Basel Accords

History of Bank Regulation

Pre-1988
1988: BIS Accord (Basel I)
1996: Amendment to BIS Accord
1999: Basel II first proposed
Basel III in response to the recent global
financial crisis

Pre-1988
Banks were regulated using balance sheet measures
such as the ratio of capital to assets
Definitions and required ratios varied from country
to country
Enforcement of regulations varied from country to
country
Bank leverage increased in 1980s
Off-balance sheet derivatives trading increased
LDC debt was a major problem
Basel Committee on Bank Supervision set up

1988: BIS Accord

Capital regulations under Basel I came into
effect in December 1992 (after development
and consultations since 1988).
The aims were:
to require banks to maintain enough capital to
absorb losses without causing systemic problems,
to level the playing field internationally (to avoid
competitiveness conflicts).

1988: BIS Accord

The assets: capital ratio must be less than
20. Assets includes off-balance sheet items
that are direct credit substitutes such as
letters of credit and guarantees
Cooke Ratio: Capital must be 8% of risk
weighted amount. At least 50% of capital
must be Tier 1.

Types of Capital
Tier 1 Capital: common equity, noncumulative perpetual preferred shares
Tier 2 Capital: cumulative preferred
stock, certain types of 99-year
debentures, subordinated debt with an
original life of more than 5 years

Risk-Weighted Capital
A risk weight is applied to each on-balance- sheet asset
according to its risk (e.g. 0% to cash and govt bonds;
20% to claims on OECD banks; 50% to residential
mortgages; 100% to corporate loans, corporate bonds,
etc.)
For each off-balance-sheet item we first calculate a
credit equivalent amount and then apply a risk weight
Risk weighted amount (RWA) consists of
sum of risk weight times asset amount for on-balance sheet
items
Sum of risk weight times credit equivalent amount for offbalance sheet items

Credit Equivalent Amount

The credit equivalent amount is
calculated as the current replacement
cost (if positive) plus an add on factor
The add on amount varies from
instrument to instrument (e.g. 0.5% for a
1-5 year swap; 5.0% for a 1-5 year
foreign currency swap)

Add-on Factors
(% of Principal)
Remaining
Maturity
(yrs)

Interest
rate

Exch
Rate and
Gold

Equit
y

Precious
Metals
except gold

Other
Commoditie
s

<1

0.0

1.0

6.0

7.0

10.0

1 to 5

0.5

5.0

8.0

7.0

12.0

>5

1.5

7.5

10.0

6.0

15.0

Example: A $100 million swap with 3 years to maturity

worth $5 million would have a credit equivalent amount
of $5.5 million

The Math
N

i 1

j 1

RWA wi Li w C j
On-balance sheet
items: principal
times risk weight

*
j

Off-balance sheet items:

credit equivalent
amount times risk
weight

For a derivative Cj = max(Vj,0) + ajLj where Vj is

value, Lj is principal and aj is add-on factor

G-30 Policy Recommendations

Influential publication from derivatives
dealers, end users, academics,
accountants, and lawyers
20 recommendations published in 1993

Netting
Netting refers to a clause in derivatives
contracts that states that if a company
defaults on one contract it must default
on all contracts
In 1995 the 1988 accord was modified to
allow banks to reduce their credit
equivalent totals when bilateral netting
agreements were in place

Netting Calculations
Without netting exposure is
N

max(V ,0)
j

j 1

With netting exposure is

max

V ,0
j 1

Net Replacement Ratio

Exposure with Netting
NRR
Exposure without Netting

Netting Calculations continued

Credit equivalent amount modified from
N

[max(V ,0) a L ]
j

j 1

To
N

j 1

j 1

max( V j ,0) a j L j (0.4 0.6 NRR )

1996 Amendment
Implemented in 1998
Requires banks to measure and hold
capital for market risk for all instruments
in the trading book including those off
balance sheet (This is in addition to the
BIS Accord credit risk capital)

The Market Risk Capital

The capital requirement is

k VaR SRC
Where k is a multiplicative factor chosen by
regulators (at least 3), VaR is the 99% 10day value at risk, and SRC is the specific
risk charge for idiosyncratic risk related to
specific companies

Problem with Basel I

Regulatory arbitrage was rampant
Basel I gave banks the ability to control the amount of
capital they required by shifting between on-balance
sheet assets with different weights, and by securitising
assets and shifting them off balance sheet a form of
disintermediation
Banks quickly accumulated capital well in excess of the
regulatory minimum and capital requirements, which,
in effect, had no constraining impact on bank risk
taking.

