capital must cover at least 8 percent of the risk-
weighted requirements related to three broad kinds of risks .

Pillar 2

The second axis of the regulatory framework is based on internal

controls and supervisory review. It requires banks to have internal
systems and models to evaluate their capital requirements in parallel to
the regulatory framework and integrating the banks particular risk
profile. Banks must also integrate the types of risks not covered (or not
fully) by the Accord, such as reputation risk and strategic risk,
concentration credit risk, interest rate risk in the banking book (IRBBB) .
Under pillar 2, regulators are also expected to see that the
requirements of pillar 1 are effectively respected, and evaluate the
appropriateness of the internal models set up by the banks. If the
regulators consider that capital is not sufficient, they can take various
actions to remedy the situation. The most obvious are requiring the
bank to increase its capital base, or restricting the amount of new
credits that can be granted, but measures can also focus on increasing
the quality of internal controls and policies.
The new Accord states explicitly those banks are expected to operate
under a capital level higher than 8 percent, as pillar 2 has to capture
additional risk sources.
Pillar 2 is very flexible because it is not very prescriptive (it represents 8
pages out of the 239 of the full Accord). Some have argued that this is a
weakness, as regulators are left with too much subjectivity, which could
undermine the level playing field objective. But it is at the same time
the most interesting part of the framework, as it will oblige regulators
and banks to cooperate closely on the evaluation of internal models. No
doubt the regulators will use benchmarking as one of the tools to
evaluate the banks different approaches. This will create the dynamic
necessary to standardize and better understand the heterogeneous
ways credit risks are currently evaluated, and will ultimately pave the
way to internal model recognition and its use as a basis for calculating
capital requirements, as happened with market risk.

Pillar 3

This concerns market-discipline, and the requirements are related to

disclosures. Banks are expected to build comprehensive reports on their
internal risk management systems and on the way the Basel 2 Accord is
being implemented. Those reports will have to be publicly disclosed to
the market at least twice a year. This raises some confidentiality issues
in the sector, since the list of elements to be published is impressive:
description of risk management objectives and policies; internal loss
experience, by risk grade; collateral management policies; exposures,
by maturity, by industry, and by geographical location; options chosen
for Basel 2 . . . The goal is to let the market place an additional pressure
on banks to improve their risk management practices. No doubt bank
credit and equity analysts, bond investors, and other market
participants will find the disclosed information very useful in evaluating
a banks soundness.

THE TIMETABLE

The timetable for implementation is year-end 2006 for Standardized

and IRBF Approaches and year-end 2007 for the IRBA and the Advanced
Measurement Approach (AMA) methods (it has been delayed several
times since the Accord was first issued) (see Table 4.1). Before those
dates, parallel calculations will be required (calculations of capital
requirements under the Basel 1988 and the Basel 2 methods). In the
early years after implementation, floors will be fixed that will prevent
banks having new required capital levels below those calculated with
the current approach multiplied by a scaling factor.

The six most noteworthy innovations of Basel 2 are the:

Increased sensitivity of capital requirements to risk levels. Introduction
of regulatory capital needs for operational risk. Important flexibility of
the Accord, through several options being left at the discretion of the
national regulators. Increased power of the national regulators, as they
are expected under pillar 2 to evaluate a banks capital adequacy
considering its specific risk profile.
Better recognition of risk reduction techniques. Detailed mandatory
disclosures of risk exposures and risk policies. Those measures should
help the global industry to progress in its general understanding of
credit risk management issues and constitute the intermediary step
before full internal model recognition.

Basel 2 requirements

Basel 2 requirements cover both traditional securitizations and

synthetic securitizations.

Traditional securitizations

Traditional securitizations are structures were the cash flows from an

underlying pool are used to service at least two different tranches of a
debt structure that bear different levels of credit risk (as the cash flows
are used first to repay the more senior debt, then the second layer, and
so on ). The difference with classical senior and subordinated debts is
that lower tranches of the debt structure can absorb losses while the
others are still serviced, whereas classical senior and subordinated debt
is an issue of priority only in the case of the liquidation of a company.

Synthetic securitizations

Synthetic securitizations are structures where the underlyings are not

physically transferred out of the balance sheet of the originating
bank, but only the credit risk is covered through the use of funded (e.g.
credit-linked notes) or unfunded (e.g. credit default swaps) credit
derivatives.
Originating and investing banks involved in a securitization structure can
be either an originator or an investor.

Originating banks
Originating banks are those that originate, directly or indirectly, the
securitized exposures, or that serve as a sponsor on an Asset-Backed
Commercial Paper (ABCP) program (as a sponsor, the bank will usually
manage or advise on the program, place securities in the market, or
provide liquidity and/or credit enhancements). Originating banks can
exclude securitized exposures from the calculation of the RWA if they
meet certain operational requirements.
For cash securitization, the assets have to be effectively transferred to
an SPV and the bank must not have any direct or indirect control on the
assets transferred. For synthetic securitization (where assets are
effectively not transferred to a third party but their credit risk is hedged
through credit derivatives), the credit risk mitigates used to transfer the
credit risk must fulfill the requirements of the Standardized Approach.
Eligible collateral and guarantors are those of the Standardized
Approach, and the instruments used to transfer the risk may not
contain terms or conditions that limit the amount of risk.
Effectively transferred (e.g. clauses that increase the banks cost of
credit protection in response to any deterioration in the pools quality).
Originating banks that provide implicit support to the securitized
exposures (they would buy them back if the structure was turning sour)
in order to protect their reputation, must compute their capital
requirements as if the underlying exposures were still in their balance
sheet. Clean-up calls (options that permit an originating bank to call the
securitized exposures before they have been repaid when the remaining
amount falls below some threshold) may be subject to regulatory
capital requirements.
To avoid this, they must not be mandatory (but at the discretion of
originating banks), they must not be structured to provide credit
enhancement, and they must be allowed only when less than 10
percent of the original portfolio value remains. If those conditions are
not respected, exposures must be risk-weighted as if they were not
securitized.
Investing banks

Investing banks are those that bear the economic risk of a securitization
exposure. Those exposures can arise from the provision of credit risk
mitigates to a securitization transaction, investment in asset-backed
securities, retention of a subordinated tranche, and extension of a
liquidity facility or credit enhancement.

