The New Basel Capital Accord

Darryll Hendricks

Senior Vice President

Federal Reserve Bank of New York

February 2, 2001

(Second Consultative Package)

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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

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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

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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

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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)

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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

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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

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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

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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

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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

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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

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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

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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

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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 for Corporate Exposures

PD(in basispoints)

3 bpAAA/AA

5 bpA

20 bpBBB

100 bp 140 bpBB

700 bpB

RW 14 19 45 125 154 400

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

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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

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IRB Approaches: Ongoing Work

• Retail exposures

• Project finance exposures

• Treatment of equities

• Slope of maturity adjustment

• Absolute capital

• Asset securitization

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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

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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

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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.

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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

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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

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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

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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

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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