Basel II
Implemented in 2007
Three pillars
New minimum capital requirements for credit
and operational risk
Supervisory review: more thorough and
uniform
Market discipline: more disclosure

New Capital Requirements

Risk weights based on either external credit
rating (standardized approach) or a banks
own internal credit ratings (IRB approach)
Recognition of credit risk mitigants
Separate capital charge for operational risk

Basel II: Pillar 1

Pillar 1 of the Basel II system defines minimum capital to
buffer unexpected losses.
Total RWA (risk weighted assets) are based on a complex
system of risk weighting that applies to
credit
market (MR)
operational risk (OR)
These risks are calculated separately and then added:
RWA= {12.5(OR+MR) + 1.06w(i)A(i)}

USA vs European
Implementation
In US Basel II applies only to large international
banks
Small regional banks required to implement
Basel 1A (similar to Basel I), rather than Basel
II
European Union requires Basel II to be
implemented by securities companies as well as
all banks

New Capital Requirements

Standardized Approach
Bank and corporations treated similarly (unlike Basel I)
Rating

AAA A+ to
to
AAA-

BBB+
to
BBB-

BB+ to
BB-

B+ to
B-

Below
B-

Unrated

Country

0%

20%

50%

100%

100%

150%

100%

Banks

20%

50%

50%

100%

100%

150%

50%

Corporates

20%

50%

100%

100%

150%

150%

100%

New Capital Requirements

IRB Approach for corporate, banks and
sovereign exposures
Basel II provides a formula for translating PD (probability of
default), LGD (loss given default), EAD (exposure at default), and M
(effective maturity) into a risk weight
Under the Advanced IRB approach banks estimate PD, LGD, EAD,
and M
Under the Foundation IRB approach banks estimate only PD and
the Basel II guidelines determine the other variables for the formula

Model for Loan Portfolio

We map the time to default for company i, Ti, to a
new variable Ui and assume

U i ai F 1 a Z i
2
i

where F and the Zi have independent standard

normal distributions
Define Qi as the cumulative probability distribution
of Ti
Prob(Ui<U) = Prob(Ti<T) when N(U) = Qi(T)

The Model continued

U a F
i

Prob(U i U F ) N

1 a
2
i

Hence
N 1 Q (T ) a F
i
i

Prob(Ti T F ) N

1 a

2
i

Assuming the Q' s and a' s are the same for all companies
N 1 Q(T ) F

Prob(Ti T F ) N

where is the copula correlation

The Model continued

The worst case default rate for portfolio for a time
horizon of T and a confidence limit of X is
N 1[Q(T )] N 1 ( X )

WCDR(T,X) N

The VaR for this time horizon and confidence limit

is

VaR (T , X ) L (1 R ) WCDR (T , X )
where L is loan principal and R is recovery rate

Key Model in Basel II IRB

(Gaussian Copula)
The 99.9% worst case default rate is

N -1 ( PD) N -1 (0.999)

WCDR N

PD probability of default
We are 99.9% certain not to exceed WCRD
next year

The Loss on the Portfolio

There is 99.9% chance that the loss on the
portfolio will be less than

VaR (99.99%,1 year) EADi LGDi WCDR

i

EADi exposure given default, i.e. the dollar amount

that is expected to be owed by the ith counterparty at
the time of default
LGDi loss given default, i.e. the percentage of EAD
expected to be lost at default

The Expected Loss and Capital

Requirements
The expected loss from default is:
EL EADi LGDi PD
i

The capital requirement is worst case loss

minus the expected loss:

EAD LGD (WCDR PD)

i

The Model Used by Regulators:

The loss probability density function and the
capital required by a financial institution
X% Worst
Case Loss

Expected
Loss

Required
Capital

Loss over time

horizon
0

Numerical Results for WCDR

PD=0.1% PD=0.5%
=0.0

0.1%

PD=1% PD=1.5%

PD=2%

0.5%

1.0%

1.5%

2.0%

=0.2

2.8%

9.1%

14.6%

18.9%

22.6%

=0.4

7.1%

21.1%

31.6%

39.0%

44.9%

=0.6

13.5%

38.7%

54.2%

63.8%

70.5%

=0.8

23.3%

66.3%

83.6%

90.8%

94.4%

Dependence of on PD
For corporate, sovereign and bank exposure

1 e 50PD
1 e 50PD
50 PD
0.12

0.24

0
.
12
[1

e
]

50
50
1 e
1 e

PD

0.1%

0.5%

1.0%

WCDR

3.4%

9.8%

14.0% 16.9% 19.0%

(For small firms is reduced)

1.5%

2.0%

Capital Requirements
Capital EAD LGD (WCDR PD) MA
where MA - - maturity adjustment
1 (M 2.5) b
MA
1 1.5 b
where M is the effective maturity and
b [0.11852 0.05478 ln(PD)]2
The risk - weighted assets are 12.5 times the Capital
so that Capital 8% of RWA

Retail Exposures
Capital EAD LGD (WCDR PD)
For residential mortgages 0.15
For revolving retail exposures 0.04
For other retail exposures

1 e 35PD
1 e 35PD
0.03
0.16 1
35
35
1 e
1

0.03 0.13e - 35 PD
There is no distinction between Foundation and Advanced IRB approaches.
Banks estimate PD, LGD, and EAD in both cases

Two Types of Losses and Two

Types of Capital under Basel II
Expected Loss (EL)
Unexpected losses (UL)
UL(T) = VaR(,T) EL(T)
Regulatory capital (Tier 1 and 2) is applied to EL
which are expected to occur but are of smaller
consequence.
Economic capital is for UL which are low
frequency but have significant magnitude. UL is
very sensitive to the shape of the loss distribution.

