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The Implications of the "New Capital Adeqaucy Framework" for Credit Risk and Capital Management in the Banking Industry

©2001 Diplomarbeit 66 Seiten

Zusammenfassung

Inhaltsangabe:Abstract:
In their role as financial intermediaries, banks have the inherent task of assuming risks. This statement follows Diamond’s model (1984) that financial intermediaries exist because they have a comparative advantage in the production of private information. Higher competition and complexity as well as a riskier environment however have increased the importance of managing and controlling one of the banks’ core risks: credit risk. Before analysing the implications on specific credit risk instruments, the thesis will describe the relevant content of“The New Basel Capital Accord” and explain the general context of credit risk and capital management within a bank. An analysis of the implications of „The New Basel Capital Accord” implies the question of how the new incentive structures will modify credit risk and capital management activities within banks and shape the competitive environment of the banking industry. More specifically, it will be investigated how the significance and type of credit risk and capital management will change and what effect ”The New Basel Capital Accord” will have on the development of credit risk measurement instruments. The paper will also describe the impacts of the new Accord on the market for credit derivatives and securitizations and on the structure of these transactions. Moreover, it is important to consider how the scarce and essential resource capital will be affected and what potential conclusions can be drawn.
The thesis will show that ”The New Basel Capital Accord” is a major step forward in banking regulation that will better align regulatory and economic capital. It will encourage the usage of internal rating approaches, credit derivatives and securitizations. It will also influence capital allocation and lead to an extended use of active portfolio management. As a consequence of changed incentive structures the analysis will indicate that ”The New Basel Capital Accord” will be an important driver for the advancement and improvement of credit risk measurement and internal credit risk models.

Inhaltsverzeichnis:Table of Contents:
Table of FiguresII
Table of EquationsIII
Table of AbbreviationsIV
1.Introduction1
1.1Motivation1
1.2Outline2
1.3Definitions4
2.Current Basel Accord and „The New Basel Capital Accord“ in comparison5
2.1Current Basel Accord in practice5
2.2Merits and weaknesses of the current Basel Accord6
2.3Objectives of „The New Basel Capital Accord“7
2.4Key […]

Leseprobe

Inhaltsverzeichnis


ID 5325
Benz, Miriam: The Implications of the "New Capital Adeqaucy Framework" for Credit Risk and
Capital Management in the Banking Industry / Miriam Benz - Hamburg: Diplomica GmbH, 2002
Zugl.: Oestrich-Winkel, Internationale Wirtschaftshochschule, Diplom, 2001
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Table of Contents
Table of Figures ... II
Table of Equations...III
Table of Abbreviations... IV
1. Introduction ...1
1.1 Motivation ... 1
1.2 Outline ... 2
1.3 Definitions ... 3
2. Current Basel Accord and "The New Basel Capital Accord" in comparison...4
2.1 Current Basel Accord in practice... 4
2.2 Merits and weaknesses of the current Basel Accord ... 5
2.3 Objectives of "The New Basel Capital Accord" ... 6
2.4 Key Content of "The New Basel Capital Accord" ... 7
2.5 Proposed Approaches for Credit Risk Measurement ... 9
3. Credit Risk and Capital Management...14
3.1 The state of Credit Risk and Capital Management... 14
3.2 Credit Risk and Capital Management Instruments... 16
3.2.1 Internal Ratings ... 16
3.2.2 Credit Risk Models ... 17
3.2.3 Credit Derivatives and Securitizations... 19
4. Influences of "The New Basel Capital Accord" on Credit Risk and Capital Management...21
4.1 Motivation for Credit Risk and Capital Management ... 21
4.2 Competitive Effects ... 22
4.3 Impact on Credit Risk and Capital Instruments ... 25
4.3.1 Rating Issues... 25
4.3.2 Credit Derivatives ... 26
4.3.3 Securitizations ... 28
4.3.4 Portfolio Management... 29
4.4 Impact on Credit Portfolio Models... 31
4.4.1 Significance of Credit Risk Models in Credit Risk Management ... 31
4.4.2 Infrastructure... 32

4.5 Impact on Capital Management... 33
4.5.1 Cost of Capital... 33
4.5.2 Bank's Lending Behavior ... 36
5. Conclusion
and Outlook ...37
Table of Appendices ...40
Bibliography ...60

