User:Monikjain987/A summary report on BASEL II Accord

A summary report on BASEL II Accord BASEL – II is revised capital accord to update the original international bank capital accord (BASEL I), which has been in effect since 1988.The BASEL committee on Banking Supervision developed BASEL II. This framework will be applied on a consolidated basis to internationally active banks, to preserve the integrity of capital in banks. The scope of application will include holding company (parent entity) of a Banking group to capture the risk of whole banking group. One of the principal objectives of supervision is protection of depositors.

Three Pillars of BASEL II A. Minimum Capital Requirements B. Supervisory Review Process C. Market Discipline Requirements

A. Minimum Capital Requirements – Pillar 1

BASEL II requires that an institution’s capital ration must be at least 8%, which is calculated by using of total regulatory capital and risk weighted assets based on the measure of Capital Risk, Market Risk & Operational Risk.

Measuring Credit Risk – Banks can use two methods for measuring credit risk:- i. Standardized Approach – In this approach external credit assessment is done by external credit agency, assets of bank are rated by them and capital is allocated for each asset. Rating of assets and capital allocation are inversely proportional. ii. Internal Rating Approach – There are two approaches used under this head ; a. Foundation IR approach b. Advanced IR approach

Three key elements for Foundation and Advanced Approach o Risk Components- These are evaluation of risk parameters provided by banks, sometimes these are based on evaluation provided by their supervisors. o Risk Weight Functions- The functions by which risk components are converted into risk weighted assets to meet the minimum capital requirement. o Minimum Requirements – The minimum criteria that must be met by a bank in order to use IRB approach for a given asset class.

Three risk components o Exposure at Default (EAD) – Amount of facility likely to be drawn in case of default. o Loss given at Default (LGD) – Measures the proportion of loss exposure at default. o Probability of Default (PD) – Chances of default in terms of percentage.

[Definition of default – A default is said to have taken place with a bank when any/both of the situation have taken place; • When bank considers that its debtor cannot meet his credit obligations to the bank in full and for which bank does not held any security too. • When the debtor’s outstanding amount has not met its past due date and crossed the sais limit by 90 days.]

a. In Foundation Approach banks provide their own estimates of PD and rely on supervisory estimates for other risk components. b. In Advanced Approach banks give their own estimates EAD, LGD, PD & Effective Maturity of facilities. For both approaches risk weigh functions must be used by banks to derive capital requirements.

To be eligible for IRB approach a bank must demonstrate to its supervisor that it meets the IRB requirements, and on an ongoing basis. Bank’s credit risk management practices must also be consistent with the guidelines issued by the committee and national supervisors. In case when a bank is not in complete compliance with all the requirements, the bank must produce a plan for its timely return to compliance and plan must be approved by its supervisor. The bank must demonstrate to its supervisor that the effect of such non-compliance is immaterial in terms of the risk posed to the institution.

Measuring Market Risk Banks are advised to use advanced internal models for calculating Market Risk, based largely on the bank’s own measurement, such as value – at – risk or standardized approach.

Measuring Operational Risk a. Basic Indicator Approach (BIA)- Banks must hold capital for operation risk which is equal to the average of a fixed percentage of positive annual gross income of previous three years, any negative annual income will be excluded from the calculation. Gross income = Net Interest Income + Non interest Income

b. Standardized Approach (SA) – Banks’ activities are divided into Eight Business Lines i.e. corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management & retail brokerage. Each business line is having gross income as its exposure indicator. To calculate capital charge for these business lines gross income is multiplied by a factor denoted as ‘Beta’ assigned to that business line. ‘Beta’ serves as a proxy for the industry wide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line. c. Alternative Standardized Approach (SA) – National supervisors can choose to allow a bank to use ASA, provided he is satisfied by the bank that ASA will provide an improved basis of measurement. Under the ASA the operational risk methodology is same as SA except for retail and commercial banking, for these business lines loans and advances multiplied by fixed factors, replaces gross income as exposure indicator. The factor ‘beta’ remains same for these two business lines. d. Advanced Measurement Approaches (AMA) – Use of AMA is subject to approval of supervisor/s. Under AMA banks calculates their own capital requirements which equals the risk measure generated by their own internal operational risk assessment system. Banks using AMA approach will be required to calculate their capital requirement using this approach as well as 1988 accord.AMA will be subject to period of initial monitoring by its supervisor before it can be used for regulatory purpose.

B. Supervisory Review Process – Pillar 2 This process recognizes the responsibility of Bank management in developing its own internal capital assessment process and setting capital targets that are commensurate with the bank’s risk profile and control environment. In this framework bank management bears the responsibility for ensuring that the bank has adequate capital to support its risks beyond the minimum requirements.

Supervisors evaluate how well the banks are assessing their capital needs & they advise on the adequacy of the same, because of this process prompt action and decision are taken where deficiencies are observed to reduce risk and restore the capital required.

As per committee framework, increased capital should not be recognized as only option for dealing with the increased risk. Strong risk management system, applying internal controls, strong level of Provision & reserves etc. are to be considered as other measures for addressing risk. Furthermore, capital should not be regarded as substitute for covering up fundamentally inadequate control or assessment process.

