Topic 9. Bank regulation and Basel
9.1 Capital
9.2 Reasons for regulating bank capital
9.3 History of bank regulation
9.4 Pre-1988
9.5 BIS Accord (Basel I)
9.6 1996 Amendment
9.7 Basel II
9.8 Basel III
1
9.1 Capital
X% Worst
Case Loss
Expected
Loss
Required
Capital
Loss over time
horizon
0
1
2
3
4
2
9.1 Capital
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Capital can be interpreted as the amount of money
that the bank should keep in order to protect it from
an extremely unfavorable loss.
The expected losses are often taken into account in
pricing the financial products by FI.
The capital a FI requires should cover the difference
between expected losses over some time horizon and
“worst-case losses” (e.g. 99% VaR) over the same
time horizon.
Source of capital:
Stockholder’s equity, issuing debt, …etc.
3
9.2 Reasons for regulating bank capital
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Banks collect deposits from ordinary savers, and they
play a key role in the payment and credit system.
In U.S. and also in H.K., the government provides
deposit insurance scheme to protect the saving of the
ordinary savers. So, the government has a direct
interest in ensuring that banks remain capable of
meeting their obligations. FDIC
To avoid a systemic “domino effect”, whereby the
failure of an individual bank, or a run on a bank
caused by the fear of such a failure, propagates to the
rest of the financial system.
4
9.3 History of bank regulation
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Pre-1988
1988: Bank of International Settlement (BIS) Accord
(Basel I)
1996: Amendment of BIS Accord
1999: Basel II first proposed
Ongoing: Basel III
5
9.4 Pre-1988
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Banks were regulated using the ratio of capital over
total assets. The lower this ratio is, the more highly
leveraged the bank is. So, the bank has to maintain
this ratio above certain specified minimum level.
The ratio is only consider the on-balance-sheet items.
The off-balance-sheet positions are ignored in this
ratio.
The definitions of capital and the required ratios
varied from country to country. And enforcement of
regulations also varied from country to country. That
made banks compete with each other on uneven
playground.
6
9.5 BIS Accord (Basel I)

The growing exposure of banks to off-balance-sheet
claims together with the problems of developing
countries (e.g. Mexico, Argentina) debt created the
needs to reconsider the regulation and led supervisory
authorities of 12 major industrial countries
Belgium, Canada, France, Germany, Italy, Japan,
Luxembourg, the Netherlands, Sweden,
Switzerland, the United Kingdom and the United
States
to form the Basel Committee on Banking Supervision.
7
9.5 BIS Accord (Basel I)
Basel is the centre of north-western Switzerland, on the border
with Germany and France, and located at the very core of
central Europe.
8
9.5 BIS Accord (Basel I)
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The committee worked out a document entitled
“International Convergence of Capital Measure and
Capital Standards”. (The 1988 BIS Accord, or Basel
I).
The 1988 BIS Accord was intended to raise capital
ratio and to harmonize minimum capital ratios for
banks in all major jurisdictions across the world.
Its main focus was on credit risk.
Two minimum standards defined:
• Assets-to-capital multiple
• Cooke ratio
9
9.5 BIS Accord (Basel I)
Assets-to-capital multiple
T otalassets
 Assets- to - capitalmultiple
T otalcapital
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
(7.1)
Total assets include specified off-balance-sheet items.
e.g. letter of credit and guarantees, and sale and
repurchases agreements. Off vs on
The maximum allowed value of the assets-to-capital
multiple is 20.
10
9.5 BIS Accord (Basel I)
Cooke ratio

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Cookeratio
T otalcapital
(7.2)
(T ot alcapitalratio) 
Risk - weighted asset s
(Capitaladequacy ratio)
The minimum requirement of Cooke ratio is 8%.
That’s mean the total regulatory capital is at least 8%
of the risk-weighted assets.
Risk-weighted assets
= Risk-weighted on-balance-sheet assets +
Risk-weighted off-balance-sheet assets
11
9.5 BIS Accord (Basel I)

