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Bank for International Settlement and the Basel Models

1. Bank for International Settlement (BIS)

1.1 Introduction

Tracing back its beginnings to 17^th May 1930, Bank for International Settlements (BIS) can safely be called the oldest financial institution. Following the forced liquidation of Hersatt on 26^th June 1974 when several international banks had released payments of their respective DEM to Hersatt, which ceased its operations due to differences in time zones, payments by the banks in USDs could not be received. It was then decided by the G-10 (which includes Belgium, France, Canada, Germany, Italy, the Netherlands, Sweden, Japan, Switzerland, the United Kingdom, and the United States) and Luxemburg to form the BIS, which would include representatives from central banks and other regulatory authorities. So came about the formal beginning of BIS.

This organisation forges international monetary and financial ties and acts as a bank for central banks.

The BIS carries on the above task by acting as:

• a round-table where central banks can discuss and carry out policy analysis
• a body for economic and financial research
• a helper for central banks assisting them in financial transactions
• a trustee dictating norms for financial operations occurring on an international level
• a body that promotes uniform capital requirements thus allowing banks from different countries to compete amongst each other on a level playing field.

BIS has its head office in Basel, Switzerland assisted by two representative offices in Mexico City and the Hong Kong Special Administrative Region of the People's Republic of China.

Following stringent working rules the BIS does not take any deposits or provide financial services to corporate bodies or private individuals except to central banks. It strongly warns against fraudulent schemes.

1.2 Organisation and Governance

The people at BIS

The current working force of BIS employs a 552 strong staff from 49 countries. The staff is required to abide by the rules jotted down in the staff code of conduct.

Structure of Governance

The statutes determine the governance of the Bank. The chief decision making bodies of this bank are:

• The Management
• Its Board of Directors
• The General Meeting held for the member central banks.

Activities of BIS

• It acts as a meeting hub for central banks. As of now, about 5000 senior executives and officials of various central banks and supervisory agencies participate in meetings organised by the BIS every year.
• The BIS staff is the prime researcher who is aided by members of the academic community and visiting researchers from central banks.
• BIS organises seminars and workshops through its Financial Stability Institute (FSI). Through these, BIS facilitates dissemination of the work carried out by the supervisory community.
• The BIS provides a wide range of financial services to help central banks and other financial institutions in the management of their foreign reserves. Around 140 customers, which include various international financial institutions, currently use these services.

The BIS does not have carry any legislative authority, but the norms laid down by it bind the participating bodies to implement its accords. It however gives some relaxation to local authorities on the way to implement its recommendations as the local laws vary from country to country.

2. Basel Models

2.1. Basel I

The accords proposed by the Basel committee in 1988 set a minimal capital requirement for banks. These were adopted as a law in G-10 countries by 1992. Japanese banks were granted and extended period of transition to enforce this law. These requirements were there after called the 1988 Basel Accord.

However at this point it is necessary to understand the meaning of bank. There was a need to distinguish between banks and securities firms (broker dealers or investment banks) as Basel accord applied only to banks. The United States under the Glass-Steagall Act had a clear distinguishing marker between banks and securities firms. The United Kingdom through adopted custom rather than law also knew how to distinguish between the two. Japan like the US had also adopted a legal distinction. Germany and other European countries as compared to that above worked on the principles of universal banking where there was no difference between banks and securities firms.

The Basel I Accord of 1988 addressed the question of banking in terms of deposit taking and lending, which in other word means that credit risk was of prime importance. Under this accord, banks required an 8% capital. Accordingly, the metrics for Capital and Credit Risk need to be calculated.

Capital: - Basel accord referred to capital adequacy, which means that the financial institution should have enough capital to protect themselves against unforeseen losses. The bank's capital by textbook definition comprised of two tiers.

Tier 1 (Core) Capital: from regulators point of view is the measure of the bank's financial strength. It usually consists of common stock, preferred stock (irredeemable and non-cumulative) and published reserves from after-tax retained earnings.

Tier 2 (Supplementary) Capital: This is the second most reliable form bank's capital from regulator's point of view. It accounts for post-tax surplus of retained earnings, loan-loss reserves; long term subordinated debt and preferred redeemable stocks. Tier 2 capital could account for a maximum of 50% of bank's capital.

The 1988 capital adequacy model required banks to have a Tier 1 ratio of 4% with total capital ratio of 8%. Tier 2 capital could not exceed 50%.