The Standardized Approach

Banks that apply the Standardized Approach to credit risk for the type
of underlying exposures securitized must use the Standardized
Approach under the securitization framework. The RWA of the exposure
is then a function of its external rating.
Banks that invest in exposures that they originate themselves that
receive an external rating below BBB must deduct them from their
capital base.
For off-balance sheet exposures, CCF are used (if they are externally
rated, the CCF is 100 percent). This is usually 100 percent except for
eligible liquidity facilities.

There are three exceptions to the deduction of unrated securitization

exposures. First, the most senior tranche can benefit from a look
through approach if the composition of the underlying pool is known
at all times.
This means that it receives the average risk-weight of the securitized
assets (if it can be determined).
Secondly, second loss or better in ABCP programs that have an
associated credit risk equivalent to investment grade, and when the
bank does not hold the first loss, can receive the higher risk-weight
assigned to any of the individual exposures (with a minimum of 100
percent).
Thirdly, eligible liquidity facilities can receive the higher risk-weight
assigned to any of the individual exposures covered by the facility.
Eligible liquidity facilities are off-balance sheet exposures that meet the
following four requirements:
Draws under the facility must be limited to the amount that is likely to
be repaid fully from the liquidation of the underlying exposures: it must
not be drawn to provide credit enhancement.
The facility must not be drawn to cover defaulted assets, and funded
exposures that are externally rated must be at least investment grade
(at the time the facility is drawn). When all credit enhancements that
benefit the liquidity line are exhausted, the facility cannot be drawn any
longer. Repayment of draws on the facility must not be subordinated to
any interest of any holder in the program or subject to deferral or
waiver. Eligible liquidity facilities can benefit from a 20 percent CCF if
they have an original maturity less than one year and a 50 percent CCF
if their original maturity is greater than one year (instead of the default
100 percent CCF).
In three other special cases, eligible liquidity facilities can receive a
0 percent CCF: When they are available only in case of market
disruption (e.g. when more than one securitization vehicle cannot roll
over maturing commercial paper for other reasons than credit-quality
problems). When there are overlapping exposures: in some cases, the
same bank can provide several facilities that cannot be drawn at the
same time (when one is drawn the others cannot be used). In those
cases, only the facility with the highest CCF is taken into account, the
other not being risk-weighted.
Certain servicer cash advance facilities can also receive a 0 percent CCF
(Subject to national discretion), if they are cancellable without prior
notice and have senior rights on all the cash flows until they are
reimbursed.
Credit risk mitigants can offset the risk of securitization exposures.
Eligible collateral is limited to that recognized in the Standardized
Approach. The early amortization provision is an option that allows
investors to be repaid before the original stated maturity of the
securities issued. They can be controlled or not. They are considered as
controlled when:
The bank has a capital/liquidity plan to cover early amortization.
Throughout the duration of the transaction, including the amortization
period, there is the same pro rata sharing of interest, principal,
expenses, losses, and recoveries based on the banks and investors
relative shares of the receivables outstanding at the beginning of each
month. The bank has set a period for amortization that would be
sufficient for at least 90 percent of the total debt outstanding at the
beginning of the early amortization period to have been repaid or
recognized as in default. The pace of repayment should not be any
more rapid than would be allowed by straight-line amortization over the
period set out. Originating banks are required to hold capital against
investors interests when the structure contains an early amortization
provision and when the exposures sold are of a revolving nature. Four
exceptions are: Replenishment structures, where the underlying
exposures do not revolve and the early amortization ends the ability of
the bank to add new exposures.
Transactions of revolving assets containing early amortization features
that mimic term structures (i.e. where the risk on the underlying
facilities does not return to the originating bank) .
Structures where a bank securitizes one or more credit line(s) and
where investors remain fully exposed to future draws by borrowers
even after an early amortization event has occurred.
The early amortization clause is triggered solely by events not related to
the performance of the securitized assets or the selling bank such as
material changes in tax laws or regulations.
In other cases, the capital requirement is equal to the product of the
revolving part of the exposures, the appropriate risk-weight (as if it had
not been securitized), and a CCF. The CCF depends upon whether the
early amortization repays investors through a controlled or non-
controlled mechanism, and upon the nature of the securitized credit
lines (uncommitted retail lines or not). Its level is a function of the
average three-months excess spread (gross income of the structure
minus certificate interest, servicing fees, charge-offs, and other
expenses), and the excess spread trapping point (the point at which the
bank is required to trap the excess spread as economically required by
the structure, by default 4.5 percent).
IRB approaches Banks that have received approval to use the IRB
Approach for the type of exposures securitized must use the IRB
approach to securitization. Under the IRB Approach, there are three
sub-approaches: The Rating-Based Approach (RBA), that must be
applied when the securitized tranche has external or internal ratings.
The Supervisory Formula (SF), used when there are no available ratings.
The Internal Assessment Approach (IAA), also used when there are no
available ratings but only for exposures extended to ABCP programs.
The capital requirements are always limited to a maximum
corresponding to the capital requirements had the exposures not been
securitized.
In the RBA, a risk-weight is assigned by function of an external or
internal inferred rating (that can be assigned with reference to an
external rating already given to another tranche that is of equal
seniority or more junior and of equal or shorter maturity), the
granularity of the pool, and the seniority of the position. The granularity
is determined by calculating the effective number of positions N, with
the following formula:

