BASEL I I AT GLAN CE
I m ple m e n t a t ion of Ba se l I I in I n don e sia
Ba n k I n don e sia
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The pur pose of t his book is t o help r eader s under st and t he im por t ance of capit al, not only for individual banks, but also in safeguar ding financial syst em st abilit y. Because of t his vit al r ole, t he r egulat ion of bank capit al is guided by int ernat ional st andar ds issued by t he Basel Com m it t ee on Banking Supervision. The Basel I st andar d, init ially adopt ed in 1988, has under gone num er ous changes over t im e in r esponse t o t he rapid developm ent of financial m ar ket inst r um ent s. Ult im at ely, agreem ent was r eached on a m or e r isk sensit ive st andard for calculat ion of bank capit al known as Basel I I .
This sim ply- w orded book is designed t o infor m r eaders of t he process of change in capit al st andar ds and t he background t o t he issuance of Basel I I , in w hich bank capit al adequacy is linked t o t he r isk pr ofile of t he individual bank.
This book does not delve int o t he in dept h t echnical det ail on each aspect of Basel I I , but rat her is aim ed m or e at pr esent ing a com m on line of t hought for Basel I I , t hat of im pr oving bank r isk m anagem ent in or der t o pr ovide bet t er assurance of financial syst em st abilit y, w hich w ill ult im at ely suppor t econom ic gr ow t h.
Ba se l I I a t a Gla nce r egulat ions governing bank capit al, w hich funct ions as a buffer against losses.
I n view of t he im por t ance of capit al t o banks, BI S issued a capit al fram ew or k concept loan r epaym ent capacit y and specific r isks associat ed w it h t he individual cust omer.
More t han a decade lat er, pr om pt ed by t he evolut ion of banking w orldwide and t he m ar ket discipline t hr ough disclosure r equir em ent s.
looking appr oach t hat enables im pr ovem ent s and changes t o be m ade over t im e. I n t his appropriat e t o t he nat ure of business and risk pr ofile of t he individual bank.
I n assessing bank capit al adequacy, it is not only necessary t o allocat e capit al on t he basis of Pillar 1, but also capit al t o ant icipat e losses from ot her r isks, such as liquidit y r isk, st rat egic r isk, int er est rat e r isk in t he banking book and ot her r isks. This appr oach is capt ur ed in Pillar 2, t he Super visor y Review Pr ocess, and is r efer r ed t o as t he I ndividual Capit al Adequacy Assessm ent Process ( I CAAP) . I t w ill pose an im por t ant challenge for banks and super visors. Building of super visor com pet ence and capacit y w ill be essent ial, as also t he support of t he r egulat or y fram ework for bank super vision. Wit h t im e, super visor s w ill becom e effect i ve in t he assessm ent of r isks ot her t han t hose cover ed in Pillar 1 and m ay even or der banks t o add t o t heir capit al if bank capit al is deem ed inadequat e.
Fur t her m or e, t he act ive public r ole in scr ut iny of banks is seen as cr ucial. From t he beginning, t he public w ill also be expect ed t o assess bank r isks and ascer t ain t he level of capit al adequacy as envisaged in Pillar 3 – Mar ket Discipline. The syner gy of t he t hr ee Pillars in Basel I I is int egral t o building a sound and st able banking indust ry and financial syst em .
I m pa ct of Ba se l I I on t h e Re silie n ce of t h e Ba n k in g Sy st e m
1 . W ill Ba se l I I ca u se ba n k CAR t o dr op be low t he 8 % m inim um ?
Bank I ndonesia is now w or king t oget her w it h a num ber of banks on a per iodical st udy of quant it at ive im pact t o assess t he c onsequences of Basel I I on bank capit al. For t his r eason, the im pact of Basel I I should be exam ined on an individual basis. I t is necessary t o per form assessm ent s and im prove t he effect iveness of r isk m anagem ent fr om an early st age in or der t o gain m axim um advant age fr om t he available incent ives. A dr op in t he CAR could w ell occur for banks w it h a higher r isk profile. How ever, banks w hose cr edit por t folios ar e dom inat ed by r et ail loans and hom e m ort gages w ill see a r educt ion in t heir capit al r equirem ent because of t he low er r isk w eight ings t hat w ill apply t o r et ail loans and hom e m or t gages.
2 . W ill Ba se l I I be im ple m e n t e d for a ll com m e r cia l ba n k s?
The focus of Basel I I in I ndonesia is developm ent and im pr ovem ent in r isk m anagem ent w it hin t he nat ional banking syst em . This was set out in Bank I ndonesia Regulat ion No. 5/ 8/ PBI / 2003 dat ed 19 May 2003 concer ning Applicat ion of Risk Managem ent for Com m ercial Banks. These m easures w ill apply t o all banks r egar dless of size, given t hat t he r isk m anagem ent cult ure should becom e st andar d pract ice in t he banking business. Survey show s t hat banks w ould pr efer Basel I I t o be im plem ent ed acr oss t he board. The m ain r eason is t o m inim ise t he negat ive im pact on com pet it ion t hat w ould ar ise fr om different iat ions by abilit y and r eadiness of banks t o im plem ent and develop r isk m anagem ent and t he associat ed infrast ruct ur e. Fur t her m ore, all banks in I ndonesia w ill be able t o apply t he st andar d approaches in Basel I I .
