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Unexpected losses are loss percentiles in excess of the expected loss. The expected loss is an average used for provisioning. The unexpected loss is the.
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The variables that only affect economic capital, such as the intermediation margin and the cost of capital, can account for large deviations from regulatory capital. The relative position of economic and regulatory capital is mainly determined by the cost of bank capital: economic capital is higher lower than regulatory capital when the cost of capital is low high Elizalde and Repullo, To conclude, the two concepts reflect the needs of different primary stakeholders. With the regulatory tendency in recent years to come closer to credit risk modelling and to allow banks to develop their own models for determining the amount of regulatory capital to hold, comparing the current regulatory and economic capital is becoming an insightful exercise for the regulatory decisions of the future Zhu, References: Allen, B.

Basel Committee on Banking Supervision Carey, M. Mishkin ed. Caruana, J. Elizalde, A. Jones, D. Zhu, H. The most common approach was to lay down minimum capital requirements for banks in the respective banking legislations and determine the relative strength of capital position of a bank by ratios such as debt-equity ratio, or its other variants for measuring the level of leverage. Though capital regulation in banking existed even before the Basel Accord of , there were vast variations in the method and timing of its adoption in different countries.

In the pre-Basel phase, the use of capital ratios to establish minimum regulatory requirements was being tested for more than a century. Even the banking sector was in favour of a more subjective system where the regulators could decide which capital requirements were suited for a particular bank as a function of its risk profile Laurent, This in turn, led to the demand for Government intervention and new financial architecture Kapstein, The G central bankers met in June , but failed to evolve a consensus.

The US argued for an explicit signalling of lender of the last resort facility, while the Germans were on the other side citing lack of mandate and the moral hazard problem. However, the failure of the talks led to the exclusion of many small banks from the inter-bank market which resulted in strong political pressure on the central bankers to meet again in September In the meeting, concern was expressed about the inadequate supervision of international banking and an assurance was given that the means for the provision of temporary liquidity be made available, which could be used as and when necessary.

In the autumn of , the Bank of England began to conceptualise the formation of a G group of bank supervisors leading to the formation of the Standing Committee on Banking Regulation and Supervisory Practices, or the Basel Committee in December Nevertheless, it led to an unimaginable degree of regulatory harmonisation later. As a first step towards home country control, the Basel Committee in recommended that the use of consolidated financial statement for international banking supervision.

While consolidated banking statements were a norm in the US and a few other countries, these were not so widespread in Europe. For example, in Germany, strict limits were placed on the ability of its supervisors to collect information about foreign activities of their banks. The emergence of macroeconomic weakness, more bank failures and diminishing bank capital triggered a regulatory response in when, for the first time, the federal banking agencies in the US introduced explicit numerical regulatory capital requirements.

The standards adopted employed a leverage ratio of primary capital which consisted mainly of equity and loan loss reserves to average total assets. However, each regulator had a different view as to what exactly constituted bank capital. The debt crisis of August led to injection of liquidity and left a corresponding demand of institution of minimum capital standards. The Congress in the US passed legislations in , directing the federal banking agencies to issue regulations addressing capital adequacy.

The legislation provided the impetus for a common definition of regulatory capital and final uniform capital requirements in By , regulators in the US were concerned that the primary capital ratio failed to differentiate among risks and did not provide an accurate measure of the risk exposures associated with innovative and expanding banking activities, most notably off-balance-sheet activities at larger institutions.

The agencies also revisited the earlier studies of risk-based capital ratios. A proposal by the Federal Reserve Bank of New York, for example, assigned asset categories based on credit risk, interest rate risk and liquidity risk factors. The regulators agreed that the definition of capital adequacy needed to be better tailored to bank risk-taking in order to address two major trends in the banking industry.

First, banks were moving away from safer, but lower yielding, liquid assets. At the same time, they were increasing their off-balance-sheet activities, whose risks were not accounted for by the then capital ratios. However, leading the initiative in , the US joined the UK in announcing a bilateral agreement on capital adequacy, soon to be joined by Japan buoyed by a booming stock market in raising capital.

The Committee after a consultative process, whereby the proposals were circulated not only to the central bank Governors of G countries, but also to the supervisory authorities worldwide, finalised the Basel Capital Accord in now popularly known as Basel I.

One, the framework should serve to strengthen the soundness and stability of the international banking system. Two, the framework should be fair and have a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks. The central focus of this framework was credit risk and, as a further aspect of credit risk, country transfer risk. Capital, for supervisory purposes was defined in two tiers. The other elements of capital supplementary capital Tier 2 were allowed up to an amount equal to that of the core capital.

These supplementary capital elements and the particular conditions attaching to their inclusion in the capital base were prescribed in detail. The risk weighted approach was preferred over a simple gearing ratio approach because i it provided a fairer basis for making international comparisons among banking systems whose structures might differ; ii it allowed off-balance-sheet exposures to be incorporated more easily into the measure; and iii it did not deter banks from holding liquid or other assets which carried low risk.

