The Role of the BIS –
The Basel Capital Accords
Saunders & Allen, Chapter 3
Basel Committee, “Revised
Framework,” June 2004.
BIS I
• Major Focus: distinguish credit risk of
sovereign, bank and mortgage obligations
from non-bank private sector or commercial
loan obligations
• Not to differentiate the credit risk exposure
within the commercial load classification
• Issue: regulatory capital arbitrage activities
BIS II
• To correct the mispricing inherent in BIS I
• To incorporate more risk sensitive credit exposure
measures into bank capital requirement
• Key motivations
– Structural change in credit markets
– Remove inefficiencies in lending market
– Correlation among economic cycle, debt levels, and a
potential debt servicing crisis
Part 1: Scope of Application
Part 2:
The First Pillar
-Minimum Capital Requirements
I. Calculation of minimum
capital requirements
II. Credit risk
-The
Standardized
Approach
III. Credit Risk
-The Internal
Ratings Based
Approach
IV. Credit Risk
-Securitization
Framework
V.
Operational
Risk
VI.
Trading Book
Issues
(including
Market risk)
Part 3
The Second
Pillar
-Supervisory
Review Process
Part 4:
The Third Pillar
-Market
Discipline
Pillar 1
• A three step evolutionary paradigm
– Standardized Model
– Foundations Approach Internal Ratings-Based (IRB)
Model
– Advanced IRB Model
• Regulatory Total Capital-unchanged total amount
– Credit Risk Capital Requirement
– Market Risk Capital Requirement
– Operational Risk Capital Requirement
Credit Risk
The Standardized Approach
• Based on External Credit Assessment
Institutions (e.g., credit rating agencies) that
must:
–
–
–
–
–
–
Be objective
Be independent
Provide international access & transparency
Offer full disclosure
Have sufficient resources
Be Credible
Credit Risk – The Standardized Approach
Claims on Sovereigns
Claims on sovereigns and their central banks will be risk weighted as follows:
Credit
Assessment
AAA to
AA-
A+ to A-
BBB+ to
BBB-
BB+ to B-
Below B-
Unrated
Risk Weight
0%
20%
50%
100%
150%
100%
Claims on Banks
There are two options for claims on banks. National supervisors will apply one option
To all banks in their jurisdiction. No claim on an unrated bank may receive a risk weight
Lower than that applied to claims on its sovereign of incorporation.
Option 1
Credit
assessment of
Sovereign
Risk weight
under
Option 1
AAA to
AA-
A+ to A-
BBB+ to
BBB-
BB+ to B-
Below B-
Unrated
20%
50%
100%
100%
150%
100%
Option 2
Credit
assessment of
Banks
AAA to
AA-
A+ to A-
BBB+ to
BBB-
BB+ to B-
Below B-
Unrated
Risk weight
under
Option 2
20%
50%
50%
100%
150%
50%
Risk weight for
short-term
claims22 under
Option 2
20%
50%
100%
100%
150%
100%
Short Term Exposures (e.g., commercial paper)
A-1/P-1
A-2/P-2
20%
50%
Risk Weight
A-3/P-3
100%
Others
150%
Claims on corporate
The table provided below illustrates the risk weighting of rated corporate
claims, including claims on insurance companies. The standard risk weight for unrated
claims on corporates will be 100%. No claim on an unrated corporate may be given a
risk weight preferential to that assigned to its sovereign of incorporation.
Credit Assessment
Risk Weight
AAA to
AA20%
A+ to A-
BBB+ to BB-
50%
100%
Below
BB150%
Unrated
100%
Claims included in the regulatory retail portfolios
Claims that may be considered as retail claims for regulatory capital purposes
and included in a regulatory retail portfolio. Exposures included in such a portfolio
may be risk-weighted at 75%.
Regulatory Retail Portfolios
• Exposure to individuals or small businesses
• Revolving credit, credit card & overdrafts,
lines of credit, personal term loans, small
business facilities
• Must be sufficiently granular (no single
counterparty has > 0.20% of overall)
• Maximum exposure to a single counterparty is
less than 1 million euros.
Claims secured by residential property
Lending fully secured by mortgages on residential property that is or will be
occupied by the borrower, or that is rented, will be risk weighted at 35%.
Claim secured by commercial real estate
In view of the experience in numerous countries that commercial property
lending has been a recurring cause of troubled assets in the banking industry over the
past few decades, mortgages on commercial real estate do not, in principle, justify other
than a 100% weighting of the loans secured.
Higher-risk categories
The following claims will be risk weighted at 150% or higher:
• Claims on sovereigns, PSEs, banks, and securities firms rated below B-.
• Claims on corporates rated below BB-.
• Past due loans.
• Securitization tranches that are rated between BB+ and BB- will be risk
weighted at 350%.
Off-balance sheet items
Off-balance sheet items under the standardized approach will be converted
into credit exposure equivalents through the use of credit conversion factors (CCF).
