Bank Basel Capital Accords by YTN
Bank Basel Capital Accords by YTN
Bank Basel Capital Accords by YTN
Despite Ethiopian is under Basel I, having awareness on Basel II and III has paramount
importance. This is due to the fact that adopting advanced Basel framework is one of the tasks
ahead awaiting Banks in Ethiopia. Besides, there are external factors such as Ethiopia WTO
accession and its subsequent required commitment when and how to liberalize financial sector to
foreign investor is inevitable. The purpose of this article is to create common knowledge and
understanding on the area in advance, motivate more reading in the topic and appreciate its
broadness.
Supervisors promote stability in the financial system by ensuring that banks have sufficient
capital to absorb losses. The capital they require banks to hold is related to the amount of risk
they take. The calculation of 'regulatory capital' differs from 'economic capital' calculated by
banks themselves as the risk tolerances and calculation methodologies differ.
The BCBS developed the first capital adequacy framework, Basel I, in 1988. The underlying
principle involved comparing qualifying capital with the amount of risk taken by an institution.
However, Basel I is a fairly crude framework of simple regulatory charges for credit risk. It was
extended in 1996 to include market risk, before the introduction of the 'three pillars' approach in
Basel II (finalized in 2006).
Basel II enables banks to achieve finer differentiation of the risk associated with various
exposures. Basel II is not perfect. The financial crisis of 2007-2009 highlighted several flaws in
the framework, which are being addressed by Basel III.
Under Pillar 1, regulatory capital must be held to support credit, market, and operational risk. In
each case, institutions can choose to adopt, subject to supervisory approval, simple or more
advanced calculations. There are significant standards which must be met in order to adopt the
advanced approaches. Capital is categorized into 'tiers', according to characteristics such as its
loss-absorption properties. The minimum tier 1 capital ratio under Basel II is 4%. Under Basel III,
this increases to 6% and a new minimum common equity tier 1 ratio of 4.5% is introduced.
Under Pillar 2, banks must conduct an internal risk assessment (ICAAP) to achieve a more
comprehensive picture of capital adequacy. This may include additional capital for areas already
covered under Pillar I, as well as addressing risks outside of this. Supervisors are responsible to
review banks' ICAAP.
Under Pillar 3, banks must regularly disclose key information, including qualitative and
quantitative measures of risk exposure and capital adequacy ratios.
Basel III reforms are enhancements to the existing Basel II framework. The main components
from a regulatory capital and liquidity perspectives includes increasing the level and improving
the quality of regulatory capital; enhancing the risk coverage; applying a leverage ratio to
supplement existing capital ratios; promoting the build-up of capital buffers; introducing
additional loss absorbency requirements for global systemically important banks (G-SIBs) and
the introduction of international liquidity standards.
1. Introduction
1.2 Bank Risks
Risk-taking is an inherent element of banking, but excessive, poorly managed risk can lead to
losses and thus endanger the safety of a bank's deposits. To operate in a safe and sound manner
holding capital and reserves sufficient to protect against the risks that arise in its business has
paramount importance.
A bank faces a significant number of risks which can be categorized as credit, liquidity, market
and operational risks.
Credit risk is the potential that a bank's borrower or counterparty will fail to meet its obligations
in accordance with agreed terms. It is the single largest factor threatening the soundness of
financial institutions and the financial system as a whole.
Liquidity risk is the inability to fund increases in assets and meet obligations as they become due.
It is crucial to the ongoing viability of any banking organization.
Market risk is the risk that movements in market prices will adversely affect the value of on- or
off-balance sheet positions. These movements can occur in: interest rates, foreign exchange (FX)
rates, equity prices, and commodity prices.
The Basel Committee defines operational risk as "the risk of loss resulting from inadequate or
failed internal processes, people and systems, or from external events". This definition includes
legal risk, but excludes reputational and strategic risk.
It is the supervision of banks that has given rise to regulatory capital. Regulatory capital is the
capital supervisory authorities require banks to set aside in order to meet potential losses.
Regulatory capital requirements are one of the main components of banking supervision.
Specific purposes are assigned to regulatory capital and these are reflected in the regulatory
definition of capital and in the regulatory capital adequacy ratios.
Capital is a bank's most expensive resource so banks have a strong incentive to manage it as
effectively as possible. Banks to operate in a safe and sound manner, they must hold capital and
reserves sufficient to support the risks that arise in their business.
The common definition of regulatory bank capital was established in 1988 under Basel I – the
first common approach to capital adequacy. This definition remains largely the same today and is
also applicable under Basel II. Regulatory capital is comprised of three levels (or 'tiers') of
capital. An item may be classified under one of these tiers if it satisfies specific eligibility criteria.
