Basel Committee on Bank Supervision Flashcards
What is the whole purpose of the Basel Committee?
- To minimise credit risk & provide financial stability.
- Ensure that financial institutions have an adequate amount of capital.
“International Convergence of Capital Measurement and Capital Standards”
How many tiers does Basel 1 (July 1988) have?
2
How does Tier 1 in Basel 1 (July 1988) function?
- Includes any financial asset or instrument that is very stable and money will not flow away
> Common shareholders’ equity
> Disclosed reserves
> Minority interest in common shareholders’ equity of consolidated subsidiaries
How does Tier 2 in Basel 1 (July 1988) function?
- Not as stable as Tier 1’s capital (non-call capital)
> Undisclosed reserves
> Asset revaluation reserves
> General provisions/general loan loss reserves
> Hybrid (debt or equity) capital instruments: e.g. preference stocks and convertibles
> Subordinated debt
How does Tier 1 and Tier 2 function together in Basel 1 (July 1988)
Tier 2 cannot weigh more than Tier 1.
- Banks should aim for high quality assets for Tier 1
Investments in unconsolidated banking and financial subsidiary companies.
Investments in the capital of other banks and financial institutions (discretion of national authorities.)
What are some risk-weighted assets in Basel 1 (July 1988)?
1) On Balance Sheet items:
0% [risk-free]:
- Cash (Very safe, not risky, do not need capital)
- Claims on central banks
- Claims on Organisation for Economic Co-operation and Development (OECD) governments or central banks
E.g. Loans provided to central banks (T-bills, etc) + loans provided to other governments
50% [Some riskiness]:
- Fully secured mortgage loans
E.g. Banks will not lose everything as they can still sell the house
100%:
- Claims on non-OECD governments and banks
- Premises, plant and equipment and other fixed assets
- All other assets
2) Off Balance Sheet items:
* These are also assigned risk categories via conversion factor
- Standard: To reach capital to weighted risk assets of 8% by end of 1992
What was wrong with Basel 1 (July 1988)?
1) One Size fits all system
- Did not factor in proportion to the time cost of capital & risk of specific assets
- The standard to reach capital to weighted risk assets of 8% does not let us know how risky the loan is –> Does not reward safe risk management to banks, thus encourage more risky practices
2) Not all non-OECD countries are risky
E.g. Singapore is a non-OECD country but yet we have a AAA credit rating, indicating that we are not very risky.
How is Basel 2 (June 2004) revised from Basel 1 (July 1988)?
1) 3-pillar system
2) Pay due regard to particular features of the present supervisory and accounting systems in individual member countries
3) Maintain the 8% capital to risk-weighted assets (1st pillar)
Total Capital/(Credit Risk + 12.5(Market Risk + Operational Risk)
4) Greater use of assessments of risk provided by banks’ internal systems as inputs to capital calculations
5) More national discretions (Constraints are set domestically - Too much?)
6) Supervisory review process (2nd pillar)
7) Market discipline (3rd pillar)
How is credit risk calculated in Basel 2 (June 2004)?
1) Standardised approach - similar to the 1988 method where each country come up with own table
2) Internal-Rating-Based (IRB) approach - reliance on internal estimates of risk components (Banks calculate the risks weighting themselves + come up with their own risk model)
> PD (Probability of default)
> LGD (Loss given default)
> EAD (Exposure at default)
> M (effective maturity)
*Complex rules and risk-weighted functions
How is operational risk calculated in Basel 2 (June 2004)?
Risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. [System and human errors]
1) Basic Indicator Approach
2) Standardised Approach
3) Advanced Measurement Approach
How is market risk calculated in Basel 2 (June 2004)?
Risk resulting from trading activities.
1) Standardised measurement method
2) Internal models approach
When are all the new revisions in Basel 2 (June 2004) aim to be achieved?
End 2007 by G-10.
But, then came the sub-prime crisis in 2008/2009.
Is the 8% capital enough?
No.
