BASEL I and II

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BASEL I and II
Fulbright Scholar at XIMB Dr. Sunil Mohanty

• CAPITAL ADEQUACY

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Role Of Capital

• The primary role of capital is to protect a FI
  against the risk of insolvency/failure.
• Several Functions of Capital
• To absorb unanticipated loss.
• To protect uninsured depositors, bondholders, and
  creditors in the event of insolvency and
  liquidation.
• To protect FI insurance funds and the tax payers.
• To protect FI against increases in insurance
  premium
• To acquire the plant and other real investments
  necessary to provide financial services.

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Capital and Insolvency Risk

• To see how capital protects an FI against
  insolvency risk,we define the market value versus
  book value of capital.
• Market Value of an FIs Capital Net Worth
• A measure of an FIs capital which is equal to
  the difference between the market value of its
  assets and the market value of its liabilities.
• Book Value of Capital
• The difference between the asset and liability
  values based on their historical costs.

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• Table 1
• An FIs Market Value Balance Sheet (in millions
  of dollars)
• Table 2
• An FIs Market Value Balance Sheet after a
  Decline in the
• Value of Loans ( in millions of dollars)

Assets Liabilities Long-term
securities 80 Liabilities (short-term,
floating-rate deposits) 90 Long-term loans
20 Net worth 10 100 100
Assets Liabilities Long-term
securities 80 Liabilities 90 Long-term loans
12 Net worth 2 92 92
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• Table 3

• Assets Liabilities
• Long-term securities 80 Liabilities
• (short-term, floating-rate deposits)90
• Long-term loans 8 Net worth -2
• 88
  88

An FIs Balance sheet after a Major Decline in
the Value of the Loan Portfolio(in millions of
dollars)

• Table 4

Assets Liabilities Long-term
securities 75 Liabilities
(short-term, floating-rate deposits)90 Long-term
loans 17 Net worth 2 92
92
An FIs Market Value Balance Sheet after a rise
in Interest Rates (in millions of dollars)
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• Table 5

Assets Liabilities Long-term
securities 80 Liabilities (short-term,
floating-rate deposits)90 Long-term loans
20 Net worth 10
100
100
Book Value of an FIs Assets and Liabilities (in
millions of dollars)

• Table 6

Assets Liabilities Long-term
securities 80 Liabilities (short-term,
floating-rate deposits)90 Long-term loans
17 Net worth 7
97 97
The effect of a Loan Loss Charge-Off against the
Book Value of an FIs Equity (in millions of
dollars).
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The Discrepancy Between the Market and Book
Values Of Equity

1. Interest rate volatility The higher the interest
   rate volatility, the greater the discrepancy.
2. Examination and Enforcement The more frequent
   the on-site and off-site examination and the
   stiffer the examiner/regulator standards
   regarding changing of problem loans, the smaller
   the discrepancy.

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Market To Book RatioThe Ratio MV/BV

• For publicly traded FIs
• MV Market value of equity ownership
  outstanding
• Number of shares
• BV Par value of equity surplus value
  retained earnings loan loss reserves
• Number of Shares
• The lower the ratio (MV/BV) , book value of
  capital overstate the economic net worth of an
  FI.

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• Table 7

FDICIA and Capital Regulations
(1) (2) (3)
Total Risk- Tier I
Risk- Leverage Zone
Based Ratio Based Ratio
Ratio 1.Well capitalized 10
or above 6 or above 5
or above 2.Adequately capitalized 8 or
above 4 or above 4 or
above 3.Undercapitalized Under 8
or Under 4 or Under
4 4.Significantly Undercapitalized
Under 6 or Under3 or
Under 3 5.Critically Undercapitalized
2 or Under or 2 or Under or 2
or Under
Specifications of Capital Categories for Prompt
Corrective Action (in present)
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FDICIA and Capital Regulations

• Table 8A

Zone Mandatory Provisions Discretionary
Provisions 1.Well capitalized
2.Adequately capitalized 1.No brokered
deposits except with FDIC 3.Undercapitaliz
ed 1. Suspend dividend Management 1. Order
restriction. Fees. 2. Require capital
restoration plan. 2. Restrict interaffiliate
transactions. 3. Restrict Asset
growth. 3. Restrict deposit interest
rates. 4. Approval required for
acquisitions, 4. Restrict certain other
branching, and new activities.
activities. 5. No brokered deposits. 5. Any
other action that would better carry
out prompt corrective action.