- II -
Table of Figures
Figure 1: Procedure of analysis... 3
Figure 2: Pillar II Objectives
...
10
Figure 3: Risk weight scheme for sovereign, bank, corporate and other
exposures under the standardized approach ... 10

- III -
Table of Equations
Equation 1: Minimum Capital Ratio ... 7
Equation 2: Function for calculation of minimum capital requirement for
credit risk under the standardized approach... 10
Equation 3: Function for calculation of minimum capital requirement for credit risk
under the foundation internal ratings-based approach ... 12
Equation 4: Function for calculation of minimum capital requirement for
credit risk under the advanced internal ratings-based approach ... 13
Equation 5: Capital Asset Pricing Model ... 343

- IV -
Table of Abbreviations
approx. approximately
BRW
Benchmark Risk Weight
CAPM
Capital Asset Pricing Model
CLO
Collateralized Loan Obligations
EAD
Exposure at Default
EL Expected
Loss
IAS
International Accounting Standards
incl. including
IRB internal
ratings-based
IT Information
Technology
LGD
Loss Given Default
KMV
Kealhofer, McCrouhy, Vasicek
KWG Kreditwesengesetz
LTCM
Long Term Capital Management
M Maturity
OECD
Organization for Economic Cooperation and Development
PD
Probability of Default
RAROC
Risk Adjusted Return on Capital
RW Risk
Weight
SFAS
Securities and Futures Authorities Standards
SPV
Special Purpose Vehicle
UL Unexpected
Loss
US United
States
VaR Value-at-Risk
w.a. without
author
w.l. without
location
w.p. without
page
w.y. without
year

- 1 -
1. Introduction
1.1 Motivation
In their role as financial intermediaries, banks have the inherent task of assuming risks. This statement
follows Diamond's model (1984) that financial intermediaries exist because they have a comparative ad-
vantage in the production of private information.
1
Higher competition and complexity as well as a riskier
environment however have increased the importance of managing and controlling one of the banks' core
risks: credit risk.
External events such as banking crises, augmented credit defaults during the Asian or Russian crisis or the
almost collapse of the LTCM hedge fund
2
have shown that the existing banking supervision and regulation
might not be able to guarantee the stability of the global financial system.
3
Internal factors such as the de-
velopment of more precise credit risk measurement and sophisticated management tools, the use of credit
derivatives and securitizations, as well as new insights in portfolio theory have revealed that the incentive
structure of the present banking regulation is outdated and leads to distortions in the form of capital misal-
locations.
4
In contrast to the objectives of banking supervision, the current regulations have resulted in the
tendency towards taking higher risks and regulatory capital arbitrage. The consequence is higher systemic
risk.
5
By setting constraints, banking regulation has a direct influence on credit risk management and the
capital allocation within banks so that it must provide an adequate incentive structure that reflects the latest
developments.
All these factors have resulted in questioning the current banking supervision and regulation based on the
1988 Basel Accord, and have created the demand for a revised approach that better responds to today's
challenges of the banking industry. One reaction to these considerations is the "New Capital Adequacy
Framework" released in June 1999 and "The New Basel Capital Accord" announced in January 2001 by
the Basel Committee on Banking Supervision that is expected to replace the current banking regulation in
2004.
There seems to be an overall perception that "The New Basel Capital Accord" is more than a slight altera-
tion of the current standards but a quantum leap in banking supervision that will reshape banks' credit risk
measurement and management systems.
6
It is also widely discussed what effects a revised Basel Accord
will have on competition in the banking industry. Therefore it is appropriate to examine the magnitude of
potential implications of a new Accord.
1
See Berger/Herring/Szegoe (1995), p. 7
2
The LTCM hedge fund is discussed in the context of banking regulation in: Harris (1999), p. 2f.
3
See Blount (2000), p. 88
4
See Pfingsten/Schroeck (2000), p. 8f.; See also Goodhart et al. (1998), p. 87
5
See Jones (2000), p. 49; "Systemic risk can be defined as the risk of a sudden, unanticipated event that
would damage the financial system to such an extent that economic activity in the wider economy
would suffer." Herring/Santomero (2000), p. 4
6
See Schenk (2001), p. 28

