1 Lecture 6b: An Introduction The Basel I & Basel II

2 “Knowledge has to be improved, challenged and increased constantly or it vanishes ” Peter Drucker Risk Management and Basel II Risk Management Division Bank Alfalah Limited Javed H. Siddiqi

3 Managing Risk Effectively: Three Critical Challenges GLOBALISM TECHNOLOGY CHANGE Management Challenges for the 21 st Century

4 Agenda What is Risk ? Types of Capital and Role of Capital in Financial Institution Capital Allocation and RAPM Expected and Unexpected Loss Minimum Capital Requirements and Basel II Pillars Understanding of Value of Risk-VaR Basel II approach to Operational Risk management Basel II approach to Credit Risk management Credit Risk Mitigation-CRM, Simple and Comprehensive approach. The Causes of Credit Risk Best Practices in Credit Risk Management Correlation and Credit Risk Management. Credit Rating and Transition matrix. Issues and Challenges Summary

5 What is Risk? Risk, in traditional terms, is viewed as a ‘negative’. Webster’s dictionary, for instance, defines risk as “exposing to danger or hazard”. The Chinese give a much better description of risk >The first is the symbol for “danger”, while >the second is the symbol for “opportunity”, making risk a mix of danger and opportunity.

6 Risk Management Risk management is present in all aspects of life; It is about the everyday trade-off between an expected reward an a potential danger. We, in the business world, often associate risk with some variability in financial outcomes. However, the notion of risk is much larger. It is universal, in the sense that it refers to human behaviour in the decision making process. Risk management is an attempt to identify, to measure, to monitor and to manage uncertainty.

7 Capital Allocation and RAPM The role of the capital in financial institutions and the different type of capital. The key concepts and objective behind regulatory capital. The main calculations principles in the Basel II the current Basel II Accord. The definition and mechanics of economic capital. The use of economic capital as a management tool for risk aggregation, risk-adjusted performance measurement and optimal decision making through capital allocation.

8 Role of Capital in Financial Institution Absorb large unexpected losses Protect depositors and other claim holders Provide enough confidence to external investors and rating agencies on the financial heath and viability of the institution.

9 Type of Capital Economic Capital (EC) or Risk Capital. An estimate of the level of capital that a firm requires to operate its business. Regulatory Capital (RC). The capital that a bank is required to hold by regulators in order to operate. Bank Capital (BC) The actual physical capital held

10 Economic Capital Economic capital acts as a buffer that provides protection against all the credit, market, operational and business risks faced by an institution. EC is set at a confidence level that is less than 100% (e.g. 99.9%), since it would be too costly to operate at the 100% level.

11 Risk Measurement- Expected and Unexpected Loss The Expected Loss (EL) and Unexpected Loss (UL) framework may be used to measure economic capital Expected Loss: the mean loss due to a specific event or combination of events over a specified period Unexpected Loss: loss that is not budgeted for (expected) and is absorbed by an attributed amount of economic capital Losses so remote that capital is not provided to cover them. 500 Expected Loss, Reserves Economic Capital = Difference 2,000 0 Total Loss incurred at x% confidence level Determined by confidence level associated with targeted rating Probability Cost 2,500 EL UL

12 Minimum Capital Requirements Basel II And Risk Management

13 History

14 Comparison Basel IBasel 2 Focus on a single risk measureMore emphasis on banks’ internal methodologies, supervisory review and market discipline One size fits allFlexibility, menu of approaches. Provides incentives for better risk management Operational risk not consideredIntroduces approaches for Credit risk and Operational risk in addition to Market risk introduced earlier. Broad brush structureMore risk sensitivity

15 Objectives The objective of the New Basel Capital accord (“Basel II) is: 1.To promote safety and soundness in the financial system 2.To continue to enhance completive equality 3.To constitute a more comprehensive approach to addressing risks 4.To render capital adequacy more risk-sensitive 5.To provide incentives for banks to enhance their risk measurement capabilities

16 MINIMUM CAPITAL REQUREMENTS FOR BANKS (SBP Circular no 6 of 2005) IRAF RatingRequired CAR effective from Institutional Risk Assessment Framework (IRAF) 31 st Dec st Dec., 2006 and onwards 1 & 28% 39%10% 4 12% 5 14%

17 Overview of Basel II Pillars The new Basel Accord is comprised of ‘three pillars’… Pillar I Minimum Capital Requirements Establishes minimum standards for management of capital on a more risk sensitive basis: Credit Risk Operational Risk Market Risk Pillar II Supervisory Review Process Increases the responsibilities and levels of discretion for supervisory reviews and controls covering: Evaluate Bank’s Capital Adequacy Strategies Certify Internal Models Level of capital charge Proactive monitoring of capital levels and ensuring remedial action Pillar III Market Discipline Bank will be required to increase their information disclosure, especially on the measurement of credit and operational risks. Expands the content and improves the transparency of financial disclosures to the market.

18 Development of a revised capital adequacy framework Components of Basel II Pillar 1Pillar 2Pillar 3 The three pillars of Basel II and their principles Basel II Supervisory review process How will supervisory bodies assess, monitor and ensure capital adequacy? Internal process for assessing capital in relation to risk profile Supervisors to review and evaluate banks’ internal processes Supervisors to require banks to hold capital in excess of minimum to cover other risks, e.g. strategic risk Supervisors seek to intervene and ensure compliance Market disclosure What and how should banks disclose to external parties? Effective disclosure of: -Banks’ risk profiles -Adequacy of capital positions Specific qualitative and quantitative disclosures -Scope of application -Composition of capital -Risk exposure assessment -Capital adequacy Minimum capital requirements How is capital adequacy measured particularly for Advanced approaches? Better align regulatory capital with economic risk Evolutionary approach to assessing credit risk -Standardised (external factors) -Foundation Internal Ratings Based (IRB) -Advanced IRB Evolutionary approach to operational risk -Basic indicator -Standardised -Adv. Measurement Issue Principle Continue to promote safety and soundness in the banking system Ensure capital adequacy is sensitive to the level of risks borne by banks Constitute a more comprehensive approach to addressing risks Continue to enhance competitive equality Objectives

19 Overview of Basel II Approaches (Pillar I) Approaches that can be followed in determination of Regulatory Capital under Basel II Total Regulatory Capital Operational Risk Capital Credit Risk Capital Market Risk Capital Basic Indicator Approach Standardized Approach Advanced Measurement Approach (AMA) Standardized Approach Internal Ratings Based (IRB) Foundation Advanced Standard Model Internal Model Score Card Loss Distribution Internal Modeling