Commitments with an original maturity up to one year and commitments
with an original maturity over one year will receive a CCF of 20% and 50%,
respectively. However, any commitments that are unconditionally cancelable at any
time by the bank without prior notice, or that effectively provide for automatic
cancellation due to deterioration in a borrower’s creditworthiness, will receive a 0%
CCF.
The Standardized Approach – Credit Risk Mitigation
Use either the simple approach or the comprehensive approach in the banking book.
The trading book must use the comprehensive approach.
1. The simple approach
In the simple approach the risk weighting of the collateral instrument
collateralizing or partially collateralizing the exposure is substituted for the risk
weighting of the counterparty (subject to a 20% floor).
2. The comprehensive approach
Calculation of capital requirement
For a collateralized transaction, the exposure amount after risk
mitigation is calculated as follows:
E* = max {0, [E x (1 + He) – C x (1 – Hc – Hfx)]}
where:
E* = the exposure value after risk mitigation
E = current value of the exposure
He = haircut appropriate to the exposure
C = the current value of the collateral received
Hc = haircut appropriate to the collateral
Hfx = haircut appropriate for currency mismatch between
the collateral and exposure
The exposure amount after risk mitigation will be multiplied by the
risk of the counterparty to obtain the risk-weighted asset amount for the
collateralized transaction.
Haircuts can be either established by the supervisor or the bank’s own estimates
of volatility:
Own estimates for haircut
The calculation of the exposure E* for banks using their internal market
risk model will be the following:
E* = max {0, [ΣE – ΣC) + (VaR output from internal market risk
model x multiplier)]}
The multiplier ranges between 1 and 1.33 depending on annual backtesting of
the bank’s own estimate of volatility. Exceptions = daily volatility – VaR estimate
Green Light (multiplier=1) if exceptions <99; Red light (multiplier=1.33) if
exceptions >200; Yellow light (multiplier between 1-1.33) if between 100-199
exceptions.
Credit Risk – The Internal Ratings-Based Approach
Foundation and advanced approaches
Under the foundation approach, as a general rule, banks provide their
own estimated of PD and rely on supervisory estimates for other risk
components. Under the advanced approach, banks provide more of their own
estimates of PD, LGD and EAD, and their own calculation of M, subject to
meeting minimum standards. For both the foundation and advanced
approaches, banks must always use the risk-weight functions provided in this
Framework for the purpose of deriving capital requirements.
Assessment of Standardized Model
• Insufficient risk sensitivity in the proposed risk
buckets
• Issue of “unrated” risk bucket
• Tying capital requirements to external rating
– Heterogeneity within each rating class
– Rating may be lagging indicator
– May lead to regulatory attempts to influence rating
agencies
– Risk of rating shopping
– Loss of bank’s private information.
Assessment of Standardized Model
• Inconsistency in concept: attributes the
function of assessing and monitoring credit
risk to external rating agencies – banks are
“delegated monitors.”
– Should use standalone firm ratings, not related
to specific debt issues with protective features
– Ratings are pro-cyclical. Systemic risk
increases as downgrades occur in recessions
requiring additional capital at cyclical trough.
IRB Models
• Two Approach
– Foundation IRB Approach
– Advanced IRB Approach
• Establish an internal rating model to classify the
credit risk exposure of each activity
• Calibrated to a 99.9% VAR
• Foundation IRB Approach
– PD – estimates of 1 year probability of default
– EAD – exposure at default
IRB
• Advanced IRB approach
– PD, EAD
– LGD – loss given default
– M – maturity
• Computes risk weights by incorporating
estimates of PD, EAD, LGD and M
• Model assumes that average default
correlation among borrowers is 10-20%
IRB
• Five elements to any IRB approach
–
–
–
–
Internal rating model
Risk components
Risk weight function
Minimum requirements of eligibility to apply
the IRB approach
– Supervisory reviews of compliance with the
minimum requirement
Risk Components of the IRB Approach
• PD
– Probability of default
– Internal Ratings based on historical experience or credit
scoring model
– Lower bound 3 basis points – no 0% risk weight
• EAD
– Loan’s exposure at default – allows netting.
– Nominal (book) among for on-balance-sheet
transactions
(1) Amount by which regulatory capital would be reduced if the
exposure were written off fully; and (2) any additional specific
provisions or write-offs.
Risk Components of the IRB Approach
(Continued)
• LGD = Loss Given Default Under the Foundation
Approach:
– 45% for senior claims not secured
– 75% for subordinated claims
– For secured claims, use the comprehensive approach
under the standardized model to calculate the LGD as
follows:
LGD* = LGD x (E*/E)
where LGD is the senior unsecured exposure (45%)
E is the current value of the exposure
E* is the exposure value after risk mitigation.
• LGD Under the Advanced Approach is the bank’s
internal estimate of actual LGD.
