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The New Basel Capital Accord

The New Basel Capital Accord. (Second Consultative Package) . Darryll Hendricks Senior Vice President Federal Reserve Bank of New York February 2, 2001. Major Basel Objectives.

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The New Basel Capital Accord

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  1. The New Basel Capital Accord (Second Consultative Package) Darryll Hendricks Senior Vice President Federal Reserve Bank of New York February 2, 2001

  2. Major Basel Objectives • Better align regulatory capital to underlying risk and provide incentives for banks to enhance their risk management capabilities • Capital adequacy more than compliance with required minimum ratios -- also encompasses supervisory review and market discipline • Meaningful minimum prudential requirements and international consistency

  3. Basel Committee Effort • Release of first Consultative Paper (June 1999) • Significant work has continued • More than 200 comments received from a variety of sources (financial institutions, supervisors, etc.) • Internal ratings-based (IRB) approach to capital adequacy has taken on a greater role in the Committee’s thinking • Strong support for three pillar framework and increased risk differentiation

  4. Second Consultative Package • Released January 16, 2001 • Comprises three parts: • Overview Paper • New Basel Accord or “Rules” document • Supporting Technical Documents • Comment period ends May 31, 2001 • Implementation in 2004

  5. Revisions to capital measures • Definition of capital to remain unchanged • Modifications to denominator of risk-based capital ratios Total Capital (Credit risk + Market risk + Operational risk)

  6. Scope of Application of New Accord • Continues to apply to internationally-active banks on a consolidated basis • Explicit application to consolidated BHCs that are parents of banking groups • Securities activities generally considered banking activities -- full consolidation • Insurance activities not considered banking activities -- general rule to deduct investments and de-consolidate assets

  7. Pillar 1: Minimum Capital • Two approaches to credit risk: • Revised Standardized approach • Internal ratings-based (IRB) approaches • Explicit capital charge for operational risk • Basic indicator, standardized and internal measurement approaches • 1996 Market Risk Amendment to remain largely unchanged

  8. Approaches to Credit Risk • Revised Standardized Approach • Improved risk sensitivity compared to 1988 Accord • IRB Approaches: Foundation & Advanced • Reliance on banks’ own internal risk ratings • Considerably more risk sensitive • Accompanied by minimum standards and disclosure requirements • Allow for evolution over time

  9. Revised Standardized Approach • Similar to 1988 Accord in that risk-weights determined by category of borrower (sovereign, bank, corporate) • Risk weights now based on external credit ratings with unrated credits assigned to 100% risk bucket • Elements of improved risk sensitivity • Elimination of OECD club preference • Greater differentiation for corporate credits • Introduction of higher risk categories (150%) • Option to allow higher risk weights for equities • Targeted at banks desiring simplified capital framework

  10. Key elements of IRB Approaches • Four variables: • Probability of default (PD) of borrower over one-year time horizon • Loss given default (LGD) • Maturity (M) • Exposure at default (EAD) • Risk weights will be function of these four variables and type of exposure (e.g., corporate, retail) • “Foundation” and “Advanced” IRB approaches

  11. Foundation IRB Approach • Banks to develop own estimates of PD for each rating grade • Rigorous minimum standards and disclosure requirements for entry and ongoing use • LGD estimates based on supervisory values • 50% for senior unsecured claims • 75% for subordinated claims • EAD estimates based on supervisory values • 75% for irrevocable undrawn commitments

  12. Foundation IRB Approach (cont.) • Likely no maturity distinction • Assume single average maturity (e.g., 3 years) • Standardized treatment of credit risk mitigation techniques (H & w framework) to apply

  13. Advanced IRB Approach • Banks’ own estimates of PD, LGD, EAD • Subject to rigorous but attainable standards that reflect the need for long data series • Maturity adjustments to be incorporated • Additional work to be conducted • Greater flexibility in the treatment of collateral, guarantees and credit derivatives • Floor equal to 90% of simplified foundation IRB charges imposed for first two years

  14. Example Risk Weights under Foundation IRB Approach • Risk weights for Advanced IRB approach scaled up and down to reflect maturity of the exposure • Granularity adjustment to result in increased capital charges for concentrated portfolios of exposures * Risk weights based on a 50% LGD and an average maturity of 3 years.

  15. IRB Absolute Capital • How much capital is needed to cover the risk? • How conservative do minimum requirements need to be? • How will the new capital adequacy framework compare to the current Accord? • What is the impact on an average bank? • What incentives should be provided to move toward the more advanced approaches? • Second CP starting point for dialogue with industry • Survey evidence to inform IRB calibration

  16. IRB Approaches: Ongoing Work • Retail exposures • Project finance exposures • Treatment of equities • Slope of maturity adjustment • Absolute capital • Asset securitization

  17. Credit Risk Mitigation • Expansion of regulatory treatment for collateral, guarantees, credit derivatives and on-balance sheet netting • Similar rules-based treatment in standardized and foundation IRB approaches • Simple approach (substitution based) • Comprehensive approach (captures residual risks) • Recognition of internal assessments under advanced IRB approach

  18. Credit Risk Mitigation (cont.) • Broader range of collateral accepted, including listed equities and all investment-grade debt • Value of collateral subject to haircuts (H) and a floor (w) on the total capital reduction • Domestic repo market transactions carved out from capital requirements • Expanded recognition of guarantors (sovereigns, banks, corporates rated A or better) • Credit derivatives explicitly addressed

  19. Asset Securitization • Proposals for treatment of explicit risks in standardized and IRB approaches • Deduction of first loss protection held by bank • Committee considering treatment of implicit risks • Potential for securitized assets to return to banks’ balance sheet • Future work plan • IRB treatment, synthetic securitizations, implicit and other residual risks, etc.

  20. Operational Risk • Narrowed focus to treatment of operational risk • A range of approaches outlined • Basic indicator approach (measure of total activity) • Standardized approach (business line) • Internal measurement approach • Eligibility to use approaches tied to compliance with measurement and control criteria • Consultation with industry to continue

  21. Interest Rate Risk • Interest rate risk in the banking book to be assessed through supervisory review (Pillar 2) • Guidance provided for “outlier” banks -- those for which economic value of capital declines by more than 20% from a 200 bp interest rate shock • Supervisory options include asking outlier banks to reduce risk, hold a specific amount of capital or some combination thereof

  22. Pillar 2: Supervisory Review • Consultative Package outlines four principles for supervisory review: • Each bank should assess its internal capital adequacy in light of its risk profile • Supervisors should review internal assessments • Recommendation that banks hold capital above regulatory minimums • Supervisors should intervene at an early stage

  23. Pillar 3: Market Discipline • Promote market discipline through greater transparency and improved public disclosure • Disclosure “recommendations” and “requirements” particularly important given increased reliance on internal assessments • IRB disclosure requirements include: • PDs, LGDs, and EADs within portfolios • Composition and assessment of risk • Performance of internal assessments

  24. Pillar 3: Market Discipline • “Strong” recommended disclosures put forth: • Scope of application • Components of regulatory capital (Tier 1, Tier 2, etc.) • Risk exposures and assessments (credit, market and operational risk) • Capital adequacy disclosures (risk-based capital ratios) • Appropriate level of data disaggregation subject to further work

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