CHAPTEIR 6 CHAPTEIR 6
6.3 Coverage of Risk Components by Constituents of Capital (Current Methodology)
The Basel capital adequacy standard is based on the principle that the level of a bank's capital should be related to the bank's specific risk pro- file. In addition to directly relating capital to a bank's risks, this frame- work was deemed flexible enough to allow consistent incorporation of other types of risks and was expected to provide a fairer basis for com- parison between banking systems. The central focus of the Basel capital adequacy framework is credit risk, including the aspect of country risk.
The credit risk profile of a bank is determined by assigning to its assets and off-balance-sheet commitments various risk weights, according to the terms set out in the 1988 Basel Accord.
Credit risk related to on-balance-sheet items - covered by Tier 1 and Tier 2 capital. The following risk weights are typically assigned to major categories of loans and advances:
* Cash claims on central governments or on central banks denominated and funded in the national currency: 0 percent.
This weighting indicates that financial assets related to govern- ments or central banks are internationally regarded as of zero risk, if denominated in the national currency. This assumption clearly does not hold true when a government's fiscal condition gives reason for concerns or when a government defaults on its debt.
* Claims on domestic public sector agencies: 0 to 50 percent, at national discretion. This risk weighting relates to financing, including off-balance-sheet financing and guarantees, made avail- able to the public sector and to semi-governmental organizations.
This relatively low weighting reflects the view that quasi-govern- mental bodies are also regarded as low risk. Loans guaranteed by or collateralized by securities of such entities are also subject to the same risk weight. National authorities typically assign the weight of 10 or 20 percent, which may not be realistic, especially in developing countries. While claims on public sector agencies may ultimately be realized, in many situations the point of collec-
CAPITAL ADEQUACY 109
tion is not within the timeframe of the original financial contract.
En Claims on banks: 20 pereent. This low weighting is a conse- quence of the intensive regulation and supervision to which banks are subjected. As a result of formalized risk management proce- dures and the available central bank accommodation, interbank loans are regarded as less of a credit risk than other loans and advances. For banks outside the OECD, the 20 percent risk weighting applies only to claims with a residual maturity of less than one year.
Ei Residential mortgages: 50 percent. This weighting indicates the traditionally sound nature of such investments. Mortgages, how- ever, are increasingly risky due to the high level of consumption expenditures secured by mortgage bonds, which are in turn tied to more flexible mortgage products (e.g., home equity loans or advances against capital that has already been paid).
Consequently, the relatively low risk weight accorded to residen- tial mortgages could distort the allocation of credit, since loans that finance consumption expenditures can be granted at a price that is not economically justifiable.
S Other loans: 1100 percent. This weighting generally indicates the higher risk to which a bank is exposed when it extends loans to the private sector. Other claims in this category include claims on governments outside the OECD that are denominated in curren- cies that are not national currencies; on banks outside the OECD, for claims of residual maturities of more than one year; on real estate and other investments; and on fixed and other assets.
Credit risk related to off-balance-sheet itens - covered by Tier 1 and Tier 2 capital. The framework established in the Basel Accord also includes off-balance-sheet items. Off-balance-sheet exposures are treated by converting them into on-balance-sheet credit risk exposures by apply- ing the corresponding credit conversion factors to different types of instru- ments or transactions. The multiplication factors are derived from the esti- mated likelihood of default. Credit conversion factors for major off-bal- ance-sheet categories are defined as follows:
* Comnmitments (such as standby facilities and credit lines) with maturities of up to one year, or those that can be unconditionally cancelled at any time: 0 percent.
* Short-term, self-liquidating, trade-related contingencies, such as documentary credits subject to collateral by underlying ship- ments: 20 percent.
* Certain transaction-related contingent items, such as performance bonds, bid bonds, warranties, and standby letters of credit related to a particular transaction; note issuance facilities and revolving underwriting facilities; and other commitments, such as formal standby facilities and credit lines with maturities of more than one year: 50 percent.
* Direct credit substitutes such as general guarantees of indebtedness (e.g., standby letters of credit that serve as financial guarantees for loans and securities) and acceptances (e.g., endorsements); sale and repurchase agreements; and forward asset purchases: 100 percent.
The risk weighting of assets and off-balance-sheet positions has pro- vided a major step toward improved objectivity in assessing the adequacy of bank capital. The simplicity of this methodology has also enabled it to be introduced in banking systems that are in their early stages of develop- ment. However, this simple weighting of assets provides only a crude measure of economic risk, primarily because the methodology is not effectively calibrated to account for different default risks.