There were inevitably some broad-brush judgements in deciding which weight should apply to different types of asset and the framework of weights was kept as simple as possible with only five weights being used for on balance-sheet items, i. Government bonds of the countries that were members of the Organisation for Economic Cooperation and Development OECD which includes all members of the Basel Committee were assigned a zero risk weight, all short-term inter-bank loans and all long-term inter-bank loans to banks headquartered in OECD countries a 20 per cent risk weight, home mortgages a 50 per cent risk weight, and most other loans a per cent risk weight.

The capital adequacy ratio was prescribed at eight per cent. Banks, however, developed new types of financial transactions that did not fit well into the risk weights and credit conversion factors in the laid down standards. For instance, there was a significant growth in securitisation activity, which banks engaged in partly as regulatory arbitrage opportunities.

Thus, through this amendment an explicit capital cushion was provided for the price risks to which banks were exposed, particularly those arising from their trading activities. The novelty of this amendment lay in the fact that it allowed banks to use, as an alternative to the standardised measurement framework originally put forward in April , their internal models to determine the required capital charge for market risk. The standard approach defined the risk charges associated with each position and specified how these charges were to be aggregated into an overall market risk capital charge.

Over the years, however, several deficiencies of the design of the Basel I framework surfaced. This standard encouraged capital arbitrage through securitisation and off-balance sheet exposures. The Basel rules encouraged some banks to move high quality assets off their balance sheet, thereby reducing the average quality of bank loan portfolios. Furthermore, banks took large credit risks in the least creditworthy borrowers who had the highest expected returns in a risk-weighted class Kupiec, But, most of the times, the risk-weight classes did not match realised losses Flood, At first, banks used to sell their mortgage loans, for such loans represented accurately evaluated risks.

But after the advent of e-finance, it became possible to expand this activity to other types of loans, including those made to small businesses. This type of activity also allowed banks to have a much more liquid credit-risk portfolio and, in theory, to adjust their capital ratio to an optimal economic level rather than sticking to the ratio prescribed by the Basel Committee. The aggregate risk of a bank was not equal to the sum of its individual risks —diversification through the pooling of risks could significantly reduce the overall portfolio risk of a bank. Indeed, a well-established principle of finance is that the combination in a single portfolio of assets with different risk characteristics can produce less overall risk than merely adding up the risks of the individual assets.

The Accord, however, did not take into account the benefits of portfolio diversification. Financial crises of the s involving international banks highlighted several additional weaknesses in the Basel standards that permitted and in some cases, even encouraged, excessive risk taking and misallocations of bank credit White, Basel I did not explicitly address all the risks faced by banks such as liquidity risk, and operational risks that may be important sources of insolvency exposure for banks.

Banks used economic capital models as tools to inform their management activities, including measuring risk-adjusted performance, setting pricing and limits on loans and other products, and allocating capital among various business lines and risks. Economic capital models measure risks by estimating the probability of potential losses over a specified period and up to a defined confidence level using historical loss data. The rapid rate of innovation in financial markets and the growing complexity of financial transactions reduced the relevance of Basel I as a risk managing framework, especially for large and complex banking organisations.

Various shortcomings also distorted the behaviour of banks and made it much more complicated to monitor them. The framework is also designed to create incentives for better r isk measurement and management. Major features of Basel II framework are presented below. Pillar 1: Capital Adequacy 5. Capital Charge for Credit Risk 5. Basel II proposes a range of approaches to credit risk.

The simplest methodology is the standardised approach which aligns regulatory capital requirements more closely with the key elements of banking risk by introducing a wider differentiation of risk weights and a wider recognition of credit risk mitigation techniques, while avoiding excessive complexity. In this method, risk weights are defined for certain types of credit exposures primarily on the basis of credit assessments provided by rating agencies.

The default risk as reflected in the credit rating is then translated into the resulting capital requirements Chart V. Expected losses should be calculated as standard risk costs in the credit approval process. In order to ensure that these data can be compared and aggregated with other risks for instance, market risks , the unexpected loss should be used as the uniform basis for risk measurement. Regardless of whether a distinction is drawn between expected and unexpected loss, the most important criterion in selecting suitable risk quantification methods is their risk orientation i.

The risk components include measures of the probability of default PD — the probability that counterparty will default within one year, loss given default LGD — the amount of the loss expressed as a percentage of the amount outstanding at the time when the counterparty defaults, the exposure at default EAD — the credit amount outstanding at the time of default, and effective maturity M. In some cases, banks may be required to use a supervisory value as opposed to an internal estimate for one or more of the risk components.