- 2 -
The objective of the present thesis is to emphasize the major changes in banking regulation and to analyze
selected aspects
7
of "The New Basel Capital Accord" as a new proposal that imposes new constraints
8
and
incentives
9
for banks. An analysis of the implications of the new Accord implies the question of how the
new incentive structures will modify credit risk and capital management activities within banks and shape
the competitive environment of the banking industry. More specifically, it will be investigated how the
significance and type of credit risk and capital management will change and what effect "The New Basel
Capital Accord" will have on the development of credit risk measurement instruments. The paper will also
describe the impacts of the new Accord on the market for credit derivatives and securitizations and on the
structure of these transactions. Moreover, it is important to consider how the scarce and essential resource
capital will be affected and what potential conclusions can be drawn.
The thesis will show that "The New Basel Capital Accord" is a major step forward in banking regulation
that will better align regulatory and economic capital. It will encourage the usage of internal rating ap-
proaches, credit derivatives and securitizations. It will also influence capital allocation and lead to an ex-
tended use of active portfolio management. As a consequence of changed incentive structures the analysis
will indicate that "The New Basel Capital Accord" will be an important driver for the advancement and
improvement of credit risk measurement and internal credit risk models.
1.2 Outline
The basis for the examination of the present thesis is the consultative document "The New Basel Capital
Accord" issued in January 2001 by the Basel Committee on Banking Supervision that will replace the 1988
Basel Accord after another consultation period. It represents the detailing of the consultative paper "A New
Capital Adequacy Framework" issued in June 1999.
The analysis of the revision of the Basel Accord on credit risk and capital management in the banking in-
dustry is based on the content presented in Chapter 2.4 and the approved approaches for credit risk meas-
urement presented in 2.5. Although "The New Basel Capital Accord" also addresses other than credit risk,
the thesis is only based on the latter. Totally aware that banks have exposures to different borrower types,
the thesis is restricted to the implications of the regulatory treatment of corporate loan portfolios in the
banking book
10
in contrast to retail portfolios due to their relevance for international banks. Figure 1 visual-
izes the procedure of the analysis.
7
Mainly: determination of minimum capital requirements, recognition of internal ratings in the calcula-
tion of regulatory capital charges, treatment of credit risk mitigants and securitizations.
8
Regulatory capital charges require banks to hold equity that limits their risk-taking and expansion. The
question is whether more or less capital charges apply under the proposal.
9
A risk-sensitive calculation of regulatory capital charges and other measures might incite more prudent
risk management and an alteration of lending behavior for example.
10
Banks have a banking and a trading book. For a definition of trading book see Basel Committee on
Banking Supervision (1996), p. 1f.; See also footnote 58

- 3 -
Figure 1: Procedure of analysis
At first, it is necessary to define the terms "credit risk" and "capital management" as the underlying issues
of the whole investigation and outline the understanding of "banking industry". The fundament of any
subsequently drawn implications will be laid down in Chapter 2. In order to understand the magnitude of
change, the 1988 Basel Accord will be reviewed. A more detailed description of the objectives, content and
methodologies of "The New Basel Capital Accord" follows. The beginning of Chapter 3 is dedicated to
explain the general context of credit risk and capital management within a bank. It must be distinguished
between credit risk management and capital management before both functions can be integrated. A de-
scription of selected instruments for both ­ credit risk and capital management ensues. The rationale for the
selection of the specifically chosen instruments is the fact that banks do not only attach the greatest impor-
tance to them in practice but that these will be the most affected by "The New Basel Capital Accord". In a
next step, the contents of Chapter 2 and Chapter 3 are combined in Chapter 4 where the consequences of
the changes presented in Chapter 2 are examined. As highlighted, Chapter 4 represents the main focus of
the thesis. "The New Basel Capital Accord" sets a new competitive framework, therefore potential com-
petitive effects will be investigated. This will be done in a general treatise. The last three sections of Chap-
ter 4 reference competition in the banking industry while focusing on effects on credit risk and capital man-
agement. Finally, conclusions are drawn from the examination and further issues are raised in Chapter 5.
1.3 Definitions
To understand the concepts of credit risk and capital management and the need for any regulatory action it
is necessary to define credit risk.
11
In general, risk is the danger of a negative deviation of the actual from
the expected value of an event.
12
Whereby deviations around an expected value can occur upwards and
11
Credit risk occurs with positions in the banking book as well as with products assigned to the trading
book of a bank. In addition to credit risk there is a number of other risks that contribute to a bank's
overall risk position and that must be dealt with. These are liquidity, interest rate, operational and sol-
vency or capital risk. See Koch (1992)
12
See Muehlhaupt (1980), p. 188; See also Markowitz (1952), p. 77 who defines risk as the variance (
2
)
of expected returns.
Chapter 2: Basel Accord as regulatory framework for Credit Risk and Capital Management
3.1 State of Credit Risk and Capital Management
Credit Risk and
Capital Management
3.2 Credit Risk and Capital Management Instruments
Chapter 4: Implications of "The New Basel Capital Accord" on
credit risk and capital management and banking competition
Credit Risk
Management
Capital
Management