Main areas which are mainly treated under Pillar 2 may be categorized as below:

a) Risks considered under Pillar 1 process but not fully captured. b) Factors not considered under Pillar 1 process. c) Factors external to the bank. d) Assessment of compliance with the minimum standards and disclosure requirements of the more advance methods used in Pillar 1 process (IRB framework for credit risk and AMA framework for operational risk)

Four Key Principles of Supervising Review Process:-

1. Bank should adopt and follow an assessment procedure for assessing its overall capital adequacy, to ensure if it is consistent with their risk profile and present operating environment and to follow a strategy for maintaining the capital level intact. 2. Supervisors should regularly review and evaluate the quality and strength of banks’ capital adequacy assessment procedures as well as its risk management policies and internal controls. Supervisors should also review banks’ ability to monitor and ensure their compliance with regulatory capital ratios. They should take appropriate supervisory action if they are not satisfied with the result of the procedures adopted by the banks. 3. Supervisors should encourage and require banks to operate above the minimum regulatory capital ratios and standards required under Pillar 1 process and should use several techniques to ensure banks to operate above minimum requirements. 4. Supervisors should take necessary action at a early stage if it believes that capital of a bank is falling below the minimum levels required to supp ort the risk characteristics of a particular bank, it should take necessary steps to ensure that bank restoring its capital adequacy on immediate basis as and should require quick remedial action if capital is not maintained or restored as required under operating environment.

  Specific issues to be addressed under the Supervisory Review Process:-

a) Interest Rate risk in banking book b) Credit Risk c) Operational Risk

Important aspects of Pillar 2:-

o There is no exact supervision technique defined, supervisors must take care to carry out their obligation in a transparent and accountable manner at their own discretion and judgment. o For effective supervision of large banking organization a close and continuous communication between industry participants and supervisors is indispensable. Committee framework requires co-operation between supervisors for effective cross border supervision of complex international banking groups.

C. Market Discipline – Pillar 3

General Considerations

i. Disclosure requirements – Under Pillar 3 framework of the committee supervisors using their aligned measures require banks to make few disclosures, some of which will be qualifying criteria for the use of particular techiniques or the recognition of particular instruments & transactions.

ii. Guiding Principles – The committee aims to encourage market discipline by developing a set of disclosures which will allow market participants to assess important aspects of the information on the scope of application, capital, risk exposures, risk assessment processes & hence the capital adequacy of the banking institution, to support the Pillar 1 & Pillar 2 process.

- Banks’ disclosure should be consistent with how their senior manager and the Board of directors assess & manage their risk.

iii. Achieving Appropriate Disclosure – Supervisors requires banks to disclose information under safe and sound grounds. They have authority to require banks to provide information in regulatory reports. Furthermore, supervisors may enforce disclosure requirements .The nature of measure used will depend upon the legal power of the supervisor and criticality of disclosure deficiency.

iv. Interaction with accounting disclosures –

- The committee recognizes the need for Pillar 3 disclosure does not conflict with the disclosure requirements under accounting standards, for capital adequacy of a bank. - Management should use its own judgment in determining the appropriate medium and location of the disclosures. Disclosures made by bank under accounting or any other regulatory requirement may be used to fulfill Pillar 3 requirements. However, in these situation banks should explain the material difference between other disclosures and supervisory basis of disclosure. - Banks may make Pillar 3 supervisory disclosures which do not fall under accounting or any other regulatory requirements at some other location or means, but same should be indicated at the place where disclosure under accounting / other requirements are made. - Disclosures made under accounting or other mandate requirements should clarify validation of disclosures. In case disclosures not made under a validation regime appropriate verification of same should be ensured by the management.

v. Materiality – A bank should decide which disclosures are relevant for it based on materiality concept. Information would be considered as material if its omission or misstatement could change or affect the assessment or decision of a user relying on the information for the purpose of making economic decision. This definition is consistent with International Accounting Standards and many other national accounting frameworks. It requires a fair disclosure of information by banks based on their own qualitative judgment. vi. Frequency – The disclosure set out in Pillar 3 should be made on a semi annual basis except qualitative disclosures may be published on an annual basis. Tier 1 capital and total capital adequacy ratios and their components are to be published on a quarterly basis. In all cases all material information should be published on timely basis, as soon as practicable. vii. Proprietary & Confidential Information – Bank need not disclose its proprietary and confidential information about its business and customer data base in order to protect its business interest as well as interest of its customers except in exceptional circumstances.

Disclosure Requirements

a) General disclosure principle - Bank should have a formal disclosure policy approved by Board of directors. b) Scope of Application – Qualitative disclosure; e.g. name of the corporate entity to which framework applies.

          Quantitative Disclosures -  e.g. the aggregate amount of surplus capital.

c) Capital -

 Capital Structure-Qualitative disclosure; e.g. summary information on the main features if all capital instruments. Quantitative disclosure; e.g. amount of tier 1 , tier 2 and tier 3 capital.  Capital Adequacy – Qualitative Disclosure; e.g. summary discussion of the bank’s approach to assessing the adequacy of capital.

              Quantitative Disclosure; e.g. capital requirement for credit risk.

d) Risk exposure and assessment – the risk to which banks are exposed and the techniques and control which banks use to identify, measure, monitor and control these risks are important factors which market participant consider while their assessment of institution. The risks which are assessed and monitored by banks are; Credit Risk, Market Risk, Operational Risk, Banking book interest risk & equity risk (qualitative and quantitative disclosure).

External links

• Bank for International Settlements