Luo Ping China Banking Regulatory /Commission luoping@cbrc.gov.cm At APEC seminar in Shanghia, Dec 8, 2008

1. Basel II overview and its implications for emerging markets Luo Ping China Banking Regulatory /Commission luoping@cbrc.gov.cm At APEC seminar in Shanghia, Dec 8, 2008

2. Table of content • Basel II overview Agenda • Implications for emerging markets

3. The Organization of the New Accord

4. Outline of the New Accord - Basic Structure

5. 8% > = Operational Risk in the New Basel Capital Accord Tier 1 + Tier 2 + Tier 3 CRWA + 12.5 (MR) + 12.5 (OR)

6. Standardised Approach – Risk Weights 1Risk weighting based on risk weights of sovereign in which the bank is incorporated, but one category less favourable. 2 Risk weighting based on the assessment of the individual bank. 3 Claims on banks of an original maturity of less than three months generally receive a weighting that is one category more favourable than theusual risk weight on the bank’s claim.0

7. Risk sensitivity of various approaches Comparison of Proposed Total Regulatory Capital Charges for Corporations Source for VaR Data: Breitling Study (%) 30 99.97% VaR for unexpected losses 25 Basel II’s standardised approach 20 1988 Basel Accord requirements for claims on corporations 15 10 5 0 AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC and worse

8. Elements of IRB Risk Components Key components • Obligor risk: probability of default (PD) • Transaction risk: loss given default (LGD) • Size of exposure: exposure at default (EAD) Other important elements • Maturity • Borrower size

9. Risk Components: Drivers of Credit Risk

10. Capital provisions Risk Weight Function • The risk weight function is calibrated to “unexpected losses” (UL) only. chosen confidence level Frequency ofloss stress loss  Expected loss unexpected loss 99.9% under IRB 0 amount of loss

11. Definition of Operational Risk • Risk of lossresulting from: • inadequate or failed • internal processes • people • systems • or from external events • includes legal risk • excludes strategic and reputational risk Includes, but not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements

12. -Damage to Physical Assets Natural disasters and human-instigated acts of damage Operational Risk Events Risk Events Examples -Internal Fraud Employee robbery, misreporting positions -External Fraud Hacking, branch robbery -Employment Practices & Workplace Safety Costs and legal liabilities related to workers’ wrongful dismissal, harassment, compensation, etc -Clients, Products & Business Practices Costs and legal liabilities associated with suitability issues, breach of fiduciary duties, sales practices, etc -Business Disruption and System Failures Software, hardware and telecommunication problems -Execution & Processing Errors Front office / mid office / back office execution errors, system failures

13. Basic Indicator Approach (BIA) • Capital charge is based on the average of a fixed percentage (alpha: ) of positive annual gross income (GI) over the previous 3 years • GI: net interest income + net non-interest income as defined by national supervisors and/or national accounting standards • Figures for any year in which annual gross income is negative or zero should be excluded •  =15% • No qualifying criteria – encouraged to comply with sound practices paper • Not expected to be used by internationally active banks or banks with significant operational risk exposures Capital charge = [ (GI1…n x )] /n

14. Basic Indicator Approach (BIA)

15. Standardised Approach (TSA)

16. Standardised Approach (TSA)

17. AMA Qualifying Criteria Frequency of loss Can not be absorbed by a firm Capital Pricing, expenses, reserves Expected loss Unexpected loss Catastrophic loss Amount of loss

18. Basel II - The four principles of Pillar 2 Principle 1 Principle 2 • “Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies as well as their ability to monitor and ensure their compliance with regulatory capital ratios. [SREP] Supervisors should take supervisory action if they are not satisfied with the result of this process” • “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” [ICAAP] Principle 3 Principle 4 • “Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored” • “Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum”

19. 2 views on Pillar 2 • Pillar 2 as a holistic view of capital, with Pillar 1 as a sub-set? Pillar 2 Pillar 2 as an “add-on” to Pillar 1? Pillar 1 Pillar 2 Pillar 1

20. SREP and ICAAP components Basic risk Fairness Supervisory action Other risks Other considerations Peer group Correlation and diversification Credit risk Settlement risk • Supervisory outcomes • Prudential measures • Capital adjustment • Provisioning • Systems and controls • Restriction on business • Reduction of inherent risk Residual risk Securitisation risk Market risk Supervisory review process IRR in non-trading activities Legal and compliance risk • Forward capital planning • Business risks (earnings and costs • Strategy • Stress test Operational risk Liquidity risk Economic & regulatory Environment Source: FSA

21. Table of content • Basel II overview Agenda • Implications for emerging markets

22. Financial Stability Institute survey 2006 Adoption of Basel II seems to be on a very fast track • Among 115 countries, 82 non-Basel Committee member countries intend to implement Basel II, in most cases as of 2008 or 2009.

23. The FSI survey too optimistic? • Moving toward Basel II adoption in the near future may not be the first priority for all non-G10 supervisory authorities. • The IMF also cautions that premature adoption of Basel II in countries with limited capacity could inappropriately divert resources away from more urgent priorities, ultimately weakening rather than strengthening supervision. • As Basel II is designed and calibrated accordingly to G10 countries, adoption of Basel II in many emerging markets will not be able to achieve the same set of objectives for G10 countries

24. China’s approach A dual-track or a bifurcated approach to Basel II • Large banks to adopt Basel II in 2010 with a phase-in period of three years, while the rest of the banking industry will follow the current capital regulation. • Small and medium-sized banks, particularly foreign bank subsidiaries, have the flexibility to opt in.

25. De facto international standard for capital regulation Our strategy for adopting Basel II is driven by • To introduce better corporate governance practices and to enhance risk management and internal controls. • Market and official pressure for large banks to move toward Basel II for either compliance and/or competitive purposes

26. Basel II implementation challenges Challenges • Pro-cyclicality • Alignment of Basel II and IFRS for provisioning • Further enhancement of capital regulation in light of the sub-prime crisis

27. In search for customerization of Basel II On the technical level, changes made in light of our market conditions • Lower threshold for SMEs • More conservative PD estimation • A higher Beta factor to reflect the high incidence of internal fraud and the inadequacies of internal controls

28. Pillar I • IRB approach for credit risk • Internal model approach for market risk • Standardized approach and AMA for op risk Application of pillar I and pillar II

29. And pillar II Pillar II: • All large banks to have an adequate assessment process • key elements of capital planning and management • adequate amount of capital to provide a cushion to cover various risks. • Other prudential measures that would require banks to improve their systems and controls rather than hard and fast rules that would translate the supervisory assessment process into an automatic capital add-on.

30. Basel II: flexible and adaptable Basle Committee’s comprehensive strategy Nov 20, 2008 • Strengthening the risk capture of the Basel II framework (in particular for trading book and off-balance sheet exposures) • Enhancing the quality of Tier 1 capital • Building additional shock absorbers into the capital framework that can be drawn upon during periods of stress and dampen pro-cyclicality

31. Continued search for a better capital regulatory framework • Building additional shock absorbers into the capital framework that can be drawn upon during periods of stress and dampen procyclicality • Evaluating the need to supplement risk-based measures with simple gross measures of exposure in both prudential and risk management frameworks to help contain leverage in the banking system • Strengthening supervisory frameworks to assess funding liquidity at cross-border banks • Leveraging Basel II to strengthen risk management and governance practices at banks • Strengthening counterparty credit risk capital, risk management and disclosure at banks • Promoting globally coordinated supervisory follow-up exercises to ensure implementation of supervisory and industry sound principles