Risk Components of the IRB Approach
(Continued)
• Effective Maturity = M
For the foundation approach, the effective maturity is 2.5 years
For the advanced approach, the effective maturity is the greater of
either one year or the cash flow weighted time to maturity:
  t * CFt /  CFt
t
t
Where CFt is the cash flow contractually payable at time t.
June 2004 Proposals:
Risk-weighted assets for corporate, sovereign, and bank exposures (UL)
Formula for derivation of risk-weighted assets
The derivation of risk-weighted assets is dependent on estimates of the PD,
LGD, EAD and, in some cases, effective maturity (M), for a given exposure.
Correlation (R) = 0.12 x (1 – EXP (-50 x PD)) / (1 – EXP (-50)) +
0.24 x [1 – (1 – EXP(-50 x PD))/(1 – EXP(-50))]
Maturity adjustment (b) = (0.11852 – 0.05478 x In (PD))^2
Capital requirement (K) = [LGD x N [(1 – R)^-0.5 x G (PD) + (R/(1-R))^0.5 x G
(0.999)] – PD x LGD] x (1 – 1.5 x b)^ -1 x (1 +(M – 2.5) x b)
Risk-weighted assets (RWA) = K x 12.5 x EAD
$ Capital Requirement = 8% x RWA
Foundation IRB Approach:
January 2001 Proposals
• RW = risk weight on corporate obligations
– Calibrated to 8% capital requirement for loan with 3 yr.
maturity, PD=0.7%, and LGD=50%.
– RW = (LGD/50) • BRW
– BRW = benchmark risk weight (Figure 3.1)
BRW = 976.5 x N(1.118 x G(PD)+1.288) x (1+.0470 x (1-PD)/PD0.44)
• RWA
– Risk-weighted assets
– RWA = RW • EAD
(3.2)
Figure 3.1
Proposed IRB risk w eights for hypothetical corporate
exposure having LGD equal to 50 percent.
Source: Bank of International Settlements,
“The Internal Ratings-Based Approach” (2001).
700
600
500
400
300
200
100
0
0
5
10
PD (Percent)
15
20
(ii) Firm-size adjustments for small- and medium-sized entities (SME)
Under the IRB approach for corporate credits, banks will be permitted to
separately distinguish exposures to SME borrowers (defined as corporate
exposures where the reported sales for the consolidated group of which the firm is
a part is less than €50 million) from those to large firms. A firm-size adjustment
(i.e., 0.04 x (1- (S-5)/45)) is made to the corporate risk weight formula for
exposures to SME borrowers. S is expressed as total annual sales in millions of
euros with values of S falling in the range of equal to or less than €5 million will be
treated as if they were equivalent to € million for the purposes of the firm-size
adjustment for SME borrowers.
Correlation (R) = 0.12 x (1 – EXP (-50 x PD)) / (1 – EXP(-50)) +
0.24 x [1 – EXP(-50 x PD))/(1 – EXP(-50))] – 0.04 x (1 – (S-5)/45)
(iii) Risk weights for specialized lending
Supervisory categories and UL risk weights for other SL exposures
Strong
Good
Satisfactory
Weak
Default
70%
90%
115%
250%
0%
Strong
Good
Satisfactory
Weak
Default
BBB- or Better
BB+ or BB
BB- or B+
B to C-
Not applicable
Risk weights for HVCRE
Supervisory categories and UL risk weights for high-volatility commercial
real estate
Strong
Good
Satisfactory
Weak
Default
95%
120%
140%
250%
0%
Rules for Retail Exposures
(i) Residential mortgage exposures
Correlation (R) = 0.15
Capital requirement (K) = LGD x N[(1 – R)^-0.5 x G(PD) + (R / (1 – R))^0.5 x
G(0.999)] – PD x LGD
Risk-weighted assets = K x 12.5 x EAD
The capital requirement (K) for a defaulted exposure is equal to the greater
of zero and the difference between its LGD and the bank’s best estimate of
expected loss. The risk-weighted asset amount for the defaulted exposure is
the product of K, 12.5, and the EAD.
(ii) Qualifying revolving retail exposures
Correlation (R) = 0.04
Capital requirement (K) = LGD x N[(1 – R)^-0.5 x G(PD) + (R / (1 – R))^0.5 x
G(0.999)] – PD x LGD
Risk-weighted assets = K x 12.5 x EAD
(iii) Other retail exposures
For all other retail exposures that are not in default, risk weights are
assigned based on the following function, which also allows correlation to vary
with PD:
Correlation (R) = 0.03 x (1 – EXP(-35 x PD)) / (1 – EXP(-35)) +
0.16 x [1 – (1 – EXP(-35 x PD))/(1 – EXP(-35))]
Capital requirement (K) = LGD x N[(1 – R)^-0.5 x G(PD) + (R / (1 – R))^0.5
x G(0.999)] – PD x LGD
Risk – weighted assets = K x 12.5 x EAD
Illustrative IRB Risk Weights
The following tables provide illustrative risk weights calculated for four
asset classes types under the internal ratings-based (IRB) approach to credit
risk. Each set of risk weights for unexpected loss (UL) was produced using
the appropriate risk-weight function of the risk-weight functions. The inputs
used to calculate the illustrative risk weights include measures of the PD,
LGD, and an assumed effective maturity (M) of 2.5 years.
