Capital Adequacy

in line with

Basel II
Presented by:

Islami Bank Bangladesh Ltd.

Basel II Implementation Unit Financial Administration Division Head Office, Dhaka.
1

What is Capital?

The money contributed by the proprietors/ owners to an organization to enable it to function. Example: Book Capital Regulatory Capital Minimum Capital Adequate Capital

Why A Bank Needs Capital?

To get the bank started before deposit come flowing in; To absorb unanticipated losses with sufficient margin of safety to maintain public confidence; To assure shareholders of bank solvency; To comply with regulators; To expand/ growth the business of the Bank.
2

Risk & Risk Weighted Assets (RWA)

Risk is nothing but possibility of losing assets some activity. through

Risk Weighted Assets (RWA): Example

Asset Category
Cash Investment Fixed Assets

Amount in Taka Risk Weight

10,000 1,00,000 50,000 0% 100% 50%

Risk Weighted Assets

0 1,00,000 25,000

Total

1,60,000

1,25,000
3

Risk Based Capital (Basel-II) Pillars & Approaches

Pillar-I Minimum Capital Requirement
Market Risk
(Risk of loss arising from movements in market price in On-Balance Sheet positions) Standardized Approach (*)
(the risks pertaining to Profit (interest) rate related instruments, equities and foreign exchange in the trading book)

Pillar-II Supervisory Review Process

Operational Risk
Risk of loss resulting from operation

Pillar-III Market Discipline

Investment (Credit) Risk

Standardized Approach (*)
(Based on external assessments of Investment (Credit) exposures risk weights by Rating Agencies)

Basic Indicator Approach (*)

(15% of average Gross Income of last 3 (three) years)

Simple Approach
(calculation of risk weight on the basis of the countries risk scores by OECD)

Internal Models Approach

(Value At Risk (VAR) models for pricing of exposures in the trading book)

Standardized Approach
(the risks pertaining to Profit (interest) rate related instruments and equities in the trading book)

Comprehensive Approach (*)

(Risk Weight is assigned by ECAIs.

Foundation Approach Internal Rating Based Approach

(Based on previous 5 (five) years data base) (It is derived from Probability of Default (PD), Loss given default (LGD), Exposure at Default (EAD) & maturity (M) determined by Supervisor and concerned Bank)

Advanced Measurement Approach

(Banks estimates of Expected Loss (EL) and Unexpected Loss (UL))

Advanced Approach
( It is derived from PD, LGD, EAD and M determined by concerned Bank only)

(*) Approaches selected by the Bangladesh Bank

Minimum Capital Requirements (MCR) (1st Pillar)

a) No Scheduled Bank in Bangladesh shall commence and carry on its business unless it has a minimum Paid up Capital as fixed by BB from time to time {currently
Tk.200 crore (BRPD Circular No.12 dated 05.11.2007 & Tk.400 crore within 2011 (BRPD Circular No.11 14.08.2008)} .

b) Banks shall also maintain a minimum Capital Adequacy Ratio (CAR) at least 10% of Risk Weighted Assets (RWA) with core capital (Tier-1) not less than 5% (i.e. 50% of Core Capital) of RWA. CAR would be derived dividing total Eligible Regulatory Capital by RWA and multiplied by 100.
Eligible Regulatory Capital CAR = RWA 100

c) Total Risk weighted Assets (RWA): Total RWA will be determined by multiplying capital charge for market risk and operational risk by 10 (i.e. the reciprocal of the minimum capital adequacy ratio of 10%) and adding the resulting figures to the sum of risk weighted assets for Investment (credit) risk i.e. Total RWA = RWA for Credit Risk + 10 (Capital Charge for Market Risk + Capital Charge for Operational Risk)

MCR = 10% of Total RWA

5

Regulatory capital

Tier 1 Capital Core Capital

a. Paid up capital/capital deposited with BB b. Non-repayable share premium account c. Statutory Reserve d. General Reserve e. Retained Earnings f. Dividend Equalization Account g. Minority Interest in subsidiaries h. Non-Cumulative irredeemable Preference Shares

Tier 2 Capital Supplementary Capital

a. General Provision b. Asset Revaluation Reserves c. Revaluation Reserves for Securities d. Perpetual Subordinated Debt e. Investment Loss Offsetting Reserve f. All other Preference Shares g. Exchange Equalization Account

Tier 3 Capital Additional Supplementary Capital

consisting of short-term subordinated debt (original/ residual maturity less than or equal to five years but greater than or equal to two years).

