Presented By :

Ameya lakhe
Amit Kumar
Ashish Jha
Jagdish Agarwal
Basel II Norms
Sunday, March 02, 2014
2
Agenda
Introduction
Basel II-Framework
Pillar 1 Minimum Capital Adequacy
Pillar 2- Supervisory
Pillar 3- Market Discipline
Conclusion
Aim- 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 face
How- by setting up rigorous risk and capital
management requirements to ensure that a bank
holds capital reserves appropriate to the risk the bank
exposes itself to through lending and investment
practices.
Greater the risk greater the amount of capital bank
needs to hold to safeguard its solvency and overall
economic stability.
Introduction
Shortcomings of Basel I
Capital required did not mirror a banks true risk profile
Too simple for advanced banks
Inflexible against new developments
Covers only credit and market risks
Only quantitative in nature
Limited recognition of collateral

Basel I
Basel I
Pillar 1:




Minimum capital
requirements
Risk-weighted
Assets
(Denominator)
Definition of
Capital
(Numerator)
Credit Risk
(1988)
Market Risk
(1996)
Greater emphasis on banks own assessment of risk
Comprehensive framework for credit, market and
operational risk
Encourages rigorous bank supervision
Ensures market transparency, disclosure
More risk sensitive; better align regulatory capital with
actual risk exposure
Objectives of Basel II
Three Pillars of Basel II
Pillar 1 sets out the minimum capital requirements firms will be
required to meet to cover credit, market and operational risk.
Pillar 2 sets out a new supervisory review process. Requires
financial institutions to have their own internal processes to
assess their overall capital adequacy in relation to their risk
profile.
Pillar 3 cements Pillars 1 and 2 and is designed to improve
market discipline by requiring firms to publish certain details of
their risks, capital and risk management as to how senior
management and the Board assess and will manage the
institution's risks.
The Basel II Framework
Three Pillars
Minimum
capital
requireme
nts
Risk
weighted
assets
Credit risk
Standardiz
ed
Internal
Ratings-
based
Operational
risk
Basic
Indicator
Standardiz
ed
Advanced
Measurem
ent
Market
risks
Standardiz
ed
Models
Definition
of
capital
Core
Capital
Suppleme
ntary
Capital
Supervisor
y review
process
Market
discipline
A measure of adequacy of an entitys capital resources in
relation to its current liabilities and also in relation to risk
associated with its assets.
An appropriate level of capital adequacy ensures that the
entity has sufficient capital to support its activities and its net
worth is sufficient to absorb adverse changes in the value of
its assets without becoming insolvent e.g. Banks are required
to maintain a certain level of capital against their (risk
adjusted) assets.
Banks are required to maintain a minimum CRAR of 9% on an
ongoing basis with Tier 1 CRAR of minimum 6%.
Risks weights assigned based on the different assets types
and obligors (higher for commercial real estate, equity/capital
market exposure, consumer credit)

Capital Adequacy
Total Capital=Tier 1 capital + Tier 2 capital less following deduction
adjustments
equity investments in subsidiaries;
shareholdings in other banks that exceed 10% of that bank's capital;
unrealized revaluation losses on securities holdings
Total risk-weighted assets are determined by:
multiplying the capital requirements for market risk and operational risk
by 12.5 and adding the resulting figures to the sum of risk-weighted
assets for credit risk.




Pillar 1: Minimum Capital Requirements
Capital Funds
Capital Funds to include both Tier I and Tier II Capital Funds
Tier I Capital
Paid Up Capital, Statutory Reserves, and other disclosed Free Reserves.
Capital Reserve
Innovative perpetual debt instruments subject to compliance with certain regulatory
requirements
Perpetual non cumulative Preference Shares subject to compliance with certain
regulatory requirements
Any other Instrument notified by RBI from time to time.
Tier II Capital
Revaluation Reserve (at discount of 55 percent)
General Provision and Loss Reserves
Hybrid Debt Capital Instruments
Subordinated Debt
Debt instruments, Perpetual Cumulative Preference Shares, Redeemable Non
Cumulative preference shares, redeemable cumulative preference shares.
Tier I Capital should at no point of time be less than 50% of the total capital. This
implies that Tier II cannot be more than 50% of the total capital.
Credit Risk
Previous norms prescribed single credit risk factor across a class of
obligors thus ignoring the default probability or risk rating of different
obligors. This results in assigning same amount of capital for exposures
to AAA rated and BB rated corporate.
Three approaches for computing RWAs for Credit Risk:
Standardized Approach: Risk Weights linked to external ratings of obligors
and tenor of the loan. Range between 0% to 150%. Unrated exposures to
be assigned 100% risk weight.
Foundational Internal Rating Approach: Risk Weights assigned on the basis
of obligors PD (Probability of Default).
Advanced Internal Rating Approach: Banks to use internal rating model for
key statistical data: credit ratings (probability of default or PD), Loss given
Default (LGD) and Exposure at default (EAD). Road map for migrating to
these approaches is issued.
To start with RBI has asked all banks to follow Standardized approach
and use external ratings assigned by any of the RBI approved local and
international rating agencies.
In determining the risk weights in the standardised
approach, banks may use assessments by external
credit assessment institutions.
Risk Weights linked to external ratings of obligors and
tenor of the loan.
Unrated exposures to be assigned 100% risk weight
Credit Risk - Standardised Approach
( )