A firm-size adjustment applies to exposures made to small- and mediumsized entity (SME) borrowers (defined as corporate exposures where the
reported sales for the consolidated group of which the firm is a part is less
than €50 million). Accordingly, the firm size adjustment was made in
determining the second set of risk weights provided in column two given that
the turnover of the firm receiving the exposure is assumed to be €5 million
Illustrative IRB Risk Weights for UL
Asset Class:
LGD:
Maturity: 2.5
Turnover
(millions of €)
Corporate Exposures
(Big)
(SME)
45%
45%
50
Residential Mortgages
45%
25%
Other Retail Exposures
45%
85%
Qualifying Revolving Retail
Exposures
45%
85%
5
PD:
0.03%
0.05%
0.10%
0.25%
0.40%
0.50%
0.75%
1.00%
1.30%
1.50%
2.00%
2.50%
3.00%
4.00%
5.00%
6.00%
10.00%
15.00%
20.00%
14.44%
19.65%
29.65%
49.47%
62.72%
69.61%
82.78%
92.32%
100.95%
105.59%
114.86%
122.16%
128.44%
139.58%
149.86%
159.61%
193.09%
221.54%
238.23%
11.30%
15.39%
23.30%
39.01%
49.49%
54.91%
65.14%
72.40%
78.77%
82.11%
88.55%
93.43%
97.58%
105.04%
112.27%
119.48%
146.51%
171.91%
188.42%
4.15%
6.23%
10.69%
21.30%
29.94%
35.08%
46.46%
56.40%
67.00%
73.45%
87.95%
100.64%
111.99%
131.63%
148.22%
162.52%
204.41%
235.72%
253.12%
2.30%
3.46%
5.94%
11.83%
16.64%
19.49%
25.81%
31.33%
37.22%
40.80%
48.85%
55.91%
62.22%
73.13%
82.35%
90.29%
113.56%
130.96%
140.62%
4.45%
6.63%
11.16%
21.15%
28.42%
32.36%
40.10%
45.77%
50.80%
53.37%
57.99%
60.90%
62.79%
65.01%
66.42%
67.73%
75.54%
88.60%
100.28%
8.41%
12.52%
21.08%
39.96%
53.69%
61.13%
75.74%
86.46%
95.95%
100.81%
109.81%
115.03%
118.61%
122.80%
125.45%
127.94%
142.69%
167.36%
189.41%
0.98%
1.51%
2.71%
5.76%
8.41%
10.04%
13.80%
17.22%
21.02%
23.40%
28.92%
33.98%
38.66%
47.16%
54.75%
61.61%
83.89%
103.89%
117.99%
1.85%
2.86%
5.12%
10.88%
15.88%
18.97%
26.06%
32.53%
39.70%
44.19%
54.63%
64.18%
73.03%
89.08%
103.41%
116.37%
158.47%
196.23%
222.86%
Assessment of IRB Model
• BIS II is a great improvement over BIS I in its
sophistication in measuring credit risk
• Moves regulatory capital in the direction of
economic capital
• Far from an integrated portfolio management
approach to credit risk measure
• Capital requirements are likely to be higher than
economically necessary when considering actual
portfolio correlation
Assessment (cont.)
• Foundation IRB – correlations inversely
related to PD: not empirically observed.
• Advanced IRB contains properties that may
distort bank incentives to manage their
credit risk exposure
– Maturity adjustment
– Penalized increases in LGD more than increase
in PD
Operational Risk
Definition of operation risk
Operational risk is defined as the risk of loss resulting from inadequate or
failed internal processes, people and systems or from external events. This
definition includes legal risk, but excludes strategic and reputational risk.
Legal risk includes, but is not limited to, exposure to fines, penalties, or
punitive damages resulting from supervisory actions, as well as private
settlements.
The measurement methodologies
The framework outlined below presents three methods for calculating
operational risk capital charges in a continuum of increasing sophistication and
risk sensitivity: (i) the Basic Indicator Approach; (ii) the Standardized Approach;
and (iii) Advanced Measurement Approaches (AMA).
The Basic Indicator Approach
Banks using the Basic Indicator Approach must hold capital for operational
risk equal to the average over the previous three years of a fixed
percentage (denoted alpha) of positive annual gross income. Figures for
any year in which annual gross income is negative or zero should be
excluded from both the numerator and denominator when calculating the
average. The charge may be expressed as follows:
KBIA = [Σ(GI1…3 x )]/n
where
KBIA= the capital charge under the Basic Indicator Approach
GI = annual gross income, where positive, over the previous three years
n = number of the previous three years for which gross income is positive
 = 15%, which is set by the Committee, relating the industry wide level of
required capital to the industry wide level of the indicator.