- 4 -
downwards, upward deviations are denoted chances and downward deviations are risks.
13
Following this
definition of risk, in a broad sense credit risk describes the losses caused by the default of a borrower or its
deterioration in credit quality.
14
Expected losses are empirically known and represent a material risk in
terms of an impairment of profit in the case of realization of the expected loss. They are excluded from the
definition of credit risk because they are already priced into the overall costs of a loan so that no "real"
losses are incurred when the expected loss is realized.
15
More specifically, credit risks are only negative
stochastic deviations around the expected loss. These are named unexpected losses
16
that can also be de-
scribed as a downside risk in terms of Value-at-Risk
17
. They represent the "real" credit risk and are also
called formal risk.
18
To provide protection against the maximum loss exceeding the expected amount banks
hold economic capital
19
in order to be able to absorb unexpected losses with a high degree of certainty.
20
A
particularity of credit risks is their non-normal probability distribution of credit returns/losses with a highly
skewed (extreme) tail.
21
Each bank that knows about this probability distribution of credit returns/losses
can allocate capital accordingly, to any confidence level that can be considered as a target solvency prob-
ability.
22
Capital management refers to the allocation and budgeting processes of capital within banking institu-
tions. Capital, in terms of equity, is a limited resource for banks that must be allocated following certain
defined criteria.
23
The term banking industry comprises all banks that can be described from a micro- or macroeconomic, an
economic or legal point of view.
24
Article 1 German Banking Act contains a description of banks using the
term "Kreditinstitut". This group and all institutions that fall under the regulation of the Basel Accord are
considered in this thesis.
25
2.
The current Basel Accord and "The New Basel Capital Accord" in comparison
2.1
The current Basel Accord in practice
The capital standards that prevail in most countries are based on the "International Convergence of Capital
Measurement and Capital Standards" (current or 1988 Accord) which the Basel Committee on Banking
13
See Hartmann-Wendels/Pfingsten/Weber (1998), p. 532f.
14
There can be found various definitions of credit risk in the literature. See for example
Brasch/Nonnenmacher (2000), p. 409; See Harrington/Niehaus (1999), p. 5; See Brustany (1997), p.
697; See Nishiguchi/Kawai/Sazaki (1998), p. 83
15
See Bueschgen (1998), p. 866
16
See Altman/Saunders (2000), p. 8; "Unexpected losses are the difference between the loss rate at a
given confidence level and the mean, or expected loss rate." Altman/Saunders (2000), p. 10
17
Value-at-Risk (VaR) is the maximum loss on a given asset or liability over a certain time period at a
given confidence interval. See Saunders (1999), p. 38
18
See Bueschgen (1998), p. 867
19
Economic capital and risk-based capital are synonyms. Economic capital is a product of unexpected
losses and an individually chosen capital multiplier that relies on the risk tolerance and preferred rating
of a bank. See Ong (1999), p. 202-204
20
See Anders (2000), p. 315
21
See Appendix 1 for a typical probability distribution of credit losses/returns.
22
See Basel Committee on Banking Supervision (2001c), p. 34
23
See Anders (2000), p. 316
24
See Bueschgen (1998), p. 11
25
See Article 1 Kreditwesengesetz; See Basel Committee on Banking Supervision (2001b), p. 1

