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VaR Model (Value at Risk)
"Risk of loss resulting from inadequate or failed internal processes, people and systems or from external events"
(Finance Batch 1)
Pitfalls of Basel I
Introduction of 3 Pillar
In 1988, the Basel Committee(BCBS) in Basel, Switzerland, published a set of minimal capital requirements for banks, known as 1988 BaselAccord or Basel 1.
Primary focus on credit risk
Assets of banks were classified and grouped in five categories to credit risk weights of zero ‘0’, 10, 20, 50 and up to 100%.
Assets like cash and coins usually have zero risk weight, while unsecured loans might have a risk weight of 100%.
Limited differentiation of credit risk
(0%, 20%, 50% and 100%)
Static measure of default risk
The assumption that a minimum 8% capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk.
No recognition of term-structure of credit risk
The capital charges are set at the same level regardless of the maturity of a credit exposure.
Simplified calculation of potential future counterparty risk
The current capital requirements ignore the different level of risks associated with different currencies and macroeconomic risk. In other words, it assumes a common market to all actors, which is not true in reality.
Lack of recognition of portfolio diversification effects
In reality, the sum of individual risk exposures is not the same as the risk reduction through portfolio diversification.
Therefore, summing all risks might provide incorrect judgment of risk
Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.
Basel II, initially published in June 2004, was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face. One focus was to maintain sufficient consistency of regulations so that this does not become a source of competitive inequality amongst internationally active banks. Advocates of Basel II believed that such an international standard could help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.
Politically, it was difficult to implement Basel II in the regulatory environment prior to 2008, and progress was generally slow until that year's major banking crisis caused mostly by credit default swaps, mortgage-backed security markets and similar derivatives.
Nirmal Patel (1500)
Kundan Deep Kaur
Why BASEL 1..??
The Committee was formed in response to
messy liquidation of a Cologne-based bank
(Herstatt Bank) in 1974.
Hence a Basel committee was formed of 11
nations to harmonize banking standards
and regulations within and between all
Their goal was to:
Extend regulatory coverage.
Promote adequate banking supervision.
Ensure that no foreign banking establishment can escape supervision.
Ensuring that capital allocation is more risk sensitive;
Enhance disclosure requirements which will allow market participants to assess the capital adequacy of an institution;
Ensuring that credit risk, operational risk and market risk are quantified based on data and formal techniques;
Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.
Pillar 1 ( Minimum Capital Requirement )
Pillar 2 ( Supervisory Review Process )
Framework for Banks (ICAAP)
Pillar 3 ( Market Discipline )
Disclosure requirement for bank
Pillar 1 deals with three major components of risk that a bank faces:
Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital
A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame.
A Bank having 1day VaR of Rs10crore with 99% confidence interval. This means that there will be only 1 chance when a daily loss will be more than 10crore under normal trading condition.
Operational Risk events having the potential to result in substanial losses include:
Employment practices and workplace safety
Client, products and business practices
Damage to physical assets
Execution, delivery and process management
Computation of Capital charge for Operational Risk
Basic Indicator Approach
The Standardized Approach
Advance Measurement Approach
The basic approach or basic indicator approach is a set of operational risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions.
Based on the original Basel Accord, 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 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 fixed percentage ‘alpha’ is typically 15 percent of annual gross income.
RBI issues fresh norms for Basel-II
All banks operating in India to maintain minimum “Capital Funds” at 9% of “Total Risk Weighted Assets”.
Capital Funds is an addition of Tier-I Capital and Tier-II Capital.
Total Risk Weighted Assets is computed on the basis of risk weights assigned for different asset types and obligors:
Government - 0%
Banks - 20%
Others - 100% [except Housing (50-75%), Consumer (125%) loans,
equity/ capital market exposure (125%) and Venture capital funds (150%)].
Market Risk Capital Charge is based on modified duration methodology.
Reserve Bank has approved four local and three international credit rating agencies for rating local and international exposures, respectively.
1. THE MISPLACED HOPES FOR BASEL II.
Basel ii is an unusual structure within the international legal system.
Basel ii is not a treaty.
2. A POST-CRISIS POST-MORTEM
maintaining higher capital requirements will limit the overall availability of credit in the economy.
3. WHY NATIONAL CAPITAL ADEQUACY STANDARDS?
the notion of requiring financial institutions to maintain minimal levels of capital is much older than the first Basel accord.
A. FALSE SENSE
B. RELIANCE ON RATING AGENCIES