Credit Risk: - It is the sum of risk-weighted asset values. G-10 government debt was weighted as 0%; G-10 bank debt was weighted 20% while other debt such as corporate debt and non-G10 government debt was weighted 100%. Other sundries like mortgages and local government debt of G-10 countries and letters of credit and derivatives were governed by different rules.

The accord provided the flexibility for banks to calculate their credit-risk using the model of their choice. Thus, they could choose from:

a)                  Standardized Approach,

b)                  Foundations Internal Ratings-Based Approach (IRB)

c)                  Advanced IRB Model

IRB Models

These models are used to establish an internal ratings model to ascertain the credit risk exposure of a portfolio.

The two approaches used are:

1)                  Foundation IRB approach

2)                  Advanced IRB approach

Foundation IRB Approach

This model evaluates credit risk using two factors:

a)                  PD - This estimates a 1-year probability of default.

b)                  EAD - It stands for exposure at default.

Advanced IRB approach

This model computes risk weights by taking into account the following factors:

a)                  PD, EAD

b)                  LGD - which stands for Loss Given Default

c)                  M - It stands for maturity

This model assumes a 10% -20% average default correlation among borrowers.

The five elements of IRB approach are as follows:

1.                  Internal Rating Model

2.                  Risk Components such as PD, EAD, LGD

3.                  Risk weight function

4.                  Minimum requirements for being eligible to apply the IRB approach.

5.                  Supervisory reviews of compliance with minimum requirement.

2.1.1 Explaining the Risk Components of IRB

PD- Probability of default gives the internal ratings based on past history or credit scoring model. There is no 0% risk weight i.e. lower bound 3 basis points.

EAD- The loan's exposure at default allows netting. This gives the amount by which the regulatory capital can be lessened if we fully write off the exposure and also includes any additional provisions.

LGD- Loss Given Default under the foundation IRB approach gives risk values of 45% for senior claims not secured and 75% for subordinated claims. As for secured claims, the LGD can be calculated under the standardised model using the following formula:

LGD* = LGD x (E*/E)

Where E is current value of exposure and E* is the value of exposure after risk alleviation.

Under Advanced IRB Approach LGD represents the bank's internal estimate of actual LGD.

With the advent of the 90's the Basel committee thought of updating the 1998 accord. The new accord would include bank capital requirement to consider market risk. However, this was to have implications for the securities firms. These additional capital requirements in the form of bank's market risk would be added into the future updates of Europe's Capital Adequacy Derivatives (CAD). These updates would then automatically apply to Britain's non-banks' securities firms. If this new accord would be applied to non-bank securities firms outside of Europe then the market risk capital requirements could be in global harmony for both banks and securities firms. In order to implement the Basel committee held discussions with the International Organisation of Securities Commissions (IOSCO). The two organisation joined forces and started work by forming a technical committee in January 1992.However, April 1993 saw the failure of this joint venture. The Basel committee then independently proposed amendments to the 1988 accord. These changes confirmed to Europe's CAD. According to this new amendment, banks were required to keep a trading book and maintain capital for trading book market risk and foreign exchange exposures. The trading book capital charges were based upon raw value at risk (VaR) somewhat like the 10 days VaR Metric. This model was similar to Europe's CAD, but with its own shortcomings.

Now, banks would have to take into account capital for credit risk as well as maintain a capital amount equal to the calculated VaR.This amendment added a third Tier to the definition of Capital.

Tier 3: This consisted of short terms subordinated debts but could only cover market risk.

The concept of crude VaR was frowned upon by several banks and the committee received adverse comments. Several banks had already been using their proprietary VaR models, which took into account diversification effect and also recognised portfolio non-linearities. Several analysts commented that by adopting the crude VaR measure the regulators night be able to suppress innovation in the risk management practice.

With these comments in mind, the Basel committee introduced a revised proposal in April 1995. These had many changes, which extended the market risks capital requirements to take into account organisation wide commodities exposure. This amendment also provided the flexibility for banks to use either the building block VaR measure or their proprietary VaR measure for calculation market risk capital requirement. The use of proprietary VaR measure had several clauses. The banks using proprietary measure were required to have an independent risk management function in order to satisfy regulators that they were following acceptable risk management practices. These proprietary measures were based on a 10 day 99% VaR Metric and could also account for non-linear exposures of options. Diversification effects were applicable to broad assets categories such as foreign exchange, equity, commodities and fixed income. While calculating the market risk the capital requirement would have to be equal to the greater of either the previous day's VaR or the average VaR over the previous 60 business days multiplied by the factor of 3. The original VaR measure called the standardised measure had only change modestly from the 1993 proposal. But still reflected a 10 day 95% VaR Metric. Non- Linear exposures were taken into account by levying additional capital charges.