IRB approaches banks that have received approval to use the IRB
Approach for the type of exposures securitized must use the IRB
Approach to securitization. Under the IRB Approach, there are three
sub-approaches:
The Rating-Based Approach (RBA), that must be applied when the
securitized tranche has external or internal ratings.
The Supervisory Formula (SF), used when there are no available ratings.
The Internal Assessment Approach (IAA), also used when there are no
available ratings but only for exposures extended to ABCP programs.
The capital requirements are always limited to a maximum
corresponding to the capital requirements had the exposures not been
securitized.
In the RBA, a risk-weight is assigned by function of an external or
internal inferred rating (that can be assigned with reference to an
external rating already given to another tranche that is of equal
seniority or more junior and of equal or shorter maturity), the
granularity of the pool, and the seniority of the position. The granularity
is determined by calculating the effective number of positions N.
The IAA applies only to ABCP programs. Banks can use their internal
ratings if they meet three operational requirements:
_ The ABCP must be externally rated (the underlying, not the securitized
tranche).
_ The internal assessment of the tranche must be based on ECAI criteria
and used in the banks internal risk management systems.
_ A credit analysis of the asset sellers risk profile must be performed.
The risk-weight associated with the internal rating is then the same as in
the RBA The SF is used when there is no external rating, no inferred
internal rating, and no internal rating given to an ABCP program. The
capital requirement is a function of: the IRB capital charge had the
underlying exposures not been securitized (KIRB), the tranches credit
enhancement level (L) and thickness (T), the pools effective number of
exposures (N), and the pools exposure-weighted average loss given
default (LGD).

Beta refers to the cumulative Beta distribution. Parameters and

equal, respectively, 1,000 and 20. KIRB is the ratio of the IRB
requirement including EL for the underlying exposures of the pool and
the total exposure amount of the pool. L is the ratio of the amount of all
securitization exposures subordinate to the tranche in question to the
amount of exposures in the pool.
T is measured as the ratio of the nominal size of the tranche of interest
to the notional amount of exposures in the pool.
The securitization framework of Basel 2 is an important improvement
over the current rules. This is a critical issue, as many capital arbitrage
operations under the current Accord rules are done through
securitization. Coming from simplified propositions at the beginning of
the consultative process, the regulators ended with much more refined
approaches in the final document thanks to an intense debate with the
sector. This debate helped the sector itself to progress in its
understanding of the main risk drivers of securitization. The SF is
directly derived from a model proposed by Gordy (interested readers
can consult Gordy and Jones, 2003; a detailed description of the model
specifications is available on the BIS website). It integrates the
underlying pool granularity, credit quality, asset correlation, and tranche
thickness. Of course, each deal has its own specific structure and
features that make it unique and it is very hard to find an analytical
formula that captures precisely its risks; only a full-blown simulation
approach (Monte Carlo simulations) can offer enough flexibility to be
adapted to each operation. Even the RBA integrates the fact that a
corporate bond AAA is not a securitized exposure AAA. It is widely
recognized that a securitization tranche with a good rating is less risky
than its corporate bond counterpart (except perhaps in leveraged
structures), and that a securitization tranche with a low rating is much
more risky than a corporate bond with the same rating.
Looking at the risk-weighting given by the regulators we can see that it
is integrated in the risk-weighting scheme). Of course, not everybody
agrees with the given weights (especially the 7 percent floor of a
minimum RWA in both the RBA and SF approaches), but as we said the
main risk drivers are incorporated in the formula and the approach is
significantly improved compared to current rules. And before putting
the new framework to the test the industry had to admit that there
were still (even if the situation has improved over recent years) a lot of
market participants, even among banks, that invest in securitization
without having fully understood all the risks involved in such deals. The
debate catalyzed by Basel 2 and the relative sophistication of the
proposed formula will without any doubt help in the diffusion of a
better understanding of these issues.
OPERATIONAL RISK
Operational risk is defined as 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. Capital requirements can be defined using three approaches, that
have each their own specific quantitative and qualitative requirements.
Basic Indicator Approach (BIA) The simplest method considers only that
the amount of operational risk is proportional to the size of the banks
activities, estimated through their gross income (net interest and
commission income gross of provisions and operating expenses, and
excluding profit/losses from the sale of securities in the banking book
and extraordinary items). The capital requirement is then the average
positive gross income over the last three years multiplied by 15 percent.
There are no specific requirements for banks to be allowed to use the
BIA.

