Presentation on theme: "BASEL I and BASEL II: HISTORY OF AN EVOLUTION"— Presentation transcript:
1 BASEL I and BASEL II: HISTORY OF AN EVOLUTION Hasan ErselHSEMay 23, 2011
2 SEARCHING WAYS TO REGULATE BANKS: THE U.S. PRACTICE Capital Adequacy Requirements (1900s)Regulation Q of the Federal Reserve ( ): limited interest rate paid banks, restrained price competition.Prohibition of interstate branching ( ) (Bank Holding Company Act of 1956; Repealed by Riggle-Neal Interstate Banking and Branching Efficiency Act of 1994)Glass-Steagal Act ( ) forbade investment banks from engaging in “banking activities
3 HISTORY OF CAPITAL ADEQUACY RULES IN THE U.S. 1900-late 1930s: Capital to Deposit Ratio (The Office of Comptroller of the Currency [OCC] adopted the 10% minimum)Late 1930s: Capital to Total Assets (FDIC)II WW: No capital ratios (Banks were buying US Government bonds)1945-late 1970s: Capital to “Risk Assets” Ratio (FED and FDIC), Capital to Total Assets Ratio (FDIC)
4 BANK SAFETY AND SOUNDNESS Capital adequacy requirementsi) provide a buffer against bank lossesii) protects creditors in the event of bank failsiii) creates disincentive for excessive risk taking
5 INTERNATIONAL REGULATION 1988 Basel Accord (Basel-I)1993 Proposal: Standard Model1996 Modification: Internal ModelNew Basel Accord (Basel-II)
6 THE FIRST BASEL ACCORDThe first Basel Accord (Basel-I) was completed in 1988
7 WHY BASEL-I WAS NEEDED?The reason was to create a level playing field for “internationally active banks”Banks from different countries competing for the same loans would have to set aside roughly the same amount of capital on the loans
8 1988 BASEL ACCORD (BASEL-I) 1)The purpose was to prevent international banks from building business volume without adequate capital backing2) The focus was on credit risk3) Set minimum capital standards for banks4) Became effective at the end of 1992
9 A NEW CONCEPT: RISK BASED CAPITAL Basel-I was hailed for incorporating risk into the calculation of capital requirements
10 “COOKE” RATIONamed after Peter Cooke (Bank of England), the chairman of the Basel committee)Cooke Ratio=Capital/ Risk Weighted Assets≥8%Definition of CapitalCapital= Core Capital+ Supplementary Capital- Deductions
11 BASEL-I CAPITAL REQIREMENTS Capital was set at 8% and was adjusted by a loan’s credit risk weightCredit risk was divided into 5 categories: 0%, 10%, 20%, 50%, and 100%Commercial loans, for example, were assigned to the 100% risk weight category
12 CALCULATION OF REQUIRED CAPITAL To calculate required capital, a bank would multiply the assets in each risk category by the category’s risk weight and then multiply the result by 8%Thus a $100 commercial loan would be multiplied by 100% and then by 8%, resulting in a capital requirement of $8
13 CORE & SUPPLEMENTARY CAPITAL Core Capital (Tier I Capital)i) Paid Up Capitalii) Disclosed Reserves (General and Legal Reserves)Supplementary Capital (Tier II Capital)i) General Loan-loss Provisionsii) Undisclosed Reserves (other provisions againstprobable losses)iii) Asset Revaluation Reservesiv) Subordinated Term Debt (5+ years maturity)v) Hybrid (debt/equity) instruments
14 DEDUCTIONS FROM THE CAPITAL Investments in unconsolidated banking and financial subsidiary companies and investments in the capital of other banks & financial institutionsGoodwill
15 DEFINITION OF CAPITAL IN BASEL-I (1) TIER 1Paid-up share capital/common stockDisclosed reserves (legal reserves, surplus and/or retained profits)
16 DEFINITION OF CAPITAL IN BASEL-I (2) TIER 2Undisclosed reserves (bank has made a profit but this has not appeared in normal retained profits or in general reserves of the bank.)Asset revaluation reserves (when a company has an asset revalued and an increase in value is brought to account)General Provisions (created when a company is aware that a loss may have occurred but is not sure of the exact nature of that loss) /General loan-loss reservesHybrid debt/equity instruments (such as preferred stock)Subordinated debt
17 RISK WEIGHT CATEGORIES IN BASEL-I (1) Cash,Claims on central governments and central banks denominated in national currency and funded in that currencyOther claims on OECD countries, central governments and central banksClaims collateralized by cash of OECD government securities or guaranteed by OECD Governments
18 RISK WEIGHT CATEGORIES IN BASEL-I (2) Claims on multilateral development banks and claims guaranteed or collateralized by securities issued by such banksClaims on, or guaranteed by, banks incorporated in the OECDClaims on, or guaranteed by, banks incorporated in countries outside the OECD with residual maturity of up to one yearClaims on non-domestic OECD public-sector entities, excluding central government, and claims on guaranteed securities issued by such entitiesCash items in the process of collection
19 RISK WEIGHT CATEGORIES IN BASEL-I (3) Loans fully securitized by mortgage on residential property that is or will be occupied by the borrower or that is rented.