- 5 -
Supervision
26
(the Basel Committee) has accepted in 1988. The Basel rules are not legally binding but can
be converted into national law.
Due to the importance of banks in the economic transformation process, banking regulation is targeted at
ensuring the functioning of the economy. There are three different aspects that can cause market failure.
These are negative externalities, information asymmetries and the absence of sufficient competition.
27
This
in mind, the current Accord was aimed at all internationally active banks and has been implemented on a
national basis in more than 100 countries since 1992.
28
The Accord was elaborated with the objectives to
ensure the soundness and stability of the international banking system and to provide a "level playing field"
for international banks defining standards for the international measurement and requirements of capital
adequacy. These standards are achieved by requiring banks to hold regulatory capital
29
in terms of mini-
mum capital standards while only directly addressing credit risk. The framework of minimum capital re-
quirements in the 1988 Accord mainly consists of a definition of the components of capital, the establish-
ment of five risk weights applicable to on-balance sheet and converted off-balance sheet exposures and a
ratio of capital to risk weighted assets of 8% whereby Tier 1 capital must be at least 4%. The five risk
weights are 0% for Central Banks of OECD countries, 10% for public sector entities located in the same
country as the regulated bank, 20% for OECD banks, 50% for mortgage loans, 100% for all other borrow-
ers (e.g. corporates).
30
Since 1988 the Basel Accord has experienced five amendments in order to keep pace
with market developments whereof the last one was introduced in 1996 dealing with capital requirements to
cover market risk.
Despite the relevance and recognition that the current Basel Accord has experienced for international bank-
ing regulation, it has received significant criticism.
2.2
Merits and weaknesses of the current Basel Accord
It must be recognized in support of the 1988 Basel Accord that it was the first effort to ensure competitive
equality among internationally active banks by setting one single regulatory framework that has reached an
immense scope. Through its simple approach for assessing capital adequacy by setting minimum capital
requirements, it promoted comparability and verifiability.
31
Despite these advantages, market developments such as the use of new credit risk instruments and credit
risk mitigation techniques (credit derivatives, securitization and netting) and the improvement of internal
credit risk models have made its deficiencies increasingly evident.
32
It is argued that the current Basel Ac-
cord is not apt to reflect best practices of credit risk measurement and management used in the banking
26
The Basel Committee on Banking Supervision consists of representatives of supervisory bodies and
central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands,
Sweden, Switzerland, the United Kingdom and the United States of America.
27
See Kotz (2000), p. 21/639
28
See Meister/Vollbracht/Baum (2000), p. 757
29
The original task of regulatory capital was to ensure soundness of the financial system and not to cover
any specific risk.
30
See Basel Committee on Banking Supervision (1988), p. 8; 21f. or Article 13, Grundsatz I, Federal Law
Gazette 210
31
See Karacadag/Taylor (2000), p. 11
32
See Meister/Vollbracht/Baum (2000), p. 757

