Nov 14

Basel II in the United States (and links to our free 14-part Basel Primer!)

by David Harper, CFA, FRM, CIPM

A Basel Primer in fourteen chapters (posts)

Last week U.S. banking agencies approved the U.S. final rule for Basel II. I recently published a series of tutorials (based on the 2007 FRM learning outcomes) that introduce Basel II. This includes the three pillars, treatment of the three risk buckets (credit, market and operational) and basic/advanced approaches:

Selected high-level highlights from U.S. rule

Scope: "The agencies have identified three groups of banks: (i) large or internationally active banks that are required to adopt the advanced approaches (core banks); (ii) banks that voluntarily decide to adopt the advanced approaches (opt-in banks); and (iii) banks that do not adopt the advanced approaches (general banks)."
Mandatory advanced approaches for credit and operational risk: The final U.S. includes only advanced approaches for credit and operational risk
Small banks. What about small banks who don't qualify for advanced approaches? "The agencies have decided to issue a new standardized proposal, which would replace the Basel IA proposal for banks that do not apply the advanced approaches. The standardized proposal would allow banks that are not core banks to implement a standardized approach for credit risk and an approach to operational risk consistent with the New Accord. Like the Basel IA proposal, the standardized proposal will retain the existing general risk-based capital rules for those banks that do not wish to move to the new rules. The agencies expect to issue the standardized proposal in the first quarter of 2008."
All approaches lead to VaR. The "conceptual foundation" is a value-at-risk (VaR) approach. Since market risk is already VaR-based (internal models approach, per 1996 Amendment), that means all three primary risk categories (credit, market, and operational risk) are VaR-based, at least if implemented at the advanced level. VaR in this context refers to a cumulative loss distribution: unexpected losses, in excess of expected loss (mean), given a confidence level (e.g., 99.9%). The devil's in the many details, but at a very high level, treating regulatory capital like this has its advantages: you can add up (apples-to-apples) the capital for different risk types and, at the end of the day, the idea is "have enough capital to cover the loss distribution out to the far tail, short of the extreme loss tail."
VaR and credit at risk (CaR) are similar but very different! Although both market and credit risk are VaR-oriented, market risk specifies a 99.0% (point-zero) confidence level while credit risk is nominally based on a 99.9% (point-nine) confidence level. We might say "superficially" instead of nominally since the IRB approach to credit risk requires some aggressively simplifying assumptions (namely, portfolio invariance). The bottom line here is the IRB credit risk function is very susceptible to model risk; e.g., the output is highly sensitive to supervisory asset value correlations (AVC)
Transition floors. Three year transition with maximum of 5% capital reduction per year: The transitional floors "prohibit a bank’s risk-based capital requirement under the advanced approaches from falling below 95 percent, 90 percent, and 85 percent of what it would be under the general risk-based capital rules during the bank’s first, second, and third transitional floor periods, respectively."
Qualification depends on a detailed implementation plan. Extensive qualification process, banks must submit an implementation plan: Under the final rule, as under the proposed rule, a bank preparing to implement the advanced approaches must adopt a written implementation plan, approved by its board of directors, describing in detail how the bank complies, or intends to comply, with the qualification requirements.
Four quarter parallel run: "once a bank has adopted its implementation plan, it must complete a satisfactory parallel run before it may use the advanced
approaches to calculate its risk-based capital requirements. The proposed rule defined a satisfactory parallel run as a period of at least four consecutive calendar quarters during which a bank complied with all of the qualification requirements to the satisfaction of its primary Federal supervisor."
Scaling factor. The final rule keeps the 1.06 scaling factor (the scales up the credit risk weighted assets with the sole purpose of maintaining the total level of capital required in the banking system)
The definition of operational risk includes legal risk but excludes strategic and reputational risk
The Cooke ratio continues to survive: at minimum, total risk-based capital must be 8% with Tier I accounting for at least half of that (4% must be Tier I)
Banks "must identify whether each of its on- and off-balance sheet exposures is a wholesale, retail, securitization, or equity exposure. Assets that are
not defined by any exposure category (and certain immaterial portfolios of exposures) generally are assigned risk-weighted asset amounts equal to their carrying value (for on balance sheet exposures) or notional amount (for off-balance sheet exposures)."
Even advanced approaches will need rating agencies: "The securitization framework relies principally on two sources of information, where available, to determine risk-based capital requirements: (i) an assessment of the securitization exposure’s credit risk made by a nationally recognized statistical rating organization (NRSRO); or (ii) the risk-based capital requirement for the underlying exposures as if the exposures had not been securitized (along with certain other objective information about the securitization exposure, such as the size and relative seniority of the exposure).
Much of the future load will be carried by the second and third pillars. Said Governor Randall S. Kroszner yesterday,

"[Banks] should not lose sight of Pillars 2 and 3, which may ultimately be more important to the success of Basel II than Pillar 1, which has received the bulk of the attention so far. Under Pillar 2, banks are required to have an internal process--which will be subject to rigorous supervisory review--for ensuring that they are holding enough overall capital to support their entire risk profile. Thus, Pillar 2 should be a key area of focus for banks implementing Basel II....Pillar 3 [market discipline though disclosure] is a key mechanism for banks to communicate to market participants about their risk profiles, their associated levels of capital, and the manner in which they are meeting the requirements in the final rule. In addition to providing information about its various components of regulatory capital and its minimum capital requirements and ratios, a bank must disclose information about how it measures and manages credit risk, operational risk, equity risk, and interest-rate risk in non-trading activities [emphasis mine], as well as the range of risks related to securitizations. For example, a bank has to describe the operation of its credit risk rating system as well as the data used in parameter estimates for credit losses." Governor Kroszner, 11/13