A risk weight is applied to each on-balance-sheet
asset according to its risk.
Table 9.1 Risk weights for on-balance-sheet items
Risk weight
(%)
Asset category
0
Cash, OECD governments bonds or insured residential
mortgages.
20
Claims on OECD banks and OECD public sector entities.
50
Uninsured residential mortgage loans.
100
All other claims, such as corporate bonds and lessdeveloped country debt, claims on non-OECD banks.
OECD: Organisation for Economic Co-operation and Development
12
9.5 BIS Accord (Basel I)
The total risk-weighted assets for N on-balance-sheet
items equals
N
w L
i 1
i
i
(7.3)
where Li is the principal amount of the ith item and wi is
its risk weight.
Example 9.1
The assets of a bank consists of $100 million of
corporate loans, $10 million OECD government bonds
and $50 million of uninsured residential mortgage. The
risk-weighted assets is
1.0100 + 0.010 + 0.5 50 = $125 million
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9.5 BIS Accord (Basel I)

For each off-balance-sheet item, we first calculate a
credit equivalent amount and then apply the
corresponding risk weight.
The credit equivalent amount for nonderivative
instruments is calculated by applying a conversion
factor to the principal amount of the instrument.
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9.5 BIS Accord (Basel I)
Table 9.2 Credit conversion factors for nonderivative off-balance-sheet items
Conversion
factor (%)
Category
100
Direct credit substitutes, bankers’ acceptances, standby
letters of credit, sale and repurchase agreements,
forward purchase of assets.
50
Transaction-related contingencies such as performance
bonds.
20
Short-term self-liquidating trade-related contingencies
such as letters of credit.
0
Commitments with an original maturity of one year or
less.
15
9.5 BIS Accord (Basel I)
Table 9.3 Risk weight for off-balance-sheet items from different counter
party
Risk weight Type of counterparty
(%)
0
OECD governments
20
OECD banks and public-sector entities
50
Corporations and other counterparties
16
9.5 BIS Accord (Basel I)
Example 9.2
A bank has $200 million of GM performance bonds , $20
million OECD bank 3-month letter of credit and $50
million forward purchase of coal from OECD public sector
entity. The risk-weighted off-balance-sheet assets is
Risk weight
0.50.5200 + 0.20.220 + 0.21.0 50 = $60.8 million
Conversion
factor
17
9.5 BIS Accord (Basel I)
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Example 9.3
By combining the risk-weighted assets in Examples
9.1 and 9.2, the total risk-weighted assets is $185.8
million.
On-the-balance sheet items, risk weight
Off-the-balance sheet items, risk weight + conversion
The regulatory capital is at least $14.86 million
(=8%185.8).
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9.5 BIS Accord (Basel I)
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The bank could raise up the regulatory capital through
two sources:
• Tier 1 (Core) capital: Most reliable form of capital. At
least 50% of the Tier 1 capital should come from the
common equity.
• Tier 2 (Supplementary) capital: The second reliable form
of financial capital such as revaluation reserve, cumulative
preferred stocks, subordinated debt with an original life of
more than 5 years.