3 . Could Ba se l I I h a m pe r t h e in t e r m e dia t ion pr oce ss?
Basel I I is not int ended t o ham per t he int erm ediat ion pr ocess cur r ent ly in operat ion in t he banking syst em . At t he m acr o level, it also does not seek t o r educe t he dom inant r ole of t he banking syst em in financing econom ic act ivit ies. The overall t hrust of t he appr oaches put forwar d in Basel I I is int ended m ore as an effor t t o r eposit ion and r edefine w hat has been achieved by t he banking syst em , w it h focus on im proving r isk m anagem ent .
sect or s ( e.g. because of t he use of rat ings in lending t o cor porat e ent it ies) , on t he ot her hand it w ill also encourage incr eased exposur es t o ot her sect ors, such as r et ail lending ( e.g. sm all- scale business credit , per sonal loans and so on) and housing m ort gages t hrough r educed r isk w eight ings. I t is under st ood t hat t his shift in exposur es w ill br ing som e shock t o banks, debt or s and t he econom y as a w hole. Even so, t his effect is not expect ed t o last long, and w ill be no m ore t han a fine t uning cust om ary t o any econom y.
4 . W h a t w ill be t h e im pa ct for ba nk s cu r r e nt ly w or k ing on r a ising t h e ir ca pit a l for t h e im ple m e n t a t ion of t h e I n don e sia n Ba nk ing Ar ch it e ct u r e ?
Raising addit ional capit al for t he pur poses of t he I ndonesian Banking Ar chit ect ur e w ill not in it self pr ovide t he m eans for a bank t o achieve full com pliance w it h Basel I I . How ever, a n adequat e capit al base w ill enable a bank t o develop t he hum an r esour ces and infor m at ion t echnology capabilit ies essent ial for Basel I I . I n t his w ay, t he Rp 80 billion t ier 1 capit al r equirem ent for com m ercial banks, t o be m et by t he end of 2007, and t he Rp 100 billion r equirem ent for t he end of 2010 w ill not only expand t he econom y of scale in conduct ing operat ions, but also pr ovide oppor t unit y for t he bank t o st rengt hen it s r isk m anagem ent capabilit ies for im plem ent at ion of Basel I I .
5 . W h a t a r e t h e pr er e qu isit e s for pr ope r im ple m e nt a t ion of Ba se l I I ? Condit ions t hat m ust be sat isfied for pr oper im plem ent at ion of Basel I I include:
- Applicat ion of r isk m anagem ent pract ices in t he banking syst em as st ipulat ed in Bank I ndonesia Regulat ion No. 5/ 8/ PBI / 2003 dat ed 19 May 2003 concerning Applicat ion of Risk Managem ent for Com m er cial Banks
- Adj ust m ent s in account ing st andar ds in keeping w it h int er nat ional account ing st andar ds ( I AS) , including but not lim it ed t o I AS 32 and I AS 39
- Consolidat ed calculat ion of bank capit al t o cover com panies in t he sam e gr oup operat ing in t he financial sect or, w it h t he except ion of insurance com panies
- Recognit ion of a rat ing agency t o enable obj ect ive rat ing of bank debt ors.
Roa dm a p for Ba se l I I in I n done sia : W h a t Ba n k I n don e sia a n d t h e Ba nk ing Syst e m M ust D o t o Pr e pa r e
Basel I I st at es t hat each supervisor y aut hor it y m ust w eigh pr ior it ies befor e adopt ing Basel I I . I n im plem ent ing Basel I I , Bank I ndonesia is essent ially seeking t o st rengt hen r isk m anagem ent so t hat banks w ill b ecom e m or e r esist ant t o dom est ic, r egional and int er nat ional shocks. Bank I ndonesia has developed a r ealist ic for m at t o be follow ed in t he im plem ent at ion of Basel I I t hat t akes account of t he cur rent condit ion of t he banking indust ry. For t his r eason, t he default m ode for im plem ent at ion w ill be t o t ake t he sim plest pat h, i.e. t he st andar dised appr oach. This m eans t hat all banks w ill m ake adj ust m ent s t o t heir capit al adequacy calculat ions on t he basis of t he Basel I I guidelines. Basel I I also pr ovides for nat ional discret ion, in w hich som e m at t ers are decided by t he local super visory aut horit y. Judgem ent s can t her efor e be m ade for t he condit ion of t he I ndonesian banking syst em and com plexit y of I ndonesia's banking pr oduct s.