Assets of Valus Book Assets for t Risk Weigh

In the internal ratings-based(IRB) approach, its based on
banks internal assessment.
The approach combines the quantitative inputs provides by
banks and formula specified by the Committee.
Four quantitative inputs (risk components):









Credit Risk - IRB Approach
Data Input

Foundation IRB

Advanced IRB


Probability of default
(PD)

From banks

From banks

Loss given default
(LGD)


Set by the
Committee

From banks

Exposure at default
(EAD)


Set by the
Committee

From banks

Maturity (M)


Set by the
Committee or from
banks

From banks

Credit Risk Capital Requirement
Credit Risk Probability of Default

Standardised method
the standards of the Committee

Internal models
use banks internal assessments
Value at Risk (VaR)
The value at risk is $1 million means that the bank is
99% confident that there will not be a loss greater than
$1 million over given time period.

Market Risk
The risk of losses results from inadequate or failed internal
processes, people and system, or external events.

It defines three approaches for this calculation:
Basic Indicator Approach: Capital Charge computed at 15%
of Gross Income of the Bank.
Standardized Approach: Capital Charge ranges between 12-
18% of gross income of different business lines.
Advanced Measurement Approach: Banks to use internal
model for computing potential operational loss.

To start with RBI has asked all banks to apply the Basic
Indicator Approach. Basic Indicator Approach is required to be
implemented by all banks operating in India. Roadmap for
Advanced approaches is prescribed by RBI.

Operational Risk
Basic Indicator Approach

GI = average annual gross income(three years, excepted the negative amounts)
= 15%

Standardised Approach


GI
1-8
= average annual gross income from business line from one to eight (three years,
excepted the negative amounts)
= A fixed percentage set by the Committee. ; 12% < < 18%

Advanced Measurement Approaches
Under the AMA, the regulatory capital requirement will equal the risk measure
generated by the banks internal operational risk measurement system using the
quantitative and qualitative criteria for the AMA.
Use of the AMA is subject to supervisory approval

Operational Risk Calculation
o =GI KBIA
( )

8 1 = | 8 1 GI KTSA
Beta of Business Lines
Business Lines

Beta Factors

Corporate finance (1)

18%

Trading and sales (2)

18%

Retail banking (3)

12%

Commercial banking (4)

15%

Payment and settlement (5)

18%

Agency services (6)

15%

Asset management (7)

12%

Retail brokerage (8)

12%

Principle 1: Banks should have a process for
assessing and maintaining their overall capital
adequacy.
Principle 2: Supervisors should review and evaluate
banks internal capital adequacy assessments and
strategies.
Principle 3: Supervisors should expect banks to
operate above the minimum regulatory capital ratios.
Principle 4: Supervisors should intervene at an early
stage to prevent capital from falling below the
minimum levels.

Pillar 2: Supervisory Review
The purpose of pillar three is to complement the pillar
one and pillar two.
Develop a set of disclosure requirements to allow
market participants to assess information about a
banks risk profile and level of capitalization.
Pillar 3: Market Discipline
Basel II - a more risk sensitive framework

Increased reliance on internal risk management
systems for regulatory capital
requires supervisory oversight (Pillar 2)
better disclosure of banks risk profile (Pillar 3)

Regardless of which Basel II approaches to adopt,
banks should continue to enhance their risk
management systems and practices
Conclusion
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Thank you