Basel III framework for liquidity - Frequently asked questions
This document sets out the first set of frequently asked questions that relate to Basel III’s liquidity rules. The first section of the document provides clarification on the calculation of the cap on Level 2 assets with regard to short-term secured funding. Section 2 addresses other questions and answers pertaining to the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) of the rules text. Section 3 sets out miscellaneous edits to the rules text.
Sovereign risk is the extra dimension of risk
involved in international, as distinct from domestic, transactions. Sovereign
risk is an aspect of the credit
proposal that is additional to the usual commercial risks such as credit, foreign
exchange and transport risks, and is outside the individual borrower's
control; it can override the borrower's willingness and ability to repay
financial obligations, even though the borrower may be a government. Sovereign risk implies the possibility that
conditions will develop in a country which inhibit repayment of funds
due from that country, such as exchange
controls, strikes or declarations of war.
Credit Management System in Bank
Presentation on Credit Management System in Bank. Total Credit management in a bank.
Liquidity and Profitability Comparative Study in MS Power Point
A Comparative study of Liquidity and Profitability of the Conventional Banks and Islamic Banks.
Evolution of Basell I & II
This is the full version of Basel I & II evolution in MS Power Point. Download it for your further references and recommend for others.
Just click the title to download.
Just click the title to download.
Basel II - Pillar I
Pillar I
In the United States, all banks that will be required to conform to the new capital standard will use the Advanced Internal Ratings Based approach (AIRB).
AIRB Approach Requirements
Collect sufficient data on loans to develop a method for rating loans within various portfolios
Develop a Probability of Default (PD) for each rated loanDevelop a Loss Given Default (LGD) for each loan.
Example: Safe v. Risky Loans
Safe loans:Over a 1-year period, only 0.25% of these loans default
If a loan defaults, the bank only loses 1% on the outstanding amount
Risky loans:
Over a 1-year period, 1% of loans default every year
If a loan defaults, the bank loses 10% of the outstanding amount.
For a $100 million portfolio of the safe loans, the bank would expect to see $250,000 in defaults in a year and a loss on the defaults of $2500
($100 million X .25% = $250,000)
($250,000 X 1% loss rate = $2500)
Goal of Pillar I
Although simplistic, this example demonstrates what Pillar I is trying to achieve
If the bank’s own internal calculations show that they have extremely risky, loss-prone loans that generate high internal capital charges, their formal risk-based capital charges should also be high
Likewise, lower risk loans should carry lower risk-based capital charges.
Banks have many different asset classes each of which may require different treatment
Each asset class needs to be defined and the approach to each exposure determined
Minimum standards must be established for rating system design, including testing and documentation requirements
The proposals must be tested in the real world
If the bank’s own internal calculations show that they have extremely risky, loss-prone loans that generate high internal capital charges, their formal risk-based capital charges should also be high
Likewise, lower risk loans should carry lower risk-based capital charges.
Banks have many different asset classes each of which may require different treatment
Each asset class needs to be defined and the approach to each exposure determined
Minimum standards must be established for rating system design, including testing and documentation requirements
The proposals must be tested in the real world
Complexity of Pillar I
Basel II - The 3 Pillars
3 Pillars of Basel II
Basel II consists of three pillars:
Minimum capital requirements for credit risk, market risk and operational risk—expanding the 1988 Accord (Pillar I)
Supervisory review of an institution’s capital adequacy and internal assessment process (Pillar II)
Effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices (Pillar III)
Basel II consists of three pillars:
Minimum capital requirements for credit risk, market risk and operational risk—expanding the 1988 Accord (Pillar I)
Supervisory review of an institution’s capital adequacy and internal assessment process (Pillar II)
Effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices (Pillar III)
Basel II - New Approach
New Approach to Risk-Based Capital
By the late 1990s, growth in the use of regulatory capital arbitrage led the Basel Committee to begin work on a new capital regime (Basel II)
Effort focused on using banks’ internal rating models and internal risk models
June 1999: Committee issued a proposal for a new capital adequacy framework to replace the 1998 Accord.
Basel II - Capital Arbitrage
Capital Arbitrage
If a loan is calculated to have an internal capital charge that is low compared to the 8% standard, the bank has a strong incentive to undertake regulatory capital arbitrage
Securitization is the main means used by U.S. banks to engage in regulatory capital arbitrage.
Securitization is the main means used by U.S. banks to engage in regulatory capital arbitrage.
Example of Capital Arbitrage
Assume a bank has a portfolio of commercial loans with the following ratings and internally generated capital requirements
AA-A: 3%-4% capital needed
B+-B: 8% capital needed
B- and below: 12%-16% capital needed
Under Basel I, the bank has to hold 8% risk-based capital against all of these loans
To ensure the profitability of the better quality loans, the bank engages in capital arbitrage--it securitizes the loans so that they are reclassified into a lower regulatory risk category with a lower capital charge
Lower quality loans with higher internal capital charges are kept on the bank’s books because they require less risk-based capital than the bank’s internal model indicates.