Ba nk Ca pit a l
For banks, as for com panies in general, capi t al funct ions not only as t he m ain r esour ce for financing operat ions, but also pr ovides a buffer against possible losses. Capit al also helps t o m aint ain public confidence in t he abilit y of a bank t o operat e in t he int er m ediat ion of cust om er funds.
The bank super vision aut horit y is r esponsible for ensur ing a m inim um adequacy of bank capit al by est ablishing r ules concer ning t his issue. Regulat or y Capit al is t he capit al r equirem ent prescribed by t he super visory aut horit y as a buffer against pot ent ial losses. The r equirem ent s applying t o Regulat ory Capit al are a key com ponent of bank super vision and are r eflect ed in t he definit ion of r egulat or y capit al and t he capit al adequacy rat io ( CAR) .
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A general definit ion of capit al was fir st int roduced in Basel I , t he fir st br oad approach t o capit al adequacy. This definit ion has r em ained unchanged and is r et ained in Basel I I . The definit ion st at es t hat r egulat ory capit al is divided int o t hree t ier s. An it em m ay be gr ouped int o one of t hese t ier s, provided t hat it sat isfies cer t ain crit er ia. The definit ion of r egulat ory capit al set s out t he cr it eria for cat egor isat ion as an elem ent of capit al, and t hus ensures consist ency of capit al adequacy am ong differ ent nat ions. This has pr om ot ed m ore com m on under st anding am ong banks in general and t he m or e int er nat ionally act ive banks in part icular.
Under Basel I and Basel I I , r egulat or y capit al is divided int o t hr ee levels or t iers of capit al as follows:
o Tier 1 capit al. This t ier c onsist s of inst r um ent s w it h t he gr eat est capacit y t o absor b losses arising at any t im e.
o Tier 2 capit al. This t ier consist s of a broad m ix of equit y com ponent s and hybr id capit al/ debt inst r um ent s. Tot al Tier 2 capit al is r est r ict ed t o 100% of Tier 1 and is divided int o t w o cat egor ies:
?Upper Tier 2, r est r ict ed t o 100% of Tier 1 capit al,
?Lower Tier 2, r est r ict ed t o 50% of Tier 1 capit al.
o Tier 3 capit al was added in 1996 , and is used only t o m eet capit al r equir em ent s for m ar ket r isk.
Th e Ca pit a l Ade qu a cy Ra t io ( CAR)
The obj ect ive of t his rat io is t o ensur e t hat banks ar e capable of absor bing losses incur r ed in t he course of t heir act ivit ies. The exist ing r egulat or y rat io is t he 8% m inim um . This links bank capit al t o t he r isk w eight ings of asset s held by t he bank. Super visor r isk w eight ing is t he per cent age used t o convert t he nom inal value of credit exposur es t o a specific value r eflect ing level of r isk. The r isk w eight ing for each asset is pr escribed in a Bank I ndonesia r egulat ion. The capit al t hat m ust be allocat ed t o cover pot ent ial loss in r elat ion t o t he exposur es is obt ained by m ult iplying t he exposur e value by t he w eight ing for t he asset s and t he m inim um capit al r equirem ent ( i.e. 8% ) .
been driven by evidence t hat capit al is a very cost ly r esource for a bank. The bank m ust t her efor e have st r ong incent ives t o m anage capit al as effect ively as possible. Since t he m id- 1990s, som e of t he w orld's largest and m ost sophist icat ed inst it ut ions have developed various m easures of econom ic capit al and have specifically com bined t hese w it h risk m anagem ent syst em s for m or e efficient m anagem ent of r isks and capit al.
The obj ect ive of bank super vision is t o ensur e t hat banks conduct t heir operat ions in line w it h prudent , sound principles. To t his end, banks m ust m aint ain adequat e capit al and reser ves t o offset r isks ar ising in t he cour se of business. The m ain pr inciples of t he Basel Com m it t ee on Banking Super vision ( BCBS) st at e t hat bank super visor s m ust est ablish a safe and appropriat e level of m inim um capit al r equir em ent for all banks. The ult i m at e goal of all aut horit ies involved in bank super vision is t o pr ot ect t he st abilit y and soundness of t he financial syst em . Since t he end of 1980, st andardised calculat ions of bank capit al based on t he BCBS guidelines have com e int o w idespr ead int er nat ional use in suppor t of t his goal.
