Before jumping to basel III, this is a quick review of Basel II foundations.

1. Basel II – Quick Review
Ali BELCAID – Managing Consultant
It is intended toward people who are looking for a quick review of
the major components of Basel II.

2. Basel II history
 1975 Report to the Governors on the Supervision of Banks’ Foreign
Establishments
 1988 Internal Convergence of Capital Measurement and Capital
Standards
 The Basle I Capital Accord
 1996 Amendment to the Capital Accord to Incorporate Market Risks
 2004 Internal Convergence of Capital Measurement and Capital
Standards : A Revised Framework
 The Basle II Capital Accord

3. Main Objectives
 More risk sensitive: better reflection of risk
 More comprehensive: assesment of additional risks
 Taking into account increasing financial innovation
 Recognising improvment in risk measurement and control
 Putting more emphasis on market discipline
 Maintaining the overall level of regulatory capital

4. Basel II - Structure
Basel II Capital Accord
Pillar 1 Pillar 2 Pillar 3
Minimum capital Supervisory review Market discipline
requirements process
Credit risk Operational
Market risk
risk
Standardized IRB IRB Basic Advanced
Securitization Standardized
Approach Foundation Advanced Indicator Measurement
Approach
Approach Approaches
Internal
Standardized
Model
Approach
Approach

5. Pillar 1 – Capital Ratio
Basle II Pillar 1 - Capital Requirement
Regulatory capital
(Definition unchanged) Minimum required
= capital ratio
Risk-weighted assets (8% minimum unchanged)
(Measure revised)
Credit Risk Market Risk Operational Risk
Exposure + Exposure + Exposure
(Measure revised) (Measure unchanged) (Measure added)

6. Pillar 1 - Credit Risk
Different approaches are now recognised to compute the credit risk exposure
and the associated capital requirement.
 Standardised approach
 New weighting categories
 Recognition of external credit assesment (external ratings)
 Internal Rating Based approach (IRB)
 Foundation IRB
 Advanced IRB

7. Standardized Approach : Rating
Probability of
S&P Moody’s Interpretation
default (1Y)
Investment Grade
AAA Aaa Superior quality – very strong 0,00%
AA+ Aa1
AA Aa2 Good quality 0,01%
AA- Aa3
A+ A1
A A2 Good Capacity to service the debt 0,05%
A- A3
BBB+ Baa1
BBB+ Baa2 Appropriate payment capacity 0,37%
BBB- Baa3
Speculative Grade
BB+ Ba1
Probable but uncertain service of
BB Ba2 1,36%
the debt
BB- Ba3
B+ B1
B B2 Risky debt, speculatif 6,08%
B- B3
CCC – C Caa1 - C Vulnerable, probable default 30,85%
D - Default 100%

8. Standardized Approach : Risk Weight
Based on S&P classification
Risk Weighting categories
AAA to A+ to BBB+ to BB+ to B+ to Below
Unrated
AA- A- BBB- BB- B- B-
Sovereigns 0% 20% 50% 100% 100% 150% 100%
Option 1 20% 50% 100% 100% 100% 150% 100%
Banks
Option 2 20% 50% 50% 100% 100% 150% 50%
ST 3m 20% 20% 20% 50% 50% 150% 20%
Corporates 20% 50% 100% 100% 150% 150% 100%
Retail Portfolio 75%
Asset securitisation 1250 1250
20% 50% 100% 350% 1250%
tranches % %

9. Pillar 1 - IRB Approach
 Under IRB approaches, capital charges are computed on basis of expected credit losses
and unexpected credit losses.
 Capital charges for expected losses are a function of the difference between the
estimation of these losses and the general provisions constituted by the bank.
 3 risk components for the computation of unexpected losses:
 PD = probability of default: over a 1-year time horizon
 LGD = loss given default: prediction of the economic loss after a default has
occured
 EAD = exposure at default: potential exposure of a credit facility at the moment of
default
 M = effective maturity

10. Pillar 1 - IRB Approach
Summary of different approaches for credit risk exposure computations
Standardised Exposure x Risk Weight = RWA
Increasing complexity
Approach
Decreasing capital
IRB Foundation
EAD PD LGD M
IRB
EAD PD LGD M
Advanced
External Valorisation rules – Defined by the Basle Committee and the supervisory authority
Internal Valorisation rules – Computed by the banks’ risk management system

11. Pillar 1 - Credit Risk – Risk Mitigation
 Credit risk mitigation techniques are recognised and allowed by the regulator.
 3 types of risk mitigation:
 Transaction with collateral
 Bank has a claim from a debitor that is fully or partially
covered by a guarantee provided by the debitor
 Simple or comprehensive approach
 Netting
 Bank’s loans and deposits with one signle counterparty are
compensated
 Guarantees and credit derivatives

12. Pillar 2 – Supervisory Review Process
 The second pillar refers to the supervisory review process and risk management
guidance. This applies to all risks that a financial institution is facing, regardless of whether
there is a minimum capital requirement.
 The supervisory review process requires regulators to ensure that each bank has a sound
Financial Risk Management methodology, which enables such institution to be able to
assess the adequate capital requirement.
 Supervisors would be responsible for evaluating how banks are assessing their
capital adequacy needs relative to their risks.
 Supervisors should require remedial actions when capital requirements are not met. These
could include: improve the Risk Management process, improve internal controls, or
increase the regulatory capital.

13. Pillar 2 – Supervision Process
Four Key Principles
1. Banks should have an internal process for assessing their capital in relation to
their risk profile.
2. Supervisors should review and evaluate banks internal process as well as their
ability to monitor and ensure their compliance with regulatory capital ratios.
Supervisors should take appropriate action if they are not satisfied with the
results of this process.
3. Supervisors should expect banks to operate above the minimum regulatory
capital ratios.
4. Supervisors should seek to intervene at an early stage to prevent capital from
falling below the minimum levels required.

14. Pillar 3 – Market Discipline
 The third pillar of the new framework aims to bolster market discipline
through enhanced disclosure by financial institutions.
 Effective disclosure allows the stake-holders of financial institutions to better
understand the risk profiles and to better assess the adequacy of capital
reserves, of such institutions.
 Disclosure of quantitative and qualitative information in four key areas:
 Scope of application
 Composition of capital
 Risk exposure assessment & management processes (information per
risk category)
 Capital adequacy

15. Knowledge, is quite simply question of sharing.
http://intelligenteenterprise.blogspot.com/
http://www.linkedin.com/in/albel