Standardized Approach (SA)

This is close to the BIA, except that banks activities are divided into
eight business lines and each one has its own capital requirement as a
function of its specific gross income. Again, the average gross income
over the last three years must be calculated. But this time the negative
gross income of one business line can offset the capital requirements of
another (as long as the sum of capital requirements over the year is
positive)
To be allowed to use the SA Approach, banks must fulfill a number of
operational requirements: Board of directors and senior management
must be actively involved in the supervision of the operational risk
framework. Banks must have sufficient resources involved in
Operational Risk Management (ORM) in each business line and in the
audit department. There must be an independent ORM function, with
clear responsibilities for tracking and monitoring operational risks.
There must be a regular reporting of operational risk exposures and
material losses. The banks ORM systems must be subject to regular
review by external auditors and/or supervisors. Advanced
Measurement Approach (AMA) as with VAR models for market risk and
internal rating systems, the regulators offer the banks the opportunity
with the AMA Approach to develop internal models for a self-
assessment of the level of operational risk. There is no specific model
recommended by the regulators. In addition to the qualitative
requirements that are close to those of the SA Approach the models
have to respect some quantitative requirements:
The model must capture losses due to operational risk over a one-year
period with a confidence interval of 99.9 percent (the expected loss is in
principle not deducted).
The model must be sufficiently granular to capture tail events i.e. events
with very low probability of occurrence.
The model can use a mix of internal (minimum five years) and external
data and scenario analysis.
The bank must have robust procedures to collect operational loss
historical data, store them, and allocate them to the correct business
line. Regarding risk mitigation, banks can incorporate the effects of
insurance to mitigate operational risk up to 20 percent of the
operational risk capital requirements.
Operational risk is an innovation, as currently no capital is required to
cover this type of risk, and it has been very controversial. For market
risk, a lot of historical data are available to feed and back-test the
models; for credit risk, data are already scarce; and for operational risk
there are very few banks that have any efficient internal databases
showing operational loss events. This is the more qualitative type of
risk, as it is closely linked to procedures and control systems and
depends significantly on experts opinions. Many people in the industry
consider that it cannot be captured through quantitative requirements
the BIA and SA above all, requiring a fixed percentage of gross income
as operational risk capital, are considered as very poor estimates of
what should be the correct level of capital.
The AMA is more interesting from a conceptual point of view, but as the
major part of model parameters (loss frequencies and severities,
correlation between loss types) cannot be inferred from historical data
but have to be estimated by experts, it is hard to be sanguine as we
work with such a high confidence level as 99.9 percent. But perhaps the
regulators requirements are a necessary step to oblige banks to take a
closer look at the operational risks associated with their businesses. We
have to recognize that, even if the final amount of capital is open to
discussion, many banks have gained a deeper understanding of the
nature and the magnitude of such risks, and as they involve the whole
organization (and not only market and credit risk specialists) it is an
opportunity to spread risk consciousness throughout all financial
groups.

Internal model method (IMM).

Banks can finally use the IMM. In this approach, no particular model is
prescribed and banks are free to develop their internal effective EPE
measurement approach as long as they fulfill certain requirements and
convince their regulators that their approach is adequate (as in the
AMA for operational risk). The effective EPE is then also multiplied by a
regulatory factor Alpha () (in Principle, 1.4, but it can be changed by
the regulator). Under specific conditions, banks can also estimate
themselves the Alpha factor in their internal model (but there is a
minimum of 1.2). To do this, banks should have a fully integrated credit
and market risk model, and compare the economic capital allocated
with a full simulation with the economic capital allocated on the basis
of EPE
(Banks have to demonstrate that the potential correlation between
credit and market risks has been captured).
The basic requirements for model approval are quite close to those for
the VAR model under the Market Risk Amendment, but with some
additional features (to work on a longer horizon, as one year is the
reference, pricing models can be different from those used for short-
term VAR, with regular back-testing, use tests, stress testing ).
The IMM can also try to integrate the margin calls, but such
novelizations are complicated, and will come under close scrutiny from
the regulators.
If the CEM and SM are limited to OTC derivatives, the IMM can also be
used for Securities Financing Transactions (SFT) such as repurchase/
reverse-repurchase agreements, securities lending and borrowing,
margin lending.
The choice of one of the two more advanced approaches has additional
impacts on pillar 2 (more internal controls, audit of the models by the
regulators) and pillar 3 (specific disclosures on the selected framework)
The IMM can be chosen just for OTC derivatives, just for SFT
transactions, or for both. But, once selected, the bank cannot return to
simpler approaches.
The two advanced approaches can also be chosen as if the bank is using
an IRB or a Standardized Approach (SA). Inside a financial group, some
entities can use advanced approaches on a permanent basis and others
the CEM. Inside an entity, all portfolios have to follow the same
approach.

BREAKING DOWN 'Basel II'

Basel II is a second international banking regulatory accord that is based
on three main pillars: minimal capital requirements, regulatory
supervision and market discipline. Minimal capital requirements play
the most important role in Basel II and obligate banks to maintain
minimum capital ratios of regulatory capital over risk-weighted assets.
Because banking regulations significantly varied among countries before
the introduction of Basel accords, a unified framework of Basel I and,
subsequently, Basel II helped countries alleviate anxiety over regulatory
competitiveness and drastically different national capital requirements
for banks.
Minimum Capital Requirements

Basel II provides guidelines for calculation of minimum regulatory

capital ratios and confirms the definition of regulatory capital and 8%
minimum coefficient for regulatory capital over risk-weighted assets.
Basel II divides the eligible regulatory capital of a bank into three tiers.
The higher the tier, the less subordinated securities a bank is allowed to
include in it. Each tier must be of certain minimum percentage of the
total regulatory capital and is used as a numerator in the calculation of
regulatory capital ratios.
Tier 1 capital is the most strict definition of regulatory capital that is
subordinate to all other capital instruments, and includes shareholders'
equity, disclosed reserves, retained earnings and certain innovative
capital instruments. Tier 2 is Tier 1 instruments plus various other bank
reserves, hybrid instruments, and medium- and long-term subordinated
loans. Tier 3 consists of Tier 2 plus short-term subordinated loans.
Another important part in Basel II is refining the definition of risk-
weighted assets, which are used as a denominator in regulatory capital
ratios, and are calculated by using the sum of assets that are multiplied
by respective risk weights for each asset type. The riskier the asset, the
higher its weight. The notion of risk-weighted assets is intended to
punish banks for holding risky assets, which significantly increases risk-
weighted assets and lowers regulatory capital ratios. The main
innovation of Basel II in comparison to Basel I is that it takes into
account the credit rating of assets in determining risk weights.The
higher the credit rating, the lower risk weight.
Regulatory Supervision and Market Discipline
Regulatory supervision is the second pillar of Basel II that provides the
framework for national regulatory bodies to deal with various types of
risks, including systemic risk, liquidity risk and legal risks. The market
discipline pillar provides various disclosure requirements for banks' risk
exposures, risk assessment processes and capital adequacy, which are
helpful for users of financial statements.

