Overview of the New Basel Capital Accord

1. Overview of the New Basel Capital Accord Basel Committee on Banking Supervision R94723073 陳世樺 R93723093 蘇郁惠 R94723051 郭于綺

2. Agenda • Capital Adequacy • Review of Basel I • Overview of Basel II • Implementation and future prospect

3. Capital Protects Against Insolvency • Importance of Capital Adequacy • Protection from Credit and Interest Rate Risks

4. Enforcement of Capital Adequacy • Two Capital Requirements -Leverage Ratio -Risk-Based Capital Ratio • Leverage Ratio = Core Capital / Assets • Risk-Based Approach implemented by Bank of International Settlements (BIS) -Basel Agreement

5. Basel I to Basel II • Basel I’ s Risk Assessment -Market Risk -Different Credit Risks of Assets • Basel II -3 Pillars -Unchanged – Market Risk -Reassessed Credit Risk Methods *Standardised Approach / Internal Ratings Based / Securitisation -Added Operational Risk

6. Outline of the Basel II Framework Implementation: End of 2006

7. 3 Pillars

8. Market Risk • Standardised Method -BIS Standards • Internal Models -Regulatory Approval -Risk Metrics / History / Monte Carlo Simulation -Subject to Audits and Reviews

9. Credit Risk - Basel I • Core (Tier I) and Supplementary (Tier II) Capital • On Balance Sheet and Off Balance Sheet Assets • Assigns risk weighting to different asset classes to obtain a Credit Risk Adjusted Asset Value

10. Credit Risk - Capital

11. Credit Risk – On Balance Sheet Credit Risk Adjusted On Balance Sheet Assets wi = Risk Weight of Asset ai = Book Value of Asset on Balance Sheet

12. On BS Weightings – Basel I

13. On BS Weightings – Basel II • Basel I categories too broad • Standardised Approach • Better differentiation of assets • Introduces external credit rating (S&P) • Improves Risk Sensitivity

14. On BS Weightings – Basel II

15. Credit Risk – Off Balance Sheet • Contingent, not actual claims • Not Face Value, but an amount equivalent to an eventual on-balance-sheet credit risk -Convert to Credit Equivalent Amount (CEA) -Conversion Factors • Guaranty Contracts • Basel II introduces Derivative Contracts

16. Off BS – Guaranty Contracts Face Value * Conversion Factor = CEA CEA * Risk Weight = Risk Adjusted Value

17. Off BS Conversion Factors

18. Guaranty Contracts - Basel II • Unused portion of loan commitments with original maturity of one year or less will be 20%. (Previously 0%) • Uses the Basel II assigned credit risk weights

19. Derivative Contracts - Basel II • FI is exposed to “Counterparty Credit Risk” • Distinction between Exchange Traded and Over-the-Counter contracts • Credit Risk of Exchange-Traded Derivatives is ~zero • OTC Contract Credit Risk in two element • Potential Exposure / Current Exposure

20. CEA for Derivative Contract Potential ($) + Current ($) = CEA CEA * Risk Weight = Risk Adjusted Value Current Exposure, if Replacement Value is –ve, then zero. If +ve, then use that value

21. Credit Risk – Risk Based Ratio

22. IRB Approach • Banks’ internal assessment • Some risk weights and formulas still given • Covers a range of portfolios with different exposures. -Corporate, Bank and Sovereign Exposures -Retail Exposure -Specialized Lending -Equity Exposures

23. IRB – Data Inputs • Probability of Default (PD) • Loss Given Default • Exposure at Default • Maturity • Provided by bank based on own estimates • Supervisory values set by the Committee • Foundation IRB – Use BIS values (except PD) • Advanced IRB – Use own estimates

24. IRB – Implementation • Relies on internally generated inputs • Still a minimum standard to ensure comparability across banks • Requires bank have strong control environment and process to collect data

25. Securitization absorb losses on the underlying pool exposure

26. Treatment of the securitisation exposures : recognition of risk transfer KIRB: capital required on underlying pool had it not securitised

27. Rating based approach

28. Supervisory Formula Approach

29. Inputs for the Supervisory formula • Credit enhancement level (L) • Degree of the exposure (T) • Capital requirement for the underlying assets (KIRB)

30. Operational Risk (Def) risk of loss from inadequate or failed ‧ internal processes ‧ people ‧ systems ‧ external events

