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Basel Capital Adequacy Framework

Basel Capital Adequacy Framework. Eric Falkenstein Vice President ICM Credit Risk Management for Asian Financial Institutions June 28, 2000 eric.falkenstein@moodys.com 212.553.7231. Topics. The current capital regulations The current Basel dialogue Next Steps. What is Bank Capital?.

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Basel Capital Adequacy Framework

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  1. Basel Capital Adequacy Framework Eric Falkenstein Vice President ICM Credit Risk Management for Asian Financial Institutions June 28, 2000 eric.falkenstein@moodys.com 212.553.7231

  2. Topics • The current capital regulations • The current Basel dialogue • Next Steps

  3. What is Bank Capital? Bank Capital is:Bank Capital is not: - Common Equity - Customer Deposits - Preferred Equity - Short-term Debt - Subordinated Debt - Other Liabilities - Loan Loss Reserve - Goodwill

  4. Regulatory Capital Measures A) Tier I or Core Capital Ratio • Tier I equity divided by risk-weighted assets • Risk-weighted assets have 100% weighting for loans, 20% weighting for OECD bank debt, 0% for Treasury debt • Tier I equity consists mainly of common stock, perpetual preferred stock, minus intangibles B) Total Capital Ratio • Tier I + Tier II equity divided by risk-weighted assets. Tier II capital consists mainly of qualifying subordinated debt and long-term preferred stock, plus Loan Loss Reserve (up to 1.25% of risk-weighted assets)

  5. Regulatory Requirements for Risk-based Capital Ratios Basic “Well-Capitalized” Tier 1 or Core Capital 4% 6% Tier 1 + Tier 2 or Total Capital 8% 10%

  6. Limitations of the Current Risk-based Capital Approach • Risk-weightings are not truly risk sensitive: an Aaa loan has the same risk-weighting as a B loan. • Capital methodology falling behind financial innovations: securitization, derivatives, netting, etc. • Ignores capital needed for operating, interest rate, market and other risks.

  7. Credit Risk Modeling: Current Practice and Applications Purpose: 1) Provide summary of best practices of credit models 2) Assess the potential applications and limitations of credit risk models for supervisory and regulatory purposes 3) Solicit feedback

  8. Basel, Key Literature • No. 4 International Convergence of Capital Measurement and Capital Standards, July 1988 (the Basel Capital Accord) • No. 55 Credit Risk Modeling: Current Practices and Applications, April 1999 • No. 50, A new capital adequacy framework, June 1999 • No. 71, Summary of responses received on the report "Credit Risk Modeling: Current Practices and Applications", May 2000 download at www. bis.org

  9. Credit Risk Modeling: Current Practice and Applications (4/99) Current credit management methods potentially rational direction for future refinements, yet there are limitations: 1) Lack of Data. 2) Validation (see #1). Key quotes: “Regulators would have to be confident that models were used to actively manage risk, and that conceptually sound, empirically validated, and produce capital assessments comparable across financial institutions.” “Significant hurdles, principally concerning data availability and model validation, still need to be cleared before these objectives can be met, and the Committee sees difficulties in overcoming these hurdles in the timescale envisaged for amending the capital Accord."

  10. A New Capital Adequacy Framework (6/99) 3 pillars to the revised capital framework 1) minimums (most of the focus) 2) supervisory review (probably more important!) 3) market discipline (good idea, but need broad liquid debt markets) New ideas: • May have more or less than 100% weightings on corporate loans • Internal credit models could guide capital allocations • Address derivatives and netting agreements more logically

  11. A New Capital Adequacy Framework 6/99 An example of the new refinements put forth by Basel:

  12. Summary of Responses (5/00) Subject: Loss Given Default comment: US and European data is all that's really available Subject: Shape of the density function of losses comment: Unknown (lognormal? Normal?), but not considered a major limitation Subject: Conditional upon the economy comment: Need sound linkage

  13. Summary of Responses (5/00) Subject: Conceptual Approaches Comments: Credit Value-at-Risk and/or Scenario Subject: Default mode and Mark-to-Market Mode Comments: Mark-to-market superior perhaps Subject: Horizon Comments: Not a big issue, 1 year likely

  14. Summary of Responses (5/00) Subject: Parameter Specifications Comments: US corporate bond rating information good Use conservative assumptions when missing data Proxies Start collecting data as soon as possible Subject: Validation Comments: Stress tests Panel data set compiled from regulatory bodies

  15. Summary of Responses (5/00) Subject: Supervision and Regulatory Application Comments: Portfolio by portfolio Link evaluation of credit models to how models are actually used General comment: Simple models not necessarily bad Don't use US data to parameterize models

  16. Next Steps Best Case Scenario: Basel will make preliminary proposal by February 2001. Phase-in will start in January 2003. Probable Scenario: year or two later...

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