Gross income is defined as net interest income plus net non-interest income.
It is intended that this measure should: (i) be gross of any provisions (e.g., for
unpaid interest); (ii) be gross of operating expenses, including fees paid to
outsourcing service providers, (iii) exclude realized profits/losses form the sale of
securities in the banking book, and (iv) exclude extraordinary or irregular items as
well as income derived from insurance
2. The Standardized Approach
In the Standardized Approach, banks’ activities are divided into eight business
lines: corporate finance, trading & sales, retail banking, commercial banking,
payment & settlement, agency services, asset management, and retail
brokerage.
Within each business line, gross income is a broad indicator that serves as a
proxy for the scale of business operations and thus the likely scale of operational
risk exposure within each of these business lines. The capital charge for each
business line is calculated by multiplying gross income by a factor (denoted beta)
assigned to that business line. Beta serves as a proxy for the industry-wide
relationship between the operational risk loss experience for a given business line
and the aggregate level of gross income for that business line. It should be noted
that in the Standardized Approach gross income is measured for each business
line, not the whole institution, i.e., corporate finance, the indicator is the gross
income generated in the corporate finance business line.
The total capital charge is calculated as the three-year average of the simple
summation of the regulatory capital charges across each of the business lines in
each year. In any given year, negative capital charges (resulting form negative
gross income) in any business line may offset positive capital charges in other
business lines without limit. However, where the aggregate capital charge
across all business lines within a given year is negative, then the input to the
numerator for that year will be zero. The total capital charge my be expressed
as:
KTSA = {Σyears 1-3 max[Σ(GI1-8 x 1-8),0]}/3
where
KTSA = the capital charge under the Standardized Approach
GI1-8 = annual gross income in a given year, as defined above in the Basic
Indicator Approach, for each of the eight business lines.
1-8 = a fixed percentage, set by the Committee, relating the level of required
capital to the level of the gross income for each of the eight business lines.
The values of the betas are detailed below
Business Lines
Corporate finance (1)
Trading and sales (2)
Retail banking (3)
Commercial banking (4)
Payment and settlement 5)
Agency services (6)
Asset management (7)
Retail brokerage (8)
Beta Factors
18%
18%
12%
15%
18%
15%
12%
12%
Standardized Approach Mapping of Business Lines
Level 1
Level 2
Activity Groups
Corporate Finance
Corporate Finance
Municipal/Gov’t Finance
Mergers and acquisitions,
underwriting, privatizations,
securitization, research, debt (gov’t,
high yield), equity, syndications,
IPO, secondary private placements
Merchant Banking
Advisory Services
Trading & Sales
Retail Banking
Sales
Market Making
Proprietary Positions
Treasury
Fixed income, equity, foreign
exchanges, commodities, credit,
funding, own position securities,
lending and repos, brokerage, debt,
prime brokerage
Retail Banking
Retail lending and deposits, banking
services, trust and estates
Private Banking
Private lending and deposits,
banking services, trust and estates,
investment advice
Card Services
Merchant/commercial/corporate
cards, private labels and retail
Mapping of Business Lines cont’d……..
Commercial Banking
Commercial Banking
Project finance, real estate, export finance, trade
finance, factoring, leasing, lending, guarantees,
bills of exchange
Payment & Settlement
External Clients
Payments and collections, funds transfer, clearing
and settlement
Agency Services
Custody
Escrow, depository receipts, securities lending
(customers) corporate actions
Corporate Agency
Issuer and paying agents
Corporate Trust
Asset Management
Retail Brokerage
Discretionary Fund
Pooled, segregated, retail, institutional, closed,
open, private equity
Non-Discretionary
Fund Management
Pooled, segregated, retail, institutional, closed,
open
Retail Brokerage
Execution and full service
The Alternative Standardized Approach (upon supervisory discretion)
Under the ASA, the operational risk capital charge/methodology is the same as
for the Standardized Approach except for two business lines – retail banking and
commercial banking. For these business lines, loans and advances – multiplied
by a fixed factor ‘m’ – replaces gross income as the exposure indicator. The
betas for retail and commercial banking are unchanged from the Standardized
Approach. The ASA operational risk capital charge for retail banking (with the
same basic formula for commercial banking) can be expressed as:
KRB = RB x m x LARB
Where
KRB is the capital charge for the retail banking business line
RB is the beta for the retail banking business line
LARB is total outstanding retail loans and advances (non-risk weighted and gross
of provisions), averaged over the past three years
m is 0.035
For the purposes of the ASA, total loans and advances in the retail banking
business line consists of the total drawn amounts in the following credit portfolios:
retail, SMEs treated as retail, and purchased retail receivables. For commercial
banking, total loans and advances consists of the drawn amounts in the
following credit portfolios: corporate, sovereign, bank, specialized lending, SMEs
treated as corporate and purchased corporate receivables. The book value of
securities held in the banking book should also be included.