Com pliance w it h t he m inim um capit al r equir em ent ( or solvency rat io) is det er m ined by t wo com ponent s as follows:
o The r isk w eight ings for bank asset s—i.e. all bank exposures convert ed int o asset s w it h each exposur e t hen m ultiplied by t he super visor r isk w eight ing, based on level of r isk
o 2 m inim um rat ios ( or lim it s) in w hich r egulat ory capit al is linked t o asset r isk w eight ings:
Regulat ory capit al divided by r isk- w eight ed asset s m ust be equal t o or gr eat er t han 8%
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The new capit al adequacy fram ew ork - Basel I I - offer s gr eat er flexibilit y by est ablishing a num ber of r isk- sensit ive appr oaches and incent ives for im pr oved r isk m anagem ent . Banks are asked t o allocat e less capit al for count er par t ies w it h higher rat ings and m ore capit al for t hose w it h higher r isk. The fram ework consist s of t hr ee pillars as follows:
o Pillar 1 ( Minim um Capit al Requir em ent ) deals w it h t he r equired m inim um capit al t hat each bank m ust provide t o cover credit , m arket and operat ional exposures.
o Pillar 2 ( Super visor y Review Pr ocess) est ablishes t he super visor y r eview pr ocess aim ed at ensur ing an adequat e level of bank capit al t o cover t he full scope of bank risks.
o Pillar 3 (Mar ket Discipline) addr esses m ar ket discipline and t he specifics of m inim um lim it s of public disclosure.
I . Pilla r 1 - M in im u m Ca pit a l Re qu ir e m e n t
Pillar 1 est ablishes t he m inim um capit al r equirem ent in r elat ion t o cr edit r isk, m arket r isk and operat ional r isk. I n Basel I I , t he r equir ed level of bank capit al is at least 8% of risk - w eight ed asset s. Wit hin t his cont ext , capit al is divided int o several cat egor ies:
o Tier 1 capit al, i.e. t he m ost basic level of capit al consist ing of shares plus non-cum ulat ive preferent ial shares and r eser ves, subt ract ed by goodw ill. Tier 1 capit al m ust com pr ise at least 50 per cent of bank capit al.
o Tier 2 capit al, consist ing of asset r evaluat ion value, general r eser ves, hybrid capit al inst r um ent s and subor dinat ed loans. This t ier m ay not exceed 50 per cent of capit al o Tier 3 capit al, was added in t he 1996 Capit al Accor d Am endm ent , but is used only t o
cover t he port ion of t he bank capit al r equirem ent allocat ed t o m arket r isk. Th is cat egor y consist s of special t ypes of shor t- t erm subor dinat ed loans.
I .1 . Cre dit Risk
Basel I I allow s a financial inst it ut ion t o calculat e cr edit r isk for com pliance w it h capit al r egulat ions by one of t he following t w o m et hods:
o Under t he St andar dised Appr oach ( SA) , t he bank uses a list of r isk w eight ings t o calculat e t he credit r isk for it s asset s. The r isk w eight ings ar e linked t o rat ings issued for t he gover nm ent , financial inst it ut ions and com panies by an ext er nal rat ing agency.
o The I nt er nal Rat ing Based Approach ( I RB) allow s banks t o use t heir own int er nal m odels for count er par t ies and exposur es. This allow s for m or e specific differ ent iat ion of r isk am ong var ious exposur es, pr oducing a level of capit al m ore com m ensurat e t o r isk.
Cr e dit Risk —St a n da r dise d Appr oa ch ( SA)
Under t his approach, t he bank allocat es cert ain r isk w eight ings for each cat egor y of asset s and off- balance sheet it em s t o ar rive at a t ot al figur e for r isk- w eight ed asset s as follows:
Allocat ions for each r isk w eight ing ar e based on general debt or cat egor ies ( gover nm ent , bank or cor porat e) , w hich subsequent ly classified fur t her accor ding t o rat ings issued by an ext er nal cr edit rat ing agency. The st andar dised appr oach pr escribes r isk w eight ings based on differences in t he nat ure of t he asset s and ext er nal credit rat ings t o produce a m ore r isk- sensit ive r esult in com par ison t o t he cur r ent Accor d. The r isk w eight ings for t he governm ent , ot her banks and corporat e exposures are differ ent iat ed according t o t he ext er nal cr edit rat ings. A 100 percent r isk w eight ing pr oduces a capit al char ge at 8% of t he exposur e value. Sim ilar ly, a 20% r isk w eight ing pr oduces an equivalent capit al char ge of 1.6% ( 20% x 8% ) .
Ot her r isk w eight ings have also been est ablished accor ding t o differences in t he nat ur e of exposure. Exam ples of r isk weight ings for t hese cat egor ies in use are:
- 35% for exposur es t o resident ial housing com plying w it h st r ict pr udent ial crit er ia;
- 75% for r et ail exposur es ( loans t o sm all and m edium ent er pr ises m eet ing cer t ain crit eria enabling t hem t o be t reat ed as r et ail businesses) ;
- 100% for exposur es t o com m er cial pr oper t ies, w it h lim it ed exem pt ions under cer t ain condit ions;
- 150% for high r isk exposures, such as loans past due; and
- 350% for securit ised com ponent s rat ed BB+ and BB- .
Cr e dit Risk —I n t e r na l Ra t in g Ba se d Appr oa ch ( I RB)
The I RB approach r ecognises t hat banks are cust om arily bet t er infor m ed of t heir debt ors t han a rat ing agency. This approach enables a bank t o apply m or e precise differ ent iat ions for each r isk in com par ison to t he seven r isk cat egor ies ( 0% , 20% , 35% , 50% , 75% , 100% and 150% ) in t he st andar dised appr oach.