Credit risk related to derivative instruments - covered by Tier 1 and Tier 2 capital. In 1995, the Basel Accord was amended to include the treatment of forward contracts, swaps, options, and similar derivative con-
TABLE 6.1 CREDIT RISK MULTIPLICATION FACTORS FOR DERIVATIVE INSTRUMENTS
Interest Exchange
Residual Maturity Rate Rate and Gold Equity Commodities
One year or less 0.0% 1.0% 6.0% 10.0%
One to five years 0.5% 8.0% 7.0% 12.0%
More than five years 1.5% 10.0% 8.0% 15.0%
CAPITAL ADEQUACY 11i
tracts. With such derivative instruments, banks are exposed to credit risk not for the full face value of their contracts, but only to the potential cost of restoring the cash flows if the counterparty defaults. The theoretical basis for assessing the risk on all derivative instruments is the same, with the "credit equivalent" amounts being dependent on the maturity of the respective con- tract and on the volatility of the rates and prices underlying this type of instru- ment. For capital adequacy assessment, the derivative instruments are con- verted according to the same principles as the other types of off-balance- sheet exposures. Table 6.1 summarizes the weights used for multiplication.
Market risk related to on- aind off-balance-sheet positions - par- tially covered by l'ier 3 capital. Another major amendment was the 1996 inclusion of market risk exposures in the capital adequacy framework.
Market risk is defined as the risk of losses in on- and off-balance-sheet positions that arise from shifts in market prices. The risks covered by the amendment include the general and specific interest rate and equity price risks for a bank's trading book of debt and equity instruments and related off-balance-sheet contracts, and general foreign exchange and commodi- ties risks throughout the bank (i.e., in the trading and banking books).
Banks may use either a standardized approach or an internal model approach. Both approaches result in the calculation of an actual capital charge, which is then converted into a notional risk-weight, by using the percentage capital requirement set by the local regulatory authorities. Tier 1, 2, or 3 capital can be used to satisfy this charge, subject to the limitations explained in Section 6.2. Assets subject to market risk capital requirements are excluded from the risk-weighted credit capital requirements.
The standardized framework for market risk is based on a building- block approach, and comprises the general market risk that arises from the bank's overall open position in four fundamental markets and the spe- cific risk associated with the individual securities positions of a bank. The capital requirement is calculated separately for the following risks:
El Interest risk - trading book
E Equities risk - trading book
E Currency risk - trading and banking books (see Section 13.4 and Figure 13.4)
Ei Commodities risk - trading and banking books
Once quantified, the separate capital charges are added together and multiplied by the reciprocal of the regulatory percentage capital adequacy requirement, to create a notional risk weight for market risk, from which the allowable portion of the Tier 3 capital adequacy requirement can be calculated (e.g., an 8 percent capital adequacy requirement would result in a 12.5 multiplication factor -see footnote 1 in Section 6.2 and the annex- ure to this chapter for details of the calculation).
The market risk capital charge, when using an internal model, is based on whichever is higher: the previous day's value at risk (VAR; see Section 11.5) or the average VAR over the last 60 business days. The actu- al capital requirement is calculated by using a model that falls within the recommended Basel Committee parameters. This figure is then multiplied by the factor k, designated by the national supervisory authorities and related to the quality of a bank's risk management system - k has a min- imum value of 3.0.
Banks are expected by their supervisory authorities to also add to k a
"plus" factor, of between 0.0 and 1.0, that is determined by the number of times back-testing of the internal model disclosed the predicted VAR to have been exceeded. Since this plus factor is related to the ex-post per- formance of the internal model, its addition is expected to serve as a pos- itive incentive to maintain a good quality model.
The Basel Committee market risk-related capital standard requires that the VAR must be computed daily and the market risk-related capital requirements met on a daily basis.
The use of internal models for the measurement of market risk is subject to the approval of supervisory authorities, and must meet certain criteria. In addition, the use of internal models includes a set of detailed requirements related to the following:
* Market risk management process. This should be comprehen- sive; under senior management scrutiny; integrated with but inde- pendent from operations; with adequate controls; and with learn- ing capacity.
* Coverage. The risk measurement system should include specific risk factors related to interest rate risk, currency risk, equity price risk, and commodity price risk.
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mE Quantitative parameters of an acceptable internal model.