BASEL III
BASEL III is an international regulatory accord that introduced a set of
reforms designed to improve the regulation, supervision and risk
management within the banking sector. The Basel Committee on
Banking Supervision published the first version of Basel III in late 2009,
giving banks approximately three years to satisfy all requirements.
Largely in response to the credit crisis, banks are required to maintain
proper leverage ratios and meet certain minimum capital requirements.

The Basel III Accord:

Basel III is a comprehensive set of reform measures, developed by
the Basel Committee on Banking Supervision, to strengthen the
regulation, supervision and risk of the banking sector.

The Basel Committee is the primary global standard-setter for the

prudential regulation of banks and provides a forum for cooperation on
banking supervisory matters. Its mandate is to strengthen the
regulation, supervision and practices of banks worldwide with the
purpose of enhancing financial stability.

The Committee reports to the Group of Governors and Heads of

Supervision (GHOS). The Committee seeks the endorsement of GHOS
for its major decisions and its work programme.

The Committee's members come from Argentina, Australia, Belgium,

Brazil, Canada, China, European Union, France, Germany, Hong Kong
SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the
Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain,
Sweden, Switzerland, Turkey, the United Kingdom and the United
States.

The Basel III reform measures aim to:

1. Improve the banking sector's ability to absorb shocks arising from

financial and economic stress, whatever the source

2. Improve risk management and governance

 3. Strengthen banks' transparency and disclosures.

The reforms target:

A. Bank-level, or micro prudential, regulation, which will help raise the

resilience of individual banking institutions to periods of stress.

B. Macro prudential, system wide risks that can build up across the
banking sector as well as the procyclical amplification of these risks over
time.

These two approaches to supervision are complementary as greater

resilience at the individual bank level reduces the risk of system wide
shocks.

From 1993 to 2008 the total assets of a sample of what we call global
systemically important banks saw a twelve-fold increase (increasing
from $2.6 trillion to just over $30 trillion). But the capital funding these
assets only increased seven-fold, (from $125 billion to $890 billion). Put
differently, the average risk weight declined from 70% to below 40%.

The problem was that this reduction did not represent a genuine
reduction in risk in the banking system.

One of the main reasons the economic and financial crisis became so
severe was that the banking sectors of many countries had built up
excessive on and off-balance sheet leverage. This was accompanied by
a gradual erosion of the level and quality of the capital base.

At the same time, many banks were holding insufficient liquidity

buffers.
The banking system therefore was not able to absorb the resulting
systemic trading and credit losses nor could it cope with the
reintermediation of large off-balance sheet exposures that had built up
in the shadow banking system.

The crisis was further amplified by a procyclical deleveraging

process and by the interconnectedness of systemic institutions through
an array of complex transactions.

During the most severe episode of the crisis, the market lost
confidence in the solvency and liquidity of many banking institutions.
The weaknesses in the banking sector were rapidly transmitted to the
rest of the financial system and the real economy, resulting in a massive
contraction of liquidity and credit availability.

Ultimately the public sector had to step in with unprecedented

injections of liquidity, capital support and guarantees, exposing
taxpayers to large losses.

The effect on banks, financial systems and economies at the epicentre

of the crisis was immediate. However, the crisis also spread to a wider
circle of countries around the globe. For these countries the
transmission channels were less direct, resulting from a severe
contraction in global liquidity, cross-border credit availability and
demand for exports.

Given the scope and speed with which the recent and previous crises
have been transmitted around the globe as well as the unpredictable
nature of future crises, it is critical that all countries raise the resilience
of their banking sectors to both internal and external shocks.
The G20 Leaders at the Seoul Summit endorsed the Basel III
framework and the Financial Stability Boards (FSB) policy framework for
reducing the moral hazard of systemically important financial
institutions (SIFIs), including the work processes and timelines set out in
the report submitted to the Summit.

SIFIs are financial institutions whose disorderly failure, because of their

size, complexity and systemic interconnectedness, would cause
significant disruption to the wider financial system and economic
activity.

We read in the final G20 Communiqu:

"We endorsed the landmark agreement reached by the Basel

Committee on the new bank capital and liquidity framework, which
increases the resilience of the global banking system by raising the
quality, quantity and international consistency of bank capital and
liquidity, constrains the build-up of leverage and maturity
mismatches, and introduces capital buffers above the minimum
requirements that can be drawn upon in bad times.

The framework includes an internationally harmonized leverage ratio to

serve as a backstop to the risk-based capital measures.

With this, we have achieved far-reaching reform of the global banking

system.

The new standards will markedly reduce banks' incentive to take

excessive risks, lower the likelihood and severity of future crises, and
enable banks to withstand - without extraordinary government support
- stresses of a magnitude associated with the recent financial crisis.
This will result in a banking system that can better support stable
economic growth.

We are committed to adopt and implement fully these standards within

the agreed timeframe that is consistent with economic recovery and
financial stability.

