The Revision of Basel Capital Rules 15 December 2000 ISDA, London Danièle Nouy Secretary General of the Basel Committee B.I.S.

Structure of Presentation A: A few general comments B: Three Pillars and three Options for Pillar 1 C: The Standardised Approach D: The Internal Ratings-Based Approach E: Brief overview of credit risk models F: Other elements 2 Basel Committee on Banking Supervision

A: A Few General Comments Reasons and objectives of the revision The weaknesses of the 1988 Accord: Does not assess capital adequacy in relation to a bank’s true risk profile; Does not sufficiently take into account hedging strategies; Banks can arbitrage their regulatory capital requirements; Covers only credit and market risks; Portfolio diversification is not taken into account. 3 Basel Committee on Banking Supervision

A: A Few General Comments Principles of the Capital Requirements: Theoretical soundness, Operational feasibility, Incorporation of incentives for sound and prudent behaviour, Flexibility. 4 Basel Committee on Banking Supervision

B: Three Pillars & Three Options for Pillar 1 Minimum Capital Requirements (Pillar 1) - Main Changes: More emphasis on credit risk measurement and management and therefore on both external and internal ratings, Better recognition of credit risk mitigation techniques, 3 Options for credit risk; Capital charge for operational risk. 5 Basel Committee on Banking Supervision

B: Three Pillars & Three Options for Pillar 1 The Definition of Capital is unchanged : Tier 1: core capital - Equity - Disclosed reserves - October 1998 interpretation note Tier 2: supplementary capital (limited to 100% Tier 1) - Undisclosed reserves - Revaluation provisions / General loan loss reserves - Hybrid instruments - Subordinated debt (lower Tier 2) Tier 3: (for market risks) short term subordinated debt 6 Basel Committee on Banking Supervision

B: Three Pillars & Three Options for Pillar 1 7 Basel Committee on Banking Supervision

B: Three Pillars & Three Options for Pillar 1 The Standardised Approach (option 1) Risk-weightings are given for certain classes of instruments. The Internal Ratings-Based Approach (option 2) Risk-weightings are based on internal risk assessments, It can more finely distinguish between classes of risk, It can take into account additional risk factors (granularity, maturity, etc.), Credit Risk Models: (option 3). They address concentration and sectoral diversification. The result: “a whole spectrum of choices” depending on each bank’s sophistication. 8 Basel Committee on Banking Supervision

(using Standard & Poor’s Methodology as an example) C: The Standardised Approach Broad Summary (using Standard & Poor’s Methodology as an example) 1 Risk weighting based on risk weighting of sovereign in which the bank is incorporated. 2 Risk weighting based on the assessment of the individual bank. 3 Claims on banks of a short original maturity, for example less than six months, would receive a weighting that is one category more favourable than the usual risk weight on the bank’s claim. 9 Basel Committee on Banking Supervision

C: The Standardised Approach Some changes decided so far: Suppression of the “sovereign floor”, Suppression of the “conditionality elements” to get a less than 100% risk weight: IMF disclosure standards, Basel Committee and IOSCO core principles, etc. Modification of the maturity parameter for interbank claims (option 2) from 6 months to 3 months, Creation of a 50% risk weight for corporates. 10 Basel Committee on Banking Supervision

D: Developing the IRB Approach The Key Objectives in moving beyond the standardised approach to an internal ratings-based approach are: More closely link capital charges with underlying risks, Provide incentives for innovation and improved risk-measurement and management (even more so, due to the different IRB approaches: foundation, advanced), Develop capital charges that are consistent and comparable between banks, across countries, and over time. 11 Basel Committee on Banking Supervision

D: Developing the IRB Approach The consultation paper on capital says:” The Internal Ratings-Based Approach will be applicable to sophisticated banks, subject to supervisory approval”. What do we mean by that? Potentially many banks (many more than we expected when we started developing this option), especially as we offer different “sub-options” , Namely those which can meet defined minimum standards and which internal rating systems can be validated by their national supervisors. 12 Basel Committee on Banking Supervision

D: Developing the IRB Approach The different steps: Step 1: Identifying key elements of rating systems (see the January 2000 paper: Range of Practice in Banks Internal Ratings Systems), Step 2: Building the regulatory framework for eligible internal ratings systems (for commercial and industrial lending but also, other portfolios: Retail, Banks and Sovereigns, Securitised Assets, Project Finance, and Equity in the banking book), Step 3: Linking ratings to capital requirements, Step 4: Developing standards and guidelines for internal systems and processes, as well as validation guidelines. 13 Basel Committee on Banking Supervision

D. Developing the IRB Approach What is an internal rating? It is an indicator of riskiness of loss in individual credit, due to a borrower’s failure to pay as promised. The risk is assessed: through intuitive assessment of general credit quality, or explicitly, through consideration of measurable loss concept, or more likely, and very rightfully, a mix of both. 14 Basel Committee on Banking Supervision