T ier1 (Core)captialratio
T ier1 (Core)capital
Risk - weighted assets
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9.5 BIS Accord (Basel I)
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Under the regulation, the Tier 1 capital ratio should be
at least 4%. (i.e. at least 50% of Cooke ratio.)
Example 9.4
From Example 9.3, at least $7.43 million
(=0.514.86) must come from Tier 1 capital.
In practice, banks tend to exceed the minimum
requirement on regulatory capital. The reasons
include:
• To create a buffer that prevent them from accidentally
against the regulatory rules.
• To maintain credit ratings allowing them to access
wholesale markets cheaply.
20
9.6 1996 Amendment
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In 1995, the Basel Committee issued a consultative
proposal to amend the 1988 Accord. This is known as
the “1996 Amendment”. It was implemented in 1998
(BIS 98).
In addition to the 1988 BIS Accord credit risk capital,
BIS 98 outlined a standardized approach for measuring
the capital charge for market risk.
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9.6 1996 Amendment
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The regulatory capital required by BIS 98
= Credit risk capital charge + Market risk capital charge
= 8%(Credit risk RWA + Market risk RWA)
(7.4)
where RWA stands for risk-weighted assets.
From (7.4),
Market risk RWA = Market risk capital charge  8%.
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9.6 1996 Amendment
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The BIS 98 also allowed sophisticated banks with
well-established risk management functions to use
their own VaR model, known as the “internal models
approach”, for setting market risk capital. The
examples include RiskMetrics, historical simulation
and Monte Carlo.
It gave banks freedom to set up more suitable risk
management practice for their own interests and to
lead to lower capital requirement.
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9.6 1996 Amendment
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Further than Tier 1 and Tier 2 capital, a bank can also
use Tier 3 capital as a part of capital requirement for
market risk.
Tier 3 capital: short term subordinated debt with an
original maturity of at least 2 years.
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9.7 Basel II
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Basel I has significant weakness:
• All corporation loans, irrespective to the corporation’s
credit rating, have the same risk weight of 100%.
• No model of default correlation.
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To overcome such weakness, the Basel Committee
proposed new rules in June 1999 and finally
implemented them from 2007 after several revisions
(Basel II).
Details may refer to:
• http://www.bis.org/publ/bcbsca.htm
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9.7 Basel II
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Three pillars:
• Pillar 1: Capital charges for market risk, credit risk and
operational risk
• Pillar 2: Supervisory review
• Pillar 3: Market discipline
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9.7 Basel II
Pillar 1: Calculation of capital charges
 Under Basel II, the minimum capital adequacy (total
capital) ratio and Tier 1 capital ratio are still 8% and 4%
respectively.
 However, the total capital charge is made up of 3
components.
Capital charge
= Market risk capital charge + Credit risk capital charge
+ Operational risk capital charge
= 8%×(Market risk RWA + Credit risk RWA +
Operational risk RWA)
(7.5)
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9.7 Basel II
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The calculation of the market risk capital charge
remains unchanged from the 1996 Amendment.
The calculation of the capital charges for credit risk and
operational risk are modified and newly introduced
respectively.
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9.7 Basel II
Credit risk
 Banks have two choices in calculating the credit risk
capital charge:
• Standardized approach
• Internal rating based (IRB) approach

The standardized approach is conceptually the same
as Basel I (1988 BIS Accord) but it has been designed
to be more risk sensitive.
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9.7 Basel II
Table 9.4 Risk weights for calculation credit risk RWA under Basel II’s
standardized approach.
Rating
AAA
to
AA-
A+ to
A-
BBB+
to
BBB-
BB+ to
BB-
B+ to
B-
Below
B-
Unrated
Country
0%
20%
50%
100%
100%
150%
100%
Banks
20%
50%
50%
100%
100%
150%
50%
Corporates
20%
50%
50%
100%
150%
150%
100%
Risk weights of other categories:
Retail lending - 100%; Claims are secured by a residential mortgage - 35%.
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9.7 Basel II
By comparing Table 9.4 with Table 9.1, we see that the
OECD status of a bank or a country is no longer
important under Basel II. Under Basel II, the risk
weights depend much more on the credit rating.
Example 9.5
Suppose that the assets of a bank consist of $100 million
of loans to corporation rated A, $10 million of
government bonds rated AAA, and $50 million of
residential mortgages.
The risk weighted assets under standardized approach is
0.5100 + 0.0 10 + 0.35 50 = 67.5 million (< 125
million in Example 9.1)
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9.7 Basel II
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In IRB approach, we have the following input and output.
Input:
• The one-year probability of default of each loan.
• The outstanding amount of each loan at default (exposure at
default).
• The proportion of the exposure that is lost at default.
• The credit correlation among the loans in the portfolio.
Output:
• 99.9% 1-year Credit VaR.
(The details of IRB approach are omitted.)
Credit risk capital charge
= 99.9% 1-year Credit VaR – Expected portfolio credit loss.
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9.7 Basel II
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In Basel II, the capital requirement (Standardized and
IRB approach) for credit risk could be reduced for a
bank if it adopts some strategies to mitigate its credit
risk like collaterals, guarantees and credit derivatives.
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9.7 Basel II
Operational risk
 Basel II requires banks to keep capital for operational
risks:
• An increasingly complex business environment
• Regulators want banks to pay more attention to their
internal systems.
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9.7 Basel II