- 6 -
industry.
33
The Accord is unable to reflect a bank's true risk profile with its rough "one-size-fits-all" ap-
proach since it apportions the same risk weight to one class of assets.
34
Neither different creditworthiness
nor maturities of assets are considered although both factors have a tremendous effect on risk.
35
New in-
sights in portfolio theory are not taken into account since risk is measured on a stand-alone instead of a
portfolio basis that would take correlation and diversification effects into account.
36
In practice, the Accord has led to credit mispricing and to disincentives for prudent credit risk management
partly because no appropriate recognition is given to credit risk mitigation techniques. The incorrect treat-
ment of asset classes has resulted in regulatory capital arbitrage
37
enhanced by the use of securitization and
credit derivatives.
38
Riskier assets will be kept in the banking book when the regulatory capital requirement
is less than internal economic capital allocation whereby high quality assets will be securitized or sold due
to excessive regulatory capital charges. Although regulatory capital arbitrage is not necessarily undesirable
if it helps to counteract adverse effects of regulation, it is a costly measure.
39
In any case, it is stated that the
current Accord results in misallocation of capital, non-meaningful capital ratios
40
and in a tendency towards
riskier loan portfolios due to adverse selection
41
.
All in all, the incentive structures are not able to fulfil the initial objectives of the Accord and the definition
of minimum capital requirements in the Accord is no longer effective.
42
2.3
Objectives of "The New Basel Capital Accord"
"The New Basel Capital Accord" has been elaborated to revise the current Basel Accord as a direct conse-
quence of its observed shortcomings. Its intention is to reconstitute the effectiveness and efficiency of in-
ternational banking regulation and supervision and promote improved risk management.
The new Accord incorporates the objectives of the 1988 Accord to provide safety and soundness of the
financial system and to strengthen competitive equality. These objectives have been expanded by the inten-
tion to make it more risk-sensitive. This time banks of different complexity and sophistication are taken into
consideration following the experience of the 1988 Accord that has been applied to the whole banking
industry in many countries through the conversion into national law.
43
The new measures and approaches to better determine a bank's true risk profile are intended to set the right
incentive structure to improve risk management and to reduce capital arbitrage since it is difficult for the
supervisors to assess the adequate residual capital of a bank's loan portfolio. Consequently, economic and
33
See Mingo (1998), p. 62
34
See Gleeson (1999), p. 6
35
See Krumnow (2000), p. 692
36
See Hall (1994), p. 271
37
Regulatory capital arbitrage exists whenever the regulatory capital requirement exceeds the bank's best-
practice of economic capital allocation, see Robert Morris Associates (2000), p. 8; Jones states that the
1996 amendment of the Basel Accord has enlarged the incentives for regulatory capital arbitrage due to
the different treatment of credit risk in the trading book in comparison to the banking book. Banks
might try to shift assets from the banking to the trading book. See Jones (2000), p. 48
38
See Das (2000), p. 840
39
See Greenspan (1998), p. 166
40
Banks have found ways to lower capital requirements without lowering risk accordingly.
41
Higher margins can generally be received for higher risks so that relationship managers will tend to
grant loans to low-quality borrowers for the same charge of regulatory capital under the current Accord.
42
See Basel Committee on Banking Supervision (1999b), p. 9
43
See Basel Committee on Banking Supervision (1999b), p. 9

- 7 -
regulatory capital should be better aligned. By so doing, the new Accord promotes prudent risk manage-
ment and rewards a well-balanced portfolio. This requires a better reflection of credit risk mitigation tech-
niques. Whereas the new proposal aims at a better risk-related allocation of capital that might lead to lower
capital requirements for individual institutions, it is not the objective to lower the overall capital cushion.
44
Therefore risk weights and capital for high quality loans should be lowered since banks' economic capital
is less than regulatory capital, risk weights and regulatory capital for riskier assets must be increased and
new risk classes are to be considered.
Whether the "The New Basel Capital Accord" is able to meet these requirements or not will be determined
by its implementation.
2.4
Key Content of "The New Basel Capital Accord"
In comparison to the 1988 Basel Accord, "The New Basel Capital Accord" has substantially gained in
detail and widened the scope of banking supervision by shifting towards a more process- and qualitiative-
oriented banking supervision introducing two new pillars.
45
"The New Basel Capital Accord" is based on the following three interacting pillars of banking supervision:
Minimum Capital Requirements (Pillar I), Supervisory Review Process (Pillar II) and Market Discipline
(Pillar III). Each of them is deemed necessary for an effective banking supervision that is better suited to
reflect the complexity and risk profile of a bank.
Pillar I: Minimum Capital Requirements
The definition of regulatory capital has not experienced any modification from the 1988 Accord. Minimum
capital requirements are expressed by a minimum capital ratio of 8% that is the result of total regulatory
capital over credit (expressed by risk-weighted assets
46
), market and newly operational
47
risks. Total regu-
latory capital thereby consists of Tier 1
48
capital, Tier 2
49
capital that is limited to 100% of Tier 1 and to a
certain limit Tier 3
50
capital.
(
)
[
]
Assets
ted
Risk Weigh
Risk
l
Operationa
Risk
Market
for
ts
Requiremen
Capital
5
.
12
Capital
Regulatory
Total
%
8
+
+
51
Equation 1:
Minimum Capital Ratio
44
See Basel Committee on Banking Supervision (1999b), p. 10
45
See Karacadag/Taylor (2000), p. 7
46
A risk-weighted asset is the risk weight of a transaction multiplied by the measured exposure of the
transaction. See Basel Committee on Banking Supervision (2001b), p. 35
47
"Operational risk is defined as the risk of direct or indirect loss resulting from inadequate or failed in-
ternal processes, people and systems or from external events." Basel Committee on Banking Supervi-
sion (2001b), p. 118
48
Tier 1 is defined as the core capital and mainly comprises equity capital and disclosed reserves less
goodwill. It is the only element of capital that is the same in all countries and must be at least 50% of a
bank's capital base. See Basel Committee on Banking Supervision (1988), p. 3
49
Tier 2 might vary among countries and is made up of undisclosed reserves, revaluation reserves, general
provisions or general loan-loss reserves, hybrid debt capital and subordinated term debt. See Basel
Committee on Banking Supervision (1988), p. 4-6
50
Tier 3 capital consists of short-term subordinated debt and is only to support market risks. It is limited
to 250% of Tier 1 capital. See Basel Committee on Banking Supervision (1996), p. 7
51
See Basel Committee on Banking Supervision (2001b), p. 6

