The Revision of Basel Capital
Rules
15 December 2000
ISDA, London
Danièle Nouy
Secretary General of the Basel Committee
B.I.S.
Structure of Presentation
A: A few general comments
B: Three Pillars and three Options for Pillar 1
C: The Standardised Approach
D: The Internal Ratings-Based Approach
E: Brief overview of credit risk models
F:
Other elements
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Basel Committee on Banking Supervision
A: A Few General Comments
Reasons and objectives of the revision
The weaknesses of the 1988 Accord:
•
Does not assess capital adequacy in relation to a bank’s true risk profile;
•
Does not sufficiently take into account hedging strategies;
•
Banks can arbitrage their regulatory capital requirements;
•
Covers only credit and market risks;
•
Portfolio diversification is not taken into account.
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Basel Committee on Banking Supervision
A: A Few General Comments
Principles of the Capital Requirements:
• Theoretical soundness,
• Operational feasibility,
• Incorporation of incentives for sound and prudent
behaviour,
• Flexibility.
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Basel Committee on Banking Supervision
B: Three Pillars & Three Options for Pillar 1
Minimum Capital Requirements (Pillar 1) - Main
Changes:
•
More emphasis on credit risk measurement and
management and therefore on both external and internal
ratings,
•
Better recognition of credit risk mitigation techniques,
•
3 Options for credit risk;
•
Capital charge for operational risk.
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Basel Committee on Banking Supervision
B: Three Pillars & Three Options for Pillar 1
The Definition of Capital is unchanged :
•
Tier 1: core capital
- Equity
- Disclosed reserves
- October 1998 interpretation note
•
Tier 2: supplementary capital (limited to 100% Tier 1)
- Undisclosed reserves
- Revaluation provisions / General loan loss reserves
- Hybrid instruments
- Subordinated debt (lower Tier 2)
•
Tier 3: (for market risks) short term subordinated debt
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B: Three Pillars & Three Options for Pillar 1
Three Basic Pillars
Minimum capital
requirements
Supervisory
Review
Process
Market
Discipline
Requirements
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Basel Committee on Banking Supervision
B: Three Pillars & Three Options for Pillar 1
• The Standardised Approach (option 1)
– Risk-weightings are given for certain classes of instruments.
• The Internal Ratings-Based Approach (option 2)
– Risk-weightings are based on internal risk assessments,
– It can more finely distinguish between classes of risk,
– It can take into account additional risk factors (granularity,
maturity, etc.),
• Credit Risk Models: (option 3). They address concentration
and sectoral diversification.
The result: “a whole spectrum of choices”
depending on each bank’s sophistication.
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Basel Committee on Banking Supervision
C: The Standardised Approach
Broad Summary
(using Standard & Poor’s Methodology as an example)
Claim
Assessment
AAA to
AA-
Sovereigns
A+ to A-
BBB+ to
BBB-
BB+ to
B-
Below B-
Unrated
0%
20%
50%
100%
150%
100%
100%
100%
150%
100%
150%
50%
150%
100%
Option 1
1
20%
50%
Option 2
2
20%
50%
50%
20%
100%
100%
Banks
Corporates
3
3
100%
100%
3
1
Risk weighting based on risk weighting of sovereign in which the bank is incorporated.
2
Risk weighting based on the assessment of the individual bank.
3
Claims on banks of a short original maturity, for example less than six months, would receive a
weighting that is one category more favourable than the usual risk weight on the bank’s claim.
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C: The Standardised Approach
Some changes decided so far:
• Suppression of the “sovereign floor”,
• Suppression of the “conditionality elements” to get a less
than 100% risk weight:
– IMF disclosure standards,
– Basel Committee and IOSCO core principles, etc.
• Modification of the maturity parameter for interbank
claims (option 2) from 6 months to 3 months,
• Creation of a 50% risk weight for corporates.
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D: Developing the IRB Approach
The Key Objectives in moving beyond the standardised
approach to an internal ratings-based approach are:
– More closely link capital charges with underlying risks,
– Provide incentives for innovation and improved riskmeasurement and management (even more so, due to the different
IRB approaches: foundation, advanced),
– Develop capital charges that are consistent and comparable
between banks, across countries, and over time.
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Basel Committee on Banking Supervision
D: Developing the IRB Approach
The consultation paper on capital says:” The Internal
Ratings-Based Approach will be applicable to
sophisticated banks, subject to supervisory approval”.
What do we mean by that?
– Potentially many banks (many more than we expected when
we started developing this option), especially as we offer
different “sub-options” ,
– Namely those which can meet defined minimum standards and
which internal rating systems can be validated by their
national supervisors.
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D: Developing the IRB Approach
The different steps:
–
Step 1: Identifying key elements of rating systems (see the
January 2000 paper: Range of Practice in Banks Internal Ratings
Systems),
–
Step 2: Building the regulatory framework for eligible
internal ratings systems (for commercial and industrial lending
but also, other portfolios: Retail, Banks and Sovereigns,
Securitised Assets, Project Finance, and Equity in the banking
book),
–
–
Step 3: Linking ratings to capital requirements,
Step 4: Developing standards and guidelines for internal
systems and processes, as well as validation guidelines.
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Basel Committee on Banking Supervision
D. Developing the IRB Approach
What is an internal rating?
• It is an indicator of riskiness of loss in individual credit,
due to a borrower’s failure to pay as promised.
• The risk is assessed:
– through intuitive assessment of general credit
quality,
– or explicitly, through consideration of measurable
loss concept,
– or more likely, and very rightfully, a mix of both.