Summary of prompt Corrective Action Provisions of
the Federal Deposit Insurance
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• Table 8B

FDICIA and Capital Regulations
Zone Mandatory Provisions Discretionary
Provisions 4.Significantly
Undercapitalized 1.Same as for Zone 3 1. Any
Zone 3 discretionary actions. 2.
Order recapitalization 2. Conservatorship or
receivership if fails to submit or
implement plan or recapitalize
pursuant to order. 3. Restrict
interaffiliate 3. Any other Zone 5
transactions. provisions if such action
is necessary to carry out
prompt corrective action. 4. Restrict
deposit interest rate. 5. Pay of officers
restricted. 5.Critically Undercapitalized
1.Same as for Zone 3. 2.Receiver/Conservator
within 90 days. 3. Receiver if still in Zone
5 four quarters after becoming critically
undercapitalized. 4. Suspend payments on
subordinated debt. 5. Restrict certain other
activities.
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Risk-based Capital Standards

• The 1988 Based Accord (Basel I) or the New Basel
  II Capital Accord (Basel II) is applicable to
  Banks only
• Basel Accords are Regulatory frameworks
• Basel Committee on Banking Supervision (BCBS) of
  the Bank for International Settlements (BIS)

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Brief History of Basel I

• 1988, the G-10 central banks agreed to apply a
  common minimum capital standards to all
  internationally active banks
• Basel I is not applicable directly, but through
  national regulatory authorities or through
  transnational rules (EU Directive Capital
  Adequacy Directive)
• A huge success for Basel I, which is applied to
  all internationally active banks in most
  countries (Approx, 100 countries)

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Minimum Capital Requirements Under Basel I

• Assets Liability Equity
• Loan Assets (100) Debt (92) Equity (8)
• Minimum Capital Requirements
• 8 Loan Amount Risk Weight
• Basel I Risk Weightings
• (OECD) Sovereigns 0
• (OECD) Banks 20
• Mortgage Loans 50
• Other Loans 100

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Risk Categories

• Table 9

Basel I Category 1 (0 weight) Cash, Federal
Reserve Bank balances, securities of the U.S.
Treasury, QECD governments, some U.S.
agencies. Category 2 (20 weight) Cash items in
the process of collection. U.S. and OECD
interbank deposits and guaranteed deposits and
guaranteed claims. Some non-OECD bank and
government deposits and securities. General
obligation municipal bonds. Some mortgage backed
securities. Claims collateralized by the U.S.
Treasury and some other government
securities. Category 3 (50 weight) Loans fully
secured by first liens on the one-to four-family
residential properties. Other (revenue) municipal
bonds. Category 4 (100 weight) All other
on-balance-sheet assets not listed above,
including loans to private entities and
individuals, some claims on non-OECD governments
and banks, real assets, and investments
in subsidiaries.
Summary of the Risk-based Capital Standards for
On-Balance-Sheet Items under Basel I
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• Table 10

Off-Balance-Sheet Items (Basel I)
Sale and repurchase agreements and assets sold
with recourse that are not included on the
balance sheet (100). Direct credit substitute
standby letters of credit (100). Performance-rela
ted standby letters of credit (50). Unused
portion of loan commitments with original
maturity of more than one year (50). Commercial
letters of credit (20). Bankers acceptances
conveyed (20). Other loan commitments (10).
Conversion factors for Off-Balance-Sheet
Contingent or Guaranty Contracts, Basel I
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Capital Adequacy Rules ( Basel I)

• Under the Risk-based Capital Plan, banks must
  meet three minimum capital requirements
  simultaneously.
• Tier I (core) Capital Ratio
• Core Capital (Tier1) gt 4
• Risk-adjusted assets
• Core capital is primarily the book value of
  stockholders equity.
• Total Risk-based Capital Ratio
• Total Capital (Tier1Tier 2) gt 8
• Risk-adjusted assets

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Capital Adequacy Rules (cont.)

• Tier II capital is supplementary capital which
  includes subordinate debt, convertible debt
  instruments, and loan loss reserve.
• Leverage Ratio Core capital Tier1 gt 3
• Assets Assets
• Risk-adjusted Assets
• Risk-adjusted on-balance-sheet assets
  Risk-adjusted off-balance-sheet assets

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Banks Balance Sheet (in million )Basel I

• An example See Appendix A

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Risk Adjusted On-Balance-Sheet Assets (Basel I)

• 0 ( 8m 13m 60 m 50m 42m)
• 0.2 ( 10m 10m 20)
• 0.5 (34m 308m)
• 1.0 (10m 55m 75m 390m 10m 108m 22
  )
• 849 million
• Note Book value of On-Balance-Sheet Assets
  1,215 million

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• Risk-adjusted Asset Value of OBS Contingent
  Guaranty Contracts
• Credit Equivalent Amount
• OBS Item Face Conversion Credit
• Value Factor Equivalent Amount
• Two-year loan
• commitment 80 .5 40
• Standby
• letter of credit 10 1.0 10
• Commercial
• letter of credit 50 .2 10
• Note See Table 1 Conversion Factor

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• Risk-adjusted Assets for OBS Guaranty Contracts
• OBS Item Credit Equivalent Risk Weight
  Risk-adjusted Asset
• Amount, mil (wi) Amount, millions
• Two-year loan
• commitment 40 X 1.0 40
• Standby
• letter of credit 10 X 1.0
  10
• Commercial
• letter of credit 10 X 1.0
  10
• 60
• Note The banks risk-adjusted asset value of its
  OBS contingent/ guaranty contracts is 60.

