1. Basel Committee Norms

2. Basel Framework Basel Committee set up in 1974 Objectives –Supervision must be adequate –No foreign bank should escape supervision

3. BASEL I Risk management Capital adequacy, sound supervision and regulation Transparency of operations Unquestionably accepted by developed and developing countries –Capital requirement 8% of assets –Tier 1 capital at 4% –Tier 2 capital at 4%

4. BASEL I Focused on credit risk In 1996, the accord was amended to include market risk Did not recognize risk exposure according to credibility of borrowers No recognition of operational risk

5. BASEL II Following the South East Asian currency crisis, the Basel Committee met in June 1999 and came up with Basel II. Short term funds played a major role in Asian currency crisis. Risk weights accordingly adjusted under Basel II.

6. BASEL II Brings order, discipline and safety to banking institutions. Involves complex calculations based on huge data. Provides a number of approaches for risk measurement. Flexibility for banks to choose an approach in line with their risk profile. Incentives for stronger and more accurate risk measurement.

7. The Three Pillars Supervisory review process Minimum capital Market discipline

8. Capital Adequacy Supervisors can impose additional capital Early intervention by regulators in case of problem

9. Market Discipline Disclosure of information –Capital structure –Capital adequacy –Different types of risk

10. Minimum Capital Requirement BASEL II Banks can choose from different methods Credit risk –Standardized approach –Internal ratings based approach Market risk –Standardized approach –Internal models approach

11. Minimum Capital Requirement BASEL II Operational risk –Basic indicator approach –Standardized approach –Advanced measurement approach

12. Measurement of Credit Risk Standardized approach Internal ratings based approach –Foundation –Advanced

13. Standardised Approach Useful for less sophisticated banks Concept of capital ratio Numerator is amount available Denominator is the measure of risk faced by the bank Risk weights – 0, 20%, 50%, 100%, 150%

14. Internal Ratings Based Approach Prime objectives of IRB approach – Allocation of capital based on internal ratings – More sensitivity to drivers of credit risk Encouraging banks to continue to improve their internal risk management process Foundation and advanced IRB approach Segments portfolios according to bank’s own criteria

15. Internal Ratings Based Approach Apply formula to determine capital ratio for each segment Foundation IRB approach –Banks indicate only Probability of Default (PD) and loss in each segment –Supervisory estimates other components of loss Advanced IRB approach –Banks provide estimates of Loss Given Default (LGD) and Exposure at Default (EAD) and maturity –Requirement of reliable database

16. Internal Ratings Based Approach Probability of default – Likelihood that customers will default in the next 12 months. Exposure at default – Expected amount of exposure at the point of default. Loss given default – Likely financial loss associated with the default.

17. Internal Ratings Based Approach Banks can use their internal estimates of borrower credit worthiness to assess credit risk Credit risk = Exposure x Probability of Default x Loss given Default

18. Measurement of Market Risk Standardized approach Internal model approach

19. Market Risk Interest rate sensitive position –General market risk, Duration or Maturity method –Specific market risk, Net position x weight factor Equity instruments –General market risk – 8% of net position per market –Specific market risk – 8% of net position per issue Precious metals: 10% of net position

20. Market Risk Currencies –10% of all net long or short positions whichever is greater Commodities –20% of net position per commodity group + 3% of net position of all commodity groups

21. Measurement of Operational Risk Any risk not characterized as market or credit risk Risk arising out of human or technical error Settlement or payment risk Business interruption risk Inadequate systems, controls, processes Fraud

22. Measurement of Operational Risk Exists almost anywhere in the organization –Can be high occurrence low value or low occurrence high value Basic indicator approach Standardized approach Advanced measurement approach

23. Types of Operational Risk Based on causes – People oriented – Process oriented – Technology oriented – External

24. Types of Operational Risk Based on effect – Legal liability – Regulatory compliance and taxation penalties – Loss or damage to assets

25. Types of Operational Risk Based on event –Internal fraud –External fraud –Employment practices and workplace safety –Clients, products and business practices –Business disruption and systems failures –Execution, delivery and process management

26. Basic Indicator Approach Capital allocation is based on a single indicator –Gross income as a proxy for operational risk –Regulatory norm (%) X Gross income Easy to implement Limited responsiveness to firm specific needs and characteristics Applicable for smaller size domestic banks

27. Standardised Approach More complex than basic indicator approach Better able to reflect the differing risk profiles across banks Within each business line, a broad indicator can be chosen Bank activities segregated into eight business lines

28. Standardised Approach (Example) Business LinePercentage Corporate finance18% Trading and sales18% Retail banking12% Commercial banking15% Payment and settlement18% Agency services15% Asset management12% Retail brokerage12%

29. Standardised Approach Split gross income into business lines Multiply average gross income for three years by the regulator stated beta In a simplified approach, split gross income across traditional banking (commercial and retail) and other activities.

30. Advanced Measurement Approach Bank uses internal measurement using both quantitative and qualitative criteria Internal loss data is used in determining required capital Qualitative criteria –Independent function –Involvement of Board –Reporting of exposure and loss experience

31. Advanced Measurement Approach Documentation of risk management system Quantitative criteria Stress testing Approximate risk measurement Expected loss and unexpected loss Minimum 5 years of observation period of internal loss data