Regulatory capital is made up of: Tier 1 capital (core capital), Tier 2 capital (supplementary
capital) and Tier 3 Capital (additional supplementary capital).
As mentioned earlier, economic capital is capital held by the bank to act as a buffer against
potential losses. How much economic capital is held, what form it takes and what areas of a
bank's business it supports varies from bank to bank.
Economic capital methods attempt to assess the amount of capital needed to support different
sets of business activities or risks. They seek to translate quantitative risk assessments of
different types (or sources) of risk into a common metric – Economic Capital. These methods are
becoming an extremely powerful tool for managing risks and capital and, in a broader context,
for defining and adjusting a bank's strategy.
Regulatory capital follows standardized definitions whereas economic capital is derived from
bank-specific methodologies.
In addition, regulatory capital's overriding concern is the safety and soundness of the financial
system, so it has a national and global scope.
The scope of a bank's economic capital is somewhat different. It is determined by – and for –
each specific bank, and no other. It is derived from the bank's own measurements of risk and
relates the risks the bank is exposed to with its returns, and to its ultimate ability to absorb losses.
The differences in scope lead to differences in substance. Definitions and eligibility criteria for
regulatory capital are standardized to a large extent so that it is relevant to compare one bank's
capital ratios with those of another bank. Economic capital is bank specific. Comparisons of
economic capital between two banks are not informative unless all the parameters of the methods
are known and understood. At best, regulatory and economic capital can be compared, but only
for a given bank.
Basel Accords (Basel I, II, and III) have been issued by Basel Committee on Banking
Supervision (BCBS). BCBS is a committee of bank supervisors from 13 countries (Belgium,
Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden,
Switzerland, the United Kingdom, and the United States of America).
The body of this document gives bird’s eye view of Basel I, II and III as well as the Way
Forward.
2. Basel I
2.2 Rationale Behind Basel I
In the mid-1980s, BCBS initiated a project to achieve better international convergence of
supervisory standards for the capital adequacy of internationally active banks. Two main
supervisory concerns triggered Basel Accord (Basel I) were:
i. Increased Risk Exposure – As G10 countries deregulated their financial
markets and banking systems from the beginning of the 1980s onwards, one of
the side-effects was a rapid increase in the size of banks' exposures to risk, both
on and off-balance sheet. In many cases, growth was not matched by an increase
in capital. As a result, the capital level of large banks was eroded.
ii. Lack of Common Regulatory Environment – As banks started to expand into
new business lines and increase cross-border operations, issues surrounding the
creation of a level playing field among banks from different jurisdictions gained
considerable importance.
In July 1988, the BCBS published 'International Convergence of Capital Measurement and
Capital Standards' to address these issues.
The definition of regulatory capital is currently comprised of three levels (or 'tiers') of capital.
Each tier corresponds to a certain capacity for absorption of losses. An item is classified in one of
these tiers if it satisfies specific criteria.
The overall amount of Tier 3 capital is limited to 250 percent of a bank’s Tier 1 capital required
to support market risks.
Tier 2 elements may be substituted for Tier 3 capital up to the same limit of 250 percent as long
as the overall limits are not breached:
Deductions from Regulatory Capital corresponds to the amounts that are, for various reasons, not
available to cover the bank’s losses an ongoing basis. The deductions refer to:
i. Goodwill
Goodwill has to be deducted from Tier 1 capital elements. Banking organizations that
have been grown through mergers and acquisitions generally have a significant amount
of goodwill on their balance sheet.
ii. Non-consolidated subsidiaries
Investment in subsidiaries engaged in banking and financial activities that are not
consolidated are unavailable, so they are deducted from the bank’s regulatory capital.
2.4 Supervisory Risk Weights and Conversion Factors
The risk weights and credit conversion factors applied to broad categories of exposures are key
elements of the Basel I framework.
A supervisory risk weight is an estimate of the credit risk associated with an exposure. Expressed
as a percentage, it is used to translate the nominal amount of a credit exposure into a risk-
weighted asset (RWA).
This cannot be done directly for off-balance sheet items because the amount at risk for such
exposures does not necessarily correspond to the nominal amount listed in the bank’s accounts.
Before a risk weight can be applied, the off-balance sheet items need to be converted to credit
risk equivalents by using credit risk conversion factors (CCFs).
The supervisory risk weight and conversion factor framework is aimed at ensuring that the
regulatory capital maintained by banks is broadly commensurate with the degree of risk inherent
in different types of exposures.