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Calculating the Overall Risk-based Capital
Position of a Bank (Basel I)

• Tier I capital Common stock perpetual
  preferred Stock Retained earnings
• 30 10 10
• 50 million
• Tier II capital Convertible bonds Subordinate
  bonds Perpetual Preferred Stock
  (nonqualifying) Reserve for Loan
  losses
• 15 15 5 10
• 45 million.

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Risk-based Capital Ratios

• Total Risk-adjusted Assets Risk-adjusted
  On-Balance-Sheet assets
  Risk-adjusted assets for OBS items
• 849m 60m
• 909 million.
• Total Risk-based capital Ratio Tier I Tier II
  capital
• Total Risk-adjusted assets
• (50 45)
• 909
• 10.45 gt 8
• Tier I Capital Ratio Tier I Capital
• Total Risk-adjusted Asset
• 50
• 909
• 5.1 gt 4

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• Leverage Ratio Tier I Capital
• Total Assets
• 50
• 1,215
• 4.11 lt 5
• Note The bank meets risk based capital
  requirements under Basel I. The Bank is
  adequately capitalized.

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Why New Capital Standards ?(Basel II)

• Basel II aims to better align regulatory capital
  with underlying risk
• Basel II explicitly accounts for credit risk,
  market risk and operational risk
• Better address capital requirements for banking
  innovation such as asset securitization
• Basel II will be implemented by year end 2006

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Deficiencies of Basel I

• While simple in application, it is easy to
  achieve significant capital reduction with little
  or no risk transfer
• Did not sufficiently discriminate between
  different levels of risks
• Encouraged excessive risky lending and investing
  in certain areas Subprime loans, asset-backed
  securities (ABS)

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The New Capital Standards (Basel II)

• Risk sensitivity of capital requirements for
  credit risk
• New capital charges for operational risk
• No more one-size-fits-all approach
• More flexible approach through a menu options
• New incentives for sound risk management
  practices

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Three Pillars of Basel II
Basel II

• Minimum Capital
  Supervisory Disclosure
• Requirement Review Process
  Market
• (Pillar 1) (Pillar 2) Discipline
• (Pillar 3)

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Flexible Approach to Determine Regulatory Capital
under Basel II

• Basel II offers many different approaches to
  compute regulatory capital against credit risk
  and operational risk
• Banks opt for one approach for all for some
  segments of activities or some asset classes
• Banks opting for the most advanced approaches
  must be authorized by their supervisors
• Basel II incorporates minimum capital
  requirements into a three pillar structure that
  includes supervisory review and market discipline

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Calculating Risk Weighted Assets
Risk Weighted Assets
Market Risk
Credit Risk
Op Risk
Standardized Approach
Basic Indication Approach
Standardized Approach
Foundation IRB Approach
Standardized Approach
Internal Model Approach
Advanced IRB Approach
Advanced Measurement Approach
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Standardized Approach to Credit Risk

• Use fixed risk weights based on external credit
  ratings
• Least sophisticated capital calculation with
  highest capital burden
• Except for the largest 20 banks, most US banks
  will use standardized approach

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Internal Ratings-Based (IRB) Approaches to Credit
Risk

• Substantially differ from the standardized
  approach
• Banks internal assessments of key risk drivers
  serve as primary inputs to the capital
  calculation
• The risk weights and capital changes are
  determined through the combination of
  quantitative inputs provided by banks and
  formulas specified by the committee
• Banks have strong incentive to move to IRB status
  and reduce capital changes by improving risk
  management system.

