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 loan

Develop 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
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 - 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.



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.

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 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.

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.
 
 

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.

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.

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