Conditions for maintaining Regulatory Capital

1) Eligible Tier 2 plus Tier 3 capital shall not exceed total Tier 1 capital. 2) Fifty percent (50%) of Asset Revaluation Reserves shall be eligible for Tier 2 i.e. Supplementary Capital. 3) A minimum of about 20% of market risk needs to be supported by Tier 1 capital. Supporting of Market Risk from Tier 3 capital shall be limited up to maximum of 250% of a banks Tier 1 capital that is available after meeting credit risk capital requirement. 4) Up to 50% of Revaluation Reserves for Securities shall be eligible for Supplementary Capital. 5) Subordinated debt shall be limited to a maximum of 30% of the amount of Tier 1 capital and shall also include rated and listed subordinated debt instruments/bonds raised in the capital market.
7

Investment (Credit) Risk

Credit risk means probability of violation of commitment by an obligor.

Measurement Methodology of RWA for Investment Risk (under SA)

According to the standardized approach of Basel II framework, the risk weight will be based on the risk assessment made by External Credit Assessment Institutions (ECAIs) duly recognized by BB. Risk weights are based on external rating or a fixed weight that is broadly aligned with the likelihood of counterparty default.

Some Important Definitions

Claims: All exposures such as deposit, placement, investments, loans and advances underlying with counterparties. Claims on Government/ Public Sector Entities (PSE): All exposures including loans and advances to and investments in all public corporations, statutory boards & authorities, local government bodies etc. owned or controlled by Government of Bangladesh or any entity is categorized by BB as PSE. Claims on Corporate: This includes all exposures including loans and advances to and investments in corporate. Corporate refers to any proprietorship, partnership or limited company that is neither a PSE, Bank, Non bank financial Institutions (NBFIs) nor borrower within the definition of Retail Portfolio and Small Enterprises. Claims secured by Residential Property: Investment (Lending) fully secured by mortgages on residential property that is or will be occupied by the borrower or that is rented. Claims secured by Commercial Real Estate: Investment (Lending) fully secured by mortgages on commercial real estate mortgages will be used for office and /or multipurpose commercial premises and/or multitenanted commercial premises etc. except residential property. Past Due Claims: All claims including all exposures such as investments, loans and advances classified as per the prudential regulations issued by BB and as amended from time to time, net of specific provisions should be considered as past due claims.

Some Important Definitions

Retail Portfolio: Qualifying Criteria for the Retail Portfolio are as follows: Orientation criterion: The exposure should be to an individual person or persons. Product criterion : The exposure should be of one of the following product types: - Revolving credit and lines of credit including overdrafts and credit cards; - Personal term Investment (loans) and leases {e.g. installment Investment (loans), vehicle Investment (loans) & leases, student & educational Investment (loans), personal finance} Granularity criterion: In order to meet this criterion, no aggregate exposure without considering Credit Risk Mitigation (CRM), to one counterpart should exceed 0.2% of the overall retail portfolio excluding any non-performing Investment (loans). Maximum value of individual exposures: 0.2% of the overall Retail or BDT 75,00,000 (Seventy five lac), which ever is lower. l) Small and Medium Enterprises (SME): Small and Medium enterprise mean that enterprise which is ideally not any public limited company and fulfills the following criteria: Small Enterprise (Total fixed assets excluding land and building)
Tk.50,000/- to Tk.50,00,000/Tk.50,000/- to Tk.50,00,000/Tk.50,000/- to Tk.1,50,00,000/Not exceeding 25 persons (In all cases)

Enterprise/ Concern
Trading Concern Service Sector Manufacturing Working Manpower

Medium Enterprise (Total fixed assets excluding land and building)

Tk.50,00,000/- to Tk.10,00,00,000/Tk.50,00,000/- to Tk.10,00,00,000/Tk.1,50,00,000/- to Tk.20,00,00,000/Total 50 persons for Trading & Service and 150 persons for Manufacturing

10

External Credit Assessment Institutions (ECAIs)