Under the ASA, banks may aggregate retail and commercial banking (if they wish
to) using a beta of 15%. Similarly, those banks that are unable to disaggregate
their gross income into the other six business lines can aggregate the total gross
income for these six business lines using a beta of 18%.
As under the Standardized Approach, the total capital charge for the ASA is
calculated as the simple summation of the regulatory capital charges across each
of the eight business lines.
3. Advanced Measurement Approaches (AMA)
Under the AMA, the regulatory capital requirement will equal the risk measure
generated by the bank’s internal operational risk measurement system quantitative
and qualitative criteria. Use of the AMA is subject to supervisory approval.
Quantitative Standards
AMA soundness standard
Given the continuing evolution of analytical approaches for operational risk,
the Committee is not specifying the approach or distributional assumptions used
to generate the operational risk measure for regulatory capital purposes.
However, a bank must be able to demonstrate that its approach captures
potentially severe ‘tail’ loss events. Whatever approach is used, a bank must
demonstrate that its operational risk measure meets a soundness standard
comparable to that of the internal ratings-based approach for credit risk, (i.e.,
comparable to a one year holding period and a 99.9th percentile confidence
interval)
Quantitative Standards cont’d…….
The Committee recognizes that the AMA soundness standard provides
significant flexibility to banks in the development of an operational risk
measurement and management system. However, in the development of these
systems, banks must have and maintain rigorous procedures for operational risk
model development and independent model validation. Prior to implementation,
the Committee will review evolving industry practices regarding credible and
consistent estimates of potential operational losses.
It will also review accumulated data, and the level of capital requirements
estimated by the AMA, and may refine its proposals if appropriate.
Any internal operational risk measurement system must be consistent with
the scope of operational risk defined by the Committee.
Supervisors will require the bank to calculated its regulatory capital requirements
as the sum of expected loss (EL) and unexpected loss (UL), unless the bank
can demonstrate that it is adequately capturing EL in its internal business
practices.
AMA Detailed Loss Event Type Classification
Event-Type
Category (Level 1)
Definition
Categories
(Level 2)
Activity Examples (Level 3)
Internal fraud
Losses due to acts of a type intended to
defraud misappropriate property or
circumvent regulations, the law or
company policy, excluding
diversity/discrimination events, which
involves at least one internal party
Unauthorized
Activity
Transactions not reported (intentional)
Transaction type unauthorized
(w/monetary loss)
Mismarking of position (intentional)
Theft and Fraud
Fraud/credit fraud/worthless deposits
Theft/extortion/embezzlement/robbery
Misappropriation of assets
Malicious destruction of assets
Forgery
Check kiting
Smuggling
Account take-over/impersonation/etc
Tax non-compliance/evasion (wilful)
Bribes/kickbacks
Insider trading (not on firm’s account)
Theft and Fraud
Theft/Robbery
Forgery
Check kiting
System Security
Hacking damage
Theft of information (w/monetary loss)
External fraud
Losses due to acts of a type intended to
defraud, misappropriate property or
circumvent the law, by a third party
Detailed Loss Event cont’d…….
Employment
Practices and
Workplace Safety
Clients, Products &
Business Practices
Losses arising from acts inconsistent with
employment, health or safety laws or
agreements, from payment of personal
injury claims, or from
diversity/discrimination events
Losses arising from an unintentional or
negligent failure to meet a professional
obligation to specific clients (including
fiduciary and suitability requirements), or
from the nature or design of a product
Employee Relations
Compensation, benefit, termination issues
Organized labour activity
Safe Environment
General liability (slip and fall, etc)
Employee health & safety rules events
Workers Compensation
Diversity &
Discrimination
All discrimination types
Suitability,
Disclosure &
Fiduciary
Fiduciary breaches/ guideline violations
Suitability/disclosure issues (KYC, etc)
Retail customer disclosure violations
Breach of privacy
Aggressive sales
Account churning
Misuse of confidential information
Lender liability
Detailed Loss Event cont’d…….
Event-Type
Category (Level 1)
Definition
Categories
(Level 2)
Activity Examples (Level 3)
Improper Bus or
Mkt Practices
Antitrust
Improper trade/market practices
Market manipulation
Insider Trading (on firm’s account)
Unlicensed activity
Money Laundering
Product flaws
Product defects (unauthorized, etc)
Model errors
Selection,
Sponsorship &
Exposure
Failure to investigate client per guidelines
Exceeding client exposure limits
Advisory Activities
Disputes over performance of advisory
activities
Damage to Physical
Assets
Losses arising form loss or damage to
physical assets from natural disaster or
other events
Disasters and other
events
Natural disaster losses
Human losses form external sources
(terrorism, vandalism)
Business disruption
and system failures
Losses arising from disruption of
business or system failures
Systems
Hardware
Software
Telecommunications
Utility outage/disruptions
Detailed Loss Event cont’d………
Execution, Delivery &
Process Management
Losses from failed transaction processing or
process management, from relations with
trade counterparties and vendors
Transaction Capture, Execution &
Maintenance
Miscommunication
Data entry, maintenance or loading error
Missed deadline or responsibility
Model/system misoperation
Accounting error/entity attribution error
Other task misperformance
Delivery failure
Collateral management failure
Reference Data Maintenance
Failed mandatory reporting obligation
Inaccurate external report (loss incurred)
Monitoring & Reporting
Client permissions/disclaimers missing
Legal doc. missing/incomplete
Customer Intake & Documentation
Customer/Client Account
Management
Unapproved access given to accts.
