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Basel II: Light at the end of the tunnel? . Chris Matten [email protected] PWC. Agenda. The final Framework What next?. The final Framework is finally here!. Agreed by Central Bank Governors and Heads of Banking Supervision for all G10 countries Intended for broader use

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Basel II: Light at the end of the tunnel?

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Basel ii light at the end of the tunnel l.jpg

Basel II:Light at the end of the tunnel?

Chris Matten

[email protected]


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  • The final Framework

  • What next?

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The final Framework is finally here!

  • Agreed by Central Bank Governors and Heads of Banking Supervision for all G10 countries

  • Intended for broader use

  • EU to proceed with Risk-Based Capital Directive

    • PwC/NIESR Impact Study completed and published in April 04

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Changes to CP3 (1)

  • New transitional arrangements, with A-IRB/AMA delayed by one year

  • Banks must address any shortfall in the floor by increasing stated RWAs under Basel II

  • Intended to assist US banks and others in meeting the deadlines

  • Flagged 11 May 04

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Changes to CP3 (2)

  • Scaling factor introduced

  • Initially set at 1.06

  • I.e. whatever the resulting calculation under Basel II, result must be multiplied by 1.06

  • Intended to maintain same level of aggregate capital in the banking system

  • Flagged 11 May 04

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Changes to CP3 (3)

  • Segregation of EL from UL under IRB risk-weights

  • Different, simpler RW function for defaulted assets

    • To reflect potential adverse move in LGDs and EAD

  • Provisions under IRB to be held equal to EL

    • Any shortfall to be deducted equally from Tier 1 and Tier 2

    • Any surplus may be allowed in Tier 2, up to 0.6% of RWAs

  • Intended to address criticism of double-counting of EL

  • BUT raises problems with IFRS (IAS 39)

  • Covered in 30 Jan 04 press release



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Changes to CP3 (4)

  • Reduction in RW factors for QRRE

  • Fixed correlation factor (0.04) rather than a function of PD

  • Intended to reduce RW esp. for credit cards

  • Flagged 11 May 04

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Changes to CP3 (5)

  • Default RW for other assets is 100%

  • Intended to fix a ‘hole’ in CP3 which did not specify a RW for other assets

  • BUT does not seem right

    • Standardised approach defaults to Basel 1988 where RW not specified

    • Under IRB, cash would appear to take 100% RW! (vs 0% under standarised approach)

  • Awaiting clarification from BCBS

  • Local supervisors expected to be pragmatic in interpretation

  • New provision not previously announced

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Changes to CP3 (6)

  • LGDs to be based on economic downturn, not average

  • Need to calculate (a) default-weighted average over full observation period (ideally covering at least one cycle), and (b) potential LGD ‘which reflects economic downturn conditions’.

  • LGD to be used is higher of (a) and (b)

  • Intention is for single LGD, but in practice?

  • Flagged 11 May 04

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Changes to CP3 (7)

  • Provisions for securitised assets under IRB have been completely revised

  • Internal Assessment Approach (IAA) introduced for ABCP

  • No differentiation under RBA for issuers and investors

  • Intended to address industry criticisms

  • Flagged 30 Jan 04

RBA - ratings based approach; SF – Supervisory Formula; IAA – Internal Assessment Approach

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Changes to CP3 (8)

  • Some diversification benefit for banks using AMA

  • Overseas subsidiaries which are not ‘significant’ can have allocated portion of group-wide diversified AMA

  • ‘Significant’ means in the context of the banking group, not the country of operation

  • BUT “banking subs whose host supervisors determine that must calculate stand-alone capital requirements may not incorporate group-wide diversification benefits…”

  • Intended to provide relief from multiple AMA calculations in large banking groups

  • Covered in 30 Jan 04 press release

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Importance of Pillar 2

  • Principle 1: “ Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels”

  • Board and senior management oversight

  • Sound capital assessment

    • Policies and procedures.. to measure.. all material risks

    • Process to relate capital to level of risk

  • Comprehensive assessment of all risks

  • Monitoring and reporting

  • Internal control review

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2 views on Pillar 2

  • Pillar 2 as a holistic view of capital, with Pillar 1 as a sub-set

Pillar 2

Pillar 1

Pillar 2

  • Pillar 2 as an “add-on” to Pillar 1

Pillar 1

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Does Principle 1 require an EC model?

  • Adoption of an EC model is consistent with Principle 1

  • BUT other approaches may also qualify:

    • Stress tests

    • DFA

    • Scenario analysis

  • Adoption of an EC model should be driven primarily by business demands; Pillar 2 compliance is then an added requirement

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  • The final Framework

  • What next?

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The final Framework is finally here!… or is it?

  • Need to leave door open for US lawmakers and supervisors

    • Framework is a ‘statement of the Committee agreed by all its members’

    • Adoption procedures ..’will include additional impact assessments…as well as further opportunities to comment’

  • National supervisors may set higher levels for Pillar 1 and/or specific requirements in Pillar 2

    • Eg APRA – IRR capital in Pillar 1 for sophisticated banks

    • Eg EBK – ‘Swiss finish’ higher risk weights

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BCBS work-in-progress (1)

  • “Double-default”issues

    • Recognition of double-default effects necessary

    • BUT need to work through the issues

    • Aim to produce a solution prior to Basel II implementation

  • Trading book issues

    • Potential future exposure (EADs)

    • Counterparty risk

    • Joint working group with IOSCO due to report back in 2005

  • Re-calibration of scaling factor

  • Definition of ‘eligible capital’

    • Treatment of provisions (EL) tends to depress Tier 1 relative to total CAR

    • Uniform standards on hybrid Tier 1 required

    • No changes expected prior to implementation of Basel II.

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BCBS work-in-progress (2)

  • Encouragement of ‘Economic Capital’ re-introduced

    • Does Pillar 2 require an EC model?

    • Can other methods (DFA, stress testing, scenario analysis etc) apply?

  • Use of full credit risk models an option for the future

    • “IRB..represents a point on the continuum between purely regulatory measures….and internal credit risk models”

  • Future clarification of suitable AMA approaches for operational risk

    • BCBS waiting for an industry standard to emerge.

  • Co-ordination with IAS

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Implementation in EU

  • Risk-Based Capital Directive in preparation

  • 4 options for implementation:

    1. Full implementation from 31 Dec 06

    2. Any option allowed during 2007, including old Accord and Basel II, with

    full adoption of Basel II from 31/12/07

    3. Same as 2, but A-IRB/AMA only allowed from 31/12/07

    4. Delay implementation until 31/12/07

  • This is a political issue as much as a technical one

  • Parity with US banks as well as within EU a critical factor

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Implementation in Singapore

  • Locally-incorporated full banks to comply by 31/12/06

  • Choice of methodologies: no compulsion, no prohibition

  • Branches to follow home country supervisor requirements

  • Restricted licence banks: currently net worth and other criteria, but Basel II a possible future option

  • Finance companies: remain on Basel 1988 (as amended)

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Implementation in Malaysia

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