UL is Connected to VaR and

Inherits its Shortcomings
UL of the portfolio can be great than sum of the ULs of
its components. This is because VaR is not sub-additive.
Star-Treck problem of VaR: How do we estimate
something where we have never even gone before. VaR
depends on the tail of the loss distribution for which we
have no data. 99.99% cutoff is arbitrary.
VaR is know to depend on the number of samples
generated in Mode Carlo simulations. The greater
sampling increases the number of outlier observations
and stretches out the tail.
If you want to reduce UL simulate less.

Components of Credit Risk Losses

If each element comes from a distribution, there

are issues of Jensens inequality. That means that
inputs are correlated with each other.
Foundation IRB (F-IRB) vs Advanced IRB (AIRB): In the former, LGD is mandated by
regulator.

Granularity and Aggregation

n=210 = 1024 normalized assets
2
Portfolio P: w = 1/n, mean 0, variance =
Expected loss:

w' w

As the assets get clubbed into portfolios, within

portfolio diversification needs to be offset by
higher correlations across groups; correlation
must be a function of granularity (not fixed).

Table: Expected loss, unexpected loss and Valueat-Risk for varying levels of granularity and
aggregation
The first column shows the number of business units
The second column gives the number of assets within each portfolio.
Each asset has a standard normal distribution. :Corr is the average
pairwise correlation between portfolio values.

Credit Risk Mitigants

Credit risk mitigants (CRMs) include
collateral, guarantees, netting, the use of
credit derivatives, etc
The benefits of CRMs increase as a bank
moves from the standardized approach
to the foundation IRB approach to the
advanced IRB approach

Adjustments for Collateral

Two approaches
Simple approach: risk weight of counterparty
replaced by risk weight of collateral
Comprehensive approach: exposure adjusted
upwards to allow to possible increases; value of
collateral adjusted downward to allow for possible
decreases; new exposure equals excess of adjusted
exposure over adjusted collateral; counterparty
risk weight applied to the new exposure

Guarantees
Traditionally the Basel Committee has used the credit
substitution approach (where the credit rating of the
guarantor is substituted for that of the borrower)
However this overstates the credit risk because both the
guarantor and the borrower must default for money to
be lost
Alternative proposed by Basel Committee: capital
equals the capital required without the guarantee
multiplied by 0.15+160PDg where PDg is probability of
default of guarantor

Operational Risk Capital

Basic Indicator Approach: 15% of gross
income
Standardized Approach: different
multiplicative factor for gross income
arising from each business line
Internal Measurement Approach: assess
99.9% worst case loss over one year.

Supervisory Review Changes

Similar amount of thoroughness in
different countries
Local regulators can adjust parameters
to suit local conditions
Importance of early intervention stressed

Market Discipline
Banks will be required to disclose

Scope and application of Basel framework

Nature of capital held
Regulatory capital requirements
Nature of institutions risk exposures

Comparison of Basel I and

Basel II

Solvency II
Similar three pillars to Basel II
Pillar I specifies the minimum capital requirement
(MCR) and solvency capital requirement (SCR)
If capital falls below SCR the insurance company
must submit a plan for bringing it back up to
SCR.
If capital; drops below MCR supervisors are likely
to prevent the insurance company from taking
new business

Solvency II continued
Internal models vs standardized
approach
One year 99.5% confidence for internal
models
Capital charge for investment risk,
underwriting risk, and operational risk
Three types of capital

Problems With Basel II

Portfolio invariance.
Single global risk factor.
Financial system promises are not treated
equallyregulatory arbitrage facilitated by
complete markets in credit (the CDS market
particularly).
Pro-cyclicality.
Subjective inputs.
Unclear and inconsistent definitions.

Example of Regulatory Arbitrage

Bank A lends $1000 to a BBB rated company, 100% risk
weighted, by buying a bond and would have to hold $80
capital. Bank A holds a promise by the company to pay
a coupon and redeem at maturity.
Bank A buys a CDS from Bank B on the bond, shorting
the bond and passing the promise to redeem from the
company to Bank B.
Because B is a bank, which carries a 20% capital
weight, Bank A reduces its required capital to 20% of
$80, or $16.
Bank B underwrites the risk with a reinsurance
company outside of the banking system; the promise to
redeem is now outside the banks and the BIS capital
rules dont apply.

Example of Regulatory Arbitrage

(cont.)

Bank Bs capital required for counterparty risk is only 8% of an amount

determined as follows:
the CDS spread price of say $50 (500bps)
plus a regulatory surcharge coefficient of 1.5% of the face value of
the bond (i.e. $15)
all multiplied by the 50% weighting for off balance sheet
commitments. That is, $2.60 (i.e. 0.08*$65*0.5).

So jointly the banks have managed to reduce their capital required from
$80 to $18.60 a 70.6% fall.

In effect, in this example, the CDS contracts make it possible to reduce

risky debt to some combination of the lower bank risk weight and a
small weight that applies to moving the risk outside of the bank sector

There is little point in defining an ex ante risk bucket

of company bond as 100% risk weighted in the first place.

Shifting the Promises Example

of Regulatory Arbitrage (cont.)