The new framework will be translated into our national laws and
regulations, and will be implemented starting on January 1, 2013 and
fully phased in by January 1, 2019."

To ensure visibility of the implementation of reforms, the Basel

Committee has been regularly publishing information about members
adoption of Basel III to keep all stakeholders and the markets informed,
and to maintain peer pressure where necessary.

It is especially important that jurisdictions that are home to global

systemically important banks (G-SIBs)make every effort to issue final
regulations at the earliest possible opportunity.

But simply issuing domestic rules is not enough to achieve what the
G20 Leaders asked for: full, timely and consistent implementation of
Basel III. In response to this call, in 2012 the Committee initiated what
has become known as the Regulatory Consistency Assessment
Programme (RCAP).

The regular progress reports are simply one part of this programme,
which assesses domestic regulations compliance with the Basel
standards, and examines the outcomes at individual banks.
The RCAP process will be fundamental to ensuring confidence in
regulatory ratios and promoting a level playing field for internationally-
operating banks.

It is inevitable that, as the Committee begins to review aspects of the

regulatory framework in far more detailthan it (or anyone else) has ever
done in the past, there will be aspects of implementation that do not
meet the G20s aspiration: full, timely and consistent.

The financial crisis identified that, like the standards themselves,

implementation of global standards was not as robust as it should have
been.

This could be classed as a failure by global standard setters.

To some extent, the criticism can be justified not enough has been
done in the past to ensure global agreements have been truly
implemented by national authorities.

However, just as the Committee has been determined to revise the

Basel framework to fix the problems that emerged from the lessons of
the crisis, the RCAP should be seen as demonstrating the Committees
determination to also find implementation problems and fix them.

BREAKING DOWN 'Basel III'

Basel III is part of the continuous effort to enhance the banking

regulatory framework. It builds on the Basel I and Basel II documents,
and seeks to improve the banking sector's ability to deal with financial
stress, improve risk management, and strengthen the
banks' transparency. A focus of Basel III is to foster greater resilience at
the individual bank level in order to reduce the risk of system-wide
shocks.
Minimum Capital Requirements

Basel III introduced tighter capital requirements in comparison to Basel I

and Basel II. Banks' regulatory capital is divided into Tier 1 and Tier 2,
while Tier 1 is subdivided into Common Equity Tier 1 and additional Tier
1 capital. The distinction is important because security instruments
included in Tier 1 capital have the highest level of subordination.
Common Equity Tier 1 capital includes equity instruments that have
discretionary dividends and no maturity, while additional Tier 1 capital
comprises securities that are subordinated to most subordinated debt,
have no maturity, and their dividends can be cancelled at any time. Tier
2 capital consists of unsecured subordinated debt with an original
maturity of at least five years.
Basel III left the guidelines for risk-weighted assets largely unchanged
from Basel II. Risk-weighted assets represent a bank's assets weighted
by coefficients of risk set forth by Basel III. The higher the credit risk of
an asset, the higher its risk weight. Basel III uses credit ratings of certain
assets to establish their risk coefficients.
In comparison to Basel II, Basel III strengthened regulatory capital
ratios, which are computed as a percent of risk-weighted assets. In
particular, Basel III increased minimum Common Equity Tier 1 capital
from 4% to 4.5%, and minimum Tier 1 capital from 4% to 6%. The
overall regulatory capital was left unchanged at 8%.
Countercyclical Measures

Basel III introduced new requirements with respect to regulatory capital

for large banks to cushion against cyclical changes on their balance
sheets. During credit expansion, banks have to set aside additional
capital, while during the credit contraction, capital requirements can be
loosened. The new guidelines also introduced the bucketing method, in
which banks are grouped according to their size, complexity and
importance to the overall economy. Systematically important banks are
subject to higher capital requirements.
Leverage and Liquidity Measures

Additionally, Basel III introduced leverage and liquidity requirements to

safeguard against excessive borrowings and ensure that banks have
sufficient liquidity during financial stress. In particular, the leverage
ratio, computed as Tier 1 capital divided by the total of on and off-
balance assets less intangible assets, was capped at 3%.

Comparison between BASEL I, BASEL II & BASEL III:

Banks are one among the major triggers in most of the economic crises.
Banks are the veins of circulation of money in an economy. So the
soundness of banking system is imperative to prevent the collapse of
the system. The premature liberalization of the local financial markets
and the failure to keep adequate checks on lending functions of the
banks are the major reasons for the Asian economic crisis of 1997.
Absence of effective regulation and supervision led to large capital
inflows in the domestic short term debt market. Banks lent on long
term basis using the foreign inflows. Later when signs of pessimism
became visible foreign inflows to economies such as Philippines,
Malaysia etc... Started to decline. (Buckley n.d.) Similarly, in the year
2008 the reckless lending of US banks like Lehman brothers and
securitization of the sub-standard loans into instruments known as
CDO-s (Collateral Debt Obligations) and trading of the securities in the
stock market led to the sub-prime crisis of 2008 and resultant recession
in the follow-up. Thus a perfect regulation and prudential supervision of
banks is tellingly important for the smooth sailing of an economy.
Basel I
Capital is the last recourse that would be available for any bank to
prevent its failure. In the year 1974, after the failure of Herstatt bank in
Germany the need for better regulation of banking sector was felt by G-
10 countries. They constituted the Basel Committee for Banking
Supervisory practices (BCBS) under the aegis of Bank for International
Settlements (BIS). Basel I was recommended for implementation by the
BCBS for mainly addressing the issue of Credit risk in the year 1988.
Credit risk implies the risk involved in the recovery of loans that were
lent. In order to address the issue BCBS fixed a minimum capital
adequacy requirement to be maintained by the banks. It pegged the
Capital adequacy ratio (CAR) at 8%. (Tarullo n.d.) Capital Adequacy Ratio
(CAR) = Tier 1 Capital + Tier 2 Capital/ Risk Weighted Assets Tier 1
capital represents the capital that is more permanent in nature and is
more reliable. Tier 1 capital or core capital of a bank includes the
normal paid up share capital of the bank and other disclosed reserves
as reduced by the intangible assets of the bank such as Goodwill,
fictitious assets such as debit balance to the Profit and loss account, any
expenditure that is not written off and the deferred tax asset. The Tier 1
capital should form at least 50% of the banks total capital base. Tier 2
represents the capital that is not as much reliable as the Tier 1 capital
because of the lack of corroborated ownership as in the case of Tier 1
capital. Tier 2 or Supplementary capital consists of Undisclosed
reserves, Cumulative non-redeemable preference share capital, General
provisions and loss reserves written back as surplus if the actual loss or
diminution is found to be in excess of the provision or loss reserves
created earlier, Revaluation reserves, Hybrid capital instruments and
Subordinated debt with minimum maturity of 5 years. There are also
restrictions such as subordinated debts could not exceed 50% of the
core capital, general provisions and loss reserves could not exceed
1.25% of the total risk weighted assets. Risk weighted assets is the
value of the assets adjusted for the risk of the asset failing to liquidate
as valued. Risk Weights Under Basel I, risk weights were classified into 5
Categories namely, 0%, 0% to 50%, 20, 50%, 100%. (Tarullo n.d.)

The weight of zero per cent was assigned to assets such as

loans lent to OECD states, Investment with OECD central
governments securities, loans to borrowers, who are backed by
the guaranties of the OECD states or who had given the
securities of the OECD countries as collateral. Since OECD states
are considered to be developed countries their securities were
assigned zero credit risk. Loans to non OECD countries and
central banks too were assigned 0% risk weights, provided loans
advanced to them were in their own currency i.e., in the
currency of the borrowing country. This is done to eliminate the
risk of exchange rate movements on the loans advanced in view
of the probable depreciation of the currencies of the non-OECD
countries.
Loans or investment with domestic public sector enterprises
that remain outside the ambit of central government were given
risk weights ranging from 0% to 50% at the discretion of nations
regulator , which could be 0%, 10%, 20% and 50%.
 Loans or investment with institutions such as Multilateral
development banks, OECD banks, Non-OECD banks with tenor
extending upto 1 year, loans guaranteed by OECD incorporated
banks, short term loans guaranteed by non-OECD banks were
assigned a weight of 20%.
Loans to non-OECD banks given on a tenor of more than 1 year
are assigned a weight of 50%.
Loans or investment with private sector enterprises, Non
OECD banks with tenor more than one year, capital market
instruments issued by other banks were assigned a weight of
100%.
In order to capture the risk that resides with the off balance
sheet items such as contingent liabilities, a new parameter
called "Credit conversion factor" (CCF) was deployed. For
instance :
o General guarantees against loans were assigned 0%
o Letter of credits against Shipments were assigned 20%
In 1996, in response to the financial innovations, as instruments like
derivatives were started to be widely used, a new factor called market
risk was introduced to strengthen the standards. Market risk is the risk
of losses on account of movements in market prices with the on-
balance sheet and off-balance sheet positions. (Basel Committee on
Banking Supervision 2005) The way CAR would be calculated was
modified to factor in Market risk and a new category of capital called as
Tier 3 capital. The Tier 3 capital is composed of Short term subordinated
bonds that would exclusively cover market risks. Market risk consists of
interest rate risk, equity position risk, foreign exchange risk and
commodities risk. For measuring market risk, BCBS proposed two
approaches namely Standardized approach, where the principles of
gauging the market risk were completely prescribed by the BCBS and
Internal grading based approach, where a certain degree of
independence was granted to banks in assessing market risk.
BASEL II
As years passed by, Basel II evolved. Basel II was given approval in the
year 2004. The norms of Basel II accord were on three fronts, which are
given by the three pillars viz: 1.The minimum capital requirement; 2.The
supervisory review; 3.The market discipline. The level of minimum
capital requirement was continued to be maintained at 8% under the
new framework. A new benchmark of risk called Operational risk was
introduced. Operational risk is defined as the risk of loss resulting from
the failure of internal processes or from the external events. For
instance, Operational risk includes employee frauds, sabotage of assets
of the bank, external frauds etc Put simply, the losses that the bank
may suffer, other than, in the normal course of business.
Pillar 1
Basel II provided three different approaches for credit risk
determination. They are:
1. Standardized approach
2. Foundation internal rating based approach (F-IRB)
3. Advanced internal rating based approach (A-IRB).
The standardized approach provides that the risk weights should be
assigned based on the ratings given by the External Credit Rating
Institutions (ECAI). Under the new approach risk weights may range
from 0% to 150%. Unlike Basel I, where loans to OECD central banks and
OECD states where assigned a lower risk weights considering their
credibility, in Basel II ratings assigned by the external credit rating
agencies were considered as benchmarks and loans to foreign banks
were assigned risk weights based on the ratings given by them.
However when a foreign bank that is operating in a country lends to the
central bank of the country, where it is incorporated then a lower risk
weight may be applied to such asset provided the loan is funded and
denominated in the domestic currency of the foreign bank. Another
prominent feature of the Basel II accord is a corporate may get rated by
an ECAI and be assigned a lower risk weight based on the ratings. This
stands in contrast to the Basel I accord, where all the corporates were
assigned a uniform risk weight of 100%. This might cause the banks to
infer that lending to SME-s (Small and Medium Scale Enterprise) may
prove to be expensive. (Francis n.d.) Internal ratings based approach
allows the banks to devise their own models to assess the risk. Under
the other two approaches, Banks use their own model to measure the
parameters like PD (Probability of default), EAD (Exposure at default),
LGD (Loss given default), which are used in calculating the Risk weighted
assets (RWA). To cover operational risk of loss, Basel II prescribes three
approaches namely basic indicator approach, standardized approach
and advanced measurement approach.