While the Basel I framework was confined to the minimum capital requirements for banks, the Basel II accord expands this approach to include two additional areas, viz. In terms of Basel II, the stability of the banking system rests on the following three pillars, which are designed to reinforce each other: i Pillar 1: Minimum Capital Requirements - a largely new, risk-adequate calculation of capital requirements which for the first time explicitly includes operational risk in addition to market and credit risk; ii Pillar 2: Supervisory Review Process SRP -the establishment of suitable risk management systems in banks and their review by the supervisory authority; and iii Pillar 3: Market Discipline - increased transparency due to expanded disclosure requirements for banks.

The central focus of this framework as in Basel I, continues to be credit risk. In the revised framework, the minimum regulatory capital requirements take into account not just credit risk and market risk, but also operational risk. The measures for credit risk are more complex, for market risk they are the same, while those for operational risk are new. Besides, Basel II includes certain Pillar 2 risks such as credit concentration risks and liquidity risks. Apart from an increase in the number of risks, banks are required to achieve a more comprehensive risk management framework.

While Basel I required lenders to calculate a minimum level of capital based on a single risk weight for each of the limited number of asset classes, under Basel II, the capital requirements are more risk sensitive. The credit risk weights are related directly to the credit rating of each counterparty instead of the counterparty category.

The minimum requirements for the advanced approaches are technically more demanding and require extensive databases and more sophisticated risk management techniques. Basel II prescriptions have ushered in a transition from capital adequacy to capital efficiency which implies that banks adopt a more dynamic use of capital, in which capital will flow quickly to its most efficient use. Unlike Basel I, Basel II is quite complex as it offers choices, some of which involve application of quantitative techniques.

One essential pre-requisite for calculating unexpected loss is the availability of default probabilities PDs. In comparison with standardised approach, the IRB approach is more risk sensitive. However, such methods also increase the complexity of capital calculation. Risk Mitigation Techniques 5.

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In recent years, credit intermediation has been vastly facilitated by the proliferation of complex risk transfer instruments, including credit derivatives and various types of asset-backed securities. In the calculation of capital requirements under Basel II, various credit risk mitigation techniques can be used in order to limit credit risk.

Under the standardised approach, these include financial collateral as well as guarantees and credit derivatives. Basel II better assesses the risk inherent in arrangements using evolving technologies, such as securitisation and credit derivatives, that are used to buy and sell credit risk. Basel II also establishes benchmarks for recognising risk transfer and mitigation in securitisation and credit derivatives structures. It sets a boundary between the point at which a firm transfers risk and actually retains the risk. Capital Charge for Operational Risk 5. This definition includes legal risk, but excludes strategic and reputational risk.

The most important types of operational risk involve breakdowns in internal controls and corporate governance. Such breakdowns can lead to financial losses through error, fraud, or failure to perform in a timely manner or cause the interests of the bank to be compromised in some other way, for example, by its dealers, lending officers or other staff exceeding their authority or conducting business in an unethical or risky manner.

Other aspects of operational risk include major failure of information technology systems or events such as major fires or other disasters. As the number of employees, business par tners, customers, branches, systems and processes at a bank increases, its risk potential also tends to rise. Other operational risk indicator is process intensity, i. In cases where business operations for instance , the processing activities mentioned above are outsourced, the bank cannot automatically assume that operational risks have been eliminated completely. Therefore, the content and quality of the service level agreement as well as the quality for instance, ISO certification and creditworthiness of the outsourcing service provider can also serve as risk indicators in this context.

The Basel II framework has given guidance to three broad methods of capital calculation for operational risk — basic indicator approach which is based on annual revenue of the financial institution , standardised approach which is based on annual revenue of each of the broad business lines of the financial institution and advanced measurement approaches which are based on the internally developed risk measurement framework of the bank adhering to the standards prescribed and include methods such as internal measurement approach IMA , loss distribution approach LDA , scenario-based, and scorecard.

In this approach, a risk weight of 15 per cent is applied to a single indicator, specifically the average gross income i. The advantage of applying the basic indicator approach primarily lies in its simplicity. In order to come to a better assessment of the risk profile, it is advisable not to rely on the basic indicator approach alone to capture risks.

However, in this case the indicator is not calculated for the bank as a whole, but individually for specific business lines as defined by the supervisory authority retail, corporate, trading, etc. Accordingly, the standardised approach includes not only a risk weight of 15 per cent, but specific risk weights defined for each business line. This means that applying the standardised approach basically involves the same problems as applying the basic indicator approach.

Advanced measurement approaches provide banks with substantial flexibility and do not prescribe specific methodologies or assumptions. However, they do specify several qualitative and quantitative standards to be met by banks before adopting these approaches. The quantification models for operational risk using internal methods are currently in the developmental stage. Since the international accord was issued in , individual countries have been implementing national rules based on the principles and detailed framework that it sets forth, and each country has used some measure of national discretion within its jurisdiction.

