Basel II – Standardized Approach

1. Overview of Basel I.

The 1988 Basel Capital Accord (“Basel I”) has been implemented as the capital adequacy standard for banks and has been adopted by more than 100 countries successfully.   The fundamental objectives of the Accord were to strengthen the soundness and stability of the international banking system. Basel I, has been adopted by the leading industrialised nations as well as the emerging economies, including most in Asia.

The Basel Accord I focused primarily on credit risk where the  assets of the banks were  classified based on their types (sovereign, banks, public sector and others) and risk weights of 0%, 20%, 50% and 100% are assigned based on the types of the asset. Banks in India are required to hold capital equal to 9% of the risk-weighted value of assets. For example a loan to a corporate (other category) with an outstanding of Rs.100 Cr will attract 100% risk weight and thus the Risk Weighted Asset (RWA) will be Rs.100 Cr.  The required capital charge for the loan will be Rs. 9 Cr at 9% of the RWA.

2. Shortcomings of Basel I

Basel I, despite being effective in raising capital standards globally, had few shortcomings, especially with respect to its crude measurement of a bank’s credit risk exposure.  The Risk weights assigned for the capital assessment purposes were based on the type of the assets and not on the quality of the assets.  For example, the broad brush approach of assigning 100% risk-weight to almost all corporate  loans induced some banks to take high risk assets in their portfolio with a view to earn higher returns thereby increasing the risk in their portfolio.  Thus there were two different classes of banks, one having a portfolio with low risk assets and the other having a portfolio of high risk assets.  But both classes of banks were attracting the same level of capital charge as uniform risk weight is applied to all the borrowers categorised within the same type of asset (eg. All corporate accounts attract 100% risk weight).

3. Credit Risk:

Credit risk is the potential that a bank borrower or counter party fails to meet the financial obligations on agreed terms.  The losses stem from outright default due to inability or unwillingness of a customer or counter party to meet commitments in relation to lending, trading, settlement and other financial transactions.  Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality.  Credit risk emanates from banks dealings with an individual, corporate, bank financial institution or a sovereign.

There are basically two alternative approaches to measure credit risk viz. one based on External Credit Rating Agencies (ECRA) and the other on Internal Rating Based (IRB).  The former is also known as Standardized Approach where the risk weights are determined depending on the rating of the counter party by the ECRA, approved by the country’s central bank on the basis of certain criteria stipulated in the Basel II.

Basel II has provided discretion to the National Supervisors (RBI in India) on many issues to make the Accord adoptable in all the countries. RBI has issued Draft guidelines on Implementation of New Capital Adequacy Framework based on Basel II, according to which Banks will be required to implement the revised capital framework with effect from 31.3.2007 and the parallel run to start from 1.4.2006.  In this paper we shall discuss the Standardized approach broadly based on the draft guidelines issued by RBI.

4. Risk weight frame work (Basel I Vs New Framework):

A range of risk weights is to be applied based on the credit rating of the external agencies (Rating reflects the credit quality of the asset) within each type of the asset class.  A broad comparison of risk weights applicable under the New Capital Adequacy Framework is as under:

Claims on	RWA Basel I	RWA New Framework
Domestic Sovereigns	0%	0%
Foreign Sovereign	20%	20% – 150%
BanksScheduled Banks Foreign Banks Other Banks	20% 20% 20%	20% 20% – 150% 100%
Corporates	100%	20% – 150%
Retail Portfolio*	100%	75%
Secured by mortgages on Residential Property	75%	75%
NPAsProvisions < 20% of Outstanding Provisions > or = 20% of Outstanding Provisions > or = 50% of Outstanding	100% 100% 100%	150% 100% 50%
High risk categories (Categories under New frameworkto be indicated by RBI) $	125%	150%

* Under Basel II maximum aggregated exposure up to Euro 1 million to one borrower/counterparty is defined as Retail Portfolio.  RBI has prescribed threshold limit for classifying an account as retail based on the capital funds of a Bank.  The limit applicable to our Bank is Rs. 5 Cr.

** Basel II provides discretion to national supervisor (RBI in India) to assign risk weight to Public Sector Enterprises (PSE) as applicable to Banks, Sovereigns or Corporates.  RBI has indicated that claims on PSEs shall be treated as claims on corporates.

$ At present advances under consumer credit, commercial real estate and capital market exposures are treated as high risks and risk weight of 125% is made applicable.  This has since been increased to 150% for advances under commercial real estate and capital market exposures in the annual policy of 06-07 by RBI.

In respect of off balance sheet exposures, credit conversion factors are used to arrive at the exposure amount (as done under Basel I) and then the risk weight applicable to the borrower shall be applied.

5. Credit risk Mitigation:

Banks use a number of techniques to mitigate the credit risks to which they are exposed. For example, exposures may be collateralized with cash or securities, a loan exposure may be guaranteed by a third party, or a bank may buy a credit derivative to offset various forms of credit risk or  banks may net loans owed to them against deposits from the same counter party.

The revised approach to credit risk mitigation allows a wider range of credit risk mitigants to be recognized for regulatory capital purposes than is permitted under Basel I subject to meeting the requirements of legal certainty i.e documentation for all the credit risk mitigation used in collateralized transactions and the same must be binding on all parties and legally enforceable in all relevant jurisdictions.  Banks must have conducted sufficient legal review to verify this and have a well founded legal basis to reach this conclusion and undertake such further review as necessary to ensure continuing enforceability.

6. Collateralized transaction:

A collateralized transaction is one in which banks have a credit exposure or potential credit exposure; and that credit exposure or potential credit exposure is hedged in whole or in part by collateral provided by a counter party or by a third party on behalf of the counter party.  Here, “counterparty” is used to denote a party to whom a bank has an on or off-balance sheet credit exposure.