Six criteria for recognition of ECAI :
rating methodology is rigorous and systematic. Independent - from political or economic pressure, conflict of interest. Transparency - available to both domestic and foreign institutions. Rating Methodology is made publicly available. Disclosure Information related to definition of default, actual default rate, rating transition, etc. Resources - sufficient to carry out high quality rating . Credibility - Confidence of investors, reputation, etc.
Objectivity

Market Segments:
Sovereign (Government, PSE & Autonomous Bodies) Financial Institutions (Banks, Insurance & Other FI)

Corporate Others

Finally, supervisors will map as to which assessment category corresponds to which RW.
11

ECAIs Rating Category (Assumed)

Table 1 (*)

BB Rating Grade
1
2 3 4 5 6

Equivalent Rating of CRISL

AAA, AA+, AA, AAA+, A, ABBB+, BBB, BBBBB+, BB, BBB+, B, BC, D Short-Term Rating Category Mapping

Equivalent Rating of CRAB

AAA, AA1, AA2, AA3
A1, A2, A3 BBB1, BBB2, BBB3 BB1, BB2, BB3 B1, B2, B3 C, D

S1
S2

ST-1
ST-2

ST-1
ST-2

S3
S4

ST-3
Others

ST-3
Others

(*) Recognition of ECAIs is not yet finalised by the Bangladesh Bank. CRISL: CRAB: Credit Rating Information Services Limited Credit Rating of Bangladesh Limited 12

Risk Weighted Asset (RWA) for Balance Sheet Exposure

Table 2
Sl. No
a) b) c) d) e)

Exposure Type

BBs Rating Grade

Risk Weight (%)

0 0

Cash and Cash Equivalents

Claims on Bangladesh Government (other than PSEs) and BB Claims on other Sovereigns & Central Banks Claims on Bank for International Settlements, International Monetary Fund and European Central Bank Claims on Multilateral Development Banks (MDBs) i) IBRD , IFC, ADB, AfDB, EBRD, IADB, EIB, EIF, NIB, CDB, IDB, CEDB ii) Other MDBs {e.g. (i) Central American Bank for Economic Integration (CABEI) (ii) East African Development Bank (EABD) (iii) International Fund for Agricultural Development (IFAD)} 1 2,3 4,5 6 Unrated

0 20 50 100 150 50

13

Sl. No
f)

Exposure Type

BBs Rating Grade

1 2,3 4,5 6 Unrated

Risk Weight (%)

20 50 100 150 50

Claims on Public Sector Entities (other than Government)

in Bangladesh

g)

Claims on Banks
i) Maturity over 3 months 1 2,3 4,5 6 20 50 100 150

Unrated
ii) Maturity less than 3 months h) 20 1 2 3,4 5,6 Unrated

100

Claims on Corporate (excluding equity exposures)

20 50 100 150 125 14

Fixed Risk Weight Groups

SN.
i) j) k) l) m)

Exposure Type
Claims as Retail Portfolio & Small Enterprise (excluding consumer finance) Consumer Investment (Finance) Claims fully secured by Residential Property Claims fully secured by Commercial Real Estate
Past Due Claims 1. The claim (other than claims secured by eligible residential property) that is past due for more than 90 days, where specific provisions are: - less than 20% of the outstanding amount of the past due claim ; - no less than 20% of the outstanding amount of the past due claim. - more than 50% of the outstanding amount of the past due claim. 2. Claims fully secured against residential property past due for more than 90 days and/or impaired specific provision is less than 20% of outstanding amount. 3. Claims fully secured against residential property past due by 90 days and /or impaired & specific provision held is more than 20% of outstanding amount.

RW (%)
75 100 50 100

150 100 50 100 75 150 100 100 100 15

n) o) p) q)

Investments in venture capital Investments in premises, plant and equipment and all other fixed assets Claims on all fixed assets under operating lease All other assets

Risk Weighted Assets for Off-Balance Sheet (OBS) Exposures

The risk-weighted amount of the OBS transaction is generally calculated by means of a two-step process:
(a)

First, the notional amount of the transaction is converted into a balance sheet equivalent (i.e. credit equivalent amount) by multiplying the amount by a specified Credit Conversion Factor (CCF). Second, after conversion of the contingencies the resulting credit equivalent amount will be multiplied by the risk-weight associated with that counterparty Credit Rating.

