Basel Accord

Basel Accords Basel II and beyond: Current status across the world. Table of Contents Introduction2 Need for the study2 The Need for Regulation2 Goals and Tools for Bank Regulation and Supervision3 The Basel I Accord4 Basel Committee on Banking Supervision (BCBS)4 1988 Basel Accord5 1996 Amendment to include Market Risk6 Salient Features6 Evolution of Basel Committee Initiatives6 The New Accord (Basel II)7 The Need for Basel II8 PILLAR I: Minimum Capital Requirements8 Credit Risk9 Operational Risk11 PILLAR 2: Supervisory Review Process12 Pillar 3: Market Discipline13 Criticism of Basel II13

Challenges for developing countries16 Standardized Approach-related16 IRB Approach-related17 Policy Implications18 Global survey by Financial Stability Institute (FSI)19 Impact of the financial crisis on Basel II implementation plans19 Global results of the survey20 Basel II in China and India21 Bibliography22 Annexure23 Various Risks23 Liquidity Risk23 Introduction The Basel Accords refer to the banking supervision Accords (recommendations on banking laws and regulations) — Basel I and Basel II issued and Basel III under development — by the Basel Committee on Banking Supervision (BCBS).

They are called the Basel Accords as the BCBS maintains its secretariat at the Bank of International Settlements in Basel, Switzerland and the committee normally meets there. The Basel I Capital Accord, published in 1988, represented a major breakthrough in the international convergence of supervisory regulations concerning capital adequacy. Its main objectives were to promote the soundness and stability of the international banking system and to ensure a level playing field for internationally active banks.

Even though it was originally intended solely for internationally active banks in G-10 countries, it was eventually recognized as a global standard and adopted by over 120 countries around the world. Need for the study Basel Accord has become a worldwide excepted norm across the banking industry. Basel norm compliance has become almost a compulsion for any bank that intends to set up its branch operation in other country than its own home country. Even the country governments and Regulators are making it a part of their regulations for banking industry.

Hence it becomes of prime importance to study Basel Accord and latest developments in it. The Need for Regulation Banking is one of the most heavily regulated businesses since it is a very highly leveraged (high debt-equity ratio or low capital-assets ratio) industry. In fact, it is an irony that banks, which constantly judge their borrowers on debt-equity ratio, have themselves a debt-equity ratio far too adverse than their borrowers! In simple words, they earn by taking risk on their creditors’ money rather than shareholders’ money.

And since it is not their money (shareholders’ stake) on the block, their appetite for risk needs to be controlled. Goals and Tools for Bank Regulation and Supervision The main goal of all regulators is the stability of the banking system. However, regulators cannot be concerned solely with the safety of the banking system, for if that was the only purpose, it would impose a narrow banking system, in which checkable deposits are fully backed by absolutely safe assets – in the extreme, currency.

Coexistent with this primary concern is the need to ensure that the financial system operates efficiently. As we have seen, banks need to take risks to be in business despite a probability of failure. The twin supervisory or regulatory goals of stability and efficiency of the financial system often seem to pull in opposite directions and there is much debate raging on the nature and extent of the trade-off between the two. Though very interesting, it is outside the scope of this report to elaborate upon.

Instead, let us take a look at the list of some tools that regulators employ: * Restrictions on bank activities and banking-commerce links: To avoid conflicts of interest that may arise when banks engage in diverse activities such as securities underwriting, insurance underwriting, and real estate investment. * Restrictions on domestic and foreign bank entry: The assumption here is that effective screening of bank entry can promote stability. * Capital Adequacy: Capital serves as a buffer against losses and hence also against failure.