There are t wo approaches used in t he I RB, bot h of w hich are based on st r ict m easurem ent st andards and m et hodology and r equir e super visor approval:
- Fou n da t ion I RB – t he bank calculat es probabilit y of default ( PD) for each debt or and t he super visor pr ovides ot her input , such as loss given default ( LGD) and exposur e at default ( EAD) .
- Adv a n ce d I RB – in addit ion t o PD, t he bank includes ot her input s such as EAD, LGD and m at ur it y ( M) . St rict er r equirem ent s apply for using t his appr oach in com parison t o foundat ion I RB.
Maj or param et ers in t he I RB appr oach:
- Pr obabilit y of Default is t he likelihood t hat a debt or w ill default on obligat ions. All banks m ust pr ovide an int ernal m odel of PD for each debt or cat egor y.
- Loss Given Default ( LGD) is t he est im at ed percent age of loss t hat w ould occur in t he event of a debt or's default .
- Exposur e at Default ( EAD) is t he est im at ed exposur e t o a par t icular debt or in t he event of default .
- Mat ur it y ( M) is t he effect ive t enor ( in years) of a bank exposur e.
Asse t Ca t e gor ie s in t h e I RB Appr oa ch
- Cor porat e Exposur es – debt liabilit ies ow ed by com panies or arising from par t ner ships or ow ner ship. This cat egor y is divided int o five sub- asset s: pr oj ect financing, purchase financing, com m odit y financing, incom e- generat ing r eal est at e and high volat ilit y com m er cial r eal est at e.
- Governm ent Exposur es – exposur es t o t he gover nm ent , t he cent ral bank, public sect or ent it ies and MDBs.
- Ret ail Exposur es – r et ail loans including loans t o individuals and sm all- scale businesses, cr edit car d operat ions, w or king capit al loans, hom e m or t gages and fixed inst alm ent loans. Basel I I ident ifies t w o sub- cat egor ies: exposur es guarant eed by r esident ial pr opert y and r et ail exposur es m eet ing cert ain qualificat ions, including ot her r et ail credit .
- Equit y Exposur es – ow ner ship int er est s in com panies, part ner ships and ot her cor porat e business.
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The capit al r ules are designed t o encourage banks t o shift from t he st andar dised approach t o t he I RB and from Foundat ion I RB t o Advanced I RB. By sw it ching t o a m ore advanced appr oach, m any banks w ill benefit from r educed capit al allocat ion under t he capit al r ules as a r esult of t he m or e accurat e linkage bet ween capit al and r isk. Nevert heless, t he possibilit y r em ains t hat bank por t folios are on average higher r isk and t he I RB appr oach dem ands a higher st andar d t han t he st andar dised approach.
M it iga t ion of Cr e dit Risk
A lender can m it igat e cr edit r isk if a debt or pr ovides collat eral or a t hird par t y under w r it es t he debt or ’s obligat ions or t he bank buys cr edit pr ot ect ion, for exam ple t hr ough credit der ivat ives, or by ot her m eans. Com pared t o t he Accor d 88, Basel I I pr ovides for br oader r ecognit ion of cr edit r isk m it igat ion t echniques. Basel I I allow s banks t o r ecognise t he follow ing for m s of collat eral:
- Cash
- Designat ed securit ies issued by t he governm ent , public sect or ent it ies, banks, com panies and secur it ies com panies
- Designat ed negot iable equit ies - Designat ed m ut ual funds - Gold
For banks using t he st andardised appr oach t o calculat e credit r isk, Basel I I offer s t wo possible m et hods for cr edit risk m it igat ion:
- The sim ple approach, w hich enables g uarant eed claim s t o be assigned a r isk w eight ing against t he collat eral inst rum ent , subj ect t o a m inim um lim it of 20% .
- The com pr ehensive appr oach, focused on t he cash value of collat eral. This approach uses t he haircut t o calculat e volat ilit y of collat eral value. This m ay be t he st andar d haircut as det er m ined by t he Basel Com m it t ee or an est im at e of collat eral volat ilit y prepared by t he bank.
I f a bank is appr oved for use of an int er nal m odel, t he opt ions of t he sim ple appr oaches descr ibed above are not available. I n t he case of banks using t he I RB approach, t he LGD com ponent is also adj ust ed t o reflect t he benefit of using collat eral t o reduce losses.
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calculat ing t heir capit al r equirem ent s against exposur es ar ising fr om t radit ional secur it isat ion and synt heses or sim ilar st r uct ures w it h t hese feat ur es.
Because of t he m any differ ent m et hods of secur it isat ion, t he det erm inat ion of t he capit al r equir ed t o cover securit isat ion exposures m ust be based on econom ics subst ance over for m . The sam e pr inciple also applies t o super visor s, w ho m ust give gr eat er em phasis t o econom ics subst ance in det er m ining w het her t he exposur e fit w it hin t he secur it isat ion fram ework for calculat ing bank capit al adequacy.