The Basel Committee noted that as a result, regulators from different countries would need to make substantial efforts to ensure sufficient consistency in the application of the framework across jurisdictions. Pillar 2: Supervisory Review 5. On the other hand, Pillar 2 also requires the supervisory authorities to subject all banks to an evaluation process and to impose any necessary supervisory measures based on the evaluations Box V.

Banks are required to employ suitable procedures and systems in order to ensure adequate capital in the long-term with due attention to all material risks. The Basel Committee has defined the following four basic principles for the supervisory review process. 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.

Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process. 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.

Reference: Bank for International Settlements. In particular, it is important to detect, at the earliest possible, developments which may endanger the institution in order to enable the bank to take suitable countermeasures. For this purpose, the bank needs to ensure that the available risk coverage capital is sufficient at all times to cover the risks taken. Secondly, the bank must review the extent to which risks are worth assuming, that is, it is necessary to analyse the opportunities arising from risk taking evaluation of the risk and return.

The ICAAP thus constitutes a comprehensive package which delivers significant benefits from a business perspective. The purpose of assessing risks is to depict the significance and effects of risks taken on the bank. Banks need to implement efficient and appropriate stress testing framework and assess the impact not only of specific events, but also the impact of various scenarios. In the first step, a bank needs to use risk indicators to assess which of its risks are actually material.

In the second step, the bank needs to quantify its risks, wherever possible. The results of these impact studies need to be integrated into capital planning and business strategy. Finally, the bank needs to calculate the internal capital required to cover its risks. Pillar 3: Market Discipline 5. Market discipline in the banking sector can be described as private counterparty supervision that has always been the first line of regulatory defence in protecting the safety and soundness of the banking system Greenspan, Banks with higher capital ratios may be able to access the capital market for raising resources, which, in turn, allow banks to maintain higher capital levels.

The aim is to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution. The area of validation might emerge as a key challenge for banking institutions in the foreseeable future. At present, few banks possess processes that both span the range of validation efforts listed and address all elements of model uncertainty.

The components of model validation can be grouped into four broad categories: a backtesting, or verifying that the ex ante estimation of expected and unexpected losses is consistent with ex post experience; b stress testing, or analysing the results of model output given various economic scenarios; c assessing the sensitivity of credit risk estimates to underlying parameters and assumptions; and d ensuring the existence of independent review and oversight of a model. Backtesting The methodology applied to backtesting market risk VaR models is not easily transferable to credit risk models due to the data constraints.

The Market Risk Amendment requires a minimum of trading days of forecasts and realised losses. Given the limited availability of data for out-of-sample testing, backtesting estimates of unexpected credit loss are certain to be problematic in practice. It is difficult to find a formal backtesting programme for validating estimates of credit risk — or unexpected loss. Where analyses of ex ante estimates and ex post experience are made, banks typically compare estimated credit risk losses to a historical series of actual credit losses captured over some years.

While such independent work on backtesting is limited, some literature indicates the difficulty of ensuring that capital requirements generated using credit risk models will provide an adequately large capital buffer. However, the assumption underlying these approaches is that prevailing market perceptions of appropriate capital levels for peer analysis or credit spreads for rate of return analysis are substantially accurate and economically well founded.

If this is not so, reliance on such techniques raises questions as to the comparability and consistency of credit risk models, an issue which may be of particular importance to supervisors. Stress Testing Stress tests aim to overcome some of the major uncertainties in credit risk models — such as the estimation of default rates or the joint probability distribution of risk factors — by specifying particular economic scenarios and judging the adequacy of bank capital against those scenarios, regardless of the probability that such events may occur. Stress tests could cover a range of scenarios, including the performance of certain sectors during crises, or the magnitude of losses at extreme points of the credit cycle.

In theory, a robust process of stress testing could act as a complement to backtesting given the limitations inherent in current backtesting methods. However, there is no ideal framework or single component of best practice on stress testing, and industry practices vary widely. In , the Committee on the Global Financial System conducted an extensive survey covering 64 banks and securities firms from 16 countries BIS, More than 80 per cent of the stress tests reported were based on trading portfolios.

The use of stress tests has expanded from the exploration of exceptional but plausible events, to encompass a range of applications. Among the major challenges are those related to stress testing credit risk, integrated stress testing and the treatment of market liquidity in stress situtations. With respect to stressed conditions, Basel II has advanced comprehensive stress testing frameworks. The Basel II framework requires that stress scenarios capture the effects of a downturn on market and credit risks, as well as on liquidity. Such an improved firm-wide approach to risk assessment is essential for ensuring that banks have a sufficient capital buffer that will carry them through difficult periods.