Capital adequacy is deemed to control risk appetite of the bank by aligning the incentives of bank owners with depositors and other creditors. * Deposit Insurance: Deposit insurance schemes are to prevent widespread bank runs and to protect small depositors but can create moral hazard (which means in simple terms the propensity of both firms and individuals to take more risks when insured). * Information disclosure & private sector monitoring: Includes certified audits and/or ratings from international rating agencies. Involves directing banks to produce accurate, comprehensive nd consolidated information on the full range of their activities and risk management procedures. * Government Ownership: The assumption here is that governments have adequate information and incentives to promote socially desirable investments and in extreme cases can transfer the depositors’ loss to tax payers! Government ownership can, at times, promote financing of politically attractive projects and not the economically efficient ones. * Mandated liquidity reserves: To control credit expansion and to ensure that banks have a reasonable amount of liquid assets to meet their liabilities. Loan classification, provisioning standards & diversification guidelines: These are controls to manage credit risk. The Basel I Accord Basel Committee on Banking Supervision (BCBS) On 26th June 1974, a number of banks had released Deutschmarks to Bank Herstatt in Frankfurt in exchange for dollar payments that were to be delivered in New York. Due to differences in time zones, there was a lag in dollar payments to counter-party banks during which Bank Herstatt was liquidated by German regulators, i. e. before the dollar payments could be affected.

The Herstatt accident prompted the G-10 countries (the G-10 is today 13 countries: Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States) to form, towards the end of 1974, the Basel Committee on Banking Supervision (BCBS), under the auspices of the Bank for International Settlements (BIS), comprising of Central Bank Governors from the participating countries. BCBS has been instrumental in standardizing bank regulations across jurisdictions with special emphasis on defining the roles of regulators in cross-jurisdictional situations.

The committee meets four times a year. It has around 30 technical working groups and task forces that meet regularly. `The Committee does not possess any formal supranational supervisory authority, and its conclusions do not, and were never intended to, have legal force. Rather, it formulates broad supervisory standards and guidelines and recommends statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements – statutory or otherwise – which are best suited to their own national systems.

In this way, the Committee encourages convergence towards common approaches and common standards without attempting detailed harmonisation of member countries’ supervisory techniques. One important objective of the Committee’s work has been to close gaps in international supervisory coverage in pursuit of two basic principles: that no foreign banking establishment should escape supervision; and that supervision should be adequate. ’ – BCBS. 1988 Basel Accord In 1988, the Basel Committee published a set of minimal capital requirements for banks, known as the 1988 Basel Accord.

These were enforced by law in the G-10 countries in 1992, with Japanese banks permitted an extended transition period. The 1988 Basel Accord focused primarily on credit risk. Bank assets were classified into five risk buckets i. e. grouped under five categories according to credit risk carrying risk weights of zero, ten, twenty, fifty and one hundred per cent. Assets were to be classified into one of these risk buckets based on the parameters of counter-party (sovereign, banks, public sector enterprises or others), collateral (e. g. mortgages of residential property) and maturity.

Generally, government debt was categorised at zero per cent, bank debt at twenty per cent, and other debt at one hundred per cent. 100%. OBS exposures such as performance guarantees and letters of credit were brought into the calculation of risk weighted assets using the mechanism of variable credit conversion factor. Banks were required to hold capital equal to 8% of the risk weighted value of assets. Since 1988, this framework has been progressively introduced not only in member countries but also in almost all other countries having active international banks.

The 1988 accord can be summarized in the following equation: Total Capital = 0. 08 x Risk Weighted Assets (RWA) The accord provided a detailed definition of capital. Tier 1 or core capital, which includes equity and disclosed reserves, and Tier 2 or supplementary capital, which could include undisclosed reserves, asset revaluation reserves, general provisions & loan–loss reserves, hybrid (debt/equity) capital instruments and subordinated debt. 1996 Amendment to include Market Risk

In 1996, BCBS published an amendment to the 1988 Basel Accord to provide an explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities. This amendment was brought into effect in 1998. Salient Features * Allows banks to use proprietary in-house models for measuring market risks. * Banks using proprietary models must compute VAR daily, using a 99th percentile, one-tailed confidence interval with a time horizon of ten trading days using a historical observation period of at least one year. The capital charge for a bank that uses a proprietary model will be the higher of the previous day’s VAR and three times the average of the daily VAR of the preceding sixty business days. * Use of `back-testing’ (ex-post comparisons between model results and actual performance) to arrive at the `plus factor’ that is added to the multiplication factor of three. * Allows banks to issue short-term subordinated debt subject to a lock-in clause (Tier 3 capital) to meet a part of their market risks. Alternate standardized approach using the `building block’ approach where general market risk and specific security risk are calculated separately and added up. * Banks to segregate trading book and mark to market all portfolio/position in the trading book. * Applicable to both trading activities of banks and non-banking securities firms. Evolution of Basel Committee Initiatives The Basel I Accord and the 1996 Amendment thereto have evolved into Basel II, as depicted in the figure above. The New Accord (Basel II)