I n secur it isat ion, t he bank m ay act as t he or iginal cr edit or or invest or for t he secur it ised asset s. I n eit her of t he t w o cat egor ies, t he bank r ole can var y w idely. What ever t he for m , Basel I I st r esses t hat banks m ust allocat e capit al t o cover various for m s of secur it isat ion.
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On 1 January 1998, banks in t he G - 10 count ries w er e r equired t o allocat e capit al t o cover m arket r isk ( as st ipulat ed in t he m arket r isk am endm ent t o t he Basel Accor d) . The bank capit al r equirem ent for m arket r isk is det er m ined by t w o m et hods.
The fir st is t he st a nda r dise d a ppr oa ch, w hich applies a building block appr oach for int er est rat e and equit y inst r um ent - r elat ed t ransact ions. This appr oach differ ent iat es bet w een calculat ion of capit al charges for specific r isks and general m arket risk.
The second is t he in t e r n a l m ode l a ppr oa ch, w hich enables banks t o use int er nal m et hods com plying w it h t he qualit at ive and quant it at ive cr it eria det er m ined by t he Basel Com m it t ee, subj ect t o appr oval from t he supervisor y aut hor it y. This approach set s capit al charges at a higher level t han t he pr evious day's VaR or t he average daily VaR for 60 w orking days m ult iplied by t hree m inim um fact ors. Banks m ust calculat e t he VaR on t he basis of daily value w it h
- on e- t ailed confidence int er val of 99%
- 10 - day m inim um holding per iod
- on e- year m inim um obser vat ion per iod.
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The Basel Com m it t ee defines operat ional r isk as t he “ risk t hat originat es dir ect ly or indir ect ly fr om inabilit y or failur e of int er nal processes, per sons and syst em s, as w ell as from ext er nal event s." Thr ee approaches m ay be used t o det er m ine t he capit al charges for operat ional r isk:
o The Ba sic I ndica t or Appr oa ch calculat es capit al charges for operat ional r isks on t he basis of a cer t ain per cent age ( alpha fact or) of gross incom e used as an est im at e for bank r isk exposures. Under t his appr oach, t he capit al t hat m ust be allocat ed by t he bank t o cover losses ar ising fr om operat ional r isks equals a cert ain percent age of average gr oss incom e over a t hr ee year per iod.
o The St a nda r dise d Appr oa ch r equir es an inst it ut ion t o disaggregat e it s act ivit ies int o eight st andar d business lines. The capit al charge for each business line is calculat ed by m ult iplying it s gr oss incom e by a cert ain pr edet er m ined const ant ( bet a fact or) t hat is different for each business line.
o I n t he Adva n ce d M e a su r e m e n t Appr oa ch, t he calculat ion of t he capit al r equirem ent is t he sam e as t he r isk m easurem ent generat ed by a m odel for m easuring operat ional r isk developed i nt ernally by t he bank. The bank m ust m eet t he qualit at ive and quant it at ive cr it eria st ipulat ed in Basel I I and m ust have appr oval fr om t he supervisor y aut hor it y.
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Basel I I r equires banks t o allocat e capit al at 8% of r isk- w eight ed asset s, calculat ed accor ding t o t he following for m ula:
For exam ple, a bank has USD10 billion in r isk- w eight ed asset s, a USD300 m illion capit al char ge for m arket r isk and a USD100 m illion capit al char ge for operat ional r isk. The m inim um capit al r equir em ent for t he bank is:
= [ USD10 billion + 12.5 x ( USD300 m illion + USD100 m illion) ] x 8% = USD1.2 billion
This m eans t hat t he bank m ust allocat e capit al of at least USD1.2 billion.
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Pillar 2 focuses on t he r eview process w it hin t he super visor y fram ework t hat is aim ed at ensur ing t hat banks m aint ain levels of capit al com m ensurat e t o t heir r isk pr ofile. The super visory r eview process seeks t o ensur e t hat banks calculat e t heir capit al adequacy t o cover t he full scope of r isk and super visors assess and t ake any necessary act ions t o r espond t o t he capit al calculat ions m ade by t he bank.
Pillar 2 r equires banks t o conduct r egular st ress t est ing t o est im at e how m uch capit al w ould be r equir ed under cr isis condit ions. The bank and t he super visor m ust use t he t est r esult s t o ensur e t hat bank capit al is at an adequat e level.
