The New Basel Capital Accord

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
  Committees 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 based on a 50 LGD and an average
maturity of 3 years.

• 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

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