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