(b)

16

Non-Market Related OBS Transactions

Sl. Nature of transaction No.
1 2 3 4 5 Direct Credit Substitutes Performance-related Contingencies Trade-related Contingencies Lending of securities or posting of securities as collateral Other Commitments Commitments with certain drawdown. Commitments (e.g. undrawn formal standby facilities and credit lines) with an original maturity of: (i) one year or less. (ii) over one year. (c) Commitments that can be unconditionally cancelled at any time without notice (e.g. undrawn overdraft and credit card facilities providing 0% that any outstanding unused balance is subject to review at least annually) or effectively provide for automatic cancellation due to deterioration in a borrowers creditworthiness.

Credit Conversion Factor (CCF)

100% 50% 20% 100% 100%

20% 50% 0%

17

Risk Weighted Amount for Off-Balance Sheet Exposures

Sl. No
a) b) c) d)

Exposure Type

BBs Rating Grade

Risk Weight (%)

0

Exposure

Risk Weighted Assets

Cash and Cash Equivalents

Claims on Bangladesh Government (other than PSEs) and BB Claims on other Sovereigns & Central Banks Claims on Bank for International Settlements, International Monetary Fund and European Central Bank Claims on Multilateral Development Banks (MDBs) i) IBRD , IFC, ADB, AFDB, EBRD, IADB, EIB, EIF, NIB, CDB, IDB, CEDB ii) Other MDBs 1 2,3 4,5 6 Unrated

e)

0 20 50 100 150 50 18

Risk Weighted Amount for Off-Balance Sheet Exposures

Sl. No f) Exposure Type BBs Rating Grade Risk Weight (%) Exposure Risk Weighted Assets

Claims on Banks

(i) Maturity over 3 months

1
2,3 4,5 6 Unrated

20
50 100 150 50

(ii) Maturity less than 3 months g) Claims on Corporate 1 2 3,4 5,6 Unrated h) i) j) Claims as Retail Portfolio & SE Consumer Finance All Other Assets

20 20 50 100 150 125 75 100 100 19

Credit Risk Mitigation (CRM)

Eligible financial Collateral:
i) Cash (Fixed Deposit or comparable instruments of the same bank) ii) Gold iii) Debt securities rated by a recognized ECAI iv) Debt securities not rated by a recognized ECAI v) Equities (including convertible bonds) included in a DSE/CSE-20. vi) Undertakings for Collective Investments in Transferable Securities (UCITS) and mutual funds; and vii) Equities (including convertible bonds) which are not included in a DSE/CSE-20 but which are listed on a recognized exchange;

20

Haircuts
Where transactions secured by eligible collateral, banks need to first calculate the net exposure amount by taking into account the effect of collateral. The net exposure amount (if positive) is then weighted according to risk weight of the counterparty to obtain the risk weighted asset amount for the collateralized transaction. In calculating the adjusted exposure amount after risk mitigation, adjustments are applied to both the collateral and the exposure to take into account possible future price fluctuations.

E* = max [0, E x (1 + He) - C x (1 - Hc - Hfx)] Where: E* = the exposure value after risk mitigation E = current value of the exposure for which the collateral qualifies as a risk mitigate He = haircut weight appropriate to the exposure C = the current value of the collateral received Hc = haircut weight appropriate to the collateral Hfx = haircut weight appropriate for currency mismatch between the collateral & exposure

21

Market Risk
Market risk is the possibility of losing assets in balance
sheet and off-balance sheet positions arising out of volatility in market variables i.e. interest rate, exchange rate and price. The total capital requirement for banks against their market risk shall be the sum of capital charge against i. interest rate risk ii. equity position risk (trading book) iii. foreign exchange position risk throughout the banks balance sheet.

22

Market Risk

I) Capital Charges for Interest Rate Risk

A. Capital charges for Specific risk B. Capital charge for General market risk

II) Capital Charges for Equity Position Risk

(a) As with debt securities, the minimum capital standard for equities is expressed in terms of two separately calculated charges the specific risk and the general market risk for the holdings. (b) The capital charge for specific risk will be 10% and the general market risk charge will be 10%.

III) Capital Charges for Foreign Exchange Risk

The capital charge for foreign exchange risk will be 10% of banks overall foreign exchange exposure.