31. Basic Indicator Approach Operational capital =  * I  =0.15 I = Gross income (Avg. over the previous 3 years) Proxy for risk exposure (scale of business operation) Standardized Approach Operational capital = i * Ii • i=1,2,…,8 (business lines) • i = supervisory factor, ranging from 12~18% • Ii = exposure indicator

32. Business lines (Standardised Approach)

33. Recent modification after QIS3 QIS3 (Quantitative Impact Study 3)： – the most recent quantitative exercise – conducted in 2002 – gather information from banks of varying size from more than 40 countries on the impact of Basel proposals on their existing portfolios

34. Modification to the Pillar One • Recognition of provisions (for IRB) ‧provision(P)= general provision + specific provision ‧expected loss(EL)= 12.5*PD*LGD(%)*EAD (1) general provisions will be removed from the numerator (2) Let k = EL – P If k<0 (provision shortfall) 0.5*|k| deducted from Tier 1 capital, 0.5*|k| deducted from Tier 2capital If k>0 (provision excess) amount of k added to Tier 2 capital (up to a limit of 0-6% of the risk-weighted assets at national discretion)

35. Each year, recognize Loan Loss Provision (提列壞帳損失) and Allowances for Loan Loss (備抵壞帳, same as Loan Loss Reserve 壞帳準備) on a accrual basis. Loan loss expense XXX Allowances for Loan Loss XXX • When actual loan loss occurs Allowances for Loan Loss XXX Loan XXX Expense Reduction of net loan asset

36. Recent modification after QIS3 2. Recognition of provisions (for standardized) -different risk weights for past due loans with specific provision (Ex)

37. Recent modification after QIS3 3. Operational risk: partial adoption of AMA - Advanced Measurement Approach is required for large international banks and banks with significant risk exposures - allowed partial adoption: partially AMA, partially basic indicator approach or standardized approach

38. Recent modification after QIS3 4. Operational risk: risk reduced by insurance (for AMA) - recognition of insurance as risk mitigant： insurance amount deducted from capital requirement (up to 20% of total operational risk capital requirement )

39. Pillar 2：Supervisory review Guiding Principals -For Banks：assess their capital adequacy positions relative to their overall risks. -For Supervisors：review and take appropriate actions in response to those assessments.

40. 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. • 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.

41. 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.

42. Update of Pillar 2 • -stress testing • Estimate the extent to which the IRB capital requirements • could increase during a stress scenario. • -banks’ review of concentration risks and the treatment • of residual risks that arise from the use of collateral, • guarantees and credit derivatives.

43. Pillar 3：Market discipline Purpose -Complement the minimum capital requirements of Pillar 1 and the supervisory review process addressed in Pillar 2. Disclosures requirements -allow market participants to assess key information about a bank’s risk profile and level of capitalization.

44. Table：Disclosures in the New Accord

45. Dialogue with market participants and supervisors -avoid potentially flooding the market with information that would be hard to use in understanding a bank’s actual risk profile. • Align with national accounting standards

46. Implementation of New Accord • Transition to New Accord -Committee members within the G10 Implementation date for New Accord of year-end 2006. -outside the G10 *The minimum capital requirements will be implemented after year-end 2006. *The first priority is implementing key elements of the supervisory review and market discipline components of the New Accord.

47. Forward looking aspects -AIG (the Accord Implementation Group) for national supervisors to exchange information on the practical implementation challenges of Basel 2 and on the strategies they are using to address these issues. -CTF (Committee’s Capital Force) responsible for considering substantive modifications to and interpretations of the New Accord.

48. -reconciling any major unintended inconsistencies in the treatment of similar exposures. -close any loopholes and unintended effects of the new framework. -banks adopting the more advanced approaches to risk assessment will be required to run them in parallel with the existing Accord for 1 year prior to the implementation of Basel II.

49. Cross-border implementations -enhance cooperation between supervisors on a practical basis. -supervisors should avoid performing uncoordinated approval and validation work in order to reduce the implementation burden for banks. -the legal responsibilities of supervisors for the regulation of their domestic banking organizations and the arrangements of consolidated supervision will not change. -mutual recognition

50. Conclusion • Capital adequacy -capital requirement • Basel I to Basel II • Pillar1：minimum capital requirements - Credit Risk *On BS & Off BS *IRB APPROACH *Securitization *Rating based approach *Supervisory Formula Approach