1. Basel Capital Adequacy Framework
Eric Falkenstein
Vice President
ICM Credit Risk Management for Asian Financial Institutions
June 28, 2000
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2. Topics The current capital regulations The current Basel dialogue
Next Steps

3. What is Bank Capital?
Bank Capital is: Bank Capital is not:
- Common Equity - Customer Deposits
- Preferred Equity - Short-term Debt
- Subordinated Debt - Other Liabilities
- Loan Loss Reserve Goodwill

4. Regulatory Capital Measures
A) Tier I or Core Capital Ratio
Tier I equity divided by risk-weighted assets
Risk-weighted assets have 100% weighting for loans, 20% weighting for OECD bank debt, 0% for Treasury debt
Tier I equity consists mainly of common stock, perpetual preferred stock, minus intangibles
B) Total Capital Ratio
Tier I + Tier II equity divided by risk-weighted assets. Tier II capital consists mainly of qualifying subordinated debt and long-term preferred stock, plus Loan Loss Reserve (up to 1.25% of risk-weighted assets)

5. Regulatory Requirements for Risk-based Capital Ratios
Basic “Well-Capitalized”
Tier 1 or Core Capital 4% 6%
Tier 1 + Tier 2 or Total Capital 8% 10%

6. Limitations of the Current Risk-based Capital Approach
Risk-weightings are not truly risk sensitive: an Aaa loan has the same risk-weighting as a B loan.
Capital methodology falling behind financial innovations: securitization, derivatives, netting, etc.
Ignores capital needed for operating, interest rate, market and other risks.

7. Credit Risk Modeling: Current Practice and Applications
Purpose:
1) Provide summary of best practices of credit models
2) Assess the potential applications and limitations of credit risk models for supervisory and regulatory purposes
3) Solicit feedback

8. Basel, Key Literature
No. 4 International Convergence of Capital Measurement and Capital Standards, July 1988 (the Basel Capital Accord)
No. 55 Credit Risk Modeling: Current Practices and Applications, April 1999
No. 50, A new capital adequacy framework, June 1999
No. 71, Summary of responses received on the report "Credit Risk Modeling: Current Practices and Applications", May 2000
download at www. bis.org

9. Credit Risk Modeling: Current Practice and Applications (4/99)
Current credit management methods potentially rational direction for future refinements, yet there are limitations:
1) Lack of Data.
2) Validation (see #1).
Key quotes:
“Regulators would have to be confident that models were used to actively manage risk, and that conceptually sound, empirically validated, and produce capital assessments comparable across financial institutions.”
“Significant hurdles, principally concerning data availability and model validation, still need to be cleared before these objectives can be met, and the Committee sees difficulties in overcoming these hurdles in the timescale envisaged for amending the capital Accord."

10. A New Capital Adequacy Framework (6/99)
3 pillars to the revised capital framework
1) minimums (most of the focus)
2) supervisory review (probably more important!)
3) market discipline (good idea, but need broad liquid debt markets)
New ideas:
May have more or less than 100% weightings on corporate loans
Internal credit models could guide capital allocations
Address derivatives and netting agreements more logically

11. A New Capital Adequacy Framework 6/99
An example of the new refinements put forth by Basel:

12. Summary of Responses (5/00)
Subject: Loss Given Default
comment: US and European data is all that's really available
Subject: Shape of the density function of losses
comment: Unknown (lognormal? Normal?), but not considered a major limitation
Subject: Conditional upon the economy
comment: Need sound linkage

13. Summary of Responses (5/00)
Subject: Conceptual Approaches
Comments: Credit Value-at-Risk and/or Scenario
Subject: Default mode and Mark-to-Market Mode
Comments: Mark-to-market superior perhaps
Subject: Horizon
Comments: Not a big issue, 1 year likely

14. Summary of Responses (5/00)
Subject: Parameter Specifications
Comments:
US corporate bond rating information good
Use conservative assumptions when missing data
Proxies
Start collecting data as soon as possible
Subject: Validation
Stress tests
Panel data set compiled from regulatory bodies

15. Summary of Responses (5/00)
Subject: Supervision and Regulatory Application
Comments:
Portfolio by portfolio
Link evaluation of credit models to how models are actually used
General comment:
Simple models not necessarily bad
Don't use US data to parameterize models

16. Next Steps Best Case Scenario:
Basel will make preliminary proposal by February 2001.
Phase-in will start in January 2003.
Probable Scenario: year or two later...