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Basel II: Light at the end of the tunnel?

Basel II: Light at the end of the tunnel? . Chris Matten chris.matten@sg.pwc.com. PWC. Agenda. The final Framework What next?. The final Framework is finally here!. Agreed by Central Bank Governors and Heads of Banking Supervision for all G10 countries Intended for broader use

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Basel II: Light at the end of the tunnel?

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  1. Basel II:Light at the end of the tunnel? Chris Matten chris.matten@sg.pwc.com PWC

  2. Agenda • The final Framework • What next?

  3. The final Framework is finally here! • Agreed by Central Bank Governors and Heads of Banking Supervision for all G10 countries • Intended for broader use • EU to proceed with Risk-Based Capital Directive • PwC/NIESR Impact Study completed and published in April 04

  4. Changes to CP3 (1) • New transitional arrangements, with A-IRB/AMA delayed by one year • Banks must address any shortfall in the floor by increasing stated RWAs under Basel II • Intended to assist US banks and others in meeting the deadlines • Flagged 11 May 04

  5. Changes to CP3 (2) • Scaling factor introduced • Initially set at 1.06 • I.e. whatever the resulting calculation under Basel II, result must be multiplied by 1.06 • Intended to maintain same level of aggregate capital in the banking system • Flagged 11 May 04

  6. Changes to CP3 (3) • Segregation of EL from UL under IRB risk-weights • Different, simpler RW function for defaulted assets • To reflect potential adverse move in LGDs and EAD • Provisions under IRB to be held equal to EL • Any shortfall to be deducted equally from Tier 1 and Tier 2 • Any surplus may be allowed in Tier 2, up to 0.6% of RWAs • Intended to address criticism of double-counting of EL • BUT raises problems with IFRS (IAS 39) • Covered in 30 Jan 04 press release Final CP3

  7. Changes to CP3 (4) • Reduction in RW factors for QRRE • Fixed correlation factor (0.04) rather than a function of PD • Intended to reduce RW esp. for credit cards • Flagged 11 May 04

  8. Changes to CP3 (5) • Default RW for other assets is 100% • Intended to fix a ‘hole’ in CP3 which did not specify a RW for other assets • BUT does not seem right • Standardised approach defaults to Basel 1988 where RW not specified • Under IRB, cash would appear to take 100% RW! (vs 0% under standarised approach) • Awaiting clarification from BCBS • Local supervisors expected to be pragmatic in interpretation • New provision not previously announced

  9. Changes to CP3 (6) • LGDs to be based on economic downturn, not average • Need to calculate (a) default-weighted average over full observation period (ideally covering at least one cycle), and (b) potential LGD ‘which reflects economic downturn conditions’. • LGD to be used is higher of (a) and (b) • Intention is for single LGD, but in practice? • Flagged 11 May 04

  10. Changes to CP3 (7) • Provisions for securitised assets under IRB have been completely revised • Internal Assessment Approach (IAA) introduced for ABCP • No differentiation under RBA for issuers and investors • Intended to address industry criticisms • Flagged 30 Jan 04 RBA - ratings based approach; SF – Supervisory Formula; IAA – Internal Assessment Approach

  11. Changes to CP3 (8) • Some diversification benefit for banks using AMA • Overseas subsidiaries which are not ‘significant’ can have allocated portion of group-wide diversified AMA • ‘Significant’ means in the context of the banking group, not the country of operation • BUT “banking subs whose host supervisors determine that must calculate stand-alone capital requirements may not incorporate group-wide diversification benefits…” • Intended to provide relief from multiple AMA calculations in large banking groups • Covered in 30 Jan 04 press release

  12. Importance of Pillar 2 • 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” • Board and senior management oversight • Sound capital assessment • Policies and procedures.. to measure.. all material risks • Process to relate capital to level of risk • Comprehensive assessment of all risks • Monitoring and reporting • Internal control review

  13. 2 views on Pillar 2 • Pillar 2 as a holistic view of capital, with Pillar 1 as a sub-set Pillar 2 Pillar 1 Pillar 2 • Pillar 2 as an “add-on” to Pillar 1 Pillar 1

  14. Does Principle 1 require an EC model? • Adoption of an EC model is consistent with Principle 1 • BUT other approaches may also qualify: • Stress tests • DFA • Scenario analysis • Adoption of an EC model should be driven primarily by business demands; Pillar 2 compliance is then an added requirement

  15. Agenda • The final Framework • What next?

  16. The final Framework is finally here!… or is it? • Need to leave door open for US lawmakers and supervisors • Framework is a ‘statement of the Committee agreed by all its members’ • Adoption procedures ..’will include additional impact assessments…as well as further opportunities to comment’ • National supervisors may set higher levels for Pillar 1 and/or specific requirements in Pillar 2 • Eg APRA – IRR capital in Pillar 1 for sophisticated banks • Eg EBK – ‘Swiss finish’ higher risk weights

  17. BCBS work-in-progress (1) • “Double-default”issues • Recognition of double-default effects necessary • BUT need to work through the issues • Aim to produce a solution prior to Basel II implementation • Trading book issues • Potential future exposure (EADs) • Counterparty risk • Joint working group with IOSCO due to report back in 2005 • Re-calibration of scaling factor • Definition of ‘eligible capital’ • Treatment of provisions (EL) tends to depress Tier 1 relative to total CAR • Uniform standards on hybrid Tier 1 required • No changes expected prior to implementation of Basel II.

  18. BCBS work-in-progress (2) • Encouragement of ‘Economic Capital’ re-introduced • Does Pillar 2 require an EC model? • Can other methods (DFA, stress testing, scenario analysis etc) apply? • Use of full credit risk models an option for the future • “IRB..represents a point on the continuum between purely regulatory measures….and internal credit risk models” • Future clarification of suitable AMA approaches for operational risk • BCBS waiting for an industry standard to emerge. • Co-ordination with IAS

  19. Implementation in EU • Risk-Based Capital Directive in preparation • 4 options for implementation: 1. Full implementation from 31 Dec 06 2. Any option allowed during 2007, including old Accord and Basel II, with full adoption of Basel II from 31/12/07 3. Same as 2, but A-IRB/AMA only allowed from 31/12/07 4. Delay implementation until 31/12/07 • This is a political issue as much as a technical one • Parity with US banks as well as within EU a critical factor

  20. Implementation in Singapore • Locally-incorporated full banks to comply by 31/12/06 • Choice of methodologies: no compulsion, no prohibition • Branches to follow home country supervisor requirements • Restricted licence banks: currently net worth and other criteria, but Basel II a possible future option • Finance companies: remain on Basel 1988 (as amended)

  21. Implementation in Malaysia

  22. pwc

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