Sensitivity Analysis The practice of testing the sensitivity of model output to parameter values or to critical assumptions is also not common. In the case of certain proprietary models, some parameter and even structural assumptions are unknown to the user, and thus sensitivity testing and parameter modification are difficult. However, the depth of the analysis differed between the 54 respondent banks.

Furthermore, none of the respondents attempted to quantify the degree of potential error in the estimation of the probability distribution of credit losses, though a few compared the results generated by the internal model with those from a vendor model. Management Oversight and Reporting The mathematical and technical aspects of validation are important. Equally important, however, is the internal environment in which a model operates.

The amount of senior manager oversight, the proficiency of loan officers, the quality of internal controls and other traditional features of the credit culture will continue to play a key part in the risk management framework. References: Riskmetrics Group. Risk Management: A Practical Guide.

Bank for International Settlements. However, direct additional capital requirements rarely serve as a response to non-disclosure, except in certain cases. In addition to the general intervention measures, the revised framework also anticipates a role for specific measures. These elements of Basel II take the regulatory framework closer to the business models employed in several large banks. Basel II compliant banks can also achieve better capital efficiency as identification, measurement and management of credit, market and operational risks have a direct bearing on regulatory capital relief.

Operational risk management would result in continuous review of systems and control mechanisms. Capital charge for better managed risks is lower and banks adopting risk-based pricing are able to offer a better price interest rate for better risks. This helps banks not only to attract better business but also to formulate a business strategy driven by efficient risk-return parameters.

However, competition in the market where pricing is controlled by market might override the risk-based pricing. Risk levels enable estimation of risk appetite and capital allocation. Basel II would improve the collection and use of data so that they could aggregate and better understand information about their risk portfolios. For instance, the framework requires fundamental improvement in the data supporting the probability of default PD , exposure at default EAD and loss given default LGD 2 estimates that underpin economic and regulatory capital assessments over an economic cycle.

This has spurred improvements in areas such as data collection and management information systems. These advances, along with the incentives to improve risk management practices, will support further innovation, and improvement in risk management and economic capital modelling. Thus, banks would be required to adopt superior technology and information systems which aid them in better data collection, support high quality data and provide scope for detailed technical analysis. The recent financial turmoil exhibited that even such technical analysis have their limitations, such as incomplete data or assumptions that have not been tested across business cycles.

Therefore, quantitative assessment of risks also needs to be supplemented by qualitative measures and sound judgement. Pillar 2 of the framework provides greater scope for bankers and supervisors to engage in a dialogue, which ultimately will be one of the important benefits emanating from the implementation of Basel II. Indeed, market participants play a useful role by requiring banks to hold more capital than implied by minimum regulatory capital requirements - or sometimes their own economic capital models - and by demanding additional disclosures about how risks are being identified, measured, and managed.

A strong understanding by the market of pillars 1 and 2 would make Pillar 3 more comprehensible and market discipline a more reliable tool for supervisors and the market. A more risk sensitive minimum capital ratio is also intended to encourage large banks to make lending, investment, and credit risk hedging decisions based on the underlying economics of the transactions. Moreover, increasing the risk sensitivity of the minimum capital requirements is intended to give large banks stronger incentives to manage and measure their own risk. Finally, Basel II sets minimum risk-based capital requirements at the level of the individual credit exposure, and in doing so sharply differentiates in terms of quality of credit.

Over three-quarters of respondents believed that Basel II will change the competitive landscape for banking. Those organisations with better risk systems are expected to benefit at the expense of those which have been slower to absorb change. Eighty-five per cent of respondents believed that economic capital would guide some, if not all, pricing. Greater specialisation was also expected, due to increased use of risk transfer instruments.

A majority of respondents over 70 per cent believe that portfolio risk management would become more active, driven by the availability of better and more timely risk information as well as the differential capital requirements resulting from Basel II. This could improve the profitability of some banks relative to others, and encourage the trend towards consolidation in the sector.

First, holding assets with higher risk under Basel II would require banks to hold more capital relative to lower risk assets. Second, banks with higher risk credit portfolios or greater exposure to operational risk would be required to hold relatively more capital than banks with lower risk profiles.

For instance, a bank with a business line more susceptible to fraud, could face relatively higher capital requirements in those areas. Third, although more risk sensitive capital requirements can help enhance safety and soundness, the level of regulatory capital must also be sufficient to account for broader risks to the economy and safety and soundness of the banking system, which will require ongoing regulatory scrutiny.

Moreover, it is essential to have robust and resilient core firms at the centre of the financial system operating on safe and sound risk management practices Box V. The Basel II plays an important role in this respect by ensuring the robustness and resilience of these firms through a sound global capital adequacy framework along with other benefits including greater operational efficiencies, better capital allocation and greater shareholder value through the use of improved risk models and reporting capabilities.