3 choices are available for calculating capital
requirement of the operational risk:
• Basic indicator approach:
Capital = Multiplicative factor (=15%)  Gross income
Gross income = interest income + noninterest income
• Standardized approach:
Different multiplicative factor for gross income arising from
each business line.
• Internal measurement approach:
Assess 99.9% worst case operational risk loss over one year.
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9.7 Basel II
Table 9.5 Multiplicative factor for the standardized approach
Business line
Multiplicative factor (%)
Corporate finance
18
Trading & Sales
18
Retail banking
12
Commercial banking
15
Payment &Settlement
18
Agency services
15
Asset management
12
Retail brokerage
12
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9.7 Basel II
Pillar 2: Supervisory review
 The supervisory review is intended to ensure that a
bank’s capital position and strategy are consistent
with its overall risk portfolio.
 Early supervisory intervention will be encouraged if
the capital amount is thought not to provide a
sufficient buffer against risk.
 Regulators need to define a sound conceptual
framework for the determination of bank capital
adequacy.
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9.7 Basel II
Pillar 3: Market discipline
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The Basel Committee intends to foster market
transparency so that market participants can better
assess bank capital adequacy.

Banks will be required to disclose
• Scope and application of Basel framework
• Nature and components of capital (composition in each
tier of capital and % allocation to each tier of capital)
• Capital requirements for credit, market and operational
risk
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9.8 Basel III
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Aims:
•
•
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Microprudential - To increase the resilience of individual
banking institutions in periods of stress.
Macroprudential - To address system wide risks which will
build up across the banking sector.
Basel III will be phased-in between 1 January 2013 and
1 January 2019.
The details of Basel III may refer to
•
•
http://www.bis.org/bcbs/basel3.htm
http://www.hkma.gov.hk/eng/key-functions/bankingstability/basel-3.shtml
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9.8 Basel III
Microprudential
 In the microprudential (firm-specific) approach, it mainly
focuses on the three elements of the capital adequacy
ratio: capital, risk-weighted assets and the ratio itself.
Capitaladequacy (T otalcapital)ratio 

T otalcapital
Risk - weighted assets
Capital:
•
•
As learned from the crisis, credit losses and writedowns come
directly out of common equity. So, Common equity (or just call
“equity” if there is no confusion) is considered as the most
reliable form of loss absorbing capital.
The component of common equity in Tier 1 capital is increased
from 2% of RWA (in Basel II) to 4.5% of RWA in Basel III.
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9.8 Basel III
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Risk-weighted asset:
•
•
•
Apparently low-risk assets under normal time may suddenly
become very risky during a systemic crisis. For example,
highly rated sovereigns and AAA-rated CDO tranches.
The risk weights for calculating credit risk RWA are refined
especially higher risk weights are assigned for
resecuritisation exposures such as CDOs of ABS.
Increasing regulatory capital for the trading book, around
three to four times the original capital requirements.
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9.8 Basel III

Capital ratio:
•
•
The Tier 1 capital ratio will increase from 4% to 6% but the
capital adequacy ratio is unchanged (= 8%).
Besides the capital adequacy ratio, a capital conservation
buffer comprising common equity of 2.5% of RWA is
established. Together with the new requirement in Tier 1
capital, it brings the total common equity level to 7% of
RWA. The buffer requires the bank to maintain higher
percentage of equity which can absorb losses more
effectively during the period of economic stress.
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9.8 Basel III
Macroprudential
 The macroprudential approach is an entirely new way of
thinking about capital in Basel III. It involves FIVE new
elements.
 Leverage ratio:
•
•
A non-risk-based leverage is established to supplement the riskbased capital ratio to safeguard the bank who tries to build up
high levels of on and off balance sheet leverage.
The leverage ratio will be a measure of a bank’s Tier 1 capital
as a percentage of its assets plus off balance sheet exposures
and derivatives.
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9.8 Basel III

Countercyclical capital buffer:
•
•
•
A countercyclical capital buffer which is made up of common
equity or other fully loss absorbing capital is established.
According to the national credit growth condition in the
banking system, each jurisdiction can set the countercyclical
capital buffer within the range of 0% to 2.5% of RWA.
The countercyclical capital buffer not only protects the banking
sector from losses resulting from periods of excess credit
growth followed by periods of stress, but it helps to ensure that
credit remains available during this period.
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9.8 Basel III

The other three elements are in progress
•
•
•
Systemic capital surcharge for systemically important financial
institutions in order to reduce the moral hazard posed by them.
The higher capital requirements for bilateral over the counter
(OTC) derivatives in order to increase incentive to use central
counterparty clearing houses and exchanges as the derivative
counterparty.
To encourage the banks to enhance their stress testing
programmes in the VaR calculation model in order to capture
the tail events more effectively.
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9.8 Basel III
46