D. Developing the IRB Approach Key loss statistics in the IRBA will include: A rating that reflects the Expected Default Frequency (EDF), or Default Probability (PD) of the borrower, estimated over one year, A separate consideration of the facility’s risk; the Loss Given Default (LGD), A measure of exposure (EAD), Expected losses (EL), Unexpected losses (UL), A maturity adjustment, A granularity adjustment. 15 Basel Committee on Banking Supervision

D. Developing the IRB Approach Among Issues to be Considered: The Number of Grades and the appropriate risk differenciation. - Significant variation in banks: Average around 10 for ‘performing’ and 3 for ‘non-performing’ loans, - No consensus where cut-offs should be (although what should be achieved is rather clear). The Definition of Default, The Eligibility Criteria (for Foundation and Advanced Approaches), The Disclosure requirements. 16 Basel Committee on Banking Supervision

D. Developing the IRB Approach 17 Basel Committee on Banking Supervision

D. Developing the IRB Approach Comparison between Portfolios, for example Commercial and Industrial loans and Retail: C and I: A foundation approach and at least 3 advanced ones, Retail: No foundation approach and 2 different advanced frameworks, based on EL/UL, or on the PD/LGD framework; Different eligibility and validation criteria, Different disclosure requirements, Different risk weight frameworks. 18 Basel Committee on Banking Supervision

D. Developing the IRB Approach What qualitative standards do we expect banks to meet? banks’ rating systems should provide for a meaningful differentiation of risk, data sources used by banks should be suitably rich and robust, ratings should be subject to some form of independent review, ratings should be an integral part of “the culture and management of the bank”: the “Use Test”. 19 Basel Committee on Banking Supervision

D. Developing the IRB Approach Six Key Considerations in developing an IRB approach: Develop more risk-sensitive capital charges achieving a good trade-off between simplicity and conceptual rigor; Decide on acceptable tolerance in the comparability of system inputs and outputs; Maintain sound credit management policies; not impinge on credit culture; Provide incentives for risk management improvements; Overcome data constraints; and validate banks’ inputs. 20 Basel Committee on Banking Supervision

D. Developing the IRB Approach To reconciliate these trade-offs and considerations: a magic concept, “The Evolutionary Approach”: A spectrum of IRB options permitting a more risk-sensitive treatment for banks able to meet higher standards (For example, at least three Advanced approaches for C and I portfolios). 21 Basel Committee on Banking Supervision

E: Credit Risk Models Models represent the right-most point in our continuum: They reflect many of the benefits of internal ratings, while distinguishing risk more finely; They take into account very important additional factors, such as concentration effects: they incorporate correlation between obligors, facilities, and risk factors. 22 Basel Committee on Banking Supervision

E: Credit Risk Models The conclusion of the April 1999 Consultative Document: The report analysed practices in credit risk modelling, and assessed the potential uses of credit risk models for supervisory and regulatory purposes; It welcomed advances in modelling and recognised the potential of models for use in supervisory oversight of banks; But noted, several hurdles (data limitations, parameter specification and estimation, models validation, back and stress-testing, etc.) that must be overcome before models can be used for setting regulatory capital. 23 Basel Committee on Banking Supervision

F: Other Elements A proposed capital charge for other risks: Operational risk - an evolutionary approach starting with 3 options (and a 4th one later on) in Pillar 1; Interest rate in the banking book. A capital charge for outliers, and therefore related to Pillar 2. 24 Basel Committee on Banking Supervision

F: Other Elements Definition of operational risk: “The risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from certain external events”. Options considered for measuring and treating operational risk: the Basic Indicator Approach, The Standardised Approach, The Internal Measurement Approach, The Loss Distribution Approach. 25 Basel Committee on Banking Supervision

F: Other Elements Second Pillar: Supervisory Review of Capital Adequacy Principles relevant to the supervisory review of a bank’s capital adequacy: Capital Above Regulatory Minima, Banks’ Internal Assessment of Capital Adequacy, Supervisory Review Process and comparison between regulatory capital and economic capital, Supervisory Intervention (including Prompt Corrective Action, if need be). 26 Basel Committee on Banking Supervision

F: Other Elements Third Pillar: Market Discipline It implies disclosure of information on: The amount of capital, The risk profile, The capital adequacy. … as well as internal systems when banks use IRB approaches. In this case, it is even a minimum requirement / eligibility criteria. 27 Basel Committee on Banking Supervision

Conclusion Possible calendar of the reform: January 2001, Publication of the 2nd Consultative Package; May 2001, end of the 2nd consultation period; End of 2001, new final document. 28 Basel Committee on Banking Supervision