Limitations of Basel II 5. Compared to Basel I, Basel II is considered to be highly complex, making its understanding and implementation a challenge to both the regulators and the regulated entities, par ticularly in the emerging market economies. The complexity of Basel II arises from several options available. Consequently, many of the countries that have voluntarily adopted Basel I also view these issues with considerable caution.

Since the revised Framework has been designed to provide options for banks and the banking systems worldwide, the Basel Committee on Banking Supervision BCBS acknowledged that moving toward its adoption in the near future may not be the first priority for all non-G10 supervisory authorities in terms of what was needed to strengthen their supervision. It observed that each national supervisor was expected to consider carefully the benefits of the Basel II framework in the context of its domestic banking system when developing a timetable and approach for implementation.

While it is true that the Basel II framework is more complex, at the same time, it has also been argued that this complexity is largely unavoidable mainly because the banking system and related instruments that have evolved in recent times are inherently complex in nature. The risk management system itself has become more sophisticated over the time and applying equal risk weights as done in the Basel I accord may not be realistic anymore. Moreover, for banks with straightforward business models and non-complex loan portfolios, the option to use the standardised approach in the Basel II framework is open, which adds very little in the way of complexity to their already existing models.

The financial turmoil that occurred in mid - widely known as the sub-prime crisis - has affected the balance sheets of some major global financial institutions and has also resulted in market liquidity crisis. This turmoil was a fallout of an exceptional credit boom and leverage in the financial system. A long period of consistent economic growth and stable financial conditions had resulted in increased risk appetite of borrowers as well as investors. Financial institutions responded by expanding the market for securitisation of credit risk and aggressively developing the originate-to-distribute model for financial intermediation.

A slowdown in the US real estate market triggered a series of defaults and this snowballed into accumulated losses, especially in the case of complex structured securities. The build-up to and unfolding of the financial turmoil took place under the Basel I capital framework as most of the countries have started implementation of Basel II framework only recently. This financial turmoil has, in fact, highlighted many of the shortcomings of the Basel I framework, including its lack of risk sensitivity and its inflexibility to rapid innovations.

In contrast, the Basel II framework has provision for better risk management practices by closely aligning the minimum capital requirements with the risks that banks face Pillar 1 , by strengthening supervisory review of bank practices Pillar 2 and by encouraging improved market disclosure Pillar 3. Notwithstanding the improvements over the Basel I framework, the current Basel II framework still has certain deficiencies if evaluated in the light of current financial turmoil.

Under the first pillar, a relook at the treatment of highly rated securitisation exposures, especially the so-called collateralised debt obligations CDOs of asset backed securities ABS is necessary. The role of this securitisation process in the current turmoil and its leverage capacity and their systemic implications have come under intense scrutiny in recent times.

These products include structured credit assets and leveraged lending and the VaR-based approach is insufficient for these types of exposures and needs to be supplemented with a default risk charge. Though banks are already required to conduct stress tests of their credit portfolio under the second pillar of the Basel framework to validate the adequacy of their capital cushions, the importance of conducting scenario analyses and stress tests of their contingent credit exposures, both contractual and non-contractual, need to be reemphasised.

In Pillar 3, there are opportunities to further leverage off the types of disclosures required under Basel II. Against this backdrop, several measures have been suggested for mitigating the impact and improving the global financial system. The most noteworthy among these are the proposals made by the Financial Stability Forum FSF 1 and ratified in early April by the G-7 to be implemented over the next days. By the mid, the Basel Committee is expected to issue revised liquidity risk management guidelines and IOSCO is expected to revise its code of conduct for credit rating agencies.

References : Financial Stability Forum. Buiter, W. Noyer, C. Wellink, N. Trichet, J. However, rating agencies have limited penetration in many emerging countries. In the absence of reliable ratings for different assets, banking industry will not be able to fully exploit the flexibility of Basel II and most credit risks will tend to end up in the unrated per cent category and as a result there will be little change in capital requirements relative to Basel I. It has also been argued that in the case of standardised approach, unrated borrowers will have a lower risk weight per cent as compared to the lowest graded borrower per cent and this may lead to moral hazard problem with lower grade borrowers preferring to remain unrated.

This may also lead to adverse selection. Even in the developed economies, the recent sub-prime crisis has highlighted the problems relating to the role of rating agencies. Thus, the regulators in developing countries need to independently assess whether all the assumptions of Basel II framework are applicable to their domestic markets and modify them suitably, if required. In such a situation, there are some concerns that small businesses and poor segments of the society would receive no or very costly credit. This problem may prove to be serious, especially in developing countries. The regulatory and supervisory authorities in developing countries were, therefore, required to initiate other steps to ensure adequate supply of credit to these areas.

