Regulation of Banks and Risk Capital by jxg91389


									    Regulation of Banks and Risk

             By A V Vedpuriswar

February 8, 2009
The Basle Framework

 Basle I had provisions for:

       Tier I capital or core capital

       Tier II capital or supplementary capital

 Risk capital = 8% of total risk weighted assets

 Tier I capital = 4% of total risk weighted assets

Basle II

  Basle II emerged out of the criticism of Basle I.

   Some of the gaps in Basle I were:

         -      Simplistic and rigid rules

         -    Insufficient alignment of regulatory and
         economic risk based capital

         -     Regulatory arbitrage – Securitisation for
         example can take assets off balance sheet
         and reduce the capital requirement.

The three pillars of Basle 2

    Minimum capital requirements
    Supervisory review
    Market discipline

Total risk charge

   Market

   Credit

   Operational

   Total risk charge
    = credit risk + market risk + operational risk charge
    ( Total remains 8%)

More Flexibility and Risk Sensitivity

      The existing Capital Accord           The new Capital Accord

    Focus on a single risk measure.    More emphasis on banks' own
                                          internal methodologies, supervisory
                                          review, and market discipline.

    One size fits all.                 Flexibility, menu of approaches,
                                          incentives for better risk

    Broad brush structure.             More risk sensitivity.
Market Risk Charge

Standardised Method
 – Interest rate
 – Equity
 – Foreign Currency
 – Commodity
Internal Models Approach
 – Need to meet qualitative criteria
 – Rigorous backtesting
Qualitative criteria for using internal model
Independent risk control unit
Involvement of senior management and board
Integration with day to day management
Use of limits
Stress testing
Independent review
Credit risk charge

                                 Internal Ratings          Internal Ratings
                                based Approach -          based Approach -
                                    Foundation                Advanced

     standardized regulatory       internal PDs and
                                                          internal PDs, LGDs and
          risk weights          standardized regulatory
       and external ratings           EAD/LGDs

                               accepted collateral:
    accepted collateral:
                                   — residential and      all types of collateral are
        — residential real
                                       commercial real    accepted as long as the
                                       estate              bank can provide LGD
        — financial                                               estimates
                                   — financial
More Risk Sensitivity : Differentiated Risk
 Weights Under Basel II
  Standardized External Rating Internal Rating IRBA Corporate
  Corporate RW                                      RW
       20%        AAA,AA+            C1            14.5%
       20%       AA,AA-,A+           C2            17.2%
       50%          A,A-             C3            26.0%
      100%       BBB+,BBB            C4            40.1%
      100%          BBB-             C5            58.8%
      100%          BB+              C6            77.0%
      100%           BB              C7            92.3%
      100%           BB-             C8           108.7%
      150%           B+              C9           124.8%
      150%            B              D0           145.8%
      150%           B-              D1           175.4%
      150%     CCC+,CCC,CCC-         D2           211.8%
      150%            D              D3           238.2%
      150%            D              D4           238.2%

           Note: the above assumes an LGD of 45% and a residual maturity of 2.5 years.
Operational Risk Charge

Basic Indicator Approach
Standardised approach
 – Activities divided into 8 business lines
 – Multiply by respective beta factors and sum
Advanced Measurement approach
 – Sound track record in control and management of
   operational risk
Capital standards for banks and securities houses

    Capital standards for banks and securities houses
     have different purposes.
    Bank capital is designed to maintain the safety and
     soundness of banks.
    So capital standards for banks are calculated on a
     going concern basis.
    In contrast, capital standards for securities firms are
     calculated on liquidation basis.
    During the recent sub prime crisis, central banks have
     provided lines of liquidity to investment banks; so
     the Fed’s hold over the investment banks is likely to

Convergence of Regulation

     The    regulation   of non    bank   financial
      intermediaries is now converging with that of
      commercial banks.
     The lines of business are getting increasingly
      blurred, thanks to the 1999 repeal of the Glass
      Steagall Act and financial innovation.
     Goldman and Morgan Stanley have become
      bank holding companies
     JP Morgan Chase and Citi are already universal

Emerging challenges

Cyclicality bias
Originate to distribute
Quantum of capital


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