Pillar 2 encom passes four key pr inciples:
o Banks m ust have a pr ocess for calculat ing overall capit al adequacy based on t heir r isk pr ofile and a st rat egy for m aint aining t heir level of capit al;
o The super visor m ust r eview and evaluat e t he st rat egy and capit al adequacy calculat ions m ade int er nally by t he bank and t he abilit y of t he bank t o m onit or and ensur e com pliance w it h t he pr escr ibed capit al rat io;
o The super visor m ay order a financi al inst it ut ion t o operat e above t he prescribed capit al rat io and has t he aut horit y t o order a bank t o allocat e capit al above t he m inim um lim it ; and
o The super visor m ay int er vene at an ear ly st age t o prevent decline in bank capit al below t he m inim um lim it and t o ensur e t hat t he bank t akes r em edial m easures if t he level of capit al is not m aint ained or sinks t o it s for m er level.
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Pillar 3 r equires banks t o disclose adequat e infor m at ion for m ar ket players t o underst and t he r isks involved in t he banks. This enables m arket player s t o assess t he key infor m at ion on t he scope of r isk, capit al, r isk exposur es, r isk m easurem ent process and bank capit al adequacy.
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1 . W h a t is BI S?
The Bank for I nt er nat ional Set t lem ent s ( BI S) is an int er nat ional or ganisat ion t hat pr om ot es int er nat ional m onet ar y and financial cooperat ion and operat es as t he bank for cent ral banks. To m eet it s responsibilit ies, BI S carr ies out a num ber of key act ivit ies.
o As a forum for pr om ot ing discussions and policy analyses am ong cent ral banks and w it hin t he int ernat ional financial syst em .
o As a r esear ch cent re for econom ics and m onet ary policy o As a leading par t ner for cent ral banks in financial t ransact ions
o As an agent or r epr esent at ive for cent ral bank dealings in int er nat ional financial act ivit ies.
2 . W h a t is t he Ba se l Com m it t e e on Ba n k in g Su pe r vision ?
The Basel Com m it t ee on Banking Super vision ( BCBS) , bet t er know n as t he Basel Com m it t ee, was est ablished in a volunt ar y act ion by t he m onet ar y aut hor it ies of t he G-10 count ries and a num ber of ot her nat ions. The com m it t ee has no official r each as an int er nat ional super visor y aut horit y and it s decisions ar e never int ended t o be legally binding.
The Basel Com m it t ee was set up by cent ral bank gover nor s fr om t he G- 10 count r ies at t he end of 1974 and convenes four t im es a year. These count ries are r epresent ed by t heir cent ral banks and also t he aut horit ies r esponsible for super vision of t he banking business if not under t he power s of t he cent ral bank. The Com m it t ee develops policy guidelines t hat nat ional super visory aut horit ies m ay decide on as appr opr iat e t o t he super visory policy t o be im plem ent ed by t he individual count ry.
The Basel Com m it t ee for m ulat es super vision st andar ds and guidelines of a g eneral nat ur e and issues st at em ent s w it h br oad applicat ion on best pract ices. This is int ended t o enable each aut horit y t o t ake m easures for applying t hese st andar ds w it hin a legal and r egulat ory fram ework appr opriat e t o t he individual count ry’s syst em .
The m ost im por t ant out put of t he Basel Com m it t ee is t he r uling on m inim um capit al st andar ds for banks w or ldwide. The Basel Capit al Accor d was fir st announced in July 1988 and was im plem ent ed by all m em bers of t he Basel Com m it t ee in 1992. Alt hough t he accor d was init ially t ar get ed at int er nat ionally act ive banks, it ult im at ely gained br oad int ernat ional accept ance am ong banks and supervisor y aut hor it ies. More t han 100 count r ies around t he world have now adopt ed t he Basel Accor d.
3 . W h a t a r e t h e diffe r e n ce s be t w e e n Ba se l I a n d Ba se l I I ?
Basel I I builds on t he basic st r uct ure of t he 1998 accor d ( Basel I ) t o det er m ine capit al r equirem ent s in r elat ion t o cr edit and m arket r isk and t o develop a m ore r isk - sensit ive capit al fram ew ork. This has been achieved by adj ust ing capit al r equirem ent s t o credit r isk and also by int r oducing changes in t he m et hod for calculat ing capit al t o cover exposur es from risk of losses at t ribut able t o operat ional failur es.
4 . W h a t a r e t h e obj e ct iv e s of t h e Ba se l Ca pit a l Accor ds?
The obj ect ives of Basel I and Basel I I are essent ially t he sam e. Fir st , t he Basel I fram ew ork was designed t o im pr ove soundness and st abilit y of t he int er nat ional banking syst em . Secondly, t he Basel I fram ew or k was expect ed t o cr eat e a level playing field am ong differ ent count r ies w it h a high level of consist ency in per cept ions t o r educe sour ces of unfair com pet it ion am ong int er nat ionally act ive banks. I n t he Basel I I fram ework, t he Com m it t ee believes t hat t he changes t o t he exist ing approaches w ill encourage t he banking indust ry t o use t he im pr oved risk m anagem ent m et hods.
5 . I s it com pulsor y for a n a t ion t o im ple m e n t Ba se l I I ?
