Chapter Fifteen

The Management of Capital & Basel

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 15-2

Key Risks in Financial Institutions

Management
• Credit Risk
▫ Probability of default on any promised payments of
interest or principal or both
• Liquidity Risk
▫ Probability of being unable to raise cash when needed
at reasonable cost
• Interest Rate Risk
▫ Probability that changes in interest rates will
adversely affect the value of net worth
• Operational Risk
▫ Probability of adverse affect of earnings due to
failures in computer systems, management errors,
etc.
• Exchange Risk
▫ Probability of loss due to fluctuating currency prices
• Crime Risk
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▫ Due to embezzlement, robbery, fraud,
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BASEL Committee on Banking Supervision

Keep an eye on BCBS website

www.bis.org/BCBS

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THE FIRST BASEL ACCORD

The first Basel Accord (Basel-I) was completed

in 1988

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1988 BASEL ACCORD (BASEL-I)

1)The purpose was to prevent international banks from

building business volume without adequate capital
backing
2) The focus was on credit risk
3) Set minimum capital standards for banks
4) Became effective at the end of 1992

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Overview of Basel I

Basel I
Pillar 1:

Regulatory capital
Minimum capital ≥ 8%
requirements Risk-weighted assets
Risk-weighted Definition of
Assets Capital
(Denominator) (Numerator)

Credit Risk Market Risk

(1988) (1996)

Standardized Models
Approach Approach

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Tier 1 Capital
• Common Stock and Surplus
• Undivided Profits
• Qualifying Noncumulative Preferred Stock
• Minority Interests in the Equity Accounts of
Consolidated Subsidiaries
• Selected Identifiable Intangible Assets Less
Goodwill and Other Intangible Assets

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Tier 2 Capital
• Allowance for Loan and Lease Losses
• Subordinated Debt Capital Instruments
• Mandatory Convertible Debt
• Cumulative Perpetual Preferred Stock with
Unpaid Dividends
• Equity Notes
• Other Long Term Capital Instruments that
Combine Debt and Equity Features

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 15-9

Total Regulatory Capital Calculations

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Basel Agreement Capital Requirements

• Ratio of Core Capital (Tier 1) to Risk

Weighted Assets Must Be At Least 4 Percent
• Ratio of Total Capital (Tier 1 and Tier 2) to
Risk Weighted Assets Must Be At Least 8
Percent
• The Amount of Tier 2 Capital Limited to 100
Percent of Tier 1 Capital

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Basel 1988

Capital Adequacy Ratio =

Capital (Tier1+Tier2)
‫ = ـــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬8 %
Risk Weighted Assets (Credit Risk)

•1996 Market Risk + Tier 3

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BASEL-I CAPITAL REQUIREMENTS

• Capital was set at 8% and was adjusted by a

loan’s credit risk weight
• Credit risk was divided into 5 categories: 0%,
10%, 20%, 50%, and 100%
▫ Commercial loans, for example, were assigned to
the 100% risk weight category

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Example

• Corporates : 100 million

• Risk Weighted Assets = Asset * Risk weight
• RWA = 100 * 100%
• RWA = 100
• Minimum Capital Requirements= 100* 8%
• MCR = 8
• Observe : All Corporate Credit Portfolio with
RW 100%

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 14

Basel II
• To create a level playing field in interbank
competition according to international banking
standards
• To address weaknesses in the Basel I
framework:
− One-size-fits-all approach is no longer relevant
− Does not cover all bank risks (e.g. operational,
reputational, strategic and liquidity risks, etc.).
− Does not recognize collateral and other forms of
risk mitigation that could create incentives for
improvement in risk management.
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Three Reinforcing Pillars under Basel II

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 Expected Loss & Unexpected Loss

99.9% Shaded area is equal to

1 - confidence level

Frequency

Potential
loss rate
Expected loss: Unexpected loss: Unexpected loss: NOT covered
covered by provisions covered by capital
Crisis

Basel II & Basel III

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 5-17

The First Pillar –

Minimum Capital Requirements

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Capital Requirement under Basel II