This risk weight framework also places a lot of emphasis on country risk, a key concern in the
1980s that still remains an important risk to banks.
0 0
10 0.8
20 1.6
50 4
100 8
This relationship also exists under Basel II, the revised framework for international convergence
of capital measurement and capital standards.
Applying the same set of risk weights for the same exposure types across countries was – and
still is – intended to promote the international convergence of capital measurement and capital
standards.
Basel I’s risk weight structure is made up of five risk weights, four of which are compulsory (0,
20, 50 and 100 percent) while one (10 percent) is optional. In addition, there are four credit
conversion factors (0, 20, 50 and 100 percent) used to convert off-balance sheet exposures into
credit equivalents.
Each risk weight and each conversion factor corresponds to a specific set of assets and off-
balance sheet items, respectively.
3 Basel II
More than a decade later, the evolution of banking worldwide and the realization that the best
way to measure, manage and mitigate risks, differs from bank to bank, led the Basel
Committee to initiate revisions to the 1988 Accord.
In June 1999, the Basel Committee issued a first proposal to replace the 1988 Accord with a
more risk-sensitive agreement that would cover credit, market and operational risks. Following
subsequent modified proposals and broad consultation, the new capital adequacy framework –
Basel II – was released in mid-2004, for implementation from year-end 2006 of everything but
the most advanced approaches, which were available for implementation from year-end 2007.
Pillar 1 relates to the minimum capital requirements each bank must hold to cover its
exposure to credit, market and operational risk.
Pillar 2 is concerned with supervisory reviews that aim to ensure that a bank's capital
level is sufficient to cover its overall risk.
Pillar 3 relates to market discipline and details minimum levels of public disclosure.
Basel II allows a financial institution to measure credit risk for regulatory capital purposes in one
of two ways. Under the Standardized Approach (SA), banks use a risk-weighting schedule for
measuring the credit risk of bank assets. The risk weightings are linked to ratings given to
sovereigns, financial institutions and corporations by external credit rating agencies. The Internal
Ratings Based Approach (IRB) allows banks to use their own internal ratings of counterparties
and exposures, which permit a finer differentiation of risk for various exposures and hence
delivers capital requirements that are better aligned to the degree of risk.
Standardized Approach
Under the standardized approach the bank allocates a risk weight to each asset and off-balance
sheet position, producing a sum of risk-weighted assets as follows:
Risk-weighted Asset = Amount of Exposure x Risk Weight
The allocation of each individual risk weight is based on the broad category of the borrower
(sovereign, bank or corporate), refined by reviewing the rating provided by an external credit
assessment institution. This assessment can be adjusted, based on qualifying credit risk mitigants.
The standardized approach establishes risk weights corresponding to different types of assets and
makes use of external credit assessments to enhance risk sensitivity compared to Basel I. The
risk weights for sovereign, interbank, and corporate exposures are differentiated based on
external credit assessments.
The IRB approach recognizes that banks generally know more than credit rating agencies about
their borrowers. This approach enables a bank to apply much finer differentiation between risks
than the seven risk-weight buckets (0, 20, 35, 50, 75, 100 and 150%) in the standardized
approach.
There are two IRB approaches, both of which are subject to strict methodological and disclosure
standards, and the approval of the supervisor.
Foundation IRB - the bank estimates the probability of default (PD) associated with each
borrower, and the supervisor supplies other inputs, such as loss given default and exposure at
default.
Advanced IRB - in addition to PD, the bank adds other inputs such as exposure at default, loss
given default, and maturity. The requirements for this approach are more exacting.
Banks' capital requirements for market risk are established by using one of two methods.
The Standardized Approach adopts a so-called 'building block' approach for interest-rate
related and equity instruments which differentiates capital requirements (charges) for specific
risk from those for general market risk.
The Internal Models Approach enables a bank to use its proprietary in-house method which
must meet the qualitative and quantitative criteria set out by the Basel Committee and is subject
to the explicit approval of a bank's supervisory authority.
Operational risk is defined by the Basel Committee as "the risk of direct or indirect loss resulting
from inadequate or failed internal processes, people and systems or from external events".
There are three approaches to setting capital charges for operational risk.
The Basic Indicator Approach sets a charge for operational risk as a fixed percentage (known
as the "alpha factor") of gross income, which serves as a proxy for the bank's risk exposure.
Under this approach, the capital a bank must set aside to protect against losses arising from
operational risk is equal to a fixed percentage of average annual gross income over the previous
three years.