Close on the heels of the 1996 amendment to the Basel I accord, in June 1999 BCBS issued a proposal for a New Capital Adequacy Framework to replace the 1988 Accord. The proposed capital framework consists of three pillars: minimum capital requirements, which seek to refine the standardised rules set forth in the 1988 Accord; supervisory review of an institution’s internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline as a complement to supervisory efforts. The accord has been finalized recently on 11th May 2004 and the final draft is expected by the end of June 2004.

For banks adopting advanced approaches for measuring credit and operational risk the deadline has been shifted to 2008, whereas for those opting for basic approaches it is retained at 2006. The Need for Basel II The 1988 Basel I Accord has very limited risk sensitivity and lacks risk differentiation (broad brush structure) for measuring credit risk. For example, all corporations carry the same risk weight of 100 per cent. It also gave rise to a significant gap between the regulatory measurement of the risk of a given transaction and its actual economic risk.

The most troubling side effect of the gap between regulatory and actual economic risk has been the distortion of financial decision-making, including large amounts of regulatory arbitrage, or investments made on the basis of regulatory constraints rather than genuine economic opportunities. The strict rule based approach of the 1988 accord has also been criticised for its `one size fits all’ prescription. In addition, it lacked proper recognition of credit risk mitigants such as credit derivatives, securitisation, and collaterals.

The recent cases of frauds, acts of terrorism, hacking, have brought into focus the operational risk that the banks and financial institutions are exposed to. The proposed new accord (Basel II) is claimed by BCBS to be `an improved capital adequacy framework intended to foster a strong emphasis on risk management and to encourage ongoing improvements in banks’ risk assessment capabilities’. It also seeks to provide a `level playing field’ for international competition and attempts to ensure that its implementation maintains the aggregate regulatory capital requirements as obtaining under the current accord.

The new framework deliberately includes incentives for using more advanced and sophisticated approaches for risk measurement and attempts to align the regulatory capital with internal risk measurements of banks subject to supervisory review and market disclosure. PILLAR I: Minimum Capital Requirements There is a need to look at proposed changes in the measurement of credit risk and operational risk. Credit Risk Three alternate approaches for measurement of credit risk have been proposed. These are: • Standardised • Internal Ratings Based (IRB) Foundation • Internal Ratings Based (IRB) Advanced

The standardised approach is similar to the current accord in that banks are required to slot their credit exposures into supervisory categories based on observable characteristics of the exposures (e. g. whether the exposure is a corporate loan or a residential mortgage loan). The standardised approach establishes fixed risk weights corresponding to each supervisory category and makes use of external credit assessments to enhance risk sensitivity compared to the current accord. The risk weights for sovereign, inter-bank, and corporate exposures are differentiated based on external credit assessments.

An important innovation of the standardised approach is the requirement that loans considered `past due’ be risk weighted at 150 per cent unless, a threshold amount of specific provisions has already been set aside by the bank against that loan. Credit risk mitigants (collaterals, guarantees, and credit derivatives) can be used by banks under this approach for capital reduction based on the market risk of the collateral instrument or the threshold external credit rating of recognised guarantors. Reduced risk weights for retail exposures, small and medium size enterprises (SME) category and residential mortgages have been proposed.