23

Operational Risk
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. Gross income: Gross Income (GI) is defined as Net Investment (interest) income (i.e. Investment Income Profit Paid on Deposits) plus net Non-Investment (non-interest) income (i.e. Commission, Exchange, Others). Under BIA, the capital charge for operational risk is a fixed percentage of average positive annual gross income of the bank over the past three years. Figures for any year in which annual gross income is negative or zero, should be excluded from both the numerator and denominator when calculating the average. The capital charge may be expressed as follows: K = [(GI1+GI2+GI3) x ] / n

24

Operational Risk
Type of Risk:

Losses from employee fraud Accounting error Computer breakdowns Natural disasters

To meet the Risk:

Knowledgeable & capable BoD & skilled Management Require constructive plan, policy & effective oversee Functional check list to establish accountability of operations Audit (Internal & External)

25

Supervisory Review Process (2nd Pillar)

Importance of supervisory review:

i) Better risk management techniques in monitoring and managing their risks. ii) Developing an internal capital assessment process and setting capital targets that are commensurate with the banks risk profile and control environment. iii) Establishing relationship between the planning of adequate capital against all risks and the strength and effectiveness of the banks risk management and internal control processes. iv) The process will consider three main areas of risks i.e. a) Risks covered under minimum regulatory capital, b) Other risks which are not captured by minimum regulatory capital, and c) Risk factors external to the bank.
26

Supervisory Risk
Possibility of losses due to lacking of:
Effective supervisory activity Skilled oversee Control operation Losing integration

To meet the risk:

Require compliance of regulations & instruction of regulatory & supervisory authority Effective own supervision To meet unforeseen losses Regulatory capital (MCR & Adequate)
27

Supervisory Review Process

Banks should have a process for assessing their capital adequacy in relation to their risk profile and a strategy for marinating their capital levels

Main features of a rigorous review process:

1. Board and senior management oversight; 2. Sound capital assessment; 3. Comprehensive assessment of risks; 4. Monitoring and reporting; 5. Internal control review.

28

Market Discipline (3rd Pillar)

1) Scope & purpose

a) The aim of introducing Market discipline is to establish more transparent and more disciplined financial market so that stakeholders can assess the position of a bank regarding holding of assets and to identify the risks relating to the assets and capital adequacy to meet probable loss of assets. For the said purpose, banks will develop a set of disclosure containing the key pieces of information on the assets, risk exposures, risk assessment processes, and hence the capital adequacy to meet the risks.

b) Banks should have a formal disclosure framework approved by the Board of Directors/CEO. The process of their disclosures will include validation and frequency.

29

Market Discipline (3rd Pillar)

2) Relations with accounting disclosures

a) It is expected that the disclosure framework does not conflict with requirements under accounting standards as set by Bangladesh Bank from time to time. b) Banks will use specified approaches/methodologies for measuring the various risks they face and the resulting capital requirements and inform the stakeholders about those risks and provides a consistent and comprehensive disclosure framework of risks. c) The disclosures should be subject to adequate validation. Since information in the annual financial statements would generally be audited, the additionally published with such statements must be consistent with the audited statements.

30

Market Discipline (3rd Pillar)

3) Materiality of Disclosure
Any information which will consider as material and its omission or misstatement is very crucial for economic decision making by the user. To set specific thresholds is difficult for disclosures can be open to manipulation and are difficult to determine, as it can the user who will think over the sufficiency of disclosure.

31

Market Discipline (3rd Pillar)

4) Frequency of disclosures
a) Banks should provide all required disclosures in both qualitative and quantitative, as at end March of each year along with the annual financial statements. Banks may make their annual disclosures both in their annual reports as well as their respective web sites. b) The disclosure on the websites should be made in a web page titled Disclosures on Risk Based Capital (Basel II) and the link to this page should be prominently provided on the home page of the banks website. Each of these disclosures pertaining to a financial year should be available on the websites until disclosure of the 4th subsequent annual (as on March 31) disclosure is made.

32

Market Discipline (3rd Pillar)

5) Disclosure framework
The following components set out in tabular form are the disclosure requirements under: 1. Assets 2. Credit Risk on Banking Book 3. Market risk in Trading Book 4. Operational Risk 5. Specific Provisions 6. Regulatory Capital 7. Capital Adequacy

6) Effective date of disclosures

The first of the disclosures as per these guidelines shall be made as on the effective date viz. March 31, 2010. Banks are, however, encouraged to make the disclosures at an earlier date.
33

Thanks For Your Patience Hearing

34