Included among these are the frequency of VAR computations, an historical observation period, confidence parameters, a holding period, and multiplication factors.
mE Stress testing and external validation requirements. These include parameters to ensure that a bank tests against various assumptions and factors that potentially could create extraordi- nary gains or losses in the trading portfolio or make the control of risk difficult; to ensure that the bank has a system to act on what it learns from the stress test; and to ensure that the system is exter- nally validated in terms of meeting the Basel criteria.
6A0 Basel III Proposed Changes for Determining Capital Adequacy
The Basel II proposals are based on three pillars: a capital adequacy requirement, a supervisory review process and a market discipline requirement (see Table 6.2). While the Accord offers a menu of approach- es for measuring credit, market and operational risk, the approaches them- selves are a balance between simplicity and accuracy. For example, in credit risk, the standardized approach is less accurate, but more simple to implement. Advanced models on the other hand, are more accurate, but more difficult to implement.
Pillar 1: Capital Adequacy Requirement. Measurement of the cap- ital adequacy requirement is determined by three risk components - credit risk, market risk, and operational risk. For each of these risk com- ponents, a menu of different approaches will be available, as follows:
a Credit risk. The options for calculation of the credit risk capital adequacy requirement include a standardized approach and two versions of an internal ratings-based model (IRB). The stan- dardized approach proposes that the credit risk weighting of banking assets rely in large part on the assessments of external rating agencies. The criteria for acceptability of such credit assessments encompass the issues of the objectivity, independ- ence, transparency, credibility, international recognition, and
Credit Risk Market Risk Operational Risk
Basic Regulators Enhance disclosure
indi- Stan- Advanced must ensure regarding the calcu-
Standardized Internal ratings- Standardized Internal cator dardized measurement that banks have lation of capital and
R approach based approaches approach model approach approach approach sound internal risk assessment
Same indi- processes for methods. More detail
One cator for Internal Loss capital assessment required for banks
Foun- Building indicator: different measure- distri- based on risk that use advanced
dations Advanced block VAR, gross business ment bution Scorecard commensurate risk management approach approach approach etc. revenue lines approach approach approach with risk profile. approaches.
1 2 3 4 5 6 7 8 - 9 10 11 12
_ Places more emphasis on banks' own internal control and management, the supervisory review process, and market discidline.
1 Similar to Basel 1. but additional and changed risk-weight buckets. Expanded use of credit risk mitigation techniques (financial collateral). More reliance on rating agencies.
2 Divide loan portfolio into 7 portfolios. Probability of default (PD) is provided by bank, with the exposure at default (EAD) and loss given default (LGD) provided by the regulator.
3 Divide loan portfolio into 7 portfolios. Probability of default (PD), Exposure at default (EAD) and loss given default (LGD) all provided by the bank, using historical experience.
4 Capital charge captured separately for each risk and then summed. Trading book used for general and specific risk in interest and equities markets. Both trading and banking books are used for general risks in currency and commodities markets.
5 Market risk capital is based on higher of average VAR over past 60 days, or previous day's VAR (multiplied by a scaling factor).
6 A simplistic approach which uses a single indicator (gross revenue) as proxy for overall operational risk exposure - to be multiplied by an alpha-factor set by the Basel Committee.
7 Bank organizes itself into eight standard business lines, currently all using a common indicator, but flexibility built in for future differentiation of indicators - to be multiplied by a beta-factor, which varies by business line and which is set by Basel.
8 IMA uses information from standardized approach. Calculates exposure indicator (El) and loss should an operational risk event occur (LGE). Expected loss (EL) is product of EI*LGE. IMA uses assumptions about relationship between expected and unexpected loss.
9 LDA allows bank to estimate distribution of losses and therefore attempts to assess unexpected losses directly.
10 Bank determnines initial level of operational risk capital. Amount is modified over time by capturing underlying risk profile of different business lines. Approach relies more on qualitative judgment, less on historical data.
11 Regulators must ensure that banks have sound internal processes for capital assessment based on risk commensurate with risk profile.
12 Enhance disclosure regarding the calculation of capital and risk assessment methods. More detail required for banks that use advanced risk management approaches.
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access to resources of the providing agency. Reservations about the use of such assessments nonetheless remain due to the mixed record of agencies when rating less than ultra-prime borrowers and on the use by the separate agencies of different credit analy- sis methodologies. In addition, there exists a lack of ratings depth in many emerging market countries.
The external ratings that would determine the standard weights for claims on governments, non-domestic banks, and domestic or international corporates are illustrated in Table 6.3 (according to the Standard and Poor's rating methodology).