The approach draws a number of distinctions between exposures and transactions in an effort to improve the risk sensitivity of the resulting capital ratios. The IRB approach uses banks’ internal assessments of key risk drivers as primary inputs to the capital calculation. The risk weights and resultant capital charges are determined through the combination of quantitative inputs provided by banks and formulae specified by the Committee. The IRB calculation of risk weighted assets for exposures to sovereigns, banks, or corporate entities relies on the following four parameters: Probability of default (PD), which measures the likelihood that the borrower will default over a given time horizon. * Loss given default (LGD), which measures the proportion of the exposure that will be lost if a default occurs. * Exposure at default (EAD), which for loan commitment measures the amount of the facility that is likely to be drawn in the event of a default. * Maturity (M), which measures the remaining economic maturity of the exposure. The differences between foundation and advanced IRB approaches are captured in the table below based on who provides the inputs on the various parameters:

For retail exposures only advanced IRB is prescribed where, obviously, the maturity parameter is omitted. Securitisation, provisions and specialized lending have been accorded special treatment. Operational Risk Within the Basel II framework, operational risk is defined as the risk of losses resulting from inadequate or failed internal processes, people and systems, or external events. Operational risk identification and measurement is still in an evolutionary stage as compared to the maturity that market and credit risk measurements have achieved.

As in credit risk, three alternate approaches are prescribed: • Basic Indicator • Standardised • Advanced Measurement (AMA) The following table captures the provisions of the proposed accord across different approaches: Compliance of BCBS’ `Sound Practices for Management & Supervision of Operational Risk’ is also required. PILLAR 2: Supervisory Review Process Pillar 2 introduces two critical risk management concepts: the use of economic capital, and the enhancement of corporate governance, encapsulated in the following four principles:

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. The key elements of this rigorous process are: • board and senior management attention; • sound capital assessment; • comprehensive assessment of risks; • monitoring and reporting; and • internal control review. Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios.

Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process. This could be achieved through: • on-site examinations or inspections; • off-site review; • discussions with bank management; • review of work done by external auditors; and • periodic reporting. Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.

Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored. Prescriptions under Pillar 2 seek to address the residual risks not adequately covered under Pillar 1, such as concentration risk, interest rate risk in banking book, business risk and strategic risk. `Stress testing’ is recommended to capture event risk.

Pillar 2 also seeks to ensure that internal risk management process in the banks is robust enough. The combination of Pillar 1 and Pillar 2 attempt to align regulatory capital with economic capital. Pillar 3: Market Discipline The focus of Pillar 3 on market discipline is designed to complement the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2). With this, the Basel Committee seeks to enable market participants to assess key information about a bank’s risk profile and level of capitalization—thereby encouraging market discipline through increased disclosure.

Public disclosure assumes greater importance in helping banks and supervisors to manage risk and improve stability under the new provisions which place reliance on internal methodologies providing banks with greater discretion in determining their capital needs. There has been some confusion on the extent, medium, confidentiality and materiality of such disclosures. It has been agreed that such disclosures will depend on the legal authority and accounting standards existing in each country.

Efforts are in progress to harmonise these disclosures with International Financial Reporting Standards’ (IFRS’) Board Standards (International Accounting Standards 30 & 32). Criticism of Basel II It must acknowledge the fact that any attempt to regulate the complexity that current global financial infrastructure presents is far from easy. Pro-cyclicality In simple terms, pro-cyclicality means that banks governed by Basel II (capital tied to risks) will loosen credit in `good times’ (when risk perceptions are low) and restrict it when times are bad (when risks rise again).

If most banks act in this fashion, having adopted the accord, they would accentuate the crisis in bad times, jeopardizing stability. Risk-based financial regulation is inherently pro-cyclic. The pro-cyclicality springs from the treatment of risk as an exogenous variable, whereas in reality, it is endogenous. The actions of a market participant based on a predictive model affects the market and if many participants are using the same model, their combined actions render the basic assumptions of the model on the heterogeneous nature of the market (normal distribution) false.

Credit Risk Concerns Using the standardized approach, un-rated corporate borrowers attract less risk weight (100 per cent) than the lowest rated borrower (150 per cent) giving incentives to high-risk borrowers to remain un-rated. Another argument against Basel II is that it does not resort to full credit risk modelling–it fails to take into account portfolio effects of risk mitigation through diversification. Cost of implementation

Even though a cost-benefit assessment of the framework’s implementation will vary by country, the operational requirements (especially for the IRB Approach) will likely be prohibitively expensive for many smaller developing countries. Large international banks are already closer to the adoption of Basel II-compatible risk management systems and can spread the costs over a larger asset base. Supervisors will need to decide between trying to maintain a level playing field by keeping all banks on a less advanced capital standard, or allowing some banks to adopt the IRB Approach.

