Introduction to Basel ll Accord

Introduction to Basel ll Accord February 2009 1 Introduction - Do know anything about BASEL? - Yes! Basel is: 1) a canton (i.e. political division) of NW Switzerland, divided into the demi-cantons: Basle-Landschaft and Basle-Stadt. Areas: 427 sq. km (165 sq. miles) and 36 sq. km (14 sq. miles) respectively; and 2) a city in NW Switzerland, capital of Basle canton, on the Rhine: oldest university in Switzerland. 2 Introduction (cont.) - In fact the Basel is not only the canton or city, but also is: • the International Convergence of Capital Measurement and Capital Standards; or • Revised Framework (the “Basel II Framework”) which offers a new set of standards for establishing minimum capital requirements for banking organizations. - But what was Basel I Framework? - Basel I Framework was: • The international accord to set minimum capital requirements or banks, building societies and other deposit taking institutions. It was developed to create a level playing field for lenders operating in different countries and to ensure that lenders had sufficient capitalization in order to protect their depositors and the financial system. • First Basel Framework (or Basel Capital Accord) was prepared by the Basel Committee on Banking Supervision, a group of central banks and bank supervisory authorities in the G10 countries*, that developed the first standard in 1988. Then it became acknowledged as a benchmark measure of a bank’s solvency and was applied in many other countries. However, later relevant supervisors and sophisticated banking organizations have detected that the static rules set out in the Basel Capital Accord, 1988 have not kept pace with advances in risk management practices. This suggests that the implemented capital regulations may not reflect banks’ actual business practices. 3 * A Group of Ten Nations who met in Paris in 1961 to arrange the special drawing rights of the IMF ( Belgium, Canada, France, Italy, Japan, Netherlands, Sweden, UK, US, and West Germany). • • Introduction (cont.) - So, what is the solution? Basel II….? - Yes, it is a Basel II. • Basel II Framework is a voluntary agreement between the banking authorities of the major developed countries. However, the provisions of Basel II have been included in the EU Capital Requirements Directive (CRD). It makes the provisions a part of the law applicable throughout the EU. - What's new in Basel II? • The new updated Basel II Framework is more reflective in terms of risk management of underlying banking risks. • It was created based on the Basel Accord 1988 structure for setting capital requirements. • It improves the sensitivity of capital framework to the actual risks faced by the banks. • Capital requirements are more closely aligned to the risk of credit loss. 4 Basel I v/s Basel II • Basel I required lenders to calculate a minimum level of capital based on a single risk weight for each limited number of asset classes (e.g. mortgages, consumer lending, corporate loans, exposures, etc). Basel II also permits some lenders to use their own risk measurement models to calculate required regulatory capital, and seeking to ensure that lenders implement a relevant risk management culture at the heart of the business up to the highest managerial level. • - When the Basel II shall be implemented? • In the EU all deposit takers had to implement Basel II before or by no later than 1 January 2008. The US delayed this date to January 2009. 5 The goals of Basel II The major goal for the Basel II Framework is to promote the adequate capitalization of banks and to encourage improvement in risk management strategies, and strengthen the stability of respective financial systems. The aforementioned goal will be accomplished through the introduction of “three pillars”: Wealth economy and financial system stability Capital Adequacy (Supervisory Review) (Market Discipline) Minimum Capital Requirements Reporting 6 Three Pillars: Pillar 1 Pillar 1 – Minimum Capital Requirements: • Pillar 1 aligns the minimum capital requirements more closely to actual risks of bank’s economic loss (i.e. credit risk , market risk and operational risk). • Revised Basel risks: Credit risk (revised) Operational risk (new provision) Market risk (minor changes) • • • First, Basel II improves the capital framework’s sensitivity to the risk of credit. Capital is calculated based on the standardized and internal approaches for further reporting to responsible regulators and other stakeholders. 3-Approaches: Standardized approach (RSA) a-Foundation internal rating based approach (IRBA) b-Advance internal rating base approach (IRBA) Securitization framework 7 Three Pillars: Pillar 1 (cont.) Credit risk • In Risk Standardized Approach (RSA), Risk weight depends on external credit rating. • In foundation Independent Regulatory Board for Auditors (IRBA), banks use internal credit rating and supply Probability of Default (PD). • Advance IRBA, bank use internal rating and supply Probability of Default, Loss Given Default, Exposure at Default. • Securitization framework provides with various approaches to compute capital. Operational risk • Basic indicator approach, capital is fraction of gross income (15% of average 3 year gross income). • Standardized approach capital is computed by business lines (fixed percentages). • Advance measurement use statistical methods (Estimation, Standard Deviation, Correlation) to calculate capital. Market risk • Market risk is calculated on the basis of internal rating of organization. • Specific ratings (AA-BB) are charged specific level of risks percentage. 