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Basel Capital Adequacy Framework. Eric Falkenstein Vice President ICM Credit Risk Management for Asian Financial Institutions June 28, 2000 [email protected] 212.553.7231. Topics. The current capital regulations The current Basel dialogue Next Steps. What is Bank Capital?.

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Basel capital adequacy framework
Basel Capital Adequacy Framework

Eric Falkenstein

Vice President

ICM Credit Risk Management for Asian Financial Institutions

June 28, 2000

[email protected]



  • The current capital regulations

  • The current Basel dialogue

  • Next Steps

What is Bank Capital?

Bank Capital is:Bank Capital is not:

- Common Equity - Customer Deposits

- Preferred Equity - Short-term Debt

- Subordinated Debt - Other Liabilities

- Loan Loss Reserve - Goodwill

Regulatory capital measures
Regulatory Capital Measures

A) Tier I or Core Capital Ratio

  • Tier I equity divided by risk-weighted assets

  • Risk-weighted assets have 100% weighting for loans, 20% weighting for OECD bank debt, 0% for Treasury debt

  • Tier I equity consists mainly of common stock, perpetual preferred stock, minus intangibles

    B) Total Capital Ratio

  • Tier I + Tier II equity divided by risk-weighted assets. Tier II capital consists mainly of qualifying subordinated debt and long-term preferred stock, plus Loan Loss Reserve (up to 1.25% of risk-weighted assets)

Regulatory requirements for risk based capital ratios
Regulatory Requirements for Risk-based Capital Ratios

Basic “Well-Capitalized”

Tier 1 or Core Capital 4% 6%

Tier 1 + Tier 2 or Total Capital 8% 10%

Limitations of the current risk based capital approach
Limitations of the Current Risk-based Capital Approach

  • Risk-weightings are not truly risk sensitive: an Aaa loan has the same risk-weighting as a B loan.

  • Capital methodology falling behind financial innovations: securitization, derivatives, netting, etc.

  • Ignores capital needed for operating, interest rate, market and other risks.

Credit risk modeling current practice and applications
Credit Risk Modeling: Current Practice and Applications


1) Provide summary of best practices of credit models

2) Assess the potential applications and limitations of credit risk models for supervisory and regulatory purposes

3) Solicit feedback

Basel key literature
Basel, Key Literature

  • No. 4 International Convergence of Capital Measurement and Capital Standards, July 1988 (the Basel Capital Accord)

  • No. 55 Credit Risk Modeling: Current Practices and Applications, April 1999

  • No. 50, A new capital adequacy framework, June 1999

  • No. 71, Summary of responses received on the report "Credit Risk Modeling: Current Practices and Applications", May 2000

    download at www.

Credit risk modeling current practice and applications 4 99
Credit Risk Modeling: Current Practice and Applications (4/99)

Current credit management methods potentially rational direction for future refinements, yet there are limitations:

1) Lack of Data.

2) Validation (see #1).

Key quotes:

“Regulators would have to be confident that models were used to actively manage risk, and that conceptually sound, empirically validated, and produce capital assessments comparable across financial institutions.”

“Significant hurdles, principally concerning data availability and model validation, still need to be cleared before these objectives can be met, and the Committee sees difficulties in overcoming these hurdles in the timescale envisaged for amending the capital Accord."

A new capital adequacy framework 6 99
A New Capital Adequacy Framework (6/99) (4/99)

3 pillars to the revised capital framework

1) minimums (most of the focus)

2) supervisory review (probably more important!)

3) market discipline (good idea, but need broad liquid debt markets)

New ideas:

  • May have more or less than 100% weightings on corporate loans

  • Internal credit models could guide capital allocations

  • Address derivatives and netting agreements more logically

A new capital adequacy framework 6 991
A New Capital Adequacy Framework 6/99 (4/99)

An example of the new refinements put forth by Basel:

Summary of responses 5 00
Summary of Responses (5/00) (4/99)

Subject: Loss Given Default

comment: US and European data is all that's really available

Subject: Shape of the density function of losses

comment: Unknown (lognormal? Normal?), but not considered a major limitation

Subject: Conditional upon the economy

comment: Need sound linkage

Summary of responses 5 001
Summary of Responses (5/00) (4/99)

Subject: Conceptual Approaches

Comments: Credit Value-at-Risk and/or Scenario

Subject: Default mode and Mark-to-Market Mode

Comments: Mark-to-market superior perhaps

Subject: Horizon

Comments: Not a big issue, 1 year likely

Summary of responses 5 002
Summary of Responses (5/00) (4/99)

Subject: Parameter Specifications


US corporate bond rating information good

Use conservative assumptions when missing data


Start collecting data as soon as possible

Subject: Validation


Stress tests

Panel data set compiled from regulatory bodies

Summary of responses 5 003
Summary of Responses (5/00) (4/99)

Subject: Supervision and Regulatory Application


Portfolio by portfolio

Link evaluation of credit models to how models are actually used

General comment:

Simple models not necessarily bad

Don't use US data to parameterize models

Next steps
Next Steps (4/99)

Best Case Scenario:

Basel will make preliminary proposal by February 2001.

Phase-in will start in January 2003.

Probable Scenario: year or two later...