Inadequate supervisory capacity The greater burden and wide discretion placed on them by Pillars 1 (e. g. model validation) and 2 (e. g. treatment of other risks) will stretch scarce supervisory resources and will require a step-up improvement in available skills and information technology. In addition, regulators must have the ability to carry out ex-ante impact analysis before rule issuance, which represents a substantial change from an environment that has traditionally been compliance-driven.

Even when supervisors build up required skills, it is likely that many of them will be poached by domestic banks that are eager to adopt these new risk management tools and able to provide them with higher salaries – an unfortunate consequence of the fact that regulators often drive (rather than respond to) change in many developing countries. Impact on domestic banking systems is not fully understood. The multiplicity of approaches places a de facto end to the notion of a level playing field among banks under the same regulatory jurisdiction.

Firstly, there will likely be a redistribution of capital requirements within and across banks depending on their individual customer, product, and portfolio mixes; the dislocation in bank behavior that may result from this redistribution has not generally been sufficiently studied or considered. Secondly, smaller domestic banks will likely be at a competitive disadvantage since they will only afford to adopt less sophisticated (and more capital-onerous) approaches to credit risk and will probably be subject to moral hazard (attracting riskier assets) because of their inability to properly differentiate and price for risk.

Thirdly, to the extent that they are not already operating under an economic capital framework, a few less sophisticated foreign banks may cut back/refocus their exposures to some developing countries in response to the revised capital requirements. Home-host supervisory coordination Given the significant presence of G-10 banks in developing countries and the considerable discretion given to national supervisory authorities, a significant degree of home-host cooperation is essential to ensure consistency across jurisdictions. This cooperation must address a undamental asymmetry of incentives: since the local subsidiary or branch is usually small compared to the overall size of the international bank but oftentimes large relative to the rest of the domestic banking system, materiality (as well as resource) considerations might discourage the home country supervisor from monitoring risks in the bank’s activities in the host country, practically deferring to the host rules. A dual treatment with separate guidelines would lead the bank having to comply with the more onerous of the two requirements and would lead to inefficient duplication.

Alternatively, a concerted approach could be established whereby the two regulators agree on a single set of supervisory arrangements that satisfies both home and host requirements. Consultations on developing a framework to facilitate closer practical cooperation among supervisors are currently taking place in several Basel Committee working groups, the most important of which are the Accord Implementation Group (AIG) and the Core Principles Liaison Group (CPLG). Ineffective Pillar 3

Aside from the broader issue of the relevance of specific disclosures for market participants, this Pillar is not a very useful discipline device in countries with small private markets or few incentives for creditors to monitor banks (e. g. due to presence of implicit public guarantees). In addition, the Pillar might be inapplicable in those countries whose systems are dominated by foreign banks, since the latter will likely have entered by purchasing and delisting the domestic institution.

Since those banks are not obliged to publicly disclose information for their operations in such jurisdictions (unless requested by the domestic authorities), there is little market transparency or discipline. Challenges for developing countries Standardized Approach-related * Considerable and perhaps excessive supervisory discretion. Given the substantial discretion given to supervisory authorities in the Standardized and the Simplified Standardized Approach, it is highly likely that many will opt for maintaining the ‘painless’ status quo in which there is little elation of capital requirements to risk. In particular, this would imply that sovereign exposures will continue to be riskweighted at 0%, which (together with the valuation of such debt at face value) has encouraged excessive sovereign lending by domestic banks to the detriment of private sector lending and financial intermediation in many developing countries. * Little experience with ECAIs. There is a low ratings penetration in most developing countries, which tends to be corporations concentrated in a few large corporates.

The sample of counterparties that are rated is also biased to the extent that only companies with higher creditworthiness tend to seek external ratings. These two facts, combined with the likely adoption of a Simplified Standardized Approach by many developing countries, would result in little meaningful change to (or redistribution of) capital requirements compared to Basel I. Finally, the ECAIs industry in developing countries is only now being developed, so there is little local experience with its proper functioning and regulation.