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Foundation IRB VS. Advanced IRB
Data Input Foundation IRB
Advanced IRB

• -Probability of -Provided by bank based
  - Provided by bank
• Default (PD) on own estimates
  based on own estimates
• -Loss Given -Supervisory Values set -
  Provided by bank based on
• Default (LGD) by the committee
  own estimates
• -Exposure at -Supervisory values set
  - Provided by bank based on
• Default (EAD) by the committee own
  estimates
• -Maturity (M) -Supervisory values -
  Provided by bank based on
• provided by the own estimates
• committee

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• Table 11A

Risk Categories under Basel II
Category 1 (0 weight) Cash, Federal Reserve
Bank balances, securities of the U.S. Treasury,
QECD governments, some U.S. agencies, and loans
to sovereigns with an SP credit rating of AA
or better. Category 2 (20 weight) Cash items in
the process of collection. U.S. and OECD
interbank deposits and guaranteed deposits and
guaranteed claims. Some non-OECD bank and
government deposits and securities. General
obligation municipal bonds. Some mortgage backed
securities. Claims collateralized by the U.S.
Treasury and some other government
securities. Loans to Sovereigns with an SP
credit rating of A or A-. Loans to banks and
corporates with an SP credit rating of AA- or
better.
Summary of the Risk-Based Capital Standards for
On-Balance Sheet Items Under Basel II effective
2006
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CONTINUED from Table 11A

• Table 11B

Category 3 (50 weight) Loans fully secured by
first liens on the one-to four-family residential
properties. Other (revenue) municipal bonds.
Loans to Sovereign with an SP credit rating of
BBB to BBB-. Loans to banks and corporates with
an SP credit rating of A to A-. Category 4
(100 weight) Loans to Sovereigns with an SP
credit rating of BB to B-. Loans to banks with a
credit rating of BBB to B-. Loans to corporates
with a credit rating of BBB to BB-. All other
on-balance-sheet assets not listed above,
including loans to private entities and
individuals, some claims on non-OECD governments
and banks, real assets, and investments in
subsidiaries. Category 5 (150 weight) Loans to
sovereigns, banks and securities firm with an SP
credit rating below B-. Loans to corporates with
a credit rating below BB-.
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• Table 12

Conversion Factors for OBS items
Sale and repurchase agreements and assets sold
with recourse that are not included on the
balance sheet (100). Direct credit substitute
standby letters of credit (100). Performance-rela
ted standby letters of credit (50). Unused
portion of loan commitments with original
maturity of more than one year (50). Commercial
letters of credit (20). Bankers acceptances
conveyed (20). Other loan commitments (10).
Loan commitments with original maturity lt 1year
(Conversion factor is zero based on Basel I and
20 percent based on Basel II)
Conversion factors for Off-Balance-Sheet
Contingent or Guaranty Contracts, Basel II (Same
as Basel I)
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Banks Balance-Sheet under Basel II

• An example See Appendix B

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Risk-adjusted On-Balance-Sheet Assets

• 0 ( 8m 13m 60 m 50m 42m)
• 0.2 ( 10m 10m 20 10m 55m)
• 0.5 (34m 308m 75m)
• 1.0 (390m 108m 22m )
• 1.5 (10)
• 764.5 million
• Risk-Adjusted assets for Off-Balance-Sheet items
• 60 million (same as before)
• Total Risk-adjustment assets
• 764.5 million 60
• 824.5 million

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Risk-based Capital Ratios under Basel II

• Tier I (Core) Capital Ratio Core Capital
• Total Risk-adjusted Assets
• 50 million
• 824.5 million
• 6.06 gt 4
• Total Risk-based Capital Ratio Tier I Tier II
  Capital
• Total Risk-adjusted Assets
• (50 m 45) m
• 824.5
• 11.52 gt 8
• Leverage Ratio Tier I Capital
• Total Assets
• 50 mil
• 1,215 mil
• 4.11 lt 5

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Comparison of Basel I Basel II

• Basel I Basel II
• Tier 1 (core) capital Ratio 5.5 6.06
• Total risk-based Capital Ratio 10.45 11.52
• Leverage Ratio 4.11 4.11

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Bank Book Capital Ratios
Table 13
Asset Size Bucket 1996(in bn) 0.5-1 1-2 2-5 5-10
10-30 gt 30 Number of Banks 203 112 65 33 32 29
Tier 1 capital/Avg Assets (in ) 8.58 8.57 7.8
0 8.46 7.50 7.14 Total Capital (Tier 1Tier2)/
Risk-Weighted Assets 14.47 14.23 13.46 13.75 13
.25 12.80 Source Adapted from Davis and Lee
(1997) Observation 1 Smaller banks hold
(relatively) more capital. Why?
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Capital serves as substitute for Risk Management
to ensure bank safety

• Smaller banks tend to have following
  characteristics
• Concentrated ownership and owner-managers, thus
  prefer more risk management to less.
• Limited access to sophisticated risk management.
• More operating risk due to the lack of management
  depth.
• Lack of fee-based income might lead to more
  earnings volatility.
• Lack of diversification of their credit
  portfolios (with geographical and/or industry
  concentrations).
• The capital structure choice in banks is closely
  related to the underlying risks held on the books
  of a bank.