Basic indicator approach and standardized approach requires

an appropriation of 15%, 12% to 18% respectively of banks
average annual gross income to the reserves in the preceding
three years.
Under the standardized approach, banks activities are divided
into eight business lines each possessing a different "Denoted
beta" ranging from the 12% to 18%. The past three years
average of the gross annual income of each business line is
multiplied with the respective beta to arrive at the capital
charge.
Under the Advanced measurement approach banks can
quantify the capital to cover operational risk using their own
internal model taking into account internal risk variables and
profiles.
Pillar 2
Pillar 2 specifies the norms for regulatory authorities. The banks should
have deployed a system for assessing the stability of the capital and
preclude any fall below the standard level. The regulator should
mandate the banks to operate above the minimum capital requirement
and should prevent the capital of the banks from falling below the
minimum level, which is specified. Pillar 3 Under the Pillar 3, banks are
required to follow a formal disclosure policy. Disclosures regarding
capital adequacy, credit risk mitigation, the internal ratings systems that
it follows under the IRB approach were all specified under Pillar 3.

Basel III:
Basel III was introduced in December 2010. It came as a response to the
sub-prime crisis in the year 2008. As of now, it's implementation has
been extended to 31st March 2019.
The Key modifications happened with Basel III are as follows:
 The requirement of minimum Tier 1 capital has been increased
from 4% in Basel II to 6%
A new buffer called as Capital conservation buffer with Tier 1
capital needs to maintained and the requirement level for this
has been pegged at 2.5% of the RWA.
The total "Capital adequacy ratio" requirement has been
maintained at 8%
But when combined with the newly introduced conservation
buffer, the requirement of capital increases to 10.5%
At the discretion of the central banks of the countries, banks
may be required to maintain a "Counter cyclical buffer" ranging
from 0% to 2.5% depending on the economic conditions.
A new measure called leverage ratio is introduced. It measures
the proportion of Tier 1 capital to the total exposure of the bank
( Not RWA). A minimum ratio of 3% is to be maintained.
How Basel 1 Affected Banks:

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

(For related reading, see Analysing A Bank's Financial Statements.)

As a result, the potential for the bankruptcy of the major international

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

The committee drafted a first document to set up an international

'minimum' amount of capital that banks should hold. This minimum is a
percentage of the total capital of a bank, which is also called the
minimum risk-based capital adequacy. In 1988, the Basel I Capital
Accord (agreement) was created. The Basel II Capital Accord follows as
an extension of the former, and was implemented in 2007. In this
article, we'll take a look at Basel I and how it impacted the banking
industry.

The Purpose of Base lI:

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

1. Strengthen the stability of international banking system.

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

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

Two-Tiered CAPITAL

Basil I defines capital based on two tiers:

1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or

shareholders equity) and declared reserves, such as loan loss
reserves set aside to cushion future losses or for smoothing out income
variations.

2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital

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

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

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

 The trading off-balance sheet risk. These are derivatives, namely
interest rates, foreign exchange, equity
derivatives and commodities.

The non-trading off-balance sheet risk. These include general

guarantees, such as forward purchase of assets or transaction-
related debt assets.

Let's take a look at some calculations related to RWA and capital

requirement. Figure 1 displays predefined category of on-balance sheet
exposures, such as vulnerability to loss from an unexpected event,
weighted according to four relative risk categories.

Figure 1: Basel\'s Classification of risk

weights of on-balance sheet assets

As shown in Figure 2, there is an unsecured loan of $1,000 to a non-

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

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

Limited differentiation of credit risk

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

Static measure of default risk. The assumption that a minimum

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

No recognition of term-structure of credit risk. The capital

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

Simplified calculation of potential future counterparty risk the

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

Lack of recognition of portfolio diversification effects In reality,

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

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

The Basel I Capital Accord aimed to assess capital in relation to credit

risk, or the risk that a loss will occur if a party does not fulfil its
obligations. It launched the trend toward increasing risk modelling
research; however, its over-simplified calculations, and classifications
have simultaneously called for its disappearance, paving the way for the
Basel II Capital Accord and further agreements as the symbol of the
continuous refinement of risk and capital. Nevertheless, Basel I, as the
first international instrument assessing the importance of risk in
relation to capital, will remain a milestone in the finance and banking
history.
BASEL IV:

Basel 4 as it is dubbed by the financial industry is a proposed standard

on capital reserves for banks, to mitigate against the risk of financial
crisis. It is expected to follow the third Basel accords (Basel III) , and
would require more stringent capital requirements and greater financial
disclosure.

Requirements:
Basel 4 is likely to include:

Requiring banks to meet higher maximum leverage ratios (an

initial leverage ratio maximum is likely to be set as part of the
completion of the Basel III package);

Emphasising simpler or standardised models, rather than banks'

internal models, for calculation of capital requirements (the Basel
committee has made initial proposals on simpler models as part of
the completion of the Basel III framework);

More detailed disclosure of reserves and other financial statistics.

British banks alone may have to set aside another 50Bn of reserves to
meet Basel 4 requirements