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 5-19

Risk Measurement

•Credit Risk
•Operational Risk
•Market Risk

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Overview of Basel II Approaches (Pillar I)

Basic Indicator
Approach

Operational
Standardized
Risk Approach
Capital

Advanced Measurement
Approach (AMA)

Standardized
Total Credit Approach
Regulatory Risk
Capital Capital
Internal Ratings
Based (IRB)

Standardized
Approach
Market
Risk
Capital Internal
Model

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 5-21

Basel II Capital Charges

Measurement Approaches

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 5-22

Standardized Approach
Under this approach,the bank allocates certain risk
weightings for each category of assets and off-balance
sheet items depends on External Credit Rating Agencies
(ECRA) to arrive at a total figure for risk-weighted assets
(RWA)

Credit RWA = Total of credit exposures × risk

weighting

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 5-23

Standardized Approach – Risk Weights

Claim Assessment
AAA - BBB+ -
A + - A- BB+ - B- Below B- Unrated
AA- BBB-

Sovereigns 0% 20% 50% 100% 150%

100%
(Export credit agencies) (1) (2) (3) (4-6) (7)

Option 11 20% 50% 100% 100% 150% 100%

Banks
20% 50% 50% 100% 150% 50%
Option 22
(20%)3 (20%)3 (20%)3 (50%)3 (150%)3 (20%)3
BB+ - BB- Below BB-
Corporates 20% 50% 100% 100%
100% 150%
Mortgages 35%
Retail
Other retail 75%

3 Claims on banks of an original maturity of less than three months

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Calculate the risk weighted assets and minimum

capital requirements for the following exposures:

Asset Rate Value Provisions

Bank- option1 A 230 7
Mortgages 80 2
Company1 BBB 150 15
Company2 A- 90 4.5
Auto Loan 50 2
Company3 Unrated 70 3.5
Total 670 34

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RWA & Capital Requirements

Capital
Asset Rate Value Provisions Exposure RW RWA
Req.

Bank- option1 A 230 7 223 %50 112 8.9

Mortgages 80 2 78 %35 27 2.2

Company1 BBB 150 15 135 %100 135 10.8
Company2 A- 90 4.5 86 %50 43 3.4
Auto Loan 50 2 48 %75 36 2.9
Company3 Unrated 70 3.5 67 %100 67 5.3

Total 670 34 636 419 33.5

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 5-26

Internal Risk Rating-based Approach

• The IRB approach recognizes that banks are customarily
better informed of their debtors than a rating agency .
• By switching to a more advanced approach , many banks
will benefit from reduced capital allocation under the capital
rules as a result of the more accurate linkage between
capital and risk .

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 5-27

Introduction to Credit Risk

Credit Risk Types and Drivers
Types of credit risk Drivers of the credit risks

Riskiness of a borrower, including Probability of default (PD)

approximation of size

Riskiness of a transaction Loss given default (LGD)

Likely size of exposures Exposure at default (EAD)

Time dimension Maturity

Diversification / concentration Correlation

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 Risk Components & Expected Loss
• Credit Risk Components are :

1. PD = Probability of default

2. LGD = Loss Given Default

3. EAD = Exposure at Default

4. M = Maturity

Expected Loss = PD * LGD * EAD

Risk-weighted assets (RWA) = K x 12.5 x EAD

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 5-29

Example

• Exposure value = 200

• Capital charge = 1.91%

Calculate Capital Requirements and RWA

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Example

• Capital Requirements = Exposure * capital

charge”K”
• Capital R.= 200* 1.91%= 3.82

• RWA= K * 12.5 * EAD

• RWA = 1.91% * 12.5 * 200
• RWA = 47.75

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 5-31

Example
• PD = .3%
• Value = 300
• Provision = 3
• Credit risk mitigation with collateral = 170
• LGD = 40%
• K = 0.93%
Calculate Expected Loss, RWA , and Capital
requirements .