Option 1 implies that the risk weight used for banks in a coun- try will be one rating category below the sovereign risk weight in that country (for AAA to BBB ratings). Option 2 ignores the sov- ereign rating and uses a set of risk weights based on the actual rat- ing of the borrowing bank. Lending to foreign banks in countries where there are no ratings agencies will follow the risk weights shown in the "unrated" column. Domestic banks will continue to carry a 20 percent risk weighting.
Some changes additionally are proposed that would address asset securitization transactions through special purpose vehicles, using an external ratings approach. Only minor changes are pro- posed to the treatment of off-balance-sheet items. In the stan- dardized approach, credit-risk mitigation techniques for financial collateral, netting and guarantees will be permitted. Also, in very limited cases, commercial real estate will be permitted as a cred- it risk mitigant when using the standardized approach.
TABLE 6.3 PROPOSED STANDARDIZED APPROACH: RISK WEIGHTS BASED ON EXTERNAL RATINGS
Assessnmtent
AAA to A+ to BBB+ to BB+ to Below
Claim AA- A- BBB- B- B- Unrated
Governments 0% 20% 50% 100% 150% 100%
Banks Option 1 20% 50% 100% 100% 150% 100%
Option 2 20% 50% 50% 100% 150% 50 %
Corporates 20% 100% 100% 100% 150% 100%
The two alternative internal ratings-based (IRB) approach- es are a foundations and an advanced approach. There is a com- mon misconception that using one of the IRB approaches to measure credit risk, will result in lower capital charges. This is not true. The measurement will be more accurate, but also, the risk-weight curve is far steeper for IRB approaches than for the standardized approach and as a consequence, a poor quality loan portfolio will produce a higher capital requirement when using an IRB approach. It is also worth noting that an IRB methodology will result in increased volatility in the capital requirement. The probability of default (PD) of a borrower or group of borrowers is the central measurable concept on which the IRB approach is founded. Banks' internal measures of credit risk are normally based on assessments of the risk characteristics of both the bor- rower and the specific type of transaction. In addition, a bank must estimate exactly how much it is likely to lose should a bor- rower default on an obligation. The magnitude of likely loss is termed Loss Given Default (LGD) and is normally expressed as a percentage of a bank's exposure. The actual loss is contingent upon the amount at the time of default, commonly expressed as Exposure at Default (EAD). The final element normally included in the IRB is the maturity (M) of exposures. These components (PD, LGD, EAD and M) form the basic inputs to the IRB approach. They combine to provide a measure of the expected intrinsic, or economic, loss and, consequently, they formn a basis for credit risk related capital adequacy requirements.
The IRB may be implemented in two ways, using a "founda- tion" (basic) approach or an advanced approach. The founda- tions approach requires the loan portfolio to be subdivided into at least seven different "buckets," with the (PD) provided by the bank and the EAD and LGD, provided by the supervisory author- ity. Once the total probable loss (given the various probabilities of default) is calculated, a capital charge is determined, based on a risk weight for each "bucket."
The advanced approach to calculating capital adequacy pro- poses use of the same methodology as used for the foundations
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approach, with the exception that the bank determines its own PD, EAD, and LGD figures based on historical experience. This alternative opens the door to credit risk modeling and introduces the concept of correlation, which although not yet accepted by regulatory authorities and not permitted by the capital accord, is common practice among the more sophisticated banks.
In practice, implementation of the IRB approach includes the following elements:
- a classification of exposures by broad exposure type (e.g., gov- ernmental, corporate, retail);
- for each exposure class, risk estimates that the bank must assign using standardized parameters or its internal estimates;
- a risk-weight function deriving the respective capital require- ments for each exposure type;
- a set of minimum requirements that a bank must meet in order to be eligible to use an IRB approach;
- across all exposure classes, supervisory review of a bank's compliance with the minimum requirements.
E Market risk. The market risk capital adequacy requirement remains unchanged. Calculation of the market risk capital requirement is also permitted via a standardized approach or an internal models approach.
ODperational risk. Operational risk is defined by the Basel Committee on Banking Supervision as "the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events." Developments such as the increasing use of highly automated technology, the increase in retail opera- tions and growth of e-commerce, increased outsourcing, and the greater use of sophisticated techniques to reduce credit and mar- ket risk have created increased operational risk. This recognition has led to an increased emphasis on sound operational risk man- agement by banks, as well as to the inclusion of operational risk in a bank's internal capital assessments and allocation process.
Consequently, Basel II includes capital charges explicitly related to the assessment of operational risk. The initial proposal