2fr04-inscoefdic basel ii

8/3/2019 2fr04-Inscoefdic Basel II

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The Evolution to Basel IIXBRL and the Basel II Capital Accord

Donald Inscoe

Deputy Director

Division of Insurance and Research

U.S. Federal Deposit Insurance Corporation

XBRLInternational, Tokyo, Japan November 8, 2005


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First Basel Accord

The first Basel Accord (Basel I) was

completed in 1988 Set minimum capital standards for banks

Standards focused on credit risk, the main riskincurred by banks

Became effective end-year 1992


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Reason for the Accord

To create a level playing field for

internationally active banks Banks from different countries competing for the

same loans would have to set aside roughly thesame amount of capital on the loans


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1988 Accord Capital Requirements

Capital was set at 8% and was adjusted by a

loans credit risk weight Credit risk was divided into 5 categories:

0%, 10%, 20%, 50%, and 100%

Commercial loans, for example, were assigned to

the 100% risk weight category


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Risk-Based Capital

The Accord was hailed for incorporating risk

into the calculation of capital requirements


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Capital Calculation

To calculate required capital, a bank would

multiply the assets in each risk category bythe categorys risk weight and then multiplythe result by 8%

Thus a $100 commercial loan would be multiplied

by 100% and then by 8%, resulting in a capitalrequirement of $8


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Criticisms of the Accord

The Accord, however, was criticized for

taking too simplistic an approach to settingcredit risk weights and for ignoring othertypes of risk


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Risk Weights

Risk weights were based on what the parties

to the Accord negotiated rather than on theactual risk of each asset

Risk weights did not flow from any particularinsolvency probability standard, and were for the

most part, arbitrary


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Operational and Other Risks

The requirements did not explicitly account

for operating and other forms of risk that mayalso be important

Except for trading account activities, the capitalstandards did not account for hedging,

diversification, and differences in riskmanagement techniques


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Banks Develop Own CapitalAllocation Models

Advances in technology and finance allowed

banks to develop their own capital allocation(internal) models in the 1990s

This resulted in more accurate calculations ofbank capital than possible underBasel I

These models allowed banks to align theamount of risk they undertook on a loan withthe overall goals of the bank


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Internal Models and Basel I

Internal models allow banks to more finely

differentiate risks of individual loans than ispossible underBasel I

Risk can be differentiated within loan categoriesand between loan categories

Allows the application of a capital charge toeach loan, rather than each category of loan


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Variation in Credit Quality

Banks discovered a wide variation in credit

quality within risk-weight categories Basel I lumps all commercial loans into the 8%

capital category

Internal models calculations can lead to capital

allocations on commercial loans that vary from1% to 30%, depending on the loans estimatedrisk


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Capital Arbitrage

If a loan is calculated to have an internal

capital charge that is low compared to the8% standard, the bank has a strong incentiveto undertake regulatory capital arbitrage

Securitization is the main means used by

U.S. banks to engage in regulatory capitalarbitrage


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Example of Capital Arbitrage

Assume a bank has a portfolio of commercial loans with the followingratings and internally generated capital requirements AA-A: 3%-4% capital needed B+-B: 8% capital needed B- and below: 12%-16% capital needed

UnderBasel I, the bank has to hold 8% risk-based capital against all ofthese loans

To ensure the profitability of the better quality loans, the bank engagesin capital arbitrage--it securitizes the loans so that they are reclassifiedinto a lowerregulatory risk category with a lower capital charge

Lower quality loans with higher internal capital charges are kept on thebanks books because they require less risk-based capital than thebanks internal model indicates


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New Approach to Risk-Based Capital

By the late 1990s, growth in the use of

regulatory capital arbitrage led the BaselCommittee to begin work on a new capitalregime (Basel II)

Effort focused on using banks internal rating

models and internal risk models June 1999: Committee issued a proposal for

a new capital adequacy framework to replacethe 1998 Accord


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Basel II

Basel II consists of three pillars:

Minimum capital requirements for credit risk,market risk and operational riskexpanding the1988 Accord (Pillar I)

Supervisory review of an institutions capitaladequacy and internal assessment process (Pillar

II) Effective use of market discipline as a lever to

strengthen disclosure and encourage safe andsound banking practices (Pillar III)


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Pillar I

In the United States, all banks that will be

required to conform to the new capitalstandard will use the Advanced InternalRatings Based approach (AIRB)


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AIRB Approach Requirements

Collect sufficient data on loans to develop a

method for rating loans within variousportfolios

Develop a Probability of Default (PD) foreach rated loan

Develop a Loss Given Default (LGD) for eachloan


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Example: Safe v. Risky Loans

Safe loans:

Over a 1-year period, only 0.25% of these loansdefault

If a loan defaults, the bank only loses 1% on theoutstanding amount

R

isky loans: Over a 1-year period, 1% of loans default every

year

If a loan defaults, the bank loses 10% of theoutstanding amount


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(continued)

For a $100 million portfolio of the safe loans,

the bank would expect to see $250,000 indefaults in a year and a loss on the defaultsof $2500

($100 million X .25% = $250,000)

($250,000 X 1% loss rate = $2500)


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(continued)

For a $100 million in a risky portfolio the

bank would expect to see $1 million indefaults in a year and a loss on the defaultsof $100,000

($100 million X 1% = $1 million)

($1 million X 10% = $100,000)


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Goal ofPillar I

Although simplistic, this example

demonstrates what Pillar I is trying to achieve If the banks own internal calculations show that

they have extremely risky, loss-prone loans thatgenerate high internal capital charges, theirformal risk-based capital charges should also behigh