No count ry is requir ed t o im plem ent Basel I I . No policy issued by BI S is legally binding on any count ry. For t his r eason, im plem ent at ion of Basel I I is a decision at t he individual count ry level, t aking int o account t he st at e of preparedness of t hat count ry's banking syst em .
6 . W h a t im pact doe s Ba se l I I h a v e on a na t ion ?
When a count r y im plem ent s Basel I I , t his act ion is expect ed t o st r engt hen financial syst em st abilit y by pr om ot ing advancem ent in r isk m anagem ent and capit al adequacy in t he banking syst em . Furt her m or e, Basel I I is also expect ed t o:
o I m prove cor porat e governance and r isk m anagem ent
o Cr eat e m ore efficient capit al allocat ion and build a r obust capit al st r uct ur e o St r engt hen st andards of t ransparency
o I m prove bank supervision in r egar d t o processes and im plem ent at ion.
7 . Ca n Ba se l I I be im ple m e n t e d in I n don e sia ?
Yes. Basel I I is a br oad policy fram ew ork consist ing of a set of best pract ices applied w orldwide. The concept s in Basel I I can t herefore be applied in any count r y, including I ndonesia.
8 . W h y m u st Ba se l I I be im ple m e n t ed in I n done sia ?
Basel I I prescribes a m or e r isk- sensit ive fram ew ork for calculat ion of t he capit al
r equirem ent . These capit al adequacy calculat ions also t ake int o account t he various r isks involved on a m ore com prehensive scale. This w ill encourage banks t o im prove t heir r isk m anagem ent in or der t o obt ain a m or e precise value of econom ic capit al. I t will also encourage super visors and m ar ket players t o play a great er r ole in financial syst em st abilit y.
9 . I s it a ppr opr ia t e for I n don e sia t o im ple m e n t Ba se l in t h e n e a r fu t u r e ?
Yes. Since t he int r oduct ion of Basel I , t he I ndonesian banking syst em has under gone far r eaching changes from :
o Globalisat ion
o Developm ent s in t echnology o I nnovat ions in t he financial w or ld
Fur t her m or e, Basel I focuses only on cr edit r isk and m ar ket r isk, t hereby sim plifying assum pt ions of r isks in a w ay t hat w ill not prot ect bank soundness.
Basel I I pr ovides a fram ew ork capable of m aint aining t he soundness and st abilit y of t he banking syst em t hr ough:
o St rengt hening of int ernal pr ocesses
o Prom ot ing t he use of m ore advanced and sophist icat ed r isk m anagem ent pract ices
o Risk m easur em ent s m ore accurat ely depict ing t he t r ue level of r isks carr ied by t he bank
1 0 . W h a t a ppr oa ch w ill be use d in I n don e sia ?
Bank I ndonesia w ill int r oduce t he st andar dised, int ernal rat ing- based and advanced approaches. These approaches w ill be phased in over t im e. The decision on t he appr oach t o be used w ill be m ade by individual banks w it h appr oval from t he supervisor.
1 1 . M a y ba n k s choose t h e a ppr oa ch t h e y use ?
Yes, banks m ay choose t he approach t hey w ish t o use. However, t he use of any approach ot her t han t he st andar dised approach m ust be approved by t he bank super visor. I f a bank has alr eady used t he int er nal rat ing based or advanced appr oach, it w ill not be perm it t ed t o r eplace t he appr oach in use w it h t he st andar dised appr oach w it hout appr oval from t he bank super visor.
1 2 . W ill ba nk s be r e qu ir e d t o u se t h e I n t e r na l Ra t in g- Ba se d or Adva n ce d a ppr oa ch?
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- Pillar 1: Rules est ablishing a m inim um rat io of capit al t o r isk- w eight ed asset s.
- Pillar 2: The super visor y r eview pillar, r equiring super visor s t o perform a qualit at ive r eview of t he capit al allocat ion t echniques used by t he bank and com pliance w it h r elevant st andards.
- Pillar 3: Disclosur e r equirem ent s t hat facilit at e m arket discipline.
- I nt er nal Rat ing: Result of a bank’s r isk m easur em ent of it s cr edit por t folio.
- Ext er nal Cr edit Rat ing: Rat ing issued by an ext ernal rat ing agency.
- Consolidat ion: Measurem ent of bank r isk encom passing t he ent ir e business gr oup linked t o t he bank.
- Operat ional Risk : Risk ar ising direct ly or indir ect ly fr om t he inabilit y or failure of int er nal pr ocesses, per sons or syst em or from ext ernal event s.
- Credit Risk: Risk of loss ar ising fr om default by a debt or or count erpart y.
- Mar ket Risk: Risk of loss arising fr om a t rading posit ion w hen pr ices under go change.
- Mit igat ion of Cr edit Risk : A set of t echniques enabling a bank t o pr ot ect part of it s posit ion fr om count er par t y default ( for exam ple, by t aking over collat eral or encashing a guarant ee or pur chasing hedging inst rum ent s) .