AA-A: 3%-4% capital needed
B+-B: 8% capital needed
B- and below: 12%-16% capital needed
Under Basel I, the bank has to hold 8% risk-based capital against all of these loans
To ensure the profitability of the better quality loans, the bank engages in capital arbitrage--it securitizes the loans so that they are reclassified into a lower regulatory risk category with a lower capital charge
Lower quality loans with higher internal capital charges are kept on the bank’s books because they require less risk-based capital than the bank’s internal model indicates.
Basel II
Variation in Credit Quality
Banks discovered a wide variation in credit quality within risk-weight categories
Basel I lumps all commercial loans into the 8% capital category
Internal models calculations can lead to capital allocations on commercial loans that vary from 1% to 30%, depending on the loan’s estimated riskBanks discovered a wide variation in credit quality within risk-weight categories
Basel I lumps all commercial loans into the 8% capital category
Internal models calculations can lead to capital allocations on commercial loans that vary from 1% to 30%, depending on the loan’s estimated risk.
Basel I lumps all commercial loans into the 8% capital category
Internal models calculations can lead to capital allocations on commercial loans that vary from 1% to 30%, depending on the loan’s estimated riskBanks discovered a wide variation in credit quality within risk-weight categories
Basel I lumps all commercial loans into the 8% capital category
Internal models calculations can lead to capital allocations on commercial loans that vary from 1% to 30%, depending on the loan’s estimated risk.
Basel II - Models
Banks Develop Own “Capital Allocation” Models
Advances in technology and finance allowed banks to develop their own capital allocation (internal) models in the 1990s
This resulted in more accurate calculations of bank capital than possible under Basel I
These models allowed banks to align the amount of risk they undertook on a loan with the overall goals of the bank.
This resulted in more accurate calculations of bank capital than possible under Basel I
These models allowed banks to align the amount of risk they undertook on a loan with the overall goals of the bank.
Basel II - Risk Weights
Risk Weights
Risk weights were based on what the parties to the Accord negotiated rather than on the actual risk of each asset
Risk weights did not flow from any particular insolvency probability standard, and were for the most part, arbitrary.
Risk weights did not flow from any particular insolvency probability standard, and were for the most part, arbitrary.
Operational and Other Risks
The requirements did not explicitly account for operating and other forms of risk that may also be important
Except for trading account activities, the capital standards did not account for hedging, diversification, and differences in risk management techniques.
Except for trading account activities, the capital standards did not account for hedging, diversification, and differences in risk management techniques.
Basel II - Critisism of the Accord
Criticisms of the Accord
The Accord, however, was criticized for taking too simplistic an approach to setting credit risk weights and for ignoring other types of risk.
Basel II Capital Calculation
Capital Calculation
To calculate required capital, a bank would multiply the assets in each risk category by the category’s risk weight and then multiply the result by 8%
Thus a $100 commercial loan would be multiplied by 100% and then by 8%, resulting in a capital requirement of $8.
Thus a $100 commercial loan would be multiplied by 100% and then by 8%, resulting in a capital requirement of $8.
Basel II
Credit Risk – On Balance Sheet
Credit Risk AdjustedOn Balance Sheet Assets =
where,
wi = Risk Weight of Asset
ai = Book Value of Asset on Balance Sheet
On BS Weightings – Basel II
The Evolution to Basel II (part 2)
Credit Risk - Basel I
- Core (Tier I) and Supplementary (Tier II) Capital
- On Balance Sheet and Off Balance Sheet Assets
- Assigns risk weighting to different asset classes to obtain a Credit Risk Adjusted Asset Value
Credit Risk - Capital
The Evolution to Basel II
First Basel Accord
The first Basel Accord (Basel I) was completed in 1988
- Set minimum capital standards for banks
- Standards focused on credit risk, the main risk incurred by banks
- Became effective end-year 1992
To create a level playing field for internationally active banks
- Banks from different countries competing for the same loans would have to set aside roughly the same amount of capital on the loans
1988 Accord Capital Requirements
Capital was set at 8% and was adjusted by a loan’s credit risk weight. Credit risk was divided into 5 categories: 0%, 10%, 20%, 50%, and 100%
- Commercial loans, for example, were assigned to the 100% risk weight category
Risk-Based Capital
The Accord was hailed for incorporating risk into the calculation of capital requirements
Enforcement of Capital Adequacy
Two Capital Requirements
-Leverage Ratio
-Risk-Based Capital Ratio
Leverage Ratio = Core Capital / Assets
Risk-Based Approach implemented by Bank of International Settlements (BIS)
-Basel Agreement
-Leverage Ratio
-Risk-Based Capital Ratio
Leverage Ratio = Core Capital / Assets
Risk-Based Approach implemented by Bank of International Settlements (BIS)
-Basel Agreement
Reason for the Accord
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