While initial estimates of the potential impact of Basel II showed some decline in minimum required risk-based capital, a considerable amount of uncertainty remains about the potential impact of Basel II on the level of regulatory capital requirements and the degree of variability in these requirements over the business cycle. One of the major challenges is the availability of long time series data. Good and reliable data and information as also sophisticated IT resources are critical to the proper risk assessment under the Basel II framework. However, this may prove to be a major challenge in developing countries given the level of industry expertise, lack of historical data and absence of adequate technology.

In view of these constraints, banks in emerging economies are forced to adopt the standardised approach. Moreover, the cost that medium to small banks may incur on acquiring the required technology as well as training staff may prove to be enormous given their size. Banks would be required to use fully scalable state of the art technology, ensure enhanced information system security and develop capability to use the central database to generate any data required for risk management as well as reporting.

The emphasis on improved data standards in the revised accord is not merely a regulatory capital requirement, but rather it is a foundation for risk-management practices that will strengthen the value of the banking franchise. Most credit instruments are not marked to market; hence, the predictive nature of a credit risk model does not derive from a statistical projection of future prices based on comprehensive historical experience. The scarcity of the data required to estimate credit risk models also stems from the infrequent nature of default events and the longer term time horizons used in measuring credit risk.

Thus, in specifying model parameters, credit risk models require the use of simplifying assumptions and proxy data. Where market risk models typically employ a horizon of a few days, credit risk models generally rely on a timeframe of one year or more. The longer holding period, coupled with the higher target loss quantiles4 used in credit risk models, presents problems to model-builders in assessing the accuracy of their models. A quantitative validation standard similar to that in the Market Risk Amendment would require an impractical number of years of data, spanning multiple credit cycles.

Moreover, it is more likely that significant losses can accumulate unnoticed in the banking book, as they are not marked to market. Even in the absence of Basel II, well managed financial institutions and regulatory authorities would have continued to update and improve their IT systems and risk management practices simply to keep pace with the evolving practices in the marketplace.


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However, Basel II has pushed banks and supervisors for development of human resource skills and IT upgradation. In this context, the challenge that banks are likely to face will have many facets, viz. The existence of separate supervisory bodies to regulate different segments of the markets within a jurisdiction may create challenges in implementation of Basel II not only within a jurisdiction but also across jurisdictions. This is because when different market participants are regulated by separate supervisors, it is difficult to maintain comparable quality of policy formulation and vigilance.

In many developing countries, only the banks are coming under the ambit of Basel II and not other financial services providers, thus creating some scope for regulatory arbitrage.

Grief following sudden or unexpected death

The Executive Board of the International Monetary Fund IMF indicated that premature adoption of Basel II in countries with limited capacity could inappropriately divert resources from the more urgent priorities, ultimately weakening rather than strengthening supervision. Furthermore, they felt that countries should give priority to strengthening their financial systems comprising institutions, markets and infrastructure and focus on achieving greater level of compliance with the Basel Core Principles.

In the same vein, it is recognised by the BCBS that while Basel II has been designed to provide options for banks and banking systems worldwide, moving towards its adoption may not be a first priority for all supervisory authorities in terms of what is needed to strengthen their supervision.

In the course of 71 confidential assessments covering 12 advanced, 15 transition and 44 emerging economies, it was found that all advanced economies under consideration complied with the core principles regarding market risk and risk management. In contrast, 66 per cent of emerging economies and 53 per cent of transition economies did not comply with such principles.

Expected Loss Unexpected Loss, Economic Capital case study

Given this level of compliance, the challenges that are likely to be faced by the emerging economies in implementing the Basel II framework will be daunting. Based on assessment of its own position with respect to the principles, working groups were set up to make recommendations on strengthening certain areas such as risk management system for banks, amendments to banking legislation, developing a framework for home and host country relations, and enhancing inter-agency and inter-department cooperation.

The new BCPs revised in include several new regulatory issues relating to capital adequacy, risk management, consolidated supervision and lack of supervisory independence, which are the building blocks for Basel II framework. As mentioned earlier, all scheduled commercial banks in India would be implementing the Basel II norms by end-March By then, several new core principles are expected to be complied with.

The Reserve Bank is currently in the process of examining the new BCPs on banking supervision for implementation. Basel II and Pro-cyclicality 5. This is because banks continue to be the main source of credit for most businesses and entrepreneurs. Further, one might be able to link the choice of the above broad ranges to the extent of share of foreign banks in the respective banking sectors.

It is observed that the banking systems where foreign banks account for a significant share in the banking assets Singapore and Hong Kong are reflecting a desire to adopt the advanced approaches ahead of those territories where the foreign bank share is not significant. One might also see a similar trend in respect of countries which might remain on Basel I for a longer period before migrating to Basel II China Annex V. In terms of Section 17 of the Banking Regulation Act, , every banking company incorporated in India is required to create a reserve fund5.