This new proposal adopted in 1996 with amendments to the 1988 accord came to be known as the 1996 amendment coming into effect only in 1998.

With the advent of the new accord, the failures of original accord which incorporated only credit risk were becoming clear. In the original system of risk weightings, the G-10 government's debts had a 0% risk weight. Since, these debts tended to be quiet unprofitable banks were often lured to hold these debts. Corporate debts compare to these were far more profitable being weighted at 100%. Under the new system, all the corporate debts were weighted equally and the banks could now hold the most risky corporate debt. Corporate debts taken by high-profile organisations also incurred the same capital charges but were less profitable. This transition period saw a landslide growth in the market of credit derivatives and securities. The practice of regulatory arbitrage was being exploited by banks to use the shortcomings of 1988 accord's simple risk evaluation system to their advantage.

2.1.2 Effectiveness of Basel I

After looking at the Basel I model, its attributes, risk factors, and implementation, the question now boils down to how the G-10 banks have complied with the 1988 Basel accords and the following amendments. We also need to evaluate how good the above model has been so far.

So far very little was known about the effects on non-US banks to the imposition of capital adequacy requirements that use risk weight ratios. Among several models used to analyse the effectiveness of the Basel I model here we take the simultaneous equations model approach as a yardstick to measure the bank outcomes from G-10 countries during the period of 1988 to 1995. It has been seen that the regulatory pressure imposed by the Basel accord was quiet successful in helping the under capitalised banks in UK, US, Canada and Japan to raise their capital to asset ratios. The same ratios remain unchanged for banks in France and Italy. However, from the data analysed little evidence is obtained about the under-capitalised G-10 banks as to whether they increase or decrease their credit risk over the above period. It is interesting to note that the results introduced whole new dimension of market discipline, which influence bank capital and risk choices. It can also be safely said from the results that the 1988 Basel Model were effective after their wide adoption in increasing the capital of under capitalised G-10 banks but not their credit risk.

Basel accords were successful in bringing about world wide banking metamorphosis. They have now been accepted world wide among most internationally active banks, which give some measure of success of this model, which had been proposed in 1988 and was piloted in the G-10 countries and Luxembourg. The model adoption started in 1989 and by 1993, it was completely implemented. The accord has been beneficial in two ways. Firstly, it has been successful in creating a level playing field for banks worldwide by forcing them to raise their capital ratios, which had a lot of disparity among different countries. Secondly, it fostered financial stability by sketching out a simple approach to credit risk with the potential to manipulate incentives for the bank's risk-taking ability.

However, standing at the threshold of Basel-II accords there are few questions that need to be considered about the effectiveness about the 1988 agreement. To numerate a few - how far did the 1988 accord helped in boosting the capital ratios among the banks, which fell short of minimal capital requirement? What measures did banks take to fulfil the capital adequacy requirement that is did they increase their capital amount or wash their hands off risky projects or did they sell off their assets? Also, in accordance with the guidelines what steps did the banks take to change the credit risk of their portfolios i.e. did they reallocate their assets to riskier ones or less riskier ones? In order to answer the above questions we here make us of Shrieves and Dahl (1992) model. We apply the model at a multi country level to infer the link between changes in capital and credit risk at the G-10 level. This model is effective in the sense that it provides cross-country comparisons of the behaviour of under capitalised banks' towards capital and risk. Consistent with the earlier results the deduction obtained from this model shows that the G-10 banks on the threshold of Basel minimum requirements were successful in raising their capital to asset ratios but were ineffective in raising or lowering the credit risk. These reductions indicate towards the necessity to include another factor of market discipline. The results also show that all in all the 1988 accord has had a positive desired impact on the banks' behaviour. The findings also show no relation between changes in capital and risk for UK, Italian and French banks, the two are positively related for Japanese banks whereas they show an inverse relation for US banks. The above result shows that banks (capitalised and under-capitalised) adjust their capital and risk levels differently.

The concept of setting a capital adequacy requirement in the Basel accord and the ensuing implication for banks to regulate their capital is based on the justification that it avoids the risk shifting incentive created by badly priced deposit insurance. This although may promote financial stability in the short term, the risk insensitive deposit insurance tries to adversely affect banks' incentives to maintain adequate capital which threatens the long term stability. Thus, whether or not the concept of capital standard set by the accord successfully eliminates this moral hazard problem has stood at the forefront of debate for more than 20 years. This is because as the flat capital adequacy ratio increases, banks tend to shift towards risky portfolios. One method of eliminating the moral hazard problem can be by forcing banks to meet risk related capital ratios. To summarise the debate is unending because it is unclear that by imposing harsher capital requirements banks tend to increase the risk structure of their asset portfolios.

