Lecture 6b: An Introduction The Basel I & Basel II

1. Lecture 6b: An Introduction The Basel I & Basel II

2. “Knowledge has to be improved, challenged and increased constantly or it vanishes”Peter Drucker Risk Management and Basel II Risk Management DivisionBank Alfalah Limited Javed H. Siddiqi

3. Managing Risk Effectively: Three Critical Challenges Management Challenges for the 21st Century GLOBALISM TECHNOLOGY CHANGE

4. Agenda • What is Risk ? • Types of Capital and Role of Capital in Financial Institution • Capital Allocation and RAPM • Expected and Unexpected Loss • Minimum Capital Requirements and Basel II Pillars • Understanding of Value of Risk-VaR • Basel II approach to Operational Risk management • Basel II approach to Credit Risk management • Credit Risk Mitigation-CRM, Simple and Comprehensive approach. • The Causes of Credit Risk • Best Practices in Credit Risk Management • Correlation and Credit Risk Management. • Credit Rating and Transition matrix. • Issues and Challenges • Summary

5. What is Risk? • Risk, in traditional terms, is viewed as a ‘negative’. Webster’s • dictionary, for instance, defines risk as “exposing to danger or hazard”. • The Chinese give a much better description of risk • >The first is the symbol for “danger”, while • >the second is the symbol for “opportunity”, making risk a mix of danger and opportunity.

6. Risk Management Risk management is present in all aspects of life; It is about the everyday trade-off between an expected reward an a potential danger. We, in the business world, often associate risk with some variability in financial outcomes. However, the notion of risk is much larger. It is universal, in the sense that it refers to human behaviour in the decision making process. Risk management is an attempt to identify, to measure, to monitor and to manage uncertainty.

7. Capital Allocation and RAPM • The role of the capital in financial institutions and the different type of capital. • The key concepts and objective behind regulatory capital. • The main calculations principles in the Basel II the current Basel II Accord. • The definition and mechanics of economic capital. • The use of economic capital as a management tool for risk aggregation, risk-adjusted performance measurement and optimal decision making through capital allocation.

8. Role of Capital in Financial Institution • Absorb large unexpected losses • Protect depositors and other claim holders • Provide enough confidence to external investors and rating agencies on the financial heath and viability of the institution.

9. Type of Capital • Economic Capital (EC) or Risk Capital. An estimate of the level of capital that a firm requires to operate its business. • Regulatory Capital (RC). The capital that a bank is required to hold by regulators in order to operate. • Bank Capital (BC) The actual physical capital held

10. Economic Capital • Economic capital acts as a buffer that provides protection against all the credit, market, operational and business risks faced by an institution. • EC is set at a confidence level that is less than 100% (e.g. 99.9%), since it would be too costly to operate at the 100% level.

11. Risk Measurement- Expected and Unexpected Loss • The Expected Loss (EL) and Unexpected Loss (UL) framework may be used to measure economic capital • Expected Loss: the mean loss due to a specific event or combination of events over a specified period • Unexpected Loss: loss that is not budgeted for (expected) and is absorbed by an attributed amount of economic capital Determined by confidence level associated with targeted rating Losses so remote that capital is not provided to cover them. Probability EL UL Cost 2,500 0 Economic Capital = Difference 2,000 500 Expected Loss, Reserves Total Loss incurred at x% confidence level

12. Minimum Capital Requirements Basel II And Risk Management

13. History

14. Comparison

15. Objectives • The objective of the New Basel Capital accord (“Basel II) is: • To promote safety and soundness in the financial system • To continue to enhance completive equality • To constitute a more comprehensive approach to addressing risks • To render capital adequacy more risk-sensitive • To provide incentives for banks to enhance their risk measurement capabilities

16. MINIMUM CAPITAL REQUREMENTS FOR BANKS(SBP Circular no 6 of 2005)

17. Overview of Basel II Pillars The new Basel Accord is comprised of ‘three pillars’… Pillar I Pillar II Pillar III • Minimum Capital Requirements • Establishes minimum standards for management of capital on a more risk sensitive basis: • Credit Risk • Operational Risk • Market Risk • Supervisory Review Process • Increases the responsibilities and levels of discretion for supervisory reviews and controls covering: • Evaluate Bank’s Capital Adequacy Strategies • Certify Internal Models • Level of capital charge • Proactive monitoring of capital levels and ensuring remedial action Market Discipline Bank will be required to increase their information disclosure, especially on the measurement of credit and operational risks. Expands the content and improves the transparency of financial disclosures to the market.

18. Minimum capital requirements Supervisory review process Market disclosure • How is capital adequacy measured particularly for Advanced approaches? • How will supervisory bodies assess, monitor and ensure capital adequacy? • What and how should banks disclose to external parties? Issue • Better align regulatory capital with economic risk • Evolutionary approach to assessing credit risk • Standardised (external factors) • Foundation Internal Ratings Based (IRB) • Advanced IRB • Evolutionary approach to operational risk • Basic indicator • Standardised • Adv. Measurement • Internal process for assessing capital in relation to risk profile • Supervisors to review and evaluate banks’ internal processes • Supervisors to require banks to hold capital in excess of minimum to cover other risks, e.g. strategic risk • Supervisors seek to intervene and ensure compliance • Effective disclosure of: • Banks’ risk profiles • Adequacy of capital positions • Specific qualitative and quantitative disclosures • Scope of application • Composition of capital • Risk exposure assessment • Capital adequacy Principle Development of a revised capital adequacy framework Components of Basel II Objectives The three pillars of Basel II and their principles • Continue to promote safety and soundness in the banking system • Ensure capital adequacy is sensitive to the level of risks borne by banks • Constitute a more comprehensive approach to addressing risks • Continue to enhance competitive equality Basel II Pillar 1 Pillar 2 Pillar 3

19. Overview of Basel II Approaches (Pillar I) Approaches that can be followed in determination of Regulatory Capital under Basel II Basic Indicator Approach Score Card Operational Risk Capital Standardized Approach Loss Distribution Advanced Measurement Approach (AMA) Internal Modeling Total Regulatory Capital Credit Risk Capital Standardized Approach Foundation Internal Ratings Based (IRB) Advanced Standard Model Market Risk Capital Internal Model