Banks are allowed fuller offset of collateral against exposures, by effectively reducing the exposure amount by the value ascribed to the collaterals.  Under this approach Banks which take eligible financial collateral (e.g. cash or securities as detailed below), are allowed to reduce their credit exposure to a counter party when calculating their capital requirements to take in to account the risk mitigating effect of the collateral.

The Banks will need to calculate the exposure to which the risk weight is to be applied, after adjusting for the collateral value.  In order to take into account the future variation in the value of the collateral (as the value of the collaterals can change from time to time) a discount is to be applied to the value of the collateral before it is adjusted against the outstanding in the account.   Similarly, the exposure to the counter party is also required to be adjusted to take into account the future fluctuations in the exposure value, as in certain type of transactions the exposure value may change due to possible market movements.  These adjustments are referred to as ‘Haircuts’.  Additionally where the exposure and collateral are held in different currencies an additional downwards adjustment must be made to the volatility adjusted collateral amount to take into account the possible future fluctuations in exchange rates.

Further guarantees provided by a range of guarantors have also been recognized as credit risk mitigants and a substitution approach will be applied i.e. wherever the applicable risk weight to the guarantor based on his rating is lower than the applicable risk weight of the borrower, the risk weight of the borrower shall be substituted by the risk weight of the guarantor to the extent the exposure is guaranteed.  For the balance the risk weight of the borrower shall be applied.

7. Eligible Financial Collaterals:

The major collateral instruments that are eligible for recognition of the Credit Risk Mitigation under the comprehensive approach are i) Cash (as well as certificates of deposit or comparable instruments issued by the lending bank) on deposit with the bank ii) Gold, iii) Certain Debt securities, Equities (including convertible bonds) that are listed in a recognized exchange, iv) Undertakings for Collective Investments in Transferable Securities (UCITS) and mutual funds where a price for the units is publicly quoted daily and the UCITS/mutual fund is limited to investing in specified (generally low risk investments) instruments etc.

The exposure amount after risk mitigation is calculated as give below:

E* = max {0, [E x (1 + He) – C x (1 – Hc – Hfx)]} where:

E*= the exposure value after risk mitigation

E = current value of the exposure

He= adjustment appropriate to the exposure

C= the current value of the collateral received

Hc= Discount (haircut) appropriate to the collateral

Hfx= Discount (haircut) appropriate for currency mismatch between the collateral and exposure

8. Following highlights impact of credit risk mitigation recognized under Basel II:

Rs. In Cr

Particulars	Basel I	Basel II
Exposure	100	100
Adjustment (Haircut) for Exposure	NA	5%
Exposure after Haircut	NA	105
Collateral	40	40
Haircut (Discount)	NA	15%
Net Value of collateral after haircut	NA	34
Net Exposure	100	71
Capital at 9%	9.00	6.39

The discount rates and the adjustment factor for the exposure are to be provided by the supervisor i.e. RBI.

A detailed example illustrating how the capital requirement for an account is to be calculated is given in item no. 10

9. Basel I and Standardized approach of New Capital Adequacy Framework:

The following are the major changes from the existing accord that has been proposed in the Standardized Approach:

1. Within the type of assets, assigning of risk weights has been tuned to the risk sensitivity by using the External credit ratings
2. Credit Risk Mitigation has been given a wider recognition by off setting the exposure with the collateral value.
3. Banks managing their credit portfolio with better risk management principles will be benefited with a lower regulatory capital requirement.
4. Banks managing their credit portfolio with better risk management principles will be benefited with a lower regulatory capital requirement.

10. Illustration on calculation of capital requirement under Standardized Approach

The following are the details of a corporate borrower rated by External Rating agency as “A” as at 31.3.2006:

Rs. In lakh

Nature	Limit	Out standing
Cash Credit	1000	600
Term Loan	2000	500
LC (DA)	200	200

 Collateral securities available:

Nature	Amount
Fixed Deposit	50
AA rated Bond with residual maturity 5 years	300
Corporate Guarantee With AAA rating	500

The capital requirement for this account under Basel I and Basel II shall be calculated as under.  The risk weights are applied to the borrower and guarantor as prescribed in Basel II.

BASEL I:

Facility	Amount	CCF	Converted Exposure	Risk Weight	Risk weighted asset	Capital at 9%
Cash Credit	600	NA	600	100%	600	54
Term Loan	500	NA	500	100%	500	45
LC DA	200	100%	200	100%	200	18
Total	1300		1300		1300	117

Basel II: 1. Adjustment for the collateral value:

Facility	Amt.	Credit  conversion  factor	Adjustment For exposure	Converted Exposure	Collateral Type	Amt.	Hair cut	Adjusted value of collateral
1	2	3	4	5=(2*3)+4	6	7	8	9=7-(8*7)
CC	600	NA	NA	600	FDR	50	NA	50
TL	500	NA	NA	500	AA rated  bond	300	8%	276
LC  DA	200	100%	NA	200
Total				1300	Total	350	—	326

Total Osg	Adjusted value of collateral	Amount Osg After adjusting Collateral	Guar. amount	Risk Weight applicable (as per rating of guarantor)	Risk weight applicable to guar. portion
1	2	3=1-2	4	5	6=4*5
1300	326	974	500	20%	100
Capital required at 9%*

Balance (Unguar- anteed Amount)	Risk weight applicable to borrower	RWA for borrower	Total RWA
7=3-4	8	9=7*8	10=9+6
474	50%	237	337
			30.33

Thus capital required under Basel I will be Rs. 117 lakh and under the New Framework the same will be Rs 30.33 lakh.

*Though Basel II prescribes capital requirement at 8% RBI has prescribed the same at 9%.