In India, before adoption of Basel I, the only regulatory capital requirement for banks was the minimum capital requirements laid down in the Banking Regulation Act, and the respective acts governing the functioning of public sector banks. The declining ratio of capital paid-up capital plus reserves to total deposits from 9 per cent in to 4 per cent in for Indian banks, prompted the Reserve Bank to advise banks to aim at a ratio of 6 per cent, through compulsory transfers of 20 per cent of declared profits to reserves Jagirdar, In the post-nationalisation period, however, the issue of capitalisation received less attention, and the capital to deposit ratio for public sector banks fell to fairly low levels less than 2 per cent in the early s.

The capital to debt ratio of the scheduled commercial banks, which was 0. The ratio increased to 3. The sharp increase in the ratio from the year ended March and onwards was on account of application of capital adequacy norms from the year ended March Moreover, there is a need to provide the right incentives to the management of public sector banks so that they can perform in a competitive environment. However, Government ownership makes an indirect favourable impact on the capital position of banks as at the same level of financial indicators, the rating agencies would perhaps accord a better rating to a public sector bank.

Also, the customers in many areas still view the public sector banks as safer entities for placing their deposits and are ready to forego some higher interest on deposits offered by others. The definition of liquid assets included cash, gold or unencumbered approved securities, reflecting the concept of immediate mobilisation or liquefaction of the assets.

The introduction of SLR was the outcome of the action taken to prevent banks from offsetting the impact of variable reserve requirements by liquidating their Government security holdings, amounting to not less than 20 per cent of the total demand and time liabilities. The Act was, therefore, amended in by insertion of a new sub-section 2A in Section 24, requiring all banks to maintain a minimum amount of liquid assets equal to not less than 25 per cent of their demand and time liabilities in India, exclusive of the balances maintained under Section 42 of the Reserve Bank of India Act in the case of scheduled banks, and exclusive of the cash balances maintained under Section 18 of the Banking Regulation Act in the case of non-scheduled banks.

Although the SLR was instituted as a prudential requirement, it became an instrument for financing the Government deficit and requirements of certain public sector entities in the s and the s. P rogram directors are prepared for many eventualities, but the sudden death of a trainee from an accident, an acute medical event, or suicide can come without any road map for response. Faculty must manage practical issues and their own emotions while at the same time helping residents deal with the loss of a peer. When Chandlee C. Dickey, MD, found herself in this situation in , as the training director of the Harvard South Shore psychiatry residency training program in Boston, she initially turned to PubMed for advice but came up empty.

After some time had passed, she and her associate training director, Barbara Cannon, MD, reflected on what they had learned and published a paper in the August Journal of Graduate Medical Education , offering a potential framework for other programs that might someday need it. The framework covers gathering resources, breaking the news, talking with the deceased's family, and handling memorial services , among other topics.

A: The key was to send out an email broadly that I needed all the residents in a particular location by a particular time and that the expectation was that the residents, except for those on call, would not be returning to clinical duties. To get an email like that from me would be very unusual—and it was very short and very clear—so it let people know that something was up. I am grateful to all of the faculty as they responded without question.

I put all the chairs in a massive circle because I wanted everyone to be together. I gave the news slowly, and we passed a microphone around so that if someone wanted to say something, they could.


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  • They wouldn't be overshadowed by others' voices. Another thing I did was express my anger, that it was OK to be angry at this person who died, and to express my sadness. I expressed my grief and my worry for the other residents. I modeled the kind of emotions that others might have, very intentionally, which I think allowed others to express what they needed to express.

    A: That meeting lasted two hours. I allowed for a lot of quiet time, because with the quiet, other people spoke up. It seemed to me that that meeting would define how things would go, future messages, and what the residents experienced. That was critical, having absolutely everyone together, free from future responsibilities for that day, with time to be together and time to build our trust and community. Q: You talk in the paper about disenfranchised grief, which you define as grief that's not freely expressed and even repressed, and how the effects of a trainee's death can come up after you might expect it.

    How might that manifest itself? A: I heard from a resident or two that it became very difficult to know how to support people. Two or three weeks after the death, a caring faculty member probed residents' feelings instead of teaching during didactics and it was a disaster. Because the residents didn't want to delve into their feelings right then. They wanted to learn about motivational interviewing or whatever the topic of the day was. It was not very easy—in fact quite difficult—to know with whom do we need to intervene, when, and in what way. You really have to know your team, and a lot of leaders don't necessarily know their team that well, and people who are grieving silently aren't necessarily going to tell you.

    I think that time between one month and four months out is pretty tricky. A: What to do about the anniversary, the one-year memorial. I knew we had to mark it, and I had some initial ideas on how we might mark it. They had ideas that they thought would work better for them. But having those discussions raised a lot of complicated issues. Six years down the road, when people don't remember the deceased and staff has turned over, a memorial lecture may no longer have the same meaning for the people involved. How do you stop an annual event?