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 Committee’s 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 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 * Risk weights based on a 50% LGD and an average maturity of 3 years.

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