IRB Approach-related * Unavailability of required risk data in easily accessible or comprehensive format. Historical loss data is required to calculate the main IRB risk parameters; that data are frequently incomplete/unavailable (i. e. not required to be collected in the past) or prohibitively expensive to collect (i. e. not in electronic format). Particularly for the development of rating systems and LGD parameters, individual banks may not have a meaningful loss dataset to enable them to build the required models and back-test their performance.

In such an environment, it is essential to tackle the root causes of this problem (e. g. legal or cultural factors impeding loss data collection and sharing) prior to proceeding with Basel II adoption. * Potentially excessive capital requirements due to inappropriate calibration. Perhaps the most fundamental IRB implementation issue for developing countries is the manner in which supervisory authorities will trade off and reconcile increased risk sensitivity with the desire to maintain aggregate capital requirements. The current calibration f the supervisory formulas is primarily based on survey data (including three QIS rounds) and model results from G-10 banks, and reflects the Committee’s stated objective of broadly maintaining aggregate capital requirements. However, the selected solvency level implicit in the formulas (99. 9%, corresponding to a credit rating of A-) is uniform for all banks irrespective of their country of origin. This level is inappropriately high for banks in lowly- rated countries, and may result (based on historical loss data used to calibrate the risk parameters) in excessively high IRB capital requirements.

It therefore remains an open question whether the current calibration will provide enough incentives (in terms of capital reduction) for such banks and their supervisors to migrate from the Standardized to the IRB Approach. Policy Implications The ultimate choice of what capital standard to adopt will be made by national authorities, and it is likely several developing countries will seek to adopt Basel II as early as possible.

The World Bank and the IMF have publicly stated their desire to support countries preparing for the decision of whether, when and how to implement Basel II. However, both institutions emphasize that Basel I remains a viable option in the foreseeable future, and that Basel II must be built on a solid foundation (as exemplified by compliance with key codes and standards) of sound accounting and governance standards, realistic valuation rules and loan classification and provisioning practices, effective legal and judicial systems, and adequate supervisory resources and powers.

In the absence of a sound foundation, countries that want to proceed with Basel II implementation need to incorporate improvements in their financial infrastructure as part of a robust (and potentially long-term) Basel II roadmap. An effective and realistic roadmap can be created starting from a low base, although it should be adapted to the specific needs of the country, be realistic as to the implementation time horizon, and focus (at least in its early stages) on getting the basics of a credit risk-based supervision framework in place, namely: Improvement in risk management practices of the banking system. This implies an assessment of current business and risk management practices domestically and encouragement of best practice, particularly in terms of the risk governance framework (e. g. bank senior management and Board involvement, functional independence between origination and risk evaluation, appropriate reporting and loss data collection, adoption of risk-adjusted performance measures etc. ). * Training and development of a new supervisory culture.

Basel II will oblige bank supervisors to learn new risk measurement and management techniques but, even more importantly, will necessitate a change in culture from one of “compliance verification” to one of “risk assessment”. This will have important knock-on effects on the way that supervisors understand and conduct their business (e. g. on supervisory independence, enforcement, resources and compensation), as well as on their internal organization and staffing. Upgrading of financial infrastructure. The foundations of the financial system (i. e. accounting and governance standards, legal and judicial systems, contract enforcement practices) must be strengthened in order to move to Basel II. New infrastructure may also need to be developed during this process, such as the creation of credit bureaus, collateral registries, loss data consortia and ECAIs.

Finally, developing countries will need to resort to creative solutions to address some of the aforementioned weaknesses, such as the incorporation of debtor data from nonfinancial institutions, partnerships with local academic institutions to launch risk management training courses, or the obligatory pooling of loss data and the use of public credit registers for calculating risk parameters in smaller or less advanced banking systems.

If implemented correctly, Basel II has the potential to significantly improve credit risk measurement and management practices in developing countries, and thereby contribute to the effectiveness and stability of their financial systems. Global survey by Financial Stability Institute (FSI) Over the past years, the Financial Stability Institute (FSI) hasconducted surveys on subjects of supervisory interest and shared the results with the supervisory community. The FSI carried out a survey on Basel II implementation in 2004, followed by updates in 2006, 2008 and 2010.

