Oct 09

Basel II: Cheatsheet for 2007 FRM

by David Harper, CFA, FRM, CIPM

FRM |

For customers, I just published a 'new and improved' Basel II cheatsheet. Actually, more like a 'cheatmap' (and I am giddy to practice Adobe CS3 Illustrator skills learned from the fantastic Mordy Golding).

When you try to learn Basel II for the first time, the first hurdle is sorting out the relationships. You will immediately notice there is never one approach, there are "evolving" sets of approaches: from basic ("standardized") to advanced ("internal").

First, it is three pillars, minimum capital, supervisor review and market discipline.

Three Pillars

threePillars

My sports analogy: the first pillar is the rule book (i.e.,  technical rules for capital requirements), the second pillar is the referee system (i.e., guidance for supervisors, or national regulators), the third pillar is like televised reply for the audience (i.e., disclosure requirements that ensure investors are informed about risk so they can exercise market discipline).

Same old Cooke ratio

Under the first pillar, banks have the same capital ratio requirement: they must hold capital against eight percent (8%) of their risk-weighted assets (RWA). Almost all of the changes in Basel II are about the denominator, RWA:

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Total capital

What is the total capital, that must be eight percent of RWA? It comes in three tiers, but Tier 3 is only for market risk and Tier 2 cannot exceed Tier 1. Tier 2 is supplementary, it probably can be used to buffer losses but not as readily as Tier 1. So, Tier 1 is the important equity capital. And equity-like capital; for example, non-cumulative preferred is Tier 1 but cumulative preferred is Tier 2.

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First Pillar contains all the rules around estimating risk-weighed assets

The 'cheatmap has four screens, one each for credit risk, market risk, operation risk. And one for two areas that attach to credit risk: mitigation (e.g., collateral) and securitization.

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...and there are screens (pages) for the second and third Pillars, too!

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