Implementing Basel II: Treatment of Credit Risk

1
Implementing Basel IITreatment of Credit Risk

• Presentation by
• Peter Hayward
• peterchayward_at_btinternet.com
• to a Conference held by the Palestine Monetary
  Authority
• November 29, 2008

2
What is capital?

• Capital is a residual. It is the difference
  between the value of assets and the value of
  liabilities.
• Key factor then is the value attributed to assets
• Modern accounting standards require a value that
  represents the amount likely to be recovered,
  commonly described as fair value

3
Asset valuation

• Second step is to attribute a risk factor to the
  asset
• Some assets have higher risk than others
• Basel I attempts to refine the simple leverage
  ratio still used in many countries

4
Risk weighting assets

• Basel I gave low weightings to claims on
  governments and central banks where the risk is
  minimal
• Also a low weighting for short-term claims on
  banks to avoid discouraging banks from holding
  liquidity
• Loans, however, all treated the same to avoid
  prejudging a banks own judgment of relative risk

5
Basel II treatment of credit risk

• A single weighting for loans was felt to distort
  bank behaviour by encouraging high risk assets
  and discouraging low risk assets
• So alternative approaches permitted
• Standardised approach allows external ratings as
  a basis for valuing risk assets
• Advanced approaches permit banks own internal
  ratings

6
Advanced approaches

• Designed for large internationally active banks
  for major industrial countries
• Even in such countries few banks will be able to
  satisfy supervisors that they have sufficient
  data and methodology to be able to satisfy
  supervisors that they can cope with this approach

7
Standardised approaches

• Designed for the majority of banks
• Possibility of using external ratings by approved
  rating agencies here available
• Simplified approach where they are not
• Very similar to existing Basel I

8
Basel Core Principles

• BCP for effective banking supervision a necessary
  precursor for using any alternative in Basel II
• The BCP do not mandate any particular capital
  treatment. Simply that the supervisory authority
  has an adequate and effective regime which is
  enforced
• Effectively this means that the requirement be as
  stringent as Basel I

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BCP - Preconditions

• Implementation of the BCP depends on
• Effective legal system that allows prompt and
  consistent enforcement of contracts and
  possession and disposal of collateral
• A court system that provides consistent and
  reliable judgments that can be enforced
• Accounting and auditing practices that meet
  international requirements

10
Basel II simplified approach

• Without external ratings the approach is very
  similar to the existing Basel I
• Possibility of lower weightings for lending to
  small businesses and housing finance but only if
  stringent conditions are met
• Does not mean that Basel II is not useful

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Pillar II and III

• Pillar II provides much helpful guidance on risk
  management and corporate governance without which
  effective implementation of Basel II is not
  possible
• Pillar III requires disclosure so that depositors
  and lenders to banks as well as shareholders can
  make informed decisions

12
Basel II conclusions

• Arguably for a small country without organised
  financial markets Pillar II is more important
  than Pillar I
• Much of Basel II on risk management and corporate
  governance is required to satisfy the new version
  of the BCP
• This a more important priority than modifying the
  existing capital requirement