8 Three Pillars: Pillar 2 • Pillar 2 (Internal Capital Adequacy Assessment Process - ICAAP) recognizes the necessity of exercising effective supervisory review of internal assessments of the overall risks of the banks to ensure that the management is exercising relevant judgment and has set aside adequate capital for these risks. Supervisory Review: Bank should implement a process of assessment of capital adequacy in relation to risk and strategy for maintaining capital level. Supervisors shall review bank’s internal capital adequacy and compliance with regulatory capital requirements, and if necessary, to take actions. • • Coverage in Pillar-II: risks that are not fully covered by Pillar 1 Credit concentration risk Counterparty credit risk Risks that are not covered by Pillar 1 Interest rate risk in the banking book Liquidity risk Business risk Stress testing 9 Three Pillars: Pillar 3 • Pillar 3 (Reporting) leverages the ability of market discipline to motivate prudent management by enhancing the degree of transparency in banks’ public reporting. It sets out the public disclosures that banks must make that lend greater insight into the adequacy of their capitalization. In other words, it proposes bank’s disclosure requirement and enhance degree of transparency by recognizing disciplinary market mechanisms and reward that manage risk and penalization if not. Qualitative & quantitative disclosure wherever relevant on: Capital & capital structure Capital adequacy Credit risk Credit risk mitigation Counterparty credit risk Securitization Market risk Operational risk Equities in the banking book Interest rate risk in the banking book 10 • • Basel 2 and CAMELS Approach Basel 2 is similar to CAMELS rating and encourages growth by increasing assets quality (Pillar 1),operational competency, earning ability, and manages risks to keep up sustainability (Pillar 2 & 3) in long run. BASEL 2 Pillar 1--Risk-Capital matching (increases) Asset quality & utilization Risk in bank books is removed by market efficiency Corporate governance Increases Market mechanisms, Income and Credibility CAMELS Approach: • • • • • • C A M E L S Capital Adequacy Asset Quality Management Competence Earnings Ability Liquidity Risk Sensitivity to Market Risk Pillar 2--- Pillar 3--- 11 Retail v/s Wholesale Basel II differentiates Retail and Wholesale, broadly: Retail Generally Exposures to Individuals (managed on a pool basis), including residential mortgages, qualifying revolver exposure and other retail exposure Wholesale Wholesale generally comprise Exposures to Individually Managed (e.g. Classifiable) obligors, including private sector corporate, sovereign (central governments and banks, etc) and financial institutions. 12 DIFC Jurisdiction • • • As Dubai Financial Centre is a financial hub in the Middle East region it is also has adopted the Basel principles. Regardless the fact that DIFC is located in the Dubai, it adopted its own legislation. All DIFC registrants engaged in the financial services are monitored by the Dubai Financial Services Authority (DFSA)*. The legislation of the DIFC is based on the “common law” principles and has been designed in accordance with the international standards (including Basel) applied in certain jurisdictions. The Basel principles are expressed in the following DIFC/DFSA rules: Prudential - Investment, Insurance, Intermediation and Banking Module (PIB) Prudential - Insurance Business Module (PIN) – applicable to all insurance/reinsurance businesses Prudential Returns Module (PRU) • • DFSA is a separate integrated legal entity responsible for the regulation of the financial services and related activities through the DIFC (including authorization, licensing, recognition and registration of the businesses engaged in financial or ancillary services as well as the authorization of their members – individuals). 13 PIB Module • General chapters: General Requirements Capital requirements • Specific chapters: Islamic Financial Business (including Displaced Commercial Risk Capital Requirement) Credit Risk Market Risk Liquidity Risk Group Risk Operational Risk 14 Conclusion: “Pros and Cons” • • • • • Some analysts and researches believe that current minimum capital adequacy tool (i.e. 8-10% of equity) presented in Basel Framework and other alternative local standards adopted by almost all countries is ideal way of using available financial resources. Others claim that this tool of capitalization is more unsecure strategy rather than conservative approaches applied in XIX century and first part of XX century, such as gold bullion securitization and product backing currency. Recent cases, namely, “soap bubbles”; “shrinking pies - banks” ideally exemplify the level practical reliability of Basel and other alternative standards. Has the current recession developed the need for a new accord? Ongoing financial crisis has made regulators rethink on the principles on which Basel 2 Accord was framed. 15 Contact details • • • • • Saad Maniar – Managing Partner (saad@horwathmak.com) Gillian McMeekin – Director - Risk Consulting (gillian@horwathmak.com) Firdaus Maniar – Senior Risk Consultant (firdaus@horwathmak.com) Muhammad Raashid – Senior Risk Analyst (raashid@horwathmak.com) Vladimir Abanin – Senior Consultant (vladimir@horwathmak.com) DIFC, Dubai, UAE PO Box 506705 Telephone: +971 4 438 0288 Fax: 971 4 367 2820 16