The 2010 survey was sent to 173 jurisdictions, including members of the Basel Committee on Banking Supervision (BCBS). Responses were received from 133 jurisdictions, representing an overall response rate of 77%. Impact of the financial crisis on Basel II implementation plans The 2010 survey asked jurisdictions if the financial crisis and/or subsequent regulatory response had an impact on their Basel II implementation plans. Out of the 133 responses received, 32 jurisdictions (three from Africa, four from Asia, five from the Caribbean, 10 from Europe, six from Latin America and four from the Middle East) answered in the affirmative.

Twenty-three jurisdictions mentioned that the crisis had led to a delayed timetable for Basel II implementation, whereas five jurisdictions reported that the crisis had led to an accelerated timetable for implementation. One jurisdiction mentioned that, whereas some aspects of Basel II implementation were kept on an accelerated timetable, some other aspects were delayed due to the crisis. Three jurisdictions reported that, although the crisis had affected Basel II implementation, the overall timetable for Basel II implementation remained on track – there was neither a delay nor an acceleration of the timetable.

Two jurisdictions reported that there was a change in the permissible approaches under Pillar 1 due to the crisis. Global results of the survey The 2010 survey was sent to 173 jurisdictions, including Basel Committee member countries. Responses were received from 133 jurisdictions. A comparative analysis of the number of responses received in the 2008 and 2010 surveys, and the number of jurisdictions intending to adopt Basel II are furnished in Table 1. The results of the 2010 survey reinforce the conclusion of the earlier FSI surveys in 2004, 2006 and 2008 that Basel II will be implemented3 widely around the world.

As per the 2010 survey, 112 jurisdictions, including the 27 Basel Committee member countries, intend to adopt Basel II (Table 2). Basel II in China and India China has announced that its regime for the capital requirements for its banks will continue be that of the 1988 Basel Capital Accord. A revised version of rules based on this Accord was announced in February 2004 and is to be fully implemented by January 2007. 17 Shifting to new rules soon after the implementation of this revised version would clearly impose considerable costs on both banks and supervisors.

The high levels of non-performing loans (NPLs) among the assets of the Chinese banks would also make application of Basel II complex, since the authorities would have to decide on a solution to the problem of these NPLs which did not involve too great a an increase in interest rates due increased provisioning or a collapse of credit to particular sectors and firms. After initially stating their intention to remain with the 1988 Basel Capital Accord the Indian authorities have more recently stated that they would apply Basel II.

In February 2005 the Reserve Bank of India announced that all Indian banks would have to adopt the Standardised approach for the capital requirements for credit risk and the Basic Indicator approach for the capital requirements for operational risk. Eventual migration to the IRB approach would be permitted as supervisors and banks themselves developed adequate skills. Bibliography * 2008 FSI Survey on the Implementation of the new capital adequacy framework in non-Basel Committee member countries, BIS, August 2008 Credit Risk Measurement Under Basel II: An Overview and Implementation Issues for Developing Countries by CONSTANTINOS STEPHANOU & JUAN CARLOS MENDOZA, World Bank Policy Research Working Paper 3556, April 2005 * 2010 FSI Survey on the Implementation of the New Capital Adequacy Framework, BIS, August 2010 * THE GLOBAL IMPLEMENTATION OF BASEL II: PROSPECTS AND OUTSTANDING PROBLEMS by Andrew Cornford, Research Fellow, Financial Markets Center, June 2005 * Basel II implementation in developing countries and effects on SME development, Ricardo Gottschalk, Nov 2007 Capital Adequacy Regime in India: An Overview by Mandira Sarma Yuko Nikaido, INDIAN COUNCIL FOR RESEARCH ON INTERNATIONAL ECONOMIC RELATIONS, July 2007 * The Basel II accord and the development of market-based finance in Asia. By Bruno Jetin * BASEL NORMS Challenges In India by Swapan Bakshi Annexure Various Risks Liquidity Risk Market Liquidity Risk arises when a bank is unable to conclude a large transaction in a particular instrument near the current market price. Funding Liquidity Risk is defined as the inability to obtain funds to meet cash flow obligations.