20 RISK WEIGHT CATEGORIES IN BASEL-I (4) Claims on the private sectorClaims on banks incorporated outside the OECD with residual maturity of over one yearClaims on central governments outside the OECD (unless denominated and funded in national currency)Claims on commercial companies owned by the public sectorPremises, plant and equipment, and other fixed assetsReal estate and other investmentsCapital instruments issued by other banks (unless deducted from capital)All other assets
21 RISK WEIGHT CATEGORIES IN BASEL-I (5) At National Discretion (0,10,20 or 50%)Claims on domestic public sector entities, excluding central governments, and loans guaranteed by securities issued by such entities
22 Basel-I accord was criticized CRITIQUE OF BASEL-IBasel-I accord was criticizedi) for taking a too simplistic approach to setting credit risk weightsandii) for ignoring other types of risk
23 THE PROBLEM WITH THE RISK WEIGHTS Risk weights were based on what the parties to the Accord negotiated rather than on the actual risk of each assetRisk weights did not flow from any particular insolvency probability standard, and were for the most part, arbitrary.
24 OPERATIONAL AND OTHER RISKS The requirements did not explicitly account for operating and other forms of risk that may also be importantExcept for trading account activities, the capital standards did not account for hedging, diversification, and differences in risk management techniques
25 1993 PROPOSAL: STANDARD MODEL Total Risk= Credit Risk+ Market RiskMarket Risk= General Market Risk+ Specific RiskGeneral Market Risk= Interest Rate Risk+ Currency Risk+ Equity Price Risk + Commodity Price RiskSpecific Risk= Instruments Exposed to Interest Rate Risk and Equity Price Risk
26 1996 MODIFICATION: INTERNAL MODEL Internal Model → Value at Risk MethodologyTier III Capital (Only for Market Risk)i) Long Term subordinated debtii) Option not to pay if minimum required capital is <8%
27 BANKS’ OWN CAPITAL ALLOCATION MODELS Advances in technology and finance allowed banks to develop their own capital allocation (internal) models in the 1990sThis resulted in more accurate calculations of bank capital than possible under Basel-IThese models allowed banks to align the amount of risk they undertook on a loan with the overall goals of the bank
28 INTERNAL MODELS AND BASEL I Internal models allow banks to more finely differentiate risks of individual loans than is possible under Basel-IRisk can be differentiated within loan categories and between loan categoriesAllows the application of a “capital charge” to each loan, rather than each category of loanFor instance, it may appear to be good business to originate risky loans with their accompanying high interest rates. However, if the internal models calculate that these loans default more and thus need more capital charged against them, the loans may not be as profitable as lower risk, lower earning loans that require far less capital.
29 VARIATION IN RISK QUALITY Banks discovered a wide variation in credit quality within risk-weight categoriesBasel-I lumps all commercial loans into the 8% capital categoryInternal models calculations can lead to capital allocations on commercial loans that vary from 1% to 30%, depending on the loan’s estimated risk
30 CAPITAL ARBITRAGEIf a loan is calculated to have an internal capital charge that is low compared to the 8% standard, the bank has a strong incentive to undertake regulatory capital arbitrageSecuritization is the main means used especially by U.S. banks to engage in regulatory capital arbitrageAt present, securitization is, without a doubt, the major regulatory capital arbitrage tool used by large U.S. banks
31 EXAMPLES OF CAPITAL ARBITRAGE Assume a bank has a portfolio of commercial loans with the following ratings and internally generated capital requirementsAA-A: 3%-4% capital neededB+-B: 8% capital neededB- and below: 12%-16% capital neededUnder Basel-I, the bank has to hold 8% risk-based capital against all of these loansTo ensure the profitability of the better quality loans, the bank engages in capital arbitrage--it securitizes the loans so that they are reclassified into a lower regulatory risk category with a lower capital chargeLower quality loans with higher internal capital charges are kept on the bank’s books because they require less risk-based capital than the bank’s internal model indicatesAs this form of regulatory capital arbitrage grew, it became obvious that a new approach to risk based capital was needed.