The Standardized Approach requires that the institution separate its operations into eight
standard business lines, for example, retail banking, corporate finance, and so on. The capital
charge for each business line is calculated by multiplying gross income for that business line by a
factor (denoted beta) assigned to that business line. The beta factor will differ between business
lines.
Under Advanced Measurement Approaches, the regulatory capital requirement will equal the
risk measure generated by the bank's internal operational risk measurement system. The bank
must meet quantitative and qualitative criteria as set out in Basel II and must be approved by the
supervisor.
The supervisory review process aims to ensure that banks assess their capital adequacy positions
relative to their overall risks, and that supervisor’s review and take appropriate actions in
response to those assessments. Supervisors may require banks to hold capital in excess of
minimum regulatory capital ratios or take other remedial measures such as strengthening
pertinent risk management or other practices. If higher ratios are required, supervisors will need
to intervene if capital falls below these levels. Pillar 2 requires that banks perform stress tests to
estimate the extent to which their IRB capital requirements could increase during a stress
scenario. The results of such tests should be used by banks and supervisors to ensure that banks
hold sufficient capital buffers.
Pillar 3 sets out disclosure requirements which will allow market participants to assess key
pieces of information on the scope of application, capital, risk exposures, risk assessment
processes, and hence the capital adequacy of the institution.
In some cases disclosure is a qualifying criterion under Pillar 1 to obtain lower risk weightings
and/or to apply specific methodologies. It is expected that there would be a direct sanction for
non-disclosure (not being allowed to apply the lower weighting or the specific methodology).
Pillar 3 also discusses the role of materiality of information, frequency of disclosures and the
issue of proprietary or confidential information.
To sum up, Basel II consists of three pillars. Pillar 1 set out capital requirements taking into
account credit, market, and operational risks. Pillar 3 points out supervisory review process and
pillar 3 is about market disclosures.
4 Basel III
Basel III’s reforms are in fact enhancements to the existing Basel II framework. The main
components from a regulatory capital and liquidity perspectives include:
Regulatory capital has been enhanced by giving predominance to common equity. Eligibility
criteria have been established for common equity, for Additional Tier 1 capital and for Tier 2
capital. A minimum common equity Tier 1 ratio (CET 1 ratio), which will reach 4.5% of RWAs,
has been introduced. Efforts have been made to harmonize supervisory deductions, which also
serve to increase the level of capital.
The objective of the additional loss absorbency for G-SIBs is to reduce the probability of
failure by increasing their going-concern loss absorbency. An indicator-based measurement
approach is used to determine G-SIBs and the additional loss absorbency will be achieved
through an extension of the capital conservation buffer.
Various studies have been made by local and abroad researchers show that banking industry in
Ethiopia is at its infant stage and the society is both unbanked and under banked taking into
account parameters such us branches per population, branches per area and number of loan and
deposit account holders compared to populations aged more than 18. However, recently due to
GTP plan to increase access to finance commercial banks are expanding in branches and their
operations are increasing year to year. Majority of banks are using core banking technology and
new products and services are launched more frequently than before by all commercial banks.
Inevitably all these increase exposures to all risks and holding adequate capital taking into
account credit operational and market risks will be necessary.
Ethiopia has lodged accession to World Trade Organization (WTO) and has passed various stages.
Currently, WTO has requested to present service sector program. Financial sector is one of the
most sensitive service sectors to Ethiopia to include in the program. Ethiopia government has
unshakable stand not to liberalize this sector to foreign investors and banks. Nevertheless, it is
unthinkable be a member of WTO without putting commitment when and how to liberalize the
financial sector. When financial sector liberalizes, the financial sector landscape would be
expected to change totally.
In my view, economic liberalization and financial liberalization is not any easy task. It needs
deep policy thinking and research as well as take experience of East Africa like Shilling
Countries. In my visit to Uganda and Tanzania three trips, the people of two countries are not
benefited from liberalization. For example, Tanzania Commercial Bank collapsed in the short
time. This is because lack of proper preparedness by experience and capital. Basel Capital
Accords are one preparation for financial sector liberalization.
5.5 Conclusion
Ethiopia is under the Basel I still now but other countries reached Basel III. In fact, since our country
financial sector is not liberalized for foreign investors and the sector is young, it is difficult if not possible
to adopt Basel III. Tomorrow after tomorrow, we will be going to Basel II taking into account the above
mentioned basic facts. Having adequate knowledge and following curiously the development in the area
has paramount importance. The major objective of this document is to give highlight in the area and
appreciate its deepness and motivate you read more.
References
1. Financial Stability Institute Connect Version 11 and 12 January 2011 and
September 2012
2. NBE Press Releases
3. Various Online News Papers