Incorrect client records (loss incurred)
Negligent loss or damage of client assets
Non-client counterparty misperformance
Misc non-client counterparty disputes
Outsourcing
Vendor disputes
Trade Counterparties
Vendors & Suppliers
Data Sources
Internal data
Internally generated operational risk measures used for regulatory capital
purposes must be based on a minimum five-year observation period of internal
loss data, whether the internal loss data is used directly to build the loss measure
or to validate it. When the bank first moves to the AMA, a three-year historical
data window is acceptable.
External data
A bank’s operational risk measurement system must use relevant external
data (either public data and/or pooled industry data), especially when there is
reason to believe that the bank is exposed to infrequent, yet potentially severe,
losses. These external data should include data on actual loss amounts,
information on the scale of business operations where the event occurred,
information on the causes and circumstances of the loss events.
Scenario analysis
A bank must use scenario analysis of expert opinion in conjunction with
external data to evaluate its exposure to high-severity events. This approach
draws on the knowledge of experienced business managers and risk
management experts to derive reasoned assessments of plausible severe loses.
For instance, these expert assessments could be expressed as parameters of
an assumed statistical loss distribution. In addition, scenario analysis should be
used to assess the impact of deviations from the correlation assumptions
embedded in the bank’s operational risk measurement framework, in particular,
to evaluate potential losses arising from multiple simultaneous operational risk
loss events. Over time, such assessments need to be validated and reassessed through comparison to actual loss experience to ensure their
reasonableness.
Risk mitigation
Under the AMA, a bank will be allowed to recognize the risk mitigating
impact of insurance in the measures of operational risk used for regulatory
minimum capital requirements. The recognition of insurance mitigation will be
limited to 20% of the total operational risk capital charge calculated under the
AMA
A bank’s ability to take advantage of such risk mitigation will depend on
compliance with the following criteria:
•
The insurance provider has a minimum claims paying ability rating of A (or
equivalent).
•
The insurance policy must have an initial term of no less than one year. For
policies with a residual term of less than one year, the bank must make
appropriate haircuts reflecting the declining residual term of the policy, up to a
full 100% haircut for policies with a residual term of 90 days or less.
•
The insurance policy has a minimum notice period for cancellation of 90 days.
•
The insurance policy has no exclusions or limitations triggered by supervisory
actions or, in the case of a failed bank, that preclude the bank, receiver or
liquidator from recovering for damages suffered or expenses incurred by the
bank, except in respect of events occurring after the initiation of receivership or
liquidation proceedings in respect of the bank, provided that the insurance
policy may exclude any fine, penalty, or punitive damages resulting form
supervisory actions.
•
The risk mitigation calculations must reflect the bank’s insurance coverage in
a manner that is transparent in its relationship to, and consistent with, the
actual likelihood and impact of loss used in the bank’s overall determination
of its operational risk capital.
•
The insurance is provided by a third-party entity. In the case of insurance
through captives and affiliates, the exposure has to be laid off to an
independent third-party entity, for example through re-insurance, that meets
the eligibility criteria.
•
The framework for recognizing insurance is well reasoned and documented.
•
The bank discloses a description of its use of insurance for the purpose of
mitigating operational risk.
The Second Pillar – Supervisory Review Process
There are three main areas that might be particularly suited to treatment
under Pillar 2: risks considered under Pillar 1 that are not fully captured by
the Pillar 1 process (e.g., credit concentration risk); those factors not taken
into account by the Pillar 1 process (e.g., bank (e.g., business cycle effects).
A further important aspect of Pillar 2 is the assessment of compliance with
the minimum standards and disclosure requirements of the more advanced
methods in Pillar 1, in particular the IRB framework for credit risk and the
Advanced Measurement Approaches for operational risk. Supervisors must
endure that these requirements are being met, both as qualifying criteria and
on a continuing basis.
Four Key Principles of Supervisory Review
Principle 1: Banks should have a process for assessing their overall capital
adequacy in relation to their risk profile and strategy for maintaining their capital
levels.
The five main features of a rigorous process are as follows:
•
Board and senior management oversight;
•
Sound capital assessment;
•
Comprehensive assessment of risks;
•
Monitoring and reporting; and
•
Internal control review
Principle 2: Supervisors should review and evaluate banks’ internal capital
adequacy assessments and strategies, as well as their ability to monitor and
ensure their compliance with regulatory capital ratios. Supervisors should take
appropriate supervisory action if they are not satisfied with the result of this
process.