32 NEW APPRACH TO RISK-BASED CAPITAL By the late 1990s, growth in the use of regulatory capital arbitrage led the Basel Committee to begin work on a new capital regime (Basel-II)Effort focused on using banks’ internal rating models and internal risk modelsJune 1999: Committee issued a proposal for a new capital adequacy framework to replace the 1998 Accord
34 Basel-II consists of three pillars: Minimum capital requirements for credit risk, market risk and operational risk—expanding the 1988 Accord (Pillar I)Supervisory review of an institution’s capital adequacy and internal assessment process (Pillar II)Effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices (Pillar III)
35 IMPLEMENTATION OF THE BASEL II ACCORD Implementation of the Basel II Framework continues to move forward around the globe. A significant number of countries and banks already implemented the standardized and foundation approaches as of the beginning of 2007.In many other jurisdictions, the necessary infrastructure (legislation, regulation, supervisory guidance, etc) to implement the Framework is either in place or in process, which will allow a growing number of countries to proceed with implementation of Basel II’s advanced approaches in 2008 and 2009.This progress is taking place in both Basel Committee member and non-member countries.
37 BASEL-II (2) PILLAR I: Minimum Capital Requirement Capital Measurement: New MethodsMarket Risk: In Line with 1993 & 1996Operational Risk: Working on new methods
38 BASEL-II (3) Pillar I is trying to achieve If the bank’s own internal calculations show that they have extremely risky, loss-prone loans that generate high internal capital charges, their formal risk-based capital charges should also be highLikewise, lower risk loans should carry lower risk-based capital charges
39 1) Standard Method: Using external rating for BASEL-II (4)Credit Risk Measurement1) Standard Method: Using external rating fordetermining risk weights2) Internal Ratings Method (IRB)a) Basic IRB: Bank computes only the probability ofdefaultb) Advanced IRB: Bank computes all risk components(except effective maturity)
41 BASEL-II (6)Pillar I also adds a new capital component for operational riskOperational risk covers the risk of loss due to system breakdowns, employee fraud or misconduct, errors in models or natural or man-made catastrophes, among othersOperational risk events can be quite expensive. Citibank and JP Morgan Chase suffered large losses from Enron and MCI, the Royal Bank of Scotland took a very large fraud loss at their American subsidiary All First Financial.
42 BASEL-II (7) PILLAR 2: Supervisory Review Process Banks are advised to develop an internal capital assessment process and set targets for capital to commensurate with the bank’s risk profileSupervisory authority is responsible for evaluating how well banks are assessing their capital adequacy
43 PILLAR 3: Market Discipline BASEL-II (8)PILLAR 3: Market DisciplineAims to reinforce market discipline through enhanced disclosure by banks. It is an indirect approach, that assumes sufficient competition within the banking sector.
44 ASSESSING BASEL-IITo determine if the proposed rules are likely to yield reasonable risk-based capital requirements within and between countries for banks with similar portfolios, four quantitative impact studies (QIS) have been undertaken
45 RESULTS OF QUANTITATIVE IMPACT STUDIES (QIS) Results of the QIS studies have been troublingWide swings in risk-based capital requirementsSome individual banks show unreasonably large declines in required capitalAs a result, parts of the Basel II Accord have been revised
46 IMPLICATIONS OF BASEL-II (1) The practices in Basel II represent several important departures from the traditional calculation of bank capitalThe very largest banks will operate under a system that is different than that used by other banksThe implications of this for long-term competition between these banks is uncertain, but merits further attention
47 IMPLICATIONS OF BASEL-II (2) Basel II’s proposals rely on banks’ own internal risk estimates to set capital requirementsThis represents a conceptual leap in determining adequate regulatory capitalFor regulators, evaluating the integrity of bank models is a significant step beyond the traditional supervisory process
48 IMPLICATIONS OF BASEL-II (3) Despite Basel II’s quantitative basis, much will still depend on the judgment1) of banks in formulating their estimatesand2) of supervisors in validating the assumptions used by banks in their models
49 PRO-CYCLICALITY OF THE CAPITAL ADEQUACY REQUIREMENT “In a downturn, when a bank’s capital base is likely being eroded by loan losses, its existing (non-defaulted) borrowers will be downgraded by the relevant credit-risk models, forcing the bank to hold more capital against its current loan portfolio. To the extent that it is difficult or costly for the bank to raise fresh external capital in bad times, it will be forced to cut back on its lending activity, thereby contributing to a worsening of the initial downturn.”Kashyap & Stein (2004, p. 18)