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Basel Committee on Banking Supervision
D. Developing the IRB Approach
Key loss statistics in the IRBA will include:
–
A rating that reflects the Expected Default Frequency (EDF), or
Default Probability (PD) of the borrower, estimated over one
year,
–
A separate consideration of the facility’s risk; the Loss Given
Default (LGD),
–
A measure of exposure (EAD),
–
Expected losses (EL),
–
Unexpected losses (UL),
–
A maturity adjustment,
–
A granularity adjustment.
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Basel Committee on Banking Supervision
D. Developing the IRB Approach
Among Issues to be Considered:
• The Number of Grades and the appropriate risk
differenciation.
- Significant variation in banks: Average around 10 for
‘performing’ and 3 for ‘non-performing’ loans,
- No consensus where cut-offs should be (although what should
be achieved is rather clear).
• The Definition of Default,
• The Eligibility Criteria (for Foundation and Advanced
Approaches),
• The Disclosure requirements.
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Basel Committee on Banking Supervision
D. Developing the IRB Approach
Slotting of a Bank’s Loan Portfolio into regulatory
benchmark matrix based on these risk characteristics
LGD
EDF
50%
100%
0.1-0.5%
Loan to Company Z
Loan to Company P
0.5-1.0%
Loan to Company I
No Loans
1.0-1.5%
Loan to Company E
Loan to Company T
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Basel Committee on Banking Supervision
D. Developing the IRB Approach
Comparison between Portfolios, for example
Commercial and Industrial loans and Retail:
–
C and I: A foundation approach and at least 3 advanced
ones,
–
Retail: No foundation approach and 2 different advanced
frameworks, based on EL/UL, or on the PD/LGD
framework;
–
Different eligibility and validation criteria,
–
Different disclosure requirements,
–
Different risk weight frameworks.
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Basel Committee on Banking Supervision
D. Developing the IRB Approach
What qualitative standards do we expect banks to
meet?
–
–
–
–
banks’ rating systems should provide for a
meaningful differentiation of risk,
data sources used by banks should be suitably rich
and robust,
ratings should be subject to some form of
independent review,
ratings should be an integral part of “the culture and
management of the bank”: the “Use Test”.
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Basel Committee on Banking Supervision
D. Developing the IRB Approach
Six Key Considerations in developing an IRB
approach:
•
•
•
•
•
•
Develop more risk-sensitive capital charges achieving a
good trade-off between simplicity and conceptual rigor;
Decide on acceptable tolerance in the comparability of
system inputs and outputs;
Maintain sound credit management policies; not impinge
on credit culture;
Provide incentives for risk management improvements;
Overcome data constraints;
and validate banks’ inputs.
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Basel Committee on Banking Supervision
D. Developing the IRB Approach
To reconciliate these trade-offs and considerations:
a magic concept, “The Evolutionary Approach”:
A spectrum of IRB options permitting a more risksensitive treatment for banks able to meet higher
standards (For example, at least three Advanced
approaches for C and I portfolios).
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Basel Committee on Banking Supervision
E: Credit Risk Models
Models represent the right-most point in our
continuum:
–
They reflect many of the benefits of internal
ratings, while distinguishing risk more finely;
–
They take into account very important additional
factors, such as concentration effects: they
incorporate correlation between obligors, facilities,
and risk factors.
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Basel Committee on Banking Supervision
E: Credit Risk Models
The conclusion of the April 1999
Consultative Document:
•
The report analysed practices in credit risk modelling, and
assessed the potential uses of credit risk models for
supervisory and regulatory purposes;
•
It welcomed advances in modelling and recognised the
potential of models for use in supervisory oversight of banks;
•
But noted, several hurdles (data limitations, parameter
specification and estimation, models validation, back and
stress-testing, etc.) that must be overcome before models can
be used for setting regulatory capital.
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Basel Committee on Banking Supervision
F: Other Elements
A proposed capital charge for other risks:
•
Operational risk - an evolutionary approach starting with
3 options (and a 4th one later on) in Pillar 1;
•
Interest rate in the banking book. A capital charge for
outliers, and therefore related to Pillar 2.
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Basel Committee on Banking Supervision
F: Other Elements
• Definition of operational risk: “The risk of direct or
indirect loss resulting from inadequate or failed internal
processes, people and systems, or from certain external
events”.
• Options considered for measuring and treating
operational risk:
– the Basic Indicator Approach,
– The Standardised Approach,
– The Internal Measurement Approach,
– The Loss Distribution Approach.
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Basel Committee on Banking Supervision
F: Other Elements
Second Pillar: Supervisory Review of Capital
Adequacy
Principles relevant to the supervisory review of a bank’s
capital adequacy:
•
Capital Above Regulatory Minima,
•
Banks’ Internal Assessment of Capital Adequacy,
•
Supervisory Review Process and comparison
between regulatory capital and economic capital,
•
Supervisory Intervention (including Prompt
Corrective Action, if need be).
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Basel Committee on Banking Supervision
F: Other Elements
Third Pillar: Market Discipline
It implies disclosure of information on:
•
The amount of capital,
•
The risk profile,
•
The capital adequacy.
… as well as internal systems when banks use IRB
approaches. In this case, it is even a minimum
requirement / eligibility criteria.
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Conclusion
Possible calendar of the reform:
–
January 2001, Publication of the 2nd Consultative
Package;
–
May 2001, end of the 2nd consultation period;
–
End of 2001, new final document.
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