But the 1988 Basel accord falls short in several places because its entire focus is on credit risk. To strengthen it the clause of market risk was appended in the 1996 accord. Thus, whereas the 1988 Basel accord required banks to meet just two capital adequacy ratios, which were Tier 1, and total capital ratios (which includes both Tier 1 and Tier 2 capital), The 1996 accord widen the scope of capital by including a Tier 3 capital to evaluate market risk. This change strengthened the original model in some way.

To wrap it up the impact of 1988 Basel accord were non-uniform across countries Canadian, US, UK and Japanese banks falling in one bracket type identified by regulatory capital requirement improved their Tier 1 capital to asset ratio and /or total capital asset to capital ratios to meet the capital adequacy norms. French and Italian banks were rather insensitive to the regulatory pressure. Even G-10 banks facing regulatory pressure did not vary their credit risk in order to meet the capital requirement meaning they did not engage in riskier activities. Overall, there is evidence to suggest that 1988 accord was to a great degree successful in increasing the capital buffers of banks while preventing them from indulging in risky activities. The model also proved to be a testing plane and helped identify the defects, thus paving the way for New Basel accord.

2.1.3 Suggested Improvements

With the deployment and the after analysis of the Basel I model, some issues came into picture. Market discipline emerged as an important variable in the banking operations. Another major issue, which was seen during this period, was the presence of Operational Risk involved in banking operations. The older model after amendment of 1996 had only included credit risk and market risk, but it now came into light that operational risk is another significant form of risk for banks. In today's banking operation, fraud can be a major villain bringing about a bank's failure. Thus, the major improvement required in the earlier model is to include contingency capital to protect the bank in case of fraud.

2.2            Basel II

Following the implementation and close scrutiny of the Basel I model, the Basel committee in January 2001 issued a new paper on the Basel II Accords. This model would replace the erstwhile model of 1988. With close co-operation with the banking sector and introducing several changes, the committee was able to sketch out an outline of the future regulations of credit-risk. These would go on to form the basis of the final Basel II accord. The proposed capital regulatory framework would be based on three mutually reinforcing pillars.

The first pillar would specify the quantifying amount of capital required by banks to cover the risk exposure of different types of risks. In addition to the already existing capital risk and market risk mentioned in previous model, operational risk was introduced as a new type.

Operational Risk Capital: This is defined as the risk of loss resulting from failed or inadequate internal processes, systems, and people are from such external events as credit fraud.

The most extensive changes in this pillar occur from credit risk rather than market risk, which remains, unchanged compared with the 1996 update. The following pillars two and three together reinforce pillar one. The pillar two introduces a strong supervisory review. This gives the banks an opportunity to develop their own models to measure credit and operational risk based on supervisory catalogue. This process of supervision will lead to a fusion of internal and regulatory risk management technologies. The second pillar requires a supervisory review of two types:

a)                  Review of the institutions regulatory capital adequacy

b)                  Review of institutions internal assessment processes such as IRB and advanced IRB models.

The extensive disclosure requirements pertaining to the used risk management systems are proposed in the third pillar. These will vastly enhance the transparency through rigorous disclosure rules there by providing a deeper insight into the institute's risk profile. This increase transparency allows market participants to be able to assess individual risk profile and correspondingly review the capital area of the institute more rigorously. This concept called the Market discipline effect will provide an additional supervisory tool through the market participation there by transferring some supervisory duties over to the market.

It was initially proposed to implement the Basel II in 2004 but this vision was shattered due to the requirement to integrate a variety of cultures by varying the structural models. The complexity of existing regulations and public policies required more intensive scrutiny before implementation. A number of Quantitative Impact Studies showed the need of lower capital requirements and use of more innovative approaches to measure various risk. There was also a lot of public pressure and lobbying by representatives of small and medium scale enterprises. This required the model to include the political factors in this proposed economical concept.

Finally, due to these problems it is now supposed that the Basel II norms shall be implemented by various banks by the end of 2006.

