Basel I, Basel II, and
Basel I, Basel II, and
Solvency II
The Reasons for Regulating
Banks
•The purpose is to ensure banks keep enough capital for the risks they take.
•Governments would like to make the probability of a bank failing small.
•Governments would like to create and
Bank Regulation Pre-1988
•Prior to 1988, bank regulators tended to regulate bank capital by setting minimum levels for the ratio of capital to total assets. •The lack of consistency in several countries
lead to a problem in which total assets
The 1988 BIS Accord
•Supervisory authorities from several
countries formed the Basel Committee on Banking Supervision.
The Cooke Ratio
•It considers both on-balance-sheet and
off-balance-sheet items to calculate the bank’s total risk-weighted assets (amount).
•It is a measure of the bank’s total credit exposure.
•Each item on the on-balance-sheet item is
The Cooke Ratio
Risk weight
(%) Asset category
0 Cash, gold bullion, claims on OECD governments such as Treasury bonds or insured residential mortgages
20
Claims on OECD banks and OECD public sector entities such as securities issued by US government agencies or
claims on municipalities
50 Uninsured residential mortgage loans
100
All other claims such as corporate bonds and less-developed country debt, claims on non-OECD banks
Example
•The assets of a bank consist of $100
million of corporate loans, $10 million of OECD government bonds, and $50 million of residential mortgages. The total of risk-weighted assets is
The Cooke Ratio
•Off-balance-sheet items are expressed as a credit equivalent amount.
•Credit equivalent amount is the loan principal that is considered to have the same credit risk.
The Cooke Ratio
• For an over-the-counter derivative, such as an interest rate swap or a forward contract, the credit equivalent amount is calculated as
max(V,0) + aL
• where V is the current value of the derivative to the bank,
a is an add-on factor, and L is the principal amount.
• The bank’s exposure is max(V,0) and the add-on amount,
The Cooke Ratio
• The equation above is the current exposure.
• If the counterpart defaults today and V is
positive, the contract is an asset to the bank and the bank is liable to lose V.
• However, if the counterpart defaults today and V is negative, the contract is an asset to the
The Cooke Ratio
Remaining maturity
(years) Interest rate Exchange rate and gold Equity
Example
•A bank has entered into $100 million
interest rate swap with a remaining life of four years. The current value of the swap is $2 million. In this case the add-on