Likewise, lower risk loans should carry lower risk-based capital charges


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Complexity ofPillar I

Banks have many different asset classes

each of which may require different treatment Each asset class needs to be defined and the

approach to each exposure determined

Minimum standards must be established for

rating system design, including testing anddocumentation requirements

The proposals must be tested in the real world


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Assessing Basel II

To determine if the proposed rules are likely

to yield reasonable risk-based capitalrequirements within and between countriesfor banks with similar portfolios, fourquantitative impact studies (QIS) have been

undertaken


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Results of Quantitative Impact Studies

Results of the QIS studies have been

troubling Wide swings in risk-based capital requirements

Some individual banks show unreasonably largedeclines in required capital

As a result, parts of the Accord have beenrevised


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Operational Risk

Pillar I also adds a new capital component

for operational risk Operational risk covers the risk of loss due tosystem breakdowns, employee fraud ormisconduct, errors in models or natural or man-made catastrophes, among others


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Pillars II and III

Progress has also been made on Pillars II

and III Pillar II focuses on supervisory oversight

Pillar III looks at market discipline and publicdisclosure


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Pillar II

Supervisory Oversight

Requires supervisors to review a banks capitaladequacy assessment process, which mayindicate a higher capital requirement than Pillar Iminimums


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Pillar III

Market discipline and public disclosure

The United States is currently in the forefront ofdisclosure of financial data SEC disclosure requirements for publicly traded banks

Bank regulators require quarterly filing of call reports forall banks

U.S. authorities are currently considering whatbanks should publicly disclose about theirBasel IIcalculations


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U.S. Implementation of Basel II

Based on results for QIS4, which show the

potential for substantial declines in capital,the U.S. banking regulators have proposed arevised implementation timeline

The revised timeline includes a minimum three-

year transition period


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Revised U.S. Timeline for Basel II

Implementation

Year Transistional Arrangements2008 Parallel Run

2009 95% floor

2010 90% floor

2011 85% floor


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U.S. Implementation of Basel II

(Continued)

After 2011, an institutions primary federal

supervisor will assess the institutionsreadiness to operate underBasel II

Institutions will be assessed on a case-by-casebasis

Further revisions to the floors are anticipated Both Prompt Corrective Action and leverage

capital requirements will remain


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Basel I-A: The Search forEqual

Capital Treatment

In the U.S., concerns that Basel II could give

those banks operating under it a competitiveadvantage over other banks has resulted in aproposal called Basel 1-A

Basel 1-A is designed to modernize the way

allU.S. banks and thrifts calculate theirminimum capital requirements


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Implications

The practices in Basel II represent several

important departures from the traditionalcalculation of bank capital The very largest banks will operate under a

system that is different than that used by otherbanks

The implications of this for long-term competitionbetween these banks is uncertain, but meritsfurther attention


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Implications

Basel IIs proposals rely on banks own

internal risk estimates to set capitalrequirements

This represents a conceptual leap in determiningadequate regulatory capital

For regulators, evaluating the integrity ofbank models will be a significant step beyondthe traditional supervisory process


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Implications

The proposed Accord will elevate the

importance of human judgment in theprocess of capital regulation

Despite its quantitative basis, much will dependon the judgment of banks in formulating their

estimates and of supervisors in validating theassumptions used by banks in their models


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Work Continues

During the past 3 years the FDIC has

expressed its concern that the proposedAccord will result in banks having too littlerisk-based capital

Work continues on recalibrating the

proposals and a workable solution isexpected


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ImplicationsAdditional Data Needed to Counterbalance to Changes inEnvironment

Higher

Leverage

UnprovenRating

Systems

Evolving

Control

Structures

Three Year

Floors/Leverage

Ratio

Improved Risk

Management

Changes in environmentnecessitate changes in risk

analysis for banks and

supervisors/insurers

Additional information will be

needed to:

Inform policy development.

Supplement other sources of

risk information used in

supervisory resource planningand overall risk assessments

Serve as an input into deposit

insurance pricing and overall

insurance funds adequacy

analyses


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Why XBRL ?

Internal ratings based and standard approachmeasures require complex data model Common data requirements flow from Accord and

Quantitative Impact Studies (QIS I IV)

Domestic and international comparisons needed to ensureconsistent application

Taxonomy needed to compare banks internal ratings ofsimilar and diverse risks


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Common Data Elements Flow from Accord:Standardized Internal Risk Estimates

Exposure

Internal Risk

Estimate

PD

L

GD

E

AD M

O

ther

Wholesale X X X X -

Retail X X X - -

Securitization - - - - X

Equity - - - - X

Market Risk - - - - X

Operational

Risk- - - - X

Data Types Reporting Granularity

Portfolio

LevelData

Individual

ExposureData for

All Transactions

Summary

Data


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Why XBRL ?

Internal ratings based measures and standard approach requirecomplex data model

Supervisors need detailed information to qualify banks foradvanced approaches (IRB, AMA, and Market Risk)

Data can be shared across different supervisory regimes

- Independent of systems, platforms, geography and languagetranslation


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Consistent data needed to help identify risk estimatesthat may be inconsistent with peer estimates.

Follow-up: Can differences between Banks PD and benchmark be adequately

explained by differences in risk?

0

5

10

15

20

25

30

35

40

AA or better A to AA BBB to A BB to BBB B to BB >B

Banks PDDistribution Mapped to S&P Rating Scale

Peer Banks PDDistribution Mapped to S&P Rating Scale

% of Wholesale Exposures


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Why XBRL ?

XBRL provides a framework for complex data

model Open standard facilitates reuse and innovation

Analysts can spend more time analyzing data

Reduced reporting burden, especially for

organizations operating in multiple jurisdictions


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Why XBRL ?

A standard is needed in any case.


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Why XBRL ?

FINIS

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