2.2.1 The Needs for More Sophisticated Banking Supervision:

The new model, which integrated operational risk and increased the institution transparency through supervisory control, would in the long run tackle many system weaknesses of the 1988 capital accord. The main aspect of the model relates to the area of credit risk of the banking book. The major risk factors in the banking book are the traded and non-traded claims on sovereign banks and other customers. The potential loss from these positions depends mainly on two factors that is the amount outstanding and the credit worthiness of the borrower. The capital charge under the current regulation is calculated by multiplying the product of the above two parameters with the solvability co-efficient of 8%. A system of standardised risk weights is use to quantify the credit worthiness of each borrower, such as the risk factor of sovereign lies between 0-20% for banks it is a flat rate of 20% and for other borrowers irrespective ness of their credit worthiness the risk factor is weighted at 100%. Here the problem of moral hazard creeps in, as a flat risk, weight of 100 % for all non-banks is a vague measure for calculating the risk for individual borrowers. The reason for using a flat rate of 100 % is justified because there is a trade of between the complexity of implementation of the regulation and the degree of accuracy for measuring the individual credit worthiness. The other justification for using this flat rate system for risk measurement comes from the fact that the rates might not properly measure the risky ness of the individual borrower but on an over all average the total credit risk taken into account is approximately correct. It is particularly appeasing for the bank supervisor because the lump sum of credit risk for the whole banking book is covered. However, this flat rate system is not without defects because many banks abused the undifferentiated risk measurement systems for regulatory arbitrage practice. This roughly meant that they would sell off their good claims leaving more bad claims on the banking book. This reduced the average risk weight. The second consequence of the flat rate system appears in the forms of lending margins, which substitutes bad borrowers by good borrowers who end up paying too much for their loans.

In order to overcome this weakness of the current regulation banks in future shall be allowed the flexibility of using the following 3 approaches for measuring the credit risk of their banking book. These are the standardised approach; the internal ratings based approach and the advanced IRB approach.

2.2.2       Effectiveness of Basel II

This proposed model would dramatically transform the allocation of regulatory capital to credit risk factors. As opposed to the uniform 8 % capital charge, the regulatory equity capital under this model would depend upon the size of credit risk calculated by exogenous or by internal rating system. This would bring about a revitalised bank-date relation. Supervisory control would increase transparency and the risk factors would be institution specific. The credit spreads would widen making it possible to differentiate between the good and bad debtors pool making it more difficult for high-risk borrowers to acquire new loans.

Research also shows that under Basel II firms having strong banking relationships have lesser probability of being credit rationed. Large risky firms will face more credit rationing, based on the logic that their loans are more costly with regards to bank capital and the loss incurred by the bank incase of default occurrence is higher for the banks compare to smaller firms which will be less credit rationed.

2.2.3 Suggested improvements

The use of RiskMetrics^TM framework along with the standard BIS model can help in reducing the capital requirements. The RiskMetrics^TM approach for calculating VaR takes into account standard deviations, co-relations, and the time duration of financial instruments. It further assumes jointly normally distributed returns for the instruments. The RiskMetrics^TM model was developed by JP Morgan and has become a standard for internal risk management modules. It is based on a database, which is daily updated and distributed over the internet. The RiskMetrics^TM framework takes into account four basic risk categories namely stocks, interest rates, currencies, and commodities.

No amount of deliberation and theoretical concepts can visualise the advantages or disadvantages of the new accord. Until it is put into practice, it will be difficult to propose any improvements in the model. At this point, it is safe to say that this model at least promises multi fold benefits over the existing model.

3. References

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Basel Committee on Banking Supervision (1999), Capital requirements and bank behaviour: the impact of the Basel Accord, working paper # 1, Bank for International Settlements, Basel.

Basel Committee on Banking Supervision (2004), International convergence of capital measurements and capital standards, Bank for International Settlements, Basel.

Bennett W. Golub and Leo M. Tilman, John Wiley & Sons,(2000), Risk Management: Approaches for Fixed Income Markets

Aggarwal, R. and K. Jacques (1997), A Simultaneous Equations Estimation of the Impact of Prompt Corrective Action on Bank Capital and Risk, in Financial Services at the Crossroads: Capital Regulation in the 21st Century, Conference, 26-27 February 1998, Federal Reserve Bank of New York.

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Satyajit Das (Editor), John Wiley & Sons, (2000), edit Derivatives & Credit Linked Notes: Trading & Management of Credit & Default Risk,

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Shrieves, R.E. and D. Dahl (1992), The relationship between risk and capital in commercial banks, Journal of Banking and Finance, vol. 16.

Koehn, M. and A.M. Santomero (1980), Regulation of Bank Capital and Portfolio Risk, Journal of Finance, vol. 35.

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