For banks, funding liquidity risk is more crucial. Interest Rate Risk Interest Rate Risk (IRR) is the exposure of a Bank’s financial condition to adverse movements in interest rates. Banks have an appetite for this risk and use it to earn returns. IRR manifests itself in four different ways: re-pricing, yield curve, basis and embedded options. • The `re-pricing’ form of IRR is the most common and easily understood. It arises from the timing differences in the maturity (for fixed rate) and re-pricing (for floating rate) of bank assets, liabilities and off-balance-sheet (OBS) positions.

A simple example would be a five year fixed deposit contracted at ten per cent rate of interest in the past, on which the bank would have to pay more interest than the current rates which have fallen substantially since then. • `Yield Curve’ is a line graph obtained by plotting `yield to maturity’ (which is basically the total interest income receivable if the fixed coupon security is held till maturity) against `time to maturity’ for securities of the same asset class and credit rating.

The price of the security fluctuates continuously according to supply and demand, credit quality, time to maturity and changes in interest rates. This price fluctuation gives rise to changes in yield despite a fixed coupon rate. Coupon rate is just a fashionable way of naming interest rate that the security carries on its face value. The slope and shape of the yield curve changes in response to interest rate movements (and expectations thereof) and can result in exposure of underlying economic value. The `basis’ form of IRR results from the imperfect correlation between interest adjustments when linked to different index rates despite having the same re-pricing characteristics. For example, if one considers a deposit with an interest rate linked to London Inter Bank Offer Rate (LIBOR) with monthly re-pricing and use it to fund a loan having an interest rate linked to State Bank of India’s Term Prime Lending Rate (SBI TPLR) which too has a monthly re-pricing, the interest spread will fluctuate with the change in interest rates since LIBOR and SBI TPLR may not change equally. The `embedded options’ form of IRR can be easily understood if one considers the pre-payment option of a loan when interest rates decrease. If the option to pre-pay the loan is available to the borrower (without any pre-payment penalty), the borrower will liquidate the loan before it matures in order to take advantage of the falling interest rate. The result is reduction of projected cash flow and income for the bank. IRR can be viewed in two ways: Its impact on the earnings of the bank or its impact on the economic value of the bank’s assets, liabilities and OBS positions.

Pricing Risk Pricing Risk is the risk to the bank’s financial condition resulting from adverse movements in the level or volatility of the market prices of interest rate instruments, equities, commodities and currencies. Pricing Risk is usually measured as the potential gain/loss in a position/portfolio that is associated with a price movement of a given probability over a specified time horizon. This measure is typically known as value-at-risk (VAR). Foreign Currency Risk Foreign Currency Risk is pricing risk associated with foreign currency.

The term Market Risk applies to (i) that part of IRR which affects the price of interest rate instruments, (ii) Pricing Risk for all other assets/portfolio that are held in the trading book of the bank and (iii) Foreign Currency Risk. Strategic Risk Strategic Risk is the risk arising from adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes. This risk is a function of the compatibility of an organization’s strategic goals, the business strategies developed to achieve those goals, the resources deployed against these goals, and the quality of implementation. Reputation risk

Reputation risk is the risk arising from negative public opinion. This risk may expose the institution to litigation, financial loss, or a decline in customer base. Transaction risk Transaction risk is the risk arising from fraud, both internal & external, failed business processes and the inability to maintain business continuity and manage information. Compliance risk Compliance risk is the risk of legal or regulatory sanctions, financial loss or reputation loss that a bank may suffer as a result of its failure to comply with any or all of the applicable laws, regulations, codes of conduct and standards of good practice.

It is also called integrity risk since a bank’s reputation is closely linked to its adherence to principles of integrity and fair dealing. Operational Risk Operational Risk includes both compliance risk and transaction risk but excludes strategic risk and reputation risk. Credit Risk Credit Risk is most simply defined as the potential of a bank borrower or counter-party to fail to meet its obligations in accordance with agreed terms. For most banks, loans are the largest and most obvious source of credit risk.

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