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Example
• EAD = 300- 3 – 170 = 127
• EL = PD* EAD* LGD
• EL= 0.3% * 127 * 40%
• EL = 0.15
• RWA = K * 12.5 * EAD
• RWA = 0.93% * 12.5 * 127
• RWA = 14.76
• Capital requirements = K * EAD = 1.18

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 5-33
Introduction to Operational Risk
• Operational risk is the risk of direct or indirect
loss resulting from inadequate or failed internal
processes, people and systems or from external
events.

Types of operational risk Examples

Process risk can arise at any stage of an end-to-
Internal process
end process in the value chain
Inadequate training and management, human
People error, lack of segregation, reliance on key
individuals, lack of integrity, honesty, etc.
System IT systems and data corruption problems.
Adverse external events and independent
External events
external events.

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Operational Risk
Measurement Approaches
• Basel II framework offers a menu of options
for calculating the associated capital charge,
ranging from a simple mechanism to a
sophisticated methodology:
‒ The Basic Indicator Approach (BIA).
‒ The Standardized Approach (SA).
‒ The Advanced Measurement Approach (AMA).

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 5-35

Introduction to Market Risk

• Market risk is the risk of losses in on and off-
balance sheet positions arising from movements
in market prices.
• Capital charge for market risk consists of
charges for interest rate risk , foreign exchange
risk , equity risk , and commodity risk .

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 5-36

Market Risk Measurement Approaches

The bank capital requirement for market risk
is determined by two methods:
• The Standardized Approach
• The Internal Model Approach

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 5-37

The Second Pillar – Supervisory

Review Process

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 5-38

Three Reinforcing Pillars under Basel II

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 5-39

The Importance of Supervisory Review

• Under the supervisory review, supervisors

will also focus on other risks and factors not
addressed in the minimum capital
requirement structure such as credit
concentration risk, interest rate in the
banking book, business and strategic risks,
and external factors.

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 5-40

The Key Principles of

Supervisory Review
1. Calculation of Overall Capital Adequacy.
2. Review and Evaluation of Strategy and Capital
Adequacy Calculations.
3. Supervisor May Order a Higher Level of Capital
Adequacy.
4. Supervisor May Intervene at an Early Stage to
Prevent Decline in Bank Capital.

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 5-42

ICAAP Five Factors

1. Board and senior management oversight,
including the responsibility for setting the
bank’s tolerance for risks.
2. Sound capital assessment.
3. Comprehensive assessment of risks
encompassing all material risks not covered in
Pillar 1.
4. Monitoring and reporting.
5. Internal control review.

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 5-43

The Third Pillar – Market

Discipline

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 5-44

Three Reinforcing Pillars under Basel II

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 5-45

Objectives of Pillar 3
• Pillar 3, which is intended to complement Pillar 1
and Pillar 2, in principle aims to:
‒ Promote a sound business environment for the
banking system; and
‒ Provide supervisors with added powers to enforce
sound banking operations, among others through
disclosure requirements.

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 5-46

Introduction to Basel III

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 5-47

Basel III
It improves the banking sector’s ability to
absorb shocks arising from financial and
economic stress. It's introduced through two
different legal instruments.

Most of the key topics, the new definition of

capital and the new liquidity ratios.

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Basel III components

• New definition of capital
• Capital conservation buffer
• Countercyclical capital buffer
• New liquidity ratios
• Leverage ratio
• Stress Testing

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Planning to Meet a Bank’s Capital

Needs
• Raising Capital Internally
▫ Dividend Policy
▫ Internal Capital Growth Rate
• Raising Capital Externally
▫ Issuing Common Stock
▫ Issuing Preferred Stock
▫ Issuing Subordinated Notes and Debentures
▫ Selling Assets and Leasing Facilities
▫ Swapping Stock for Debt Securities
▫ Choosing the Best Alternative

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Internal Capital Growth Rate

= ROE * Retention Ratio

= Profit Margin * Asset Utilization

* Equity Multiplier * Retention
Ratio

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 51

A bank has a profit margin of 5 percent, an asset utilization ratio of 11 percent , an

equity multiplier of 12 and a retention ratio of 60 percent. What is this bank's ICGR?

A) 6.6 percent
B)3.96 percent
C)7.2 percent
D) .33 percent
E)None of the above
Answer: B

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 5-52

Thank you

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