- 8 -
To determine minimum capital requirements for credit risk, three different approaches are eligible. Banks
must either apply a standardized approach, a foundation or an advanced internal ratings-based approach
(IRB approach). The methodologies of these three approaches will be further discussed in 2.5. By introduc-
ing three possible calculation methods, a more risk-sensitive computation of risk-weighted assets can be
realized. The major step inherent in all three approaches is the extension by a second dimension: assess-
ment of borrower and facility quality in addition to the recognition of the borrower type. As part of mini-
mum capital requirement calculation under both IRB approaches, a granular-ity
52
adjustment is done for
each internal borrower grade. Total minimum capital requirements will therefore not only depend on the
sum of individual risk-weighted assets but also on the composition of a bank's overall portfolio as to the
degree of diversification respectively concentration of borrowers within rating classes.
Furthermore, the risk-reducing effect of credit risk mitigation techniques such as collateral, guarantees,
credit derivatives and netting is better reflected in the new Accord and the range of eligible mitigants has
been widened.
53
All in all, banks now have more flexibility in determining parameters that enter into the calculation of risk
weights. It is proposed to give more self-responsibility to banks in determining minimum capital require-
ments to cover their risk profile.
Pillar II: Supervisory Review Process
The second pillar consists of four key principles
54
that supervisors are asked to control through on-site, off-
site examinations and a direct dialogue with management. This pillar serves as a prevention that allows for
early intervention when internal standards do not appear to be appropriate. The intention of pillar II is as
follows:
· Supervisors must review if banks have sound internal processes in place to determine capital ade-
quacy in terms of capital in relation to their risk profile and for maintaining capital levels.
· Supervisors are to evaluate banks' internal capital adequacy assessments and strategies, their abil-
ity to monitor and must ensure compliance with regulatory capital ratios. In the case of dissatisfac-
tion with the processes, supervisors should take action.
· Supervisors have the possibility to require banks to hold capital in excess of the required regula-
tory capital.
· Supervisors are to take early action if capital runs the risk of falling below the required level.
55
Figure 2: Pillar II Objectives
52
"The granularity of a bank portfolio describes the extent to which there remain significant single bor-
rower concentrations." The more exposures a portfolio contains the less unsystematic risk remains. In
practice unsystematic risk will never be fully diversified away so that regulatory as well as economic
capital must account for this residual unsystematic and systematic risk. See Basel Committee on Bank-
ing Supervision (2001c), p. 89
53
See Basel Committee on Banking Supervision (2001b), p. 15
54
In addition to these four key principles, interest rate risk in the banking book will be treated under pillar
II due to the heterogeneity of this matter among banks. See Basel Committee on Banking Supervision
(2001a), p. 31f.

Details

Seiten
Erscheinungsform
Originalausgabe
Erscheinungsjahr
2001
ISBN (eBook)
9783832453251
ISBN (Paperback)
9783838653259
DOI
10.3239/9783832453251
Dateigröße
790 KB
Sprache
Englisch
Institution / Hochschule
European Business School - Internationale Universität Schloß Reichartshausen Oestrich-Winkel – unbekannt
Erscheinungsdatum
2002 (April)
Note
1,0
Schlagworte
basel credit risk accord rating capital management
Zurück

Titel: The Implications of the "New Capital Adeqaucy Framework" for Credit Risk and Capital Management in the Banking Industry
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66 Seiten
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