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Basel II: Light at the end of the tunnel? . Chris Matten 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?

Chris Matten


Agenda l.jpg

  • 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)