The supervisory authorities should regularly review the process by which a bank
assesses its capital adequacy, risk position, resulting capital levels, and quality of
capital held. Supervisors should also evaluate the degree to which a bank has in
place a sound internal process to assess capital adequacy. The emphasis of the
review should be on the quality of the bank’s risk management and controls and
should not result in supervisors functioning as bank management.
Principle 3: Supervisors should expect banks to operate above the minimum
regulatory capital ratios and should have the ability to require banks to hold capital
in excess of the minimum.
Principle 4: Supervisors should seek to intervene at an early stage to prevent
capital from falling below the minimum levels required to support the risk
characteristics of a particular bank and should require rapid remedial action if
capital is not maintained or restored.
Specific issues to be addressed under the supervisor review process
Interest rate risk in the banking book
The revised guidance on interest rate risk recognizes banks’ internal
systems as the principal tool for the measurement of interest rate risk in the
banking book and the supervisory response. To facilitate supervisors’
monitoring of interest rate risk exposures across institutions, banks would have
to provide the results of their internal measurement systems, expressed in
terms of economic value relative to capital, using a standardized interest rate
shock.
Credit concentration risk
Credit risk concentrations, by their nature, are based on common or
correlated risk factors, which, in times of stress, have an adverse effect on the
creditworthiness of each of the individual counterparties making up the
concentration. Such concentrations are not addressed in the Pillar 1 capital
charge for credit risk.
Banks should have in place effective internal policies, systems and controls to
identify, measure, monitor, and control their credit risk concentrations. Banks
should explicitly consider the extent of their credit risk concentrations in their
assessment of capital adequacy under Pillar 2. These policies should cover
the different forms credit risk concentrations to which a bank may be
exposed. Such concentrations include:
•
Significant exposures to an individual counterparty or group of related
counterparties. In many jurisdictions, supervisors define a limit of exposures
of this nature, commonly referred to as a large exposure limit. Banks might
also establish an aggregate limit for the management and control of all of its
large exposures as a group;
•
Credit exposures to counterparties in the same economic sector or
geographic region;
•
Credit exposures to counterparties whose financial performance is
department on the same activity or commodity; and
•
Indirect credit exposures form a bank’s CRM activities (e.g., exposure to a
single collateral type or to credit protection provided by a single counterparty).
The Third Pillar – Market Discipline
Guiding principles
The purpose of Pillar 3 – market discipline is to complement the minimum
capital requirements (Pillar 1) and the supervisory review process (Pillar 2). The
Committee aims to encourage market discipline by developing a set of disclosure
requirements which will allow market participants to assess key pieces of
information on the scope of application, capital, risk exposures, risk assessment
processes, and hence the capital adequacy of the institution. The Committee
believes that such disclosures have particular relevance under the Framework,
where reliance on internal methodologies gives banks more discretion in
assessing capital requirements
Frequency
The disclosures set out in Pillar 3 should be made on a semi-annual basis
Capital Adequacy
Qualitative disclosures
(a)
A summary discussion of the bank’s approach to assessing the adequacy of its
capital to support current and future activities.
Quantitative disclosures
(b)
Capital requirements for credit risk:
• Portfolios subject to standardized or simplified standardized approach,
disclosed separately for each portfolio;
• Portfolios subject to the IRB approaches, disclosed separately for each
portfolio under the foundation IRB approach and for each portfolio under
the advanced IRB approach:
• Corporate (including SL not subject to supervisory slotting criteria),
sovereign and bank;
• Residential mortgage;
• Qualifying revolving retail; and
• Other retail;
• Securitization exposures
(c)
Capital requirements for equity exposures in the IRB approach:
• Equity portfolios subject to the market-based approaches
• Equity portfolios subject to simple risk weight method; and
• Equities in the banking book under the internal models approach (for
banks using IMA for banking book equity exposures).
• Equity portfolios subject to PD/LGD approaches.
Capital Adequacy Cont’d…..
(d)
Capital requirements for market risk
• Standardized approach;
• Internal models approach – Trading book.
(e)
Capital requirements for operational risk:
• Basic indicator approach;
• Standardized approach;
• Advanced measurement approach (AMA).
(f)
Total and Tier 1 capital ratio:
• For the top consolidated group; and
• For significant bank subsidiaries (stand alone or sub-consolidated
depending on how the Framework is applied).
Operational Risk
(a)
In addition to the general qualitative disclosure requirement, the
approach(es) for operational risk capital assessment for which the bank
qualifies.
(b)
Description of the AMA, if used by the bank, including a discussion of
relevant internal and external factors considered in the bank’s
measurement approach. In the case of partial use, the scope and coverage
of the different approaches used.
(c)
For banks using the AMA, a description of the use of insurance for the
purpose of mitigating operational risk.
Qualitative disclosures